**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, DC 20549**

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FORM 10-K

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(Mark One)

**x**                Annual Report Pursuant to Section 13or 15(d) of the Securities Exchange Act of 1934 for the fiscal year endedDecember 31, 2004

**or**

**o**                   Transition Report Pursuant toSection 13 or 15(d) of the Securities Exchange Act of 1934 for thetransition periodfrom                   to                   .

**CommissionFile No. 000-31953**

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CATALYTICAENERGY SYSTEMS, INC.

**(Exact name of Registrant as specified in its charter)**

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| **Delaware**                                                         | **77-0410420**                             |
|----------------------------------------------------------------------|--------------------------------------------|
| **(State  or other jurisdiction of  incorporation or organization)** | **(IRS  Employer  Identification Number)** |

 

**1388 North Tech BoulevardGilbert, Arizona 85233**

**(Address of principal executiveoffices)**

**(480) 556-5555**

**(Registrant’s telephone number,including area code)**

**Securitiesregistered pursuant to Section 12(b) of the Act: NoneSecurities registered pursuant to Section 12(g) of the Act: CommonStock, $0.001 par value**(Title of Class)

Indicate by check markwhether the Registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the Registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.   Yes x   No o

Indicate by check markwhether the Registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act).   Yes o   No x

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of Registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K. x

As of March 22, 2005,there were outstanding 17,946,719 shares of the Registrant’s common stock, parvalue $0.001, which is the only class of common stock of the Registrantregistered under Section 12(g) of the Securities Act of 1933.

As of June 30, 2004, the aggregate market value ofthe shares of common stock held by non-affiliates of the Registrant (based onthe last sale price for the common stock on The NASDAQ Stock Market on suchdate) was $20,629,876. For purposes of this computation, all officers,directors and 5% beneficial owners of the Registrant’s common stock are deemedto be affiliates. Such determination should not be deemed to be an admission orrepresentation that such officers, directors or 5% beneficial owners are, infact, affiliates of the Registrant.

**Documents Incorporated byReference**

Theinformation called for by Part III is incorporated by reference to thedefinitive Proxy Statement for the Annual Meeting of Stockholders of theCompany, which will be filed with the Securities and Exchange Commission nolater than 120 days after December 31, 2004.

 

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**CATALYTICA ENERGYSYSTEMS, INC.**

**Annual Report on Form 10-KDecember 31, 2004**

**Tableof Contents**
|                   |                                                                                             | ** ** | **Page No.** |
|-------------------|---------------------------------------------------------------------------------------------|------------|-------------------|
| **PART I**   |
| Item 1.           | Business                                                                                    |       | 5                 |   |
| Item 2.           | Properties                                                                                  |       | 25                |   |
| Item 3.           | Legal  Proceedings                                                                          |       | 25                |   |
| Item  4.          | Submission  of Matters to a Vote of Security Holders                                        |       | 25                |   |
| **PART II**  |
| Item 5.           | Market for the Registrant’s Common  Stock and Related Stockholder Matters              |       | 26                |   |
| Item 6.           | Selected Consolidated Financial Data                                                        |       | 28                |   |
| Item 7.           | Management’s Discussion and  Analysis of Financial Condition and Results of Operations |       | 29                |   |
| Item  7A.         | Quantitative  and Qualitative Disclosures about Market Risk                                 |       | 61                |   |
| Item  8.          | Consolidated  Financial Statements and Supplementary Data                                   |       | 61                |   |
| Item  9.          | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure       |       | 61                |   |
| Item  9A.         | Evaluation  of Disclosure Controls and Procedures                                           |       | 61                |   |
| **PART III** |
| Item  10.         | Directors  and Executive Officers of the Registrant                                         |       | 62                |   |
| Item  11.         | Executive  Compensation                                                                     |       | 62                |   |
| Item  12.         | Security  Ownership of Certain Beneficial Owners and Management                             |       | 62                |   |
| Item  13.         | Certain  Relationships and Related Transactions                                             |       | 62                |   |
| Item  14.         | Principal  Accountant Fees and Services                                                     |       | 62                |   |
| **PART IV**  |
| Item  15.         | Exhibits,  Financial Statement Schedules and Reports on Form 8-K                       |       | 63                |   |

 

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**FORWARD-LOOKING STATEMENTS**

*This reportcontains forward-looking statements within the meaning of Section 27A ofthe Securities Act of 1933, as amended, and Section 21E of the SecuritiesExchange Act of 1934, as amended. Words such as “anticipate,” “believe,” “estimate,”“expect,” “intend,” “plan” and similar expressions identify suchforward-looking statements.*

*The forward-looking statements in this report include,but are not limited to:*

·        *statements regarding our market opportunities and the growth of themarket for our solutions*

·        *our business strategies and plan of operations*

·        *our competitive advantage in the marketplace*

·        *the nature and level of competition for our solutions*

·        *the efficiency of our solutions*

·        *the cost-effectiveness of our solutions*

·        *our commitment to funded research programs*

·        *the level of research and development by OEMs*

·        *our ability to integrate our products with OEM solutions*

·        *availability and expense of resources and raw materials necessary forproduction and manufacturing*

·        *the timing of our testing activities, our development programs, and thecommercialization of our products*

·        *the future development and commercialization costs of our products*

·        *our ability to create an industry standard associated with oursolutions*

·        *the value of our intellectual property and effectiveness of our patentportfolio*

·        *the ability of our management to adapt to changing circumstances*

·        *our relations with employees*

·        *the cost of ultra-low emissions technology and its effects*

·        *the uniqueness of Xonon Cool Combustion*

·        *our ability to design Xonon for different gas turbine models*

·        *our ability to broaden the range of uses of gas turbines through theuse of Xonon*

·        *the applicability of our solutions to different gas turbine and dieselengine applications*

·        *statements regarding the successful development and market potential ofour diesel products*

·        *the existing and proposed emissions restrictions on power generatingsources and diesel engines used in transportation applications due toenvironmental concerns*

·        *statements regarding the uniqueness, potential and market for our SCRcatalyst services*

·        *our ability to manage SCR-Tech*

·        *the role of catalyst regeneration in the catalyst replacement market*

·        *the effect of the acquisition of SCR-Tech*

·        *first-mover advantage for SCR-Tech*

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·        *our investment in research and development*

·        *sources of our revenues*

·        *our use of earnings*

·        *our ability to generate cash and the sufficiency of existing cash andcash equivalents*

·        *the impact of interest income and expense*

·        *predictions as to when we may incur material income taxes*

·        *critical accounting policies*

These forward-looking statements are subject tocertain risks and uncertainties that could cause actual results to differmaterially from those reflected in these forward-looking statements. Factorsthat might cause actual results to differ include, but are not limited to,those discussed in the sections entitled “Management’s Discussion and Analysisof Financial Condition and Results of Operations” and “Risks that Could AffectOur Financial Condition and Results of Operations.”

Althoughwe believe that the expectations reflected in the forward-looking statementsare reasonable, we cannot guarantee future results, levels of activity,performance or achievements. We undertake no responsibility to update any ofthese forward-looking statements or to conform these statements to actualresults.

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“Xonon” and “Xonon CoolCombustion” are registered trademarks and “Cool Combustion,” “Catalytica EnergySystems” and the stylized Catalytica logo are trademarks of Catalytica EnergySystems, Inc.

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**PART I**

**Item 1.**                        *BUSINESS*

**Overview**

Catalytica Energy Systems, Inc. (“CatalyticaEnergy,” the “Company,” “we” or “us”) was incorporated in Delaware in 1995 as asubsidiary of Catalytica, Inc. Catalytica Energy operated as part ofCatalytica, Inc.’s research and development group from inception throughthe date of its incorporation as a separate entity. In December 2000,Catalytica Advanced Technologies, Inc., another subsidiary of CatalyticaInc., was merged into us, and the combined entity was spun out from Catalytica, Inc.as Catalytica Energy Systems, Inc., a separate, stand-alone publiccompany.

We******provideinnovative emissions solutions to ease the environmental impact ofcombustion-related applications in the power generation and transportationindustries. Through our SCR-Tech subsidiary, we offer a variety of services forcoal-fired power plants that use selective catalytic reduction (“SCR”) systemsto reduce nitrogen oxides (“NOx”) emissions. These services include SCRcatalyst cleaning and regeneration, SCR system management services to optimizeefficiency and reduce overall operating and maintenance (“O&M”) costs, andconsulting services related to the design of SCR systems (collectively “SCRCatalyst and Management Services”). Our business activities also include thedesign, development, manufacture and servicing of advanced products based onour proprietary catalyst and fuel processing technologies to offercost-effective solutions for reducing NOx emissions from diesel engines andnatural gas-fired turbines. Our diesel fuel processing technology is designedto facilitate significant NOx reduction from mobile, stationary and off-roaddiesel engine applications by improving the performance of NOx adsorbercatalyst systems. Our commercially-available Xonon Cool Combustion® systemoffers a breakthrough pollution prevention approach that enables gas turbinesto achieve ultra-low NOx emissions through a proprietary catalytic combustionprocess. Other activities include the development of fuel processing systemsfor fuel cells used in stationary, auxiliary and back-up power applications.

We are focused on growing our business through aproduct and market diversification strategy in the area of NOx control.Increasingly stringent air quality regulations have resulted in tighteremissions restrictions being imposed on a variety of combustion-relatedapplications. NOx emissions, which are a precursor to smog formation, havebecome a primary target of government-imposed emissions regulations, creating asignificant opportunity for innovative, cost-effective NOx control solutions.Industry analysts estimate the U.S. market for NOx control represents a greaterthan $5 billion opportunity annually in the power generation and dieselindustries, and we believe this market should experience additional growth as aresult of pending Federal and State regulations calling for further reductionsin NOx emissions.

As a result of ongoing challenging conditions in theU.S. gas turbine industry, a slow to emerge distributed generation market andthe pace of gas turbine original equipment manufacturer (“OEM”)commercialization activities, we completed a rigorous exercise in 2003 torealign our strategic direction and build a stronger business. This has beenaccomplished through broadening our product and service offerings in the areaof NOx control beyond our Xonon Cool Combustion product for gas turbines,pursuing new business activity and expanding our portfolio of NOx-relatedproducts and services across new and growing markets. We are committed tosolving NOx-related problems by providing the most economically compelling andmost effective solutions available, whether it is through prevention or throughsome form of after-treatment. In addition to intensifying our development of NOxcontrol after-treatment systems for diesel engines which leverage our coreXonon® technology, we have become more active in identifyingstrategic opportunities, including business acquisitions that complement ourcurrent products, expand the breadth of our markets or build upon our technicalcapabilities. In particular, we continue to focus on opportunities that offernear-term, profitable product and service offerings.

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As part of this strategic initiative, in February 2004we acquired SCR-Tech, LLC (“SCR-Tech”), the North American leader in catalystregeneration technologies and management services for selective catalyticreduction systems used by coal-fired power plants to reduce NOx emissions. Theaddition of SCR-Tech strategically broadened and diversified our productand service offerings to the growing emissions control market for coal-firedpower plants and has served to accelerate our penetration into the NOx controlmarketplace. We believe the acquisition of SCR-Tech has created a foundationfor future growth and has strengthened our ability to continue pursuingdevelopment and commercialization efforts in other areas of our business, whilealso targeting additional business opportunities in the area of NOx control.

As a result of our February 2004acquisition of SCR-Tech, we are now conducting our business through thefollowing two business segments:

1.     SCRCatalyst and Management Services (“SCMS”)

2.     Catalyst-Based Technology Solutions (“CBTS”)

**SCRCatalyst and Management Services**

Our SCR-Tech subsidiary is based in Charlotte, NorthCarolina and offers catalyst cleaning, rejuvenation and regeneration as well asSCR system management and consulting services, to help power plant operatorsoptimize their SCR system operation while reducing O&M costs. SCR-Tech’scustomer base has included some of the largest utilities and independent powerproducers (“IPPs”) in the U.S.

SCR-Tech provides catalyst regeneration services bymeans of two patented processes that can restore the activity level of used SCRcatalyst for significantly less cost than purchasing a new catalyst. SCR-Techis the only company in North America currently operating a commercial catalystregeneration facility and offering catalyst regeneration in addition tocleaning and rejuvenation.

SCR-Tech also provides SCRsystem management and consulting services relating to system design and tuning,efficiency optimization, O&M cost reduction, catalyst specification andperformance testing.

***History of SCR-Tech***

SCR-Tech’s roots go back to the mid-90’s whenone of the founders of SCR-Tech, ENVICA GmbH, created a method for cleaning,rejuvenating and regenerating SCR catalyst in Germany. Meanwhile, EnBW, Germany’sthird largest energy company and one of SCR-Tech’s former owners, wasindependently developing an innovative “in-situ” cleaning and rejuvenationprocess.

In 1997, ENVICA, in partnership with one of Germany’slargest utilities, Hamburgische Electricitätswerke AG (“HEW”), developed anoff-site regeneration process based on ENVICA’s core technology, which not onlyphysically cleaned but also chemically regenerated depleted SCR catalyst, beganmarketing SCR catalyst regeneration services to other SCR plant operators inGermany and built the world’s first full-scale commercial SCR catalystregeneration facility. This process continues to be marketed in Germany byENVICA under the ENVICA Kat name. Both HEW and EnBW continue to use ENVICA’sregeneration processes in their coal-fired plants throughout Germany.

In March 2001, ENVICA and Energy &Environmental Consultants GmbH (“E&EC”), a German consulting company,formed SCR-Tech GmbH in Germany for marketing the regeneration processworldwide. In March 2002, EnBW Energy Solutions GmbH became a shareholderof SCR-Tech GmbH together with the two founders—ENVICA and E&EC. EnBWEnergy Solutions granted an exclusive license to SCR-Tech for its proprietaryand patented in-situ cleaning process that it had independently developed in1995.

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Since 1997, thesetechnologies have been successfully applied commercially throughout Germany bySCR-Tech’s founding owners, leading to the creation of SCR-Tech, LLC in 2001 tobegin marketing the technology in the U.S. SCR-Tech initiated commercialoperations in its Charlotte regeneration facility in early 2003.

***Industry Background and Market Opportunity***

SCR systems are used most commonly in large coal-firedand natural gas-fired power plants. SCR technology is based on catalysts thatremove NOx from the power plant exhaust by reducing it with ammonia toelemental nitrogen and water vapor. Over time, ash buildup can cause physicalclogging or blinding of the catalyst, which can negatively impact theperformance of both the SCR system and the power generating facility. Inaddition, the NOx removal efficiency of SCR systems gradually declines as aresult of catalyst deactivation caused by various catalyst poisons present inthe flue gas, resulting in the need for some form of catalyst exchange.Historically, the spent catalyst has been replaced with new catalyst, a costlyprocess. Because utilities and IPPs have been facing increasing pressure tolower their O&M costs, plant operators are seeking more cost-effective SCRcatalyst management solutions.

NOx is considered to be one of the principalcontributors to secondary, ground level ozone, or smog, and energy producersand other industries operating large power plants, particularly in the Easternhalf of the U.S, have been required to reduce their NOx emissions by at least85 percent by 2007 as part of the Environmental Protection Agency’s (“EPA”) NOxSIP Call. The NOx SIP Call requires major NOx reductions during the “ozoneseason” (May 1-September 30) in 19 Midwestern and Easternstates1 and the District of Columbia to mitigate the regionaltransport of ozone, which is contributing to the poor air quality of downwindstates. As a result, these areas have been required to revise their SIPs,outlining measures to reduce NOx emissions to a statewide limit determined bythe EPA for each affected state. As part of the NOx SIP Call, these areas wererequired to begin implementing new controls by April 2004 to reduce NOxemissions in an effort to reach compliance with EPA established limits by September 2007.In general, during non-ozone season periods, most operators do not have anyrequirements to run their SCR systems unless regulations are further tightened.

Coal-fired plants currently account for more than halfof the nation’s power generating capacity and are poised to play an evengreater role in future power generation. An October 2004 report publishedby The McIlvaine Company projects that the present coal-fired generatingcapacity in the U.S. of 329 gigawatts (“GW”) will expand to 356 GW by 2012. Coal-firedplants have also become a primary target for NOx reduction. With NOx removalefficiencies of up to 95 percent, SCR systems are considered to be the mosteffective and most widely used technology by coal-fired power plant operatorsto comply with increasingly stringent U.S. emissions regulations. As a result,the installed base of SCR systems has increased dramatically in recent years.It is projected that by the end of 2005, approximately 100 GW of coal-firedgenerating capacity in the U.S. will be operating with SCR systems to complywith the EPA’s NOx SIP Call, creating a large and growing market for SCRcatalyst management services. As a result of this recent growth in new SCRsystem installations, the market for SCR catalyst services is expected to morefully develop in the 2006-2007 timeframe. We believe the available marketfor catalyst replacement could reach $100 million by 2010. We also believecatalyst regeneration has the potential to play a significant role in thismarket, as it offers a more cost-effective approach than the replacement ofdeactivated catalyst.

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1                       Alabama,Connecticut, Delaware, Illinois, Indiana, Kentucky, Massachusetts, Maryland,Michigan, North Carolina, New Jersey, New York, Ohio, Pennsylvania, RhodeIsland, South Carolina, Tennessee, Virginia and West Virginia.

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In addition, recentFederal emissions mandates and other pending legislation offer significantupside market potential. In April 2004, the U.S. Environmental ProtectionAgency (“EPA”) announced a new 8-hour standard for the measurement ofground level ozone, or smog. Under this new standard, which took effect in June 2004,the EPA estimated that the number of areas in violation of air qualityregulations has grown from 271 to 475 counties, home to 159 million people. Asa result, 54% of the U.S. population now lives in areas where the moststringent emissions requirements are now being enforced. According to the EPA,the 8-hour ozone standard is just the first in a series of new airpollution rules expected to be issued, which could result in as much as$50 billion being spent on pollution control equipment at coal-fired powerplants over the next 15 years. For example, the EPA’s pending Clean AirInterstate Rule (“CAIR”), signed on March 10, 2005, calls for 28states in the Eastern U.S. and the District of Columbia to reduce NOx emissionsby more than 60% from 2003 levels by 2015. This rule builds on the NOx SIPCall and proposes to cut NOx emissions from power generating facilities by anadditional 1.7 million tons annually by 2009 and by 2.0 million tons annuallyby 2015. Accordingly, we expect substantial additional growth in the number ofSCR installations at coal-fired plants over the next decade.

***SCR-Tech’s Service Offerings***

SCR-Tech offers proprietary and patented processesbased on highly sophisticated and advanced technologies that can improve theNOx removal efficiency and extend the useful life of installed SCR catalyst,offering a compelling economic alternative to catalyst replacement.

SCR-Tech’s processes are capable of not onlyphysically cleaning and rejuvenating the most severely plugged, blinded orpoisoned catalyst, but of also chemically reactivating deactivated catalyst. Dependingupon the state of the installed catalyst, SCR-Tech offers several alternativesfor restoring its NOx removal efficiency and extending its life.

For lightly plugged or blinded catalyst that has notyet fully deactivated from catalyst poisons, SCR-Tech offers an “in-situ”cleaning process that can be performed on catalyst at the customer’s plant sitewithout requiring removal of the catalyst from the SCR unit.

For severely plugged or blinded catalyst that may havelimited deactivation from catalyst poisons, SCR-Tech offers an off-sitecleaning and rejuvenation process that is performed at SCR-Tech’s regenerationfacility. In this process, the customer removes the catalyst modules from theSCR unit and ships them to SCR-Tech. The cleaning process physically removesthe materials plugging the catalyst to improve its NOx removal efficiency whilethe rejuvenation process removes catalyst poisons to extend its useful life. Oncecleaned and rejuvenated, SCR-Tech returns the catalyst modules to the customerfor reinstallation in the SCR unit.

For severely plugged or blinded catalyst that hassignificantly deactivated, SCR-Tech offers an off-site regeneration processthat restores deactivated SCR catalyst back to its original specifications andcatalytic activity. In this process, the customer removes the deactivatedcatalyst modules from the SCR unit and ships them to SCR-Tech’s regenerationfacility where the catalyst is both cleaned and chemically reactivated. Onceregenerated, SCR-Tech returns the catalyst modules to the customer forreinstallation in the SCR unit. Upon reinstallation, the regenerated catalystdelivers the same level of performance and deactivation rate as the originalcatalyst. Catalyst regeneration provides SCR operators a significantly lowercost alternative to catalyst replacement and essentially eliminates the need todispose of deactivated catalyst, which can be considered hazardous waste.

SCR-Tech also provides SCR system management servicesincluding ammonia injection grid (“AIG”) tuning to optimize efficiency andreduce overall O&M costs, and consulting services related to the managementand design of SCR systems, including catalyst specification, selection andinitial performance testing for guarantee verification. These services haveprincipally been performed by, or under the supervision of, Hans Hartenstein,former president of SCR-Tech, whose employment with the Company 

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terminated in March 2005.Effective March 21, 2005, William J. McMahon, a seasoned executive withmore than 25 years of experience in the energy and utility industries, wasappointed president of SCR-Tech.

SCR-Tech’s cleaning,rejuvenation and regeneration services have represented, and are expected tocontinue to represent for the foreseeable future, the substantial majority ofSCR-Tech’s revenues.

***Customers***

Since its founding in May 2001, SCR-Tech hasperformed SCR Catalyst and Management Services for some of the largestutilities and IPPs, and their equipment suppliers, in the U.S. including AES,Alstom, Duke Power, Englehard, Mirant, National Energy & GasTransmission, South Carolina Electric & Gas, Southern Company’ssubsidiaries, Alabama Power and Georgia Power. In March 2003, SCR-Techgreatly expanded its service offerings when it commenced commercial operationin its regeneration facility.

As part of an ongoing commercialization strategy,SCR-Tech is actively targeting SCR operators throughout North America tobroaden its established customer base and is in active negotiations today withseveral potential new customers.

In 2004, SCR-Tech serviced17 plant sites for 17 different customers, and secured 23 purchase orders for avariety of SCR services, including three contracts with leading utilities toprovide SCR catalyst cleaning and regeneration services.

***Competition***

We expect SCR-Tech’s cleaning and rejuvenationprocesses to compete with alternate cleaning and rejuvenation processes currentlyin the marketplace. We are aware of at least one company, Enerfab, Inc.,that offers on-site SCR catalyst cleaning and washing process that requires theremoval of the catalyst from the SCR system. We believe that SCR-Tech’spatent-protected cleaning process offers several competitive advantages,including both an off-site process and an “in-situ” process that does notrequire the removal of the catalyst from the SCR system.

While there is somecompetition for catalyst cleaning and rejuvenation, we are not aware of anyother company in North America offering a regeneration process that canchemically reactivate SCR catalyst back to its original specifications.Accordingly, new catalyst remains the primary competition for SCR-Tech’sregeneration process. The leading SCR catalyst suppliers to the U.S. coal-firedpower generation market include Cormetech, Haldor Topsøe and Hitachi America.While we believe that SCR-Tech’s regeneration process offers a significant costadvantage over the purchase of replacement catalyst and essentially eliminateshazardous waste disposal issues associated with spent catalyst, it is possiblethat these companies and others could eventually develop a solution that maycompete with ours. Nonetheless, we believe the strength of SCR-Tech’sintellectual property and patent protection creates a significant barrier fornew entrants to the market. In addition, we believe that our first moveradvantage in the regeneration marketplace will help us maintain our leadingmarket position.

**Catalyst-BasedTechnology Solutions**

Our Catalyst-BasedTechnology Solutions segment includes our business activities associated withthe design, development, and manufacture of advanced products based on ourproprietary catalyst and fuel processing technologies to offer cost-effectivesolutions for reducing NOx emissions from combustion-related applications. Thesebusiness activities include Emissions Control Solutions for Diesel Engines, NOxControl Solutions for Gas Turbines, and Fuel Processing Solutions for Fuel CellApplications.

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**Ø     Emissions Control Solutions for Diesel Engines**

We are leveraging ourcatalyst technology expertise with a proven fuel processing competency to offerinnovative emissions reduction solutions for mobile, stationary and off-road dieselengine applications, targeted at helping diesel OEMs, government agencies, andpower producers meet the growing diesel emissions challenge.

***Industry Background***

In October 1997, the EPA adopted new NOxemissions standards for heavy-duty diesel truck and bus engines to be phased inthrough 2010. The first phase of these stricter limits took effect in October 2002when the requirements for NOx were reduced from 4.0 grams per brakehorsepower-hr (“g/bhp-hr”) to 2.5 g/bhp-hr. Non-compliance with the October 2002deadline resulted in steep fines imposed by the EPA of as much as $12,000 perengine. The most stringent of the EPA’s new emissions standards requires aphased-in 50% reduction by 2007 over the current standards, with another 80%reduction by 2010, resulting in a 0.2 g/bhp-hr limit by the end of the decadefor all heavy-duty diesel trucks and buses. The aggregate 90% reduction in NOxrequired by 2010, in particular, has created a major technological hurdle fordiesel engine OEMs for which a single technology path has yet to be adopted.Lighter-duty applications in the U.S., including heavy light-duty diesel trucksand passenger vans, are also facing tighter NOx emissions standards to bephased in through 2009.

Increasingly stringent emissions standards are alsobeing imposed on diesel engine markets in the European Union (“EU”) and Japan.For example, in April 2005 Japan will impose the world’s strictestemissions standards to date for urban heavy-duty trucks and buses, requiring a41% reduction in NOx emissions to 1.49 g/bhp-hr. Japan’s Central EnvironmentCouncil subsequently announced in February 2005 that it has drawn uprecommendations to further tighten Japan’s diesel emissions standards for allvehicles sold beginning in 2009, which could result in emissions limits thatare more closely in-line with those that are scheduled to be imposed in theU.S. in 2010. While current U.S., EU and Japanese emissions reduction mandatesremain fragmented, there is a growing demand for the harmonization of tighterstandards throughout these markets.

At the same time, mobile and stationary diesel enginesin service today along with other off-road diesel-powered equipment are comingunder increasingly intense scrutiny by government officials in an attempt toreduce urban smog in emissions-sensitive areas across the country. According tothe EPA, existing diesel sources contribute as much as 50% of NOx emitted inmany U.S. urban areas, making them a prime target for emissions controls. Governmentagency funding for diesel retrofits continues to develop in an effort to meetair quality objectives, and, in some cases, to avoid severe EPA sanctions orthe loss of Federal Highway Administration funds. In addition, a growing numberof federal and state programs to fund school bus retrofits have emerged overthe past two years in an effort to reduce asthma and other pediatricrespiratory disorders associated with diesel exhaust.

Stationary diesel engines used in both back-up andprime power applications currently face operating restrictions as a result ofhigh emissions levels. If emissions can be brought into compliance, majorutilities, municipal power producers and other end-users could benefit fromextended operation and increased utilization of their diesel power generatingunits, even in the most stringent non-attainment areas. Among the many benefitsinclude the creation of emissions credits and reduced electricity costs byrunning these units during peak pricing periods. With appropriate permitting,these units could be dispatched during peak demand to open up a new option torelieve stress on constrained utility distribution systems, provide gridsupport, and improve reliability. Anotherpotential emissions control opportunity is diesel engines that driveagricultural water pumps. Due to significant air quality degradation caused bymany such pumps, particularly in the Central Valley of California, there ismounting political pressure to re-power the pumps with electric motors usinggrid electricity. However, this could push electricity demand beyond supply 

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duringhot summer months. An economical diesel emissions reduction solution couldprovide a new option for continued operation of these pumps.

New stationary dieselengines will soon face even tougher regulations. In 2000, the state ofCalifornia passed Senate Bill 1298 (“SB 1298”) requiring the California AirResources Board (“CARB”) to set new emissions standards and provide guidancefor the permitting of new electrical generation technologies less than 50megawatt (“MW”) in size. The first phase of emissions limits under the new CARBcertification program and guidance document took effect in January 2003,with even tighter limits scheduled to be imposed beginning in January 2007.In addition, new stationary diesel engines along with other diesel-poweredequipment used in construction, agricultural and other off-road applicationswill soon have to comply with new federal emissions restrictions. In May 2004,the EPA announced the signing of the Bush Administration’s Clean Air NonroadDiesel Rule that will cut emissions from off-road diesel-powered equipmentby more than 90%. The new standards, also known as the U.S. Tier 4 emissionsstandards, will be phased in between 2008 and 2015 and are expected to resultin the widespread introduction of diesel emissions control systems for newnonroad diesel equipment.

***Market Opportunity***

Diesel engine manufacturers in the U.S., andinternationally, continue to seek enabling solutions to meet increasinglystringent emissions standards. In 2004, approximately 1.2 million dieselengines were produced in North America for on-highway applications. U.S. heavyduty diesel (“HDD”) engine manufacturers intend to pursue in-house enginemodifications similar to those used in their 2002 compliant engines to meet theinitial 2007 step-down in emissions requirements. However, the most severe NOxreduction requirements, which will be phased into various segments of the U.S.HDD market between 2008 and 2010, remain a difficult challenge that we believewill require some form of advanced NOx after-treatment or significant advancesin diesel engine technology. We are also exploring opportunities in marketsoutside of the U.S., including Japan, which produces approximately 200,000diesel bus and truck engines annually. Other global markets in Europe and Asia,which are considering more stringent emissions regulations similar to thosebeing imposed in the U.S., in addition to heavy light-duty diesel trucks andpassenger vans in the U.S. and internationally, could offer promisingadditional markets for our emissions solutions.

We believe the retrofit market for mobile andstationary diesel engines in the U.S. offers a more near-term opportunity forus than the new engine market. The EPA estimated in 2001 as many as 10 millionsources of diesel emissions were in service in the U.S., many operating inemissions-sensitive areas of the country.

Funding sources for diesel retrofits continue to buildon both the state and federal level. As a result of a recent growth in fundingsources, the total addressable market for diesel retrofits is expanding. On thefederal level, a variety of programs have been proposed to reduce emissionsfrom a variety of diesel sources. The Congestion Mitigation and Air Quality (“CMAQ”)Program, sponsored by the Department of Transportation, and administered by theFederal Highway and Federal Transit Administrations, is providing fundstotaling more than $1.75 billion per year for states to invest in air qualityimprovement projects, with diesel retrofit recently added as an acceptablecandidate for appropriations. In January 2004, the EPA called for thenation’s fleet of school buses to install pollution control devices in aneffort to combat rising health concerns associated with diesel exhaust fumes. Toassist in this effort, the EPA has allocated $7.5 million in funding for fiscal2005 for a cost-shared grant program to school districts to upgrade theirdiesel fleets under its Clean School Bus USA program.

According to the EPA, the number of states pursuingdiesel retrofit programs has grown from 10 states in 2003 to 20 states plus theDistrict of Columbia in 2004. Programs to funnel state or federal dollars toretrofit diesels with emissions control systems are in place today in Alabama,Arizona, California, 

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Colorado, Connecticut, theDistrict of Columbia, Georgia, Illinois, Indiana, Maine, Maryland,Massachusetts, New Hampshire, New Jersey, New York, North Carolina, Ohio,Pennsylvania, South Carolina, Texas and Washington.

Both California and Texas, in particular, havecommitted significant annual funding for diesel emissions reduction. California’sCarl Moyer Program has created a dedicated funding source for air pollutionreduction. This program is encouraging projects to reduce emissions fromheavy-duty diesel engines by offering up to $140 million annually in incentivegrants through 2015. As part of the Texas Emissions Reduction Program (“TERP”),the state of Texas announced NOx reduction grants for 2004 totaling in excessof $80 million, and has budgeted in excess of $130 million annually for years2005 through 2008 to help fund the deployment of diesel NOx reduction solutionsto achieve a significant reduction in air pollution and reach compliance withits State Implementation Plan (“SIP”). According to industry reports, retrofitprograms are also now emerging in Canada, Japan and in the European Union toaddress approximately five million HDD engines, as estimated by the 2003Transportation Industry Data Book.

According to the NortheastStates for Coordinated Air Use Management (“NESCAUM”), as many as 350,000stationary diesel generators are installed throughout the U.S., many of whichare restricted in operation as a result of high emissions levels. We haveidentified more than 35,000 emergency standby diesel generator sets in the 100kW to 1.5 MW size range permitted throughout the Northeast, California andTexas, areas imposing the strictest emissions regulations, that could becandidates for an emissions reduction retrofit solution. In addition, more than36,000 new stationary diesel engines are produced annually in North America forpower generation applications, many of which are candidates for emissionscontrol today, and many more which will require emissions controls beginning in2007 and 2008 when the CARB and U.S. Tier 4 emissions standards are phased in,respectively. Further, more than 200,000 additional diesel engines are producedeach year in North America for use in construction, agricultural and otherindustrial equipment that will also have to comply with the U.S. Tier 4standards.

***Diesel Emissions Reduction Applications Development***

We have developed a proprietary fuel processingtechnology that is designed to facilitate a significant reduction in NOx fromdiesel engine applications by enabling more effective regeneration of NOxadsorber systems. Our unique approach to diesel fuel processing leverages ourXonon® catalyst technology and our extensive work in gasoline and diesel fuelprocessing for fuel cell applications.

We are focused on bringing the benefits of our dieselfuel processing solutions to the growing diesel emissions reduction market bypartnering with diesel OEMs, Tier 1 catalyst providers (direct suppliers toOEMs), system integrators, and other leading companies within the dieselindustry.

In an effort to further advance the cost-effectivedevelopment of our diesel emissions reduction solutions, we completed in thefall of 2003 the construction of a diesel test facility. Since that time, wehave completed numerous in-house, full-scale engine tests. These tests areproviding us with valuable data that we are using to further optimize ourtechnology solutions for commercial application. This test facility will alsoenable us to simulate EPA certification and CARB verification protocols as wellas advanced durability testing for a broad diesel engine population as we workto accelerate the product development path of our solutions for both new engineand retrofit applications.

We are currentlydeveloping our core diesel fuel processing technology for three applications:

1.     Diesel OEMsolution for new mobile engine applications

2.     Dieselretrofit solution for “in service” mobile engine applications

3.     Diesel generator set (“genset”) solution for stationary dieselengine applications

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***1.   Diesel OEM Solution***

We have developed and are now refining a proprietarydiesel fuel processor technology for new mobile engine applications as a meansfor diesel OEMs to meet the most stringent impending NOx emissions regulations.Our Xonon fuel processor, or XFP, technology is designed to enable a greaterthan 90% reduction in NOx by improving the performance of NOx adsorber catalystsystems. NOx adsorbers, also referred to as NOx traps, represent one of theapproaches believed to have the greatest potential to meet the EPA’s 2010emissions mandate.

NOx adsorbers adsorb NOx from the exhaust and convertthe NOx to non-polluting nitrogen during a regeneration cycle. NOx adsorbertechnology today offers considerable NOx reduction capabilities, butperformance issues related to durability, operating range and fuel economy havelimited their viability for some diesel engine applications. In most cases,diesel fuel injected at the engine or in the exhaust system upstream of the NOxadsorber is used for the regeneration cycle. This process can give goodperformance at high exhaust temperatures, but historically has demonstratedpoor performance at lower exhaust temperatures. Low exhaust temperatures (aslow as 200 degrees Celsius) represent a large portion of vehicle operatingtime, particularly for medium and light duty diesel engine applications used inurban areas and for automobiles, light trucks and SUVs. Our XFP is designed todeliver rapid, low-temperature NOx adsorber regeneration with improved fuelutilization and efficient desulfation (elimination of sulfur within the NOxadsorber associated with the sulfur naturally occurring within diesel fuel) tosignificantly improve NOx adsorber performance and durability. We believe thecombination of our XFP with a NOx adsorber can enable diesel OEM implementationof a durable, economical, reasonably sized NOx reduction solution that complieswith the most stringent emissions requirements with minimal fuel penalty.

In July 2003, we announced successful completionof the first full-scale test of our prototype XFP on a 7+ liter HDD engine,which demonstrated the rapid regeneration capabilities of our technology andits potential to significantly improve the performance of NOx adsorbers. Thetests, which were conducted with a leading HDD engine manufacturer, focused onverifying the performance of our XFP at low exhaust temperatures. Test resultsdemonstrated highly efficient, rapid NOx adsorber regeneration, resulting inNOx conversion in line with the EPA’s mandated emissions requirements for 2010.

These tests provided us with valuable data we haveused to further develop and refine our technology to enhance the operatingrange and fuel economy performance of our XFP system and to facilitatedesulfation of the NOx adsorber catalyst at lower temperatures, thus providingincreased NOx adsorber durability. According to the EPA, improving thedurability of NOx adsorbers, especially as it relates to desulfation, remains afundamental hurdle to commercial NOx adsorber deployment in HDD applications.

In 2004 we completed a number of additional full-scaleengine tests and demonstrations of our XFP technology with other diesel enginemanufacturers as well as with Tier 1 system integrators. OEM test activities,in particular, included a focus on verifying operation at low exhausttemperatures as well as demonstrating desulfation strategies. Tests of our XFPcombined with a NOx adsorber catalyst were conducted on both 5 and 8 literdiesel engines at two separate OEM facilities, and successfully demonstratedNOx reduction in excess of 90% over a broad range of operating conditions witha total fuel system usage of less than 3%. In addition, both NOx adsorberoperation and regeneration were demonstrated at low exhaust temperatures. OurXFP also demonstrated full regeneration of a sulfur-poisoned NOx adsorbercatalyst, a critical requirement to enable operation of NOx adsorber systems,even with the ultra-low sulfur diesel (“ULSD”) fuel mandated in the U.S. for2007 and beyond. Further, we believe that these tests demonstrated the abilityof our XFP technology to bring added flexibility for OEM NOx adsorberregeneration and desulfation strategies to accommodate the wide variety of NOxadsorber system designs currently being pursued. For example, our XFP enabledvery rapid regeneration cycles that would be required for transient engineoperation.

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As a result of the favorable performance demonstratedin these OEM tests, we received commitments by both diesel engine manufacturersto conduct additional test activities in 2005. We continue to build on thepositive results of our recent test activities to further optimize our XFPtechnology in connection with NOx adsorber systems with the goal of bringing ahigh performing NOx reduction solution to diesel engine OEMs for their dieselengine products and ultimately a cost-effective product to the end usecustomer.

For new engine applications, we are committed toworking with diesel OEMs, NOx adsorber providers and/or emissions systemintegrators to jointly develop and commercialize robust NOx control systems tomeet the most stringent U.S. and international emissions requirements. To gainmarket share and penetrate new markets while maintaining compliance with newemissions standards, OEMs and Tier 1 suppliers seek to differentiate theirproducts with technological advances that benefit their customers. We believethat the combination of our XFP and a third party NOx adsorber has thepotential to offer a cost-effective NOx reduction solution with minimal fuelpenalty to enhance an OEM’s product line and offer significant competitiveadvantages. Accordingly, we have taken an active role over the past two yearsin establishing and building relationships within the diesel industry, both inthe U.S. and internationally, in line with our objective to secure partners tofurther develop and commercialize our XFP for new mobile engine applications.

As a result of theseefforts, in December 2004 we signed a Memorandum of Understanding (“MOU”)with a leading company in the diesel industry following our successfulcompletion of a technology demonstration at their facility. The terms of theMOU include a commitment to further evaluate our XFP in 2005 for application totheir technology platforms with the intent of entering into a future jointdevelopment agreement. We also continue to be in active discussions today witha number of other companies within the diesel industry, including both dieselOEMs and systems integrators, relating to both testing and joint developmentopportunities in North America and Asia.

***2.   Diesel Retrofit Solution***

We are also developing a retrofit solution for mobilediesel engine applications as a means for government agencies to addressgrowing urban smog issues in emissions-sensitive areas. Our mobile retrofitsolution combines a derivative of our XFP technology with a NOx adsorbercatalyst and is being designed to offer a scalable, easily integrated solutionfor diesel engines currently in service.

Successfuldevelopment and commercialization of this solution will bring three main benefitsthat could differentiate our technology from current mobile retrofit solutionson the market today:

1.                A lower installedcost when compared with alternate solutions,

2.                A potential NOxreduction capability of 50% or greater, compared with 25% offered by the onlyalternate non-SCR solution offered today, and

3.                A potential tooperate across a broad temperature range, including low temperature conditions,in which a significant portion of urban vehicles such as buses and refusetrucks operate today.

In 2003, we completed initial subscale, in-house rigtests of our retrofit solution demonstrating a 50% NOx reduction whileoperating on standard U.S. highway diesel fuel with 500 parts per million (“ppm”)sulfur content. Since that time, we have continued to develop a next generationversion of our retrofit technology with a focus on increasing the NOx reductioncapability of the system and optimizing its use for multiple diesel engineapplications. As part of this effort, we evolved our solution during the firstof half of 2004 from combining our diesel fuel processor with a lean-NOxcatalyst to now combining our diesel fuel processor with a NOx adsorbercatalyst. This current approach has enabled us to better leverage thetechnology synergies of both our OEM and stationary diesel engine applicationswhile providing enhanced performance and cost benefits. We have since assembledfull-scale prototypes of our next generation solution and have completed anumber of full-scale, in-house engine tests of our modified approach with 

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favorable results. Mostrecently, we progressed to an AVL-8 mode test using a full-scale, 7.6liter heavy-duty diesel engine. An AVL-8 mode test is a steady-stateengine test procedure with 8 test points designed to closely correlate withdifferent engine speeds and load factors, and offers a good indication of howour technology might perform in future EPA product verification testing. Inthis most recent test, we achieved another product development milestone bysuccessfully demonstrating NOx reduction well in excess of our 50% target. Weview these results as another positive step toward our commercialization goals.

In recognition of the significant technical progresswe made over the past year and the commercial prospects for our technology, wewere awarded a $330,000 grant in November 2004 by the Texas Commission onEnvironmental Quality (“TCEQ”) under its New Technology Research andDevelopment (“NTRD”) Program to help support the first on-vehicle demonstrationof our mobile retrofit solution. The field demonstration will evaluate theperformance of our diesel fuel processing technology in combination with a NOxadsorber catalyst, and its potential to offer a cost-effective, easyintegration solution for the mobile retrofit market. In support of this effort,the City of Denton, Texas has agreed to supply two heavy-duty diesel trucks forthe on-road demonstration, which is currently scheduled to commence in thesecond quarter of 2005.

Although our prospects for this market are exciting,we recognize that we still have significant technical and commercial hurdles toovercome that will be critical to our success. In preparation for a forthcomingon-road demonstration of our technology, we must first complete a variety ofintegration activities. With successful field demonstration results, we mustthen advance our technology to an EPA and / or CARB verified retrofitsolution before we can introduce the product in the marketplace as mostgovernment agencies will only fund verified products. Accordingly, we continueto evaluate our progress in developing a commercially viable retrofit solutionand our ability to capitalize on the finite time horizon associated with thediesel retrofit market.

For mobile retrofit applications, we are focused onpartnering with system integrators and field service providers to jointlydevelop and commercialize our product. We believe the scalable, viableintegration retrofit solution we are developing could have the potential toachieve maximum NOx reduction in a cost-effective manner to enhance a partner’sproduct line and offer significant competitive advantages.

In line with thisobjective, we signed an MOU in January 2005 with a leading retrofitintegrator, including a commitment to further evaluate the commercial prospectsof our mobile retrofit solution with the intent of entering into acommercialization agreement.

***3.   Diesel Genset Solution***

We are building upon the successful test results wehave achieved with our diesel fuel processor in combination with a NOx adsorbercatalyst for both new and retrofit mobile diesel engine applications and arenow extending application of this technology to stationary diesel engines. Thegoal of this development effort is to provide a cost-effective, bolt-onsolution for widespread commercial application that enables both new andinstalled stationary diesel generators to significantly reduce NOx emissions.

In June 2004, we wereawarded a $480,000 contract by the Electricity Innovation Institute (“E2I”),an affiliate of the Electric Power Research Institute (“EPRI”), and supportedby The Public Interest Energy Research (“PIER”) program of the CaliforniaEnergy Commission (“CEC”) and Hawaiian Electric Company, Inc. (“HECO”),for the Phase I development of a greater than 90% NOx reduction system forstationary diesel engines.

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In December 2004, we completed the first phase ofa potential three-phase development and demonstration program focusing on thedesign and performance of our diesel fuel processing technology in combinationwith a NOx adsorber catalyst for both new stationary diesel engines andretrofit applications. This first phase culminated in a 100-hour enginetest of our fuel processor-driven NOx adsorber catalyst system, whichsuccessfully demonstrated a greater than 90% reduction in NOx while operatingon a full-scale 8.3 liter diesel generator set rated at 160 kW.

As a result of the favorable results achieved in thisinitial engine demonstration, we have recently initiated a more in-depthevaluation of the market opportunity, and are pursuing additional funding opportunitiesfor Phase II of the program. With continued funding support, Phase II willinclude further development of the technology in 2005 in preparation for a 1000-hourfield demonstration at an end-user site in the 500 to 1000 kW power range toverify system performance in a commercial setting. In addition to targetingprospects for outside funding, we are also beginning to explore prospectivejoint development opportunities for the program with strategic partners.

With funding support,continued success in a forthcoming field demonstrations, and further assessmentof the commercial prospects for the technology, we anticipate pursuing PhaseIII field testing of pilot commercial production versions of the systemfollowed by a limited commercial release. Results from these activities willdetermine the potential for offering the product on a broader scale to thesub-two megawatt diesel power generation industry.

***Competition***

We expect our solutions to compete with currentemissions reduction technologies under development by diesel OEMs, Tier 1suppliers and systems integrators, which also represent the potential customerbase for our NOx reduction solutions. While even the most effective of thesecompetitive systems has limitations relating to the amount of NOx reductionthat can be achieved, we expect these diesel industry players will continue todevelop technologies that may compete with ours.

For new mobile engine applications, NOx adsorbersalong with diesel SCR systems, Clean Diesel Combustion (“CDC”), andLow-Temperature Combustion (“LTC”), including Homogeneous Charge CompressionIgnition (“HCCI”), solutions represent the approaches believed to have thegreatest potential to meet the EPA’s 2010 emissions mandate. Leading dieselengine manufacturers such as Cummins, Caterpillar, Detroit Diesel Corporation,Navistar-ITEC and Volvo are currently developing and exploring a variety of NOxcontrol solutions, ranging from advanced fuel systems, cooled exhaust gasrecirculation (“EGR”), NOx catalysts, advanced engine controls and SCR systems.Most of these diesel OEMs completed in-house engine modifications to achievethe October 2002 EPA mandate, and are now pursuing refinements to theirengine designs to meet the next phase of U.S. emissions requirements that willtake effect in 2007. However, diesel OEMs have indicated that further enginemodifications will not be able to achieve the 2010 U.S. mandated 90% reductionin NOx without some form of advanced NOx after-treatment or significantadvances in CDC or HCCI/LTC solutions.

While a variety of after-treatment technology pathsare currently being evaluated in the U.S. to meet the 2010 EPA mandate, theafter-treatment solutions considered to have the greatest potential to meet the0.2 g/bhp-hr target are NOx adsorbers and SCR systems. With respect to SCRsystems there are some significant downsides associated with their use inmobile diesels, which have created concerns over their widespread use. SCRrequires ammonia in urea form to neutralize NOx in the exhaust, raisingenvironmental concerns and requiring the creation of an infrastructure to houseurea or ammonia tanks at filling stations across the country as well asassociated compliance issues when tanks run dry. Nonetheless, we are aware thatsome European diesel engine OEMs are planning to implement SCR for heavy-dutydiesel engine applications in Europe to meet the Euro IV emissions standardsbeginning in October 2005.

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NOx adsorbers, on the other hand, use diesel fuel inthe NOx reduction process, eliminating the need for a costly new infrastructureand mitigating the risk of noncompliance by vehicle operators. We believe thatthrough the use of our XFP technology in combination with a NOx adsorber, wecan enable a robust, cost-effective and practical commercial solution to meetthe most stringent NOx requirements in the U.S. and select global markets.Accordingly, a growing number of diesel OEMs continue to inquire about ourability to support their next phase of emissions control needs as NOx adsorbersremain a favored technology path to comply with stringent environmentalstandards.

Over time, our XFP may also face competition from newentrants to the market for diesel emissions reduction. New entrants mayeventually develop competing technologies that achieve a similar level ofemissions reduction on a cost-effective and practical basis. We are aware of atleast three other companies which are separately pursuing the development of adiesel fuel processing technology that is designed to work in conjunction witha lean NOx adsorber to enable emissions reduction in line with the 2010 EPAmandate.

With respect to retrofit applications, we are aware ofone company, Cleaire, which is marketing a non-SCR retrofit solutionoffering a 25% reduction in NOx for mobile diesel applications. In January 2005,Extengine Transport Systems announced CARB verification of an SCR retrofitapplication for certain off-road diesel engines from 150 to 200horsepower used in excavators, bulldozers and loaders that claims a 80%reduction in NOx. There are other companies currently offering or developingalternate NOx control options that may compete with retrofit solutions. Thesetechnologies include EGR, engine “repowers” or replacements, compressed naturalgas, or CNG, and others. Both SCR solutions along with these alternatives mayresult in NOx reductions in excess of 50%, but we believe they are also morecostly than non-SCR-based retrofit solutions, such as the one we are pursuing.Our retrofit solution may also face competition from new entrants to the marketthat may eventually develop competing retrofit technologies, catalytic orotherwise, that achieve a similar reduction in NOx as our technology on acost-effective basis. Cleaire, for example, is currently developing a non-SCR-basedretrofit solution targeting a 30-35% reduction in NOx.

We believe the successful development of our retrofitsolution could offer a significant competitive advantage over alternate NOxretrofit solutions on the market today or currently under development. Inaddition to a NOx reduction potential of 50% or greater, compared with the 25%NOx reduction currently being offered by another supplier, our solution isdesigned to operate across a broader temperature range, possibly including lowtemperatures encountered while idling.

Forstationary diesel engine applications, the only available alternative today forreducing emissions to the most stringent required limits is through theaddition of an SCR system; which we believe can be costly for small diesel generatorsets. Our technology, we believe, could provide a more cost-effective means forstationary diesel engines to reduce their NOx emissions in line with thestringent emissions requirements being imposed in many areas of the U.S.  In addition, our system is being designed foreasy integration with a diesel particulate filter (“DPF”) to offer end-usecustomers a combined solution for the reduction of both NOx and particulatematter (“PM”).

**Ø     NOxControl Solutions for GasTurbines**

Our Xonon Cool Combustionproduct is the only commercially available pollution prevention technologyproven to achieve ultra-low NOx emissions of less than 3 ppm during combustion.Our Xonon® system is integrated within a gas turbine, replacing theconventional flame-based combustion system with a catalytic process thatcombusts fuel at temperatures below the threshold at which NOx forms. Thisapproach to reducing emissions is a significant departure from traditionalmethods of achieving ultra-low NOx levels in gas turbine power generation,which involve cleaning up downstream the pollution produced in the combustionprocess through costly, add-on exhaust cleanup systems. Through pollutionprevention 

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insteadof cleanup, we believe our Xonon system offers an efficient and cost-effectivemeans for gas turbine operators to meet increasingly stringent Federal andState-imposed NOx regulations.

***Industry Background and Market Opportunity***

A gas turbine operates by compressing incoming air,combining it with fuel and combusting the mixture. The combustion processreleases the fuel’s energy, forming hot gases that power the turbine. Inconventional combustion systems, a flame is used to combust the fuel. Thetemperature required to sustain a stable flame is significantly higher than thetemperature at which the gas turbine is designed to operate, so most of theincoming air is used to cool the combustion process to the level the turbinerequires. The high temperature required for a stable flame causes the nitrogenand oxygen in the air to react, forming NOx, a major contributor to airpollution. Over the past twenty years, advanced flame-based systems have beendeveloped which reduce the temperature at which the fuel is burned by alteringthe composition of the fuel—most often by using water, steam or air to dilutethe concentration of fuel in the combustor before it is mixed with thecompressed air and burned. As the fuel-air mixture becomes leaner, thecombustion temperature lowers, thus reducing the NOx emissions. These systemsare generically called “lean pre-mix” combustion systems. Today, most gasturbines are manufactured with a version of this type of system that uses airto dilute the mixture and are known as “dry low NOx” systems. Other than onegas turbine OEM that offers a 5 ppm NOx guarantee on one of its small gasturbine models, the most advanced flame-based combustion systems today arelimited to achieving NOx levels of approximately 9 ppm for certain newercommercial lean pre-mix systems, which are limited in application, and approximately25 ppm for less sophisticated systems. Historically, the only alternative formeeting increasingly stringent ultra-low NOx emissions requirements has been toadd a downstream exhaust cleanup system.

An ongoing barrier to adding new power generationcapacity is the continued public focus on environmental issues. In the UnitedStates, the Clean Air Act creates the National Ambient Air Quality Standards,or NAAQS, which are the basis for regulations that limit emissions of certainharmful pollutants such as NOx. Today, U.S. emissions regulations generallyrequire new installations of gas turbines to meet NOx emissions levels of 2.5to 25 ppm, depending on the location and size of the installation. The generaltrend is toward the lower end of this range, with all areas of the U.S. todaygenerally requiring ultra-low NOx emissions (less than 5 ppm) for newinstallations of gas turbines greater than 50 MW in size. In certain areaswhere air quality is currently unacceptable, smaller turbines are also beingrequired to achieve ultra-low NOx levels. In 2000, California passed SenateBill 1298 (“SB 1298”) requiring the California Air Resources Board (“CARB”) toset new emissions standards and provide guidance for the permitting of newelectrical generation technologies less than 50 MW in size. The first phase ofemissions limits under the new CARB certification program and guidance documenttook effect in January 2003, with even tighter limits scheduled to beimposed beginning in January 2007. On the federal level, the EPA announcedin April 2004 a new 8-hour standard for the measurement of groundlevel ozone, or smog. Under this new standard, which took effect in June 2004,the EPA estimated that the number of areas in violation of air qualityregulations has grown from 271 to 475 counties, home to 159 million people. Asa result, 54% of the U.S. population now lives in areas where the moststringent emissions requirements are now being enforced.

We believe the role ofstate and federal environmental protection requirements in the permitting ofnew power generation capacity highlights the need for a cost-effective,widely-applicable emissions technology, like Xonon, that enables turbines tomeet the most stringent existing emissions guidelines. We believe Xonon willnot only reduce the operating costs associated with complying withenvironmental standards, but could also create additional value by enablingrapid siting and permitting of projects that otherwise may not have beenpossible.

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***Xonon Cool Combustion***

Our Xonon system combusts fuel in a gas turbine usinga different principle than conventional flame-based combustion systems. Insteadof heating the fuel-air mixture in a flame until it is hot enough to burn,Xonon passes this mixture over a catalyst that allows the combustion reactionto take place at much lower temperatures. A portion of the fuel is combusted inthe catalyst. The remaining fuel is combusted downstream of the catalyst in ahomogeneous reaction, also at a temperature low enough to prevent formation ofsignificant amounts of NOx. The resulting concentration of NOx in the gasturbine exhaust will be in the range of 1 to 5 ppm and below 3 ppm in most gasturbines built today. Importantly, our flameless catalytic combustion approachprovides the same amount of output energy as flame-based combustion systemswhile achieving ultra-low NOx emissions without add-on exhaust cleanup systems.

We are focused on bringing the benefits of Xonon CoolCombustion to the power generation market through our strategic relationshipswith leading gas turbine manufacturers. In this regard, we continue tocarefully allocate our resources and priorities commensurate with opportunitieswe believe will contribute more significantly to the near-term growth of thebusiness as well as with development and commercialization activities that arelargely funded by OEM partners.

To gain market share andpenetrate new markets, OEMs seek to differentiate their products withtechnological advances that benefit their customers. The ultra-low emissionscapabilities and economic benefits offered by Xonon-equipped gas turbines couldgreatly enhance an OEM’s product line and offer significant competitiveadvantages.

***Development and Commercialization***

We have been working actively with gas turbine OEMs toadapt our technology as part of their stationary gas turbine product lines. Wecurrently have agreements in place with Kawasaki Heavy Industries, Ltd. andKawasaki Gas Turbines-Americas, a division of Kawasaki Motors Corp., U.S.A. (“Kawasaki”),and with GE Energy (“GE”), formerly known as GE Power Systems. We have alsorecently completed preliminary development work with Solar Turbines (“Solar”)associated with exploring the application of Xonon to one of its gas turbineproducts. Our development of the Xonon technology has been supported bygovernment agencies and research institutions, including the Department ofEnergy (“DOE”), the EPA, the CEC’s PIER program, CARB and others.

For each turbine model an OEM agrees to pursue, wedesign a catalytic Xonon module, the key component of the Xonon system, to beincorporated into the design of the turbine combustion system. At present, weguarantee our Xonon modules for 8,000 hours (equivalent to approximately oneyear of continuous operation), and are designed to be replaced during regularlyscheduled maintenance over the 15- to 20-year life of the turbine.We expect future revenues to be generated from the sale of both new andreplacement Xonon modules.

From 1999 through 2004, we conducted field demonstrationsof our Xonon Cool Combustion system on a 1.4 MW Kawasaki gas turbine at SiliconValley Power, a municipally-owned utility site, located in Santa Clara,California. Throughout its operation at Silicon Valley Power, the Company-ownedturbine functioned as part of the local power grid, serving alternately as ademonstration of Xonon’s performance and reliability during unattendedfull-load operation and as a development and test engine in support ofcommercial program initiatives for customers. In total, the Xonon-equippedturbine accumulated more than 20,000 hours of engine operation at SiliconValley Power with NOx emissions consistently well below 3 ppm. During thistime, the system satisfied federal EPA guidelines for an emissions controltechnology that is “achieved in practice” and demonstrated emissions levelsthat satisfy California’s South Coast Air Quality Management District (“SCAQMD”)guidelines for gas turbines. We believe Xonon is the only gas turbinecombustion system demonstrated to meet these guidelines without requiring adownstream exhaust cleanup system. Furthermore, we successfully completedevaluations by the EPA, through its 

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Environmental TechnologyVerification program, and by CARB through its technology precertificationprogram, both of which confirmed the ultra-low emissions performance of ourtechnology while operating on a gas turbine.

In partnership with Kawasaki, we installed the firstcommercial Xonon-equipped gas turbine in November 2002, marking the world’sfirst commercial operation of a catalytic combustion system in a gas turbineand a major milestone in gas turbine innovation. The 1.4 MW Kawasaki gasturbine, operating at Sonoma Developmental Center in Eldridge, California, isalso the first commercial gas turbine to generate ultra-low emissions powerwithout the use of a downstream exhaust cleanup system.

Our initial product offerings target the small gasturbine sector, which includes turbines that generate between one andapproximately 15 MW of power. According to Forecast International, theworldwide production of gas turbines in this size class is projected to average370 units annually over the next 10 years. In North America, orders for gasturbines between one and 15 MW have averaged 38 units annually over the pastthree years according to Diesel & Gas Turbine Worldwide. Turbines inthis sector serve industrial, commercial and institutional loads in both poweronly and combined heat and power, or cogeneration, applications and can helpmeet power requirements during periods of peak demand at base-load powerfacilities. Small gas turbines are also used in the pipeline industry totransport oil and gas.

Distributed generation applications, or power sourceslocated at or near the point of use, can enhance power quality and reliabilitywhile avoiding the need to expand transmission and distribution capacity. Webelieve the distributed generation concept has the potential to address anumber of ongoing problems in the power industry, including limitations in thebulk power transmission grids, environmental and community oppositionsurrounding the construction of new power lines, concerns about thevulnerability of the power infrastructure, and the need for high quality,reliable power. While the distributed generation market has proven slow toemerge, we believe there is a substantial, long-term market opportunity inconstrained transmission pockets in certain areas of the U.S., wherebyinstallations of small and medium-sized distributed power units, such asXonon-equipped gas turbines, can serve to alleviate bottlenecks. The LosAngeles basin and certain areas of New York are examples of regions we believecould benefit from such a solution.

We work withleading gas turbine manufacturers in adapting and marketing Xonon for gasturbines within the one to 15 MW size range. Below is a listing of current andrecently completed programs:

**Kawasaki GPB15X (1.4 MW)**—In December 2000, we enteredinto a collaborative commercialization agreement whereby Kawasaki could marketand sell our Xonon Cool Combustion system as part of its GPB15X generatorpackage, which features a 1.4 MW M1A-13X Kawasaki gas turbine equippedwith Xonon. Kawasaki is actively marketing and accepting commercial orders forthis generator package. The first commercial Xonon-equipped GPB15X enteredoperation at Sonoma Developmental Center in Eldridge, California in November 2002.This unit continues to operate as part of a cogeneration system, which isproviding supplemental heat and power for a 120-building campus. A secondcommercial Xonon-equipped GPB15X entered service in December 2003 atPlains Exploration and Production Company’s oil field in San Luis Obispo,California. This unit continues to operate as part of a cogeneration system,which is providing electricity to power oil pumping systems and steam createdfrom the exhaust heat to facilitate extracting oil from the ground. Kawasakihas shipped additional commercial Xonon-equipped GPB15X generator packages forother customer sites in both California and in the Northeast, which are pendinginstallation.

Kawasaki continues to pursue initiatives to expand thepenetration of Xonon-equipped gas turbines in the market. In February 2002,Kawasaki successfully petitioned the California Public Utilities Commission toexpand qualification for self-generation financial incentives to includegenerating technologies up to 1.5 MW. As a result, California power projectsconsidering installation of the Xonon-equipped M1A-13X may qualify for asubsidy of up to 30 percent of project costs. 

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Additionally, Kawasaki entered into a distributionagreement with Cummins Power Generation in December 2002, whereby Cumminswill market, sell and service Kawasaki generator sets and power systems. Thisagreement has created an additional distribution channel for Xonon-equippedKawasaki products.

**GE10 (~10 MW)**—We and GEcontinue to pursue adaptation of Xonon for the GE10 under an agreement signedin May 2000. As part of our ongoing development of a Xonon-equipped GE10,we and GE have performed a series of rig tests followed by the completion of aninitial round of full-scale engine tests in the fourth quarter of 2003. Theinitial engine test activities revealed the need for additional modificationsof the catalyst and other combustion system hardware to better match thecatalyst to the turbine characteristics and to achieve optimal performancewithin a commercial GE10 gas turbine environment. Since that time, we and GEaccomplished the necessary modifications and proceeded to complete a secondround of full-scale engine tests in January 2005. During these most recenttest activities, the Xonon-equipped GE10 successfully demonstrated NOxemissions well below 3 ppm at base-load operating conditions. We and GE arecurrently conducting a more in-depth review of the positive results achieved inrecent testing, and plan to determine next steps for the Xonon-equipped GE10program by mid-2005.

**Solar TaurusTM 70 (7.5 MW)**—In October 2001, we entered intoan agreement with Solar for the joint development and adaptation of Xonon toSolar’s TaurusTM 70 gas turbine as part of a $3.0 million grant awarded to Solarby the CEC. The scope of our work in this joint development effort, whichcommenced in the first quarter of 2002, included the design of supplementarycombustor components in addition to the Xonon module for the catalyticcombustion system. In 2004, we completed our two-year joint developmentprogram, which culminated in a full-scale rig test of the jointly designedcatalytic combustion system, and the successful demonstration of NOx emissionsless than 2 ppm. At the present time, consistent with our OEM funding strategy,we and Solar Turbines do not intend to pursue further development of aXonon-equipped TaurusTM 70 gasturbine.

**Multi-combustor development (<15 MW)**—InSeptember 2001, the CEC granted us an award to help fund application ofthe Xonon Cool Combustion system to a small, multi-combustor gas turbine. Thedevelopment effort for this program commenced during the first quarter of 2002.During 2003, we successfully completed the technology development phase of theprogram. Since that time, we have redirected our technical focus entirely oncommercialization efforts associated with our OEM gas turbine programs. As aresult, there is no current activity associated with the continued developmentof Xonon for small, multicombustor gas turbines.

We also believe Xonon combustion systems can beapplied to larger gas turbine sizes. Larger gas turbines are used by publicutilities and wholesale generating companies in base-load power generatingfacilities, as well as for meeting power requirements during periods of peakdemand and in energy intensive industrial facilities for power generation andcogeneration. OEMs who manufacture gas turbines larger than 15 MW includeAlstom Power, GE, Mitsubishi Heavy Industries, Pratt & Whitney Canadaand Siemens Westinghouse.

We have performed initial development work and testingof Xonon for large gas turbines. Preliminary tests conducted with GE andanother large gas turbine manufacturer have confirmed Xonon’s ability to reduceNOx to ultra-low levels in the high temperature and high pressure operatingconditions of a large, industrial-type gas turbine.

As a result of ongoingchallenging market conditions in the U.S. gas turbine industry, particularlyfor large gas turbines, our current focus is to complete commercial deploymentof Xonon on small gas turbines. We do not expect Xonon modules for large gasturbines to comprise a significant portion of our revenue in the foreseeablefuture.

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***Competition***

We expect Xonon-equipped gas turbines to compete withturbines outfitted with current emissions reduction technologies, includingadvanced flame-based combustion systems and downstream exhaust cleanup systems.Advanced flame-based combustion systems, such as lean pre-mix or dry low NOxsystems, are manufactured and provided by gas turbine OEMs as part of theirturbine product line. These gas turbine OEMs also represent the potential customerbase for our Xonon modules, and we expect to rely upon them to distributeXonon-equipped turbines to end-users. While even the most effective of thesesystems have been unable to achieve today’s required ultra-low emissions levelswithout add-on exhaust cleanup systems, we expect that OEMs will continue todevelop technologies that may compete with ours.

Various companies, including Cormetech, Engelhard,Mitsubishi and Siemens, manufacture conventional exhaust cleanup systems.End-users generally purchase these systems directly from the manufacturers,through packagers, or from vendors of heat recovery steam generation equipment.Gas turbine OEMs generally do not function as intermediaries in thesetransactions and do not receive any economic value from the sale of exhaustcleanup systems.

The deployment of exhaust cleanup systems involves thecombination of a gas turbine equipped with an advanced flame-based combustionsystem and the addition of downstream cleanup equipment, which is fitted ontothe turbine to clean the exhaust. While cleanup systems have been proven toreduce NOx to ultra-low levels in most gas turbine applications, they addconsiderably to the square footage of the power generating facility, and can becostly to install and operate. For most downstream cleanup systems, otherdrawbacks may include a negative impact on turbine efficiency and the use oftoxic substances, such as ammonia, to clean up the pollution after it hasformed.

Through pollution prevention instead of cleanup, webelieve our Xonon Cool Combustion system presents a more practical andcost-effective approach to reducing NOx to ultra-low levels in the form of acompact system integrated within the gas turbine itself. The installation of aXonon-equipped turbine offers power producers an environmentally friendly,one-step approach to reducing NOx that requires no additional labor or space.Xonon can be widely applied and requires no toxic chemicals. As a result, webelieve Xonon could ease the challenges associated with siting, permitting, andoperating new power sources, enabling broader deployment of gas turbines indensely populated areas.

Over time, the Xonon combustion system may also facecompetition from new entrants to the market for emissions reduction. Newentrants may eventually develop competing technologies, catalytic or otherwise,that also achieve ultra-low emissions on a cost-effective basis. We are awareof other companies pursuing the development of ultra-low NOx technologies withgas turbine OEMs, including Precision Combustion, Inc., ALZETA Corporationand Cheng Power Systems.

We are also aware of companies developing NOxreduction solutions approaching ultra-low NOx emissions. Solar Turbines, aleading gas turbine manufacturer of small gas turbines in the one to 14 MWrange, and also one of our former development partners, has commercialized a4.6 MW gas turbine with a 5 ppm NOx guarantee. We expect that other gas turbineOEMs may continue to advance their lean pre-mix or dry low NOxtechnologies and could eventually develop a system that achieves NOx emissionsapproaching the levels achieved by our Xonon system. We are also aware of onecompany, Power Systems Manufacturing (“PSM”) that has commercialized a 5 ppmretrofit NOx system for certain large gas turbine models greater than 60 MW insize.

We believe our Xononsystem has an advantage over competing emissions control alternatives as aresult of our unique pollution prevention approach for achieving ultra-lowemissions that has been proven in commercial installations.

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**Ø     Fuel Processing for Fuel Cell Applications**

In 2001, we were selected by the DOE for an$11,658,000 cost-shared contract for the development of a compact fuelprocessor that could convert conventional fuels, such as gasoline, to hydrogento power fuel cell vehicles and provide a cost-effective option to bridge thetransition to a hydrogen economy. The initial objective of the 48-monthdevelopment program was for us to deliver a compact fuel-flexible fuelprocessor prototype to be used with Proton Exchange Membrane (“PEM”) fuel cellsin an automotive application.

Accomplishments since initiation of the program in October 2001included the development of a new test reactor that simulates plate reactorperformance, and the demonstration of direct steam reforming of gasoline in aplate reactor configuration. Significant progress was also made in developinghighly active, cost-effective and durable fuel reforming, water-gas-shift andpreferential oxidation catalysts. Individual catalytic reactor components ofthe fuel processing system were successfully modeled and designed to achievethe targeted 60-second start-up time. In 2004, we fabricated a 3kW(e) steamreforming prototype plate reactor and successfully demonstrated a start-up timeof less than 60 seconds.

In August 2004, theDOE made a decision to discontinue funded research and development of on-boardfuel processing for fuel cell vehicles. This decision was due in part totechnological and economical hurdles and in part to the impact of PresidentBush’s Hydrogen Fuel Initiative, which accelerated the hydrogen technologycommercialization decision from 2030 to 2015 thereby lessening the contributionthat on-board fuel processing could make as a transitional technology. However,the DOE has redirected funding for some of these programs to support stationaryand auxiliary power unit fuel processing and other potential applications. Accordingly,we are now developing our fuel processing technology for fuel cell applicationswith a new focus on stationary, auxiliary and back-up power.  In support of these efforts, we will continueto receive funding from the DOE through 2005 after which time we plan to closeout the program.

**Catalyst-BasedTechnology Solutions**Manufacturing

In October 2002, we brought on-line a commercialmanufacturing facility in our Gilbert, Arizona location, which is being used tomanufacture both prototype and production Xonon modules for gas turbineapplications as well as prototypes of our diesel NOx reduction solutions. In thesecond quarter of 2003, we implemented an advanced product quality assurancesystem and installed a new, more robust coating line in our Gilbert facility,enabling us to further enhance our manufacturing operations. We also havemanufacturing capability in our Mountain View, California facility, which isused primarily for the manufacture of prototypes as part of our ongoingresearch, development and test activities.

We have sufficient capacity in our Gilbert facility tobuild both development and production Xonon modules for gas turbines to satisfyour needs for the near future. We plan to retain all proprietary manufacturingwithin our facilities and to outsource the manufacturing of non-criticalcomponents to third party suppliers. We expect the Xonon modules to be returnedto us at the end of their useful life. We plan to reclaim, reuse or recyclemost components of the module, particularly the precious metals palladium andplatinum, in order to reduce our costs and protect ourselves against thevolatility of precious metal prices.

While we are currently manufacturing prototypes of ourdiesel emissions control systems in both of our facilities, we are in theprocess of developing next generation manufacturing processes, scalable to meetfuture demand. In preparation for a possible 2006 commercial launch of ourDiesel Retrofit Solution, we plan to build additional manufacturing capabilityin the coming year to ensure production readiness. We also expect portions ofour future commercial production may be outsourced to leverage the expertise ofhigh-volume manufacturers and achieve our goal of producing cost-effectivediesel emissions reduction solutions.

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In the fourth quarter of1999, we earned ISO 9001 Registration from Underwriters Laboratories, Inc.for the design and manufacture of Xonon modules at our Mountain View,California facility. In the fourth quarter of 2002 we also earned IS0 9001Registration for our Gilbert, Arizona commercial manufacturing operations andsubsequently completed the transition to the ISO 9001:2000 standards in October 2003following an audit of our quality system. In addition to being awarded ISO9001:2000 certification from Underwriters Laboratories, Inc., we receivedcommendations of excellent system processes for our Integrated ProductDevelopment System and Manufacturing Control, further demonstrating ourcommitment to high quality standards and customer satisfaction. In 2004, wesuccessfully completed subsequent ISO 9001 follow-up audits and receivedcommendations for our exemplary resource management process.

**Intellectual Property**

We maintain a rigorous intellectual property programto protect our proprietary technologies and processes. Our intellectualproperty strategy is to identify key intellectual property developed or acquiredby us in order to protect it in a timely and effective manner, and tocontinually use such intellectual property to our competitive advantage in theNOx control marketplace. An objective of our intellectual property strategy isto enable us to be first to market with proprietary technology and to sustain along-term technological lead in the market. We use a combination ofpatents, trade secrets, contracts, copyrights and trademarks to protect theproprietary aspects of our core technologies, including system design, controlsystems, manufacturing processes and other know-how, and we work to activelymaintain protection of our proprietary technologies and processes over timethrough follow-on patent filings associated with technology and process improvementsthat we continually develop. As of the date of this filing, we either owned(exclusively or jointly), held exclusive license rights from third parties for,or held license rights from affiliates for 26 U.S. patents and 19 pendingapplications and the international counterparts associated with some of them. Weanticipate that when our early patents expire, we will rely on subsequentlyfiled and additional patents along with trade secrets and other know-how toprotect the foundation technology, design and manufacturing processes.

We use patents as the primary means of protecting ourtechnological advances and innovations. We have adopted a proactive approach toidentifying patentable inventions and securing patent protection through thetimely filing and aggressive prosecution of patent applications. Our employeesparticipate in a comprehensive invention disclosure program involvingpreparation of written invention memoranda and preservation of supportinglaboratory records. Patent applications are filed in various jurisdictionsinternationally, which are carefully chosen based on the likely value andenforceability of intellectual property rights in those jurisdictions and tostrategically reflect our anticipated major markets.

We actively monitor the patent position, technicaldevelopments and market activities of our competitors. We believe that ourgrowing patent portfolio, especially when coupled with a strong enforcementprogram, can provide us with a significant advantage over our competitors. We planto vigorously defend our intellectual property.

Portions of our know-howare also protected as trade secrets and supported through contractualagreements with our employees, suppliers, partners and customers. Weaggressively protect our intellectual property rights in our collaborationagreements with a view to capturing maximum value from our products in ourmarkets and ensuring a competitive advantage.

**Human Resources**

As of December 31,2004, we employed 88 persons. We added 11 employees in February 2004through our acquisition of SCR-Tech. None of our employees are represented by alabor union. We believe our relations with our employees are good. Theemployment of Hans Hartenstein, former President of 

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SCR-Tech,terminated in March 2005. As a result of this management change, SCR-Techmay be subject to potential litigation with Mr. Hartenstein and hisaffiliates.

**Available Information**

The Company’s AnnualReport on Form 10-K, Quarterly Reports on Form 10-Q, andCurrent Reports on Form 8-K, including any amendments, will be madeavailable free of charge on or through the Company’s website, *www.catalyticaenergy.com*, as soon asreasonably practicable following the filing of the reports with the Securitiesand Exchange Commission. The contents of our website are not, and shall not bedeemed to be, incorporated into this report.

**Item 2.        *PROPERTIES***

Our research and development facility, consisting ofportions of two leased buildings covering approximately 32,500 square feet, islocated in Mountain View, California. This lease expires on December 31,2005, with two options to renew for two additional years each. We currentlysublease approximately 6,300 square feet at this site.

Our manufacturing operations and executive offices arelocated in Gilbert, Arizona in an approximately 43,000 square feet facility wepurchased in 2002. We currently lease to tenants approximately 16,000 squarefeet of this facility.

Our SCR cleaning and regeneration facility, consistingof approximately 62,000 square feet of office, production, laboratory andwarehouse space, is located in Charlotte, North Carolina. This lease expires onDecember 31, 2012, with two options to renew for five years each.

Through November 2004, we leased from the City ofSanta Clara, California a site which housed a gas turbine used for fielddemonstrations of our Xonon Cool Combustion system. Having achieved theobjectives of these demonstration programs, operations at this site were ceasedand the lease was cancelled at the end of November 2004.

We believe our existingfacilities are adequate for our present needs.

**Item 3.        *LEGAL PROCEEDINGS***

Although we may be subjectto litigation from time to time in the ordinary course of our business, we arenot currently a party to any material legal proceeding.

**Item 4.        *SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS***

There were no matters submitted to a vote of thestockholders of the Company during the fourth quarter of the fiscal yearcovered by this report.

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**PART II**

**Item 5**.                        *MARKET FOR THE REGISTRANT’S COMMON STOCK AND RELATED STOCKHOLDERMATTERS*

**Common Stock**

CatalyticaEnergy Systems, Inc. common stock is listed on the NASDAQ National Marketunder the symbol “CESI.” The following table sets forth high and low closingprices per share for our common stock as quoted on the NASDAQ National Marketduring each quarter of 2003 and 2004. Such prices represent inter-dealer pricesand do not include retail mark-ups or mark-downs or commissions and may notrepresent actual transactions.
| ** **                     | ** ** | **Quarter Ended  March 31, 2003** | ** ** | **Quarter Ended  June 30, 2003** | ** ** | **Quarter Ended  September 30, 2003** | ** ** | **Quarter Ended  December 31, 2003** | ** ** |
|--------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| Common stock price per  share: |       |                                             |       |                                            |       |                                                 |       |                                                |       |   |   |   |   |   |   |   |   |
| High                           |       |                                             | $          | 2.95                                            |       |                                                 |       | $                                                   | 3.00       |   |   |   | $ | 3.54 |   |   |   | $ | 4.40 |   |   |
| Low                            |       |                                             | 2.48       |                                            |       |                                                 | 2.46       |                                                |       |   | 2.70 |   |   |   | 3.25 |   |   |
|                                |            |                                                  |            |                                                 |            |                                                      |            |                                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                     | ** ** | **Quarter Ended  March 31, 2004** | ** ** | **Quarter Ended  June 30, 2004** | ** ** | **Quarter Ended  September 30, 2004** | ** ** | **Quarter Ended  December 31, 2004** | ** ** |
|--------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| Common stock price per  share: |       |                                             |       |                                            |       |                                                 |       |                                                |       |   |   |   |   |   |   |   |   |
| High                           |       |                                             | $          | 4.19                                            |       |                                                 |       | $                                                   | 3.63       |   |   |   | $ | 2.83 |   |   |   | $ | 2.53 |   |   |
| Low                            |       |                                             | 3.33       |                                            |       |                                                 | 2.82       |                                                |       |   | 2.01 |   |   |   | 1.77 |   |   |
|                                |            |                                                  |            |                                                 |            |                                                      |            |                                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

As of March 18, 2005,there were 752 holders of record of our common stock, as shown on the recordsof our transfer agent. The number of record holders does not include sharesheld in “street name” through brokers.

**Dividend Policy**

We have never paid cashdividends on our common stock or any other securities. We anticipate we willretain any future earnings for use in the expansion and operation of ourbusiness and do not anticipate paying cash dividends in the foreseeable future.

**Shareholder RightsPlan**

In January 2002, our Board of Directors adopted aShareholder Rights Plan, which was amended in November 2004 (the “Plan”). Underthe Plan, we distributed Preferred Stock Purchase Rights as a dividend at therate of one Right for each share of its common stock held by stockholders ofrecord on February 20, 2002 (the “Record Date”). The Board of Directorsalso authorized the issuance of Rights for each share of common stock issuedafter the Record Date, until the occurrence of certain specified events. ThePlan was adopted to provide protection to stockholders in the event of anunsolicited attempt to acquire the Company. Each Right will entitle theregistered holder to purchase from the Company one one-thousandth of a share ofSeries A Participating Preferred stock at an exercise price of $45,subject to adjustment. We have authorized 5,000,000 shares of Series Apreferred stock for issuance pursuant to this plan.

Under the Plan, the Rights are not exercisable untiltriggered by certain conditions including the acquisition of beneficialownership of 20% of our common stock. However, Morgan Stanley Capital PartnersIII, L.P., and its affiliates could acquire up to 21.5% of the Company’s commonstock without triggering the Rights. If the Rights are triggered, then eachholder of a Right which has not been exercised 

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(other than Rightsbeneficially owned by the Acquiring Person) will have the right to receive,upon exercise, voting Common Shares having a value equal to two times the PurchasePrice.

The Company is entitled toredeem the Rights, for $0.001 per Right, at the discretion of the Board ofDirectors, until certain specified times. We may also require the exchange ofRights, under certain additional circumstances. We also have the ability toamend the Rights, subject to certain limitations.

**Securities Authorized for Issuance under EquityCompensation Plans**
| ** **                        | ** ** | **Number of  Securities to be  Issued upon  Exercise of  Outstanding Options** | ** ** | **Weighted-Average  Exercise Price of  Outstanding Options** | ** ** | **Common Stock  Reserved for Future  Issuance** | ** ** |
|-----------------------------------|------------|--------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| Plans approved by  stockholders:  |       |                                                                                                         |       |                                                                        |       |                                                           |       |   |   |   |   |   |   |
| 1995 Stock Option Plan            |       |                                                                                                         | 3,186,435  |                                                                        |       |                                                           | $          | 5.20 |   |   |   | 4,370,272 |   |   |
| 2000 Employee Stock Purchase Plan |       |                                                                                                         | —     |                                                                        |       |                                                           |       |   |   |   | 1,171,020 |   |   |
| Total                             |       |                                                                                                         | 3,186,435  |                                                                        |       |                                                           |       |   |   |   | 5,541,292 |   |   |
|                                   |            |                                                                                                              |            |                                                                             |            |                                                                |            |  |  |  |  |  |  |  |

 

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**Item 6**.                        *SELECTED CONSOLIDATED FINANCIAL DATA*

Thefollowing table contains selected consolidated financial data as of and foreach of the five years ended December 31, 2000, 2001, 2002, 2003 and 2004that were derived from our consolidated financial statements, which wereaudited by Ernst & Young LLP, independent registered public accountingfirm. The selected consolidated financial data are qualified by reference to,and should be read in conjunction with, our financial statements and the notesto those consolidated financial statements and Management’s Discussion andAnalysis of Financial Condition and Results of Operations. No cash dividendswere declared in any of the years presented.
| ** **                                                                      | ** ** | **Years Ended December 31,**                        | ** ** |
|---------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                      | ** ** | **2004**                                                           | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                                                      | ** ** | **(in thousands, except per share data)** | ** ** |
| **Consolidated Statements of  Operations Data:**                                |       |                                                               |       |   |   |   |   |   |   |   |   |
| Revenues                                                                        |       | $                                                                  | 5,601      |   | $ | 3,498 |   | $ | 4,795 |   | $ | 5,523 |   | $ | 5,487 |   |
| Expenses:                                                                       |       |                                                               |       |   |   |   |   |   |   |   |   |
| Cost of revenues(A)                                                             |       | 5,227                                                              |       | 4,341 |   | 5,977 |   | 9,957 |   | 9,305 |   |
| Research and development(A)                                                     |       | 7,498                                                              |       | 6,919 |   | 8,252 |   | 4,665 |   | 1,972 |   |
| Selling, general and administrative                                             |       | 6,339                                                              |       | 7,224 |   | 9,654 |   | 7,017 |   | 5,356 |   |
| Spin-off and related transaction costs(B)                                       |       | —                                                             |       | — |   | — |   | — |   | 5,304 |   |
| Legal settlements(C)                                                            |       | —                                                             |       | — |   | — |   | 3,250 |   | — |   |
| Total expenses                                                                  |       | 19,064                                                             |       | 18,484 |   | 23,883 |   | 24,889 |   | 21,937 |   |
| Operating loss                                                                  |       | (13,463                                                            | )          | (14,986 | ) | (19,088 | ) | (19,366 | ) | (16,450 | ) |
| Loss on equity  investments(D)                                                  |       | —                                                             |       | — |   | — |   | (707 | ) | (236 | ) |
| Impairment charge  to implied goodwill of an equity investment(E)               |       | —                                                             |       | — |   | — |   | (2,145 | ) | — |   |
| Interest and  other income(F)                                                   |       | 758                                                                |       | 823 |   | 1,405 |   | 2,672 |   | 886 |   |
| Interest expense                                                                |       | (564                                                               | )          | (236 | ) | (191 | ) | (43 | ) | (110 | ) |
| Net loss                                                                        |       | $                                                                  | (13,269    | ) | $ | (14,399 | ) | $ | (17,874 | ) | $ | (19,589 | ) | $ | (15,910 | ) |
| Basic and diluted  net loss per share                                           |       | $                                                                  | (0.74      | ) | $ | (0.81 | ) | $ | (1.02 | ) | $ | (1.33 | ) | $ | (15.91 | ) |
| Weighted average  shares used in computing basic and diluted net loss per share |       | 17,850                                                             |       | 17,669 |   | 17,529 |   | 14,747 |   | 1,000 |   |
| **Consolidated  Balance Sheet Data:**                                           |       |                                                               |       |   |   |   |   |   |   |   |   |
| Cash, cash  equivalents and short-term investments(F)                           |       | $                                                                  | 35,592     |   | $ | 52,682 |   | $ | 66,770 |   | $ | 87,647 |   | $ | 58,712 |   |
| Total assets                                                                    |       | $                                                                  | 51,517     |   | $ | 61,685 |   | $ | 77,021 |   | $ | 95,140 |   | $ | 67,772 |   |
| Long-term debt  and capital lease obligations(G)                                |       | $                                                                  | 6,402      |   | $ | 3,245 |   | $ | 3,250 |   | $ | 123 |   | $ | 244 |   |
| Total liabilities                                                               |       | $                                                                  | 9,178      |   | $ | 6,458 |   | $ | 7,842 |   | $ | 8,418 |   | $ | 10,302 |   |
| Total stockholders’  equity                                                |       | $                                                                  | 42,339     |   | $ | 55,227 |   | $ | 69,179 |   | $ | 86,722 |   | $ | 57,470 |   |

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(A)       Decreasefrom 2001 through 2003 due to decline in externally funded research anddevelopment, which is classified as cost of revenues. Increase in 2004 due toacquisition of SCR-Tech. Total R&D expenses, including those classified ascost of revenues, are as follows:
| ** **                  | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
|-----------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| R&D cost of  revenues   |       | 2,746    |       | 4,341    |       | 5,977    |       | 9,957    |       | 9,305    |       |
| R&D                     |       | 7,498    |       | 6,919    |       | 8,252    |       | 4,665    |       | 1,972    |       |
| Total R&D  expenditures |       | 10,244   |       | 11,260   |       | 14,229   |       | 14,622   |       | 11,277   |       |

 

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(B)        Expenses associated withour spin-off from Catalytica, Inc. on December 15, 2000.

(C)        Legal settlement recordedin 2001 with respect to a complaint filed by the City of Glendale, California in2000.

(D)       Pro-rata share of lossesrecorded under the equity method of accounting for investments in Novodynamicsand Genxon (see “Other Commitments”). The equity method of accounting for theseinvestments was discontinued when the net book carrying value of thoseinvestments reached zero.

(E)        Impairment in the carryingvalue of the equity investment in Novodynamics deemed other than temporary;resulting in an impairment charge of $1,645,000.

(F)         Follow-on stock offeringin 2001, which generated $47,642,000 in cash; resulting in increase in interestincome in 2001.

(G)      Increase in 2002 related toterm loan applied to the purchase of a manufacturing and administrativefacility in Gilbert, Arizona. Increase in 2004 related to debt incurred in theacquisition of SCR-Tech.

Thefollowing table contains selected consolidated quarterly statements ofoperations data that were derived from our unaudited financial statements foreach of the eight quarters of the past two years. We believe these unauditedfinancial results were prepared on a basis consistent with our auditedfinancial statements and include all adjustments, consisting only of normalrecurring adjustments, necessary for a fair presentation of our consolidatedresults of operations for those periods. The results of operations for anyquarter are not necessarily indicative of the results of any future period.
| ** **                            | ** ** | **First Quarter**                                             | ** ** | **Second Quarter** | ** ** | **Third Quarter** | ** ** | **Fourth Quarter** | ** ** |
|---------------------------------------|------------|--------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|-------------------------|------------|
| ** **                            | ** ** | **2004**                                                           | ** ** | **2003**                | ** ** | **2004**               | ** ** | **2003**                | ** ** | **2004** | ** ** | **2003** | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                            | ** ** | **(in thousands, except per share data)** | ** ** |
| Revenues                              |       | $                                                                  | 986        |                    | $          | 531                    |       | $                       | 1,100      |   | $ | 959 |   | $ | 1,942 |   | $ | 1,107 |   | $ | 1,573 |   | $ | 901 |   |
| Total costs and  expenses             |       | 4,323                                                              |       | 5,256                   |       | 5,125                  |       | 4,577                   |       | 4,664 |   | 4,351 |   | 4,952 |   | 4,300 |   |
| Operating loss                        |       | $                                                                  | (3,337     | )                       | $          | (4,725                 | )          | $                       | (4,025     | ) | $ | (3,618 | ) | $ | (2,722 | ) | $ | (3,244 | ) | $ | (3,379 | ) | $ | (3,399 | ) |
| Net loss                              |       | $                                                                  | (3,241     | )                       | $          | (4,555                 | )          | $                       | (4,004     | ) | $ | (3,480 | ) | $ | (2,696 | ) | $ | (3,116 | ) | $ | (3,328 | ) | $ | (3,248 | ) |
| Basic and diluted net  loss per share |       | $                                                                  | (0.18      | )                       | $          | (0.26                  | )          | $                       | (0.22      | ) | $ | (0.20 | ) | $ | (0.15 | ) | $ | (0.18 | ) | $ | (0.19 | ) | $ | (0.18 | ) |

 

**ITEM 7**.                *MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF OPERATIONS*

This Management’sDiscussion and Analysis of Financial Condition and Results of Operations andother parts of this Annual Report on Form 10-K contain forward-lookingstatements that involve risks and uncertainties. Words such as “anticipate,” “believe,”“estimate,” “expect,” “intend,” “plan” and similar expressions identify suchforward-looking statements, which are based on information available to us onthe date hereof, and we assume no obligation to update any such forward-lookingstatements. Our actual results could differ materially from those anticipatedin these forward-looking statements as a result of certain factors, includingthose set forth in “Risks That Could Affect Our Financial Condition and Resultsof Operations” and elsewhere in this Form 10-K.

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**Overview**

Catalytica Energy Systems, Inc. (“CatalyticaEnergy,” the “Company,” “we” or “us”) was incorporated in Delaware in 1995 as asubsidiary of Catalytica, Inc. Catalytica Energy operated as part ofCatalytica, Inc.’s research and development group from inception throughthe date of its incorporation as a separate entity. In December 2000,Catalytica Advanced Technologies, Inc., another subsidiary of CatalyticaInc., was merged into us, and the combined entity was spun out from Catalytica, Inc.as Catalytica Energy Systems, Inc., a separate, stand-alone publiccompany.

We******provideinnovative emissions solutions to ease the environmental impact ofcombustion-related applications in the power generation and transportationindustries. Through our SCR-Tech subsidiary, we offer a variety of services forcoal-fired power plants that use selective catalytic reduction (“SCR”) systemsto reduce nitrogen oxides (“NOx”) emissions. These services include SCRcatalyst cleaning and regeneration, SCR system management services to optimizeefficiency and reduce overall operating and maintenance (“O&M”) costs, andconsulting services related to the design of SCR systems (collectively “SCRCatalyst and Management Services”). Our business activities also include thedesign, development, manufacture and servicing of advanced products based onour proprietary catalyst and fuel processing technologies to offercost-effective solutions for reducing NOx emissions from diesel engines andnatural gas-fired turbines. Our diesel fuel processing technology is designedto facilitate significant NOx reduction from mobile, stationary and off-roaddiesel engine applications by improving the performance of NOx adsorbercatalyst systems. Our commercially-available Xonon Cool Combustion® systemoffers a breakthrough pollution prevention approach that enables gas turbinesto achieve ultra-low NOx emissions through a proprietary catalytic combustionprocess. Other activities include the development of fuel processing systemsfor fuel cells used in stationary, auxiliary and back-up power applications.

We are focused on growing our business through aproduct and market diversification strategy in the area of NOx control.Increasingly stringent air quality regulations have resulted in tighteremissions restrictions being imposed on a variety of combustion-relatedapplications. NOx emissions, which are a precursor to smog formation, havebecome a primary target of government-imposed emissions regulations, creating asignificant opportunity for innovative, cost-effective NOx control solutions.Industry analysts estimate the U.S. market for NOx control represents a greaterthan $5 billion opportunity annually in the power generation and dieselindustries, and we believe this market is poised for growth as a result ofpending Federal and State regulations calling for further reductions in NOxemissions.

As a result of ongoing challenging conditions in theU.S. gas turbine industry, a slow to emerge distributed generation market andthe pace of gas turbine original equipment manufacturer (“OEM”)commercialization activities, we completed a rigorous exercise in 2003 torealign our strategic direction and build a stronger business. This has beenaccomplished through broadening our product and service offerings in the areaof NOx control beyond our Xonon Cool Combustion product for gas turbines,pursuing new business activity and expanding our portfolio of NOx-relatedproducts and services across new and growing markets. We are committed tosolving NOx-related problems by providing the most economically compelling andmost effective solutions available, whether it is through prevention or throughsome form of after-treatment. In addition to intensifying our development ofNOx control after-treatment systems for diesel engines which leverage our coreXonon® technology, we have become more active in identifyingstrategic opportunities, including business acquisitions that complement ourcurrent products, expand the breadth of our markets or build upon our technicalcapabilities. In particular, we continue to focus on opportunities that offernear-term, profitable product and service offerings.

As part of this strategicinitiative, in February 2004 we acquired SCR-Tech, LLC (“SCR-Tech”), theNorth American leader in catalyst regeneration technologies and managementservices for selective catalytic reduction systems used by coal-fired powerplants to reduce NOx emissions. The addition of SCR-Tech strategicallybroadened and diversified our product and service offerings to the growingemissions 

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controlmarket for coal-fired power plants and has served to accelerate our penetrationinto the NOx control marketplace. We believe the acquisition of SCR-Tech hascreated a foundation for future growth and has strengthened our ability tocontinue pursuing development and commercialization efforts in other areas ofour business, while also targeting additional business opportunities in thearea of NOx control.

**Results ofOperations**

Thefollowing summary presents the results of operations and percentage change bycomparable period for the years ended December 31, 2004, 2003 and 2002:
| ** **                                   | ** ** | **Year Ended December 31,** | ** ** | **Annual Change** | ** ** |
|----------------------------------------------|------------|--------------------------------------------|------------|------------------------|------------|
| ** **                                   | ** ** | **2004**                                   | ** ** | **2003**               | ** ** | **2002** | ** ** | **2004/2003** | ** ** | ** 2003/2002 ** | ** ** |
| Revenues                                     |       |                                       |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| SCR catalyst & management  services |       | $                                          | 2,960      |                   | $          | — |   | $ | — |   |   | $ | 2,960 |   |   |   | $ | — |   |   |
| Research and development                     |       | 2,641                                      |       | 3,498                  |       | 4,795 |   |   | (857 | ) |   |   | (1,297 | ) |   |
| Total revenues                               |       | 5,601                                      |       | 3,498                  |       | 4,795 |   |   | 2,103 |   |   |   | (1,297 | ) |   |
| Costs and expenses:                          |       |                                       |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| Cost of revenues                             |       | 5,227                                      |       | 4,341                  |       | 5,977 |   |   | 886 |   |   |   | (1,636 | ) |   |
| Research and development                     |       | 7,498                                      |       | 6,919                  |       | 8,252 |   |   | 579 |   |   |   | (1,333 | ) |   |
| Selling, general and administrative          |       | 6,339                                      |       | 7,224                  |       | 9,654 |   |   | (885 | ) |   |   | (2,430 | ) |   |
| Total costs and expenses                     |       | 19,064                                     |       | 18,484                 |       | 23,883 |   |   | 580 |   |   |   | (5,399 | ) |   |
| Operating loss                               |       | (13,463                                    | )          | (14,986                | )          | (19,088 | ) |   | 1,523 |   |   |   | 4,102 |   |   |
| Interest and  other income                   |       | 758                                        |       | 823                    |       | 1,405 |   |   | (65 | ) |   |   | (582 | ) |   |
| Interest expense                             |       | (564                                       | )          | (236                   | )          | (191 | ) |   | (328 | ) |   |   | (45 | ) |   |
| Net loss                                     |       | $                                          | (13,269    | )                      | $          | (14,399 | ) | $ | (17,874 | ) |   | $ | 1,130 |   |   |   | $ | 3,475 |   |   |

 

**Comparison of theyears ended December 31, 2004, 2003 and 2002.**

**REVENUES**

Revenues in the periods presented include revenuesgenerated from SCR Catalyst and Management Services (after February 20,2004), primarily from catalyst cleaning and regeneration services. Additionally,the Company provides management and consulting services related to the design,operating efficiency, and overall operating and maintenance costs of SCRsystems. Revenues in the periods presented also include revenues generated fromresearch and development (“R&D”) contracts funded by gas turbinemanufacturers and government sources for fuel processor, diesel and gas turbinetechnology development. These R&D contracts provide for partial recovery ofour direct and indirect costs. In addition, revenues in the periods presentedinclude proceeds from the sale of our Xonon Cool Combustion modules to originalequipment manufacturers (“OEMs”).

We expect SCR Catalyst and Management Services tocontinue to be a significant component of revenue for the foreseeable future. However,this revenue is project-based, and as such, the timing of those revenues variesfrom period-to-period. We expect to continue to pursue funded research programs.Most of our R&D contracts are subject to periodic review by our fundingpartners, which could result in modifications to project scope, termination offunding, or schedule delays. We cannot ensure we will continue to receiveR&D funding. In return for funding development, collaborative partners mayreceive certain rights in the commercialization of any resulting technology,including royalty payments on future sales (see “-Other Commitments”). Thetiming of revenues from R&D contracts varies from year to year, and fromcontract to contract, based on the terms agreed upon by us and the customer orfunding party. 

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Due to the nature ofR&D funding, period-to-period comparisons of R&D revenues are notnecessarily meaningful and should not be relied upon as indications of futureperformance.

The majority of the increase in revenue during theyear ended December 31, 2004 compared to 2003 consists of the following:incremental revenue of $2,960,000 from SCR Catalyst and Management Servicesfollowing the Company’s acquisition of SCR-Tech in February 2004 and a$456,000 increase in revenue from new diesel R&D programs commencing in thethird quarter. Partially offsetting these increases was a $1,134,000 reductionin government and OEM funding, as development efforts under certain gas turbineprograms were completed, in addition to a $201,000 decline in funding from theU.S. Department of Energy under a multi-year program to develop fuel processorsfor use with fuel cells (the “DOE Fuel Processor Program”).

We believe 2005 revenues could be less than 2004revenues. With respect to SCR Catalyst and Management Services, revenues couldbe less due to our limited backlog, uncertain market conditions, competitivepressures, and changes in senior management. Backlog as of 12/31/04 for SCRCatalyst and Management Services was approximately $775,000 including $190,000of deferred revenue. We anticipate that the Company will realize substantiallyall of its current backlog in the first quarter of 2005. We are currentlypursuing several opportunities in this area; however, there can be no assurancethat our efforts will be successful. Further, with respect to revenuesgenerated from R&D contracts, the DOE Fuel Processor program, which hasbeen a significant revenue contributor in each of the last three years(including $1.8 million in 2004), is ending in September 2005. We have identifiedpotential funding sources for our Diesel Retrofit and Diesel Genset programs;however, we have not yet secured funding from those sources and theavailability of such funding is not certain.

Revenue declined$1,297,000 during the year ended December 31, 2003 compared to 2002. Themajority of the decrease consists of the following: revenue recorded from aresearch program funded by the U.S. Department of Energy to enhance theperformance of combustion systems using Xonon technology decreased by $650,000due to the completion of the program in August 2002. Funding from one OEMpartner decreased by $504,000 as the combustion system development under theprogram advanced to a stage requiring less engineering effort than in theprevious year.

**COST OF REVENUES**

Expenses relating to government and OEM fundedprograms are classified as cost of revenues. Expenses relating to internallyfunded programs are classified as R&D. Accordingly, shifts in effortbetween government and OEM funded programs versus internally funded programsproduce period-to-period variances in cost of revenues and R&D expenses.

Cost of revenues attributable to SCR Catalyst andManagement Services include direct labor, plant management wages, fringebenefits, facility rent, chemicals, depreciation, supplies and third partyconsulting services, and are expensed as incurred. Cost of revenues relating toR&D contracts consist of direct expenses including direct labor, fringebenefits, travel, consulting and other third party professional services,supplies and R&D overhead, and are expensed as incurred. R&D overheadis applied to government and OEM funded programs based on total non-directprogram expenses incurred as a percentage of direct program expenses.

The majority of the increase in cost of revenuesduring the year ended December 31, 2004 compared to 2003 consists of thefollowing: $2,401,000 in incremental expenses from SCR Catalyst and ManagementServices, offset by a $1,595,000 decrease in cost of R&D contracts(primarily direct labor, consulting services and supplies), resulting fromreduced activity relating to government and OEM funded contracts; in additionto reduced overhead between comparative periods resulting from focused expensereduction efforts and increased utilization of internal resources.

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The majority of thedecrease in cost of revenues during the year ended December 31, 2003compared to 2002 consists of the following:             a$1,636,000 decrease in cost of R&D contracts (primarily direct labor,outside contractor engineering services, supplies and market research),resulting from reduced activity relating to OEM and government fundedcontracts; in addition to increase overhead between comparative periodsresulting from internal development efforts relating to our Xonon gas turbinetechnology.

**RESEARCHAND DEVELOPMENT (“R&D”) EXPENSES**

R&D expenses include compensation and benefits forengineering and manufacturing staff, fees for contract engineers, materials tobuild prototype units, amounts paid to outside suppliers for subcontractedcomponents and services, supplies, facilities and information technology costs.We expense all R&D costs as incurred.

The majority of the increase in R&D during theyear ended December 31, 2004 compared to 2003 consists of the following: a$1,246,000 increase in direct labor and fringe benefits incurred on internallyfunded programs, primarily relating to the development of diesel applications. Offsettingthis increase was a $754,000 decrease in salaries and fringe resulting fromheadcount reductions in the fourth quarter of 2003 and the first quarter of2004.

The majority of the decrease in R&D during theyear ended December 31, 2003 compared to 2002 consists of the following: a$488,000 decrease in salaries and related benefits following a February 2003headcount reduction in which certain administrative and support positions wereeliminated from our engineering and manufacturing departments. Supplies expensewas decreased by $176,000 due to completion of developmental efforts withinresearch programs. R&D facility and information technology costs werereduced $677,000 due to the streamlining of administrative functions during2003.

Dependent upon classification as externally orinternally funded, R&D expenses may be reported as cost of revenues. TotalR&D expenses, including those classified as cost of revenues, were$10,244,000, $11,260,000, and $14,229,000, for the years ended December 31,2004, 2003, and 2002, respectively.

We expect total R&Dexpenses, including those classified as cost of revenues, will remainrelatively flat during the year ending December 31, 2005 compared to 2004.Our research and development efforts are primarily focused on diesel and fuelprocessor programs.

**SELLING,GENERAL AND ADMINISTRATIVE EXPENSES (“SG&A”)**

SG&A includes compensation, benefits and relatedcosts of corporate functions, which include management, business development,marketing, human resources, sales and finance, and un-allocated facilities andIT costs.

The majority of the decline in SG&A during theyear ended December 31, 2004 compared to 2003 consists of the following: a$267,000 reduction in personnel-related expenses associated with a February 2003headcount reduction, a $203,000 reduction in legal expenses associated withfees incurred in late 2003 related to the February 2004 purchase ofSCR-Tech, and a $1,136,000 reduction in depreciation expense resulting fromseveral assets becoming fully depreciated at the end of 2003. Partiallyoffsetting these decreases were $747,000 of incremental expenses from SCRCatalyst and Management Services.

The majority of the decline in SG&A during theyear ended December 31, 2003 compared to 2002 consists of the following:Salaries and related benefits decreased $1,347,000 following a February 2003headcount reduction in which certain positions were eliminated from ouraccounting, human resources, marketing and information technology departments. Relocationand recruiting costs were $359,000 lower in 2003 due to the completion ofpersonnel moves to a new manufacturing and administrative facility in Gilbert,Arizona, and the completion of staffing additions in 2002. Included in SG&Afor 2002 was a charge of $450,000 related to the Settlement Agreement withWoodward Governor Company and a charge 

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of $545,000 related toimpairment of certain leasehold improvements. Partially offsetting thesedecreases was a $677,000 reduction in facility and information costs allocatedto R&D in 2003 due to the overall reduction of SG&A costs incurred.

We expect SG&A willincrease during the year ending December 31, 2005 compared to 2004 as afull year’s SG&A expense will be recorded for SCR-Tech in addition toincreases in personnel-related expenses associated with the expansion of oursales and marketing initiatives at SCR-Tech. In addition, we anticipate we willincur increased expenses associated with the implementation of Sarbanes-Oxleyrequirements.

**INTEREST AND OTHER INCOME**

Interest income is generated from money market andshort-term investments. Other income consists of rental income generated fromthe leasing of certain portions of our Gilbert, Arizona building.

Interest income during the year ended December 31,2004 compared to 2003 was $152,000 lower due to declining cash and investmentsbalances; partially offset by slightly improved market yields. Other incomeduring the year ended December 31, 2004 compared to 2003 was $87,000higher primarily related to Gilbert lease income which didn’t commence untilthe second half of 2003.

Interest income during the year ended December 31,2003 compared to 2002 was $641,000 lower due to declining cash and investmentbalances and a decline in market interest rates. Other income during the yearended December 31, 2003 compared to 2002 was $59,000 higher primarily dueto the start of Gilbert lease income which commenced in the second half of2003.

We expect interest incomewill decline during the year ending December 31, 2005 compared to 2004 aswe use cash to fund operations. We expect other income will remain relativelyflat during the year ending December 31, 2005 compared to 2004 as weexpect to realize full year’s lease income for both years.

**INTEREST EXPENSE**

Interest expense reflects amounts incurred underlong-term debt and capital lease obligations.

Interest expense during the year ended December 31,2004 compared to 2003 was $328,000 higher primarily due to the amortization ofimputed interest on long-term debt recorded as part of the SCR-Tech purchase,which began in March 2004. This debt was recorded at the present value offuture cash flows. The amortization of the imputed interest will bring the netcarrying values to the amounts due at the applicable payment dates.

Interest expense during the year ended December 31,2003 compared to 2002 was $45,000 higher as a full twelve months of interestexpense was recorded on the Gilbert building loan in 2003 as compared to tenmonths expense recorded in 2002.

We expect interest expensewill increase during the year ending December 31, 2005 compared to 2004 aswe will record twelve months amortization of imputed interest on the SCR-Techdebt as compared to ten months expense recorded in 2004.

**INCOME TAXES**

No benefit from incometaxes was recorded in 2004, 2003 or 2002 due to the uncertainty of futuretaxable income that would allow us to realize deferred tax assets generatedfrom our losses. We do not believe we will incur any material income taxes inthe foreseeable future.

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**LIQUIDITY ANDCAPITAL RESOURCES**

**Historical CapitalPosition and Usage**

Prior to our spin-off in December 2000,Catalytica, Inc. made a $50.0 million cash investment in the Company.Additionally, in August 2001, we received net proceeds of $47.7 millionfrom a public offering of our common stock. Through December 31, 2004,approximately two-thirds of the proceeds from the capital contribution and ourpublic offering have been used to fund our ongoing research and developmentefforts including the commercialization of our Xonon Cool Combustiontechnology, the purchase of our commercial manufacturing and administrativefacility in Gilbert, Arizona, the purchase of SCR-Tech and for generalcorporate purposes. The remaining funds are invested in commercial andgovernment short-term paper.

Thefollowing table summarizes the yearly changes in cash, cash equivalents andshort-term investments (in thousands):
| ** **                                                           | ** ** | **Year ended December 31,** | ** ** |
|----------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                           | ** ** | **2004**                                   | ** ** | **2003** | ** ** |
| Ending balance of  cash, cash equivalents and short-term investments |       | $                                          | 35,592     |   | $ | 52,682 |   |
| Net decrease in cash,  cash equivalents and short-term investments   |       | $                                          | (17,090    | ) | $ | (14,088 | ) |

 

Our net decrease incash, cash equivalents and short-term investments (“Cash Consumption”) was$17.1 million for the year ending December 31, 2004. The following amountscomprised the decrease of $17.1 million, or 32.4%, in cash, cash equivalentsand short-term investments during 2004:

·       $11.5 million related toearnings before interest, taxes, depreciation and amortization (“EBITDA”) loss,summarized (in millions) in the following table. We elect to use EBITDA in ouranalysis of Cash Consumption as we believe it approximates cash generated fromour operations.
| Net loss |                                               | $      | (13.3 | )      |
|----------|----------------------------------------------------|--------|-------|--------|
| Plus:    | Interest expense                                   |   | 0.6   |   |
|     | Depreciation/impairment  of property and equipment |   | 1.2   |   |
|     | Amortization of  investments premium               |   | 0.2   |   |
|     | Amortization of  intangible assets                 |   | 0.1   |   |
|     | Accretion of  interest on long-term debt           |   | 0.4   |   |
| Less:    | Interest and other income                          |   | (0.7  | )      |
| EBITDA   |                                               | $      | (11.5 | )      |

 

·       $4.3million of costs related to the SCR-Tech acquisition, including cash paid onacquisition, transaction and integration costs and payments for the completionof certain training and transfer of certain intangible assets (see Note 3 ofNotes to Financial Statements);

·       $0.4million related to investment in capital expenditures; and

·       $0.9million in working capital and other.

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Our CashConsumption was $14.1 million for the year ending December 31, 2003. Thefollowing amounts comprised the decrease of $14.1 million, or 21.1%, in cash,cash equivalents and short-term investments during 2003:

·       $12.7 million related toEBITDA loss, summarized as follows (in millions):
| Net loss |                                               | $      | (14.4 | )      |
|----------|----------------------------------------------------|--------|-------|--------|
| Plus:    | Interest expense                                   |   | 0.2   |   |
|     | Depreciation/impairment  of property and equipment |   | 2.1   |   |
|     | Amortization of  investments premium               |   | 0.2   |   |
| Less:    | Interest and  other income                         |   | (0.8  | )      |
| EBITDA   |                                               | $      | (12.7 | )      |

 

·       $1.3million related to investment in capital expenditures; and

·       $0.1million in working capital and other.

In connection with ourpurchase of SCR-Tech in February 2004, we incurred several contingentliabilities. We believe the contingencies associated with the Acquired AssetPayments will be met and, therefore, such Acquired Asset Payments will be madein full. Accordingly, this contingent liability was recorded at the presentvalue of its estimated future payment amount. Since Hans Hartenstein, theformer president of SCR-Tech, is no longer employed by the Company as of March 2005,the contingencies associated with the Contingent Employment Payments will notbe met. As a result, this payment obligation has been extinguished. Given therevenue and cash flow levels and certain limitations associated with theearn-out payments, we do not believe that these payments are likely to be made.Moreover, even if such payments are made, we do not believe such payments wouldhave a material adverse impact on cash flow or liquidity. Accordingly, we havenot recorded any earn-out contingent liability.

**CapitalRequirements**

In general, our current and near-term capitalrequirements depend on numerous factors, including but not limited to ourproduct development and commercialization activities, the timing and level ofthird party research and development funding, market acceptance of our productsand our rate of sales growth. We face substantial uncertainties with ourbusiness operations and may not be able to achieve positive cash flows fromoperations. We expect to devote substantial capital resources to furthercommercialize our technology, hire and train our production staff, develop andexpand our manufacturing capacity, begin production activities, and expand ourresearch and development activities.

We believe our available cash, cash equivalents andshort-term investments in the amount of $35.6 million as of December 31,2004****will provide sufficient capital tofund operations as presently planned until at least December 31, 2006. Ourcurrent operating plans through fiscal 2006 call for further developing andcommercializing our diesel emissions reduction solutions including initialdistribution of our diesel retrofit product, achieving full commercializationof our Xonon Cool Combustion system for additional gas turbine applications,meeting payment obligations related to the SCR-Tech acquisition, expanding ourSCR Catalyst and Management Services business, and developing other potentialproducts.

We anticipate Cash Consumption of between $12.5million and $14.0 million for the year ending December 31, 2005, primarilyassociated with the continued development of our emissions control solutionsfor diesel engine applications and for SG&A. The amount of capital requiredto complete our development programs is highly uncertain and depends onnumerous factors, including unforeseen technical issues associated with ourongoing development of Catalyst-Based Technology Solutions, the nature ofpartner participation and the amount and timing of any capital or technicalcontributions from 

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such partners, the abilityof third party suppliers to develop certain components in a timely manner,market and industry demands and requirements, and the cost of requiredregulatory reviews and approvals. Specifically, we believe total futuredevelopment costs for our mobile diesel retrofit solution will be in the rangeof $5.0 to $10.0 million; if our mobile diesel retrofit solution is successfuland we decide to continue pursuing stationary diesel genset solutions, totaladditional development costs for our stationary diesel genset solutions will bein the range of $5.0 to $10.0 million; if our mobile diesel retrofit solution issuccessful, total future development costs for our diesel OEM solution willlikely be in excess of $10.0 million. If our mobile diesel retrofit solution isnot successful, it is likely that any other diesel solution we pursue willrequire substantial additional capital expenditures beyond our currentestimates. Although we are seeking to avoid incurring significant additionalexpenses for development work on our Xonon Cool Combustion system for small gasturbines, if GE, Solar, Kawasaki or any other OEM elects to use our technologyon a gas turbine platform, we likely will incur additional development expenses.The nature and amount of any such expenses cannot be determined at this timeand would depend on the nature of the products using our Xonon product.

Because our SG&A expenses have in the past been,and are expected to be for the foreseeable future, in excess of $6.0 millionper year, any delay in product development or commercial product launches willresult in us continuing to incur significant SG&A expenses withoutcorresponding revenue. In addition, because we are a public company subject tothe compliance requirements and corresponding costs relating to the Federalsecurities laws, it is difficult to reduce such expenses without substantiallycurtailing our operations.

Given the uncertainty as to the specific amounts andtiming of our required capital expenditures and other Cash Consumption, as wellas the uncertainty related to our commercialization efforts with respect to ourdiesel emissions control solutions and our Xonon Cool Combustion products, ourcurrent cash, cash equivalents and short-term investments, along with any cashgenerated from operations, may not be sufficient to fund our operations throughfiscal 2006 as is currently expected. If our overall Cash Consumption in fiscal2005 and 2006 exceeds our current expectations because of higher capitalexpenditures, increased costs of development or commercialization, lower thananticipated revenue from SCR-Tech, diesel retrofit or government andthird-party funding, higher SG&A expenditures or for any other reason, wemay be required to raise additional capital to continue our operations aspresently planned, significantly curtail our business operations and/or changeour strategic direction. In addition, we may enter into acquisitions orstrategic arrangements which could require the use of cash, reducing ouravailable capital prior to December 31, 2006, or which could requireadditional equity or debt financing. Moreover, the integration and operation ofany business acquired could require significant expenditures that materiallyand adversely impact our liquidity and capital resources. In this regard, ourrecent acquisition of SCR-Tech required, and will continue to require,significant cash outlays for acquisition-related payments and potentiallyrequire cash outlays to fund operations.

Any additional funding requirements, whether foroperations, acquisitions or otherwise, may be significant, may not be availablewhen required or may be available only on terms unsatisfactory to us. Furthermore,if we issue equity securities, the ownership percentage of our then existingstockholders may be reduced, and the holders of new equity securities may haverights senior to those of our existing holders of common stock. If we issuedebt securities, these securities would be senior in priority to any equitysecurities, including our common stock, and would subject us to the risksinherent in issuing debt, including ongoing payment and maturity obligations. Fundingrequirements satisfied through strategic relationships with industryparticipants could result in substantial dilution of our then existing equityholders and could require us to limit our potential return from our products bymaking significant business or financial concessions to such participants.

Beyond December 31,2006, our cash requirements will depend on many factors, including the amountand rate of sales growth of our diesel retrofit products, the level of growth,if any, in the small gas turbine 

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market,the market acceptance of our products, the ability of our diesel OEM product toachieve market acceptance and commitment from significant industryparticipants, the timing and level of development funding from private andgovernment sources, the ability of SCR-Tech to generate significant cash flow,the rate of expansion of our sales and marketing activities, the rate ofexpansion of our manufacturing capacity, and the timing and extent of researchand development projects.

**Other Capital Commitments**

In March 2002, wereceived a term loan of $3,010,000 from the Arizona State Compensation Fund.Proceeds of this loan were applied to the purchase of a 43,000 square footmanufacturing and administrative facility in Gilbert, Arizona. In August 2004,the remaining $2,940,254 principal balance on this loan was refinanced with afive-year term loan which bears interest at a fixed annual rate of 6.5% andmatures in April 2009. Under terms of this new loan, payments of principaland interest totaling $19,105 are due monthly with a final principal payment of$2,737,228 due at maturity. This loan is secured by a deed of trust in theacquired real property.

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**Dividend Policy**

We have never paid cash dividends on our common stockor any other securities. We anticipate that we will retain any future earningsfor use in the expansion and operation of our business and do not anticipatepaying cash dividends in the foreseeable future.

We hadthe following contractual obligations outstanding as of December 31, 2004(in thousands):
| ** **                     | ** ** | **Total** | ** ** | **2005** | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **Thereafter** | ** ** |
|--------------------------------|------------|-----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------------|------------|
| Long-Term Debt  Obligations    |       |      |       |     |       |     |       |     |       |     |       |     |       |           |       |   |   |
| Building term loan             |       | $         | 2,924      |     | $          | 40       |       | $        | 43         |     | $          | 46       |       | $              | 49         |   | $ | 2,746 |   |   | $ | — |   |   |
| SCR-Tech payments              |       | 6,747     |       | 725      |       | 1,315    |       | 384      |       | 502      |       | 502      |       |           | 3,319      |   |   |
| Other                          |       | 13        |       | 13       |       |     |       |     |       |     |       |     |       |           |       |   |   |
| Capital Lease  Obligations     |       | —    |       | —   |       | —   |       | —   |       | —   |       | —   |       |           | —     |   |   |
| Operating Lease  Obligations   |       |      |       |     |       |     |       |     |       |     |       |     |       |           |       |   |   |
| Building                       |       | 486       |       | 262      |       | 29       |       | 30       |       | 31       |       | 32       |       |           | 102        |   |   |
| Equipment                      |       | 71        |       | 56       |       | 9        |       | 4        |       | 2        |       | —   |       |           | —     |   |   |
| Purchase  Obligations          |       | —    |       | —   |       | —   |       | —   |       | —   |       | —   |       |           | —     |   |   |
| Other Long-Term  Liabilities   |       |      |       |     |       |     |       |     |       |     |       |     |       |           |       |   |   |
| Security deposits              |       | 24        |       | —   |       | 9        |       | 15       |       | —   |       | —   |       |           | —     |   |   |
| Core deposits(A)               |       | 122       |       | —   |       | 122      |       | —   |       | —   |       | —   |       |           | —     |   |   |
| Other                          |       | 73        |       | 5        |       | —   |       | 67       |       | 1        |       | —   |       |           | —     |   |   |
| Total Contractual  Obligations |       | $         | 10,460     |     | $          | 1,101    |       | $        | 1,527      |     | $          | 546      |       | $              | 585        |   | $ | 3,280 |   |   | $ | 3,421 |   |   |

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(A)       Representsdeposits made in connection with the sale of Xonon catalyst modules to berefunded upon return of the module.

**Other Commitments**

We have entered into research collaborationarrangements that may require us to make future royalty payments. Thesepayments would generally be due once specified milestones, such as thecommencement of commercial sales of a product incorporating the fundedtechnology, are achieved. Currently we have four such arrangements, with TanakaKikinzoku Kogyo K.K. (“Tanaka”), Gas Technology Institute (“GTI”) (formallyknown as Gas Research Institute), the California Energy Commission (“CEC”) andWoodward Governor Company (“WGC”).

A significant amount of the development effort relatedto our catalytic combustion technology for gas turbines was funded by Tanakaunder a January 1995 development agreement which divides commercializationrights to the technology between the parties along product market lines. Wehave exclusive rights to manufacture and market catalytic combustion systemsfor gas turbines of greater than 25 megawatt (“MW”) power output andnon-exclusive rights for gas turbines of 25 MW power output or less. Tanaka hasreciprocal exclusive rights to manufacture and market catalytic combustors foruse in automobiles and non-exclusive rights for gas turbines of 25 MW poweroutput or less. In each case, the manufacturing and marketing party will pay aroyalty of 5% of net sales to the other party. Each party is responsible forits own development expenses, and any invention made after May 1, 1995 isthe sole property of the party making the invention, while the other party hasa right to obtain a royalty-bearing, non-exclusive license to use the inventionin its areas of exclusivity. As commercialized, the Xonon system containssignificant technology developed by us after May 1, 1995 and no technologydeveloped by Tanaka after this date. Our development agreement with Tanakaexpires in 2005, and we have no further royalty obligations to Tanaka after2005.

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In September 1998, we entered into a fundingarrangement with the CEC under which they agreed to fund a portion of our Xononengine test and demonstration facility located in Santa Clara, California.Under this agreement, we are required to pay a royalty of up to 1.5% of thesales price on the sale of each product or right developed under this projectfor fifteen years upon initiation of the first commercial sale of aXonon-equipped engine greater than 1 MW.

In January 2000, we entered into a fundingarrangement with GTI to fund the development of our Xonon combustor anddemonstrate its performance. We will be required to make royalty payments toGTI of $243,000 per year for seven years beginning with the sale, lease orother transfer of the twenty-fifth catalyst module for gas turbines ratedgreater than 1 MW, up to a maximum of $1,701,000.

On December 19, 2001, we entered into a ControlPatent Assignment and Cross License Agreement (“Patent Assignment Agreement”)with WGC pursuant to which WGC assigned a patent to us, and we and WGCcross-licensed certain intellectual property to each other. Under the PatentAssignment Agreement, we must pay WGC between $5,000 and $15,000 upon eachshipment of a Xonon commercial unit. Additionally, as part of an April 2002settlement agreement with WGC (the “Settlement Agreement”), we agreed toincrease royalties by $2,500 per unit on our shipment of the first 100 gasturbines greater than 10 MW. These increased royalties are guaranteed, and wemust pay them on 100 units even if we do not ship any units of this size. Weprepaid $50,000 of these royalties to WGC in April 2002. We paid WGC$100,000 in January 2003 and an additional $100,000 in January 2004. Theseguaranteed payments totaling $250,000 were recorded as a component of SG&Aexpenses during the three months ended March 2002 and are in addition tothe $5,000 we must pay to WGC under the Patent Assignment Agreement upon eachshipment of a Xonon commercial unit in a gas turbine of this size.

The Patent Assignment Agreement also provides thateach time we sublicense the WGC technology to a gas turbine manufacturer orthird party control manufacturer; we will pay WGC a control technology licensefee of $50,000, as well as a $3,000 additional license fee for each sale of aXonon control system sold by such manufacturer. As a part of the SettlementAgreement, we paid $200,000 in April 2002 representing a pre-payment ofthe control technology license fees for our first four $50,000 sublicenses ofthe WGC control technology. This payment was recorded as a component ofSG&A expenses in March 2002. We are obligated to make the foregoinglicense payments to WGC through December 31, 2014 or until our cumulativepayments and license fees to WGC total $15,250,000, whichever occurs first.

WGC must pay us a fee of1% of the sale price of each WGC control system installed in conjunction withXonon catalytic modules for new and retrofit turbines. WGC is obligated to makethese payments through December 31, 2014 or until we have received totalpayments of $2,000,000, whichever occurs first.

**CriticalAccounting Policies and Estimates**

Our discussion and analysis of financial condition andresults of operations are based upon our consolidated financial statements,which have been prepared in accordance with accounting principles generallyaccepted in the United States. The preparation of these consolidated financialstatements requires us to make estimates and judgments that affect the reportedamounts of assets, liabilities, revenues and expenses, and related disclosureof contingent liabilities. On an on-going basis, we evaluate our estimates andjudgments, including those related to contract terms, equity investments, baddebts, inventories, investments, goodwill and other intangible assets, warrantyreserves, income taxes, financing operations, contingencies and litigation. Webase our estimates and judgments on historical experience and on various otherfactors that we believe to be reasonable under the circumstances, the resultsof which form the basis of our judgments about the carrying values of assetsand liabilities that are not readily apparent from other sources. Actualresults would differ from these estimates under different assumptions orconditions.

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Our significant accountingpolicies are disclosed in Note 2 to our consolidated financial statements. Webelieve the following critical accounting policies affect our more significantjudgments and estimates used in the preparation of our consolidated financialstatements.

*Revenue Recognition*

We recognize revenue whenpersuasive evidence of an arrangement exists, delivery has occurred or serviceshave been rendered, the price is fixed or determinable and collection isreasonably assured.

*Revenues from SCRCatalyst and Management Services*

Revenues related to SCR catalyst regeneration andcleaning services are recognized when the service is completed for eachcatalyst module. Customer acceptance is not required in that SCR-Tech’scontracts currently provide that services are completed upon receipt of testingby independent third parties confirming compliance with contract requirements.Testing generally occurs three times during a particular customer project—atthe beginning of the processing, when approximately one-half of the project hasbeen processed, and upon completion of processing. A typical customer projectmay take 30 to 90 days to complete. Once a successful test result is receivedfrom an independent third party, revenue is recognized for each catalyst moduleprocessed prior to the receipt of such test results, and revenue issubsequently recognized for each catalyst module as its processing is completed.As the Company utilizes a consistent methodology and formula for each project,it is unlikely that subsequent testing would not be successful. Nonetheless, ifa subsequent test result were to indicate failure, the Company would ceaserecognizing revenue on any subsequent modules until new testing evidenceconfirms successful processing. We maintain a revenue allowance to provide forany deficient test results that may occur after our initial test.

Due to the nature of the demand for SCR catalystregeneration and cleaning services, some of our contracts provide for extendedpayment terms. In a situation where the project for a customer is complete; butthe customer is not contractually committed to receive an invoice within thesucceeding six months (and subsequent payment is due within 30 days of invoicedate), revenue is deferred until the contractual invoice date. If the customercontract provides for a deposit or progress payments, we recognize revenue upto the amount invoiced. Because we perform a service for a customer, no rightsof return exist. The customer is responsible for the removal, transportationand subsequent installation of the catalyst. Our revenue arrangements do nothave any material multiple deliverables as defined in Emerging Issues TaskForce (“EITF”) 00-21, “Accounting for Multiple Element RevenueArrangements”.

Costs associated with performing SCR catalystregeneration and cleaning services are expensed as incurred because of theclose correlation between the costs incurred, the extent of performanceachieved and the revenue recognized. In the situation where revenue is deferreddue to collectibility uncertainties, the Company does not defer costs due tothe uncertainties related to payment for such services.

We recognize revenue fromour management and consulting services as work is performed. Costs associatedwith management and consulting services is expensed as incurred.

*Revenues fromResearch and Development Contracts*

Research and developmentrevenues are earned as contractual services are performed and are recognized inaccordance with contract terms, principally based on reimbursement of totalcosts and expenses incurred. Since research and development revenues fromgovernment-funded programs are subject to government audits, we maintain arevenue cost reserve in the event any of these funded costs, includingoverhead, are disallowed. We estimate this reserve by applying a percentage tothe revenue recorded under contracts still subject to audit by those fundingagencies based on historical experience. If we underestimate the amount ofdisallowed funding for a particular program, we will have to reduce our revenuein a subsequent period by the amount by which actual disallowed funding exceedsour estimate. 

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Noamounts recognized as revenue are refundable. In return for funding,collaborative partners may receive certain rights in the commercialization ofthe resulting technology. The contracts are also subject to periodic review bythe funding partner, which could result in modifications to program scope,including reduction or termination of funding.

*Goodwill and Other Intangible Assets*

We account for goodwilland other intangible assets in accordance with the provisions of Statement ofFinancial Accounting Standards (“SFAS”) No. 141, “Business Combinations”, and SFAS No. 142, “Goodwill and Other Intangible Assets”. Purchaseprices of acquired businesses that are accounted for as purchases have beenallocated to the assets and liabilities acquired based on the estimated fairvalues on the respective acquisition dates. Based on these values, the excesspurchase prices over the fair value of the net assets acquired were allocatedto goodwill. Pursuant to SFAS No. 142, goodwill and other intangibleassets acquired in a purchase business combination and determined to have anindefinite useful life are not amortized, but instead tested for impairment atleast annually in accordance with the provisions of SFAS No. 142. SFAS No. 142also requires that intangible assets with estimable useful lives be amortizedover their respective estimated useful lives to their estimated residual valuesand reviewed for impairment in accordance with SFAS No. 144, “Accountingfor Impairment or Disposal of Long-Lived Assets.” Other intangible assets thathave finite useful lives, including patents, trademarks, trade secrets andother purchased technology, were recorded at fair value at the time of theacquisition, and are carried at such value less accumulated amortization. Weamortize these intangible assets on a straight-line basis over their usefullives, estimated at ten years.

*Accounts Receivable Reserves*

We maintain an allowancefor doubtful accounts for estimated losses resulting from the inability of ourcustomers or funding partners to make required payments. This allowance isbased on specific customer account reviews and historical collectionsexperience. We generally reserve for balances that are 60 days past the invoicedue date. If the financial condition of any of our customers or fundingpartners were to deteriorate, resulting in an impairment of their ability tomake payments, additional allowances would be required.

*Income Taxes*

Financial AccountingStandards Board (“FASB”) SFAS No. 109, “Accounting for Income Taxes”,requires that a valuation allowance be established when it is more likely thannot that all or a portion of a deferred tax asset will not be realized. SFAS No. 109further states that it is difficult to conclude that a valuation allowance isnot needed when there is negative evidence such as cumulative losses in recentyears. As a result we have recorded a full valuation allowance against ourdeferred tax assets and expect to continue to record a full valuation allowanceon future tax benefits until we reach sustained profitability.

*Contingent Liabilities*

We record a reserve forcontingencies, including litigation settlements, when a liability becomesprobable and estimable. The amount we record for litigation reserves is basedupon our best estimate at the time and is subject to change as facts we becomeaware of change or ultimate determinations or settlements are made.

**Impactof Inflation and Foreign Currency Fluctuation**

The effect of inflationand changing prices on our operations was not significant during the periodspresented. We have operated primarily in the United States and all revenuerecognized to date has been 

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made inU.S. dollars. Accordingly, we have not had any material exposure to foreigncurrency rate fluctuations.

**Impactof Recently Issued Accounting Standards**

On December 16, 2004, the FASB issued SFASStatement No. 123 (revised 2004), “Share-Based Payment” (Statement 123R),which is a revision of FASB Statement No. 123, “Accounting for Stock-Based Compensation” (Statement 123). Statement123(R) supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees”, and amends FASBStatement No. 95, “Statement ofCash Flows”. Generally, the approach in Statement 123(R) is similarto the approach described in Statement 123. However, Statement 123(R) requires all share-based payments toemployees, including grants of employee stock options, to be recognized in theincome statement based on their fair values. Pro forma disclosure is no longeran alternative.

Statement 123(R) mustbe adopted no later than July 1, 2005. Early adoption will be permitted inperiods in which financial statements have not yet been issued. We intend toadopt Statement 123(R) on July 1, 2005, the adoption of which willlikely have a significant impact on our results of operations, although it willhave no impact on our overall financial position. The actual impact of adoptionof Statement 123(R) on our results of operations cannot be predicted atthis time because it will depend on levels of share-based payments granted inthe future. However, had we adopted Statement 123(R) in prior periods, theimpact of that standard would have approximated the impact of Statement 123 asdescribed in the disclosure of pro forma net income and earnings per share inNote 2 to our consolidated financial statements. Statement 123(R) alsorequires the benefits of tax deductions in excess of recognized compensationcost to be reported as a financing cash flow, rather than as an operating cashflow as required under current literature. This requirement will reduce netoperating cash flows and increase net financing cash flows in periods afteradoption to the extent we do not provide a full valuation reserve on such taxbenefit.

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**RISKSTHAT COULD AFFECT OUR FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

*The following risk factors could materially andadversely affect our future operating results, financial condition, the valueof our business, and the price of our common stock and also could cause actualevents to differ materially from those predicted in the forward-lookingstatements we make about our business. Investors are encouraged to carefullyconsider the risks described below before making decisions related to buying,holding or selling our common stock.*

**GENERALRISKS RELATING TO OUR FINANCIAL CONDITION AND OPERATING RESULTS**

The following risks couldnegatively impact our operating results, financial condition, the value of ourbusiness and the price of our common stock. These risks also apply to and mayadversely affect our specific business programs, products and opportunities, asmore specifically described below.

**Wehave incurred significant continuing losses since inception, and we anticipatecontinued losses for the foreseeable future.**

We incurred losses of$13,269,000, $14,399,000 and $17,874,000 for the years ended December 31,2004, 2003 and 2002, respectively. As of December 31, 2004, we had anaccumulated deficit of $125,017,000 and had not yet recorded significantrevenue from commercial sales apart from revenues from SCR-Tech, a business weacquired in 2004. We expect to continue to incur net losses for the foreseeablefuture and these losses are likely to be significant. There can be no assurancewe will ever reach or sustain profitability.

**Wemay need significant additional capital, and we may be unable to raise additionalcapital to complete our product development and commercialization plans orachieve profitability.**

In general, our current and near-term capitalrequirements depend on numerous factors, including but not limited to ourproduct development and commercialization activities, the timing and level ofthird-party research and development funding, market acceptance of our productsand our rate of sales growth. We face substantial uncertainties with ourbusiness operations and may not be able to achieve positive cash flows fromoperations. We expect to devote substantial capital resources to furthercommercialize our technology, hire and train our production staff, develop andexpand our manufacturing capacity, begin production activities, and expand ourresearch and development activities.

Our net decrease in cash, cash equivalents andshort-term investments (“Cash Consumption”) was $17,909,000 for the year ended December 31,2004, compared to Cash Consumption of $14,088,000 for the year ended December 31,2003 and Cash Consumption of $20,877,000 for the year ended December 31,2002. We expect Cash Consumption of between $12.5 and $14.0 million in 2005 aswell as significant Cash Consumption thereafter. We believe our available cash,cash equivalents and short-term investments in the amount of $35.6 million asof December 31, 2004 will provide sufficient capital to fund operations aspresently planned until at least December 31, 2006. Our current operatingplans through fiscal 2006 call for further developing and commercializing ourdiesel emissions reduction solutions including initial distribution of ourdiesel retrofit product, achieving full commercialization of our Xonon CoolCombustion system for additional gas turbine applications, meeting paymentobligations related to the SCR-Tech acquisition, expanding our SCR-TechCatalyst and Management Services business, and developing other potentialproducts.

The amount of capital required to complete ourdevelopment programs is highly uncertain and depends on numerous factors,including technical issues associated with our ongoing development ofCatalyst-Based Technology Solutions, the nature of partner participation andthe amount and timing of any capital or technical contributions from suchpartners, the ability of third party suppliers to develop certain components ina timely manner, market and industry demands and requirements, and the cost of 

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required regulatoryreviews and approvals. If our mobile diesel retrofit solution is notsuccessful, it is likely that any other diesel solution we pursue will requiresubstantial additional capital expenditures beyond our current estimates. Althoughwe are seeking to avoid incurring significant additional expenses fordevelopment work on our Xonon product for small gas turbines, if GE, Solar,Kawasaki or any other OEM elects to use our technology on a gas turbineplatform, we likely will incur additional development expenses. The nature andamount of any such expenses cannot be determined at this time and would dependon the nature of the products using our Xonon product.

Because our SG&A expenses have been and areexpected to be in excess of $6.0 million per year, any delay in productdevelopment or commercial product launches will result in us continuing toincur significant SG&A expenses without corresponding revenue. In addition,because we are a public company subject to the compliance requirements andcorresponding costs relating to the Federal securities laws, it is difficult toreduce such expenses without substantially curtailing our operations. Ourliquidity will continue to be impacted by these expenses as long as we aresubject to such requirements.

Given the uncertainty as to the specific amounts andtiming of our required capital expenditures and other Cash Consumption, as wellas the uncertainty related to our commercialization efforts with respect to ourdiesel emissions control solutions and our Xonon Cool Combustion products, ourcurrent cash, cash equivalents and short-term investments, along with any cashgenerated from operations, may not be sufficient to fund our operations throughfiscal 2006 as is currently expected. If our overall Cash Consumption in fiscal2005 and 2006 exceeds our current expectations because of higher capitalexpenditures, increased costs of development or commercialization, lower thananticipated revenue from SCR-Tech, diesel retrofit or government andthird-party funding, higher SG&A expenditures or for any other reason, wemay be required to raise additional funds to continue our operations aspresently planned, significantly curtail our business operations and/or changeour strategic direction. In addition, we may enter into acquisitions orstrategic arrangements which could require the use of cash, reducing ouravailable capital prior to December 31, 2006, or which could requireadditional equity or debt financing. Moreover, the integration and operation ofany business acquired could require significant expenditures that materiallyand adversely impact our liquidity and capital resources. In this regard, ourrecent acquisition of SCR-Tech required, and will continue to require,significant cash outlays for payments related to debt acquired as a result ofthe acquisition.

Any additional funding requirements, whether foroperations, acquisitions or otherwise, may be significant, may not be availablewhen required or may be available only on terms unsatisfactory to us. Furthermore,if we issue equity securities, the ownership percentage of our then existingstockholders may be reduced, and the holders of new equity securities may haverights senior to those of our existing holders of common stock. If we issuedebt securities, these securities would be senior in priority to any equitysecurities, including our common stock, and would subject us to the risksinherent in issuing debt, including ongoing payment and maturity obligations. Fundingrequirements satisfied through strategic relationships with industryparticipants could result in substantial dilution of our then existing equityholders and could require us to limit our potential return from our products bymaking significant business or financial concessions to such participants.

Beyond December 31,2006, our cash requirements will depend on many factors, including the amountand rate of sales growth of our diesel retrofit products, the level of growth,if any, in the small gas turbine market, the market acceptance of our products,the ability of our diesel OEM product to achieve market acceptance andcommitment from significant industry participants, the timing and level ofdevelopment funding from private and government sources, the ability ofSCR-Tech to generate significant cash flow, the rate of expansion of our salesand marketing activities, the rate of expansion of our manufacturing capacity,and the timing and extent of research and development projects.

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**Therecent acquisition of SCR-Tech and any additional acquisitions we may makecould disrupt our business and harm our financial condition.**

As part of ourgrowth strategy, we intend to review opportunities to acquire other businessesor technologies that would complement our current products, expand the breadthof our markets or enhance our technical capabilities. We have limitedexperience in making acquisitions. SCR-Tech was our first acquisition, andthere can be no assurance this acquisition will prove to be successful orultimately beneficial to us. See “Additional Risks Relating to SCR Catalyst andManagement Services.” The SCR-Tech acquisition and any future acquisitionsentail a number of risks that could materially and adversely affect ourbusiness and operating results, including but not limited to:

·       issuesassociated with integrating the acquired operations, technologies or productswith our existing business and products;

·       potentialdisruption of our ongoing business activities and distraction of ourmanagement;

·       difficultiesin retaining business relationships with suppliers and customers of theacquired companies;

·       difficultiesin coordinating and integrating overall business strategies, sales andmarketing, and research and development efforts;

·       difficultiesassociated with the maintenance of corporate cultures, controls, procedures andpolicies;

·       risksassociated with entering markets in which we lack prior experience;

·       thepotential loss of key employees; and

·       thepotential for write-offs of goodwill and other acquired intangibles.

**Themarket price of our common stock is highly volatile and may decline.**

The market price ofour common stock is highly volatile and has declined significantly since ourstock began trading in December 2000. Factors that could cause fluctuationand further declines in our stock price may include, but are not limited to:

·       announcementsor cancellations of orders or research and development arrangements;

·       conditionsor trends in our industry;

·       changesin the market valuations of other companies in our industry;

·       theeffectiveness and commercial viability of products offered by us or ourcompetitors;

·       theresults of our research and development or test activities;

·       announcementsby us or our competitors of technological innovations, new products,significant acquisitions, strategic partnerships, divestitures, joint venturesor other strategic initiatives;

·       changesin environmental regulations; and

·       additionsor departures of key personnel.

Many of these factors are beyond our control. Thesefactors may cause the market price of our common stock to decline regardless ofour operating performance. In addition, stock markets have experienced extremeprice volatility in recent years. This volatility has had a substantial effecton the market prices of securities issued by many companies for reasons thatmay be unrelated to the operating performance of the specific companies. These broadmarket fluctuations may adversely affect the market price of our common stock.

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We expect ourrevenue and operating results to vary significantly from quarter to quarter. Asa result, quarterly comparisons of our financial results are not necessarily meaningfuland investors should not rely on them as an indication of our futureperformance. In addition, due to our stage of development, we cannot predictour future revenue or results of operations accurately. As a consequence, ouroperating results may fall below the expectations of securities analysts andinvestors, which could cause the price of our common stock to decline. Factorsthat may affect our operating results include:

·       thestatus of development of our technology, products and manufacturing capabilities;

·       thecost of our raw materials and key components;

·       warrantyand service costs for products in the field;

·       theintroduction, timing and market acceptance of new products introduced by us orour competitors;

·       thedevelopment of our strategic relationships and distribution channels;

·       generaleconomic conditions, which can affect our customers’ capital investments andthe length of our sales cycle;

·       thedevelopment and/or market acceptance of NOx adsorbers; and

·       Governmentregulations.

**We mayhave difficulty managing our current operations or any expansion of ouroperations.**

Currently our managementteam is responsible for the operations of our recently acquired SCR-Techbusiness, our diesel programs, our Xonon gas turbine program, exploring andevaluating potential acquisitions or other business opportunities, and otherprograms. In light of employee headcount reductions within the past few years,including management level employees, and the increasing number of Federal andNASDAQ securities regulatory requirements, substantial additional burdens havebeen placed on our management. It may prove difficult for current management tosuccessfully operate these differing areas and meet the demands andrequirements of differing business activities. In addition, we would expect toundergo growth in the number of our employees, the size of our physical plantand the scope of our operations as we commercialize our products and as demandfor our products increases. Expansion of our manufacturing operations willrequire significant management attention. This expansion could place asignificant strain on our management team and other resources. Our businesscould be harmed if we encounter difficulties in effectively managing the issuespresented by such an expansion. Recent management changes at SCR-Tech also haverequired increased management attention to SCR-Tech’s business. No assurancecan be given that management resources will be sufficient to address currentand future business activities or that we will not be required to incursubstantial additional expenses to add to our management capabilities.

**Wehave historically focused on research and development activities and havelimited experience in marketing, selling and servicing our products.**

We have primarily focusedon research and development activities to date. Consequently, our managementteam has limited experience directing the commercialization efforts that areessential to our future success. To date, we only have limited experiencemarketing, selling and servicing our Xonon combustion systems, and noexperience marketing, selling or servicing our diesel emissions reductionsystems. We will have to expand our marketing and sales organization, as wellas our maintenance and support capability as our products become commerciallyavailable. We may not be successful in our efforts to market and service ourproducts, which could compromise our ability to increase our revenue.

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**If weare unable to attract or retain key personnel, our ability to adapt ourtechnology to diesel engines, gas turbines, or other products, to continue todevelop and commercialize our technology, to effectively market our productsand to manage our business could be harmed.**

Our business requires ahighly skilled management team and specialized workforce, including scientists,engineers, researchers, and manufacturing and marketing professionals who havedeveloped essential proprietary skills. Our future success will thereforedepend on attracting and retaining qualified management and technicalpersonnel. We do not know whether we will be successful in hiring or retainingthese qualified personnel. Our inability to hire qualified personnel on atimely basis, or the departure of key employees, could harm our existingbusiness as well as our expansion and commercialization plans.

**Certainof our manufacturing equipment is unique to our business and would be difficultand expensive to repair or replace.**

Certain of the capitalequipment used in the manufacture of our products has been developed and madespecifically for us and would be difficult to repair or replace if it were tobecome damaged or stop working. In addition, certain of our manufacturingequipment is not readily available from multiple vendors. Consequently, anydamage to or breakdown of our manufacturing equipment at a time we aremanufacturing commercial quantities of our products may have a material adverseimpact on our business.

**Significantprice increases in key materials may reduce our gross margins and profitabilityof our NOx reduction products.**

The prices of palladium,platinum, molybdenum and vanadium, all of which are used in various componentsor our business, can be volatile. If the long-term costs of these materialswere to increase significantly, we would attempt to reduce material usage orfind substitute materials. If these efforts were not successful or if thesecost increases could not be reflected in our price to customers, then our grossmargins and profitability would be reduced.

**Weare subject to significant potential environmental and product liabilityexposure.**

Since our business relates to NOx and relatedemissions controls, solutions and services, we are subject to significantpotential environmental and product liability risks. These include risks relatingto the chemicals and other materials used to manufacture our products andprovide our services; risks relating to hazardous waste and hazardous wastedisposal; potential environmental damage caused in the manufacture, sale,distribution or operation of our products and services relating thereto;employee and third party injuries from the manufacture, sale, distribution oroperation of our products and services relating thereto, including claims byour customers and their end users, including in certain cases, consumers; theinability of our products to meet environmental or other standards imposed byfederal, state or local law or by our customers; and other claims relating toour products and services. Because of our very limited experience and thelimited distribution of our products and services, we do not have anyexperience with the nature or type of claims which may arise from our business.Only limited insurance is available for environmental and product liabilityclaims, and any such claims could have an adverse impact on our business andfinancial condition. This could be the case even if we ultimately had noliability on any particular claim, since the costs of defending anyenvironmental or product liability claim could be prohibitive. To date, theCompany has not been identified as a potential responsible party to suchenvironmental or product liability risks, nor have any amounts been recorded toaccrue for these potential exposures.

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**Manyof the risks of our business have only limited insurance coverage and many ofour business risks are uninsurable.**

Our business operationsare subject to potential environmental, product liability, employee and otherrisks. Although we have insurance to cover some of these risks, the amount ofthis insurance is limited and includes numerous exceptions and limitations tocoverage. Further, no insurance is available to cover certain types of risks,such as acts of god, war, terrorism, major economic and business disruptionsand similar events. In the event we were to suffer a significant environmental,product liability, employee or other claim in excess of our insurance or a lossor damages relating to an uninsurable risk, our financial condition could benegatively impacted. In addition, the cost of our insurance has increasedsubstantially in recent years and may prove to become prohibitively expensive,thus making it impractical to obtain insurance. This may result in the need toabandon certain business activities or subject ourselves to the risks ofuninsured operations.

**If weare unable to protect our intellectual property, or our intellectual propertyprotection efforts are unsuccessful, others may duplicate our technology.**

We rely on a combination of patents, copyrights andtrade secret laws and restrictions on disclosure to protect our intellectualproperty rights. Our ability to compete effectively will depend, in part, onour ability to protect our proprietary technology, systems designs and manufacturingprocesses. In this regard, we recently entered into new emissions controlsolution markets in which we do not have as broad of intellectual propertyprotection as we do in the NOx control solutions area. Consequently, ourability to compete effectively in such new markets may be adversely affected. Theability of others to use our intellectual property could allow them toduplicate the benefits of our products and reduce our competitive advantage. Wedo not know whether any of our pending patent applications will issue or, inthe case of patents issued or to be issued, that the claims allowed are or willbe sufficiently broad to protect our technology or processes. Further, a patentissued covering one use of our technology may not be broad enough to cover usesof that technology in other business areas. Even if all our patent applicationsare issued and are sufficiently broad, they may be challenged or invalidated. Wecould incur substantial costs in prosecuting or defending patent infringementsuits. While we have attempted to safeguard and maintain our proprietaryrights, we do not know whether we have been or will be completely successful indoing so.

Further, our competitors may independently develop orpatent technologies or processes that are equivalent or superior to ours. If weare found to be infringing on third party patents, we may be unable to obtainlicenses to use those patents on acceptable terms, or at all. Any inability onour part to obtain needed licenses could delay or prevent the development,manufacture and sale of our systems.

We rely, in part, oncontractual provisions to protect our trade secrets and proprietary knowledge.These agreements may be breached, and we may not have adequate remedies for anybreach. Our trade secrets may also be known without breach of such agreementsor may be independently developed by competitors.

**Weincur substantial costs as a result of being a public company.**

As a public company, weincur significant legal, accounting, and other expenses. In addition, both theSarbanes-Oxley Act of 2002, and new rules subsequently implemented by theSecurities and Exchange Commission and NASDAQ, have required changes incorporate governance practices of public companies. These new rules andregulations have already increased our legal and financial compliance costs andthe amount of time and effort we devote to compliance activities. We expectthese new rules and regulations to further increase our legal andfinancial compliance costs and to make compliance and other activities moretime-consuming and costly. In addition, we incur costs associated with ourpublic company reporting requirements. Further, due to increased regulations,it may be more difficult for us to attract and retain 

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qualifiedpersons to serve on our board of directors or as executive officers. We haveattempted to address some of these attraction and retention issues by offeringcontractual indemnification agreements to our directors and executive officers,but this may not be sufficient. We continue to regularly monitor and evaluatedevelopments with respect to these new rules with our legal counsel, butwe cannot predict or estimate the amount of additional costs we may incur orthe timing of such costs.

**Becausea small number of stockholders own a significant percentage of our commonstock, they may exert significant influence over major corporate decisions, andour other stockholders may not be able to do so.**

As of December 31, 2004, our executive officers,directors and greater than 5% stockholders controlled approximately 60% of ouroutstanding common stock. If these parties were to act together, they couldsignificantly influence the election of directors and the approval of actionsrequiring the approval of a majority of our stockholders. The interests of ourmanagement or these investors may not always be aligned with the interests ofour other stockholders.

Based on sharesoutstanding as of December 31, 2004, the funds managed by Morgan StanleyCapital Partners and their affiliates own approximately 19% of our outstandingcommon stock. The Morgan Stanley Capital Partners funds also have stockholderrights, including rights to appoint directors and registration rights. As aresult, Morgan Stanley Capital Partners and its affiliates hold a substantialvoting position in us and may be able to significantly influence our business.

**Provisionsin our charter documents, our Shareholder Rights Plan and Delaware law mayprevent or delay an acquisition of us, which could decrease the value of oursecurities.**

Our certificate ofincorporation and bylaws and Delaware law contain provisions that could make itmore difficult for a third party to acquire us without the consent of our boardof directors. Furthermore, we have adopted a Shareholder Rights Plan withanti-takeover provisions which are triggered if any stockholder acquires 20% ormore (or 21.5% in the case of Morgan Stanley Capital Partners III, L.P. and itsaffiliates) of our outstanding common stock, resulting in significant dilutionof the shares owned by such stockholder unless such stockholder obtains consentof our Board of Directors to purchase shares in excess of the threshold. Thus,the plan could substantially impede the ability of public stockholders tobenefit from a change in control or change in our management and board ofdirectors.

**ADDITIONALRISKS RELATING TO SCR CATALYST AND MANAGEMENT SERVICES**

In addition to the risksdiscussed elsewhere, any of which also could adversely impact our SCR-Techsubsidiary and its business, the following additional risks specifically relateto SCR-Tech and could negatively impact SCR-Tech and our entire company.

**Werecently completed the acquisition of SCR-Tech, and we have very limitedexperience with the operations of SCR-Tech.**

We completed the acquisitionof SCR-Tech in February 2004. SCR-Tech was a privately held company, whichcommenced commercial operations in the U.S. in March 2003. At the time weacquired SCR-Tech, we had no experience in the SCR-related business and we havejust begun to integrate our management, technology and systems with SCR-Tech. Inaddition, SCR-Tech did not previously have audited financial statements. Thus,there is a risk of unknown financial or other liabilities which couldnegatively impact SCR-Tech and us. Although we have limited indemnificationfrom the sellers of SCR-Tech, there can be no assurance that any suchindemnification would be adequate to cover any unknown liabilities.

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**SCR-Techhas experienced a significant decline in new orders and resulting backlog forcleaning and regeneration services.**

SCR-Tech has failed togenerate significant new orders for cleaning and regeneration services, whichaccounted for approximately 80% of SCR-Tech’s revenues in 2004. Backlog as of12/31/04 for SCR Catalyst and Management Services was approximately $775,000including $190,000 of deferred revenue. We anticipate that the Company willrealize substantially all of its current backlog in the first quarter of 2005. Asa result, SCR-Tech may experience a significant decline in revenue resulting insignificant losses in 2005 and beyond. In addition, the termination of theformer president of SCR-Tech likely will negatively impact SCR managementservices revenues in the short-term. Although this revenue represented onlyapproximately 10% of SCR-Tech’s revenue in 2004, the ability of SCR-Tech togenerate new orders for cleaning and regeneration services may be significantlydependent on SCR-Tech’s ability to provide SCR management services. Noassurance can be given that SCR-Tech will be able to generate significant SCRmanagement services or an increase in cleaning and regeneration orders or thatSCR-Tech will be profitable in 2005 or in any future period.

**Recentmanagement changes at SCR-Tech may adversely affect our overall business.**

Hans Hartenstein, the former president of SCR-Tech,was one of the founders of SCR-Tech and was principally responsible for thegeneration of the business opportunities and for providing SCR management andconsulting services for SCR-Tech. Mr. Hartenstein’s employment with theCompany terminated in March 2005. It is uncertain whether the loss of Mr. Hartenstein’sSCR management and consulting services expertise will adversely impact theability of SCR-Tech to obtain new orders for cleaning and regeneration services.

William J. McMahon was appointed president of SCR-Techeffective March 21, 2005, and will be responsible for reinvigorating thebusiness of SCR-Tech. Mr. McMahon is a seasoned executive with more than25 years experience in the energy and utility industries, but has limitedexperience specifically associated with SCR Catalyst and Management Services;thus, no assurance can be given that Mr. McMahon will be successful inreinvigorating the business of SCR-Tech.

As a result of recentmanagement changes, SCR-Tech may be subject to potential litigation with Mr. Hartensteinand/or his affiliates. No assurance can be given as to the likelihood orpotential outcome of any such litigation.

**SCR-Techhas very limited operating experience in North America. SCR-Tech may not beable to profitably operate its business.**

SCR-Tech commencedcommercial operations in its U.S. regeneration facility in March 2003 andhas completed only a limited number of SCR cleaning and regeneration projects. ThusSCR-Tech does not have a substantial operational history in this facility todetermine whether it can successfully operate its business under differingenvironments and conditions or at any level of profitability.

**Thesize of the market for SCR-Tech’s business is uncertain.**

SCR-Tech offers catalystcleaning, rejuvenation and regeneration, as well as SCR system management andconsulting services. The size and growth rate for this market will ultimatelybe determined by a number of factors, including environmental regulations, thegrowth in the use of SCR systems to reduce NOx and other pollutants, the lengthof operation of SCR systems without the need for cleaning, rejuvenation orregeneration, the expansion of warranty coverage from SCR catalyst OEMs, thecost of new SCR catalyst, and other factors, most of which are beyond thecontrol of SCR-Tech. There is limited historical evidence in North America asto the cycle of replacement, cleaning and regeneration of SCR catalyst so as toaccurately estimate the potential growth of the business. In addition, thenumber of times a 

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catalystcan be regenerated is unknown, which also may affect the demand forregeneration in lieu of purchasing new catalyst. Any delay in the developmentof the market could significantly and adversely affect the value of SCR-Techand the nature of any return on our acquisition of SCR-Tech.

**SCR-Techmay be subject to vigorous competition with very large competitors that havesubstantially greater resources and operating histories.**

Although there does notappear to be a direct competitor in the business of SCR catalyst regenerationin North America, we are aware of at least one other company, Enerfab, Inc.(which uses a process developed by Envirgy/Integral), providing SCR catalystmanagement, rejuvenation and cleaning services. There also are a number of SCRcatalyst manufacturers with substantial parent companies that may seek tomaintain market share by significantly reducing or even eliminating all profitmargins. These companies includeCormetech Inc. (owned by Mitsubishi Heavy Industries and Corning, Inc.),Argillon GmbH (formerly Siemens), Haldor-Topsoe, Inc. and KWH. Further,if the SCR catalyst regeneration market expands, competitors could emerge. Ifthe intellectual property protection acquired by us becomes weakened,competition could more easily develop.

**SCR-Tech’sbusiness will be subject to potential seasonality.**

Becausesome utilities and IPPs currently operate their SCR units only during the “ozoneseason” (May 1–September 30), SCR-Tech’s business may be more limitedthan if SCR units were required to operate on a continual basis. The NOx SIPCall was configured to impose a summer ozone season NOx cap over 19 states andthe District of Columbia. During this period, utilities and IPPs seek tooperate their SCR catalyst at maximum capacity so as to reduce NOx emissionsduring this period. During non-ozone season periods, most operators currentlyhave limited (if any) requirements to run their SCR systems. Unless and untilsuch regulations are tightened, much of SCR-Tech’s business will beconcentrated outside ozone season each year. This will result in less businessthan if SCR units were required to be operated throughout the year and thisalso may result in quarters of relatively higher cash flow and earnings andquarters where cash flow and earnings may be minimal. These potentialfluctuations in revenue and cash flow during a year may be significant andcould materially impact our quarterly earnings and cash flow. This may have amaterial adverse effect on the perception of our business and the market pricefor our common stock.

**SCR-Techmay be subject to warranty claims from its customers.**

SCR-Tech typically mustprovide warranties to its customers relating to the level of success of itscatalyst cleaning and regeneration services. In the event SCR-Tech is unable toperform a complete regeneration of an SCR catalyst, SCR-Tech may be required tore-perform a regeneration or repay all or part of the fees earned for theregeneration efforts. SCR-Tech also may be required to provide warranties withrespect to its other SCR catalyst services provided to its customers. SinceSCR-Tech has only a limited operating history in North America, it is notpossible to determine the amount or extent of any potential warranty claimsthat SCR-Tech may incur. There is a risk that any such claims could besubstantial and could affect the profitability of SCR-Tech and the financialcondition of our Company.

**SCR-Techis dependent on third parties to perform certain testing required to confirmthe success of its regeneration.**

In connection with theregeneration of SCR catalyst by SCR-Tech, SCR-Tech must have an independentcompany provide testing services to determine the level of success ofregeneration. We are not aware of any company currently providing such servicesin the United States. Thus, SCR-Tech must ship samples to Europe for testing. Withoutsuch cost-effective testing, SCR-Tech cannot perform its regeneration services.

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**SCR-Techis significantly dependent on Envica.**

SCR-Tech has requiredsignificant assistance of an affiliate of one of the former owners of SCR-Tech,ENVICA Kat GmbH (“Envica”), to successfully complete certain contracts. Inaddition, SCR-Tech has been relying to a significant extent on the assistanceof Envica on various technical and support matters relating to its business. Althoughthe terms of our acquisition of SCR-Tech provides that Envica will providecontinuing intellectual property transfers and training, there can be noassurance that SCR-Tech and its current employees will be ultimately able tosuccessfully operate the business or expand the business. Further, there can beno assurance that SCR-Tech will not incur significant unanticipated technicalproblems and costs which could adversely affect SCR-Tech’s business.

**SCR-Techis highly dependent upon the strength of its intellectual property to protectits business.**

In addition to theintellectual property risks relating to ongoing dealings with Envica, there canbe no assurance the intellectual property acquired by us as part of theacquisition of SCR-Tech will prove sufficient or enforceable. The infringementrepresentation and indemnification from SCR-Tech’s sellers to us is short andof limited value. Further, much of the intellectual property from Envica is inthe form of trade secrets, for which patent protection is not available.

**SCR-Techdoes not own its regeneration facilities and it is subject to risks inherent inleasing the site of its operations.**

SCR-Tech does not own itsregeneration site; instead it leases it from Clariant Corporation, the U.S.subsidiary of a Switzerland-based public company. Although we believe the leaseterms are favorable, the dependence on Clariant and the site could subjectSCR-Tech to increased risk in the event Clariant experiences financial setbacksor loses its right to operate the site upon which SCR-Tech leases property. Thisrisk is heightened because of the fact the site is a Super Fund site, whichincreases the risks the site ultimately could be shut down or that Clariantwill be financially unable to continue its ownership of the site. It may bedifficult to locate to another site on a cost-effective basis, and SCR-Tech’sbusiness could be negatively impacted by any problems with continuing to conductits operations at its current site.

**SCR-Techcould be subject to environmental risks as a result of the operation of itsbusiness and the location of its facilities.**

The operation of SCR-Tech’sbusiness and the nature of its assets create various environmental risks. SCR-Techleases its site for operations at a property listed on the National PriorityList as a Federal Superfund site (under the Comprehensive EnvironmentalResponse, Compensation and Liability Act of 1980 (“CERCLA”). Five CERCLA Areas(those areas of concern identified under the CERCLA program) are identified onthe property, and while SCR-Tech does not lease any property identified as aCERCLA Area, one such Area has resulted in contamination of groundwater flowingunderneath one of the building leased by SCR-Tech. Although SCR-Tech hasindemnification from Clariant Corporation for any environmental liabilityarising prior to the operation of SCR-Tech’s business at the site, there can beno assurance that such indemnification will be sufficient or that SCR-Techcould be protected from an environmental claim from the nature of the site. Inaddition, the operation of SCR-Tech’s business involves removal of hazardouswastes from catalyst and the use of significant chemical materials. As a result,SCR-Tech could be subject to potential liability from such operations. To-date,the Company has not been identified as a potential responsible party to suchenvironmental risks, nor have any amounts been recorded to accrue for thesepotential exposures.

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**ADDITIONALRISKS RELATING TO EMISSIONS CONTROL SOLUTIONS FOR DIESEL ENGINES**

In addition to the risksdiscussed elsewhere, any of which could adversely impact our efforts to developemissions control solutions for diesel engines, the following additional risksparticularly relate to our efforts to develop emissions control solutions fordiesel engines and could negatively impact our entire company.

**Wemay never complete the research and development of a commercially viable NOxcontrol solution for diesel engines.**

We are in the very earlydevelopment stage associated with emissions control solutions for dieselengines. We do not know when or whether we will successfully complete researchand development of a commercially viable product in the diesel OEM, dieselretrofit, or stationary diesel genset markets. Economic and technicaldifficulties may prevent us from completing development of products for dieselengines or commercializing those products. Furthermore, a viable market for ourproduct concept may never develop. This is further complicated by the limitedtime frame we have to develop a diesel retrofit solution to meet immediatemarket requirements. If a market were to develop in the diesel OEM, dieselretrofit, or stationary genset markets using our NOx control solutions, welikely would face intense competition from various competitors, including largediesel engine OEMs, and we may be unable to compete successfully. In addition,diesel engine OEMs and other competitors may create technology alternativesthat could render our systems obsolete prior to commercialization. Moreover, wemay conclude that the potential return from our investment in the diesel OEM,diesel retrofit, or stationary diesel genset markets does not justify ourcontinued investment in these opportunities. Thus, we may at any time terminateany or all of our diesel programs, even if we do develop a commercially viablesolution.

**Wehave only a limited time to take advantage of the retrofit market for dieselengines.**

The diesel retrofit markethas a limited time frame, since new diesel engines produced in 2007 and beyondlikely will not need retrofit products. As older vehicles and other machinesusing diesel engines are retired from service and replaced with vehicles andother machines using newer diesel engines, the need to retrofit older engineswill decline. Thus, in order to take advantage of the diesel retrofit market,we must develop a solution that can quickly come to market and which results insignificant NOx reduction with an economically viable fuel penalty and have itverified to comply with federal and state emissions requirements. It is likelywe will not have our solution ready for verification testing until the end of2005, and there can be no assurance we will be able to meet such testingrequirements or find the necessary market for our retrofit product. Thus, wemay expend significant sums on developing our diesel retrofit solution with noassurance that we will be successful in developing the solution or that we willdevelop the solution in sufficient time to take advantage of the potentialmarket. Even if we are successful in developing a diesel engine retrofitsolution, our product market window will be limited and decreasing in size asnew diesel engines are introduced into the market. Further, a successful dieselretrofit solution does not imply this technology or a derivative of thistechnology can be employed in the diesel OEM market.

**Wewill be heavily dependent on developing relationships with retrofit integratorsin order to enter the diesel retrofit marketplace.**

Our diesel retrofitsolution does not address a number of significant requirements to enter thismarket. We will need to develop relationships with integrators who can procurenecessary products and services for our solution, including project management,installation of our solution on mobile, stationary or off-road applicationswith necessary attachments and system controls and other necessary components. Sincethis will be a retrofit as opposed to an OEM product, we will likely not havethe assistance of any of the manufacturers of the original equipment to supplyour solution. This may make installation and operation of our diesel retrofitsolution more difficult and expensive. Further, although we may develop 

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appropriaterelationships with retrofit integrators, we may find that they are deficient intheir abilities to complete system development, manage, market, install and/orsell our solution.

**Wewill be heavily dependent on developing relationships with diesel OEMs andtheir commitment to adopt and market our diesel fuel processor technology fortheir diesel engines in order to enter the diesel OEM marketplace; anyagreements with these OEMs may limit our market opportunities.**

In order to take advantageof the opportunities for NOx control solutions in the diesel OEM market, wemust develop a solution that results in significant NOx reduction (approximately 90%) to meet impendingUnited States, European Union or Japanese requirements for diesel engines. Thiswill require us to partner with one or more diesel OEMs. Until we candemonstrate the viability of our diesel fuel processor for the diesel OEMmarket, it is unlikely we can develop the necessary OEM relationships. Inaddition, if we are unable to develop a diesel retrofit solution, it is lesslikely we will develop the necessary credibility with diesel OEMs with respectto our diesel OEM solution.

Even if we are successfulin entering into agreements with a diesel OEM, the agreements may provide the OEMwith the right to be the exclusive market channel for distribution of ourdiesel fuel processor and may otherwise limit our ability to enter into otherOEM agreements. An agreement may provide for exclusivity for particular enginesizes and for limited periods of time. The agreements also may provide thateither party can terminate the agreement, but not necessarily the exclusivityprovision. A decision by an OEM to discontinue the commercialization our dieselfuel processor in its engines could significantly limit or foreclose our accessto the market for that OEM’s engines or prevent us from entering intoagreements with other OEMs regarding the application of our diesel fuelprocessor to some of their competing engines.

**Wemay incur significant costs in developing our diesel technology with OEMs; ifany OEM does not complete development for any reason, we may not be able torecover costs incurred for the development with that OEM.**

We may incur significantcosts in developing our diesel technology with OEMs for the diesel OEM market.Further, the technological development required to meet the requirements forthis decade may be significant, and the capital required to be invested in sucha development is likely to be substantial. Moreover, there can be no assurancethat any solution developed by us will be technically feasible, cost-effectiveor acceptable to OEMs. We are not likely to recover any significantportion of these costs through contractual reimbursement from the OEMs. Thus,we will likely bear the majority of the development costs ourselves. If OEMs donot complete development work for any reason, we will not be able to recoverour development costs through product sales.

**Wewill be dependent on third party development of NOx adsorbers for our dieselproducts.**

Even if our diesel fuelprocessor is accepted in the diesel markets, if NOx adsorbers do not evolve toa state of commercial viability, OEMs will not ultimately adopt our technology.Although our diesel fuel processor has the benefit of lessening certain NOxadsorber limitations, significant technological hurdles, including cost, size,durability, operating range and the level of NOx reduction from NOx adsorbersmust be overcome to ensure the feasibility of commercializing our diesel fuel processorin combination with a NOx adsorber. The failure of third parties to developsolutions to current NOx adsorber limitations in a timely manner willeffectively eliminate our diesel fuel processor from market consideration. Wemay not have any ability to significantly influence the resolution of NOxadsorber issues. Further, a supplier’s failure to develop and supply componentsin a timely manner or at all, or to develop or supply components that meet ourquality, quantity or cost requirements, or our inability to obtain substitutesources of these components on a timely basis or on terms acceptable to us,could harm our ability to manufacture our products. In addition, to the extentthat our supply partners use technology or manufacturing processes that areproprietary, we may be unable to obtain comparable components from alternativesources.

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**Wewill be dependent on third party suppliers for the supply of key components forour diesel products.**

We have not entered intocommercial arrangements with suppliers of the key components which may berequired for our diesel solutions. We do not know when or whether we willsecure arrangements with suppliers of required materials and components for ourdiesel solutions, even if they are successfully developed, or whether thesearrangements will be on terms that will allow us to achieve our objectives. Evenif we can develop a commercially viable diesel retrofit, diesel OEM orstationary diesel genset solution, if we are unable to obtain suppliers of allthe required materials and components for our systems, our business could beharmed. A supplier’s failure to supply materials or components in a timelymanner, its failure to supply materials or components that meet our quality,quantity or cost requirements, or our inability to obtain substitute sources ofthese materials and components on a timely basis or on terms acceptable to us,could harm our ability to manufacture our diesel solutions.

**We may be subjectto significant competition from companies with substantially greater resourcesand market credibility.**

The size of the dieselretrofit, diesel OEM and stationary diesel genset markets has attracted anumber of significant participants. Inthe diesel retrofit market, a number of companies have already developedverified NOx reduction solutions in this market, including Cleaire, Clean AirPower, Extengine Transport Systems, and Lubrizol. In addition, a number ofother companies have announced they are developing NOx reduction solutions forthe retrofit market, including Clean Air Worldwide, Combustion ComponentsAssociates, Converter Technologies Incorporated, Johnson Matthey, ROTEC DesignLtd., and STT Emtec**.**Manyof these participants have substantially greater resources and credibility thanwe do in this market. In the diesel OEM market, there are a number ofsignificant competitors, some of which have announced solutions to the initialUnited States requirements for NOx reduction in 2007, including Eaton Corporation and the major diesel OEMs such asCummins, Caterpillar, Detroit Diesel, ITEC and Volvo. These competitorsalso have substantially greater resources and credibility than we do in thismarket. There can be no assurance that we can successfully compete in eitherthe diesel retrofit or the diesel OEM markets, even if we were to develop atechnologically feasible solution to NOx reduction in these markets.

**Alternatetechnologies may provide a more effective solution than our diesel NOxreduction technology.**

Even if we are able todevelop and commercialize a NOx reduction solution for diesel engines, therecan be no assurance that any such solution will be either practical orcost-effective. Currently, a number of competitors have developed verified NOxcontrol solutions in the diesel retrofit market and a number of competitorshave developed announced solutions in the diesel OEM market to comply with theUnited States 2007 regulations. These solutions are based on differenttechnology than the basis for our proposed NOx solution, including Clean DieselCombustion and Low-Temperature Combustion such as Homogenous Charge CompressionIgnition. An additionalpotential competitive threat may come from power generation proven SCRtechnology. We are aware that some European diesel engine OEMs are planning toimplement SCR for heavy-duty diesel engine applications in Europe to meet theEuro IV emissions standards beginning in October 2005. Although we believeour proposed solution, if successful, in either the diesel retrofit or dieselOEM market will constitute a cost-effective and competitive solution, noassurance can be given that alternate technologies will not prove to be morereliable or otherwise more successful in the market.

**Failure tosuccessfully demonstrate our technology in field tests could negatively impactdemand for our products.**

During 2005 we plan tofield-test our diesel retrofit product, and we plan to conduct additional fieldtests of our other diesel products in the future. We may encounter technicalproblems and/or delays during 

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thesefield tests for a number of reasons, including the failure of our technology orthe technology of third parties, as well as our failure to maintain and serviceour products properly. Many of these potential problems and delays are beyondour control. Any problem or perceived problem with our field tests couldmaterially harm our reputation and impair market acceptance of, and demand for,our products.

**We may not meet ourproduct development and commercialization milestones, which could have amaterial adverse effect on our operations.**

We have establishedproduct development and commercialization milestones that we use to assess ourprogress toward developing commercially viable NOx control solutions for ourdiesel engine applications. These milestones relate to technology and designimprovements as well as to dates for achieving product development goals. To gaugeour progress, we operate, test and evaluate our diesel products under varioustesting conditions. If our systems exhibit technical defects or are unable tomeet cost or performance goals, including targeted levels of NOx reduction,temperature variability, durability and fuel economy, our commercializationschedule could be delayed and potential purchasers of our initial commercialproducts may decline to purchase them or choose to purchase alternativetechnologies. We cannot be sure that we will successfully achieve ourmilestones in the future or that any failure to achieve these milestones willnot result in potential competitors gaining advantages in our target market. Failureto meet publicly announced milestones could also have a material adverse effecton our operations.

**Significantwarranty and product liability risks could arise from our diesel emissionsreduction solutions.**

Even if we are able tosuccessfully develop and commercialize emissions control solutions for thediesel OEM, diesel retrofit, or stationary diesel genset markets, we will berequired to provide product warranties. It is unclear as to the nature of thesewarranties at this time, but the warranties are likely to include NOx reductionat agreed upon levels for substantial time and/or mileage requirements. If weare unable to satisfy these warranties, we could incur significant liability todiesel OEMs, retrofit market regulators, and potentially end users, includingconsumers. In addition, the manufacture, sale and distribution of our dieselfuel processor could expose us to potential product liability to customers andend users, including consumers. Any such liability could be significant and maynot be insurable.

**We have noexperience manufacturing our diesel products on a commercial basis.**

To date, we have focusedprimarily on research and development and have no experience manufacturingdiesel products on a commercial scale. We may not be able to develop efficient,low-cost manufacturing capability and processes that will enable us to meet thequality, price, engineering, design and production standards or productionvolumes required to manufacture our diesel products on a commercial scale. Wemay also encounter difficulty purchasing components and materials, particularlythose with long lead times. Even if we are successful in developing ourmanufacturing capability and processes, we do not know whether we will do so intime to meet our product commercialization schedules or to satisfy therequirements of our customers.

**ADDITIONALRISKS RELATING TO NOx CONTROL SOLUTIONS FOR GAS TURBINES**

In addition to the risksdiscussed elsewhere, any of which could adversely impact our Xonon-equipped gasturbine success, the following additional risks particularly relate to ourXonon Cool Combustion technology for gas turbines and could negatively impactour entire company.

**The market forsmall gas turbines has been adversely impacted by current unfavorableconditions in the power generation and energy markets.**

The market forXonon-equipped gas turbines is dependent on various factors, including thoserelating to the power generation and energy markets, none of which are underour control. There has been a 

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significantdecline in the demand for gas turbines in recent years as a result of a substantialsurplus in energy production capacity in the United States and Canada, a slowto emerge demand for distributed generation which especially impacts demand forsmall gas turbines, and uncertain supplies of natural gas and correspondingsubstantial increases in natural gas prices, which have reduced the demand forgas turbines of all sizes**.**The number of gas turbines producing betweenone and 15 MW of power ordered in North America declined from approximately 53during the 12-month period from June 1999 to May 2000 to 30 duringthe 12-month period from June 2003 to May 2004. Regardless ofthe performance capabilities of our Xonon Cool Combustion system with respectto lowering NOx emissions in gas turbines, if the market for small gas turbinescontinues to be weak, there will be very limited opportunity for us to sellXonon catalyst modules and we may be unable to obtain any return on our priorinvestment and may never achieve profitability. As of the date of this filing,it does not appear the market for small gas turbines will increase in anysignificant manner in the near future.

**Xonon-equipped gasturbines may never attain market acceptance.**

Xonon-equipped gasturbines represent an emerging market. If our Xonon technology does not attainwidespread market acceptance, end-users may be less inclined to purchaseturbines equipped with Xonon Cool Combustion. If a significant commercialmarket fails to develop, we may be unable to recover the losses incurred todevelop our Xonon product and may be unable to achieve profitability. Thedevelopment of a commercial market for our systems may be impacted by factorsthat are not within our control, including:

·       thecost competitiveness of the Xonon Cool Combustion system;

·       theoverall demand for new gas turbines;

·       thefuture costs of natural gas and other fuels;

·       thestatus of the power generation market;

·       economicdemand for new power generation sources;

·       economicfactors that could impact capital spending decisions;

·       thedemand for distributed generation of power;

·       changingregulatory requirements;

·       theemergence of alternative technologies and products; and

·  changesin Federal, State or local environmental regulations.

**We mustsuccessfully complete further development and adaptation work before certainXonon-equipped gas turbines can be shipped.**

Incorporating ourtechnology in a specific gas turbine model requires adaptation work by us andthe manufacturer of the gas turbine engine, or original equipment manufacturer(“OEM”), such as additional engineering work and, for some turbines, technologydevelopment. Except with respect to the Kawasaki 1.4 MW GPB15X, that work hasnot yet been completed. We may not be successful in adapting our Xonontechnology to particular gas turbine models, and even if we are successful, thedevelopment work may result in delays in commercial shipments or significantexpenses. Delays in completing this work could result in the loss of orders. Additionally,the emergence of significant technical issues, resource constraints on the partof OEMs, or limited market opportunities could result in termination by OEMs oftheir agreements to adapt Xonon to their gas turbines.

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**We are heavilydependent on our relationships with OEMs and their commitment to adopt andmarket Xonon technology on their gas turbines, and some of our agreements withOEMs may limit our market opportunities.**

Today, we have ongoing programs with only two OEMs,Kawasaki and GE Energy (“GE”), formerly GE Power Systems. In regard to ourKawasaki program, our product has been commercially available since 2001 on a1.4 MW Kawasaki GPB15X. Since its introduction, Kawasaki has completed twofully operational installations of Xonon-equipped gas turbines. Thesecommercial installations have accumulated more than 25,000 operating hours. Giventhe limited number of commercial installations to date and the December 31,2005 expiration of the Kawasaki agreement, we have no assurance that Kawasakiwill continue to market Xonon combustion systems for their gas turbines.

In regard to our GE program, we are in the midst ofincorporating our Xonon technology into the GE10 gas turbine. In January 2005,we completed a full-scale engine test with GE during which our technologydemonstrated NOx emissions well below our 3 ppm guarantee. Nonetheless, at thistime, we do not know whether or not the test fully met GE’s commercialspecifications. We and GE are currently determining the next steps for thisprogram. This program still may require significant additional funding and maynever result in the commercial launch of a Xonon-equipped GE10.

Our agreement with GE provides that GE has the rightto be the exclusive market channel for distribution of Xonon combustion systemsin GE’s gas turbines. Additionally, this agreement provides for exclusivity ina limited turbine size range and for limited periods of time. Our GE agreementprovides that either party can terminate the agreement, but not necessarily theexclusivity, if technical issues arise that cannot be resolved. A decision byGE to discontinue the commercialization of Xonon combustion systems in itsproduct line could significantly limit or foreclose our access to the marketfor GE’s turbines or prevent us from entering into agreements with other OEMsregarding the application of Xonon to competing turbines.

Our ability to sell Xonon modules for those gasturbines for which Xonon combustion systems become commercially available isheavily dependent upon the OEM’s marketing and sales strategies for Xononcombustion systems and their worldwide sales and distribution networks andservice capabilities. Many OEMs develop and offer alternative emissions controlsystems in competition with our Xonon system. Any decision on their part tolimit, constrain or otherwise fail to aggressively market and sell Xononcombustion systems, including limiting their availability or pricing themuncompetitively, could harm our potential earnings by depriving us of fullaccess to their markets.

Finally, if we and GEdecided to not pursue commercialization of the GE10, and we are unable toattract GE or another OEM to commercialize a different gas turbine platform, wewill consider alternatives to maximize our return on investment in Xonon, whichcould include a decision to sell or liquidate our Xonon gas turbine business.

**Wewill incur significant costs in developing our technology with OEMs; if any OEMdoes not complete development for any reason, we may not be able to recovercosts incurred for our development work with that OEM.**

We incur significant costsin developing our Xonon technology with OEMs. At times, we recover aportion of these costs through contractual reimbursement from the OEMs. However,we bear the balance of the development costs ourselves. If OEMs do not completedevelopment work for any reason, we will not be able to recover our share ofdevelopment costs through product sales.

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**Competitionfrom alternative technologies may adversely affect our Xonon business.**

The market for emissionsreduction technologies is intensely competitive. There are alternativetechnologies which reduce gas turbine emissions to levels comparable to orlower than Xonon-equipped gas turbines. These technologies include lean pre-mixcombustion systems, which are used in conjunction with gas turbine exhaustcleanup systems such as selective catalytic reduction. Lean pre-mix systems areoffered by several gas turbine OEMs, each of whom may prefer to use theirinternally developed emissions reduction technology rather than ours. There arealso a number of companies, universities, research institutions and governmentsengaged in the development of emissions reduction technologies that couldcompete with our Xonon technology.

**Xononcombustion systems will be deployed in complex and varied operatingenvironments, and they may have limitations or defects that we find only afterfull deployment.**

Gas turbines equipped withXonon combustion systems are expected to be subjected to a variety of operatingconditions and to be deployed in a number of extremely demanding environments.For example, gas turbines will be deployed in a wide range of temperatureconditions, in the presence of atmospheric or other contaminants, under a widerange of operating requirements and with varying maintenance practices. As aresult, technical limitations may only become apparent in the field after manyXonon-equipped gas turbines have been deployed. These limitations couldrequire correction, and the corrections could be costly. In addition, any needto develop and implement corrective measures could temporarily delay orpermanently prevent the sale of new Xonon-equipped gas turbines.

**Anyfailure of gas turbines incorporating our technology could damage ourreputation, reduce our revenues or otherwise harm our business.**

The Xonon combustionsystem includes components that are located in a critical section of the gasturbine. A mechanical failure of a Xonon-equipped gas turbine may be attributedto the Xonon combustion system, even if the immediate cause is not clear. Ifthis occurs, the reputation of the Xonon combustion system and itsacceptability in the marketplace could be negatively impacted. This also couldresult in product or other liability to us for which we may not have insuranceor adequate insurance.

**Weare dependent on third party suppliers for the development and supply of keycomponents for our Xonon products.**

We have entered intocommercial arrangements with suppliers of the key components of our Xononsystem. We do not know, however, when or whether we will secure arrangementswith suppliers of other required materials and components for our Xononmodules, or whether these arrangements will be on terms that will allow us toachieve our objectives. If we are unable to obtain suppliers of all therequired materials and components for our systems, our business could beharmed. A supplier’s failure to supply materials or components in a timelymanner, its failure to supply materials or components that meet our quality,quantity or cost requirements, or our inability to obtain substitute sources ofthese materials and components on a timely basis or on terms acceptable to us,could harm our ability to manufacture our Xonon modules. One of our componentsis provided by a single supplier and is not currently available from any othersupplier. Additionally, some of our suppliers use proprietary processes tomanufacture components. Although alternative suppliers are available, a switchin suppliers could be costly and take a significant amount of time toaccomplish.

**Wehave limited experience manufacturing Xonon modules on a commercial basis.**

To date, we have focusedprimarily on research and development of Xonon and have limited experiencemanufacturing Xonon modules on a commercial basis. We may not be able todevelop efficient, low-cost manufacturing capability and processes that willenable us to meet the quality, price, engineering, design 

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and production standardsor production volumes required to manufacture Xonon modules on a commercialscale. We may also encounter difficulty purchasing components and materials,particularly those with long lead times. Even if we are successful indeveloping our manufacturing capability and processes, we do not know whetherwe will do so in time to meet our product commercialization schedule or tosatisfy the requirements of our customers.

**ADDITIONALRISKS RELATING TO FUEL PROCESSING FOR FUEL CELL APPLICATIONS**

In addition to the risksdiscussed elsewhere, the following additional risks particularly relate to ourefforts developing fuel processing solutions for fuel cell applications. Any ofthe other risks discussed elsewhere also may impact these business activities.

**Wemay never complete the research and development of a commercially viable fuelprocessor to be utilized with PEM fuel cell applications.**

We are in the very earlydevelopment stage of a commercially viable fuel processor to be utilized withPEM fuel cells in stationary, auxiliary and back-up power applications. We donot know when or whether we will successfully complete research and developmentof a commercially viable product. Economic and technical difficulties mayprevent us from completing development of products or commercializing theseproducts. Furthermore, a viable market for our product concept may neverdevelop. If a market were to develop, we could face intense competition fromlarge OEMs, as well as companies currently established in the PEM fuel cellbusiness, and may be unable to compete successfully. In addition, automotiveOEMs or PEM fuel cell companies may create technology alternatives that couldrender our systems obsolete prior to commercialization.

**Item7A.**                *QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK*

The primary objective ofour investment activities is to preserve principal while at the same timemaximizing the income we receive from our investments without significantlyincreasing risk. Some of the securities we invest in have market risk. Thismeans that a change in prevailing interest rates would cause the principalamount of the investment to fluctuate. For example, if we hold a securityissued with a fixed interest rate at the then prevailing rate and theprevailing interest rate later rises, the principal amount of our investmentwill decline. In an effort to minimize this risk, we maintain our portfolio ofcash equivalents and short-term investments in a variety of securities,including commercial paper, money market funds, government and non-governmentdebt securities. The average duration of our investments in 2004 and 2003 wasless than one year. Due to the short-term nature of these investments, webelieve we have no material exposure to interest rate risk arising from ourinvestments. Therefore, no quantitative tabular disclosure is required.

**Item8.**                        *CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA*

Our Consolidated FinancialStatements and the report of the independent registered public accounting firmappear on pages 68 through 73 of this Form 10-K.

**Item9.**                        *CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIALDISCLOSURE*

None.

**Item9A.**                *EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES*

(a)          **Evaluation of disclosure controls and procedures.**Our chiefexecutive officer and our chief financial officer, after evaluating theeffectiveness of our “disclosure controls and procedures” (as defined in theSecurities Exchange Act of 1934 Rules 13a-14(c) and 15-d-14(c))as of a date 

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within 90 daysbefore the filing date of this annual report (the “Evaluation Date”), haveconcluded that as of the Evaluation Date, our disclosure controls andprocedures were adequate and designed to ensure that material informationrelating to us and our consolidated subsidiaries would be made known to them byothers within those entities.

(b)         **Changes in internal controls.**There have been no significantchanges in our internal controls or in other factors that could significantlyaffect our disclosure controls and procedures subsequent to the EvaluationDate.

**PART III**

Certain informationrequired by Part III is omitted from this Annual Report as we intend tofile our definitive Proxy Statement for our 2004 Annual Meeting ofStockholders, pursuant to Regulation 14A of the Securities Exchange Act of1934, as amended, not later than 120 days after the end of the fiscal yearcovered by this Report, and certain information in the Proxy Statement isincorporated herein by reference.

**Item10.**                 *DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT*

Information concerningdirectors and executive officers of Catalytica Energy Systems, Inc.required to be included in this item is set forth under the headings “Informationabout our Directors,” “Section 16(a) Beneficial Ownership ReportingCompliance,” and “Executive Officers” in Catalytica Energy’s Proxy Statement,and is incorporated into this report by reference.

The section entitled “AuditCommittee Financial Expert” appearing in our Proxy Statement will set forthcertain information with respect to the presence of an Audit CommitteeFinancial Expert and is incorporated herein by reference. The section entitled “Codeof Ethics” appearing in our Proxy Statement will set forth certain informationwith respect to our Code of Ethics and is incorporated herein by reference.

**Item 11.**                 *EXECUTIVE COMPENSATION*

The section entitled “ExecutiveCompensation” appearing in our Proxy Statement will set forth certaininformation with respect to the compensation of our management and isincorporated herein by reference.

**Item12.**                 *SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT*

The section entitled “SecurityOwnership of Principal Stockholders and Management” appearing in our ProxyStatement will set forth certain information with respect to the ownership ofour common stock and is incorporated herein by reference.

The “Equity CompensationPlan Table” is contained in Item 5 of this annual report and is incorporatedherein by reference.

**Item13.**                 *CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS*

The section entitled “Transactionswith Management” appearing in our Proxy Statement will set forth certaininformation with respect to certain business relationships and transactionsbetween us and our directors and officers and is incorporated herein byreference.

**ITEM 14.**         *PRINCIPALACCOUNTANT FEES AND SERVICES*

The section entitled “Fees Billed to the Company byIndependent Registered Public Accountants” appearing in our Proxy Statementwill set forth certain information with respect to various accounting feesbilled to us and is incorporated herein by reference.

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**PART IV**

**Item 15.**                 *EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K*

**A.     (**1)   *Consolidated FinancialStatements*

Thefollowing consolidated financial statements of the Registrant are filed as partof this Report:
|                                                                                                                                | **Page** |
|--------------------------------------------------------------------------------------------------------------------------------|----------|
| Report  of Ernst & Young LLP, Independent Registered Public Accounting Firm                                           | 68       |   |
| Consolidated  Statements of Operations for the years ended December 31, 2004, 2003 and  2002                              | 69       |   |
| Consolidated  Balance Sheets at December 31, 2004 and 2003                                                                | 70       |   |
| Consolidated  Statements of Stockholders’ Equity for the period from January 1, 2002  through December 31, 2004 | 71       |   |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2004, 2003 and  2002                              | 72       |   |
| Notes  to Consolidated Financial Statements                                                                               | 73       |   |

\

(2)          *ConsolidatedFinancial Statement Schedules*

None.   Scheduleshave been omitted because the information required to be set forth therein isnot applicable or is shown in the financial statements or notes thereto.

(3)          *Exhibits*
| Exhibit   Number | ** ** | **Notes** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|------------------|------------|-----------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1              |       | (5)       |       | Assignment and Assumption Agreement between  Catalytica, Inc. and the Registrant, effective as of July 25, 1995.                                                                                                                                                                                                                                                                                                                                                       |
| 2.1A             |       | (28)      |       | Membership Interests and Asset Purchase Agreement  dated as of January 21, 2004 by and among EnBW Energy Solutions GmbH,  with respect to Articles VII and X only, ENVICA GmbH, ENVICA Kat GmbH,  E&EC Energy & Environmental Consultants GmbH, SCR-Tech GmbH,  CESI-SCR, Inc. and, with respect to Section 11.18 and Articles VI  and IX only, Catalytica Energy Systems, Inc., filed as Exhibit 2.1,  dated as of January 21, 2004. |
| 2.2              |       | (11)      |       | Employee Matters Agreement between  Catalytica, Inc. and the Registrant, effective as of December 15,  2000.                                                                                                                                                                                                                                                                                                                                                           |
| 2.2A             |       | (28)      |       | Amendment No. 1 to Membership Interests and  Asset Purchase Agreement by and among EnBW Energy Solutions GmbH, ENVICA  GmbH, ENVICA Kat GmbH, E&EC Energy & Environmental Consultants  GmbH, SCR-Tech GmbH, SCR-Tech LLC, CESI-SCR, Inc., filed as  Exhibit 2.2, dated as of February 20, 2004.                                                                                                                                                 |
| 2.3              |       | (11)      |       | Form of Master Trademark Ownership and License  Agreement between Catalytica, Inc. and the Registrant, effective as of  December 15, 2000.                                                                                                                                                                                                                                                                                                                        |
| 2.4              |       | (11)      |       | Tax Sharing Agreement between Catalytica, Inc.,  Synotex, Inc. and the Registrant, dated as of December 15, 2000.                                                                                                                                                                                                                                                                                                                                                 |
| 2.5              |       | (11)      |       | Master Confidential Disclosure Agreement between  Catalytica, Inc. and the Registrant, effective as of December 15,  2000.                                                                                                                                                                                                                                                                                                                                             |
| 2.6              |       | (5)       |       | Cross-License Agreement between  Catalytica, Inc. and the Registrant, effective as of July 1995.                                                                                                                                                                                                                                                                                                                                                                       |
| 2.7              |       | (5)       |       | Cross-License Agreement between Catalytica Advanced  Technologies, Inc. and Catalytica, Inc., dated July 1995.                                                                                                                                                                                                                                                                                                                                                    |
| 2.8              |       | (5)       |       | Tax Sharing Agreement between Catalytica, Inc.,  Catalytica Bayview, Inc., Catalytica Advanced Technologies, Inc.  and the registrant, dated March 4, 1999.                                                                                                                                                                                                                                                                                                  |

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| 2.8A  |   | (11)  |   | Indemnification  Agreement between Catalytica, Inc. and the Registrant, filed as  Exhibit 2.8, dated December 15, 2000.                                                                                                                                                                           |
|-------|--------|-------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.9   |   | (11)  |   | Transition Services Agreement between  Catalytica, Inc. and the Registrant, dated December 15, 2000.                                                                                                                                                                                                   |
| 2.10  |   | (11)  |   | Real Estate Matters Agreement between  Catalytica, Inc. and the Registrant, dated December 15, 2000.                                                                                                                                                                                                   |
| 2.11  |   | (11)  |   | Master Separation Agreement between Catalytica, Inc.  and the Registrant, dated December 15, 2000.                                                                                                                                                                                                     |
| 3.1   |   | (11)  |   | Amended and Restated Certificate of Incorporation of  Catalytica Energy Systems, Inc., dated December 13, 2000.                                                                                                                                                                                        |
| 3.1A  |   | (18)  |   | Certificate of Designation, the form of Rights  Certificate and the Summary of Rights attached thereto as Exhibits A, B and  C, respectively, filed as Exhibit 4.1, dated January 29, 2002.                                                                                                            |
| 3.2   |   | (8)   |   | Form of Amended and Restated Bylaws.                                                                                                                                                                                                                                                                        |
| 3.3   |   | (13)  |   | Audit Committee Charter.                                                                                                                                                                                                                                                                                         |
| 4.1   |   | (11)  |   | Stock Specimen of the Registrant.                                                                                                                                                                                                                                                                                |
| 4.1A  |   | (18)  |   | Preferred Stock Rights Agreement between the  Registrant and Mellon Investor Services LLC, including the Certificate of  Designation, the form of Rights Certificate and the Summary of Rights  attached thereto as Exhibits A, B, and C, respectively, filed as  Exhibit 4.1, dated January 29, 2002. |
| 4.1B  |   | (35)  |   | Amended and Restated Preferred Stock Rights  Agreement with Mellon Investor Services LLC, filed as Exhibit 4.1, dated  November 22, 2004.                                                                                                                                                              |
| 10.4  |   | (5)*  |   | Promissory Notes from Peter B. Evans issued to Registrant,  both dated July 20, 1999.                                                                                                                                                                                                                       |
| 10.6  |   | (3)   |   | Limited Liability Company Operating Agreement of  GENXON Power Systems, LLC, dated October 21, 1996.                                                                                                                                                                                                        |
| 10.7  |   | (4)   |   | Amendment No. 1 to the Operating Agreement of  GENXON Power Systems, LLC, dated December 4, 1997.                                                                                                                                                                                                      |
| 10.8  |   | (1)+  |   | Agreement between Catalytica, Inc. and Tanaka  Kikinzoku Kogyo K.K, dated as of July 18, 1988.                                                                                                                                                                                                         |
| 10.9  |   | (2)+  |   | Agreement between Catalytica, Inc. and Tanaka  Kikinzoku Kogyo K.K, dated as of January 31, 1995.                                                                                                                                                                                                      |
| 10.11 |   | (5)   |   | Omnibus Agreement by and among  Catalytica, Inc., Sundance Assets, L.P., Enron North America Corp. and  the Registrant, dated August 29, 2000.                                                                                                                                                         |
| 10.12 |   | (5)+  |   | Collaborative Commercialization and License  Agreement among General Electric Co., GENXON Power System, LLC and the  Registrant, dated as of November 19, 1998.                                                                                                                                             |
| 10.17 |   | (8)   |   | Registration Rights Agreement between Morgan Stanley  Capital Partners III and its affiliates and the Registrant, dated  September 2000.                                                                                                                                                                    |
| 10.18 |   | (7)*  |   | 2000 Employee Stock Purchase Plan of the Registrant.                                                                                                                                                                                                                                                             |
| 10.20 |   | (12)* |   | Catalytica Energy Systems, Inc. (formerly  Catalytica Combustion Systems, Inc.) 1995 Stock Plan, as amended and  restated October 26, 2000.                                                                                                                                                       |
| 10.23 |   | (12)  |   | Share Transfer Agreement between the Registrant and  JSB Asset, LLC, dated December 15, 2000.                                                                                                                                                                                                               |
| 10.24 |   | (12)  |   | Stock Purchase Warrant Agreement between the  Registrant and GlaxoWellcome, Inc., dated December 15, 2000.                                                                                                                                                                                             |
| 10.26 |   | (16)+ |   | Technology Development and Transfer Agreement  between Kawasaki Heavy Industries, Ltd. and Registrant, dated  December 13, 2000.                                                                                                                                                                            |

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| 10.27 |   | (16)+ |   | Xonon Module Supply Agreement by and among Kawasaki  Heavy Industries, Ltd. and Registrant, dated December 13, 2000.                                                                                                                                                                                            |
|-------|--------|-------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.28 |   | (14)* |   | Change  of Control Severance Agreements between Patrick T. Conroy and the Registrant  dated April 5, 2001, Dennis S. Riebe and the Registrant dated  April 5, 2001, Craig N. Kitchen and the Registrant dated April 5,  2001, and Ralph A. Dalla Betta and the Registrant, dated April 17, 2001. |
| 10.30 |   | (19)+ |   | Amendment No. 1 to the Collaborative  Commercialization and License Agreement between Catalytica Combustion  Systems, Inc. and GENXON Power Systems, LLC and General Electric  Company, dated January 3, 2002.                                                                                        |
| 10.32 |   | (19)  |   | GENXON  Membership Transfer and Settlement Agreement between the Registrant, Woodward  Governor Company, and GENXON Power Systems, LLC, dated December 19,  2001.                                                                                                                                               |
| 10.33 |   | (19)  |   | Control  Patent Assignment and Cross-License Agreement between the Registrant and  Woodward Governor Company, dated December 19, 2001.                                                                                                                                                                          |
| 10.35 |   | (20)* |   | Letter  Agreement with Dominic Geraghty, dated February 25, 2002.                                                                                                                                                                                                                                               |
| 10.36 |   | (20)* |   | Change  of Control Severance Agreement with Dominic Geraghty, dated March 29,  2002.                                                                                                                                                                                                                            |
| 10.39 |   | (24)* |   | Letter  Agreement with Michael J. Murry, dated December 6, 2002.                                                                                                                                                                                                                                                |
| 10.40 |   | (24)* |   | Change  of Control Severance Agreement with Michael J. Murry, dated March 23,  2003.                                                                                                                                                                                                                            |
| 10.41 |   | (25)* |   | Change  of Control Severance Agreement with Robert W. Zack, dated August 16,  2002.                                                                                                                                                                                                                             |
| 10.42 |   | (25)* |   | Letter  Agreement with Robert W. Zack, dated February 6, 2003.                                                                                                                                                                                                                                                  |
| 10.43 |   | (26)  |   | Third  Amendment and Extension to Lease Agreement between Jack Dymond Associates and  Catalytica Energy Systems, Inc., dated June 20, 2003.                                                                                                                                                                |
| 10.46 |   | (29)  |   | Lease  Agreement dated December 16, 2002 between Clariant Corporation and SCR-Tech,  LLC, dated December 16, 2002, and First Amendment to Lease Agreement  between Clariant Corporation and SCR-Tech, LLC., dated February 18,  2004.                                                                 |
| 10.47 |   | (34)  |   | Loan  Modification Agreements between the Arizona State Compensation Fund and the  Registrant, as amended, dated August 9, 2004.                                                                                                                                                                                |
| 10.48 |   | (36)  |   | Form of  Indemnification Agreement between the Registrant and executive officers and  directors of the Registrant.                                                                                                                                                                                              |
| 10.49 |   | (36)  |   | Consulting  Agreement between the Registrant and David Merrion, dated February 1,  2005                                                                                                                                                                                                                         |
| 14.1  |   | **    |   | Code of Ethics                                                                                                                                                                                                                                                                                                       |
| 21.1  |   | **    |   | Subsidiaries  of Registrant.                                                                                                                                                                                                                                                                                         |
| 23.1  |   | **    |   | Consent  of Independent Registered Public Accounting Firm.                                                                                                                                                                                                                                                           |
| 24.1  |   | **    |   | Power  of Attorney (see Signatures page).                                                                                                                                                                                                                                                                            |
| 31.1  |   | **    |   | Certification  of Chief Executive Officer pursuant to Rule 13a-14(a) /  15d-14(a) of the Securities Exchange Act of 1934, as amended.                                                                                                                                                                 |
| 31.2  |   | **    |   | Certification  of Chief Financial Officer pursuant to Rule 13a-14(a) /  15d-14(a) of the Securities Exchange Act of 1934, as amended.                                                                                                                                                                 |
| 32.1  |   | **    |   | Certification  of Chief Executive Officer pursuant to 18 U.S.C. 1350.                                                                                                                                                                                                                                                |
| 32.2  |   | **    |   | Certification  of Chief Financial Officer pursuant to 18 U.S.C. 1350.                                                                                                                                                                                                                                                |

----

   +  Confidential treatment hasbeen granted for portions of these agreements.

    *       Represents managementcontracts or compensatory plans for executive officers and directors.

  **       Filed herewith.

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 (1)       Incorporated by referenceto exhibits filed with Catalytica, Inc.’s Registration Statement on Form S-1(Registration Statement No. 33-55696).

 (2)       Incorporatedby reference to exhibits filed with Catalytica, Inc.’s Form 10-K(File No. 0-20966) for the year ended December 31, 1994.

 (3)       Incorporatedby reference to exhibits filed with Catalytica, Inc.’s Form 10-K(File No. 0-20966) for the year ended December 31, 1996.

 (4)       Incorporatedby reference to exhibits filed with Catalytica, Inc.’s Form 10-K(File No. 0-20966) for the year ended December 31, 1997.

 (5)       Incorporatedby reference to exhibits filed with our Registration Statement on Form S-1(File No. 333-44772), filed on August 29, 2000.

 (7)       Incorporatedby reference to exhibits filed with our Amendment No. 2 to Form S-1(File No. 333-44772), filed on October 16, 2000.

 (8)       Incorporatedby reference to exhibits filed with our Amendment No. 3 to Form S-1(File No. 333-44772), filed on November 1, 2000.

(11)   Incorporated by reference toexhibits filed with our Post-Effective Amendment No. 1 to Form S-1(File No. 333-44772), filed on January 12, 2001.

(12)   Incorporated by reference toexhibits filed with our Form 10-K for the year ended December 31, 2000,filed on March 15, 2001.

(13)   Incorporated by reference toAppendix A to the Proxy Statement filed on Schedule 14A dated April 24,2001, filed on April 24, 2001.

(14)   Incorporated by reference toexhibits filed with our Registration Statement on Form S-1 (File No. 333-64682),filed on July 6, 2001.

(16)   Incorporated by reference toexhibits filed with our Amendment No. 2 to Form S-1 (File No. 333-64682),filed on August 6, 2001.

(18)   Incorporated by reference toexhibits filed with our Amendment No. 1 to Form 8-A12G/A, filed on February 6,2002.

(19)   Incorporated by reference toexhibits filed with our Form 10-K for the year ended December 31,2001, filed on April 01, 2002.

(20)   Incorporated by reference toexhibits filed with our Form 10-Q for the quarter ended March 31,2002, filed on May 14, 2002.

(24)   Incorporated by reference toexhibits filed with our Form 10-K for the year ended December 31,2002, filed on March 31, 2003.

(25)   Incorporated by reference toexhibits filed with our Form 10-Q for the quarter ended March 31,2003, filed on May 9, 2003.

(26)   Incorporated by reference toexhibits filed with our Form 10-Q for the quarter ended June 30,2003, filed on August 5, 2003.

(28)   Incorporated by reference toexhibits filed with our Form 8-K, filed on March 4, 2004.

(29)   Incorporated by reference toexhibits filed with our Form 10-K for the year ended December 31,2003, filed on March 30, 2004.

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(34)   Incorporated by reference toexhibits filed with our Form 10-Q for the quarter ended September 30,2004, filed on November 12, 2004.

(35)   Incorporated by reference toexhibits filed with our Amendment No. 1 to Form 8-A12G/A, filed on November 22,2004.

(36)   Incorporatedby reference to exhibits filed with our Form 8-K, filed on February 4,2005.

**B.    **Reportson Form 8-K

The Company filed thefollowing reports on Form 8-K during the quarter ended December 31,2004:
| Current Report on  Form 8-K dated November 4, 2004, furnishing a copy of the  November 4, 2004 press release announcing the Company’s financial  results for the fiscal quarter ended September 30, 2004. |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Current Report on Form 8-K dated  November 22, 2004, furnishing a copy of the November 22, 2004 press  release announcing the Company had amended its Preferred Stock Rights Agreement.                             |

 

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

Board of Directors and StockholdersCatalytica Energy Systems, Inc.

We have audited the accompanying consolidated balancesheets of Catalytica Energy Systems, Inc. as of December 31, 2004 and2003, and the related consolidated statements of operations, stockholders’equity, and cash flows for each of the three years in the period ended December 31,2004. These consolidated financial statements are the responsibility of theCompany’s management. Our responsibility is to express an opinion on theseconsolidated financial statements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. We were not engaged to perform an audit of the Company’s internalcontrol over financial reporting. Our audit included consideration of internalcontrol over financial reporting as a basis for designing audit procedures thatare appropriate in the circumstances, but not for the purpose of expressing anopinion on the effectiveness of the Company’s internal control over financialreporting. Accordingly, we express no such opinion. An audit also includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements, assessing the accounting principles used andsignificant estimates made by management, and evaluating the overall financialstatement presentation. We believe that our audits provide a reasonable basisfor our opinion.

In ouropinion, the financial statements referred to above present fairly, in allmaterial respects, the consolidated financial position of Catalytica EnergySystems, Inc. at December 31, 2004 and 2003, and the consolidatedresults of their operations and their cash flows for each of the three years inthe period ended December 31, 2004, in conformity with U.S. generallyaccepted accounting principles.
|                        | /s/ Ernst & Young LLP |
|------------------------|--------------------------------|
| Phoenix, Arizona       |                           |
| February 23, 2005 |                           |

 

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**CATALYTICA ENERGYSYSTEMS, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**for the years ended December 31, 2004, 2003 and 2002 (In thousands, except per share amounts)
| ** **                                                                      | ** ** | **For the year ended December 31,** | ** ** |
|---------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                                      | ** ** | **2004**                                                     | ** ** | **2003** | ** ** | **2002** | ** ** |
| Revenues                                                                        |       |                                                         |       |   |   |   |   |
| SCR catalyst & management services                                     |       | $                                                            | 2,960      |   | $ | — |   | $ | — |   |
| Research and development                                                        |       | 2,641                                                        |       | 3,498 |   | 4,795 |   |
| Total revenues                                                                  |       | 5,601                                                        |       | 3,498 |   | 4,795 |   |
| Costs and  expenses:                                                            |       |                                                         |       |   |   |   |   |
| Cost of revenues                                                                |       | 5,227                                                        |       | 4,341 |   | 5,977 |   |
| Research and development                                                        |       | 7,498                                                        |       | 6,919 |   | 8,252 |   |
| Selling, general and administrative                                             |       | 6,339                                                        |       | 7,224 |   | 9,654 |   |
| Total costs and expenses                                                        |       | 19,064                                                       |       | 18,484 |   | 23,883 |   |
| Operating loss                                                                  |       | (13,463                                                      | )          | (14,986 | ) | (19,088 | ) |
| Interest and other income                                                       |       | 758                                                          |       | 823 |   | 1,405 |   |
| Interest expense                                                                |       | (564                                                         | )          | (236 | ) | (191 | ) |
| Net loss                                                                        |       | $                                                            | (13,269    | ) | $ | (14,399 | ) | $ | (17,874 | ) |
| Basic and diluted net loss per share                                            |       | $                                                            | (0.74      | ) | $ | (0.81 | ) | $ | (1.02 | ) |
| Weighted average  shares used in computing basic and diluted net loss per share |       | 17,850                                                       |       | 17,669 |   | 17,529 |   |

 

See accompanying notes.

69

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**CATALYTICA ENERGYSYSTEMS, INC.**

**CONSOLIDATED BALANCE SHEETS**at December 31, 2004 and 2003(In thousands, except per share amounts)
| ** **                                                                                                                                                      | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                      | ** ** | **2004**              | ** ** | **2003** | ** ** |
| **ASSETS**                                                                                                                                                      |       |                  |       |   |   |
| Current assets:                                                                                                                                                 |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                       |       | $                     | 26,901     |   | $ | 32,806 |   |
| Short-term investments                                                                                                                                          |       | 8,691                 |       | 19,876 |   |
| Trade accounts receivable, less allowance of $30 and  $25 at December 31, 2004 and 2003, respectively                                                 |       | 1,222                 |       | 567 |   |
| Inventory                                                                                                                                                       |       | 474                   |       | 460 |   |
| Prepaid expenses and other assets                                                                                                                               |       | 601                   |       | 527 |   |
| Total current assets                                                                                                                                            |       | 37,889                |       | 54,236 |   |
| Property and equipment:                                                                                                                                         |       |                  |       |   |   |
| Land                                                                                                                                                            |       | 611                   |       | 611 |   |
| Building and leasehold improvements                                                                                                                             |       | 9,608                 |       | 11,325 |   |
| Equipment                                                                                                                                                       |       | 8,842                 |       | 8,776 |   |
| Less accumulated depreciation and amortization                                                                                                                  |       | (11,584               | )          | (13,636 | ) |
| Total property and equipment                                                                                                                                    |       | 7,477                 |       | 7,076 |   |
| Notes receivable from related parties, less  allowance of $687 and $692 at December 31, 2004 and 2003, respectively                                        |       | —                |       | 18 |   |
| Goodwill                                                                                                                                                        |       | 4,257                 |       | — |   |
| Other intangible  assets                                                                                                                                        |       | 1,584                 |       | — |   |
| Other assets                                                                                                                                                    |       | 310                   |       | 355 |   |
| Total assets                                                                                                                                                    |       | $                     | 51,517     |   | $ | 61,685 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                   |       |                  |       |   |   |
| Current liabilities:                                                                                                                                            |       |                  |       |   |   |
| Accounts payable                                                                                                                                                |       | $                     | 248        |   | $ | 380 |   |
| Accrued payroll and benefits                                                                                                                                    |       | 1,315                 |       | 1,590 |   |
| Accrued liabilities and other                                                                                                                                   |       | 1,213                 |       | 1,243 |   |
| Current portion of long-term debt and capital lease  obligations                                                                                                |       | 748                   |       | 135 |   |
| Total current liabilities                                                                                                                                       |       | 3,524                 |       | 3,348 |   |
| Long-term debt  and other long-term liabilities                                                                                                                 |       | 5,654                 |       | 3,110 |   |
| Total liabilities                                                                                                                                               |       | 9,178                 |       | 6,458 |   |
| Stockholders’ equity:                                                                                                                                      |       |                  |       |   |   |
| Series A convertible preferred stock, $0.001  par value; authorized—5,000 shares, none issued                                               |       | —                |       | — |   |
| Common stock, $0.001 par value; authorized—70,000  shares; issued and outstanding—17,890 and 17,744 at December 31, 2004  and 2003, respectively |       | 18                    |       | 18 |   |
| Additional paid-in capital                                                                                                                                      |       | 167,358               |       | 166,977 |   |
| Deferred compensation                                                                                                                                           |       | (20                   | )          | (20 | ) |
| Retained deficit                                                                                                                                                |       | (125,017              | )          | (111,748 | ) |
| Total stockholders’ equity                                                                                                                                 |       | 42,339                |       | 55,227 |   |
| Total liabilities  and stockholders’ equity                                                                                                                |       | $                     | 51,517     |   | $ | 61,685 |   |

 

See accompanying notes.

70

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**CATALYTICA ENERGYSYSTEMS, INC**

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY**for the period from January 1, 2002 through December 31, 2004(In thousands)
| ** **                                               | ** ** | **Convertible  Preferred Stock** | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional** | ** ** | ** **   | ** ** | ** **             | ** ** | ** **  | ** ** |
|----------------------------------------------------------|------------|---------------------------------------|------------|-----------------------|------------|-------------|------------|----------------|------------|--------------|------------|------------------------|------------|-------------|------------|
| ** **                                               | ** ** | **Series A**                     | ** ** | **Common Stock** | ** ** | **Paid-In** | ** ** | **Deferred**   | ** ** | **Retained** | ** ** | **Stockholders’** | ** ** |
| ** **                                               | ** ** | **Shares**                            | ** ** | **Amount**            | ** ** | **Shares**  | ** ** | **Amount**     | ** ** | **Capital**  | ** ** | **Compensation**       | ** ** | **Deficit** | ** ** | **Equity** | ** ** |
| **Balance at January 1, 2002**                      |       |                                  | —     |                  |       |        | $          | —         |       |         |       | 17,463                 |       |        |       | 17 |   |   | $ | 166,439 |   |   | $ | (260 | ) |   | $ | (79,475 | ) |   | $ | 86,721 |   |   |
| Exercise of stock  options                               |       |                                  | —     |                  |       |        | —     |           |       |         | 5          |                   |       |        | —     |   |   | 2 |   |   | — |   |   | — |   |   | 2 |   |   |
| Purchase of shares  through employee stock purchase plan |       |                                  | —     |                  |       |        | —     |           |       |         | 93         |                   |       |        | 1          |   |   | 309 |   |   | — |   |   | — |   |   | 310 |   |   |
| Issuance of stock  options                               |       |                                  | —     |                  |       |        | —     |           |       |         | —     |                   |       |        | —     |   |   | 9 |   |   | (9 | ) |   | — |   |   | — |   |   |
| Cancellation of stock  options                           |       |                                  | —     |                  |       |        | —     |           |       |         | —     |                   |       |        | —     |   |   | (203 | ) |   | 203 |   |   | — |   |   | — |   |   |
| Re-measurement of  deferred compensation                 |       |                                  | —     |                  |       |        | —     |           |       |         | —     |                   |       |        | —     |   |   | (23 | ) |   | 23 |   |   | — |   |   | — |   |   |
| Amortization of deferred  compensation                   |       |                                  | —     |                  |       |        | —     |           |       |         | —     |                   |       |        | —     |   |   | — |   |   | 20 |   |   | — |   |   | 20 |   |   |
| Net loss                                                 |       |                                  | —     |                  |       |        | —     |           |       |         | —     |                   |       |        | —     |   |   | — |   |   | — |   |   | (17,874 | ) |   | (17,874 | ) |   |
| **Balance  at December 31, 2002**                   |       |                                  | —     |                  |       |        | $          | —         |       |         |       | 17,561                 |       |        |       | $ | 18 |   |   | $ | 166,533 |   |   | $ | (23 | ) |   | $ | (97,349 | ) |   | $ | 69,179 |   |   |
| Exercise of stock  options                               |       |                                  | —     |                  |       |        | —     |           |       |         | 86         |                   |       |        | —     |   |   | 158 |   |   | — |   |   | — |   |   | 158 |   |   |
| Purchase of shares  through employee stock purchase plan |       |                                  | —     |                  |       |        | —     |           |       |         | 97         |                   |       |        | —     |   |   | 226 |   |   | — |   |   | — |   |   | 226 |   |   |
| Issuance of stock  options                               |       |                                  | —     |                  |       |        | —     |           |       |         | —     |                   |       |        | —     |   |   | 56 |   |   | (56 | ) |   | — |   |   | — |   |   |
| Re-measurement of  deferred compensation                 |       |                                  | —     |                  |       |        | —     |           |       |         | —     |                   |       |        | —     |   |   | 4 |   |   | (4 | ) |   | — |   |   | — |   |   |
| Amortization of deferred  compensation                   |       |                                  | —     |                  |       |        | —     |           |       |         | —     |                   |       |        | —     |   |   | — |   |   | 63 |   |   | — |   |   | 63 |   |   |
| Net loss                                                 |       |                                  | —     |                  |       |        | —     |           |       |         | —     |                   |       |        | —     |   |   | — |   |   | — |   |   | (14,399 | ) |   | (14,399 | ) |   |
| **Balance  at December 31, 2003**                   |       |                                  | —     |                  |       |        | $          | —         |       |         |       | 17,744                 |       |        |       | $ | 18 |   |   | $ | 166,977 |   |   | $ | (20 | ) |   | $ | (111,748 | ) |   | $ | 55,227 |   |   |
| Exercise of stock  options                               |       |                                  | —     |                  |       |        | —     |           |       |         | 24         |                   |       |        | —     |   |   | 74 |   |   | — |   |   | — |   |   | 74 |   |   |
| Purchase of shares  through employee stock purchase plan |       |                                  | —     |                  |       |        | —     |           |       |         | 122        |                   |       |        | —     |   |   | 281 |   |   | — |   |   | — |   |   | 281 |   |   |
| Issuance of stock  options                               |       |                                  | —     |                  |       |        | —     |           |       |         | —     |                   |       |        | —     |   |   | 91 |   |   | (91 | ) |   | — |   |   | — |   |   |
| Forfeiture of stock  options                             |       |                                  | —     |                  |       |        | —     |           |       |         | —     |                   |       |        | —     |   |   | (27 | ) |   | 27 |   |   | — |   |   | — |   |   |
| Re-measurement of  deferred compensation                 |       |                                  | —     |                  |       |        | —     |           |       |         | —     |                   |       |        | —     |   |   | (38 | ) |   | 38 |   |   | — |   |   | — |   |   |
| Amortization of deferred  compensation                   |       |                                  | —     |                  |       |        | —     |           |       |         | —     |                   |       |        | —     |   |   | — |   |   | 26 |   |   | — |   |   | 26 |   |   |
| Net loss                                                 |       |                                  | —     |                  |       |        | —     |           |       |         | —     |                   |       |        | —     |   |   | — |   |   | — |   |   | (13,269 | ) |   | (13,269 | ) |   |
| **Balance at December 31, 2004**                    |       |                                  | —     |                  |       |        | $          | —         |       |         |       | 17,890                 |       |        |       | $ | 18 |   |   | $ | 167,358 |   |   | $ | (20 | ) |   | $ | (125,017 | ) |   | $ | 42,339 |   |   |

 

See accompanying notes.

71

 

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**CATALYTICA ENERGY SYSTEMS, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**for the years ended December 31, 2004, 2003 and 2002(In thousands)
| ** **                                                                                 | ** ** | **For the year ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                                                 | ** ** | **2004**                                                     | ** ** | **2003** | ** ** | **2002** | ** ** |
| ***Cash flows from operating  activities:***                                               |       |                                                         |       |   |   |   |   |
| Net loss                                                                                   |       | $                                                            | (13,269    | ) | $ | (14,399 | ) | $ | (17,874 | ) |
| Adjustments to reconcile net loss to net cash used in  operating activities:               |       |                                                         |       |   |   |   |   |
| Depreciation/impairment  of property and equipment                                         |       | 1,229                                                        |       | 2,108 |   | 2,715 |   |
| Amortization of  investments premium                                                       |       | 200                                                          |       | 242 |   | 172 |   |
| Amortization of  intangible assets                                                         |       | 144                                                          |       | — |   | — |   |
| Accretion of  interest on long-term debt                                                   |       | 352                                                          |       | — |   | — |   |
| Forgiveness of  notes receivable from related parties                                      |       | 52                                                           |       | 57 |   | 60 |   |
| Provision for  uncollectable accounts and notes                                            |       | —                                                       |       | 92 |   | — |   |
| Notes payable  issued for contract modification                                            |       | —                                                       |       | — |   | 200 |   |
| Stock based  compensation                                                                  |       | 26                                                           |       | 63 |   | 20 |   |
| Loss on sale of  property and equipment                                                    |       | 225                                                          |       | — |   | — |   |
| Changes in:                                                                                |       |                                                         |       |   |   |   |   |
| Trade accounts  receivable                                                                 |       | 83                                                           |       | 859 |   | (48 | ) |
| Inventory                                                                                  |       | 46                                                           |       | 19 |   | (301 | ) |
| Prepaid expenses  and other assets                                                         |       | 14                                                           |       | (118 | ) | 68 |   |
| Accounts payable                                                                           |       | (807                                                         | )          | (358 | ) | (16 | ) |
| Accrued payroll  and benefits                                                              |       | (275                                                         | )          | (838 | ) | (4 | ) |
| Accrued  liabilities and other                                                             |       | (414                                                         | )          | (455 | ) | (3,138 | ) |
| ***Net  cash used in operating activities***                                               |       | (12,394                                                      | )          | (12,728 | ) | (18,146 | ) |
| ***Cash flows from investing  activities:***                                               |       |                                                         |       |   |   |   |   |
| Purchase of  business                                                                      |       | (4,300                                                       | )          | — |   | — |   |
| Purchases of  investments                                                                  |       | (10,164                                                      | )          | (19,257 | ) | (26,674 | ) |
| Maturities of  investments                                                                 |       | 21,149                                                       |       | 19,945 |   | 23,280 |   |
| Loans to equity  investments                                                               |       | —                                                       |       | — |   | (500 | ) |
| Sale of property  and equipment                                                            |       | 25                                                           |       | — |   | — |   |
| Additions to  property and equipment                                                       |       | (435                                                         | )          | (1,315 | ) | (5,298 | ) |
| ***Net  cash provided by (used in) investing activities***                                 |       | 6,275                                                        |       | (627 | ) | (9,192 | ) |
| ***Cash flows from financing  activities:***                                               |       |                                                         |       |   |   |   |   |
| Proceeds from  issuance of long-term debt                                                  |       | 2,940                                                        |       | — |   | 3,010 |   |
| Repayments of  long-term debt                                                              |       | (3,075                                                       | )          | (130 | ) | (21 | ) |
| Payments on  capital lease obligations                                                     |       | (6                                                           | )          | (58 | ) | (62 | ) |
| Proceeds from  exercise of stock options                                                   |       | 74                                                           |       | 158 |   | 2 |   |
| Proceeds from  issuance of common stock to employees through stock plans                   |       | 281                                                          |       | 226 |   | 310 |   |
| ***Net  cash provided by financing activities***                                           |       | 214                                                          |       | 196 |   | 3,239 |   |
| **Net  decrease in cash and cash equivalents**                                             |       | (5,905                                                       | )          | (13,159 | ) | (24,099 | ) |
| **Cash and  cash equivalents at beginning of period**                                      |       | 32,806                                                       |       | 45,965 |   | 70,064 |   |
| **Cash and  cash equivalents at end of period**                                            |       | $                                                            | 26,901     |   | $ | 32,806 |   | $ | 45,965 |   |
| ***Additional disclosure of cash  flow information:***                                     |       |                                                         |       |   |   |   |   |
| Interest paid                                                                              |       | $                                                            | 208        |   | $ | 225 |   | $ | 183 |   |
| Deferred  compensation for issuance and revaluation of stock options to non-employees |       | $                                                            | 27         |   | $ | 60 |   | $ | (14 | ) |
| Debt assumed for  purchase of business                                                     |       | $                                                            | 3,133      |   | $ | — |   | $ | — |   |

 

See accompanying notes.

72

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**CATALYTICA ENERGY SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004**

**Note 1.   Description of Business**

***Description of Business.*  **CatalyticaEnergy Systems, Inc. (“Catalytica Energy,” “the Company,” “we,” “us” or “our”)provides innovative emissions solutions to ease the environmental impact ofcombustion-related applications in the power generation andtransportation industries. Through our SCR-Tech, LLC (“SCR-Tech”)subsidiary, we offer a variety of services for coal-fired power plants that useselective catalytic reduction (“SCR”) systems to reduce nitrogen oxides (“NOx”)emissions. These services include SCR catalyst cleaning and regeneration, SCRsystem management services to optimize efficiency and reduce overall operatingand maintenance (“O&M”) costs, and consulting services related to thedesign of SCR systems (collectively “SCR Catalyst and Management Services”).Our business activities also include the design, development, manufacture andservicing of advanced products based on our proprietary catalyst and fuelprocessing technologies to offer cost-effective solutions for reducing NOxemissions from diesel engines and natural gas-fired turbines. Our diesel fuelprocessing technology is designed to facilitate significant NOx reduction frommobile, stationary and off-road diesel engine applications by improvingperformance of NOx adsorber catalyst systems. Our commercially-available XononCool Combustion® system offers a breakthrough pollution prevention approachthat enables gas turbines to achieve ultra-low NOx emissions through aproprietary catalytic combustion process. Other activities include thedevelopment of fuel processing systems for fuel cells used in stationary,auxiliary and back-up power applications.

***Formation and Operations of theCompany.*  **Catalytica Energy was incorporated inDelaware in June 1995 as a subsidiary of Catalytica, Inc.. CatalyticaEnergy operated as part of Catalytica, Inc.’s research and developmentgroup from inception through the date of its incorporation as a separate entity.In December 2000, Catalytica Advanced Technologies, Inc., anothersubsidiary of Catalytica Inc., was merged into us, and the combined entity wasspun out from Catalytica, Inc. as Catalytica Energy Systems, Inc., aseparate, stand-alone public company.

In December 2001, Catalytica Energy purchasedWoodward Governor Company’s (“WGC’s”) equity interest in GENXON Power Systems,LLC (“GENXON”) making it the sole equity owner of GENXON. GENXON was formed in October 1996as a 50/50 joint venture between Catalytica Energy and WGC to develop thepotential market for upgrading out-of-warranty turbines with new systems toimprove emissions and operating performance. The financial statements ofCatalytica Energy and GENXON were consolidated effective December 31, 2001.

In January 2004, Catalytica Energy formed two newwholly-owned subsidiaries, CESI-SCR, Inc. (“CESI-SCR”) and CESI-TechTechnologies, Inc. (“CESI-Tech”). On February 20, 2004, CESI-SCRacquired 100% of the outstanding membership interests of SCR-Tech and SCR-Techbecame a wholly-owned subsidiary of CESI-SCR. Also on February 20,2004, CESI-Tech acquired various patents and other intellectual property rightsfrom certain former owners of SCR-Tech. Operating results for the year ending December 31,2004 include the results of operations of SCR-Tech for the period from February 21,2004 through December 31, 2004.

Catalytica Energy was in the development stage frominception until February 2004, when the Company acquired SCR-Tech, acompany with established commercial operations in the area of NOx solutions, atwhich point the Company exited the development stage.

73

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**CATALYTICA ENERGY SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**

We operate in twobusiness segments, defined as follows. See Note 10 in Notes to FinancialStatements for business segment disclosures.

·       Catalystregeneration, cleaning and management services for selective catalyticreduction systems used by utility-scale power generating facilities to reduceNOx emissions—our SCR Catalyst and Management Services segment (“SCMS”).

·       Designing,developing and manufacturing advanced products based on our proprietarycatalyst and fuel processing technologies to offer cost-effective solutions forreducing NOx emissions—our Catalyst-Based Technology Solutions segment (“CBTS”).

**Note2.   Significant Accounting Policies**

***Principles of Consolidation*.  **Theconsolidated financial statements include the accounts of Catalytica Energy andits wholly owned subsidiaries in the United States. Significant intercompanyaccounts and transactions have been eliminated in consolidation.

***Reclassifications*.  **Certainreclassifications have been made to the 2002 and 2003 financial statements toconform to the 2004 presentation. Effective January 1, 2004, the Companyelected to reclassify certain expenses in its consolidated statements ofoperations. Costs of revenue-producing research and development (“R&D”)programs have been reclassified from research and development to cost ofrevenues. These reclassifications resulted in an increase to cost of revenuesand a decrease to research and development of $4,341,000 and $5,977,000 for theyears ended December 31, 2003 and 2002, respectively.

***Use of Estimates*.  **Thepreparation of consolidated financial statements in conformity with accountingprinciples generally accepted in the United States requires management to makeestimates and assumptions that affect the reported amounts in the consolidatedfinancial statements and accompanying notes. Actual results could differ fromthose estimates.

***Cash Equivalents*.  **CatalyticaEnergy considers all highly liquid investments with a remaining maturity ofthree months or less from the date of purchase to be cash equivalents. TheCompany’s investments have consisted of commercial and government short-termpaper with a remaining maturity of three months or less and money marketaccounts.

***Short-Term Investments*.  **CatalyticaEnergy accounts for short-term investments in accordance with Statement ofFinancial Accounting Standard (“SFAS”) No. 115, “Accounting for CertainInvestments in Debt and Equity Securities.” The Company’s investments areclassified as available for sale and have been recorded at fair value, whichapproximates cost. Catalytica Energy’s short-term investments consistprincipally of commercial paper with maturities of twelve months or less.

***Investments in Equity Investmentsand Joint Ventures*.  **Investments in equityinvestments and joint ventures where Catalytica Energy has a 20% to 50%ownership interest are accounted for under the equity method. Under thismethod, Catalytica Energy records its pro rata share of the investee’s netearnings or losses. Investee’s net losses are recorded until Catalytica Energy’snet investment and obligation, if any, to pay down debt are reduced to zero. AtDecember 31, 2004, there were no investments recorded on the balance sheetgiven the remaining equity investments are recorded at zero value and theCompany has no future funding commitments.

***Concentrations of Credit Risk*.  **Assetssubject to concentrations of credit risk consist principally of cashequivalents, short-term investments, and receivables. Catalytica Energy useslocal banks and various 

74

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**CATALYTICA ENERGY SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**

investment firms to investits excess cash, principally in commercial paper and money market funds from adiversified portfolio of investments with strong credit ratings. Related creditrisk would result from a default by the financial institutions or issuers ofinvestments to the extent of the recorded carrying value of these assets.Catalytica Energy performs ongoing credit evaluations of its customers andgenerally does not require collateral.

***Accounts Receivable.  ***Accountsreceivable consists of trade receivables generated from research anddevelopment contracts, trade receivables from SCR Catalyst and ManagementServices and revenues in excess of billings from SCR Catalyst and ManagementServices. Trade receivables are recorded at the invoiced amount. Payment termsfor SCR catalyst regeneration and cleaning services are typically defined inthe contract for services rendered. Revenues may be earned for those servicesin advance of amounts billable to the customer and are recognized when theservice is complete, unless the contract terms will not result in invoicegeneration within six months from the date of completion of those services. Revenuesrecognized in excess of amounts billed are recorded as accounts receivable. Revenuesin excess of billings represented $225,000 and $0 of net accounts receivable asof December 31, 2004 and December 31, 2003, respectively.

***Allowancefor Doubtful Accounts and Notes*.  **The Companymaintains allowances for doubtful accounts for estimated losses resulting fromthe inability of its funding parties or customers to make required payments. Thisallowance is based on specific customer account reviews and historicalcollections experience. We generally reserve for balances that are 60 days pastthe invoice due date. If the financial condition of the Company’s fundingparties or customers were to deteriorate, resulting in an impairment of theirability to make payments, additional allowances may be required. The followingtable summarizes the activity for the allowance for doubtful amounts on allaccounts and notes receivable: 

| **Year ended  December 31,** | ** ** | **Beginning  Balance** | ** ** | **Provision** | ** ** | **Ending  Balance** | ** ** |
|----------------------------------------|------------|------------------------|------------|---------------|------------|---------------------|------------|
| 2002                                   |       | $                      | 625,000    |          | $          | —              |       | $ | 625,000 |   |
| 2003                                   |       | 625,000                |       | 92,000        |       | 717,000             |       |
| 2004                                   |       | 717,000                |       | —        |       | 717,000             |       |
|                                        |            |                        |            |               |            |                     |            |  |  |  |

 

***Fair Value of FinancialInstruments*.  **At December 31, 2004, the Companyhas the following financial instruments: cash and cash equivalents, short-terminvestments, accounts receivable, notes receivable from related parties,accounts payable, accrued payroll and benefits, accrued legal settlements,accrued liabilities and long-term debt. The carrying value of cash and cashequivalents, short-term investments, accounts receivable, accounts payable,accrued payroll and benefits, accrued legal settlements and accrued liabilitiesapproximates their fair value based on the liquidity of these financialinstruments or based on their short-term nature. The carrying value of notesreceivable from related parties and long-term debt approximates fair valuebased on the market interest rates available to Catalytica Energy for debt ofsimilar risk and maturities.

***Inventory*.  **CatalyticaEnergy’s inventory consists principally of raw materials and is stated at thelower of cost or market. Raw materials consist mainly of various preciousmetals and high temperature foils that are used to make catalysts for our gasturbine modules and for use in our research and development activities.

***Property and Equipment*.  **Westate property and equipment at cost. We state equipment under capital leasesat the present value of the minimum lease payments. We capitalize majorimprovements and 

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**CATALYTICA ENERGY SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**

betterments, whilemaintenance, repairs and minor replacements are expensed as incurred. Depreciationis provided using the straight-line method over the economic lives of theassets ranging from 3 to 30 years. Leasehold improvements are amortized overthe shorter of the underlying lease term or asset life. Depreciation expenserecorded during the years ended December 31, 2004, 2003 and 2002 was$1,229,000, $2,254,000 and $2,190,000, respectively.

***Impairment of Long-Lived Assets*.  **Inaccordance with SFAS No. 144, “Accounting for the Impairment or Disposalof Long-Lived Assets,” the Company reviews long-lived assets for impairmentwhenever events or changes in circumstances indicate that the carrying amountof such assets may not be fully recoverable. If this review indicates thecarrying value of these assets will not be recoverable, as measured based onestimated undiscounted cash flows over their remaining life, the carryingamount would be adjusted to fair value. The cash flow estimates containmanagement’s best estimates, using appropriate and customary assumptions andprojections at the time. During the year ended December 31, 2002, theCompany determined that certain leasehold improvements were impaired andrecorded a reserve of $545,000 which is reflected as a component of selling,general and administrative expenses.

***Goodwill and OtherIntangible Assets.  ***The Company accounts forgoodwill and other intangible assets in accordance with the provisions of SFAS No. 141,“Business Combinations”, andSFAS No. 142, “Goodwill and OtherIntangible Assets”. Purchase prices of acquired businesses that areaccounted for as purchases have been allocated to the assets and liabilitiesacquired based on the estimated fair values on the respective acquisitiondates. Based on these values, the excess purchase prices over the fair value ofthe net assets acquired were allocated to goodwill. Pursuant to SFAS No. 142,goodwill and other intangible assets acquired in a purchase businesscombination and determined to have an indefinite useful life are not amortized,but instead tested for impairment at least annually in accordance with theprovisions of SFAS No. 142. SFAS No. 142 also requires thatintangible assets with estimable useful lives be amortized over theirrespective estimated useful lives to their estimated residual values andreviewed for impairment in accordance with SFAS No. 144, “Accounting forImpairment or Disposal of Long-Lived Assets.”

Goodwill represents the excess of costs over fairvalue of acquired net assets, including other intangible assets. Otherintangible assets that have finite useful lives, including patents, trademarks,trade secrets and other purchased technology, are recorded at fair value at thetime of the acquisition, and are carried at such value less accumulatedamortization. The Company amortizes these intangible assets on a straight-linebasis over their useful lives, estimated at ten years.

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**CATALYTICA ENERGY SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**

Thechanges in the carrying amount of goodwill and other intangible assets relatesonly to the SCMS business segment for the year ended December 31, 2004 areas follows (in thousands):

| *Goodwill*                         |   |   |   |
|------------------------------------|--------|--------|--------|
| Balance at December 31, 2003  |   | $      | — |   |
| Purchase of SCR-Tech               |   | 4,257  |   |
| Amortization expense               |   | — |   |
| Balance at December 31, 2004  |   | $      | 4,257  |   |
| *Other  Intangible Assets*         |   |   |   |
| Balance at December 31, 2003  |   | $      | — |   |
| Purchase of SCR-Tech               |   | 1,728  |   |
| Amortization expense               |   | (144   | )      |
| Balance at  December 31, 2004 |   | $      | 1,584  |   |

 

At December 31, 2004, goodwill totaled $4,257,000.Other acquisition-related intangibles, net of accumulated amortization, totaled$1,584,000 at December 31, 2004. Accumulated amortization through December 31,2004 was $144,000.

***Accrued Warranty Liability.  ***TheCompany’s warrants its Xonon catalytic modules for a period of 8,000 hours ofoperation or five years from first firing, whichever comes first. The Company’sobligations under this warranty are limited to repair or replacement of thedefective Xonon module(s). Warranties provided for the Company’s SCR cleaningand regeneration services vary by contract, but typically provide limitedperformance guarantees and complete structural warranties.

Estimated warranty obligations related to Xononmodules are based on the number of modules in operation and are recorded as acost of revenues. Estimated warranty obligations related to SCR cleaning andregeneration services are provided for as cost of revenues in the period inwhich the related revenue is recognized. Adjustments are made to accruals aswarranty claim data and historical experience warrant. Our warranty obligationmay be materially affected by product failure rates and other costs incurred incorrecting a product failure. Should actual product failure rates or otherrelated costs differ from our estimates, revisions to the estimated warrantyliability would be required.

Thefollowing table summarizes the changes in accrued warranty liability (inthousands):

| Balance as of  December 31, 2002         |   | $      | 50     |   |
|-----------------------------------------------|--------|--------|--------|--------|
| Warranties issued and adjustment to provision |   | — |   |
| Warranty claims                               |   | — |   |
| Balance as of  December 31, 2003         |   | 50     |   |
| Warranties issued and adjustment to provision |   | 85     |   |
| Warranty claims                               |   | — |   |
| Balance as of  December 31, 2004         |   | $      | 135    |   |

 

***Comprehensive Income*.  **CatalyticaEnergy has no significant components of other comprehensive income.

***SCR Catalyst and ManagementServices**Revenues*.  **Asprescribed in Staff Accounting Bulletin (“SAB”) 101 and 104, “RevenueRecognition in Financial Statements”, the Company recognizes revenue from SCR 

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**CATALYTICA ENERGY SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**

Catalyst and ManagementServices when persuasive evidence of an arrangement exists, services have beenrendered, the price is fixed or determinable, and collectibility is reasonablyassured.

Revenues related to SCR catalyst regeneration andcleaning services are recognized when the service is completed for eachcatalyst module. Customer acceptance is not required in that SCR-Tech’scontracts currently provide that services are completed upon receipt of testingby independent third parties confirming compliance with contract requirements.  Testing generally occurs three times during aparticular customer project—at the beginning of the processing, whenapproximately one-half of the project has been processed, and upon completionof processing.  A typical customerproject may take 30 to 90 days to complete. Once a successful test result isreceived from an independent third party, revenue is recognized for eachcatalyst module processed prior to the receipt of such test results, and revenueis subsequently recognized for each catalyst module as its processing iscompleted. As the Company utilizes a consistent methodology and formula foreach project, it is unlikely that subsequent testing would not be successful. Nonetheless,if a subsequent test result were to indicate failure, the Company would ceaserecognizing revenue on any subsequent modules until new testing evidenceconfirms successful processing. We maintain a revenue allowance to provide forany deficient test results that may occur after our initial test.

Due to the nature of the demand for SCR regenerationand cleaning services, some of our contracts provide for extended payment terms.In a situation where the project for a customer is complete; but the customeris not contractually committed to receive an invoice within the succeeding sixmonths (and subsequent payment is due within 30 days of invoice date), revenueis deferred until the contractual invoice date. If the customer contractprovides for a deposit or progress payments, we recognize revenue up to theamount invoiced. Because of the fact  weperform a service for a customer, no rights of return exist. The customer isresponsible for the removal, transportation and subsequent installation of thecatalyst. Our revenue arrangements do not have any material multipledeliverables as defined in Emerging Issues Task Force (“EITF”) 00-21, “Accountingfor Multiple Element Revenue Arrangements”.

Costs associated with performing SCR catalystregeneration and cleaning services are expensed as incurred because of theclose correlation between the costs incurred, the extent of performanceachieved and the revenue recognized. In the situation where revenue is deferreddue to collectibility uncertainties, the Company does not defer costs due tothe uncertainties related to payment for such services.

We recognize revenue from our management andconsulting services as work is performed. Costs associated with management andconsulting services is expensed as incurred.

***Research and Development Revenues.  ***Researchand development (“R&D”) revenues are recognized as contractual services areperformed and are recognized in accordance with contract terms, principallybased on reimbursement of total costs and expenses incurred. Revenues fromgovernment funded R&D programs are often multi-year, cost reimbursement orcost-share types of contracts. We are reimbursed for reasonable and allocablecosts up to the reimbursement limits set by the contract. In many cases, we arereimbursed for only a portion of the costs incurred under the contract. TheCompany generally shares in the cost of these programs with cost-sharingpercentages between 30% and 50%. We rely on general revenue recognitionguidance, as prescribed in SAB 104, to determine whether persuasive evidence ofan arrangement exists, delivery has occurred or services have been rendered,the price is fixed and determinable, and collection is reasonably assured.

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**CATALYTICA ENERGY SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**

While government research and development contractsmay extend over multiple years, funding is generally provided incrementally onan annual basis with authorization of funds by Congress. Should funding betemporarily delayed or if the Company’s strategic objectives change, we maychoose to devote resources to other activities, including internally fundedresearch and development programs.

No amounts recognized as revenue are refundable. Inreturn for funding, collaborative partners may receive certain rights in thecommercialization of any resulting technology, including royalty payments onfuture sales (see “-Other Commitments”). Most of our R&D contracts are alsosubject to periodic review by our funding partners, which could result inschedule delays or modifications to project scope, including reduction ortermination of funding.

We enter into contracts with government agencies asfunding sources to help defray costs of commercializing  our NOx control-related technologies. Thefederal government is not the sole or principal expected end-use customer forthe research and development or for products directly resulting from theR&D activity funded by the contract. We believe the funding derived fromthose sources is incidental to our anticipated costs of bringing thetechnologies we develop, with government funding support, to the marketplace. Assuch, we believe it is appropriate to present R&D revenues on a gross,rather than net, basis in the statement of operations.

The following describes the significant R&Dcontracts under which revenues were recorded for the years ending December 31,2004, 2003, and 2002.

**DOE Components**—cost-shareresearch program funded by the U.S. Department of Energy to enhance performanceof combustion systems using Xonon technology.

**CEC Multi-can**—funding fromthe California Energy Commission for development of a catalytic combustionsystem for achieving ultra-low emissions in small, multi-combustor gasturbines.

**Solar**—cost-sharing agreementwith Solar, Inc. for the development and adaptation of Xonon to the SolarTaurus 70 gas turbine.

**GE**—cost-sharing agreementwith General Electric, Inc. for the development and adaptation of Xonon tothe GE10 gas turbine.

**DOE Fuel Processor**—cost-shareresearch program funded by the U.S. Department of Energy, associated with thedevelopment of fuel reforming technology for PEM fuel cells.

**EPRI**—funding from aconsortium led by the Electric Power Research Institute in support of thedevelopment of a greater than 90% NOx reduction system for stationary dieselengines.

**TCEQ**—grant received from theTexas Commission on Environmental Quality in support of the Company’s plans foran on-vehicle demonstration of its diesel mobile retrofit solution.

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**CATALYTICA ENERGY SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**

Thefollowing table summarizes the amounts of compensation earned and relatedcosts, including overhead, incurred under the R&D programs for the years endingDecember 31, 2004, 2003, and 2002 (in thousands):
| ** **          | ** ** | **2004**                | ** ** | **2003**  | ** ** | **2002**                | ** ** |
|---------------------|------------|-------------------------|------------|-----------|------------|-------------------------|------------|
| ** **          | ** ** | ** Revenue ** | ** ** | **Costs** | ** ** | ** Revenue ** | ** ** | **Costs** | ** ** | ** Revenue ** | ** ** | **Costs** | ** ** |
| DOE fuel  processor |       |                    | $          | 1,824     |       |                    | $          | 1,542 |   |   | $ | 2,025 |   |   | $ | 2,121 |   |   | $ | 1,707 |   |   | $ | 1,536 |   |
| EPRI                |       |                    | 456        |      |       | 559                     |       |   | — |   |   | — |   |   | — |   |   | — |   |
| CEC multi-can       |       |                    | 162        |      |       | 427                     |       |   | 513 |   |   | 754 |   |   | 929 |   |   | 1,026 |   |
| TCEQ                |       |                    | 68         |      |       | 124                     |       |   | — |   |   | — |   |   | — |   |   | — |   |
| Solar               |       |                    | 24         |      |       | 94                      |       |   | 134 |   |   | 464 |   |   | 638 |   |   | 1,276 |   |
| DOE components      |       |                    | —     |      |       | —                  |       |   | — |   |   | — |   |   | 650 |   |   | 858 |   |
| GE                  |       |                    | —     |      |       | —                  |       |   | 753 |   |   | 857 |   |   | 708 |   |   | 1,281 |   |
| Other               |       |                    | 108        |      |       | —                  |       |   | 73 |   |   | 145 |   |   | 163 |   |   | — |   |
| Total R&D       |       |                    | $          | 2,642     |       |                    | $          | 2,746 |   |   | $ | 3,498 |   |   | $ | 4,341 |   |   | $ | 4,795 |   |   | $ | 5,977 |   |

 

***Revenue Cost Reserves*.  **Revenuefrom our funded research and development contracts is recorded as work isperformed and billable hours are incurred by us, in accordance with each contract.Since these programs are subject to government audits, we maintain a revenuecost reserve for our government-funded programs in the event any of thesefunded costs, including overhead, are disallowed. We estimate this reserve byapplying a percentage to the revenue recorded under contracts still subject toaudit by those funding agencies.

Thefollowing table summarizes the changes in revenue cost reserve (in thousands):

| Balance as of  December 31, 2002 |   | $      | 150    |   |
|---------------------------------------|--------|--------|--------|--------|
| Adjustment to provision               |   | — |   |
| Revenue refunds issued                |   | — |   |
| Balance as of  December 31, 2003 |   | 150    |   |
| Adjustment to provision               |   | (31    | )      |
| Revenue refunds issued                |   | — |   |
| Balance as of  December 31, 2004 |   | $      | 119    |   |

 

***Research and Development Expenses*.  **Researchand development costs are expensed as incurred.

***Stock-Based Compensation*.  **TheCompany accounts for stock-based compensation using the intrinsic value methodprescribed in Accounting Principles Board Opinion No. 25, “Accounting forStock Issued to Employees” (“APB 25”) and has adopted the disclosure onlyalternative of SFAS No. 123, “Accounting for Stock-based Compensation.”

Any deferred stock compensation calculated under APB25 and related interpretations is amortized over the vesting period of theindividual options, generally four years, using the straight-line method ofamortization.

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**CATALYTICA ENERGY SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**

Stock-based awardsto non-employees are accounted for at fair value, as generally calculated usingthe Black-Scholes model, in accordance with SFAS No. 123 and EmergingIssues Task Force Consensus No. 96-18. Related options are subject toperiodic re-measurements over their vesting terms.

Hadcompensation cost for Catalytica Energy’s stock-based compensation plan beendetermined based on the fair value at the grant dates for stock option awardsconsistent with the method of SFAS No. 123, the Company’s net loss wouldhave been increased to the pro forma amounts indicated below (in thousands,except per share amounts):
| ** **                                                | ** ** | **Year ended December 31,** | ** ** |
|-----------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| Net loss, as  reported                                    |       | $                                          | (13,269    | ) | $ | (14,399 | ) | $ | (17,874 | ) |
| SFAS No. 123  Stock option plan compensation expense |       | (1,625                                     | )          | (1,211 | ) | (2,798 | ) |
| Pro forma net loss                                        |       | $                                          | (14,894    | ) | $ | (15,610 | ) | $ | (20,672 | ) |
| Pro forma basic  and diluted net loss per share           |       | $                                          | (0.83      | ) | $ | (0.88 | ) | $ | (1.18 | ) |

 

***Income Taxes*.  **CatalyticaEnergy accounts for income taxes under the asset and liability method inaccordance with SFAS No. 109, “Accounting for Income Taxes.” Under theasset and liability method, deferred income tax assets and liabilities aredetermined based on the differences between the financial reporting and taxbases of assets and liabilities and are measured using the currently enactedtax rates and laws.

***Net Loss per Share*.  **Basicand diluted net loss per share is presented in accordance with SFAS No. 128,“Earnings Per Share.” As the Company’s potentially dilutive securities (stockoptions and warrants) were anti-dilutive for the years ended December 31,2004, 2003 and 2002, they have been excluded from the computation ofweighted-average shares outstanding used in computing diluted net loss pershare because the Company incurred a net loss for each of those periods. Totaloptions and warrants outstanding as of December 31, 2004, 2003 and 2002were approximately 3,186,000, 2,488,000 and 2,297,000, respectively.

Thefollowing table sets forth the computation of basic and diluted lossattributable to common stockholders per share (in thousands, except per shareamounts):
| ** **                                                                                   | ** ** | **Year ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                   | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| Numerator for  basic and diluted loss per share                                              |       | $                                          | (13,269    | ) | $ | (14,399 | ) | $ | (17,874 | ) |
| Denominator for  basic and diluted loss per share—  weighted-average shares outstanding |       | 17,850                                     |       | 17,669 |   | 17,529 |   |
| Basic and diluted  loss per share                                                            |       | $                                          | (0.74      | ) | $ | (0.81 | ) | $ | (1.02 | ) |

 

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**CATALYTICA ENERGY SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

***Impact of Recently IssuedAccounting Standards*.  **On December 16, 2004,the FASB issued SFAS Statement No. 123 (revised 2004), “Share-BasedPayment” (Statement 123(R)), which is a revision of FASB Statement No. 123,“Accounting for Stock-BasedCompensation” (Statement 123). Statement 123(R) supersedes APBOpinion No. 25, “Accounting forStock Issued to Employees”, and amends FASB Statement No. 95, “Statement of Cash Flows”. Generally,the approach in Statement 123(R) is similar to the approach described inStatement 123. However, Statement 123(R) requires all share-based payments to employees, including grantsof employee stock options, to be recognized in the income statement based ontheir fair values. Pro forma disclosure is no longer an alternative.

Statement 123(R) mustbe adopted no later than July 1, 2005. Early adoption will be permitted inperiods in which financial statements have not yet been issued. We intend toadopt Statement 123(R) on July 1, 2005, the adoption of which willlikely have a significant impact on our results of operations, although it willhave no impact on our overall financial position. The actual impact of adoptionof Statement 123(R) on our results of operations cannot be predicted atthis time because it will depend on levels of share-based payments granted inthe future. However, had we adopted Statement 123(R) in prior periods, theimpact of that standard would have approximated the impact of Statement 123 asdescribed in the disclosure of pro forma net income and earnings per share inNote 2 to our consolidated financial statements. Statement 123(R) alsorequires the benefits of tax deductions in excess of recognized compensationcost to be reported as a financing cash flow, rather than as an operating cashflow as required under current literature. This requirement will reduce netoperating cash flows and increase net financing cash flows in periods afteradoption to the extent we do not provide a full valuation reserve on such taxbenefits.

**Note 3.   Purchaseof SCR-Tech**

OnFebruary 20, 2004, we acquired 100% of the outstanding memberinterests of SCR-Tech and certain patents and related intellectual property. SCR-Tech is a provider of catalystregeneration technologies and management services for SCR systems, which areused by coal-fired power plants to reduce NOx emissions. As a result of theacquisition, the Company is expanding its commercial operations and leveragingits expertise in NOx control and catalysis within multiple markets.

Due to the acquisition,$7,194,000 was recorded as an investment in SCR-Tech; consisting of $3,518,000initial cash payment, $237,000 due diligence costs incurred through closing,$545,000 accrued liability and $2,894,000 present value of estimated futureacquisition payments.

Inaddition to an initial cash payment of $3,518,000, we are obligated to thefollowing payments:

(1)          Uponthe completion of certain training and delivery of the remaining assets to beacquired, a payment of $545,000 (which was recorded as an accrued liability andsubsequently paid in September 2004).

(2)          OnAugust 20, 2005, a payment of $725,000 ($875,000, less $150,000 adjustmentrelated to closing date balance sheet), which was recorded as long-term debt atthe present value of the future payment ($660,000).

(3)          OnFebruary 20, 2006, a payment of $1,000,000, which was recorded aslong-term debt at the present value of the future payment ($882,000).

(4)          OnDecember 1, 2007 and December 1, 2008, a payment of $300,000 on eachsuch date provided that Hans-Ulrich Hartenstein is an employee of SCR-Tech orits affiliates on such 

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**CATALYTICA ENERGY SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

dates(collectively, the “Contingent Employment Payments”). These ContingentEmployment Payments were not recorded as part of the purchase accounting as theoutcome of those payments was contingent upon future services and theperformance of those services was not determinable beyond a reasonable doubt. InMarch 2005, the employment of Hans Hartenstein as president of SCR-Tech terminated,and as such, this payment obligation has been extinguished.

(5)          Foreach of the calendar years 2004 through 2008, certain amounts, if any, basedupon the SCR-Tech business attaining certain revenue targets. No amount wasrecorded as part of the purchase accounting to reflect these contingentpayments as they were not determinable beyond a reasonable doubt.

(6)          Foreach of the calendar years 2004 through 2008, certain amounts, if any, basedupon the SCR-Tech business attaining certain cash flow targets. No amount wasrecorded as part of the purchase accounting to reflect these contingentpayments as they were not determinable beyond a reasonable doubt.

(7)          Foreach of the calendar years 2004 through 2018, an aggregate of up to $5,022,220payable in installments equal to the lesser of (a) 10% of certain revenuesfor the applicable calendar year and (b) $502,220 (collectively, the “AcquiredAsset Payments”). These payments will be paid over the next 10-15 years. Webelieve that the total amount payable was resolved and determinable at the dateof the acquisition beyond a reasonable doubt; however, we did have to estimateas to when over this period the amounts would be paid. We believe the timingwas reasonably estimable as prescribed in SFAS 5 and appropriate to recognizethe liability as prescribed in SFAS 141. We recorded these contingent paymentsas long-term debt at the present value of these future payments ($1,352,000).

Thefollowing table summarizes the estimated fair values of the assets acquired andliabilities assumed due to the acquisition (in thousands):

February 20, 2004
| Current assets                 |   | $      | 792    |   |
|--------------------------------|--------|--------|--------|--------|
| Property &  equipment |   | 1,422  |   |
| Other assets                   |   | 32     |   |
| Goodwill                       |   | 4,257  |   |
| Intangible assets              |   | 1,727  |   |
| Total assets acquired          |   | 8,230  |   |
| Current liabilities            |   | (957   | )      |
| Non-current liabilities        |   | (79    | )      |
| Long-term debt                 |   | (2,894 | )      |
| Net assets acquired            |   | $      | 4,300  |   |

 

Goodwill of $4,257,000 was recorded as part of thispurchase. Factors contributing to the purchase price which resulted in therecognition of goodwill include an analysis of the market in which SCR-Tech wasconducting business and it potential growth, the technology owned by SCR-Techand the opportunities to expand the technology with Catalytica know-how, thepotential to grow SCR-Tech into other service areas at power plants, theopportunity to access new market channels, the opportunity to expand ourbreadth in the large NOx control marketplace, and SCR-Tech’s competitiveposition within the marketplace.

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**CATALYTICA ENERGY SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

Other intangible assets of$1,727,000 were recorded as part of this purchase that are being amortized overtheir estimated useful lives of ten years. Acquired patents represented$1,627,000 of the identifiable intangible assets with the remaining amountattributed to secret formulas and processes, customer contracts andrelationships, lease agreements, trademarks, and internet domain names. Nointangible assets with indefinite lives were identified.

Goodwill and otherintangible assets will be tested for impairment at least annually in accordancewith the provisions of SFAS No. 142. The results of operations forSCR-Tech for the period February 21, 2004 through December 31, 2004are included in the consolidated statements of operations, cash flow andbalance sheets as of and for the year ended December 31, 2004.

The acquisition ofSCR-Tech did not meet the significance criteria as set forth under Rules 3-05(b) and11-01(b) of Regulation S-X.

**Note4.   Transactions with Related Parties**

***NovoDynamics, Inc.  ***In2001, we invested $2,258,000 in NovoDynamics, a company engaged in thedevelopment of data mining, informatics discovery and high throughput synthesisand testing technologies. During 2001, we owned shares of Series A votingpreferred stock representing approximately 38% of NovoDynamics’ outstandingequity. We recorded the investment in NovoDynamics at our actual cost and,during the period from March 2001 through December 2001, recorded ourpro-rata share of losses totaling $613,000 under the equity method ofaccounting.

Additionally in 2001, weagreed to loan NovoDynamics $500,000, which was funded in January 2002. Asof December 31, 2001, we recorded a note payable for the $500,000 and anote receivable of $500,000 on our balance sheet. Because repayment of the notewas not certain at the time it was made, an allowance of $500,000 was recordedagainst the loan and this amount was charged as impairment to implied goodwillof an equity investment on December 31, 2001. At December 31, 2004,we believe this note is still collectible and continue to carry this note onthe balance sheet with a full reserve in lieu of a permanent write-off. NovoDynamicscontinues to operate as an ongoing business and recently received receivablefinancing from a third party bank. Additionally, NovoDynamics continues to payapproximately $3,000 per month monthly interest on the note.

On December 31, 2001,we determined that an impairment in the carrying value of the equity investmentin NovoDynamics had occurred which was other than temporary based onNovoDynamics’ financial history and projected future losses. At that time, wedetermined the estimated fair value of the investment in NovoDynamics was zeroand wrote off the net investment amount of $1,645,000 as impairment to impliedgoodwill of an equity investment. At that time, we discontinued applying theequity method of accounting because the net investment was zero. Therefore, noloss related to the equity investment in NovoDynamics was recorded during theyears ended December 31, 2004, 2003 and 2002. At December 31, 2004,we owned approximately 31.6% of NovoDynamics’ outstanding equity.

As of December 31,2004, two of Catalytica Energy’s directors held a direct investment inNovoDynamics Series B voting preferred stock, which represented less than2% of NovoDynamics’ outstanding stock.

***Transactions with Officers andDirectors*.  **In January 2001, Catalytica Energy’ssenior vice president of Business Development resigned. His separationagreement provided for a one-time severance payment totaling $183,000. Inaddition, a previous loan of $100,000 was immediately forgiven. CatalyticaEnergy recorded a charge in the first quarter of 2001 for $283,000 related tothe forgiveness of the officer’s loan 

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**CATALYTICA ENERGY SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

and severance. Theformer officer is currently indebted to Catalytica Energy for $187,000 which ispayable on March 31, 2005. Interest accrues on this note at an annual rateof 6% and is payable in installments through March 31, 2005. This note isfully reserved as a result of previous delinquent interest payments; we intendto seek full repayment of the note upon its maturity on March 31, 2005.

On February 3, 2005, the Board of Directorsentered into a consulting agreement with David Merrion, a director of theCompany. As a part of the agreement, Mr. Merrion will provide consultingservices in diesel engine emission technology and related areas and will bepaid a fee of $7,500 per quarter. The agreement remains in effect until December 31,2005 and is subject to annual renewal upon the approval of the Board ofDirectors and Mr. Merrion.

***Forgiveness of Notes*.  **Forgivenessof notes receivable from related parties is attributed to forgiveness ofhousing allowance loans to employees, amortized over a period of five years. Compensationexpense related to forgiveness of notes recorded during the years ended December 31,2004, 2003 and 2002 was $52,000, $57,000 and $60,000, respectively.

***Investments*.  **CatalyticaEnergy had invested $16,493,000 and $19,790,000 with Morgan Stanley PrivateWealth Management, an affiliate of Morgan Stanley & Co., Incorporated,as of December 31, 2004 and 2003, respectively. This amount is investedprimarily in a money market account and commercial and government short-termsecurities which are classified as cash and cash equivalents or short-terminvestments. One of Catalytica Energy’s board members is the Chairman and ChiefExecutive Officer of a firm which acts as investment manager for Morgan StanleyCapital Partners.

**Note 5.   Income Taxes**

Recordedincome tax benefit differs from the expected benefit determined by applying theU.S. federal statutory rate to the net loss as follows (in thousands): 
| ** **                                  | ** ** | **Year ended December 31,** | ** ** |
|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                  | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| Income tax  benefit at U.S. statutory rate  |       | $                                          | 4,512      |   | $ | 4,895 |   | $ | 6,077 |   |
| Valuation allowance for deferred tax assets |       | (4,512                                     | )          | (4,895 | ) | (6,077 | ) |
| Income tax benefit                          |       | $                                          | —     |   | $ | — |   | $ | — |   |

 

Deferredincome taxes reflect the net tax effects of temporary differences between thecarrying amounts of assets and liabilities for financial reporting purposes andthe amounts used for income tax purposes and include the following (inthousands):
| ** **                                     | ** ** | **December 31,** | ** ** |
|------------------------------------------------|------------|-----------------------|------------|
| ** **                                     | ** ** | **2004**              | ** ** | **2003** | ** ** |
| Deferred tax assets:                           |       |                  |       |   |   |
| Net operating loss carryforwards               |       | $                     | 13,615     |   | $ | 11,700 |   |
| Capitalized research and development           |       | 12,913                |       | 9,000 |   |
| Basis in fixed assets                          |       | 976                   |       | 1,800 |   |
| Accruals and reserves not currently deductible |       | 2,156                 |       | 1,800 |   |
| Total gross  deferred tax assets               |       | 29,660                |       | 24,300 |   |
| Less valuation allowance                       |       | (29,660               | )          | (24,300 | ) |
| Net deferred tax assets                        |       | $                     | —     |   | $ | — |   |

 

85

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**CATALYTICA ENERGY SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

Realization of thedeferred tax assets is dependent on future earnings, the timing and amount ofwhich are uncertain. Accordingly, a valuation allowance, in an amount equal tothe related deferred tax assets has been established to reflect theseuncertainties. The valuation allowance increased by $5,360,000, $5,800,000, and$7,260,000 in 2004, 2003 and 2002, respectively, due to operating losses whichincreased net operating loss carryforwards that are not likely to be realizedin the near future.

As of December 31,2004, Catalytica Energy’s federal and state net operating loss carryforwardswere approximately $35,000,000 and $26,000,000, respectively. The federal netoperating loss carryforward will expire in the years 2020 through 2024 and thestate net operating loss carryforward will expire in the years 2006 through2014 if not used to offset future taxable income.

The valuation allowanceincludes approximately $820,000 for net operating loss carryforwards thatrelate to stock option compensation expense for income tax reporting purposes. Anyutilization of these net operating loss carryforwards would be recorded as anincrease in additional paid-in capital.

Utilization of the netoperating loss carryforwards may be subject to a substantial annual limitationdue to the ownership change limitations provided by the Internal Revenue Codeof 1986, as amended, and similar state provisions. The annual limitation mayresult in the expiration of net operating loss carryforwards beforeutilization.

**Note 6.   CapitalStock**

Sharesof Catalytica Energy common stock reserved for future issuance as of December 31,2004 are as follows:
| Employee stock purchase  plan |   | 1,171,020 |   |
|-------------------------------|--------|-----------|--------|
| Stock options                 |   | 4,370,272 |   |
|                          |   | 5,541,292 |   |

 

***Shareholder Rights Plan*.  **InJanuary 2002, our Board of Directors adopted a Shareholder Rights Plan,which was amended in November 2004 (the “Plan”). Under the Plan, wedistributed Preferred Stock Purchase Rights as a dividend at the rate of oneRight for each share of its common stock held by stockholders of record on February 20,2002 (the “Record Date”). The Board of Directors also authorized the issuanceof Rights for each share of common stock issued after the Record Date, untilthe occurrence of certain specified events. The Plan was adopted to provideprotection to stockholders in the event of an unsolicited attempt to acquirethe Company. Each Right will entitle the registered holder to purchase from theCompany one one-thousandth of a share of Series A Participating Preferredstock at an exercise price of $45, subject to adjustment. We have authorized5,000,000 shares of Series A preferred stock for issuance pursuant to thisplan.

Under the Plan, the Rightsare not exercisable until triggered by certain conditions including theacquisition of beneficial ownership of 20% of our common stock. However, MorganStanley Capital Partners III, L.P., and its affiliates could acquire up to21.5% of the Company’s common stock without triggering the Rights. If theRights are triggered, then each holder of a Right which has not been exercised(other than Rights beneficially owned by the Acquiring Person) will have theright to receive, upon exercise, voting Common Shares having a value equal totwo times the Purchase Price.

The Company is entitled toredeem the Rights, for $0.001 per Right, at the discretion of the Board ofDirectors, until certain specified times. We may also require the exchange ofRights, under certain additional circumstances. We also have the ability toamend the Rights, subject to certain limitations.

86

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**CATALYTICA ENERGY SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**Note 7.   EmployeeBenefit Plans**

***Stock Option Plan*.  **In1995, the Company adopted the Catalytica Energy Systems, Inc. 1995 StockPlan (the “1995 Plan”) which was subsequently amended. Under the 1995 Plan, theCompany’s Board of Directors is authorized to grant incentive stock options toeligible employees and nonqualified stock options to eligible employees,consultants, and directors. Through December 31, 2004, the Company hadreserved 5,000,000 shares of common stock for issuance under the 1995 Plan. Theincentive stock options generally vest ratably over four years from the date ofgrant and expire no later than ten years from the date of grant. Nonqualifiedstock options offered to directors vest ratably over one to four years from thedate of grant and expire no later than ten years from the date of grant.

Thefollowing table summarizes related stock option plan activity:
| ** **                         | ** ** | ** **         | ** ** | **Outstanding Options** | ** ** |
|------------------------------------|------------|--------------------|------------|------------------------------|------------|
| ** **                         | ** ** | **Shares**         | ** ** | ** **                   | ** ** | **Average** | ** ** |
| ** **                         | ** ** | **Available**      | ** ** | **Number**                   | ** ** | ** Exercise ** | ** ** |
| ** **                         | ** ** | **for Grant** | ** ** | **of Shares**           | ** ** | **Price** | ** ** |
| Balance at  December 31, 2001 |       | 1,627,998          |       | 1,357,313                    |       |   | $ | 12.26 |   |   |
| Authorized                         |       | 1,500,000          |       | —                       |       |   | — |   |   |
| Granted                            |       | (947,592           | )          | 947,592                      |       |   | 3.50 |   |   |
| Expired/forfeited                  |       | 334,046            |       | (334,046                     | )          |   | 8.66 |   |   |
| Exercised                          |       | —             |       | (5,250                       | )          |   | 0.40 |   |   |
| Balance at  December 31, 2002 |       | 2,514,452          |       | 1,965,609                    |       |   | 8.68 |   |   |
| Granted                            |       | (1,238,263         | )          | 1,238,263                    |       |   | 2.80 |   |   |
| Expired/forfeited                  |       | 630,187            |       | (630,187                     | )          |   | 9.96 |   |   |
| Exercised                          |       | —             |       | (85,891                      | )          |   | 1.84 |   |   |
| Balance at  December 31, 2003 |       | 1,906,376          |       | 2,487,794                    |       |   | 5.66 |   |   |
| Granted                            |       | (872,668           | )          | 872,668                      |       |   | 3.84 |   |   |
| Expired/forfeited                  |       | 150,129            |       | (150,129                     | )          |   | 5.29 |   |   |
| Exercised                          |       | —             |       | (23,898                      | )          |   | 3.09 |   |   |
| Balance at December 31, 2004  |       | 1,183,837          |       | 3,186,435                    |       |   | $ | 5.20 |   |   |

 

Asummary of Catalytica Energy’s stock options as of December 31, 2004 is asfollows:
| ** **      | ** **                                  | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|-----------------|---------------------------------------------|------------------------------|------------|------------------------------|------------|
| ** **      | ** **                                  | ** **                   | ** ** | **Weighted**                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **      | ** **                                  | ** **                   | ** ** | **Average**                  | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **      | ** **                                  | ** **                   | ** ** | **Remaining**                | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **      | ** **                                  | **Number**                   | ** ** | **Contractual**              | ** ** | **Exercise** | ** ** | **Number** | ** ** | **Exercise** | ** ** |
| ** **      | **Range of Exercise Prices** | ** **                   | ** ** | **Outstanding**              | ** ** | **Life (Years)** | ** ** | **Price** | ** ** | **Exercisable** | ** ** | **Price** | ** ** |
| $0.400-$2.650   |                                        | 337,175                      |       |                         | 3.82       |   |   | $ | 1.118 |   | 260,953 |   | $ | 0.758 |   |
| $2.660-$2.750   |                                        | 11,500                       |       |                         | 7.95       |   |   | 2.693 |   | 5,803 |   | 2.695 |   |
| $2.760          |                                        | 448,474                      |       |                         | 8.11       |   |   | 2.760 |   | 237,029 |   | 2.760 |   |
| $2.770          |                                        | 500,000                      |       |                         | 8.02       |   |   | 2.770 |   | 239,583 |   | 2.770 |   |
| $2.840-$3.500   |                                        | 119,025                      |       |                         | 8.30       |   |   | 3.323 |   | 50,486 |   | 3.306 |   |
| $3.530          |                                        | 394,916                      |       |                         | 7.24       |   |   | 3.530 |   | 308,820 |   | 3.530 |   |
| $3.550-$3.980   |                                        | 207,500                      |       |                         | 8.07       |   |   | 3.730 |   | 144,217 |   | 3.736 |   |
| $4.031          |                                        | 621,940                      |       |                         | 9.07       |   |   | 4.031 |   | 145,052 |   | 4.031 |   |
| $4.550-$16.937  |                                        | 406,577                      |       |                         | 5.77       |   |   | 13.030 |   | 393,028 |   | 13.188 |   |
| $19.250-$30.000 |                                        | 139,328                      |       |                         | 5.33       |   |   | 22.774 |   | 138,860 |   | 22.783 |   |
| $0.400-$30.000  |                                        | 3,186,435                    |       |                         | 7.31       |   |   | $ | 5.201 |   | 1,923,831 |   | $ | 6.372 |   |
|                 |                                             |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

87

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**CATALYTICA ENERGY SYSTEMS, INC.  NOTES TO FINANCIAL STATEMENTS—(Continued)**

Proforma information regarding net loss is required by SFAS No. 123, whichalso requires that the information be determined as if the Company hasaccounted for its employee stock awards granted subsequent to December 31,1994, under the fair value method of this Statement. The fair value for theseoptions was estimated at the date of grant using a Black-Scholes multipleoption pricing model with the following weighted average assumptions:
| ** **                              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-----------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Expected  Volatility                    |       | 58.50    | %          | 63.55    | %          | 71.04    | %          |
| Risk Free  Interest Rate                |       | 3.15     | %          | 2.98     | %          | 4.29     | %          |
| Weighted Average  Expected Life (years) |       | 5.15     |       | 5.28     |       | 5.24     |       |
| Dividend Yield                          |       | —   |       | —   |       | —   |       |

 

For pro forma purposes, the estimated fair value ofthe Company’s stock-based awards to employees is amortized over the options’vesting period. The weighted average fair value of options granted during 2004,2003 and 2002, was $2.13, $1.66, and $2.18 respectively, as calculated inaccordance with SFAS No. 123.

***DeferredStock Compensation*.  **During 2001 through 2004,Catalytica Energy granted stock options to a charitable foundation at therequest of a member of the Company’s board of directors who otherwise wouldhave received the options for his board service. Since the recipient of these optionsis not an employee or director of Catalytica Energy, the Company recordeddeferred compensation, which was re-measured at each reporting period andcharged to operations over the vesting periods. During June 2004, thisboard member resigned and the remaining deferred compensation was reversed. Thefollowing table summarizes activity related to these grants (in thousands):
|           | ** ** | ** **    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Deferred Compensation** | ** ** |
|-----------|------------|---------------|------------|------------|------------|------------|------------|------------|------------|--------------------------------|------------|
| **Grant** | ** ** | **# of** | ** ** | ** ** | ** ** | **Vest**   | ** ** | **Year**   | ** ** | **Beginning**                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Ending** | ** ** |
| **Date**  | ** ** | ** **    | ** ** | **Shares** | ** ** | **Price**  | ** ** | **Period** | ** ** | **Ending**                     | ** ** | **Balance** | ** ** | **Granted** | ** ** | **Expensed** | ** ** | **Remeasured** | ** ** | **Forfeited** | ** ** | **Balance** | ** ** |
| Dec-01    |       | 20,000        |       | $          | 4.55       |       | 4 years    |       |       | 2001                           |       |   |   | $ | — |   |   |   | $ | 91 |   |   |   | $ | — |   |   |   | $ | (34 | ) |   |   | $ | — |   |   |   | $ | 57 |   |   |
|           |       |          |       |       |       |       |       |       | 2002       |                           |       |   | 57 |   |   |   | — |   |   |   | (13 | ) |   |   | (22 | ) |   |   | — |   |   |   | 22 |   |   |
|           |       |          |       |       |       |       |       |       | 2003       |                           |       |   | 22 |   |   |   | — |   |   |   | (8 | ) |   |   | 4 |   |   |   | — |   |   |   | 18 |   |   |
|           |       |          |       |       |       |       |       |       | 2004       |                           |       |   | 18 |   |   |   | — |   |   |   | (4 | ) |   |   | — |   |   |   | (14 | ) |   |   | — |   |   |
| Feb-02    |       | 4,000         |       | $          | 3.53       |       | 1 year     |       |       | 2002                           |       |   |   | — |   |   |   | 9 |   |   |   | (7 | ) |   |   | (1 | ) |   |   | — |   |   |   | 1 |   |   |
|      |       |          |       |       |       |       |       |       | 2003       |                           |       |   | 1 |   |   |   | — |   |   |   | (1 | ) |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Feb-03    |       | 10,000        |       | $          | 2.76       |       | 1 year     |       |       | 2003                           |       |   |   | — |   |   |   | 18 |   |   |   | (16 | ) |   |   | — |   |   |   | — |   |   |   | 2 |   |   |
|           |       |          |       |       |       |       |       |       | 2004       |                           |       |   | 2 |   |   |   | — |   |   |   | (2 | ) |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Feb-04    |       | 10,000        |       | $          | 3.90       |       | 1 year     |       |       | 2004                           |       |   |   | — |   |   |   | 22 |   |   |   | (7 | ) |   |   | (2 | ) |   |   | (13 | ) |   |   | — |   |   |
|      |       |          |       |       |       |       |       |       |       |                           |       |   | $ | — |   |   |   | $ | 140 |   |   |   | $ | (58 | ) |   |   | $ | (55 | ) |   |   | $ | (27 | ) |   |   | $ | — |   |   |
|           |            |               |            |            |            |            |            |            |            |                                |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

In April 2003, the Company granted a consultantand former officer options to purchase 25,800 shares of its common stock at aprice of $2.50 per share as compensation for consulting services, vesting overa six-month period. Since the recipient of these options is not an employee ordirector of Catalytica Energy, the Company recorded a deferred compensationobligation of $38,000, of which $38,000 was earned and charged to operations inthe year ended December 31, 2003.

88

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**CATALYTICA ENERGY SYSTEMS, INC.  NOTES TO FINANCIAL STATEMENTS—(Continued)**

In January 2004, the Company granted fourconsultants options to purchase 7,500 shares each of common stock at $4.03 pershare, vesting over a four year period. Since the recipients of these optionsare not employees or directors of Catalytica Energy, the Company recorded adeferred compensation obligation of $69,000, of which $13,000 was earned andcharged to operations in the year ended December 31, 2004. This obligationwas re-measured at reporting periods during the year ended December 31,2004 resulting in a reduction to the deferred compensation obligation of$36,000. In each subsequent reporting period (through the vesting period) thisobligation will be re-measured.

***Employee Stock Purchase Plan*.  **In2000, the Company adopted the Catalytica Energy Systems, Inc. 2000Employee Stock Purchase Plan (the “2000 Plan”) under which employees areeligible to purchase shares of the Company’s common stock at a discount throughperiodic payroll deductions. The 2000 Plan is intended to meet the requirementsof Section 423 of the Internal Revenue Code. Purchases occur following sixmonth offering periods ending on June 30 and December 31 each year ata purchase price equal to 85% of the market value of the Company’s common stockat either the beginning of the offering period or the end of the offeringperiod, whichever is lower. According to the 2000 Plan, a new offering periodbegins each time the market value of the Company’s common stock at the end ofthe offering period is lower than the market value of the Company’s commonstock at the beginning of the offering period. The 2000 Plan allows for theoffering period to be no less than six and no more than twenty-four months,determined every six months.

Participants may elect to have up to 10% of their paywithheld for purchase of common stock at the end of the offering period, up toa maximum of $25,000 per calendar year. Through December 31, 2004, theCompany had reserved 1,500,000 shares of common stock for issuance under the2000 Plan and had issued 328,980 shares under the 2000 Plan. For the year endedDecember 31, 2004, employees purchased 122,204 shares for $281,160. Theweighted average fair value of those purchased shares granted during the yearsended December 31, 2004 and 2003 was $1.13 and $1.10, respectively. As of December 31,2004, 1,171,020 shares were available for future issuance under the 2000 Plan.

***401(k) Savings &Retirement Plan*.  **The Company offers a 401(k) Savings &Retirement Plan to eligible employees meeting certain age and servicerequirements. This plan permits participants to contribute up to the maximumallowable by the Internal Revenue Service regulations. The plan provides forboth a bi-monthly Company match and a discretionary annual contribution. Participantsare immediately vested in their voluntary contributions plus actual earningsand in the Company’s matching contributions. The Company’s expense for thisplan was $319,000, $303,000 and $474,000 for the years ended December 31,2004, 2003 and 2002, respectively.

89

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**CATALYTICA ENERGY SYSTEMS, INC.  NOTES TO FINANCIAL STATEMENTS—(Continued)**

**Note 8.**                       MajorCustomers and Geographic Revenues 

Majorcustomers (as a % of consolidated revenue) are as follows:
| ** **                         | ** ** | ** **  | ** ** | **Year ended December 31,**   | ** ** |
|------------------------------------|------------|-------------|------------|----------------------------------------------|------------|
| ** **                         | ** ** | **Segment** | ** ** | **   2004   ** | ** ** | **   2003   ** | ** ** | **   2002   ** | ** ** |
| U.S. Department  of Energy         |       | CBTS        |       |                                         | 33         | % |   |   | 58 | % |   |   | 49 | % |   |
| Electric Power  Research Institute |       | CBTS        |       |                                         | 8          | % |   |   | — |   |   |   | — |   |   |
| California Energy  Commission      |       | CBTS        |       |                                         | 3          | % |   |   | 15 | % |   |   | 23 | % |   |
| General Electric                   |       | CBTS        |       |                                         | —     |   |   |   | 22 | % |   |   | 15 | % |   |
| Solar Turbines                     |       | CBTS        |       |                                         | —     |   |   |   | 4 | % |   |   | 13 | % |   |
| Customer A                         |       | SCMS        |       |                                         | 19         | % |   |   | — |   |   |   | — |   |   |
| Customer B                         |       | SCMS        |       |                                         | 13         | % |   |   | — |   |   |   | — |   |   |
| Customer C                         |       | SCMS        |       |                                         | 13         | % |   |   | — |   |   |   | — |   |   |
| Other                              |       |        |       |                                         | 11         | % |   |   | 1 | % |   |   | — |   |   |
|                               |       |        |       |                                         | 100        | % |   |   | 100 | % |   |   | 100 | % |   |

 

Revenueby geographic region is as follows: 
| ** **    | ** ** | **Year ended December 31,** | ** ** |
|---------------|------------|--------------------------------------------|------------|
| ** **    | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| United States |       | 100                                        | %          |   | 78 | % |   |   | 86 | % |   |
| Europe        |       | —                                     |       |   | 22 | % |   |   | 14 | % |   |

 

**Note 9.**                       Debt,Leases, Commitments and Contingencies

***Debt agreements*.  **InMarch 2002, we received a term loan of $3,010,000 from the Arizona StateCompensation Fund. Proceeds of this loan were applied to the purchase of a43,000 square foot manufacturing and administrative facility in Gilbert,Arizona. This five-year term loan bore interest at a fixed annual rate of 7.4%and was scheduled to mature in April 2007. In August 2004, theremaining $2,940,254 principal balance on this loan was refinanced with afive-year term loan which bears interest at a fixed annual rate of 6.5% andmatures in April 2009. Under terms of this new loan, payments of principaland interest totaling $19,105 are due monthly with a final principal payment of$2,737,228 due at maturity. This loan is secured by a deed of trust in theacquired real property.

Due to the acquisition of SCR-Tech in February 2004,long-term debt bearing an imputed interest rate of 6.3% was recorded consistingof $660,000 due in August 2005 and $882,000 due in February 2006. Inaddition, long-term debt bearing an imputed interest rate of 20% was recordedin the amount of $1,352,000 and payable between 2006 and 2016.

Pursuant to an April 2002 settlement agreementwith Woodward Governor Company (“WGC”), Catalytica Energy recorded two notespayable of $100,000 each. These notes are non-interest bearing and were paid infull in January 2003 and January 2004.

90

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**CATALYTICA ENERGY SYSTEMS, INC.  NOTES TO FINANCIAL STATEMENTS—(Continued)**

At December 31,2004, future payments under debt agreements are as follows over each of thenext five years and thereafter (in thousands):
| ** **       | **Year** | ** ** | ** ** | ** **                               | **Amount**                                                | ** ** | ** ** | ** ** |
|------------------|----------|------------|------------|------------------------------------------|-----------------------------------------------------------|------------|------------|------------|
|   2005 |     | $          | 778        |                                     |                                                      |       |
|   2006 |     | 1,358      |       |                                     |                                                      |
|   2007 |     | 430        |       |                                     |                                                      |
|   2008 |     | 551        |       |                                     |                                                      |
|   2009 |     | 3,248      |       |                                     |                                                      |
| Thereafter       |     | 3,319      |       |                                     |                                                      |
| Total            |     | 9,684      |       |                                     |                                                      |
|             |     | (3,501     | )          | Less  amounts representing interest      |                                                      |
|             |     | (748       | )          | Less  current portion                    |                                                      |
|             |     | 219        |       | Plus  other long-term accrued liabilites |                                                      |
|             |     | $          | 5,654      | ** **                               | **Total long-term debt and other long-term  liabilities** | ** ** |

 

***Operating leases*.  **CatalyticaEnergy leases its research and development facility, consisting of portions oftwo leased building covering approximately 32,500 square feet located inMountain View, California, under an operating lease agreement entered into April 2003which extended a lease agreement which expired on December 31, 2003. Theamended lease is effective January 1, 2004, for a term of two years, withtwo options to renew for two additional years each. We currently subleaseapproximately 6,300 square feet leased at this site. Through November 2004,Catalytica Energy leased a site from the City of Santa Clara, California, whichhoused a gas turbine used for field demonstrations of the Company’s Xonon CoolCombustion system. Additionally, Catalytica Energy leases copiers, manufacturingequipment and office equipment under various lease agreements which expirethrough 2008.

From October 2001 to March 2002, CatalyticaEnergy leased its manufacturing and administrative facility in Gilbert, Arizona.In March 2002, Catalytica Energy completed the purchase of this facilitywhich comprises 43,000 square feet for $4,097,000. In connection with thepurchase of this building, the lease agreement was cancelled and CatalyticaEnergy has no further lease obligation. The Company currently leases to tenantsapproximately 16,000 square feet of this facility.

The Company leases approximately 62,000 square feet ofoffice, production, laboratory and warehouse space in Charlotte, North Carolina.This lease expires on December 31, 2012, with two options to renew forfive years each.

At December 31,2004, future payments under all non-cancelable operating leases are as followsover each of the next five years and thereafter (in thousands):
| **Year**   | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------|------------|------------|------------|------------|------------|
| 2005       |       | $          | 318        |       |
| 2006       |       | 38         |       |
| 2007       |       | 34         |       |
| 2008       |       | 33         |       |
| 2009       |       | 32         |       |
| Thereafter |       | 102        |       |
|       |       | $          | 557        |       |

 

91

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**CATALYTICA ENERGY SYSTEMS, INC.  NOTES TO FINANCIAL STATEMENTS—(Continued)**

Rent expense consisting of building and equipment rentwas $412,000, $1,079,000 and $1,230,000 during the years ended December 31,2004, 2003, and 2002, respectively. Rental income from the various lease andsublease arrangements was $403,000, $1,233,000 and $1,201,000 during the yearsended December 31, 2004, 2003 and 2002, respectively.  Rental income from leases of Company-ownedfacilities is recorded as other income; rental income from subleases ofCompany-leased facilities is recorded as an offset to operating expenses. Rentexpense and rental income decreased significantly in 2004 due to thenegotiation of amended lease agreements with our landlord and the expiration ofa sublease agreement with one of our tenants.

Scheduledrental income as of December 31, 2004 under the various lease and subleasearrangements, which expire through December 31, 2007, is as follows (inthousands):
| **Year** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------|------------|------------|------------|------------|------------|
| 2005     |       | $          | 455        |       |
| 2006     |       | 191        |       |
| 2007     |       | 111        |       |
|     |       | $          | 757        |       |

 

***Commitments*.  **Wehave entered into research collaboration arrangements that may require us tomake future royalty payments. These payments would generally be due oncespecified milestones, such as the commencement of commercial sales of a productincorporating the funded technology, are achieved. Currently we have four sucharrangements, with Tanaka Kikinzoku Kogyo K.K. (“Tanaka”), Gas TechnologyInstitute (“GTI”) (formally known as Gas Research Institute), the CaliforniaEnergy Commission (“CEC”) and Woodward Governor Company (“WGC”).

A significant amount of the development effort relatedto our catalytic combustion technology for gas turbines was funded by Tanakaunder a January 1995 development agreement which divides commercializationrights to the technology between the parties along product market lines. Wehave exclusive rights to manufacture and market catalytic combustion systemsfor gas turbines of greater than 25 megawatt (“MW”) power output andnon-exclusive rights for gas turbines of 25 MW power output or less. Tanaka hasreciprocal exclusive rights to manufacture and market catalytic combustors foruse in automobiles and non-exclusive rights for gas turbines of 25 MW poweroutput or less. In each case, the manufacturing and marketing party will pay aroyalty of 5% of net sales to the other party. Each party is responsible forits own development expenses, and any invention made after May 1, 1995 isthe sole property of the party making the invention, while the other party hasa right to obtain a royalty-bearing, non-exclusive license to use the inventionin its areas of exclusivity. As commercialized, the Xonon system containssignificant technology developed by us after May 1, 1995 and no technologydeveloped by Tanaka after this date. Our development agreement with Tanakaexpires in 2005, and we have no further royalty obligations to Tanaka after2005.

In January 2000, we entered into a fundingarrangement with GTI to fund the development of our Xonon combustor anddemonstrate its performance. We will be required to make royalty payments toGTI of $243,000 per year for seven years beginning with the sale, lease orother transfer of the twenty-fifth catalyst module for gas turbines ratedgreater than 1 MW, up to a maximum of $1,701,000.

In September 1998, we entered into a fundingarrangement with the CEC under which they agreed to fund a portion of our Xononengine test and demonstration facility located in Santa Clara, California.Under this agreement, we are required to pay a royalty of up to 1.5% of thesales price on the sale of each 

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**CATALYTICA ENERGY SYSTEMS, INC.  NOTES TO FINANCIAL STATEMENTS—(Continued)**

product or right developedunder this project for fifteen years upon initiation of the first commercialsale of a Xonon-equipped engine greater than 1 MW.

On December 19, 2001, we entered into a ControlPatent Assignment and Cross License Agreement (“Patent Assignment Agreement”)with WGC pursuant to which WGC assigned a patent to us, and we and WGCcross-licensed certain intellectual property to each other. Under the PatentAssignment Agreement, we must pay WGC between $5,000 and $15,000 upon eachshipment of a Xonon commercial unit. Additionally, as part of an April 2002settlement agreement with WGC (the “Settlement Agreement”), we agreed toincrease royalties by $2,500 per unit on our shipment of the first 100 gasturbines greater than 10 MW. These increased royalties are guaranteed, and wemust pay them on 100 units even if we do not ship any units of this size. Weprepaid $50,000 of these royalties to WGC in April 2002. We paid WGC$100,000 in January 2003 and an additional $100,000 in January 2004. Theseguaranteed payments totaling $250,000 were recorded as a component of SG&Aexpenses during the three months ended March 2002 and are in addition tothe $5,000 we must pay to WGC under the Patent Assignment Agreement upon eachshipment of a Xonon commercial unit in a gas turbine of this size.

The Patent Assignment Agreement also provides thateach time we sublicense the WGC technology to a gas turbine manufacturer orthird party control manufacturer; we will pay WGC a control technology licensefee of $50,000, as well as a $3,000 additional license fee for each sale of aXonon control system sold by such manufacturer. As a part of the SettlementAgreement, we paid $200,000 in April 2002 representing a pre-payment ofthe control technology license fees for our first four $50,000 sublicenses ofthe WGC control technology. This payment was recorded as a component ofSG&A expenses in March 2002. We are obligated to make the foregoinglicense payments to WGC through December 31, 2014 or until our cumulativepayments and license fees to WGC total $15,250,000, whichever occurs first.

WGC must pay us a fee of1% of the sale price of each WGC control system installed in conjunction withXonon catalytic modules for new and retrofit turbines. WGC is obligated to makethese payments through December 31, 2014 or until we have received totalpayments of $2,000,000, whichever occurs first.

**Note 10.**                SegmentDisclosures

SFAS No. 131, “Disclosures about Segments of anEnterprise and Related Information”, requires disclosures of certaininformation regarding operating segments, products and services, geographicareas of operation and major customers. The method for determining whatinformation to report under SFAS No. 131 is based upon the “managementapproach,” or the way that management organizes the operating segments withinthe Company, for which separate financial information is available that isevaluated regularly by the Chief Operating Decision Maker (“CODM”) in decidinghow to allocate resources and in assessing performance. Our CODM is our ChiefExecutive Officer.

We have thefollowing two reportable operating segments:

·       Catalystregeneration, cleaning and management services for selective catalyticreduction systems used by utility-scale power generating facilities to reduceNOx emissions—our SCR Catalyst and Management Services segment (“SCMS”).

·       Designing,developing and manufacturing advanced products based on our proprietarycatalyst and fuel processing technologies to offer cost-effective solutions forreducing NOx emissions—our Catalyst-Based Technology Solutions segment (“CBTS”).

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**CATALYTICA ENERGY SYSTEMS, INC.  NOTES TO FINANCIAL STATEMENTS—(Continued)**

All intercompany transactions are eliminated inconsolidation and there are no differences between the accounting policies usedto measure profit and loss for our operating segments and on a consolidatedbasis. The Company evaluates performance of segments based on profit or lossfrom operations before interest and income taxes. Segment costs and expensesconsidered in deriving segment operating income include cost of revenues,depreciation and amortization, research and development, and selling, generaland administrative expenses. The Company does not allocate corporate generaland administrative expenses (“corporate SG&A”) on a segment basis forinternal management reporting; corporate SG&A is reported within the CBTSsegment. Financial performance of the segments is evaluated primarily onoperating income.

Major customers by segment are disclosed in Note 8. Goodwilland other intangible assets by segment is disclosed in Note 2.

As our SCMS segment evolved from the acquisition ofSCR-Tech on February 20, 2004, the SCMS segment information belowrepresents operating results for the period from February 21, 2004 throughDecember 31, 2004. As the Company operated as one segment prior to theacquisition of SCR-Tech, no prior year’s data is presented.

Thetable below presents information about our reportable operating segments as ofand for the year ended December 31, 2004 (in thousands):
| ** **                             | ** ** | **CBTS** | ** ** | **SCMS** | ** ** | **Consolidated** | ** ** |
|----------------------------------------|------------|----------|------------|----------|------------|------------------|------------|
| **Year  Ended December 31, 2004** |       |     |       |     |       |             |       |   |   |
| Total revenue                          |       | $        | 2,641      |     | $          | 2,960            |       |   | $ | 5,601 |   |   |
| Operating loss                         |       | $        | (13,275    | )        | $          | (188             | )          |   | $ | (13,463 | ) |   |
| Depreciation and amortization          |       | $        | 1,229      |     | $          | 344              |       |   | $ | 1,573 |   |   |
| Capital expenditures                   |       | $        | 407        |     | $          | 28               |       |   | $ | 435 |   |   |
| Total assets                           |       | $        | 43,115     |     | $          | 8,402            |       |   | $ | 51,517 |   |   |

 

**Note11.**                SelectedQuarterly Financial Data (Unaudited) (In thousands, except per share amounts)
| ** **                                  | ** ** | **First Quarter** | ** ** | **Second Quarter** | ** ** | **Third Quarter** | ** ** | **Fourth Quarter** | ** ** |
|---------------------------------------------|------------|------------------------|------------|-------------------------|------------|------------------------|------------|-------------------------|------------|
| ** **                                  | ** ** | **2004**               | ** ** | **2003**                | ** ** | **2004**               | ** ** | **2003**                | ** ** | **2004** | ** ** | **2003** | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenues                                    |       | $                      | 986        |                    | $          | 531                    |       | $                       | 1,100      |   | $ | 959 |   | $ | 1,942 |   | $ | 1,107 |   | $ | 1,573 |   | $ | 901 |   |
| Total expenses                              |       | 4,323                  |       | 5,256                   |       | 5,125                  |       | 4,577                   |       | 4,664 |   | 4,351 |   | 4,952 |   | 4,300 |   |
| Operating loss                              |       | $                      | (3,337     | )                       | $          | (4,725                 | )          | $                       | (4,025     | ) | $ | (3,618 | ) | $ | (2,722 | ) | $ | (3,244 | ) | $ | (3,379 | ) | $ | (3,399 | ) |
| Net loss                                    |       | $                      | (3,241     | )                       | $          | (4,555                 | )          | $                       | (4,004     | ) | $ | (3,480 | ) | $ | (2,696 | ) | $ | (3,116 | ) | $ | (3,328 | ) | $ | (3,248 | ) |
| Basic and diluted  net loss per  share |       | $                      | (0.18      | )                       | $          | (0.26                  | )          | $                       | (0.22      | ) | $ | (0.20 | ) | $ | (0.15 | ) | $ | (0.18 | ) | $ | (0.19 | ) | $ | (0.18 | ) |

 

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities andExchange Act of 1934, the Registrant has duly caused this Report to be signedon its behalf by the undersigned, thereunto duly authorized.
|                             | CATALYTICA ENERGY SYSTEMS,  INC. |
|-----------------------------|----------------------------------|
|                        | (Registrant)                     |
| Dated: March 30,  2005 | By:                              | /s/  MICHAEL J. MURRY |
|                        |                             | **Michael  J. Murry** |
|                        |                             | **President  and Chief Executive Officer** |

 

**POWER OF ATTORNEY**

KNOW ALL PERSONS BY THESE PRESENTS, that each personwhose signature appears below constitutes and appoints Michael J. Murry hisattorney-in-fact, for him in any and all capacities, to sign any amendments tothis Report on Form 10-K, and to file the same, with exhibits thereto andother documents in connection therewith, with the Securities and ExchangeCommission, hereby ratifying and confirming all that said attorney-in-fact, orhis substitute, may do or cause to be done by virtue hereof.

Pursuantto the requirements of the Securities Exchange Act of 1934, this Report hasbeen signed below by the following persons on behalf of the Registrant in thecapacities and on the date indicated.
|                               | **Signature** | ** **                                    | ** ** | ** **           | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|-------------------------------|---------------|-----------------------------------------------|------------|----------------------|-----------|------------|------------|------------|----------|------------|
| /s/  MICHAEL J. MURRY         |          | President, Chief  Executive Officer           |       | March 21,  2005 |
| **Michael  J. Murry**         |          | (Principal  Executive Officer) and Director   |       |                 |
| /s/  ROBERT W. ZACK           |          | Chief Financial Officer                       |       | March 21,  2005 |
| **Robert  W. Zack**           |          | (Principal  Accounting and Financial Officer) |       |                 |
| /s/  RICARDO B. LEVY          |          | Chairman of the Board                         |       | March 19,  2005 |
| **Ricardo  B. Levy**          |          |                                          |       |                 |
| /s/  RICHARD A. ABDOO         |          | Director                                      |       | March 22,  2005 |
| **Richard  A. Abdoo**         |          |                                          |       |                 |
| /s/  WILLIAM B. ELLIS         |          | Director                                      |       | March 20,  2005 |
| **William  B. Ellis**         |          |                                          |       |                 |
| /s/  HOWARD I. HOFFEN         |          | Director                                      |       | March 21,  2005 |
| **Howard  I. Hoffen**         |          |                                          |       |                 |
| /s/  DAVID F. MERRION         |          | Director                                      |       | March 24,  2005 |
| **David  F. Merrion**         |          |                                          |       |                 |
| /s/  FREDERICK M. O’SUCH |          | Director                                      |       | March 22,  2005 |
| **Frederick  M. O’Such** |          |                                          |       |                 |
| /s/  SUSAN F. TIERNEY         |          | Director                                      |       | March 22,  2005 |
| **Susan  F. Tierney**         |          |                                          |       |                 |
| /s/  JOHN A. URQUHART         |          | Director                                      |       | March 21,  2005 |
| **John A.  Urquhart**         |          |                                          |       |                 |

 

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