Brazil has temporarily reduced its import tariff on foreign ethanol to zero until the end of 2011 in a move aimed at provoking the United States into letting its ethanol import tariff expire as scheduled at the end of 2010.

The US Congress is expected to debate by year end whether to extend both the tariff and a domestic tax credit that encourages blending of ethanol with vehicle fuel. Farm state legislators want to extend both through 2015. The politics of ethanol in the United States are changing. There is more opposition to the subsidies than the last time they came up for renewal.

If the US Congress is unable to pass the necessary legislation this year to keep ethanol import tariffs in place beyond 2010, what effect is this likely to have on the US and the Brazilian ethanol industries?

Outlook for a US Tariff Extension

Brazil and the United States are the two biggest ethanol fuel producing and consuming nations in the world. Brazil produces 54% of world output (10.75 billion gallons per year) and the United States produces 34% (6.57 billion gallons).

The two countries are entering an interesting new phase in ethanol diplomacy.

Both have historically had import tariffs to protect their industries from foreign competition, with the result that most of their production has gone to domestic use. The United States exported 113 million gallons of ethanol in 2009, or roughly 1% of domestic output. Brazil exported 933 million gallons, or roughly 15% of domestic output. Most US exports went to Canada, the Netherlands and the Middle East. Most Brazilian ethanol was exported to the United States.

Brazil eliminated its import tariff in April, but only through 2011. The US collects a tariff of 54¢ a gallon on imports. The tariff expires at the end of 2010.

Brazil produces ethanol from sugar cane at a cost that is one third cheaper than US ethanol, which is made principally from corn. Brazil also has a significant amount of land available to increase its current production.

Ethanol still enjoys bipartisan support in the US Congress. Democrats who control both houses have been frustrated this year by their inability to put legislation through the Senate, where Republicans have enough votes to block bills from passing by “filibustering” or objecting to votes and then voting against motions to shut off debate. It takes 60 votes out of the 100 Senators to stop debate. The Democrats have only 59 (counting two independents who tend to vote with the Democrats).

Some Democrats are hoping that support from Republican farm Senators for ethanol will allow a broader bill that includes not only an extension of the ethanol tariff and tax credit but also other ideas favored by the Democrats, like an extension of Treasury cash grants for renewable energy projects, to clear the Senate before Congress adjourns for the year.

Senators Charles Grassley (R.-Iowa) and Kent Conrad (D.-North Dakota) are leading the charge in the Senate for an extension.

However, opposition to an extension is greater this year than in past years. A coalition of cattle and hog farmers, food processors who rely on corn or corn oil, some conservatives like Senator John McCain (R.-Arizona) who are concerned about growing government budget deficits and Senators from urban states seem more outspoken this year in their opposition.

Ethanol proponents have agreed in principle with House leaders to extend the tax credit at a reduced rate of 36¢ a gallon and to maintain the current import tariff at 54¢ a gallon for another year.

The biggest risk at this point to an extension is the legislative gridlock in Washington. Little is getting through Congress. The next biggest risk is if there is a vote on the Senate floor to strip ethanol subsidies from any end-of-session bill to which the ethanol extension is likely to be appended. That will be a test of whether opponents have gained the upper hand.

Opponents in the US complain that current US ethanol production is causing food prices to rise, has a debatable environmental benefit and is incapable of making a serious dent in US reliance on foreign oil since, based on current production techniques, there are not enough US corn fields both to feed and fuel the United States. The Russian forest fires are not helping with their upward pressure on grain prices.

The picture is very different in Brazil, which has enough available agricultural land to run its entire passenger vehicle fleet easily on domestically-produced ethanol without interfering with food supplies.

The US tax credit for ethanol blending would cost US taxpayers roughly $31 billion to extend through 2015. This makes it more likely that the import tariff will be extended at the same time because advocates must find a way to pay for the extension.

The United States also supports the domestic ethanol market through a “renewable fuel standard” that requires the US vehicle fuel mix to include at least 13 billion gallons of ethanol, biodiesel and other alternative fuels this year, increasing to 36 billion gallons per year by 2022.

Effect if US Tariff Expires

The most interesting question is what effect would expiration of the US tariff have on the US and Brazilian ethanol industries?

Opinion is divided.

The Renewable Fuels Association in Washington says the effect would be significant. It says 112,000 US jobs would be lost and there would be a 38% reduction in US production capacity as foreign ethanol, mainly from Brazil, would flood the US market. A study by Iowa State University concluded that the impact would be much more limited. The study was sponsored by UNICA, the Brazilian sugar cane association.

As noted, both the US and Brazilian ethanol industries are currently structured primarily to produce ethanol for domestic, and not foreign, use. This is significant in assessing the potential consequences for two reasons.

First, if the US tariff expires, most ethanol production from both nations will continue to be directed in the short- to medium-term toward domestic use in order to meet domestic consumption targets. Second, Brazil probably lacks the infrastructure in the short term to increase output greatly for the export market.

Some analysts are concerned that the US could face an ethanol shortfall. The US renewable fuels standard requires use of at least 36 billion gallons a year of renewable fuels by 2022. Ethanol is currently the only renewable fuel that has the potential to contribute meaningfully to this target, and US ethanol production is expected to rise to about 30 billion gallons by 2022.

In Brazil, UNICA predicts that ethanol production will increase by 150% through 2020. However, according to Petrobras, the state-owned oil company in Brazil, the main factor driving the increase is the projected rise in the sale of flex fuel cars that can run on both gasoline and ethanol. Ethanol is expected by 2020 to fuel 75% of Brazilian cars as gasoline-only cars are replaced with flex fuel vehicles. Almost 100% of new vehicles sold in Brazil today are flex fuel.

Accordingly, both the US and Brazilian ethanol industries will require significant investment in the coming years just to meet their increasing domestic ethanol targets. It is not clear whether significant additional investment will be available for these industries to grow beyond their current domestic needs.

For example, growth in the Brazilian ethanol industry has largely been financed by Banco Nacional de Desenvolvimento Econômico e Social (BNDES), the Brazilian state-owned development bank, which has limits on how much funding it can provide to the industry. It currently provides approximately BRL4 billion per year. Foreign investment in the industry has also been slow, although there are signs that this is starting to change. According to the consulting group Dextron Management, the proportion of Brazilian ethanol mills backed with foreign capital has jumped to 22% from 7% in 2007-8. Petroleum giant Shell has also recently entered into a US$12 billion joint venture with Cosan, the largest sugar producer in Brazil, for the production of ethanol, sugar and power and the supply, distribution and retail of transportation fuels.

In contrast, the US ethanol industry has grown backed largely by finance from Wall Street investment banks and farm co-operatives. Although it is expected that this trend will continue, according to the Nebraska ethanol board, the biggest challenge that new ethanol projects face in the United States is finding financing in the fallout from the 2008 financial crisis and low oil prices.

Brazil needs to invest heavily in its infrastructure before it can increase its ethanol exports substantially. Most ethanol for export is transported to the coast by road or, to a much lesser extent, rail. Although new pipelines are currently being built by Petrobras and a consortium led by Cosan to transport ethanol from inland production areas to coastal ports, these projects have been slow to develop and have faced financing difficulties. Brazil’s ports are also overcrowded and are struggling to cope with the general growing demand for Brazilian exports, in particular from China.

Accordingly, perhaps the US should not fear free ethanol trade with Brazil.

In fact, earlier this year, the market price of US ethanol was reportedly lower than Brazilian ethanol making it hard for Brazilian producers to justify diverting output for sale in the US market. There has been a recent surge in US exports of ethanol in 2010 resulting from oversupply in the US market.

Looking to the long term, the future of ethanol as a fuel that can realistically replace gasoline on a global scale is dependent on technological advances being made in next generation cellulosic ethanol (ethanol that can be produced from virtually any type of plant fiber) and neither the US nor Brazil, being the world leaders in ethanol production, has a process that can produce mass quantities of cellulosic ethanol on a cost-effective basis. It is possible that free ethanol trade might encourage producers in both countries to adopt more of a joint venture approach to development that may produce quicker technological advances.