The profitable business of CO2 offsets

By Lisa Kassenaar

Nov. 7 (Bloomberg) -- 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.
Buying `Offsets'
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.
Voluntary Market
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.''
First Reserve Buys In
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.''
Nonprofit Registry
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.
$30 Per Credit
That price could shoot up 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.''
Sequestration
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.''
A `Pre-compliance' Market
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.
Investing in Solar, Wind
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.
`A Big Picture Guy'
``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.
Wasting CO2
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.
Brisket and Cola
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 three 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.
CO2 Repository
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 bete 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.
Flushing Old Oil
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.
Meeting in Midland
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.''
Cap and Trade
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'
``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.
M&A Lawyer
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.
Christian Connection
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.
Road to Rail
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.
Pig Waste
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.
Eager Investors
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.
To contact the reporter on this story: Lisa Kassenaar in New York at
lkassenaar@bloomberg.net
Last Updated: November 7, 2007 00:06 EST