Preparing for the Midterm CAFE Review

Our country is entering a critical time for the future of transportation and its associated greenhouse gas (GHG) emissions. Corporate average fuel economy (CAFE) and GHG standards for both light-duty vehicles and heavy-duty trucks are slated to tighten, reducing not only oil use but also GHG emissions. Although the severity of future heavy-duty truck standards is still uncertain, the new fuel economy standards for light-duty vehicles may cut the GHG emissions rate from the new car fleet to nearly half its current level by 2025.

The light-duty vehicle standards were established in 2012 jointly by the US Environmental Protection Agency (EPA) and the Department of Transportation’s National Highway Traffic Safety Administration (NHTSA). The standards require annual reductions in GHGs and fuel consumption, such that new vehicles sold in 2016 must reach an average tested fuel economy of 35 miles per gallon (mpg) with associated GHG reductions, ramping up to 55 mpg by model year 2025. Part of the negotiation over the final rule was that a mandated midterm review will reevaluate the basis for the standards that apply to the last years covered by the rule, model years 2022–2025, drawing on evidence and studies since the original evaluation was performed. The review must occur by November 15, 2017, and final decisions are due from the agencies by April 1, 2018.

The next several years will be an important time for research that can enhance this evaluation and inform future policies to reduce GHG emissions and oil use from the light-duty fleet. Major questions remain about consumer and manufacturer responses to the regulations and the best methods for estimating the costs and benefits. RFF’s transportation team has begun to address some of these issues, including the implications of the fuel-efficiency gap, the shift to a footprint-based standard, and the effects of the credit provisions that are designed to provide flexibility to the automakers.

What Is Causing the Fuel-Efficiency Gap?

The goals of the new CAFE standards are to reduce greenhouse gas emissions, improve energy security, and reduce consumers’ fuel costs. When EPA and NHTSA estimated the costs and benefits of meeting the standards in the recent rulemaking, they concluded that the overall benefits would be roughly three times the costs. Indeed, even the benefits to consumers in the form of reduced fuel costs were estimated to be higher than the costs of adding the needed technologies to new vehicles.

With such large fuel savings, we would expect consumers to demand fuel-saving technologies and manufacturers to adopt them. But we don’t see this happening in the marketplace. This outcome—that consumers do not appear to want to pay up front for the full value of energy savings over the life of more efficient technologies—is often referred to as the fuel-efficiency gap.

There is a large literature that attempts to examine why there might be such an efficiency gap. One explanation is that there is no gap, but rather there are hidden costs of the new technologies. For example, consumers may prefer other attributes that enhance performance or operation of the vehicle compared to the additional fuel economy. Or, there may be additional adoption costs (real or perceived) from raising fuel economy that are not included in the cost estimates.

Consumers may not be aware of how much fuel they will save over time with a more fuel-efficient vehicle, either because they have difficulty calculating the savings correctly or because it is not a salient feature compared to other attributes. Or there may be a great deal of individual variation in actual fuel economy for any given vehicle relative to its labeled fuel economy because of differences in driving conditions, driving style, or type of fuel used.

In addition, manufacturers appear slow to bring fuel-efficient vehicles to the market for other reasons. Evidence is growing that consumer demand for fuel economy is quite heterogeneous. Consequently, manufacturers don’t choose fuel economy based on average consumer demand. Instead, they may design some vehicles for consumers with a high willingness to pay for fuel savings and other vehicles for consumers with a low willingness to pay. Another possibility is that manufacturers decide to adopt technology based on what their competitors are doing. Either case could cause technology adoption to be slower than if manufacturers simply compared technology costs with the value of the fuel savings.

It is interesting that some research has found little evidence of an efficiency gap, suggesting that consumers are willing to pay just slightly less than $1 for $1 worth of expected fuel savings. One potential problem, however, is that these studies tend to use fuel price variation to estimate consumer trade-offs between vehicle costs and fuel savings—perhaps an inaccurate measure.

The presence and magnitude of the fuel-efficiency gap should be addressed because the stakes are high. Depending on the outcome, the regulatory agencies may need to adjust their cost–benefit approach, which could change the calculations and shed light on whether the slated tightening is justified—or if there should be even tighter standards. And taking into account consumer heterogeneity or competition among manufacturers would suggest that other policies—raising the gas guzzler tax or setting a minimum standard, for example— could yield the same benefits at lower costs than a fuel economy standard. More study is needed here.

Will a Footprint-Based Standard Reduce Fatalities?

Until the changes to the CAFE rules in 2012, all passenger cars were held to the same fuel economy standard—27.5 mpg from 1990 to 2011—and all light-duty trucks were held to a weaker standard of between 20 and 23 mpg. But federal legislation in the late 2000s required the regulatory agencies to base the new standards on a vehicle attribute or attributes related to fuel economy. In response, EPA and NHTSA based the new standards on a vehicle’s footprint, defined as the area between the four wheels, and they also maintained the car–truck distinction. Vehicles with a smaller footprint must meet a tighter standard than those with a larger footprint, and light-duty trucks still have a less stringent overall footprint standard than cars.

Before making this decision, the agencies considered several attributes on which to base the standards. European, Japanese, and Chinese standards depend on vehicle weight, with heavier vehicles allowed to have more lenient standards. The agencies argued that a footprint standard, by comparison, would fall relatively evenly on all manufacturers and force more technology for improved fuel economy across all vehicle sizes, with less incentive to downsize to meet the standard. This was especially appealing to NHTSA, which was particularly concerned that, with so many large vehicles on the roads, downsizing new vehicles would result in more fatalities.

But will the footprint standard work as expected? The effect of CAFE standards on traffic fatalities is highly controversial. Bigger and heavier vehicles are safer in single vehicle accidents and are safer for their own occupants in multi-vehicle crashes. But drivers and passengers face greater risk in an accident with a larger or heavier vehicle than with a smaller or lighter one. Furthermore, analysis by NHTSA researcher Tom Wenzel recently concluded that reducing weight while holding the footprint constant does not increase fatality risks; this is one of the primary reasons the agency favors the footprint-based standard.

Adding to the complications, some research suggests that optimal vehicle weight may be significantly smaller than the current average weight of vehicles on the road. Consumers believe that they are safer in heavier and larger vehicles, but they don’t account for the fact that choosing larger and heavier vehicles increases fatality risks for people in other vehicles. Because of this safety externality, consumers choose vehicles that are larger and heavier than is socially optimal.

Will the new CAFE standards reduce or exacerbate this problem? The truth is, we don’t yet know. Because size and weight disparity matters, the effect of CAFE standards on fatalities depends on how the standards affect the entire distributions of size and weight. It also matters whether CAFE causes riskier drivers to buy different vehicles. Predicting these effects is essential to predicting how the standards will affect accident fatalities.

The agencies assume that there will be no change in vehicle size or sales mix, but rather that the effect of the standards will be to improve fuel economy uniformly across the fleet. It seems likely, however, that the sales mix and vehicle sizes will change in response to differences in the costs of improving fuel economy across different vehicle sizes and types and to differences in consumer responses as new vehicles are introduced over time. The important questions are, what will be the direction and magnitudes of these effects, and will they change the expected outcomes of the new rules on safety and GHG emissions?

Several studies have taken a first look at the effects of footprint standards on vehicle size and fleet sales mix. Researchers Kate Whitefoot and Steven Skerlos, using data from earlier regulatory analyses and a combined economic–engineering model, conclude that manufacturers are likely to increase vehicle size, particularly for larger vehicles.

How Will Trading Provisions Affect the Rules?

Each manufacturer has target fuel economy and GHG emissions of its fleet in each year under the new rules. Provisions in the rules allow companies to earn credits for reducing the fuel consumption and GHG emissions on individual vehicles below their targets set by the standards. The new rules allow manufacturers to bank, borrow against, and trade those credits. Credit trading provides manufacturers with flexibility and can lower the costs of meeting these strict new standards, especially when the costs of complying vary across vehicle models.

For some vehicle sizes and models, it will be less costly to add fuel-saving technologies than for others. In addition, consumers of some models may be willing to pay more for that technology than consumers of other models. Crediting allows manufacturers to sell some vehicles that exceed their standard and others that fall short of the standard—but still meet the overall GHG and fuel consumption targets in the most cost-effective way.

Is there evidence that manufacturers will take advantage of this crediting flexibility? Indeed, some recent developments suggest that they will. In model-year 2012, most manufacturers did not meet the standards in their truck fleets and earned credits or at least had fewer deficits in their car fleets. In addition, some manufacturers seem to be taking opportunities to bank credits for the future. Manufacturers were allowed to overcomply and accumulate credits before the new standards began, and a number of them did so. These manufacturers seem to be taking advantage of the flexibility to average credits across the car and light-duty truck fleets and over time.

The new rules allow manufacturers to trade with each other for the first time, but only a handful of trades have taken place to date. A possible barrier to a competitive and robust trading market is the fact that three manufacturers accounted for close to 80 percent of the overcompliance credits outstanding as of 2012. Uncertainty about future costs of complying with the rules is another reason manufacturers may be reluctant to participate.

However, the fact that EPA’s compliance rules are different from those of NHTSA may encourage future cross-manufacturer trades. The current CAFE rules under NHTSA allow manufacturers to pay a penalty if they do not comply, and a number of manufacturers have often done exactly that. Under the new rules, penalties under the Clean Air Act are so high that they are effectively not an option—the companies must comply. This increases the value of trading credits across companies. Whether and how this market develops over the next few years is likely to be key for the success of the CAFE rules.

Informing the Midterm Review

For the research community, the midterm CAFE evaluation is an important invitation to perform research that can aid the agencies in their deliberations. Although the academic literature on vehicle markets has grown in recent years, major questions remain—a point that the agencies readily acknowledge. Because the midterm review will not be completed for another three years, there is sufficient time to undertake significant new research to address these questions. The time to start is now.