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* Refiners now wary of small biodiesel makers after scam
* Fake biodiesel credits cost refiners about $200 mln
* House Republicans investigating how EPA handled issue
By Roberta Rampton
WASHINGTON, July 11 (Reuters) - Jennifer Case had big plans for expansion of her small San Diego plant that turns used restaurant cooking oil into biodiesel fuel after it sold out its entire production of about 1.5 million gallons in 2011.
By the end of the year, business had taken a "devastating turn," Case told lawmakers at a Capitol Hill hearing on Wednesday probing fraud in the biodiesel industry.
Case and other start-up biodiesel makers became inadvertent victims of scam artists who pretended to make biofuel and cashed in on a poorly monitoried electronic system for trading biodiesel credits with oil refineries.
The credits are traded on electronically on a system hosted by the Environmental Protection Agency. Refineries use them to help them comply with a federal renewable fuel law.
When the scam became public, buyers only wanted to deal with credits that came from large, well-known biodiesel producers, leaving small players like Case -- who had legitimately sold her credits -- struggling to survive.
Lawmakers on the House Energy and Commerce Committee are investigating why the EPA waited so long to warn the market about the fraudulent credits, called Renewable Identification Numbers, or RINs - and how the problem can be fixed.
The investigation is part of renewed scrutiny of laws designed to spur production of ethanol and other types of biofuels, laws that Congressional Republicans would like to change to end what they see as preferential treatment.
Refiners that bought the fake RINs were ordered by the EPA to replace them with genuine credits, and were also assessed fines, sending a chill through the nascent biodiesel industry.
Small players can't tap into "corporate war chests" until a fix is found, said Andy Sprague, a farmer and biodiesel producer with plants in Illinois and Indiana, who told lawmakers he was facing financial ruin.
"My children's college fund is invested in biodiesel," Sprague told lawmakers
Congress passed a law in 2007 that requires refineries to blend biodiesel with petroleum-based diesel. In 2012, that Renewable Fuel Standard mandate required 1 billion gallons of biodiesel to be used.
To keep track of how the mandate is being filled, producers use a 38-character RIN. Buyers like refineries can use the RIN to show the EPA they have met their share of the annual mandate, and they can sell credits above their share to other buyers, giving flexibility to buyers who are not close to biodiesel fuel producers.
Rodney Hailey, a Baltimore, Maryland-area man, was convicted last this month of selling $9 million worth of RINs without producing a gallon of biodiesel.
He was caught after suspicions were raised about a large number of luxury cars in front of his home: BMWs, a Mercedes, a Rolls Royce Phantom, a Lamborghini, a Ferrari, a Maserati, according to a Justice Department description of the crime.
Hailey was the first to be convicted, but the EPA has said it is investigating others. Two Texas companies have been handed EPA violation notices for selling fake RINs in 2010 and 2011.
The EPA did not remove the three companies from its list of biodiesel makers on its trading platform until May 2012, Stephen Brown, a lobbyist for refiner Tesoro Corp, told Reuters.
Tesoro unwittingly bought fake RINs, and has since learned there are at least four other companies that also have fraudulently sold RINs, Brown said.
About 6.5 percent of all biodiesel RINs produced in 2011 likely were fraudulent, said Joe Jobe, chief executive of the National Biodiesel Board, an industry lobby group.
Earlier this year, the EPA announced 31 settlements with companies that bought fake RINs, including BP, ConocoPhillips, Citgo and Marathon. They had to repurchase real RINs, which cost a combined total of about $200 million, and each pay fines of up to $350,000.
Diana DeGette, a Colorado Democrat on the House Energy and Commerce hearing, said the refiners should have known that the program was "buyer beware" and done a better job on due diligence of their purchases.
"These are some of the most sophisticated petrochemical companies in the United States," DeGette said.
The American Fuel and Petrochemical Manufacturers, a lobby group for large refineries, said they were the victims of fraud, and should not have been penalized.
The industry has started using private, voluntary verification services for RIN buyers so they can prove their credits are legitimate.
The EPA is working with the industry to figure out how to amend its regulations to better spell out responsibilities and liabilities, said Byron Bunker, a compliance official.
"I think it's in front of everyone to figure out what role each party plays in this process," Bunker told lawmakers, noting the EPA hopes to have its new plan in place by early 2013.