The Environmental Protection Agency last week announced a proposal to reduce mandatory volume obligations, or the amount of biofuels that must be blended or sold into the nation's fuel supply, for 2014. This would mark the first time the agency has scaled back its ambitions since the current Renewable Fuel Standard, or RFS, was announced in 2007. While it makes sense to reduce first-generation ethanol volumes, the agency's plans for cutting or freezing other fuel volumes are highly questionable.

Refiners such as Valero (NYSE:VLO) will enjoy the stability the proposed ethanol blending requirements will bring to the Renewable Identification Number, or RIN, markets, especially considering next year's targets are well below the industry's capacity. That's very bad news for producers such as POET, Green Plains Renewable Energy (NASDAQ:GPRE), and Archer Daniels Midland, however. Meanwhile, freezing biodiesel volumes for the next two years will also bring uncertainty to high-growth producers such as Renewable Energy Group (NASDAQ:REGI) and Darling International (NYSE:DAR). Let's go fuel by fuel and dissect what the proposals mean for the industry and your investments.

At a glance
The proposal for 2014 calls for the following volumes of renewable fuels:

Source: EPA

To put the proposed cuts in perspective, consider that the RFS originally called for about 18.15 billion gallons of renewable fuel in 2014. Most of the reduction comes from corn ethanol, which has a target of 11.73 billion gallons for next year -- much lower than the 13.8 billion that will be produced this year. Advanced biofuels, which include isobutanol, electric vehicles, compressed natural gas, and hydrogen, will be slashed from the original goal of 3.75 billion gallons, while biomass-based diesel targets will be held at 2013 levels through 2015 if the mandate is finalized.

What it means for corn ethanol
The EPA has come back to reality to acknowledge that trends in rising fuel economy and declining fuel consumption don't quite jive with the first-generation ethanol mandates it set back in 2007. The Blend Wall, or the 10% blending ratio limit for gasoline, was cited as the main reason for the reduction -- something the refining industry has been trying to bring attention to for years. Unfortunately, it doesn't take much skill to see that our transportation system cannot support large volumes of better, more efficient, and more sustainable fuels in addition to 12 billion gallons of corn ethanol each year. The numbers simply don't work.

While ethanol producers had sharp words for the proposal, reductions are necessary and are far from over. Expect to see smaller producers squeezed out of the market, while larger producers idle facilities. Extra capacity could spur the E85 market, but it will be difficult to dump an extra 2 billion gallons of ethanol anywhere. The ultimate EPA goal should be to transition away from first-generation corn ethanol and to more sustainable next-generation ethanol and nonethanol blend stocks. That's easier said than done, and cellulosic technology has some hurdles to overcome, but we can't make room for both.

What it means for cellulosic ethanol
Cellulosic ethanol has been "X years away" for the last decade. There is real progress being made on multiple fronts, however. KiOR has pioneered a novel thermocatalytic process at its first commercial scale facility, while POET-DSM is bringing Project Liberty online in early 2014 to advance fermentation technologies. Several more promising futuristic projects are being funded by energy giant Total and expected to make substantial contributions by the end of the decade.

At the end of the day, however, the capacity just isn't there, which makes the low targets understandable. The EPA can't mandate that refiners blend fuel that doesn't exist and penalize them when they don't. Well, hopefully not anymore.

What it means for biodiesel
The proposed freezing of targets for biodiesel makes absolutely no sense. What do you expect from an agency that was this slow to react to the long-foreseen problems with ethanol volumes, though? Unlike ethanol, biodiesel is nowhere near the boogeyman Blend Wall. In fact, there is no accepted national blend percentage for the fuel, although the current blend of 1.16% has a very long way to go before reaching the theoretical limit of 7%.

Darling and Valero's new Diamond Green Diesel joint venture started operations at this 137 mmgy facility. How will the proposed targets affect the JV? Source: Darling International.

The proposal is quite the head-scratcher given the differences between the diesel and gasoline supply and explosion in capacity from Renewable Energy Group and Darling. The two companies alone are set to add more than 285 million gallons of annual capacity between this year and 2015. I'd expect the agency to revise its proposal for biodiesel volumes upward before finalizing 2014 mandates. Unfortunately, the increase may not be the 200 million gallon advance the industry has come to expect in the last six years.

What is means for advanced biofuels
Once again, the new targets make little sense for the heterogeneous category called advanced biofuels. The proposal is probably more realistic given market conditions. But if the major problem with fuel volumes is the dreaded ethanol Blend Wall and advanced biofuels are completely separate from gasoline blends, why reduce targets for the category? Since most technologies have yet to be implemented on a large scale and are being developed to be competitive without subsidies, there shouldn't be many consequences for the new targets, anyway.

Foolish last word
It appears that the EPA has yet to learn its lesson on the realities of the fuel market and has instead chosen to make knee-jerk, last-minute reactions. If I were the agency I would take this opportunity to slash corn ethanol mandates to address concerns about the Blend Wall, while simultaneously pushing next-generation fuels. Subsidies could be shifted away from corn ethanol and into less established technologies. The industry will surely respond in full force to the proposal before the agency reviews and finalizes 2014 targets. At this point, however, how much faith can we have that it will get it right?