The following correction was printed in the Observer's For the record column, Sunday 21 February 2010

This item contained incorrect information supplied by the Defence Advanced Research Projects Agency (Darpa). We repeated its assertion that jet fuel production from refined algae would begin next year. Darpa now says that it should have told us that testing will begin next year with production not planned until 2013.

The brains trust of the Pentagon says it is just months away from producing a jet fuel from algae for the same cost as its fossil-fuel equivalent.

The claim, which comes from the Defense Advanced Research Projects Agency (Darpa) that helped to develop the internet and satellite navigation systems, has taken industry insiders by surprise. A cheap, low-carbon fuel would not only help the US military, the nation's single largest consumer of energy, to wean itself off its oil addiction, but would also hold the promise of low-carbon driving and flying for all.

Darpa's research projects have already extracted oil from algal ponds at a cost of $2 per gallon. It is now on track to begin large-scale refining of that oil into jet fuel, at a cost of less than $3 a gallon, according to Barbara McQuiston, special assistant for energy at Darpa. That could turn a promising technology into a ­market-ready one. Researchers have cracked the problem of turning pond scum and seaweed into fuel, but finding a cost-effective method of mass production could be a game-changer. "Everyone is well aware that a lot of things were started in the military," McQuiston said.

The work is part of a broader Pentagon effort to reduce the military's thirst for oil, which runs at between 60 and 75 million barrels of oil a year. Much of that is used to keep the US Air Force in flight. Commercial airlines – such as Continental and Virgin Atlantic – have also been looking at the viability of an algae-based jet fuel, as has the Chinese government.

"Darpa has achieved the base goal to date," she said. "Oil from algae is projected at $2 per gallon, headed towards $1 per gallon."

McQuiston said a larger-scale refining operation, producing 50 million gallons a year, would come on line in 2011 and she was hopeful the costs would drop still further – ensuring that the algae-based fuel would be competitive with fossil fuels. She said the projects, run by private firms SAIC and General Atomics, expected to yield 1,000 gallons of oil per acre from the algal farm.

McQuiston's projections took several industry insiders by surprise. "It's a little farther out in time," said Mary Rosenthal, director of the Algal Biomass Association. "I am not saying it is going to happen in the next three months, but it could happen in the next two years."

But the possibilities have set off a scramble to discover the cheapest way of mass-producing an algae-based fuel. Even Exxon – which once notoriously dismissed biofuels as moonshine – invested $600m in research last July.

Unlike corn-based ethanol, algal farms do not threaten food supplies. Some strains are being grown on household waste and in brackish water. Algae draw carbon dioxide from the atmosphere when growing; when the derived fuel is burned, the same CO 2 is released, making the fuel theoretically zero-carbon, although processing and transporting the fuel requires some energy.

The industry received a further boost earlier this month, when the Environmental Protection Agency declared that algae-based diesel reduced greenhouse gas emissions by more than 50% compared with conventional diesel. The Obama administration had earlier awarded $80m in research grants to a new generation of algae and biomass fuels.

For Darpa, the support for algae is part of a broader mission for the US military to obtain half of its fuel from renewable energy sources by 2016. That time line meant that the Pentagon needed to develop technologies to make its hardware "fuel agnostic", capable that is of running on any energy source including methane and propane.

The US Air Force wants its entire fleet of jet fighters and transport aircraft to test-fly a 50-50 blend of petroleum-based fuel and other sources – including algae – by next year.

The switch is partly driven by cost, but military commanders in Afghanistan and Iraq are also anxious to create a lighter, more fuel-efficient force that is less dependent on supply convoys, which are vulnerable to attack from insurgents. Give the military the capability of creating jet fuel in the field, and you would eliminate that danger, McQuiston said. "In Afghanistan, if you could be able to create jet fuel from indigenous sources and rely on that, you'd not only be able to source energy for the military, but you'd also be able to leave an infrastructure that would be more sustainable."

McQuiston said the agency was also looking at how to make dramatic improvements in the photo-voltaic cells that collect solar energy. She said making PV 50% more efficient would create a future when even the smallest devices, such as mobile phones, would be ­powered by their own solar cells.