Consumer value of fuel choice flexibility - a case study of the flex-fuel car in Sweden

Niclas A. Krger 0 1 3 Alexander Haglund 0 1 3 0 N. A. Krger TRENoP, Royal Institute of Technology , Stockholm, Sweden 1 N. A. Krger Centre of Transport Studies , Stockholm, Sweden 2 ) Swedish National Road and Transport Research Institute , Linkping, Sweden 3 A. Haglund Department of Economics, Karlstad University , Karlstad, Sweden Purpose This paper examines the value of fuel choice flexibility derived from a flex-fuel engine. Method Based on the stochastic properties of fuel prices, we use Monte-Carlo simulation in order to value the option to switch fuel. Results Our findings indicate a considerable value of fuel choice flexibility, ranging between 7,500 and 37,800 SEK, depending on the underlying stochastic process we assume that fuel prices follow. This can be compared to the state subsidy of 10,000 SEK provided until recently for buying a flex-fuel car. Conclusion Compared to an environmentally friendly pure ethanol strategy, the switching strategy is considerably less costly, about 2,000-19,000 SEK depending on the assumed underlying stochastic process, a fact that is important to take into consideration with environmental policy. - shifted towards environmentally friendly alternatives and producers are forced by market demand and regulation to develop green commodities. Consumers are today more concerned than ever with how the products they use impact on the environment during the course of manufacture, distribution, usage and disposal. The car industry, for example, has long been the main object of debate regarding emission reduction targets because of the impact of car emissions on the environment and health. At the same time, until recently, only fossil fuels have been used for road transportation and these are exhaustible resources. There is consequently now a demand for renewable fuels with low emissions. However, the problem is not limited to the source and nature of fuel: engines must also use the fuel efficientlythat is, only a small fraction of energy should be lost during the transformation process (the conversion of the energy contained in the fuel into force on the car wheels). The type of motor most popular at the moment as a green alternative is the so-called flex-fuel motor, which is capable of using different proportions of gasoline or ethanol, for example E85 (Ethanol 85 % plus 15 % gasoline). Cars with this adaptation are classified as green cars in Sweden and until recently entitled the owners to a public payment of 10,000 SEK (approximately 1,200 EURO). Car producers in turn demand a higher price for these cars, partly reflecting the higher cost of production and partly a result of profitmaximizing price differentiation. Sweden has become the third leading country for green cars based on ethanol after Brazil and the US. An important difference, however, is that Sweden imports most of the ethanol it uses, whereas the US and Brazil are both self-sufficient [8]. The flex-fuel car has previously been analyzed by means of option valuation in Bastian-Pinto et al. [2]. In this paper we try to establish whether the results previously found will hold even in the European car market, where Sweden is the largest market for flex-fuel cars. There are many differences between Brazil and Sweden which might influence the time series properties of gasoline and E85. This might in turn influence the option value derived from the flex-fuel engine. This paper uses real option valuation based on the time series properties of fuel prices and Monte-Carlo simulation in order to examine whether there is a consumer value derived from the flexibility to choose the fuel used in a flex-fuel engine. In section 2 we present the development of the green car market in Sweden and the legal background and incentives provided by the state in order to promote green cars. Some earlier research results are also given in section 2. In section 3 we move on to the methods used in this paper. In section 4 we perform the analysis of the switching option based on the time series properties of ethanol and gasoline prices. The approach we use follows closely the analysis by Bastian-Pinto et al. [2]. Our findings indicate a considerable value of fuel choice flexibility, ranging between 7,500 and 37,800 SEK, depending on the underlying stochastic process we assume that fuel prices follow. This can be compared to the state subsidy of 10,000 SEK provided for buying a flex-fuel car and the flexi-fuel premium charged by Volvo of 6,000 SEK. The paper concludes in section 5 with a discussion of our results. 2 The flex-fuel car in Sweden The flex-fuel car was first introduced in Sweden in 1994, when three Ford Taurus flex-fuels were imported from the US. Compared to a so-called bifuel-driven car, the flex-fuel engine allows for differing proportions of ethanol in the fuel [2]. The idea was to demonstrate that the technology existed and that it worked in practice [7]. The public responded with great interest and in February 1995 a project was initiated to import 50 flexfuel cars, which ended up in different parts of Sweden. Only one chain of gas stations agreed to make ethanol available. In 1998 Stockholm City, in cooperation with the Swedish FFV Buyer Consortium, offered to buy 2,000 flex-fuel cars from any car producer capable of delivering them. The purpose of this initiative was to incentivize car manufacturers to start up production of flex-fuel cars by providing a secure buyer and thereby give Sweden a first-mover advantage in the technology. However, the two Swedish car manufacturers, Saab and Volvo, declined this offer, as did other European manufacturers. The car producers gave the insufficient number of gas stations with ethanol as their reason for this, while fuel providers gave the insufficient number of flex-fuel cars as their reason for not building ethanol gas stations. It was the American division of Ford that accepted the offer, making it possible for Sweden to import the flex-fuel version of Ford Focus [8]. Hence, Ford became the first company offering a flex-fuel car to Swedish consumers. The first car was delivered to a customer in 2001 and in 2005 more than 15,000 Ford Focus with flex-fuel engine were sold in Sweden, a market share of 80 % of flex-fuel cars. During 2005 the Swedish manufacturers Volvo and Saab introduced their flex-fuel models. Figure 1 shows the exponential growth in sales of flex-fuel cars 20012008 and the subsequent decline. Sweden is still the country in Europe with the most flex-fuel cars. The number of gas stations providing ethanol has increased in a similar way since the introduction of the first station providing ethanol in 1995, with the number reaching 1,400 in 2009 (SEKAB 2009). The ratio of ethanol gas station to flex-fuel cars is very high in comparison with the US, where six million flex-fuel cars share about 1,500 ethanol gas stations. Politics and legal regulation have had a major impact on the introduction of the flex-fuel car a (...truncated)