**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,DC  20549**

**FORM 10-K**

| **(Mark One)** |
|----------------|
| **x**          | **Annual Report Pursuant to Section 13 or  15(d) of the Securities Exchange Act of 1934 for the fiscal year ended  December 31, 2005** |
| ** **     | **or** |
| **o**          | **Transition Report Pursuant to Section 13 or  15(d) of the Securities Exchange Act of 1934 for the transition period from             to           .** |

 

**Commission File No. 000-31953**

**CATALYTICA ENERGY SYSTEMS, INC.**

(Exact name of Registrant as specified in its charter)

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

 

**1388 North TechBoulevardGilbert, Arizona 85233**(Addressof principal executive offices)

**(480) 556-5555**(Registrant’s telephone number, including area code)

**Securities registered pursuant to Section 12(b) of theAct: **None

Securities registered pursuant to Section 12(g) ofthe Act:  **CommonStock, $0.001 par value**(Title of Class)

Indicate by check mark if the Registrant is awell-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o   No x

Indicate by check mark if the Registrant is notrequired to file reports pursuant to Section 13 or Section 15(d) ofthe Act.  Yes o   No x

Indicate by check mark whether the Registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the Registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.  Yes x   No o

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not containedherein, and will not be contained, to the best of registrant’s knowledge, indefinitive proxy or information statements incorporated by reference in Part IIIof this Form 10-K or any amendment to this Form 10-K.  x

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer or a non-accelerated filer. (Seedefinition of accelerated filer and large accelerated filer in Rule 12b-2of the Exchange Act). Check one:

Large acceleratedfiler o    Accelerated filer o    Non-accelerated filer x

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act) Yes o   No x

As of June 30, 2005, 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 National Market on suchdate) was $13,792,654. 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.

As ofMarch 17, 2006, there were outstanding 18,162,272 shares of the Registrant’scommon stock, par value $0.001, which is the only class of common stock of theRegistrant registered under Section 12(g) of the Securities Act of 1933.

**Documents Incorporated byReference**

Portions of the Registrant’sproxy statement relating to the 2006 Annual Meeting of Stockholders, to befiled within 120 days of the end of the fiscal year ended December 31,2005, is incorporated by reference in Part III of this Form 10-Kto the extent stated herein.

 

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**CATALYTICA ENERGYSYSTEMS, INC.**

**Annual Report on Form 10-K**

**December 31,2005**

**Table of Contents**
|                   | ** ** | ** **                                                                                                                      | ** ** | ** ** | **Page No.** | ** ** | ** ** |
|-------------------|------------|---------------------------------------------------------------------------------------------------------------------------------|------------|------------|-------------------|------------|------------|
| **PART I**   |       |                                                                                                                            |
| Item 1.           |       | Business                                                                                                                        |       |       | 6                 |       |       |   |
| Item 1A.          |       | Risk  Factors                                                                                                                   |       |       | 20                |       |       |   |
| Item 1B.          |       | Unresolved Staff Comments                                                                                                       |       |       | 37                |       |       |   |
| Item 2.           |       | Properties                                                                                                                      |       |       | 37                |       |       |   |
| Item  3.          |       | Legal  Proceedings                                                                                                              |       |       | 37                |       |       |   |
| Item 4.           |       | Submission of Matters to a Vote of Security Holders                                                                             |       |       | 37                |       |       |   |
| **PART II**  |       |                                                                                                                            |
| Item 5.           |       | Market for the Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities          |       |       | 38                |       |       |   |
| Item 6.           |       | Selected Consolidated Financial Data                                                                                            |       |       | 40                |       |       |   |
| Item 7.           |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations       |       |       | 41                |       |       |   |
| Item 7A.          |       | Quantitative and Qualitative Disclosures about Market  Risk                                                                     |       |       | 54                |       |       |   |
| Item 8.           |       | Consolidated Financial Statements and Supplementary  Data                                                                       |       |       | 54                |       |       |   |
| Item 9.           |       | Changes in and Disagreements with Accountants on  Accounting and Financial Disclosure                  |       |       | 54                |       |       |   |
| Item 9A.          |       | Evaluation of Disclosure Controls and Procedures                                                                                |       |       | 55                |       |       |   |
| Item  9B.         |       | Other  Information                                                                                                              |       |       | 55                |       |       |   |
| **PART III** |       |                                                                                                                            |
| Item 10.          |       | Directors and Executive Officers of the Registrant                                                                              |       |       | 55                |       |       |   |
| Item 11.          |       | Executive Compensation                                                                                                          |       |       | 55                |       |       |   |
| Item 12.          |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters                                 |       |       | 56                |       |       |   |
| Item 13.          |       | Certain Relationships and Related Transactions                                                                                  |       |       | 56                |       |       |   |
| Item 14.          |       | Principal Accountant Fees and Services                                                                                          |       |       | 56                |       |       |   |
| **PART IV**  |       |                                                                                                                            |
| Item 15.          |       | Exhibits and Financial Statement Schedules                                                                                      |       |       | 57                |       |       |   |
|                   |            |                                                                                                                                 |            |            |                   |            |            |  |  |  |  |  |  |

 

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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 ourmarket opportunities and the growth of the market for our solutions, includingour consideration of alternatives such as exiting or selling any non-performingbusinesses*

*·**       our business strategies andplan of operations*

*·**       our aim to secure strategicpartnerships within the diesel industry to further develop and commercializeour XFPTM for new engine applications*

*·**       our competitive advantagein the marketplace*

*·**       the nature and level ofcompetition for our solutions*

*·**       the efficiency of oursolutions*

*·**       the cost-effectiveness ofour solutions*

*·**       our commitment to fundedresearch programs*

*·**       our intention to pursuecontinued development of our diesel genset solution only to the extent fundedby outside parties on terms that are financially acceptable to us*

*·**       the level of research anddevelopment by original equipment manufacturer (“OEM”) partners*

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

*·**       availability and expense ofresources and raw materials necessary for production and manufacturing*

*·**       the timing of our testingactivities, our development programs, and the commercialization of our products*

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

*·**       our ability to create anindustry standard associated with our solutions*

*·**       the value of ourintellectual property and effectiveness of our patent portfolio*

*·**       the ability of ourmanagement to adapt to changing circumstances*

*·**       our relations withemployees*

*·**       the cost of emissionstechnology and its effects*

*·**       statements regarding theeffect of ceasing development and commercialization of our Xonon Cool Combustionproduct for small gas turbines*

*·**       the applicability of oursolutions to different diesel engine applications*

*·**       statements regarding thesuccessful development and market potential of our diesel products*

*·**       statements regarding theeffect of discontinuing our diesel retrofit program*

*·**       the existing and proposedemissions restrictions on power generating sources and diesel engines used intransportation applications due to environmental concerns*

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*·**       statements regarding theuniqueness, potential and market for our SCR catalyst cleaning and regenerationservices*

*·**  our ability to manage SCR-Tech*

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

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

*·**       first-mover advantage forSCR-Tech*

*·**       our investment and focus inresearch and development efforts*

*·**       sources, amounts andvariability of our revenues and the timing of revenue recognition*

*·**       our use of earnings andpayment of cash dividends*

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

*·**       our anticipated total cashconsumption for the fiscal year ending December 31, 2006*

*·**       our belief that we havesufficient financial resources to fund our current business plans through December 31,2007*

*·**       our belief that EBITDAapproximates cash generated from our operations*

*·**       our expectations as to theallocation of capital resources*

*·**       our belief that we will nothave sufficient capital to achieve break-even operations if we continuedeveloping our diesel emission reduction solutions*

*·**       statements regarding ourfunding requirements and potential sources of funding*

*·**       statements regarding theeffect of funding and the level of funding of our business programs on our needfor additional capital and the timing of any such need*

*·**       predictions as to theamount and nature of anticipated losses and whether we will achieveprofitability*

*·**       our anticipated SG&Aand capital expenditures*

*·**       the impact of interestincome and expense*

*·**       predictions as to when wemay incur material income taxes*

*·**       critical accountingpolicies*

*·**       our intent to seekopportunities to consolidate our facilities*

*·**       our belief that our industryhas a significant amount of patent activity*

*·**       our expectations that theSarbanes-Oxley Act of 2002 and new rules subsequently implemented by theSecurities and Exchange Commission and NASDAQ will further increase our legaland financial compliance costs*

*·**       our belief that the leaseterms for SCR-Tech regeneration site are favorable*

*·**       our belief regarding theeffect of our dispute with Kawasaki*

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.”

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Although we believe that the expectations reflected inthe forward-looking statements are reasonable, we cannot guarantee futureresults, levels of activity, performance or achievements. We undertake noresponsibility to update any of these forward-looking statements or to conformthese statements to actual results.

“Xonon”, “Cool Combustion”, “Xonon Cool Combustion”,“Catalytica Energy Systems”, “XFP” and the stylized Catalytica logo are trademarksor registered trademarks of Catalytica Energy Systems, Inc.

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**PART I**

**Item1.**                        *BUSINESS*

**Overview**

CatalyticaEnergy Systems, Inc. (“Catalytica Energy,” the “Company,” “we,” “us” or “our”)was incorporated in Delaware in 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.

We******provideinnovative products and services to meet the growing demand for emissionscontrol solutions in the power generation and transportation industries. Ourbusiness is focused on the emissions control market, with a primary focus onnitrogen oxides (“NOx”). Increasingly stringent air quality regulations haveresulted in tighter emissions restrictions being imposed on a variety ofcombustion-related applications. NOx emissions, which are a precursor to smogformation, have become a key target of government-imposed emissionsregulations, creating a significant opportunity for innovative, cost-effectiveNOx control solutions.

Throughour SCR-Tech subsidiary, we offer a variety of services for coal-fired powerplants that use selective catalytic reduction (“SCR”) systems to reduce NOxemissions. These services include SCR catalyst management, cleaning andregeneration, as well as consulting services to help power plant operatorsoptimize efficiency and reduce overall NOx compliance costs (collectively “SCRCatalyst and Management Services”). Our business activities also include thedesign, development, manufacture and servicing of advanced products based on ourproprietary catalyst and fuel processing technologies to offer cost-effectivesolutions for reducing diesel engine emissions. Our Xonon® Diesel FuelProcessing technology is designed to facilitate a significant reduction in NOxand particulate matter (“PM”) emissions from mobile and stationary dieselengine applications by improving the performance of NOx adsorber catalystsystems and diesel particulate filters.

In September 2005,we discontinued development of our diesel retrofit product. In October 2005,we completed work on our Department of Energy-funded development of a compactfuel processor that sought to convert conventional fuels to hydrogen to powerproton exchange membrane fuel cells, and we are no longer conducting researchor development activities associated with fuel processing for fuel cellapplications. In February 2006, we announced that we are no longerconducting development or commercial activities associated with our Xonon CoolCombustion® product for gas turbines.

Weplan to continue evaluating our business in 2006 to identify opportunities tofurther streamline our operations and reduce overhead as we seek to enhance ourability to capitalize on the longer-term commercial prospects we anticipate forthe Company and maintain financial viability. The outcome of this evaluationcould include additional headcount reductions, discontinuing other businessactivities, downsizing our facilities, and other strategic initiatives to seekto realize value from our diverse asset and technology base and reduce cashconsumption.

We are currently conducting our business through thefollowing two business segments:

1.                Catalystregeneration, rejuvenation, cleaning and management services for SCR systemsused by coal-fired power generation facilities to reduce NOx emissions—our SCRCatalyst and Management Services (“SCMS”) segment; and

2.                Designing,developing and manufacturing advanced products based on our proprietarycatalyst and fuel processing technologies, primarily focused on cost-effectivesolutions for reducing emissions from diesel engine applications—ourCatalyst-Based Technology Solutions (“CBTS”) segment.

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**SCRCatalyst and Management Services**

In February 2004 we acquired SCR-Tech, LLC (“SCR-Tech”),the North American leader in catalyst regeneration technologies and managementservices for SCR systems used by coal-fired power plants to reduce NOxemissions. The addition of SCR-Tech strategically broadened and diversified ourproduct and service offerings to the growing emissions control market forcoal-fired power plants and has served to accelerate our penetration into theNOx control marketplace.

Our SCR-Tech subsidiary is based in Charlotte, NorthCarolina and offers catalyst regeneration, rejuvenation, and cleaning as wellas SCR catalyst management and consulting services, to help power plantoperators optimize their SCR system operation while reducing their overall NOxcompliance costs. SCR-Tech’s customer base includes some of the largestinvestor-owned utilities and independent power producers (“IPPs”) in the U.S.

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

SCR-Tech also provides awide variety of customized SCR catalyst management services,including catalyst inspection, performance testing and analysis, catalystspecification, and computer simulation to help power plantoperators improve their SCR system performance and achieve cost-effectiveNOx compliance.

***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 replenishment.Historically, the spent catalyst has been replaced with new catalyst, a costlyprocess. In the interest of lowering their operating and maintenance (“O&M”)costs while maintaining compliance with increasingly stringent NOx regulations,utilities and IPPs are seeking more cost-effective SCR catalyst managementsolutions.

NOx is considered to beone of the principal contributors to secondary, ground level ozone, or smog,and energy producers and other industries operating large power plants,particularly in the Eastern half of the U.S., have been required to reducetheir NOx emissions by at least 85% by 2007 as part of the EnvironmentalProtection Agency’s (“EPA”) NOx State Implementation Plan (“SIP”) Call. The NOxSIP Call has required major NOx reductions during the “ozone season” (May 1-September 30)in 19 Midwestern and Eastern states(1) andthe District of Columbia to mitigate the regional transport of ozone, which iscontributing to the poor air quality of downwind states. As a result, theseareas have been required to revise their SIPs, outlining measures to reduce NOxemissions to a statewide limit determined by the EPA for each affected state.As part of the NOx SIP Call, these areas were required to begin implementingnew controls by April 2004 to reduce NOx emissions in an effort to reachcompliance with EPA established limits by September 2007.

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(1)          Alabama, Connecticut,Delaware, Illinois, Indiana, Kentucky, Massachusetts, Maryland, Michigan, NorthCarolina, New Jersey, New York, Ohio, Pennsylvania, Rhode Island, SouthCarolina, Tennessee, Virginia and West Virginia.

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Coal-fired plantscurrently represent half of the nation’s power generating capacity, and arepoised to play an increasingly important role in the U.S. electricitygeneration market in the years ahead. According to the Annual Energy Outlookpublished by the Department of Energy (“DOE”) in February 2006, it isprojected that 174 gigawatts (“GW”) , equivalent to 174,000 megawatts (“MW”),of new coal-fired generating capacity will be added over the next 25 years tomeet baseload electricity demand, increasing coal’s share of the U.S. powermarket to 57% by 2030.

Coal-fired plants also continue to be a primary targetfor NOx reduction. With NOx removal efficiencies of up to 95%, SCR systems areconsidered to be the most effective and most widely used technology bycoal-fired power plant operators to comply with U.S. emissions regulations. Asa result, the installed base of SCR systems has increased dramatically inrecent years. According to The McIlvaine Company, more than 100 GW ofcoal-fired generating capacity in the Eastern U.S. is currently operating withSCR systems to comply with emissions regulations such as the EPA’s NOx SIP Call.This equates to approximately 150,000 cubic meters of installed SCR catalyst. Therecent growth in SCR system installations has resulted in a large and growingmarket for SCR catalyst management services. We expect this market to morefully develop in the 2006-2007 timeframe, and estimate the totalavailable market for SCR-Tech’s service offerings could reach approximately $50million during this period.

Adding to the near-term and long-term opportunitiesfor SCR catalyst services generated by the NOx SIP Call are new air qualityregulations soon to take effect that we expect will positively affect themarket for SCR catalyst services. For example, the EPA’s Clean Air Interstate Rule (“CAIR”)signed in March 2005 will require 28 states in the Eastern U.S. and theDistrict of Columbia to reduce NOx emissions by more than 60% from 2003 levelsby 2015. This rule builds on the NOx SIP Call and proposes to cut NOxemissions from power generating facilities by 1.7 million tons annually from2003 levels by 2009, and by 2.0 million tons annually from 2003 levels by 2015.The CAIR is expected to fuel additional SCR installations at coal-fired powerplants over the next decade. According to the DOE’s Annual Energy Outlook, 118GW of new SCR systems will be added to coal-fired power plants over the next 25years to maintain compliance with the CAIR, essentially doubling the installedcapacity today. In addition, it is expected that year-round SCR operation willalso be required to comply with the increasingly stringent CAIR NOxrequirements. Currently, to comply with the NOx SIP Call, the majority of SCRsystems are only required to operate during ozone season, or five months out ofthe year, when the potential for ozone formation is at its highest. Withyear-round operation to comply with the CAIR, the catalyst used in SCR systemswill either need to be replaced or regenerated on a much more frequent basis. Year-roundoperation alone is expected to increase the total addressable market forcatalyst replacement by 140%.

With the projections foradditional SCR installations combined with the prospects for year-round SCRoperation, we estimate the total available market for SCR-Tech’s serviceofferings could reach $150 million by 2010. By offering customers moreeconomical ways to operate and maintain their SCR units, along with a lowercost alternative to purchasing new catalyst, we believe SCR-Tech has thepotential to play a significant role in the growing market for SCR catalyst andmanagement services.

***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 restore the useful life of installed SCR catalyst,providing a compelling economic alternative to catalyst replacement.

SCR-Tech’sprocesses are capable of not only physically cleaning and rejuvenating the mostseverely plugged, blinded or poisoned catalyst, but of also chemicallyreactivating deactivated catalyst. Depending upon the state of the installedcatalyst, SCR-Tech offers several alternatives for restoring its NOx removalefficiency and extending its life.

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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’sregeneration facility. In this process, the customer removes the catalystmodules from the SCR unit and ships them to SCR-Tech. The cleaning processphysically removes the materials plugging the catalyst to improve its NOxremoval efficiency while the rejuvenation process removes catalyst poisons toextend its useful life. Once cleaned and rejuvenated, SCR-Tech returns thecatalyst modules to the customer for 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 may be considered hazardous waste.

SCR-Tech also provides a wide variety of customizedSCR catalyst management services to help power plantoperators improve their SCR system performance and achieve cost-effectiveNOx compliance. These services include catalyst specification, selection andinitial performance testing for guarantee verification, along with catalystinspection, testing, computer simulation and analysis. SCR-Tech also maintainsa stock of regenerated catalyst to provide emergency or spare layers ofcatalyst for its customers.

SCR-Tech’s cleaning,rejuvenation and regeneration services have represented, and are expected tocontinue to represent for the foreseeable future, along with the sale ofcleaned, rejuvenated or regenerated used or spent catalyst, the substantialmajority of SCR-Tech’s revenues.

***Customers***

Since commencing commercial operations in itsregeneration facility in March 2003, SCR-Tech has provided services forsome of the largest investor-owned utilities and IPPs, and their equipmentsuppliers, in the U.S. including AEP, AES, Alstom, Cogentrix, Detroit Edison,Dayton Power & Light, Duke Power, Englehard, First Energy, Mirant,National Energy & Gas Transmission, and Southern Company’ssubsidiaries, Alabama Power and Georgia Power.

In 2005, SCR-Tech took steps to build a strongerbusiness and better position itself to capitalize on the growing market for SCRcatalyst and management services. Under the direction of a new management team,SCR-Tech has made progress in strengthening its relationships within theutility industry, developing new sales channels, and increasing its marketpenetration. As a result of these efforts, our backlog for SCR Catalyst andManagement Services has grown from $235,000 at March 31, 2005 to more than$3.1 million at December 31, 2005. We define backlog as firm purchaseorders and deferred revenue expected to be recognized as revenue within 18months.

As part of an ongoinggrowth strategy, SCR-Tech continues to actively target SCR operators throughoutNorth America to further expand its customer base and broaden its reach in the marketplace.As of the date of this filing, SCR-Tech has secured new contracts totalingapproximately $2.3 million since 

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January 1,2006, for work to be performed in 2006 and 2007, and continues to pursue agrowing sales pipeline with active negotiations underway with several potentialnew customers.

***Research and Development Projects***

SCR-Tech endeavors to continue securing new alliancepartners as a source for future business, and to further expand its spectrum ofcost-effective environmental compliance solutions for SCR operators.

In the third quarter of 2005, SCR-Tech entered into adevelopment partnership and jointly funded project with AEP and SouthernCompany focused on evaluating and minimizing the amount of sulfur trioxide (“SO3”) produced as a byproduct ofoperating SCR systems, and the resulting sulfuric acid mist created in theatmosphere, which is both environmentally-damaging and costly to SCR operators.In addition to offering its customers a lower cost alternative to purchasingnew catalyst, SCR-Tech’s patented regeneration process has been demonstrated toreduce the conversion of sulfur dioxide (“SO2”) to SO3 when compared with the conversion ratetypically achieved by new catalyst.

Under the terms of the joint development initiative,the three companies have been working together to test and quantify the SO2 to SO3 conversion rates demonstrated by SCR catalystregenerated under a variety of conditions, and to benchmark the performance ofregenerated catalyst against new and deactivated catalyst. Results from theprogram, which is expected to be completed in the first half of 2006, will beused to ascertain the optimal balance between catalyst activity level and SO2 conversion specific to thevaried operating conditions of coal-fired boilers.

Data collected by SCR-Techis expected to be used to further tailor its catalyst regeneration process withthe objective of achieving maximum restoration of catalytic activity whileminimizing SO2 to SO3 conversion.

***Competition***

We expect SCR-Tech’s cleaning and rejuvenationprocesses to compete with alternate cleaning and rejuvenation processescurrently in the marketplace. We are aware of at least one company, Enerfab, Inc.,that offers an on-site SCR catalyst cleaning and washing process that requiresthe removal 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 Argillon, BASF / CERAM, Cormetech, HaldorTopsoe and Hitachi America. While we believe that SCR-Tech’s regenerationprocess offers a significant cost advantage over the purchase of replacementcatalyst and essentially eliminates both the cost and hazardous waste issuesassociated with disposing of spent catalyst, it is possible that thesecompanies and others could eventually develop a solution that may compete withours. Nonetheless, we believe the strength of SCR-Tech’s intellectual propertyand patent protection creates a significant barrier for new entrants to the market.In addition, we believe that our first mover advantage in the regenerationmarketplace will help us maintain our leading market position.

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**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, with a primary focustoday on developing emissions reduction solutions for diesel engineapplications.

***Industry Background***

In October 1997, the EPA adopted new NOx and PMemissions standards for heavy-duty diesel truck and bus engines to be phased inthrough 2010. The first phase of these stricter limits took effect inOctober 2002 when the requirements for NOx were reduced from 4.0 grams perbrake horsepower-hr (“g/bhp-hr”) to 2.5 g/bhp-hr. Non-compliance with theOctober 2002 deadline resulted in steep fines imposed by the EPA of asmuch as $12,000 per engine. The most stringent of the EPA’s new emissionsstandards requires a 90% reduction in PM beginning in 2007 to 0.01 g/bhp-hr,and a phased-in 50% NOx reduction by 2007 over the current standards, withanother 80% reduction by 2010, resulting in a 0.2 g/bhp-hr NOx limitby the end of the decade for all heavy-duty diesel trucks and buses. Theaggregate 90% reduction in NOx required by 2010, in particular, has created amajor technological hurdle for diesel engine OEMs for which a single technologypath has yet to be adopted. Lighter-duty applications in the U.S., includingheavy light-duty diesel trucks and passenger vans, are also facing tighter NOxemissions standards to be phased 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 implemented 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 global markets.

At the same time, stationary diesel engines in servicetoday are coming under increasingly intense scrutiny by government officials inan attempt to reduce urban smog in emissions-sensitive areas across thecountry. Stationary diesel engines used in both back-up and prime powerapplications currently face operating restrictions as a result of highemissions levels. If emissions can be brought into compliance, major utilities,municipal power producers and other end-users could benefit from extendedoperation and increased utilization of their diesel power generating units,even in the most stringent non-attainment areas. Reducing emissions could alsoresult in the creation of emissions credits and reduced electricity costs ifoperators were permitted to run these units during peak pricing periods. Withappropriate permitting, these units could be dispatched during peak demand toopen up a new option to relieve stress on constrained utility distributionsystems, provide grid support, and improve reliability. Another potential emissions control opportunity is diesel engines thatdrive agricultural water pumps. Due to significant air quality degradationcaused by many such pumps, particularly in the Central Valley of California,there is mounting political pressure to re-power the pumps with electric motorsusing grid electricity. However, this could push electricity demand beyondsupply during hot summer months. An economical diesel emissions reductionsolution could provide a new option for continued operation of these pumps.

New stationary diesel engines will soon face eventougher regulations. In 2000, the state of California passed Senate Bill 1298(“SB 1298”) requiring the California Air Resources Board (“CARB”) to set newemissions standards and provide guidance for the permitting of new electricalgeneration technologies less than 50 MW in size. The first phase of emissionslimits under the new CARB certification program and 

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guidance document tookeffect in January 2003, with even tighter limits scheduled to be imposedbeginning in January 2007.

Ona nationwide basis, the EPA announced in June 2005 plans to require stationary diesel enginesproduced from 2007 on to reduce emissions by as much as 90%, with the goal ofreducing more than 68,000 tons of pollution by 2015. The proposed rule, knownas New Source Performance Standards (“NSPS”), will impose regulations to reduceNOx, PM, sulfur dioxide, carbon monoxide and hydrocarbons from new, modifiedand reconstructed stationary diesel internal combustion engines. A final rulingis expected before July 2006.

***Market Opportunity***

Diesel engine manufacturers in the U.S. andinternationally continue to seek enabling solutions to meet increasinglystringent emissions standards. In 2005, approximately 1.2 million dieselengines were produced in North America for on-highway applications, includingmore than 500,000 heavy-duty diesel truck and bus engines. U.S. heavy dutydiesel engine manufacturers intend to pursue in-house engine modificationsbuilding upon those used in their 2002 compliant engines to meet the initial2007 step-down in NOx emissions requirements. They also plan to adopt dieselparticulate filters in 2007 to meet increasingly stringent PM standards.However, the most severe NOx reduction requirements, which will be phased intovarious segments of the U.S. heavy duty diesel (“HDD”) market between 2008 and2010, remain a difficult challenge that we believe will either require someform of advanced NOx after-treatment or significant advances in diesel enginetechnology. We are also exploring opportunities in markets outside of the U.S.,including Japan, which produces more than 700,000 diesel bus and truck enginesannually. Other global markets in Europe and Asia, which are considering morestringent emissions regulations similar to those being imposed in the U.S.,could offer promising additional markets for our emissions solutions inaddition to heavy light-duty diesel trucks and passenger vans in the U.S. andinternationally.

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, which 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 when the CARB emissions standards and the EPA’s NSPS are expected to bephased in.

***Diesel Emissions Reduction Applications Development***

We are leveraging our proprietary Xonon® catalysttechnology and our extensive work in gasoline and diesel fuel processing todevelop enabling emissions control technologies for a variety of diesel engineapplications, targeted at helping diesel engine manufacturers (“OEMs”), powerproducers, and other end-use customers meet stricter diesel emissionsrequirements in the U.S. and internationally.

We have developed a proprietary fuel processingtechnology that is designed to facilitate a significant reduction in NOx from dieselengine applications by enabling more effective regeneration of NOx adsorbersystems. We are also developing a thermal management system that is designed toimprove the performance and reduce the cost of diesel particulate filters usedto reduce PM emissions.

We aredeveloping our core Xonon® Diesel Fuel Processing technology for three marketapplications:

1.                Diesel OEM NOxreduction solution for new mobile engine applications

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2.                Diesel OEM PMreduction solution for new mobile engine applications

3.                Dieselgenerator set (“genset”) NOx reduction solution for stationary diesel engineapplications

***1.  ***Diesel OEM NOx ReductionSolution

We have developed and are now refining a proprietarydiesel fuel processing 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 XFPTM, technology is designed to enable agreater than 90% reduction in NOx by improving the performance of NOx adsorbercatalyst systems. NOx adsorbers, also referred to as NOx traps, represent oneof the approaches believed to have the greatest potential to meet the EPA’s2010 emissions mandate.

NOx adsorbers adsorb NOx from the diesel engineexhaust and convert the NOx to non-polluting nitrogen during a regenerationcycle. NOx adsorber technology today offers considerable NOx reductioncapabilities, but performance issues related to durability, operating range andfuel economy have limited their viability for some diesel engine applications.In most cases, diesel fuel injected at the engine or in the exhaust systemupstream of the NOx adsorber is used for the regeneration cycle. This processcan give good performance at high exhaust temperatures, but historically hasdemonstrated poor performance at lower exhaust temperatures. Low exhausttemperatures represent a large portion of vehicle operating time, particularlyfor medium and light duty diesel engine applications used in urban areas andfor automobiles, light trucks and SUVs.

Our XFP is designed to deliver rapid, low-temperatureNOx adsorber regeneration with improved fuel utilization and efficientdesulfation (elimination of sulfur within the NOx adsorber associated with thesulfur naturally occurring within diesel fuel) to significantly improve NOxadsorber performance and durability. We believe the combination of our XFP witha NOx adsorber can enable diesel OEM implementation of a durable, economical,reasonably sized NOx reduction solution that complies with the most stringentemissions requirements with minimal fuel penalty.

Since 2003, we have been conducting numerous test activitiesand demonstration projects with leading diesel industry companies evaluatingthe potential of our XFP technology to offer a robust, cost-effective, andfuel-efficient NOx reduction solution to meet impending diesel emissionsmandates. Full-scale tests of our prototype XFP on heavy-duty diesel engineshave successfully demonstrated the highly efficient, rapid regenerationcapabilities of our technology and its potential to significantly improve theperformance of NOx adsorbers, particularly at low engine exhaust temperatures. Inaddition to achieving NOx reduction in excess of 90% over a broad range ofoperating conditions with a total fuel system usage of less than 3%, our XFPhas demonstrated full regeneration of a sulfur-poisoned NOx adsorber catalyst,a critical requirement to enable operation of NOx adsorber systems, even withthe ultra-low sulfur diesel (“ULSD”) fuel mandated in the U.S. for 2007 andbeyond. Based on the results of our test activities, we believe that our XFPtechnology could bring added flexibility for OEM NOx adsorber regeneration anddesulfation strategies to accommodate the wide variety of NOx adsorber systemdesigns currently being pursued.

Our ongoing test activities and demonstration projectshave provided us with valuable data that we have been using to further developand refine our technology with the objective of solidifying the valueproposition we believe could be offered by our XFP. In this regard, we areworking to enhance the operating range and fuel economy performance of NOxadsorber systems, demonstrate the ability of our XFP to meet the 450,000-miledurability requirement for heavy-duty diesel trucks, and facilitate desulfationof the NOx adsorber catalyst at lower temperatures, thus providing increasedNOx adsorber durability. According to the EPA, improving the durability of NOxadsorbers, especially as it relates to desulfation, remains a fundamentalhurdle to commercial NOx adsorber deployment in HDD applications.

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Following the successful results of various testactivities and demonstration projects during2005, our XFP technology advanced from the research center to theproduct development group of a prospective commercial partner during the first quarter of 2006. Anumber of follow-on test activities with this diesel industry company are planned throughout 2006 with the objective of furtherevaluating the potential for commercializing an end product.

Inaddition, demonstration projects continue to be underway with other leading****diesel industry companies as well aswith a government agency also evaluating the environmental and economicbenefits of our technology and its prospects for meeting impending dieselemissions regulations. We have designed test activities in 2006 with these prospective partners to furthervalidate the benefits of pairing our XFP with NOx adsorber systems from a total system cost, fuelefficiency, and durability perspective.

***2.***   Diesel OEM PM Reduction Solution

We have developed and are now testing a derivative ofour XFP technology, which is designed to enable superior regeneration of dieselparticulate filters for new diesel engine applications. The adoption of dieselparticulate filters for the mass diesel market has already begun. Dieselparticulate filters, also referred to as DPF or PM filters, were mandated onall heavy-duty 2005 model year vehicles in Japan to control PM emissions, andare expected to be introduced on European trucks and buses in 2008 and ondiesel passenger cars in 2010 to comply with Euro V emissions standards. Dieselparticulate filters will also be widely adopted in the U.S. market forheavy-duty diesel engine applications in 2007 to comply with the EPA emissionsmandate. It is also expected that light-duty diesel vehicles under the U.S. EPATier 2 mandate will have PM filters installed between 2007 and 2009. As aresult, the PM market represents a substantial potential upside opportunity forus.

Diesel particulate filters trap PM from the dieselengine exhaust. The trapped PM is then converted to non-polluting gaseousbyproducts during a regeneration cycle. Diesel particulate filters offerconsiderable PM reduction capabilities, but low exhaust temperatures during alarge portion of a vehicle’s operating cycle do not allow for complete andcontinuous regeneration of the diesel particulate filter using current passivemethods, raising the potential for performance and durability issues. To combatthis problem, greater precious metal content has been added to dieselparticulate filters to more effectively oxidize the PM throughout the dutycycle of the engine.

We have developed an active diesel particulate filterregeneration technology in which diesel fuel is oxidized in the presence of aproprietary catalyst system, providing for more controlled, complete andcontinuous regeneration of diesel particulate filters. In addition to offeringmore efficient regeneration throughout the entire duty cycle of the engine,including at low engine exhaust temperatures, our Xonon fuel combustor, or XFC,technology is designed to allow for the elimination or reduction in preciousmetal loading and the use of lower cost substrate materials, offering thepotential for a lower cost PM solution.

Test activities areunderway with a leading diesel industry after-treatment system supplier who isevaluating the potential of our XFC to offer a more efficient andcost-effective commercial alternative to current passive PM filter regenerationmethods.

***3.***   Diesel Genset Solution

We have completed preliminary development work andtest activities to determine the potential of our core diesel fuel processingtechnology to offer a cost-effective, bolt-on solution that enables both newand installed stationary diesel generators to significantly reduce NOxemissions.

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 

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Company, Inc. (“HECO”),for the Phase I development of a greater than 90% NOx reduction system forstationary diesel engines.

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 and retrofitapplications. This first phase culminated in a 100-hour engine test ofour fuel processor-driven NOx adsorber catalyst system, which successfullydemonstrated a greater than 90% reduction in NOx while operating on afull-scale 8.3 liter diesel generator set rated at 160 kW.

Following our initial development work and testactivities, we have continued to pursue additional funding opportunities forfurther development of the technology and field demonstrations to verify systemperformance in a commercial setting. Due to a lack of funding commitments, wedid not conduct significant development work associated with our diesel gensetsolution in 2005.

We are continuing toassess the available funding, market opportunities, and commercial prospectsfor the technology. The outcome of this ongoing evaluation will determine thepotential for continued development of a diesel genset solution.

***Development and Commercialization Partnerships***

We are focused on bringing the benefits of our Xonon®Diesel Fuel Processing solutions to the growing diesel emissions reductionmarket by partnering with diesel engine OEMs, Tier 1 catalyst providers (directsuppliers to OEMs), system integrators, after-treatment system developers, andother leading companies within the diesel industry. In line with thisobjective, we continue to build on the positive results of our ongoing testactivities to further optimize our XFP technology with the goal of offering ahigh performing NOx reduction alternative to diesel engine OEMs for theirdiesel engine products**,**and ultimately a cost-effective product to the end use customer.

To gain market share and penetrate new markets whilemaintaining compliance with new emissions standards, OEMs and diesel industrysuppliers seek to differentiate their products with technological advances thatbenefit their customers. We believe that the combination of our technology withthird party NOx adsorbers and diesel particulate filters has the potential tooffer a cost-effective emissions reduction solution with minimal fuel penaltyto enhance an OEM’s product line and offer significant competitive advantages. Accordingly,we have taken an active role over the past three years in establishing andbuilding relationships within the diesel industry, both in the U.S. andinternationally, in line with our objective to secure partners to furtherdevelop and commercialize our XFP for new mobile engine applications.

Establishing solid strategic partnerships within thediesel industry is a critical component of our business strategy to advance thecommercial prospects for our diesel emissions reduction solutions. We recognizethat we do not have the financial resources, the market channels or therequired experience to commercialize on our own an emissions control productfor the diesel industry. While we continue to be in discussions with a numberof companies within the diesel industry relating to joint development andcommercialization opportunities in North America and Asia, as of the date ofthis filing we have not secured such a strategic arrangement.

One of our most important objectives in 2006 is tosecure product development commitments and commercial market channels for ourdiesel emissions reduction products. We believe that positive results fromnumerous follow-on test activities planned throughout the coming year couldfurther substantiate the value proposition associated with our emissionscontrol solutions and better position us to achieve this key objective.

We view 2006 as a pivotalyear for us in our efforts to secure strategic partnerships and outside fundingcommitments, particularly with respect to our diesel OEM NOx reductionsolution, as we expect 

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selectionsmust soon be made regarding technologies that will be pursued for meeting theJapanese and U.S. emissions mandates that will take effect in 2009 and 2010,respectively. Additionally, we continue to be focused on reducing our costs andextending our cash reserves. As such, if we are unable to secure strategicpartnerships and significant outside funding commitments in 2006, we willconsider significantly downsizing our diesel emissions reduction business,including the potential for discontinuing certain or all of our developmentefforts associated with this business. As a result, in addition to continuing testactivities and demonstration projects throughout 2006 with diesel industrycompanies, we are concurrently seeking other opportunities to increase theoverall value of our diesel emissions reduction business and are exploringstrategic alternatives for this business.

***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 building upon this technology tomeet the next phase of U.S. emissions requirements that will take effect in2007. However, diesel OEMs have indicated that some form of NOx after-treatmentalong with further engine modifications will be required to achieve the 2010U.S. mandated 90% reduction in NOx.

To meet the 2010 EPA mandate, the after-treatmentsolutions considered to have the greatest potential to meet the 0.2 g/bhp-hrtarget are NOx adsorbers and SCR systems. With respect to SCR systems there aresome significant downsides associated with their use in mobile diesels, whichhave created concerns over their widespread use. SCR requires ammonia in ureaform to neutralize NOx in the exhaust, raising environmental concerns andrequiring the creation of an infrastructure to house urea or ammonia tanks atfilling stations across the country as well as associated compliance issueswhen tanks run dry. It has also not yet been proven that SCR can achieve agreater than 90% NOx reduction without combining it with some form of EGR. Nonetheless,SCR has been implemented by many European diesel engine OEMs for heavy-dutydiesel engine applications in Europe to meet the Euro IV emissions standards,which took effect in October 2005.

Unlike ammonia-based SCR systems, NOx adsorbers usediesel fuel in the NOx reduction process, eliminating the need for a costly newinfrastructure and mitigating the risk of non-compliance by vehicle operators.We believe that through the use of our XFP technology in combination with a NOxadsorber, we can enable a robust, cost-effective and practical commercialsolution to meet the most stringent NOx requirements in the U.S. and selectglobal markets. Accordingly, a growing number of diesel OEMs continue toinquire about our ability to support their next phase of emissions controlneeds as NOx adsorbers remain a favored technology path to comply withstringent environmental standards.

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 

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that are separatelypursuing the development of a diesel fuel processing technology that isdesigned to work in conjunction with a lean NOx adsorber to enable emissionsreduction in line with the 2010 EPA mandate.

For stationary dieselengine applications, the only available alternative today for reducingemissions to the most stringent required limits is through the addition of anSCR system, which we believe can be costly for small diesel generator sets. Ourtechnology, 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. Inaddition, our system is being designed for easy integration with a DPF to offerend-use customers a combined solution for the reduction of both NOx andparticulate matter.

***Customers***

The substantial majorityof our 2005 revenues in our CBTS segment were derived from a single contractwith the DOE associated with a development program initiated in October 2001relating to the development of a compact fuel processor that could convertconventional fuels, such as gasoline, to hydrogen to power proton exchangemembrane (“PEM”) fuel cells, with applications in automotive, stationary,auxiliary and back-up power. We completed in October 2005 all workrequired under the terms of this contract and do not anticipate recognizingadditional revenues or funding relating to these efforts in 2006 or any futureperiod.

***Manufacturing***

In October 2002, we brought on-line a commercialmanufacturing facility in our Gilbert, Arizona location, which has been used tomanufacture both prototype and production Xonon modules for gas turbineapplications as well as prototypes of our diesel emissions reduction solutions.We anticipate selling this facility and terminating our manufacturingcapabilities in Gilbert. We also have manufacturing capability in our MountainView, California facility, which has been used primarily for new processdevelopment and for the manufacture of prototypes as part of our ongoingresearch, development and test activities. As part of this capability, we havebeen manufacturing prototypes of our diesel emissions control systems inMountain View and are currently developing high volume manufacturing processesto enable outsourcing future commercial production of certain components toallow for more cost-effective diesel emissions reduction solutions using ourtechnology.

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 ISO 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 Product DevelopmentSystem and Manufacturing Control, further demonstrating our commitment to highquality standards and customer satisfaction. In 2004, we successfully completedsubsequent ISO 9001 follow-up audits and received commendations for ourexemplary resource management process. We continue to maintain a quality systemthat meets the requirements of the ISO 9001:2000 standards.

**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 oracquired by us in order to protect it in a timely and effective manner, and tocontinually use such intellectual 

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property to ourcompetitive advantage in the NOx control marketplace. An objective of ourintellectual property strategy is to enable us to be first to market withproprietary technology and to sustain a long-term technological lead in themarket. We use a combination of patents, trade secrets, contracts, copyrightsand trademarks to protect the proprietary aspects of our core technologies,including system design, control systems, manufacturing processes and otherknow-how, and we work to actively maintain protection of our proprietarytechnologies and processes over time through follow-on patent filingsassociated with technology and process improvements that we continually develop.As of the date of this filing, we either owned (exclusively or jointly), heldexclusive license rights from third parties for, or held license rights fromaffiliates for 29 U.S. patents and 19 pending U.S. applications and theinternational counterparts associated with some of them. We anticipate thatwhen our early patents expire, we will rely on subsequently filed andadditional patents along with trade secrets and other know-how to protect thefoundation 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. Weplan to 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.

**RestructuringActivities and Recent Developments**

We are committed to balancing successful execution onour long-term business goals and growth objectives with prudent capitalmanagement. Accordingly, we regularly evaluate the status of our research anddevelopment activities, product and service offerings and associated marketopportunities, and consider sales or discontinuation of businesses or productor service offerings, as well as strategic activities or opportunities,including business mergers, acquisitions or other strategic transactions, thatcould positively impact shareholder value.

Followinga thorough review of our business in 2005, we initiated, in September,restructuring and cost-reduction activities designed to improve our financialperformance, extend our cash reserves, and better position the Company toachieve our commercial goals and growth objectives. To this end, we tookactions during the third and fourth quarters to streamline our operations andachieve a significant reduction in cash consumption by:

1.                Discontinuingcertain business activities,

2.                Reducing ourworkforce, and

3.                Reallocating ourresources with a focus on core products and markets that we believe offer thegreatest return on investment.

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As part of our restructuring activities, wediscontinued development of our diesel retrofit product during the month of September inlight of anticipated product verification delays, estimated incremental costsrequired to commercialize a product, the limited timeframe available to takeadvantage of the retrofit market, and an internal shift in product developmentpriorities. We completed our exit from the diesel retrofit business during thefourth quarter of 2005.

We also initiated a workforce reduction program, whichresulted in the elimination of 26 positions, or approximately 35% of ourfull-time staff, between September and December 2005.

In October 2005, we completed work on a$11,658,000 DOE cost-shared contract initiated in October 2001 associatedwith the development of a compact fuel processor that could convertconventional fuels, such as gasoline, to hydrogen to power proton exchangemembrane (“PEM”) fuel cells, with applications in automotive, stationary,auxiliary and back-up power. Due to a lack of continued funding or partnercommitments, and our efforts to rationalize our ongoing operations, we are nolonger conducting research or development activities associated with fuelprocessing for fuel cell applications.

In line with our ongoing focus on value creation andsustainability, we plan to continue evaluating our business in 2006 to identifyopportunities to further streamline our operations and reduce overhead toenhance our ability to seek to capitalize on the longer-term commercialprospects we anticipate for the Company and to maintain financial viability.The outcome of this evaluation could include some additional headcountreductions, discontinuing other business activities, downsizing our facilities,and other strategic initiatives to seek to realize increased value from our diverseasset and technology base and reduce cash consumption.

For example, we are currently marketing our Gilbert,Arizona facility and are evaluating the potential for consolidating facilitiesor seeking a smaller Arizona facility more suitable to our downsizedoperations.

Additionally, in February 2006,we announced that we are no longer conducting development or commercialactivities associated with our Xonon Cool Combustion® product for gas turbines.This decision was the result of a number of factors, including:

1.                Ongoingunfavorable gas turbine market conditions;

2.                Our termination inDecember 2005 of the Xonon® Module Supply Agreement with Kawasaki, havingdetermined there was no business or financial justification to continue theagreement under its existing terms;

3.                An internal shiftin our research and development priorities to products and markets that webelieve yield greater promise; and

4.                GE’s decision tono longer fund the commercial development of a GE10 gas turbine using our Xonontechnology.

On March 13, 2006, we entered into a TerminationAgreement with GE, formally terminating our agreement with GE. We plan tocontinue exploring various strategic alternatives for our gas turbine business.

In other recentdevelopments, we announced on February 13, 2006 that our President and CEORob Zack was appointed to the Company’s Board of Directors, and that Fred O’Suchand Jack Urquhart, both independent directors, will retire from their positionson the Board. Rob Zack assumed his new role as director effective upon the dateof this announcement, and the retirement of Fred O’Such and Jack Urquhart willbecome effective as of the Company’s 2006 Annual Meeting of Stockholders.

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**Human Resources**

As of December 31,2005, we employed 49 persons. Between September and December 2005, weeliminated 26 positions, or approximately 35% of our full-time staff, as partof a restructuring plan to streamline our operations and reduce our costs. Noneof our employees are represented by a labor union. We believe our relationswith our employees are good.

**AvailableInformation**

The Company’s AnnualReport on Form 10-K, Quarterly Reports on Form 10-Q andCurrent Reports on Form 8-K, including any amendments filed orfurnished pursuant to Section 13(a) or 15(d) of the ExchangeAct, will be made available free of charge on or through the Company’s website,*www.catalyticaenergy.com*, as soonas reasonably practicable following the filing of the reports with theSecurities and Exchange Commission. The contents of our website are not, andshall not be deemed to be, incorporated into this report.

**Item 1A.****                *RISK FACTORS***

**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 may neverachieve profitability.**

We incurred losses of $13,466,000, $13,269,000 and$14,399,000 for the years ended December 31, 2005, 2004 and 2003,respectively. As of December 31, 2005, we had an accumulated deficit of$138,483,000 and had not yet recorded significant revenues from commercialsales apart from revenues contributed by SCR-Tech, a business we acquired in2004. Unless we significantly curtail or successfully secure third-partyfunding for our diesel emissions solutions development activities, we expect tocontinue to incur net losses for the foreseeable future and these losses arelikely to be significant.

We exited our mobilediesel retrofit program in September 2005 and we recently decided to nolonger pursue any further development or commercialization activitiesassociated with our Xonon Cool Combustion product for small gas turbines aftera decade of development work and expense in this business. We incurredsignificant losses in both businesses. There can be no assurance that ourremaining active development activities will be successful or that our SCR Catalystand Management Services business will be profitable. Further, there can be noassurance that Catalytica Energy will ever reach or sustain profitability.

**Wemay need significant additional capital to operate our business or achieveprofitability, and we may be unable to raise additional capital.**

In general, our currentand near-term capital requirements depend on numerous factors, including butnot limited to our product development and commercialization activities, thetiming and level of third-

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partyresearch and development funding, market acceptance of our products and ourrate of sales growth. We face substantial uncertainties with respect to ourbusiness operations and we may not be able to achieve positive cash flow fromour operations. Our current operating plans through fiscal 2006 are continuallyunder review and may or may not include further developing our diesel emissionsreduction solutions and expanding our SCR Catalyst and Management Servicesbusiness.

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 such partners,the ability of third party suppliers to develop certain components in a timelymanner, market and industry demands and requirements, and the cost of requiredregulatory reviews and approvals. Further, our selling, general andadministrative (“SG&A”) expenses have been in excess of $6 million peryear, and, although reduced as part of our 2005 restructuring activities, areexpected to continue to be significant under our current business strategy. Thus,any delay in product development or commercial product launches will result inus continuing to incur significant SG&A expenses without correspondingrevenues.

We believe that our available cash, cash equivalentsand short-term investments (collectively “Cash”) in the amount of $21.3 millionas of December 31, 2005 will provide sufficient capital to fund operationsas currently conducted until at least December 31, 2007. However, if ouroverall Cash usage in 2006 or 2007 exceeds our current expectations because ofhigher capital expenditures, increased costs of development orcommercialization, lower than anticipated revenues from SCR-Tech, lowergovernment and third-party funding, higher SG&A expenditures or for anyother reason, we may be required to raise additional funds to continue ouroperations as presently planned, significantly curtail our business operationsand/or change our strategic direction. In particular, we currently estimatethat the total remaining development costs for continuing to pursue our dieselOEM NOx and PM solutions for new, over-the-road diesel engines will be inexcess of $10 million, and potentially substantially in excess of such sum. Ourbelief that we have sufficient funds through December 31, 2007, issignificantly dependent on these costs not materially exceeding $10 millionduring this period. In addition, we may enter into mergers, acquisitions orother strategic arrangements which could require the use of cash, reducing ouravailable capital prior to December 31, 2007, or which could requireadditional equity or debt financing. Moreover, the integration and operation ofany business acquired could require significant expenditures that couldmaterially and adversely impact our liquidity and capital resources. In thisregard, our 2004 acquisition of SCR-Tech required significant cash outlays foracquisition-related payments and may potentially require future cash outlays tofund 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 31,2007, our cash requirements will depend on many factors, including but notlimited to the market acceptance of our products, the ability of our dieselemissions reduction products to achieve market acceptance and commitments fromsignificant industry participants, the timing and level of development fundingfrom private and government sources, the ability of SCR-Tech to generatesignificant 

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cashflow, 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.

**Risk of changes in governmentregulation.**

Our business issignificantly dependent on the nature and level of government regulation ofemissions. Without government regulation of coal-fired power generation, SCRcatalyst would not be used by utilities, there would be no need for utilitiesto acquire, clean or regenerate SCR catalyst, and SCR-Tech would have nobusiness purpose. Further, changes in or adverse interpretations ofgovernmental accounting or rate-based emissions regulations also could have amaterial adverse effect on our business. Without government regulation ofdiesel emissions, there would be no demand for our potential diesel emissionsreduction products. Further, the level of this regulation will determine therequired level of emission solutions required, and the rate of increase, ifany, in regulation, will determine the potential growth in our target markets. Additionally,without the continued support of federal government agencies, such as the EPA,for the technology approach we are pursuing to reduce NOx emissions from mobilediesel engine applications, competing technology approaches could gain momentumin the U.S. marketplace as the technology path that will be pursued for meetingthe 2010 emissions mandate. Although government regulation of emissions hasbecome increasingly stringent in recent years, the growing costs associatedwith such regulations may limit the level of increase and scope of emissionsrequirements, which could limit the potential growth of our target markets. Anyeasing of governmental emissions requirements or the growth rate of suchrequirements could have a material adverse effect on our business.

**Our acquisition ofSCR-Tech and any significant transaction we may undertake could disrupt ourbusiness and harm our financial condition.**

We regularlyevaluate the status of our research and development activities, product andservice offerings and associated market opportunities, and consider sales ordiscontinuation of businesses or product or service offerings, as well asstrategic activities or opportunities, including business acquisitions or otherstrategic transactions that could positively impact shareholder value. We havelimited experience in these types of transactions. We acquired SCR-Tech in February 2004,and there 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 transactions,including mergers, acquisitions or similar transactions, entail a number ofrisks that could materially and adversely affect our business and operatingresults, including but not limited to:

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

·       changesin control or management;

·       dilutionof existing stockholders;

·       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

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·       the potential forwrite-offs of goodwill and other acquired intangibles.

**Themarket price of our common stock is highly volatile, has significantly declinedand may decline further. Our common stock could be de-listed by NASDAQ.**

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:

·       thenature, amounts and trends with respect to our net losses and cash consumption;

·       theamount of our capital resources and our potential need to seek additionalfunding;

·       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 or mergers, strategic partnerships, divestitures,joint ventures or other strategic initiatives;

·       changes in environmentalregulations; 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. Thesebroad market fluctuations may adversely affect the market price of our commonstock.

We expect ourrevenues and operating results to vary significantly from quarter to quarter.As a result, quarterly comparisons of our financial results are not necessarilymeaningful and investors should not rely on them as an indication of our futureperformance. In addition, due to our stage of development, we cannot predictour future revenues 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 manufacturingcapabilities;

·       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;

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

·       Governmentregulations.

Our stock has traded below$1 in the recent past. If the price of our common stock declines and remainsbelow $1 for 30 consecutive trading days, our common stock will be subject tode-listing by NASDAQ. In such event, if we are unable to regain compliancewithin a period of time specified by NASDAQ, our common stock could be moved tothe OTC Bulletin Board, and the liquidity and value of our common stock likelywould be negatively impacted.

**Wemay have difficulty managing our current operations in light of recentmanagement changes.**

Currently our managementteam is responsible for the operations of our recently acquired SCR-Techbusiness, our diesel programs, exploring and evaluating potential acquisitionsor divestitures and other strategic opportunities and other programs. In lightof employee headcount reductions over the past few years, including managementlevel employees, and the increasing number of Federal and NASDAQ securitiesregulatory requirements, substantial additional burdens have been placed on ourmanagement. Our former President and CEO Mike Murry resigned from his positionwith the Company effective June 30, 2005. Subsequent to Mr. Murry’sdeparture, Robert Zack, our CFO, was appointed President and CEO. Although ourBoard of Directors has formed a special committee to assist Mr. Zack withhis expanded duties, this departure has further strained our managementresources and required management and certain employees to assume additionalduties. Further, if Mr. Zack were to depart, we would be required to findboth a CEO and CFO to assume his duties. It may prove difficult for currentmanagement to successfully operate these differing areas and meet the demandsand requirements of our diverse business activities. In addition, our formerSenior Vice President of Business Development, Dominic Geraghty, ceasedemployment with us in September 2005. Management changes at SCR-Tech inearly 2005 also have required increased management attention to SCR-Tech’sbusiness. No assurance can be given that management resources will besufficient to address current and future business activities or that we willnot be required to incur substantial additional expenses to add to ourmanagement 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. To date, we only have limitedexperience marketing, selling and servicing our Xonon Cool Combustion systems,and we have recently ceased development and commercialization activitiesassociated with this system and experienced significant financial losses. Further,we have no experience marketing, selling or servicing our diesel emissionsreduction systems. We will have to expand our marketing and sales organization,as well as our maintenance and support capability as our products becomecommercially available. We may not be successful in our efforts to market andservice our products, which could compromise our ability to increase ourrevenues.

**If weare unable to attract or retain key personnel, our ability to adapt ourtechnology to diesel engines or other products, to continue to develop andcommercialize our technology, to effectively market our products and to manageour 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. We 

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haveexperienced the departure of key personnel over the past few years, includingthe departure of our former President and CEO Mike Murry in June 2005. Inaddition, our continuing losses make it more difficult to attract and retainkey personnel.

**Certainof our processing and manufacturing equipment is unique to our business andwould be difficult and 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 rhodium,palladium, platinum, molybdenum and vanadium, all of which are used in variouscomponents or our business, can be volatile. If the long-term costs of thesematerials were to increase significantly, we would attempt to reduce materialusage or find substitute materials. If these efforts were not successful or ifthese cost increases could not be reflected in our price to customers, then ourgross margins and profitability would be reduced.

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

Since our business relatesto NOx and related emissions controls, solutions and services, we are subjectto significant potential environmental and product liability risks. Theseinclude risks relating to the chemicals and other materials used to manufactureour products and provide our services; risks relating to hazardous waste andhazardous waste disposal; potential environmental damage caused in themanufacture, sale, distribution or operation of our products and servicesrelating thereto; employee and third party injuries from the manufacture, sale,distribution or operation of our products and services relating thereto,including claims by our customers and their end users, including in certaincases, consumers; the inability of our products to meet environmental or otherstandards imposed by federal, state or local law or by our customers; and otherclaims relating to our products and services. Because of our very limitedexperience and the limited distribution of our products and services, we do nothave any experience with the nature or type of claims which may arise from ourbusiness. Only limited insurance is available for environmental and productliability claims, and any such claims could have an adverse impact on ourbusiness and financial condition. This could be the case even if we ultimatelyhad no liability 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.

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

Our business operations are subject to potentialenvironmental, product liability, employee and other risks. Although we haveinsurance to cover some of these risks, the amount of this insurance is limitedand includes numerous exceptions and limitations to coverage. Further, noinsurance is available to cover certain types of risks, such as acts of god,war, terrorism, major economic and business disruptions and similar events. Inthe event we were to suffer a significant environmental, product liability,employee or other claim in excess of our insurance or a loss or damagesrelating to an uninsurable risk, our financial condition could be negativelyimpacted. In addition, the cost of our insurance has increased substantially in

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recent years and may proveto become prohibitively expensive, thus making it impractical to obtaininsurance. This may result in the need to abandon certain business activitiesor subject ourselves to the risks of uninsured 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 andmanufacturing processes. In this regard, we recently entered into new emissionscontrol solution markets with respect to diesel emissions technology and SCR Catalystand Management Services in which we do not have as broad of intellectualproperty protection as we do in the NOx control solutions area for small gasturbines. Consequently, our ability to compete effectively in such new emissioncontrol solution markets may be adversely affected by our inability to excludecompetitors based on our intellectual property position. The ability of othersto use our intellectual property could allow them to duplicate the benefits ofour products and reduce our competitive advantage. We do not know whether anyof our pending patent applications will issue or, in the case of patentsissued, that the claims allowed are or will be sufficiently broad to protectour technology or processes. Further, a patent issued covering one use of ourtechnology may not be broad enough to cover uses of that technology in otherbusiness areas. Even if all our patent applications are issued and aresufficiently broad, they may be challenged or invalidated. We could incursubstantial costs in prosecuting patent and other intellectual propertyinfringement suits and defending the validity of our patents and otherintellectual property. While we have attempted to safeguard and maintain ourproperty rights, we do not know whether we have been or will be completelysuccessful in doing so. These actions could place our patents, trademarks andother intellectual property rights at risk and could result in the loss ofpatent, trademark or other intellectual property rights protection for theproducts, systems and services on which our business strategy partly depends.

We rely, in part, oncontractual provisions to protect our trade secrets and proprietary knowledge. Theseagreements 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.

**Thirdparties may claim that we are infringing their intellectual property, and wecould suffer significant litigation or licensing expenses or be prevented fromselling products and services if these claims are successful.**

Our competitors may independently develop or patenttechnologies or processes that are equivalent or superior to ours. In recentyears, there has been significant litigation involving patents and otherintellectual property rights in many technology-related industries and webelieve our industry has a significant amount of patent activity. Third partiesmay claim, that the technology or intellectual property that we incorporateinto or use to develop or manufacture our current and future products, systemsor services infringe, induce or contribute to the infringement of theirintellectual property rights, and we may be found to infringe, induce orcontribute to the infringement of those intellectual property rights andrequire a license to use those rights. We may also be required to engage incostly efforts to design our products, systems and services around theintellectual property rights of others. The intellectual property rights ofothers may cover some of our technology, products, systems and services. Inaddition, the scope and validity of any particularly third party patent may besubject to significant uncertainty.

Litigation regardingpatents or other intellectual property rights is costly and time consuming, andcould divert our management and key personnel from our business operations. Thecomplexity of the technology involved and the uncertainty of intellectualproperty litigation increase these risks. Claims of 

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intellectualproperty infringement might also require us to enter into costly royalty orlicense agreements or indemnify our customers. However, we may not be able toobtain royalty or license agreements on terms acceptable to us or at all. Anyinability on our part to obtain needed licenses could delay or prevent thedevelopment, manufacture and sale of our products, systems or services. We mayalso be subject to significant damages or injunctions against development,manufacture and sale of our products, systems or services.

**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 the 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 rules and regulations to further increase our legal and financialcompliance 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 qualified persons toserve on our board of directors or as executive officers. We have attempted toaddress some of these attraction and retention issues by offering contractualindemnification agreements to our directors and executive officers, but thismay 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, 2005, our executive officers,directors and greater than 5% stockholders controlled approximately 61% 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, 2005, 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.

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**Liabilities weacquired as a result of our spin-off may have a negative effect on ourfinancial results.**

We incurred additionalliabilities as a result of our spin-off from Catalytica, Inc. For example,when the business of Catalytica Advanced Technologies, Inc. (“CAT”) wascombined with ours, we became responsible for the liabilities of CAT.Additionally, we have obligations under the separation agreements we enteredinto with Catalytica, Inc., Synotex and DSM CatalyticaPharmaceuticals, Inc., the successor corporation to Catalytica, Inc.For example, we agreed to indemnify DSM for liabilities arising out of ourbusiness, the business of CAT and other liabilities of DSM not associated withthe pharmaceuticals business it purchased from Catalytica, Inc., whichcould include, for example, potential environmental liabilities. We are alsoresponsible for specified potential liabilities arising out of the distributionof our common stock by Catalytica, Inc. To date, no claims have been madeagainst us pursuant to these indemnification provisions and, atDecember 31, 2005, we believe the likelihood of any material claim beingmade against us is remote. However, if any additional liabilities materialize,our financial results could be harmed.

**ADDITIONAL RISKSRELATING 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.

**SCR-Techhas not been profitable and there can be no assurance SCR-Tech will becomeprofitable.**

SCR-Tech has not beenprofitable. SCR-Tech failed to generate significant new orders in the firsthalf of 2005 for SCR catalyst cleaning and regeneration services, whichaccounted for approximately 90% of SCR-Tech’s revenues in 2004. Backlog as of December 31,2005 for SCR Catalyst and Management Services was approximately $3,128,000including $185,000 of deferred revenues. No assurance can be given thatSCR-Tech will be able to generate significant SCR management services revenuesor an increase in SCR catalyst cleaning and regeneration services revenues orthat SCR-Tech will be profitable in 2006 or in any future period.

**Weare dependent on management at SCR-Tech for success in its business.**

William J. McMahon wasappointed president of SCR-Tech effective March 21, 2005, and isresponsible for reinvigorating the business of SCR-Tech. Mr. McMahon haslimited experience specifically associated with SCR Catalyst and ManagementServices; thus, no assurance can be given that Mr. McMahon will continueto be successful in reinvigorating the business of SCR-Tech. In June 2005,SCR-Tech appointed Robert Deneault as vice president of sales and marketing,and Dr. Howard Franklin as director of technology. Both Deneault andFranklin are seasoned industry veterans with more than 60 years of combinedexperience in the power generation industry. While both individuals have priorexperience relating to SCR system operations, they both have limited experiencespecifically associated with SCR-Tech’s service offerings. The success ofSCR-Tech’s business will be significantly dependent upon the management ofSCR-Tech. There can be no assurance that the management of SCR-Tech will beable to successfully operate SCR-Tech’s business or that the loss of any ofSCR-Tech’s key personnel will not have an adverse affect upon the business ofSCR-Tech.

**Wehave limited experience with the operations of SCR-Tech.**

We completed theacquisition of SCR-Tech in February 2004. SCR-Tech was a privately-heldcompany, which commenced commercial operations in the U.S. in March 2003. Atthe time we acquired SCR-Tech, we had no experience in the SCR-related businessand we have just begun to integrate our management, technology and systems withSCR-Tech. In addition, SCR-Tech did not previously have 

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auditedfinancial statements. Thus, there is a risk of unknown financial or otherliabilities which could negatively impact SCR-Tech and us.

**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 SCRcatalyst cleaning, rejuvenation and regeneration, as well as SCR systemmanagement and consulting services. The size and growth rate for this marketwill ultimately be determined by a number of factors, including environmentalregulations, the growth in the use of SCR systems to reduce NOx and otherpollutants, the length of operation of SCR systems without the need forcleaning, the differences, if any, in the accounting and rate-base effect ofusing regenerated SCR catalyst as compared to new SCR catalyst as adopted orapproved by applicable federal and state regulatory authorities, rejuvenationor regeneration, 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 catalyst can be regenerated is unknown, which also may affectthe demand for regeneration in lieu of purchasing new catalyst. Any delay inthe development of the market could significantly and adversely affect thevalue of SCR-Tech and 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), BASF / CERAM, Haldor-Topsoe, Inc. and Hitachi America. Further, if the SCRcatalyst regeneration market expands, competitors could emerge. If theintellectual property protection acquired by us becomes weakened, competitioncould more easily develop.

**SCR-Tech’sbusiness is subject to potential seasonality.**

Because some utilities andindependent power producers (“IPPs”) currently operate their SCR units onlyduring the “ozone season” (May 1-September 30), SCR-Tech’sbusiness may be more limited than if SCR units were required to operate on acontinual basis. The NOx SIP Call was configured to impose a summer ozoneseason NOx limitation over 19 states and the District of Columbia. During thisperiod, utilities and IPPs seek to operate their SCR catalyst at maximumcapacity so as to reduce NOx emissions during this period. During non-ozoneseason periods, most operators currently have limited (if any) requirements torun their SCR systems. Unless and until such regulations are tightened, much ofSCR-Tech’s business may be concentrated outside the ozone season eachyear. This will likely result in less business than if SCR units were requiredto be operated throughout the year and this also may result in quarters ofrelatively higher cash flow and earnings and quarters where cash flow andearnings may be 

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minimal.These potential fluctuations in revenues and cash flow during a year may be significantand could materially impact our quarterly earnings and cash flow. This may havea material adverse effect on the perception of our business and the marketprice for 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.

**SCR-Tech is still dependent on ENVICA.**

SCR-Tech has requiredassistance of an affiliate of one of the former owners of SCR-Tech, ENVICA KatGmbH, to successfully complete certain contracts. In addition, SCR-Tech hasbeen relying to a limited extent on the assistance of ENVICA on varioustechnical and support matters relating to its business. There can be noassurance that SCR-Tech and its current employees will be ultimately able tosuccessfully operate the business or expand the business without the continuedassistance of ENVICA. Further, there can be no assurance that SCR-Tech will notincur significant unanticipated technical problems and costs which couldadversely 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 or that ouractivities will not infringe the rights of competitors or other third parties. Theinfringement representation and indemnification from SCR-Tech’s sellers to usis short and of limited value. Further, much of the intellectual property fromENVICA is in the form of trade secrets, for which patent protection is notavailable or being sought.

**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 Federal Superfund site(under the Comprehensive Environmental Response, Compensation and Liability Actof 1980 (“CERCLA”), which increases the risks the site ultimately could be shutdown or that Clariant will be financially unable to continue its ownership 

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of thesite. It may be difficult to locate to another site on a cost-effective basis,and SCR-Tech’s business could be negatively impacted by any problems withcontinuing to conduct its operations at its current site.

**SCR-Techmay require unexpected capital expenditures to expand its productionfacilities.**

SCR-Tech does not own itsregeneration site; instead it leases it from Clariant Corporation, the U.S.subsidiary of a Switzerland-based public company. We believe this site issufficient to meet SCR-Tech’s anticipated production requirements for 2006 and2007. However, orders for SCR regeneration services have increasedsignificantly in recent months, and it is possible that SCR-Tech’s currentlyfacilities may prove inadequate to meet unanticipated increased demand forregeneration services. Although we believe SCR-Tech’s current site allows forbuilding additional regeneration facilities, including a doubling of currentcapacity, such construction could require significant capital expenditures,necessary permitting and time for construction. There can be no assurance thatSCR-Tech could meet the demands of a rapid increase in orders in a timelymanner. Any failure to timely fulfill such orders could have an adverse impacton SCR-Tech’s business.

**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. Five CERCLA Areas (those areas of concernidentified under the CERCLA program) are identified on the property, and whileSCR-Tech does not lease any property identified as a CERCLA Area, one such Areahas resulted in contamination of groundwater flowing underneath one of thebuildings leased by SCR-Tech. Although SCR-Tech has indemnification fromClariant Corporation for any environmental liability arising prior to theoperation of SCR-Tech’s business at the site, there can be no assurance thatsuch indemnification will be sufficient or that SCR-Tech could be protectedfrom an environmental claim from the nature of the site. In addition, theoperation of SCR-Tech’s business involves removal of hazardous wastes fromcatalyst and the use of significant chemical materials. As a result, SCR-Techcould be subject to potential liability from such operations. To date, theCompany has not been identified as a potential responsible party to suchenvironmental risks, nor have any amounts been recorded to accrue for thesepotential exposures.

**Risks of Purchasing Used SCR Catalyst**

SCR-Tech’s primarybusiness involves the cleaning and regenerating of customer-owned SCR catalyst.In certain instances, however, SCR-Tech may purchase used or “spent” catalystfrom utilities for regeneration. This may occur, for example, when a utilitymust sell catalyst for accounting reasons or when a utility wishes to avoid thecosts and potential hazardous waste issues associated with the disposal of usedor “spent” catalyst. SCR-Tech may purchase SCR catalyst for a nominal sum andthen regenerate such catalyst for immediate sale, or may purchase spent SCRcatalyst on an opportunistic basis for future regeneration and sale. Thepurchase of spent SCR catalyst involves additional potential risks to SCR-Tech.First, spent SCR catalyst includes significant hazardous waste. Unlike theregeneration of customer-owned SCR catalyst, the purchase of spent SCR catalystrequires SCR-Tech to take ownership or “title” to the SCR catalyst, which maypotentially increase SCR-Tech’s environmental risk exposure. Further, if SCR-Techcannot find a customer to purchase the regenerated catalyst, then SCR-Tech willbe required to either store the spent catalyst, with all of the risk inherentin holding catalyst which has not been regenerated and contains hazardouswaste, or incur significant costs to dispose of the spent catalyst in a mannerwhich complies with the strict requirements to dispose of potentially hazardouswastes. It is unclear as to the amount of SCR catalyst which SCR-Tech maypurchase, but it is possible such purchases 

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ultimatelymay be substantial, which would potentially significantly increase the risk profileof SCR-Tech’s business.

**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 commercially viable emissionscontrol solutions 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 orstationary diesel genset markets. Economic and technical difficulties mayprevent us from completing development of products for diesel engines orcommercializing those products. Furthermore, a viable market for our productconcept may never develop. If demand for our emissions control solutions wereto develop in the diesel OEM or stationary genset markets using our emissionscontrol solutions, we likely would face intense competition from variouscompetitors, including large diesel engine OEMs, and we may be unable tocompete successfully. In addition, diesel engine OEMs and other competitors maycreate technology alternatives that could render our systems obsolete prior tocommercialization. Moreover, we may conclude that the potential return from ourinvestment in the diesel OEM or stationary diesel genset markets does notjustify our continued investment in these opportunities, and thus decide toshut-down this program. In this regard, we recently terminated our diesel retrofitprogram, which resulted in the loss of our investment in such program. Further,no assurance can be given that we will not incur substantial expenses todiscontinue these remaining business programs, including personnel reductioncosts, environmental clean-up and equipment disposal costs, lease terminationexpenses and other shut-down related costs.

**Wemay not have sufficient capital to complete development of a commerciallyviable emissions control solution for diesel engines.**

Even if we ultimatelyovercome all the technical and business hurdles described herein to develop acommercially viable diesel emissions product, we may never have the opportunityto fully undertake the necessary development because of the significantfinancial requirements to develop a commercial product. We currently estimatethat the total remaining development costs for continuing to pursue our dieselOEM NOx and PM solutions for new, over-the-road diesel engines will be inexcess of $10 million, and potentially substantially in excess of such sum. Welikely will not have sufficient capital to complete necessary development andcommercialization work without a significant financial or equivalent commitmentfrom diesel OEM’s or suppliers, especially since we would be unlikely toreceive any significant commercial revenues from a product until 2009. If wedetermine that we do not have the financial capability to complete thenecessary development and commercialization work, then we may determine not tocontinue pursuing some or all of our diesel-related programs even if we believewe ultimately could solve all technical and business problems related to aproduct launch and even if we believe that the financial benefits of completingsuch a product would be significant. If we reach such a conclusion, then welikely would find it necessary or desirable to sell or shut down our efforts inthe diesel emission control solutions. In such event, we likely would realizelittle if any significant value from our investment in the diesel emissionscontrol solution market. Further, the costs of discontinuing our dieselemissions control solutions business may exceed any value from a sale of thisbusiness as a result of shut-

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downrelated costs, such as personnel expenses and any environmental clean-up andequipment disposal costs.

**Wewill be heavily dependent on developing relationships with diesel industrycompanies, including large diesel OEMs or suppliers to OEMs, and theircommitment to adopt and market our diesel emissions reduction technology fortheir or their customers’ diesel engines in order to enter the diesel OEMmarketplace; any agreements with these diesel industry companies may limit ourmarket opportunities.**

In order to take advantage of the opportunities forNOx control solutions in the diesel OEM market, we must develop a solution thatresults in significant NOx reduction (approximately90%) to meet impending United States, European Union or Japaneserequirements for diesel engines. This will require us to partner with one or morediesel industry companies, including large diesel OEMs or suppliers to OEMs. Untilwe can demonstrate the viability of our diesel fuel processor for the dieselOEM market, it is unlikely we can develop the necessary OEM or OEM supplierrelationships. Our failure to commercialize a diesel retrofit solution couldadversely impact our ability develop the necessary credibility with diesel OEMsor suppliers with respect to our diesel OEM solutions.

Even if we are successfulin entering into agreements with a diesel OEM or OEM supplier, the agreementsmay provide the OEM with the right to be the exclusive market channel fordistribution of our technology and may otherwise limit our ability to enterinto other OEM or OEM supplier agreements. An agreement may provide forexclusivity for particular engine sizes and for limited periods of time. Theagreements also may provide that either party can terminate the agreement, butnot necessarily the exclusivity provision. A decision by an OEM or OEM supplierto discontinue the commercialization of our technology in certain engines couldsignificantly limit or foreclose our access to the market for those engines orprevent us from entering into agreements with other OEMs or OEM suppliersregarding the application of our technology to some of their competing engines.

**Wemay incur significant costs in developing our diesel technology with OEMs orsuppliers to OEMs; if any OEM or OEM supplier does not complete development forany reason, we may not be able to recover costs incurred for the developmentwith that OEM or OEM supplier.**

We may incur significantcosts in developing our diesel technology with OEMs or suppliers to OEMs forthe diesel OEM market. Further, the technological development required to meetthe requirements for this decade may be significant, and the capital requiredto be invested in such a development is likely to be substantial. Moreover,there can be no assurance that any solution developed by us will be technicallyfeasible, cost-effective or acceptable to OEMs or OEM suppliers. We are notlikely to recover any significant portion of these costs through contractualreimbursement from the OEMs or OEM suppliers. Thus, we will likely bear themajority of the development costs ourselves. If OEMs or OEM suppliers do notcomplete development work for any reason, we will not be able to recover ourdevelopment 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 for heavy-dutydiesel engine applications do not evolve to a state of commercial viability,OEMs will not ultimately adopt our technology. While NOx adsorbers are inlimited commercial use today in medium and light-duty diesel engineapplications, a variety of technical hurdles associated with the use of NOxadsorbers in heavy-duty diesel engine applications remain. Although our dieselfuel processor has the benefit of lessening certain NOx adsorber limitations,significant technological hurdles, including cost, size, durability, operatingrange and the level of NOx reduction from NOx adsorbers must be overcome toensure the feasibility of commercializing our diesel fuel processor incombination with a NOx adsorber for heavy-duty diesel engine applications. Thefailure of third parties to develop solutions to current NOx adsorberlimitations in 

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a timelymanner will effectively eliminate our diesel fuel processor from marketconsideration. We may not have any ability to significantly influence theresolution of NOx adsorber issues. Further, a supplier’s failure to develop andsupply components in a timely manner or at all, or to develop or supplycomponents that meet our quality, quantity or cost requirements, or ourinability to obtain substitute sources of these components on a timely basis oron terms acceptable to us, could harm our ability to manufacture our products.In addition, to the extent that our supply partners use technology ormanufacturing processes that are proprietary, we may be unable to obtaincomparable components from alternative sources.

**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 emissions reduction solutions. We do not know when orwhether we will secure arrangements with suppliers of required materials andcomponents for our diesel products, even if they are successfully developed, orwhether these arrangements will be on terms that will allow us to achieve ourobjectives. Even if we can develop a commercially viable 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.

**Wemay be subject to significant competition from companies including those thatmay have substantially greater resources and market credibility.**

The size of the diesel OEMand stationary diesel genset markets has attracted a number of significantparticipants. In the diesel OEM market, there are a number of significant competitors,including Arvin Meritor, EatonCorporation and Delphi Corporation and the major diesel OEMs such as Cummins,Caterpillar, Detroit Diesel, ITEC and Volvo. Some of these competitorshave announced solutions for the 2007 NOx regulations. Further, thesecompetitors also have substantially greater resources and credibility than wedo in this market. There can be no assurance that we can successfully competein either the diesel OEM or diesel genset markets, even if we were to develop atechnologically feasible emissions solution 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 EGR andother advanced engine controls. Anadditional potential competitive threat may come from proven SCR technology. Weare aware that some European diesel engine OEMs have implemented SCR forheavy-duty diesel engine applications in Europe to meet the Euro IV emissionsstandards took effect in October 2005. Although we believe our proposedsolution, if successful, will constitute a cost-effective and competitivesolution in the diesel OEM market, no assurance can be given that alternatetechnologies will not prove to be more reliable or otherwise more successful inthe market.

**Failureto successfully demonstrate our technology in field tests could negativelyimpact demand for our products.**

We have recentlyencountered technical problems associated with our diesel retrofit product,specifically related to the performance and integration of various third-party components and have 

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terminated this program. We also may encountertechnical problems in connection with our other diesel products for anumber of reasons, including the failure of our technology or the technology ofthird parties, or our failure to maintain and service our products properly.Many of these potential problems and any resulting commercial 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.

**Wemay not meet our product development and commercialization milestones, whichcould have a material adverse effect on our operations.**

We have establishedproduct development and commercialization milestones that we use to assess ourprogress toward developing commercially viable emissions control solutions forour diesel engine applications. These milestones relate to technology anddesign improvements as well as to dates for achieving product development goals.To gauge our progress, we operate, test and evaluate our diesel products undervarious testing conditions. If our systems exhibit technical defects or areunable to meet cost or performance goals, including targeted levels of NOx orPM reduction, temperature variability, durability and fuel economy, ourcommercialization schedule could be delayed and potential purchasers of ourinitial commercial products may decline to purchase them or choose to purchasealternative technologies. We have in the past failed to achieve announcedtechnical milestones and we cannot be sure that we will successfully achieveour milestones in the future or that any failure to achieve these milestoneswill not result in potential competitors gaining advantages in our targetmarket. Failure to meet publicly announced milestones could also have amaterial adverse effect on 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, or stationary diesel genset markets, we will be required to provideproduct warranties. It is unclear as to the nature of these warranties at thistime, but the warranties are likely to include NOx or PM reduction at agreedupon levels for substantial time and/or mileage requirements. If we are unableto satisfy these warranties, we could incur significant liability to dieselOEMs and potentially end users, including consumers. In addition, themanufacture, sale and distribution of our diesel fuel processor could expose usto potential product liability to customers and end users, including consumers.Any such liability could be significant and may not be insurable.

**We haveno experience 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.

**ADDITIONAL RISKS RELATING TO RESTRUCTURING ACTIVITIESAND RECENT DEVELOPMENTS**

In addition to the risksdiscussed elsewhere, any of which could adversely impact our operations, thefollowing additional risks particularly relate to our restructuring activitiesand recent developments and could negatively impact our entire company.

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**Wehave ceased any further development or commercialization efforts associatedwith our Xonon Cool Combustion product for gas turbines and we are exploringstrategic alternatives for such business. We may not realize any significantvalue from such alternatives.**

We have ceased any further development orcommercialization efforts associated with our Xonon Cool Combustion product forgas turbines as a result of the adverse state of the small gas turbine market,continuing delays in OEM commercial timelines, lack of OEM funding commitmentsand continuing expenses in continuing development and commercializationactivities without any significant revenues or prospects of significantrevenues. In September 2005 we announced our election to terminate ourXonon Module Supply Agreement with Kawasaki Gas Turbines-Americas (“Kawasaki”),effective December 13, 2005, having determined that there was no businessor financial justification to continue the agreement on its current terms. Weterminated our Collaborative Commercialization and License Agreement withGeneral Electric (“GE”) on March 13, 2006, after GE informed us that itdid not intend to pursue commercialization of a Xonon-equipped GE gas turbine.

We are currently exploringwhether we can sell our Xonon-equipped gas turbine business. However, we maynot receive any significant value from such a sale. If there is no buyer, wewill incur expenses to discontinue this business program, including personnelreduction costs, environmental clean-up and equipment disposal costs, leasetermination expenses and other shut-down related costs.

**Weare involved in a contract dispute with Kawasaki that could result in adversefinancial consequences and a diversion of resources and management time andattention from business operations.**

In September 2005 weannounced our election to terminate our Xonon Module Supply Agreement withKawasaki Gas Turbines-Americas (“Kawasaki”), effective December 13, 2005,having determined that there was no business or financial justification to continuethe agreement on its current terms. After receiving notice of such termination,but prior to December 13, 2005, Kawasaki purported to place an order for27 Xonon modules at a total price of approximately $1 million which we rejected.Kawasaki has disputed our rejection of the purchase order and has indicated itmay seek arbitration of the dispute pursuant to the Supply Agreement. We do notbelieve we have any obligation to fill this order upon the terms proposed byKawasaki or on any other terms. Further, we do not believe we have themanufacturing capabilities to fill such an order, and even if we did, webelieve the cost of completing such order would be substantially in excess ofthe $1 million order price. Thus, if Kawasaki was to seek arbitration and anarbitrator was to order us to complete the order, we would suffer significantlosses. However, the Supply Agreement contains a maximum limit on damages inthe amount of the order price, which we believe should limit any potentialdamages in arbitration. There can be no assurance, however, as to the result ofany arbitration or the amount of damages which could occur if Kawasaki was toprevail in such an arbitration or other litigation. In addition, resolution ofthis dispute, whether by litigation, arbitration or otherwise, could divert ourmanagement and key personnel from our business operations.

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

In October 2005, we completed work on a$11,658,000 DOE cost-shared contract initiated in October 2001 associatedwith the development of a compact fuel processor that could convertconventional fuels, such as gasoline, to hydrogen to power proton exchangemembrane (“PEM”) fuel cells, with applications in automotive, stationary,auxiliary and back-up power. Due to a lack of continued funding or partnercommitments and our efforts to rationalize our ongoing operations, we are nolonger conducting research or development activities associated with fuelprocessing for fuel cell applications.

We do not believe that ourPEM fuel cell business has any signficant value at this stage of development,and thus we do not believe we could realize any signficant value from a sale ofthis business.

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**Item 1B.**               *UNRESOLVED STAFF COMMENTS*

None.

**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 31,2006, with an option to renew for one additional year. We currently subleaseapproximately 7,300 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. This property was listed for sale in November 2005.

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.

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 matterssubmitted to a vote of the stockholders of the Company during the fourthquarter of the fiscal year covered by this report.

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**PART II**

**Item 5.**                        *MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERSAND ISSUER PURCHASES OF EQUITY SECURITIES*

**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 2004 and 2005. Such prices represent inter-dealer pricesand do not include retail mark-ups or mark-downs or commissions and may notrepresent actual transactions.

| ** **                     | ** ** | **Quarter Ended**       | ** ** | **Quarter Ended**      | ** ** | **Quarter Ended**           | ** ** | **Quarter Ended**          | ** ** |
|--------------------------------|------------|------------------------------|------------|-----------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                     | ** ** | **March 31, 2004** | ** ** | **June 30, 2004** | ** ** | **September 30, 2004** | ** ** | **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 |   |   |
|                                |            |                              |            |                             |            |                                  |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                     | ** ** | **Quarter Ended**       | ** ** | **Quarter Ended**      | ** ** | **Quarter Ended**           | ** ** | **Quarter Ended**          | ** ** |
|--------------------------------|------------|------------------------------|------------|-----------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                     | ** ** | **March 31, 2005** | ** ** | **June 30, 2005** | ** ** | **September 30, 2005** | ** ** | **December 31, 2005** | ** ** |
| Common stock price per  share: |       |                         |       |                        |       |                             |       |                            |       |   |   |   |   |   |   |   |   |
| High                           |       |                         | $          | 2.81                        |       |                             |       | $                               | 2.35       |   |   |   | $ | 2.02 |   |   |   | $ | 1.29 |   |   |
| Low                            |       |                         | 2.00       |                        |       |                             | 1.79       |                            |       |   | 1.40 |   |   |   | 0.97 |   |   |
|                                |            |                              |            |                             |            |                                  |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

As of March 17, 2006,there were 712 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 Rights Plan**

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 (other than Rights beneficiallyowned by the Acquiring Person) will have the right to receive, upon exercise,voting Common Shares having a value equal to two times the Purchase Price.

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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.

**SecuritiesAuthorized for Issuance under Equity Compensation Plans**

| ** **                        | ** ** | **Number of  Securities to be  Issued upon  Exercise of  Outstanding  Options and  Conversion of  Restricted Stock  Units** | ** ** | **Weighted-Average  Exercise Price  of Outstanding  Options** | ** ** | **Common Stock  Reserved for  Future Issuance** | ** ** |
|-----------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| Plans approved by  stockholders:  |       |                                                                                                                                                                |       |                                                                    |       |                                                           |       |   |   |   |   |   |   |
| 1995 Stock Option Plan            |       |                                                                                                                                                                | 2,462,212  |                                                                    |       |                                                           | $          | 5.21 |   |   |   | 4,199,772 |   |   |
| 2000 Employee Stock Purchase Plan |       |                                                                                                                                                                | —     |                                                                    |       |                                                           |       |   |   |   | 1,089,202 |   |   |
| Total                             |       |                                                                                                                                                                | 2,462,212  |                                                                    |       |                                                           |       |   |   |   | 5,288,974 |   |   |
|                                   |            |                                                                                                                                                                     |            |                                                                         |            |                                                                |            |  |  |  |  |  |  |  |

 

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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, 2001, 2002, 2003, 2004 and 2005that 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,**                        | ** ** |
|---------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                      | ** ** | **2005**                                                           | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                                      | ** ** | **(in thousands, except per share data)** | ** ** |
| **Consolidated Statements of  Operations Data:**                                |       |                                                               |       |   |   |   |   |   |   |   |   |
| Revenues                                                                        |       | $                                                                  | 3,529      |   | $ | 5,601 |   | $ | 3,498 |   | $ | 4,795 |   | $ | 5,523 |   |
| Expenses:                                                                       |       |                                                               |       |   |   |   |   |   |   |   |   |
| Cost of revenues(A)                                                             |       | 4,709                                                              |       | 5,227 |   | 4,341 |   | 5,977 |   | 9,957 |   |
| Research and development(A)                                                     |       | 7,470                                                              |       | 7,498 |   | 6,919 |   | 8,252 |   | 4,665 |   |
| Selling, general and administrative                                             |       | 7,440                                                              |       | 6,339 |   | 7,224 |   | 9,654 |   | 7,017 |   |
| Legal settlements(B)                                                            |       | —                                                             |       | — |   | — |   | — |   | 3,250 |   |
| Total expenses                                                                  |       | 19,619                                                             |       | 19,064 |   | 18,484 |   | 23,883 |   | 24,889 |   |
| Operating loss                                                                  |       | (16,090                                                            | )          | (13,463 | ) | (14,986 | ) | (19,088 | ) | (19,366 | ) |
| Loss on equity investments(C)                                                   |       | —                                                             |       | — |   | — |   | — |   | (707 | ) |
| Impairment charge  to implied goodwill of an equity investment(D)               |       | —                                                             |       | — |   | — |   | — |   | (2,145 | ) |
| Interest and  other income(E)                                                   |       | 3,253                                                              |       | 758 |   | 823 |   | 1,405 |   | 2,672 |   |
| Interest expense                                                                |       | (629                                                               | )          | (564 | ) | (236 | ) | (191 | ) | (43 | ) |
| Net loss                                                                        |       | $                                                                  | (13,466    | ) | $ | (13,269 | ) | $ | (14,399 | ) | $ | (17,874 | ) | $ | (19,589 | ) |
| Basic and diluted  net loss per share                                           |       | $                                                                  | (0.75      | ) | $ | (0.74 | ) | $ | (0.81 | ) | $ | (1.02 | ) | $ | (1.33 | ) |
| Weighted average  shares used in computing basic and diluted net loss per share |       | 18,048                                                             |       | 17,850 |   | 17,669 |   | 17,529 |   | 14,747 |   |
| **Consolidated  Balance Sheet Data:**                                           |       |                                                               |       |   |   |   |   |   |   |   |   |
| Cash, cash  equivalents and short-term investments                              |       | $                                                                  | 21,332     |   | $ | 35,592 |   | $ | 52,682 |   | $ | 66,770 |   | $ | 87,647 |   |
| Total assets                                                                    |       | $                                                                  | 36,345     |   | $ | 51,517 |   | $ | 61,685 |   | $ | 77,021 |   | $ | 95,140 |   |
| Long-term debt  and capital lease obligations(F)                           |       | $                                                                  | 3,051      |   | $ | 6,402 |   | $ | 3,245 |   | $ | 3,250 |   | $ | 123 |   |
| Total liabilities                                                               |       | $                                                                  | 7,300      |   | $ | 9,178 |   | $ | 6,458 |   | $ | 7,842 |   | $ | 8,418 |   |
| Total stockholders’  equity                                                |       | $                                                                  | 29,045     |   | $ | 42,339 |   | $ | 55,227 |   | $ | 69,179 |   | $ | 86,722 |   |

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(A)       Decrease from 2001 through2003 due to decline in externally funded research and development, which isclassified as cost of revenues. Increase in 2004 due to acquisition of SCR-Tech.Total R&D expenses, including those classified as cost of revenues, are asfollows:

| ** **                  | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|-----------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| R&D cost of  revenues   |       | 2,263    |       | 2,746    |       | 4,341    |       | 5,977    |       | 9,957    |       |
| R&D                     |       | 7,470    |       | 7,498    |       | 6,919    |       | 8,252    |       | 4,665    |       |
| Total R&D  expenditures |       | 9,733    |       | 10,244   |       | 11,260   |       | 14,229   |       | 14,622   |       |

 

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(B)        Legal settlement recordedin 2001 with respect to a complaint filed by the City of Glendale, Californiain 2000. 

(C)        Pro-rata share of lossesrecorded under the equity method of accounting for investments in Novodynamicsand Genxon. The equity method of accounting for these investments wasdiscontinued when the net book carrying value of those investments reachedzero.

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

(E)        Follow-on stock offeringin 2001, which generated $47,642,000 in cash; resulting in increase in interestincome in 2001. Gain on the settlement of future acquisition payments relatedto purchase of SCR-Tech in 2005 resulted in gain of $2,105,000.

(F)         Increase in 2002 relatedto term loan applied to the purchase of a manufacturing and administrativefacility in Gilbert, Arizona. Increasein 2004 related to debt incurred in the acquisition of SCR-Tech.

**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 containforward-looking statements that involve risks and uncertainties. Words such as “anticipate,”“believe,” “estimate,” “expect,” “intend,” “plan” and similar expressionsidentify such forward-looking statements, which are based on informationavailable to us on the date hereof, and we assume no obligation to update anysuch forward-looking statements. Our actual results could differ materiallyfrom those anticipated in these forward-looking statements as a result ofcertain factors, including those set forth in “Risks That Could Affect OurFinancial Condition and Results of Operations” and elsewhere in this Form 10-K.

**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 of Catalytica, Inc.’sresearch and development group from inception through the date of itsincorporation as a separate entity. In December 2000, Catalytica AdvancedTechnologies, Inc., another subsidiary of Catalytica Inc., was merged intous, and the combined entity was spun out from Catalytica, Inc. asCatalytica Energy Systems, Inc., a separate, stand-alone public company.

We******provideinnovative products and services for emissions control solutions in the powergeneration and transportation industries. Our business is focused on theemissions control market, with a primary focus on nitrogen oxides (“NOx”).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 key target of government-imposed emissions regulations, creating asignificant opportunity for innovative, cost-effective NOx control solutions.

Through our SCR-Tech subsidiary, we offer avariety of services for coal-fired power plants that use selective catalyticreduction (“SCR”) systems to reduce NOx emissions. These services include SCRcatalyst management, cleaning and regeneration, as well as consulting servicesto help power plant operators optimize efficiency and reduce overall NOxcompliance costs (collectively “SCR Catalyst and Management Services”). Ourbusiness 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 dieselengine emissions. Our Xonon® Diesel Fuel Processing technology is designed tofacilitate a significant reduction in NOx and particulate matter (“PM”) emissions

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from mobile and stationarydiesel engine applications by improving the performance of NOx adsorbercatalyst systems and diesel particulate filters.

In September 2005, we discontinued development ofour diesel retrofit product. In October 2005, we completed work on ourDepartment of Energy-funded development of a compact fuel processor that soughtto convert conventional fuels to hydrogen to power proton exchange membranefuel cells and we are no longer conducting research or development activities associatedwith fuel processing for fuel cell applications. In February 2006, weannounced that we are no longer conducting development or commercial activitiesassociated with our Xonon Cool Combustion product for gas turbines.

We plan to continue evaluating our business in 2006 toidentify opportunities to further streamline our operations and reduce overheadas we seek to enhance our ability to capitalize on the longer-term commercialprospects we anticipate for the Company and maintain financial viability. Theoutcome of this evaluation could include additional headcount reductions,discontinuing other business activities, downsizing our facilities, and otherstrategic initiatives to seek to realize value from our diverse asset andtechnology base and reduce cash consumption.

We are currentlyconducting our business through the following two business segments:

1.                Catalystregeneration, rejuvenation, cleaning and management services for SCR systemsused by coal-fired power generation facilities to reduce NOx emissions—our SCRCatalyst and Management Services (“SCMS”) segment; and

2.                Designing,developing and manufacturing advanced products based on our proprietarycatalyst and fuel processing technologies, primarily focused on cost-effectivesolutions for reducing emissions from diesel engine applications—ourCatalyst-Based Technology Solutions (“CBTS”) segment.

**Results of Operations**

Thefollowing summary presents the results of operations and changes fromcomparable periods for the years ended December 31, 2005, 2004 and 2003(in thousands):

| ** **                                  | ** ** | **Year Ended December 31,** | ** ** | **Annual Change** | ** ** |
|---------------------------------------------|------------|--------------------------------------------|------------|------------------------|------------|
| ** **                                  | ** ** | **2005**                                   | ** ** | **2004**               | ** ** | **2003** | ** ** | **2005/2004** | ** ** | **2004/2003** | ** ** |
| Revenues                                    |       |                                       |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| SCR catalyst & management services |       | $                                          | 1,725      |                   | $          | 2,960 |   | $ | — |   |   | $ | (1,235 | ) |   |   | $ | 2,960 |   |   |
| Research and development                    |       | 1,804                                      |       | 2,641                  |       | 3,498 |   |   | (837 | ) |   |   | (857 | ) |   |
| Total revenues                              |       | 3,529                                      |       | 5,601                  |       | 3,498 |   |   | (2,072 | ) |   |   | 2,103 |   |   |
| Costs and  expenses:                        |       |                                       |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| Cost of revenues                            |       | 4,709                                      |       | 5,227                  |       | 4,341 |   |   | (518 | ) |   |   | 886 |   |   |
| Research and development                    |       | 7,470                                      |       | 7,498                  |       | 6,919 |   |   | (28 | ) |   |   | 579 |   |   |
| Selling, general and administrative         |       | 7,440                                      |       | 6,339                  |       | 7,224 |   |   | 1,101 |   |   |   | (885 | ) |   |
| Total costs and expenses                    |       | 19,619                                     |       | 19,064                 |       | 18,484 |   |   | 555 |   |   |   | 580 |   |   |
| Operating loss                              |       | (16,090                                    | )          | (13,463                | )          | (14,986 | ) |   | (2,627 | ) |   |   | 1,523 |   |   |
| Interest and other income                   |       | 3,253                                      |       | 758                    |       | 823 |   |   | 2,495 |   |   |   | (65 | ) |   |
| Interest expense                            |       | (629                                       | )          | (564                   | )          | (236 | ) |   | (65 | ) |   |   | (328 | ) |   |
| Net loss                                    |       | $                                          | (13,466    | )                      | $          | (13,269 | ) | $ | (14,399 | ) |   | $ | (197 | ) |   |   | $ | 1,130 |   |   |

 

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**Comparisonof the years ended December 31, 2005, 2004 and 2003:**

**REVENUES**

SCR Catalyst and Management Services revenues (after February 20,2004) result primarily from catalyst cleaning and regeneration services. Additionally,the Company provides SCR catalyst management and consulting services,including catalyst inspection, performance testing and analysis, catalystspecification, and computer simulation to help power plantoperators improve their SCR system performance and achieve cost-effectiveNOx compliance. Research and Development revenues in the periods presentedinclude revenues generated from research and development (“R&D”) contractsfunded by gas turbine manufacturers and government sources for fuel processor,diesel and gas turbine technology development. These R&D contracts providefor partial recovery of our direct and indirect costs. In addition, R&Drevenues in the periods presented may include proceeds from the sale of ourXonon Cool Combustion modules to original equipment 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. Due to the nature of R&D funding, period-to-periodcomparisons of R&D revenues are not necessarily meaningful and should notbe relied upon as indications of future performance. It is likely that 2006funding will be significantly below 2005 levels due to the completion in 2005of several revenue producing R&D contracts.

SCR Catalyst and Management Services revenuesdecreased in 2005 despite having a full year of operations in 2005 versus justover 10 months in 2004. The decrease was largely attributable to a limitedbacklog of orders at the beginning of the year combined with a disruption inthe business early in 2005 resulting from a changeover in SCR-Tech management. Dueto the protracted time often required to complete a sale, many of the ordersreceived after the new management team was in place could not be completed in2005 and are reflected in backlog as of December 31, 2005. R&DRevenues decreased due to the completion of several large contracts in 2005. Thelargest of these completed contracts was a multi-year program funded by U.S.Department of Energy to develop fuel processors for use with fuel cells (the “DOEFuel Processor Program”), and a program funded by EPRI relating to thedevelopment of a NOx reduction solution for stationary diesel generators. Completionof these programs in 2005 resulted in $698,000 and $432,000 decreases infunding, respectively, compared with funding received in 2004. Partiallyoffsetting these decreases in funding was $202,000 of additional fundingreceived from the Texas Commission on Environmental Quality in support of anon-vehicle demonstration of the Company’s mobile diesel retrofit solution,which was also completed in 2005

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 fundingassociated with the DOE Fuel Processor Program.

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We believe 2006 SCRCatalyst and Management Services revenues will exceed 2005 revenues due to abacklog in excess of $3,100,000 as of December 31, 2005, including$185,000 of deferred revenue. Backlog as of December 31, 2004 wasapproximately $775,000, including $190,000 of deferred revenue. With respect torevenues generated from R&D contracts, however, it is likely that 2006funding will be significantly below 2005 levels due to the completion in 2005of several revenue producing R&D contracts. Accordingly, we anticipate thatSCR Catalyst and Management Services revenues will constitute the vast majorityof our revenues in 2006. We have identified potential funding sources for ourDiesel OEM and Diesel Genset programs; however, we have not yet secured fundingfrom those sources and the availability of such funding is not certain.

**COST OF REVENUES**

R&D 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-direct programexpenses incurred as a percentage of direct program expenses.

The decrease in cost of revenues during the year endedDecember 31, 2005 compared to 2004 consisted of reduced activity ongovernment and OEM funded programs in 2005 as several such programs were completedin 2005. Cost of revenues for SCR Catalyst and Management Services areprimarily fixed costs and, therefore, did not decline substantially despite adecrease in revenues.

The majority of theincrease in cost of revenues during the year ended December 31, 2004compared to 2003 consisted of $2,401,000 in incremental expenses from SCRCatalyst and Management Services, offset by a $1,595,000 decrease in cost ofR&D contracts (primarily direct labor, consulting services and supplies),resulting from reduced activity relating to government and OEM fundedcontracts; in addition to reduced overhead between comparative periodsresulting from focused expense reduction efforts and increased utilization ofinternal resources.

**RESEARCH AND DEVELOPMENT 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. R&D expenses incurred inconnection with government and OEM funded contracts are reported as cost ofrevenues. Total R&D expenses, including those classified as cost ofrevenues, were $9,733,000, $10,244,000, and $11,260,000, for the years endedDecember 31, 2005, 2004, and 2003, respectively.

Although total R&D expenditures decreased $511,000in 2005 compared with 2004, the amount of such costs incurred on government andOEM funded programs, and therefore classified as cost of revenues in theaccompanying consolidated statement of operations, decreased by $483,000,resulting in a net decrease in expenses classified as research and developmentof only $28,000. This $28,000 decrease, however, was net of $464,000 ofpersonnel-related costs and $318,000 of impairment charges resulting from thetermination of our diesel retrofit program and resulting reorganization in 2005as well as $320,000 of 

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impairment charges and$155,000 of inventory write-downs relating to the slowdown in activity andreduced market prospects of our small gas turbine program. These restructuringand impairment charges were more than offset by savings in consulting, otheroutside services and supplies of roughly $600,000 due to reduced R&Dactivity and the transition of our diesel retrofit program from prototype toon-vehicle testing, savings of roughly $452,000 in personnel-related expensesresulting from headcount reductions made in connection with the reorganization,savings of $187,000 related to the closure of a gas turbine test facility inlate 2004 and savings resulting from overall cost reduction efforts which havebeen underway since 2004.

The majority of the increase in R&D expensesduring the year ended December 31, 2004 compared to 2003 consisted of a$1,246,000 increase in direct labor and fringe benefits incurred on internallyfunded programs, primarily relating to the development of diesel applications.Offsetting this increase was a $754,000 decrease in salaries and fringebenefits resulting from headcount reductions in the fourth quarter of 2003 andthe first quarter of 2004.

We expect total R&Dexpenses, including those classified as cost of revenues, will continue todecrease during 2006 as compared to 2005 due to the headcount reductions in thethird and fourth quarters of 2005, the termination of the diesel retrofit andDOE Fuel Processor programs in 2005 and our plans to no longer conduct R&Dactivities associated with gas turbines. Our research and development effortsin 2006 are expected to focus primarily on our diesel OEM programs.

**SELLING,GENERAL AND ADMINISTRATIVE EXPENSES**

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 increase in SG&A expenses in 2005 as comparedwith 2004 is largely attributable to $563,000 of personnel-related costsresulting from the termination of our diesel retrofit program and resultingreorganization, $541,000 of additional consulting and professional fees incurredin connection with our restructuring and related activities, employment issuesrelated to the senior management changes at SCR-Tech, market studies and othercorporate matters. In addition, 2004 included a favorable adjustment to adecommissioning reserve of $155,000 while 2005 included a $192,000 favorableadjustment to the reserve for bad debts as a result of collection of a notewhich had been fully reserved for in prior years.

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.

We expect SG&A for2006 to decrease as compared to 2005 due to both the one-time and ongoing impactsof our restructuring activities in 2005 and further reductions in overheadexpenditures resulting from our ongoing cash conservation efforts.

**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 and othernon-operating gains and losses.

Interest and other income increased in 2005 ascompared to 2004 primarily because of a $2,105,000 gain recognized inconnection with our settlement of the remaining SCR-Tech acquisition liabilityfor 

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substantially less thanits recorded amount. The increase also reflects increased interest income of$359,000 in 2005 as a result of higher market interest rates partially offsetby reduced investment balances.

Interest income during theyear ended December 31, 2004 compared to 2003 was $152,000 lower due todeclining cash and investments balances partially offset by slightly improvedmarket yields. Other income during the year ended December 31, 2004 comparedto 2003 was $87,000 higher primarily as the result of Gilbert lease incomewhich did not commence until the second half of 2003.

**INTEREST EXPENSE**

Interest expense reflects amounts incurred underlong-term debt and capital lease obligations. The primary component oflong-term debt in 2005 and 2004 was the SCR-Tech acquisition liability,which was discounted to the present value of the expected future cash payments.

Interest expense for 2005 increased as compared to2004 because the SCR-Tech acquisition liability was outstanding for anextra month in 2005, combined with higher balances in 2005 resulting from themonthly compounding of interest.

Interest expense during the year endedDecember 31, 2004 compared to 2003 was $328,000 higher primarily due tothe accretion of imputed interest on the SCR-Tech acquisition liability,which began in March 2004.

We expect interest expensewill decrease dramatically during 2006 compared to 2005 as the primary sourceof interest expense, the SCR-Tech acquisition liability, was eliminatedin December 2005.

**INCOME TAXES**

No benefit from incometaxes was recorded in 2005, 2004 or 2003 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.

**LIQUIDITY ANDCAPITAL RESOURCES**

**HistoricalCapital Position 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 million from a public offering of our commonstock. Through December 31, 2005, approximately 78% of the proceeds fromthe capital contribution and our public offering have been used to fund our ongoingresearch and development efforts including the commercialization of our XononCool Combustion technology, the purchase of our commercial manufacturing andadministrative facility in Gilbert, Arizona, the purchase of SCR-Tech andfor general corporate purposes. The remaining funds are invested in commercialand government short-term paper.

Thefollowing table summarizes the yearly changes in cash, cash equivalents andshort-term investments (in thousands):

| ** **                                                           | ** ** | **Year ended December 31,** | ** ** |
|----------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                           | ** ** | **2005**                                   | ** ** | **2004** | ** ** |
| Ending balance of  cash, cash equivalents and short-term investments |       | $                                          | 21,332     |   | $ | 35,592 |   |
| Net decrease in cash,  cash equivalents and short-term investments   |       | ($14,260                                   | )          | ($17,090 | ) |
|                                                                      |            |                                            |            |  |  |  |  |

 

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Our net decrease in cash, cash equivalents andshort-term investments (“Cash Consumption”) was $14.3 million for the yearending December 31, 2005. The following amounts comprised the mostsignificant components of the decrease of $14.3 million, or 40.0%, in cash,cash equivalents and short-term investments during 2005:

$14.2million related to earnings before interest, taxes, depreciation andamortization (“EBITDA”), summarized (in millions) in the following table. Weelect to use EBITDA in our analysis of Cash Consumption as we believe itapproximates cash used in our operations:

| Net loss |   | $                                                  | (13.5  | )    |
|----------|--------|----------------------------------------------------|--------|------|
| Plus:    |   | Interest expense                                   |   | 0.6  |   |
|     |   | Depreciation/impairment  of property and equipment |   | 1.8  |   |
|     |   | Amortization of  intangible assets                 |   | 0.2  |   |
| Less:    |   | Interest and  other income                         |   | (3.3 | ) |
|     |   | EBITDA                                             |   | $    | (14.2 | ) |

 

$1.5 million paid to settle the SCR-Tech acquisitionliability

$0.3 million of capital expenditures; and

($1.7) million changes in working capital and other.

Our CashConsumption was $17.1 million for the year ending December 31, 2004. Thefollowing amounts comprised the decrease of $17.1 million, or 32.4%, in cash,cash equivalents and short-term investments during 2004:

$11.9million related to earnings before interest, taxes, depreciation andamortization (“EBITDA”), summarized (in millions) in the following table. Weelect to use EBITDA in our analysis of Cash Consumption as we believe itapproximates cash used in our 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 |   |
| Less:    |   | Interest and other  income                         |   | (0.7) |   |
|     |   | EBITDA                                             |   | $(11.9 | ) |

 

$4.3 million of costs related to the SCR-Techacquisition, including cash paid on acquisition, transaction and integrationcosts and payments for the completion of certain training and transfer ofcertain intangible assets (see Note 3 of Notes to Financial Statements);

$0.4 million of capital expenditures; and

$0.5 million changes in working capital and other.

In connection with ourpurchase of SCR-Tech in February 2004, we incurred several contingentliabilities. These liabilities were extinguished with the settlement in December2005 of all outstanding liabilities arising from the purchase for a one-timecash payment of $1.5 million.

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**Capital Requirements**

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 ourproducts and our rate of sales growth. We face substantial uncertainties withrespect to our business operations and we may not be able to achieve positivecash flow from our operations. Our current operating plans through fiscal 2006are continually under review and may or may not include further developing ourdiesel emissions reduction solutions and expanding our SCR Catalyst andManagement Services business.

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 ofrequired regulatory reviews and approvals. Further, our SG&A expenses havebeen in excess of $6 million per year, and, although reduced as part ofour 2005 restructuring activities, are expected to continue tobe significant under our current business strategy. Thus, any delay inproduct development or commercial product launches will result in us continuingto incur significant SG&A expenses without corresponding revenues. Inaddition, because we are a public company subject to the compliancerequirements and corresponding costs relating to Federal securities laws, it isdifficult to reduce such expenses without substantially curtailing ouroperations. Our liquidity will continue to be impacted by these expenses aslong as we are subject to such requirements.

Our net decrease in cash, cash equivalents andshort-term investments (“Cash Consumption”) was $14,260,000 in 2005, comparedto Cash Consumption of $17,909,000 in 2004. On a comparative basis, CashConsumption in 2005 included approximately $916,000 of restructuring-relatedpayments and a $1.5 million SCR-Tech settlement payment, while CashConsumption in 2004 included approximately $4.3 million of SCR-Techacquisition-related expenditures We estimate that our total Cash Consumptionfor 2006 will range between $7 million and $9 million. We believe ouravailable cash, cash equivalents and short-term investments (“Cash”) in theamount of $21.3 million as of December 31, 2005 will provide sufficientcapital to fund operations as currently conducted until at least December 31,2007. However, if our overall Cash Consumption in 2006 exceeds our currentexpectations because of higher capital expenditures, increased costs ofdevelopment or commercialization, lower than anticipated revenues from SCR-Tech,lower government and third-party funding, higher SG&A expenditures or forany other reason, we may be required to raise additional funds to continue ouroperations as presently planned, significantly curtail our business operationsand/or change our strategic direction. In particular, we currently estimatethat the total remaining development costs for continuing to pursue our dieselOEM NOx and PM solutions for new, over-the-road diesel engines will be inexcess of $10 million, and potentially substantially in excess of such sum. Ourbelief that we have sufficient funds through December 31, 2007, issignificantly dependent on these costs not materially exceeding $10 millionduring this period. In addition, we may enter into mergers, acquisitions orother strategic arrangements which could require the use of cash, reducing ouravailable capital prior to December 31, 2007, or which could requireadditional equity or debt financing. Moreover, the integration and operation ofany business acquired could require significant expenditures that couldmaterially and adversely impact our liquidity and capital resources. In thisregard, our 2004 acquisition of SCR-Tech required significant cashoutlays for acquisition-related payments and may potentially require futurecash 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 

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of common stock. If weissue debt securities, these securities would be senior in priority to anyequity securities, including our common stock, and would subject us to therisks inherent in issuing debt, including ongoing payment and maturityobligations. Funding requirements satisfied through strategic relationshipswith industry participants could result in substantial dilution of our thenexisting equity holders and could require us to limit our potential return fromour products by making significant business or financial concessions to suchparticipants.

Beyond December 31,2007, our cash requirements will depend on many factors, including but not limitedto the market acceptance of our products, the ability of our diesel emissionsreduction products to achieve market acceptance and commitments fromsignificant industry participants, the timing and level of development fundingfrom private and government sources, the ability of SCR-Tech to generatesignificant cash flow, the rate of expansion of our sales and marketingactivities, the rate of expansion of our manufacturing capacity, and the timingand extent of research and development projects. Most significantly, since wedo not expect any significant revenues from our diesel OEM NOx or PM solutionsuntil 2009, even if we are successful in such programs, if we continue to incursignificant development expenditures for such programs beyond 2007, we almostcertainly will require significant additional capital to continue ouroperations. Further, if SCR-Tech’s business expands significantly, we mayrequire substantial additional capital expenditures beyond 2007, includingadditional plant expansion or location of a second regeneration facility at adifferent geographic location.

**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 the 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. We are currently marketing this facility with theobjective of consolidating facilities or seeking a smaller facility moresuitable to our downsized operations. In the event of a sale of our Gilbertfacility, the loan may be assumed by a purchaser which can satisfy thefinancial requirements of the lender. The loan may be prepaid commencing in September 2006,with a prepayment penalty equal to 3% of the amount of the outstanding loan,with such prepaying penalty declining on a yearly basis over the remaining termof the loan.

**Dividend Policy**

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

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**Contractual Obligations**

We hadvarious contractual obligations outstanding as of December 31, 2005. Thefollowing table sets forth payments due for each of the next 5 years andthereafter (in thousands):

| ** **                     | ** ** | **Total** | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **Thereafter** | ** ** |
|--------------------------------|------------|-----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------------|------------|
| Long-Term Debt  Obligations    |       |      |       |     |       |     |       |     |       |     |       |     |       |           |       |   |   |
| Building term loan             |       | $         | 3,463      |     | $          | 210      |       | $        | 229        |     | $          | 229      |       | $              | 2,795      |   | $ | — |   |   | $ | — |   |   |
| Capital Lease  Obligations     |       | 27        |       | 5        |       | 5        |       | 4        |       | 5        |       | 4        |       |           | 4          |   |   |
| Operating Lease  Obligations   |       |      |       |     |       |     |       |     |       |     |       |     |       |           |       |   |   |
| Building                       |       | 2,145     |       | 541      |       | 268      |       | 268      |       | 267      |       | 267      |       |           | 534        |   |   |
| Equipment                      |       | 67        |       | 28       |       | 16       |       | 10       |       | 8        |       | 5        |       |           | —     |   |   |
| Purchase  Obligations          |       | —    |       | —   |       | —   |       | —   |       | —   |       | —   |       |           | —     |   |   |
| Other Long-Term  Liabilities   |       |      |       |     |       |     |       |     |       |     |       |     |       |           |       |   |   |
| Security deposits              |       | 27        |       | —   |       | 27       |       | —   |       | —   |       | —   |       |           | —     |   |   |
| Core deposits(A)               |       | 114       |       | 114      |       | —   |       | —   |       | —   |       | —   |       |           | —     |   |   |
| Other                          |       | 3         |       | 3        |       | —   |       | —   |       | —   |       | —   |       |           | —     |   |   |
| Total Contractual  Obligations |       | $         | 5,846      |     | $          | 901      |       | $        | 545        |     | $          | 511      |       | $              | 3,075      |   | $ | 276 |   |   | $ | 538 |   |   |

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(A)       Represents deposits made inconnection with the sale of Xonon catalyst modules to be refunded upon returnof 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 MWpower output or less. In each case, the manufacturing and marketing party willpay a royalty of 5% of net sales to the other party. Each party is responsiblefor its own development expenses, and any invention made after May 1, 1995is the sole property of the party making the invention, while the other partyhas a right to obtain a royalty-bearing, non-exclusive license to use theinvention in its areas of exclusivity. As commercialized, the Xonon systemcontains significant technology developed by us after May 1, 1995 and notechnology developed by Tanaka after this date. Our development agreement withTanaka expired in 2005, and we have no further royalty obligations to Tanakaafter 2005.

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.

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In January 2000, we entered into a funding arrangementwith GTI to fund the development of our Xonon combustor and demonstrate itsperformance. We will be required to make royalty payments to GTI of $243,000per year for seven years beginning with the sale, lease or other transfer ofthe twenty-fifth catalyst module for gas turbines rated greater than 1 MW, upto 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, andwe must 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 $100,000in 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. Actual resultswould differ from these estimates under different assumptions or conditions.

Our significant accountingpolicies are disclosed in Note 2 to our consolidated financial statements.We believe the following critical accounting policies affect our moresignificant judgments and estimates used in the preparation of our consolidatedfinancial statements.

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*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 for regeneration andcleaning services in that SCR-Tech’s contracts currently provide thatservices are completed upon receipt of testing by independent third partiesconfirming compliance with contract requirements. Testing generally occursthree times during a particular customer project—at the beginning of theprocessing, when approximately one-half of the project has been processed, andupon completion of processing. A typical customer project may take 30 to 90days to complete. Once a successful test result is received from an independentthird party, revenue is recognized for each catalyst module processed prior tothe receipt of such test results, and revenue is subsequently recognized foreach catalyst module as its processing is completed. As the Company utilizes aconsistent methodology and formula for each project, it is unlikely thatsubsequent testing would not be successful. Nonetheless, if a subsequent testresult were to indicate failure, the Company would cease recognizing revenue onany subsequent modules until new testing evidence confirms successful processing.We maintain a revenue allowance to provide for any deficient test results thatmay occur after our initial test.

From time to time, SCR-Tech purchases spentcatalyst modules, regenerates them and subsequently sells them to customers asrefurbished units. In such cases, revenues are not recognized until the unitsare delivered to the customer.

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 six month criteria is met. 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 

52

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revenuein a subsequent period by the amount by which actual disallowed funding exceedsour estimate. No amounts recognized as revenue are refundable. In return forfunding, collaborative partners may receive certain rights in thecommercialization of the resulting technology. The contracts are also subjectto periodic review by the funding partner, which could result in modificationsto program scope, including reduction or termination of funding.

*Goodwill and OtherIntangible 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. SFASNo. 142 also requires that intangible assets with estimable useful livesbe amortized over their respective estimated useful lives to their estimatedresidual values and reviewed for impairment in accordance with SFASNo. 144, “Accounting for Impairment or Disposal of Long-Lived Assets.”Other intangible assets that have finite useful lives, including patents,trademarks, trade secrets and other purchased technology, were recorded at fairvalue at the time of the acquisition, and are carried at such value lessaccumulated amortization. We amortize these intangible assets on astraight-line basis over their useful lives, estimated at ten years.

*Accounts ReceivableReserves*

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 collections experience.We generally reserve for balances that are 60 days past the invoice duedate. If the financial condition of any of our customers or funding partnerswere to deteriorate, resulting in an impairment of their ability to makepayments, 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.

*ContingentLiabilities*

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.

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**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 made in U.S. dollars. Accordingly, we have not hadany material exposure to foreign currency 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). Statement 123(R)supersedes APB Opinion No. 25, “Accountingfor Stock 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.

We adopted Statement 123(R)on January 1, 2006, the adoption of which will likely have a significantimpact on our results of operations, although it will have no impact on ouroverall financial position. The actual impact of adoption of Statement 123(R)on our results of operations cannot be predicted at this time because it willdepend on levels of share-based payments granted in the future. However, had weadopted Statement 123(R) in prior periods, the impact of that standardwould have approximated the impact of Statement 123 as described in thedisclosure of pro forma net income and earnings per share in Note 2 to ourconsolidated financial statements. Statement 123(R) also requires the benefitsof tax deductions in excess of recognized compensation cost to be reported as afinancing cash flow, rather than as an operating cash flow as required undercurrent literature. This requirement will reduce net operating cash flows andincrease net financing cash flows in periods after adoption to the extent we donot provide a full valuation reserve on such tax benefit.

**Item 7A.**                *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 investment willdecline. In an effort to minimize this risk, we maintain our portfolio of cashequivalents and short-term investments in a variety of securities, includingcommercial paper, money market funds, government and non-government debtsecurities. The average duration of our investments in 2005 and 2004 was lessthan one year. Due to the short-term nature of these investments, we believe wehave no material exposure to interest rate risk arising from our investments.Therefore, no quantitative tabular disclosure is required.

**Item 8.**                        *CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA*

Our Consolidated FinancialStatements and the report of the independent registered public accounting firmappear on pages 62 through 90 of this Form 10-K.

**Item 9.**                        *CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIALDISCLOSURE*

None.

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**Item 9A.**                *EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES*

(a)          **Evaluationof disclosure controls and procedures.  **We have carried out anevaluation under the supervision and with the participation of management,including the Chief Executive Officer and Chief Financial Officer, of theeffectiveness of the design and operation of our disclosure controls andprocedures. There are inherent limitations to the effectiveness of any systemof disclosure controls and procedures, including the possibility of human errorand the circumvention or overriding of the controls and procedures.Accordingly, even effective disclosure controls and procedures can only providereasonable assurance of achieving their control objectives. Based upon anevaluation, our Chief Executive Officer and Chief Financial Officer hasconcluded that, as of December 31, 2005, the disclosure controls andprocedures were effective to provide reasonable assurance that informationrequired to be disclosed in the reports we file and submit under the SecuritiesExchange Act of 1934 is recorded, processed, summarized and reported as andwhen required.

(b)         **Changes in internal controls.  **There were no otherchanges in the Company’s internal control over financial reporting identifiedin connection with the evaluation required by paragraph (d) of theSecurities Exchange Act Rules 13a-15(d) that occurred during thequarter ended December 31, 2005 that affected, or were reasonably likelyto affect, the Company’s internal control over financial reporting.

**Item 9B.**               *OTHER INFORMATION*

None.

**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 of Stockholders,pursuant to Regulation 14A of the Securities Exchange Act of 1934, asamended, not later than 120 days after the end of the fiscal year coveredby this Report, and certain information in the Proxy Statement is incorporatedherein by reference.

**Item 10.**                 *DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT*

Information concerning directors and executiveofficers of Catalytica Energy Systems, Inc. required to be included inthis item is set forth under the headings “Information about our Directors,” “Section 16(a)Beneficial Ownership Reporting Compliance,” and “Executive Officers” inCatalytica Energy’s 2006 Proxy Statement, and is incorporated into this reportby reference.

The section entitled “AuditCommittee Financial Expert” appearing in our 2006 Proxy Statement sets 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 2006 Proxy Statement sets 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 2006 Proxy Statement sets forth certaininformation with respect to the compensation of our management and isincorporated herein by reference.

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**Item 12.**                 *SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ANDRELATED STOCKHOLDER MATTERS*

The section entitled “Security Ownership of PrincipalStockholders and Management” appearing in our 2006 Proxy Statement sets forthcertain information with respect to the ownership of our common stock and isincorporated herein by reference.

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

**Item 13.**                 *CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS*

The section entitled “Transactionswith Management” appearing in our 2006 Proxy Statement sets forth certaininformation with respect to certain business relationships and transactionsbetween us and our directors and officers and is incorporated herein byreference.

**Item 14.**                 *PRINCIPAL ACCOUNTANT FEES AND SERVICES*

The section entitled “Fees Billed to the Company byIndependent Registered Public Accountants” appearing in our 2006 ProxyStatement sets forth certain information with respect to various accountingfees billed to us and is incorporated herein by reference.

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**PART IV**

**Item 15.   *EXHIBITS AND FINANCIAL STATEMENT SCHEDULES***

a.                 (1) *Consolidated Financial Statements*

The following consolidatedfinancial statements of the Registrant are filed as part of this Report:
|                                                                                                                                                                         | ** ** | **Page** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| Report of Independent Registered Public Accounting  Firm                                                                                                                |       | 62       |
| Consolidated Statements of Operations for the years  ended December 31, 2005, 2004 and 2003                                                                   |       | 63       |
| Consolidated Balance Sheets at December 31, 2005  and 2004                                                                                                         |       | 64       |
| Consolidated Statements of Stockholders’ Equity for  the period from January 1, 2003 through December 31, 2005        |       | 65       |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2005, 2004 and  2003                                                                  |       | 66       |
| Notes  to Consolidated Financial Statements                                                                                                                             |       | 67       |

 

(2) *Consolidated FinancialStatement Schedules*

None.   Schedules havebeen omitted because the information required to be set forth therein is notapplicable 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.                                                                                                                                                                                                                                                                                                                                              |

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|   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.                                                                                                                                 |
|   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.                                                                                                                                                                                                                                                                       |
|   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.                                                                                                                                                         |

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| 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.                                                                                                                                                                                |
| 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.                                                                                                                                                                          |
| 10.43 |   | (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                                                                                                                                                                                                                         |

59

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| 10.50 |   | (37) |   | Retention Agreement by and between the Registrant and  Ralph Dalla Betta, dated as of September 27, 2005                                                                                                                                                                                                                  |
|-------|--------|------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.51 |   | (37) |   | Retention Agreement by and between the Registrant  and Joe Barry, dated as of September 27, 2005                                                                                                                                                                                                                          |
| 10.52 |   | (37) |   | Severance Consulting and Release Agreement by and  between the Registrant and Dominic Geraghty, dated as of September 27,  2005                                                                                                                                                                                           |
| 10.53 |   | (38) |   | Employment Agreement by and between the Registrant  and Robert W. Zack, dated as of September 27, 2005                                                                                                                                                                                                               |
| 10.54 |   | (39) |   | Settlement Agreement and Mutual Release among the  Registrant, EnBW Energy Solutions GmbH, ENVICA Kat GmbH, E&EC  Energy & Environmental Consultants GmbH, SCR-Tech GmbH, SCR-Tech  LLC, CESI-SCR, Inc., ENVICA GmbH, CESI-Tech  Technologies, Inc., Hans-Ulrich Hartenstein, and Brigitte  Hartenstein |
| 10.55 |   | (40) |   | Form of Option Acceleration Agreement                                                                                                                                                                                                                                                                                     |
| 10.56 |   | **   |   | Employment Letter and Change of Control Agreement  between the Registrant and William McMahon                                                                                                                                                                                                                                  |
| 10.57 |   | (41) |   | Termination Agreement between the Registrant and  General Electric Company                                                                                                                                                                                                                                                     |
| 14.1  |   | (42) |   | Code of Ethics                                                                                                                                                                                                                                                                                                                 |
| 21.1  |   | **   |   | Subsidiaries of Registrant.                                                                                                                                                                                                                                                                                                    |
| 23.1  |   | **   |   | Consent of  Independent Registered Public Accounting Firm.                                                                                                                                                                                                                                                                     |
| 24.1  |   | **   |   | Power of Attorney  (see Signature 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 has been granted for portions of theseagreements.

             *  Represents management contracts orcompensatory plans for executive officers and directors.

      **  Filed herewith.

   (1)  Incorporated by reference to exhibits filed withCatalytica, Inc.’s Registration Statement on Form S-1(Registration Statement No. 33-55696). 

   (2)  Incorporated by reference to exhibits filed withCatalytica, Inc.’s Form 10-K (File No. 0-20966) forthe year ended December 31, 1994. 

   (3)  Incorporated by reference to exhibits filed withCatalytica, Inc.’s Form 10-K (File No. 0-20966) forthe year ended December 31, 1996. 

60

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   (4)  Incorporated by reference to exhibits filed withCatalytica, Inc.’s Form 10-K (File No. 0-20966) forthe year ended December 31, 1997. 

   (5)  Incorporated by reference to exhibits filed with our RegistrationStatement on Form S-1 (File No. 333-44772), filed onAugust 29, 2000.

   (7)  Incorporated by reference to exhibits filed with our AmendmentNo. 2 to Form S-1 (File No. 333-44772), filed onOctober 16, 2000.

   (8)  Incorporated by reference to exhibits filed with our AmendmentNo. 3 to Form S-1 (File No. 333-44772), filed onNovember 1, 2000.

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

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

(14) Incorporated by reference to exhibits filed with our RegistrationStatement on Form S-1 (File No. 333-64682), filed onJuly 6, 2001.

(16) Incorporated by reference to exhibits filed with our AmendmentNo. 2 to Form S-1 (File No. 333-64682), filed onAugust 6, 2001.

(18) Incorporated by reference to exhibits filed with our AmendmentNo. 1 to Form 8-A12G/A, filed on February 6, 2002.

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

(26) Incorporated by reference to exhibits filed with our Form 10-Qfor the quarter ended June 30, 2003, filed on August 5, 2003.

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

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

(34) Incorporated by reference to exhibits filed with our Form 10-Qfor the quarter ended September 30, 2004, filed on November 12, 2004.

(35) Incorporated by reference to exhibits filed with our AmendmentNo. 1 to Form 8-A12G/A, filed on November 22, 2004.

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

(37) Incorporated by reference to exhibits filed with our Form 8-K,filed on September 28, 2005

(38) Incorporated by reference to exhibit filed with our amendedForm 8-K, filed on September 28, 2005

(39) Incorporated by reference to the exhibit filed with our Form 8-K,filed on December 22, 2005

(40) Incorporated by reference to the exhibit filed with our Form 8-K,filed on November 21, 2005

(41) Incorporated by reference to the exhibit filed with our Form 8-K,filed on March 15, 2006

(42)   Incorporated by reference toexhibits filed with our Form 10-K for the year endedDecember 31, 2004, filed on March 30, 2005

61

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**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

Board of Directors andStockholdersCatalytica Energy Systems, Inc.

We have audited the accompanying consolidated balancesheets of Catalytica Energy Systems, Inc. as of December 31, 2005 and2004, and the related consolidated statements of operations, stockholders’equity, and cash flows for each of the three years in the period ended December 31,2005. 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 audits 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.

Inour opinion, the financial statements referred to above present fairly, in allmaterial respects, the consolidated financial position of Catalytica EnergySystems, Inc. at December 31, 2005 and 2004, and the consolidatedresults of their operations and their cash flows for each of the three years inthe period ended December 31, 2005, in conformity with U.S. generallyaccepted accounting principles.

/s/ ERNST & YOUNG LLP

Phoenix, ArizonaMarch 24, 2006

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**CATALYTICAENERGY SYSTEMS, INC.CONSOLIDATED STATEMENTS OF OPERATIONSfor the years ended December 31, 2005, 2004 and 2003(In thousands, except per share amounts)**

| ** **                                                                      | ** ** | **For the year ended December 31,** | ** ** |
|---------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                                      | ** ** | **2005**                                                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenues                                                                        |       |                                                         |       |   |   |   |   |
| SCR catalyst & management services                                     |       | $                                                            | 1,725      |   | $ | 2,960 |   | $ | — |   |
| Research and development                                                        |       | 1,804                                                        |       | 2,641 |   | 3,498 |   |
| Total revenues                                                                  |       | 3,529                                                        |       | 5,601 |   | 3,498 |   |
| Costs and  expenses:                                                            |       |                                                         |       |   |   |   |   |
| Cost of revenues                                                                |       | 4,709                                                        |       | 5,227 |   | 4,341 |   |
| Research and development                                                        |       | 7,470                                                        |       | 7,498 |   | 6,919 |   |
| Selling, general and administrative                                             |       | 7,440                                                        |       | 6,339 |   | 7,224 |   |
| Total costs and  expenses                                                       |       | 19,619                                                       |       | 19,064 |   | 18,484 |   |
| Operating loss                                                                  |       | (16,090                                                      | )          | (13,463 | ) | (14,986 | ) |
| Interest and other income                                                       |       | 3,253                                                        |       | 758 |   | 823 |   |
| Interest expense                                                                |       | (629                                                         | )          | (564 | ) | (236 | ) |
| Net loss                                                                        |       | $                                                            | (13,466    | ) | $ | (13,269 | ) | $ | (14,399 | ) |
| Basic and diluted net loss per share                                            |       | $                                                            | (0.75      | ) | $ | (0.74 | ) | $ | (0.81 | ) |
| Weighted average  shares used in computing basic and diluted net loss per share |       | 18,048                                                       |       | 17,850 |   | 17,669 |   |

 

See accompanying notes.

63

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**CATALYTICAENERGY SYSTEMS, INC.CONSOLIDATED BALANCE SHEETSat December 31, 2005 and 2004(In thousands, except per share amounts)**

| ** **                                                                                                                                                      | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                      | ** ** | **2005**              | ** ** | **2004** | ** ** |
| **ASSETS**                                                                                                                                                      |       |                  |       |   |   |
| Current assets:                                                                                                                                                 |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                       |       | $                     | 1,490      |   | $ | 26,901 |   |
| Short-term investments                                                                                                                                          |       | 19,842                |       | 8,691 |   |
| Trade accounts receivable, less allowance of $25 and  $30 at December 31, 2005 and 2004, respectively                                                      |       | 1,434                 |       | 1,222 |   |
| Inventory                                                                                                                                                       |       | 986                   |       | 474 |   |
| Prepaid expenses and other assets                                                                                                                               |       | 652                   |       | 601 |   |
| Total current assets                                                                                                                                            |       | 24,404                |       | 37,889 |   |
| Property and  equipment:                                                                                                                                        |       |                  |       |   |   |
| Land                                                                                                                                                            |       | 611                   |       | 611 |   |
| Building and leasehold improvements                                                                                                                             |       | 7,701                 |       | 9,608 |   |
| Equipment                                                                                                                                                       |       | 6,936                 |       | 8,842 |   |
| Less accumulated depreciation and amortization                                                                                                                  |       | (9,265                | )          | (11,584 | ) |
| Total property and equipment                                                                                                                                    |       | 5,983                 |       | 7,477 |   |
| Notes receivable  from related parties, less allowance of $500 and $687 at December 31,  2005 and 2004, respectively                                       |       | —                |       | — |   |
| Goodwill                                                                                                                                                        |       | 4,257                 |       | 4,257 |   |
| Other intangible  assets                                                                                                                                        |       | 1,411                 |       | 1,584 |   |
| Other assets                                                                                                                                                    |       | 290                   |       | 310 |   |
| Total assets                                                                                                                                                    |       | $                     | 36,345     |   | $ | 51,517 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                   |       |                  |       |   |   |
| Current liabilities:                                                                                                                                            |       |                  |       |   |   |
| Accounts payable                                                                                                                                                |       | $                     | 285        |   | $ | 248 |   |
| Customer deposits                                                                                                                                               |       | 1,220                 |       | — |   |
| Accrued payroll and benefits                                                                                                                                    |       | 1,027                 |       | 1,315 |   |
| Accrued liabilities and other                                                                                                                                   |       | 1,717                 |       | 1,213 |   |
| Current portion of long-term debt and capital lease  obligations                                                                                                |       | 47                    |       | 748 |   |
| Total current liabilities                                                                                                                                       |       | 4,296                 |       | 3,524 |   |
| Long-term debt and  other long-term liabilities                                                                                                                 |       | 3,004                 |       | 5,654 |   |
| Total liabilities                                                                                                                                               |       | 7,300                 |       | 9,178 |   |
| 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—18,141 and 17,890 at December 31, 2005  and 2004, respectively |       | 18                    |       | 18 |   |
| Additional paid-in capital                                                                                                                                      |       | 167,644               |       | 167,358 |   |
| Deferred compensation                                                                                                                                           |       | (70                   | )          | (20 | ) |
| Retained deficit                                                                                                                                                |       | (138,483              | )          | (125,017 | ) |
| Accumulated comprehensive other loss                                                                                                                            |       | (64                   | )          | — |   |
| Total stockholders’ equity                                                                                                                                 |       | 29,045                |       | 42,339 |   |
| Total liabilities  and stockholders’ equity                                                                                                                |       | $                     | 36,345     |   | $ | 51,517 |   |

 

See accompanying notes.

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**CATALYTICAENERGY SYSTEMS, INCCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITYfor the period from January 1, 2003 through December 31, 2005(In thousands)**

| ** **                                                   | ** ** | **Convertible**          | ** ** | ** **            | ** ** | ** **  | ** ** | ** **     | ** ** | ** **   | ** ** | ** **       | ** ** | **Accumulated**        | ** ** | ** ** | ** ** |
|--------------------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|-------------|------------|----------------|------------|--------------|------------|------------------|------------|------------------------|------------|------------|------------|
| ** **                                                   | ** ** | **Preferred Stock** | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional** | ** ** | ** **   | ** ** | ** **       | ** ** | **Comprehensive**      | ** ** | ** ** | ** ** |
| ** **                                                   | ** ** | **Series A**        | ** ** | **Common Stock** | ** ** | **Paid-In** | ** ** | **Deferred**   | ** ** | **Retained** | ** ** | **Other**        | ** ** | **Stockholders’** | ** ** |
| ** **                                                   | ** ** | **Shares**               | ** ** | **Amount**            | ** ** | **Shares**  | ** ** | **Amount**     | ** ** | **Capital**  | ** ** | **Compensation** | ** ** | **Deficit**            | ** ** | **Loss**   | ** ** | **Equity** | ** ** |
| **Balance at January 1, 2003**                     |       |                     | —     |                  |       |        | $          | —         |       |         |       | 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 |   |   |
| Exercise of stock options and issuance of restricted  shares |       |                     | —     |                  |       |        | —     |           |       |         | 169        |             |       |                   | —     |       |       |   | 73 |   |   |   | — |   |   | — |   |   | — |   |   |   | 73 |   |   |
| Purchase of shares through employee stock purchase  plan     |       |                     | —     |                  |       |        | —     |           |       |         | 82         |             |       |                   | —     |       |       |   | 153 |   |   |   | — |   |   | — |   |   | — |   |   |   | 153 |   |   |
| Issuance of restricted stock units                           |       |                     | —     |                  |       |        | —     |           |       |         | —     |             |       |                   | —     |       |       |   | 75 |   |   |   | (75 | ) |   | — |   |   | — |   |   |   | — |   |   |
| Forfeiture of stock options                             |       |                     | —     |                  |       |        | —     |           |       |         | —     |             |       |                   | —     |       |       |   | (7 | ) |   |   | 7 |   |   | — |   |   | — |   |   |   | — |   |   |
| Re-measurement of deferred compensation                      |       |                     | —     |                  |       |        | —     |           |       |         | —     |             |       |                   | —     |       |       |   | (8 | ) |   |   | 8 |   |   | — |   |   | — |   |   |   | — |   |   |
| Amortization of deferred compensation                        |       |                     | —     |                  |       |        | —     |           |       |         | —     |             |       |                   | —     |       |       |   | — |   |   |   | 10 |   |   | — |   |   | — |   |   |   | 10 |   |   |
| Unrealized loss on available-for-sale securities             |       |                     | —     |                  |       |        | —     |           |       |         | —     |             |       |                   | —     |       |       |   | — |   |   |   | — |   |   | — |   |   | (64 | ) |   |   | (64 | ) |   |
| Net loss                                                     |       |                     | —     |                  |       |        | —     |           |       |         | —     |             |       |                   | —     |       |       |   | — |   |   |   | — |   |   | (13,466 | ) |   | — |   |   |   | (13,466 | ) |   |
| **Balance  at December 31, 2005**                       |       |                     | —     |                  |       |        | $          | —         |       |         |       | 18,141           |       |                   |       | $          | 18         |   |   |   | $ | 167,644 |   |   |   | $ | (70 | ) |   | $ | (138,483 | ) |   | $ | (64 | ) |   |   | $ | 29,045 |   |   |

 

See accompanying notes.

65

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**CATALYTICAENERGY SYSTEMS, INC.CONSOLIDATED STATEMENTS OF CASH FLOWSfor the years ended December 31, 2005, 2004 and 2003(In thousands)**

| ** **                                                                           | ** ** | **For the year ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                                           | ** ** | **2005**                                                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| ***Cash  flows from operating activities:***                                         |       |                                                         |       |   |   |   |   |
| Net loss                                                                             |       | $                                                            | (13,466    | ) | $ | (13,269 | ) | $ | (14,399 | ) |
| Adjustments to reconcile  net loss to net cash used in operating activities:         |       |                                                         |       |   |   |   |   |
| Gain on settlement of acquisition liability                                          |       | (2,105                                                       | )          | — |   | — |   |
| Depreciation/impairment of property and equipment                                    |       | 1,826                                                        |       | 1,229 |   | 2,108 |   |
| Amortization of investments premium                                                  |       | 25                                                           |       | 200 |   | 242 |   |
| Amortization of intangible assets                                                    |       | 173                                                          |       | 144 |   | — |   |
| Accretion of interest on long-term debt                                              |       | 421                                                          |       | 352 |   | — |   |
| Forgiveness of notes receivable from related parties                                 |       | 23                                                           |       | 52 |   | 57 |   |
| (Recovery of) provision for uncollectable accounts  and notes                        |       | (192                                                         | )          | — |   | 92 |   |
| Stock based compensation                                                             |       | 10                                                           |       | 26 |   | 63 |   |
| Loss on sale of property and equipment                                               |       | 54                                                           |       | 225 |   | — |   |
| Changes in:                                                                          |       |                                                         |       |   |   |   |   |
| Trade accounts receivable                                                            |       | (207                                                         | )          | 83 |   | 859 |   |
| Inventory                                                                            |       | (519                                                         | )          | 46 |   | 19 |   |
| Prepaid expenses and other assets                                                    |       | (52                                                          | )          | 14 |   | (118 | ) |
| Accounts payable                                                                     |       | 37                                                           |       | (807 | ) | (358 | ) |
| Customer deposits                                                                    |       | 1,220                                                        |       | — |   | — |   |
| Accrued payroll and benefits                                                         |       | (288                                                         | )          | (275 | ) | (838 | ) |
| Accrued liabilities and other                                                        |       | 255                                                          |       | (414 | ) | (455 | ) |
| ***Net cash used in operating  activities***                                         |       | (12,785                                                      | )          | (12,394 | ) | (12,728 | ) |
| ***Cash  flows from investing activities:***                                         |       |                                                         |       |   |   |   |   |
| Purchase of business                                                                 |       | —                                                       |       | (4,300 | ) | — |   |
| Purchases of investments                                                             |       | (35,525                                                      | )          | (10,164 | ) | (19,257 | ) |
| Maturities of investments                                                            |       | 24,284                                                       |       | 21,149 |   | 19,945 |   |
| Sale of property and equipment                                                       |       | 65                                                           |       | 25 |   | — |   |
| Additions to property and equipment                                                  |       | (308                                                         | )          | (435 | ) | (1,315 | ) |
| ***Net cash (used in) provided by  investing activities***                           |       | (11,484                                                      | )          | 6,275 |   | (627 | ) |
| ***Cash  flows from financing activities:***                                         |       |                                                         |       |   |   |   |   |
| Collection of note receivable from former employee                                   |       | 187                                                          |       | — |   | — |   |
| Proceeds from issuance of long-term debt                                             |       | —                                                       |       | 2,940 |   | — |   |
| Repayments of long-term debt                                                         |       | (1,552                                                       | )          | (3,075 | ) | (130 | ) |
| Payments on capital lease obligations                                                |       | (3                                                           | )          | (6 | ) | (58 | ) |
| Proceeds from exercise of stock options                                              |       | 73                                                           |       | 74 |   | 158 |   |
| Proceeds from issuance of common stock to employees  through stock plans        |       | 153                                                          |       | 281 |   | 226 |   |
| ***Net cash (used in) provided by  financing activities***                           |       | (1,142                                                       | )          | 214 |   | 196 |   |
| **Net decrease in cash and cash equivalents**                                        |       | (25,411                                                      | )          | (5,905 | ) | (13,159 | ) |
| **Cash and cash equivalents at beginning of period**                                 |       | 26,901                                                       |       | 32,806 |   | 45,965 |   |
| **Cash and cash equivalents at end of period**                                       |       | $                                                            | 1,490      |   | $ | 26,901 |   | $ | 32,806 |   |
| ***Additional  disclosure of cash flow information:***                               |       |                                                         |       |   |   |   |   |
| Interest paid                                                                        |       | $                                                            | 199        |   | $ | 208 |   | $ | 225 |   |
| Deferred compensation for issuance and revaluation of  stock optionsto non-employees |       | $                                                            | 67         |   | $ | 27 |   | $ | 60 |   |
| Debt assumed for  purchase of business                                               |       | $                                                            | —     |   | $ | 3,133 |   | $ | — |   |

 

See accompanying notes.

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**CATALYTICA ENERGY SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2005**

**Note 1.   Description of Business**

***Description ofBusiness.*****  **CatalyticaEnergy Systems, Inc. (“Catalytica Energy,” “the Company,” “we,” “us” or “our”)provide innovative products and services to meet the growing demand foremissions control solutions 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 management, cleaning and regeneration, as well as consulting servicesto help power plant operators optimize efficiency and reduce overall NOxcompliance costs (collectively “SCR Catalyst and Management Services”). Ourbusiness 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 dieselengine emissions. Our Xonon® Diesel Fuel Processing technology is designedto facilitate a significant reduction in NOx and particulate matter (“PM”)emissions from mobile, stationary and off-road diesel engine applications byimproving the performance of NOx adsorber catalyst systems and diesel particulatefilters.

***Formation andOperations of the Company.*****  **CatalyticaEnergy was incorporated in Delaware in June 1995 as a subsidiary ofCatalytica, Inc. Catalytica Energy operated as part of Catalytica, Inc.’sresearch and development group from inception through the date of itsincorporation as a separate entity. In December 2000, Catalytica AdvancedTechnologies, Inc., another subsidiary of Catalytica Inc., was merged intous, and the combined entity was spun out from Catalytica, Inc. asCatalytica Energy Systems, Inc., a separate, stand-alone public company.

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 rights fromcertain 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.

We operate in twobusiness segments, defined as follows. See Note 11 in Notes to Financial Statementsfor 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 andmanufacturing advanced products based on our proprietary catalyst and fuelprocessing technologies, primarily focused on cost-effective solutions forreducing emissions from diesel engine applications—our Catalyst-BasedTechnology Solutions segment (“CBTS”).

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

**Note2.   Significant Accounting Policies**

***Principles ofConsolidation.*****  **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 2004 and 2003 financial statements toconform to the 2005 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 for the year ended December 31,2003.

***Use of Estimates.*****  **The preparation of consolidated financial statementsin conformity with accounting principles generally accepted in the UnitedStates requires management to make estimates and assumptions that affect thereported amounts in the consolidated financial statements and accompanyingnotes. Actual results could differ from those estimates.

***Cash Equivalents.*****  **Catalytica Energy considers all highly liquidinvestments with a remaining maturity of three months or less from the date ofpurchase to be cash equivalents. The Company’s cash equivalent investmentsconsist of money market accounts.

***Short-TermInvestments.*****  **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 and U.S. Government agency notes withmaturities of twelve months or less.

***Investments inEquity Investments and Joint Ventures.*****  **Investments in equity investments and joint ventureswhere Catalytica Energy has a 20% to 50% ownership interest are accounted forunder the equity method. Under this method, Catalytica Energy records its prorata share of the investee’s net earnings or losses. Investee’s net losses arerecorded until Catalytica Energy’s net investment and obligation, if any, topay down debt are reduced to zero. At December 31, 2005, there were noinvestments recorded on the balance sheet given the remaining equity investmentsare recorded at zero value and the Company has no future funding commitments.

***Concentrations ofCredit Risk.*****  **Assetssubject to concentrations of credit risk consist principally of cashequivalents, short-term investments, and receivables. Catalytica Energy useslocal banks and various investment firms to invest its excess cash, principallyin commercial paper and money market funds from a diversified portfolio ofinvestments with strong credit ratings. Related credit risk would result from adefault by the financial institutions or issuers of investments to the extentof the recorded carrying value of these assets. Catalytica Energy performsongoing credit evaluations of its customers and generally does not requirecollateral.

***AccountsReceivable.***   Accounts receivable consists oftrade receivables generated from research and development contracts, tradereceivables from SCR Catalyst and Management Services and revenues in excess ofbillings from SCR Catalyst and Management Services. Trade receivables arerecorded at the invoiced amount. Payment terms for SCR catalyst regenerationand cleaning services are typically defined in the contract for servicesrendered. Revenues may be earned for those services in advance of amounts 

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

billable to the customer andare recognized when the service is complete, unless the contract terms will notresult in invoice generation within six months from the date of completion ofthose services. Revenues recognized in excess of amounts billed are recorded asaccounts receivable. Revenues in excess of billings represented $585,000 and$225,000 of net accounts receivable as of December 31, 2005 and December 31,2004, respectively.

***Allowance for Doubtful Accounts and Notes.*****  **The Company maintains allowances for doubtfulaccounts for estimated losses resulting from the inability of its fundingparties or customers to make required payments. This allowance is based onspecific customer account reviews and historical collections experience. If thefinancial condition of the Company’s funding parties or customers were todeteriorate, resulting in an impairment of their ability to make payments,additional allowances may be required. The following table summarizes theactivity for the allowance for doubtful amounts on all accounts and notesreceivable:

| **Year ended**   | ** ** | **Beginning** | ** ** | **Net Provision/** | ** ** | **Ending**       | ** ** |
|-----------------------|------------|---------------|------------|-------------------------|------------|------------------|------------|
| **December 31,** | ** ** | ** **    | ** ** | **Balance**             | ** ** | **(Recoveries)** | ** ** | **Balance** | ** ** |
| 2003                  |       | $             | 625,000    |                    |       | $                | 92,000     |   |   | $ | 717,000 |   |
| 2004                  |       | 717,000       |       |                    | —     |             |       | 717,000 |   |
| 2005                  |       | 717,000       |       |                    | (192,000   | )                |       | 525,000 |   |
|                       |            |               |            |                         |            |                  |            |  |  |  |  |  |  |  |

 

***Fair Value ofFinancial Instruments.*****  **AtDecember 31, 2005, the Company has the following financial instruments:cash and cash equivalents, short-term investments, accounts receivable, notesreceivable from related parties, accounts payable, accrued payroll andbenefits, other accrued liabilities and long-term debt. The carrying value ofcash and cash equivalents, short-term investments, accounts receivable,accounts payable, accrued payroll and benefits, accrued legal settlements andaccrued liabilities approximates their fair value based on the liquidity ofthese financial instruments or based on their short-term nature. The carryingvalue of notes receivable from related parties and long-term debt approximatesfair value based on the market interest rates available to Catalytica Energyfor debt of similar risk and maturities.

***Inventory.*****  **Catalytica Energy’s inventory, apart from that ofSCR-Tech, consists principally of raw materials and finished Xonon modules andare stated at the lower of cost or market. Raw materials consist mainly ofvarious precious metals and high temperature foils that are used to makecatalysts for our gas turbine modules and for use in our research anddevelopment activities. SCR-Tech’s inventories include raw materials consistingprimarily of chemicals and SCR modules which have been regenerated and areawaiting delivery to a customer.

***Property andEquipment.*****  **We stateproperty and equipment at cost. We state equipment under capital leases at thepresent value of the minimum lease payments. We capitalize major improvementsand betterments, while maintenance, repairs and minor replacements are expensedas incurred. Depreciation is provided using the straight-line method over theeconomic lives of the assets ranging from 3 to 30 years. Leasehold improvementsare amortized over the shorter of the underlying lease term or asset life. Depreciationexpense recorded during the years ended December 31, 2005, 2004 and 2003was $1,188,000, $1,229,000 and $2,254,000, respectively.

***Impairment ofLong-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. 

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

If this review indicatesthe carrying value of these assets will not be recoverable, as measured basedon estimated 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 2005, $638,000 of impaired long-lived assetswere written-off.

***Goodwill and OtherIntangible Assets.******  ***The Company accounts for goodwilland 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, including intangibles, based on the estimated fair values on therespective acquisition dates. Based on these values, the excess purchase pricesover the fair value of the net assets acquired were allocated to goodwill.Pursuant to SFAS No. 142, goodwill and other intangible assets acquired ina purchase business combination and determined to have an indefinite usefullife are not amortized, but instead tested for impairment at least annually inaccordance with the provisions of SFAS No. 142. SFAS No. 142 alsorequires that intangible assets with estimable useful lives be amortized overtheir respective 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.”

Other intangible assets that have finite useful lives,including patents, trademarks, trade secrets and other purchased technology,are recorded at fair value at the time of the acquisition, and are carried atsuch value less accumulated amortization. The Company amortizes theseintangible assets on a straight-line basis over their useful lives, estimatedat ten years.

As of December 31, 2005 and 2004, all of theCompany’s goodwill is attributable to its SCMS business segment. The Companytests this goodwill annually. The Company performed its annual goodwillimpairment analysis as of December 31, 2005 using discounted expectedfuture cash flows based on a discount rate consistent with the guidanceprovided in FASB Concepts Statement No. 7, *Using Cash Flow Information and Present Value in AccountingMeasurements*, to estimatefair value and the carrying value of its SCMS business segment,including goodwill*.*Impairment isbased on the excess of the carrying amount over the fair value of those assets.This analysis resulted in the conclusion that the goodwill was not impaired.

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

Thechanges in the balances of goodwill and other intangible assets for the yearsended December 31, 2005 and 2004 are as follows (in thousands):

| *Goodwill*                         |   |   |   |
|------------------------------------|--------|--------|--------|
| Balance at December 31, 2003  |   | $      | — |   |
| Purchase of SCR-Tech               |   | 4,257  |   |
| Amortization expense               |   | — |   |
| Balance at December 31, 2004  |   | 4,257  |   |
| Amortization expense               |   | — |   |
| Balance at December 31, 2005  |   | $      | 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  |   |
| Amortization expense               |   | (173   | )      |
| Balance at  December 31, 2005 |   | $      | 1,411  |   |

 

Accumulated amortization through December 31,2005 and 2004 was $317,000 and $144,000, respectively.

***Accrued WarrantyLiability.******  ***TheCompany warranties its gas turbine Xonon 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 catalystcleaning and regeneration services are provided for as cost of revenues in theperiod in which the related revenue is recognized. Adjustments are made toaccruals as warranty claim data and historical experience warrant. Our warrantyobligation may be materially affected by product failure rates and other costsincurred in correcting a product failure. Should actual product failure ratesor other related costs differ from our estimates, revisions to the estimatedwarranty liability would be required.

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

| Balance as of  December 31, 2003         |   | $      | 50     |   |
|-----------------------------------------------|--------|--------|--------|--------|
| Warranties issued and adjustment to provision |   | 85     |   |
| Warranty claims                               |   | — |   |
| Balance as of  December 31, 2004         |   | 135    |   |
| Warranties issued and adjustment to provision |   | 21     |   |
| Warranty claims                               |   | — |   |
| Balance as of  December 31, 2005         |   | $      | 156    |   |

 

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

***Comprehensive Income.*****  **The following is a reconciliation of net loss tocomprehensive loss (in thousands):

| ** **                                                  | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net loss                                                    |       | $        | (13,466    | )        | $          | (13,269  | )          | $ | (14,399 | ) |
| Other  comprehensive loss:                                  |       |     |       |     |       |     |       |
| Change in unrealized loss on available-for-sale  securities |       | (64      | )          | —   |       | —   |       |
| Comprehensive loss                                          |       | $        | (13,530    | )        | $          | (13,269  | )          | $ | (14,399 | ) |

 

As of December 31, 2005, total losses forsecurities with unrealized losses totaled approximately $64,000. There were nosecurities with unrealized gains at December 31, 2005.

***SCR Catalyst andManagement Services Revenues.*****  **Asprescribed in Staff Accounting Bulletin (“SAB”) 101 and 104, “RevenueRecognition in Financial Statements”, the Company recognizes revenue from SCRCatalyst and Management Services when persuasive evidence of an arrangementexists, services have been rendered, the price is fixed or determinable, andcollectibility is reasonably assured.

Revenues related to SCR catalyst regeneration andcleaning services are recognized when the service is completed for eachcatalyst module. Customer acceptance is not required for regeneration andcleaning services in that SCR-Tech’s contracts currently provide that servicesare completed upon receipt of testing by independent third parties confirmingcompliance with contract requirements. Testing generally occurs three timesduring a particular customer project—at the beginning of the processing, whenapproximately one-half of the project has been processed, and upon completionof processing. A typical customer project may take 30 to 90 days to complete.Once a successful test result is received from an independent third party,revenue is recognized for each catalyst module processed prior to the receiptof such test results, and revenue is subsequently recognized for each catalystmodule as its processing is completed. As the Company utilizes a consistentmethodology and formula for each project, it is unlikely that subsequenttesting would not be successful. Nonetheless, if a subsequent test result wereto indicate failure, the Company would cease recognizing revenue on anysubsequent modules until new testing evidence confirms successful processing.We maintain a revenue allowance to provide for any deficient test results thatmay occur after our initial test.

From time to time, SCR-Tech purchases spent catalystmodules, regenerates them and subsequently sells them to customers asrefurbished units. In such cases, revenues are not recognized until the unitsare delivered to the customer.

Due to the nature of the demand for SCR regenerationand cleaning services, some of our contracts provide for extended paymentterms. In a situation where the project for a customer is complete; but thecustomer is not contractually committed to receive an invoice within thesucceeding six months (and subsequent payment is due within 30 days of invoicedate), revenues are deferred until the six month criteria is met. If thecustomer contract provides for a deposit or progress payments, we recognizerevenue up to the amount invoiced. Because of the fact we perform a service fora customer, no rights of return exist. The customer is responsible for theremoval, transportation and subsequent installation of the catalyst. Ourrevenue arrangements do not have any material multiple deliverables as definedin Emerging Issues Task Force (“EITF”) 00-21, “Accounting for MultipleElement 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 performance achieved

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

and the revenuerecognized. In the situation where revenue is deferred due to collectibilityuncertainties, the Company does not defer costs due to the uncertaintiesrelated to payment for such services.

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

***Research andDevelopment 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.

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-relatedtechnologies. The federal government is not the sole or principal expectedend-use customer for the research and development or for products directlyresulting from the R&D activity funded by the contract. We believe thefunding derived from those sources is incidental to our anticipated costs ofbringing the technologies we develop, with government funding support, to themarketplace. As such, we believe it is appropriate to present R&D revenueson 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 31,2005, 2004, and 2003.

**DOE Fuel Processor—****cost-share******research program funded by the U.S. Department of Energy,associated with the development of fuel reforming technology for PEM fuelcells.

**TCEQ—****grant******received from the Texas Commission on Environmental Qualityin support of the Company’s plans for an on-vehicle demonstration of its dieselmobile retrofit solution.

**CEC Multi-can—****funding******from the California Energy Commission for development of acatalytic combustion system for achieving ultra-low emissions in small,multi-combustor gas turbines.

**Diesel OEM—****represents******the use of Company laboratories and purchase of certain partsby a diesel engine manufacturer.

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

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

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

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

Thefollowing table summarizes the amounts of compensation earned and relatedcosts, including overhead, incurred under the R&D programs for the yearsending December 31, 2005, 2004, and 2003 (in thousands):

| ** **          | ** ** | **2005**    | ** ** | **2004**  | ** ** | **2003**    | ** ** |
|---------------------|------------|-------------|------------|-----------|------------|-------------|------------|
| ** **          | ** ** | **Revenue** | ** ** | **Costs** | ** ** | **Revenue** | ** ** | **Costs** | ** ** | **Revenue** | ** ** | **Costs** | ** ** |
| DOE fuel  processor |       |        | $          | 1,126     |       |        | $          | 1,091 |   |   | $ | 1,824 |   |   | $ | 1,542 |   |   | $ | 2,025 |   |   | $ | 2,121 |   |
| TCEQ                |       |        | 270        |      |       | 936         |       |   | 68 |   |   | 124 |   |   | — |   |   | — |   |
| CEC multi-can       |       |        | 186        |      |       | 55          |       |   | 162 |   |   | 427 |   |   | 513 |   |   | 754 |   |
| Diesel OEM          |       |        | 104        |      |       | 15          |       |   | 31 |   |   | — |   |   | — |   |   | — |   |
| GE                  |       |        | 90         |      |       | 166         |       |   | — |   |   | — |   |   | 753 |   |   | 857 |   |
| EPRI                |       |        | 24         |      |       | —      |       |   | 456 |   |   | 559 |   |   | — |   |   | — |   |
| Solar               |       |        | —     |      |       | —      |       |   | 24 |   |   | 94 |   |   | 134 |   |   | 464 |   |
| Other               |       |        | 4          |      |       | —      |       |   | 76 |   |   | — |   |   | 73 |   |   | 145 |   |
| Total R&D       |       |        | $          | 1,804     |       |        | $          | 2,263 |   |   | $ | 2,641 |   |   | $ | 2,746 |   |   | $ | 3,498 |   |   | $ | 4,341 |   |

 

***Revenue CostReserves.*****  **Revenuefrom our funded research and development contracts is recorded as work isperformed and billable hours are incurred by us, in accordance with eachcontract. Since these programs are subject to government audits, we maintain arevenue cost reserve for our government-funded programs in the event any ofthese funded costs, including overhead, are disallowed. We estimate thisreserve by applying a percentage to the revenue recorded under contracts stillsubject to audit by those funding agencies.

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

| Balance as of  December 31, 2003 |   | $      | 150    |   |
|---------------------------------------|--------|--------|--------|--------|
| Adjustment to provision               |   | (31    | )      |
| Revenue refunds issued                |   | — |   |
| Balance as of  December 31, 2004 |   | 119    |   |
| Adjustment to provision               |   | 3      |   |
| Revenue refunds issued                |   | — |   |
| Balance as of  December 31, 2005 |   | $      | 122    |   |

 

***Research andDevelopment Expenses.*****  **Researchand development costs are expensed as incurred.

***Stock-BasedCompensation.*****  **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.”

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

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.

Stock-based awards to non-employees are accounted forat fair value, as generally calculated using the Black-Scholes model, inaccordance with SFAS No. 123 and Emerging Issues Task Force ConsensusNo. 96-18. Related options are subject to periodic re-measurementsover their vesting terms.

Had compensationcost for Catalytica Energy’s stock-based compensation plan been determinedbased on the fair value at the grant dates for stock option awards consistentwith the method of SFAS No. 123, the Company’s net loss would have beenincreased to the pro forma amounts indicated below (in thousands, except pershare amounts):

| ** **                                                | ** ** | **Year ended December 31,** | ** ** |
|-----------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net loss, as  reported                                    |       | $                                          | (13,466    | ) | $ | (13,269 | ) | $ | (14,399 | ) |
| SFAS No. 123  Stock option plan compensation expense |       | (1,299                                     | )          | (1,837 | ) | (1,211 | ) |
| Pro forma net loss                                        |       | $                                          | (14,765    | ) | $ | (15,106 | ) | $ | (15,610 | ) |
| Pro forma basic  and diluted net loss per share           |       | $                                          | (0.82      | ) | $ | (0.85 | ) | $ | (0.88 | ) |

 

***Income Taxes.*****  **Catalytica Energy accounts for income taxes under theasset and liability method in accordance with SFAS No. 109, “Accountingfor Income Taxes.” Under the asset and liability method, deferred income taxassets and liabilities are determined based on the differences between thefinancial reporting and tax bases of assets and liabilities and are measuredusing the currently enacted tax rates and laws. Valuation reserves are providedto the extent that deferred tax assets are not deemed more likely than not tobe recoverable.

***Net Loss per Share.*****  **Basic and diluted net loss per share is presented inaccordance with SFAS No. 128, “Earnings Per Share.”  As the Company’s potentially dilutivesecurities (stock options and restricted stock units) were anti-dilutive forthe years ended December 31, 2005, 2004 and 2003, they have been excludedfrom the computation of weighted-average shares outstanding used in computingdiluted net loss per share because the Company incurred a net loss for each ofthose periods. Total options and restricted stock units outstanding as ofDecember 31, 2005, 2004 and 2003 were approximately 2,462,000, 3,186,000and 2,488,000, respectively.

***Impact of RecentlyIssued Accounting Standards.*****  **OnDecember 16, 2004, the FASB issued SFAS Statement No. 123 (revised2004), “Share-Based Payment” (Statement 123(R)), which is a revision of FASBStatement No. 123, “Accountingfor 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.

The Company must adoptStatement 123(R) on January 1, 2006 which will likely have asignificant impact on our results of operations, although it will have noimpact on our overall financial position. The actual impact of adoption ofStatement 123(R) on our results of operations cannot be predicted at this 

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

timebecause it will depend on levels of share-based payments granted in the future.However, had we adopted Statement 123(R) in prior periods, the impact ofthat standard would have approximated the impact of Statement 123 as describedin the disclosure of pro forma net income and earnings per share in Note 2 toour consolidated financial statements. Statement 123(R) also requires thebenefits of tax deductions in excess of recognized compensation cost to bereported as a financing cash flow, rather than as an operating cash flow asrequired under current literature. This requirement will reduce net operatingcash flows and increase net financing cash flows in periods after adoption tothe extent we do not provide a full valuation reserve on such tax benefits.

**Note 3.   Purchase of SCR-Tech**

On February 20, 2004,we acquired 100% of the outstanding member interests of SCR-Tech andcertain patents and related intellectual property. SCR-Tech is a provider of catalyst regeneration technologies andmanagement services for SCR systems, which are used by coal-fired power plantsto reduce NOx emissions. As a result of the acquisition, the Company expendedits commercial operations and leveraging its expertise in NOx control andcatalysis within multiple markets.

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

In addition to aninitial cash payment of $3,518,000, we were obligated to the followingpayments:

(1)         Upon the completion ofcertain training and delivery of the remaining assets to be acquired, a paymentof $545,000 (which was recorded as an accrued liability and subsequently paidin September 2004).

(2)         On August 20, 2005,a payment of $725,000 ($875,000, less $150,000 adjustment related to closingdate balance sheet), which was recorded as long-term debt at the present valueof the future payment ($660,000).

(3)         On February 20,2006, a payment of $1,000,000, which was recorded as long-term debt at thepresent value of the future payment ($882,000).

(4)         On December 1, 2007and December 1, 2008, a payment of $300,000 on each such date providedthat Hans-Ulrich Hartenstein is an employee of SCR-Tech or its affiliates onsuch dates (collectively, the “Contingent Employment Payments”). TheseContingent Employment Payments were not recorded as part of the purchaseaccounting as the outcome of those payments was contingent upon future servicesand the performance of those services was not determinable beyond a reasonabledoubt. In March 2005, the employment of Hans Hartenstein as president ofSCR-Tech terminated, and as such, this payment obligation has beenextinguished.

(5)         For each of the calendaryears 2004 through 2008, certain amounts, if any, based upon the SCR-Techbusiness attaining certain revenue targets. No amount was recorded as part ofthe purchase accounting to reflect these contingent payments as they were notdeterminable beyond a reasonable doubt.

(6)         For each of the calendaryears 2004 through 2008, certain amounts, if any, based upon the SCR-Techbusiness attaining certain cash flow targets. No amount was recorded as part ofthe 

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

purchase accounting toreflect these contingent payments as they were not determinable beyond areasonable doubt.

(7)         For each of the calendaryears 2004 through 2018, an aggregate of up to $5,022,220 payable ininstallments equal to the lesser of (a) 10% of certain revenues for theapplicable calendar year and (b) $502,220 (collectively, the “AcquiredAsset Payments”). These payments will be paid over the next 10-15 years.We believe that the total amount payable was resolved and determinable at thedate of the acquisition beyond a reasonable doubt; however, we did have toestimate as to when over this period the amounts would be paid. We believe thetiming was reasonably estimable as prescribed in SFAS 5 and appropriate torecognize the liability as prescribed in SFAS 141. We recorded these contingentpayments as long-term debt at the present value of these future payments($1,352,000).

In December 2005, the Company negotiated asettlement of and release from all remaining liabilities related to theacquisition of SCR-Tech including those described in items (2) through(7) above, in return for a cash payment of $1,500,000 which was accountedfor as a reduction of long-term debt. As a result, all then existing balancesrecorded pursuant to items (2), (3) and (7) above were eliminated anda gain on the settlement of acquisition related liabilities of $2,105,000 wasrecorded as other income in the accompanying Consolidated Statement ofOperations.

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

| **As of 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 the recognitionof goodwill include an analysis of the market in which SCR-Tech was conductingbusiness and it potential growth, the technology owned by SCR-Tech and theopportunities to expand the technology with Catalytica know-how, the potentialto grow SCR-Tech into other service areas at power plants, the opportunity toaccess new market channels, the opportunity to expand our breadth in the largeNOx control marketplace, and SCR-Tech’s competitive position within themarketplace.

Other intangible assets of $1,728,000 were recorded aspart of this purchase that are being amortized over their estimated usefullives of ten years. Acquired patents represented $1,627,000 of the identifiableintangible assets with the remaining amount attributed to secret formulas andprocesses, customer 

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

contracts andrelationships, lease agreements, trademarks, and internet domain names. Nointangible assets with indefinite lives were identified.

Goodwill and other intangible assets will be testedfor impairment at least annually in accordance with the provisions of SFASNo. 142. The results of operations for SCR-Tech for the periodFebruary 21, 2004 through December 31, 2004 are included in theconsolidated statements of operations, cash flow and balance sheets as of andfor 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.   Exit and Reorganization Costs**

OnSeptember 1, 2005, the Company announced it would be discontinuing itsdiesel retrofit program due to delays incurred in the commercialization processand the Company’s view of limited market opportunities. The Company alsoannounced that due to that decision, it would be reducing and reorganizing itsworkforce. An impairment charge of $318,000 was taken to Research and Development expenses at that time torecognize the diminished value of certain assets which were used exclusivelyfor the diesel retrofit program. The following table summarizes personnel terminationcosts incurred in connection with the decision to exit the diesel retrofitprogram (in thousands):

| ** **                            | ** ** | **R&D** | ** ** | **S,G&A** | ** ** | **Total** | ** ** |
|---------------------------------------|------------|-------------|------------|---------------|------------|-----------|------------|
| Expensed                              |       | $           | 464        |          | $          | 563       |       | $ | 1,027 |   |
| Paid                                  |       | (399        | )          | (517          | )          | (916      | )          |
| Accrued as of December 31,  2005 |       | $           | 65         |          | $          | 46        |       | $ | 111 |   |

 

The exit activities affected only the CBTS segment ofour business and were completed as of December 31, 2005.

**Note5.   Transactions with Related Parties**

***NovoDynamics, Inc.*****  **In 2001, we invested $2,258,000 in NovoDynamics, acompany engaged in the development of data mining, informatics discovery andhigh throughput synthesis and testing technologies. During 2001, we owned sharesof Series A voting preferred stock representing approximately 31% ofNovoDynamics’ outstanding equity. We recorded the investment in NovoDynamics atour actual cost and, during the period from March 2001 through December 2001,recorded our pro-rata share of losses totaling $613,000 under the equity methodof accounting.

Additionally in 2001, we agreed to loan NovoDynamics$500,000, which was funded in January 2002. As of December 31, 2001,we recorded a note payable for the $500,000 and a note receivable of $500,000on our balance sheet. Because repayment of the note was not certain at the timeit was made, an allowance of $500,000 was recorded against the loan and thisamount was charged as impairment to implied goodwill of an equity investment onDecember 31, 2001. At December 31, 2005, we believe this note isstill collectible and continue to carry this note on the balance sheet with afull reserve in lieu of a permanent write-off. NovoDynamics continues tooperate as an ongoing business and recently received receivable financing froma third party bank. Additionally, NovoDynamics continues to pay approximately$3,000 per month monthly interest on the note.

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

On December 31, 2001, we determined that animpairment in the carrying value of the equity investment in NovoDynamics hadoccurred which was other than temporary based on NovoDynamics’ financialhistory and projected future losses. At that time, we determined the estimatedfair value of the investment in NovoDynamics was zero and wrote off the net investmentamount of $1,645,000 as impairment to implied goodwill of an equity investment.At that time, we discontinued applying the equity method of accounting becausethe net investment was zero. Therefore, no loss related to the equityinvestment in NovoDynamics was recorded during the years ended December 31,2005, 2004 and 2003. At December 31, 2005, we owned approximately 31% ofNovoDynamics’ outstanding equity.

As of December 31, 2005, two of Catalytica Energy’sdirectors held a direct investment in NovoDynamics Series B votingpreferred stock, which represented less than 2% of NovoDynamics’ outstandingstock.

***Transactions withOfficers and Directors.*****  **Asof December 31, 2004, a $187,000 note receivable from a former officer,along with related interest, had been fully reserved due to delinquent interestpayments. The note and related interest was collected in full during 2005 andthe reserve was reversed.

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 provided consultingservices in diesel engine emission technology and related areas and was paid afee of $27,500 in 2005. The agreement expired on December 31, 2005.

***Forgiveness of Notes.*****  **Forgiveness of notes receivable from related partiesis attributed to forgiveness of housing allowance loans to employees, amortizedover a period of five years. Compensation expense related to forgiveness ofnotes recorded during the years ended December 31, 2005, 2004 and 2003 was$23,000 $52,000 and $57,000, respectively.

***Investments.*****  **Catalytica Energy had $16,493,000 invested withMorgan Stanley Private Wealth Management, an affiliate of Morgan Stanley &Co., Inc., as of December 31, 2004. This amount was 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. The Company no longer invests with Morgan Stanley &Co., Inc. or its affiliates.

**Note 6.   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,** | ** ** |
|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                  | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Income tax  benefit at U.S. statutory rate  |       | $                                          | 4,578      |   | $ | 4,512 |   | $ | 4,895 |   |
| Valuation allowance for deferred tax assets |       | (4,578                                     | )          | (4,512 | ) | (4,895 | ) |
| Income tax benefit                          |       | $                                          | —     |   | $ | — |   | $ | — |   |

 

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

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,** | ** ** |
|------------------------------------------------|------------|-----------------------|------------|
| ** **                                     | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Deferred tax  assets:                          |       |                  |       |   |   |
| Net operating loss carryforwards               |       | $                     | 17,450     |   | $ | 13,615 |   |
| Capitalized research and development           |       | 14,259                |       | 12,913 |   |
| Basis in fixed assets                          |       | 759                   |       | 976 |   |
| Accruals and reserves not currently deductible |       | 2,041                 |       | 2,156 |   |
| Total gross  deferred tax assets               |       | 34,509                |       | 29,660 |   |
| Less valuation allowance                       |       | (34,509               | )          | (29,660 | ) |
| Net deferred tax assets                        |       | $                     | —     |   | $ | — |   |

 

Realization of the deferred tax assets is dependent onfuture earnings, the timing and amount of which are uncertain. Accordingly, avaluation allowance, in an amount equal to the related deferred tax assets hasbeen established to reflect these uncertainties. The valuation allowanceincreased by $4,849,000, $5,360,000, and $5,800,000 in 2005, 2004 and 2003,respectively, due to operating losses which increased net operating losscarryforwards that are not likely to be realized in the near future.

As of December 31, 2005, Catalytica Energy’sfederal and state net operating loss carryforwards were approximately $46,000,000and $35,000,000, respectively. The federal net operating loss carryforward willexpire in the years 2020 through 2025 and the state net operating losscarryforward will expire in the years 2006 through 2015 if not used to offsetfuture taxable income.

The valuation allowance includes approximately$840,000 for net operating loss carryforwards that relate to stock optioncompensation expense for income tax reporting purposes. Any utilization ofthese net operating loss carryforwards would be recorded as an increase inadditional 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 7.   Capital Stock**

Sharesof Catalytica Energy common stock reserved for future issuance as of December 31,2005 are as follows:

| Employee stock  purchase plan |   | 1,089,202 |   |
|-------------------------------|--------|-----------|--------|
| 1995 Stock Option  Plan       |   | 4,199,772 |   |
|                          |   | 5,288,974 |   |

*** ***

***Shareholder RightsPlan.*****  **In January 2002,our Board of Directors adopted a Shareholder Rights Plan, which was amended in November 2004(the “Plan”). Under the Plan, we distributed Preferred Stock Purchase Rights asa dividend at the rate of one Right for each share of its common stock held bystockholders of record on February 20, 2002 (the “Record Date”). The Boardof Directors also authorized 

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

the issuance of Rights foreach share of common stock issued after the Record Date, until the occurrenceof certain specified events. The Plan was adopted to provide protection tostockholders in the event of an unsolicited attempt to acquire the Company. EachRight will entitle the registered holder to purchase from the Company oneone-thousandth of a share of Series A Participating Preferred stock at anexercise price of $45, subject to adjustment. We have authorized 5,000,000shares of Series A preferred 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 each holderof a Right which has not been exercised (other than Rights beneficially ownedby the Acquiring Person) will have the right to receive, upon exercise, votingCommon Shares having a value equal to two 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.

**Note 8.   Employee Benefit Plans**

***Stock Option Plan.*****  **In 1995, the Company adopted the Catalytica EnergySystems, Inc. 1995 Stock Plan (the “1995 Plan”) which was subsequentlyamended. Under the 1995 Plan, the Company’s Board of Directors is authorized togrant incentive stock options to eligible employees and nonqualified stockoptions to eligible employees, consultants, and directors. Through December 31,2005, the Company had reserved 5,000,000 shares of common stock for issuanceunder the 1995 Plan. The incentive stock options generally vest ratably overfour years from the date of grant and expire no later than ten years from thedate of grant. Nonqualified stock options offered to directors vest ratablyover one to four years from the date of grant and expire no later than tenyears from the date of grant.

On August 31, 2005, the 1995 Plan was amended toprovide for the grant of Restricted Stock Units (RSU). On September 22,2005, the board of directors granted 50,000 RSU to Robert Zack, the Company’sChief Executive Officer.   The closingprice of the Company’s common stock on that date was $1.50 per share and,accordingly, a deferred compensation obligation of $75,000 was recorded ofwhich $5,000 was amortized to compensation expense in 2005. The RSU vestratably each quarter over a 4 year period and is payable in shares upon vesting.Shares will be issued net of shares with a fair market value equal to theminimum statutory withholding taxes on each vesting date. Pursuant to theseprovisions, the Company issued 2,054 shares, net of tax, to Mr. Zack in2005.

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

Thefollowing table summarizes related stock option plan activity: 

| ** **                         | ** ** | ** **         | ** ** | **Outstanding Options** | ** ** | ** **   | ** ** |
|------------------------------------|------------|--------------------|------------|------------------------------|------------|--------------|------------|
| ** **                         | ** ** | **Shares**         | ** ** | ** **                   | ** ** | **Average**  | ** ** | **Restricted** | ** ** |
| ** **                         | ** ** | **Available**      | ** ** | **Number**                   | ** ** | **Exercise** | ** ** | **Stock Units** | ** ** |
| ** **                         | ** ** | **for Grant** | ** ** | **of Shares**           | ** ** | **Price**    | ** ** | **Outstanding** | ** ** |
| Balance at  December 31, 2002 |       | 2,514,452          |       | 1,965,609                    |       |         | $          | 8.68 |   |   |   |   |   |   |
| Granted                            |       | (1,238,263         | )          | 1,238,263                    |       |         | 2.80       |   |   |   |   |   |   |
| Expired or 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 or 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       |   |   |   |   |   |   |
| Granted                            |       | (672,567           | )          | 622,567                      |       |         | 2.34       |   |   |   | 50,000 |   |   |
| Expired or forfeited               |       | 1,226,290          |       | (1,226,290                   | )          |         | 4.37       |   |   |   | (1,071 | ) |   |
| Exercised/converted to shares      |       | —             |       | (167,375                     | )          |         | 0.44       |   |   |   | (2,054 | ) |   |
| Balance at  December 31, 2005 |       | 1,737,560          |       | 2,415,337                    |       |         | $          | 5.21 |   |   |   | 46,875 |   |   |

 

Asummary of Catalytica Energy’s stock options outstanding as of December 31,2005 is as follows:

| ** **                                  | ** ** | **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** | ** ** |
| $0.40                                       |       |                         | 53,000     |                         |       |   | 0.67 |   |   | $ | 0.400 |   | 53,000 |   | $ | 0.400 |   |
| $1.75 - $1.91                               |       |                         | 78,000     |                         |       |   | 9.42 |   |   | 1.859 |   | 78,000 |   | 1.859 |   |
| $2.05 - $2.50                               |       |                         | 435,790    |                         |       |   | 8.88 |   |   | 2.412 |   | 435,790 |   | 2.412 |   |
| $2.61 - $3.00                               |       |                         | 449,246    |                         |       |   | 7.26 |   |   | 2.751 |   | 449,246 |   | 2.751 |   |
| $3.20 - $3.55                               |       |                         | 461,383    |                         |       |   | 6.31 |   |   | 3.503 |   | 461,383 |   | 3.503 |   |
| $3.57 - $4.55                               |       |                         | 520,752    |                         |       |   | 7.94 |   |   | 4.019 |   | 520,752 |   | 4.019 |   |
| $5.60 - $7.10                               |       |                         | 55,050     |                         |       |   | 4.38 |   |   | 6.212 |   | 55,050 |   | 6.212 |   |
| $10.451 - $16.937                           |       |                         | 253,316    |                         |       |   | 4.67 |   |   | 14.615 |   | 253,316 |   | 14.615 |   |
| $19.250 - $30.000                           |       |                         | 108,800    |                         |       |   | 4.33 |   |   | 21.916 |   | 108,800 |   | 21.916 |   |
| $0.400 - $30.000                            |       |                         | 2,415,337  |                         |       |   | 6.97 |   |   | $ | 5.213 |   | 2,415,337 |   | $ | 5.213 |   |
|                                             |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

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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:

| ** **                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Expected  Volatility                    |       | 62.50    | %          | 58.50    | %          | 63.55    | %          |
| Risk Free  Interest Rate                |       | 3.71     | %          | 3.15     | %          | 2.98     | %          |
| Weighted Average  Expected Life (years) |       | 5.20     | ** ** | 5.15     | ** ** | 5.28     |       |
| 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 2005,2004 and 2003, was $1.31, $2.13, and $1.66 respectively, as calculated inaccordance with SFAS No. 123.

On November 17, 2005, the Company accelerated thevesting of all then unvested and “out-of-the-money” stock options granted underthe 1995 Plan. As a result, unvested options to purchase 769,814 shares of theCompany’s common stock became immediately exercisable. The action was taken toavoid future charges to operations of approximately $510,000 related to theseoptions which would have resulted upon the Company’s adoption of Statement 123(R) onJanuary 1, 2006. In accordance with the provisions of APB 25, no financialstatement impact resulted from the acceleration. Executive officers anddirectors with unvested options on November 17, 2005, as well as employeesand consultants who held unvested options with an exercise price of less than$2.00 on that date, are subject to restrictions upon the sale of any sharesreceived through the exercise of accelerated options. These restrictionspreclude the sale of any shares acquired from the exercise of an acceleratedoption prior to the earlier of the original vesting date of the option or theindividual’s termination of employment. Options to acquire 250,630 shares ofcommon stock were subject to such restrictions as of December 31, 2005.

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

***Deferred Stock Option Compensation.*****  **During 2001 through 2004, Catalytica Energy grantedstock options to a charitable foundation at the request of a member of theCompany’s board of directors who otherwise would have received the options forhis board service. Since the recipient of these options is not an employee ordirector of Catalytica Energy, the Company recorded deferred compensation, whichwas re-measured at each reporting period and charged to operations over thevesting periods. During June 2004, this board member resigned and theremaining deferred compensation was reversed. The following table summarizesactivity related to these grants (in thousands):

|                     | ** ** | ** **    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Deferred Compensation** | ** ** |
|---------------------|------------|---------------|------------|------------|------------|------------|------------|------------|------------|--------------------------------|------------|
| ** **          | ** ** | **# of** | ** ** | ** ** | ** ** | **Vest**   | ** ** | **Year**   | ** ** | **Beginning**                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Ending** | ** ** |
| **Grant 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.

In January 2004, the Company granted four consultantsoptions to purchase 7,500 shares each of common stock at $4.03 per share,vesting over a four year period. Since the recipients of these options are notemployees or directors of Catalytica Energy, the Company recorded a deferredcompensation obligation of $69,000, of which $5,000 and $13,000 was earned andcharged to operations in the years ended December 31, 2005 and 2004,respectively. This obligation was re-measured at reporting periods during theyears ended December 31, 2005 and 2004 resulting in a reduction to thedeferred compensation obligation of $8,000 and $36,000, respectively. Theconsultants service to the Company terminated on December 31, 2005 and theremaining unamortized balance of deferred compensation was eliminated.

***Employee StockPurchase Plan.*****  **In 2000,the Company adopted the Catalytica Energy Systems, Inc. 2000 EmployeeStock Purchase Plan (the “2000 Plan”) under which employees are eligible topurchase shares of the Company’s common stock at a discount through periodicpayroll deductions. The 2000 Plan is intended to meet the requirements of Section 423of the Internal Revenue Code. Purchases occur following six month offeringperiods ending on June 30 and December 31 each year at a purchaseprice equal to 85% of the market value of the Company’s common stock at eitherthe beginning of the offering period or the end of the offering period,whichever is lower. According to the 2000 Plan, a new offering period beginseach time the market value of the Company’s common stock at the end of theoffering period is lower than the market value of the Company’s common stock atthe beginning of the offering period. The 2000 Plan allows for the offeringperiod to be no less than six and no more than twenty-four months, determinedevery six months.

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

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, 2005, theCompany had reserved 1,500,000 shares of common stock for issuance under the2000 Plan and had issued 410,798 shares under the 2000 Plan. For the year endedDecember 31, 2005, employees purchased 81,818 shares for $152,697. Theweighted average fair value of those purchased shares granted during the yearsended December 31, 2005 and 2004 was $.87 and $1.13, respectively. As of December 31,2005, 1,089,202 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 $283,000, $319,000 and $303,000 for the years ended December 31,2005, 2004 and 2003, respectively.

**Note9. Major Customers and Geographic Revenues**

Majorcustomers (as a % of consolidated revenue) are as follows:

| ** **                         | ** ** | ** **  | ** ** | **Year ended December 31,** | ** ** |
|------------------------------------|------------|-------------|------------|--------------------------------------------|------------|
| ** **                         | ** ** | **Segment** | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| U.S. Department  of Energy         |       |        | CBTS       |                                       |       |   | 32 | % |   |   | 33 | % |   |   | 58 | % |   |
| Customer D                         |       |        | SCMS       |                                       |       |   | 20 | % |   |   | — |   |   |   | — |   |   |
| Customer B                         |       |        | SCMS       |                                       |       |   | 14 | % |   |   | 13 | % |   |   | — |   |   |
| TCEQ                               |       |        | CBTS       |                                       |       |   | 8 | % |   |   | 1 | % |   |   | — |   |   |
| California Energy  Commission      |       |        | CBTS       |                                       |       |   | 5 | % |   |   | 3 | % |   |   | 15 | % |   |
| Customer A                         |       |        | SCMS       |                                       |       |   | 5 | % |   |   | 19 | % |   |   | — |   |   |
| General Electric                   |       |        | CBTS       |                                       |       |   | 3 | % |   |   | — |   |   |   | 22 | % |   |
| Electric Power  Research Institute |       |        | CBTS       |                                       |       |   | 1 | % |   |   | 8 | % |   |   | — |   |   |
| Customer C                         |       |        | SCMS       |                                       |       |   | — |   |   |   | 13 | % |   |   | — |   |   |
| Other                              |       |        |       |                                       |       |   | 12 | % |   |   | 10 | % |   |   | 5 | % |   |
|                               |       |        |       |                                       |       |   | 100 | % |   |   | 100 | % |   |   | 100 | % |   |

 

Revenueby geographic region is as follows: 

| ** **    | ** ** | **Year ended December 31,** | ** ** |
|---------------|------------|--------------------------------------------|------------|
| ** **    | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| United States |       |                                       | 100        | % |   |   | 100 | % |   |   | 78 | % |   |
| Europe        |       |                                       | —     |   |   |   | — |   |   |   | 22 | % |   |

 

**Note10. Debt, Leases, Commitments and Contingencies**

***Debt agreements.*****  **In March 2002, we received a term loan of$3,010,000 from the Arizona State Compensation Fund. Proceeds of this loan wereapplied to the purchase of a 43,000 square foot manufacturing andadministrative facility in Gilbert, Arizona. This five-year term loan boreinterest at a fixed annual rate of 7.4% and was scheduled to mature in April 2007.In August 2004, the remaining $2,940,254 principal balance on this loanwas refinanced with a five-year term loan which bears interest at a 

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

fixed annual rate of 6.5%and matures in April 2009. Under terms of this new loan, payments ofprincipal and interest totaling $19,105 are due monthly with a final principalpayment of $2,737,228 due at maturity. This loan is secured by a deed of trustin the acquired 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, payable between 2006 and 2016. These obligationswere extinguished in December 2005 with the settlement of all remainingliabilities related to the acquisition of SCR-Tech in return for a one-timecash payment of $1,500,000.

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.

At December 31,2005, future payments under debt agreements and capital leases are as followsover each of the next five years and thereafter (in thousands):

| **Year**   | ** ** | ** ** | ** ** | **Amount** | ** ** | ** **                               | ** **                                            |
|------------|------------|------------|------------|------------|------------|------------------------------------------|-------------------------------------------------------|
| 2006       |       |       | $          | 215        |       |                                     |                                                  |   |
| 2007       |       |       | 234        |       |       |                                     |                                                  |
| 2008       |       |       | 233        |       |       |                                     |                                                  |
| 2009       |       |       | 2,800      |       |       |                                     |                                                  |
| 2010       |       |       | 4          |       |       |                                     |                                                  |
| Thereafter |       |       | 4          |       |       |                                     |                                                  |
| Total      |       |       | 3,490      |       |       |                                     |                                                  |
|       |       |       | (583       | )          |       | Less  amounts representing interest      |                                                  |
|       |       |       | (47        | )          |       | Less  current portion                    |                                                  |
|       |       |       | 144        |       |       | Plus  other long-term accrued liabilites |                                                  |
|       |       |       | $          | 3,004      |       |                                     | Total long-term debt and  other long-term liabilities |   |

 

***Operating leases.*****  **Catalytica Energy leases its research and developmentfacility, consisting of portions of two leased building covering approximately32,500 square feet located in Mountain View, California, under an operatinglease agreement which was amended effective January 1, 2006, to a term of oneyear, with an option to renew for one additional year. We currently subleaseapproximately 7,300 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, the Company leases manufacturing, office andwarehouse equipment under various lease agreements which expire through 2010.

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.

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

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 31,2005, future payments under all non-cancelable operating leases are as followsover each of the next five years and thereafter (in thousands):

| **Year**   | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------|------------|------------|------------|------------|------------|
| 2006       |       | $          | 569        |       |
| 2007       |       | 284        |       |
| 2008       |       | 278        |       |
| 2009       |       | 275        |       |
| 2010       |       | 272        |       |
| Thereafter |       | 534        |       |
|       |       | $          | 2,212      |       |

 

Rent expense consisting of building and equipment rentwas $639,000, $412,000 and $1,079,000 during the years ended December 31,2005, 2004, and 2003, respectively. Rental income from the various lease andsublease arrangements was $457,000, $403,000 and $1,233,000 during the yearsended December 31, 2005, 2004 and 2003, 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, 2005 under the various lease and subleasearrangements, which expire through December 31, 2007, is as follows (inthousands):

| **Year** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------|------------|------------|------------|------------|------------|
| 2006     |       | $          | 494        |       |
| 2007     |       | 111        |       |
|     |       | $          | 605        |       |

 

***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 three such arrangements, with GasTechnology Institute (“GTI”) (formally known as Gas Research Institute), theCalifornia Energy Commission (“CEC”) and Woodward Governor Company (“WGC”).

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 September 20, 2005, the Company notifiedKawasaki Gas Turbines (“Kawasaki”), a customer for its Xonon modules, of itselection to terminate its supply agreement with Kawasaki pursuant to the termsof the agreement effective December 13, 2005. In October 2005, theCompany received a purchase order 

87

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

from Kawasaki for 27additional modules which we rejected. We do not believe we have any obligationto fill this order upon the terms proposed by Kawasaki or on any other terms. Kawasakihas disputed our rejection of the purchase order and has indicated it may seekarbitration of the dispute pursuant to the supply agreement. We do not believethe ultimate resolution of this matter will have a material adverse impact onthe Company’s financial position or results of operations.

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.

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, andwe must 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 11. Segment Disclosures**

SFAS No. 131, “Disclosures about Segments of anEnterprise and Related Information”, requires disclosures of certain information regarding operatingsegments, products and services, geographic areas of operation and majorcustomers. The method for determining what information to report under SFAS No. 131is based upon the “management approach,” or the way that management organizesthe operating segments within the Company, for which separate financialinformation is available that is evaluated regularly by the Chief OperatingDecision Maker (“CODM”) in deciding how to allocate resources and in assessingperformance. Our CODM is our Chief Executive Officer.

88

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

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, primarily focused on cost-effectivesolutions for reducing emissions from diesel engine applications—ourCatalyst-Based Technology Solutions segment (“CBTS”).

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.

 

89

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

Thetables below presents information about our reportable operating segments as ofand for the years ended December 31, 2005 and 2004 (in thousands):  

| ** **                        | ** ** | **Year Ended  December 31,** | ** ** |
|-----------------------------------|------------|----------------------------------------|------------|
| ** **                        | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| Total revenue                     |       |                                   |       |   |   |
| CBTS                              |       | $                                      | 1,804      |   | $ | 2,641 |   |
| SCMS                              |       | 1,725                                  |       | 2,960 |   |
| Consolidated                      |       | $                                      | 3,529      |   | $ | 5,601 |   |
| Operating  income/(loss)          |       |                                   |       |   |   |
| CBTS                              |       | $                                      | (13,925    | ) | $ | (13,275 | ) |
| SCMS                              |       | (2,165                                 | )          | (188 | ) |
| Consolidated                      |       | $                                      | (16,090    | ) | $ | (13,463 | ) |
| Depreciation and  amortization(1) |       |                                   |       |   |   |
| CBTS                              |       | $                                      | 1,594      |   | $ | 1,229 |   |
| SCMS                              |       | 430                                    |       | 344 |   |
| Consolidated                      |       | $                                      | 2,024      |   | $ | 1,573 |   |
| Capital  expenditures             |       |                                   |       |   |   |
| CBTS                              |       | $                                      | 215        |   | $ | 407 |   |
| SCMS                              |       | 118                                    |       | 28 |   |
| Consolidated                      |       | $                                      | 333        |   | $ | 435 |   |

----

(1)          Depreciationof fixed assets and amortization of intangible assets. Operating loss,excluding this depreciation and amortization, constitutes EBITDA by segmentwhich is the basis of evaluation used by the Chief Operation Decision Maker.

| ** **   | ** ** | **December 31,** | ** ** |
|--------------|------------|-----------------------|------------|
| ** **   | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Total assets |       |                  |       |   |   |
| CBTS         |       | $                     | 27,392     |   | $ | 43,115 |   |
| SCMS         |       | 8,953                 |       | 8,402 |   |
| Consolidated |       | $                     | 36,345     |   | $ | 51,517 |   |

 

**Note12. Selected Quarterly Financial Data (Unaudited) (In thousands, except pershare amounts):**

| ** **                            | ** ** | **First Quarter** | ** ** | **Second Quarter** | ** ** | **Third Quarter** | ** ** | **Fourth Quarter** | ** ** |
|---------------------------------------|------------|------------------------|------------|-------------------------|------------|------------------------|------------|-------------------------|------------|
| ** **                            | ** ** | **2005**               | ** ** | **2004**                | ** ** | **2005**               | ** ** | **2004**                | ** ** | **2005** | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues                              |       | $                      | 1,299      |                    | $          | 986                    |       | $                       | 762        |   | $ | 1,100 |   | $ | 868 |   | $ | 1,942 |   | $ | 600 |   | $ | 1,573 |   |
| Total expenses                        |       | 4,921                  |       | 4,323                   |       | 4,416                  |       | 5,125                   |       | 5,831 |   | 4,664 |   | 4,451 |   | 4,952 |   |
| Operating loss                        |       | $                      | (3,622     | )                       | $          | (3,337                 | )          | $                       | (3,654     | ) | $ | (4,025 | ) | $ | (4,963 | ) | $ | (2,722 | ) | $ | (3,851 | ) | $ | (3,379 | ) |
| Net loss                              |       | $                      | (3,538     | )                       | $          | (3,241                 | )          | $                       | (3,490     | ) | $ | (4,004 | ) | $ | (4,852 | ) | $ | (2,696 | ) | $ | (1,586 | ) | $ | (3,328 | ) |
| Basic and diluted net  loss per share |       | $                      | (0.20      | )                       | $          | (0.18                  | )          | $                       | (0.19      | ) | $ | (0.22 | ) | $ | (0.27 | ) | $ | (0.15 | ) | $ | (0.09 | ) | $ | (0.19 | ) |

 

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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, 2006 | By:                                           | /s/  ROBERT W. ZACK |
| ** **            | ** **                                    | **Robert  W. Zack** |
| ** **            | ** **                                    | ***President  and Chief Executive Officer*** |

 

**POWER OF ATTORNEY**

KNOW ALL PERSONS BY THESE PRESENTS, that each personwhose signature appears below constitutes and appoints Robert W. Zack 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 exhibitsthereto and other documents in connection therewith, with the Securities andExchange Commission, hereby ratifying and confirming all that saidattorney-in-fact, or his substitute, may do or cause to be done by virtuehereof.

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 dates indicated.

|                               | **Signature** | ** **                                                                                             | ** ** |                      | **Title** | ** ** | ** ** |  | **Date** | ** ** |
|-------------------------------|---------------|--------------------------------------------------------------------------------------------------------|------------|----------------------|-----------|------------|------------|--|----------|------------|
| /s/ ROBERT W.  ZACK           |          | President, Chief  Executive Officer (Principal Executive Officer), Chief Financial Officer  (Principal |       |                 |
| **Robert W. Zack**            |          | Accounting and Financial  Officer) and Director                                                        |       | March  30, 2006      |
| /s/ RICARDO B.  LEVY          |          | Chairman of the  Board                                                                                 |       | March 21, 2006  |
| **Ricardo B. Levy**           |          |                                                                                                   |       |                 |
| /s/ RICHARD A.  ABDOO         |          | Director                                                                                               |       | March 24, 2006  |
| **Richard A. Abdoo**          |          |                                                                                                   |       |                 |
| /s/ WILLIAM B.  ELLIS         |          | Director                                                                                               |       | March 23, 2006  |
| **William B. Ellis**          |          |                                                                                                   |       |                 |
| /s/ HOWARD I.  HOFFEN         |          | Director                                                                                               |       | March 29, 2006  |
| **Howard I. Hoffen**          |          |                                                                                                   |       |                 |
| /s/ DAVID F.  MERRION         |          | Director                                                                                               |       | March 27, 2006  |
| **David F. Merrion**          |          |                                                                                                   |       |                 |
| /s/ FREDERICK  M. O’SUCH |          | Director                                                                                               |       | March 23, 2006  |
| **Frederick M. O’Such**  |          |                                                                                                   |       |                 |
| /s/ SUSAN F.  TIERNEY         |          | Director                                                                                               |       | March 27, 2006  |
| **Susan F. Tierney**          |          |                                                                                                   |       |                 |
| /s/  JOHN A. URQUHART         |          | Director                                                                                               |       | March 27,  2006 |
| **John A.  Urquhart**         |          |                                                                                                   |       |                 |

 

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