An Economic Model of Brazil’s Ethanol-Sugar Markets and Impacts of Fuel Policies

We develop an economic model of flex plants, export demands and two domestic fuel demand curves: E25, a 25 percent blend of ethanol with gasoline consumed by conventional cars, and E100, ethanol consumed only by flex cars. This allows us to analyze the market impacts of specific policies, namely the E25 blend mandate, fixing gasoline prices below world prices, the high gasoline tax, and a higher tax exemption for ethanol used in E25. Because Brazilian and U.S. ethanol prices have become linked, a change in Brazilian ethanol policy or a shock in world sugar markets can now impact U.S. ethanol and corn prices. Because of two demand curves, with flex car owners switching between fuels depending on relative prices, and because the mandate is for E25 only, the impact of each Brazilian policy in theory has an ambiguous impact on ethanol and sugar prices. Conventional wisdom is that a higher level of the mandate, gasoline tax exemptions for ethanol and gasoline price, and a lower gasoline tax, all help the ethanol industry. But for two policies, a low gasoline tax and a high tax exemption for ethanol used in E25, our empirical results show ethanol and sugar prices decline. Overall, we find that the package of policy reforms implemented in 2010 offset the ethanol price increase due outward shifts in fuel transportation and sugar export demand curves, and reduced sugarcane supply due to bad weather, by about 27 percent. Our model illustrates the importance of Brazil’s ethanol policies on world commodity markets and provides insights on how the Brazilian government can adjust policies to better control domestic inflation while minimizing impacts on investment.