A January deadline looms for a U.S. law that will go into effect requiring the use of advanced biofuels, but producers of cellulosic biofuel are not on track to meet the Renewable Fuel Standard until 2012, and the shortfall  will likely drive up the price of the fuel, according to a report.

The report published last week by investment bank ThinkEquity forecasts that in 2010 the U.S. will produce no more than 28.5 million gallons of cellulosic biofuel, or 81.5 million gallons short of the RFS mandate.

“I think the industry will be playing catch up to the RFS for a number of years,” said David Woodburn, the ThinkEquity analyst who wrote the report.

The Energy Independence and Security Act of 2007 calls for the U.S. fuel market to use 100 million gallons of cellulosic biofuel in 2010, increasing rapidly to 16 billion gallons per year by 2022.

Mr. Woodburn estimates that cellulosic biofuel production will sharply increase by 2011 and be just shy of the 250 million gallons required that year. But he cautioned that his figures are best-case scenarios based on capacities of plants that are not yet built. It can take months or years before a facility reaches full capacity even after it has come online. And there are currently no cellulosic biofuel plants in commercial production.

But dozens of startups and established ethanol makers with millions of dollars in venture backing and other financing are racing to develop cellulosic biofuel. The hope is that the next-generation fuel—which is made from fast growing grass, agricultural waste and other biomass sources—eventually will be cheaper and cleaner than gasoline while not depending on food crops, like corn, as a feedstock.

Broomfield, Colorado-based Range Fuels’ 10 million gallon-per-year facility, scheduled to open in late 2009 or early 2010, is likely to be the first commercial  cellulosic plant, according to the report. Other large cellulosic plants that should come online by 2011: Sioux Falls, S.D.-based POET’s 25 million GPY plant and Cambridge, Mass.-based Verenium’s 36 million GPY plant.

But the near-term shortfall could work in the fledgling industry’s favor. Because of a little-known rule adopted as part of the RFS, the Environmental Protection Agency has the authority to require fuel retailers to buy credits to make up the difference between cellulosic biofuel production and the mandated volumes. This is the government’s “stick” for forcing demand for the fuel.

The credits will be sold for up to $3 per gallon, depending on the price of gasoline. The higher the price of gasoline, the cheaper the credits, and vice versa. What that means, said Mr. Woodburn, is that if there is a shortfall of cellulosic biofuel, the price of the fuel should be driven up to close to $3 per gallon—or the point at which retailers would break even between buying credits or buying the fuel on the open market.

The government, in effect, has created a minimum price for cellulosic biofuel through to 2022 as long as there is a production shortfall.

Future contracts for ethanol, the dominant biofuel in the market today, currently trade at about $1.50 per gallon. As long as cellulosic ethanol production is at or below the RFS mandates, at current prices producers could sell the fuel for nearly twice as much as their corn-based competitors.

That’s good news for a young industry that could use the breathing room as it ramps up production, improves its technology, and decreases costs.

But the credits and even the RFS mandates can be changed on a yearly basis at the discretion of the EPA. Because of that lack of certainty, Jim Imbler, chief executive of biofuel startup ZeaChem in Colorado, said the $3 price isn’t driving his company to move more aggressively into the market.

“If I move on an option, then I’m a gambler,” Mr. Imbler said.

The company’s goal is to produce cellulosic ethanol for less than $1 per gallon. ZeaChem is building a 1.5 million GPY pilot plant in Oregon to begin production in early 2009.

“We’re on a path that may not meet government mandates but that does meet economic realities,” Mr. Imbler said.

Industry observers believe cellulosic biofuel will need to drop below $1 per gallon to be cost competitive with gasoline, which currently sells on wholesale markets for about that price. But the cost of the fossil fuel has dramatically declined recently, dropping below $50 per barrel this month from a high of $150 in the summer.

Wes Bolsen, VP of business development for Coskata, a cellulosic biofuel startup in Illinois, said his only worry is that the shortfall could lead people to call for removing the RFS mandates.

“We cannot lose our resolve because the industry is in its infancy,” he said. “Even if we’re 50 million gallons short, that is one-half of a corn ethanol plant.”

Corn ethanol plants have capacities as high as 250 million gallons per year, with the average being about 100 million in the United States. But if cellulosic biofuel producers are going to meet the 16 billion GPY mandate by 2022, they’ll need more than just one of those corn ethanol-sized plants.