Kleen Energy's fatal deal - Full version

FORTUNE -- When the natural gas ignited, it caused a blast so powerful that people 30 miles away thought there had been an earthquake. Inside the almost finished power plant in Middletown, Conn., around 11:15 a.m. on Feb. 7, the explosion blew the siding off the structure, crumpled construction trailers, and sparked a conflagration that sent a dense plume of black smoke hundreds of feet in the air. Six men died. Another 50 were injured, some of them gravely.

They had all been laboring at the Kleen Energy plant that Super Bowl Sunday, pushing to wrap up construction ahead of schedule so that the lead contractor could collect a $14 million bonus for early completion. The cause of the disaster was identified almost instantly: a "gas blow" gone awry. In theory, it's a simple procedure -- highly pressurized nitrogen, steam, air, or natural gas is propelled through pipes to clean out debris. Natural gas is the most dangerous choice; safety depends on dispersing the gas effectively and avoiding even the slightest spark. At the Kleen plant large quantities of gas were vented into a partially enclosed area that had a door that opened into a space where pipefitters were using blowtorches and open-flame industrial heaters warmed the men on a frigid winter day.

In retrospect, it wasn't surprising that something went wrong. There was no safety meeting that morning. Workers complained about the strong smell of gas, according to their affidavits, but were told to keep working. "This is a gas plant -- what do you expect to smell?" a supervisor said, according to the affidavits, only moments before losing his life in the explosion.

The federal authorities rendered harsh judgments. The Occupational Safety and Health Administration concluded in August that the construction firms "blatantly disregarded well-known and accepted industry procedures." OSHA cited 370 violations and imposed a $16.6 million fine, its second largest ever (exceeded only by the penalties for BP's (BP) Texas City refinery explosion). The Chemical Safety Board deemed the Kleen accident "preventable." Criminal investigations are ongoing, and the inevitable wave of civil litigation has begun.

There will be endless squabbling about who had what responsibility in the calamity. But that ignores the bigger mystery: How did this power plant, the sort of heavily regulated, billion-dollar engineering challenge usually developed and built by a handful of multinational construction behemoths, end up in the hands of a homegrown trio -- a Connecticut construction firm, a former city councilman, and a garbage hauler in his seventies? That's not just a historical question either, since the same firm has repaired the plant, restarted construction, and expects to open it next year. This is a tale of a trio who smoothly navigated local politics, sweet-talked the legislature, and outmaneuvered a Fortune 500 corporation to win a giant prize. But ultimately their understanding of power (the political kind) would far exceed their understanding of power (the electric kind).

No Kleen without Armetta

If you own the joint, you can enter any way you like. Phil Armetta is driving me to visit the outer reaches of the Kleen Energy site. He sees no need to use the main entrance. Instead Armetta steers his Lexus off the town road, through a gate with a no trespassing sign, and into a dusty, unpaved expanse with rocks the size of baseballs, before sailing slowly and majestically down the side of a steep embankment and landing on a rough construction road. "I used to drive a cab in New York City," he assures me as I flinch. "We're fine."

There would be no Kleen Energy without Phil Armetta, who bought the land and hatched the idea for the power plant. He's an institution in these parts -- owner of the memorably named Dainty Rubbish and sometimes referred to as a "trash magnate" in the local press. At 79, the Brooklyn native is bursting with energy, charm, and affability. "I used to dream of girls, and now I dream of projects," he croons, though you get the feeling he hasn't completely forgotten the charms of the opposite sex.

Armetta presents me with a three-ring binder filled with details of a half-dozen past and current business ventures, a biography, newspaper clippings, and a collection of his maxims. The biography cites "my first visit to an incinerator" as helping inspire his career in garbage. "You make your money when you buy, not when you sell," he tells me. "That's in the book."

As Armetta sees it, Kleen is a story of renewal. Its site was ravaged by decades of feldspar mining. Hoodlums used to congregate there, and it was used as an illegal dumping ground. But Armetta saw potential, and in 2000 he scooped up the 137 acres on the Connecticut River for a mere $300,000.

Beyond professions of regret for the lives lost in the explosion -- " Deaths like these are always tragic" -- Armetta deflects questions about sensitive topics by repeatedly saying, "I'm just a high school dropout," and suggesting that I talk to his partners. Despite the tragedy, Armetta maintains the plant will be a boon. Connecticut depends on outdated coal-fired plants, and Kleen will boast gas turbines that provide electricity to power one-fifth of the state's homes while emitting dramatically less pollution than coal. He claims the plant will save consumers $1.25 billion over 15 years. "Everybody makes out," he says. "We lower prices, it helps consumers. We make hundreds of jobs. And since it's a cleaner plant, it should be easier to sell."

A tight-knit community

Electricity was a politically charged issue in the first years of the new millennium. Deregulation in the 1990s separated the selling of electricity (still handled by utilities) from the production of electricity (now handled by independent power companies). Once expected to reduce energy bills, deregulation led to outlandish rate increases and turmoil in California (aided by Enron), terminating the career of Gov. Gray Davis. Meanwhile, electricity use was rising, and states needed to find new sources.

In 2004, New England's power authority proposed a plan to divide the region, which till then had shared capacity, into four separate markets. Connecticut lawmakers feared this would raise rates for its residents because parts of the state consumed more power than it could produce or import economically. The state, it appeared, needed new power sources.

It's in that context that Phil Armetta and his partners, O&G Industries, a $613 million firm best known for constructing roads and buildings, and local political broker William Corvo, launched their plans for the Kleen plant. Armetta and Corvo are prominent figures in tight-knit Middletown, home not only to a long-standing community of Sicilians but also to many descendants of a single town there, Melilli. Armetta, who regularly visits family and associates in Sicily, has developed several ventures that required municipal government cooperation, including two waste-to-energy plants.

Corvo, 59, is the son of Biagio Max Corvo, a local hero who was born in the village next to Melilli and worked with Sicilians and their émigré families to gather intelligence for the Office of Strategic Services during World War II. Max published the Middletown Bulletin, the source for local political scuttlebutt, and though he never held office, he was a political adviser and revered civic figure. William Corvo is a smoother, but less venerated, version of his dad. Known to all as Billy, Corvo is short, stout, and well-connected. He served in Middletown's city council from 1991 to 1993 and is often described as brilliant, less often as too clever by half. The Kleen project would make him a formidable local presence. (Corvo declined to be interviewed for this article.)

As for O&G, the majority of its contracts are within the state of Connecticut and with its universities.* Its name figured in the controversy that led to Gov. John Rowland's 2004 resignation. O&G was benefiting from large state contracts for roads and office buildings even as it renovated Rowland's weekend home.

When it came to Kleen, the trio of partners had a clear division of labor, Armetta says: "I bought the property, Billy did the permits, and O&G brought the know-how and a lot of money. One of those three legs goes, and the stool is broken. No project."

Kleen faced some local opposition, particularly from a man named Earle Roberts, who wanted the site made into a nature conservation area. But Kleen knew how to play politics. It promised residents they'd benefit from taxes paid by the plant. And when the town approved a proposal for Kleen to draw water from the aquifers beneath the site (water is essential for a power plant), the company spent about $13 million on an extra pump for the town so that it, too, could draw water for residents.

The benefits flowed in both directions. Then-mayor Domenique Thornton inked a generous tax deal with Kleen in 2003. The electric plant's tax bill was based on the facility's proposed $260 million cost in 2002. Over the decade, construction and land prices soared. The plant and property are now worth $760 million, but Kleen will pay taxes on the original assessment. "So much for that great source of tax revenue," says Roberts.

Just how close was Kleen to Middletown? For several years Kleen actually paid the lawyers representing the town on the power plant issue. Mayor Sebastian Giuliano (who took office in November 2005) put an end to the practice in 2006. Corvo shrugged it off. The law firm, he told the Hartford Courant, "would send the bills to the city, the city would review them and send them to us, and we'd pay them. I didn't have control or direction" of the law firm.

The hands-down winner

For all its progress, by 2004, Kleen was stymied. It had won key permits, but nobody wanted to lend hundreds of millions of dollars for merchant power plants, especially one proposed by a trio of neophytes. So Corvo hired a prominent former assemblyman, Richard Balducci (still known as "Mr. Speaker"), to lobby the state legislature. Balducci delivered: The 2005 Energy Independence Act contained a provision tailored specifically for Kleen. It mandated a handful of new power plants and required that Connecticut utilities guarantee predictable, steady revenue for those facilities. That would be a game-changer for Kleen: Lenders would undoubtedly fund a project with state-assured revenues. "Corvo was actually a visionary here," says Don Downes, who headed the state's Department of Public Utility Control (DPUC) at the time. "The legislature wrote the bill, but they were not necessarily the intellectual authors."

The law also required competitive bids for the new plants. The only serious threat to Kleen came from NRG Energy (NRG, Fortune 500), a $9 billion public corporation that has operated plants in Connecticut, including one in Middletown, for years. NRG proposed transforming one of its coal facilities into a bigger gas-fired plant, a low-cost way to add energy to Connecticut's grid.

NRG expected to prevail, but it blundered. The giant corporation didn't realize that the most important selection criterion was new generation capacity. The company's proposal to refurbish a plant didn't add as many megawatts as building something from scratch.

On May 3, 2007, the DPUC named Kleen the winner. The good news was tempered only by the fact that Armetta had experienced an unfortunate brush with the law. Well, a bit more than a brush: He was indicted by federal prosecutors as part of a case alleging a conspiracy among a large group (including two alleged members of the Genovese crime family) to control the state's garbage contracts. Armetta was charged with one count of extortion "induced by the wrongful use of actual and threatened force, violence and fear" and ultimately pleaded guilty on April 27, 2007, to concealing his knowledge of racketeering in the industry. Armetta says he took the plea to save Kleen's chances at financing. He placed his stake in a trust, with his children and long-time secretary as beneficiaries, and relinquished any control of the partnership.

Once Kleen had regulatory approvals and a guaranteed contract with Connecticut Light & Power, financing quickly followed. In May 2008, Energy Investors Fund, a $2.4 billion private equity firm that specializes in power projects, took an 80% stake in Kleen in exchange for about $350 million and an agreement to raise additional money. Goldman Sachs (GS, Fortune 500) and BNP Paribas financed the project, along with a consortium of banks. In total, EIF helped Kleen raise $985 million in loans and credit facilities. Project Finance magazine named it the North American Single Asset Power Deal of the Year.

We're not just the contractor...

There was one more oddity to come in the Kleen saga. O&G, one of the three developers, had made its name building roads and office buildings. But it also harbored ambitions for power plants. It had worked on four small to midsize operations but had been the lead contractor on only one of the jobs, a 116-megawatt electrical engineering station.

Plants of Kleen's magnitude -- 620 megawatts -- are almost always built by a handful of giant construction firms, such as Bechtel or Fluor (FLR, Fortune 500). "The larger the plant, the greater the complexity," notes Jeff Merrifield, a senior vice president in the power group of Shaw, the construction giant. Merrifield argues that to handle jobs of this magnitude, a firm needs a division that does nothing but lead and oversee mammoth projects. O&G has no such division. Moreover, five power construction experts interviewed by Fortune say they've never even heard of O&G.

But when it came time to select a contractor for Kleen's plant, the developers -- which included O&G -- picked ... O&G. Kleen agreed to pay O&G $760 million to deliver a plant by Nov. 30, 2010. O&G was entitled to a $14 million bonus if it completed the plant early, according to Fitch's rating report on Kleen's bonds. "It's the first time I have known [a lead] contractor that was also the owner and developer," O&G project manager Rick Audette told Business Excellence magazine in September 2009. O&G insists in a statement that "without question" it had "the experience and resources necessary to deliver a project like Kleen Energy."

Allegations that O&G placed speed above all else are at the heart of the many lawsuits filed against Kleen, O&G, and its subcontractors. Kleen had a nearly flawless safety record before the blast, but workers say management never made safety a priority. Small violations, like not wearing protective gear, were ignored by O&G, whereas on other sites workers would be issued warnings or even escorted off the job. OSHA's report portrayed a site where safety was the last consideration. In a statement, O&G, which is contesting OSHA's findings, asserts that it "requires strict compliance with safety rules, regulations, and procedures from all those working on its sites. O&G routinely disciplines employees and censures contractors for noncompliance."

But eyebrow-raising choices were made at Kleen. Natural gas is so explosive that before a gas blow, contractors usually turn off electricity to avoid the chance of a spark, and clear a site of all but those involved in the blow. O&G left the electricity on. And the contractor not only told other workers to show up, but also directed them to perform tasks that produce open flames.

The companies that were in charge on the day of the blast are still in charge today. And there are signs the commitment to safety has not improved. According to multiple sources, O&G's safety director recently told workers that to avoid scrutiny, they should drive one another to the hospital rather than call 911 if they are injured. (O&G asserts that the director denies making the statement and adds that it is company policy and practice to call 911 when appropriate.)

The building goes on

These days Kleen is attempting a resurrection. The project faces a deadline it can't beat: Its permit from the Siting Council, the state regulator that oversees environmental reviews of power plants, expires Nov. 21. Kleen appears likely to win an extension, putting the plant on track to open in April, according to Corvo's testimony. But O&G is also contractually obligated to pay damages for any delay, which could well put the interests of O&G the contractor directly at odds with those of O&G the developer/owner.

Among the bitter ironies is that electricity use hasn't soared, and the 2004 plan to break up the New England market was dropped. The state that believed it needed new supply now faces a glut, and prices are hovering at$2.50 per kilowatt/month, well below the $13.40 Kleen is guaranteed.

Armetta isn't worried. "I can guarantee you it's going to get done," he says. "Everybody makes out when this plant is done." Especially Armetta. His guilty plea turned out to be a boon for him: Because he turned his Kleen stake over to a blind trust and was uninvolved in the project at the time of the accident, he is not a defendant in the explosion litigation. He sold the plant site to Kleen, has been paid developer's fees, and he and the beneficiaries of his trust will receive payments that he says could amount to tens of millions of dollars over the next two decades.

In the end the Kleen plant will be far more lucrative for Armetta and Corvo than their other joint power plant foray. The two entered a bid to construct one in Melilli but lost. "Our connections were in Sicily," Armetta says. Alas, the decision was made in Rome.

*Editor's note: An earlier version of this story incorrectly stated that the majority of O&G's contracts are with the state of Connecticut and its universities. The majority of O&G's contracts are within the state of Connecticut and with its universities.