CO2 Wildcatters

Blue Source, a Utah company run by two Evangelical Christians, is on a mission to save the planet from global warming and get rich doing it.

By Lisa Kassenaar
Bloomberg Markets December 2007

Bill Townsend, a one-time Texas oilman, gazes up at a dark-red smokestack jutting from the cracked clay of southern Colorado and shakes his head. The chimney is connected to a small plant that processes natural gas from the surrounding plains. About 25 percent of the gas is methane, which is separated out and sold to Colorado Interstate Gas Co. Most of the rest is carbon dioxide, which, on this August morning, climbs the stack and pours into the cobalt-blue sky.

This plant, the brainchild of Townsend and his partner, Greg Spencer, is ready to sell its CO2, a major cause of global warming. Yet $7 million in new equipment to ship the gas sits idle because oil company BP Plc has yet to open part of a 400-mile (644-kilometer) pipeline that will take it to West Texas. There, Townsend and Spencer's plan is to bury the CO2 in aging oil wells. "All our money now is going up that pipe," Townsend says.

Townsend and Spencer, who met in a Utah Bible study group in 1985, are wildcatters of the CO2 era. Like American oil prospectors of a century ago, they comb the country for environmental projects that, one day, may gush profit. The two Christian capitalists say they've found their mission: They help companies cut greenhouse gas emissions and then take a cut of the profit. They've signed contracts with more than a dozen companies giving them a share of earnings when captured emissions, mostly CO2, sell in the fledgling U.S. carbon trading market. In that market, greenhouse gases that have been diverted from the atmosphere are packaged as pollution credits, known in the U.S. as "offsets," and are bought or sold by the metric ton.

Since 2001, Townsend and Spencer's company, Salt Lake City-based Blue Source LLC, has quietly amassed the largest collection of offsets in the country, about 270 million metric tons. They have projects in 45 states, including efforts to bury CO2 from power plants, capture methane from rotting pig waste and mountains of garbage and curb pollution from trucks by shifting cargo to railroads. "There's a biblical mandate to care for the planet that we have failed, as a culture and as followers of Christ, to do effectively," Spencer, 50, says. "This opportunity is a privilege. The success is a blessing."

Offsets trade in the U.S. even though President George W. Bush in 2001 pulled the country out of the Kyoto Protocol, a climate agreement that creates a cap-and-trade program to reduce global carbon emissions. In cap and trade, governments allow polluting companies a set level of annual emissions. Companies then may buy offset credits--representing tons of emissions that haven't gone into the atmosphere--to atone for any additional pollution. U.S. companies, though not burdened by federally mandated caps, trade pollution credits to meet their own environmental goals, according to EcoSystem Marketplace, a Washington-based research group. The voluntary market grew 200 percent in 2006 to about $91 million, the group says. As public concern about climate change ramps up, the U.S. Congress is considering 12 bills proposing a federally regulated cap-and-trade system.

Blue Source, which both builds physical infrastructure to create offsets and sells them to other companies, marks a new wave of U.S. carbon entrepreneurship. The big money is already moving in: Blackstone Group LP's advisory unit signed Blue Source as one of its smallest clients in April 2006, the day after hearing Townsend and Spencer's story. "Bill and Greg are the real deal," says Erik Katz, senior managing director at the New York-based firm. "Blue Source is well positioned to be a key architect in the development of the carbon highway. They have been able to thread the needle between financial gain and social conscience."

Katz hooked up Blue Source with First Reserve Corp., the world's biggest energy-focused private equity firm, which acquired 50 percent of the company for an undisclosed sum in September 2006. As part of the agreement, First Reserve will make up to $1 billion available to Blue Source for new projects. Already, Tyson Foods Inc., the biggest U.S. meat and poultry processor, and trucker J.B. Hunt Transport Services Inc. are on Blue Source's client list. As of October, forward sales contracts were up 350 percent from a year earlier, and profit for 2007 will be about $5 million, Spencer says. "We feel we have a lead on how this is going to be done," Townsend says. "The carbon economy is going to happen on a grand scale."

Blue Source's offsets exist as numbers on a computer screen, much like money looks in a bank account. About 45 million metric tons are on registries such as Washington-based Environmental Resources Trust Inc., a nonprofit that lists credits from more than 20 sources, including News Corp. and Nike Inc. The rest are managed out of Blue Source's office in a Salt Lake City business park with little more than a spreadsheet identifying offsets by date and category: energy and power, transportation, agriculture. Offset verification, which confirms that an activity avoided pollution, is typically shown with an engineering report.

Customers who come to Blue Source usually sign up to buy groups of credits over time, Spencer says, and Blue Source's supply agreements guarantee that it will have new offsets flowing in until 2022. Buyers include New York-based securities firm Cantor Fitzgerald LP and New Orleans-based Entergy Corp., the second- biggest U.S. operator of nuclear power plants. One large financial services firm that phoned Blue Source in early October wants to secure prices now for offsets to be delivered after 2012, Spencer says. Blue Source now usually sells its offsets for $4-$6 a ton. That price could shoot to $30 or more, in line with trading in Europe's government-regulated market, if Washington caps U.S. emissions, says Jon Anda, a former Morgan Stanley vice chairman who heads the Environmental Markets Network for New York-based Environmental Defense. "It'll be like lighting a match to methane," says Anda, who, as a banker, worked on Google Inc.'s initial public offering. "The dollars invested now will go to the moon."

In Washington, more Republicans now recognize climate change as an issue in the 2008 race for the White House, says Blythe Masters, head of JPMorgan Chase & Co.'s global commodities group. She testified to a Senate committee on the subject in July. California and 11 Northeast states are discussing their own cap-and-trade programs. Charlotte, North Carolina-based Duke Energy Corp. and San Francisco-based PG&E Corp., two of the biggest U.S. utilities, have said they want a plan too. "The biggest emitters are holding up business decisions waiting to see what the rules are going to be," Anda, 50, says. "They want something soon."

For Blue Source, the gamble is huge. More than half of its banked offsets stem from reducing CO2 in the air by burying it underground, a storage system called geologic carbon sequestration. The process is not currently a source of tradable offsets under the Kyoto Protocol. In addition, Blue Source has been collecting credits for six years, and buyers are more interested in pollution credits that represent recent saved emissions, Townsend says. That's because verification rules are constantly evolving. Also, creators of all manner of carbon credits in the U.S. are at the mercy of lawmakers in Washington, who'll decide what constitutes a tradable offset. "If only half our offsets end up qualifying, it would be a disappointment," Spencer says. "But we're positioned to do well unless offsets aren't allowed at all."

Investment banks, including Goldman Sachs Group Inc. and Merrill Lynch & Co., are already adding traders and ?designing securities to sell in what they call the "pre-compliance" market, meaning trading before regulations are passed. Credit Suisse, the second- biggest Swiss bank, is so sure the global carbon market, now centered in London, will include the U.S. that it located its main trading desk in New York, says Paul Ezekiel, a managing director who runs the carbon trading operation. "People see the possibility of profit and of enormous risk," JPMorgan Chase's Masters says. She spends about 25 percent of her time on building the firm's environment-related businesses. "The most dangerous position to be in is one of ignorance," she says.

Blue Source was once almost alone in the field. Now, competition is moving in. Credit Suisse in June bought 10 percent of Dublin- based Eco Securities Group Plc, which is working on more than 400 projects around the world to create offsets. Some 20 of its staff are now focused on the U.S., up from none a year ago, U.S. country director Eron Bloomgarden says. In January, Morgan Stanley bought 38 percent of Miami-based MGM International, which has offset projects in China, Mexico and South America and is also accumulating credits in the U.S.

Private equity firms, hedge funds and banks have billions of dollars earmarked for energy projects that may generate tradable offset credits. They're investing in solar and wind power, ethanol production and plants that capture methane. In March, First Reserve raised a $7.8 billion fund, of which about 10 percent will go to alternative energy, says Glenn Payne, who oversees those deals for the Greenwich, Connecticut-based company.

Payne helped negotiate First Reserve's Blue Source purchase, which left Townsend, the chief executive officer, and Spencer, the president, with 25 percent each. "The green has George Washington on it," Payne says. The timing looks even better than it did in 2006, says Payne, an Australian who formerly worked at McKinsey & Co. "We thought something would shake free in Washington in the middle of the next decade, but the discussion has started already."

In Colorado, Blue Source is working with Manzano LLC, a gas exploration company based in Roswell, New Mexico. Mike Hanagan, a co-owner of Manzano, met Townsend at an oil industry conference in Midland, Texas, in 2003, when he was designing his facility. "Bill's a very big-picture kind of guy," Hanagan says. "They kept pushing that the big picture was greenhouse gas emissions credits."

Hanagan was persuaded to spend an extra 30 percent on the plant, which cost about $35 million. The additional $7 million bought a CO2 compressor and 16 miles of pipeline to funnel his CO2 into a network that goes to Denver City, Texas. Hanagan's CO2 will be used by oil companies to flush thick, sticky oil out of older wells, and then it will remain underground. Blue Source consulted on the engineering and lined up sales contracts for both the CO2 and the offsets.

On a midsummer Tuesday, Townsend and Spencer fly in and greet Hanagan on the runway of a ?broken concrete airstrip outside La Veta, Colorado, a town of 924 people. In the distance lie the Spanish Peaks, landmarks of the Southwest that Native Americans call Wahatoya, or "breasts of the Earth." The three hop into a white pickup truck and drive to Hanagan's plant, about three miles away.

Fourteen months after Hanagan's facility was finished, CO2 still spills into the air. Manzano and Blue Source have been calling everyone they know at BP to try to get the gas flowing. The London-based oil company has been slow to respond. Says Spencer, waving at the chimney, "If you believe in the science of climate change, it's hard to look at that and have it not make you sick." One day earlier, in 92-degree-Fahrenheit (33-degree?Celsius) heat, Townsend and Spencer drive 20 minutes into a canyon north of their Salt Lake City office for lunch on the balcony of the Silver Fork Lodge, a 60-year-old log hotel decorated with old snowshoes and stuffed black bears. On the way, they point out sheer Rocky Mountain cliffs they've climbed over the years with their adult children. At the table, they both order beef brisket and Coca- Cola. Then they tell their tale. They talk for 3 hours, sometimes finishing each other's sentences.

Townsend, 53, grew up in Baton Rouge, Louisiana. His father worked for Ethyl Corp., a gasoline additives company, and read the Bible every day, Townsend says. At 18, Townsend headed to Purdue University in West Lafayette, Indiana, and earned bachelor's degrees in microbiology and mechanical engineering. He met his future wife, Andrea, at Purdue. All three of their children, now aged 29, 27 and 23, are also Purdue grads.

In 1978, Townsend joined Houston-based Conoco Inc. and rose to manage the company's Gulf Coast crude oil and liquid products pipeline systems. Seven years later, at age 31, he joined the senior management of Petro Source Co., a crude-oil blending company with $70 million in annual sales, and moved his family to Salt Lake City. Among his first tasks was building Petro Source's business in refined oil products. He laughs now about an early project selling grass-scented green asphalt to Rocky Mountain golf clubs.

As Petro Source added oil refining and transportation to its repertoire over a dozen years, sales rose to more than $1 billion, Townsend says. In 1995, he took on the company's CO2 ?division, pushing to spend $17.6 million on an 82-mile pipeline to carry carbon dioxide from four natural gas plants near Val Verde, Texas, to Denver City, the main CO2 gathering center for the U.S. domestic oil industry.

Townsend wasn't looking to create offsets when he initiated the Val Verde project, he says, although he did consider the environmental gain in reusing the CO2. His long experience in the petroleum business had taught him that one of the few commercial uses of CO2, the bête noire of climate change, was right in front of him. For three decades, the biggest oil companies operating in Texas, including Exxon Mobil Corp., had been tapping the ground and building pipelines to gather CO2 from geologic formations.

They shoot the gas deep into aging wells, where it adheres to trapped oil, lowers its viscosity and helps flush it out in a process called enhanced oil recovery, or EOR. EOR could help recover 240 billion barrels of U.S. oil left in the ground by conventional drilling, according to the U.S. Energy Department. Kim Gerard, an oil industry engineer, was working in Chicago when Townsend phoned in 1997 for help with the Val Verde pipeline. They had been colleagues at Conoco (now ConocoPhillips), where he was a fast-rising star, she says. She quit her job and moved to Midland, Texas, to work for him. "In this industry, you have to make huge leaps of faith," says Gerard, who talks with a Texas twang and wears oversized belt buckles engraved with horses and bulls.

Midland, now at the center of the U.S. oil industry, was a sleepy West Texas rail town until May 1923, when an oil gusher blew 70 miles away. Midland turned out to be in the heart of the Permian Basin, which contains 22 percent of U.S. oil reserves. Former President George H.W. Bush worked in the oil business in Midland, and his son George W., the current president, grew up there, as did his wife Laura.

Gerard recalls a late night in a Midland hotel conference room in December 1998 with Townsend and Steve Melzer, an oil industry CO2 consultant. They talked about how the Earth was heating up because of carbon dioxide. "At the time, there were companies that said climate change was bull," Gerard says. "We thought we could just capture this stuff and actually make money off capturing it. It was one of those times when you start discussing something and the juices start flowing, and you reach a point where you go, 'This thing could become huge.' It went on and on."

The Val Verde pipeline was the U.S. oil industry's first system using so-called anthropogenic, or man-made, carbon dioxide, for EOR. Buyers were wary at first because the supply was potentially inconsistent, Townsend says. His first sale was to Exxon at a 20 percent discount to the market. "We built out $13 million of the $17 million project before we had a physical CO2 sale," he says. "We were way out on a limb with the investment and had absolutely no flow through the pipeline. It was a very white-knuckle time."

Concerned about revenue, Townsend took the project further. He knew that the offset market was developing and had talked about it with Carlton Bartels, a managing director at Cantor Fitzgerald's environmental brokerage unit. The Kyoto Protocol was gathering signatures, and Europe was working on developing a cap-and-trade market. Townsend reckoned he could earn pollution credits because his pipeline kept CO2 from flying into the atmosphere. At the time, no standards or contracts existed for carbon capture and storage offsets, he says.

After a year of meetings, Townsend and Bartels secured a deal to sell 1 million tons of offsets from Val Verde to Ontario Power Generation Inc., a Canadian public utility. "We were inventing as we went along," Townsend says. "It was exciting and scary."

In November 2000, the two men announced their Ontario trades at a United Nations conference on climate change in The Hague. Townsend expected the crowd of environmentalists to cheer, he says.

Instead, hecklers were so noisy that some were escorted out. "We got booed," Townsend says. "People were still thinking that selling offsets was just about moving money around. Europe still wasn't sold on carbon trading at that point."

As Petro Source grew, Townsend became increasingly active in Salt Lake City's Christian community. He and Spencer belong to the Evangelical Free Church, which sees the Bible as the inspired, final word of God. Their church connections forged their friendship. They raised $2 million together for Salt Lake's Intermountain Christian School, an elementary school attended by Spencer's two sons. Townsend was chairman of Life@Work Companies, a group advising Christians on bringing their faith into the workplace. Spencer served as a legal and financial adviser to the board.

Townsend is now on the board of K2 The Church, a Salt Lake City- based congregation founded in 2002 and named for the world's second-highest mountain, in the Himalayas. K2 attracts outdoorsy congregants with a rock-climbing wall, pool tables and a jeans- wearing pastor who podcasts his sermons. Spencer belongs to the Mountain Life Evangelical Church in Park City, Utah, the ski town 31 miles from Salt Lake City that hosted the 2002 Winter Olympics' giant slalom competition.

Spencer moved to Utah from Colorado as a college student because he loved skiing in the powdery snow, he says. At the University of Utah, he earned a bachelor's degree in environmental science and a law degree. In 1983, he joined American Stores Co., a food and drug retailer; 10 years later, he joined its mergers and acquisitions team. In 1999, he took part in selling American Stores to rival Albertsons Inc. in an $8.7 billion deal. Then he was let go, along with other senior managers.

Spencer doesn't call himself an environmentalist. "You don't have to be either an environmentalist or a capitalist now," he says. "There's a new concept of sustainability." Americans should be able to drive SUVs and use air conditioners, he says, if they are willing to pay for it, including accounting for the pollution they create.

While Townsend brought CO2 experience to Blue Source, Spencer brought a relentless ability to network. Shortly after founding the company in 2001, he called Steve Graves, an Arkansan who led Life@Work, to help land a meeting at J.B. Hunt, a Lowell, Arkansas-based transportation company with 12,000 truckers on American highways.

In the corner office of John Roberts, a J.B. Hunt division president, Townsend and Spencer made their pitch: They would help reduce the trucker's carbon emissions and then pay to verify and market offset credits they created. When the offsets were sold, they would get a percentage of the profit. "John was curious," Spencer says. "But he was also thinking, 'Why are you in my office talking about a market that doesn't yet exist?'" It took 18 months to sign a contract, Spencer says. J.B. Hunt signed on partly because the risk to the company was so low, he adds. "They had nothing to lose," he says.

Blue Source began looking at the company's use of trains, which emit only a third the carbon of trucks. By shifting long-haul shipping to rail, J.B. Hunt soon saw an environmental benefit, says Gary Whicker, a senior vice president in charge of engineering. Blue Source also came up with ideas for restructuring so-called empty-mile operations, when trucks travel with no cargo, and for reducing the amount of time drivers' trucks stand idling-- and spewing CO2 into the air.

Once a few emission-cutting ideas were put in place, J.B. Hunt's extensive data collection system started showing big declines in energy use, Whicker says. The company sold its first offset credits in partnership with Blue Source in 2005 and is now earning about $100,000 a year from credit sales. "Is it a big moneymaker for J.B. Hunt?" Whicker asks. "No. But it opened our eyes. They gave us a free education in the carbon world." J.B. Hunt's customers increasingly want details of its environmental record. "If Blue Source hadn't been here, we'd be clueless as to what to do in this area," Whicker says.

In 2001, Blue Source also picked up a client in northern Arkansas: Springdale-based Tyson. The company had already started capping the vast pools of waste from its beef, chicken and pork slaughterhouses with plastic covers, says Kevin Igli, Tyson's chief environmental officer. The system steers methane gas from the waste to a central collection area, where some is used to power Tyson plants and the rest is flared off. Blue Source helped Tyson do an offset trade in 2004, Igli says, and is now advising on new projects to capture methane.

By mid-2005, Townsend and Spencer were examining dozens of potential carbon capture projects and rapidly building their offset portfolio. They still had just four employees. They'd funded small jobs themselves and otherwise sought project financing. They decided they needed a backer. "So we called Blackstone," Townsend says.

Once again, Spencer's contacts were critical. While negotiating Albertsons' buyout of American Stores in 1998, he'd worked with Katz. Spencer arranged a meeting in New York on a Monday to get some friendly advice. By Tuesday afternoon, Blue Source was a client.

In their initial meeting in early 2006, Katz told Townsend and Spencer they could raise more money than the few hundred million they anticipated, says Townsend, declining to offer more specific figures. "There has been no shortage of interest," Katz says. The banker set up about 10 meetings with potential investors, including First Reserve.

With the private equity firm's backing, Townsend and Spencer have the resources to provide both technical and ?financial help to people like Mike Hanagan, who are willing to take a chance on the future market for pollution offsets. For his part, Hanagan finally has his project under way. In early September, BP allowed him to open the valve that lets his CO2 gas stream south. The project took longer than expected to be completed safely, according to BP spokeswoman Sarah Howell.

For Townsend and Spencer, the connection means tons of new pollution credits to sell to future customers--and more fuel for their mission to make money and save the planet.?

LISA KASSENAAR is a senior writer at Bloomberg News in New York. lkassenaar@bloomberg.net

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