IMPLICATIONS OF U.S. CLIMATE POLICY CHOICES FOR AGRICULTURAL INPUT COMPETITIVENESS, COSTS, AND USAGE

• Sponsoring Institution: National Institute of Food and Agriculture
• Project Status: COMPLETE
• Funding Source: AFRI COMPETITIVE GRANT
• Reporting Frequency: Annual
• Accession No.: 0227895
• Grant No.: 2012-67023-30236
• Cumulative Award Amt.: $288,185.00
• Proposal No.: 2011-05606
• Project Start Date: Jul 1, 2011
• Project End Date: Jun 30, 2015
• Grant Year: 2012
• Program Code: [A1611]- Foundational Program: Economics of Markets and Development

Recipient Organization
UNIVERSITY OF CALIFORNIA, DAVIS
410 MRAK HALL
DAVIS,CA 95616-8671

Performing Department
Economics Department

Non Technical Summary
The nitrogenous fertilizer industry, producers of one of the most greenhouse gas (GHG) intensive products, could experience substantial cost increases under GHG regulation. The inclusion of GHG costs in fertilizer prices would carry implications for crop choice, application rates, and the development of lower GHG intensive alternatives. However, the fertilizer industry is heavily trade-exposed and, absent adjustments, application of GHG regulations to U.S. manufacturers could result in substantial "leakage" of production to outside the U.S. The industry is also highly concentrated, and the degree of market power would complicate the transmission of increased costs through to retail prices. Alternative approaches for combating leakage could either subsidize domestic producers - thereby potentially limiting price increases - or tax imported products according to their GHG content. Further, emissions from the sector may remain uncapped altogether and instead qualify for "offset" payments to reduce their emissions. These alternatives present very different implications firm conduct, international trade, and retail prices and therefore downstream usage and emissions. This project will examine these questions from producer, consumer, and equilibrium perspectives. We will develop industry aggregate estimates of the incidence of wholesale cost increases on retail prices. Later, we will develop a structural model of competition between internationally positioned oligopoly producers, and examine the impacts of alternative policy instruments on producer behavior and retail prices. These models will be combined with existing and newly developed demand models to refine estimates of price impacts. Last, the international equilibrium impacts of alternative policies will be simulated using the FAPRI model. The long-term goal of the project is to provide both qualitative and quantitative insight into several aspects of the market for this critical agricultural input. First, enhance the understanding of market conduct in the nitrogenous fertilizer industry, and the impacts of GHG regulations on firm conduct and therefore retail prices. Second, provide insight into how alternative climate change policies would influence international trade for, and domestic prices of, nitrogenous fertilizer products. Third, assess the downstream impacts of changes in retail fertilizer prices. These impacts include domestic and international land-use decisions, emissions related to N fertilizer, and the potential impacts on important related markets such as biofuels. This research can therefore inform policy related to both the design of specific regulatory instruments and addressing the impacts of those policy choices on the agricultural sector.

Animal Health Component

60%

Research Effort Categories

Basic

20%

Applied

60%

Developmental

20%

Classification

Knowledge Area (KA)	Subject of Investigation (SOI)	Field of Science (FOS)	Percent
603	5210	3010	50%
603	6110	3010	10%
605	5210	3010	40%

Knowledge Area
605 - Natural Resource and Environmental Economics; 603 - Market Economics;

Subject Of Investigation
6110 - Economy of the United States and sectors thereof; 5210 - Fertilizers;

Field Of Science
3010 - Economics;

Keywords

fertilizer

climate policy

pricing

environmental regulation

market conduct

tax

incidence

nitrogen

cap and trade

structural estimation

yield response

domestic

offsets

supply elasticity

Goals / Objectives
This project will examine the interaction of climate change policies with conduct and pricing in the nitrogenous fertilizer industry. Because the industry is both highly concentrated in the U.S. and highly integrated with other regions of the globe, these interactions will likely be more complex than that predicted by models that implicitly assume the industry is perfectly competitive. The impact of greenhouse gas (GHG) regulations on retail fertilizer prices will in turn carry implications for crop choice, application rates, and the development of lower GHG intensive alternatives. These "downstream" effects will therefore play a role in the net emissions impacts of these policies. The specific design of policy instruments directed at reducing GHG emissions will play an important role in determining the cost impact on both US nitrogenous fertilizer production and imported fertilizer. The first phase of the project will simultaneously explore estimation of the reduced-form relationship between natural gas prices and N-fertilizer prices along with beginning construction of a firm-level structural model of N-fertilizer supply. We expect to be able to combine the results of this project with the enhanced capabilities of the FAPRI model during the second and third phases of the project. We expect this work to produce several research papers on the subjects of competition in the fertilizer industry, GHG regulations, international fertilizer demand, and possibly the calibration methodologies applied to the structural model. Work will proceed along the following timeline. In year 1, we would complete estimation of a reduced form relationship and translation of GHG regulations into comparable input costs. The predicted changes in fertilizer prices would be simulated in FAPRI to calculate downstream impacts on acreage, crop prices, and emissions. This work would result in at least one research paper that would be completed by December 2012. In year 2, the firm-level structural model will be assembled and calibrated to a panel of market data on regional production, prices, and trade flows. This model will utilize the estimates of regional fertilizer demand that would be under development during year one and completed during year 2. Using the calibrated model, impacts of alternative GHG policies (e.g. import tax, output-based updating)on firm-level and regional production will be simulated. This work would result in one research paper and at least one policy oriented paper that would be completed by February 2014. In year 3, results from the structural model of fertilizer production will be combined with an agricultural market model, such as FAPRI to simulate international impacts of GHG regulations on the fertilizer industry. The simulation can calculate regional impacts of changes in fertilizer prices, including indirect impacts of shifts in both fertilizer production and/or fertilizer intensive crops to regions outside the U.S. that could result from increased fertilizer costs inside the U.S.

Project Methods
The project will address three broad research questions. First, what would the incidence of a significant increase in input costs on the N-fertilizer industry be on U.S. retail fertilizer prices Second, how will the various GHG policies effect the costs and incentives, and behavior of key players in the N-fertilizer industry Third, how will changes in fertilizer prices, possibly combined with other policies, impact consumption of fertilizer and the agricultural markets for which it is a key input To address the question of input costs and retail price incidence, we will focus on historical relationships between costs and prices. Several papers have utilized state-level variation in taxes to estimate both the extent of market power and incidence of those taxes on retail prices for products such as tobacco and gasoline. While we do not have the cross-sectional variation in policy exploited by these papers, we can take advantage of the substantial time-series variation in natural gas prices. The cost of natural gas feedstock comprises 80 to 90% of the costs of producing anhydrous ammonia. This variation in supply costs can be combined with variation in important demand factors, notably crop prices. The initial phase will take advantage of this variation in supply and demand drivers to develop reduce form estimate of cost pass-through. This approach will not attempt to diagnose the causal relationship between input costs and prices in the industry, but rather develop descriptive regressions of that relationship. We would then use these estimates to predict potential impacts of GHG regulations on retail prices by representing the impacts of those regulations as similar to the impacts of observable input cost shocks. In the second phase of the project, we intend to construct a firm level model of international fertilizer trade and competition. We believe that this more detailed model may be an important extension over the reduced-form model estimated in phase one for several reasons. First, although the specification in (1) may not satisfactorily capture the nuances of intra-firm competition, particularly when there is large asymmetry among firms with substantial production in varying regions of the globe. Second, the market structure in the industry has changed in observable ways over time, so a specification that does not explicitly represent that market structure can lead to erroneous projections. Third, a firm specific structural model can allow for more nuanced representation of the impacts of alternative climate policy instruments on firm and market level outcomes. In the third phase, we plan to use our estimates of the supply of fertilizer to simulate various impacts of GHG policy options on downstream prices, usages, and production in various agricultural markets. For this work, we would employ the FAPRI agricultural market model in conjunction with the GreenAgSim model of GHG emissions.

Progress 07/01/11 to 06/30/15

Outputs
Target Audience:Research on the incidence of natural gas price changes on fertlizer priceswas presented at a semianr at the University of California at Berkeley summer workshop on energy economics. The audience was research faculty and graduate students. Changes/Problems:The one change made in methodology from the original proposal was the decision not to pursue a structural modeling approach. Several factors influced this decision, including lack of quality data on input prices and consumption outside the US, and more importantly, the fact that obvious significant changes had impacted the industry around the time the project began. Because of these obvious and dramaticchanges to the market conditions, it was no longer defensible to argue the industry had reached some form of stable long-run equilibrium. We further concluded that a structural simulationof potential price impacts of climate regulations would be highly dependent upon functional form assumptions of demand and were leary of letting such assumptions drive the results. At the same time, the variation provided by these shifts in natural gas prices allowed for the implementation of the time-series econometric approaches that were adopted in the two papers studying the incidence of cost shocks on fertilizer prices. What opportunities for training and professional development has the project provided?Three graduate students were heavily involved in the research produced in this project. Juan Francisco Rosas completed his Ph.D.in Economicsat Iowa State Univeristy in 2012 and is currently an Assistant Professor of Economics at Universidad ORT in Uraguay. Jacob Humber is expected to complete his Ph.D. in Agricultural and Resource Economics in the Spring of 2016. Chao Lin will complete his Ph.D in Economics at Iowa State in November 2015. How have the results been disseminated to communities of interest?Research on the incidence of natural gas prices on fertilzer prices was presented at the UC Berkeley summer workshop on energy economics in June 2015. James Bushnell has been an advisor to the California Air Resources Board (ARB) on the design of their cap and trade program and has periodically briefed ARB Staff on these research findings and their implications for California's policy toward energy intensive trade exposed industries. What do you plan to do during the next reporting period to accomplish the goals? Nothing Reported

Impacts
What was accomplished under these goals? Project Impact The project has expanded understanding of the interaction of possible climate policies with conduct and pricing in the fertilizer industry, and more generally documented the implications of recent dramatic changes experienced in the industry. Since 2010 the industry has undergone increased concentration of producers and a dramatic reduction in US natural gas prices. While the decline in domestic gas prices has reduced production costs, it has not produced a corresponding decrease in fertilizer prices. Our research establishes that the "pass-through" of changes in natural gas prices, a key input to nitrogenous fertilizer, declined from roughly 80% prior to 2010 to effectively zero through 2014. One implication of this change in pricing dynamics is that the imposition of greenhouse gas (GHG) regulations on producers of nitrogen fertilizers would have almost no impact on fertilizer prices. Within the context of a GHG cap-and-trade program, the allocation of emissions allowances as considered under proposed Federal legislation, and as practiced in California today, would likely result in a transfer to fertilizer producers on the order of hundreds of millions of dollars with no impact on fertilizer prices or emissions. An alternative mechanism, imposing a GHG tax on imported fertilizer at a level comparable with charges imposed on domestic producers, would have more effect on fertilizer prices, raising them by a level comparable to the tax. However, simulations of global agricultural markets show that the decline in domestic emissions from reduced fertilizer production and use would be more than offset by increases in usage in other agricultural producing regions around the world. Project Goals The project included two distinct but related research objectives. The first was to estimate and document the potential incidence (e.g. pass-through) of GHG charges on firms and markets in the fertilizer industry. The second was to estimate the impacts of those charges on GHG emissions and Fertilizer use, both within the US and globally. Estimating Incidence of Environmental Charges. In the paper "Rethinking Trade Exposure" James Bushnell and Jacob Humber expand the literature on the incidence of taxation and other cost shocks by applying it to data on nitrogenous fertilizer and natural gas prices. Since 2010, the industry has undergone increased concentration of producers and experienced a dramatic reduction in natural gas costs. Utilizing time series econometric methods they document a structural break in the relationship between natural gas and ammonia prices in 2010. The result is that while the pass-through of changes in gas prices to ammonia prices was between 64% and 81% prior to 2010, there was no significant pass-through of gas prices to fertilizer prices post 2010. There are two potential causes of this break in the pricing relationship. One is that the industry, which remains a net importer of product in the US, is capacity constrained and imports are setting a perfectly competitive price at the world ammonia price level. The other possibility is that the increased concentration of suppliers allowed for a reduction in output from competitive levels. In the paper "The examination of market power in the U.S. nitrogen fertilizer industry..", Chao Lin and Dermot Hayes examine the causal linkage between fertilizer, its main feedstock (gas), and its main market (corn). The results of time varying estimation show that the U.S. nitrogen fertilizer price has started more closely following the value of its marginal revenue than to its marginal cost of production, indicating a less competitive structure of the markets. 1.1 Outcomes. This part of the project has to date produced two working papers; "Rethinking Trade Exposure: The Incidence of Environmental Charges in the Nitrogen Fertilizer Industry" by James Bushnell and Jacob Humber and "The examination of market power in the U.S. nitrogen fertilizer industry: a Bayesian based approach" by Chao Lin and Dermot Hayes. The Bushnell and Humber paper has been submitted to the Journal of the Association of Environmental and Resource Economists (JAERE). The Lin and Hayes paper will soon be submitted to a journal. 2.0 Evaluating Environmental Impacts. In order to examine a broad set of alternative mechanisms, we combined reduced form estimates of demand elasticities with data on ammonia production, imports, and emissions intensities assembled from a variety of sources. The primary finding was that due to changes in the market conditions experienced by the domestic nitrogen industry, GHG charges would have almost no impact on ammonia prices and therefore downstream emissions. The main exception to that scenario would be the combination of domestic GHG regulations with a "border adjustment" that would tax imported nitrogen fertilizers. This would raise fertilizer prices to levels commiserate with the GHG charge and according to our estimates reduce GHG emissions from between 1to 2mmTons per year at the low end our our elasticity estimates and 5to 10at the high end of the elasticity estimates. These local effects need to be considered in a global context however. An increase in US agricultural costs would also induce a shift in global production through interconnected agricultural markets. The FAPRI-CARD agricultural modeling system was deployed to test this aspect of the problem. After calibrating a baseline to 2010 market conditions, this project simulated a stable 10\% increase in US fertilizer prices relative to the rest of the world, effectively mimicking the impact of a carbon charge plus a border tax on US nitrogen fertilizer. The equilibrium effects are complex and indicate the limits of local regulations of greenhouse gasses. The net effect of all these changes is that, while agricultural emissions are reduced in the US by about 1.5 mmTons CO2e, global emissions increase by about 1.6 mmTons of CO2e. Both of these studies envisioned a relatively simple carbon pricing mechanism. Further research indicates the limitations of a linear emissions charge and the potential benefits of more complex instruments. In "A Nonlinear Offset Program to Reduce Nitrous Oxide Emissions Induced by Excessive Nitrogen Application," by Francisco Rosas, Bruce Babcock, and Dermot Hayes, the authors argue that conventional emissions taxes would be an inefficient way to reduce nitrogen applications due to the way farmers respond the changes in nutrient prices. They present a nonlinear offset program that induces farmers to reduce their nitrogen applications to the level that will be consumed by the plant in a typical year and, as a result, reduce N2O emissions from agriculture. By adjusting the size of the offset payment nonlinearly according to the level of N2O reductions, the mechanism more efficiently interacts with the decision making process of risk averse farmers. 2.1 Outcomes. In addition to the Bushnell and Humber paper described in section 1.1, two further papers were produced on this topic. The paper "Biofuel Expansion, Fertilizer Use, and GHG Emissions: Unintended Consequences of Mitigation Policies" by Elobeid, Amani, Miguel Carriquiry, Jerome Dumortier, Francisco Rosas, Kranti Mulik, Jacinto F. Fabiosa, Dermot J. Hayes, and Bruce A. Babcock, was published in the journal Economics Research International, in 2013. The paper "A Nonlinear Offset Program to Reduce Nitrous Oxide Emissions Induced by Excessive Nitrogen Application," by Francisco Rosas, Bruce Babcock, and Dermot Hayes," is under submission after a 2nd round of revisions at the journal Climatic Change.

Publications

• Type: Journal Articles Status: Under Review Year Published: 2015 Citation: Rosas, Francisco, Bruce Alan Babcock, and Dermot James Hayes. A nonlinear offset program to reduce nitrous oxide emissions induced by excessive nitrogen application. Under second review at Climatic Change.
• Type: Journal Articles Status: Submitted Year Published: 2015 Citation: Bushnell, James, and Jacob Humber. "Rethinking Trade Exposure: The Incidence of Environmental Charges in the Nitrogenous Fertilizer Industry." Davis Energy Economics Program Working Paper DEEP-010. 2015. Submitted to the Journal of the Association of Environmental and Resource Economics (JAERE).
• Type: Other Status: Other Year Published: 2015 Citation: Chao Lin and Dermot Hayes. The examination of market power of U.S. nitrogen fertilizer industry: A Bayesian based approach Center for Agricultural and Rural Development, Iowa State University, 2015.

Progress 07/01/13 to 06/30/14

Outputs
Target Audience: Nothing Reported Changes/Problems: Nothing Reported What opportunities for training and professional development has the project provided? Nothing Reported How have the results been disseminated to communities of interest? Nothing Reported What do you plan to do during the next reporting period to accomplish the goals? 1. Finish analyis of the competitive effects of structural changes in the industry since 2008. 2. Apply competitiveness analysis to implications for climate policy mechanisms such as an upstream carbon tax or retail tax on fertilizer application.

Impacts
What was accomplished under these goals? Two of the main goals of this project were to 1 increase understanding of and quantify the compettiveness of the nitrogenous fertilzer industry and 2. Quantify the implications of that competitiveness on the transmittel of input costs (such as a GHG fee or tax) on fertilzer prices. During this period substantial progress was made in these two areas. The project has quantified the impacts of market structure changes in the nitrogenous fertilzer industry on the competitiveness of that industry in the United States, particuarly since a key merger in that industry during 2010. We have also quantified the impact of these competitive changes on the transmittel of input costs (in this case natural gas prices) on wholesale fertilizer prices.

Publications

• Type: Conference Papers and Presentations Status: Accepted Year Published: 2014 Citation: Mergers and Market Power in the US Nitrogen Fertilizer Industry. Jacob Humber. University of California at Davis. Selected Paper prepared for presentation at the Agricultural & Applied Economics Association's 2014 AAEA Annual Meeting Minneapolis, MN, July 27-29, 2014.
• Type: Journal Articles Status: Published Year Published: 2013 Citation: Elobeid, Amani, Miguel Carriquiry, Jerome Dumortier, Francisco Rosas, Kranti Mulik, Jacinto F. Fabiosa, Dermot J. Hayes, and Bruce A. Babcock. "Biofuel Expansion, Fertilizer Use, and GHG Emissions: Unintended Consequences of Mitigation Policies." Economics Research International 2013 (2013).

Progress 07/01/12 to 06/30/13

Outputs
Target Audience: Nothing Reported Changes/Problems: The main changes we are considering are motivated by changes in the policy landscape. The original motivation of the project was assessment of aspects of a potential Federal cap and trade program for greenhouse gasses that would cover N fertilizer production. Such a broad based program seems unlikely at this time and while EPA is pursuing source-based standards under the clean air act, our understanding is that such standards for fertilzer production facilities are not currently under development. In light of these policy changes we intend to focus more on competitiveness questions in the fertilizer supply change. What opportunities for training and professional development has the project provided? Nothing Reported How have the results been disseminated to communities of interest? Nothing Reported What do you plan to do during the next reporting period to accomplish the goals? A model of supply responses to input cost shocks will be developed and combined with the FAPRI demand interface.

Impacts
What was accomplished under these goals? A fertilizer demand model was fully integrated into the FAPRI model at CARD. A full database on supply capacity, regional wholesale fertilizer prices, and country level production has been assembled.

Publications

• Type: Other Status: Other Year Published: 2012 Citation: Francisco Rosas. ''Fertilizer Use by Crop at the Country Level(19902010).'' WP-535. Center for Agricultural and Rural Development. Iowa State University.

Progress 07/01/11 to 06/30/12

Outputs
OUTPUTS: This project's goal is to increase understanding of the interaction of climate change policies with conduct and pricing in the nitrogenous fertilizer industry. The project will combine work modeling the demand for nitrogenous fertilizer with models of the supply of fertilizer. These models will be tested against proxy models of potential policies to address greenhouse gas emissions. During the first year of the project, the team established a world fertilizers model that is capable of producing projections by crop, country, and nutrient. The fertilizer model interacts with the yield equations of the FAPRI/CARD model (Food and Agricultural Policy Research Institute and Center for Agricultural and Rural Development at Iowa State University), and by means of a set of production elasticities, projects each nutrient's application rate per hectare for each commodity and each country covered by the FAPRI/CARD model. On the supply side, the team now has assembled and processed an extensive panel data set of production capacity for all of the major fertilizer products. The data include facility level production capacity as well as ownership by firm. These data can form the foundation of a structural supply model. On the policy front much has changed. Federal cap-and-trade regulation of GHG now seems unlikely in the near future. However California currently plans to implement a comprehensive cap and trade program that will include nitrogenous fertilizer production and will feature many of the same mechanisms as the proposed Federal legislation. During the past year, members of the research team have participated in regulatory forums and closely tracked these policy developments and adjusted proxy policy models to reflect these changes. PARTICIPANTS: Principle Investigators are James Bushnell and Dermot Hayes. Danielle Sandler, a Ph.D. student in economics at UC Davis worked as a graduate student researcher during Spring 2012. TARGET AUDIENCES: Nothing significant to report during this reporting period. PROJECT MODIFICATIONS: Nothing significant to report during this reporting period.

Impacts
The competitiveness and efficiency of the US Agricultural sector is strongly influenced by the cost and availability of fertilizers. Policies that influence the supply and production of fertilizers need to consider the impacts of those policies on cost, availability, as well as spill-over effects on trade partners. The environmental integrity of policies directed at fertilizers will also depend upon the upstream effects on production as well as the downstream effects, through price, on end-use consumption of fertilizers.

Publications

• No publications reported this period