SECURITIES
      AND EXCHANGE COMMISSION


WASHINGTON,
      DC 20549





**FORM
      10-Q**





(Mark
      one)


x
            **QUARTERLY
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934**  For the quarterly period ended June
              30,
              2006  OR


o
            **TRANSITION
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE EXCHANGE ACT FOR THE
                TRANSITION PERIOD FROM _______ TO
                ________.**





COMMISSION
      FILE NUMBER:


0-10238





**U.S.
      ENERGY SYSTEMS, INC.**





**Delaware**
              (State
                or other jurisdiction of
              incorporation
                or organization)
            **52-1216347**
              (I.R.S.
                Employer
              Identification
                Number)**545
                Madison Avenue**
              **Sixth
                Floor**
              **New
                York, New York**
            **10022**(Address
                of Principal Executive
                Offices)
            (Zip
                Code)


**(212)
      588-8901**


(Registrant’s
      telephone number, including area code)





Indicate
      by check mark the registrant: (1) has filed all reports required to be filed
      by
      section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding
      12 months (or for such shorter period that the registrant was required to file
      such reports), and (2) has been subject to the filing requirements for at least
      90 days.




YES
x NO
o





Indicate
      by check mark the registrant is a large accelerated filer, an accelerated filer,
      or a non-accelerated filer. See definition of “accelerated filer and large
      accelerated filer” in Rule 12b-2 of the Exchange Act.




Large
                accelerated filer o
            Accelerated
                filer o
            Non-accelerated
                filer x





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act).





YES
o NO
x





State
      the
      number of shares outstanding of each of issuer’s classes of common equity, as of
      June 30, 2006: 17,340,360 shares of Common Stock










**U.S.
      ENERGY SYSTEMS, INC. AND SUBSIDIARIES**


**CONTENTS**











**PART
      I: Financial Information**











**PAGE****Item
                1:**Condensed Consolidated Financial Statements - UnauditedCondensed
                Consolidated Balance Sheets as of June 30, 2006 and December 31,
                2005
            
            3Condensed
                Consolidated Statements of Operations and Comprehensive Income (Loss)
                for
                the three and six months ended June 30, 2006 and 2005
            
            5Condensed
                Consolidated Statements of Cash Flows for the six months ended June
                30,
                2006 and 2005
            
            7Notes
                to Condensed Consolidated Financial Statements
            
            9**Item
                2**:
                Management’s Discussion and Analysis of Financial Condition and Results of
                Operations
            
            15**Item
                3**:
                Quantitative and Qualitative Disclosures About Market Risk
            
            19**Item
                4:**Controls and Procedures
            
            19**PART
                II:**Other
                Information**Item
                1A:**Risk
                Factors
            
            19**Item
                5**:
                Other Events
            
            21**Item
                6**:
                Exhibits
            
            21Signatures
            
            22






2





**U.
      S. ENERGY SYSTEMS INC. AND SUBSIDIARIES**


**CONDENSED
      CONSOLIDATED BALANCE SHEETS**


**(In
      thousands, except share amounts)**





**June
                30, 2006**
            
            **December
                31, 2005**(Unaudited)**ASSETS**Current
                Assets:Cash
                and Cash Equivalents
            
            $
            4,644
            
            $
            11,301Restricted
                Cash and Marketable Securities
            
            
            5,553
            
            
            5,501Accounts
                Receivable Trade (less allowance for doubtful accounts of $1,118
                and $888
                in 2006 and 2005, respectively)
            
            
            657
            
            
            2,198Accounts
                Receivable Affiliates (less allowance for doubtful accounts of $511
                in
                2006 and 2005)
            
            
            3,536
            
            
            2,789Notes
                and Interest Receivable, Current Portion
            
            
            2,032
            
            
            1,976Other
                Current Assets
            
            
            2,772
            
            
            1,633Total
                Current Assets
            
            
            19,194
            
            
            25,398Restricted
                Cash and Marketable Securities
            
            
            26,924
            
            
            26,429Property,
                Plant and Equipment, Net
            
            
            38,549
            
            
            40,306Construction
                in Progress
            
            
            198
            
            
            198Deferred
                Costs - UK Acquisition
            
            
            4,860
            
            
            261Notes
                Receivable, less Current Portion
            
            
            21,367
            
            
            22,088Investments
            
            
            1,361
            
            
            1,234Debt
                Issuance Costs, Net of Accumulated Amortization
            
            
            10,080
            
            
            10,476Goodwill
            
            
            26,618
            
            
            26,618Foreign
                Currency Hedge
            
            
            1,476
            
            
            1,860Deferred
                    Tax Asset (less valuation allowance of $12,360 in 2006 and $11,340
                    in
                    2005)
            
            
            16,394
            
            
            13,878Other
                Assets
            
            
            65
            
            
            283**TOTAL
                ASSETS**
            
            **$**
            **167,086**
            
            **$**
            **169,029****LIABILITIES**Current
                Liabilities:Current
                Portion of Long-Term Debt
            
            $
            1,928
            
            $
            1,879Accounts
                Payable Trade and Accrued Expenses
            
            
            3,246
            
            
            4,083Accounts
                Payable Affiliates
            
            
            1,135
            
            
            1,091Deferred
                Revenue
            
            
            272
            
            
            272Total
                Current Liabilities
            
            
            6,581
            
            
            7,325Long-Term
                Debt, less Current Portion
            
            
            90,001
            
            
            87,282Deferred
                Revenue
            
            
            16,098
            
            
            16,224Deferred
                Royalty
            
            
            5,170
            
            
            5,379Illinois
                Subsidy Liability
            
            
            34,659
            
            
            31,678Total
                Liabilities
            
            
            152,509
            
            
            147,888Commitments
                and ContingenciesMinority
                Interest
            
            
            2,210
            
            
            4,968


See
        notes
        to condensed consolidated financial statements
 which
        are
        an integral part of the financial statements.
 (continued)


3


**U.
      S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES**


**CONDENSED
      CONSOLIDATED BALANCE SHEETS**


**(In
      thousands, except share amounts)**





**June
                30, 2006**
            
            **December
                31, 2005**(Unaudited)**STOCKHOLDERS
                EQUITY**Preferred
                Stock, $.01 par value, Authorized 10,000,000 Shares:Series
                B, Cumulative, Convertible, Issued and Outstanding, 368 Shares,
                Liquidation Preference, $1,000 per share
            
            $
            -
            
            $
            -Series
                C, Cumulative, Convertible, Issued and Outstanding, 38,809 Shares
                as of
                June 30, 2006 and 97,333 Shares as of December 31, 2005, Liquidation
                Preference, $30 per share
            
            
            -
            
            
            1Series
                D, Cumulative, Convertible, Issued and Outstanding, 0 shares as of
                June
                30, 2006 and 916,666 Shares as of December 31, 2005, Liquidation
                Preference, $9 per share
            
            
            -
            
            
            9Common
                Stock, $.01 par Value, Authorized 50,000,000 Shares, Issued 17,786,290,
                outstanding 17,340,360 at 6/30/2006 and Issued 13,490,098, outstanding
                13,044,109 at 12/31/2005.
            
            
            178
            
            
            135Treasury
                Stock at Cost - 445,930 Shares
            
            
            (2,204
            )
            
            (2,204
            )Additional
                Paid-In Capital
            
            
            63,929
            
            
            62,583Accumulated
                Deficit
            
            
            (51,419
            )
            
            (46,528
            )Other
                Comprehensive Income
            
            
            1,883
            
            
            2,177Total
                Stockholders’ Equity
            
            
            12,367
            
            
            16,173**TOTAL
                LIABILITIES AND STOCKHOLDERS’ EQUITY**
            
            **$**
            **167,086**
            
            **$**
            **169,029**







See
      notes
      to condensed consolidated financial statements


which
      are
      an integral part of the financial statements.


(concluded)




4


**U.S.
      ENERGY SYSTEMS, INC. AND SUBSIDIARIES**


**CONDENSED
      CONSOLIDATED STATEMENTS OF OPERATIONS**


**AND
      COMPREHENSIVE INCOME (LOSS)**


**(Unaudited)**


**(In
      thousands, except Income(Loss) per Share)**





**THREE
                MONTHS ENDED**
            
            **SIX
                MONTHS ENDED****June
                30, 2006**
            
            **June
                30, 2005**
            
            **June
                30, 2006**
            
            **June
                30, 2005**Revenues
            
            $
            4,732
            
            $
            4,476
            
            $
            9,556
            
            $
            9,500Costs
                and Expenses:Operating
                Expenses
            
            
            2,189
            
            
            2,296
            
            
            5,050
            
            
            4,475General
                and Administrative Expenses
            
            
            2,257
            
            
            1,223
            
            
            4,088
            
            
            2,430Depreciation
                and Amortization
            
            
            1,212
            
            
            1,096
            
            
            2,424
            
            
            2,191Income
                (Loss) from Joint Ventures
            
            
            (30
            )
            
            -
            
            
            (145
            )
            
            -Total
                Costs and Expenses
            
            
            5,628
            
            
            4,615
            
            
            11,417
            
            
            9,096(Loss)
                Income from Operations
            
            
            (896
            )
            
            (139
            )
            
            (1,861
            )
            
            404Interest
                and Dividend Income
            
            
            1,009
            
            
            1,051
            
            
            2,243
            
            
            1,859Foreign
                  Currency Transaction Income (Expense)
            
            
            (3,553
            )
            
            1,307
            
            
            (3,429
            )
            
            1,652Interest
                Expense
            
            
            (2,779
            )
            
            (2,706
            )
            
            (5,569
            )
            
            (5,420
            )Other
                Income (Loss)
            
            
            21
            
            
            11
            
            
            (42
            )
            
            7(Loss)
                Income before Taxes, Minority Interest and Disposal of
                Segment
            
            
            (6,198
            )
            
            (476
            )
            
            (8,658
            )
            
            (1,498
            )Income
                Tax Benefit (Expense)
            
            
            1,816
            
            
            (25
            )
            
            2,321
            
            
            86Minority
                Interest
            
            
            1,465
            
            
            (342
            )
            
            1,446
            
            
            (262
            )Loss
                from Continuing Operations
            
            
            (2,917
            )
            
            (843
            )
            
            (4,891
            )
            
            (1,674
            )Gain
                on Disposal of a Segment (Net
                of taxes)
            
            
            -
            
            
            -
            
            
            -
            
            
            150Net
                Loss
            
            
            (2,917
            )
            
            (843
            )
            
            (4,891
            )
            
            (1,524
            )Dividends
                on Preferred Stock
            
            
            (8
            )
            
            (206
            )
            
            (200
            )
            
            (413
            )Net
                Loss Applicable to Common Stockholders
            
            $
            (2,925
            )
            $
            (1,049
            )
            $
            (5,091
            )
            $
            (1,937
            )Other
                Comprehensive Loss:Net
                Loss
            
            $
            (2,917
            )
            $
            (843
            )
            $
            (4,891
            )
            $
            (1,524
            )Unrealized
                (Loss) Gain on Investments (Net
                of taxes)
            
            
            (500
            )
            
            11
            
            
            (294
            )
            
            (256
            )Total
                Comprehensive Loss
            
            $
            (3,417
            )
            $
            (832
            )
            $
            (5,185
            )
            $
            (1,780
            )





See
      notes
      to condensed consolidated financial statements


which
      are
      an integral part of the financial statements.


(continued)




5


**U.S.
      ENERGY SYSTEMS, INC. AND SUBSIDIARIES**


**CONDENSED
      CONSOLIDATED STATEMENTS OF OPERATIONS AND**


**COMPREHENSIVE
      INCOME (LOSS)**


**(Unaudited)**


**(In
      thousands, except Income (Loss) per Share** )




**THREE
                MONTHS ENDED**
            
            **SIX
                MONTHS ENDED****June
                30 ,2006**
            
            **June
                  30, 2005**
            
            **June
                  30, 2006**
            
            **June
                30, 2005**NET
                INCOME(LOSS) PER SHARE OF COMMON STOCK:Loss
                per Share of Common Stock Continuing Operations
            
            $
            (0.17
            )
            $
            (0.07
            )
            $
            (0.33
            )
            $
            (0.14
            )Income
                per Share of Common Stock Discontinued Operations
            
            
            __
            
            
            __
            
            
            __
            
            $
            0.01Net
                Loss per Share of Common Stock
            
            $
            (0.17
            )
            $
            (0.09
            )
            $
            (0.34
            )
            $
            (0.16
            )Weighted
                Average Number of Common Shares Outstanding -Basic
                and Diluted
            
            
            16,738
            
            
            12,003
            
            
            14,912
            
            
            12,003








See
      notes
      to condensed consolidated financial statements


which
      are
      an integral part of the financial statements.


(concluded)




6




**U.S.
      ENERGY SYSTEMS, INC. AND SUBSIDIARIES**


**CONDENSED
      CONSOLIDATED STATEMENTS OF CASH FLOWS**


**(Unaudited)**


**(in
      thousands)**





**SIX
                MONTHS ENDED**
              **June
                30,****2006**
            
            **2005**CASH
                FLOWS FROM OPERATING ACTIVITIES:Net
                Loss
            
            $
            (4,891
            )
            $
            (1,524
            )Adjustments
                to Reconcile Net Loss to Net Cash Provided by (Used in) Operating
                Activities:Depreciation
                and Amortization
            
            
            2,424
            
            
            2,191Minority
                Interest
            
            
            (1,446
            )
            
            (1,473
            )Foreign
                Currency Transaction
            
            
            3,429
            
            
            (1,652
            )Deferred
                Taxes
            
            
            (2,516
            )
            
            (542
            )Equity
                Gains In Subsidiary
            
            
            (111
            )
            
            -Provision
                for Bad Debts
            
            
            302
            
            
            -Stock
                Based Compensation
            
            
            883
            
            
            -Increase
                (Decrease) in Cash Attributable to Changes in Operating Assets and
                Liabilities:Accounts
                Receivable Trade
            
            
            1,239
            
            
            248Accounts
                Receivable Affiliates
            
            
            (747
            )
            
            (275
            )Foreign
                Currency Hedge
            
            
            146
            
            
            388Other
                Current Assets
            
            
            (442
            )
            
            (282
            )Other
                Assets
            
            
            218
            
            
            (45
            )Accounts
                Payable Trade and Accrued Expenses
            
            
            (837
            )
            
            (140
            )Accounts
                Payable Affiliates
            
            
            43
            
            
            (456
            )Deferred
                Royalty
            
            
            (209
            )
            
            (133
            )Deferred
                Revenue
            
            
            (126
            )
            
            (200
            )Illinois
                Subsidy Liability
            
            
            2,981
            
            
            3,083Net
                Cash Flows Provided by (Used in) Operating Activities
            
            
            340
            
            
            (812
            )CASH
                FLOWS FROM INVESTING ACTIVITIES:Restricted
                Cash
            
            
            (767
            )
            
            (601
            )Deferred
                Costs - UK Transaction
            
            
            (4,599
            )
            
            -Payments
                  of Notes Receivable
            
            
            665
            
            
            1,516Purchase
                  of Investments
            
            
            (16
            )
            
            (386
            )Acquisition
                of Equipment and Leasehold Improvements
            
            
            (272
            )
            
            (450
            )Net
                Cash (Used in)Provided by Investing Activities
            
            
            (4,989
            )
            
            79CASH
                FLOWS FROM FINANCING ACTIVITIES:Payments
                of Long-Term Debt
            
            
            (746
            )
            
            (667
            )Minority
                Interest
            
            
            (1,062
            )
            
            -Additional
                Paid in Capital
            
            
            -
            
            
            37Dividends
                on Preferred Stock
            
            
            (200
            )
            
            (413
            )Net
                Cash Used in Financing Activities
            
            
            (2,008
            )
            
            (1,043
            )


See
        notes
        to consolidated financial statements
 which
        are
        an integral part of the financial statements.(continued)


7




**U.S.
      ENERGY SYSTEMS, INC. AND SUBSIDIARIES**


**CONDENSED
      CONSOLIDATED STATEMENTS OF CASH FLOWS**


**(Unaudited)**


**(in
      thousands)**





**SIX
                MONTHS ENDED**
              **June
                30,****2006**
            
            **2005**NET
                DECREASE IN CASH AND CASH EQUIVALENTS
            
            $
            (6,657
            )
            $
            (1,776
            )CASH
                AND CASH EQUIVALENTS - BEGINNING OF PERIOD
            
            
            11,301
            
            
            15,982CASH
                AND CASH EQUIVALENTS - END OF PERIOD
            
            $
            4,644
            
            $
            14,206




Supplemental
                Disclosure of Cash Flow InformationCash
                Paid for Interest
            
            $
            4,279
            
            $
            4,356Cash
                Paid For Taxes
            
            $
            195
            
            $
            18Supplemental
                Schedule of Non-cash FinancingConversion
                of Preferred Stock to Common Stock
            
            $
            38
            
            $
            ---





See
      notes
      to consolidated financial statements


which
      are
      an integral part of the financial statements.


(concluded)





8


**U.S.
      ENERGY SYSTEMS, INC. AND SUBSIDIARIES**


**NOTES
      TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**


**FOR
      THE THREE AND SIX MONTHS ENDED JUNE 30, 2006 AND 2005**








**NOTE
      A - BASIS OF PRESENTATION**





The
      accompanying unaudited condensed consolidated financial statements have been
      prepared in accordance with instructions to Form 10-Q and Regulation S-X, and
      accordingly, do not include all of the information and footnotes required by
      accounting principles generally accepted in the United States for complete
      financial statements. In the opinion of management, all adjustments (consisting
      of normal accruals) considered necessary for a fair presentation have been
      included. The results for the three and six months ended June 30, 2006 are
      not
      necessarily indicative of results for the full year or any other period. For
      a
      more complete discussion of significant accounting policies and certain other
      information, you should refer to the financial statements included in the U.S.
      Energy Systems, Inc.’s (the “Company”) Annual Report on Form 10-K for the year
      ended December 31, 2005.





Certain
      reclassifications, primarily regarding related party activities, have been
      made
      to the prior year’s condensed consolidated financial statements to conform to
      the current year’s presentation.





**NOTE
      B - BASIS OF REPORTING**





The
      condensed consolidated financial statements of the Company include the accounts
      of the Company and its wholly owned and majority-owned subsidiaries. Investments
      in joint ventures are accounted for under the equity method. Investments in
      partnerships, in which our ownership does not exceed 1% are unconsolidated
      and
      carried at cost. All inter-company accounts and transactions have been
      eliminated in consolidation.





**NOTE
      C - REVENUE RECOGNITION**





Revenues
      are recognized upon delivery of energy or service. The energy rates the Company
      collects fluctuate with rates approved for use by utilities and municipalities
      local to the respective projects. These rates may be estimates that are
      reconciled annually. Any difference between the estimated rate and the actual
      rate may apply to a previous period based on the effective date of the power
      purchase agreement. The adjustment, if any, is booked in the period it is
      determined. Revenue related to the Illinois subsidy received by certain projects
      of U.S. Energy Biogas Corp. (“USEB”), our majority owned subsidiary, is
      accounted for in a manner similar to an original issue discount whereby the
      amount to be repaid in the future is discounted to its net present value and
      the
      discount is amortized as interest expense over the intervening period until
      repayment begins.





**NOTE
      D -LOSS PER SHARE DATA**




Loss
        per
        share is computed by dividing the loss applicable to common stockholders
        by the
        weighted average number of common shares outstanding during the periods.
        In
        arriving at loss available to common stockholders, preferred stock dividends
        have been deducted. Potential common shares, amounting to 7,838,211 shares,
        have
        not been included due to their anti-dilutive effect for 2006.





**NOTE
      E - STOCK-BASED COMPENSATION**





In
      December 2004, the Financial Accounting Standards Board revised Statement of
      Financial Accounting Standards No. 123, “Accounting for Stock-Based
      Compensation” (“SFAS 123R”), requiring companies to record share-based payment
      transactions as compensation expense at fair value on the grant date. SFAS
      123R
      further defines the concept of fair market value as it relates to such
      arrangements. Based on SEC guidance issued in Staff Accounting Bulletin 107
      in
      April 2005, the provisions of this statement are effective for the Company
      as of
      January 1, 2006.





The
      Company has elected to implement SFAS 123R using the modified prospective
      transition method, which requires compensation costs be recorded as earned
      for
      all unvested stock options outstanding at the beginning of the first fiscal
      year
      of adoption of SFAS 123R based on the grant date fair value estimated in
      accordance with the original provisions of SFAS 123 and for compensation costs
      for all share-based payments granted or modified subsequent to the adoption,
      based on fair value estimated in accordance with the provisions of SFAS 123R.
      The impact of SFAS 123R is reflected in the Company’s financial statements for
      the period ended June 30, 2006. In accordance with the modified prospective
      transition method, the Company has not restated the financial statements for
      prior periods and those statements do not include the impact of SFAS 123R.
      The
      Company recorded share-based compensation expense of $883,000 for the six months
      ended June 30, 2006.





9


The
      Company maintains the 2000 Executive Incentive Compensation Plan (the “2000
      Plan”) which provides for the granting of stock options, stock appreciation
      rights, restricted stock, deferred stock and other stock related awards and
      incentive awards that may be settled in cash, stock or property. A summary
      of
      the Company’s stock option activity as of June 30, 2006 is as
      follows:








**Shares**
            
            **Weighted
                average exercise price**
            
            **Weighted
                average remaining contractual term (years)**
            
            **Aggregate
                intrinsic value**Outstanding,
                January 1, 2006
            
            
            7,156,425
            
            $
            3.67
            
            
            4.96Granted
            
            
            33,333
            
            
            4.30
            
            
            5.00Exercised
            
            
            -
            
            
            -
            
            
            -Forfeited
            
            
            -
            
            
            -
            
            
            -Expired
            
            
            -
            
            
            -
            
            
            -Outstanding,
                June 30, 2006
            
            
            7,189,758
            
            $
            3.67
            
            
            4.96
            
            $
            6,390,856Exercisable,
                June 30, 2006
            
            
            6,374,758
            
            $
            3.77
            
            
            4.96
            
            $
            4,734,431





The
      Company estimates the fair value of stock options using a Black-Scholes
      valuation model, consistent with the provisions of SFAS 123R, Securities and
      Exchange Commission Staff Accounting Bulletin 107 and the Company’s prior
      pro-forma disclosures of net earnings, including the fair value of stock-based
      compensation. Key input assumptions used to estimate the fair value of stock
      options include the expected term until the exercise of the option, expected
      volatility of the Company’s stock, the risk free rate of return, option
      forfeiture rates, and dividends, if any. The expected term of the options is
      based on a historical weighted average of vesting periods. The expected
      volatility is derived from the historical volatility of the Company’s stock on
      the NASDAQ market. The risk-free interest rate is the yield from a Treasury
      bond
      or note corresponding to the expected term of the option. Option forfeiture
      rates are based on the Company’s historical forfeiture rates. The Company has
      not paid dividends on its common stock and does not expect to pay dividends
      on
      its common stock the near future.





The
      fair
      value of each option grant in 2006 was estimated on the date of grant using
      the
      Black-Scholes option-pricing model with the following assumptions:





Risk-free
                Interest Rate
            
            
            4.70
            %Expected
                Option Life in Years
            
            
            5.00Expected
                Stock Price Volatility
            
            
            0.68Expected
                Dividend Yield
            
            
            0.00
            %





Compensation
      costs for stock options with tiered vesting terms are recognized ratably over
      the vesting period. As of June 30, 2006, the total unrecognized compensation
      costs related to granted stock options is $1,063,000. These costs will be
      recognized over the next 18 months assuming no changes to the underlying
      assumptions.





During
      the three-month period ended June 30, 2006, options to acquire 33,333 shares
      of
      common stock were granted and 161,336 shares of common stock were issued
      relating to consulting agreements pursuant to the 2000 Plan.








**NOTE
      F - FOREIGN CURRENCY**





The
      functional currency for our foreign debt is the local currency, which is
      Canadian dollars. For this foreign debt, we translate assets and liabilities
      at
      the end-of-period exchange rates. We report transaction adjustments on
      inter-company foreign currency transactions in Other Comprehensive Income.
      Foreign currency transaction gains or losses are recognized in the period
      incurred and are included in Other Income (Loss) in the condensed consolidated
      statement of operations.





10


**NOTE
      G - INVESTMENTS IN DERIVATIVES**





The
      Company holds derivative financial instruments for the sole purpose of hedging
      the risks relating to changes in foreign currency exchange rates through March,
      2007, the variability of which impacts future earnings and cash flows. The
      Company documents its risk management strategy and hedge effectiveness at the
      inception of and during the term of the hedge. Changes in the fair market value
      of our foreign currency cash flow hedge derivatives are recorded each period
      in
      other comprehensive income.





**NOTE
      H - SUBSIDIARIES AND AFFILIATES**




On
        May
        11, 2001 we, together with Cinergy Energy Solutions Inc. (“Cinergy Energy”),
        acquired through a merger, Zahren Alternative Power Corporation, and renamed
        such entity U.S. Energy Biogas Corp (“USEB”). The Company owns 54.26% and
        Cinergy Energy Solutions, Inc, a wholly owned subsidiary of Cinergy Corp.
        (“Cinergy”), owns 45.74% of USEB.


**NOTE
      I - RESTRICTED CASH AND MARKETABLE SECURITIES**





USEB’s
      financing arrangement with the Countryside Power Income Fund (the “Countryside
      Fund”) established various reserve accounts, which are also collateral for the
      financing. These accounts include the Illinois Subsidy Liability Account (the
      “Illinois Accounts”), a debt service reserve account and an improvement reserve
      account. The funds held in the improvement reserve account can be utilized
      to
      fund capital expenditures. The funds in the Illinois Accounts are to be utilized
      to retire the Illinois subsidy liability as it becomes due.





Restricted
      cash and marketable securities were as follows:





June
                30, 2006
            
            December
                31, 2005Illinois
                Subsidy Liability Reserve Accounts
            
            $
            26,924,000
            
            $
            26,429,000Improvement
                Reserve
            
            
            3,426,000
            
            
            3,367,000Debt
                Service Reserve
            
            
            2,097,000
            
            
            2,104,000Project
                Contract Reserve
            
            
            30,000
            
            
            30,000Totals
            
            $
            32,477,000
            
            $
            31,930,000




Included
        in the Illinois Accounts at June 30, 2006 is $24,924,000 that is managed
        by a
        professional investment manager under investment allocation parameters
        established by the Company. Of such sum, $15,950,000 is invested in equity
        fund
        accounts, $7,570,000 is invested in debt accounts, and $1,404,000 is held
        in
        cash or cash equivalent accounts. These investments, which are classified
        as
        available for sale, are carried at fair value, with unrealized gains and
        losses,
        net of any tax effects, reported in Stockholders’ Equity as Accumulated Other
        Comprehensive Income (Loss). The original cost of the investments is
        $21,417,000.





**NOTE
      J - ILLINOIS RETAIL RATE PROGRAM**




USEB
        has
        ten operating projects in Illinois, which are receiving a subsidy for each
        kilowatt hour (“kwh”) of electricity sold to the local utility under the
        Illinois Retail Rate Program. In accordance with the Illinois Retail Rate
        Program, the utility has contracted, for a ten-year period, with each project
        to
        purchase electricity for an amount that exceeds the utility’s Avoided Cost (what
        it would otherwise pay for the generation of electricity). The excess paid
        above
        avoided cost is the subsidy. The utility then receives a tax credit from
        the
        State of Illinois (“Illinois”) equal to the amount of that excess. Each project
        is obligated to begin to repay the subsidy to Illinois after the project
        has
        recouped its capital investment and retired all debt associated with the
        financing and construction of the project but, in any case, no later than
        ten
        years from the date the project commenced commercial operations. All subsidy
        liabilities must be fully repaid to Illinois (without interest) by the end
        of
        the actual useful life of the project but no later than 20 years from the
        date
        the project commenced commercial operations.


This
      subsidy is accounted for reporting purposes in a manner similar to an original
      issue discount whereby the amount to be repaid in the future is discounted
      to
      its net present value and the discount is amortized (as interest expense) over
      the ten-year period until repayment begins. The amount of power generation
      revenue recognized each period is equal to the Avoided Cost plus the difference
      between the subsidy received by the project and the net present value of the
      subsidy. This unamortized discount and the liability are shown net on the
      consolidated balance sheet as Illinois Subsidy Liability.





11


USEB
      is
      required by the Countryside Fund to deposit funds into the Illinois Accounts
      for
      repayment of the Illinois subsidy liability. The Illinois Accounts are
      classified as restricted cash and marketable securities in non-current assets
      on
      the Company’s balance sheet. The amount deposited into the Illinois Accounts is
      based upon the amount of subsidy received and contemplates an annual return
      sufficient to fund the current period subsidy liability repayment as it becomes
      due. Regular deposits combined with actual and expected returns on those
      deposits may not be sufficient to fully repay the respective liabilities as
      they
      become due. Should the amounts in the Illinois Accounts be insufficient to
      fully
      repay the obligations, any shortfall would have to be funded from the project’s
      operations.





Following
      is a summary of significant dates pertaining to each project’s participation in
      the Illinois Retail Rate Program.


**Commencement
                  of**
              
              **Expiration
                  of Illinois**
              
              **Estimated
                  Commencement of****Project**
              
              **Commercial
                  Operations**
              
              **Retail
                  Rate Program**
              
              **Repayment
                  of Subsidy Liability******(1)Countryside
              
              April,
                  2001
              
              April,
                  2011
              
              May,
                  2011Dolton
              
              May,
                  1998
              
              May,
                  2008
              
              June,
                  2008Dixon
                  Lee
              
              July,
                  1999
              
              July,
                  2009
              
              August,
                  2009Morris
              
              December,
                  2000
              
              December,
                  2010
              
              January,
                  2011Roxanna
              
              November,
                  1999
              
              November,
                  2009
              
              December,
                  2009Upper
                  Rock
              
              April,
                  2000
              
              April,
                  2010
              
              May,
                  2010122ndStreet
              
              July,
                  1998
              
              July,
                  2008
              
              August,
                  2008Brickyard
              
              September,
                  1999
              
              September,
                  2009
              
              October,
                  2009Streator
              
              January,
                  2000
              
              January,
                  2010
              
              February,
                  2010Willow
                  Ranch
              
              January,
                  1998
              
              January,
                  2008
              
              February,
                  2008


(1)
            The
                estimated commencement of the repayment of the liability is based
                upon
                management’s assumptions. One year before a project’s eligibility for
                participation in the program terminates, a proposed repayment schedule
                must be presented to the Illinois Commerce Commission for their approval.
                Until any repayment schedule is approved by the Illinois Commerce
                Commission, it will continue to be an estimated
                schedule.





The
      funds
      held in the Illinois Accounts are currently invested in equities and fixed
      income securities. These investments are being managed by a third-party
      professional money manager with the investment allocations being approved by
      the
      management of the Company and USEB. The amount held in the Illinois Accounts
      as
      of June 30, 2006 was $26,924,000. The amount of the subsidy liability owed
      to
      Illinois as of June 30, 2006 was $60,108,000, before the unamortized discount.
      It is anticipated that repayments of the incentive will begin in 2008 and
      continue through 2021.





Under
      the
      terms of the Illinois Retail Rate Program, estimated rates are paid for
      production sold to the utility with that rate being trued up annually, on the
      anniversary date of the commencement of commercial operations of the applicable
      project, to the actual rates paid for electricity by the local municipality.
      After the actual rate is determined, sales for the preceding calendar year,
      retroactive to the last anniversary date, are adjusted based upon the actual
      rate. If the actual rate is greater than the estimated rate, additional sales
      proceeds are paid to the project. If the actual rate is less than the estimated
      rate, then prior sales proceeds received, equal to the excess amounts paid,
      must
      be refunded to the utility. This actual rate then becomes the estimated rate
      for
      the subsequent year.




In
        the
        past, the annual reconciliation of estimated rates to the actual rates has
        resulted in both increases and decreases in retroactive revenue. USEB cannot
        predict whether any changes in future rates will result in increases or
        decreases in revenues from the Illinois projects. For the three and six months
        ended June 30, 2006, the Company received approximately 22% of its revenues
        from
        the subsidy paid under the Illinois Retail Rate Program.


**NOTE
      K - TRANSACTIONS WITH AFFILIATES**


USEB
        is a
        general partner in alternative energy and equipment finance transactions
        with
        related unconsolidated limited partnerships and collects management fees
        from
        the partnerships. Fees earned from such general partner undertakings for
        the
        three and six months ended June 30, 2006 were $62,000 and $124,000 respectively
        compared with $58,000 and $126,000 for the comparable 2005 periods.
 
 USEB
        reimburses its shareholders, including the Company, for a majority of the
        costs
        incurred by them for the benefit of USEB. These costs include management
        and
        accounting salary and benefit costs, office expenses associated with the
        accounting services and an allocation of rent expenses. The total reimbursements
        for the three and six months ended June 30, 2006 were $25,000 and $53,000
        respectively compared with $5,000 and $189,000 for the comparable 2005 periods.




12


**NOTE
      L - FOREIGN CURRENCY TRANSACTIONS**





USEB’s
      debt obligation to the Countryside Fund requires that debt service payments
      be
      made in Canadian dollars. USEB has entered into a cash flow foreign currency
      hedge agreement with financial institutions fixing the Canadian dollar to US
      dollar exchange rate at $1.331 Canadian dollar per US dollar. This hedge
      agreement, in an amount equal to the debt service payments, expires on March
      31,
      2007. Subsequent to the expiration of the hedge agreement, USEB’s debt service
      payments to the Countryside Fund are subject to fluctuations in the currency
      exchange rate.





As
      required by Statement of Financial Accounting Standards No. 52 - “Foreign
      Currency Translation” and Statement of Financial Accounting Standards No. 133 -
“Accounting for Derivative Instruments and Hedge Activities”, USEB has adjusted
      the unhedged outstanding principal on the debt owed to the Countryside Fund
      to
      reflect the currency exchange rate as of the end of the financial reporting
      period. The gain or loss resulting from the adjustment of the outstanding
      principal from that recorded in the previous reporting periods is recorded
      as
      Foreign Currency Transaction Income (Loss).





Following
      is a summary of the Foreign Currency Translation account as of June 30, 2006
      (the exchange rates are Canadian dollars per one US dollar and are stated whole
      dollars):


Three
                  Months Ended
                June
                  30, 2006
              
              Six
                  Months Ended
                June
                  30, 2006Currency
                  Exchange Rate at Loan Origination, April 8, 2004
              
              $
              1.3310
              
              $
              1.3310Currency
                  Exchange Rate at December 31, 2005
              
              $
              1.1660
              
              $
              1.1660Currency
                  Exchange Rate as of March 31, 2006
              
              $
              1.1676
              
              $
              1.1676Currency
                  Exchange Rate as of June 30, 2006
              
              $
              1.1201
              
              $
              1.1201Cumulative
                  Translation Adjustments Beginning Of Reporting Period
              
              $
              9,640,000
              
              $
              9,764,000Cumulative
                  Translation Adjustments End Of Reporting Period
              
              $
              13,193,000
              
              $
              13,193,000Aggregate
                  Adjustment for the Current Reporting Period
              
              $
              3,553,000
              
              $
              3,429,000Deferred
                  Income Taxes Allocated To Adjustment in the Reporting
                  Period
              
              $
              1,375,000
              
              $
              1,328,000





**NOTE
      M - OTHER COMPREHENSIVE INCOME/(LOSS)**





Other
      Comprehensive Income (Loss) for the three and six months ended June 30, 2006
      and
      2005 is comprised of the following:





**Three
                Months Ended**
              **June
                30**
            
            **Six
                Months Ended**
              **June
                30****2006**
            
            **2005**
            
            **2006**
            
            **2005**Unrealized
                gains and (losses) on investments available for sale
            
            $
            (438,000
            )
            $
            215,000
            
            $
            (119,000
            )
            $
            (88,000
            )Foreign
                currency exchange rates (see Note F)
            
            
            (62,000
            )
            
            (204,000
            )
            
            (175,000
            )
            
            (168,000
            )Total
            
            $
            (500,000
            )
            $
            11,000
            
            $
            (294,000
            )
            $
            (256,000
            )





**NOTE
      N - DEFERRED INCOME TAXES**





In
      accordance with Statement of Financial Accounting Standards 109 - “Accounting
      for Income Taxes” (“SFAS 109”), the Company evaluates the likelihood of the near
      term future realization of the value of the net deferred tax assets. Such an
      evaluation includes an analysis of the anticipated near term generation of
      taxable income and the implementation of tax planning strategies. Potential
      future taxable income from projects yet to be acquired or developed is not
      included in the evaluation.




Based
        on
        this analysis and to comply with SFAS No. 109, an increase in the valuation
        allowance of $610,000 and $1,020,000 was recorded against the net deferred
        tax
        assets for the three and six months ended June 30, 2006, respectively,
        increasing the total valuation allowance to $12,360,000. There were no
        adjustments to the valuation allowance during the three or six months ended
        June
        30, 2005.


13


The
      establishment of the additional valuation allowance against the deferred tax
      asset will not have any effect on the Company’s ability to utilize existing net
      operating losses to offset future taxable income and will not have any effect
      on
      the Company’s cash flows. As of December 31, 2005, the Company has approximately
      $71,003,000 of Net Operating Losses being carried forward, expiring between
      2006
      and 2025.





**NOTE
      O - COMMITMENTS AND CONTINGENCIES**




The
      Company and its subsidiaries have various financial commitments under office
      and
      equipment leases and under the Development Agreement with the Countryside Fund.
      The office and equipment leases expire on various dates. The $288,000 obligation
      under the Development Agreement with the Countryside Fund expires in March,
      2009. Financial commitments for the next five years are:




**Year**
            
            **Commitments**2006
            
            $
            173,0002007
            
            
            335,0002008
            
            
            323,0002009
            
            
            79,0002010
            
            
            −Total
            
            $
            910,000





Lease
      expenses for the Company were $134,000 and $207,000 for the three and six months
      ended June 30, 2006 and $76,000 and $122,000 for the three and six months ended
      June 30, 2005, respectively.





In
      April,
      2001, USEB acquired its Brookhaven, Countryside and Morris project entities
      from
      Yankee Energy Services Company (“YESCO”). Two of the projects, Countryside and
      Morris, produce electricity from landfill gas and participate in the Illinois
      Retail Rate program. As part of the transaction, the acquired entities entered
      into a secured, contingent acquisition consideration agreement with YESCO.
      The
      agreement stipulates that additional acquisition consideration will be due
      and
      payable should, for the Countryside and Morris projects, actual electricity
      rates received exceed established levels and should actual operation and
      maintenance expenses be beneath established amounts. The contingent obligation
      has a face amount of $4,700,000, accrues interest at a rate of 9.5% per annum
      and is secured by the assets of the entities. The amount of payment due, if
      any,
      is calculated and paid on a quarterly basis. The contingent obligation
      terminates on March 31, 2011 when all unpaid balances remaining are forgiven
      and
      all security interests in the associated collateral will be released.
      Consideration paid under this agreement is treated as an operating expense
      in
      the Company’s financial statements.





USEB
      had
      provided the buyers related to certain installment sale notes with tax
      indemnifications related to the validity of the Section 29 tax credits generated
      by the assests sold to the buyers. US Energy Systems has no liability in the
      indemnifications other than through its ownership interests in USEB. To date,
      there ha s
      not
      been any claims made on these indemnifications. The Company will accrue any
      amounts related to these issues as they become quantifiable.


On
        June
        13, 2006, an affiliate of the Countryside Fund filed a lawsuit against us
        in the
        Supreme Court of the State of New York, New York County, entitled Countryside
        U.S. Power Inc. v U.S. Energy Systems, Inc., (Index No. 602079/2006),
        Countryside asserts two causes of action for breach of contract relating
        to the
        Development Agreement by and among Countryside, us and Cinergy Solutions,
        Inc.,
        dated April 8, 2004. Countryside alleges that we breached the Development
        Agreement by failing to pay monthly fees (first cause of action) and failing
        to
        provide certain office services to Countryside (second cause of action).
        Countryside seeks damages in the amount of $1,163,244 on the first cause
        of
        action, $745,152 on the second cause of action, and unspecified attorneys’ fees
        pursuant to a third cause of action based on an indemnification provision
        in the
        Development Agreement, together with interest and costs. If we are unable
        to
        settle this action, as to which no assurance can be given, we intend to defend
        it vigorously.
  **NOTE
        P - CONVERSION OF PREFERRED STOCK**




Effective
      on March 31, 2006, the Company caused the conversion of each share of its Series
      D Convertible Preferred Stock into four shares of common stock. A total of
      916,666 shares of the Series D Convertible Preferred Stock were converted into
      3,666,664 shares of common stock. This conversion will reduce preferred
      dividends by approximately $495,000 per year. The
      conversion resulted in a decrease in preferred stock equity of $9,000 and an
      increase in common stock equity of $37,000.




Effective
      on June 26, 2006, stockholders owning 58,524 of the Company’s Series C
      Convertible Preferred Stock exchaged such shares for 468,192 shares of common
      stock. This conversion will reduce preferred dividends by approximately $105,000
      per year. This conversion resulted in a decrease in preferred stock equity
      of
      $1,000 and an increase in common equity of $4,600.




14


**NOTE
      Q -SUBSEQUENT EVENT - UK ACQUISITION**




On
      August
      7, 2006, we completed our acquisition and financing (the “UK Transaction”) of
      certain energy assets in the United Kingdom through certain of our subsidiaries.
      The assets (the “UK Assets”) acquired include (i) gas licenses for approximately
      100,000 acres of onshore natural gas properties and mineral rights in North
      Yorkshire, England (the “Gas Licenses”), containing approximately 62.4 bcf (P2)
      of proved and probable reserves (consisting of approximately 46 bcf (P1) of
      proved reserves and approximately 16.4 bcf of probable reserves), (ii) the Knapton
      Generating Station, a 42 MW gas-fired power plant associated with and located
      in
      the vicinity of the natural gas reserves in North Yorkshire, England, (iii)
      and
      certain related gas gathering and processing assets. As part of the UK
      Transaction, our subsidiaries entered into a power purchase agreement and a
      gas
      sales agreement with Scottish Power Energy Management (“Scottish Power”) under
      which Scottish Power is required to take all of the electricity generated by
      the
      Knapton Generating Station and all of the natural gas produced from the
      associated reserves up to 100 bcf for a term of up to 12 years. We paid
      approximately $70.1 million and issued rights to acquire up to 2.4 million
      shares of our common stock, to acquire the UK Assets. The financing of the
      UK
      Transaction provided approximately $166.3 million for, among other things,
      the
      acquisition of the UK Assets, for certain reserves required by the terms of
      the
      financing and for working capital to be used by our subsidiaries for the
      operation and upgrading of the UK Assets and the proposed increased production
      of natural gas from the reserves covered by the Gas Licenses. These loans mature
      in 2013 and 2014, subject to acceleration or mandatory prepayments upon the
      occurrence of certain events, and are currently secured by substantially all
      of
      our and our subsidiaries assets, other than our USEB assets.




We,
      through GBGH, LLC (“GBGH”), in which we own a 79% interest, intend to further
      develop the natural gas fields subject to the Gas Licenses in a several phase
      process which will involve resolving certain operational issues, expanding
      the
      gas collection system, constructing a pipeline and making modifications to
      the
      Knapton Generating Station (the “Expansion”).


We
        also
        entered into various hedging and similar arrangements with respect to, among
        other things, gas and electricity prices, interest and currency rates, and
        carbon emission allowances. Our gas and electric hedges assure us that we
        will
        receive not less than specified prices for the sale of electricity from the
        Knapton Generating Station until August 2009 and for the sale of gas from
        the
        facility in 2010 and 2011. Our currency and interest rate hedges ensure that
        the
        results of operations with respect to our UK activities will not be adversely
        impacted, until at least August 2009, as a result of fluctuation in such
        rates.
        Our hedge with respect to carbon emission allowances ensures that we will
        be
        able to purchase such allowances, if needed, at fixed prices through December
        31, 2007.





The
      financing arrangement we entered into with respect to the UK transaction require
      that GBGH set aside funds for various purposes, including maintenance and the
      Expansion. Management believes that such funds are sufficient for such purposes,
      including the completion of the Expansion. Nonetheless, we agreed, pursuant
      to
      an equity support agreement, to provide additional funds to GBGH as follows:
      (i)
₤2.66 million (approximately $5,000,000 based upon the exchange rate in effect
      on or about August 7, 2006) no later than September 7, 2007 to cover certain
      of
      GBGH’s maintenance expenses; (ii) to cover certain shortfalls in the reserve
      account for Expansion; (iii) $20,000,000, less specified amounts, upon default
      under specified financing arrangements; (iv) up to $4 million for certain
      breaches of warranties (or the discovery of certain negative information)
      arising with respect to the agreements pursuant to which we acquired the UK
      Assets; (v) $20 million, if GBGH elects to extend the initial interest rate
      and
      currency hedge agreements which is due to expire on August 7, 2009, and (vi)
      if
      GBGH enters into one or more replacement interest rate and currency hedge
      agreements, the amounts payable as an upfront fee or premium to the providers
      thereunder.




**ITEM
      2: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
      OPERATIONS**





**RECENT
      DEVELOPMENTS**





See
      Note
      Q - Subsequent Event - UK Transaction for information regarding the UK
      Transaction





**RESULTS
      OF OPERATIONS**




The
      net
      loss of $2,917,000 for the three months ended June 30, 2006, represents an
      increase of $2,074,000 or 246% from the $843,000 net loss for the three months
      ended June 30, 2005. The increase in the loss is primarily the result of changes
      in the expense or income related to foreign currency transaction associated
      with
      USEB’s Countryside debt. For the three months ended June 30, 2006, foreign
      currency transaction resulted in an expense of $3,553,000 while for the three
      months ended June 30, 2005, foreign currency transaction resulted in income
      of
      $1,307,000. The total change between the comparative periods related to foreign
      currency transaction was $4,860,000 or $3,013,000 after adjusting for taxes.





15




The
      net
      loss of $4,891,000 for the six months ended June 30, 2006, represents an
      increase of $3,217,000 or 192% from the $1,674,000 net loss from continuing
      operations for the six months ended June 30, 2005. The increase in the loss
      is
      primarily the result of changes in the expense or income related to foreign
      currency transaction associated with USEB’s Countryside debt. For the six months
      ended June 30, 2006, foreign currency transaction resulted in an expense of
      $3,429,000 while for the six months ended June 30, 2005, foreign currency
      transaction resulted in income of $1,652,000. The total change between the
      comparative periods related to foreign currency transaction was $5,081,000
      or
      $3,150,000 after adjusting for taxes.




Revenues
      for the three and six months ended June 30, 2006 were $4,732,000 and $9,556,000,
      respectively, compared with $4,476,000 and $9,500,000 for the corresponding
      2005
      periods, representing increases of $256,000, or 6%, and $56,000, or 1% from
      the
      prior corresponding period. For the three months ended June 30, 2006, the
      increase of $256,000 was primarily due to a $124,000 increase in the volume
      of
      landfill gas sold for utilization as boiler fuel and a $346,000 increase due
      to
      an increase in the average rate per kilowatt hour (“kwh”) sold, offset by a
      $155,000 decrease due to a reduction in kwh output sold and a $60,000 decrease
      in other miscellaneous income. For the six months ended June 30, 2006, the
      $56,000 increase was primarily due to a $357,000 increase in the volume of
      landfill gas sold for utilization as boiler fuel and a $42,000 increase due
      to
      an increase in the average rate per kwh sold offset by a $198,000 decrease
      due
      to a reduction in kwh output sold and $131,000 decrease in miscellaneous income.





Operating
      expenses for the three and six months ended June 30, 2006 were $2,189,000 and
      $5,050,000, respectively, compared with $2,296,000 and $4,475,000 for the
      corresponding 2005 periods, representing a decrease of $107,000, or 5%, and
      an
      increase of $575,000, or 13%, from the prior corresponding period. Operating
      expenses as a percentage of revenues were 46% and 53% for the three and six
      months ended June 30, 2006 compared with 51% and 47% for the corresponding
      2005
      periods, respectively. For the three month period, the decrease was primarily
      due to an $83,000 increase in production rental payments due to increases in
      associated sales volumes and a $40,000 increase in third party operating and
      maintenance costs due to rate increases offset by a $162,000 reduction in site
      lease expenses. For the six month period, the increase was primarily due to
      a
      $153,000 increase in production rental payments due to increase in associated
      sales volumes, a $224,000 increase in third party operating and maintenance
      costs due to rate increases and a $105,000 increase in scheduled,
      non-capitalized maintenance expenses for USEB’s generation equipment.





General
      and administrative expenses were $2,257,000 and $4,088,000 for the three and
      six
      months ended June 30, 2006, respectively, resulting in an increase of $1,034,000
      or 84% and $1,658,000 or 68% from the $1,223,000 and $2,430,000 for the
      corresponding 2005 periods. The increase for the three months was primarily
      due
      to a $302,000 increase in the allowance for doubtful accounts (included in
      Corporate Expense) and $488,000 of expense related to the vesting of previously
      granted options as required by the SFAS 123R. The increase for the six months
      was primarily due to a $251,000 increase in legal and accounting fees, a
      $302,000 increase in the allowance for doubtful accounts (included in Corporate
      Expense) and $883,000 of expense related to SFAS 123R. As of June 30, 2006,
      the
      total unrecognized compensation costs related to granted stock options is
      $1,063,000. These costs will be recognized over the next 18 months.





The
      components of general and administrative expenses were as follows:




**Three
                Months Ended**
              **June
                30**
            
            **Six
                Months Ended**
              **June
                30****2006**
            
            **2005**
            
            **2006**
            
            **2005**Salary
                and Benefits
            
            $
            500,000
            
            $
            543,000
            
            $
            940,000
            
            $
            1,033,000Compensation
                Expense - Vesting Options
            
            
            488,000
            
            
            −
            
            
            883,000
            
            
            −Insurance
            
            
            44,000
            
            
            75,000
            
            
            89,000
            
            
            88,000Corporate
                Expenses
            
            
            732,000
            
            
            242,000
            
            
            1,187,000
            
            
            633,000Legal
                and Accounting
            
            
            271,000
            
            
            210,000
            
            
            584,000
            
            
            333,000Countryside
                Development Fee
            
            
            73,000
            
            
            72,000
            
            
            145,000
            
            
            131,000Royalty
                Expense
            
            
            149,000
            
            
            81,000
            
            
            260,000
            
            
            212,000Total:
            
            $
            2,257,000
            
            $
            1,223,000
            
            $
            4,088,000
            
            
            2,430,000




Depreciation
      and amortization expenses were $1,212,000 and $2,424,000 for the three and
      six
      months ended June 30, 2006 compared with $1,096,000 and $2,191,000 for the
      corresponding 2005 periods representing an increase of $116,000 and $233,000
      or
      11% for each period. The increase is related to depreciation associated with
      capital improvements on the USEB assets completed in 2005. We anticipate that
      such expenses will increase in the future as a result of the amortization of
      debt issuance and other costs associated with completing the UK transaction
      and
      the potential depreciation associated with the UK assets.





16


Interest
        and dividend income was $1,009,000 and $2,243,000 for the three and six months
        ended June 30, 2006 compare with $1,051,000 and $1,859,000 reported for the
        corresponding 2005 periods, as follows:


**Three
                Months Ended**
              **June
                30**
            
            **Six
                Months Ended**
              **June
                30****2006**
            
            **2005**
            
            **2006**
            
            **2005**Notes
                Receivable
            
            $
            635,000
            
            $
            746,000
            
            $
            1,267,000
            
            $
            1,374,000Earnings
                - Illinois Reserve Accounts
            
            
            173,000
            
            
            261,000
            
            
            668,000
            
            
            249,000Investments
            
            
            201,000
            
            
            44,000
            
            
            308,000
            
            
            236,000Total:
            
            $
            1,009,000
            
            $
            1,051,000
            
            $
            2,243,000
            
            $
            1,859,000




Interest
      expense was $2,779,000 and $5,569,000 for the three and six months ended June
      30, 2006, representing an increase of $73,000 and $149,000, or 3% for both
      periods, from the $2,706,000 and $5,420,000 reported for the corresponding
      2005
      periods. Interest expense is comprised of interest paid by USEB on the
      Countryside debt and the amortization of the discount associated with the
      accounting treatment of the Illinois subsidy (see note J to the condensed
      consolidated financial statements). The interest expense associated with the
      Illinois subsidy does not have any effect on the Company’s cash flows. A
      comparison of the components of interest expense follows:





**Three
                Months Ended**
              **June
                30**
            
            **Six
                Months Ended**
              **June
                30****2006**
            
            **2005**
            
            **2006**
            
            **2005**CPIF
                Interest
            
            $
            2,134,000
            
            $
            2,175,000
            
            $
            4,279,000
            
            $
            4,358,000Illinois
                Subsidy Amortization
            
            
            645,000
            
            
            531,000
            
            
            1,290,000
            
            
            1,062,000Total:
            
            $
            2,779,000
            
            $
            2,706,000
            
            $
            5,569,000
            
            $
            5,420,000




We
      anticipate that interest expense will increase significantly in the future
      as a
      result of the $166.3 million of debt incurred in the financing associated with
      the UK transaction.




Foreign
      Currency Transaction Expense for the three and six months ended June 30, 2006
      was $3,553,000 and $3,429,000 respectively, compared with Foreign Currency
      Transaction Income for the three and six months ended June 30, 2005 of
      $1,307,000 and $1,652,000, respectively. These amounts represent the
      adjustments, as required by SFAS 52, Foreign Currency Translations, to the
      outstanding principal owed to the Countryside Fund to reflect the change in
      the
      currency exchange rate from the start of the reporting periods to the end of
      the
      reporting periods. The Canadian dollar to US dollar exchange rate decreased
      to
      $1.1201 as of June 30, 2006 from $1.1676 as of March 31, 2006 and from $1.1660
      as of December 31, 2005. See Note L to the Condensed Consolidated Financial
      Statements. The Canadian dollar to US dollar exchange rate was $1.2287 as of
      June 30, 2005, $1.2096 as of March 31, 2005 and $1.2047 as of December 31,
      2004.




The
      provision for income taxes for the three and six months ended June 30, 2006
      and
      2005 was a benefit of $1,816,000 and an expense of $25,000 for the three months,
      respectively and a benefit of $2,321,000 and $86,000 for the six months,
      respectively. The provisions for taxes are based on an effective tax rate of
      38%
      and for the three and six month periods ended June 30, 2006 are net of a
      $1,020,000 and $410,000 increase in the valuation allowance against the deferred
      tax asset, respectively.





Gain
      on
      Disposal of a Segment of $150,000 for the six months ended June 30, 2005
      represents residual income from the operations of USE Canada Energy Corp which
      was sold in 2004.





17





**LIQUIDITY
      AND CAPITAL RESOURCES**





At
      June
      30, 2006, unrestricted cash amounted to $4,644,000 compared with $11,301,000
      of
      unrestricted cash at December 31, 2005, a reduction of $6,657,000. The decrease
      was primarily due to expenditures of $4,599.000 during this period related
      to
      the UK transaction. See Note Q to the Condensed Consolidated Financial
      Statements.





During
      the six months ended June 30, 2006, cash provided by operating activities was
      $340,000, an increase of $1,152,000 from the $812,000 used by operating
      activities for the six months ended June 30, 2005. The increase was due
      primarily to a $79,000 decrease in interest paid on the Countryside debt, a
      $384,000 increase in interest and dividend income and a $519,000 increase
      related to the collection of trade accounts receivable offset by a $198,000
      decrease related to the payment of accounts payable.





Cash
      used
      in investing activities increased to $4,989,000 for the six months ended June
      30, 2006, compared to $79,000 of cash provided by investing activities for
      the six months ended June 30, 2005, an increase of $5,068,000. This increase
      was
      primarily the result of $4,599,000 of expenditures related to the UK
      transaction. These funds were utilized to satisfy the Company’s equity funding
      requirement at closing and as such are being classified as Other Assets in
      the
      consolidated financial statements.





Cash
      used
      in financing activities increased to $2,008,000 for the six months ended June
      30, 2006, an increase of $965,000 from the $1,043,000 used in financing
      activities for the six months ended June 30, 2005. The decrease is primarily
      due
      to the payment of minority interest distributions related to the ownership
      of
      certain USEB project entities offset by a reduction in preferred dividends
      due
      to the conversion of the Company’s Series D preferred stock





Effective
      on April 1, 2007, USEB’s foreign currency hedge agreement which fixes the
      Canadian dollar to US Dollar exchange rate expires. As USEB is required to
      make
      payments to Countryside in Canadian dollars, USEB will be subject to adjustments
      in debt service payments made to Countryside to reflect existing exchange rates
      upon the expiration of the existing hedging arrangement. While USEB is required
      to hedge at least 75% of its future debt service payments to Countryside, any
      new hedging arrangement will result in an adjustment to the amount of US dollar
      debt service payments made by USEB. Based upon the exchange rate existing as
      of
      June 30, 2006, USEB’s debt service payments to Countryside will increase by
      approximately $157,000 per month beginning in April of 2007. This amount is
      subject to fluctuations in the exchange rate. It is anticipated that USEB’s
      operations will absorb the increase in the debt service payments but no
      assurance can be given in this regard.




The
      financing arrangements between the Countryside Fund and the USEB projects
      require these projects maintain various restricted cash accounts, which, as
      of
      June 30, 2006, amounted to $32,447,000 including $26,924,000 classified as
      a
      long-term asset. These funds are presented as a long-term asset as they are
      being reserved to retire the long term Illinois Subsidy Liabilities as they
      become due.




The
      financing arrangement we entered into with respect to the UK transaction
      requires that GBGH set aside funds for various purposes, including maintenance
      and the Expansion. See Note Q to the Consolidated Financial Statements.
      Management believes that the funds provided by the financing arrangements are
      sufficient for such purposes, including the completion of the Expansion.
      Nonetheless, we agreed, pursuant to an equity support agreement, to provide
      additional funds to GBGH as follows: (i) ₤2.66 million (approximately $5,000,000
      based upon the exchange rate in effect on or about August 7, 2006) no later
      than
      September 7, 2007 to cover certain of GBGH’s maintenance expenses; (ii) to cover
      certain shortfalls in the reserve account for Expansion; (iii) $20,000,000,
      less
      specified amounts, upon default under specified financing arrangements; (iv)
      up
      to $4 million for certain breaches of warranties (or the discovery of certain
      negative information) arising with respect to the agreements pursuant to which
      we acquired the UK Assets; (v) $20 million, if GBGH elects to extend the initial
      interest rate and currency hedge agreements which is due to expire on August
      7,
      2009, and (vi) if GBGH enters into one or more replacement interest rate and
      currency hedge agreements, the amounts payable as an upfront fee or premium
      to
      the providers thereunder.





The
      Countryside and UK Transaction financing arrangements generally limit or
      prohibit our principal cash generating subsidiaries from (i) making improvements
      or expanding certain projects unless specified conditions are satisfied; and/or
      (ii) distributing funds to US Energy, at the parent company level. As a result
      of these limitations and the expenditures incurred in connection with, among
      other things, the UK Transaction, we estimate that, at the parent company level,
      US Energy will require additional funds for general corporate and working
      capital purposes. We anticipate that a portion of the funds required will be
      generated by the exercise of outstanding in-the-money stock options and from
      external financing we intend to obtain. However, as previously noted, our
      ability to raise additional funds is restricted by these financing arrangements
      which, among other things, limit our and our subsidiaries ability to issue
      equity, incur debt or sell assets. In particular, the Silver Point financing
      arrangement prohibits US Energy, at the parent company level, from incurring
      any
      further debt and requires US Energy, with certain exceptions, to prepay the
      Silver Point loan if we or our subsidiaries issue equity (provided that only
      50%
      of the net proceeds in excess of the first $3 million from issuances of our
      equity is to be applied to reduce such loan). Further, Silver Point has the
      exclusive right to arrange financing for us through December 2006. Accordingly,
      no assurance can be given that we will be able to obtain the necessary funding
      on acceptable terms.





18


**CAUTIONARY
      STATEMENT RELATING TO FORWARD LOOKING STATEMENTS**





This
      Form
      10-Q contains certain “forward looking statements” which represent our
      expectations or beliefs, including, but not limited to, statements concerning
      industry performance and our operations, performance, financial, growth and
      strategies. For this purpose, any statements contained in this Form 10-Q that
      are not statements of historical fact may be deemed to be forward looking
      statements. Without limiting the generality of the foregoing, words such as
      “may”, “will”, “expect”, “believe”, “anticipate”, “intend”, “could”, “estimate”,
      or “continue” or the negative or other variations thereof or comparable
      terminology are intended to identify forward-looking statements. These
      statements by their nature involve substantial risks and uncertainties, certain
      of which are beyond our control, and actual results may differ materially
      depending on a variety of important factors which are noted herein, including
      but not limited to the potential impact of competition, changes in local or
      regional economic conditions, our ability to continue our growth strategy,
      dependence on management and key personnel, supervision and regulation issues
      and the ability to find financing on terms suitable to us. Additional factors
      which may impact our business, prospects, operating results and financial
      condition are described under the caption “Risk Factors” in our Annual Report on
      Form 10-K for the year ended December 31, 2005.








**ITEM
      3: Quantitative and Qualitative Disclosures about Market
      Risk**





We
      are
      exposed to various types of market risk in the normal course of our business,
      including the impact of interest rate changes, foreign currency exchange rate
      fluctuations, changes in equity investment prices and changes in corporate
      tax
      rates.





Generally
      the Company does not enter into any interest rate or derivative transactions
      as
      a hedge against these market risks as the underlying assets and investments
      are
      long-term in nature. However, the foreign currency hedge entered into by USEB
      as
      discussed in Note L to the Consolidated Financial Statements eliminates the
      impact of fluctuations in exchange rates on our Countryside debt service
      payments through March 31, 2007. This issue is discussed in more detail in
      our
      Annual Report on Form 10-K for the year ended December 31, 2005.








**ITEM
      4: Controls and Procedures**





Evaluation
      of Disclosure Controls and Procedures:





The
      Company has established a series of systems and procedures to assure full and
      timely disclosure of material information respecting the Company. Our Chief
      Executive Officer and Chief Accounting Officer (the person who performs the
      functions of the Chief Financial Officer), carried out an evaluation of the
      design and operation of our disclosure controls and procedures as of the end
      of
      the period covered by this report. Based on such evaluation, they concluded
      that
      our disclosure controls and procedures are effective in alerting them on a
      timely basis to material information relating to us (including our consolidated
      subsidiaries) required to be included in our periodic SEC filings.





**PART
      II - Other Information**





**Item
      1A Risk Factors**





In
      addition to the information set forth in this report, and the risk factors
      discussed below, you should carefully consider the factors discussed in Part
      I,
“Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended
      December 31, 2005, which could materially affect our business, financial
      condition or future results. The risks described in our Annual Report on Form
      10-K are not the only risks facing our Company.





*We
      are required to pay approximately $47 million and a $23.3 million loan becomes
      immediately payable if our stockholders do not approve the issuance of the
      shares of our common stock issuable in connection with the UK
      Transaction.*





19


In
      connection with the UK Transaction and the related financing arrangements,
      we
      issued warrants and other convertible securities (collectively, the “Rights”) to
      acquire up to 8,074,000 shares (the “Shares”) of our common stock, subject to
      increase as described below. The NASDAQ Stock Market requires that our
      stockholders approve issuances and potential issuances of more than 3,342,000
      Shares. Our financing arrangements provide that if stockholder approval is
      not
      obtained by November 6, 2006, subject to an additional 59 days in specified
      circumstances, we are required to pay our financing sources approximately $
      47
      million and our $23.3 million Silver Point loan becomes payable immediately.
      In
      such event, we will also be required (and are permitted under NASDAQ’s rules) to
      allow approximately 3,342,000 Shares with respect to the Rights to become
      exercisable. We do not currently have the funds to make these payments and
      no
      assurance can be given that such funds, if required, will be
      available.




*We
      may be required to issue Rights to acquire an additional 3,998,000 shares if
      we
      do not obtain USEB’s guaranty of the Silver Point financing arrangements by
      December 31, 2006.*





Our
      financing arrangements with Silver Point provides that USEB, by December 31,
      2006, must guaranty (the “USEB Guaranty”) the $23.3 million Silver Point
      financing. If the guaranty is not timely provided, we are required to issue
      to
      Silver Point Rights to acquire 3,998,000 Shares (the “Additional Shares”) in
      addition to the 8,074,000 Shares issuable as described above. We need the
      consent of Cinergy Energy Solutions, Inc., our minority partner in USEB, and
      the
      Countryside Power Income Fund or its affiliates, to obtain this guaranty. We
      are
      involved in litigation with the Countryside Fund and no assurance can be given
      that Cinergy or the Countryside Fund will consent to the issuance of the USEB
      Guaranty. See “Item 5: Other Events”




*Our
      stockholders may be diluted as a result of the issuance of the
      Rights.*




In
      connection with the UK Transaction and the related financing arrangements,
      we
      issued Rights allowing the issuance of up to 8,074,000 Shares (subject to
      increase for the Additional Shares). Of these Rights (as well as the Rights
      to
      acquire the Additional Shares): (i) Rights to acquire 5,074,000 Shares are
      exercisable at an exercise price of $0.01 per share; and (ii) the $0.01 exercise
      price of Rights to acquire 4,488,780 of these Shares will be reduced (and the
      number of Shares to be issued will increase) on a weighted average basis if
      we
      issue common stock or rights to acquire common stock at a price per share (the
      “Trigger Price”) below the greater of $3.00 or fair market value (as determined
      pursuant to the applicable Right). Your equity interests in US Energy may be
      diluted as a result of these issuances, the potential issuances that may result
      from the failure to obtain the USEB Guaranty on a timely basis and as a result
      of the application of these anti-dilution adjustments.





*We
      may require additional capital to fund our general corporate and working capital
      requirements.*





We
      estimate that at the parent company level, US Energy will require additional
      funds for general corporate and working capital purposes. As a result of
      limitations imposed by our various financing arrangements, funds for such
      purposes are generally not available from cash flows generated by our
      subsidiaries, as such subsidiaries are restricted in their ability to make
      distributions to us. Our ability to raise additional funds is restricted by
      our
      financing arrangements which, among other things, limit our and our subsidiaries
      ability to issue equity, incur debt or sell assets. In particular, the Silver
      Point financing arrangements prohibits us, at the parent company level, from
      incurring any additional debt and requires us, with certain exceptions, to
      prepay the Silver Point loan if we or our subsidiaries issue equity (provided
      that only 50% of the net proceeds in excess of the first $3 million from
      issuances of equity is to be applied to reduce such loan). Further, Silver
      Point
      has the exclusive right to arrange financing for us through December 2006.
      No
      assurance can be given that we will be able to obtain the necessary funding
      on
      acceptable terms.




Additional
      risks and uncertainties not currently known to us or that we currently deem
      to
      be immaterial may materially adversely affect our business, financial condition
      and/or operating results.




20




**Item
      5: Other Events**


On
        June
        13, 2006, an affiliate of the Countryside Fund filed a lawsuit against us
        in the
        Supreme Court of the State of New York, New York County, entitled Countryside
        U.S. Power Inc. v U.S. Energy Systems, Inc., (Index No. 602079/2006),
        Countryside asserts two causes of action for breach of contract relating
        to the
        Development Agreement by and among Countryside, us and Cinergy Solutions,
        Inc.,
        dated April 8, 2004. Countryside alleges that we breached the Development
        Agreement by failing to pay monthly fees (first cause of action) and failing
        to
        provide certain office services to Countryside (second cause of action).
        Countryside seeks damages in the amount of $1,163,244 on the first cause
        of
        action, $745,152 on the second cause of action, and unspecified attorneys’ fees
        pursuant to a third cause of action based on an indemnification provision
        in the
        Development Agreement, together with interest and costs. If we are unable
        to
        settle this action, as to which no assurance can be given, we intend to defend
        it vigorously.




**Item
      6: Exhibits**





**Exhibit
                Number**
            
            **Description**31.1
            
            Rule
                13a-14(a)/15d-14(a) certifications31.2
            
            Rule
                13a-14(a)/15d-14(a) certifications32.1
            
            Section
                1350 certification






21


**SIGNATURES**








Pursuant
      to the requirements of the Securities and Exchange Act of 1934, the registrant
      has duly caused this report to be signed on its behalf by the undersigned
      thereunto duly authorized.











U.S.
      ENERGY SYSTEMS, INC.





By:
            /s/ Asher
              E.
              FogelAsher
              E. FogelChief
                Executive Officer
              (Principal Executive Officer)
            
            
            Dated:August
              21, 2006  
 By:
              /s/ Richard
                J. AugustineRichard
                J. AugustineChief
                  Accounting Officer
                (Principal Accounting and Financial
                  Officer)
              
              
              Dated:August
                21, 2006








22