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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 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, 2008

Or



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------

For the transition period from  to

Commission file number: 000-30939





ACTIVE POWER, INC.

(Exact name of
registrant as specified in its charter)







|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 74-2961657                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)



|                                         |  |           
|---------------------------------------- |  | ----------
|2128 W. Braker Lane, BK12, Austin, Texas |  | 78758     
|(Address of principal executive offices) |  | (Zip Code)

(512) 836-6464

(Registrants telephone number, including area code)



(Former name, former address and former fiscal year, if changed since last report)





Indicate by check mark whether
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 such filing requirements for the past 90 days.    x  Yes     ̈  No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting
company. See definitions of accelerated filer, large accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one)



|                             |  |                                |  |  |  | 
|---------------------------- |  | ------------------------------ |  |  |  | 
|Large Accelerated Filer     ̈ |  | Accelerated Filer    x        
|Non-Accelerated Filer     ̈   |  | Smaller Reporting Company     ̈

(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a Shell Company (as defined in Rule 12b-2 of the Exchange Act).     ̈  Yes    x  No

APPLICABLE ONLY TO
CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuers classes of common stock, as of the latest
practicable date.

The number of shares of common stock, par value of $0.001 per share, outstanding at July 24, 2008 was
60,458,311.









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ACTIVE POWER, INC.

FORM 10-Q

INDEX



|                                                                                               |  |   
|---------------------------------------------------------------------------------------------- |  | --
|PART I  FINANCIAL INFORMATION                                                                 |  | 1 
|                                                                                               | 
|Item 1. Consolidated Financial Statements.                                                     |  | 1 
|                                                                                               | 
|Item 2. Managements Discussion and Analysis of Financial Condition and Results of
Operations. |  | 7 
|                                                                                               | 
|Item 3. Quantitative and Qualitative Disclosures about Market Risk                             |  | 12
|                                                                                               | 
|Item 4. Controls and Procedures                                                                |  | 12
|                                                                                               | 
|PART II  OTHER INFORMATION                                                                    |  | 12
|                                                                                               | 
|Item 1. Legal Proceedings                                                                      |  | 12
|                                                                                               | 
|Item 1A. Risk Factors                                                                          |  | 13
|                                                                                               | 
|Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.                           |  | 13
|                                                                                               | 
|Item 3. Defaults Upon Senior Securities.                                                       |  | 13
|                                                                                               | 
|Item 4. Submission of Matters to a Vote of Security Holders.                                   |  | 13
|                                                                                               | 
|Item 5. Other Information.                                                                     |  | 14
|                                                                                               | 
|Item 6. Exhibits.                                                                              |  | 14



i



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PART I  FINANCIAL INFORMATION



|Item 1. | Consolidated Financial Statements.
|------- | ----------------------------------

Active Power, Inc.

Condensed Consolidated Balance Sheets

(in thousands)



|                                                |  |              |          |   |                  |   |          |  
|----------------------------------------------- |  | ------------ | -------- | - | ---------------- | - | -------- | -
|                                                |  | June 30,2008 |          |   | December 31,2007 |  
|                                                |  | (unaudited)  |          |   |                  |  
|ASSETS                                          |  |              |          |   |                  |   |          |  
|                                                |  |             
|Current assets:                                 |  |              |          |   |                  |   |          |  
|Cash and cash equivalents                       |  | $            | 12,298   |   |                  | $ | 15,504   |  
|Short-term investments in marketable securities |  |              | 655      |   |                  |   | 6,581    |  
|Accounts receivable, net                        |  |              | 5,934    |   |                  |   | 5,177    |  
|Inventories                                     |  |              | 8,678    |   |                  |   | 9,198    |  
|Prepaid expenses and other                      |  |              | 593      |   |                  |   | 540      |  
|                                                |  |              |          |   |                  |   |          |  
|Total current assets                            |  |              | 28,158   |   |                  |   | 37,000   |  
|Property and equipment, net                     |  |              | 5,191    |   |                  |   | 5,530    |  
|Long-term investments in marketable securities  |  |              | 1,241    |   |                  |   | 407      |  
|Other assets                                    |  |              | 439      |   |                  |   | 389      |  
|                                                |  |              |          |   |                  |   |          |  
|Total assets                                    |  | $            | 35,029   |   |                  | $ | 43,326   |  
|                                                |  |              |          |   |                  |   |          |  
|LIABILITIES AND STOCKHOLDERS EQUITY            |  |              |          |   |                  |   |          |  
|Current liabilities:                            |  |              |          |   |                  |   |          |  
|Accounts payable                                |  | $            | 2,526    |   |                  | $ | 2,342    |  
|Accrued expenses                                |  |              | 4,681    |   |                  |   | 5,793    |  
|Deferred revenue                                |  |              | 2,351    |   |                  |   | 1,918    |  
|                                                |  |              |          |   |                  |   |          |  
|Total current liabilities                       |  |              | 9,558    |   |                  |   | 10,053   |  
|Long-term liabilities                           |  |              | 25       |   |                  |   | 25       |  
|Stockholders equity:                           |  |              |          |   |                  |   |          |  
|Common stock                                    |  |              | 60       |   |                  |   | 60       |  
|Treasury stock                                  |  |              | (59      | ) |                  |   | (5       | )
|Additional paid-in capital                      |  |              | 259,458  |   |                  |   | 258,630  |  
|Accumulated deficit                             |  |              | (234,297 | ) |                  |   | (225,401 | )
|Other accumulated comprehensive income          |  |              | 284      |   |                  |   | (36      | )
|                                                |  |              |          |   |                  |   |          |  
|Total stockholders equity                      |  |              | 25,446   |   |                  |   | 33,248   |  
|                                                |  |              |          |   |                  |   |          |  
|Total liabilities and stockholders equity      |  | $            | 35,029   |   |                  | $ | 43,326   |  
|                                                |  |              |          |   |                  |   |          |  

See accompanying notes.



1



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Active Power, Inc.

Condensed Consolidated Statements of Operations and Comprehensive Loss

(in thousands, except per
share amounts)

(Unaudited)



|                                                                  |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  
|----------------------------------------------------------------- |  | -------------------------- | ------ | - | ------------------------ | - | ------ | ---- |  | - | ------ | - |  | - | ------- | -
|                                                                  |  | Three Months EndedJune 30, |        |   | Six Months EndedJune 30, |  
|                                                                  |  | 2008                       |        |   | 2007                     |   |        | 2008 |  |   | 2007   |  
|Product revenue                                                   |  | $                          | 5,592  |   |                          | $ | 7,725  |      |  | $ | 11,840 |   |  | $ | 12,996  |  
|Service and spares revenue                                        |  |                            | 1,196  |   |                          |   | 1,457  |      |  |   | 2,486  |   |  |   | 2,159   |  
|                                                                  |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  
|Total revenue                                                     |  |                            | 6,788  |   |                          |   | 9,182  |      |  |   | 14,326 |   |  |   | 15,155  |  
|                                                                  |  |                            |        |  
|Cost of product revenue                                           |  |                            | 4,765  |   |                          |   | 6,469  |      |  |   | 10,422 |   |  |   | 11,380  |  
|Cost of service and spares revenue                                |  |                            | 1,081  |   |                          |   | 1,166  |      |  |   | 2,179  |   |  |   | 1,891   |  
|                                                                  |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  
|Total cost of revenue                                             |  |                            | 5,846  |   |                          |   | 7,635  |      |  |   | 12,601 |   |  |   | 13,271  |  
|                                                                  |  |                            |        |  
|Gross profit                                                      |  |                            | 942    |   |                          |   | 1,547  |      |  |   | 1,725  |   |  |   | 1,884   |  
|                                                                  |  |                            |        |  
|Operating expenses:                                               |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  
|Research and development                                          |  |                            | 1,304  |   |                          |   | 1,326  |      |  |   | 2,706  |   |  |   | 2,910   |  
|Selling and marketing                                             |  |                            | 3,055  |   |                          |   | 2,621  |      |  |   | 6,005  |   |  |   | 5,246   |  
|General and administrative                                        |  |                            | 1,186  |   |                          |   | 2,456  |      |  |   | 2,368  |   |  |   | 5,207   |  
|                                                                  |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  
|Total operating expenses                                          |  |                            | 5,545  |   |                          |   | 6,403  |      |  |   | 11,079 |   |  |   | 13,363  |  
|                                                                  |  |                            |        |  
|Operating loss                                                    |  |                            | (4,603 | ) |                          |   | (4,856 | )    |  |   | (9,354 | ) |  |   | (11,479 | )
|                                                                  |  |                            |        |  
|Interest income                                                   |  |                            | 91     |   |                          |   | 159    |      |  |   | 254    |   |  |   | 360     |  
|Other income                                                      |  |                            | 85     |   |                          |   | 51     |      |  |   | 204    |   |  |   | 49      |  
|                                                                  |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  
|Net loss                                                          |  | $                          | (4,427 | ) |                          | $ | (4,646 | )    |  | $ | (8,896 | ) |  | $ | (11,070 | )
|                                                                  |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  
|Net loss per share, basic & diluted                               |  | $                          | (0.07  | ) |                          | $ | (0.09  | )    |  | $ | (0.15  | ) |  | $ | (0.22   | )
|Shares used in computing net loss per share, basic & diluted      |  |                            | 60,124 |   |                          |   | 50,090 |      |  |   | 60,124 |   |  |   | 50,089  |  
|                                                                  |  |                            |        |  
|Comprehensive loss:                                               |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  
|                                                                  |  |                            |        |  
|Net loss                                                          |  | $                          | (4,427 | ) |                          | $ | (4,646 | )    |  | $ | (8,896 | ) |  | $ | (11,070 | )
|Translation gain on subsidiaries in foreign currencies            |  |                            | 152    |   |                          |   | 38     |      |  |   | 322    |   |  |   | (106    | )
|Change in unrealized loss on investments in marketable securities |  |                            | (5     | ) |                          |   | 5      |      |  |   | (2     | ) |  |   | 17      |  
|                                                                  |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  
|Comprehensive loss                                                |  | $                          | (4,280 | ) |                          | $ | (4,603 | )    |  | $ | (8,576 | ) |  | $ | (11,159 | )
|                                                                  |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  

See accompanying notes.



2



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Active Power, Inc.

Condensed Consolidated Statements of Cash Flows

(in thousands)

(Unaudited)



|                                                                        |  |                          |        |   |      |   |         |  
|----------------------------------------------------------------------- |  | ------------------------ | ------ | - | ---- | - | ------- | -
|                                                                        |  | Six Months EndedJune 30, |       
|                                                                        |  | 2008                     |        |   | 2007 |  
|Operating activities                                                    |  |                          |        |   |      |   |         |  
|Net loss                                                                |  | $                        | (8,896 | ) |      | $ | (11,070 | )
|Adjustments to reconcile net loss to cash used in operating activities: |  |                          |        |   |      |   |         |  
|Depreciation expense                                                    |  |                          | 928    |   |      |   | 1,001   |  
|Change in allowance for doubtful accounts                               |  |                          | 7      |   |      |   | (31     | )
|Accretion of premium/discount on marketable securities                  |  |                          | (48    | ) |      |   | (17     | )
|(Gain) Loss on disposal of fixed assets                                 |  |                          | (61    | ) |      |   | 288     |  
|Stock-based compensation                                                |  |                          | 810    |   |      |   | 1,045   |  
|Changes in operating assets and liabilities:                            |  |                          |        |   |      |   |         |  
|Accounts receivable                                                     |  |                          | (764   | ) |      |   | (468    | )
|Inventories                                                             |  |                          | 564    |   |      |   | (542    | )
|Prepaid expenses and other assets                                       |  |                          | (103   | ) |      |   | 158     |  
|Accounts payable                                                        |  |                          | 184    |   |      |   | (226    | )
|Accrued expenses                                                        |  |                          | (1,112 | ) |      |   | 1,845   |  
|Deferred revenue                                                        |  |                          | 433    |   |      |   | 328     |  
|Long term liabilities                                                   |  |                          |       |   |      |   | 25      |  
|                                                                        |  |                          |        |   |      |   |         |  
|Net cash used in operating activities                                   |  |                          | (8,058 | ) |      |   | (7,664  | )
|                                                                        |  |                         
|Investing activities                                                    |  |                          |        |   |      |   |         |  
|Purchases of marketable securities                                      |  |                          | (2,032 | ) |      |   | (246    | )
|Sales/maturities of marketable securities                               |  |                          | 7,172  |   |      |   | 7,300   |  
|Purchases of property and equipment                                     |  |                          | (668   | ) |      |   | (433    | )
|Sales of property and equipment                                         |  |                          | 94     |   |      |   |        |  
|                                                                        |  |                          |        |   |      |   |         |  
|Net cash provided by investing activities                               |  |                          | 4,566  |   |      |   | 6,621   |  
|                                                                        |  |                         
|Financing activities                                                    |  |                          |        |   |      |   |         |  
|Net proceeds from issuance of common stock                              |  |                          | 18     |   |      |   | 6       |  
|Purchases of treasury stock                                             |  |                          | (54    | ) |      |   |        |  
|                                                                        |  |                          |        |   |      |   |         |  
|Net cash (used) provided by financing activities                        |  |                          | (36    | ) |      |   | 6       |  
|                                                                        |  |                         
|Translation gain (loss) on subsidiaries in foreign currencies           |  |                          | 322    |   |      |   | (106    | )
|                                                                        |  |                         
|Change in cash and cash equivalents                                     |  |                          | (3,206 | ) |      |   | (1,143  | )
|Cash and cash equivalents, beginning of period                          |  |                          | 15,504 |   |      |   | 7,652   |  
|                                                                        |  |                          |        |   |      |   |         |  
|Cash and cash equivalents, end of period                                |  | $                        | 12,298 |   |      | $ | 6,509   |  
|                                                                        |  |                          |        |   |      |   |         |  

See accompanying notes.



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Active Power, Inc.

Notes to Condensed Consolidated Financial Statements

June 30, 2008

(Unaudited)



|1. | Significant Accounting Policies
|-- | -------------------------------

Basis of
presentation:Active Power, Inc. and its subsidiaries (hereinafter referred to as we, us, Active Power or the Company) design, manufacture and market critical power quality solutions that provide
business continuity and protect customers in the event of an electrical power disturbance. Our products are designed to provide power quality to protect customers from voltage fluctuations, such as surges and sags, and frequency fluctuations, and
also to provide ride-through, or temporary, power to bridge the gap between a power outage and the restoration of utility power, or the time required to switch to electrical generator power. We target global enterprises with zero tolerance for
downtime in their mission critical business operations. The Uninterruptible Power Supply (UPS) products we manufacture utilize green technologies to create a renewable energy source. We sell our products globally through direct,
manufacturers representative and Original Equipment Manufacturer (OEM) channels. Our current principal markets are North America and Europe, Middle East and Africa (EMEA).

The accompanying condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles and
include the accounts of the Company and its consolidated subsidiaries. In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments necessary to present fairly the consolidated
financial position of the Company and its consolidated results of operations and cash flows. These interim financial statements should be read in conjunction with the financial statements and accompanying notes included in the Companys Annual
Report on Form 10-K for the year ended December 31, 2007.

Recently issued accounting standards:

In December 2007, the FASB issued Statement of Financial Accounting Standards No. 141R (revised 2007), Business Combinations (SFAS 141(R)),
which establishes the acquisition method to account for business combinations. SFAS 141(R) requires the acquiring entity to recognize all of the assets acquired and liabilities assumed in the transaction, establishes the acquisition-date fair value
as the measurement objective for all assets acquired and liabilities assumed and requires the acquirer to disclose to investors and other users all of the information they need to evaluate and understand the nature and financial effect of the
business combination. These rules are effective for transactions closing after January 1, 2009.



|2. | Supplemental Balance Sheet Information
|-- | --------------------------------------

Receivables

Accounts receivable consist of the following (in thousands):



|                                |  |              |       |   |                  |   |       |  
|------------------------------- |  | ------------ | ----- | - | ---------------- | - | ----- | -
|                                |  | June 30,2008 |       |   | December 31,2007 |  
|Trade receivables               |  | $            | 6,347 |   |                  | $ | 5,583 |  
|Allowance for doubtful accounts |  |              | (413  | ) |                  |   | (406  | )
|                                |  |              |       |   |                  |   |       |  
|                                |  | $            | 5,934 |   |                  | $ | 5,177 |  
|                                |  |              |       |   |                  |   |       |  

Inventory

We state inventories at the lower of cost or market, using the first-in-first-out method (in thousands):



|                                   |  |              |        |   |                  |   |        |  
|---------------------------------- |  | ------------ | ------ | - | ---------------- | - | ------ | -
|                                   |  | June 30,2008 |        |   | December 31,2007 |  
|Raw materials                      |  | $            | 6,096  |   |                  | $ | 6,340  |  
|Work in process and finished goods |  |              | 4,596  |   |                  |   | 5,054  |  
|Allowances for obsolescence        |  |              | (2,014 | ) |                  |   | (2,196 | )
|                                   |  |              |        |   |                  |   |        |  
|                                   |  | $            | 8,678  |   |                  | $ | 9,198  |  
|                                   |  |              |        |   |                  |   |        |  

Included in inventory at June 30, 2008 and December 31, 2007 were $1.8
and $2.2 million, respectively, of inventory net of reserves relating exclusively to our CoolAir family of products. In December 2007 we recorded reserves of $1.8 million against the CoolAir inventory as a result of our expectations of future
product demand and



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future product development initiatives that potentially would result in excess quantities of CoolAir inventory. If these expectations are not met during 2008
and we are unable to sell sufficient quantities of our finished CoolAir products, we may need to record an additional impairment charge for some or all of the remaining amount of this inventory.

Property and Equipment

Property and
equipment consist of the following (in thousands):



|                         |  |              |         |   |                  |   |         |  
|------------------------ |  | ------------ | ------- | - | ---------------- | - | ------- | -
|                         |  | June 30,2008 |         |   | December 31,2007 |  
|Equipment                |  | $            | 9,668   |   |                  | $ | 9,409   |  
|Computers and software   |  |              | 2,751   |   |                  |   | 2,672   |  
|Demonstration units      |  |              | 1,042   |   |                  |   | 1,082   |  
|Furniture and fixtures   |  |              | 351     |   |                  |   | 331     |  
|Leasehold improvements   |  |              | 7,268   |   |                  |   | 7,232   |  
|Construction in progress |  |              | 71      |   |                  |   |        |  
|                         |  |              |         |   |                  |   |         |  
|                         |  |              | 21,151  |   |                  |   | 20,726  |  
|                         |  |              |         |   |                  |   |         |  
|Accumulated depreciation |  |              | (15,960 | ) |                  |   | (15,196 | )
|                         |  |              |         |   |                  |   |         |  
|                         |  | $            | 5,191   |   |                  | $ | 5,530   |  
|                         |  |              |         |   |                  |   |         |  

Accrued Expenses

Accrued expenses consist of the following (in thousands):



|                                         |  |              |       |                  |   |      
|---------------------------------------- |  | ------------ | ----- | ---------------- | - | -----
|                                         |  | June 30,2008 |       | December 31,2007
|Compensation and benefits                |  | $            | 1,474 |                  | $ | 1,812
|Warranty liability                       |  |              | 976   |                  |   | 819  
|Federal, state, property and sales taxes |  |              | 950   |                  |   | 1,177
|Professional fees                        |  |              | 625   |                  |   | 1,008
|Other                                    |  |              | 656   |                  |   | 977  
|                                         |  |              |       |                  |   |      
|                                         |  | $            | 4,681 |                  | $ | 5,793
|                                         |  |              |       |                  |   |      

Warranty Liability

Generally, the warranty period for our power quality products is 12 months from the date of commissioning or 18 months from the date of
shipment from us, whichever period is shorter. We provide for the estimated cost of product warranties at the time revenue is recognized and this accrual is contained in accrued expenses on the accompanying balance sheet.

Changes in our warranty liability are presented in the following table (in thousands):



|                             |  |   |      |  
|---------------------------- |  | - | ---- | -
|Balance at December 31, 2007 |  | $ | 819  |  
|Warranty expense             |  |   | 404  |  
|Warranty charges incurred    |  |   | (247 | )
|                             |  |   |      |  
|Balance at June 30, 2008     |  | $ | 976  |  
|                             |  |   |      |  



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|3. | Net Loss Per Share
|-- | ------------------

The following table sets forth
the computation of basic and diluted net loss per share (in thousands, except per share data):



|                                                               |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  
|-------------------------------------------------------------- |  | -------------------------- | ------ | - | ------------------------ | - | ------ | ---- |  | - | ------ | - |  | - | ------- | -
|                                                               |  | Three MonthsEnded June 30, |        |   | Six MonthsEnded June 30, |  
|                                                               |  | 2008                       |        |   | 2007                     |   |        | 2008 |  |   | 2007   |  
|Net loss                                                       |  | $                          | (4,427 | ) |                          | $ | (4,646 | )    |  | $ | (8,896 | ) |  | $ | (11,070 | )
|                                                               |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  
|Basic and diluted:                                             |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  
|Weighted-average shares of common stock outstanding            |  |                            | 60,124 |   |                          |   | 50,090 |      |  |   | 60,124 |   |  |   | 50,089  |  
|                                                               |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  
|Shares used in computing net loss per share, basic and diluted |  |                            | 60,124 |   |                          |   | 50,090 |      |  |   | 60,124 |   |  |   | 50,089  |  
|                                                               |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  
|Net loss per share, basic and diluted                          |  | $                          | (0.07  | ) |                          | $ | (0.09  | )    |  | $ | (0.15  | ) |  | $ | (0.22   | )
|                                                               |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |         |  

Our calculation of diluted loss per share excludes 6,050,717 and 5,400,995 shares of common stock
issuable upon exercise of employee stock options as of June 30, 2008 and 2007, respectively, and 235,344 and 250,000 of non-vested shares issuable upon exercise of restricted stock awards as of June 30, 2008 and 2007, respectively, because
their inclusion in the calculation would be anti-dilutive. As of June 30, 2008 and 2007, there was no common stock subject to repurchase.



|4. | Investments in Marketable Securities
|-- | ------------------------------------

Investments
in marketable securities consist of money market funds, commercial paper and debt securities with readily determinable fair values. We account for investments that are reasonably expected to be realized in cash, sold or consumed during the year as
short-term investments. We classify investments in marketable securities as available-for-sale and all reclassifications made from unrealized gains/losses to realized gains/losses are determined based on the specific identification method.

Included within our short-term investments at December 31, 2007 was $2.4 million of AAA and AAA1/A1 rated investments in auction rate
securities. Auction rate securities held by us are taxable municipal bonds with long-term nominal maturities for which the interest rates are reset through a dutch auction each month. The monthly auctions historically have provided a liquid market
for these securities. During the first two quarters we redeemed an aggregate of $1.6 million of these securities and at June 30, 2008 we held $825,000 of auction rate securities. The liquidity issues in U.S. and global credit and capital
markets during 2008 have resulted in a number of failed dutch auctions in the auction rate securities market. We have experienced failed auctions for our remaining auction rate securities during 2008, meaning that the amount of securities submitted
for sale exceeded the amount of purchase orders for these securities. This has resulted in an illiquid asset for us, even though we continue to earn interest on these securities according to their stated terms. Because of this lack of liquidity, the
remaining balance of our auction rate securities has been classified as a long-term asset at June 30, 2008.

We continue to work with
the financial institution that marketed these auction rate securities to us as a liquid money-market asset to enable us to liquidate these securities in an orderly manner. None of the underlying securities have had any credit rating adjustments, but
the overall lack of liquidity in the auction rate securities market has resulted in us holding an illiquid asset. Our current liquidity situation is such that we do not have to redeem these securities in the short term. The lack of liquidity also
means that we do not have a readily discernable market valuation with which to value these securities. Therefore we continue to carry these securities at par value as we have historically valued them at par value since that is the value we receive
when we trade these securities in an established market. Any differences between par value and the purchase price or settlement have historically been comprised of accrued interest.



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##### Table of Contents

|Item 2. | Managements Discussion and Analysis of Financial Condition and Results of Operations.
|------- | --------------------------------------------------------------------------------------

The following discussion should be read in conjunction with, and is qualified in its entirety by reference to, the financial statements and notes
thereto included in Item 1 of this Form 10-Q and the financial statements and notes thereto and our Managements Discussion and Analysis of Financial Condition and Results of Operations for the year ended December 31, 2007 included in
our 2007 Annual Report on Form 10-K. This report contains forward-looking statements, within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, that involve risks and
uncertainties. Our expectations with respect to future results of operations that may be embodied in oral and written forward-looking statements, including any forward looking statements that may be included in this report, are subject to risks and
uncertainties that must be considered when evaluating the likelihood of our realization of such expectations. Our actual results could differ materially. The words believe, expect, intend, plan,
project, will and similar phrases as they relate to us are intended to identify such forward-looking statements. In addition, please see the Risk Factors of Part 1, Item 1A of our 2007 Annual Report on Form
10-K and in Part II, Item 1A of this Form 10-Q for a discussion of items that may affect our future results.

Overview

We design, manufacture and market efficient, reliable and green power quality solutions and Uninterruptible Power Supply (UPS) systems that provide
business continuity and protect customers in the event of an electric power disturbance. Our products are designed to provide power quality to protect customers from voltage fluctuations, such as surges and sags, and frequency fluctuations, and also
to provide ride-through, or temporary, power to bridge the gap between a power outage and the restoration of utility power, or the time required to switch to electric generator power. Our products are designed to be environmentally friendly compared
to existing solutions without compromising functionality, efficiency or cost. As of June 30, 2008 we have shipped over 1,800 flywheels in UPS system installations, delivering more than 450 megawatts of power to customers in over 40 countries
around the world.

Our patented flywheel energy storage systems store kinetic energy by constantly spinning a compact steel wheel
(flywheel) driven from utility power in a low friction environment. When the utility power used to spin the flywheel fluctuates or is interrupted, the flywheels inertia causes it to continue spinning. The resulting kinetic energy of the
spinning flywheel generates electricity known as bridging power for short periods until utility power is fully restored or a backup electricity generator starts and takes over generating longer term power in the case of an extended
electrical outage. We sell our flywheel products to commercial and industrial customers across a variety of vertical markets, including manufacturing, technology, communications, utilities, healthcare, banking and military and in all geographic
regions of the world, but particularly in North America, Western Europe and Asia.

We believe that our flywheel products provide many advantages over traditional battery-based systems, including substantial space savings, higher power densities, green energy storage and power efficiencies as high as 98% that
reduce total operating costs. We offer our flywheel products with load capabilities from 130 kVA to 3,600 kVA, while typically targeting power density applications above 200 kVA since the majority of these customers already have back-up generators.
We market our flywheel products under the brand name CleanSource®. CleanSource DC is a non-chemical replacement for lead-acid batteries used for bridging power. Utilizing our flywheel
energy storage technology, the CleanSource DC is a stand-alone, direct current (DC) product that is compatible with all major brands of UPS. We built on the technological success of CleanSource DC by creating a battery-free UPS, CleanSource UPS,
which integrates the UPS electronics and our flywheel energy storage system into one compact cabinet. CleanSource UPS represents the majority of our current revenue. The CleanSource UPS is also marketed directly by Caterpillar Inc. under an OEM
relationship with us. Combining our CleanSource UPS with a generator provides customers with complete short and long-term protection in the event of a power disturbance.

To meet the requirements of customers without backup generators that require protection from
utility disturbances, we have also developed a patented extended runtime product that we call CoolAirTMDC. We initially have targeted CoolAir DC at
lower power levels than our flywheel products, and it is sold as a minute-for-minute replacement for lead-acid batteries. CoolAir DC can provide backup power for several minutes to hours depending on the customer application. CoolAir DC utilizes
mature thermal and compressed air storage (TACAS) technologies combined in a proprietary manner to produce backup power during an electrical disturbance. This product discharges cool air as a by-product of its operation that also can be used by
customers during an electrical disturbance as a transitional source of backup cooling.

Our primary sales channels in North America have
traditionally been through our OEM partners, Caterpillar, Inc. and Eaton Electrical (formerly known as PowerWare). Since 2005 we have developed additional sales channels in North America including direct sales employees and a network of
manufacturers representatives. Direct sales tend to improve our relationships with clients, improve our gross margins and add service and other revenue opportunities. Our primary sales channels in Europe, Middle East and Asia (EMEA) include
selling directly to end users and indirectly through select value added resellers (VARs). We also provide services including engineering, installation, start-up, monitoring, and repair for our products under contracts with our customers.



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Results of Operations



|                                   |  |                             |        |   |                       |     |    |      |   |         |                  |  |     |    |  |   |        |   |  |     |   
|---------------------------------- |  | --------------------------- | ------ | - | --------------------- | --- | -- | ---- | - | ------- | ---------------- |  | --- | -- |  | - | ------ | - |  | --- | --
|                                   |  | Three months ended June 30, |        |   | Variance2008 vs. 2007 |    
|($ in thousands)                   |  | 2008                        |        |   | % oftotalrevenue      |     |    | 2007 |   |         | % oftotalrevenue |  |     | $  |  |   | %      |  
|Product revenue                    |  | $                           | 5,592  |   |                       | 82  | %  |      | $ | 7,725   |                  |  | 84  | %  |  | $ | (2,133 | ) |  | (28 | )%
|Service and spares revenue         |  |                             | 1,196  |   |                       | 18  | %  |      |   | 1,457   |                  |  | 16  | %  |  |   | (261   | ) |  | (18 | )%
|                                   |  |                             |        |   |                       |     |    |      |   |         |                  |  |     |    |  |   |        |   |  |     |   
|Total revenue                      |  |                             | 6,788  |   |                       | 100 | %  |      |   | 9,182   |                  |  | 100 | %  |  |   | (2,394 | ) |  | (26 | )%
|                                   |  |                             |        |   |                       |     |    |      |   |         |                  |  |     |    |  |   |        |   |  |     |   
|Cost of product revenue            |  |                             | 4,765  |   |                       | 70  | %  |      |   | 6,469   |                  |  | 70  | %  |  |   | (1,704 | ) |  | (26 | )%
|Cost of service and spares revenue |  |                             | 1,081  |   |                       | 16  | %  |      |   | 1,166   |                  |  | 13  | %  |  |   | (85    | ) |  | (7  | )%
|                                   |  |                             |        |   |                       |     |    |      |   |         |                  |  |     |    |  |   |        |   |  |     |   
|Total cost of revenue              |  |                             | 5,846  |   |                       | 86  | %  |      |   | 7,635   |                  |  | 83  | %  |  |   | (1,789 | ) |  | (23 | )%
|                                   |  |                             |        |   |                       |     |    |      |   |         |                  |  |     |    |  |   |        |   |  |     |   
|Gross profit                       |  |                             | 942    |   |                       | 14  | %  |      |   | 1,547   |                  |  | 17  | %  |  |   | (605   | ) |  | (39 | )%
|Operating expenses:                |  |                             |        |   |                       |     |    |      |   |         |                  |  |     |    |  |   |        |   |  |     |   
|Research and development           |  |                             | 1,304  |   |                       | 19  | %  |      |   | 1,326   |                  |  | 14  | %  |  |   | (22    | ) |  | (2  | )%
|Selling and marketing              |  |                             | 3,055  |   |                       | 45  | %  |      |   | 2,621   |                  |  | 29  | %  |  |   | 434    |   |  | 17  | % 
|General and administrative         |  |                             | 1,186  |   |                       | 17  | %  |      |   | 2,456   |                  |  | 27  | %  |  |   | (1,270 | ) |  | (52 | )%
|                                   |  |                             |        |   |                       |     |    |      |   |         |                  |  |     |    |  |   |        |   |  |     |   
|Total operating expenses           |  |                             | 5,545  |   |                       | 82  | %  |      |   | 6,403   |                  |  | 70  | %  |  |   | (858   | ) |  | (13 | )%
|                                   |  |                             |        |   |                       |     |    |      |   |         |                  |  |     |    |  |   |        |   |  |     |   
|Operating loss                     |  |                             | (4,603 | ) |                       | (68 | )% |      |   | (4,856  | )                |  | (53 | )% |  |   | 253    |   |  | 5   | % 
|Interest income                    |  |                             | 91     |   |                       | 1   | %  |      |   | 159     |                  |  | 2   | %  |  |   | (68    | ) |  | (43 | )%
|Other income                       |  |                             | 85     |   |                       | 1   | %  |      |   | 51      |                  |  | 1   | %  |  |   | 34     |   |  | 67  | % 
|                                   |  |                             |        |   |                       |     |    |      |   |         |                  |  |     |    |  |   |        |   |  |     |   
|Net loss                           |  | $                           | (4,427 | ) |                       | (65 | )% |      | $ | (4,646  | )                |  | (51 | )% |  | $ | 219    |   |  | 5   | % 
|                                   |  |                             |        |   |                       |     |    |      |   |         |                  |  |     |    |  |   |        |   |  |     |   
|                                   |  |                            
|                                   |  | Six months ended June 30,   |        |   | Variance2008 vs. 2007 |    
|($ in thousands)                   |  | 2008                        |        |   | % oftotalrevenue      |     |    | 2007 |   |         | % oftotalrevenue |  |     | $  |  |   | %      |  
|Product revenue                    |  | $                           | 11,840 |   |                       | 83  | %  |      | $ | 12,996  |                  |  | 86  | %  |  | $ | (1,156 | ) |  | (9  | )%
|Service and spares revenue         |  |                             | 2,486  |   |                       | 17  | %  |      |   | 2,159   |                  |  | 14  | %  |  |   | 327    |   |  | 15  | % 
|                                   |  |                             |        |   |                       |     |    |      |   |         |                  |  |     |    |  |   |        |   |  |     |   
|Total revenue                      |  |                             | 14,326 |   |                       | 100 | %  |      |   | 15,155  |                  |  | 100 | %  |  |   | (829   | ) |  | (5  | )%
|                                   |  |                             |        |   |                       |     |    |      |   |         |                  |  |     |    |  |   |        |   |  |     |   
|Cost of product revenue            |  |                             | 10,422 |   |                       | 73  | %  |      |   | 11,380  |                  |  | 75  | %  |  |   | (958   | ) |  | (8  | )%
|Cost of service and spares revenue |  |                             | 2,179  |   |                       | 15  | %  |      |   | 1,891   |                  |  | 12  | %  |  |   | 288    |   |  | 15  | % 
|                                   |  |                             |        |   |                       |     |    |      |   |         |                  |  |     |    |  |   |        |   |  |     |   
|Total cost of revenue              |  |                             | 12,601 |   |                       | 88  | %  |      |   | 13,271  |                  |  | 88  | %  |  |   | (670   | ) |  | (5  | )%
|                                   |  |                             |        |   |                       |     |    |      |   |         |                  |  |     |    |  |   |        |   |  |     |   
|Gross profit                       |  |                             | 1,725  |   |                       | 12  | %  |      |   | 1,884   |                  |  | 12  | %  |  |   | (159   | ) |  | (8  | )%
|Operating expenses:                |  |                             |        |   |                       |     |    |      |   |         |                  |  |     |    |  |   |        |   |  |     |   
|Research and development           |  |                             | 2,706  |   |                       | 19  | %  |      |   | 2,910   |                  |  | 19  | %  |  |   | (204   | ) |  | (7  | )%
|Selling and marketing              |  |                             | 6,005  |   |                       | 42  | %  |      |   | 5,246   |                  |  | 35  | %  |  |   | 759    |   |  | 14  | % 
|General and administrative         |  |                             | 2,368  |   |                       | 17  | %  |      |   | 5,207   |                  |  | 34  | %  |  |   | (2,839 | ) |  | (55 | )%
|                                   |  |                             |        |   |                       |     |    |      |   |         |                  |  |     |    |  |   |        |   |  |     |   
|Total operating expenses           |  |                             | 11,079 |   |                       | 77  | %  |      |   | 13,363  |                  |  | 88  | %  |  |   | (2,284 | ) |  | (17 | )%
|                                   |  |                             |        |   |                       |     |    |      |   |         |                  |  |     |    |  |   |        |   |  |     |   
|Operating loss                     |  |                             | (9,354 | ) |                       | (65 | )% |      |   | (11,479 | )                |  | (76 | )% |  |   | 2,125  |   |  | 19  | % 
|Interest income                    |  |                             | 254    |   |                       | 2   | %  |      |   | 360     |                  |  | 2   | %  |  |   | (106   | ) |  | (29 | )%
|Other income                       |  |                             | 204    |   |                       | 1   | %  |      |   | 49      |                  |  |    |    |  |   | 155    |   |  | 316 | % 
|                                   |  |                             |        |   |                       |     |    |      |   |         |                  |  |     |    |  |   |        |   |  |     |   
|Net loss                           |  | $                           | (8,896 | ) |                       | (62 | )% |      | $ | (11,070 | )                |  | (73 | )% |  | $ | 2,174  |   |  | 20  | % 
|                                   |  |                             |        |   |                       |     |    |      |   |         |                  |  |     |    |  |   |        |   |  |     |   



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Product revenue. Product revenue consists of sales of our CleanSource power quality
products, comprised of both UPS and DC product lines, and sales of third-party ancillary equipment, such as engine generators, electrical and switchgear products.

The decrease in product revenue for the three and six month periods ended June 30, 2008 was due to lower ancillary project revenue compared to the same periods of 2007 as a result of timing of orders and a lower
number of flywheel units sold. A single product, depending on its power rating, may be comprised of multiple flywheel units. The average selling price during the second quarter of 2008 was $82,000 per quarter-megawatt flywheel, compared to $69,000
over the same period in 2007. Although the average selling price increased, which reflects an increase in the sale of higher priced products, such as the 250-900 kVA UPS product line, and price increases that we made in 2008, the lower number of
units sold and the lower ancillary project revenue resulted in lower product revenue compared to the second quarter of 2007.

During the
three-month period ended June 30, 2008 we sold 62 flywheel units compared to 81 flywheel units in the comparable period of 2007. The frequency and timing of our larger system sales, including megawatt class UPS products, made directly by us is
more unpredictable than orders received from our OEM partners, and can result in material changes in period-to-period revenue and the number of units sold. Such revenues may also occur in periods other than when originally anticipated, which can add
to the potential variability in our quarterly financial results and affect our ability to meet forecasted targets.

North American sales
were 77% of our total revenue for the three-month period ended June 30, 2008 compared to 66% for the same period of 2007, and 61% in the immediately preceding quarter of 2008.

Since 2005 we have been increasing the size of our direct sales organization in an effort to expand the territories in which we sell our Active Power
branded products. Most of this effort initially was focused in the EMEA market where we now have multiple sales offices. In 2007 we also opened our first Asian sales office in Tokyo. Sales of Active Power branded products through our direct and
manufacturers representative channels were 50% of our total revenues for the three-month period ended June 30, 2008 compared to 67% for the same period of 2007. Although our overall direct sales have decreased in the second quarter of
2008, we expect direct sales will continue to increase in both the EMEA and North American markets as we continue to focus on building a direct sales organization. As direct sales typically have higher profit margins than sales through our OEM
channels, we will continue to focus on our direct sales channel to increase revenue and improve profit margins. We believe sales of our Active Power branded products to government facilities and industrial customers in regions that are not covered
by our OEMs will continue to increase over time and will continue to become a larger percentage of our total revenue.

Caterpillar remains
our largest OEM partner and largest overall customer and represented 50% of our revenue for the three-month period ended June 30, 2008, compared to 32% of our revenue for the three-month period ended June 30, 2007. On April 23, 2008,
we entered into a new purchase agreement with Caterpillar, effective as of January 1, 2008, governing the sale of products by us to Caterpillar. This purchase agreement has an initial term of three years and provides that Caterpillar will
continue to market certain of our flywheel-based uninterruptible power supply products under the Caterpillar brand as a complement to Caterpillars own product line. We will supply and Caterpillar will purchase all of Caterpillars
Electric Power Divisions requirements for our products. We have had recent success with Caterpillar selling our megawatt-class UPS products along with their large engine generators, and expect total revenue from this channel to continue to
increase in 2008 in absolute terms.

Our products perform well in harsh environments where power quality is particularly poor, which makes
them a good fit for industrial countries with a poor power infrastructure and therefore we have focused our direct sales efforts to these customers. Due to the large size of some of our customer orders relative to our current total revenue levels,
our quarterly total revenue trend and the proportion of sales made directly by us can be expected to fluctuate quarterly from the amounts recorded so far in 2008. We have also seen and anticipate a further increase in capital spending in data
centers where there is a requirement for higher-density power solutions such as flywheels, and believe that this along with our expanding direct sales strategy will result in higher product revenue levels for us for the remainder of 2008.

Service and spares revenue. Service and spares revenue primarily relates to revenue generated from installation, startup,
repairs or reconfigurations of our products and the sale of spare or replacement parts to our OEM and end-user customers. It also includes revenue associated with the costs of travel of our service personnel. Service and spares revenue decreased by
18% for the three-month period ended June 30, 2008 compared to the same prior year period. This decrease was primarily due to timing of contract work related to large systems projects, and the absence of such projects in the second quarter of
2008. For some of these customers we provide a full power solution, including site preparation, installation of an entire power solution and provision of all products required to provide a turnkey product to the end user. We anticipate that service
and spares revenue will continue to grow with product revenue and as our installed base of product expands, because as more units are sold to customers, more installation, startup and maintenance services will be required. Where we make sales
through our OEM channel, it is typical for the OEM to provide these types of services to their end-user customers.



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Cost of product revenue. Cost of product revenue includes the cost of component parts of
our products that are sourced from suppliers, personnel, equipment and other costs associated with our assembly and test operations, including costs from having underutilized facilities, shipping costs, warranty costs, and the costs of manufacturing
support functions such as logistics and quality assurance. The cost of product revenue as a percentage of total product revenue in the three-month period ended June 30, 2008 remained at 70%, compared to the same period in 2007. Although we have
instituted programs to reduce product and component costs where feasible, the impact of increased raw commodity pricing and a lower number of flywheel units sold has kept the product cost as a percentage of total product revenue steady. We continue
to operate a manufacturing facility that has a capacity level significantly greater than our current product revenue levels. In addition, a large portion of the costs involved in operating our manufacturing facility are fixed in nature and we incur
approximately $1.2 million to $1.5 million in unabsorbed overhead each quarter. We continue to work on reducing our product costs through design enhancements and modifications and vendor management programs. The accomplishment of material gross
margin levels is heavily dependent upon our sales channel mix and the effectiveness of our product pricing to our customers, as well as the actual volume of units produced. Our ability to maintain and grow positive product gross margin will depend
on multiple factors, including our ability to continue to reduce material costs, improve our sales channel mix in favor of direct sales versus OEM, increase product prices, and increase our unit volume and total revenues to a level that will allow
us to improve the utilization of our manufacturing operations.

Items that could impact our ability to further improve our gross margin
include sales product volume and mix, pricing discounts and customer incentives, currency fluctuations, and variations in our product cost and productivity. Also, if current expectations of future demand for our CoolAir product are not realized, we
may be required to record an additional impairment charge for some or all of our remaining CoolAir inventory, which would negatively impact our gross margins.

Cost of service and spares revenue. Cost of service and spares revenue includes the cost of component parts, as well as labor and overhead of our spare parts, costs associated with travel and labor used
in servicing a unit and unabsorbed overhead from the service group. The cost of service and spares revenue increased to 90% of service and spares revenue in the three-month period ended June 30, 2008, compared to 80% in the same period of 2007.
This decrease reflects less contract work in the second quarter of 2008, as well as higher costs from the expansion of our service department in Europe and Asia to support the growth in the number of units in these regions as well as anticipated
growth in the future.

Research and development. Research and development expense primarily consists of compensation and
related costs of employees engaged in research, development and engineering activities, third party consulting and product development activities, as well as an allocated portion of our occupancy costs. Overall our research and development expenses
decreased by $22,000, or 2%, from the second quarter of 2007, and decreased by $98,000, or 7%, from the first quarter of 2008. The decrease from the same period in 2007 was due to headcount reductions and lower project related development costs this
year. The prior year expenses included higher prototype and development costs for our CoolAir DC product and costs incurred in paralleling our megawatt-class UPS product. We believe research and development expenses in the third quarter will stay at
similar levels to those recorded in the second quarter.

Selling and marketing.Selling and marketing expenses primarily
consist of compensation, including variable sales compensation, and related costs for sales and marketing personnel, related travel, selling and marketing expenses, as well as an allocated portion of our occupancy costs. Selling and marketing costs
were $434,000, or 17%, higher than the amount recorded in the second quarter of 2007, and were $105,000, or 4%, higher than the first quarter of 2008. The increase from the same period in 2007 was due to increased variable sales compensation
associated with increased channel partners and distributors compared to 2007 and higher marketing and promotion spending in 2008. The increase in our sales and marketing costs from the first quarter of 2008 reflects increased marketing efforts of
our products globally. Our total headcount in sales and marketing has decreased slightly compared to last quarter, and we have changed the composition of our sales team over the last year as we expand our direct sales force. We believe that sales
and marketing expenses will increase slightly in the third quarter as our revenue levels increase and our variable compensation increases.

General and administrative. General and administrative expense is primarily comprised of compensation and related costs for executive and administrative personnel, professional fees, and taxes, including sales, property and
franchise taxes. General and administrative expenses decreased by $1,270,000, or 52%, from the levels of the same period in 2007 and remained steady when compared to the first quarter of 2008. This decrease from the same period in the prior year was
primarily attributable to $1.2 million of professional fees incurred last year with a review of our historical stock option granting procedures that covered the period from 2000 through 2006. We are currently in the process of negotiating to settle
the outstanding tax matters resulting from the option investigation with the Internal Revenue Service, and may still record additional expense to cover tax obligations for innocent employees who were affected by the option review.



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We would record any further expenses at the time we legally finalize those obligations for our employees. Absent the impact of any significant expenses from
the option review, we anticipate that the level of general and administrative expenses should stay at similar levels in the third quarter of 2008.

Interest income.Interest income has decreased from $159,000 in the three-month period ended June 30, 2007 to $91,000 in the three-month period ended June 30, 2008. Our average cash and investments balance over the
three month period ending June 30, 2008 has increased by approximately $1.0 million, or 7%, compared to the average balance over the comparable period ending June 30, 2007. Interest income decreased due to decreasing interest rates
available in credit markets and the mix of our investments between short and long term and cash and cash equivalents.

Other income.Other income in the second quarter of 2008 increased over the preceding quarter due to sale of previous expensed equipment and foreign exchange gains on a bank account held in foreign currency.

Liquidity and Capital Resources

Our principal
sources of liquidity as of June 30, 2008 consisted of $14.2 million of cash and investments and the funds available to us under our $5.0 million revolving credit facility with our bank. We have primarily funded our operations through public and
private placements of our common stock as well as $10.0 million in development funding received from Caterpillar since 1999, and from our product, service and spares revenue. We believe that our cash and investments on hand will be sufficient to
fund our operations through the next twelve months based upon our historical and projected cash burn.

The following table summarizes the
changes in cash used in operating activities for the six-month periods ended June 30:



|                                  |  |                          |        |   |                       |   |        |   |  |   |     |  |   |  
|--------------------------------- |  | ------------------------ | ------ | - | --------------------- | - | ------ | - |  | - | --- |  | - | -
|                                  |  | Six months endedJune 30, |        |   | Variance2008 vs. 2007 |  
|($ in thousands)                  |  | 2008                     |        |   | 2007                  |   |        | $ |  | % |    
|Cash used in operating activities |  | $                        | (8,058 | ) |                       | $ | (7,664 | ) |  | $ | 394 |  | 5 | %

Cash used in operating activities for the six-month period ending June 30, 2008 increased by
5% compared to the same period of 2007. This is primarily attributable to changes in our working capital compared to the prior period. Although our operating loss declined in 2008, we have used more funds to finance additional accounts receivable,
and have paid more accrued liabilities compared to the previous year. We have offset some of this impact through increased levels of customer deposits that are included as deferred revenue on some of our larger system projects and by reducing our
inventory levels. We anticipate that the level of cash used in operating activities will be similar to the second quarter as we continue to increase our revenue and have fewer fluctuations in our working capital.

Investing activities primarily consist of sales and purchases of investments and purchases of property and equipment. Fluctuations in the sale and
purchase of investments generally reflect our use of these funds to finance our ongoing operations. Capital expenditures were $668,000 in the six-month period ending June 30, 2008 compared to $433,000 in the same period of 2007.

Funds used by financing activities during the six months ended June 30, 2008 reflect the issuance of restricted shares to employees less the
proceeds from employee share purchases.

As noted above, we believe our existing cash and investments balances at June 30, 2008 will
be sufficient to meet our cash requirements through at least the next 12 months, although we may elect to seek additional funding prior to that time. Beyond the next 12 months, our cash requirements will depend on many factors, including the rate of
sales growth, the success of our direct selling strategy, the market acceptance of our products, including the CoolAir DC product family, the timing and level of development funding, the rate of expansion of our sales and marketing activities, the
efficiency of our manufacturing processes, and the timing and extent of research and development projects.

As of June 30, 2008, we
held $825,000 in auction rate securities. Due to difficulties in U.S. credit and capital markets, there have been a number of failed auctions in the U.S. auction rate securities market in 2008. We have experienced failed auctions for the municipal
bond instruments that we hold, resulting in a lack of liquidity for these securities. We continue to earn interest on these securities but are, in the short term at least, unable to liquidate these investments in an orderly manner. As a result we
have classified these securities as a long-term investment at June 30, 2008.

We continue to work with the financial institution that
marketed these auction rate securities to us as a liquid money-market asset to enable us to liquidate these securities in an orderly manner. None of the underlying securities have had any credit rating adjustments, but the overall lack of liquidity
in the auction rate securities market has resulted in us holding an



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illiquid asset. Our current liquidity situation is such that we do not have to redeem these securities in the short term. The lack of liquidity also means
that we do not have a readily discernable market valuation with which to value these securities. Therefore we continue to carry these securities at par value consistent with our historical practice since that is the value we receive when we trade
these securities in an established market. Any differences between par value and the purchase price or settlement have historically been comprised of accrued interest.

Recent Accounting Pronouncements

In December 2007, the FASB issued Statement of Financial Accounting
Standards No. 141R (revised 2007), Business Combinations (SFAS 141(R)), which establishes the acquisition method to account for business combinations. SFAS 141(R) requires the acquiring entity to recognize all of the assets acquired and
liabilities assumed in the transaction, establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed and requires the acquirer to disclose to investors and other users all of the
information they need to evaluate and understand the nature and financial effect of the business combination. These rules are effective for transactions closing after January 1, 2009.



|Item 3. | Quantitative and Qualitative Disclosures about Market Risk
|------- | ----------------------------------------------------------

We invest our cash in a variety of financial instruments, including bank time deposits, and taxable variable rate and fixed rate obligations of corporations, municipalities, and local, state and national government entities and agencies.
These investments are denominated in U.S. dollars.

Our interest income is sensitive to changes in the general level of U.S. interest
rates, particularly since the majority of our investments are in short-term instruments. We believe that our investment policy is conservative, both in terms of the average maturity of investments that we allow and in terms of the credit quality of
the investments we hold. We estimate that a 1% decrease in market interest rates would decrease our annual interest income by $85,000.

Our
international sales have historically been made in U.S. dollars. As we increase sales in foreign markets, particularly those markets where we have a physical presence, we are making more sales that are denominated on other currencies, primarily
euros and British pounds. Those sales in currencies other than U.S. dollars can result in transaction gains and losses which have not been material to date. Currently, we do not engage in hedging activities for our international operations other
than an increasing amount of sales and support expenses being incurred in foreign currencies. However, we may engage in hedging activities in the future.

Our international business is subject to the typical risks of any international business, including, but not limited to, the risks described in Item 1A  Risk Factors in our 2007 Annual Report on
Form 10-K. Accordingly, our future results could be materially harmed by the actual occurrence of any of these or other risks.



|Item 4. | Controls and Procedures
|------- | -----------------------

Evaluation of disclosure controls and
procedures.

We performed an evaluation under the supervision and with the participation of our management, including our Chief
Executive Officer (CEO) and Chief Financial Officer (CFO), of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d -15(e) under the Securities Exchange Act of 1934. Based on
their evaluation, our management, including our CEO and CFO, concluded that our disclosure controls and procedures were effective as of June 30, 2008 (the end of the period covered by this Quarterly Report on Form 10-Q) to ensure that
information required to be disclosed by us in the reports filed or submitted by us under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SECs rules and forms.

Changes in internal control over financial reporting.

During the three months ended June 30, 2008 there was no change in our internal control over financial reporting that occurred that has materially affected, or that we believe is reasonably likely to materially affect, our internal
control over financial reporting.

PART II  OTHER INFORMATION



|Item 1. | Legal Proceedings
|------- | -----------------

On January 22, 2008, we initiated
legal proceedings in the U.S. District Court for the District of Puerto Rico against Antilles Power Depot, Inc. (Antilles), our distributor in Puerto Rico, seeking payment of outstanding balances from Antilles, our costs of litigation, and a
declaratory judgment establishing that we have just cause to terminate our distribution agreement due to Antilles non-performance of its contractual obligations, including non-payment of outstanding amounts. Antilles has formally
responded to our complaint and has filed counterclaims against us seeking (i) approximately $100,000



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in finance charges, (ii) a declaratory judgment establishing we do not have just cause to terminate the distribution agreement, and
(iii) damages of no less than $560,000 in the event that we terminate the distribution agreement without just cause. We have filed a motion to dismiss these counterclaims and are currently waiting for Antilles opposition to the
same.

We have previously reserved fully for the amounts due from Antilles. We have initiated the declaratory judgment action to obtain a
judicial determination that we are not subject to potential payments or penalties that would be otherwise payable to Antilles under the Puerto Rico Act No. 75 which is designed to compensate local distributors whose distribution rights are
terminated without just cause (as that term is defined under Puerto Rico law). Until this matter is resolved we are unable to sell our products in Puerto Rico directly or to engage a new distributor in that market. We do not anticipate
the costs of this litigation to be material to our financial results. Since June 30, Antilles has contacted us to negotiate the return of equipment to us that was not paid for as a preliminary effort to settle this dispute. We anticipate
potential discovery of this case to continue into the third quarter of 2008.



|Item 1A. | Risk Factors
|-------- | ------------

You should carefully consider the risks described in
Item 1A of our 2007 Annual Report on Form 10-K before making a decision to invest in our common stock or in evaluating Active Power and our business. The risks and uncertainties described in our 2007 Annual Report on Form 10-K are not the only
ones we face. Additional risks and uncertainties that we do not presently know, or that we currently view as immaterial, may also impair our business operations. This report is qualified in its entirety by these risk factors.

The actual occurrence of any of the risks described in our 2007 Annual Report on Form 10-K could materially harm our business, financial condition and results of
operations. In that case, the trading price of our common stock could decline.

Our increased emphasis on a direct sales model and our transaction
and customer concentration may affect our ability to accurately predict the timing of revenues and to meet short-term expectations of operating results.

Our increased emphasis on a direct sales model has increased the effort and time required by us to complete sales to customers. Further, a larger portion of our quarterly revenue is derived from relatively few large
transactions with relatively few customers. For example, in the second quarter of 2008, our five largest customers contributed 65% of our revenue. Our shift to the direct sales model, or any delay in completing these large sales transactions or
reduction in the number of customers or large transactions, may result in significant fluctuations in our quarterly revenue. Further, we use anticipated revenues to establish our operating budgets and a large portion of our expenses, particularly
rent and salaries, are fixed in the short term. As a result, any shortfall or delay in revenue could result in increased losses and would likely cause our operating results to be below public expectations. The occurrence of any of these events would
likely cause the market price of our common stock to decline.



|Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds.
|------- | ------------------------------------------------------------

None.



|Item 3. | Defaults Upon Senior Securities.
|------- | --------------------------------

None.



|Item 4. | Submission of Matters to a Vote of Security Holders.
|------- | ----------------------------------------------------

At
our annual meeting of stockholders held on May 15, 2008, our stockholders voted on the following matters:



| | (1) | The election of two Class II directors to serve until our 2011 annual meeting or until their successors have been elected and qualified. The nominees of the board of directors were
elected by the following vote:
| | --- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|                  |  |                       |  |                                 
|----------------- |  | --------------------- |  | --------------------------------
|Class II Director |  | Shares Voted in Favor |  | Shares Voted Against or Withheld
|Jan H. Lindelow   |  | 48,228,363            |  | 1,510,747                       
|James A. Clishem  |  | 49,200,411            |  | 538,699                         



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| | (2) | The election of one Class III director to serve until our 2008 annual meeting or until his successor has been elected and qualified. The nominee of the board of directors was
elected by the following vote:
| | --- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|                     |  |                       |  |                                 
|-------------------- |  | --------------------- |  | --------------------------------
|Class III Director   |  | Shares Voted in Favor |  | Shares Voted Against or Withheld
|James E. deVenny III |  | 49,211,595            |  | 527,515                         

The directors who were not up for election at the annual meeting but whose terms continued
thereafter are Richard E. Anderson, Rodney S. Bond, Benjamin L. Scott and Ake Almgren.



| | (3) | The approval of the appointment of Ernst & Young LLP as independent auditors for the fiscal year ending December 31, 2008. The appointment was approved by the
following vote:
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|                      |  |                      |  |                  
|--------------------- |  | -------------------- |  | -----------------
|Shares Voted in Favor |  | Shares Voted Opposed |  | Shares Abstaining
|39,737,682            |  | 1,054,852            |  | 29,247           



|Item 5. | Other Information.
|------- | ------------------

None.



|Item 6. | Exhibits.
|------- | ---------

The following documents are filed as exhibits
to this report:



|      |  |                                                                                                                                                                                                                                                                                                                                                                                                                                              
|----- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|3.1*  |  | Amended and Restated Certificate of Incorporation (filed as Exhibit 3.1 to Active Powers IPO Registration Statement on Form S-l (SEC File No. 333-36946) (the IPO Registration
Statement))                                                                                                                                                                                                                                                
|      | 
|3.2.* |  | Second Amended and Restated Bylaws (filed as Exhibit 3.2 to Active Powers Current Report on Form 8-K filed on February 2, 2007)                                                                                                                                                                                                                                                                                                             
|      | 
|3.3*  |  | Amendment to Second Amended and Restated Bylaws (filed as Exhibit 3.01 to Active Powers Current Report on Form 8-K filed December 7, 2007)                                                                                                                                                                                                                                                                                                  
|      | 
|4.1*  |  | Specimen certificate for shares of Common Stock (filed as Exhibit 4.1 to the IPO Registration Statement)                                                                                                                                                                                                                                                                                                                                     
|      | 
|4.2*  |  | Rights Agreement, dated as of December 13, 2001, between Active Power and Equiserve Trust N.A., which includes the form of Certificate of Designation for the Series A Junior
Participating Preferred Stock as Exhibit A, the form of Rights Certificate as Exhibit B and the Summary of Rights to Purchase Series A Preferred Stock as Exhibit C (filed as Exhibit 4.1 to Active Powers Current Report on Form 8-K dated
December 13, 2001)
|      | 
|4.3*  |  | See Exhibits 3.1 and 3.2 for provisions of the Certificate of Incorporation and Bylaws of the registrant defining the rights of holders of common stock                                                                                                                                                                                                                                                                                      
|      | 
|4.4*  |  | Registration Rights Agreement dated August 14, 2007 (filed as Exhibit 10.2 to Registrants Current Report on Form 8-K filed August 14, 2007)                                                                                                                                                                                                                                                                                                 
|      | 
|10.1* |  | Purchase Agreement effective as of January 1, 2008 between Active Power and Caterpillar, Inc. (filed as Exhibit 10.1 to Registrants Quarterly Report on Form 10-Q filed on April 28,
2008.)                                                                                                                                                                                                                                                 
|      | 
|10.2  |  | Form of Change of Control Severance Agreement                                                                                                                                                                                                                                                                                                                                                                                                
|      | 
|31.1  |  | Certification of Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2003                                                                                                                                                                                                                                                                        
|      | 
|31.2  |  | Certification of Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a) and 15(d)-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2003                                                                                                                                                                                                                                                                      
|      | 
|32.1  |  | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2003                                                                                                                                                                                                                                                                                            
|      | 
|32.2  |  | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2003                                                                                                                                                                                                                                                                                            



|* | Incorporated by reference to the indicated filing.
|- | --------------------------------------------------



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SIGNATURES

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



|              |  |                                                                                                              
|------------- |  | -------------------------------------------------------------------------------------------------------------
|              |  | ACTIVE POWER, INC.                                                                                           
|              |  | (Registrant)                                                                                                 
|              | 
|July 28, 2008 |  | /s/ James A. Clishem                                                                                         
|(Date)        |  | James A. Clishem                                                                                             
|              |  | President and Chief Executive Officer (Principal
Executive Officer)                                          
|              | 
|July 28, 2008 |  | /s/ John K. Penver                                                                                           
|(Date)        |  | John K. Penver                                                                                               
|              |  | Vice President of Finance, Chief Financial Officer and Secretary (Principal Financial and Accounting Officer)



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