Why strict fuel-economy rules still make sense — even when oil's cheap

One of the very first things the next president will have to do — whether it's Hillary Clinton, Marco Rubio, or, heck, Donald Trump — is make a big decision on automobiles. Specifically, on whether to strengthen or weaken President Obama's fuel-economy rules for cars and light trucks, which come up for a midterm review in 2017.

Some automakers are already urging the government to relax its so-called CAFE standards, which have been rising steadily since 2011. Their logic: oil prices have plummeted, gasoline is cheap again, and Americans are less keen on buying smaller, fuel-efficient cars. Not only could that make it tougher for manufacturers to meet the standards, but it means there's less financial benefit to conserving gasoline.

For a sharp counterargument, however, check out this new peer-reviewed paper by Varun Sivaram and Michael Levi of the Council on Foreign Relations. They crunch the numbers on costs and benefits and find that, even if oil prices do remain low, there's an excellent case for keeping the CAFE rules in place, letting them rise on schedule through 2025. Partly that's because the rules still have significant climate change benefits. But they also offer valuable insurance against future oil-market volatility.

Since this could end up being one of the major energy debates of the next few years, it's worth looking at Sivaram and Levi's paper in more detail.

How Obama's vehicle rules could get weakened in 2017

Back in 2011, Obama reached an agreement with 13 major automakers to ratchet up the average mileage of all new light-duty vehicles sold in the United States. The CAFE standards for passenger cars are currently set to double, from 27.3 miles per gallon in 2011 to 54.5 miles per gallon by 2025. The standards for light trucks will also rise.**

(Sivaram and Levi, 2015)

(Note: because of quirks in how CAFE standards are calculated, these numbers don't exactly reflect real-world mileage. By 2025, the average new car will likely get around 37 miles per gallon on the road.)

These car standards are easily one of Obama's most important climate change policies, projected to save almost as much carbon dioxide as his much-hyped CO2 rules for power plants. Over their lifetime, the CAFE rules are expected to reduce US oil consumption by about 12 billion barrels. They're a big deal.

But the rules also aren't engraved in stone. Back in 2011, automakers were worried about whether they could meet the ambitious targets. So the Obama administration agreed to schedule a midterm review for 2017. Federal agencies would take stock of how the rules were working, see how automakers were coping, and then decide by April 1, 2018 whether to keep the standards currently proposed for model years 2022 to 2025 in place, soften them a bit, or crank them up even tighter.

That review could prove contentious. So far, automakers have coped with the rules just fine, technology-wise. They've reduced the weight of vehicles by using lighter materials like aluminum, and they've deployed technologies like gasoline direct injection and cylinder deactivation to improve the efficiency of their engines. Yet some companies are insisting that meeting the post-2020 standards could prove far more arduous.

Automakers are also grappling with the collapse of oil prices that began back in mid-2014. With gasoline cheap, more and more Americans are buying larger pickup trucks and SUVs. And some automakers have been arguing that CAFE rules should be revamped to accommodate these shifting preferences. In March, Chris Nevers of the Alliance of Automobile Manufacturers told the Detroit News that this changing vehicle mix would be "key" to the midterm review.

Lower oil prices could also, potentially, weaken the cost-benefit rationale for stricter CAFE standards. After all, it costs extra to improve fuel-efficiency, which typically raises the sticker price of new vehicles. In theory, drivers can offset these costs and save money over the long run by buying less fuel. But if gasoline prices remain low, that benefit shrinks. So how does this all shake out?

The case for keeping ambitious CAFE standards in place

For that, we turn to Sivaram and Levi's new paper, appropriately titled "Automobile Fuel Economy Standards in a Lower-Oil-Price World." The authors carefully scrutinize that last argument, looking to see whether the benefits of the proposed CAFE standards still outweigh the costs now that oil prices have nosedived.

They start by noting that fuel savings made up about 80 percent of the estimated economic benefits when the Obama administration originally proposed its 2022-2025 standards:

(Sivaram and Levi, 2015)

But that analysis needs updating. Back then, the government had considered a range of potential oil price projections, but even the very low end of its range had oil around $65 per barrel in 2017. In fact, oil prices have plunged below $50 per barrel, and it's now quite possible they could stay low for the foreseeable future. If so, that would diminish the expected benefits of stricter fuel-economy rules.

But there's more. The administration's estimate of the damage caused by global warming has also gone up significantly since the CAFE rules were first proposed, as seen through its revised calculation for the "social cost of carbon." Averting this climate damage was a significant chunk of the rationale for stricter fuel-economy rules, so this change would seem to bolster the case for the rules.

When you take both lower oil prices and the higher social cost of carbon into account, the newly estimated net benefits of the CAFE standards (seen on the dotted blue line below) are a bit lower than, but still comparable to, the estimated net benefits when they were first proposed (the solid red line):

(Sivaram and Levi, 2015)

After additional comparisons to other alternatives, the authors conclude that keeping the proposed standards in place — that is, allowing them to keep rising on schedule through 2025 — would "still deliver greater net benefits than any less stringent target would."

In an interview, Levi and Sivaram told me this analysis was still sensitive to the cost of compliance with these rules. If it turns out that getting to 54.5 mpg by 2025 proves much harder or more expensive for automakers than anyone thought, that might justify relaxing the rules a bit. But, Levi said, "the drop in oil price alone isn’t enough of a reason to change course."

And even that's not the whole story. In their paper, Sivaram and Levi also point out that CAFE standards bring a few other crucial benefits that aren't usually accounted for when the government assesses regulations. First, you can think of stricter fuel-economy rules as a hedge against future oil-price volatility. If the nation's vehicle fleet is more efficient, then consumers will face less of a price shock in the future if oil prices spike — say, because there's a disruption in the Middle East.

Economists have long observed that consumers place a lot of value on this sort of hedging, known as a "risk premium." Based on that earlier work, Sivaram and Levi estimate that the insurance value of CAFE standards is worth nearly one-fifth of the total fuel savings.

Second, tightening the fuel-economy rules now would give policymakers the option of tightening them even further in the future if need be. A look at recent history shows why this might be valuable. During the 1980s and 1990s, Congress allowed CAFE standards to stagnate at around 27.5 miles per gallon because oil prices were so low. But when global crude prices started spiking in the 2000s, it became much harder for drivers and automakers to adjust — they couldn't just magically ramp up efficiency all of the sudden.

Both of these benefits are well-established in the economic literature, but they aren't typically included in the federal government's analysis of fuel-economy rules. (The Office of Management and Budget explicitly tells federal agencies to "assume 'risk neutrality'" in their analysis, thereby undervaluing the insurance aspect of fuel-economy rules.) But giving these factors due consideration, the authors argue, "would strengthen the case for maintaining stringent CAFE standards."

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** Updated footnote: The CAFE standards are "footprint based." Under the rules, all cars have to get steadily more efficient over time. But bigger cars are allowed to get relatively worse mileage than small cars.

So if more Americans start buying bigger cars due to lower gas prices, then overall fuel economy won't rise as fast as these charts imply. In other words, you should think of that 54.5 mpg figure as a rough estimate, based on projections about the mix of vehicle sales, rather than a hard mandate. (Thanks to David Cooke of the Union of Concerned Scientists for setting me straight on this point.)

Further reading: Cars in the US are more fuel efficient than ever. Here's why.

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