New CAFE Standards:
Will they be cost-effective?
3 Dec 2007 in Regulatory Economics, Regulatory Policy, Legislation
Wall Street Journal reporter Mike Spector writes on the draft agreement within the Congressional leadership on Corporate Average Fuel Economy (CAFE) standards. The text of the bill is not yet available, but Spector's reporting provides useful information.
According to Spector, average new vehicle fuel economy standards would be increased to 35 miles per gallon by 2020.
Assuming a 35-mpg target average, consumers could expect to save nearly $22 billion a year in gasoline costs, assuming a price at the pump of $2.55, according to the Union of Concerned Scientists. But the introduction of advanced technologies by auto makers to meet that target won't come without costs. Price premiums for advanced-technology autos could exceed $5,000 on average, car makers say.
We cannot validate either of these figures, but the provisions of the bill arguably are too new to be on the web. More importantly, there is no way to compare estimates of aggregate fuel savings with individual vehicle costs without considerably more information.What can be done is estimate how much consumers must save in fuel costs to make it cost-effective to voluntarily spend $5,000 more for a car just for fuel savings. This is actually a complicated calculation for both technical and economic reasons. On the technical side, vehicle lifetimes are variable and vehicle use is not constant over vehicle lifetime. On the economic side, higher prices lead to reduced market demand for new vehicles and induce owners to keep and maintain existing vehicles longer than they previously intended. By reducing fuel costs, higher mileage induces increased intensity of vehicle use, meaning more vehicle miles traveled.
We'll explore these details more carefully in subsequent posts. For now, we provide two stylized examples that provide useful insights even though they overstate the actual savings from more stringent CAFE standards.
EXAMPLE #1
Suppose a consumer replaces a 27.5 mpg vehicle (the current CAFE standard) with a new 35 mpg vehicle, thus saving 7.5 mpg. Suppose further that the vehicle is driven 12,000 miles per year every year and fuel costs $4 per gallon every year (in real dollars). All other factors held constant, the consumer's savings look like this for the first year after purchase of a new car that meets the proposed new CAFE fleet average standard:
- Year 0 (before purchase) annual fuel cost = (12,000 miles/27.5 mpg) x ($4/gallon) = $1,745.
- Year 1 (after purchase) fuel cost = (12,000 miles/35 mpg) x ($4/gallon) = $1,371.
- Year 1 savings = $374.
We assume here that the consumer replaces a 15 mpg SUV with a 35 mpg new CAFE average car -- a vast change in the product, but arguably the very change that bill proponents want consumers to make.
- Year 0 (before purchase) annual fuel cost = (12,000 miles/15 mpg) x ($4/gallon) = $3,200.
- Year 1 (after purchase) fuel cost = (12,000 miles/35 mpg) x ($4/gallon) = $1,371.
- Year 1 savings = $1,829.
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Break-Even Payback Period for a $5,000 Increase in Vehicle Price
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| Example #1: Save $374 per Year on Fuel1 |
Example #2: Save $1,829 per Year on Fuel2 |
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| Interest Rate | Years | Years | |
| 0% | 14 | 3 | |
| 1% | 15 | 3 | |
| 2% | 16 | 3 | |
| 3% | 18 | 3 | |
| 4% | 20 | 3 | |
| 5% | 23 | 4 | |
| 7% | 41 | 4 | |
| 10% | >1003 | 4 | |
| 15% | >1004 | 4 | |
| 20% | >1005 | 5 | |
| 1 Replacing CAFE average 27.5 mpg vehicle with new CAFE average 35 mpg vehicle; 12,000 per year VMT; fuel cost $4/gallon. 2 Replacing 15 mpg vehicle with new CAFE average 35 mpg vehicle; 12,000 per year VMT; fuel cost $4/gallon. 3 Maximum (~$3,750) in 100 years. 4 Maximum (~$2,500) in 100 years. 4 Maximum (~$1,900) in 100 years. |
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This $5,000 investment in fuel economy is always cost-effective with respect to fuel savings in the case of the switch from 15 mpg SUV to new-CAFE fleet average vehicle, but it almost never cost-effective for the switch from current CAFE average vehicle. But in the SUV case, this switch is cost-effective without any change in CAFE standards. Vehicles are on the market that achieve 35 mpg, so consumers who want to make this switch can do so now without impediment. That they often do not do so despite high fuel prices (Spector says trucks made up 55% of October vehicle sales) means that consumers are willing to trade fuel economy for other vehicle attributes.
Because the switch from current- to new-CAFE average vehicles is not cost-effective, consumers will not voluntarily choose it. (Those who do gain other benefits besides fuel savings, such as access to HOV lanes [with hybrids] or what economists call a "warm-glow" effect from doing good deeds.)
The original CAFE legislation restricted consumers' ability to trade off fuel economy with other vehicle attributes, much like Congress has done with motor vehicle safety standards. The practical effect of the proposed CAFE revision is to further restrict consumer choice on this margin, and make fuel economy as an attribute much more like motor vehicle safety standards -- something that consumers simply are not allowed to do without. One important difference, however, is that motor vehicle safety standards have been justified on benefit-cost grounds -- that is, the value of safety benefits is said by advocates to exceed the cost of safety devices, and it is the irrational shortsightedness of motor vehicle manufacturers which leads them not to install these features in every vehicle. (Manufacturers say some but not all consumers are willing to pay for additional safety features, so they sell them as options or include them as standard equipment on more expensive vehicles where the vast majority of prospective purchasers do want them.)
CAFE appears to have a different benefit-cost profile than motor vehicle safety standards. We have not yet uncovered a credible analysis showing that more stringent fuel economy standards have net benefits. A logical reason why advocates would not promote such an analysis is that a credible case is hard to make. We will keep looking.
