The already dismal outlook for cellulosic biofuels–a type of fuel made from sources such as grass and wood chips–just got worse. For the second year in a row, the U.S. Environmental Protection Agency will drastically cut the amount of cellulosic biofuels that oil companies are required to blend into their fuel stocks under its Renewable Fuels Standard. This year’s mandate was supposed to be 100 million gallons of cellulosic biofuels, but that was reduced to 6.5 million. Last month, the EPA announced that it would lower the requirement in 2011, from 250 million to somewhere between five million and 17.1 million gallons.

The EPA is doing this because not enough cellulosic biofuel is being produced to meet the targets. So far, no commercial plants have been built–just some small pilot and demonstration-scale plants.

The market for cellulosic biofuels seemed assured after Congress passed the Renewable Fuels Standard in 2007, which by 2022 would require 16 billion gallons of these fuels every year. It required gasoline and diesel companies to blend biofuels made from cellulosic materials into their supplies. Now the companies hoping to provide cellulosic biofuels to the oil industry are struggling, and they are years behind schedule, having failed to collect the financing needed to build large commercial biorefineries.

Several leaders in the cellulosic biofuels industry argue that the technology is ready–it’s just that the recession has severely limited the amount of financing available, and the funds that are available for clean energy are largely going to solar and wind projects, which are getting more direct government support. The mandates could provide vital help, they argue, by encouraging oil companies to give their backing to cellulosic biofuel.

“There are production facilities that are queued up to be built, but they’re getting hung up by the capital markets and the bankers,” says John McCarthy, CEO of the cellulosic ethanol startup Qteros, based in Marlborough, MA. Maintaining the original levels of the mandates would help open up financing, and lowering them “has taken the legs out from under that required demand,” he says. “Unless the EPA and the White House hold firm on the level of mandated demand, then you might as well not have a Renewable Fuels Standard.”

According to the Biotechnology Industry Association (BIO), at least a dozen commercial cellulosic biofuel projects are ready to be built, pending financing, that together could supply a couple hundred million gallons of fuel. Commercial plants are expected to cost between $100 million, for a plant added to an existing corn ethanol facility, to as much as $600 million, including financing costs, for a completely new facility.

Several cellulosic biofuel industry leaders are calling on Congress to change a law that directed EPA to lower the mandates to match cellulosic ethanol supplies. Under their scenario, if the mandate were to exceed the amount of cellulosic fuel produced, so that oil companies could not buy enough to satisfy the requirement, they would be penalized. “If the EPA chose not to waive those gallons, the oil companies would have to pay a per-gallon penalty” for the amount that they could not blend, says Matthew Carr, a policy director at BIO.

The penalties would give the oil companies a reason to support the construction of cellulosic biofuels plants, says Wes Bolsen, VP of government affairs at Coskata, based in Warrenville, IL. “You need to put a stick in the oil companies’ backs to say, you need to start building something to meet your obligation under the Renewable Fuels Standard,” he says.

The mandates, even in their reduced form, are somewhat helpful. They guarantee a market for the cellulosic fuel produced, since the EPA says it will match the mandate to what cellulosic biofuels companies can produce. But Bolsen and others say this isn’t enough to overcome the risk aversion of the banks. Unlike wind and solar projects, banks are particularly reluctant to finance cellulosic biofuels plants because no commercial ones have yet been built. “It’s really about getting the first plant built,” Bolsen says. If that plant is successful, he believes this would prove to investors that the technology works, and make them more willing to invest in other plants. “After the first plant is open, banks will be begging to help finance them,” he says.

Industry representatives are calling for other changes to help get money flowing for new biorefineries. Some would like President Obama to instruct the U.S. Department of Energy to be more lenient in its requirements for loan guarantees to support new plants. Many also support a provision in a bill now being considered in Congress that would provide a large tax credit on investments in advanced biofuels plants–something they argue would put biofuels on par with solar and wind projects, which already qualify for such help.

But not everyone thinks so much government support is necessary. Funding can be found, says Carrie Atiyeh, director of public affairs at ZeaChem, based in Lakewood, CO, but the industry might not grow as fast as the government intends. “If the EPA is really serious about its goal of 16 billion gallons by 2022, we will need some initial help to accelerate the process.”