By John Carey

A horde of startups have smart ideas. But the challenges are many, and the winners likely will be Shell, BP, DuPont, and other majors.

It's a bold vision: Replace billions of gallons of gasoline not with ethanol from corn or other food crops but with biofuels made from plants, such as prairie grass in Tennessee pastures or algae percolating in Florida. Such a move would slash dependence on oil, create thousands of jobs, and reduce emissions that contribute to global warming. In the U.S., the idea has powerful political support. Congress has decreed that the country must be using 21 billion gallons of "advanced" biofuels a year by 2022. Washington is backing that goal with tax breaks, loan guarantees, and scores of millions of dollars in grants, with more support expected in upcoming energy bills. These inducements and the vast potential market have stimulated investments of more than $3 billion and spawned a new industry.

More than 200 companies, from 12-person startups to oil giants, are developing next-generation biofuels using a bewildering array of technologies. Pilot and demonstration plants are operating or are under construction from Florida to California. "We can have it all: more fuel, more food, and fewer carbon emissions," says John B. Howe, vice-president of Verenium (VRNM), a Cambridge (Mass.) company that makes ethanol from sugarcane waste at a demonstration plant in Jennings, La.

Yet behind the very real innovations and investments, the brash claims and the breathless headlines, lies an inconvenient truth. Replacing petroleum with biofuels is a tough business. Even as the industry develops, many of the companies—probably most—will not survive. "We've seen a venture capital-led bubble," says Alan Shaw, CEO of Codexis, a Redwood City (Calif.) manufacturer of enzymes used to make drugs, chemicals, and biofuels. "I cannot see how the small companies can build a business and still get a return to their original investors. The numbers just don't add up."

Nor will many Americans soon be filling their gas tanks with these next-generation fuels. Industry executives concede they'll fall far short of the mandated 2010 level of 100 million gallons of biofuels made from cellulosic materials such as prairie grass or cornstalks. Meeting the 2022 goal is also unlikely. It would require not only building hundreds of fuel factories—at a cost of $500 million or more each—but also surrounding each one with thousands of acres of land planted with energy crops such as prairie grass. "We're talking about a fairly substantial transformation of the rural economic landscape," says Jack Huttner, vice-president of DuPont Danisco Cellulosic Ethanol, a joint venture of Danisco and DuPont (DD) that is building a demonstration plant in Tennessee.

These difficulties don't mean advanced biofuels aren't coming, or that they won't play a crucial role in fighting climate change. But everything will happen more slowly than many venture capitalists say. And the probable winners will be those with deep pockets and patience, such as Royal Dutch Shell (RDS), BP (BP), DuPont, agriculture giant Archer Daniels Midland (ADM), or the rare startup with revenues from another business, such as making drugs. For the rest, the demonstration biorefineries now being built are more like high-stakes auditions than a step in the process of becoming commercial biofuels producers. "The business model that makes sense for most of us is demonstrating the technology and getting it into the hands of those who have balance sheets," says Bill Roe, CEO of biofuel producer Coskata in Warrenville, Ill.

Yet even with this strategy, there's a problem for individual companies: There could be a glut of innovative biofuel technologies, from clever microbes to processes using heat and chemicals. As startups stumble, big companies should be able to snap up technologies on the cheap, when and where they need them.

For the companies that do succeed in building a business, the irony is that their success will only increase the challenges. Right now the feedstocks of plant or waste materials needed for biofuels are cheap. BlueFire Ethanol Fuels (BFRE) hopes soon to break ground on a facility in Lancaster, Calif., that will use paper trash and other municipal waste. CEO Arnold R. Klann figures he'll make ethanol for $1 per gallon by getting the waste he needs for free—or better. "If communities are paying Waste Management (WMI) to take their waste away, they can pay me to take it, too," he says. Trouble is, the economics will change. Rising biofuel production, or the burning of biomass to generate electricity, will drive up demand and prices for the raw material, just as production of corn ethanol helped raise the price of that crop. "Biomass is cheap right now because no one wants it. As people want it, it will become more expensive," says Robert Chess, chairman of OPX Biotechnologies in Boulder, Colo., which is engineering microbes to make chemicals and fuels.

More important, the laws of supply and demand mean that replacing a significant amount of gasoline with biofuels would drastically lower the demand for gas. That, in turn, would cause the price of gas to plunge, making biofuels less competitive. The 5% drop in gasoline use in the second half of 2008 (compared with the previous year) helped push down the average price at the pump from $4.14 per gallon to $1.74, dampening enthusiasm for biofuels. "Low oil prices have a numbing effect on consumers and their interest in this area," says David C. Aldous, CEO of Colorado's Range Fuels, which is building a plant in Soperton, Ga. Imagine what would happen if tens of billions of gallons of biofuel were to become available. The world could be awash in cheap oil and gas.

It has happened before. In the early 1980s, higher-mileage cars and an economic downturn sent petroleum prices swooning, killing off many renewable-energy efforts, including those supported by Big Oil. Avoiding that scenario today requires an additional policy step: raising the cost of using fossil fuels through taxes or limits on carbon dioxide emissions. "The major thing holding us back is the lack of a price on carbon," says Jim McMillan, a biofuels expert at the National Renewal Energy Laboratory (NREL) in Golden, Colo.

The crucial need for putting a price on carbon emissions is also a reminder that the industry is still pretty much a government creation. "The reason why renewable fuels exist at all is because politicians have decided they meet policy objectives. The whole market is 100% political," says Jeff Passmore, executive vice-president of Ottawa-based Iogen, the first company to make ethanol from a cellulosic feedstock—in this case, wheat straw. Those policy objectives: reducing energy dependence, fighting climate change, helping farmers, and creating jobs. But government policy can be fickle. Philip New, head of biofuels for BP, isn't so much worried that advanced biofuel technology won't pan out as he is that "the world might lose its enthusiasm for supporting these technologies through the difficult interim years," he says.

Even if the political winds do blow steady, however, the carnage on the path to the future's billions of gallons of advanced biofuels is likely to be great, with many companies and technologies losing out in the competition or being gobbled up by a few deep-pocketed survivors.

Source : BusinessWeek