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E340 Environmental Economics and Finance

Benefit-Cost Analysis of Honda Accord Hybrid Sedan

BACKGROUND

Hybrid vehicles use both a conventional powertrain and an electric motor as power sources. The electric motor is run from a battery that is charged through a generator that receives energy from regenerative braking, or from the power train when the vehicle is going down-hill.  “Plug-in hybrids” also allow for the battery to be charged independently using an electric power supply, such as an electrical socket in a homeowner’s garage. Hybrid vehicles are more fuel-efficient, in terms of gasoline consumption, than conventional vehicles. Less gasoline (or diesel) is used per mile driven with hybrid vehicles compared to conventional alternatives.

Beginning around 2003, many states and the U.S. federal government applied incentives to encourage individuals to purchase hybrid vehicles. The 2005 Energy Policy Act granted individuals who purchased new hybrid vehicles a tax credit, which depended on the fuel efficiency of the model. This tax credit expired December 31, 2009.

In the period since, there have been calls to renew a subsidy program for hybrid vehicle purchases. Some states offer incentives programs, but the current focus in federal policy is on electric vehicles as well as “plug-in hybrids.” In terms of climate policy, promoting plug-in hybrids or electric cars is a long-term strategy. These vehicles – in particular, electric-only vehicles -- are not likely to reduce CO₂ emissions in the near-term, given that fossil fuels continue to be used to generate electric power.

This case explores whether it makes economic sense to subsidize conventional hybrids – not the plug-in variety – as a transitional strategy to reduce CO₂ emissions and other externalities. The issue is whether renewing subsidy programs like those from 2005 to 2009 is a wise use of public resources.

To answer this question, there are two related issues to consider.

First, from society’s perspective, the question is whether the additional (incremental) benefits of driving a hybrid are greater than the additional (incremental) costs, compared to the non-hybrid model. Fundamentally, the issue here is whether the value of the fuel savings from driving the hybrid are larger than the increased technology cost of hybrid vehicles, plus battery replacement costs.

The value of fuel savings includes the value of conserving a scarce resource – energy-- but also the value of avoiding the social costs associated with energy usage, such as CO₂ emissions, local air pollution, and the risks to national security associated with importing oil.

In terms of the consumer perspective, prospective hybrid buyers are aware of the fuel savings benefits that they will realize if they buy and drive hybrids. However, the consumer’s perspective on fuel savings benefits will differ from the societal perspective, because fuel prices are distorted by fuel taxes.  So the “price signals” consumers face about the value of fuel savings differ from the “shadow price” of fuel savings – the value of fuel savings from a societal perspective. (more on this below).

Additionally, consumers are not fully aware of the value of the reduced global warming risks, or benefits to reducing local air pollution, or reducing national security risks. These  external benefits are diffused and distributed to everyone.

 In sum, consumers may ignore the positive externalities associated with reducing fuel consumption, and get inaccurate price signals about the monetized value of fuel savings as seen from the larger societal perspective.

The increased costs of hybrid vehicles are in the form. of the additional costs for the hybrid drivetrain, which adds to the conventional system: (1) an electric motor (2) a large capacity battery and (3) the power electronics that links these components together. The price consumers pay for hybrids will actually be higher than these costs, because there is 7% sales tax imposed on the purchase of hybrids. The societal analysis will “shadow price” the cost of producing Honda civic hybrids  -- giving the “pure technology” cost -- as the price consumer’s pay less the sales tax. This gives the economic cost (from a societal perspective) of the hybrid technology.

The costs of replacing a hybrid battery once during the vehicle’s life must also be added to the analysis. From the consumer perspective a 7% state sales tax must be added to this cost.

The net-value of purchasing and driving hybrids from a societal perspective can be obtained in two equally valid ways. First, the net effect of driving a hybrid on all “stakeholders” can be summed.  If the net-effects are positive, the project passes the Kaldor-Hicks standard. Passing that standard is equivalent to the benefits being larger than the costs.

The stakeholders in this situation can be aggregated to the following four groups:

(1) The hybrid user;

(2) State governments, who receive additional sales tax revenue from higher hybrid sales prices, but also lose fuel tax revenue from improved hybrid fuel economy;

(3) The federal government, which loses fuel tax revenue;

(4) “the public” that gains the “societal” or external benefits of hybrid use;  that is, the reduced air pollution, lower carbon dioxide emissions, and the value of reduced oil imports.

Summing the net effects in (1)-(4) will give the same result as directly comparing the shadow-priced value of the fuel savings – the monetized benefits from the societal perspective -- against the costs. This conventional benefit-cost comparison is the second method for determining economic efficiency.

The complete picture is shown in Table 1. Summing the net-stakeholder effects in the bottom row of the tableau produces the societal net benefit in the rightmost bottom cell, B1+B2-C1-C2. This is the pre-tax value of fuel savings plus environmental benefits less hybrid technology and battery replacement costs.  You can see the same result by comparing the benefits against the cost in the right most column of the tableau.

Note that the column for the “Hybrid Buyer” shows the private perspective from the purchase of the hybrid. This column represents the financial returns and losses to purchasing and using a hybrid. Comparing this column to the right-most column of the tableau shows how the private buyer perspective differs from the societal perspective.  As mentioned above, there are two differences between these perspectives. First, there is the added benefits to society of avoided pollution and other external costs of fuel use, which the private user themselves do not experience, but society gains (B2). As noted, the private buyer might not account for this external benefit when they purchase the hybrid. Secondly, part of the hybrid buyer’s financial gain in avoiding fuel expenses is not a net gain from the societal perspective. That’s because fuel tax savings of the hybrid driver (T2+T3) are lost to governments, i.e., -T2 is lost to the state government, and -T3 is lost to the federal government. In short, what is the buyers’ gain is another stakeholder’s loss. As “financial transfers,” these effects cancel to zero from a societal perspective.

Similarly, the additional financial loss to the buyer of paying a sales tax on hybrids (-T1a) and battery replacement (-T1b) are not a net-societal loss, because another stakeholder – the state in this case -- collects these sales tax (T1a+T1b). Again, the loss to one stakeholder is counterbalanced by the gain to another, so these gains and losses net to zero from the societal perspective.

A table like Table 1 with actual values will show whether B1+B2-C1-C2 in the far right-hand corner is positive or negative.

If it is negative, it does not make sense for the government to promote hybrid usage  -- assuming  the Kaldor-Hicks standard (Potential Pareto Criteria) is the decision-making standard. That is, if benefits are less than costs, it doesn’t make sense to subsidize hybrids on efficiency grounds.

If it is positive, we then have to look at the net result (bottom cell) in the “Hybrid Buyer” column. If it is privately profitable to buy a hybrid without assistance, then the argument for providing subsidies is diminished – whatever the merits of driving hybrids. Why subsidize people to buy hybrids if they are going to buy them anyway? If, however, private hybrid buyers are taking a financial loss and yet driving hybrids has positive societal benefits, then it might make sense to offer a subsidy to promote the socially desirable behavior. (This is like subsidizing people to get flu shots, given that individuals may not account for the larger social benefits of reducing flu in the population when they make a decision about getting a flu shot). Note that such a subsidy is a pure financial transfer from the societal perspective – a gain to the hybrid driver, and a loss of equal amount to the government. So subsidizing hybrid users has no net efficiency effect from the societal perspective. But from an equity point of view, it wouldn’t make sense to transfer taxpayer money to hybrid drivers unless there was some larger societal purpose to do so.

Note: As shown in Table 1 and discussed above, the computation of the buyer’s financial effect should not include tax credits. It is necessary to compute the impact on the buyer without the tax credit, to see whether a tax credit is needed.

The impact on state and federal fuel tax collections is also policy relevant. States and the federal government rely on fuel tax receipts to fund transportation investments. Growing fuel economy will reduce overall tax receipts, thereby reducing funds for transportation infrastructure.  “Erosion” of fuel tax revenue from greater fuel economy has worried some states enough to consider switching the tax base from fuel consumption to mileage.  See the state of Oregon’s experiments in this regard: http://www.terrapass.com/blog/posts/oregons-successful-mileage-tax-experiment

In short, the impact of hybrid driving on the receipts of state and federal tax revenues is policy relevant. 

THE ASSIGNMENT

Your tasks are as follows:

(1)  produce two Kaldor-Hicks tableaus (Tables 1 and Tables 2) to represent the nature of the program for these specific scenarios:

10,000 miles driving per year, $2.5/gallon, and $100/ton of carbon emissions

20,000 miles of driving per year, $4.5/gallon, and $300/ton of carbon emissions

(2) Fill in the values for a “Table 3” that shows the incremental NPV of driving a hybrid from the societal (economic) perspective as follows:

Table 3: Net Present Value of Purchasing and Using Hybrids from a Societal Perspective

(3) Fill in the values for a “Table 4” that shows the incremental NPV of driving a hybrid from the private buyer’s point of view as follows:

Table 4: Net Present Value of Purchasing and Using Hybrids from a Private Buyer Perspective

4. Write a no-longer-than 4 page double-space memorandum (this page length EXCLUDES THE TABLES YOU INCLUDE) that describes the analysis, presents the results, and then makes a recommendation whether or not Congress should renew tax credits for conventional hybrids. Your memo should be broken down explicitly into sections with bolded headers as follows:

Introduction

Analysis Method and Assumptions

Results

Policy Recommendation

See memo for Cincinnati Vehicle Emissions Inspections case as a model for this kind of policy/decision memo.

GROUND RULES AND INSTRUCTIONS

(1) You are encouraged to form. working groups (of no more than 3) to collaborate on the analysis.

(2) You can write the memo individually, or as a group of no more than 3.

(3) To complete the assignment, post two things on the assignment tab in Canvas:

* your memo in Word, which should include the tables as at the end of the memo under the

   heading “Tables” (NOT AS AN APPENDIX).

* a copy of your spreadsheet work.

(4) If you do the assignment as a group, be sure to put all group member names on the memo/spreadsheet.

(5) If you do your assignment as a group, you can post one assignment (memo/spreadsheet) per group.

(6) Do the  analysis from the end of 2020 perspective. Thus, for discounting purposes, period zero is 2020, period 1 is 2021, etc.

Comment 1: This analysis implicitly assumes that consumers are making a purchase decision about the hybrid version of the Honda Accord purely as an investment option with this question to be answered: do the fuel bill savings justify the additional costs?  In fact, many hybrid owners are likely to make the decision to drive hybrids because they want to be socially responsible citizens, e.g., to lower their carbon footprint. This group may be willing to buy hybrids even if the fuel bill savings do not cover the costs. Given this, it might be useful to think about this analysis as a way to encourage hybrid purchases beyond the group who would buy them anyway. That is, the purpose of the subsidies is to expand the purchase of hybrids to consumers who would not be considering the social benefits of driving hybrids, but would just be comparing the benefits of long-run fuel bill savings to the higher initial expense.

Comment 2. It might (or might not) make sense to subsidize hybrid vehicle fleets used as “company cars” by business firms, or to subsidize hybrid use in ride hailing services, or taxi companies. Some of these companies may have thin profit margins, and not be able to purchase more expensive cars when the cost is not covered by private fuel savings.

Note: B1+T2+T3=consumer fuel expenditure savings, which equals avoided fuel tax payments, plus net-of-tax fuel expenditures.

The retail price differential of the hybrid (before sales tax) is C1.

The after sales-tax price differential is T1+C1.

So the net for consumers is the difference between avoided fuel expenses (B1+T2+T3) less the incremental price of hybrids (T1+C1).

All figures in the table should be discounted present values.

Table 2: Data on Alternatives

NOTE: For the analysis, assume (1) equal country-city driving (2) battery replacement cost of $14,500, and (3) battery replaced in the 10^th year for 10,000 mile driving scenario, and 8^th year for 20,000 mile driving scenario.

Other Basic Assumptions

● Operation and maintenance (O&M) costs: no difference between options

● Insurance costs: no difference between options.

● Average vehicle life: 15 years/no salvage value at end:  no difference between options (it does not matter to the analysis whether the car is sold, and resold during this period. It is simplest therefore to treat it as a single ownership over the whole period)

● Driving behavior. assume no difference between options:

Low: 10,000 miles per year

High: 20,000 miles per year

Equal mix of city and highway driving

Table 5: Societal Costs of Automobile Usage, Excluding Carbon ($2021)

**Note: this was listed as $.52 per mile. I took about half of this figure, because local auto emissions are controlled by catalytic converters, so reducing fuel consumption doesn’t necessarily reduce pollution that much. And these external costs are at least partially related to miles driven, which we are assuming is the same for both vehicles

***I have included mileage related externalities just to show the external costs of driving beyond what the driver themselves imposes. However, YOU SHOULD NOT INCLUDE THESE IN THE ANALYSIS. REASON? WE’RE ASSUMING THAT THE MILES DRIVEN BY BOTH HYBRIDS AND NONHYBRIDS ARE THE SAME. SO THESE EXTERNAL COSTS DON’T VARY ACROSS OPTIONS.

Source: Parry, I. W. H., Walls, M. & Harrington, W. (2007). Automobile externalities and policies. Journal of Economic Literature, XLV, 373–399.