The skyline of downtown Los Angeles through a layer of smog is seen in the distance from a rooftop in Hollywood, California, May 31, 2006. REUTERS/Fred Prouser/Files

By Cezary Podkul

NEW YORK (Reuters) - With two words, the U.S. environment regulator may be handing oil refiners the biggest win of a long battle to beat back the seemingly inexorable rise of ethanol fuel.

In a leaked proposal that would significantly scale back biofuel blending requirements next year, the U.S. Environmental Protection Agency (EPA) says the blend wall - the 10 percent threshold of ethanol-mixed gasoline that is at the crux of the lobbying war - is an "important reality".

The agency's rationale for a cut in the volume of ethanol that must be blended echoes an argument the oil industry has been making for months: the U.S. fuel chain cannot absorb more ethanol.

Few retailers are able to sell ethanol blends beyond the 10 percent maximum, or willing to take the legal risk that comes with it, they argue.

The words will cut deep for proponents of biofuels. They have argued for years that the blend wall is largely a fiction constructed by an oil industry that doesn't want to cede any more share of a shrinking U.S. gasoline market.

If approved, the proposed cut in the biofuel mandate in 2014 to 15.21 billion gallons from 18.15 billion would mark an historic retreat from the ambitious 2007 Renewable Fuel Standard (RFS) law that charted a path toward ever-greater use of clean, home-grown fuel, which the biofuel industry counts on to underpin bank loans and new factories.

Even though the EPA proposal has not been publicly released or approved by the White House, both sides are gearing up to shift the fight over the future of the country's fuel supply to a new venue: the courts.

This week two U.S. oil industry groups sued the EPA over its 2013 biofuel targets. On Thursday, their opponents appeared to signal a likely challenge to the 2014 rule.

"Let me be clear: any plan to roll back the targets ... under the guise of addressing the blend wall would be patently unlawful," said Bob Dinneen, president of the Renewable Fuels Association, an industry group.

The EPA's proposal puts ethanol proponents in a tough spot.

The Renewable Fuels Association has previously argued that Congress need not amend the 2007 law because the EPA has enough flexibility under the law to make changes to reflect market realities. The agency is now exercising some of that discretion - but certainly not as proponents would like.

The law has run up against an unexpected reversal in U.S. gasoline use, an emboldened oil industry saddled with soaring ethanol credit costs, and differences over what kind of fuel can be safely used in today's cars.

The EPA has ruled that gasoline blended with as much as 15 percent ethanol (E15) is safe for use in cars made after the 2001 model year.

But most car warranties only cover use of up to 10 percent ethanol, or E10. And most service stations don't sell anything more than E10 due to a lack of infrastructure to distribute higher blends or concerns over liability if motorists use the wrong pump.

'INADEQUATE DOMESTIC SUPPLY'

The mechanism for the EPA's proposed rollback is an escape hatch called a "general waiver" that Congress built into the 2007 law. This can be used to reduce the volumes in two cases: if enforcing the law were to cause economic hardship; or if it were simply not feasible due to "inadequate domestic supply".

The EPA has set a high bar for the economic hardship scenario. Last year, the worst drought in 50 years prompted a waiver petition from several state governors and food producers concerned about the soaring price of corn, the main ingredient for domestic ethanol production. The EPA denied the request.

This year, with the blend wall concerns forcing a jump of almost 2,800 percent in the cost of credits used to enforce the ethanol mandate, the agency itself is proposing for the first time to use a waiver, citing a lack of usable fuel.

Ethanol supply is certainly not the problem. Bouncing back from last year's drought, the corn industry is looking at a record crop this year. And production of other biofuels, such as biodiesel - a kind of diesel that can be made from recycled cooking oil - is continuing at a healthy pace, EPA data shows.

Instead, the agency appears to be viewing the blend wall as a factor: "We interpret the term 'inadequate domestic supply' as it is used under the general waiver authority to include consideration of factors that affect consumption of renewable fuel," the agency wrote in the proposed rules.

Story continues