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 March 31, 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 AvenueSixth FloorNew 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
        March 31, 2006: 16,710,832 shares of Common Stock
  1
 
 **U.S.
        ENERGY SYSTEMS, INC AND SUBSIDIARIES**
 **CONTENTS**
 
  
 **PAGE****PART
                I:
                Financial Information****Item
                  1:**Condensed Consolidated Financial Statements - UnauditedConsolidated
                  Balance Sheets as of March 31, 2006 and December 31, 2005
              3Consolidated
                  Statements of Operations and Comprehensive Income for the three
                  months
                  ended March 31, 2006 and 2005
              5Consolidated
                  Statements of Cash Flows for the three months ended March 31, 2006
                  and
                  2005
              7Notes
                  to 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
              18**Item
                  4:**Controls and Procedures
              18**PART
                  II:**Other
                  Information**Item
                  1A:**Risk
                  Factors
              19**Item
                  6**:
                  Exhibits
              19Signatures
              20
 
  2
  **U.
        S. ENERGY SYSTEMS INC. AND SUBSIDIARIES**
 **CONDENSED
        CONSOLIDATED BALANCE SHEETS**
 **(In
        thousands, except share amounts)**
 
 **March
                  31, 2006**
              
              **December
                  31, 2005****(Unaudited)**
              
              **(Audited)****ASSETS**Current
                  Assets:Cash
                  and Cash Equivalents
              
              $
              7,623
              
              $
              11,301Restricted
                  Cash and Marketable Securities
              
              
              5,521
              
              
              5,501Accounts
                  Receivable Trade (less allowance for doubtful accounts of $888
                  in 2006 and
                  2005)
              
              
              2,812
              
              
              2,198Accounts
                  Receivable Affiliates (less allowance for doubtful accounts of
                  $511 in
                  2006 and 2005)
              
              
              1,906
              
              
              2,789Installment
                  Sale Partnership Interests and Interest Receivable, Current
                  Portion
              
              
              2,021
              
              
              1,976Other
                  Current Assets
              
              
              2,045
              
              
              1,633Total
                  Current Assets, Net
              
              
              21,928
              
              
              25,398Restricted
                  Cash and Marketable Securities
              
              
              27,518
              
              
              26,429Property,
                  Plant and Equipment, Net
              
              
              39,388
              
              
              40,306Construction
                  in Progress
              
              
              198
              
              
              198Installment
                  Sale Partnership Interest, less Current Portion
              
              
              21,625
              
              
              22,088Investments
              
              
              1,364
              
              
              1,234Debt
                  Issuance Costs, Net of Accumulated Amortization
              
              
              10,278
              
              
              10,476Goodwill
              
              
              26,618
              
              
              26,618Foreign
                  Currency Hedge
              
              
              1,444
              
              
              1,860Deferred
                  Tax Asset (less valuation allowance of $11,750 in 2006 and $11,340
                  in
                  2005)
              
              
              14,589
              
              
              13,878Investment
                  in UK Acquisition
              
              
              2,909
              
              
              261Other
                  Assets
              
              
              65
              
              
              283**TOTAL
                  ASSETS**
              
              **$**
              **167,924**
              
              **$**
              **169,029****LIABILITIES**Current
                  Liabilities:Current
                  Portion of Long-Term Debt
              
              $
              1,795
              
              $
              1,879Accounts
                  Payable Trade and Accrued Expenses
              
              
              4,163
              
              
              4,083Accounts
                  Payable Affiliates
              
              
              970
              
              
              1,091Deferred
                  Revenue
              
              
              272
              
              
              272Total
                  Current Liabilities
              
              
              7,200
              
              
              7,325Long-Term
                  Debt, less Current Portion
              
              
              86,825
              
              
              87,282Deferred
                  Revenue
              
              
              16,182
              
              
              16,224Deferred
                  Royalty
              
              
              5,276
              
              
              5,379Illinois
                  Subsidy Liability
              
              
              33,149
              
              
              31,678Total
                  Liabilities
              
              
              148,632
              
              
              147,888Commitments
                  and Contingencies (Note O)
              
              
              —
              
              
              —Minority
                  Interest
              
              
              4,684
              
              
              4,968
 
 See
        notes
        to consolidated financial statements
 which
        are
        an integral part of the financial statements.
  3
 
 **U.
        S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES**
 **CONDENSED
        CONSOLIDATED BALANCE SHEETS (continued)**
 **(In
        thousands, except share amounts)**
 
 **March
                  31, 2006**
              
              **December
                  31, 2005****(Unaudited)**
              
              **(Audited)****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, 100,000 Shares
                  at 2006
                  and 2005, Liquidation Preference, $30 per share
              
              
              1
              
              
              1Series
                  D, Cumulative, Convertible, Issued and Outstanding, 0 shares as
                  of March
                  31, 2006 and 916,666 Shares as of December 31, 2005, Liquidation
                  Preference, $9 per share
              
              
              —
              
              
              9Total
                  Common Stock, $.01 par Value, Authorized 50,000,000 Shares, Issued
                  17,154,036 and 13,487,372 at 2006 and 2005, respectively
              
              
              172
              
              
              135Treasury
                  Stock, at Cost –
                  445,930
                  Shares
              
              
              (2,204
              )
              
              (2,204
              )Additional
                  Paid-In Capital
              
              
              62,758
              
              
              62,583Accumulated
                  Deficit
              
              
              (48,502
              )
              
              (46,528
              )Other
                  Comprehensive Income
              
              
              2,383
              
              
              2,177Total
                  Stockholders’ Equity
              
              
              14,608
              
              
              16,173**TOTAL
                  LIABILITIES AND STOCKHOLDERS’ EQUITY**
              
              **$**
              **167,924**
              
              **$**
              **169,029**
 
  See
        notes
        to consolidated financial statements
 which
        are
        an integral part of the financial statements.
  4
  **U.S.
        ENERGY SYSTEMS, INC. AND SUBSIDIARIES**
 **CONDENSED
        CONSOLIDATED STATEMENTS OF OPERATIONS**
 **AND
        COMPREHENSIVE INCOME**
 **(Unaudited)**
 **(In
        thousands, except Income(Loss) per Share)**
 
 **Three
                  Months Ended**
                **March
                  31,****2006**
              
              **2005**Revenues
              
              $
              4,824
              
              $
              5,024Costs
                  and Expenses:Operating
                  Expenses
              
              
              2,861
              
              
              2,179General
                  and Administrative Expenses
              
              
              1,831
              
              
              1,292Depreciation
                  and Amortization
              
              
              1,212
              
              
              1,095Income
                  from Joint Ventures
              
              
              (115
              )
              
              (85
              )Total
                  Costs and Expenses
              
              
              5,789
              
              
              4,481(Loss)Income
                  from Operations
              
              
              (965
              )
              
              543Interest
                  and Dividend Income
              
              
              1,236
              
              
              808Foreign
                  Currency Translation Income
              
              
              124
              
              
              345Interest
                  Expense
              
              
              (2,790
              )
              
              (2,714
              )Other
                  Loss
              
              
              (65
              )
              
              (4
              )Loss
                  before Taxes, Minority Interest and Disposal of Segment
              
              
              (2,460
              )
              
              (1,022
              )Income
                  Tax Benefit
              
              
              505
              
              
              111Minority
                  Interest
              
              
              (19
              )
              
              80Loss
                  from Continuing Operations
              
              
              (1,974
              )
              
              (831
              )Gain
                  on Disposal of a Segment
              
              
              —
              
              
              150Net
                  Loss
              
              
              (1,974
              )
              
              (681
              )Dividends
                  on Preferred Stock
              
              
              (192
              )
              
              (207
              )Net
                  Loss Applicable to Common Stock
              
              $
              (2,166
              )
              $
              (888
              )Other
                  Comprehensive LossNet
                  Loss
              
              $
              (1,974
              )
              $
              (681
              )Unrealized
                  Gain(Loss) on Investments
              
              
              206
              
              
              (267
              )Total
                  Comprehensive Loss
              
              $
              (1,768
              )
              $
              (948
              )
  See
        notes
        to consolidated financial statements
 which
        are
        an integral part of the financial statements.
  5
  **U.S.
        ENERGY SYSTEMS, INC. AND SUBSIDIARIES**
 **CONDENSED
        CONSOLIDATED STATEMENTS OF OPERATIONS AND**
 **COMPREHENSIVE
        INCOME (LOSS) (continued)**
 **(Unaudited)**
 
 **Three
                  Months Ended**
                **March
                  31,****2006**
              
              **2005**NET
                  INCOME(LOSS) PER SHARE OF COMMON STOCK:Loss
                  per Share of Common Stock Continuing Operations
              
              $
              (0.15
              )
              $
              (0.09
              )Income
                  per Share of Common Stock Discontinued Operations
              
              
              —
              
              $
              0.02Net
                  Loss per Share of Common Stock
              
              $
              (0.15
              )
              $
              (0.07
              )Weighted
                  Average Number of Common Shares Outstanding –
                  Basic and
                  Diluted
              
              
              14,710
              
              
              11,970
  See
        notes
        to consolidated financial statements
 which
        are
        an integral part of the financial statements.
  6
  **U.S.
        ENERGY SYSTEMS, INC. AND SUBSIDIARIES**
 **CONDENSED
        CONSOLIDATED STATEMENTS OF CASH FLOWS**
 **(Unaudited)**
 **(in
        thousands)**
 
 **THREE
                  MONTHS ENDED**
                **March
                  31,****2006**
              
              **2005**CASH
                  FLOWS FROM OPERATING ACTIVITIES:Net
                  Loss
              
              $
              (1,974
              )
              $
              (681
              )Adjustments
                  to Reconcile Net Loss to Net Cash (Used in)Provided by Operating
                  activities:Depreciation
                  and Amortization
              
              
              1,212
              
              
              1,095Minority
                  Interest in Loss
              
              
              19
              
              
              (80
              )Foreign
                  Currency Translation
              
              
              (124
              )
              
              (345
              )Deferred
                  Taxes
              
              
              (711
              )
              
              (741
              )Equity
                  Gains In Subsidiary
              
              
              (111
              )
              
              —Stock
                  Based Compensation
              
              
              396
              
              
              —Changes
                  in:Accounts
                  Receivable, Trade
              
              
              269
              
              
              (295
              )Foreign
                  Currency Hedge
              
              
              160
              
              
              134Other
                  Current Assets
              
              
              (186
              )
              
              (187
              )Other
                  Assets
              
              
              (9
              )
              
              (46
              )Accounts
                  Payable and Accrued Expenses
              
              
              (41
              )
              
              314Deferred
                  Royalty
              
              
              (103
              )
              
              (88
              )Deferred
                  Revenue
              
              
              (42
              )
              
              (100
              )Illinois
                  Subsidy Liability
              
              
              1,471
              
              
              1,256Net
                  Cash Flows Provided by Operating Activities
              
              
              266
              
              
              236CASH
                  FLOWS FROM INVESTING ACTIVITIES:Restricted
                  Cash
              
              
              (524
              )
              
              (416
              )Capitalized
                  Transaction Costs –
                  UK
                  Transaction
              
              
              (2,648
              )
              
              —Changes
                  in Notes Receivable
              
              
              418
              
              
              8Investments
              
              
              (19
              )
              
              (373
              )Acquisition
                  of Equipment and Leasehold Improvements
              
              
              (96
              )
              
              (156
              )Net
                  Cash Used in Investing Activities
              
              
              (2,869
              )
              
              (937
              )
  See
        notes
        to consolidated financial statements
 which
        are
        an integral part of the financial statements.
  7
  **U.S.
        ENERGY SYSTEMS, INC. AND SUBSIDIARIES**
 **CONDENSED
        CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)**
 **(Unaudited)**
 **(in
        thousands)**
 
 **THREE
                  MONTHS ENDED**
                **March
                  31,****2006**
              
              **2005**CASH
                  FLOWS FROM FINANCING ACTIVITIES:Payments
                  of Long-Term Debt
              
              
              (367
              )
              
              (328
              )Minority
                  Interest
              
              
              (476
              )
              
              —Dividends
                  on Preferred Stock
              
              
              (192
              )
              
              (207
              )Net
                  Cash Used in Financing Activities
              
              
              (1,035
              )
              
              (535
              )NET
                  DECREASE IN CASH AND CASH EQUIVALENTS
              
              
              (3,678
              )
              
              (1,236
              )CASH
                  AND CASH EQUIVALENTS – BEGINNING OF PERIOD
              
              
              11,301
              
              
              15,982CASH
                  AND CASH EQUIVALENTS – END OF PERIOD
              

        $
              7,623
              

        $
              14,746Supplemental
                  Disclosure of Cash Flow InformationCash
                  Paid for Interest
              
              
              2,145
              
              
              2,183Supplemental
                  Schedule of Non-cash FinancingConversion
                  of Preferred Stock to Common
              
              
              (37
              )
              
              —
  8


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


**NOTES
      TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**


**FOR
      THE THREE MONTHS ENDED MARCH 31, 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 months ended March 31, 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.





The
      condensed and consolidated balance sheet at December 31, 2005 was derived from
      the audited financial statements at December 31, 2005.





Certain
      reclassifications have been made to prior years to conform to the current year’s
      presentation.





**NOTE
      B – BASIS OF REPORTING**





The
      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 the 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 791,000 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 March 31, 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 $395,000 for the period
      ended March 31, 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 March 31, 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
            
            
            4.96
            
            $
            601,000Granted
            
            
            —
            
            
            —
            
            
            —
            
            
            —Exercised
            
            
            —
            
            
            —
            
            
            —
            
            
            —Forfeited
            
            
            —
            
            
            —
            
            
            —
            
            
            —Expired
            
            
            —
            
            
            —
            
            
            —
            
            
            —Outstanding,
                March 31, 2006
            
            
            7,156,425
            
            $
            3.67
            
            
            4.96
            
            $
            601,000Exercisable,
                March 31, 2006
            
            
            5,716,425
            
            $
            3.86
            
            
            3.47
            
            $
            341,000





The
      Company estimates the fair value of stock options using a Black-Scholes
      valuation model, consistent with the provisions of SFAS No. 123R, Securities
      and
      Exchange Commission Staff Accounting Bulletin No. 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. This 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 and does not expect to pay dividends in the near
      future.





Compensation
      costs for stock options with tiered vesting terms are recognized ratably over
      the vesting period. As of March 31, 2006, the total unrecognized compensation
      costs related to granted stock options is $1,457,000. These costs will be
      recognized over the next 21 months assuming no changes to the underlying
      assumptions.





There
      were no options granted during the three month period ended March 31,
      2006.





The
      fair
      value of each option grant in 2005 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
            
            
            5.50Expected
                Stock Price Volatility
            
            
            1.44Expected
                Dividend Yield
            
            
            0.00
            %





SFAS
      No.
      123 required disclosure of net income on a pro forma basis as if the expense
      treatment had been applied. Had the Company elected to recognize compensation
      expense for the stock option plan, consistent with the method prescribed by
      SFAS
      No. 123R there would have been no change to the net loss reported in the period
      ended March 31, 2005.




**NOTE
      F – FOREIGN CURRENCY**





The
      functional currency for our foreign debt is the local currency. The local
      currency is Canadian dollars. For this foreign debt, we translate assets and
      liabilities at the end-of-period exchange rates. We report translation
      adjustments on inter-company foreign currency transactions of a long-term nature
      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
      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, 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. The Company owns 54.26% and Cinergy Energy,
      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 fund held in the improvement reserve account can be utilized to
      fund capital expenditures. The funds in the Illinois Account are to be utilized
      to retire the Illinois subsidy liability as it becomes due.





Restricted
      cash and marketable securities were as follows:





**March
                31, 2006**
            ****
            **December
                31, 2005**Illinois
                Subsidy Liability Reserve Accounts
            
            $
            27,518,000
            
            $
            26,429,000Improvement
                Reserve
            
            
            3,396,000
            
            
            3,367,000Debt
                Service Reserve
            
            
            2,095,000
            
            
            2,104,000Project
                Contract Reserve
            
            
            30,000
            
            
            30,000Totals
            
            $
            33,039,000
            
            $
            31,930,000





Included
      in the Illinois Accounts at March 31, 2006 is $25,518,000 that is managed by
      a
      professional investment manager under investment allocation parameters
      established by the Company. Of such sum, $16,761,000 is invested in equity
      fund
      accounts, $7,592,000 is invested in debt accounts, and $1,165,000 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 investment, which has
      been
      invested since July 2004, 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.




11


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.





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 a project’s participation in the
      Illinois Retail Rate Program.





**Project**
            
            **Commencement
                of**
              **Commercial
                Operations**
            
            **Expiration
                of Illinois**
              **Retail
                Rate Program**
            
            **Estimated
                Commencement of**
              **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 March 31, 2006 was $27,518,000. The amount of the subsidy liability owed
      to
      Illinois as of March 31, 2006 was $58,180,000, 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 months ended
      March 31, 2006, the Company received approximately 21% 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 months ended March 31, 2006 and 2005 amount to $62,000 and $68,000,
      respectively.


12





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 months ended March 31, 2006 and 2005 were $28,000 and $184,000,
      respectively. The decrease between periods is due to a reduction in the
      allocation of rent expenses.





**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 SFAS No. 52 - “Foreign Currency Translation” and SFAS 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 March 31, 2006
      (the exchange rates are Canadian dollars per one US dollar and are stated whole
      dollars):





Currency
                Exchange Rate at Loan Origination, April 8, 2004
            
            $
            1.3310Currency
                  Exchange Rate at March 31, 2005
            
            $
            1.2096Currency
                Exchange Rate at December 31, 2005
            
            $
            1.1660Currency
                Exchange Rate as of March 31, 2006
            
            $
            1.1676Cumulative
                Translation Adjustments Beginning of Reporting Period
            
            $
            9,764,000Cumulative
                Translation Adjustments End of Reporting Period
            
            $
            9,640,000Aggregate
                Adjustment for the Current Reporting Period Income
                /(Expense)
            
            $
            124,000Deferred
                Income Taxes Allocated to Adjustment in the Reporting
                Period
            
            $
            (47,000
            )





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





Other
      Comprehensive Income(Loss) for the three months ended March 31, 2006 and 2005
      is
      comprised of the following:





**Three
                Months Ended March 31****2006**
            
            **2005**Unrealized
                gains and losses on availablefor
                sale investment securities
            
            $
            318,000
            
            $
            (303,000
            )Foreign
                currency exchange rates (see Note F)
            
            
            (112,000
            )
            
            36,000Total:
            
            $
            206,000
            
            $
            (267,000
            )





**NOTE
      N – DEFERRED INCOME TAXES**





In
      accordance with Statement of Financial Accounting Standards No. 109 -
“Accounting for Income Taxes” (“FAS 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.


13





Based
      on
      this analysis and to comply with FAS No. 109, an increase in the valuation
      allowance of $410,000 was recorded against the net deferred tax assets during
      the three months ended March 31, 2006 increasing the total valuation allowance
      to $11,750,000. There was no adjustment to the valuation allowance during the
      three months ended March 31, 2005.




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, which include the lease for the former
      corporate headquarters in White Plains, New York expire on various dates. The
      $288,000 annual obligation under the Development Agreement with the Countryside
      Fund expires in March, 2009. Financial commitments for the next five years
      are:




**Year**
            
            **Commitments**2006
            
            $
            386,0002007
            
            
            503,0002008
            
            
            365,0002009
            
            
            29,0002010
            
            
            −Total
            
            $
            1,283,000





Lease
      expenses for the Company were $64,500 and $61,300 for the three months ended
      March 31, 2006 and 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 and all unpaid balances remaining are forgiven.
      Consideration paid under this agreement is treated as an operating expense
      in
      the Company’s financial statements.





In
      December 2005, two stockholders of the Company commenced a suit entitled Bernard
      Zahren and Frederick Rose v. U.S. Energy Systems, Inc., et al .
      in the
      Delaware Court of Chancery, New Castle County (Civil Action No. 1814-N), against
      the Company, the current directors of the Company, certain former directors
      and
      officers of the Company and the Countryside Fund and an affiliate thereof,
      alleging, among other things, that the defendants violated or will violate
      the
      Delaware General Corporation Law and fiduciary duties to the Company's
      stockholders in connection with the Company's sale of USE Canada to the
      Countryside Fund, the consummation of the financing transaction between USEB
      and
      the Countryside Fund, the acquisition of Viking Petroleum (as defined below)
      and
      the related transactions and the benefits paid or to be paid in connection
      therewith. The plaintiffs seek damages (though a specific dollar amount is
      not
      indicated) and equitable relief. The various defendants have either moved to
      dismiss the action or obtained an extension of time to respond to the complaint.
      In the event the suit is neither settled nor dismissed, the Company intends
      to
      defend the suit vigorously.


14





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 have not been any claims made on these indemnifications. The Company
      will
      accrue any amounts related to these issues as they become
      quantifiable.




**NOTE
      P – CONVERSION OF SERIES D PREFERRED SHARE**




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 share 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.




**NOTE
      Q – PENDING ACQUISITION**




The
      Company, through its indirect 50% or greater owned subsidiary, UK Energy Systems
      Limited (the “Buyer”), is in the process of acquiring Viking Petroleum UK
      Limited (“Viking Petroleum”) which owns, directly or indirectly, six gas
      licenses containing 46 bcf (P1) of proved reserves and 16.4 bcf of probable
      reserves, for a cumulative 62.4 bcf (P2) of onshore gas in the United Kingdom.
      Specifically, in connection with an October 2005 Agreement (as defined below),
      the Buyer agreed on March 9, 2006 to (i) buy a 65.7% interest in Viking
      Petroleum for an aggregate of $69.00 and (ii) to repay the principal and
      interest (approximately $37 million as of March 9, 2006 and not to exceed
      approximately $40 million at closing) in loans issued by Viking Petroleum and
      its affiliates. The Buyer deposited $942,000 in an account which, with certain
      exceptions, is to be remitted to the sellers of this interest at closing.
      Completion of this purchase is subject to customary conditions. The Company
      is
      in the process of arranging financing for this transaction though the receipt
      of
      such financing is not a condition to closing.




Of
      the
      remaining 34.3% interest in Viking Petroleum, 24.8% is owned by VTEX Energy,
      Inc., and 9.5% is owned by two Viking Petroleum employees. Pursuant to an
      agreement between the Company, VTEX and Marathon Capital, LLC (the “October 2005
      Agreement”), (i) VTEX agreed to enter into agreements to cause its 24.8% Viking
      Petroleum interest to be contributed to a newly organized entity, 50% of which
      would be owned by the Company and 25% of which would be owned by each of
      Marathon and VTEX and (ii) the Company agreed to contribute up to $5 million
      in
      equity with respect to these transactions. The Buyer anticipates purchasing
      the
      9.5% interests owned by the employees for relatively nominal consideration.





The
      Buyer
      also plans to acquire a 42 MW gas fired power plant from a European utility
      and
      to enter into long term gas and power sales agreements so that the full economic
      benefit of the purchase of Viking Petroleum can be realized.





As
      of
      March 31, 2006, the Company had expended $2,909,000 related to these
      transactions. Of this amount, $2,648,000 was expended during the three months
      ended March 31, 2006. As it is anticipated that these funds will applied against
      the Company’s equity funding requirement on the closing date, these expenditures
      are being treated as Other Assets on the consolidated financial statements.
      Should the acquisition not be consummated, these costs will be expensed.




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





**RESULTS
      OF OPERATIONS**





The
      net
      loss of $1,974,000 for the three months ended March 31, 2006, represents an
      increase of $1,293,000 or 189% from the $681,000 net loss for the three months
      ended March 31, 2005. The increase in the loss is primarily the result of a
      decrease in revenues of $200,000, an increase in operating expenses of $682,000,
      an increase in general and administrative expenses of $144,000, compensation
      expense of $395,000 related to the vesting of previously granted stock options,
      a decrease in foreign currency translation income of $221,000, offset by a
      $507,000 increase in income related to the investment of the Illinois reserve
      accounts.


15







Revenues
      for the three months ended March 31, 2006 were $4,824,000 compared with
      $5,024,000 for the corresponding period representing a decrease of $200,000,
      4%,
      from the prior corresponding period. This decrease was primarily due to a
      decrease of $346,000 related to reductions in rates per kilowatt hour (“kwh”)
      paid to certain USEB projects under the Illinois Retail Rate Program (see Note
      J
      to the Condensed Consolidated Financial Statements) offset by a $167,000
      increase in revenues from the sale of landfill gas to be utilized as boiler
      fuel
      due to an increase in the volume of gas sold. For the three months ended March
      31, 2006, the average net effective rate, which is equal to the gross rates
      less
      amounts deposited into the Illinois reserve accounts, received under the Program
      was $0.0496 per kwh sold compared with $0.0563 per kwh sold for the comparable
      2005 period.





Total
      operating expenses for the three months ended March 31, 2006 were $2,861,000
      representing an increase of $682,000, or 31%, from the $2,179,000 reported
      for
      the corresponding 2005 period. Operating expenses as a percentage of revenues
      were 59% and 43% for the three months ended March 31, 2006 and 2005,
      respectively. The increase is due to $189,000 of increases in scheduled
      non-capitalized maintenance expenses for USEB generation equipment, increases
      of
      $194,000 for third party operating and maintenance costs due to rate increases
      and $64,000 increases in production rental payments due to increases in
      associated sales volumes.





General
      and administrative expenses were $1,831,000 for the three months ended March
      31,
      2006, an increase of $539,000 from the $1,292,000 for the corresponding 2005
      period. The increase was primarily due to a $167,000 increase in legal and
      accounting expenses and $395,000 of expense related to the vesting of options
      previously granted as required by the Statement of Financial Accounting
      Standards No. 123R.





The
      components of general and administrative expenses were as follows:





**Three
                Months Ended March 31****2006**
            
            **2005**Salary
                and Benefits
            
            $
            441,000
            
            $
            489,000Salary
                - Vesting Options
            
            
            395,000
            
            
            —Insurance
            
            
            45,000
            
            
            13,000Corporate
                Expenses
            
            
            455,000
            
            
            477,000Legal
                and Accounting
            
            
            313,000
            
            
            123,000Countryside
                Development Fee
            
            
            72,000
            
            
            59,000Royalty
                Expense
            
            
            110,000
            
            
            131,000Total:
            
            $
            1,831,000
            
            $
            1,292,000




Depreciation
      and amortization expenses were $1,212,000 for the three months ended March
      31,
      2006 compared with $1,095,000 for the corresponding 2005 period representing
      an
      increase of $117,000 or 11%. The increase is related to depreciation associated
      with capital improvements on the USEB assets completed in 2005.





Interest
      and dividend income was $1,236,000 for the three months ended March 31, 2006
      reflecting an increase of $428,000 from the $808,000 reported for the
      corresponding 2005 period. The components of interest and dividend income are
      as
      follows:








**Three
                Months Ended March 31****2006**
            
            **2005**Installment
                Sale Notes Receivable
            
            $
            632,000
            
            $
            689,000Earnings
                –
                Illinois Reserve Accounts
            
            
            497,000
            
            
            (12,000
            )Investments
            
            
            107,000
            
            
            131,000Total:
            
            $
            1,236,000
            
            $
            808,000





The
      decrease in interest income related to the Installment Sale Notes Receivable
      for
      the 2006 period is the result of the continuing reduction in outstanding
      principal on the notes resulting from principal payments received on the notes.
      The increase in earnings in the Illinois Reserve Accounts is due to an increase
      in the amounts of funds invested in the accounts and an increase in the
      investment yield on the invested funds.


16





Interest
      expense was $2,790,000 for the three months ended March 31, 2006, representing
      an increase of $76,000, or 3%, from the $2,714,000 reported for the
      corresponding 2005 period. 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
      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 March 31****2006**
            
            **2005**CPIF
                Interest
            
            $
            2,145,000
            
            $
            2,183,000Illinois
                Subsidy Amortization
            
            
            645,000
            
            
            531,000Total:
            
            $
            2,790,000
            
            $
            2,714,000





Foreign
      Currency Translation income was $124,000 for the three months ended March 31,
      2006 representing a decrease of $221,000 when compared to the $345,000 of such
      income reported for the corresponding 2005 period. This amount represents the
      adjustment, 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 period. The Canadian
      dollar to US dollar exchange rate increased to $1.1676 as of March 31, 2006
      from
      $1.1660 as of December 31, 2005 resulting in a foreign currency translation
      gain
      for the three months ended March 31, 2006. See Note L to the Condensed
      Consolidated Financial Statements. The Canadian dollar to US dollar exchange
      rate was $1.2565 as of March 31, 2005 compared with $1.2096 as of December
      31,
      2004.





The
      provision for income taxes resulted in benefits of $505,000 and $111,000 for
      the
      three months ended March 31, 2006 and 2005, respectively. The benefits are
      based
      on an effective tax rate of 38% and for the three month period ended March
      31,
      2006 is net of a $410,000 increase in the valuation allowance against the
      deferred tax asset.





Gain
      on
      Disposal of a Segment of $150,000 for the three months ended March 31, 2005
      represents residual income from the operations of USE Canada Energy Corp which
      was sold in 2004.




**LIQUIDITY
      AND CAPITAL RESOURCES**





At
      March
      31, 2006, unrestricted cash amounted to $7,623,000 compared with $11,301,000
      of
      unrestricted cash at December 31, 2005, a reduction of $3,678,000. The decrease
      was primarily due to expenditures of $2,648,000 during this period related
      to
      the potential acquisition of Viking Petroleum. See Note Q to the Condensed
      Consolidated Financial Statements.





The
      financing arrangements between the Countryside Fund and the USEB projects
      require these projects maintain various restricted cash accounts, which, at
      March 31, 2006, amounted to $33,039,000 including $27,518,000 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. These arrangements limit the ability of USEB and its subsidiaries
      to
      distribute funds to the Company or to make improvements or expand certain
      projects unless specified conditions are satisfied. See Note J to the
      Consolidated Financial Statements.





During
      the three months ended March 31, 2006, cash provided by operating activities
      was
      $226,000, a decrease of $10,000 from the $236,000 generated by
      operating activities for the three months ended March 31, 2005. This change
      is due to normal fluctuations of operating results between reporting
      periods.





Cash
      used
      in investing activities increased to $2,869,000 for the three months ended
      March
      31, 2006, from $937,000 for the three months ended March 31, 2005, an increase
      of $1,932,000. This increase was primarily the result of $2,648,000 of
      expenditures related to the Viking Petroleum and related transactions. Its
      is
      anticipated that these funds will be 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 $1,035,000 for the three months ended
      March
      31, 2006, an increase of $500,000 from the $535,000 used in financing activities
      for the three months ended March 31, 2005. The decrease is primarily due to
      the
      payment of minority interest distributions related to the ownership of certain
      USEB project entities.


17





The
      Company, through an indirect 50% or greater owned subsidiary, is in the process
      of acquiring certain energy assets in the United Kingdom. The
      total
      expenditures to be incurred in connection with the acquisition of these assets
      is currently estimated to be approximately $78,000,000. Furthermore, in
      connection with this transaction, it is currently estimated that: (i) reserves
      of approximately $20,000,000 must be funded and (ii) additional capital
      expenditures required to modify or expand to these assets will require, during
      the next three years, approximately $34,000,000. It is anticipated that these
      expenditures will be funded through the Company’s available funds and external
      financing which may include project debt financing secured by the project
      assets. No assurance can be given that external financing will be available
      on
      terms acceptable to the Company, and if unavailable, the Company may be unable
      to complete the acquisition or fully realize the potential of such assets.
      It is
      currently contemplated that these transactions will be completed in mid to
      late
      June 2006 though no assurance can be provided in this regard.





Except
      as
      noted with respect to the acquisition of these energy assets and the related
      expenditures and subject to the risks discussed in Part I, “Item 1A. Risk
      Factors” in our Annual Report on Form 10-K for the year ended December 31, 2005,
      management believes that the Company has sufficient cash flow from operations
      and working capital to satisfy its current obligations under outstanding
      indebtedness, to finance anticipated capital expenditures and to fund working
      capital requirements during the next twelve months.




**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.


18





**PART
      II - Other Information**





**Item
      1A Risk Factors**





In
      addition to the other information set forth in this report, 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.
      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.





**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





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**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. Fogel
                Chief
                  Executive Officer
                (Principal
                  Executive Officer)
              
              Dated:
                  May 19, 2006
 
 By:
              /s/
                  Richard J. AugustineRichard
                  J. Augustine
                Chief
                  Accounting Officer
                (Principal
                  Accounting and Financial Officer)
              
              Dated:
                  May 19, 2006


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