CHAPTER
6
Rewarding Automakers for Fuel Economy Improvements
Sir, we urge you to introduce legislation directing the National Highway Traffic Safety Administration to write regulations making the “credits” that automakers can earn for exceeding current fuel economy requirements fully salable, both between a given manufacturer’s passenger car and light-duty truck fleets and also between different manufacturers. Doing so would provide significant savings to manufacturers and consumers at no cost to the environment. Whereas considerable acrimony surrounds every major effort to change fuel economy standards, the benefits of tradable credits should be uncontroversial, regardless of the prevailing standard.
The CAFE Program
Paralleling current concerns, Congress was worried in 1975 about increasing imports of crude oil, especially from politically and militarily unstable parts of the world. One response was the Energy Policy and Conservation Act of 1975, in which Congress mandated for the first time that passenger cars and so-called light-duty trucks (pickup trucks, minivans, and sport utility vehicles) had to meet fleetwide Corporate Average Fuel Economy (CAFE) standards. Congress itself set the target for passenger cars at 27.5 miles per gallon (mpg), nearly double the pre-1975 average. The National Highway Traffic Safety Administration (NHTSA) was given the responsibility of setting fuel economy targets for light-duty trucks, which now stands at 20.7 mpg—a nearly 50 percent increase over 1975—and is due to increase to 22.2 mpg by 2007.
Working in concert with sharply increasing gasoline prices in the early years of the program, the CAFE standards resulted in significant improvements in fuel economy for both passenger cars and light-duty trucks. As pointed out in a 2002 report by the National Academy of Sciences, some of these fuel economy gains were the result of the rapid downsizing of vehicles, which may have had adverse effects on the safety of these vehicles in crashes, although this opinion was not without dissent. Nevertheless, the CAFE program contributed to significant reductions in oil consumption; as a consequence, between 1977 and 1986, imported oil fell from 47 percent to 27 percent of total oil consumption.
An important feature of the current CAFE program is that it requires each manufacturer separately to meet the standards for each of its own car and light truck fleets. In implementing the program, NHTSA did allow some limited flexibility by taking into account the fact that some automakers might produce higher fleetwide fuel economy in a given year than is required. To reward such performance, NHTSA offers credits for excess compliance and allows the automaker to bank them to offset its own possible future shortfalls against the CAFE standards. However, this offset system currently is limited in several important ways. First, any credits that are earned must be used within three years; after that time the credits expire. Second, credits earned in the passenger car segment of the market cannot be used to offset possible shortfalls in light-duty truck fuel economy, and vice versa. Because most carmakers produce both types of vehicles, this restriction is significant. Third, credits earned by one manufacturer cannot be traded to another. Automakers are allowed to pay a penalty of $5.50 per vehicle for every tenth of a mile that their fleet average falls short of the relevant standard. Domestic manufacturers have never taken advantage of this option, however, always choosing to make and sell enough small vehicles to ensure that they are in compliance with the fleet average requirement.
Fully Tradable Credits
The CAFE program has become very controversial for many reasons, with its critics alleging that it is ineffective, plagued by unintended consequences, likely to result in less safe vehicles, and likely also to spur much less enhanced fuel economy than would result from higher gasoline prices. Although valid responses exist to most of these concerns, they are unlikely to mollify the critics. One change in the CAFE program, however, would work to the benefit of automakers and consumers alike, and should engender relatively little opposition: making the fuel economy credits fully tradable.
Some carmakers might prefer to specialize in the large-vehicle segment of the passenger car or light-duty truck markets because of a comparative advantage they feel they have in manufacturing or marketing such vehicles. They cannot do so now.
To understand the benefits of trade, we should recognize that with an alternate means of compliance, some carmakers might prefer to specialize in the large-vehicle segment of the passenger car or light-duty truck markets because of a comparative advantage they feel they have in manufacturing or marketing such vehicles. They cannot do so now; if an automaker is able to sell 1 million passenger cars that average 26 mpg, it has to sell another million such vehicles averaging 29.2 mpg in order to meet the 27.5 mpg standard. (Although standards are stated in the familiar miles per gallon [mpg], the average is actually calculated based on gallons per mile, which is the rate of fuel consumption.) This has resulted in a situation in which at least some carmakers end up producing and selling for little or no profit (or even at a loss) significant numbers of smaller cars or light-duty trucks to enable them to produce the larger cars or trucks on which they make their money.
For this reason, CAFE has not had the same effects on all manufacturers. Some foreign automakers have been able to leverage the popularity of their fuel-efficient small cars and compact SUVs into lower compliance costs for their larger vehicles, allowing them to expand their market share in sedans and light trucks of all sizes. Meanwhile, domestic manufacturers have closely paced their fuel economy gains in line with the CAFE requirements, having to expand production of smaller cars in order to stay in compliance while producing the large vehicles their consumers demand. These disparities result from the fact that each manufacturer must on its own meet the requirement for each of its fleets.
Because what we care about is whether the overall vehicle fleet is meeting the fuel economy goals the nation feels are appropriate, this system makes no sense. If fuel economy credits were fully tradable, an automaker would have another option open to it. If it decided that it could not profitably compete in the small-car (or light-duty truck) market, it could use any fuel economy credits that it had generated in the other segment of the new vehicle market, or it could purchase credits from another automaker that had exceeded its passenger car or light-truck targets in a previous year. Automakers purchasing credits would be those that find it difficult to manufacture and sell enough smaller vehicles to offset their large-vehicle sales. The automakers choosing to sell credits would be those for which exceeding the standard is less expensive than purchasing credits. Both companies would benefit from the exchange.
Eliminating the restrictions on the existing credit banking system and allowing full credit trading would improve the allocation of resources in the auto industry. Automakers would have more freedom to optimize the composition of their fleets, and collectively, they could better allocate their efforts for improving fuel economy. For example, currently, a manufacturer that easily meets the standard receives little or no reward for further improving the fuel economy of any of its vehicles. Meanwhile, a manufacturer struggling to meet the standard as a result of many large-car sales has more incentive than its competitors to improve the fuel economy of both its small and large cars. The same disparity applies with respect to cars and light trucks: if the car standard is more difficult to meet than the truck standard, manufacturers will put more effort into improving car fuel economy than light-truck fuel economy. Yet fuel is fuel, no matter what kind of vehicle burns it. With trading, fuel economy has the same value for all vehicles, so efforts to improve fuel economy are directed wherever they are most cost-effective, whether small or large cars or trucks, imported or domestic.
Fuel is fuel, no matter what kind of vehicle burns it. With trading, fuel economy has the same value for all vehicles, so efforts to improve fuel economy are directed wherever they are most cost-effective, whether small or large cars or trucks, imported or domestic.
The benefit of credit trading would flow through to consumers, as well. The lower manufacturing costs from better specialization and more effective allocation of technologies for fuel economy will translate into lower prices for consumers. Furthermore, the environmental impact would be negligible. The overall fleet of passenger vehicles will have the same average fuel economy. Although some foreign manufacturers have overcomplied with the standards in the past, their average fuel economy has been declining toward the mandate in recent years as they sell more large vehicles, so trading is unlikely to forgo “free” overcompliance. In response to lower prices, some consumers may own more vehicles, but others will buy new vehicles sooner and retire older ones. This will help speed the transition to a more fuel-efficient vehicle stock, leading to better performance with respect to other emissions in the meantime, as newer vehicles are cleaner.
Just as the costs of complying with CAFE increase with the stringency of the standards, so do the benefits of trading. Technical progress has helped ease the costs of achieving greater fuel economy, and emerging technologies will continue to do so as they become more widely available. However, technical progress also can be applied to other vehicle qualities that consumers value, such as power, acceleration, and towing capacity. Trading can help ensure that all qualities—including fuel economy—are applied where they are most valued. These potential savings become more important if we rely on increases in CAFE standards to respond to heightened concerns about oil consumption and dependence. A recent study by the Congressional Budget Office suggests that the costs of tightening CAFE to 31.3 mpg for cars and 24.5 mpg for trucks would be about 17 percent lower if credits were tradable.
Recommendations
We recommend that CAFE credits be made fully tradable, across vehicle types and across manufacturers. Given any fleetwide targets that society demands, allowing trade in fuel economy credits will minimize the costs of meeting these targets. As each manufacturer still has the option to continue as before and meet the standards on its own for each fleet, trading will occur only if it makes both parties better off. Manufacturers and their customers will benefit from lower costs, while the same environmental goals are met.
With fully tradable credits, manufacturers and their customers will benefit from lower costs, while the same environmental goals are met.
We recognize that setting fuel economy standards is a contentious issue and must be decided via the appropriate policy process. Our recommendation does not hinge on raising (or lowering) CAFE standards, although trading could allow the United States to raise fuel economy standards to some extent without raising costs beyond what they are today without trading. Nor need we weigh in on the question of separate standards for cars and light trucks to promote trading. Those standards determine the free credits the policy allocates to each vehicle type. That allocation may well be worth debating—whether SUVs should receive more fuel consumption credits than cars, whether all vehicles should receive the same, or whether the allocation should be based on weight and safety factors. But whatever the standards are, we can do better. With tradable credits, we allow the automakers and drivers to decide collectively how best to meet the challenge.
C.F.
P.R.P.