The Costs of Tier 3 Regulations

The Environmental Protection Agency (EPA) is moving ahead with its efforts to impose a “Tier 3” tightening of standards that would further reduce the permissible levels of sulfur in refined gasoline. According to a study by Baker & O’Brien, Tier 3 standards would impose upfront costs on refiners of just under $10 billion, and cause a permanent increase in refining costs of 6 to 9 cents per gallon of gasoline. These economic harms would come with only a relatively small reduction in sulfur content, because previous regulations have already greatly reduced the sulfur content in gasoline.

Tightening Standards

In 1999 EPA issued its Tier 2 regulatory framework, which for the first time including all passenger vehicles (including SUVs and light-duty trucks) to the same emission standards as cars. The Tier 2 framework also began treating “vehicles and fuels as a system,” so that standards for tailpipe emissions were linked to stringent requirements on sulfur concentrations in gasoline. (It is easier for passenger vehicles to comply with emission limits, if the gasoline they use has a reduced sulfur content.)

In its December 1999 document, EPA proudly announced how drastic the Tier 2 measures were: “These new standards require passenger vehicles to be 77 to 95 percent cleaner than those on the road today and reduce the sulfur content of gasoline by up to 90 percent.” Specifically, here is their discussion of the sharp reduction in permissible sulfur concentrations:

Beginning in 2004, the nation’s refiners and importers of gasoline will have the flexibility to manufacture gasoline with a range of sulfur levels as long as all of their production is capped at 300 parts per million (ppm) and their annual corporate average sulfur levels are 120 ppm. In 2005, the refinery average will be set at 30 ppm, with a corporate average of 90 ppm and a cap of 300 ppm….Finally, in 2006, refiners will meet a 30 ppm average sulfur level with a maximum cap of 80 ppm.

To clarify, EPA makes a distinction between the average sulfur content for the entire mix of output, and the maximum permissible sulfur content on any particular product. As the earlier EPA quote illustrated, the Tier 2 regulations, when fully phased in over a few years, would reduce gasoline sulfur content by up to 90 percent, depending on the benchmark.

Yet even though the Tier 2 standard has already reduced gasoline sulfur content some 90 percent, down to an average level of 30 parts per million (ppm), EPA wants to ratchet up the standard yet again. Although it hasn’t explicitly announced the specific standard in its Tier 3 regulations, EPA officials (e.g. Margo Oge in late January of this year) have publicly stated that the standard will probably be 10 ppm. That is to say, on top of the 90 percent reduction in sulfur content that Tier 2 involved, the move to Tier 3 (if Oge is correct in her statement) would require a further reduction of 67 percent from the Tier 2 baseline.

The Baker & O’Brien Analysis

The American Petroleum Institute (API) commissioned Baker & O’Brien to perform a study that was originally released in July 2011 on the impact of Tier 3 regulations on the refining sector and gasoline market. In light of criticism from EPA—claiming that the original study should not have included a scenario considering a 5 ppm standard, but instead a looser 10 ppm standard—API commissioned Baker & O’Brien to issue a March 2012 addendum. In this addendum, the analysts consider a “Case 4” that keeps all other regulations constant, and only changes the gasoline sulfur content from the current 30 ppm down to 10 ppm.

Before reporting the results of the addendum, we should point out that the regulatory uncertainty itself is costly and inhibits the U.S. refining sector, and thus raises gasoline prices relative to what would occur in a more predictable setting. After all, even now EPA hasn’t officially said what the Tier 3 standard will actually be, so the original Baker & O’Brien study—which was released in July 2011—can hardly be faulted for including a spectrum of scenarios, one of which was more draconian than what EPA officials are now telling us will likely be the actual rule.

In any event, the new Case 4 scenario—which models only the tightening of gasoline sulfur standards, in light of the recent remarks from EPA officials—projects the upfront compliance costs to refiners at $9.8 billion. Furthermore, the total annual compliance cost (which includes capital recovery) is estimated at $2.4 billion. Spread out over the range of projected gasoline production, this higher operating cost works out to 6 to 9 cents per gallon in increased costs. (The addendum does not explicitly model the gasoline market directly, and thus does not say how much of this burden will be borne by shareholders in the refining sector versus motorists in the form of higher prices at the pump.)

Ironically, the study also finds that even under the milder Case 4 assumptions, refiners would be forced to alter their activities in ways that would end up emitting an extra 1.7 million tons of carbon dioxide per year. This counteracts one of the primary purposes of the program, which is to produce gasoline low in sulfur and thus make vehicle emissions targets (including CO₂ emissions) easier to achieve.

Conclusion

The EPA’s Tier 2 standards for gasoline have already reduced its sulfur content by 90 percent relative to 1999 levels. EPA’s consideration of further tightening the regulations is harmful to the refining sector both for its ambiguity—we still don’t know what the rule eventually will be—but also because it will likely impose billions of dollars in upfront and annual compliance costs on the sector. Refiners won’t stay in business if they are losing money, and so the new measure will reduce growth and employment in the refining sector, while raising gasoline prices for motorists.