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B. Limitations of the API Approach

The API report does not model foreign supply, although it notes that foreign supply and price-induced reductions in U.S. consumption together will have to meet any reductions in U.S. supply. The API report appropriately treats foreign supply as a factor that will mitigate price increases. But the assumption regarding the likely price of foreign products is arbitrary and pessimistic. The API report notes its assumption regarding import prices as follows:

“[I]f imports are available at a price equal to the highest full-cost domestic
supply (15 cents per gallon) in unlimited quantities, then price increases can be
capped at that level." (API report, p.7)

There are three reasons why this critical assumption about foreign supply may substantially understate imports and overstate future price increases.

First, the API report's assumption that imports are available at a price equal to the highest full cost domestic supply is unduly pessimistic. Foreign refineries, like U.S. refineries, will differ in the cost of desulfuring diesel fuel, and the foreign refineries most likely to respond to the U.S. mandate for ultra-low sulfur diesel are those who can produce it most cheaply. API's analysis (See Figure 2) suggests that that average cost increase for U.S. refineries is about 6 cents per gallon, and that 90 percent of the total projected increase in supply would be forthcoming at a cost of less than 8 cents per gallon. A more reasonable assumption to use instead of API's would be that foreign refineries could supply diesel meeting the U.S. requirements at a price equal to the average cost among U.S. suppliers. A pessimistic assumption might be that foreign supply would be forthcoming at a premium of 8 cents a gallon, a level that corresponds to the cost of ultra-low sulfur diesel for about 90 percent of the U.S. refineries that according to API would produce it. In these cases the foreign supply would be forthcoming at either 6 or 8 cents per gallon, and that would be the price increase for complying diesel, assuming all other parts of API's analysis are valid.

Second, European and Japanese refineries may be able to export ultra-low sulfur diesel to the U.S. to the extent that local regulations require sulfur levels in diesel approximately as stringent as the 15 ppm level. Current EU diesel regulations will specify 50 ppm sulfur by 2005, but the adequacy of that level is currently being challenged, with Germany leading the

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way." Thus the EU may issue regulations as stringent as 10 ppm sulfur or lower by 2007, going beyond EPA's proposal. Japan is also considering 10 ppm sulfur levels in diesel by 2007, and it currently has a considerable surplus in refining capacity. If regulations in EU or Japan were (approximately) as stringent as in the U.S., refineries could export diesel to U.S. markets for transportation charges that would be much less than the 15 cpg price increase forecast by API. Even if foreign sulfur regulations are not exactly as stringent as in the U.S., foreign refiners still may be able to produce significant amounts of ultra-low sulfur fuel for export to the U.S..

Third. some refineries in the EU or Japan as well as in the Caribbean and Venezuela. when making investment decisions, may elect to acquire the hydro treating capability necessary to remove sulfur to meet the proposed EPA sulfur cap. U.S. refineries, after all, will prefer to make such investments instead of forgoing diesel sales because they anticipate that higher prices for ultra-low-sulfur diesel will offer reasonable returns to the investment. Some foreign refineries that export diesel to U.S. markets will face similar incentives and respond in the same way. Several foreign refineries export significant portions of their production to U.S. markets. Venezuela, for example, exported to the U.S. nearly 19 million of the 98 million barrels of distillate fuels that it produced in 1997. Canada exported to the U.S. nearly 31 million of the 192 million barrels of distillate fuels that it produced in 1997.20 Thus for both of these countries the U.S. market provides an important share of total revenue. Moreover, swings in U.S. imports from these countries by as much as 40 percent from one year to another suggest that the flow of imports responds to economic incentives.

Refinery managers in these countries will have to assess whether to invest in the hydro treating capacity necessary to produce ultra-low sulfur diesel that meets EPA's standards, or whether to forgo this market. Forecasts of high prices for ultra-low-sulfur diesel several years in the future provide these managers with the incentives and the opportunity to make profitable investments that will serve to increase imports and lower projected price hikes below the range forecast by API.

19

See, "Euro Commission to Probe 5 PPM Fuel Sulfur Impact on Refining Industry." Hart's Diesel Fuel News Vol. 4 (No. 15). August 2000, p. 1.

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C. Implications of the API Assumptions

We can illustrate the implications of imports using the same conceptual framework outlined in the API report. Figure 6 shows the same demand and supply conditions as Figure I but adds a price for imports. We have relabeled the curve in the API report the Domestic Supply with Regulations case to indicate that it includes only domestic supply responses due to higher diesel prices. The line labeled Import Supply Price illustrates the implications of including imports in the analysis. Since foreign countries would supply ultra-low sulfur diesel at the price P,. imports effectively cap the potential price increase from the environmental regulations. Supply is now the kinked curve labeled import + Partial Domestic Supply with Regulations. (Note that this analysis ignores the effects of additional domestic supply.) Figure 6. Price at Which Imports Are Supplied Significantly Affects New Diesel Price

20

See EIA Table "Annual International Distillate Fuel Oil Production and U.S. Imports by Country".

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The net effect of accounting for potential imports is to reduce the maximum price impact of the environmental regulations. In Figure 6. the price increase under the "domestic supply" case is P-P. In contrast, when imports are included, the price increase is only P-P This graph suggests that the API report overstates the price increase due to environmental controls-assuming that the import price is less that the maximum cost increase for domestic refineries-although the formulation does not provide an indication of how much difference including a more realistic import option might make in the price projection.

D. Implications of More Plausible Assumptions

It is possible to provide some indication of the likely empirical significance of including a more realistic import option. Figure 7 modifies the API report results by adding an assumption that the import price is equal to the price without environmental regulations plus a compliance cost increase equal to about the 90th percentile of the values for domestic refineries in the API report sample. The implication of this assumption—which seems more reasonable than assuming that imports would face cost increases equal to the very most expensive domestic refinery-would be to reduce the estimated price rise from 15 cpg reported in the API report to about 8 cpg. (Note that this calculation focuses only on the implications of imports and ignores the other difficulties with the API report, including the extreme correlation between compliance cost and production cost and disregard of additional domestic supply responses.)

V.

THE API REPORT APPEARS TO INCLUDE SOME UNREALISTIC
ASSUMPTIONS CONCERNING COMPLIANCE COSTS

The API report develops estimates of compliance costs that appear to include unrealistic or poorly substantiated assumptions. Two assumptions appear to overstate the impacts of the ultra-low-sulfur regulations on costs and market prices.

First, in estimating the appropriate scale for HDS units, API appears to use a conservative assumption about the capacity of the hydrodesulfurizing unit (API report, p. 34). In particular API multiplies the calendar production rate by 1.20 to determine the stream day capacity required to design the HDS unit. This assumption apparently does not take into account other technological factors such as technological advances for new technologies or

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"learning by doing" effects. These developments may increase the refineries' abilities to use the existing and new capacity.

Second. in estimating costs API uses an uncertainty cost multiplier, saying only that other studies used a range or 115 percent to 140 percent (API report, p. 35) Apart from commenting that other studies have used similar estimates, API provides no justification for these estimates. Although new technology is uncertain, plant managers can learn with experience to lower costs by making small-scale innovations; the API report appears to neglect such effects.

The API report provides both a conceptual formulation for analyzing the potential effects of environmental regulations on the price of diesel fuel as well as empirical estimates of price increases in 2007. The empirical estimates predict that environmental regulations could boost diesel fuel prices in 2007 by more than 15 cents per gallon, with even greater possible short-term increases.

The API price projection is highly pessimistic, however, because the empirical analyses do not implement a full conceptual formulation and because the results are based upon extreme and overly pessimistic assumptions. Specifically,

• The API price projections assume that the firm with the highest cost of compliance is also the firm with the highest cost of production.

The API price projections appear to exclude the effects of higher prices on additional domestic investment in new capacity.

The API price projections assume that imports would only be available at the highest compliance cost reported for U.S. refineries.

It is possible to provide some indication of the possible empirical implications of these unnecessarily pessimistic assumptions. Assuming that the API report empirical estimates are accurate for the refineries that were surveyed-and as noted above, there are some reasons to question this assumption-the price rise seems likely to be 8 cpg or less. A price increase of 8 cpg would result from any one of the following assumptions:

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