Southeast Asia's Clean Air Conundrum

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But regional officials don't believe things are getting out of hand. Malaysian Commodities and Plantation Industries Minister Peter Chin says countries like his own are only catering to a growing global demand for cleaner alternative fuel. "It's all private-sector driven by plantation companies who obviously know what they are doing," he says. Citigroup estimates global biodiesel capacity will more than double to 13.5 million tons by the end of next year vs. 2005 levels.

AGGRESSIVE EXPLORATION.

Analysts say three catalysts are driving the current biodiesel mania. High crude oil prices, the Kyoto Protocol on global warming, and the need to lessen reliance on crude oil. Though oil prices have fallen 20% from the peak in recent months, anything above $55 a barrel makes palm oil-based biodiesel a commercially viable option.

Moreover, adherence to the Kyoto pact on global warming, which sets limits on greenhouse gases (including carbon dioxide emissions), has made it necessary for countries to aggressively explore cleaner and renewable fuels.

Demand from Europe, where diesel fuel use is widespread, is also driving demand. Palm oil exports from Malaysia and Indonesia to Europe surged 19% last year—higher than the 15% growth in palm oil exports to China. South Korea and Japan are starting to emerge as large consumers of biodiesel as they try to reduce carbon emissions and their own dependence on oil.

HANDSOME REWARDS.

Is this stuff really cost competitive? Some, such as IOI's Yeo, argue no, not at current and more moderate oil prices, especially when you screen out the lavish government subsidies and tax incentives being showered on producers. Malaysian palm-diesel plants, for instance, operate under a so-called "pioneer status."

That means that their profits are tax free for 5 to 10 years. "The key bet you are making right now by investing in a biofuel plant is not whether oil prices will be $70 or $50—but whether there will be political will to support the biodiesel industry" says Yeo.

If there is, the rewards could be handsome for investors. With the help of huge tax incentives, biodiesel plants can be fairly lucrative. Credit Suisse analyst Tan Ting Min figures that biodiesel plants have an annual rate of return of over 30% on invested capital and cover their upfront costs in less than three years. All of this sounds promising except for one thing: the biofuel boom right now seems to be inflicting more environmental damage than it is averting.

Assif Shameen covers Southeast Asia for BusinessWeek.com from Singapore.