1616 P St. NW Washington, DC 20036 202-328-5000 www.rff.org November 2003  RFF DP 03-44 The Economics of Fuel Economy Standards Paul R. Portney, Ian W.H. Parry, Howard K. Gruenspecht, and Winston Harrington DISCUSSION PAPER© 2003 Resources for the Future. All rights reserved. No portion of this paper may be reproduced without permission of the authors. Discussion papers are research materials circulated by their authors for purposes of information and discussion. They have not necessarily undergone formal peer review. The Economics of Fuel Economy Standards Paul R. Portney, Ian W.H. Parry, Howard K. Gruenspecht, and Winston Harrington Abstract This paper discusses several rationales for the Corporate Average Fuel Economy (CAFE) program, including reduced oil dependence, reduced greenhouse gas emissions, and the possibility that fuel saving benefits from higher standards might exceed added vehicle costs. We then summarize what can be said about the welfare effects of tightening standards, accounting for prior fuel taxes, and perverse effects on congestion and traffic accidents through the impact of improved fuel economy on the incentive to drive. Implications of CAFE on local air pollution, and the controversy over CAFE, vehicle weight, and road safety, are also discussed. Finally, we describe ways in which the existing CAFE program could be substantially improved and identify a variety of alternative, and much superior, policy approaches. Key Words: fuel economy, externalities, oil dependency, vehicle safety, climate change JEL Classification Numbers: R48, Q48, H23Contents1. Introduction and Background ........................................................................................... 12. Rationales for Fuel Economy Standards .......................................................................... 32.1 Macroeconomic Effects of Oil Price Shocks................................................................ 32.2 Market Power................................................................................................................ 42.3 Environmental Concerns............................................................................................... 52.4 Imperfect Markets for Improvements in Fuel Economy............................................... 63. Unintended Consequences of CAFE and the Controversy over Highway Safety........ 83.1 Prior Fuel Taxes............................................................................................................ 83.2 The Rebound Effect...................................................................................................... 83.3 Fleet mix effects and its implications for safety......................................................... 103.4 Would Tighter CAFE Standards Increase or Decrease Social Welfare?.................... 114. Alternatives to the Current CAFE Policy....................................................................... 124.1 Improvements within the existing CAFE structure .................................................... 124.2 Other policies to increase fuel economy..................................................................... 134.3 Insurance Reform........................................................................................................ 134.4 Gasoline taxes............................................................................................................. 144.5 Policies Addressing Specific Externalities ................................................................. 155. Conclusion ......................................................................................................................... 15References.............................................................................................................................. 171The Economics of Fuel Economy StandardsPaul R. Portney, Ian W.H. Parry, Howard K. Gruenspecht and Winston Harrington∗1. Introduction and BackgroundPublic policy debates are often overheated, but those regarding government-mandatednew-car fuel economy standards have been extreme. Proponents of more stringent standardsallege that the declining fuel economy of the new-vehicle fleet in the United States plays into thehands of Al Qaeda; opponents claim that tighter standards would lead directly to smaller carsand, therefore, carnage on the highways. With important industries and public interests at stake,it is important to disentagle fact from fiction.In the Energy Policy and Conservation Act of 1975 (EPCA), Congress created theCorporate Average Fuel Economy (or CAFE) program. Congress itself required eachmanufacturer of new passenger cars to meet a sales-weighted average of 18 miles per gallon(mpg) by Model Year 1978, increasing steadily to 27.5 mpg for Model Year 1985 and beyond.Congress also directed the National Highway Traffic Safety Administration (NHTSA) toestablish fuel economy standards for what are called light-duty trucks—a category that includespickup trucks, minivans and sport utility vehicles (or SUVs). Standards for light-duty trucksbegan with Model Year 1979, and today each manufacturer’s fleet must average at least 20.7mpg. Vehicle manufacturers have always had the option to pay $5.50 per vehicle sold for each0.1 mile-per-gallon (mpg) that their fleet average falls short of the relevant standard. However,only a few European manufacturers of luxury cars (Mercedes and BMW, for example) havechosen this route; no Japanese or U.S. carmaker (prior to the merger of Daimler and Chrysler)has ever fallen short of the standards. ∗ *Paul Portney is President, Ian Parry a Fellow, and Winston Harrington a Senior Fellow of Resources for theFuture; Howard Gruenspecht is Deputy Administrator, Energy Information Administration, Department of Energy.Gruenspecht was a Resident Scholar at Resources for the Future when this paper was written. Portney chaired theNational Research Council report on the future of the Corporate Average Fuel Economy program. Please address allcorrespondence to [email protected] for the Future Portney, Parry, Gruenspecht and Harrington2Together in concert with higher real gasoline prices, which began rising in 1973 (seeFigure 1), the new standards had a significant effect on fuel economy. According to the U.S.Environmental Protection Agency (EPA), new passenger car fuel economy rose from 17 mpg in1978 to more than 22 mpg in 1982, an increase