The Great Energy Scam

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ILLUSTRATION FOR TIME BY ROSS MACDONALD

You would think that a modern industrial process that creates $1 billion a year in profits would make its creators and operators proud. You'd think they would be doubly pleased with themselves for doing it under the banner of reducing America's dependence on foreign energy. In fact, you'd think they would want their names in the paper and awards on their wall. But in the case of a strange kind of American alchemy involving coal, don't expect to be welcome on a plant tour. The reason isn't that secrecy is necessary to protect a technological marvel but just the opposite. What you would see behind the curtain is a scheme that would make the Wizard of Oz envious. And you wouldn't be amused, because as an American taxpayer, you're paying for it.

About a mile off the twisting, two-lane road to the south of Central City, Pa., set back in the woods along a private road, past the truck scales and the raw-coal stockpile, invisible from the highway, is the Shade Creek processing plant of PBS Coals Inc. There freshly mined coal is washed, the sulfur, rock, ash and other impurities removed and the cleaned coal carried by an overhead conveyor belt across the dusty road. It goes into a building on the other side that is operated by a second company, Central City Synfuels. Another belt comes out of that building—off limits to the public—carrying what looks a lot like the same coal back across the road and dumps it on a stockpile. Then it's loaded into railcars and shipped to electric utilities.

Except it isn't coal any longer.

Forget that it looks like coal. And will burn like coal. It's now called "synthetic fuel." As such, the coal-like product, along with roughly 50 million tons of similar stuff from more than 50 similar plants in Pennsylvania, West Virginia, Alabama and other states, is worth more than $1 billion a year in federal income-tax credits, a corporate giveaway protected by a bipartisan group of supporters in Congress. Those who have profited from the system range from fast-buck artists to giant corporations. They include one of the nation's largest hotel operators, a commodities trader barred from the industry for fraudulent practices, a chain of electronics stores, an electric utility that unplugged the lights during the great blackout of 2003, technology firms run by friends of influential lawmakers, limited partnerships of wealthy investors and scores of individuals and businesses preferring to keep their identities secret.

To qualify for the tax credits, the makers of this so-called synfuel don't have to prove that they are making a better kind of coal, one that burns more efficiently or offers any other benefit. By IRS ruling, they need only modify the chemical composition of coal. As a result, dozens of plants have sprung up across America to carry out a process that in many cases is so slight that critics call it spray and pray, a reference to their hopes that no one will peek too closely. "You can't believe what goes on," a government official long involved with the coal industry told TIME, blaming Congress for its role in perpetuating the handout. "The people who spend the tax money don't have a clue." The IRS launched an investigation last June into the "scientific validity of the test procedures" used to measure compliance with the minimal standards, but the synfuels credit has enough support in Congress that members have tried (and failed so far) to block the IRS probe.

Why America is stuck with this wasteful program is worth holding up to the light because it demonstrates the failures of U.S. energy policy at a time when prices are rising again and America's dependence on foreign oil is once more creating economic pain. As TIME reported in July, Congress's failure to adopt a serious energy strategy over the past three decades is taking its toll on consumers in bloated prices for petroleum products and natural gas, looming shortages of certain fuels, lost jobs, rolling brownouts and little hope for any relief, given that lawmakers are fixated on passing out subsidies, like the synfuel credit, that will do little or nothing to ease U.S. dependence on foreign oil.

Two weeks ago, crude-oil prices jumped when opec moved to keep supplies tight by reducing its output quotas 3.5%, cutting off nearly 1 million bbl. a day from the global market. American consumers are even more vulnerable to energy shocks than they were two decades ago, in part because the U.S. government's policy during that time has failed to produce alternative energy sources. Whipsawed by lobbyists and special interests, taxpayer-supported programs have succeeded mainly in making a few people rich and protecting ineffectual schemes. To be sure, not all energy programs have been a bust. For example, tax credits that gave homeowners an incentive to install storm windows and insulate their homes got results. But the synfuel tax credit is a dead end. It doesn't increase U.S. energy production. It's just a windfall for those who have found a way to exploit it. A TIME investigation into the congressionally authorized, billion-dollar scheme shows how it works:

DAWN OF A GIVEAWAY
More than two decades ago, in the wake of the energy crises of the 1970s, Congress enacted a tax break to spur the creation of a broad-based synthetic-fuels industry to ease U.S. dependence on foreign oil. The idea was to turn plentiful coal into synthetic natural gas to heat homes and run factories or into synthetic crude oil that could be refined into gasoline and other petroleum products. The law was supposed to encourage new technology and the building of giant plants each costing upwards of $1 billion to turn coal into liquids or gas. For a variety of reasons, including falling oil prices and changing administrations, Washington lost interest, and the industry never materialized as it was envisioned. The original goal wasn't folly, as demonstrated across the border in Canada, where the government and industry persevered with synfuel development and built a thriving business that today sells millions of barrels of synthetic crude oil to the U.S. annually (see following story). Meanwhile, the U.S. synfuels tax credit stayed on the books, dormant until the 1990s, when those who comb the Internal Revenue Code for opportunities came up with a new kind of synfuel plant, one that would cost a few million dollars and be portable.

What happens inside them? To alter coal's chemistry so it qualifies as a synthetic fuel even though it looks and burns like regular coal, some plants merely spray newly mined coal with diesel fuel, pine-tar resin, limestone, acid or other substances. Others mix coal waste with chemicals, coat it with latex and blend it with untreated coal to form briquettes. And plant operators in some extreme cases do nothing at all. Whatever the process, it's still coal.

This may explain why synfuel owners, in addition to being reluctant to talk about their processes, are not eager to let anyone actually see one of these so-called plants. Half a dozen electric utilities contacted, from DTE in Detroit to Progress Energy in Raleigh, N.C., declined to give TIME a tour. As did plant operators.

Actually, plant is a grandiose term for such operations. The facilities consist of little more than a collection of conveyor belts, nozzles, mixing vats, a few small buildings and sometimes equipment to convert the coal into pellets or briquettes. The spraying equipment is fairly simple. According to an industry consultant who asked not to be identified, it resembles "what you go through in a car wash, like the sprayers that wash your car." The plants can be easily taken apart and trucked hundreds of miles and then reassembled. "It's not that complicated to take one of these apart, load it on trucks and take it someplace else and put it back together," says an industry official. If the process seems flimsy, keep in mind that the real product is not synfuel but tax credits. And lots of people are cashing in.

FUEL FOR THE BOTTOM LINE Who benefits? a carnival of characters. But the most stunning numbers have been posted by big companies that wanted to boost their bottom line. The hotel chain Marriott International Inc., which has 2,500 lodging properties worldwide, bought four synfuel plants in October 2001. The next year, the fIRSt full year of production, Marriott's new synthetic-fuel operations generated $159 million in tax credits. Marriott had paid $46 million in cash for the facilities, meaning the tax credits gave the company a return of 246% on its investment in just one year. It was a welcome boost for the company at a time when the average room revenue from Marriott's traditional lodging business fell 4.8%. Moreover, the company's effective income tax rate plunged to 6.8% in 2002 from 36.1% in 2001, "primarily due to the impact of our synthetic-fuel business," according to its annual report. Consequently, Marriott paid federal income taxes at a rate below that paid by individuals and families earning less than $20,000 a year.

Rex Stores Corp., with headquarters in Dayton, Ohio, is a chain of some 250 retail electronics and appliance stores in 37 states—and two synthetic-fuel facilities. While sales of the company's main products have declined, its synthetic-fuel sideline has thrived. Stuart Rose, Rex's ceo, told stock analysts in June that "it's an asset that's still returning unbelievable returns for our investment." Echoed Douglas Bruggeman, Rex's vice president for finance: "We feel real good about that whole part of our business right now."

Even when a company's operating income goes down, its profits can still go up if it has tax credits on tap. PPL Montana LLC, a subsidiary of PPL Corp., the holding company for such utilities as Pennsylvania Power & Light and Montana Power, reported that "although operating income from synfuel operations declined in 2002 compared to 2001, the synfuel projects contributed $7 million more to net income after recording tax credits."

Electric utilities that have a stake in synthetic-fuel plants and burn their own product have achieved stunning financial results. Through 2002, Progress Energy Inc., a holding company for public utilities that generate electricity in North Carolina, South Carolina and Florida, raked in $897 million in tax credits from the program. SCANA Corp., the holding company for South Carolina Electric & Gas, reported that it received $58 million in tax credits from an investment of "approximately $2 million" in synthetic-fuel partnerships. That works out to a return of 2,800%. Think of the numbers this way: if you invested $4,000 on Jan. 1, you would collect $116,000 the next New Year's Day.

DTE Energy, the diversified energy company based in Detroit that is the parent of Detroit Edison Co.—which provides electricity to 2.1 million customers in southeast Michigan who lost their power on Aug. 14—has profited richly, generating $425 million in credits in the past three years from nine synfuel plants in eight states. Yet the cash flow did not seem to help DTE prepare for crunch time in its main business. It lagged behind utilities in New York and Ohio and took three days to restore power to all its customers after the blackout. And it plans to charge consumers for the $30 million to $40 million that it lost during the shutdown.

SEMPRA Energy, the holding company for San Diego Gas & Electric, chalked up a comparatively low tax rate of 17% in the fIRSt quarter of this year. After questioning by a UBS Warburg analyst, the company acknowledged that the reduced taxes were attributable to synthetic-fuel tax credits of $45 million to $50 million. And then there are all the plants' part owners that share the tax credits. Such is the case with Pace Carbon Synfuels Investors, a Delaware limited partnership with a stake in four facilities. Among the investors who have taken advantage of the tax credits: the Federal National Mortgage Association (Fannie Mae), the publicly owned but government-sponsored corporation that bills itself as the nation's largest source of financing for home mortgages; Morgan Stanley, the global financial-services firm; and Norfolk Southern Corp., which owns two major railroads in the Northeast as well as half of Conrail.

Many individuals and businesses cashing in on the tax credits prefer to remain anonymous. Earlier this year, TECO Energy, the holding company for Florida's Tampa Electric, disclosed in a filing with the U.S. Securities and Exchange Commission that it had received "more than $50 million from the sale of half of TECO Coal's synthetic-fuel production facilities." The buyer was not named. A TECO official told TIME that "part of the agreement that we signed says that we are not allowed to reveal the name of the purchaser." WPS Resources, the parent company of Wisconsin Public Service, sold a portion of its operation to "a subsidiary of a public company" whose name was not disclosed. Massey Energy Company sold its interest in a synthetic-fuel plant to an "unidentified affiliate of a major financial institution."

The manager at Warrior Synfuel, near Tuscaloosa, Ala., declined to identify the "private parties," as he called them, that own the plant. He said he had conveyed TIME's request to speak with them: "I believe their choice was that they didn't feel that this was appropriate."

THE TECHNOLOGY WIZARDS With some exceptions, the 21st century version of synthetic-fuel plants uses competing coal-altering processes developed by a handful of companies, which make money by licensing their technology. One is Earthco, a mysterious Las Vegas enterprise whose technology is used in 10 plants in six states. An Earthco founding principal was Jerry W. Slusser, 57, who has been involved in a string of curious businesses. In 1998 a Commodity Futures Trading Commission judge found that Slusser and two of his companies "pilfered millions of dollars from customers using the commodities market to carry out their scheme." Some of the money was funneled through accounts of Slusser's Sterling International Bank Ltd., which existed as a post office drop on the Caribbean island of Montserrat. The commission barred Slusser and his firms from trading commodity futures and assessed a $10 million penalty, the largest ever in an administrative hearing. A U.S. appeals court, while acknowledging there had been "multiple frauds," reduced the fines to $600,000, which Slusser has again appealed.

The investor's home in a gated country-club community just off the Las Vegas strip is also the official address of more than 80 Slusser-related business ventures with names like 481TL LLC, CCHDDNV Inc., N15SB LLC and QEAT4 LLC. With their principals scattered across the country, the companies have the appearance of being tax-avoidance devices, just like the synfuels scheme. What, if anything, does Earthco's synfuel process do? Calls for information to Earthco and its employees were fruitless. When TIME reached Slusser, he promptly hung up the telephone after hearing the writer identify himself. A call to Earthco's office in Las Vegas proved equally unproductive. A woman who identified herself as Susan Trimboli said any questions would have to be answered by a Jim Scott in Sacramento, Calif. He turned out to be James Scott, who works out of Earthco's Las Vegas office. He is the president of Mid-Power Service Corp., another Las Vegas energy business. Until two weeks ago it was in bankruptcy court. Scott did not return calls, but Mark Davis, a Sacramento attorney and Scott associate, did. Asked about Slusser's current connection with Earthco, Davis replied, "The answer is zero. Neither as a shareholder, officer—no capacity whatsoever." But Davis declined to discuss Slusser's earlier involvement, the nature or origin of Earthco's technology or how it has reduced American dependence on foreign oil. "That's really all I have to say," he said.

Startec Inc., like Earthco, has a proprietary process for turning coal into synthetic fuel. The Dublin, Ohio, penny-stock company (last week's closing price: 35(cent)), whose formula is used by nine plants in four states, started life in 1990 as Sports International Inc., owner of Ohio's Columbus Thunderbolts arena-football team. That lasted only a year. The team was sold in 1991, and Sports International transformed into Startec, hoping to cash in on the technology boom. Among its announced ventures was a plan to convert tires to energy. That didn't turn out either, but somewhere along the line, Startec latched onto a synthetic-fuel process that other companies would license.

At one point, it forged a working alliance with yet another penny-stock company, WasteMasters Inc., one of the fringe enterprises that flit in and out of the synfuel industry. Two former top WasteMasters operatives, a Dallas father-and-son team, are under federal indictment on charges of securities fraud, money laundering, assisting in the preparation of false tax returns and conspiracy—all unrelated to synthetic fuels. As was the case with Earthco, officials at Startec were unavailable for interviews.

Another company that licenses its technology, Headwaters Inc. of Salt Lake City, Utah, was the only company willing to discuss the business in general terms with TIME. So exactly what kind of synthetic fuel is produced? The kind that meets the IRS definition of changing coal's chemical composition. "The tax code does not require you to show a change in the coal's performance," says Headwaters spokesman John Ward, whose company's processes are in use in 20 synfuel operations in nine states. "For the tax credit, you just need to show there has been a substantial chemical change." Ward said that Headwaters' latex reagents produce a "chemical change that is verified by a number of different laboratory tests." Ward said that "tests show that not only are the molecules different but that the coal also behaves differently. Coal products treated with our reagent show an increased level of combustion efficiency, which translates into reduced environmental impact."

THE WASHINGTON CONNECTION Whenever there's a billion dollars to hand out to special interests, influential members of Congress—Democrats and Republicans—are always lurking in the background. After the IRS decided in June to take a closer look at the coal that is being called synthetic fuel, the synfuels industry turned to its old friends on Capitol Hill. In a rare public display of congressional meddling in a tax investigation, industry supporters persuaded a House Appropriations subcommittee to introduce a bill to call off the industrywide audit. It failed to pass in an 8-to-8 vote. Since then, the campaign has moved behind the scenes. The IRS has questioned the legitimacy of the synfuels in the past and then backed off after lawmakers intervened. In many ways, the IRS has created the dilemma. Some years ago, it ruled that any significant change in the chemical makeup of the coal would be sufficient to qualify for the credit. The agency then promptly issued to all the synthetic-fuel facilities so-called private-letter rulings stating that they qualified for the credit. Now it is debating whether to revise its standard.

Kenneth Kies, a Washington lawyer who represents the Council for Energy Independence, a synfuel coalition, said the group is "outraged" by the IRS review. On three previous occasions, Kies said, the IRS has reviewed the program and set rules for claiming the credit. "How many times do you get to do this?" Kies asks. "Good tax administration says that if the service has set up a series of rules and taxpayers adhere to them, they ought to be able to rely on that. And Congress, if they don't like what is happening, should come back and amend the statute." At the same time, Kies acknowledges the importance of the tax break. "People only do this because of the tax credit." In short, when it ends, so does the synfuel industry. The credit is so generous that some investors can't take full advantage of it each year because they don't pay enough taxes on their other income. Rather than let the credit go to waste, they sell a portion of their synfuel operations to another group of investors who are looking for ways to reduce their taxes—a sort of perpetual tax-avoidance machine that never stops giving.

That's what WPS Resources did in 2001. WPS bought a synfuel facility near Tuscaloosa, Ala., and moved it near a coal mine in Hopkins County, Ky. Naturally, the plant lost money. But it generated such bountiful tax breaks that before long, WPS could no longer take full advantage of the credit because it lacked sufficient income. In 2001 and 2002, for example, WPS claimed a total of $45 million in credits. As WPS ceo Larry Weyers put it in remarks to shareholders: "What we've discovered is that the operation has tax-credit potential that exceeds our needs." In other words, the company had more credits it could use than taxes owed. So WPS did what other synfuel owners do in similar situations. It sold a portion of its operation to a third party for $40 million while benefitting from the leftover credit. The only losers were American taxpayers.

The IRS review of the synfuel industry has for the time being halted the buying and selling of credits. Congress could resolve the issue by ending the credit, but it has shown little inclination to do so. In fact, the pending energy bill preserves it. Although the credit is due to expire at the end of 2007, until then it's worth $5 billion to $10 billion. And there's always the possibility that Congress will extend it. On four different occasions friendly lawmakers have intervened to rescue it—lawmakers like Orrin Hatch, the Republican Senator from Utah, where Headwaters is based. A longtime champion of the credit, Hatch told colleagues in 1998, "This is a very important tax credit for alternative fuels. It is an issue of fairness, not one of corporate welfare."

It is, of course, just that. Congress's idea of a synthetic-fuel industry is unlike any other business model: it doesn't make a profit and never will. The cost of treating the coal makes synfuel more expensive than conventional coal. Thus this new generation of synfuel plants makes no economic sense. Their only allure is the tax credit. To be sure, those who benefit from the tax credit dispute the notion that it is a windfall. They claim that it has increased the supply of low-cost coal, lowered electricity prices, improved the efficiency of coal-fired generators and been environmentally friendly. What's more, according to the Council for Energy Independence, the credit "has created new jobs in an otherwise shrinking business." Those jobs come with a stiff price: at least $200,000 from taxpayers for each one. Beyond the drain on the treasury, the credit has destabilized coal markets because synfuel producers periodically undercut conventional coal producers in this country and abroad, which they can afford to do because of their tax credits. Coal associations in Canada and Australia have complained that the tax credit is nothing less than a government subsidy interfering with the free market.

To preserve the break, the synfuel industry is lobbying intensely in Washington. The industry's Council for Energy Independence, whose members include Headwaters, GE Capital, Pacific Gas & Electric and other utilities, investment firms and coal companies, has been meeting with officials from Congress and the IRS. Says Kies, a former chief of staff of Congress's Joint Committee on Taxation, who heads the effort: "There is a lot of energy being put forth on behalf of taxpayers to force the IRS to back off of this."

But if common sense prevailed, Congress would scrap the entire program. In a critique to the IRS three years ago, Jack Workman, a West Virginia coal man, said the credit as used "has made good coal producers bad and has messed over the general economy of the coal industry." Alas, for that matter, it has messed over taxpayers and energy consumers in all 50 states as well.

—With reporting by Laura Karmatz/New York and research by Joan Levinstein/New York