HENRY FORD dubbed ethanol “the fuel of the future” and planned to run his ubiquitous Model T car on it. Unfortunately, the discovery of cheap petrol and the prohibition of alcohol in America in 1920 put the brakes on his plans.

But now ethanol, a type of alcohol, is making a comeback. It is one of two biofuels — fuels made from plants rather than pumped out of the ground — that are being driven into the limelight by fears over climate change.

Governments across Europe have encouraged biofuel for several years, but last week’s Stern report into the economic consequences of global warming gave producers an extra boost. In what Tony Blair called “the most important report on the future I have received since becoming prime minister”, Sir Nicholas Stern, a former chief economist at the World Bank, warned of a serious economic downturn unless prompt action was taken to reduce greenhouse gases.

“Stern added that extra impetus,” said Sean Sutcliffe, chief executive of Biofuels Corporation, a manufacturer of biodiesel. “He has focused minds on what can be done now — like biofuels — rather than waiting for some long-term solution like fuel cells or electric cars.”

Elliott Mannis, chief executive of D1 Fuels, a rival biodiesel group, agreed. “He (Stern) has put in place a background to the debate, and made people think directly about how we will tackle climate change.”

European governments have other reasons for liking biofuels. They may provide a lifeline to politically important farming communities, and have the potential to reduce reliance on imported fossil fuels.

But despite generous incentives, including a tax rebate of 20p a litre, their use in Britain is still minimal (see chart above). Last year the government upped the ante by introducing the Renewable Transport Fuels Obligation, which forces fuel distributors to use 5% biodiesels by 2010.

If they do not meet the target, to be progressively phased in from 2008, they will have to pay a penalty of 15p a litre — later it will be raised to 30p. Similar measures by other governments mean world production of biofuels is expected to grow from last year’s 20m tonnes to nearly 50m by 2010.

Only a cataclysmic slide in oil prices would halt biofuel’s rise. “You would need the diesel price to get down to about $10 a barrel (it is now about $80 a barrel) for fuel companies to choose not to meet the targets,” said Mariano Alarco, analyst at Goldman Sachs, the investment bank. “That is extremely unlikely. But producers have another price risk to bear in mind — the price of their feedstock.”

The risk comes from the feedstock’s alternative use. The raw materials used in making biofuels can also feed humans. Biodiesel is made from plant oils, including edible ones, while bioethanol is made from any plant that can be fermented, including corn, sugar and wheat. Such is the excitement about bioethanol in America, where some 50 new plants are estimated to be in the planning stages, that corn futures prices last week reached 10-year highs.

At present D1 makes biodiesel from soya imported from South America, but has high hopes for jatropha, a crop that produces an inedible plant oil and can be grown on marginal land. D1 has 110,000 hectares planted, and expects its first meaningful production of diesel from jatropha in 2008. “Using corn to make ethanol when you could be feeding people seems a pretty odd thing to do,” said Mannis.

Ethanol producers say Europe’s current wheat surplus makes the debate academic in the medium term. Alwyn Hughes, chief executive of Ensus, a biofuel company that plans to build an ethanol plant on Teesside, said the UK had a wheat surplus of 2m to 3m tonnes a year, with a 15m tonne surplus across the EU. “And you can add to that what the farmers in the expansion countries like Romania and Bulgaria will produce,” he said.

Biofuels’ exciting growth prospects have drawn in investors. Renova Energy, a British company with bioethanol interests in America, is trading on a price-earnings ratio of 84 — a figure the most hyped dotcom stock might have blushed at. Executive chairman Chris Thomas said the figure was an anomaly and would fall as production was stepped up. “On the prospective numbers two years out, the p/e is about 10,” he said.

Well-known entrepreneurs are also pushing into the sector, with Sir Richard Branson having invested in plants in California. Branson plans a biofuels joint venture with NTR, the Dublin infrastructure group, which insiders say could eventually lead to the development of biodiesel plants in Britain.

Although independents like D1, Biofuels and Ensus have big plans for growth, food companies and oil giants are likely to dominate European production in the near future.

Alarco at Goldman Sachs estimates that independents make only 600,000 tonnes of the 4m tonnes of biofuel produced in Europe. “At the moment the market is dominated by the agriculture business,” he said.

Oil companies are also jumping into the market with plans for large plants, and are concentrating their research and development funds on “second-stage” biofuels technology, which could use any type of biomass as a feedstock, even wood.

Hughes and Ensus’s chairman, Sir Rob Margetts, believe the environmental credentials of new businesses are all-important. “We are working on a methodology that will allow a proper look at the carbon-dioxide implications of the entire process,” said Margetts.

Jonathan Johns, head of renewable energy at Ernst & Young, said environmental soundness could make a big difference to investors. “This is a new phenomenon where ethical concerns have become extremely good business. So a biofuels business that does not have an environmentally sound source of feedstock is not in the long-term sustainable,” he said.