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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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FORM 10-K



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(Mark One)

|x | ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ------------------------------------------------------------------------------

For the fiscal year ended December 31, 2006

OR



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

Commission File Number: 0-10238



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U.S. ENERGY SYSTEMS, INC.

(Exact name of Registrant as specified in its
charter)



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|                                                               |  |                                        
|-------------------------------------------------------------- |  | ---------------------------------------
|Delaware                                                       |  | 52-1216347                             
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification Number)



|                                                             |  |                                                     
|------------------------------------------------------------ |  | ----------------------------------------------------
|750 Lexington Avenue, 15thFloor New York, New York 10022     |  | (212) 588-8901                                      
|(Address of principal executive offices, including zip code) |  | (Registrants telephone number, including area code)
|                                                             |  |                                                     

545 Madison Avenue, 6thFloor

New York, New York 10022

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



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Securities
registered pursuant to Section 12(b) of the Act: None.

Securities registered pursuant to Section 12(g) of the Act:

Title of Each Class

Common Stock, par value $.01 per share



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

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the
Act. ̈Yes    x  No

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 a 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 if disclosure of delinquent filers in response to Item 405 of Regulation S-K is not contained herein, and will not be
contained, to the best of the registrants knowledge, in definitive proxy or information statement incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ̈

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

Large accelerated filer ̈Accelerated
filer ̈Non- accelerated filer  x

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

The aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the last sales price of the Common
Stock as of June 30, 2006 (i.e. $4.32 per share) was approximately $74,910,355 based on 17,340,360 shares outstanding as of that date.

As of June 1, 2007, the number of outstanding shares of the registrants Common Stock was 21,704,236.



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##### Table of Contents

U.S. Energy Systems, Inc.

Annual Report for the year ended December 31, 2006

TABLE OF CONTENTS



|           |  |         |  |                                                                                                              |  |   
|---------- |  | ------- |  | ------------------------------------------------------------------------------------------------------------ |  | --
|PART I     |  |         |  | 2                                                                                                           
|           |  |         | 
|           |  | Item 1  |  | Business                                                                                                     |  | 2 
|           |  |         | 
|           |  | Item 1A |  | Risk Factors                                                                                                 |  | 7 
|           |  |         | 
|           |  | Item 1B |  | Unresolved Staff Comments                                                                                    |  | 13
|           |  |         | 
|           |  | Item 2  |  | Properties                                                                                                   |  | 13
|           |  |         | 
|           |  | Item 3  |  | Legal Proceedings                                                                                            |  | 13
|           |  |         | 
|           |  | Item 4  |  | Submission of Matters to a Vote of Security Holders                                                          |  | 14
|           |  |        
|PART II    |  |         |  | 14                                                                                                          
|           |  |         | 
|           |  | Item 5  |  | Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities |  | 14
|           |  |         | 
|           |  | Item 6  |  | Selected Financial Data                                                                                      |  | 16
|           |  |         | 
|           |  | Item 7  |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                        |  | 17
|           |  |         | 
|           |  | Item 7A |  | Quantitative and Qualitative Disclosures About Market Risk                                                   |  | 23
|           |  |         | 
|           |  | Item 8  |  | Financial Statements and Supplementary Data                                                                  |  | 23
|           |  |         | 
|           |  | Item 9  |  | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure                         |  | 23
|           |  |         | 
|           |  | Item 9A |  | Controls and Procedures                                                                                      |  | 23
|           |  |         | 
|           |  | Item 9B |  | Other Information                                                                                            |  | 24
|           |  |        
|PART III   |  |         |  | 25                                                                                                          
|           |  |         | 
|           |  | Item 10 |  | Directors, Executive Officers and Corporate Governance                                                       |  | 25
|           |  |         | 
|           |  | Item 11 |  | Executive Compensation                                                                                       |  | 29
|           |  |         | 
|           |  | Item 12 |  | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters               |  | 39
|           |  |         | 
|           |  | Item 13 |  | Certain Relationships and Related Transactions, and Director Independence                                    |  | 41
|           |  |         | 
|           |  | Item 14 |  | Principal Accountant Fees and Services                                                                       |  | 41
|           |  |        
|PART IV    |  |         |  | 43                                                                                                          
|           |  |         | 
|           |  | Item 15 |  | Exhibits and Financial Statement Schedules                                                                   |  | 43
|           |  |        
|SIGNATURES |  |         |  | 47                                                                                                          



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CAUTIONARY STATEMENT RELATING TO FORWARD LOOKING STATEMENTS

We may from time to time make written or oral forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended, including statements contained in our filings with the Securities and Exchange Commission and in our press releases. Forward-looking statements relate to expectations, beliefs,
projections, future plans and strategies, anticipated events or trends and similar expressions concerning matters that are not historical facts. In some cases, you can identify forward-looking statements by terms such as anticipate,
believe, could, estimate, expect, intend, may, plan, potential, should, strategy, will and other words of similar
meaning. The forward-looking statements are based on our beliefs, assumptions and expectations of future performance, taking into account all information currently available to us. These beliefs, assumptions and expectations can change as a result
of many possible events or factors, not all of which are known to us or are within our control. If a change occurs, our business, financial condition, liquidity and results of operations may vary materially from those expressed in our
forward-looking statements. In connection with the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, we are hereby identifying important factors that could cause actual results and outcomes to differ
materially from those contained in any forward-looking statement made by or on our behalf. Such factors include, but are not limited to:



| |  |  | access to needed financing or refinancing on acceptable terms,
| | - |  | --------------------------------------------------------------



| |  |  | revisions in the initial estimates in the fair value of the acquired assets,
| | - |  | ----------------------------------------------------------------------------



| |  |  | failure to realize the estimated savings or operating results of an acquisition, and other risks associated with acquisitions generally, including risks relating to
managing and integrating acquired businesses,
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | access to capital markets,
| | - |  | --------------------------



| |  |  | changes in market conditions,
| | - |  | -----------------------------



| |  |  | the impact of competition,
| | - |  | --------------------------



| |  |  | changes in local or regional economic conditions, and the amount and rate of growth in expenses,
| | - |  | ------------------------------------------------------------------------------------------------



| |  |  | dependence on management and key personnel,
| | - |  | -------------------------------------------



| |  |  | changes in federal or state laws and their interpretation with respect to regulation, energy policy and other business issues,
| | - |  | ------------------------------------------------------------------------------------------------------------------------------



| |  |  | the inability to commence planned projects in a timely manner,
| | - |  | --------------------------------------------------------------



| |  |  | our ability to continue our growth strategy, and
| | - |  | ------------------------------------------------



| |  |  | the ability to complete acquisitions.
| | - |  | -------------------------------------

New factors
emerge from time to time. We cannot predict what factors may arise or how such factors may cause our results to differ materially from those contained in any forward-looking statement. Any forward-looking statements speak only as of the date on
which such statements are made. We undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made or to reflect the occurrence of unanticipated events.



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##### Table of Contents

PART I



|ITEM 1. | BUSINESS
|------- | --------

OVERVIEW AND RECENT DEVELOPMENTS

U.S. Energy Systems, Inc. (the Company or US Energy) is a Delaware corporation that owns and operates, through its subsidiaries,
energy facilities producing electricity and energy alternatives to natural gas. The Company owns:



| |  |  | a 100% interest in U.S. Energy Biogas Corp. (USEB) effective November 28, 2006. USEB owns and operates 23 landfill gas to energy projects in the
United States, 20 of which produce electricity and three of which sell landfill gas as an alternative to natural gas;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | a 79% interest in GBGH, LLC (GBGH). GBGH owns energy assets and mineral rights in the United Kingdom including a 42MW gas-fired power plant and gas
licenses for approximately 100,000 acres of onshore natural gas properties and mineral rights in North Yorkshire, England; and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | a 100% interest in Plymouth Envirosystems, Inc., which owns a 50% interest in Plymouth Cogeneration Limited Partnership. Plymouth Cogeneration Limited Partnership
owns and operates a combined heat and power plant (CHP) in Massachusetts that produces 1.2MWs of electricity and 7 MWs of heat.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Acquisition of UK Assets

On August 7, 2006, the Company completed its acquisition and financing of certain energy
assets in the United Kingdom through certain of its subsidiaries (the UK Transaction). The assets (the UK Assets) acquired include (i) gas licenses for approximately 100,000 acres of onshore natural gas properties and
mineral rights in North Yorkshire, England (the Gas Licenses), containing significant proved reserves, (ii) the Knapton Generating Station, a 42 MW gas-fired power plant associated with and located in the vicinity of the natural gas
reserves in North Yorkshire, England, and (iii) certain related gas gathering and processing assets. As part of the UK Transaction, a subsidiary of the Company entered into a power purchase agreement and a gas sales agreement with Scottish
Power Energy Management (Scottish Power) under which Scottish Power is required to purchase all of the electricity generated by the Knapton Generating Station and all of the natural gas produced from the associated reserves up to 100 bcf
in the aggregate for a term of up to 12 years. The Company paid approximately $72.6 million and issued rights to acquire up to 9.2 million shares of its common stock, to acquire the UK Assets and obtain the associated financing. The financing
of the UK Transaction provided approximately $166.3 million for, among other things, the acquisition of the UK Assets, the funding of certain reserves required by the terms of the financing and working capital to be used by the Companys
subsidiaries for the operation and upgrade of the UK Assets necessary to increase gas production. These loans mature in 2013 and 2014, subject to acceleration or mandatory prepayments upon the occurrence of certain events, and are currently secured
by substantially all of the Companys and its subsidiaries assets, other than USEBs assets.

The Gas Licenses acquired
represent the mineral rights of the associated properties where the Company does not own the surface land. Individual land leases have been negotiated with the surface rights landowners that provide for small fixed payments to the landowners for the
surface rights. The individuals do not receive royalties associated with extraction of natural resources.

The Company, through GBGH, LLC
(GBGH), owns a 79% interest in the UK Assets. GBGH intends to further develop the natural gas fields subject to the Gas Licenses in a several phase process that includes the expansion of the gas collection system in order to supply the
Knapton Generating Station with sufficient gas to operate on a 24/7 basis, the making of modifications to the Knapton Generating Station, the expansion of proved and collectible gas reserves and the construction a pipeline to the gas distribution
system (the Expansion).



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As part of the transaction, various derivatives, including hedging and similar arrangements, were entered
into with respect to, among other things, gas and electricity prices, interest and currency rates, and carbon emission allowances. The gas and electric hedges assure the Company that it will receive not less than specified prices for the sale of
electricity from the Knapton Generating Station through August 2009 and for the sale of gas from the facility in 2010 and 2011. The currency and interest rate hedges ensure that the results of operations with respect to our activities in connection
with the UK Assets will not be adversely impacted, through August 2009, as a result of fluctuation in such rates. The agreement with respect to carbon emission allowances requires that the Company purchase specified amounts of such allowances at
fixed prices through December 31, 2007.

The financing arrangements entered into with respect to the UK Transaction require that GBGH
set aside funds for various purposes, including maintenance and the Expansion. Management does not believe that such funds are sufficient for purposes of completing the Expansion. The Company agreed, pursuant to the UK financing documentation, to
provide additional funds to GBGH as follows: (i) £3.9 million (approximately $7.6 million based upon the exchange rate in effect on December 31, 2006) between September 7, 2007 and December 31, 2007 to be deposited into an expansion
reserve account and a major maintenance reserve account for the UK Assets; (ii) up to $21 million, less specified amounts (including any amounts paid pursuant to clause (iii) below) to cover certain shortfalls in the reserve account for
Expansion; (iii) $21 million, less specified amounts (including any amounts paid pursuant to clause (ii) above), upon default under specified financing arrangements; (iv) up to $4 million for certain breaches of warranties (or the
discovery of certain negative information) arising with respect to the agreements pursuant to which we acquired the UK Assets; (v) $20 million, if GBGH elects to extend the initial interest rate and currency hedge agreements which is due to
expire on August 7, 2009; and (vi) if GBGH enters into one or more replacement interest rate and currency hedge agreements, the amounts payable as an upfront fee or premium to the providers thereunder. To date, the Company has not been
required to provide additional funding for the items described above. Absent a refinancing or the raising of additional capital, there can be no assurance that the Company will have sufficient cash to provide the required additional funds to GBGH.

Acquisition of U.S. Energy Biogas Corp. Stock

On November 28, 2006, the Company entered into a Stock Purchase Agreement with DEGS Biogas, Inc. (formerly Cinergy Energy Solutions, Inc., DEGS) pursuant to which the Company acquired the remaining outstanding 4,574 shares
of the Class B Common Stock of USEB from DEGS (the DEGS Shares). The Company now owns 100% of the outstanding stock of USEB.

In consideration for the DEGS Shares, the Company agreed to: (i) assume two promissory notes, payable to BMC Energy LLC, a subsidiary of USEB, each dated May 1, 2001, (a) one note is a fixed obligation with remaining payments
aggregating $430,000 and (b) the other note is a contingent obligation, based on the value of Section 29 tax credits generated by the company and its subsidiaries, the face amount of which is $4.3 million, (ii) assume DEGS GASCO
LLCs obligations to fund operating and capital expenses of certain limited partnerships or limited liability companies that own and operate landfill gas collection systems and related assets in an amount not to exceed $1 million, and
(iii) pay to DEGS as additional consideration 50% of the net proceeds received from the sale of greenhouse gas emission credits from specified projects through 2010 with the aggregate amount not to exceed $6,000,000. Management currently
anticipates that the operating and capital expense funding obligations and payments on the contingent note will not exceed an aggregate of $1 million. Management cannot at this time estimate the total amount to be paid for the additional
consideration from the greenhouse gas emission credit sales as a liquid market for the credits has yet to develop. The amount of purchase price recorded was based upon the Section 29 tax credit obligation assumed by the Company. To the extent
additional payments are required, an adjustment to the purchase price will be required.

Chapter 11 Filing by U.S. Energy Biogas Corp.

On November 29, 2006, USEB and certain of its subsidiaries filed for reorganization under Chapter 11 of the U.S. Bankruptcy Code in the Southern
District of New York in order to facilitate the restructuring of its capital structure particularly related to its debt with Countryside Power Income Fund (Countryside). At the time of the filing, USEB was current in its payment of all
principal and interest and did not have any monetary defaults under the loan agreements. The USEB Chapter 11 case number is 06-12827(RDD).

On January 16, 2007, USEB announced that it reached an agreement with Countryside concerning the principal issue in the case, the restructuring of the Countryside debt obligations. The agreement, which was approved by the Court,
allowed Countryside a US$99,000,000 secured claim. The claim is the only allowed claim that



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Countryside had in the Chapter 11 case and Countryside agreed to forgo any claims related to USEBs April 8, 2004 Royalty Agreement with
Countryside, any fees incurred by Countryside pertaining to the case, all accrued but unpaid interest through January 31, 2007 and any claims against US Energy under the April 8, 2004 Development Agreement between US Energy and
Countryside. USEB made a US$3,000,000 payment against the secured claim in January, 2007 and a US$30,000,000 payment in March, 2007. The remaining outstanding principal of US$66,000,000 was deemed over secured for purposes of adequate protection
providing USEB with the right to use its cash collateral for operating expense and professional fees related to the bankruptcy during the term of bankruptcy proceedings and bore interest at a rate of 10% per annum (down from 11% per the
original loan agreement) payable monthly in US dollars to Countryside. The final installment against the secured claim was due and paid on May 31, 2007. Mutual general releases have been exchanged among the parties involved and cover certain
individuals affiliated with Countryside who have been threatened with lawsuits arising out of their prior employment by US Energy.

On
March 19, 2007, USEB announced that it reached an agreement with the State of Illinois and the Illinois Commerce Commission (the ICC) resolving the principal remaining outstanding issue in the Chapter 11 case. The agreement has been
approved by the Court and provides that the ICC will not pursue repayment of approximately $65,000,000 in interest-free loans provided to certain of USEBs landfill gas to energy projects under the Illinois Retail Rate Program. In return, USEB
or its subsidiaries paid the ICC $5,250,000 on the effective date of USEBs Plan of Reorganization, May 31, 2007, and withdrew its 10 operating projects from participation in the program on May 31, 2007. The funds paid to the ICC include
the establishment of a $250,000 reserve account that will be utilized to pay any and all rate adjustment claims, up to a $250,000 limit, for a period of six months immediately following the effective date of the reorganization. As of June 1, 2007,
USEB has entered into agreements with electricity buyers outside the Illinois Retail Rate program and all output is being sold as of that date at market prices which vary per the local market.

On May 23, 2007, the U.S. Bankruptcy Court of the Southern District of New York approved the USEB Plan of Reorganization. The plan includes the payment
of USEBs $66,000,000 obligation to Countryside, the payment of the $5,250,000 settlement with the Illinois Commerce Commission which eliminated approximately $65,000,000 of a long term debt obligation owed by USEB to the State of Illinois, the
payment in full of all approved unsecured creditors and the payment of legal and professional fees related to the case.

On May 31, 2007,
USEB completed it financing with a private equity fund obtaining $80,000,000 in financing and satisfying its $66,000,000 obligation to Countryside, paying the $5,250,000 due the Illinois Commerce commission pursuant to the settlement agreement and
paying its unsecured creditors the full value of all undisputed claims. The debt is in the form of a $77,000,000 fixed term obligation and a $3,000,000 revolving credit facility. Interest is based on LIBOR plus 4.50% and is adjusted every three
months for the subsequent three month period. The current interest rate is 9.88%. Interest is payable quarterly and principal reductions are based upon the excess cash flow generated by USEBs operations. USEY issued $2,000,000 of its common
stock as part of the payment of USEBs $66,000,000 obligation to Countryside. The debt is collateralized by all of USEBs assets. In connection with the debt facilities, USEB agreed to a sharing of net profits for a significant number of
years following the amortization or prepayment of the debt. This net profit interest will be cancelled and no sharing of net profits will be required if US Energy sells a controlling interest in USEB by February 28, 2008 and prepays the debt
facilities, subject to an additional interest payment. Any sale of a controlling interest in USEB is subject to Silver Points consent. The maturity date of the debt is May 31, 2014.

NASDAQ Delisting Notice

On April 18, 2007, the
Company received a NASDAQ Staff Determination notice indicating that, due to the Companys failure to timely file its Annual Report on Form 10-K for the fiscal year ended December 31, 2006, the Company was no longer in compliance with the
requirements for continued listing as set forth in NASDAQ Marketplace Rule 4310(c)(14). On May 22, 2007, the Company received a similar NASDAQ Staff Determination notice due to the Companys failure to timely file its Quarterly Report on Form
10-Q for the quarter ended March 31, 2007. The Companys securities are therefore subject to delisting from the NASDAQ Capital Market. The Companys failure to file these reports on a timely basis constitutes a breach of the UK and Silver
Point financing agreements. The Company must file the Quarterly Report on Form 10-Q for the quarter ended March 31, 2007 no later than June 14 to cure the breach. In accordance with the procedures of the NASDAQ Stock Market, the Company requested a
hearing before the NASDAQ Listing Qualifications Panel (the Panel) to review the NASDAQ Staff Determination. The Company has received a response from the NASDAQ Office of General Counsel indicating that the suspension of trading and
delisting of the Companys securities will be stayed pending the Panels decision subsequent to a hearing scheduled to take place on June 7, 2007.

DESCRIPTION OF OPERATIONS AND FACILITIES

The Companys principal operations include the following:

U.S. Energy Biogas Corp.

Effective on
November 28, 2006, the Company owns 100% of USEB. USEB owns and operates 23 biogas projects (Biogas Projects). The Biogas Projects currently have approximately 52MW of electric generation capacity. Nineteen of the 23 Biogas Projects
have contracts with local electric utilities for the sale of electrical output. The contracts have a weighted average remaining life of approximately 11 years, based upon the revenue generated from the project operations. The Brookhaven project
leases electric generation equipment to a third party, which in turn has a contract to sell the output to an electric utility. The remaining three Biogas Projects sell landfill gas for use as boiler fuel under long-term contracts. All of the
generation projects are qualified as renewable energy projects.



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During 2006, USEB sold 269,917,000 kwh of electricity and 653,185 mmbtus of landfill gas as a substitute
for natural gas to its customers. For 2006, 4,246,000 mmbtus of landfill gas was consumed through either the production of electricity or through the sale of the gas. The average sale price per megawatt hour (mwh) was $66/mwh including
the subsidy received under the Illinois Retail Rate Program of $27/mwh. Excluding the subsidy, the average sales price per mwh was $39, of which $32 is production from the Illinois projects participating in the Illinois Retail Rate Program and $63
is from the other electricity generating projects. The average price per mmbtu of landfill gas sold as a substitute to natural gas was $3.95. The average cost of the landfill gas acquired for the production of energy was $0.47/mmbtu.

Also during 2006, USEB sold $349,000 worth of renewable energy credits (REC). One REC is produced when the project sells one megawatt of
qualified renewable energy to the utility grid. The average sales price per REC was $35. The contracts do not require USEB to deliver any specified quantities of RECs. A portion of gross proceeds from the sale of the RECs for one project totaling
approximately $15,400 was paid to the local utility pursuant to an agreement with the utility. Amounts paid to the utility pursuant to the agreement are recorded as operating expenses. The REC revenue is in addition to the energy value which is sold
under a separate contract. In 2007, USEB registered 234,900 RECs from the production in 2006 and is currently marketing the RECs for sale.

Approximately 71% of the engine generating capacity of the Biogas Projects is operated and maintained by two third-party operators under fixed price per unit of production contracts. The balance of the engine generating capacity is operated
and maintained by USEB staff.

USEB competes with other landfill gas developers in obtaining the rights to the landfill gas from the
landfill owners. As the number of operating landfills decreases, competition for the gas rights agreements with the landfill owners increases as fewer opportunities are available. Once USEB obtains the rights to the gas, there is no direct
competition for the sale of the energy derived from the landfill gas. It is either sold directly to the local utility or to an end user under a long term contract.

Commercial Structure of the Biogas Projects

The Biogas Projects may incorporate up to three separate legal entities
as further described below.

Gasco

Gascos are the legal entities that typically own the biogas extraction rights and collection systems and collect and sell the biogas to an electric generating facility (Genco) and/or a gas transmission
facility (Transco), as the case may be, under long-term, fixed-rate contracts. Gascos are typically structured as limited partnerships whereby the beneficiaries of the Section 29 tax credits own a 99% limited partnership interest in
the Gasco and USEB, directly or indirectly, owns a 1% general partnership interest or less in the Gasco. The limited partnership interests are held by investment grade third parties.

The price for the landfill gas sold by the Gascos to the Gencos and/or Transcos is established in the applicable gas purchase agreement. The Gencos
typically incur various expenses and provide operating and maintenance services for the Gascos. The Gascos reimburse the Gencos for these items per the terms of the landfill gas purchase agreement. The total revenues received by the Gascos for the
sale of biogas is approximately equal to the total reimbursement to the Gencos.

Genco

Gencos are the legal entities that typically own the power generating equipment, purchase the biogas from a Gasco and sell the electricity it generates to
an electric utility or industrial user under long-term contracts. The Biogas Projects include 19 Gencos that are wholly-owned subsidiaries of USEB, except for the Illinois-based



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projects, which are owned 50% by USEB and 50% by an unaffiliated entity, Landgas of Illinois Corp. Gencos typically lease a portion of a landfill site from
an independent third party landfill owner and pay the landfill owner a percentage of revenues as a site lease payment. The terms of the site leases typically are coterminous with the projects gas rights agreement with the same landfill owner.
One Genco owns the land used as the site for the generating plant.

Transco

Transcos are the legal entities that typically own the gas transportation equipment and purchase biogas from a Gasco to transport and sell to a third
party as boiler fuel under long-term contracts. The Biogas Projects include three Transcos which are all wholly-owned subsidiaries of USEB. Transcos typically lease a portion of a landfill site from an independent third party landfill owner and pay
the landfill owner a percentage of revenues as a site lease payment. The terms of the site leases typically are coterminous with the projects gas rights agreement with the same landfill owner.

GBGH, LLC

GBGH, LLC, which is owned 79% by the
Company, completed the acquisition of the UK Assets on August 7, 2006 through its wholly-owned subsidiary, UK Energy Systems, LTD (UKES). The assets are operated by wholly-owned subsidiaries of UKES, Viking UK Gas, LTD and RGS
Energy, LTD. Included in the assets the subsidiaries operate is the Knapton Generating Station (the Generating Station), a 42 MW single cycle, gas-fired combustion turbine that was acquired from Scottish Power. Immediately upon the
closing of the acquisition, UKES commenced Phase I of the Expansion.

Phase I of the Expansion consisted of improvements to the natural gas
production and collection system with the goals of maximizing the natural gas supply to the Generating Station to enable the station to produce electricity on a 24/7 basis and allowing for the conversion of the natural gas reserves in the fields to
proven reserves from probable reserves. Phase I included the drilling of a sidetrack well in the Kirby Misperton field, drilling a new well in the Ebberston Moor field, installing a compression unit and other operational issues. The acquisition
financing agreements required that the Generating Station be operational on a 24/7 basis for a required period of time by March 7, 2007.

The Generating Station became operational on a 24/7 basis in November 2006. By December 31, 2006, the Generating Station satisfied 24/7 operational time requirements of the financing. For the period from the acquisition date
August 7, 2006, through December 31, 2006, the plant produced 42,439 mwhs of electricity as summarized below:



|          |  |       
|--------- |  | ------
|          |  | MWHs  
|August    |  | 3,003 
|September |  | 4,428 
|October   |  | 4,286 
|November  |  | 2,751 
|December  |  | 27,971
|          |  |       
|Totals    |  | 42,439
|          |  |       

As part of the acquisition of the Knapton Generating Facility from Scottish Power, the Company
entered into a power purchase agreement and a gas sales agreement with Scottish Power under which Scottish Power is required to purchase all of the electricity generated by the Knapton Generating Facility for a period of 12 years or until they
receive 100 bcfs of natural gas. Due to the contract, the Company is not in competition with other electricity generators for the sale of the electricity. Currently, all of the gas production is being utilized by the Knapton Generating
Facility for the production of electricity. All of the gas production is in or around North Yorkshire, England.



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For the period from the acquisition date, August 7, 2006 through December 31, 2006, the gas
production wells produced 415 million standard cubic feet (MMscf) of natural gas as summarized below:



|          |  |      
|--------- |  | -----
|          |  | MMscf
|August    |  | 30   
|September |  | 49   
|October   |  | 44   
|November  |  | 33   
|December  |  | 259  
|          |  |      
|Totals    |  | 415  
|          |  |      

As of December 31, 2006, UKES was operating six gas production wells throughout its license
areas.

On December 31, 2006, the turbine at the Generating Station experienced sudden vibrations and was shut down. Subsequent
inspections revealed damage to the Low Pressure Turbine. The turbine was shipped offsite for repairs and was replaced with a leased turbine of the same make, model and generating capacity which began operations on January 13, 2007. The repair
of the damaged turbine was completed and was reinstalled in March 2007. A claim of approximately $1,850,000, based upon the exchange rate as of December 31, 2006 of 1.9586 US dollars to 1 pound sterling, has been submitted to the insurance
carrier for reimbursement. It is anticipated that the Company will receive the full amount of the property claim.

OTHER OPERATIONS AND INTERESTS

Plymouth Envirosystems, Inc.:Our wholly-owned subsidiary, Plymouth Envirosystems, Inc., owns a 50% interest in Plymouth
Cogeneration Limited Partnership (Plymouth Facility) which owns and operates a CHP plant producing 1.2 MW of electricity and 7 MW of heat at Plymouth State College, in Plymouth, New Hampshire. The Plymouth Facility provides, under a
long-term contract, 100% of the electrical and heating requirements for the campus, which is a part of the University of New Hampshire system.

The day-to-day operations of the Plymouth Facility are managed by one of the partners in this facility. Management decisions are made by a committee composed of representatives of the three partners in this project.

EMPLOYEES

At December 31, 2006, the Company,
directly or indirectly, employed approximately 60 employees, excluding personnel at facilities operated and maintained by third parties.

GOVERNMENT
REGULATION

None of the Companys energy projects in the United States are currently subject to federal or state utility rate
regulation.

Separate from federal and state utility rate regulation, the construction and operation of power generation facilities require
numerous permits, approvals and certificates from appropriate federal, state and local governmental agencies, as well as compliance with environmental protection legislation and other regulations. We believe that we are in substantial compliance
with all applicable rules and regulations and that the projects in which we are involved have the requisite approvals for existing operations and are operated in accordance with applicable laws.



|ITEM 1A. | RISK FACTORS
|-------- | ------------

Set forth below and elsewhere in this
report and other documents we file with the Securities and Exchange Commission (SEC) are risks and uncertainties that could cause actual results to differ materially from the results contemplated by the forward looking statements
contained in this report.



7



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Our operations are not profitable and may not become profitable in the future.

We had net losses of $27,574,000, $9,466,000 and $9,244,000 in 2006, 2005 and 2004, respectively, and losses from operations of $7,521,000, $801,000 and
$4,029,000 in 2006, 2005 and 2004, respectively. Our ability to become profitable depends significantly upon factors over which we have limited or no control. Those factors include, among other things, the quantity and quality of our
subsidiaries long term fuel supply, fluctuations in foreign currency exchange rates, rates paid for energy sales, the continuing development of the green energy market and interest rates. While we are pursuing value enhancement alternatives,
including accreditive acquisitions, there can be no assurance that we will become profitable.

Our subsidiaries have substantial indebtedness and
related interest expense and in connection with their existing indebtedness we have agreed to significant restrictions upon their operations, including their ability to use their cash.

We have substantial debt that has been incurred to finance the acquisition and development of energy facilities. As of December 31, 2006, our total
consolidated debt, exclusive of debt issuance costs which offset the debt for financial statement presentation purposes, was $266,341,000. Our interest expense in 2006 was $22,971,000. For the debt associated with the UK Transaction, the interest
associated with a portion of the debt is not paid currently but added to the outstanding principal balance thereby increasing subsequent periods interest expense.

The actual quantity and quality of the landfill gas extracted by USEB from the various landfills may vary from that anticipated by management which could result in lower production and a subsequent reduction in
revenues.

The quantity and quality of the landfill gas extracted by USEB from the various landfills is predicated on
variables over which the Company has no control, including the rate at which the landfill accepts trash, the type of trash the landfill accepts, the application of landfill cover by the landfill operator and other operating characteristics of the
landfill. Changes in these variables can effect the quantity and quality of the landfill gas produced by the landfill, a decrease of which could result in a reduction of USEBs production and revenues.

We have rate risk in the replacement of electricity rates received within the Illinois Retail Rate Program.

Ten of USEBs Illinois projects were participating in the Illinois Retail Rate Program (the Program), which provided subsidies in excess
of the utilitys avoided costs rates. This subsidy was in the form of a 10 year interest free loan. As part of USEBs settlement with the ICC, USEB agreed to withdraw its ten Illinois projects from the Program effective May 31, 2007,
which terminated each projects eligibility to receive the subsidized rates. USEB must now sell its output from the Illinois projects at market rates which may not be equivalent to those provided under the Program. During 2006, 2005 and 2004,
the Company received 19%, 21% and 26%, respectively, of its revenues from the rates provided under the Program.

A significant source of USEBs
revenues are generated from special tax credits provided for the sale of landfill gas to third parties and these credits expire on December 31, 2007.

USEB benefits from Section 29 of the Internal Revenue Code (Section 29). Section 29 provides that owners of biogas facilities that collect and sell biogas as fuel are permitted to reduce their
annual federal income tax liability with a tax credit based upon the volume of the biogas sold to unrelated third parties. USEB has sold interests in the Gascos producing these tax credits to financial investors and such sales have provided USEB
with additional revenue. Part of the purchase price is contingent on gas production. If gas production were to fall, USEBs revenues may decline.

The tax credit is available for biogas produced at projects that had existing gas collection facilities that were placed in service before July 1, 1998. The tax credits are available for qualifying projects until
December 31, 2007, except that projects which were in operation prior to 1993 qualified for the tax credits only through 2002. Upon the expiration of the Section 29 tax credits on December 31, 2007, USEBs revenues may be
reduced. Revenues related to the Section 29 tax credits were $914,000, $926,000, and $1,212,000 for 2006, 2005 and 2004, respectively.



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Neither USEB, nor any of the Gascos, nor any Gasco partners have received a ruling from the IRS
confirming that the biogas facilities of the Gascos meet the requirements of Section 29, that the sales of interests in the Gascos by USEB were structured in a way that would entitle the buyers to Section 29 credits, or that sales of
methane from the Gascos to the Gencos or Transcos generate Section 29 credits. While a ruling is not required, as is the case with any Section 29 transaction in which a ruling is not obtained, the IRS may challenge the availability of
Section 29 credits to any of the Gascos or to other partners. USEB has agreed to indemnify the financial investors that have purchased interests in the Gascos for certain losses suffered by such investors in the event that the Section 29
tax credits are denied in certain circumstances.

Under Section 29, the amount of the tax credit generated from non-conventional fuel
sources, such as landfill gas, shall be reduced or eliminated should the reference price of an equivalent barrel of energy (EBE) utilized to establish the value of the credit reach certain levels. Should the EBE reference price exceed
the specified levels, the resultant decline in the tax credit value generated by the sale of landfill gas by USEB will reduce the amount of proceeds USEB receives related to the tax credits. For the year 2006, based on a reference price for oil of
$59.28, the value of the 2006 section 29 tax credits were reduced by 33% due to this phase out provision.

We may face substantial impediments to
completing future acquisitions and development projects.

Our growth strategy depends on our ability to identify and acquire
appropriate companies or energy projects, our ability to develop new energy projects, our ability to integrate the acquired and developed operations effectively and our ability to increase our market share. We cannot assure you that we will be able
to identify viable acquisition candidates or development projects, that any identified candidates or development projects will be acquired or developed, that acquired companies or power facilities and developed projects will be effectively
integrated to realize expected efficiencies and economies of scale, or that any acquisitions or development projects will prove to be profitable or be without unforeseen liabilities. In the event that acquisition candidates or development projects
are not identifiable or acquisitions or development projects are prohibitively costly, we may be forced to alter our future growth strategy. As we continue to pursue our acquisition and development strategy in the future, our stock price, financial
condition and results of operations may fluctuate significantly from period to period.

We may be unable to acquire or renew the numerous permits and
approvals required to operate power facilities.

The construction and operation of energy projects, both in the United States and
the United Kingdom, require numerous permits and approvals from governmental agencies, as well as compliance with environmental laws and other regulations. While we believe that we are in substantial compliance with all applicable regulations and
that each of our projects has the requisite approvals, our projects require compliance with a varied and complex body of laws and regulations that both public officials and private individuals may seek to enforce. There can be no assurance that new
laws or amendments to existing laws which would have a materially adverse affect will not be adopted, nor can there be any assurance that we will be able to obtain all necessary permits and approvals for proposed projects or that completed
facilities will comply with all applicable permit conditions, statutes and regulations. In addition, regulatory compliance for the construction of new facilities is a costly and time consuming process which may necessitate substantial expenditures
to obtain permits, and may create a significant risk of expensive delays or loss of value if a project is unable to function as planned due to changing requirements or local opposition.

We are subject to commodity price risk.

The price received for our energy output is subject
to market fluctuations and our revenues, operating cash flows and remaining cash reserves are dependent upon the price of electricity and gas. Changes in the market price for energy could substantially reduce revenues, operating cash flows and could
result in a reduction in the carrying value of our gas assets and goodwill. While the energy prices for the output from the UK Assets are hedged, establishing a minimum floor pricing for our output, the hedge expires in July 2009 and subsequent to
the expiration of the hedge, UK sales will be subject to market fluctuations.



9



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##### Table of Contents

The actual natural gas reserve acquired in the UK Transaction may be below estimated quantities or quality and the
actual costs associated with location and extraction of the gas may exceed current estimates.

The actual quantities of natural gas
reserves acquired in the UK Transaction and the costs associated with the location and extraction of the natural gas, while based upon professional, third-party engineering studies, may vary from estimates as they constitute future events which
cannot be predicted with certainty. In the event the actual amounts of natural gas fall below estimated quantities or the cost associated with the exploration and extraction of the gas exceed estimated costs, the net cash flow derived from the UK
operations may be adversely affected. A reduction in the actual amount or quality of gas available for the production of energy would have a negative effect on the Companys revenues and could result in a reduction in the carrying value of our
gas assets.

We have risks associated with the exploration for gas.

We have risks associated with gas exploration including the failure to locate adequate gas reserves, the investment in dry wells or wells that do not
result in adequate output and cost overruns associated with the construction of the wells and the distribution system. In addition, we have safety and environmental risks associated with the exploration, development and construction process.

US Energy is a holding company and has no operations or revenues.

US Energy is a holding company. All of its operations are conducted through its subsidiaries. Its operating subsidiaries have substantial debt, and the
terms of the loan agreements underlying such debt restrict the subsidiaries ability to declare dividends or otherwise transfer cash or assets to US Energy. In particular, USEB has agreed to a sharing of its net profits in connection with the
Silver Point financing which will result in limitations on USEBs ability to declare dividends to US Energy for a significant number of years following the amortization or prepayment of the Silver Point financing. If US Energy were able to sell
a controlling interest in USEB by February 28, 2008 and prepay the Silver Point financing, the net profits interest will be cancelled and no sharing of net profits will be required, subject to an additional interest payment. Any sale of a
controlling interest in USEB is subject to Silver Points consent. US Energy relies on a USEB management agreement with Silver Point and issuances of US Energy common stock to fund US Energys expenses. Due to certain contractual
restrictions, there can be no assurance that US Energy will receive all, or any portion, of the management fee. If US Energy issues its common stock to raise funds, there can be no assurance that it will be at current market rates, which would be
dilutive to existing stockholders.

We may have insufficient funds available to complete the expansion plans for the UK Assets which could have a
material adverse effect on the Companys operations and value.

The Company has significant reserves intended to fund the
expansion plans for the UK Assets but those funds may not be adequate to complete the expansion as planned or for any modified expansion plans. If current funds are insufficient, the Company would have to obtain such funds through the execution of a
refinancing or through the raising of additional equity. There can be no assurance that the Company could refinance or raise additional equity and, if so, whether it would be on acceptable terms. The failure to obtain such funds would have a
material adverse effect on the Companys operations and value.

US Energy has insufficient funds currently available to fund the required
additional contributions pursuant to the UK financing agreements.

US Energy does not have sufficient funds currently available to
fund the required additional contributions pursuant to the UK financing agreements. US Energy intends to obtain these funds through a refinancing or through the raising of additional equity. There can be no assurance that US Energy could refinance
or raise additional equity and, if so, whether it would be on acceptable terms. The failure to obtain such funds would have a material adverse effect on the Companys operations and value.

We have risks associated with compliance with various agreements and contracts.

The Company and its subsidiaries operate under various contractual obligations and financing agreements. A failure to maintain compliance with these
contracts and obligations could result in the cancellation or non-renewal of the contract which may have a negative effect on the operations of the Company.

We have limited available capital, and we may need additional financing in the future.

We believe that our current
and anticipated cash flow from operations, financings and equity transactions will be sufficient to meet our anticipated cash requirements for the next twelve months; however, there can be no assurance in this regard. If we are unable to generate
cash flows from operations to fund our working capital needs or other contemplated expenditures, we would be required to obtain additional equity or debt financing to continue to operate our business. In addition, we anticipate that each project we
acquire or develop will require us to raise additional financing, some of which may be in the form of additional equity.

Our ability to
raise additional funds is restricted by our financing arrangements which, among other things, limit our and our subsidiaries ability to issue equity, incur debt or sell assets. In particular, the Silver Point financing



10



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##### Table of Contents

arrangements prohibit us and our subsidiaries from incurring any additional debt and require us, with certain exceptions, to prepay the UK Silver Point loan
if, among other things, we or our subsidiaries issue equity. As the result of the sale of $6,400,000 worth of U.S. Energy Systems, Inc.s common stock, as further described in Note X to the consolidated financial statements, the Company paid
Silver Point $1,700,000 against the UK loan and is obligated in the future to make additional payments against the UK loan equal to 50% of the net proceeds from any future equity sales. Further, Silver Point has the exclusive right to arrange
financing for us through December 31, 2007.

There can be no assurance that additional financing will be available to us, or if
available, that it will be on terms acceptable to us. If we are required to issue equity to raise additional funds, significant dilution to existing stockholders may result. If additional financing for projects is not available on acceptable terms,
we may have to cancel, decline or defer new projects. Any inability by us to obtain additional financing to meet cash or capital requirements, if required, may have a material adverse effect on our operations.

There are environmental health and safety risks which may result in additional expense, capital expenditures, restrictions and delays in projects and
systems activities, the extent of which cannot be predicted and which may be material.

Our projects are regulated by
numerous and significant laws, including statutes, regulations, by-laws, guidelines, policies, directives and other requirements governing or relating to, among other things: air emissions, discharges into water, the storage, handling, use,
transportation and distribution of dangerous goods and hazardous and residual materials, such as chemicals; the prevention of releases of contaminants, pollutants or hazardous materials into the environment; the presence, remediation and monitoring
of contaminants, pollutants or hazardous materials in soil and water, including surface or groundwater, both on and off site; land use and zoning matters; and workers health and safety matters. As such, the operation of the projects and systems
carry an inherent risk of environmental, health and safety liabilities (including potential civil actions, compliance or remediation orders, fines and other penalties), and may result in the projects and systems being involved from time to time in
administrative and judicial proceedings relating to such matters, which could have a material adverse effect on the Companys business, financial condition and results of operations.

Our projects have obtained environmental permits that are required for their operation. Although we believe that the operations of the facilities are
currently in material compliance with applicable environmental laws, including permits required for the operation of the projects and systems and although there are environmental monitoring and reporting systems in place with respect to all the
projects and systems, there is no guarantee that more stringent laws will not be imposed, that there will not be more stringent enforcement of applicable laws or that such systems may not fail, which may result in material expenditures. Failure by
the projects and systems to comply with any environmental, health or safety requirements, or increases in the cost of such compliance, including as a result of unanticipated liabilities (whether as a result of newly discovered issues or known issues
that have not been quantified) or expenditures for investigation, assessment, remediation or monitoring, could result in additional expense, capital expenditures, restrictions and delays in the projects and systems activities, the extent
of which cannot be predicted and which may be material.

We depend on our electricity and landfill gas customers.

Our energy facilities rely on one or more energy sales agreements with one or more customers for a substantial portion of their revenues. Any material
failure by any customer to fulfill its obligations under an energy sales agreement could have a negative effect on the cash flow available to us and on our results of operations. Commonwealth Edison accounted for 33%, 39% and 42% of our revenues in
2006, 2005 and 2004, respectively. Our business of owning and operating power plants and district energy systems involves considerable operating risk.

Our equipment may break down which could have an adverse effect of operating results and cash flows.

The operation
of energy generation facilities involves many risks, including the breakdown or failure of power generation, heating and cooling equipment, transmission lines, pipes or other equipment or processes and performance below expected levels of output or
efficiency. Although we have insurance that will allow us to recover certain expenses and lost revenues, such insurance is subject to deductibles and other limitations. Any costs incurred or revenue lost and not recovered through such insurance
could have an adverse effect on operating results and cash flows.



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Some of our projects are operated by independent, third party operators.

USEBs ten Illinois projects are operated by two independent third-party operators. USEB is and will be dependent on these third party operators for
the successful operation of these projects. To the extent that these parties do not fulfill their obligations, USEBs operations at these projects could be adversely affected.

The energy business is very competitive and increased competition could adversely affect us.

In addition to competition from electric utilities in the markets where our projects are located, our energy business also faces competition from companies currently involved in the cogeneration, landfill gas to energy market and the
independent power market. Some of these companies are larger and better financed than we are. No assurances can be made that there will not be significant competition in such markets. Additionally, in recent years, such competition has contributed
to a reduction in electricity prices in certain markets.

We may experience project development risks.

Our ability to develop new projects is dependent on a number of factors outside our control, including obtaining customer contracts, power agreements,
governmental permits and approvals, fuel supply and transportation agreements, electrical transmission agreements, site agreements, permits and appraisals. Project development involves significant environmental, engineering and construction risks.

Although we have insurance it may not cover every potential risk associated with our operations.

Although we maintain insurance of various types to cover many of the risks that apply to our operations, including $1,000,000 of general liability
insurance, a $20,000,000 umbrella policy, as well as separate insurance for each project, our insurance will not cover every potential risk associated with our operations. The occurrence of a significant adverse event, the risks of which are not
fully covered by insurance, could have a material adverse effect on our financial condition and results of operations. Moreover, no assurance can be given that we will be able to maintain adequate insurance in the future at rates we consider
reasonable.

We have numerous outstanding options and warrants which may adversely affect the price of our common stock.

As of December 31, 2006, we had outstanding options, restricted stock units, both vested and unvested, and warrants to acquire up to an aggregate of
17,539,139 shares of our common stock at prices ranging from $0.01 to $25 per share. For the term of the agreements, the holders thereof will have an opportunity to profit from a rise in the market price of our common stock without assuming the risk
of ownership. This may have an adverse effect on the price of our common stock and on the terms upon which we could obtain additional capital.



12



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##### Table of Contents

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



|ITEM 1B. | UNRESOLVED STAFF COMMENTS
|-------- | -------------------------

Not applicable.



|ITEM 2. | PROPERTIES
|------- | ----------

Property owned by USEBs projects
includes all buildings and improvements, electricity generating equipment, switchgears, controls and associated ancillary equipment. USEB has no ownership interest in the landfills, nor does it have any contractual responsibility, environmental or
legal liability for the operation of the landfills. USEB projects (Gencos, Transcos and Gascos) occupy land on the landfills pursuant to leases. At the end of the lease, USEB is obligated to return the leased site to the state such site was in
immediately prior to the construction of the project. This obligation includes the removal of the generating equipment, switchgear and the peripheral equipment structures. The costs incurred to fulfill this obligation are immaterial and are expensed
as incurred. One USEB project owns the land used as the site for the generation plant. Substantially all of USEBs project assets are collateral for the USEB loan from Silver Point (see Item 1). USEB rents office space in Avon, Connecticut and
Bohemia, New York.

Property owned by GBGH or its subsidiaries includes all buildings, electricity generating equipment and gas collection
assets related to the UK operations. Included in the assets of GBGH is a 42 MW single cycle, gas-fired combustion turbine and gas licenses for approximately 100,000 acres of onshore natural gas properties and mineral rights in North Yorkshire,
England. Please refer to the Supplementary Gas Data discussion contained in the consolidated financial statements for a detailed discussion of gas reserves. All of GBGHs assets are collateral for the financings associated with the acquisition.
GBGH rents office space in London, England.

Plymouth Cogeneration, a Delaware partnership, of which we own 50%, owns the Plymouth
Facility. Plymouth Cogeneration owns plant and equipment associated with the cogeneration project including the engines, generators, boilers, switchgear, controls and piping.

The Lehi Facility is owned by LIPA, a Utah limited liability company, of which we own 50%. The property is in Lehi, Utah, and includes land, buildings
and permits. The Company has no asset value recorded on its books for this investment as management believes that the assets owned by the company has little or no value.

Our executive headquarters are located in a commercial office building in New York City and the financial management function is located in an office building in Avon, Connecticut.

All our properties are in satisfactory condition and we believe that they are adequately covered by insurance.



|ITEM 3. | LEGAL PROCEEDINGS
|------- | -----------------

See Chapter 11 Filing by
U.S. Energy Biogas Corp. in Item 1. Business above.

On or about March 20, 2007, Marathon Capital Holdings (UK), LLC
(Marathon) and Richard T. Brandt II as director, filed suit in the Supreme Court of the State of New York against the Company, one of its subsidiaries and certain officers and directors of the Company. The suit asserts causes of action
seeking permanent injunctive relief directing the defendants to provide the plaintiffs with access to the books and records of the Company and to allow the plaintiffs to more fully participate in the management and affairs of the Company. The suit
seeks an award of attorneys fees and costs in connection with the litigation, but does not otherwise seek monetary damages. The defendants intend to vigorously defend against the suit.



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##### Table of Contents

|ITEM 4. | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
|------- | ---------------------------------------------------

At the Companys annual stockholders meeting held on November 6, 2006, our stockholders elected Asher E. Fogel and Stephen L. Brown as directors, casting the following votes:



|                 |  |                |  |               
|---------------- |  | -------------- |  | --------------
|                 |  | Votes In Favor |  | Votes Withheld
|Asher E. Fogel   |  | 14,679,957     |  | 356,852       
|Stephen L. Brown |  | 13,540,159     |  | 1,496,650     

Jacob Feinstein, Carl W. Greene, Lawrence I. Schneider and Ronny Strauss continued as directors
after the Companys annual stockholders meeting. In December 2006, Messrs. Brown, Greene and Schneider resigned from the Board.

The
stockholders also voted to: (1) approve the issuance of shares of common stock upon the exercise and conversion of securities issued in connection with the UK Transaction and (2) approve an amendment to the Companys Certificate of
Incorporation increasing the number of shares of common stock that the Company is allowed to issue to 75,000,000. Both items were approved with votes cast as follows:



|                                                                                                      |  |                |  |               |  |                
|----------------------------------------------------------------------------------------------------- |  | -------------- |  | ------------- |  | ---------------
|                                                                                                      |  | Votes In Favor |  | Votes Against |  | Votes Abstained
|Issuance of common stock upon the exercise and conversion of securities related to the UK Transaction |  | 6,519,231      |  | 205,929       |  | 32,831         
|To amend the Certificate of Incorporation to increase number of authorized shares                     |  | 14,720,695     |  | 292,961       |  | 23,152         

PART II



|ITEM 5. | MARKET FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASE OF EQUITY SECURITIES
|------- | -----------------------------------------------------------------------------------------------------------

PRICE RANGE OF COMMON STOCK

Our common stock trades
on the NASDAQ Capital Market under the symbol USEY. The table below sets forth, for the periods indicated, the high and low sales prices for the common stock as reported by the NASDAQ Capital Market.



|                             |  |                |      |     |   |     
|---------------------------- |  | -------------- | ---- | --- | - | ----
|                             |  | Closing Prices
|                             |  | High           |      | Low
|Year ended December 31, 2005 |  |                |      |     |   |     
|First Quarter                |  | $              | 1.94 |     | $ | 0.74
|Second Quarter               |  |                | 1.37 |     |   | 0.81
|Third Quarter                |  |                | 1.68 |     |   | 0.95
|Fourth Quarter               |  |                | 2.84 |     |   | 1.17
|                             |  |               
|Year ended December 31, 2006 |  |                |      |     |   |     
|First Quarter                |  | $              | 3.10 |     | $ | 2.12
|Second Quarter               |  |                | 4.35 |     |   | 2.36
|Third Quarter                |  |                | 6.90 |     |   | 3.11
|Fourth Quarter               |  |                | 5.38 |     |   | 3.34



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On June 1, 2007, the reported closing sale price per share of common stock on Nasdaq was $4.72.

Stock Performance Graph

The following
performance graph shows a comparison of cumulative total stockholder returns for our common stock with the cumulative returns on the NASDAQ-US Index and the S&P 500 SmallCap 600 Index and assuming that on December 31, 2001, $100 was
invested in our common stock and the other indices and that all dividends were reinvested. We note that the total stockholder return performance shown in the graph below is not indicative nor intended to forecast the potential future performance of
our common stock.



|                       |  |      |       |      |   |        |  |      |        |      |   |        |  |   |       
|---------------------- |  | ---- | ----- | ---- | - | ------ |  | ---- | ------ | ---- | - | ------ |  | - | ------
|                       |  | 2002 |       | 2003 |   | 2004   |  | 2005 |        | 2006
|U.S. Energy            |  | $    | 20.61 |      | $ | 24.78  |  | $    | 17.54  |      | $ | 49.12  |  | $ | 113.16
|NASDAQ Composite Index |  |      | 68.47 |      |   | 102.72 |  |      | 111.54 |      |   | 113.07 |  |   | 123.84
|S&P SmallCap 600 Index |  |      | 84.68 |      |   | 116.47 |  |      | 141.61 |      |   | 151.03 |  |   | 172.29

LOGO

DIVIDENDS

We have not paid cash dividends on our common stock and currently do not anticipate paying cash dividends on our common stock in the foreseeable future. Our ability to pay cash dividends on our common stock may be limited by our outstanding
shares of preferred stock. Generally, no dividends may be paid on our common stock unless dividends have been set aside for the outstanding preferred stock. The Companys ability to pay dividends on common stock are limited by the various
financing arrangements with the Companys subsidiaries.



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EQUITY COMPENSATION PLAN INFORMATION AS OF DECEMBER 31, 2006



|                                                           |  |                                                                         |  |                                                                                 |            |                                                                                               |          
|---------------------------------------------------------- |  | ----------------------------------------------------------------------- |  | ------------------------------------------------------------------------------- | ---------- | --------------------------------------------------------------------------------------------- | ---------
|Plan Category                                              |  | Number of securities to beissued upon exercise ofoutstanding options(1) |  | Weighted-average exerciseprice of outstanding optionsunder
compensationplans(1) |            | Number of securitiesremaining available forfuture issuance under equitycompensation plans (2)
|Equity compensation plans approved by security holders     |  | 6,980,758                                                               |  | $                                                                               | 3.67/share |                                                                                               | 2,875,470
|Equity compensation plans not approved by security holders |  | 150,000                                                                 |  | $                                                                               | 4.83/share |                                                                                               | 0        
|                                                           |  |                                                                         |  |                                                                                 |            |                                                                                               |          
|Total                                                      |  | 7,130,758                                                               |  | $                                                                               | 3.69/share |                                                                                               | 2,875,470

---

|(1) | Does not include 976,015 restricted stock units as of December 31, 2006. Restricted stock units are not used in the calculation of the weighted average exercise price.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Represents the number of securities available for issuance after giving effect to the restricted stock units outstanding at December 31, 2006.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------

Equity compensation issued under plans not approved by security holders pertain to options issued prior to the year 2000. The exercise prices for these options range
from $4.00 to $7.00. No additional equity awards will be issued under any plans not approved by security holders.



|ITEM 6. | SELECTED FINANCIAL DATA
|------- | -----------------------

(Dollars in thousands, except share data)



|                                                   |  |      |         |   |      |   |         |      |  |   |         |   |      |   |         |  |   |         |  
|-------------------------------------------------- |  | ---- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | - | ---- | - | ------- |  | - | ------- | -
|                                                   |  | 2006 |         |   | 2005 |   |         | 2004 |  |   | 2003    |   | 2002 |  
|Total Assets                                       |  | $    | 346,930 |   |      | $ | 169,029 |      |  | $ | 175,788 |   |      | $ | 172,041 |  | $ | 219,008 |  
|Debt                                               |  |      | 225,126 |   |      |   | 89,161  |      |  |   | 87,814  |   |      |   | 70,084  |  |   | 114,277 |  
|Total Stockholders Equity                         |  |      | 31,477  |   |      |   | 16,173  |      |  |   | 26,942  |   |      |   | 39,085  |  |   | 38,754  |  
|Revenues                                           |  |      | 21,244  |   |      |   | 19,620  |      |  |   | 20,108  |   |      |   | 24,999  |  |   | 28,620  |  
|(Loss) Income from Operations                      |  |      | (7,521  | ) |      |   | (801    | )    |  |   | (4,029  | ) |      |   | 5,035   |  |   | (5,710  | )
|(Loss) Income Applicable to Common Stock           |  |      | (27,835 | ) |      |   | (10,292 | )    |  |   | (10,072 | ) |      |   | 1,009   |  |   | (16,979 | )
|Basic and Diluted (Loss) Earnings per Common Share |  | $    | (1.72   | ) |      | $ | (0.83   | )    |  | $ | (0.85   | ) |      | $ | 0.08    |  | $ | (1.39   | )

The following should be taken into consideration in reviewing this table:



|(1) | Our investment in a Swedish district energy system (SEFL) was included in our consolidated operating results from March 2002 through September 2003, at which time our
ownership interests were reduced to less than 50% and was accounted for by the equity method through 2003. In 2004, the entire net investment ($7,089) was written off.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(2) | USEB acquired its subordinated debt owed to AJG Financial Services on September 30, 2004 which resulted in a $2,729,000 gain in 2004.
|--- | -------------------------------------------------------------------------------------------------------------------------------------



|(3) | AJG Financial Services satisfied its obligation to pay for the remaining 50% ownership in certain Illinois Gencos which resulted in a $2,000,000 pre-tax gain in 2004. See Note H to
the consolidated financial statements.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(4) | USEY commenced operations related to the UK transaction on August 7, 2006.
|--- | --------------------------------------------------------------------------



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##### Table of Contents

|ITEM 7. | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
|------- | -------------------------------------------------------------------------------------

RECENT DEVELOPMENTS

On August 7, 2006, the Company completed the acquisition and financing of
certain energy assets in the United Kingdom through certain of its subsidiaries. Please refer to Note D of the consolidated financial statements for a description of the transaction.

See Item 1 for additional recent developments.

RESULTS OF OPERATIONS

Comparison of 2006, 2005 and 2004

Net Loss:

The net loss applicable to common stock of $27,835,000 for the year ended
December 31, 2006 represents an increase of $17,543,000 from the $10,292,000 net loss reported for the year ended December 31, 2005. The net loss for 2006 includes $996,000 of legal costs and other expenses related to the Countryside
settlement, $1,688,000 of expense related to the valuing of previously granted employee equity grants as required by SFAS 123R, a $3,595,000 reserve against the outstanding balance related to a note receivable for the sale of USEBs ownership
interest in certain gasco entities and $872,000 of expenses related to the settlement of the Zahren lawsuit. The balance of the change is primarily due to $9,137,000 of net operating losses from the UK operations which commenced operations on
August 7, 2006.

The net loss applicable to common stock of $10,292,000 for the year ended December 31, 2005 was an increase of
$220,000 from the $10,072,000 reported for the year ended December 31, 2004. The increased net loss in 2005 when compared to 2004 reflects a $4,409,000 increase in the valuation allowance against the deferred tax asset, as of December 31,
2004, a $1,357,000 increase in interest expense, a $332,000 increase in debt issuance costs resulting from the refinancing of USEBs debt with Countryside and a $1,353,000 increase in the valuation allowance against accounts receivable; which
were offset, in part, by a $4,214,000 decrease in foreign currency translation expense and a $6,560,000 gain in 2004 resulting from the sale of certain assets.

Operating Loss:

A summary of the principal components of operating loss follows:

(Dollars in thousands)



|                                    |  |      |        |   |      |   |        |      |  |   |        |  
|----------------------------------- |  | ---- | ------ | - | ---- | - | ------ | ---- |  | - | ------ | -
|                                    |  | 2006 |        |   | 2005 |   |        | 2004 | 
|Revenues                            |  | $    | 21,244 |   |      | $ | 19,620 |      |  | $ | 20,108 |  
|Operating Expenses                  |  |      | 13,260 |   |      |   | 9,721  |      |  |   | 9,646  |  
|General and Administrative Expenses |  |      | 9,367  |   |      |   | 6,399  |      |  |   | 3,241  |  
|Depreciation and Amortization       |  |      | 6,249  |   |      |   | 4,611  |      |  |   | 4,279  |  
|Investment Writeoffs                |  |      |       |   |      |   |       |      |  |   | 7,089  |  
|(Income) from Joint Ventures        |  |      | (111   | ) |      |   | (310   | )    |  |   | (118   | )
|                                    |  |      |        |   |      |   |        |      |  |   |        |  
|Loss from Operations                |  | $    | (7,521 | ) |      | $ | (801   | )    |  | $ | (4,029 | )
|                                    |  |      |        |   |      |   |        |      |  |   |        |  

REVENUES

The Companys 2006 revenues were $21,244,000 compared with $19,620,000 for 2005 and $20,108,000 for 2004. The increase of $1,624,000, or 8%, in 2006 from 2005 was primarily due to $2,384,000 in revenues related
to the UK operations which commenced operations on August 7, 2006 less a $760,000 reduction in USEB revenues resulting from a decrease in production.



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##### Table of Contents

The decrease in revenues in 2005 from 2004 of $488,000 or 2% was primarily due to fluctuations in rates
paid for electricity produced by USEB.

Included in revenues for 2006, 2005 and 2004 were $914,000, $926,000 and $1,212,000, respectively,
in revenues from the installment sales of certain partnership interests whose buyers benefit from Section 29 tax credits. Upon the expiration of these credits on December 31, 2007, revenues from these installment sales will cease. See Note
H of the consolidated financial statements.

The Companys future revenues may be reduced due to USEBs settlement with the
Illinois Commerce Commission (ICC) and the subsequent withdrawal, effective May 31, 2007, of USEBs Illinois projects from the Illinois Retail Rate Program effective May 31, 2007. USEB received $4,056,000, $4,082,000 and
$5,267,000 in revenues from the Illinois Retail Rate Program in 2006, 2005 and 2004, respectively. See Note F of the consolidated financial statements for further discussion of this issue. See Item 1A. Risk Factors for a discussion of such
concerns.

EXPENSES

Operating
Expenses: The Companys 2006 operating expenses were $13,260,000 compared with $9,721,000 in 2005 and $9,646,000 in 2004. Operating expense as a percentage of revenues was 62% in 2006, 50% in 2005 and 48% in 2004. Operating
expenses for 2006 increased by $3,539,000 from 2005 primarily due to $3,466,000 in operating expenses related to the UK operations which commenced operations on August 7, 2006. US operating expenses increased by $75,000, or less than 1%, from
2005 to 2006. Management expects operating expenses to increase in future periods as the UK operations continue to expand.

General and
Administrative Expenses: General and administrative expenses were $9,367,000 for 2006 and $6,399,000 for 2005, an increase of $2,968,000 or 46%. The increase is primarily due to the addition of $1,018,000 of expenses related to the UK
operations which commenced on August 7, 2006, an increase of $829,000 in legal and accounting fees related to US Energy operations, a $1,149,000 increase in salaries and benefits and a $1,668,000 increase in expense related to the valuing of
previously granted stock options as required by SFAS 123R. These increases were offset by a $488,000 reduction in fees related to the Development Agreement dated April 8, 2004 between the Company and Countryside and a $946,000 recovery of a
2005 charge against the allowance for doubtful accounts due to the collection of the receivable. The following table summarizes the components of these expenses for these years:



|                                                        |  |      |           |      |   |           |  |   |            |  
|------------------------------------------------------- |  | ---- | --------- | ---- | - | --------- |  | - | ---------- | -
|                                                        |  | 2006 |           | 2005 |   | 2004      | 
|General and Administrative Expenses                     |  |      |           |      |   |           |  |   |            |  
|Salaries, Other Compensation and Consulting             |  | $    | 3,215,000 |      | $ | 2,766,000 |  | $ | 5,659,000  |  
|Compensation Cost related to Options, 123R compensation |  |      | 1,668,000 |      |   |          |  |   |           |  
|Legal and Professional                                  |  |      | 1,776,000 |      |   | 1,371,000 |  |   | 712,000    |  
|Insurance                                               |  |      | 177,000   |      |   | 191,000   |  |   | 470,000    |  
|Corporate Expenses                                      |  |      | 1,171,000 |      |   | 1,017,000 |  |   | 412,000    |  
|UK Operations                                           |  |      | 1,018,000 |      |   |          |  |   |           |  
|Other                                                   |  |      | 342,000   |      |   | 1,054,000 |  |   | 827,000    |  
|Countryside Fund Expense Reimbursement                  |  |      |          |      |   |          |  |   | (4,839,000 | )
|                                                        |  |      |           |      |   |           |  |   |            |  
|Total:                                                  |  | $    | 9,367,000 |      | $ | 6,399,000 |  | $ | 3,241,000  |  
|                                                        |  |      |           |      |   |           |  |   |            |  

Management expects general and administrative expenses to increase in future periods as additional
staff and consultants are hired to handle the complex reporting requirements deriving from the various financing arrangements and to provide support for the execution of the Companys growth plans.

For 2004, general and administrative expenses included a non-recurring reimbursement from Countryside of $4,839,000 for expenses incurred by the Company
related to the Countryside transaction. This reimbursement was utilized in part to offset the non-recurring increase in additional compensation (approximately $2,900,000) awarded to employees generally pursuant to existing employment arrangements
and bonus plans.



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##### Table of Contents

When compared to the adjusted 2004 amount, the 2005 expense increased by $1,219,000 or 24%. This increase
was primarily the result of increases in accounting charges resulting from the required restatements of the 2004 financial statements and the change of auditors, $333,000, an increase in the reserve for bad debts related to USEBs accounts
receivable, $578,000 and increases in consulting and legal expenses, $485,000.

Depreciation and Amortization:
Depreciation and amortization expenses were $6,249,000 in 2006 compared with $4,611,000 for 2005, an increase of $1,638,000. The increase is primarily due to $1,148,000 of depreciation related to the UK Assets which were acquired on August 7,
2006. The increase of $332,000 in 2005 from the $4,279,000 for 2004 was related to an increase in the amortization of debt issuance costs related USEBs Countryside financing which closed in April, 2004. The annual amortization of these costs
was approximately $791,000. Depreciation expenses are expected to increase in future periods resulting from a full years depreciation of the UK Assets and the expansion of the asset base for the UK and USEB asset portfolios.

Interest and Dividend Income: Interest and dividend income for 2006 was $3,894,000, an increase of $442,000, or 13%, compared with
$3,452,000 for 2005. The increase is primarily due to an increase of $813,000 in interest earned on the various restricted cash accounts related to the UK Transaction less a reduction in interest associated with the various notes receivable due to
USEB due to the reduction in the outstanding principal balances. Interest and dividend income for 2005 increased by $624,000 or 22% from the $2,828,000 reported for 2004.

Foreign Currency Translation Expense: Foreign Currency Translation Expense was $2,536,000 for 2006, $2,775,000 for 2005 and $6,989,000 for 2004. This expense represents the adjustment, as required by
SFAS 52, Foreign Currency Translations, to the outstanding principal owed to Countryside reflecting the change in the currency exchange rate from the start of the reporting period. The settlement agreement entered into by USEB with Countryside
established that the payment of the remaining outstanding obligations to Countryside be made in US dollars thereby eliminating USEBs foreign currency exposure pertaining to the satisfaction of its Countryside debt obligations. This debt was
repaid on May 31, 2007. We expect to continue to have foreign currency translation activity associated with our UK operations.

Interest Expense: Interest expense for 2006 was $22,971,000, an increase of $12,171,000 or 112% when compared the $10,800,000 in interest expense reported in 2005. This increase is due to $10,694,000 in interest related
to the UK acquisition which closed in August 2006 and an increase in costs associated with USEBs settlement with Countryside including the reimbursement of any professional fees incurred by Countryside which were recorded as interest expense
for financial statement purposes. Included in the interest expense is $1,993,000 of interest related to the amortization of debt issuance costs associated with the UK debt and $2,579,000 of interest related to the amortization of USEBs
Illinois subsidy income. Management expects interest expense to increase significantly in future periods due to inclusion during those periods of a full years interest related to the UK financing arrangements.

For 2005, interest expense was $10,800,000, an increase of $1,357,000, or 14%, when compared to the $9,443,000 in interest expense reported for 2004.
This expense increased in 2005 from 2004 due to the inclusion of twelve months of interest to Countryside in 2005 compared with nine months of interest in 2004. See Note K to the consolidated financial statements.

Income Tax: Provision for income taxes resulted in a tax expense of $21,000 for 2006 compared with a tax expense of $870,000 for 2005. The
valuation reserve against the deferred tax asset has been increased by $11,752,000 representing the full amount of any tax benefit generated by the Companys 2006 operations. The tax expense for 2005 included a $4,164,000 increase in the
valuation allowance against USEYs deferred tax asset. The increase in the valuation allowances will not have an impact on the ability of the Company to utilize the net operating losses that comprise the deferred tax asset. Exclusive of the
increase in the valuation allowance, the tax provision for 2005 would have been a benefit of $3,294,000.

The 2004 increase in the
provision for income taxes is primarily due to the write off of the SEFL investment, the expensing of costs associated with the Countryside transaction and Foreign Currency Translation Expense associated with the Countryside financing.

USEBs settlement with the Illinois Commerce Commission, completed on May 31, 2007, resulted in a substantial taxable gain resulting from the
debt forgiveness income that will result from the settlement of the obligation significantly below it par value. This tax obligation is expected to be wholly offset by the utilization of a significant portion of the net operating loss carryforwards
held by USEB.



19



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##### Table of Contents

Transaction Costs: No transaction costs were incurred in 2006 and 2005. In 2004,
transaction costs of $13,858,000 associated with Countryside were incurred. These costs include $10,428,000 in debt prepayment fees paid to John Hancock and ABB Energy Capital due to the prepayment of the debt prior to its maturity, $1,802,000
related to the write off of unamortized debt issuance cost associated with John Hancock and ABB Energy Capital debt and $1,628,000 for internal Company expenses associated with the transaction.

Other (Loss) Income:Other (Loss) Income for 2006 was a loss of $2,490,000 compared with a $997,000 gain for 2005. For 2006, the amount
represents a $3,595,000 reserve against a note receivable due USEB for the 1999 sale of ownership interests in certain gasco entities offset by income of $1,105,000 related to investment of USEBs Illinois reserve accounts. For 2005, the
$997,000 income was comprised of income related to the investment of USEBs Illinois reserve accounts. In 2004, the $2,641,000 of Other Income was primarily comprised of a $2,729,000 pre tax gain associated with the acquisition of the AJG
subordinated debt for less than the face value thereof.

Reorganization Expenses: In 2006, USEB incurred $1,369,000 in legal
fees related to its bankruptcy proceedings. USEB filed for reorganization under Chapter 11 of the U.S. Bankruptcy Code in the Southern District of New York in order to facilitate the restructuring of its capital structure. It is expected to continue
to incur expenses related to the filing beyond the May 31, 2007 effective date of the plan and through the third quarter of 2007.

Gain on Disposal of a Segment: Gain on disposal of a segment of $150,000 for 2005 represents residual income from the operations of US Canada Energy Corp. which was sold in 2004. For 2004, the amount represents the gain on the
sale of US Energys Canadian assets to Countryside.

Unrealized Gain (Loss): For 2006, the net unrealized gain of
$589,000 is comprised of $1,016,000 of mark to market gains in open trading positions from the investment of the Illinois Accounts and $427,000 in losses associated with foreign currency exchange rates. For 2005, the net unrealized gain of $167,000
is comprised of $298,000 of mark to market gains in open trading positions from the investment of the Illinois Accounts and $131,000 in losses associated with foreign currency exchange rates. For 2004 the unrealized gain of $1,588,000 is comprised
of $773,000 of mark to market gains in open trading positions from the investment of the Illinois Accounts and $815,000 in gains associated with foreign currency exchange rates.

LIQUIDITY AND CAPITAL RESOURCES

The Company believes that its current and anticipated cash flow from
operations and reserves will be adequate to fully fund operating expenses for the next twelve months beginning on June 1, 2007. But, in order to fund its equity funding requirements pertaining to the development of the UK Assets and funding of
maintenance reserves, the Company will have to raise additional funds through the selling of equity in the Company or the UK subsidiaries or the refinancing of the debt associated with the UK Assets. As proven through its recent history, including
the refinancing of the USEB debt, the original financing for the UK acquisition and the raising of equity through a sale of common stock, the Company has a successful track record in the raising of equity and the obtaining of financing. While no
guarantees of success can be provided, the Company believes that it will be successful in the obtaining of equity and/or debt in amounts sufficient to fulfill its obligations. However, management cannot assure that such financing will be available,
or if available, on terms acceptable to management.

At December 31, 2006, cash and restricted cash and marketable securities totaled
$95,249,000, including $56,329,000 which is recorded as a long term asset. Of this amount, $3,873,000 was unrestricted compared with $11,301,000 of unrestricted cash at December 31, 2005. The financing arrangements for USEB and GBGH require
these subsidiaries to maintain various restricted cash accounts, which, at December 31, 2006, amounted to $91,376,000. The amount of restricted cash is comprised of $35,047,000 held by USEB and $56,329,000 related to the UK operations.

As of December 31, 2006, the Company had a working capital deficit, defined as current liabilities in excess of current assets, of
$1,085,000. Included in current liabilities and therefore in the working capital deficit is $5,250,000 representing the amount of the Illinois Subsidy Liability due by May 31, 2007 per USEBs settlement with the Illinois Commerce Commission.
This amount was paid on May 31, 2007 from proceeds from USEBs financing which closed on that day.

USEB utilized $33,000,000 of its
restricted cash to fund the $33,000,000 in principal payments required by its settlement agreement with Countryside. $3,000,000 of principal was paid in January, 2007 and $30,000,000 was paid in March, 2007. The remaining balance of approximately
$2,500,000 was made available to USEB as unrestricted cash as the result of the May 31, 2007 closing of USEBs financing.

The
restricted cash held by GBGH is comprised of a debt service reserve account in the amount of $11,503,000, an interest during construction account in the amount of $4,986,000, a capital expenditure reserve account in the amount of $1,161,000, a
capital expansion account in the amount of $21,218,000 and a major maintenance reserve account in the amount of $17,461,000. Please refer to Note E to the consolidated financial statements for additional information pertaining to these reserve
accounts.

During 2006, the decrease in net cash of $7,428,000 consisted of $1,974,000 of cash used by operating activities, $157,853,000
of cash used by investing activities and $151,874,000 of cash provided by financing activities. The net cash utilized by investing activities and provided by financing activities is primarily due to the UK Transaction.



20



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##### Table of Contents

During 2005, cash flow provided by operating activities was $2,868,000, an increase of $4,460,000 from
the $1,592,000 of cash used by operating activities in 2004. The increase is primarily the result of a smaller net loss from operations in 2005 when compared to 2004.

During 2005, cash flows used in investing activities was $2,589,000, compared to the $6,161,000 provided by investing activities in 2004. The change was primarily due to the inclusion in 2004 of the sale of USE Canada
and an increase in 2005 in acquisition of equipment and leasehold improvements resulting from USEBs capital maintenance program.

During 2005, cash flow used by financing activities was $4,960,000, a decrease from the $8,203,000 provided by financing activities in 2004. The decrease is primarily the result of the inclusion in 2004 of the refinancing of the USEB debt
with Countryside, the sale of the USEB royalty interest to Countryside and an increase in USEBs debt service payments due to the refinancing with Countryside.

In 2004, net cash increased by $12,772,000 to $15,982,000 from the $3,210,000 reported as of December 31, 2003. The net increase was primarily due to the net cash received through the Countryside transaction
which included the sale of USEYs Canadian assets and the refinancing of USEBs debt, $15,500,000, offset by an approximate $2,000,000 reduction in 2004 net operating income exclusive of the write off of the SEFL investment.

Off Balance Sheet Arrangements

As of
December 31, 2006, the Company did not have any significant off-balance-sheet arrangements as defined in Item 303(a) (4) (ii) of SEC Regulation S-K.

CONTRACTUAL OBLIGATIONS

The following table summarizes our significant contractual obligations at
December 31, 2006 which are expected to have an effect on our liquidity and cash flows in future periods.



|                                    |  |                       |         |                  |   |           |  |           |     |                   |   |     |  |   |        
|----------------------------------- |  | --------------------- | ------- | ---------------- | - | --------- |  | --------- | --- | ----------------- | - | --- |  | - | -------
|(Dollars in thousands)              |  |                       |         |                  |   |           |  |           |     |                  
|                                    | 
|                                    |  | Payment Due by Period
|                                    |  | Total                 |         | Less then 1 year |   | 1-3 years |  | 3-5 years |     | More than 5 years
|Long Term Debt Obligations(1)(2)(3) |  | $                     | 266,341 |                  | $ | 33,000    |  | $         | 0   |                   | $ | 0   |  | $ | 233,341
|Operating Leases                    |  |                       | 1,817   |                  |   | 622       |  |           | 850 |                   |   | 345 |  |   | 0      
|                                    |  |                       |         |                  |   |           |  |           |     |                   |   |     |  |   |        
|Total                               |  | $                     | 268,158 |                  | $ | 33,622    |  | $         | 850 |                   | $ | 345 |  | $ | 233,341
|                                    |  |                       |         |                  |   |           |  |           |     |                   |   |     |  |   |        

---

|(1) | The Company is a party to contractual obligations including gas purchase agreements and operation and maintenance agreements which do not specifically provide for a minimum purchase
obligation and accordingly are not included above. In 2006, we paid an aggregate of $1,911,000 pursuant to such arrangements.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Payments on the Long Term Debt Obligations are required to be made from excess cash flow generated by the UK operations. As the payments from such excess cash flow cannot be
predicted with accuracy it was assumed for the purposes of this table that the debt obligations would be paid upon the maturity of the various debt instruments which occur in 2013 and 2014. The long term debt obligations are exclusive of $39,311,000
of Unamortized Debt Issuance Costs which reduce the obligations for financial statement purposes.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | On May 31, 2007, USEB completed its financing with a private equity fund obtaining $80,000,000 in financing and satisfying its $66,000,000 obligation to Countryside, paying the
$5,250,000 due the Illinois Commerce Commission pursuant to the settlement agreement (not included in this table) and paying its unsecured creditors full value of all undisputed claims. The debt is in the form of a $77,000,000 fixed term obligation
and a $3,000,000 revolving credit facility. Interest is based on LIBOR plus 4.50% and is adjusted every three months for the subsequent three month period. The current interest rate is 9.88%. Interest is payable quarterly and principal reductions
are based upon the excess cash flow generated by USEBs operations. The Company issued $2,000,000 of its common stock as part of the payment of USEBs $66,000,000 obligation to Countryside.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

CRITICAL ACCOUNTING POLICIES

Use of Estimates

Managements Discussion and Analysis of Financial Condition and Results of Operations is based on the Companys audited consolidated financial
statements which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements required management to make estimates and judgments that affect the reported amounts
of assets, liabilities, revenues and



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##### Table of Contents

expenses, and related disclosures of contingent assets and liabilities. Estimates by their nature are based on judgments and available information. Estimates
are made based on historical factors, current circumstances and the experience and judgment of management. Assumptions and estimates are evaluated on an ongoing basis and the Company may employ outside experts to assist in evaluations. Therefore,
actual results could materially differ from those estimates under different assumptions and conditions. Management believes the following critical accounting estimates are more significantly affected by judgment and estimates used in the preparation
of the Companys consolidated financial statements: the value of long-lived assets, the valuation of goodwill, the determination of revenue from Biogas projects participating in the Illinois Retail Rate program, the valuation of the
decommissioning liability associated with the UK Assets, the valuation allowance against notes receivable, the valuation of derivative instruments (see Item 7a), the valuation of deferred tax assets, the valuation of the equity interests granted
relating to the UK Transaction and the application of Statement of Financial Accounting Standards No. 141-Business Combinations (FAS141) in accounting for the entire UK Transaction.

In accordance with FAS141, the Company has one year from the date of acquisition, which was August 2006, to finalize its purchase price allocation of the
acquisition.

The Company used estimates in the valuation of Goodwill. See Note A(6) to the consolidated financial statements. Actual
future operating results that deviate from the estimates would have an effect on the future valuation of Goodwill.

Rates currently paid to
projects participating in the Illinois Retail Rate program utilize estimated rates which are reconciled annually, by the utility purchasing the electricity, on the anniversary date of the projects commercial operations date. Variations in
actual rates to the estimated rates would have an effect on the Companys financial results and cash flows. The Company is unable to predict changes in rates as they are dictated by the actions of the local utilities and municipalities of the
respective projects and will be subject to rate adjustments for all sales made under the Illinois Retail Rate Program through the projects May 31, 2007 expiration of eligibility for participation in the program. The Company uses estimates in
the determination of the likelihood of the ability to use Net Operating Losses (NOLs). See Note O to the consolidated financial statements. Actual future operating results that deviate from the estimates would have an effect on the
Companys ability to use NOLs, the valuation of the deferred tax asset and the Companys future taxability on both an accrual and cash basis.

Gas Properties  The Company follows the full cost method of accounting for gas properties. Accordingly, all costs associated with acquisition, exploration and development of gas reserves, including
directly related overhead costs and related asset retirement costs, are capitalized.

All capitalized costs of gas properties are amortized
on the unit-of-production method using estimates of proved reserves. Investments in unproved properties and major development projects are not amortized until proved reserves are associated with the projects can be determined or until impairment
occurs. Investments in unproved properties are carried on the Companys balance sheet as Gas Property and Equipment  Non-Depleting.

Recently
Issued Accounting Pronouncements

In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in
Income Taxesan interpretation of FASB Statement No. 109 (FIN 48), which clarifies the accounting and disclosure for uncertain tax positions, as defined. FIN 48 seeks to reduce the diversity in practice associated with
certain aspects of the recognition and measurement related to accounting for income taxes. This interpretation is effective for fiscal years beginning after December 15, 2006. The Company has assessed the application of FIN 48 and has
determined that its application will not have any material impact on its results of operations or financial position.

In September 2006,
the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value, and expands disclosure requirements
regarding fair value measurement. Where applicable, this statement simplifies and codifies fair value related guidance previously issued within U.S. generally accepted accounting principles. SFAS 157 is effective for financial statements issued for
fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company does not expect the application of SFAS 157 to have any material effect of the Companys financial statements.

In September 2006, the FASB issued Statement of Financial Standards No. 158 (SFAS 158) Employers Accounting for Defined Benefit
Pension and Other Postretirement Plans (an amendment of Financial Accounting Standards Board (FASB) Statements No. 87, 88, 106 and 132R). SFAS 158 requires companies with defined benefit plans and certain other plans to recognize on the
balance sheet the difference between benefit obligations and any plan assets of those benefit plans. This Statement is effective for fiscal year ending after December 15, 2006. The Company does not have any plans of this nature; therefore FASB 158
is not applicable to the Company and will have no impact.

In February 2007, the FASB issued Statement of
Financial Standards No. 159 (FASB 159), The Fair Value Option for Financial Assets and Financial Liabilities - Including an Amendment of FASB Statement No. 115. This Statement provides companies with an option to measure, at
specified election dates, many financial instruments and certain other items at fair value that are not currently measured at fair value. A company that adopts SFAS 159 will report unrealized gains and losses on items for which the fair value option
has been elected in earnings at each subsequent reporting date. This Statement also establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar
types of assets and liabilities. This Statement is effective for fiscal years beginning after November 15, 2007. The Company does not believe that the adoption of SFAS 159 will have a material impact on our results of operations or financial
condition.

In September 2006, the SEC staff issued Staff Accounting Bulletin No. 108 (SAB No. 108),
Considering the Effects of Prior Years Misstatements when Quantifying Misstatements in Current Year Financial Statement. SAB No. 108 specifies how the carryover or reversal of prior year unrecorded financial statement misstatements
should be considered in quantifying a current year misstatement. SAB No. 108 requires a dual approach that considers both the amount by which the current year consolidated statement of operations is misstated (rollover method) and
an approach that considers the cumulative amount by which the current year consolidated balance sheet is misstated (iron curtain method). Prior to the issuance of SAB No. 108, either the rollover or iron curtain method was
acceptable for quantifying financial statement misstatements. Prior to the Companys application of the guidance in SAB No. 108, management used the rollover approach for quantifying financial statement misstatements.

Initial application of SAB No. 108 allows registrants to elect not to restate prior periods but to reflect the initial application in their annual
financial statements covering the first fiscal year ending after November 15, 2006. The cumulative effect of the initial application should be reported in the carrying amounts of assets and liabilities as of the beginning of that fiscal year
and the offsetting adjustment, net of tax, should be made to the opening balance of retained earnings for that year. The Company elected to record the effects of applying SAB No. 108 using the cumulative effect transition method to the
misstatement that has been corrected below.

The Companys management has determined that accumulated other comprehensive income as of
January 1, 2006 was not presented net of income taxes as required by Statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income. In accordance with the transition method of SAB No. 108, the Company
recorded a cumulative effect adjustment of $827,000 as both a decrease to accumulated other comprehensive income and a decrease to accumulated deficit as of January 1, 2006. There was no tax effect of this adjustment.

Based on the nature of the adjustment the Company has concluded that this adjustment is immaterial to prior years consolidated financial statements
under the previous method of assessing materiality, and therefore, has elected, as permitted under the transition provisions of SAB No. 108, to reflect the effect of this adjustment as of January 1, 2006.

The following table summarizes the effect (up to January 1, 2006) of applying guidance SAB No. 108.



|                                           |  |                                                |          |   |                                                   |   |          |                            |  |   |          |   |  |   |          |  
|------------------------------------------ |  | ---------------------------------------------- | -------- | - | ------------------------------------------------- | - | -------- | -------------------------- |  | - | -------- | - |  | - | -------- | -
|                                           |  | Period in which the Misstatement Originated(1) |          |   | SAB No. 108Adjustmentrecorded as ofJanuary 1,2006 |  
|                                           |  | CumulativePrior toJanuary 1,2004               |          |   | Year EndedDecember 31,2004                        |   |          | Year EndedDecember 31,2005 |  |  
|Accumulated Other Comprehensive Income (2) |  | $                                              | (160,000 | ) |                                                   | $ | (764,000 | )                          |  | $ | (827,000 | ) |  | $ | (827,000 | )
|                                           |  |                                                |          |   |                                                   |   |          |                            |  |   |          |   |  |   |          |  
|Impact on Other Comprehensive Income (3)   |  | $                                              | (160,000 | ) |                                                   | $ | (604,000 | )                          |  | $ | (63,000  | ) |  | $ |         |  
|                                           |  |                                                |          |   |                                                   |   |          |                            |  |   |          |   |  |   |          |  
|Accumulated Deficit (4)                    |  | $                                              |         |   |                                                   | $ |         |                            |  | $ |         |   |  | $ | 827,000  |  
|                                           |  |                                                |          |   |                                                   |   |          |                            |  |   |          |   |  |   |          |  

---

|(1) | The Company previously quantified these errors under the roll-over method and concluded that they were immaterial.
|--- | ------------------------------------------------------------------------------------------------------------------

|(2) | The Company incorrectly overstated accumulated other comprehensive income by $160,000 (cumulatively) in years prior to 2004, by $604,000 in 2004 and by $63,000 in 2005. The Company
recorded a reduction in accumulated other comprehensive income as of January 1, 2006 with a corresponding decrease in accumulated deficit to correct these misstatements.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Represents the net over-statement of other comprehensive income for the indicated periods resulting from the misstatements.
|--- | ---------------------------------------------------------------------------------------------------------------------------

|(4) | Represents the net reduction to accumulated deficit recorded as of January 1, 2006 to record the initial application of SAB No. 108.
|--- | ------------------------------------------------------------------------------------------------------------------------------------



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|ITEM 7A. | QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
|-------- | ---------------------------------------------------------

We are exposed to various types of market risk in the normal course of our business including the impact of interest rate changes, foreign currency exchange rate fluctuations, changes in the wholesale price of energy and changes in
corporate tax rates. Fluctuations in interest rates and investment yields will affect earnings derived from the investment of the various reserve accounts which could have a material effect on the Companys financial performance.

The Company has entered into various derivatives including hedging and similar arrangements for the UK operations related to gas and electricity prices,
interest and currency rate and the price of carbon emission allowances. The gas and electric hedges assure the Company that it will receive not less than specified prices for the sale of electricity from the Knapton Generating Station through August
2009 and for the sale of gas from the facility in 2010 and 2011. The currency and interest rate hedges ensure that the results of operations with respect to our UK activities will not be adversely impacted, through August 2009, as a result of
fluctuation in such rates. The agreement with respect to carbon emission allowances requires that the Company purchase specified amounts of such allowances at fixed prices through December 31, 2007.

USEB had a foreign currency hedge which eliminated the impact of fluctuations in exchange rates on its Countryside debt service payments which was
terminated upon the filing of its Chapter 11 case.



|ITEM 8. | FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
|------- | -------------------------------------------

The
information required by this item is hereby incorporated by reference to the index to Consolidated Financial Statements in Item 15 and made a part hereof.

Supplementary Financial Information



|                                                   |  |              |        |   |               |   |        |              |  |   |               |   |  |   |         |  
|-------------------------------------------------- |  | ------------ | ------ | - | ------------- | - | ------ | ------------ |  | - | ------------- | - |  | - | ------- | -
|2006 (Dollars in thousands, except share amounts)  | 
|                                                   |  |              |        |  
|                                                   |  | FirstQuarter |        |   | SecondQuarter |   |        | ThirdQuarter |  |   | FourthQuarter |  
|Revenues                                           |  | $            | 4,824  |   |               | $ | 4,732  |              |  | $ | 5,154         |   |  | $ | 6,534   |  
|Operating Loss                                     |  |              | (965   | ) |               |   | (896   | )            |  |   | (1,377        | ) |  |   | (4,283  | )
|Net Loss Applicable to Common Stock                |  |              | (2,166 | ) |               |   | (2,925 | )            |  |   | (7,636        | ) |  |   | (15,108 | )
|Loss per Share of Common Stock  Basic and Diluted |  |              | (0.15  | ) |               |   | (0.17  | )            |  |   | (0.47         | ) |  |   | (0.93   | )
|                                                  
|2005 (Dollars in thousands, except share amounts)  | 
|                                                   |  | FirstQuarter |        |   | SecondQuarter |   |        | ThirdQuarter |  |   | FourthQuarter |  
|Revenues                                           |  | $            | 5,024  |   |               | $ | 4,476  |              |  | $ | 4,616         |   |  | $ | 5,504   |  
|Operating Income/(Loss)                            |  |              | 543    |   |               |   | (139   | )            |  |   | 164           |   |  |   | (1,369  | )
|Net Loss Applicable to Common Stock                |  |              | (888   | ) |               |   | (1,049 | )            |  |   | (6,474        | ) |  |   | (1,881  | )
|Loss per share of Common Stock  Basic and Diluted |  |              | (0.07  | ) |               |   | (0.09  | )            |  |   | (0.52         | ) |  |   | (0.15   | )



|ITEM 9. | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
|------- | ------------------------------------------------------------------------------------

Not applicable.



|ITEM 9A. | CONTROLS AND PROCEDURES
|-------- | -----------------------

Pursuant to Rule 13a-15(b)
under the Exchange Act, the Company, under the supervision and with the participation of the Companys management, including our Chief Executive Officer and our Chief Accounting Officer, performed an evaluation of the effectiveness of our
disclosure controls and procedures as of the end of the



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period covered by this report. The Company has also retained an outside consulting firm to assist in the evaluation which is ongoing. The Company has
presented unaudited restated consolidated financial statements for the quarter ended September 30, 2006 and has been delinquent in the filing of the Form 10-K for the period ended December 31, 2006. It has been determined that the Company
had an insufficient number of personnel possessing the appropriate knowledge, experience and training in applying US GAAP to non-routine and complex transactions resulting in incorrect analysis and treatment of those transactions during the
period covered by this report. Accordingly, the Company has determined that its disclosure controls and procedures as of December 31, 2006 were not effective as they related to the timely processing, analyzing and recording of complex
transactions. In order to improve the timeliness of its disclosure filings, the Company has and will continue to improve its disclosure controls and procedures through (i) the ongoing installation of new, updated accounting software,
(ii) the recently completed hiring of additional accounting staff, (iii) the planned hiring of additional internal staff and (iv) the completed execution of arrangements with independent specialists with expertise in interpretation
and implementation of new GAAP pronouncements. The Company believes that the additional accounting staff already in place along with the engagement of the independent specialists has already improved the Companys ability to address complex
accounting issues on a timely basis and that the Companys internal controls and procedures and the planned additions to our accounting staff along with further improvements that will be made based upon the recommendations of our consultants
will further strengthen our capabilities. Management believes the internal controls and disclosure controls and procedures to be effective at this time. The Companys management and Board of Directors are fully committed to the review and
evaluation of our procedures and controls designed to assure continued effective internal control over financial reporting.

Except as
provided in the preceding paragraph, there was no change in the Companys internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Securities and Exchange Act of 1934, as amended) during the
Companys most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Companys internal control over financial reporting.



|ITEM 9B. | OTHER INFORMATION
|-------- | -----------------

Not applicable.



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PART III



|ITEM 10. | DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE.
|-------- | -------------------------------------------------------

DIRECTORS AND EXECUTIVE OFFICERS

The following individuals served as members of the Board of Directors (the
Board) of U.S. Energy Systems, Inc. (US Energy or the Company) during 2006:



|                           |  |     |  |       |  |                                                       
|-------------------------- |  | --- |  | ----- |  | ------------------------------------------------------
|Name                       |  | Age |  | Class |  | Position(s) with US Energy                            
|Lawrence I. Schneider (4)  |  | 70  |  | 1     |  | Chairman of the Board                                 
|                           |  |     | 
|Asher E. Fogel             |  | 58  |  | 2     |  | CEO, President, Chairman of the Board and Director (5)
|                           |  |     | 
|Stephen L. Brown (2,3,4)   |  | 69  |  | 2     |  | Director                                              
|                           |  |     | 
|Carl W. Greene (1,2,3,4)   |  | 72  |  | 3     |  | Director                                              
|                           |  |     | 
|Jacob Feinstein (1,2,3)    |  | 64  |  | 3     |  | Director                                              
|                           |  |     | 
|Ronny Strauss (1,2,3)      |  | 63  |  | 1     |  | Director                                              
|                           |  |     | 
|Robert Schneider (1,2,3,6) |  | 52  |  | 3     |  | Director                                              

---

|(1) | Member of the Audit Committee.
|--- | ------------------------------

|(2) | Member of the Compensation Committee. Mr. Feinstein was appointed to the Compensation Committee on December 7, 2006.
|--- | --------------------------------------------------------------------------------------------------------------------

|(3) | Member of the Nominating and Governance Committee. Mr. Strauss was appointed to the Nominating and Governance Committee on December 7, 2006.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------

|(4) | Messrs. Larry Schneider and Greene resigned from the Board and each committee on which they served effective December 6, 2006 and Mr. Brown resigned from the Board and
each committee on which he served effective December 8, 2006.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(5) | Mr. Fogel was appointed Chairman of the Board and President of the Company on December 7, 2006.
|--- | -----------------------------------------------------------------------------------------------

|(6) | Mr. Robert Schneider was elected to the Board and to each committee of the Board on December 7, 2006.
|--- | -----------------------------------------------------------------------------------------------------

The executive officers of the Company as of December 31, 2006 were as follows:



|                     |  |     |  |                                                
|-------------------- |  | --- |  | -----------------------------------------------
|Name                 |  | Age |  | Position(s) within US Energy                   
|Asher E. Fogel       |  | 58  |  | CEO, President and Chairman of the Board       
|                     |  |    
|Richard J. Augustine |  | 53  |  | Chief Accounting Officer and Vice President    
|Adam D. Greene       |  | 43  |  | Senior Vice President and Secretary            
|Grant Emms           |  | 54  |  | Chief Executive Officer, UK Energy Systems Ltd.
|James Anthony Lobban |  | 53  |  | Chief Operating Officer, Viking UK Gas Limited 
|Joseph Reynolds      |  | 58  |  | Programme Director, UK Energy Systems Ltd.     

Set forth below is certain biographical information regarding our executive officers and
directors.

Asher E. Fogel. Mr. Fogel served as a director of US Energy from 1998 to 2001 and was appointed to serve as Chief
Executive Officer and a director in August 2005. In December 2006, he was appointed to serve as President of the Company and Chairman of the Board. He worked for Citigroup in London and New York where he held a variety of senior positions in the
corporate finance, capital markets, and investment advisory areas. Mr. Fogel was a Managing Director of Citicorp Securities Inc. Prior to joining Citicorp, he held a number of positions at both Bank of America and Samuel Montagu & Co.
In June 1997, Mr. Fogel founded Dovertower Capital, a merchant banking boutique providing corporate finance



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services in both the US and international markets. In 1998, Mr. Fogel led a US investor group to acquire the Ampa Group in Israel. The Ampa Group is a
diversified group involved in real estate, packaging, consumer products and financial services. Subsequent to this acquisition, Mr. Fogel has served as chairman of Ampa Investmentsthe financial services arm of the Ampa Group and as a
member of the four team management committee of the Ampa Group. In 2000, Ampa Investments acquired the Industrial Development Investment Company (IDIC) from the State of Israels Industrial Development Bank in a privatization
transaction and established Ampa Capital as a leading non-bank finance company in Israel. Mr. Fogel has extensive experience in the areas of corporate finance, capital markets and investments in the US and the international markets.
Mr. Fogel holds a BA in economics and an MBA from the Hebrew University. He also attended the Advanced Management program in the Harvard Business School specializing in Finance.

Richard J. Augustine. Mr. Augustine was appointed as Vice President and Chief Accounting Officer of US Energy effective as of September 1, 2004. Mr. Augustine has served as an
officer of U.S. Energy Biogas Corp. (Biogas), a subsidiary of US Energy and its corporate predecessor, Zahren Alternative Power Corporation (Zapco), since 1996 and currently serves as President of Biogas. Prior to his
involvement with Biogas and Zapco, Mr. Augustine served as Vice President of Finance and Administration at Richard Roberts Group, a real estate syndicator. Mr. Augustine graduated with a BA in Economics and Accounting from the College of
the Holy Cross and an MBA in Finance from the University of Connecticut.

Adam D. Greene. Mr. Greene has served as Executive Vice
President and Secretary since February 2007, and he had served as Senior Vice President since December 2005. He also serves as Chief Executive Officer of Biogas, a position he has held since November 2006. For more than the five years prior to 2006,
he served as Managing Director of Marathon Capital LLC, a boutique investment bank which specialized in power project and renewable energy finance. He also served as a Managing Director and co-founder of Dovertower Capital LLC. Mr. Greene has
over 15 years of experience in international finance and structured finance. He has wide-ranging experience in finance and M&A including renewable energy, power and refining. Mr. Greene has advised on various financing and M&A
transactions including land-fill gas, cogeneration, geothermal, biomass, refining, gas trading and ethanol transactions. Mr. Greene received his BA from Oberlin College and attended the Wagner School at New York University.

Grant Emms.Mr. Emms has served as Chief Executive Officer of UK Energy Systems Ltd., a subsidiary of the Company, since August 2006. He was
previously employed by Viking International Petroleum plc from October 2002 to July 2006 as Chief Executive Officer. Mr. Emms is a geoscientist by training and has over thirty years of experience in the oil and gas industry and has worked at
numerous companies including Amoco, Nexen, and Vanguard.

James Anthony Lobban. Mr. Lobban has served as Chief Operating Officer of
Viking UK Gas Limited, a subsidiary of the Company, since August 2006. Prior to the transaction, he was employed by Viking UK Gas Ltd. as General Manager from September 2004 to August 2006. He also worked as an independent oil and gas
consultant until January 2003 and at PricewaterhouseCoopers prior to that. Mr Lobban is a Petroleum Engineer by training and has over thirty years of experience in the oil and gas industry.

Joseph Reynolds. Mr. Reynolds has served as Programme Director of UK Energy Systems Ltd., a subsidiary of the Company, since August 2006. Prior to his
employment with UK Energy Systems Ltd., Mr. Reynolds was employed by Dun Elmet Company, LLC, his own consulting business. He has extensive energy and process industries experience in the development and management of capital projects and
operating assets, including LNG facilities, oil & gas, cross-country pipelines, marine terminals, power generation, and process plants for Occidental Petroleum, Unocal and Enron. He has successfully managed contractors and labour forces
with total responsibility for safety, technical, schedule, cost and contractual performance including projects in remote locations with difficult logistics.



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Jacob Feinstein. Mr. Feinstein joined our Board in October 2004. Since 1999, Mr. Feinstein
has served as a consultant to independent power producers, electric utilities and other businesses engaged in the energy and construction industries. From 1998 through 1999, he was a Vice President of Cogen Technologies, Inc., a business engaged in
power plant development and from 1991 through 1998, he was Vice PresidentSystem and Transmission Operations, for Consolidated Edison Co. of NY Inc. For the fifteen years prior thereto, Mr. Feinstein held various positions in the energy
industry. He is a registered Professional Engineer in the State of New Jersey and a senior member of the Institute of Electrical and Electronic Engineers (IEEE). Mr. Feinstein had served as a member of technical committees of the Electric Power
Research Institute and the Edison Electric Institute and as a senior visiting lecturer (adjunct position) at the Stevens Institute of Technology. Mr. Feinstein received a B.E.E. from City College of New York.

Ronny Strauss. Mr. Strauss has served as a member of our Board since March 2005. From 2000 to 2004 he served as a financial advisor and director of
Digital Wireless Corporation, and from 1979 to 2000, served in various capacities with Citigroup and its divisions and affiliates, including Global Treasurer and Market Risk Manager for Citibank Private Bank and Chief Executive Officer and Country
Corporate Officer for Citibank Israel. He has also served as a lecturer at Syracuse Universitys School of Management and as an Assistant Professor at Ithaca College, School of Business. Mr. Strauss received his BA in Economics and
Statistics from Hebrew University, an M.A. in Finance from Hebrew University and an M.Sc. in Finance, Quantitative Methods and Managerial Economics from Cornell University.

Robert Schneider. Mr. Robert Schneider has served as a member of our Board since December 7, 2006. For about twenty years, he has served as a partner in a regional mid-sized CPA firm which
provides services including tax, accounting and business consulting. Mr. Robert Schneider received his MBA degree in accounting from Fairleigh Dickinson University and is a member of both the New York State Society of CPAs and the American
Institute of CPAs. Mr. Robert Schneider is not related to Lawrence or Henry Schneider.

Lawrence I. Schneider. Mr. Schneider was
elected to the Board in March 1998. He served as Chairman of the Board from September 2000 to December 2006, when he resigned. Mr. Schneider served as our Chief Executive Officer from January 2000 until May 2001 and from October 2004 until
August 2005. Mr. Schneider has been associated with numerous businesses through the years, including Newpark Resources, Inc., a company involved with oil field environmental remediation, where he was chairman of the executive committee.
Mr. Schneider was also a partner in the New York Stock Exchange firm Sassower, Jacobs and Schneider. He received a BS degree from New York University. He is the father of Henry N. Schneider.

Carl W. Greene. Mr. Greene served as a director from March 2003 to December 2006, when he resigned. For over twenty years, he has served in various
senior financial executive positions for the Consolidated Edison Company of New York, including Senior Vice President of financial and regulatory matters, Senior Vice President of accounting and treasury operations and Chief Accounting Officer, and
Vice President and Controller. Mr. Greene currently is Senior Vice President of Lynch & Associates, a full service executive benefit consulting firm. Mr. Greene has been with Lynch & Associates and its prior parent, TBG
Financial, since 1997. Mr. Greene has been an active member of several high profile industry trade groups during his tenure at Con Edison, including the Edison Electric Institute and the American Gas Association. In those positions, he has
played a role in shaping accounting, financial and risk management policies in the electric utility industry. In addition, Mr. Greene served for four years as a member of FASAC, the Financial Accounting Standards Advisory Council.
Mr. Greene holds a BS in economics from The Wharton School of University of Pennsylvania and an MBA from New York University.



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Stephen Brown. Mr. Brown served as a director from March 2003 to December 2006, when he resigned. He
is currently the managing member of Brimco LLC, a private equity firm. From November 1986 until October 2004, he served as Chairman of the Board and Chief Executive Officer of The Franklin Capital Corporation, a publicly traded business development
corporation. Mr. Brown serves on the board of directors of Copley Financial Services Corp., a mutual fund manager, as a director and Secretary of Ascend Acquisition Corporation and as a director of CASHBOX plc, an ATM Deployer based in the
United Kingdom and listed on the London Stock Exchanges AIM Market. In addition, Mr. Brown is an active board member and trustee of The Peddie School. Mr. Brown is a graduate of New York University School of Law and Brown University.

SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE

Section 16(a) of the Securities Exchange Act of 1934, as amended (the Exchange Act), requires that our officers and directors, and persons who beneficially own more than ten percent of a registered
class of our equity securities, file reports of ownership and changes in ownership with the Securities and Exchange Commission (SEC). Officers, directors and greater than ten percent beneficial owners are required by regulation to
furnish to us copies of all Section 16(a) forms they file. Based solely on our review of the copies of such forms we have received, or written representations from certain reporting persons, we believe that during the year ended
December 31, 2006 (and for prior years, except to the extent previously disclosed), all officers, directors, and greater than ten percent beneficial owners complied with all applicable Section 16(a) filing requirements, except for Jacob
Feinstein, Henry Schneider, Carl Greene, Ronny Strauss, Richard J. Augustine and Stephen Brown, who each filed a late report with respect to one transaction, Asher Fogel, who filed three late reports with respect to three transactions, Adam D.
Greene, who filed two late reports for two transactions, and Mark Brody, d/b/a Financial Planning Analysts, who filed a late report with respect to his acquisition of common stock.

CODE OF ETHICS

The Company has adopted the
Code of Ethics which complies with requirements set forth in Item 406 of Regulation S-K. This Code of Ethics applies to all of the Companys employees, including its principal executive officer, principal financial officer, principal
accounting officer or controller, and persons performing similar functions. The Code of Ethics is available free of charge on the Companys website at www.useyinc.com and will be provided free of charge to any stockholder requesting a copy by
writing to: Secretary, U.S. Energy Systems, Inc., 750 Lexington Avenue, 15thFloor, New York, NY 10017.

AUDIT COMMITTEE

The Company has a
separately-designated Audit Committee. Jacob Feinstein, Ronny Strauss and Robert Schneider are members of the Audit Committee, all of whom the Board has determined are independent as defined by the listing standards of the Nasdaq Stock Market
(Nasdaq). Carl Greene served as a member of the Audit Committee, and was the audit committee financial expert within the meaning set forth in regulations of the SEC, until his resignation from the Board effective
December 7, 2006. Following Mr. Greenes resignation from the Board, the Company ceased to have an audit committee financial expert. Mr. Schneider, who is a partner at a regional mid-sized CPA firm, satisfies the
requirements set forth in Nasdaq Marketplace Rule 4350(d)(2).



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As a relatively small public company, it is difficult to identify and retain potential qualified
candidates to serve on our Board. The Company is committed to seeking an Audit Committee member who will meet the SEC requirements for an audit committee financial expert, but we do not know if or when we will appoint a new Board member
who qualifies as an audit committee financial expert. Although none of the members of our Audit Committee qualify as audit committee financial experts as defined by the SEC, each of our Audit Committee members has made
valuable contributions to the Company and its stockholders as members of the Audit Committee. The Board has determined that each member is fully qualified to monitor the performance of management, the public disclosures by the Company of its
financial condition and performance, our internal accounting operations, and our independent auditors.



|ITEM 11. | EXECUTIVE COMPENSATION.
|-------- | -----------------------

COMPENSATION COMMITTEE REPORT FOR THE
YEAR ENDED DECEMBER 31, 2006

To Our Stockholders:

The Compensation Committee has reviewed and discussed the Compensation Discussion and Analysis required by Item 402(b) of Regulation S-K with management of the Company. Based on its review and discussions with management, the
Compensation Committee recommended to the Board that the Compensation Discussion and Analysis be included in this Annual Report on Form 10-K.

Compensation Committee:

Jacob Feinstein*

Ronny Strauss

---

|* | Appointed to the Compensation Committee on December 7, 2006.
|- | ------------------------------------------------------------

The
information contained in the report above shall not be deemed to be soliciting material or to be filed with the Securities and Exchange Commission, nor shall such information be incorporated by reference into any future
filing under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, except to the extent specifically incorporated by reference therein.

COMPENSATION DISCUSSION AND ANALYSIS

The primary function of the Compensation Committee is to assist the Board of
Directors in fulfilling its oversight responsibilities by setting the Companys compensation strategy and approving the Companys executive compensation. Consistent with this function, the Compensation Committees principal objectives
are to increase stockholder value; to align the long-term interests of our executives and other key employees with those of the stockholders; and to attract and retain top quality executives.

Total compensation consists of base salary and incentive compensation. The Committee strives to distinguish between compensation for past performance, generally
consisting of base salary and cash bonuses, and compensation designed to encourage future performance and retention of executives and other key employees, generally long-term compensation, primarily in the form of equity awards. Vesting terms for
long-term compensation may be tied to the Companys stock price so as to focus the attention of the executive officers on managing the Company from the perspective of an owner with an equity stake.



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The principal components of the Companys compensation programs are (i) base salary, (ii) cash bonuses and
(iii) equity awards. The Committee believes that these three elements reflect market practice and balance the need to offer our executive officers a compensation package that rewards past and current performance while providing strong
short-term and long-term incentives. Based on the Committees assessment of the level of individual executive and Company performance, the Committee generally determines actual total compensation relative to market target total compensation.
The Committee retains significant discretion on how to allocate compensation to individual officers and amongst compensation components. Cash bonus and equity awards for Company executives are entirely at the Committees discretion, and
determinations by the Committee reflect its assessment of the competitive marketplace and performance. Because the Committee believes in the exercise of independent judgment, its compensation determinations are not formulaic but reflect a
significant component of subjective analysis. In determining cash bonus and equity awards, the Committee reviews both individual executive and overall company performance, both long term and short term. The review of individual performance factors
is mainly subjective.

The Committee seeks to assure that the total compensation package, and each of its components, is competitive in the relevant
marketplace. The Committee makes these determinations based on information from a variety of sources, including information supplied by consultants, information obtained from the media and other publicly available sources as well as from the
Committees own knowledge and experience.

During the 2006 fiscal year, our employees and the Board were focused on completing the UK Transaction. As
a result, the Committee determined that compensation goals would be set once the transaction was consummated. The Company is currently working with a reputable firm of executive compensation consultants with knowledge of the energy sector to design
a comprehensive compensation plan which will include a recommended process for setting annual and long-term performance goals for executives and target percentages for each element of compensation for fiscal year 2007. No compensation goals were set
for fiscal year 2006.

Base SalaryThe Committee tries to ensure that the base salary ranges reflect the competitive
market. The Committee is working with the compensation consultants to select the relevant comparable companies for the survey and to formulate the salary ranges for the various executive and key employee positions. Generally, it is likely that the
base salary levels will be targeted to the median compensation of the relevant companies included in the survey.

Cash
BonusThe Committee tries to ensure that cash bonus reflects past performance of the individual and the Company. The Committee is working with our compensation consultants to determine individual and Company performance goals by which
to measure future performance for fiscal year 2007 and to develop bonus ranges.

Incentive CompensationWe use incentive
compensation to encourage future performance and long-term commitment to the Company. We have in place a 2000 Executive Incentive Compensation Plan (Plan) which allows us to grant awards to eligible persons up to a maximum amount of
2,500,000 per individual in each fiscal year, subject to certain adjustments. In accordance with the terms of the Plan, we granted restricted stock units (RSUs) to certain individuals in the third quarter of 2006. The individual
grants are discussed in further detail below. These RSUs include terms that link their performance to the Companys stock price in order to encourage employees to meet specific Company performance goals related to the UK Transaction. We may or
may not decide to continue to grant these types of equity awards in the future.



30



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##### Table of Contents

In addition to annual grants of incentive compensation, from time to time, the Committee may grant additional long-term
incentives to recognize special contributions or recognize other special circumstances.

Recent Developments

As mentioned above, in the third quarter of 2005, the Company decided to pursue a major business opportunity in the U.K., which at that time was considered, if completed,
to become a major defining event of the Companys business future. As a result, the Committee did not set any goals or make compensation adjustments while the transaction was pending. The Committee believed that once the transaction was
consummated, it would focus on meeting the following compensation goals.

First, the Company sought to put in place a comprehensive competitive
compensation plan for the Companys executives and key employees by hiring and working with a reputable consulting firm with specialized knowledge in executive compensation within the energy sector.

Second, the Committee had been aware, for quite some time, that the compensation of the Companys executive officers was significantly below market and sought to
align the base salaries of its executives and key employees with the marketplace while taking into account the major business challenges and potential of the Company. The increase in pay would also serve to provide incentives for the management team
to stay with the Company and realize the embedded potential value in the UK Transaction once it has been consummated.

Compensation Consultant

In addition, due to the fact that the Companys major efforts and resources in 2006 were focused on and devoted to the consummation of the UK
Transaction, the fiscal year was also characterized by a shortage of cash at the corporate level. As a result, the Committee decided to delay the hiring of a consulting firm to help us develop the desired comprehensive compensation plan until we
were comfortable that enough resources and cash were available. We reached this point during the first quarter of 2007. The Committee then hired a reputable consulting firm and received its initial report (Phase I) in April 2007. In addition, the
Committee has already approved the continued engagement of the consulting firm to complete Phase II of the project that should result in a proposed structure for a comprehensive compensation plan for the executives and key employees of the Company.
We expect to receive the results of Phase II late in the second quarter or early in the third quarter of 2007. The next step will be for the Committee to work closely with the consulting firm to implement its recommendations.

Compensation Adjustments

In August 2006, as the UK Transaction
neared completion, the Committee took two actions to meet its compensation goals, as follows:

Base Salaries

Based on publicly available information and using the members own knowledge and experience, the Committee decided that it was the appropriate time to approve base
salary adjustments for the following executives and key employees of the Company, to be effective September 1, 2006.

The salary of Asher Fogel, CEO,
was increased approximately 67% from $180,000 to $300,000. The salary of Richard Augustine, Chief Accounting Officer, was increased approximately 11% from $135,000 to $150,000.



31



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Given the strained cash position of the Company at the corporate level at the time of the decision, the Committee
stipulated that until the Companys cash position was restored to acceptable levels, $100,000 of Mr. Fogels base salary increase would be paid in the Company common stock, quarterly in arrears. Following the Committees
satisfactory review of the cash position of the Company in February 2007, all base salaries are being paid in cash as of March 1, 2007.

It is
relevant to point out that the results of Phase I of the compensation project undertaken by the compensation consulting firm that were submitted to the Committee in April 2007, indicate, based on the initial data provided, that the above mentioned
adjusted base salaries are generally consistent with the market-based 50th percentile base salaries of the competitive market survey used by the consulting firm. The Committee has also been advised (though no final decisions have been made at this
time) that it would be appropriate for the Company to target its executives and key employees base salaries to the median of the survey.

Incentive Compensation

The Committee is currently working with the compensation consultants to determine
whether cash bonuses and long-term incentive awards for fiscal year 2006 are appropriate and, if so, in what amounts.

In the third quarter of 2006, as we
neared the completion of the UK Transaction, the Committees objective was to provide the management team with two incentives: (a) to remain with the Company on a long-term basis and (b) to realize the embedded potential value of the
Companys common stock over the next three to four years. The Committee also sought to recognize the immense efforts and work that went into consummating this highly complicated transaction.

The Committee, based on all the information available to it related to the UK Transaction and being convinced of the potential embedded value of the project to both its
stockholders and to the Company, decided to approve equity awards to the management team in the form of RSUs. The key characteristic of the granted RSUs relates to their vesting terms over an approximately three and half year period (in three equal
tranches), consistent with the various phases of the UK Transaction, at trigger prices that represented a premium over the closing price of the common stock of the Company on the award date in the range of 250% to 410%. It is also stipulated that
the employee must be employed by the Company at the time the RSUs vest in order to receive the shares. The RSUs were granted with these vesting terms to encourage management to achieve the embedded long-term value of the transaction to stockholders
and to our Company.

The Committee determined independently the number of RSUs to be awarded to the CEO and asked for the CEOs input as to his
recommendation for the number of RSUs to be awarded to other members of the management team. The number of RSUs granted were meant to reflect each individuals contribution to the success of the transaction.

The following RSU awards were subsequently approved by the Committee:



| |  |  | Asher Fogel, CEO 150,000
| | - |  | ------------------------



| |  |  | Richard Augustine, Chief Accounting Officer 50,000
| | - |  | --------------------------------------------------



32



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In December 2006, Messrs. C. Greene and S. Brown resigned from the Board of Directors of the Company. Upon their
resignation, Messrs. Jacob Feinstein and Robert Schneider replaced them as members of the Compensation Committee.

SUMMARY COMPENSATION
TABLE



|                                                                                                       |  |      |  |            |     |  |              |     |  |                |     |  |                                    |  |                              |        |  |          
|------------------------------------------------------------------------------------------------------ |  | ---- |  | ---------- | --- |  | ------------ | --- |  | -------------- | --- |  | ---------------------------------- |  | ---------------------------- | ------ |  | ---------
|Name and Principal Position                                                                            |  | Year |  | Salary ($) |     |  | Bonus(8) ($) |     |  | StockAwards($) |     |  | Non-EquityIncentiveCompensation($) |  | All OtherCompensation(9) ($) |        |  | Total ($)
|Asher E. Fogel Chairman of the Board, Chief
Executive Officer and President, U.S. Energy Systems, Inc. |  | 2006 |  | 188,333    |     |  |             |     |  | 616,500        | (3) |  |                                   |  | 12,267                       | (4)    |  | 817,100  
|                                                                                                       |  |      |  |            |     |  |             
|Richard J. Augustine Chief Accounting Officer,
U.S. Energy Systems, Inc.                               |  | 2006 |  | 137,615    |     |  |             |     |  | 205,500        | (3) |  |                                   |  | 14,267                       | (4)    |  | 357,382  
|                                                                                                       |  |      |  |            |     |  |             
|Grant Emms Chief Executive Officer, UK Energy
Systems Ltd.                                             |  | 2006 |  | 163,217    | (1) |  | 48,965       | (2) |  |               |     |  | 50,000                             |  | 13,552                       | (5)    |  | 275,734  
|                                                                                                       |  |      |  |            |     |  |             
|James Anthony Lobban Chief Operating Officer,
Viking UK Gas Limited                                    |  | 2006 |  | 122,413    | (1) |  | 73,448       | (2) |  |               |     |  | 50,000                             |  |                             |        |  | 245,861  
|                                                                                                       |  |      |  |            |     |  |             
|Joseph Reynolds Programme Director, UK Energy
Systems Ltd.                                             |  | 2006 |  | 97,930     | (1) |  | 58,758       | (2) |  |               |     |  | 50,000                             |  | 18,491                       | (5)(6) |  | 225,179  
|                                                                                                       |  |      |  |            |     |  |             
|Lawrence I. Schneider Former Chairman of the
Board (7)                                                 |  | 2006 |  | 254,291    |     |  |             |     |  |               |     |  |                                   |  |                             |        |  | 254,291  

---

|(1) | Represents salary for the period beginning August 7, 2006, which is the date of the acquisition of the UK Assets, through December 31, 2006. Salaries are paid in pounds
sterling and converted to U.S. dollars for the purposes of this table based on a conversion rate of £1.9586 as of December 31, 2006.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Contractual bonuses paid in pounds sterling and converted to U.S. dollars for the purposes of this table based on a conversion rate of £1.9586 as of December 31, 2006.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Represents the value as of the date of the grant of the restricted stock units. Mr. Fogel received restricted stock units to acquire 150,000 shares of common stock and
Mr. Augustine received restricted stock units to acquire 50,000 shares of common stock. The value (i.e., the closing price of a share of US Energy common stock) on August 8, 2006, the date of issuance, was $4.11 per share. These restricted
stock units vest in three equal tranches on the later of December 13, 2007 or when the average trading price for one share of US Energys common stock (the Price) is greater than $15, on the later of December 13, 2008 or
when the Price is greater than $20 and on the later of December 13, 2009 or when the Price is greater than $25.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(4) | Represents contributions made by US Energy and its subsidiaries to the 401(k) plan on behalf of each person plus compensation related to automobile usage. Compensation for the
reimbursement of automobile expenses is calculated based upon the specified monthly allowance or the cost of the usage of a Company owned vehicle including the lease cost and the cost of insurance.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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|(5) | Represents compensation related to automobile usage and the reimbursement of personal travel expenses. Compensation related to the reimbursement of automobile expenses is based upon
a specified expense reimbursement allowance included in the employment agreements. Compensation related to the reimbursement of personal travel expense is the estimated costs from the contractual obligation to reimburse the employee for a specified
number of trips for the employee and his family from the UK to the US. The amounts included represent estimates of annual costs prorated for the portion of the year in which they were employed by the Company.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(6) | Represents compensation related to automobile usage, the reimbursement of personal travel expenses and an allowance for the reimbursement of housing expenses consisting of rent for
an apartment.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(7) | Mr. Larry Schneider resigned from the Board of Directors on December 6, 2006.
|--- | -----------------------------------------------------------------------------

|(8) | The bonuses for Messrs. Fogel and Augustine have not been calculated or approved by the Compensation Committee as of the latest practicable date.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------

|(9) | Details of All Other Compensation includes: (a) for Mr. Fogel, $5,067 for 401(k) plan match and $7,200 for automobile allowance; (b) for Mr. Augustine, $6,043
for 401(k) plan match and $8,019 for reimbursement of automobile expenses; (c) for Mr. Emms, $9,385 for automobile allowance and $4,167 for reimbursement of personal travel expenses; and (d) for Mr. Reynolds, $4,080 for housing
allowance, $8,161 for automobile allowance and $6,250 for reimbursement of personal travel expenses.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

OUTSTANDING EQUITY
AWARDS AT FISCAL YEAR-END



|                                                                                                       |                                                                   |                                   |                        |                      |                      |                                      |                                                         |                   |           |                                                                |                    
|------------------------------------------------------------------------------------------------------ | ----------------------------------------------------------------- | --------------------------------- | ---------------------- | -------------------- | -------------------- | ------------------------------------ | ------------------------------------------------------- | ----------------- | --------- | -------------------------------------------------------------- | -------------------
|Name                                                                                                   |                                                                   | Option Awards                     |                        | Stock Awards        
|                                                                                                       | Number ofSecuritiesUnderlyingUnexercisedOptions (1)(#)Exercisable |                                   | OptionExercisePrice($) |                      | OptionExpirationDate |                                      | Number ofShares or Unitsor Stock ThatHave Not Vested(#) |                   |           | Market Value ofShares or Units ofStock
That HaveNot Vested ($)
|Asher E. Fogel Chairman of the Board, Chief Executive Officer and President, U.S. Energy Systems, Inc. |                                                                   | 150,00080,00070,000450,000        |                        | 1.252.002.003.50     |                      | 8/16/158/16/158/16/155/03/14         |                                                         | 75,000150,000     | (2)(3)    |                                                                | 146,250616,500     
|                                                                                                       |                                                                   |                                   |                        |                      |                     
|Richard J. Augustine Chief Accounting Officer, U.S. Energy Systems, Inc.                               |                                                                   | 50,00025,000                      |                        | 6.003.50             |                      | 5/11/115/03/14                       |                                                         | 7,50050,00018,115 | (2)(3)(4) |                                                                | 14,625205,50014,140
|                                                                                                       |                                                                   |                                   |                        |                      |                     
|Grant Emms Chief Executive Officer, UK Energy Systems Ltd.                                             |                                                                   |                                  |                        |                     |                      |                                     |                                                         |                  |           |                                                                |                   
|                                                                                                       |                                                                   |                                   |                        |                      |                     
|James Anthony Lobban Chief Operating Officer, Viking UK Gas Limited                                    |                                                                   |                                  |                        |                     |                      |                                     |                                                         |                  |           |                                                                |                   
|                                                                                                       |                                                                   |                                   |                        |                      |                     
|Joseph Reynolds Programme Director, UK Energy Systems Ltd.                                             |                                                                   |                                  |                        |                     |                      |                                     |                                                         |                  |           |                                                                |                   
|                                                                                                       |                                                                   |                                   |                        |                      |                     
|Larry Schneider Former Chairman of the Board                                                           |                                                                   | 350,000450,00040,000100,00046,800 |                        | 3.004.002.502.882.94 |                      | 5/09/105/09/108/26/087/05/0912/08/09 |                                                         |                  |           |                                                                |                   



34



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---

|(1) | All options are vested as of December 31, 2006 with the exception of Mr. Fogels 80,000 options which vested in January 2007.
|--- | -----------------------------------------------------------------------------------------------------------------------------

|(2) | Vest in equal three equal annual installments at December 31, 2007, December 31, 2008 and December 31, 2009. Based on a closing market price per share of $1.95.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Vest in three equal annual installments at the later of (i) December 31, 2007 or the market price of common stock is $15/share, (ii) December 31, 2008 or the
market price of common stock is $20/share and (iii) December 31, 2009 or the market price of common stock is $25/share. Based on a closing market price per share of $4.11.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(4) | Vest in two equal annual installments at August 23, 2007 and August 23, 2008. Based on a closing market price per share of $0.78.
|--- | ---------------------------------------------------------------------------------------------------------------------------------

Employment of Our Executives

The Company has employment agreements with Messrs. Fogel, Emms, Lobban and Reynolds. Mr. Fogels agreement was entered into in August 2005 for a two year term. The agreement renews automatically for
successive one year periods unless terminated by either party on at least 90 day advance notice. The agreement stipulates that Mr. Fogels annual salary compensation is $180,000, subject to adjustment, and provides an allowance for
automobile expenses of $600 per month. During 2006, Mr. Fogel received $33,333 of his compensation through the issuance of shares of USEYs common stock.

Mr. Emms annual compensation is £200,000 and that of Mr. Lobbans is £150,000. In addition, both contracts include the payment of an automobile reimbursement allowance.
Mr. Emms contract also provides for the reimbursement of expenses for one round trip per year to North America for him and his family. Mr. Reynolds agreement is in effect until September 1, 2008 and provides him with an annual
salary of £120,000, and the payment of an automobile reimbursement allowance. Included in Mr. Reynolds contract is the obligation for the Company to reimburse him for three round trips to the United States for him and his spouse.
Messrs Emms, Lobban and Reynolds contract also provide for both contractual and specified milestone bonuses. Mr. Augustine is an employee at will with an annual salary of $150,000.

Mr. Larry Schneider had an employment agreement with US Energy for a term through May 2007 but the parties mutually agreed to terminate the
agreement in December 2006 pursuant to a separation agreement.

In 2006, the Compensation Committee awarded RSUs to Messrs. Fogel and
Augustine in order to encourage them to remain with the Company over the long term and to realize the embedded potential value of the Company over the next three to four years. The RSUs also served as an award for the consummation of the UK
Transaction. The RSUs vest over an approximately three and a half year period in three equal tranches which are consistent with the various phases of the project in connection with the UK Transaction, at trigger prices which represented a premium
over the closing price of the common stock of the Company on the award date in the range of 250% to 410%.

Potential Payments Upon Termination or
Change-in-Control

Employment Agreements

Our employment agreement with Asher Fogel expires in August 2007. This agreement renews automatically (unless timely notice of non-renewal is given) for successive one year periods and provides for the following
payment obligations by the Company upon termination: (i) in the case of disability, full compensation and other benefits net of any payments received or to be received under any disability policy provided or paid for by the Company for a period
as prescribed by the agreement and (ii) in the



35



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case of voluntary resignation, medical, dental and hospitalization insurance coverage for a period as prescribed by the agreement. Mr. Fogel has also
agreed not to disclose certain confidential information for a period of two years after his term of employment with the Company.

UK Energy
Systems Ltd. (UK Energy), an indirect subsidiary of the Company, has an employment agreement with Joseph P. Reynolds, which expires in September 2008. The agreement provides for the following payments by UK Energy in the case of
termination by UK Energy without cause or resignation by Mr. Reynolds for good reason: (i) any unpaid salary earned and accrued; (ii) the total remaining salary payments payable until the end of his two-year original term; and
(iii) a pro rata bonus, if applicable. Mr. Reynolds has agreed not to disclose certain confidential information at any time after the termination of his employment.

UK Energy has a service agreement with Grant Emms. The agreement provides that if the company terminates Mr. Emms, the company shall pay Mr. Emms a sum
equal to his basic salary and other contractual benefits for 4.5 months. The agreement also provides that if the company terminates Mr. Emms without cause, and Mr. Emms notifies the company within a specified period that he intends to relocate to
North America, the company will pay for Mr. Emms reasonable relocation expenses, provided that relocation occurs within six months of his termination of employment.

Viking UK Gas Limited, a subsidiary of UK Energy, has a service agreement with James A. Lobban. The agreement provides that if the company terminates Mr. Lobban, the company shall pay Mr. Lobban a sum equal to his
basic salary and other contractual benefits for six months.

Payment upon termination of employment contracts, calculated as if termination
occurred on December 31, 2006, would be as follows:



|                   |  |                      |         |    
|------------------ |  | -------------------- | ------- | ---
|                   |  | Termination Payments |        
|Asher E. Fogel     |  | $                    | 187,000 |    
|Grant Emms         |  |                      | 147,000 | (1)
|Joseph P. Reynolds |  |                      | 431,000 | (1)
|James A. Lobban    |  |                      | 147,000 | (1)

---

|(1) | Converted to U.S. dollars for purposes of this table based on a conversion rate of £1.9586 as of December 31, 2006.
|--- | -------------------------------------------------------------------------------------------------------------------

Benefit Plans

Under the terms of the 2000
Executive Incentive Compensation Plan (the 2000 Plan), upon a change in control of US Energy:



| |  | any option, SAR (including limited SAR), restricted stock, deferred stock, stock granted as a bonus or in lieu of another award, dividend equivalent, other
stock-based award, performance award or annual incentive award carrying a right to exercise that was not previously exercisable and vested shall become fully exercisable and vested;
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | limited SARs (and other SARs if so provided by their terms) shall become exercisable for amounts, in cash, determined by reference to the change in control price;
|- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | the restrictions, deferral of settlement, and forfeiture conditions applicable to any other award granted under the 2000 Plan shall lapse and such awards shall be
deemed fully vested as of the time of the change in control; and
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | with respect to any such outstanding award subject to achievement of performance goals and conditions under the 2000 Plan, such performance goals and other
conditions will be deemed to be met if and to the extent so provided by the committee administering the 2000 Plan in the agreement relating to such award.
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

A change in control is generally defined to occur upon:

(i) approval by the stockholders of the Company of a reorganization, merger, consolidation or other form of corporate transaction, in each case, with respect to which persons who were the stockholders of the Company
immediately prior to such transaction do not own more than 50% of the combined voting power of the surviving entity immediately thereafter;



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(ii) a liquidation or dissolution of the Company or the sale of all or substantially all of the assets of
the Company;

(ii) individuals who, as of the date on which the award is granted, constitute the board of directors cease for any reason to
constitute at least a majority of the board of directors; or

(iii) the acquisition (other than from the Company) by any person of more than
50% of either the then outstanding shares of the Companys common stock or the combined voting power of the Companys then outstanding voting securities entitled to vote generally in the election of directors.

Payments upon a change of control, calculated as if a change of control occurred on December 31, 2006, are as follows:



|                     |  |                               |          
|-------------------- |  | ----------------------------- | ---------
|                     |  | Unvested Restricted Stock (1)
|Asher E. Fogel       |  | $                             | 1,161,000
|Richard J. Augustine |  |                               | 390,178  

---

|(1) | Assumes change of control price is equal to closing market price of $5.16 on December 29, 2006.
|--- | -----------------------------------------------------------------------------------------------

COMPENSATION OF DIRECTORS

The following table presents the compensation received by non-employee
directors in 2006:

DIRECTOR COMPENSATION



|                 |  |                                |  |                |  |                 |     |  |          
|---------------- |  | ------------------------------ |  | -------------- |  | --------------- | --- |  | ---------
|Name             |  | Fees Earned or Paid in Cash($) |  | StockAwards($) |  | OptionAwards($) |     |  | Total ($)
|Stephen Brown    |  | 47,500                         |  | 5,475          |  |                 |     |  | 52,975   
|Jacob Feinstein  |  | 49,000                         |  | 5,475          |  |                 |     |  | 54,475   
|Carl Greene      |  | 70,500                         |  | 5,475          |  |                 |     |  | 75,975   
|Ronny Strauss    |  | 68,500                         |  | 5,475          |  |                 |     |  | 73,975   
|Robert Schneider |  |                                |  |                |  | 140,028         | (1) |  | 140,027  

---

|(1) | Represents the estimated present value of 40,000 stock options with an exercise price of $4.55 per share (i.e., the grant date closing market price on Nasdaq) using the Black
Scholes option pricing model.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Effective as of October 1, 2005, independent directors receive (i) a $20,000 annual
retainer, (ii) $1,000 for each Board (including the board of directors of US Energy Biogas Corp., our majority owned



37



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##### Table of Contents

subsidiary), audit, compensation or special committee meeting in which they participate and (iii) $500 for participating in meetings of other committees
of the Board (each such committee, an Additional Committee) on which they serve; provided, however, that the aggregate fees payable to any director for participating in meetings on any day shall not exceed $1,000, with the exception of
special committee meetings. The Chairman of the Audit Committee, the Compensation Committee and any Additional Committee receive annual retainers of $15,000, $10,000 and $2,500, respectively. Annual retainers are payable in arrears in equal
quarterly installments on the last business day of the applicable calendar quarter (or any portion thereof) during which the director is serving in the capacity entitling him to such fee.

On the first business day of each calendar year, each independent director who, as of such date, served as a director for at least 90 days prior thereto,
is to be issued 2,500 shares of US Energys common stock. Newly elected independent directors receive ten year options to acquire 40,000 shares of our common stock at an exercise price equal to fair market value of a share of common stock on
the date of grant.

COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION

During 2006, Stephen L. Brown, Carl W. Greene, Jacob Feinstein, Ronny Strauss and Robert Schneider served on the Compensation Committee. Messrs. Brown and
Greene resigned from the Board effective December 8, 2006 and December 6, 2006, respectively. Messrs. Schneider and Feinstein were appointed to the Compensation Committee on December 7, 2006.

No member of the Compensation Committee at any time during 2006 or at any other time had any relationship with us that would be required to be disclosed
as a related person transaction. During 2006, none of our executive officers served on the board of directors or compensation committee of another entity one or more of whose executive officers served as a member of our Board of Directors or
Compensation Committee.



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##### Table of Contents

|ITEM 12. | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.
|-------- | -----------------------------------------------------------------------------------------------

The following table sets forth the number of shares of common stock owned as of April 30, 2007 (including shares of common stock that each person has
the right to acquire by April 30, 2007) by: (i) each director, (ii) each of our executive officers, (iii) those persons known to us to beneficially own 5% or more of common stock, and (iv) all of our directors and officers
as a group. As of March 31, 2007, there were 21,290,443 shares of our common stock outstanding. Unless otherwise indicated, the address of each of the beneficial owners identified below is c/o U.S. Energy Systems, Inc., 750 Lexington Avenue,
New York, New York 10022.



|                                                                                                    |  |                                          |      |  |                
|--------------------------------------------------------------------------------------------------- |  | ---------------------------------------- | ---- |  | ---------------
|Name and Address of Beneficial Owner                                                                |  | Amount and Nature ofBeneficial Ownership |      |  | Percent ofClass
|Asher E. Fogel                                                                                      |  | 785,942                                  | (1)  |  | 2.1            
|                                                                                                    |  |                                         
|Richard J. Augustine                                                                                |  | 66,060                                   | (2)  |  | *              
|                                                                                                    |  |                                         
|Adam D. Greene                                                                                      |  | 60,428                                   | (3)  |  | *              
|                                                                                                    |  |                                         
|Grant Emms                                                                                          |  | 0                                        |      |  | *              
|                                                                                                    |  |                                         
|Anthony Lobban                                                                                      |  | 0                                        |      |  | *              
|                                                                                                    |  |                                         
|Joseph Reynolds                                                                                     |  | 0                                        |      |  | *              
|                                                                                                    |  |                                         
|Jacob Feinstein                                                                                     |  | 64,130                                   | (4)  |  | *              
|                                                                                                    |  |                                         
|Robert Schneider                                                                                    |  | 224,785                                  | (5)  |  | *              
|                                                                                                    |  |                                         
|Ronny Strauss                                                                                       |  | 56,929                                   | (6)  |  | *              
|                                                                                                    |  |                                         
|Lawrence I. Schneider                                                                               |  | 3,864,911                                | (7)  |  | 9.7            
|                                                                                                    |  |                                         
|Rita Schneider                                                                                      |  | 3,684,911                                | (8)  |  | 8.6            
|                                                                                                    |  |                                         
|Mark S. Brody d/b/a Financial Planning Analysts 734 Walt Whitman Road, Suite 301 Melville, NY 11747 |  | 2,781,833                                | (9)  |  | 7.4            
|                                                                                                    |  |                                         
|Silver Point Capital Management, LLC and affiliates 2 Greenwich Plaza, 1stFloor Greenwich, CT 06830 |  | 5,588,780                                | (10) |  | 14.7           
|                                                                                                    |  |                                         
|All executive officers and directors as a group (9 persons)                                         |  | 1,258,274                                |      |  | 3.3            

---

|* | Indicates less than 1%
|- | ----------------------



39



---

##### Table of Contents

|(1) | Includes: (i) 10,942 shares, (ii) options to acquire 750,000 shares and (iii) vested
restricted stock units convertible into 25,000 shares. Does not include non-vested restricted stock units to acquire 225,000 shares.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Includes (i) 20,444 shares of common stock owned directly, (ii) options to acquire 25,000
shares and (iii) vested restricted stock units convertible into 20,616 shares. Excludes options to acquire 50,000 shares of common stock with strike prices above market price and 75,616 shares issuable in connection with non-vested restricted
stock units.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Includes (i) 7,928 shares of common stock, (ii) options to acquire 50,000 shares and
(iii) vested restricted stock units convertible into 2,500 shares. Excludes 107,500 shares issuable in connection with non-vested restricted stock units.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(4) | Includes 24,130 shares of common stock and 40,000 shares of common stock issuable upon exercise of
options.
|--- | -----------------------------------------------------------------------------------------------------------

|(5) | Includes (i) 157,400 shares of common stock, (ii) 40,000 shares of common stock issuable upon
exercise of options, (iii) 22,900 as UGMA custodian for child and (iv) 4,485 shares of common stock held by his spouse. Robert Schneider is not related to Lawrence Schneider, Henry Schneider or Rita Schneider.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(6) | Includes 16,929 shares of common stock and 40,000 shares of common stock issuable upon exercise of
options.
|--- | -----------------------------------------------------------------------------------------------------------

|(7) | Includes: (i) 1,345,895 shares, (ii) 1,342,216 shares owned by his spouse, Rita Schneider, and
over which he disclaims beneficial ownership and (iii) options to acquire 996,800 shares.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(8) | Includes (i) 1,342,216 shares and (ii) the following securities beneficially owned by her
spouse, Lawrence Schneider, and over which she disclaims beneficial ownership: (a) 1,345,895 shares and (b) options to acquire 996,800 shares.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(9) | Based on the Schedule 13G filed by such person on January 17, 2007 which reported that such person
has the sole power to vote or direct the disposition with respect to 200,000 shares and shares the power to dispose or direct the disposition of 2,581,833 shares. These shares are held for discretionary accounts of certain clients. No individual
interest relates to more than five percent of the shares outstanding.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(10) | Pursuant to a Schedule 13D/A filed with Silver Point Capital Management, LLC and its affiliates
(Holders) on December 11, 2006. Filed with respect to ownership of the shares of common stock issuable upon exercise of warrants issued by the Company to the Holders in connection with a Credit Agreement entered into on
August 7, 2006 between the Company, U.S. Energy Overseas Investments LLC, Silver Point Finance, LLC and the Lenders party there.
|---- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

For a discussion of securities authorized for issuance under equity compensation plans, see Part II, Item 5 herein.



40



---

##### Table of Contents

|ITEM 13. | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE.
|-------- | --------------------------------------------------------------------------

Transactions with Related Persons

The Company did not have any transactions since the beginning of the last fiscal year, or
any currently proposed transaction, in which the Company was or is to be a participant and the amount involved exceeds $120,000, and in which any related person had or will have a direct or indirect material interest.

Related-person transactions have the potential to create actual or perceived conflicts of interest. The Company has policies in place to address
related-party transactions. In general, employees and directors may not be involved in a business transaction where there is a conflict of interest with the Company. For directors and officers, any waivers of the Companys conflict of interest
policy must be approved by the Board.

Director Independence

The Board has determined that the following directors are independent as defined by Nasdaq listing standards and the relevant regulations of the SEC: Jacob Feinstein, Carl Greene, Stephen Brown, Ronny Strauss and
Robert Schneider. Carl Greene and Stephen Brown resigned from the Board effective December 6, 2006 and December 8, 2006, respectively.



|ITEM 14. | PRINCIPAL ACCOUNTING FEES AND SERVICES.
|-------- | ---------------------------------------

The
following table shows the fees billed (after applicable adjustments) for the audit and other services provided by Weiser LLP in 2006 and Eisner, LLP in 2006 and 2005. Tax fees for 2006 represent fees paid to Kostin and Company for the preparation of
the 2005 annual tax returns.



|                   |  |      |         |         |   |        
|------------------ |  | ---- | ------- | ------- | - | -------
|                   |  | 2006 |         | 2005(1)
|Audit fees         |  | $    | 413,576 |         | $ | 394,046
|Audit-Related fees |  |      | 103,394 |         |   | 50,000 
|Tax fees           |  |      | 62,220  |         |   |       
|All other fees     |  |      |        |         |   |       
|                   |  |      |         |         |   |        
|Total              |  | $    | 579,190 |         | $ | 445,046

---

|(1) | Kostinbilled the Company an aggregate of $365,366 in 2005 for work on the 2004 fiscal year financial statements, consisting of $115,931 in Audit Fees and $240,435 in Tax Fees, which are not reflected in this
column.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Audit Fees. This category includes fees for the audits of our financial statements included in our Annual
Report on Form 10-K, review of financial statements included in our Quarterly Reports on Form 10-Q or services normally provided by our accountant in connection with statutory and regulatory filings.

Audit-related Fees. This category consists of assurance and related services that are reasonably related to the performance of the audit or review
of our financial statements and are not reported under Audit Fees above.



41



---

##### Table of Contents

Tax Fees. This category consists of professional services for tax compliance, tax planning and tax
advice. The services for the fees disclosed under this category include tax return preparation, research and technical tax advice.

All
Other Fees. This category consists of other professional products and services provided by our auditors.

Pre-Approval Policy

The audit committee has not adopted any pre-approval policies and procedures and none of the services reflected above were approved by such committee
through any such policy.



42



---

##### Table of Contents

PART IV



|ITEM 15. | EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
|-------- | ------------------------------------------

(a) The following
documents are filed as part of this report.

(1) Financial Statements

See Index to Consolidated Financial Statements at page F-1.

(3) Exhibits



|               |  |                                                                                                                                                                            
|-------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Description                                                                                                                                                                
|3.1            |  | Amended and Restated Certificate of Incorporation of the Company, filed herewith.                                                                                          
|               | 
|3.2            |  | Certificate of Amendment of Amended and Restated Certificate of Incorporation of the Company. (4)                                                                          
|               | 
|3.3            |  | Certificate of Amendment of Certificate of Incorporation of the Company. (14)                                                                                              
|               | 
|3.4            |  | Second Amended and Restated By-Laws of the Company, as amended through December 7, 2006. (15)                                                                              
|               | 
|3.5            |  | Certificate of Designation for Series B Preferred Stock of the Company. (7)                                                                                                
|               | 
|3.6            |  | Certificate of Correction to Certificate of Designation of Series B Preferred Stock. (8)                                                                                   
|               | 
|3.7            |  | Form of Certificate of Designation for Series C Preferred Stock of the Company. (8)                                                                                        
|               | 
|3.8            |  | Form of Certificate of Designation for Series D Preferred Stock of the Company. (8)                                                                                        
|               | 
|4.1            |  | Specimen Stock Certificate. (1)                                                                                                                                            
|               | 
|4.2            |  | Amended and Restated Plan of Recapitalization dated as of July 31, 2000 by and between the Company and the parties identified therein. (8)                                 
|               | 
|4.3            |  | Form of Series B Warrant to Purchase Common Stock. (4)                                                                                                                     
|               | 
|4.4            |  | Form of Series C Redeemable Common Stock Purchase Warrant. (5)                                                                                                             
|               | 
|4.5            |  | Form of Series D Common Stock Purchase Warrant. (20)                                                                                                                       
|               | 
|4.6            |  | Form of Series E Common Stock Purchase Warrant. (20)                                                                                                                       
|               | 
|4.7            |  | Form of Series F Common Stock Purchase Warrant. (20)                                                                                                                       
|               | 
|4.8            |  | Form of Series G Warrant to Purchase Common Stock. (20)                                                                                                                    
|               | 
|4.9            |  | Form of Series H Warrant to Purchase Common Stock. (20)                                                                                                                    
|               | 
|4.10           |  | Form of Series I Warrant to Purchase Common Stock. (20)                                                                                                                    
|               | 
|4.11           |  | Form of Series J Common Stock Purchase Warrant, filed herewith.                                                                                                            
|               | 
|4.12           |  | Class B membership units convertible into Common Stock (a description of which is set forth in Exhibit 10.46)                                                              
|               | 
|10.1           |  | 1996 Stock Option Plan. (21) *                                                                                                                                             
|               | 
|10.2           |  | 1997 Stock Option Plan. (22)*                                                                                                                                              
|               | 
|10.3           |  | 1998 Executive Incentive Compensation Plan. (6) *                                                                                                                          
|               | 
|10.4           |  | 2000 Executive Incentive Compensation Plan. (6) *                                                                                                                          
|               | 
|10.5           |  | 2000 Executive Bonus Plan. (6) *                                                                                                                                           
|               | 
|10.6           |  | Description of compensation program for directors. * (16)                                                                                                                  
|               | 
|10.7           |  | Form of Restricted Stock Unit Award Agreement for Directors. (13) *                                                                                                        
|               | 
|10.8           |  | Form of Restricted Stock Unit Award Agreement for Officers. (13) *                                                                                                         
|               | 
|10.9           |  | Stock Option Agreement between the Company and Lawrence Schneider with respect to 1,000,000 shares of Common Stock. (6) *                                                  
|               | 
|10.10          |  | Amended and Restated Stock Option Agreement between the Company and Lawrence Schneider dated May 10, 2000 with respect to 750,000 shares of the Company Common Stock. (4) *
|               | 
|10.11          |  | Employment Agreement dated as of August 17, 2005 by and between the Company and Asher Fogel. (17) *                                                                        
|               | 
|10.12          |  | Registration Rights Agreement, dated March 20, 1998, between the Company and Energy Systems Investors, LLC. (3)                                                            
|               | 
|10.13          |  | Registration Rights Agreement dated November 28, 2000 by and among U.S. Energy Systems, Inc. and the Zapco Stockholders. (5)                                               
|               | 
|10.14          |  | Warrant Purchase Agreement dated August 7, 2006, between the Company and Kenmont Special Opportunities Master Fund, L.P.                                                   
|               | 
|10.15          |  | Warrant Purchase Agreement dated August 7, 2006, between the Company and Credit Suisse Securities (USA) LLC.                                                               



43



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##### Table of Contents

|               |  |                                                                                                                                                                                                                                                                                
|-------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Description                                                                                                                                                                                                                                                                    
|10.16          |  | Warrant Purchase Agreement dated August 7, 2006, between the Company and SPCP Group, L.L.C. and SPCP Group III LLC.                                                                                                                                                            
|               | 
|10.17          |  | Form of 2007 Subscription Agreement to purchase common stock of the Company.                                                                                                                                                                                                   
|               | 
|10.18          |  | Purchase Agreement, dated as of January 24, 1994, between Lehi Co-Gen Associates, L.C. and Lehi Envirosystems, Inc. (2)                                                                                                                                                        
|               | 
|10.19          |  | Operating Agreement among Far West Capital, Inc., Suma Corporation and Lehi Envirosystems, Inc. dated January 24, 1994. (2)                                                                                                                                                    
|               | 
|10.20          |  | Agreement among the Company, Plymouth Envirosystems, Inc., IEC Plymouth, Inc. and Independent Energy Finance Corporation dated November 16, 1994. (1)                                                                                                                          
|               | 
|10.21          |  | Amended and Restated Agreement of Limited Partnership of Plymouth Cogeneration Limited Partnership between PSC Cogeneration Limited Partnership, Central Hudson Cogeneration, Inc. and Plymouth
Envirosystems, Inc. dated November 1, 1994. (1)                                
|               | 
|10.22          |  | Amended and Restated Agreement of Limited Partnership of PSC Cogeneration Limited Partnership among IEC Plymouth, Inc., Independent Energy Finance Corporation and Plymouth Envirosystems, Inc.
dated December 28, 1994. (1)                                                   
|               | 
|10.23          |  | Security Agreement and Financing Statement among the Company, Lehi Envirosystems, Inc., Plymouth Envirosystems, Inc. and Anchor Capital Company, LLC dated June 14, 1995, as amended.
(1)                                                                                      
|               | 
|10.24          |  | Loan and Option Agreement dated August, 1996 by and among NRG Company, LLC and Reno Energy, LLC and ART, LLC and FWC Energy, LLC, and Amendments thereto. (1)                                                                                                                  
|               | 
|10.25          |  | Pledge Agreement dated as of July 31, 2000 by and between the Company and Energy Systems Investors, L.L.C. (4)                                                                                                                                                                 
|               | 
|10.26          |  | Limited Recourse Promissory Note dated July 31, 2000 issued by Energy Systems Investors, L.L.C. in favor of the Company. (4)                                                                                                                                                   
|               | 
|10.27          |  | Performance Guaranty for Zapco Stockholders dated as November 28, 2000 of U.S. Energy Systems, Inc. (5)                                                                                                                                                                        
|               | 
|10.28          |  | Performance Guaranty of Cinergy Solutions Holding Company, Inc. dated as of November 28, 2000 (5)                                                                                                                                                                              
|               | 
|10.29          |  | Subscription Agreement dated as of November 28, 2000 by and among U.S. Energy Systems, Inc., USE Acquisition Corp. and Cinergy Energy Solutions, Inc. (5)                                                                                                                      
|               | 
|10.30          |  | Stockholders Agreement dated as of November 28, 2000 by and among U.S. Energy Systems, Inc., USE Acquisition Corp. and Cinergy Energy Solutions, Inc. (5)                                                                                                                      
|               | 
|10.31          |  | Indemnification Agreement dated as of November 28, 2000 by and among U.S. Energy Systems, Inc., USE Acquisition Corp. and Cinergy Energy Solutions, Inc. (5)                                                                                                                   
|               | 
|10.32          |  | Standby Payment Agreement dated as of June 11, 2001 by and among U.S. Energy Systems, Inc., USE Canada Acquisition Corp. and AJG Financial Services, Inc. (9)                                                                                                                  
|               | 
|10.33          |  | Agreement by and among AJG Financial Services, Inc., as agent, U.S. Energy Systems, Inc., Cinergy Energy Solutions, Inc., U.S. Energy Biogas Corp. and Tannenbaum, Helpern Syracuse &
Hirschtritt LLP as escrow agent dated as of October 16, 2003. (11)                       
|               | 
|10.34          |  | Escrow letter by and among, Tannenbaum, Halpern escrow agent, AJG Financial Services, Inc., as agent, Cinergy Energy, U.S. Energy Systems, Inc., USE Acquisition Corp., Cinergy Energy Solutions,
Inc. and Tannenbaum, Helpern Syracuse & Hirschtritt LLP as escrow agent. (11)
|               | 
|10.35          |  | Amended and Restated Subordinated Note from U.S. Energy Biogas Corp. to AJG Financial Services, Inc. (11)                                                                                                                                                                      
|               | 
|10.36          |  | Purchase Agreement dated September 30, 2004 among AJG Financial Services, Inc. and U.S. Energy Biogas Corp. (13)                                                                                                                                                               
|               | 
|10.37          |  | Assignment Agreement dated September 30, 2004 among AJG Financial Services, Inc. and U.S. Energy Biogas Corp. (13)                                                                                                                                                             
|               | 
|10.38          |  | Loan Agreement dated as of November 3, 2003 among Scandinavian Energy Finance Ltd. and EIC Electricity SA. (11)                                                                                                                                                                
|               | 
|10.39          |  | Amendment to Note Purchase Agreement dated as of April 8, 2004 by and between U.S. Energy Biogas Corp., Avon Energy Partners, LLC and the other parties identified therein. (12)                                                                                               



44



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##### Table of Contents

|               |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|-------------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Description                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|10.40          |  | Amendment dated April 8, 2004 among BMC Energy LLC, Countryside Canada Power Inc. and the other parties identified therein to the (i) Security Agreement dated as of May 2, 2001 among
BMC Energy LLC, Countryside Canada Power Inc. (as successor to AJG Financial Services, Inc.) and the other parties identified therein and (ii) Cash Collateral Pledge and Security Agreement dated as of April 30, 2001 among BMC Energy, LLC,
Countryside Canada Power Inc. (as successor to ABB Energy Capital, LLC) and the other parties identified therein (12)
|               | 
|10.41          |  | Agreement dated as of October 7, 2005 by and between the Company, Marathon Capital LLC and VTEX Energy Inc. (17)                                                                                                                                                                                                                                                                                                                                                                                                                                           
|               | 
|10.42          |  | Stock Purchase Agreement, dated as of November 28, 2006 by and between DEGS Biogas, Inc. and U.S. Energy Systems, Inc. (19)                                                                                                                                                                                                                                                                                                                                                                                                                                
|               | 
|10.43          |  | First Lien Credit Agreement, dated as of August 7, 2006, among GBGH, LLC, the lenders party thereto, Credit Suisse, Cayman Islands Branch, as First Lien Collateral Agent and First Lien
Administrative Agent, and Credit Suisse Securities (USA) LLC, as Sole Lead Arranger and Sole Bookrunner. (20)                                                                                                                                                                                                                                                     
|               | 
|10.44          |  | Second Lien Credit Agreement, dated as of August 7, 2006, among GBGH, LLC, the lenders party thereto, Credit Suisse, Cayman Islands Branch, as Second Lien Collateral Agent and Second Lien
Administrative Agent, Credit Suisse Securities (USA) LLC, as Sole Lead Arranger and Sole Bookrunner. (20)                                                                                                                                                                                                                                                      
|               | 
|10.45          |  | Equity Support Agreement, dated as of August 7, 2006, among U.S. Energy Systems, Inc., GBGH, LLC and Credit Suisse. (20)                                                                                                                                                                                                                                                                                                                                                                                                                                   
|               | 
|10.46          |  | Credit and Guaranty Agreement, dated as of August 7, 2006, among U.S. Energy Overseas Investments LLC, U.S. Energy Systems, Inc., various lenders and Silver Point Finance, LLC, as Administrative
Agent, Collateral Agent, Syndication Agent and Lead Arranger. (20)                                                                                                                                                                                                                                                                                      
|               | 
|10.47          |  | Second Amended and Restated Limited Liability Company Agreement, dated August 3, 2006, with respect to GBGH, LLC between US Energy Overseas Investments LLC and Marathon Capital Holdings (UK),
LLC. (20)                                                                                                                                                                                                                                                                                                                                                  
|               | 
|10.48          |  | Amended and Restated Limited Liability Company Agreement, dated May 22, 2006, with respect to US Energy Overseas Investments LLC between U.S. Energy Systems, Inc. and VTEX Energy Inc.
(20)                                                                                                                                                                                                                                                                                                                                                               
|               | 
|10.49          |  | Amendment No. 1 to the Amended and Restated Limited Liability Company Agreement, dated as of August 1, 2006, with respect to US Energy Overseas Investments LLC, between U.S. Energy Systems, Inc.
and VTEX Energy Inc. (20)                                                                                                                                                                                                                                                                                                                               
|               | 
|10.50          |  | Service Agreement, dated August 2006 between Viking UK Gas Limited and Anthony Lobban                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|               | 
|10.51          |  | Service Agreement, dated August 7, 2006 between UK Energy Systems Limited and Grant Emms                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|               | 
|10.52          |  | Employment Agreement, dated September 1, 2006 between UK Energy Systems, Ltd and Joseph P. Reynolds                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|               | 
|16.1           |  | Letter from Eisner, LLP dated June 19, 2006. (18)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|               | 
|23.1           |  | Consent of Weiser, LLP.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|               | 
|23.2           |  | Consent of Eisner LLP.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|               | 
|23.3           |  | Consent of Kostin and Company.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|               | 
|31.1           |  | Rule 13a-14(a)/15d-14(a) certifications.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|               | 
|31.2           |  | Rule 13a-14(a)/15d-14(a) certifications.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|               | 
|32.1           |  | Section 1350 certification.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                

---

|* | Management contract or compensatory plan or arrangement
|- | -------------------------------------------------------

|(1) | Incorporated by reference to the Companys Registration Statement on Form SB-2 (File No. 333-94612).
|--- | ----------------------------------------------------------------------------------------------------

|(2) | Incorporated by reference to the Companys Annual Report on Form 10-KSB for the year ended January 31, 1994.
|--- | ------------------------------------------------------------------------------------------------------------

|(3) | Incorporated by reference to the Companys Current Report on Form 8-K filed on March 26, 1998.
|--- | ----------------------------------------------------------------------------------------------

|(4) | Incorporated by reference to the Companys Quarterly Report on Form 10-QSB for the quarter ended July 31, 2000.
|--- | ---------------------------------------------------------------------------------------------------------------

|(5) | Incorporated by reference to the Companys Quarterly Report on Form 10-QSB for the quarter ended October 31, 2000.
|--- | ------------------------------------------------------------------------------------------------------------------

|(6) | Incorporated by reference to the Companys Current Report on Form 8-K dated May 4, 2000.
|--- | ----------------------------------------------------------------------------------------

|(7) | Incorporated by reference to the Companys Annual Report on Form 10-KSB for the year ended January 31, 1999.
|--- | ------------------------------------------------------------------------------------------------------------

|(8) | Incorporated by reference to the Companys Report on Form 10-KSB for the period ended December 31, 2000.
|--- | --------------------------------------------------------------------------------------------------------

|(9) | Incorporated by reference to the Companys Current Report on Form 8-K dated June 11, 2001.
|--- | ------------------------------------------------------------------------------------------



45



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##### Table of Contents

|(10) | Incorporated by reference to the Companys Quarterly Report on Form 10-QSB for the period ended June 30, 2002.
|---- | --------------------------------------------------------------------------------------------------------------

|(11) | Incorporated by reference to the Companys Report on Form 10-K for the period ended December 31, 2003, as amended.
|---- | ------------------------------------------------------------------------------------------------------------------

|(12) | Incorporated by reference to the Companys Report on Form 10-Q for the period ended March 31, 2004.
|---- | ---------------------------------------------------------------------------------------------------

|(13) | Incorporated by reference to the Companys Report on Form 10-Q for the period ended September 30, 2004.
|---- | -------------------------------------------------------------------------------------------------------

|(14) | Incorporated by reference to the Companys Current Report on Form 8-K filed with the SEC on November 30, 2006.
|---- | --------------------------------------------------------------------------------------------------------------

|(15) | Incorporated by reference to the Companys Current Report on Form 8-K filed with the SEC on December 12, 2006.
|---- | --------------------------------------------------------------------------------------------------------------

|(16) | Incorporated by reference to the Companys Current Report on Form 8-K filed with the SEC on October 3, 2005.
|---- | ------------------------------------------------------------------------------------------------------------

|(17) | Incorporated by reference to the Companys Quarterly Report on Form 10-Q for the period ended September 30, 2005.
|---- | -----------------------------------------------------------------------------------------------------------------

|(18) | Incorporated by reference to the Companys Current Report on Form 8-K filed with the SEC on June 19, 2006.
|---- | ----------------------------------------------------------------------------------------------------------

|(19) | Incorporated by reference to the Companys Current Report on Form 8-K dated November 28, 2006.
|---- | ----------------------------------------------------------------------------------------------

|(20) | Incorporated by reference to the Companys Quarterly Report on Form 10-Q for the period ended September 30, 2006, as amended.
|---- | -----------------------------------------------------------------------------------------------------------------------------

|(21) | Incorporated by reference to the Companys Annual Report on Form 10-KSB for the year ended January 31, 1997.
|---- | ------------------------------------------------------------------------------------------------------------

|(22) | Incorporated by reference to the Companys Registration Statement on Form S-8 (File No. 333-31030).
|---- | ---------------------------------------------------------------------------------------------------



46



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##### Table of Contents

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant
has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.



U.S. ENERGY SYSTEMS, INC.REGISTRANTBy:

/s/ Asher E. FogelAsher E. Fogel,Chief Executive Officer and PresidentJune 8, 2007


Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by
the following persons on behalf of the registrant and in the capacities and on the dates indicated.



|                                                |  |  |  |             
|----------------------------------------------- |  |  |  | ------------
|/s/ Jacob Feinstein                             |  |  |  | June 8, 2007
|Jacob Feinstein,                                |  |  |  |             
|Director                                        |  |  |  |             
|                                                |  | 
|/s/ Robert Schneider                            |  |  |  | June 8, 2007
|Robert Schneider,                               |  |  |  |             
|Director                                        |  |  |  |             
|                                                |  | 
|/s/ Ronny Strauss                               |  |  |  |             
|Ronny Strauss,                                  |  |  |  | June 8, 2007
|Director                                        |  |  |  |             
|                                                |  | 
|/s/ Asher E. Fogel                              |  |  |  |             
|Asher E. Fogel,                                 |  |  |  | June 8, 2007
|Chief Executive Officer, President and Director |  |  |  |             
|                                                |  | 
|/s/ Richard J. Augustine                        |  |  |  |             
|Richard J. Augustine,                           |  |  |  | June 8, 2007
|Chief Accounting Officer and Controller         |  |  |  |             



47



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##### Table of Contents

U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS



|                                                                                                                        |  |     
|----------------------------------------------------------------------------------------------------------------------- |  | ----
|Report of Independent Registered Public Accounting Firm                                                                 |  | F-2 
|                                                                                                                        | 
|Report of Independent Registered Public Accounting Firm                                                                 |  | F-3 
|                                                                                                                        | 
|Report of Independent Registered Public Accounting Firm                                                                 |  | F-4 
|                                                                                                                        | 
|Consolidated Balance Sheets as of December 31, 2006 and 2005                                                            |  | F-5 
|                                                                                                                        | 
|Consolidated Statements of Operations and Other Comprehensive Loss for the Years Ended December 31, 2006, 2005 and 2004 |  | F-7 
|                                                                                                                        | 
|Consolidated Statements of Cash Flows for the Years Ended December 31, 2006, 2005 and 2004                              |  | F-9 
|                                                                                                                        | 
|Consolidated Statements of Changes in Stockholders Equity for the Years Ended December 31, 2006, 2005 and 2004         |  | F-11
|                                                                                                                        | 
|Notes to Consolidated Financial Statements                                                                              |  | F-13



F-1



---

##### Table of Contents

Report of Independent Registered Public Accounting Firm

To the Board of Directors and

Stockholders of U.S. Energy Systems, Inc.

We have audited the accompanying
consolidated balance sheet of U.S. Energy Systems, Inc. and subsidiaries as of December 31, 2006 and the related consolidated statements of operations and other comprehensive loss, cash flows and changes in stockholders equity for the
year then ended. These consolidated financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these consolidated financial statements based upon our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and the significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of
U.S. Energy Systems, Inc. and subsidiaries as of December 31, 2006, and the consolidated results of their operations and their consolidated cash flows for the year then ended in conformity with U.S. generally accepted accounting principles.

The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note A
(1) to the consolidated financial statements, the Company has a working capital deficiency and has experienced continuing operating losses. These matters raise substantial doubt about the Companys ability to continue as a going concern.
Managements plans in regard to these matters are also described in Note A (1). The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

As discussed in Note A (11) to the consolidated financial statements, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123
(Revised 2004), Share-Based Payment, applying the modified prospective method at the beginning of the year ended December 31, 2006. Also, as discussed in Note C to the consolidated financial statements, the Company changed
its method of evaluating misstatements effective for fiscal years ended after November 15, 2006, to conform to Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in
Current Year Financial Statements.

/s/ Weiser LLP

New
York, New York

June 7, 2007



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##### Table of Contents

Report of Independent Registered Public Accounting Firm

Board of Directors and Stockholders

U.S. Energy Systems, Inc.

We have audited the accompanying consolidated
balance sheet of U.S. Energy Systems, Inc. and subsidiaries as of December 31, 2005 and the related consolidated statements of operations and other comprehensive income (loss), cash flows and changes in stockholders equity for the year
then ended. These financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of
U.S. Energy Systems, Inc. and subsidiaries as of December 31, 2005, and the consolidated results of their operations and their consolidated cash flows for the year then ended in conformity with accounting principles generally accepted in the
United States of America.

/s/ Eisner LLP

March 31, 2006



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##### Table of Contents

Report of Independent Registered Public Accounting Firm

Board of Directors and Stockholders

U.S. Energy Systems, Inc.

New York, New York

We have audited the accompanying consolidated statement of operations, stockholders equity and cash flows of U.S. Energy Systems, Inc. and subsidiaries as of
December 31, 2004 and the related consolidated statements of operations and other comprehensive income (loss), changes in stockholders equity and cash flows for the year ended December 31, 2004. These financial statements are the
responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements based on our audit.

We
conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, based on our audit, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated results of their operation and their consolidated cash flows for the year ended
December 31, 2004 in conformity with accounting principles generally accepted in the United States of America.

/s/ Kostin, Ruffkess & Company,
LLC

Farmington, Connecticut

March 31, 2005

Except as to the restatement discussed in Note Y to the consolidated financial statement which is as of May 23, 2005.



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##### Table of Contents

U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(In thousands, except share amounts)



|                                                                                                                 |  |                   |         |                   |   |        
|---------------------------------------------------------------------------------------------------------------- |  | ----------------- | ------- | ----------------- | - | -------
|                                                                                                                 |  | December 31, 2006 |         | December 31, 2005
|ASSETS                                                                                                           |  |                   |         |                   |   |        
|Current Assets:                                                                                                  |  |                   |         |                   |   |        
|Cash and Cash Equivalents                                                                                        |  | $                 | 3,873   |                   | $ | 11,301 
|Restricted Cash and Marketable Securities                                                                        |  |                   | 35,047  |                   |   | 5,501  
|Accounts Receivable Trade (less allowance for doubtful accounts of $159 and $888 in 2006 and 2005, respectively) |  |                   | 6,152   |                   |   | 2,198  
|Accounts Receivable Affiliates (less allowance for doubtful accounts of $511 in 2006 and 2005)                   |  |                   | 1,736   |                   |   | 2,789  
|Notes and Interest Receivable, Current Portion (less reserve of $739 in 2006)                                    |  |                   | 1,109   |                   |   | 1,976  
|Other Current Assets                                                                                             |  |                   | 3,346   |                   |   | 1,633  
|                                                                                                                 |  |                   |         |                   |   |        
|Total Current Assets                                                                                             |  |                   | 51,263  |                   |   | 25,398 
|                                                                                                                 |  |                  
|Restricted Cash and Marketable Securities                                                                        |  |                   | 56,329  |                   |   | 26,429 
|Property, Plant and Equipment, Net                                                                               |  |                   | 48,437  |                   |   | 40,306 
|Gas Property and Equipment, Depleting                                                                            |  |                   | 85,886  |                   |   |       
|Gas Property and Equipment, Non-Depleting                                                                        |  |                   | 5,427   |                   |   |       
|Construction in Progress                                                                                         |  |                   | 200     |                   |   | 198    
|Notes and Interest Receivable, less Current Portion (less reserve of $2,856 in 2006)                             |  |                   | 13,824  |                   |   | 22,088 
|Investments                                                                                                      |  |                   | 1,385   |                   |   | 1,234  
|Debt Issuance Costs, Net of Accumulated Amortization                                                             |  |                   | 9,685   |                   |   | 10,476 
|Goodwill                                                                                                         |  |                   | 26,618  |                   |   | 26,618 
|Derivative Instruments                                                                                           |  |                   | 23,823  |                   |   | 1,860  
|Deferred Tax Asset - Net                                                                                         |  |                   | 14,138  |                   |   | 13,878 
|Other Assets                                                                                                     |  |                   | 9,915   |                   |   | 544    
|                                                                                                                 |  |                   |         |                   |   |        
|Total Assets                                                                                                     |  | $                 | 346,930 |                   | $ | 169,029
|                                                                                                                 |  |                   |         |                   |   |        
|LIABILITIES                                                                                                      |  |                   |         |                   |   |        
|Current Liabilities:                                                                                             |  |                   |         |                   |   |        
|Current Portion of Long-Term Debt                                                                                |  | $                 | 33,000  |                   | $ | 1,879  
|Illinois Subsidy Liability - Current Portion                                                                     |  |                   | 5,250   |                   |   |       
|Accounts Payable Trade and Accrued Expenses                                                                      |  |                   | 12,517  |                   |   | 4,083  
|Accounts Payable Affiliates                                                                                      |  |                   | 1,530   |                   |   | 1,091  
|Deferred Revenue                                                                                                 |  |                   | 51      |                   |   | 272    
|                                                                                                                 |  |                   |         |                   |   |        
|Total Current Liabilities                                                                                        |  |                   | 52,348  |                   |   | 7,325  
|                                                                                                                 |  |                  
|Long-Term Debt, less Current Portion                                                                             |  |                   | 192,126 |                   |   | 87,282 
|Deferred Revenue                                                                                                 |  |                   | 13,486  |                   |   | 16,224 
|Deferred Royalty                                                                                                 |  |                   |        |                   |   | 5,379  
|Illinois Subsidy Liability, less current portion                                                                 |  |                   | 32,234  |                   |   | 31,678 
|Derivative Instruments                                                                                           |  |                   | 978     |                   |   |       
|Decommissioning Liability                                                                                        |  |                   | 6,273   |                   |   |       
|                                                                                                                 |  |                   |         |                   |   |        
|Total Liabilities                                                                                                |  |                   | 297,445 |                   |   | 147,888
|                                                                                                                 |  |                  
|Minority Interests                                                                                               |  |                   | 18,005  |                   |   | 4,968  

See notes to consolidated financial statements



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##### Table of Contents

U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS (Continued)

(In thousands, except share amounts)



|                                                                                                                                                                                                                 |  |                   |         |   |                   |   |         |  
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------- | ------- | - | ----------------- | - | ------- | -
|                                                                                                                                                                                                                 |  | December 31, 2006 |         |   | December 31, 2005 |  
|EQUITY                                                                                                                                                                                                           |  |                   |         |   |                   |   |         |  
|Preferred Stock, $.01 par value, Authorized 10,000 Shares:                                                                                                                                                       |  |                   |         |   |                   |   |         |  
|Series B, Cumulative, Convertible, Issued and Outstanding 241 and 368 Shares as of December 31, 2006 and December 31, 2005,
liquidation preference $1,000 per share                                              |  |                   |        |   |                   |   |        |  
|Series C Cumulative, Convertible, Issued and Outstanding 24,067 and 97,333 Shares as of December 31, 2006 and December 31, 2005,
liquidation preference $30 per share                                            |  |                   |        |   |                   |   | 1       |  
|Series D, Cumulative, Convertible, Issued and Outstanding 0 shares as of December 31, 2006 and 916,666 Shares as of December 31,
2005                                                                            |  |                   |        |   |                   |   | 9       |  
|                                                                                                                                                                                                                 |  |                  
|Total Common Stock, $.01 par value, Authorized 75,000,000 Shares, issued 18,065,579 and, outstanding 17,622,316 as of December 31, 2006
and issued 13,487,372 and outstanding 13,044,109 as of December 31, 2005 |  |                   | 181     |   |                   |   | 135     |  
|Treasury Stock, at Cost  443,263 Shares                                                                                                                                                                         |  |                   | (2,204  | ) |                   |   | (2,204  | )
|Additional Paid-in Capital                                                                                                                                                                                       |  |                   | 101,007 |   |                   |   | 62,583  |  
|Accumulated Deficit                                                                                                                                                                                              |  |                   | (73,275 | ) |                   |   | (46,528 | )
|Accumulated Other Comprehensive Income                                                                                                                                                                           |  |                   | 5,771   |   |                   |   | 2,177   |  
|                                                                                                                                                                                                                 |  |                   |         |   |                   |   |         |  
|Total Stockholders Equity                                                                                                                                                                                       |  |                   | 31,480  |   |                   |   | 16,173  |  
|                                                                                                                                                                                                                 |  |                   |         |   |                   |   |         |  
|TOTAL LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                                                       |  | $                 | 346,930 |   |                   | $ | 169,029 |  
|                                                                                                                                                                                                                 |  |                   |         |   |                   |   |         |  

See notes to consolidated financial statements



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##### Table of Contents

U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS AND OTHER COMPREHENSIVE
LOSS

(In thousands, except share data)



|                                                                                       |  |                             |         |   |                             |   |         |                             |  |   |         |  
|-------------------------------------------------------------------------------------- |  | --------------------------- | ------- | - | --------------------------- | - | ------- | --------------------------- |  | - | ------- | -
|                                                                                       |  | Year EndedDecember 31, 2006 |         |   | Year EndedDecember 31, 2005 |   |         | Year
EndedDecember 31, 2004 | 
|Revenues                                                                               |  | $                           | 21,244  |   |                             | $ | 19,620  |                             |  | $ | 20,108  |  
|                                                                                       |  |                             |         |   |                             |   |         |                             |  |   |         |  
|Costs and Expenses:                                                                    |  |                             |         |   |                             |   |         |                             |  |   |         |  
|Operating Expenses                                                                     |  |                             | 13,260  |   |                             |   | 9,721   |                             |  |   | 9,646   |  
|General and Administrative Expenses                                                    |  |                             | 9,367   |   |                             |   | 6,399   |                             |  |   | 3,241   |  
|Depreciation and Amortization                                                          |  |                             | 6,249   |   |                             |   | 4,611   |                             |  |   | 4,279   |  
|Investment Write-Offs                                                                  |  |                             |        |   |                             |   |        |                             |  |   | 7,089   |  
|Income from Joint Ventures                                                             |  |                             | (111    | ) |                             |   | (310    | )                           |  |   | (118    | )
|                                                                                       |  |                             |         |   |                             |   |         |                             |  |   |         |  
|Total Costs and Expenses                                                               |  |                             | 28,765  |   |                             |   | 20,421  |                             |  |   | 24,137  |  
|                                                                                       |  |                             |        
|Loss from Operations                                                                   |  |                             | (7,521  | ) |                             |   | (801    | )                           |  |   | (4,029  | )
|Interest and Dividend Income                                                           |  |                             | 3,894   |   |                             |   | 3,452   |                             |  |   | 2,828   |  
|Foreign Currency Transaction Expense                                                   |  |                             | (2,536  | ) |                             |   | (2,775  | )                           |  |   | (6,989  | )
|Gain on Derivatives                                                                    |  |                             | 2,756   |   |                             |   |        |                             |  |   |        |  
|Interest Expense                                                                       |  |                             | (22,971 | ) |                             |   | (10,800 | )                           |  |   | (9,443  | )
|Transaction costs                                                                      |  |                             |        |   |                             |   |        |                             |  |   | (13,858 | )
|Other (Expense) Income                                                                 |  |                             | (2,490  | ) |                             |   | 997     |                             |  |   | 2,641   |  
|                                                                                       |  |                             |         |   |                             |   |         |                             |  |   |         |  
|Loss before Reorganization Expense, Taxes, Minority Interest and Disposal of a Segment |  |                             | (28,868 | ) |                             |   | (9,927  | )                           |  |   | (28,850 | )
|                                                                                       |  |                             |        
|Reorganization Expense - Legal Fees                                                    |  |                             | (1,369  | ) |                             |   |        |                             |  |   |        |  
|                                                                                       |  |                             |         |   |                             |   |         |                             |  |   |         |  
|Loss Before Income Taxes, Minority Interest and Disposal of a Segment                  |  |                             | (30,237 | ) |                             |   | (9,927  | )                           |  |   | (28,850 | )
|                                                                                       |  |                             |        
|Income Tax (Expense) Benefit                                                           |  |                             | (21     | ) |                             |   | (870    | )                           |  |   | 6,694   |  
|Minority Interest                                                                      |  |                             | 2,684   |   |                             |   | 1,181   |                             |  |   | 5,857   |  
|                                                                                       |  |                             |         |   |                             |   |         |                             |  |   |         |  
|Loss from Continuing Operations                                                        |  |                             | (27,574 | ) |                             |   | (9,616  | )                           |  |   | (16,299 | )
|Income from Discontinued Operations                                                    |  |                             |        |   |                             |   |        |                             |  |   | 495     |  
|Gain on Disposal of a Segment                                                          |  |                             |        |   |                             |   | 150     |                             |  |   | 6,560   |  
|                                                                                       |  |                             |         |   |                             |   |         |                             |  |   |         |  
|Net Loss                                                                               |  |                             | (27,574 | ) |                             |   | (9,466  | )                           |  |   | (9,244  | )
|Dividends on Preferred Stock                                                           |  |                             | (261    | ) |                             |   | (826    | )                           |  |   | (828    | )
|                                                                                       |  |                             |         |   |                             |   |         |                             |  |   |         |  
|Net Loss Applicable to Common Stock                                                    |  | $                           | (27,835 | ) |                             | $ | (10,292 | )                           |  | $ | (10,072 | )
|                                                                                       |  |                             |         |   |                             |   |         |                             |  |   |         |  
|Other Comprehensive Loss:                                                              |  |                             |         |   |                             |   |         |                             |  |   |         |  
|Net Loss                                                                               |  | $                           | (27,574 | ) |                             | $ | (9,466  | )                           |  | $ | (9,244  | )
|Unrealized Gain                                                                        |  |                             | 589     |   |                             |   | 167     |                             |  |   | 1,588   |  
|Foreign Currency Translation                                                           |  |                             | 3,832   |   |                             |   |        |                             |  |   |        |  
|                                                                                       |  |                             |         |   |                             |   |         |                             |  |   |         |  
|Total Comprehensive Loss                                                               |  | $                           | (23,153 | ) |                             | $ | (9,299  | )                           |  | $ | (7,656  | )
|                                                                                       |  |                             |         |   |                             |   |         |                             |  |   |         |  

See notes to consolidated financial statements



F-7



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##### Table of Contents

U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS AND OTHER COMPREHENSIVE LOSS (continued)

(In thousands, except share data)



|                                                                         |  |                              |            |   |                              |   |            |                             |  |   |            |  
|------------------------------------------------------------------------ |  | ---------------------------- | ---------- | - | ---------------------------- | - | ---------- | --------------------------- |  | - | ---------- | -
|                                                                         |  | Year Ended December 31, 2006 |            |   | Year Ended December 31, 2005 |   |            | Year
EndedDecember 31, 2004 | 
|NET LOSS PER SHARE OF COMMON STOCK:                                      |  |                              |            |   |                              |   |            |                             |  |   |            |  
|Net Loss per Share from Continuing Operations - Basic and Diluted        |  | $                            | (1.72      | ) |                              | $ | (0.85      | )                           |  | $ | (1.44      | )
|Net Income per Share - Discontinued Operations - Basic and Diluted       |  | $                            |           |   |                              | $ |           |                             |  | $ | 0.04       |  
|                                                                         |  |                              |           
|Net Income per Share - Gain on Disposal of a Segment  Basic and Diluted |  | $                            |           |   |                              | $ | 0.02       |                             |  | $ | 0.55       |  
|                                                                         |  |                              |           
|Net Loss per Share of Common Stock  Basic and Diluted                   |  | $                            | (1.72      | ) |                              | $ | (0.83      | )                           |  | $ | (0.85      | )
|                                                                         |  |                              |           
|Weighted Average Number of Common Shares Outstanding  Basic and Diluted |  |                              | 16,204,000 |   |                              |   | 12,356,000 |                             |  |   | 11,890,000 |  

See notes to consolidated financial statements



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##### Table of Contents

U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)



|                                                                                          |  |                              |          |   |                              |   |        |                              |  |   |         |  
|----------------------------------------------------------------------------------------- |  | ---------------------------- | -------- | - | ---------------------------- | - | ------ | ---------------------------- |  | - | ------- | -
|                                                                                          |  | Year Ended December 31, 2006 |          |   | Year Ended December 31, 2005 |   |        | Year Ended December 31, 2004 | 
|CASH FLOWS FROM OPERATING ACTIVITIES:                                                     |  |                              |          |   |                              |   |        |                              |  |   |         |  
|Net loss                                                                                  |  | $                            | (27,574  | ) |                              | $ | (9,466 | )                            |  | $ | (9,244  | )
|                                                                                          |  |                              |         
|Adjustments to Reconcile Net Loss to net cash (used in) provided by operating activities: |  |                              |          |   |                              |   |        |                              |  |   |         |  
|Depreciation and Amortization                                                             |  |                              | 6,249    |   |                              |   | 4,611  |                              |  |   | 4,279   |  
|Gain on Derivatives                                                                       |  |                              | (2,756   | ) |                              |   |       |                              |  |   |        |  
|Reserve Against Notes Receivable                                                          |  |                              | 3,595    |   |                              |   |       |                              |  |   |        |  
|Gain on Sale of Subsidiary                                                                |  |                              |         |   |                              |   | (150   | )                            |  |   | 1,384   |  
|Minority Interest                                                                         |  |                              | (2,472   | ) |                              |   | (1,181 | )                            |  |   | (1,734  | )
|Foreign Currency Transaction Expense                                                      |  |                              | 2,536    |   |                              |   | 2,775  |                              |  |   | 7,293   |  
|Deferred Taxes                                                                            |  |                              | (60      | ) |                              |   | 727    |                              |  |   | 3,287   |  
|Provision for Bad Debts                                                                   |  |                              | (715     | ) |                              |   | 1,353  |                              |  |   |        |  
|Stock Based Compensation                                                                  |  |                              | 2,602    |   |                              |   | 360    |                              |  |   |        |  
|Income from Joint Ventures                                                                |  |                              | (111     | ) |                              |   | (310   | )                            |  |   |        |  
|Non-Cash Interest Expense                                                                 |  |                              | 3,514    |   |                              |   |       |                              |  |   |        |  
|Changes in:                                                                               |  |                              |          |   |                              |   |        |                              |  |   |         |  
|Accounts Receivable, Trade                                                                |  |                              | (1,500   | ) |                              |   | (1,473 | )                            |  |   | 4,247   |  
|Foreign Currency Hedge                                                                    |  |                              |         |   |                              |   | 614    |                              |  |   | (2,414  | )
|Other Current Assets                                                                      |  |                              | (1,310   | ) |                              |   | 6      |                              |  |   | 2,025   |  
|Other Assets                                                                              |  |                              | 439      |   |                              |   | (535   | )                            |  |   | 249     |  
|Accounts Payable and Accrued Expenses                                                     |  |                              | 4,003    |   |                              |   | 1,113  |                              |  |   | (1,829  | )
|Deferred Royalty                                                                          |  |                              |         |   |                              |   | (307   | )                            |  |   | (314    | )
|Deferred Revenue                                                                          |  |                              | (493     | ) |                              |   | (601   | )                            |  |   | (14,515 | )
|Illinois Subsidy Liability                                                                |  |                              | 5,806    |   |                              |   | 5,332  |                              |  |   | 5,694   |  
|Decommissioning Liability                                                                 |  |                              | 6,273    |   |                              |   |       |                              |  |   |        |  
|                                                                                          |  |                              |          |   |                              |   |        |                              |  |   |         |  
|Net cash flows (used in) provided by Operating Activities                                 |  |                              | (1,974   | ) |                              |   | 2,868  |                              |  |   | (1,592  | )
|                                                                                          |  |                              |          |   |                              |   |        |                              |  |   |         |  
|CASH FLOWS FROM INVESTING ACTIVITIES:                                                     |  |                              |          |   |                              |   |        |                              |  |   |         |  
|Deposits to Restricted Cash                                                               |  |                              | (1,263   | ) |                              |   | (2,209 | )                            |  |   | (10,317 | )
|Deposits to Restricted Cash-Capital Expansion  UK                                        |  |                              | (39,840  | ) |                              |   |       |                              |  |   |        |  
|Acquisition/Capital Improvements UK Operations                                            |  |                              | (81,052  | ) |                              |   |       |                              |  |   |        |  
|Proceeds from Sale of Subsidiary                                                          |  |                              |         |   |                              |   |       |                              |  |   | 15,885  |  
|Proceeds from Notes Receivable                                                            |  |                              | 641      |   |                              |   | 1,969  |                              |  |   | 2,378   |  
|Purchase of Investments                                                                   |  |                              | (41      | ) |                              |   | (124   | )                            |  |   |        |  
|Purchase of Derivatives                                                                   |  |                              | (21,047  | ) |                              |   |       |                              |  |   |        |  
|Debt Issuance Costs                                                                       |  |                              | (7,455   | ) |                              |   |       |                              |  |   |        |  
|Acquisition of Equipment                                                                  |  |                              | (7,796   | ) |                              |   | (2,225 | )                            |  |   | (1,384  | )
|Goodwill                                                                                  |  |                              |         |   |                              |   |       |                              |  |   | (401    | )
|                                                                                          |  |                              |          |   |                              |   |        |                              |  |   |         |  
|Net cash (used in) provided by Investing Activities                                       |  |                              | (157,853 | ) |                              |   | (2,589 | )                            |  |   | 6,161   |  
|                                                                                          |  |                              |          |   |                              |   |        |                              |  |   |         |  

See notes to consolidated financial statements



F-9



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##### Table of Contents

U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)

(in thousands)



|                                                                   |  |                              |         |   |                              |   |        |                              |  |   |         |  
|------------------------------------------------------------------ |  | ---------------------------- | ------- | - | ---------------------------- | - | ------ | ---------------------------- |  | - | ------- | -
|                                                                   |  | Year Ended December 31, 2006 |         |   | Year Ended December 31, 2005 |   |        | Year Ended December 31, 2004 | 
|CASH FLOWS FROM FINANCING ACTIVITIES:                              |  |                              |         |   |                              |   |        |                              |  |   |         |  
|Issuance of Long-term Debt                                         |  |                              | 166,335 |   |                              |   |       |                              |  |   | 81,430  |  
|Payments of Long-term Debt                                         |  |                              | (1,265  | ) |                              |   | (1,373 | )                            |  |   | (66,039 | )
|Effect of Exchange Rates of Principal Payments                     |  |                              |        |   |                              |   | (60    | )                            |  |   |        |  
|Deposits to Restricted Cash                                        |  |                              | (16,489 | ) |                              |   |       |                              |  |   |        |  
|Proceeds from Subsidiary Issuance of Ownership Interests           |  |                              | 3,343   |   |                              |   | (1,696 | )                            |  |   |        |  
|Debt Prepayment Penalties                                          |  |                              |        |   |                              |   |       |                              |  |   | (9,531  | )
|Gain on Acquisition of Debt                                        |  |                              |        |   |                              |   |       |                              |  |   | (2,729  | )
|Deferred Royalty                                                   |  |                              |        |   |                              |   |       |                              |  |   | 6,000   |  
|Dividends on Preferred Stock                                       |  |                              | (261    | ) |                              |   | (826   | )                            |  |   | (828    | )
|Proceeds from Exercise of Options                                  |  |                              | 211     |   |                              |   |       |                              |  |   |        |  
|Distributions                                                      |  |                              |        |   |                              |   | (1,005 | )                            |  |   |        |  
|Advance from Joint Ventures                                        |  |                              |        |   |                              |   |       |                              |  |   | (100    | )
|                                                                   |  |                              |         |   |                              |   |        |                              |  |   |         |  
|Net cash provided by (used in) Financing Activities                |  |                              | 151,874 |   |                              |   | (4,960 | )                            |  |   | 8,203   |  
|                                                                   |  |                              |         |   |                              |   |        |                              |  |   |         |  
|Effect of Exchange Rate                                            |  |                              |         |   |                              |   |        |                              |  |   |         |  
|Changes on Cash and Cash Equivalents                               |  |                              | 525     |   |                              |   |       |                              |  |   |        |  
|                                                                   |  |                              |         |   |                              |   |        |                              |  |   |         |  
|NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS               |  |                              | (7,428  | ) |                              |   | (4,681 | )                            |  |   | 12,772  |  
|                                                                   |  |                              |        
|CASH AND CASH EQUIVALENTS  BEGINNING OF YEAR                      |  |                              | 11,301  |   |                              |   | 15,982 |                              |  |   | 3,210   |  
|                                                                   |  |                              |         |   |                              |   |        |                              |  |   |         |  
|CASH AND CASH EQUIVALENTS  END OF YEAR                            |  | $                            | 3,873   |   |                              | $ | 11,301 |                              |  | $ | 15,982  |  
|                                                                   |  |                              |         |   |                              |   |        |                              |  |   |         |  
|Supplemental Disclosure of Cash Flow Information:                  |  |                              |         |   |                              |   |        |                              |  |   |         |  
|Cash paid for Interest                                             |  | $                            | 18,376  |   |                              | $ | 8,677  |                              |  | $ | 7,445   |  
|State Taxes Paid, net                                              |  |                              | 188     |   |                              |   | 109    |                              |  |   | 240     |  
|                                                                   |  |                              |        
|Supplemental Schedule of Non-cash Investing & Financing Activities |  |                              |         |   |                              |   |        |                              |  |   |         |  
|                                                                   |  |                              |        
|Gain on Acquisition of Debt                                        |  |                              |        |   |                              |   |       |                              |  |   | 2,728   |  
|                                                                   |  |                              |        
|Contingent Note Receivable                                         |  |                              |        |   |                              |   |       |                              |  |   | 2,502   |  
|                                                                   |  |                              |        
|Conversion of Preferred Stock to Common Stock                      |  |                              | 10      |   |                              |   | 9      |                              |  |   |        |  
|                                                                   |  |                              |        
|Non Cash Component of UK Acquisition Price                         |  |                              | 15,433  |   |                              |   |       |                              |  |   |        |  
|                                                                   |  |                              |        
|Non Cash Component of UK Debt Issuance Costs                       |  |                              | 34,081  |   |                              |   |       |                              |  |   |        |  

See notes to consolidated financial statements



F-10



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##### Table of Contents

U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS EQUITY

FOR THE YEAR ENDED DECEMBER 31, 2006

(in thousands, except share data)



|                                              |  |                          |   |                          |        |   |                          |         |   |              |   |                |              |  |          |        |  |   |              |   |        |            |               |   |     |        |          |   |                          |   |        |                                     |  |   |                    |   |  |       |       |   |  |   |         |   |  |   |         |  
|--------------------------------------------- |  | ------------------------ | - | ------------------------ | ------ | - | ------------------------ | ------- | - | ------------ | - | -------------- | ------------ |  | -------- | ------ |  | - | ------------ | - | ------ | ---------- | ------------- | - | --- | ------ | -------- | - | ------------------------ | - | ------ | ----------------------------------- |  | - | ------------------ | - |  | ----- | ----- | - |  | - | ------- | - |  | - | ------- | -
|                                              |  | Preferred Stock Series B |   | Preferred Stock Series C |        |   | Preferred Stock Series D |         |   | Common Stock |   | Treasury Stock |              |  |          |       
|                                              |  | No. ofShares             |   |                          | Amount |   | No. ofShares             |         |   | Amount       |   |                | No. ofShares |  |          | Amount |  |   | No. ofShares |   | Amount |            | No. of Shares |   |     | Amount |          |   | AdditionalPaid inCapital |   |        | AccumulatedOtherComprehensiveIncome |  |   | AccumulatedDeficit |   |  | Total |      
|Balance December 31, 2005                    |  | 368                      |   |                          | $      |  |                          | 97,333  |   |              | $ | 1              |              |  | 916,666  |        |  | $ | 9            |   |        | 13,487,372 |               | $ | 135 |        | (443,263 | ) |                          | $ | (2,204 | )                                   |  | $ | 62,583             |   |  | $     | 2,177 |   |  | $ | (46,528 | ) |  | $ | 16,173  |  
|Conversion to Common                          |  | (127                     | ) |                          |        |  |                          | (73,266 | ) |              |   | (1             | )            |  | (916,666 | )      |  | $ | (9           | ) |        | 4,287,817  |               |   |     |        |          |   |                          |   |        |                                     |  |   | (33                | ) |  |       |       |   |  |   |         |   |  |   | (43     | )
|Issuance of Common Stock                      |  |                          |   |                          |        |   |                          |         |   |              |   |                |              |  |          |        |  |   |              |   |        | 290,390    |               |   | 46  |        |          |   |                          |   |        |                                     |  |   | 172                |   |  |       |       |   |  |   |         |   |  |   | 218     |  
|Issuance of Warrants                          |  |                          |   |                          |        |   |                          |         |   |              |   |                |              |  |          |        |  |   |              |   |        |            |               |   |     |        |          |   |                          |   |        |                                     |  |   | 36,014             |   |  |       |       |   |  |   |         |   |  |   | 36,014  |  
|Stock Based Compensation                      |  |                          |   |                          |        |   |                          |         |   |              |   |                |              |  |          |        |  |   |              |   |        |            |               |   |     |        |          |   |                          |   |        |                                     |  |   | 2,602              |   |  |       |       |   |  |   |         |   |  |   | 2,602   |  
|Foreign Currency Translation                  |  |                          |   |                          |        |   |                          |         |   |              |   |                |              |  |          |        |  |   |              |   |        |            |               |   |     |        |          |   |                          |   |        |                                     |  |   |                    |   |  |       | 3,832 |   |  |   |         |   |  |   | 3,832   |  
|Distributions                                 |  |                          |   |                          |        |   |                          |         |   |              |   |                |              |  |          |        |  |   |              |   |        |            |               |   |     |        |          |   |                          |   |        |                                     |  |   | (70                | ) |  |       |       |   |  |   |         |   |  |   | (70     | )
|Cumulative Effect of Adoption of SAB 108      |  |                          |   |                          |        |   |                          |         |   |              |   |                |              |  |          |        |  |   |              |   |        |            |               |   |     |        |          |   |                          |   |        |                                     |  |   |                    |   |  |       | (827  | ) |  |   | 827     |   |  |   |        |  
|Net Loss for the year ended December 31, 2006 |  |                          |   |                          |        |   |                          |         |   |              |   |                |              |  |          |        |  |   |              |   |        |            |               |   |     |        |          |   |                          |   |        |                                     |  |   |                    |   |  |       |       |   |  |   | (27,574 | ) |  |   | (27,574 | )
|Unrealized Gain                               |  |                          |   |                          |        |   |                          |         |   |              |   |                |              |  |          |        |  |   |              |   |        |            |               |   |     |        |          |   |                          |   |        |                                     |  |   |                    |   |  |       | 589   |   |  |   |         |   |  |   | 589     |  
|Dividends on Preferred Stock:                 |  |                          |   |                          |        |   |                          |         |   |              |   |                |              |  |          |        |  |   |              |   |        |            |               |   |     |        |          |   |                          |   |        |                                     |  |   |                    |   |  |       |       |   |  |   |         |   |  |   |         |  
|Series B                                      |  |                          |   |                          |        |   |                          |         |   |              |   |                |              |  |          |        |  |   |              |   |        |            |               |   |     |        |          |   |                          |   |        |                                     |  |   | (31                | ) |  |       |       |   |  |   |         |   |  |   | (31     | )
|Series C                                      |  |                          |   |                          |        |   |                          |         |   |              |   |                |              |  |          |        |  |   |              |   |        |            |               |   |     |        |          |   |                          |   |        |                                     |  |   | (106               | ) |  |       |       |   |  |   |         |   |  |   | (106    | )
|Series D                                      |  |                          |   |                          |        |   |                          |         |   |              |   |                |              |  |          |        |  |   |              |   |        |            |               |   |     |        |          |   |                          |   |        |                                     |  |   | (124               | ) |  |       |       |   |  |   |         |   |  |   | (124    | )
|                                              |  |                          |   |                          |        |   |                          |         |   |              |   |                |              |  |          |        |  |   |              |   |        |            |               |   |     |        |          |   |                          |   |        |                                     |  |   |                    |   |  |       |       |   |  |   |         |   |  |   |         |  
|Balance  December 31, 2006                   |  | 241                      |   |                          | $      |  |                          | 24,067  |   |              | $ |               |              |  |         |        |  | $ |             |   |        | 18,065,579 |               | $ | 181 |        | (443,263 | ) |                          | $ | (2,204 | )                                   |  | $ | 101,007            |   |  | $     | 5,771 |   |  | $ | (73,275 | ) |  | $ | 31,480  |  
|                                              |  |                          |   |                          |        |   |                          |         |   |              |   |                |              |  |          |        |  |   |              |   |        |            |               |   |     |        |          |   |                          |   |        |                                     |  |   |                    |   |  |       |       |   |  |   |         |   |  |   |         |  

See notes to consolidated financial statements



F-11



---

##### Table of Contents

CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS EQUITY

FOR THE YEAR ENDED DECEMBER 31, 2005

(in thousands, except share data)



|                                              |  |                          |  |                          |   |                          |        |        |              |              |                |           |        |  |   |              |   |        |            |              |   |     |        |          |   |                          |   |        |                                     |  |                    |        |   |       |   |       |  |   |         |   |  |   |        |  
|--------------------------------------------- |  | ------------------------ |  | ------------------------ | - | ------------------------ | ------ | ------ | ------------ | ------------ | -------------- | --------- | ------ |  | - | ------------ | - | ------ | ---------- | ------------ | - | --- | ------ | -------- | - | ------------------------ | - | ------ | ----------------------------------- |  | ------------------ | ------ | - | ----- | - | ----- |  | - | ------- | - |  | - | ------ | -
|                                              |  | Preferred Stock Series B |  | Preferred Stock Series C |   | Preferred Stock Series D |        |        | Common Stock |              | Treasury Stock |           |        |  |   |              |   |        |            |              |   |     |       
|                                              |  | No. ofShares             |  | Amount                   |   | No. ofShares             |        | Amount |              | No. ofShares |                |           | Amount |  |   | No. ofShares |   | Amount |            | No. ofShares |   |     | Amount |          |   | AdditionalPaid inCapital |   |        | AccumulatedOtherComprehensiveIncome |  | AccumulatedDeficit |        |   | Total |  
|Balance  December 31, 2004 Restated (Note Y) |  | 368                      |  | $                        |  |                          | 97,333 |        | $            | 1            |                | 1,138,888 |        |  | $ | 11           |   |        | 12,333,974 |              | $ | 123 |        | (443,263 | ) |                          | $ | (2,204 | )                                   |  | $                  | 64,063 |   |       | $ | 2,010 |  | $ | (37,062 | ) |  | $ | 26,942 |  
|Conversion to Common                          |  |                          |  |                          |   |                          |        |        |              |              |                | (222,222  | )      |  |   | (2           | ) |        | 888,888    |              |   | 9   |        |          |   |                          |   |        |                                     |  |                    | (7     | ) |       |   |       |  |   |         |   |  |   |       |  
|Issuance of Common Stock                      |  |                          |  |                          |   |                          |        |        |              |              |                |           |        |  |   |              |   |        | 185,210    |              |   | 2   |        |          |   |                          |   |        |                                     |  |                    | 198    |   |       |   |       |  |   |         |   |  |   | 200    |  
|Restricted Stock Vesting                      |  |                          |  |                          |   |                          |        |        |              |              |                |           |        |  |   |              |   |        | 79,300     |              |   | 1   |        |          |   |                          |   |        |                                     |  |                    | 159    |   |       |   |       |  |   |         |   |  |   | 160    |  
|Other Comprehensive Income/(Loss)             |  |                          |  |                          |   |                          |        |        |              |              |                |           |        |  |   |              |   |        |            |              |   |     |        |          |   |                          |   |        |                                     |  |                    |        |   |       |   | 167   |  |   |         |   |  |   | 167    |  
|Distributions                                 |  |                          |  |                          |   |                          |        |        |              |              |                |           |        |  |   |              |   |        |            |              |   |     |        |          |   |                          |   |        |                                     |  |                    | (1,005 | ) |       |   |       |  |   |         |   |  |   | (1,005 | )
|Net Loss for the year ended December 31, 2005 |  |                          |  |                          |   |                          |        |        |              |              |                |           |        |  |   |              |   |        |            |              |   |     |        |          |   |                          |   |        |                                     |  |                    |        |   |       |   |       |  |   | (9,466  | ) |  |   | (9,466 | )
|Dividends on Preferred Stock:                 |  |                          |  |                          |   |                          |        |        |              |              |                |           |        |  |   |              |   |        |            |              |   |     |        |          |   |                          |   |        |                                     |  |                    |        |   |       |   |       |  |   |         |   |  |   |        |  
|Series B                                      |  |                          |  |                          |   |                          |        |        |              |              |                |           |        |  |   |              |   |        |            |              |   |     |        |          |   |                          |   |        |                                     |  |                    | (30    | ) |       |   |       |  |   |         |   |  |   | (30    | )
|Series C                                      |  |                          |  |                          |   |                          |        |        |              |              |                |           |        |  |   |              |   |        |            |              |   |     |        |          |   |                          |   |        |                                     |  |                    | (180   | ) |       |   |       |  |   |         |   |  |   | (180   | )
|Series D                                      |  |                          |  |                          |   |                          |        |        |              |              |                |           |        |  |   |              |   |        |            |              |   |     |        |          |   |                          |   |        |                                     |  |                    | (615   | ) |       |   |       |  |   |         |   |  |   | (615   | )
|                                              |  |                          |  |                          |   |                          |        |        |              |              |                |           |        |  |   |              |   |        |            |              |   |     |        |          |   |                          |   |        |                                     |  |                    |        |   |       |   |       |  |   |         |   |  |   |        |  
|Balance  December 31, 2005                   |  | 368                      |  | $                        |  |                          | 97,333 |        | $            | 1            |                | 916,666   |        |  | $ | 9            |   |        | 13,487,372 |              | $ | 135 |        | (443,263 | ) |                          | $ | (2,204 | )                                   |  | $                  | 62,583 |   |       | $ | 2,177 |  | $ | (46,528 | ) |  | $ | 16,173 |  
|                                              |  |                          |  |                          |   |                          |        |        |              |              |                |           |        |  |   |              |   |        |            |              |   |     |        |          |   |                          |   |        |                                     |  |                    |        |   |       |   |       |  |   |         |   |  |   |        |  

See notes to consolidated financial statements

CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS EQUITY

FOR THE YEAR ENDED DECEMBER 31, 2004

(in thousands, except share data)



|                                                   |  |                         |  |                         |   |                         |        |              |   |                |  |           |  |              |    |        |            |              |   |     |        |          |   |                          |   |        |                                     |  |                    |        |   |       |   |       |  |   |         |   |  |   |        |  
|-------------------------------------------------- |  | ----------------------- |  | ----------------------- | - | ----------------------- | ------ | ------------ | - | -------------- |  | --------- |  | ------------ | -- | ------ | ---------- | ------------ | - | --- | ------ | -------- | - | ------------------------ | - | ------ | ----------------------------------- |  | ------------------ | ------ | - | ----- | - | ----- |  | - | ------- | - |  | - | ------ | -
|                                                   |  | Preferred StockSeries B |  | Preferred StockSeries C |   | Preferred StockSeries D |        | Common Stock |   | Treasury Stock |  |           |  |              |    |        |            |              |   |     |        |         
|                                                   |  | No. ofShares            |  | Amount                  |   | No. ofShares            |        | Amount       |   | No. ofShares   |  | Amount    |  | No. ofShares |    | Amount |            | No. ofShares |   |     | Amount |          |   | AdditionalPaid inCapital |   |        | AccumulatedOtherComprehensiveIncome |  | AccumulatedDeficit |        |   | Total |  
|Balance  December 31, 2003 as previously reported |  | 368                     |  | $                       |  |                         | 97,333 |              | $ | 1              |  | 1,138,888 |  | $            | 11 |        | 12,333,974 |              | $ | 123 |        | (443,263 | ) |                          | $ | (2,204 | )                                   |  | $                  | 64,891 |   |       | $ | 422   |  | $ | (27,818 | ) |  | $ | 35,426 |  
|Issuance of Common Stock                           |  |                         |  |                         |   |                         |        |              |   |                |  |           |  |              |    |        |            |              |   |     |        |          |   |                          |   |        |                                     |  |                    |        |   |       |   |       |  |   |         |   |  |   |        |  
|Other Comprehensive Income/(Loss)                  |  |                         |  |                         |   |                         |        |              |   |                |  |           |  |              |    |        |            |              |   |     |        |          |   |                          |   |        |                                     |  |                    |        |   |       |   | 1,588 |  |   |         |   |  |   | 1,588  |  
|Treasury Stock                                     |  |                         |  |                         |   |                         |        |              |   |                |  |           |  |              |    |        |            |              |   |     |        |          |   |                          |   |        |                                     |  |                    |        |   |       |   |       |  |   |         |   |  |   |        |  
|Net Loss for the year ended December 31, 2004      |  |                         |  |                         |   |                         |        |              |   |                |  |           |  |              |    |        |            |              |   |     |        |          |   |                          |   |        |                                     |  |                    |        |   |       |   |       |  |   | (9,244  | ) |  |   | (9,244 | )
|Dividends on Preferred Stock:                      |  |                         |  |                         |   |                         |        |              |   |                |  |           |  |              |    |        |            |              |   |     |        |          |   |                          |   |        |                                     |  |                    |        |   |       |   |       |  |   |         |   |  |   |        |  
|Series B                                           |  |                         |  |                         |   |                         |        |              |   |                |  |           |  |              |    |        |            |              |   |     |        |          |   |                          |   |        |                                     |  |                    | (33    | ) |       |   |       |  |   |         |   |  |   | (33    | )
|Series C                                           |  |                         |  |                         |   |                         |        |              |   |                |  |           |  |              |    |        |            |              |   |     |        |          |   |                          |   |        |                                     |  |                    | (180   | ) |       |   |       |  |   |         |   |  |   | (180   | )
|Series D                                           |  |                         |  |                         |   |                         |        |              |   |                |  |           |  |              |    |        |            |              |   |     |        |          |   |                          |   |        |                                     |  |                    | (615   | ) |       |   |       |  |   |         |   |  |   | (615   | )
|                                                   |  |                         |  |                         |   |                         |        |              |   |                |  |           |  |              |    |        |            |              |   |     |        |          |   |                          |   |        |                                     |  |                    |        |   |       |   |       |  |   |         |   |  |   |        |  
|Balance December 31, 2004                          |  | 368                     |  | $                       |  |                         | 97,333 |              | $ | 1              |  | 1,138,888 |  | $            | 11 |        | 12,333,974 |              | $ | 123 |        | (443,263 | ) |                          | $ | (2,204 | )                                   |  | $                  | 64,063 |   |       | $ | 2,010 |  | $ | (37,062 | ) |  | $ | 26,942 |  
|                                                   |  |                         |  |                         |   |                         |        |              |   |                |  |           |  |              |    |        |            |              |   |     |        |          |   |                          |   |        |                                     |  |                    |        |   |       |   |       |  |   |         |   |  |   |        |  

See notes to consolidated financial statements



F-12



---

##### Table of Contents

U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004

NOTE A  SIGNIFICANT ACCOUNTING POLICIES

Significant accounting policies followed in the preparation of the
consolidated financial statements are as follows:

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

The
accompanying unaudited condensed consolidated financial statements have been prepared assuming that the Company will continue as a going concern, which contemplates the realization of assets and the satisfaction of liabilities in the normal course
of business. The Company has continuing operating losses and a working capital deficit. Based on the Companys estimates of cash requirements, the Company expects that the $375,000 of unrestricted cash held directly by the Company, exclusive of
cash held by the Companys subsidiaries which is restricted for use by only the subsidiary for its operating purposes (see Notes E and K) by their respective financing arrangements, at December 31, 2006 is insufficient to fund the
Companys operations for the next year and will necessitate additional cash funding no later than the third quarter of 2007 to continue its operations. As discussed in Note X, during the first five months of 2007, the Company (i) raised
$6,400,000 from the sale of 1,280,000 shares of its common stock at a price of $5.00 per share, exclusive of warrants (from this amount $1,700,000 was required to be paid to Silver Point Capital as a paydown of their loan related to the UK
acquisition, (ii) had owners of 1,632,000 options to acquire the Companys common stock exercise those options and received proceeds from the exercise of the options of $5,100,000, and (iii) refinanced USEBs debt to emerge from bankruptcy
proceedings. Management believes that these transactions will provide the Company with sufficient working capital to sustain operations for the future. However, management cannot assure that such financing will be available or, if available, on
terms acceptable to management.

USEB Chapter 11 Filing - On November 29, 2006, USEB and certain of its subsidiaries filed for
reorganization under Chapter 11 of the U.S. Bankruptcy Code in the Southern District of New York in order to facilitate the restructuring of its capital structure particularly related to its debt with Countryside Power Income Fund
(Countryside). At the time of the filing, USEB was current in its payment of all principal and interest and did not have any monetary defaults under the loan agreements. The USEB Chapter 11 case number is 06-12827(RDD). USEB emerged from
bankruptcy on May 31, 2007.

On January 16, 2007, USEB announced that it reached an agreement with Countryside concerning the
principal issue in the case, the restructuring of the Countryside debt obligations. The agreement, which was subsequently approved by the Court, allowed Countryside a US$99,000,000 secured claim. The claim is the only allowed claim that Countryside
had in the Chapter 11 case and Countryside agreed to forgo any claims related to USEBs April 8, 2004 Royalty Agreement with Countryside, any fees incurred by Countryside pertaining to the case, all accrued but unpaid interest through
January 31, 2007 and any claims against the Company under the April 8, 2004 Development Agreement between USEY and Countryside. The Company made a US$3,000,000 payment against the secured claim in January 2007 and a US$30,000,000 payment
in March 2007. The remaining outstanding principal of US$66,000,000 was deemed over secured for purposes of adequate protection and the use of cash collateral in the bankruptcy case and bore interest at a rate of 10% per annum (down from
11% per the original loan agreement) payable monthly in US dollars to Countryside. The final installment against the secured claim was paid on May 31, 2007. Mutual general releases have been exchanged among the parties involved and will
cover certain individuals affiliated with the Fund who have been threatened with lawsuits arising out of their prior employment by the Company.

The
components of the secured claim were as follows:



|                                  |  |            |           
|--------------------------------- |  | ---------- | ----------
|Description                       |  | US Dollars
|Principal                         |  | $          | 90,168,000
|Interest through January 31, 2007 |  |            | 2,473,000 
|Royalty Agreement                 |  |            | 5,869,000 
|Expenses                          |  |            | 490,000   
|USEY Development Agreement        |  |            |          
|                                  |  |            |           
|Totals                            |  | $          | 99,000,000
|                                  |  |            |           

This obligation was paid in full on May 31, 2007, as noted below.

On March 19, 2007, USEB announced that it reached an agreement with the State of Illinois and the Illinois Commerce
Commission (the ICC) resolving the principal remaining outstanding issue in the Chapter 11 case. The agreement, which was approved by the Court, provided that the ICC would not pursue repayment of approximately $63,000,000 in
interest-free loans provided to certain of USEBs landfill gas to energy projects under the Illinois Retail Rate Program. In return, USEB or its subsidiaries would pay the ICC $5,250,000 on the effective date of USEBs Plan of
Reorganization but no later than May 31, 2007 and would withdraw its 10 operating projects from participation in the program by the effective date but no later than May 31, 2007. If USEB failed to pay the ICC by May 31, 2007, none of the
terms of the agreement would be effective or enforceable and the ICC will reinstate its claim for all funds due. The funds paid to the ICC included the establishment of a $250,000 escrow reserve account that will be utilized to pay any and all rate
adjustment claims, up to a $250,000 limit, for a period of six months immediately following effective date. USEB is currently executing plans to sell its electricity output from the 10 Illinois projects to other customers outside of the Illinois
Retail Rate Program. The Company is working with energy brokers and consultants to identify the optimum market for the energy and to execute power sales contracts. It is not anticipated that changes in rates from the exiting of the Illinois Retail
Rate Program and the entering into new contracts will have a significant adverse effect on the Companys revenues.

On May 31, 2007,
USEB completed is plan of reorganization through the obtaining of $80,000,000 in secured financing. The funds from the financing were utilized to repay Countryside its remaining $66,000,000 in debt, pay the Illinois Commerce Commission $5,250,000
per the terms of its settlement agreement with USEB, pay all undisputed, unsecured vendor claims and to establish various reserve accounts to be utilized for future capital expenditures, disputed unsecured vendor claims and other potential future
claims. See Note K.

In connection with the USEB bankruptcy, all claims were settled at their pre-petition recorded amounts except the
obligation related to the Illinois Subsidy Liability. Such amount was settled for $5,250,000 which is approximately $32,234,000 below the recorded amount as of December 31, 2006.



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U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004



(2) Foreign Currency Translation. The Companys Foreign Currency activity
relates to the translation to U.S. dollars from the Canadian dollar and the British Pound. USEBs debt with the Countryside Power Income Fund and its subsidiaries (the Countryside Debt) was denominated in Canadian dollars through
November 28, 2006 when the exchange rate was fixed through the May 31, 2007 repayment date. The functional currency of the Companys UK operations is British Pounds. The Company applies the Statement of Financial Accounting Standards
No. 52, Foreign Currency Translation, as amended (SFAS No. 52) and Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended (SFAS
No. 133), in the accounting treatment of the debt and the swap arrangements.

(3) Gain Recognition on Installment
Note. USEB has a $14,000,000 installment note receivable related to the sale of certain ownership interests in project entities. The Company recognizes gains associated with the note as principal payments are received, as such
principal payments are dependent upon future operations of the assets sold.

(4) Statement of Cash Flows and Cash
Equivalents. For purposes of reporting cash flows, cash and cash equivalents include cash on hand and investments in debt instruments with maturities of three months or less at the time of purchase. All carrying amounts approximate
fair value.

(5) Property, Plant and Equipment. Property, plant and equipment is stated at cost and is depreciated
using the straight-line method over their estimated useful lives ranging from three to 40 years with the power generation plants between 3 to 25 years.

(6) Goodwill. Goodwill represents the excess of the cost of acquired companies over the fair value of their tangible and identified intangible net assets acquired. Goodwill is evaluated at least
annually considering, among other factors, expected cash flows and profits of the business to which the goodwill relates. More specifically, the Company performed a discounted cash flow analysis using a risk adjusted rate of return, commensurate
with specific business or asset characteristics and potential business opportunities for the investment as of September 30, 2006. Significant estimates utilized in the discounted cash flow analysis include the amount of landfill gas available
for power generation, the rate paid for the power generation and the investment yields on the investment of reserve accounts. Changes in the actual results compared to these estimates would effect the valuation of goodwill.

Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (SFAS 142), requires goodwill to be assessed
for impairment at least annually by applying a fair-value-based test applied at the reporting unit level. An annual impairment test of the goodwill asset resulting from the acquisition of USEB was performed with no resulting change in
the valuation required. The Company performs goodwill impairment tests annually or when circumstances indicate that the fair value of a reporting unit has declined. In addition, the Company reassessed the carrying value of its recorded goodwill as
the result of the USEB bankruptcy filing. Based upon this assessment, management has determined that no impairment should have been recorded.



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##### Table of Contents

U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004



Goodwill at December 31, 2006 and 2005 is net of amortization of $592. Amortization ceased with
the adoption of SFAS No. 142.

(7) Per Share Data:Net Loss per share is computed by dividing income available to common
stockholders by the weighted average number of common stock outstanding during the period. In arriving at income available to common stockholders, preferred stock dividends have been deducted.

(8) Use of Estimates.The preparation of financial statements in conformity with accounting principles generally accepted in the
United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported
amounts of revenues and expenses during the reporting period. Estimates are used in the valuation of Goodwill, Deferred Tax Assets, the Allowance for Doubtful Accounts, the long-lived assets and the application of Statement of Accounting Financial
Standards No. 141, Business Combination (FAS141) in accounting for the entire UK Transaction. Estimates of gas production, investment returns on reserve accounts, inflation and energy rates are used in the valuation of these items.
Estimates are also utilized in the determination of future costs for the decommission liability related to the UK operations. Actual results may differ from the estimates used thereby affecting the future valuation of the items.

(9) Fair Values of Financial Instruments. The estimated fair value of financial instruments has been determined based on available
market information and appropriate valuation methodologies. The carrying amounts of cash, accounts receivable, other current assets, accounts payable and accrued expenses payable approximate fair value at December 31, 2006 and 2005 because of
the short maturity of these financial instruments. The carrying value of the notes receivable and long term debt approximate fair value, since interest rates approximate market rates for these types of instruments. The fair value estimates were
based on information available to management as of December 31, 2006 and 2005. If subsequent circumstances indicate that a decline in the fair market value of a financial asset is other than temporary, the financial instrument is written down
to its fair market value.

(10) Impairment of Long-Lived Assets.Long-lived assets, such as property, plant and
equipment are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount
of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized in the amount by which the carrying amount
of the asset exceeds the fair value of the asset. Assets to be disposed of would be separately presented in the balance sheet and reported at the lower of the carrying amount or the fair value less costs to sell, and are no longer depreciated. The
assets and liabilities of a disposed group classified as held for sale would be presented separately in the appropriate asset and liability sections of the financial statements. There was no impairment of assets in 2006, 2005 or 2004.

(11) Stock-Based Compensation. Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards (SFAS
No. 123R, Share-Based Payment (SFAS 123R) which establishes standards for transactions in which an entity exchanges its equity instruments for goods or services, including employee services. These transactions include
the issuance of stock options and restricted stock units to employees. As the result of the adoption of SFAS 123R, the Company recorded a charge of $1,668,000 in the year ended December 31, 2006, representing the effect on the loss from
operations and the net loss applicable to common stock. The impact of the adoption of SFAS 123R increased the basic and diluted net loss per share by $0.10.

For the fiscal years 2005 and 2004, the Company applied the intrinsic value method pursuant to APB Opinion No. 25 in accounting for its equity compensation plans. Accordingly, no compensation expenses have been
recognized in the financial statements for the years ended December 31, 2005 and 2004. Had the Company determined compensation expenses based on the fair value at the grant date for its equity instruments under SFAS 123R, and amortized such
expense over the vesting period, the Companys net loss for the years ended December 31, 2005 and 2004 would have increased as indicated below:



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##### Table of Contents

U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004



(in thousands, except share data)



|                                                                                           |  |      |         |   |      |   |         |  
|------------------------------------------------------------------------------------------ |  | ---- | ------- | - | ---- | - | ------- | -
|                                                                                           |  | 2005 |         |   | 2004 |  
|Reported Net Loss applicable to common stock                                               |  | $    | (10,292 | ) |      | $ | (10,072 | )
|                                                                                           |  |     
|Stock-Based Employee Compensation Included in Reported Net Income, net of tax              |  |      | 160     |   |      |   |        |  
|                                                                                           |  |     
|Stock-Based Employee Compensation Determined Under the Fair Value Based Method, net of tax |  |      | (2,356  | ) |      |   | (274    | )
|                                                                                           |  |      |         |   |      |   |         |  
|                                                                                           |  |     
|Pro Forma Net Loss applicable to common stock                                              |  | $    | (12,488 | ) |      | $ | (10,346 | )
|                                                                                           |  |      |         |   |      |   |         |  
|                                                                                           |  |     
|Basic and Diluted Loss Per Share:                                                          |  |      |         |   |      |   |         |  
|As Reported                                                                                |  | $    | (0.83   | ) |      | $ | (0.85   | )
|Pro Forma                                                                                  |  | $    | (1.01   | ) |      | $ | (0.87   | )

The weighted average fair value of options granted in 2006, 2005, and 2004 was approximately
$2.85, $1.08, and $0.21, respectively, using the Black-Scholes options-pricing model with the following assumptions:



|                                |  |       |   |  |      |   |  |       |  
|------------------------------- |  | ----- | - |  | ---- | - |  | ----- | -
|                                |  | 2006  |   |  | 2005 |   |  | 2004  |  
|Risk Free Interest Rate         |  | 4.625 | % |  | 4.77 | % |  | 4.20  | %
|Expected Option Life in Years   |  | 5.00  |   |  | 8.50 |   |  | 10.00 |  
|Expected Stock Price Volatility |  | 0.77  |   |  | 0.45 |   |  | 0.26  |  
|Expected Dividend Yield         |  | 0.00  | % |  | 0.00 | % |  | 0.00  | %

(12) Concentration of Credit Risk. A significant portion of the
Companys revenues are derived from investment grade utilities, and government and industrial customers. They have contracted with the Company to purchase energy over various terms. The concentration of credit with investment grade customers
reduces the Companys overall credit exposure. The Company received approximately 33% of its 2006 revenues from one Illinois utility, Commonwealth Edison in 2006. For 2005 and 2004, the Company received approximately 39% and 42%, respectively,
of its revenues from Commonwealth Edison.

The Company maintains demand deposits in excess of $100,000 with individual banks. The Federal
Deposit Insurance Corporation does not insure amounts in excess of $100,000.

(13) Debt Issuance Costs. For 2006, 2005
and 2004, amortization expense related to USEBs debt with Countryside was $791,000, $791,000 and $670,000, respectively.

(14)
Deferred Revenues. Deferred revenues primarily represent gains to be recognized from the sale of the Companys limited partnership interests in certain partnerships, further described in Note H. The majority of the proceeds
from the sale are to be paid in installments, the amount of which will be determined by production and the value of benefits received by the purchasers; therefore, the gain will be recognized as payments are received.

(15) Income Taxes. Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are
recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax
assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in tax rates on deferred tax assets and
liabilities is recognized in income (loss) in the period that includes the enactment date.



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##### Table of Contents

U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004



(16) Revenue Recognition. Revenues are recognized upon delivery of energy or
service. The energy rates the Company collects fluctuates with rates approved for use by utilities and municipalities local to the respective project. These rates may be estimates that are reconciled annually. Any difference between the estimated
rate and the actual rate may apply to the previous twelve month period based on the effective date of the power purchase agreement. The adjustment, if any, is booked in the period it is determined. Revenue related to the Illinois subsidy received by
certain USEB projects is accounted for reporting purposes in a manner similar to an original issue discount whereby the amount to be repaid in the future is discounted to its net present value and the discount is amortized (as interest expense) over
the ten-year period until repayment begins. See Note X.

(17) Capitalization Policy. As the Company has major holdings
in revenue producing property, plant and equipment, it is critical to adhere to maintenance and overhaul schedules to keep the equipment in good condition. For accounting purposes it is equally important to discern and account for these two
activities properly. Unscheduled maintenance that does not extend the useful life of the asset or enhance production is recognized as operations and maintenance expense in the period incurred. Scheduled overhauls and major repairs that either extend
the useful life or enhance production are normally capitalized and depreciated over the time until the next scheduled overhaul.

(18)
Investments in Derivatives. The Company holds derivative financial instruments for the sole purpose of hedging the risk of identifiable transactions. The types of risks hedged are those relating to changes in foreign currency
exchange rates, the price of electricity and gas for the UK Assets and fluctuations in interest rates associated with the UK debt, the variability of which impacts future earnings and cash flows. Changes in the fair value of derivatives are recorded
each period as Unrealized Gains/Losses on Derivatives in the Statement of Operations.

(19) Accounts Receivable. Accounts
receivable consist of trade receivables recorded at original invoice amount, less an estimated allowance for uncollectible accounts. Trade credit is generally extended on a short-term basis and does not bear interest. Trade receivables are
periodically evaluated for collectibility based upon the customer. Changes in the estimated collectibility of trade receivables are recorded in the results of operations for the period in which the estimate is revised. Trade receivables that are
deemed uncollectible are offset against the allowance for uncollectible accounts. The Company generally does not require collateral for trade receivables.

(20) Decommissioning Liability. The Company accounts for asset retirement obligations as Decommissioning Liabilities. The liability is recorded, as required by FAS No. 143, Accounting for Asset
Retirement Obligations and FASB Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations, for the fair value of obligations associated with long-lived assets in the period in which a retirement obligation is incurred. In
addition, the fair value of any legally required material conditional asset retirement obligations is recorded if the liability can be reasonably estimated. The Company capitalizes asset retirement costs as part of the carrying amount of the
long-lived assets. All of the costs included in the Decommission Liability pertain to the UK assets.

NOTE B  SUBSIDIARIES AND AFFILIATES

(1) U.S. Energy Biogas Corp. (USEB). On May 11, 2001 the Company, together with DEGS Biogas Inc.
(formerly Cinergy Energy Solutions, Inc., (DEGS)), acquired through a merger, Zahren Alternative Power Corporation (Zapco), and renamed such entity U.S. Energy Biogas Corp. The Company owned 54.26% and Cinergy Energy, a
wholly-owned subsidiary of Cinergy Corp. (Cinergy), owned 45.74% of USEB. On November 28, 2006, the Company acquired Cinergys 45.74% ownership interest in USEB and currently owns 100% of USEB.

In connection with this transaction, the Company forgave a receivable in the amount of $2,428,000 owed from Cinergy and recorded a liability of $633,000
resulting from negative goodwill recorded to the extent of contingent obligations. At the date of the acquisition, the recorded value of the minority interest to Cinergy was eliminated.

In consideration for the DEGS Shares, the Company agreed to: (i) assume two promissory notes, payable to BMC Energy LLC, a subsidiary of USEB, each
dated May 1, 2001, (a) one note is a fixed obligation with remaining payments aggregating $430,000 and (b) the other note is a contingent obligation, based on the value of Section 29 tax credits generated by the company and its
subsidiaries, the face amount of which is $4.3 million, (ii) assume DEGS GASCO LLCs obligations to fund operating and capital expenses of certain limited partnerships or limited liability companies that own and operate landfill gas
collection systems and related assets in an amount not to exceed $1 million, and (iii) subject to execution of definitive documentation, appoint a broker in connection with sales of greenhouse gas emission credits by the Company or its
subsidiaries. Management currently anticipates that the operating and capital expense funding obligations and payments on the contingent note will not exceed an aggregate of $1 million.

On November 28, 2006, the Company entered into a Stock Purchase Agreement with DEGS pursuant to which the Company acquired the remaining outstanding
4,574 shares of the Class B Common Stock of USEB from DEGS (the DEGS Shares). The Company now owns 100% of the outstanding stock of USEB.

The carrying value of the minority interest acquired was approximately $3,061,000 and the total purchase price was $2,428,000. The difference of $633,000 was recorded as a liability to the extent of contingent
consideration in accordance with FAS 141.



|                                             |  |   |           |  
|-------------------------------------------- |  | - | --------- | -
|Forgiven Receivable for Acquisition          |  | $ | 2,428,000 |  
|Cash Paid for Acquisition                    |  |   |          |  
|                                             |  |   |           |  
|Total Acquisition Price                      |  | $ | 2,428,000 |  
|                                             |  |   |           |  
|                                             | 
|Carrying Value of Minority Interest Acquired |  |   | 3,061,000 |  
|Liabilities - Contingent Consideration       |  |   | (633,000  | )
|                                             |  |   |           |  
|Carrying Value of Minority Interest Acquired |  | $ | 2,428,000 |  
|                                             |  |   |           |  

(2) GBGH, LLC (GBGH)  On March 1, 2006, the Company, along
with Marathon Capital Holdings (UK), LLC (Marathon) formed GBGH. The Company owns 79% of GBGH and Marathon owns the remaining 21%. GBGH owns, through various subsidiaries, 100% of the UK Assets.



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##### Table of Contents

U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004



NOTE C  RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement
No. 109 (FIN 48), which clarifies the accounting and disclosure for uncertain tax positions, as defined. FIN 48 seeks to reduce the diversity in practice associated with certain aspects of the recognition and measurement
related to accounting for income taxes. This interpretation is effective for fiscal years beginning after December 15, 2006. The Company has determined that FIN 48 will not have a material impact on its results of operations or financial
position.

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements
(SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value, and expands disclosure requirements regarding fair value measurement. Where applicable, this statement simplifies and codifies fair value related
guidance previously issued within U.S. generally accepted accounting principles. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The
Company has reviewed SFAS 157 and has determined that its adoption will not have any material effect on the Companys financial statements.

In September 2006, the FASB issued Statement of Financial Standards No. 158, (SFAS 158) Employers Accounting for Defined Benefit Pension and Other Postretirement Plans (an amendment of Financial Accounting Standards
Board (FASB) Statements No. 87, 88, 106 and 132R). SFAS 158 requires companies with defined benefit plans and certain other plans to recognize on the balance sheet the difference between benefit obligations and any plan assets of those benefit
plans. This Statement is effective for fiscal years ending after December 15, 2006. The Company does not have any plans of this nature; therefore FASB 158 is not applicable to the Company and will have no impact.

In February 2007, the FASB issued Statement of Financial Standards No. 159 (FASB 159), The Fair Value Option for Financial Assets and
Financial Liabilities - Including an Amendment of FASB Statement No. 115. This Statement provides companies with an option to measure, at specified election dates, many financial instruments and certain other items at fair value that are not
currently measured at fair value. A company that adopts SFAS 159 will report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. This Statement also establishes
presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. This Statement is effective for fiscal years beginning after
November 15, 2007. We do not believe that the adoption of SFAS 159 will have a material impact on our results of operations or financial condition.

In September 2006, the SEC staff issued Staff Accounting Bulletin No. 108 (SAB No. 108), Considering the Effects of Prior Years Misstatements when Quantifying Misstatements in Current Year Financial
Statement. SAB No. 108 specifies how the carryover or reversal of prior year unrecorded financial statement misstatements should be considered in quantifying a current year misstatement. SAB No. 108 requires a dual approach that
considers both the amount by which the current year consolidated statement of operations is misstated (rollover method) and an approach that considers the cumulative amount by which the current year consolidated balance sheet is
misstated (iron curtain method). Prior to the issuance of SAB No. 108, either the rollover or iron curtain method was acceptable for quantifying financial statement misstatements. Prior to the Companys application of the
guidance in SAB No. 108, management used the rollover approach for quantifying financial statement misstatements.

Initial application
of SAB No. 108 allows registrants to elect not to restate prior periods but to reflect the initial application in their annual financial statements covering the first fiscal year ending after November 15, 2006. The cumulative effect of the
initial application should be reported in the carrying amounts of assets and liabilities as of the beginning of that fiscal year and the offsetting adjustment, net of tax, should be made to the opening balance of retained earnings for that year. The
Company elected to record the effects of applying SAB No. 108 using the cumulative effect transition method to the misstatement that has been corrected below.

The Companys management has determined that accumulated other comprehensive income as of January 1, 2006 was not presented net of income taxes as required by Statement of Financial Accounting Standards
No. 130, Reporting Comprehensive Income. In accordance with the transition method of SAB No. 108, the Company recorded a cumulative effect adjustment of $827,000 as both a decrease to accumulated other comprehensive income and
a decrease to accumulated deficit as of January 1, 2006. There was no tax effect of this adjustment.

Based on the nature of the
adjustment the Company has concluded that this adjustment is immaterial to prior years consolidated financial statements under the previous method of assessing materiality, and therefore, has elected, as permitted under the transition
provisions of SAB No. 108, to reflect the effect of this adjustment as of January 1, 2006.



The following table summarizes the effect (up to January 1, 2006) of applying guidance SAB No. 108.



|                                           |  |                                                |          |   |                                                   |   |          |                            |  |   |          |   |  |   |          |  
|------------------------------------------ |  | ---------------------------------------------- | -------- | - | ------------------------------------------------- | - | -------- | -------------------------- |  | - | -------- | - |  | - | -------- | -
|                                           |  | Period in which the Misstatement Originated(1) |          |   | SAB No. 108Adjustmentrecorded as ofJanuary 1,2006 |  
|                                           |  | CumulativePrior toJanuary 1,2004               |          |   | Year EndedDecember 31,2004                        |   |          | Year EndedDecember 31,2005 |  |  
|Accumulated Other Comprehensive Income (2) |  | $                                              | (160,000 | ) |                                                   | $ | (764,000 | )                          |  | $ | (827,000 | ) |  | $ | (827,000 | )
|                                           |  |                                                |          |   |                                                   |   |          |                            |  |   |          |   |  |   |          |  
|Impact on Other Comprehensive Income (3)   |  | $                                              | (160,000 | ) |                                                   | $ | (604,000 | )                          |  | $ | (63,000  | ) |  | $ |         |  
|                                           |  |                                                |          |   |                                                   |   |          |                            |  |   |          |   |  |   |          |  
|Accumulated Deficit (4)                    |  | $                                              |         |   |                                                   | $ |         |                            |  | $ |         |   |  | $ | 827,000  |  
|                                           |  |                                                |          |   |                                                   |   |          |                            |  |   |          |   |  |   |          |  

---

|(1) | The Company previously quantified these errors under the roll-over method and concluded that they were immaterial.
|--- | ------------------------------------------------------------------------------------------------------------------

|(2) | The Company incorrectly overstated accumulated other comprehensive income by $160,000 (cumulatively) in years prior to 2004, by $604,000 in 2004 and by $63,000 in 2005. The Company
recorded a reduction in accumulated other comprehensive income as of January 1, 2006 with a corresponding decrease in accumulated deficit to correct these misstatements.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Represents the net over-statement of other comprehensive income for the indicated periods resulting from the misstatements.
|--- | ---------------------------------------------------------------------------------------------------------------------------

|(4) | Represents the net reduction to accumulated deficit recorded as of January 1, 2006 to record the initial application of SAB No. 108.
|--- | ------------------------------------------------------------------------------------------------------------------------------------

NOTE D  ACQUISITIONS

On August 7, 2006,
the Company completed its acquisition and financing of certain energy assets in the United Kingdom through certain of its subsidiaries (the UK Transaction). The assets (the UK Assets) acquired include (i) gas licenses
for approximately 100,000 acres of onshore natural gas properties and mineral rights in North Yorkshire, England (the Gas Licenses), containing significant proved reserves, (ii) the Knapton Generating Station, a 42 MW gas-fired
power plant associated with and located in the vicinity of the natural gas reserves in North Yorkshire, England, and (iii) certain related gas gathering and processing assets. As part of the UK Transaction, a subsidiary of the Company entered
into a power purchase agreement and a gas sales agreement with Scottish Power Energy Management (Scottish Power) under which Scottish Power is required to purchase all of the electricity generated by the Knapton Generating Station and
all of the natural gas produced from the associated reserves up to 100 bcf for a term of up to 12 years. The Company paid approximately $72.6 million and issued rights to acquire up to 9.2 million shares of its common stock to acquire the UK
Assets and to obtain the necessary financing. The financing of the UK Transaction provided approximately $166.3 million for, among other things, the acquisition of the UK Assets, the funding of certain reserves required by the terms of the financing
and working capital to be used by the Companys subsidiaries for the operation and upgrade of the UK Assets necessary to increase gas production. These loans mature in 2013 and 2014, subject to acceleration or mandatory prepayments upon the
occurrence of certain events, and are currently secured by substantially all of the Companys and its subsidiaries assets, other than U.S. Energy Biogas Corp.s (USEB) assets.

The Gas Licenses acquired represent the mineral rights of the associated properties; the Company does not own the surface land. Individual land leases
have been negotiated with the surface rights landowners that provide for small fixed payments to the landowners for the surface rights. The individuals do not receive royalties associated with extraction of natural resources.

The Company, through GBGH, LLC (GBGH), owns a 79% interest in the UK Assets. GBGH intends to further develop the natural gas fields subject
to the Gas Licenses in a several phase process that includes the expansion of the gas collection system in order to supply the Knapton Generating Station with sufficient gas to operate on a 24/7 basis, the making of modifications to the Knapton
Generating Station, the expansion of proved and collectible gas reserves and the construction a pipeline to the gas distribution system (the Expansion).

As part of the transaction, various derivatives including hedging and similar arrangements were entered into with respect to, among other things, gas and electricity prices, interest and currency rates, and carbon
emission allowances. The gas and electric hedges assure the Company that it will receive not less than specified prices for the sale of electricity from the Knapton Generating Station through August 2009 and for the sale of gas from the facility in
2010 and 2011. The currency and interest rate hedges ensure that the results of operations with respect to our UK activities will not be adversely impacted, through August 2009, as a result of fluctuation in such rates. The agreement with respect to
carbon emission allowances requires that the Company purchase specified amounts of such allowances at fixed prices through December 31, 2007.



F-18



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##### Table of Contents

U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004



The financing arrangements entered into with respect to the UK Transaction require that GBGH set
aside funds for various purposes, including maintenance and the Expansion. Management believes that such funds are sufficient for such purposes, including the completion of the Expansion. Nonetheless, the Company agreed, pursuant to an equity
support agreement, to provide additional funds to GBGH as follows: (i) £3.9 million (approximately $7.6 million based upon the exchange rate in effect on or about December 31, 2006) between September 7, 2007 and December 31,
2007 to cover certain of GBGHs maintenance expenses; (ii) to cover certain shortfalls in the reserve account for Expansion; (iii) $20 million, less specified amounts, upon default under specified financing arrangements; (iv) up
to $4 million for certain breaches of warranties (or the discovery of certain negative information) arising with respect to the agreements pursuant to which we acquired the UK Assets; (v) $20 million, if GBGH elects to extend the initial
interest rate and currency hedge agreements which is due to expire on August 7, 2009; and (vi) if GBGH enters into one or more replacement interest rate and currency hedge agreements, the amounts payable as an upfront fee or premium to the
providers thereunder. Absent a refinancing or the raising of additional capital, there can be no assurance that the Company will have sufficient cash to provide the required additional funds to GBGH.

The following table details the purchase price and our allocation for the UK Transaction through the application of FAS141 as of December 31, 2006.
This information, specifically the allocation of purchase price to the assets acquired is based upon the results of the independent valuation of the assets. In accordance with FAS141, the Company has one year from the acquisition date,
August 7, 2006, to finalize the allocation of the purchase price to the net assets acquired.

The total fair value of the net assets
acquired was approximately $156,760,000 and the total purchase price was $94,746,000. The difference of $62,014,000 has been allocated as a reduction to the long term assets in accordance with FAS 141.



|                                          |  |   |            |  
|----------------------------------------- |  | - | ---------- | -
|Cash Paid for Acquisition                 |  | $ | 72,634,000 |  
|Equity Instruments Issued for Acquisition |  |   | 15,433,000 |  
|Direct Acquisition Costs                  |  |   | 6,679,000  |  
|                                          |  |   |            |  
|Total Acquisition Price                   |  |   | 94,746,000 |  
|                                          |  |   |            |  
|                                          | 
|Property, Plant and Equipment             |  |   | 10,552,000 |  
|Gas Property and Equipment, Depleting     |  |   | 84,624,000 |  
|Long Term Power/Gas Contract              |  |   | 2,236,000  |  
|Decommissioning Liabilities               |  |   | (2,666,000 | )
|                                          |  |   |            |  
|Total Net Assets Acquired                 |  | $ | 94,746,000 |  
|                                          |  |   |            |  

Following are the Pro Forma Condensed Consolidated Statements of Operations for the Company for
the years ended December 31, 2005 and 2006. These Pro Forma Condensed Consolidated Statements of Operations estimate the operations of the Company as if the acquisition had occurred on January 1, 2005 and January 1, 2006,
respectively.

The Pro Forma Condensed Consolidated Statement of Operations for 2005 includes the actual results of the Company combined
with the historical results of the entities acquired for the same periods. This statement also includes the estimated operations of the distressed power plant giving effect to the new power purchase agreement entered into as a result of the
acquisition with production based on actual historical generating results of the plant for the relevant period. Depletion charges have been calculated based on the new value assigned to the gas reserves. These statements also include the impact of
the borrowing agreements entered into by the Company reflecting the resulting interest expense on the debt that would have been outstanding and interest income from the reserve accounts established as a result of the acquisition.

The Pro Forma Condensed Consolidated Statement of Operations for 2006 includes the actual results of the Company through December 31, 2006, which
includes the actual results of entities acquired since the date of acquisition. The historical results of the entities acquired from January 1, 2006 through the date of acquisition are added to these actual results. The historical data for 2006
is prepared on the same basis as the historical information for 2005.



F-19



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##### Table of Contents

U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004



U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

PRO FORMA CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS

AND COMPREHENSIVE INCOME (LOSS)

FOR THE YEAR ENDED DECEMBER 31, 2005

(Unaudited)

(In thousands, except
per share data)



|                                                     |  |                                                                        |         |   |                                      |   |         |                                                                       |  |   |         |  
|---------------------------------------------------- |  | ---------------------------------------------------------------------- | ------- | - | ------------------------------------ | - | ------- | --------------------------------------------------------------------- |  | - | ------- | -
|                                                     |  | U.S. EnergySystems, Inc.before givingconsiderationto the UKTransaction |         |   | Pro Formaimpact ofthe UK Transaction |   |         | U.S. EnergySystems, Inc.after givingconsiderationto the UKTransaction | 
|Revenue                                              |  | $                                                                      | 19,620  |   |                                      | $ | 4,845   |                                                                       |  | $ | 24,465  |  
|                                                     |  |                                                                        |         |   |                                      |   |         |                                                                       |  |   |         |  
|Costs and Expenses:                                  |  |                                                                        |         |   |                                      |   |         |                                                                       |  |   |         |  
|Operating Expenses                                   |  |                                                                        | 9,721   |   |                                      |   | 413     |                                                                       |  |   | 10,134  |  
|General, Administrative and Other Expenses           |  |                                                                        | 6,399   |   |                                      |   | 1,327   |                                                                       |  |   | 7,726   |  
|Depreciation, Depletion and Amortization             |  |                                                                        | 4,611   |   |                                      |   | 2,607   |                                                                       |  |   | 7,218   |  
|Income from Joint Ventures                           |  |                                                                        | (310    | ) |                                      |   |        |                                                                       |  |   | (310    | )
|                                                     |  |                                                                        |         |   |                                      |   |         |                                                                       |  |   |         |  
|Total Costs and Expenses                             |  |                                                                        | 20,421  |   |                                      |   | 4,347   |                                                                       |  |   | 24,768  |  
|                                                     |  |                                                                        |         |   |                                      |   |         |                                                                       |  |   |         |  
|(Loss) Income from Operations                        |  |                                                                        | (801    | ) |                                      |   | 498     |                                                                       |  |   | (303    | )
|                                                     |  |                                                                        |        
|Interest and Dividend Income                         |  |                                                                        | 3,452   |   |                                      |   | 2,380   |                                                                       |  |   | 5,832   |  
|Foreign Currency Translation Expense                 |  |                                                                        | (2,775  | ) |                                      |   |        |                                                                       |  |   | (2,775  | )
|Interest Expense                                     |  |                                                                        | (10,800 | ) |                                      |   | (14,564 | )                                                                     |  |   | (25,364 | )
|Other Income                                         |  |                                                                        | 997     |   |                                      |   |        |                                                                       |  |   | 997     |  
|                                                     |  |                                                                        |         |   |                                      |   |         |                                                                       |  |   |         |  
|Loss before Provision of Taxes and Minority Interest |  |                                                                        | (9,927  | ) |                                      |   | (11,686 | )                                                                     |  |   | (21,613 | )
|                                                     |  |                                                                        |        
|Income Tax Expense                                   |  |                                                                        | (870    | ) |                                      |   |        |                                                                       |  |   | (870    | )
|Minority Interest                                    |  |                                                                        | 1,181   |   |                                      |   | 2,454   |                                                                       |  |   | 3,635   |  
|                                                     |  |                                                                        |         |   |                                      |   |         |                                                                       |  |   |         |  
|Loss from Continuing Operations                      |  |                                                                        | (9,616  | ) |                                      |   | (9,232  | )                                                                     |  |   | (18,848 | )
|                                                     |  |                                                                        |        
|Gain on Disposal of Segment (net of Income Tax)      |  |                                                                        | 150     |   |                                      |   |        |                                                                       |  |   | 150     |  
|                                                     |  |                                                                        |         |   |                                      |   |         |                                                                       |  |   |         |  
|Net Loss                                             |  |                                                                        | (9,466  | ) |                                      |   | (9,232  | )                                                                     |  |   | (18,698 | )
|                                                     |  |                                                                        |        
|Dividends on Preferred Stock                         |  |                                                                        | (826    | ) |                                      |   |        |                                                                       |  |   | (826    | )
|                                                     |  |                                                                        |         |   |                                      |   |         |                                                                       |  |   |         |  
|Net Loss Applicable to Common Stock                  |  | $                                                                      | (10,292 | ) |                                      | $ | (9,232  | )                                                                     |  | $ | (19,524 | )
|                                                     |  |                                                                        |         |   |                                      |   |         |                                                                       |  |   |         |  
|Other Comprehensive Loss:                            |  |                                                                        |         |   |                                      |   |         |                                                                       |  |   |         |  
|Net Loss                                             |  | $                                                                      | (9,466  | ) |                                      | $ | (9,232  | )                                                                     |  | $ | (18,698 | )
|Unrealized Gain                                      |  |                                                                        | 167     |   |                                      |   |        |                                                                       |  |   | 167     |  
|                                                     |  |                                                                        |         |   |                                      |   |         |                                                                       |  |   |         |  
|Total Comprehensive Loss                             |  | $                                                                      | (9,299  | ) |                                      | $ | (9,232  | )                                                                     |  | $ | (18,531 | )
|                                                     |  |                                                                        |         |   |                                      |   |         |                                                                       |  |   |         |  



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##### Table of Contents

U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004



U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

PRO FORMA CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS

AND COMPREHENSIVE INCOME (LOSS)

FOR THE YEAR ENDED DECEMBER 31, 2005

(Unaudited)

(In thousands, except
per share data)



|                                                                         |  |                                                                        |            |   |                                     |   |            |                                                                       |  |   |            |  
|------------------------------------------------------------------------ |  | ---------------------------------------------------------------------- | ---------- | - | ----------------------------------- | - | ---------- | --------------------------------------------------------------------- |  | - | ---------- | -
|                                                                         |  | U.S. EnergySystems, Inc.before givingconsiderationto the UKTransaction |            |   | Pro Formaimpact of theUKTransaction |   |            | U.S. EnergySystems, Inc.after givingconsiderationto the UKTransaction | 
|NET LOSS PER SHARE OF COMMON STOCK:                                      |  |                                                                        |            |   |                                     |   |            |                                                                       |  |   |            |  
|Net Loss per share from Continuing Operations  Basic and Diluted        |  | $                                                                      | (0.85      | ) |                                     | $ | (0.75      | )                                                                     |  | $ | (1.60      | )
|Net Income per share from Discontinued Operations  Basic and Diluted    |  | $                                                                      | 0.02       |   |                                     |   |           |                                                                       |  | $ | 0.02       |  
|Net Loss per share of Common Stock  Basic and Diluted                   |  | $                                                                      | (0.83      | ) |                                     | $ | (0.75      | )                                                                     |  | $ | (1.58      | )
|Weighted Average Number of Common Shares Outstanding  Basic and Diluted |  |                                                                        | 12,356,000 |   |                                     |   | 12,356,000 |                                                                       |  |   | 12,356,000 |  



F-21



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##### Table of Contents

U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004



U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

PRO FORMA CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS

AND COMPREHENSIVE INCOME (LOSS)

FOR THE YEAR ENDED DECEMBER 31, 2006

(Unaudited)

(In thousands, except
per share data)



|                                                                |  |                                                                        |         |   |                                     |   |        |                                                                       |  |   |         |  
|--------------------------------------------------------------- |  | ---------------------------------------------------------------------- | ------- | - | ----------------------------------- | - | ------ | --------------------------------------------------------------------- |  | - | ------- | -
|                                                                |  | U.S. EnergySystems, Inc.before givingconsiderationto the UKTransaction |         |   | Pro Formaimpact of theUKTransaction |   |        | U.S. EnergySystems, Inc.after givingconsiderationto the UKTransaction | 
|Revenue                                                         |  | $                                                                      | 21,244  |   |                                     | $ | 1,537  |                                                                       |  | $ | 22,781  |  
|                                                                |  |                                                                        |         |   |                                     |   |        |                                                                       |  |   |         |  
|Costs and Expenses:                                             |  |                                                                        |         |   |                                     |   |        |                                                                       |  |   |         |  
|Operating Expenses                                              |  |                                                                        | 13,260  |   |                                     |   | 897    |                                                                       |  |   | 14,157  |  
|General, Administrative and Other Expenses                      |  |                                                                        | 9,367   |   |                                     |   | 338    |                                                                       |  |   | 9,705   |  
|Depreciation, Depletion and Amortization                        |  |                                                                        | 6,249   |   |                                     |   | 1,286  |                                                                       |  |   | 7,535   |  
|Income from Joint Ventures                                      |  |                                                                        | (111    | ) |                                     |   |       |                                                                       |  |   | (111    | )
|                                                                |  |                                                                        |         |   |                                     |   |        |                                                                       |  |   |         |  
|Total Costs and Expenses                                        |  |                                                                        | 28,765  |   |                                     |   | 2,521  |                                                                       |  |   | 31,286  |  
|                                                                |  |                                                                        |         |   |                                     |   |        |                                                                       |  |   |         |  
|Loss from Operations                                            |  |                                                                        | (7,521  | ) |                                     |   | (984   | )                                                                     |  |   | (8,505  | )
|                                                                |  |                                                                        |        
|Interest and Dividend Income                                    |  |                                                                        | 3,894   |   |                                     |   | 1,236  |                                                                       |  |   | 5,130   |  
|Foreign Currency Translation Expense                            |  |                                                                        | (2,536  | ) |                                     |   |       |                                                                       |  |   | (2,536  | )
|Gain on Hedges                                                  |  |                                                                        | 2,756   |   |                                     |   |       |                                                                       |  |   | 2,756   |  
|Interest Expense                                                |  |                                                                        | (22,971 | ) |                                     |   | (7,276 | )                                                                     |  |   | (30,247 | )
|Other Expense                                                   |  |                                                                        | (2,490  | ) |                                     |   |        |                                                                       |  |   | (2,490  | )
|                                                                |  |                                                                        |         |   |                                     |   |        |                                                                       |  |   |         |  
|Loss before Reorganization Expense, Taxes and Minority Interest |  |                                                                        | (28,868 | ) |                                     |   | (7,024 | )                                                                     |  |   | (35,892 | )
|                                                                |  |                                                                        |        
|Reorganization Expense  Legal Fees                             |  |                                                                        | (1,369  | ) |                                     |   |       |                                                                       |  |   | (1,369  | )
|                                                                |  |                                                                        |         |   |                                     |   |        |                                                                       |  |   |         |  
|                                                                |  |                                                                        |        
|Loss before Taxes and Minority Interest                         |  |                                                                        | (30,237 | ) |                                     |   | (7,024 | )                                                                     |  |   | (37,261 | )
|                                                                |  |                                                                        |        
|Income Tax Expense                                              |  |                                                                        | (21     | ) |                                     |   |       |                                                                       |  |   | (21     | )
|Minority Interest                                               |  |                                                                        | 2,684   |   |                                     |   | 1,475  |                                                                       |  |   | 4,159   |  
|                                                                |  |                                                                        |         |   |                                     |   |        |                                                                       |  |   |         |  
|Net Loss                                                        |  |                                                                        | (27,574 | ) |                                     |   | (5,549 | )                                                                     |  |   | (33,123 | )
|                                                                |  |                                                                        |        
|Dividends on Preferred Stock                                    |  |                                                                        | (261    | ) |                                     |   |       |                                                                       |  |   | (261    | )
|                                                                |  |                                                                        |         |   |                                     |   |        |                                                                       |  |   |         |  
|Net Loss Applicable to Common Stock                             |  | $                                                                      | (27,835 | ) |                                     | $ | (5,549 | )                                                                     |  | $ | (33,384 | )
|                                                                |  |                                                                        |         |   |                                     |   |        |                                                                       |  |   |         |  
|Other Comprehensive Loss:                                       |  |                                                                        |         |   |                                     |   |        |                                                                       |  |   |         |  
|Net Loss                                                        |  | $                                                                      | (27,574 | ) |                                     | $ | (5,549 | )                                                                     |  | $ | (33,123 | )
|Unrealized Gain                                                 |  |                                                                        | 589     |   |                                     |   |       |                                                                       |  |   | 589     |  
|Foreign Currency Translation                                    |  |                                                                        | 3,832   |   |                                     |   |       |                                                                       |  |   | 3,832   |  
|                                                                |  |                                                                        |         |   |                                     |   |        |                                                                       |  |   |         |  
|Total Comprehensive Loss                                        |  | $                                                                      | (23,153 | ) |                                     | $ | (5,549 | )                                                                     |  | $ | (28,702 | )
|                                                                |  |                                                                        |         |   |                                     |   |        |                                                                       |  |   |         |  



F-22



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##### Table of Contents

U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004



U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

PRO FORMA CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS

AND COMPREHENSIVE INCOME (LOSS)

FOR THE YEAR ENDED DECEMBER 31, 2006

(Unaudited)

(In thousands, except
per share data)



|                                                                         |  |                                                                         |            |   |                                       |   |            |                                                                        |  |   |            |  
|------------------------------------------------------------------------ |  | ----------------------------------------------------------------------- | ---------- | - | ------------------------------------- | - | ---------- | ---------------------------------------------------------------------- |  | - | ---------- | -
|                                                                         |  | U.S. EnergySystems, Inc.before givingconsideration to theUK Transaction |            |   | Pro Forma impactof the UK Transaction |   |            | U.S. EnergySystems, Inc. aftergiving considerationto the UKTransaction | 
|NET LOSS PER SHARE OF COMMON STOCK:                                      |  |                                                                         |            |   |                                       |   |            |                                                                        |  |   |            |  
|Net Loss per share from Continuing Operations  Basic and Diluted        |  | $                                                                       | (1.72      | ) |                                       | $ | (0.34      | )                                                                      |  | $ | (2.06      | )
|Weighted Average Number of Common Shares Outstanding  Basic and Diluted |  |                                                                         | 16,204,000 |   |                                       |   | 16,204,000 |                                                                        |  |   | 16,204,000 |  

NOTE E  RESTRICTED CASH AND MARKETABLE SECURITIES

The various financing agreements for the Company and its subsidiaries require the establishment and maintenance of various reserve accounts, which are also collateral for
the financings. Access to the funds in the accounts is restricted by the terms of the loan agreements. The funds are invested in highly liquid assets approximating cash in accordance with the terms of the loan agreements.

USEBs financing arrangement with the Countryside Power Income Fund (Countryside) required the maintenance of the Illinois Subsidy Liability Reserve
Account (the Illinois Accounts), a debt service reserve account and an improvement reserve account. The funds held in the improvement reserve account could be utilized to fund capital expenditures. The funds in the Illinois Accounts were
intended to be utilized to retire the Illinois subsidy liability as it became due. With the completion of USEBs refinancing on May 31, 2007, the requirement to maintain these reserves, with the exception of a $3,000,000 construction reserve,
was eliminated.

GBGHs financing agreements with Credit Suisse provide for the maintenance of debt service reserve accounts, an interest during
construction reserve account, a major maintenance reserve account and capital improvement reserve accounts, including the expansion account. The funds held in the interest during construction reserve account can be utilized to satisfy the interest
payment obligations as they come due. The capital improvement reserve accounts will be utilized to fund improvements to and expansion of the existing well fields and gas collection systems as well as exploratory work to identify and establish new
reserves. The major maintenance reserve account will be used to cover any major unforeseen repairs necessary to the gas collection and power generation systems.

Restricted cash and marketable securities were as follows:



|                                            |  |            |  |                  |            |                  |   |           
|------------------------------------------- |  | ---------- |  | ---------------- | ---------- | ---------------- | - | ----------
|                                            |  | Subsidiary |  | December 31,2006 |            | December 31,2005
|Illinois Subsidy Liability Reserve Accounts |  | USEB       |  | $                | 29,357,000 |                  | $ | 26,429,000
|Improvement Reserve                         |  | USEB       |  |                  | 3,508,000  |                  |   | 3,367,000 
|Debt Service Reserve                        |  | USEB       |  |                  | 2,182,000  |                  |   | 2,104,000 
|Contract Escrow                             |  | USEB       |  |                  |           |                  |   | 30,000    
|Debt Service Reserve (*)                    |  | GBGH       |  |                  | 11,503,000 |                  |   |          
|Interest During Construction Reserve (*)    |  | GBGH       |  |                  | 4,986,000  |                  |   |          
|Capital Expenditure Reserve (*)             |  | GBGH       |  |                  | 1,161,000  |                  |   |          
|Expansion (*)                               |  | UKES       |  |                  | 21,218,000 |                  |   |          
|Major Maintenance (*)                       |  | UKES       |  |                  | 17,461,000 |                  |   |          
|                                            |  |            |  |                  |            |                  |   |           
|Totals                                      |  |            |  | $                | 91,376,000 |                  | $ | 31,930,000
|                                            |  |            |  |                  |            |                  |   |           

---

(*)  associated with the UK Transaction



F-23



---

##### Table of Contents

U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004



USEB utilized $33,000,000 of its reserve accounts, including all funds managed by a professional
investment manager as described above, to fund the $33,000,000 in principal payments required by its settlement agreement with Countryside. $3,000,000 of principal was paid in January 2007 and $30,000,000 was paid in March 2007. All balances
remaining in the USEB accounts were transferred to unrestricted cash upon USEBs May 31, 2007 completion of its Plan of Reorganization. Per the terms of the new financing, USEB was required to fund a $3,000,000 construction reserve account
which will be utilized to fund future capital needs. See Note X.

Included in the Illinois Accounts at December 31 2006 is $27,356,000
that is managed by a professional investment manager under investment allocation parameters established by the Company. Of such sum, $18,433,000 is invested in equity fund accounts, $7,983,000 is invested in debt accounts, and $940,000 is held in
cash or cash equivalent accounts. These investments, which are classified as available for sale, are carried at fair value, with unrealized gains and losses, net of any tax effects, reported in Stockholders Equity as Accumulated Other
Comprehensive Income. The original cost of these investments, which has been invested since July 2004, is $21,417,000.

The reserve account
related to the UK Transaction are invested in money market accounts with a major, global financial institution.

NOTE F  ILLINOIS RETAIL RATE
PROGRAM

USEB has 10 operating projects in Illinois which are receiving a subsidy for each kilowatt hour (kwh) of
electricity sold to the local utility under the Illinois Retail Rate Program. In accordance with the settlement with the Illinois Commerce Commission (ICC), eligibility for participation in the Illinois Retail Rate program terminated for
all projects on the effective date of the Plan of Reorganization which was May 31, 2007. The Company made a $5,250,000 payment upon the completion of the Chapter 11 filing to the State of Illinois in full satisfaction of the approximately
$65,000,000 liability owed to the State of Illinois for subsidies received since 1998. Effective on May 31, 2007, USEB began selling its generating output into the open market at rates determined by the day ahead energy market.

Under the terms of the Illinois Retail Rate Program, estimated rates were paid for production sold to the utility with that rate being reconciled
annually, on the anniversary date of the commencement of commercial operations of the applicable project, to the actual rates paid for electricity by the local municipality. After the actual rate was determined, sales for the preceding calendar
year, retroactive to the last anniversary date, were adjusted based upon the actual rate. If the actual rate is greater than the estimated rate, additional sales proceeds are paid to the project. If the actual rate is less than the estimated rate,
then prior sales proceeds received, equal to the excess amounts paid, were refunded to the utility. This actual rate then becomes the estimated rate for the subsequent year. USEB was subject to these rate adjustments through May 31, 2007. A
$250,000 escrow has been established with the Illinois Commerce Commission from the proceeds of the settlement payment.



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U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004



NOTE G  TRANSACTIONS WITH AFFILIATES

USEB is a general partner in alternative energy and equipment finance transactions with related limited partnerships and collects management fees from the
partnerships. Fees earned from such general partner undertakings amount to $242,000 for 2006, $272,000 for 2005 and $459,000 for 2004. Accounts receivable and accounts payable from these affiliates are presented separately in the Consolidated
Balance Sheets.

USEB reimburses the Company for a majority of the costs incurred by them for the benefit of USEB. These costs include
management and accounting salary and benefit costs, office expenses associated with the accounting services and an allocation of rent expenses. The total reimbursements for 2006, 2005 and 2004 were $99,000, $293,000 and $639,000, respectively.

NOTE H  NOTES AND INTEREST RECEIVABLE

Notes and Interest Receivable consist of four notes pertaining to USEBs sale of its limited partnership interests in several Gasco entities. Payments of principal and interest on the three contingent installment notes are made
quarterly based upon the amount of landfill gas sold and the value of the tax credits generated by the sale. Payments of principal and interest on the Fixed Installment Notes are made quarterly based upon a mortgage style amortization. In June 2004,
the contingent installment note receivable for the 1999 sale of Gasco interests was written down by approximately $2,500,000 to reflect updated projections for the amount of gas projected to be sold and the dollar value of payments required under
the contingent note. The write down of the note receivable was offset by an equivalent reduction in deferred revenue and did not result in a charge to other income or loss. In 2006, USEB fully reserved for the outstanding balance of the note due to
the potential phase out provisions of the Section 29 tax credits.

On April 8, 2004, AJG Financial Services, Inc. (AJG)
made a cash down payment of $2,000,000 and delivered a $14,000,000 note payable to a subsidiary of USEB to satisfy its obligation to pay for certain ownership interests in Illinois based generating project entities AJG had previously acquired. The
note matures in 2024, requires scheduled payments of principal and interest and bears interest at a rate of 15% per annum. Payments on the note are limited to cash distributions from the project entities with any excesses to the scheduled
payments being applied as an additional principal payment and any deficits to scheduled payments being deferred. This transaction resulted in a gain for USEB of $2,000,000 which was recognized in June, 2004. Future principal payments received on the
note will result in the recording of additional gains on this transaction when they are received. USEB intends to exercise its right to reacquire, as allowed for in the sale agreements, the ownership interests in the Illinois based generating
project entities during 2007. USEB has the right to reacquire the ownership interests through the termination of the note receivable.



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U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004



Notes receivable as of December 31, 2006 consisted of the following:



|                                                                                                                               |  |              |   |  |                |       |                  |   |       
|------------------------------------------------------------------------------------------------------------------------------ |  | ------------ | - |  | -------------- | ----- | ---------------- | - | ------
|(Dollars in thousands)                                                                                                         |  | InterestRate |   |  | CurrentPortion |       | Long-TermPortion
|Contingent Installment Note Receivable for 1999 Sale of GASCO Interests Secured by the Interests                               |  | 9.47         | % |  |                |      |                  |   |      
|Fixed Installment Note Receivable for 2001 Sale of GASCO Interests Secured by the Interests                                    |  | 6.00         | % |  |                |      |                  |   |      
|Contingent Installment Note Receivable for 2001 Sale of GASCO Interests Secured by the Interests                               |  | 6.00         | % |  |                |      |                  |   |      
|Contingent Notes Receivable for Sale of Barre, MA Projects Gas Collection System and Related Assets, Secured by the
Interests |  | 10.00        | % |  |                |      |                  |   | 543   
|Installment Note Receivable From AJG For Illinois Electric Generation Partners IISecured by
Interests                          |  | 15.00        | % |  |                | 181   |                  |   | 13,281
|Term Note Due                                                                                                                  |  |             |   |  |                |      |                  |   |      
|Accrued Interest Receivable                                                                                                    |  |             |   |  |                | 928   |                  |   |      
|                                                                                                                               |  |              |   |  |                |       |                  |   |       
|                                                                                                                               |  |              |   |  | $              | 1,109 |                  | $ | 13,824
|                                                                                                                               |  |              |   |  |                |       |                  |   |       

A comparable breakdown as of December 31, 2005 is as follows:



|                                                                                                                               |  |              |   |  |                |       |                  |   |       
|------------------------------------------------------------------------------------------------------------------------------ |  | ------------ | - |  | -------------- | ----- | ---------------- | - | ------
|(Dollars in thousands)                                                                                                         |  | InterestRate |   |  | CurrentPortion |       | Long-TermPortion
|Contingent Installment Note Receivable for 1999 Sale of GASCO Interests Secured by the Interests                               |  | 9.47         | % |  | $              | 720   |                  | $ | 3,054 
|Fixed Installment Note Receivable for 2001 Sale of GASCO Interests Secured by the Interests                                    |  | 6.00         | % |  |                | 542   |                  |   | 151   
|Contingent Installment Note Receivable for 2001 Sale of GASCO Interests Secured by the Interests                               |  | 6.00         | % |  |                | 370   |                  |   | 4,369 
|Contingent Notes Receivable for Sale of Barre, MA Projects Gas Collection System and Related Assets, Secured by the
Interests |  | 10.00        | % |  |                | 10    |                  |   | 532   
|Installment Note Receivable From AJG For Illinois Electric Generation Partners IISecured by Interests                          |  | 15.00        | % |  |                | 158   |                  |   | 13,482
|Term Note                                                                                                                      |  |             |   |  |                |      |                  |   | 500   
|Accrued Interest Receivable                                                                                                    |  |             |   |  |                | 176   |                  |   |      
|                                                                                                                               |  |              |   |  |                |       |                  |   |       
|                                                                                                                               |  |              |   |  | $              | 1,976 |                  | $ | 22,088
|                                                                                                                               |  |              |   |  |                |       |                  |   |       



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##### Table of Contents

U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004



A Gasco project is a project level entity (normally a limited partnership for which USEB or a USEB
subsidiary serves as general partner), which collects and sells biogas to an affiliated project level entity (a Genco), which uses the biogas to generate electricity.

USEB sold its limited partnership interests in several Gascos during December 1999. The total sales price was approximately $22,000,000 including
interest imputed at 9.47%. A down payment of approximately $4,285,000 was received in 1999. The balance of the sales proceeds will be received based on the actual gas production of the projects over six years. During 2006, a valuation reserve
against the $3,595,000 contingent note receivable for the 1999 sale of Gasco interest was established. The valuation allowance was established due to the phase out provision of the Section 29 tax credits due to the current and projected market price
of oil. Section 29 tax credits phase out and can be eliminated in totality if the reference price of oil exceeds established base prices. During 2006, the amount of Section 29 tax credits was reduced by approximately 33% due to the phase out
provisions based on a reference price of oil of approximately $59.

In 2004, USEBs sale of certain limited partnership interests was
completed with the receipt of a $14,000,000 non-recourse note payable to a USEB subsidiary. The note matures in 2024 and bears interest at a rate of 15% per annum. Payments on the note are limited to cash distributions from the project entities
with any excesses to the scheduled payments being applied as an additional principal payment and any deficits to scheduled payments being deferred. The note is secured by the ownership interests.

In November 2006, as consideration for U.S. Energys acquisition of Cinergys 45.74% ownership interest in USEB, U.S. Energy assumed
Cinergys installment note payable obligations due USEB for their purchase of certain Gasco interests. Such amount has been accounted for in the purchase of Cinergys interest.

NOTE I  PROPERTY, PLANT AND EQUIPMENT

Power generation and gas transmission assets consist
primarily of the value of the internal combustion engines and related equipment located at the landfill gas to energy projects. The majority of these assets are depreciated using the straight-line method over the useful life of the assets, between
three and twenty-five years, for financial statement purposes.

Other property and equipment as of December 31, 2006 and 2005 consists
of site tools, office furniture, computer equipment and company vehicles. These assets are depreciated over lives ranging from three to ten years.

Consolidated property, plant and equipment consist of the following at December 31, 2006 and 2005:



|                                                      |  |                        |         |   |      |   |         |  
|----------------------------------------------------- |  | ---------------------- | ------- | - | ---- | - | ------- | -
|                                                      |  | (Dollars in Thousands) |        
|                                                      |  | 2006                   |         |   | 2005 |  
|Land                                                  |  | $                      | 98      |   |      | $ | 98      |  
|Generation and Transmission Equipment and Peripherals |  |                        | 67,953  |   |      |   | 65,868  |  
|UK Property, Plant and Equipment                      |  |                        | 10,075  |   |      |   |        |  
|Other Property and Equipment                          |  |                        | 785     |   |      |   | 503     |  
|                                                      |  |                        |         |   |      |   |         |  
|                                                      |  | $                      | 78,911  |   |      | $ | 66,469  |  
|Less Accumulated Depreciation                         |  |                        | (30,474 | ) |      |   | (26,163 | )
|                                                      |  |                        |         |   |      |   |         |  
|                                                      |  | $                      | 48,437  |   |      | $ | 40,306  |  
|                                                      |  |                        |         |   |      |   |         |  

NOTE J  INVESTMENTS

Our total investments, including joint ventures, as of December 31, 2006 and 2005 are as follows:



|                         |  |                        |       |                   |   |      
|------------------------ |  | ---------------------- | ----- | ----------------- | - | -----
|                         |  | (Dollars in Thousands)
|                         |  | December 31, 2006      |       | December 31, 2005
|Plymouth Cogeneration    |  | $                      | 432   |                   | $ | 321  
|Various Holdings of USEB |  |                        | 953   |                   |   | 913  
|                         |  |                        |       |                   |   |      
|Total Investments        |  | $                      | 1,385 |                   | $ | 1,234
|                         |  |                        |       |                   |   |      



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##### Table of Contents

U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004



Plymouth Envirosystems, Inc. Our wholly-owned subsidiary, Plymouth Envirosystems, Inc., owns a
50% interest in Plymouth Cogeneration Limited Partnership (Plymouth Cogeneration) which owns and operates a CHP plant producing 1.2 MW of electricity and 7 MW of heat at Plymouth State College, in Plymouth, New Hampshire. The Plymouth
Facility provides 100% of the electrical and heating requirements for the campus, which is a part of the University of New Hampshire system, under a long-term contract.

The day-to-day operations of the Plymouth Facility are managed by one of our partners in this project, and management decisions are made by a committee composed of representatives of the three partners in this
project. The Company reports gains from its investment in Plymouth Cogeneration under the category Income from Joint Ventures in the financial statements.

Lehi Envirosystems, Inc. In 1997, our wholly-owned subsidiary, Lehi Envirosystems, Inc. (LEHI), acquired a 50% equity interest in Lehi Independent Power Associates (LIPA), which
owns a cogeneration facility in Lehi, Utah (the Lehi Facility) and the underlying real estate. The Lehi Facility has been dormant since 1990.

Various Holdings of USEB. USEB owns a general partnership interest in various entities (the Gascos) that are parties to the gas rights agreements for the respective landfills and own the gas
collection systems on the landfills. The investment value increased during 2006 due to capital contributions made by USEB to various Gascos in order to fund the expansion of the gas collection systems.

NOTE K LONG-TERM DEBT

The Companys consolidated debt is
summarized as follows:



|                                   |  |                     |   |  |          |  |                                    |             |   |                                    |   |           
|---------------------------------- |  | ------------------- | - |  | -------- |  | ---------------------------------- | ----------- | - | ---------------------------------- | - | ----------
|Borrowing Entity                   |  | CurrentInterestRate |   |  | Maturity |  | Principal BalanceDecember 31, 2006 |             |   | Principal BalanceDecember 31, 2005
|U.S. Energy Biogas Corp.           |  | 10.00               | % |  | 2019     |  | $                                  | 99,000,000  |   |                                    | $ | 89,161,000
|US Energy Overseas Investments LLC |  | 10.50               | % |  | 2014     |  |                                    | 24,341,000  |   |                                    |   |          
|GBGH, LLC  1stLien Debt           |  | 11.25               | % |  | 2013     |  |                                    | 113,500,000 |   |                                    |   |          
|GBGH, LLC  2ndLien Debt           |  | 14.00               | % |  | 2014     |  |                                    | 29,500,000  |   |                                    |   |          
|Unamortized Debt Issuance Costs    |  |                     |   |  |          |  |                                    | (41,215,000 | ) |                                    |   |          
|                                   |  |                     |   |  |          |  |                                    |             |   |                                    |   |           
|Totals                             |  |                     |   |  |          |  | $                                  | 225,126,000 |   |                                    | $ | 89,161,000
|                                   |  |                     |   |  |          |  |                                    |             |   |                                    |   |           

Additional information pertaining to the components of the Companys debt follows:

U.S. Energy Biogas Corp.  USEBs debt was payable to Countryside Canada Power Inc. (Countryside). Pursuant to USEBs settlement agreement with
Countryside, which was approved by the Court, Countryside was allowed a US$99,000,000 secured claim against certain of USEBs assets. The claim included all outstanding



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U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004



principal plus unpaid interest through January 31, 2007, any claims pertaining to the Royalty Agreement between Countryside and USEB, any and all fees
and expenses incurred by Countryside related to USEBs proceedings and claims related to the Development Agreement between U.S. Energy and Countryside. Payments on the secured claim plus additional interest was denominated in US dollars as of
the settlement date.

The components of the secured claim are as follows:



|                                  |  |            |           
|--------------------------------- |  | ---------- | ----------
|Description                       |  | US Dollars
|Principal                         |  | $          | 90,168,000
|Interest through January 31, 2007 |  |            | 2,473,000 
|Royalty Agreement                 |  |            | 5,869,000 
|Expenses                          |  |            | 490,000   
|USEY Development Agreement        |  |            |          
|                                  |  |            |           
|Totals                            |  | $          | 99,000,000
|                                  |  |            |           

USEB made a $3,000,000 payment against the secured claim in January, 2007 and a $30,000,000 payment in March,
2007. The remaining outstanding principal of $66,000,000 was deemed over secured for purposes of adequate protection providing USEB with the right to use its cash collateral for the payment of its operating expenses and the legal and professional
fees associated with the bankruptcy during the term of bankruptcy proceedings and bore interest at a rate of 10% per annum (down from 11% per the original loan agreement) payable monthly in US dollars to Countryside. The final installment
against the secured claim was paid on May 31, 2007. The funding for the final installment was obtained through the completion of $80,000,000 of financing obtained from a private equity fund. The debt is in the form of a $77,000,000 fixed term
obligation and a $3,000,000 revolving credit facility. Interest is based on LIBOR plus 4.50% and is adjusted every three months for the subsequent three month period. The current interest rate is 9.88%. Interest is payable quarterly and principal
reductions are based upon 75% of the excess cash flow generated by USEBs operations. The debt is collateralized by all of USEBs assets. The financing arrangements contain various financial covenants that must be met including an Interest
Coverage Ratio, a Fixed Charge Coverage Ratio, a Leverage Ratio and minimum Consolidated Adjusted EBITDA. In connection with the debt facilities, USEB has agreed to a sharing of net profits for a significant number of years following the
amortization or prepayment of the debt. The maturity date of the debt is May 31, 2014. Based upon the terms of the debt agreement, principal payments for 2007, if any, are not required to be paid until after December 31, 2007.

While the foreign currency exchange rate for debt service payments made during 2006 were fixed though a swap agreement, the outstanding principal was subject to
fluctuations in the exchange rate. Due to fluctuations in the foreign currency exchange rate, the change in outstanding principal for the comparative periods is comprised of $1,265,000 of principal payments made offset by $2,272,000 of additional
principal due resulting from changes in the foreign currency exchange rate. The debt was collateralized by substantially all of USEBs assets.

US
Energy Overseas Investments LLC (Overseas)  Overseass debt is payable to Silver Point Finance, LLC. The interest rate on the debt is adjusted periodically based upon fluctuations in the base interest rates. All interest is
accrued and added to the outstanding principal balance. As of December 31, 2006, the outstanding principal balance consists of $23,335,000 in original principal and $1,006,000 of accrued interest. Principal payments on the debt are required
from cash receipts received by Overseas or the raising of equity by the Company. The debt is collateralized by the UK Assets.

GBGH, LLC  GBGH,
LLCs debt is payable to Credit Suisse, as collateral agent. The interest rate on the debt is adjusted periodically based upon fluctuations in the base interest rate. Principal payments on the debt are payable from excess cash flows generated
by GBGH, LLC and its subsidiaries. The debt is collateralized by the UK Assets.

The debt arrangements generally restrict the Companys and its
subsidiaries ability to sell assets, incur additional indebtedness and may limit equity distributions.

NOTE L DEFERRED REVENUES

Deferred revenues are primarily comprised of gains to be recognized from the sale of USEBs limited partnership interests in
certain partnerships, further described in Note H. The majority of the proceeds from the sales are to be paid in installments, the amounts of which will be determined by production and other considerations; therefore, the gain will be recognized as
payments are received.



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U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004



NOTE M  DEFERRED ROYALTY

On April 8, 2004, Countryside acquired a convertible royalty interest in USEB for $6,000,000. Pursuant to the terms of the Royalty Agreement, dated April 8, 2004 (the Royalty Agreement),
Countryside had the right to receive, on a quarterly basis, the sum of 7% of net distributable cash flow and 1.8% of USEBs gross revenues, determined pursuant to the Royalty Agreement, not to exceed 49% of total distributions made to
Countryside and the shareholders of USEB, combined. Countryside had the option to convert the royalty interest into non-voting common shares of USEB, equal to 49% of the outstanding equity. The amount of the royalty was accrued on a quarterly basis.
For 2006, 2005 and 2004, royalty expense related to Countryside was $307,000, $307,000 and $314,000 respectively.

Pursuant to the
settlement agreement between USEB and Countryside, all of USEBs obligations to Countryside under the Royalty Agreement, including the option to convert the interest into non-voting common shares of USEB equal to 49% of the outstanding equity
and the obligation for future royalty payments, were included in the $99,000,000 secured claim granted to Countryside by USEB.

NOTE N  FOREIGN
CURRENCY TRANSACTIONS

USEBs debt obligation to Countryside prior to the Chapter 11 filing required that debt service payments be
made in Canadian dollars. USEB had entered into a cash flow foreign currency hedge agreement with financial institutions fixing the Canadian dollar to US dollar exchange rate at $1.331 Canadian dollar per US dollar. This hedge agreement was
terminated as of the date of the Chapter 11 filing. Pursuant to bankruptcy law, the foreign currency exchange rate was fixed as of the date of the filing of the case. As of November 29, 2006, the exchange rate was $1.1343 Canadian dollar per US
dollar.

As required by SFAS No. 52 and SFAS No. 133, USEB had adjusted the outstanding principal on the debt owed to Countryside
to reflect the currency exchange rate as of the end of the financial reporting period. The gain or loss resulting from the adjustment of the outstanding principal from that recorded in the previous reporting periods is recorded as Foreign Currency
Transaction Expense.

Following is a summary of the Foreign Currency Translation account as of December 31, 2006 and 2005 (the
exchange rates are Canadian dollars per US dollar and are stated in whole dollars, all other amounts are in thousand:



|                                                           |  |                   |        |   |                   |   |        |  
|---------------------------------------------------------- |  | ----------------- | ------ | - | ----------------- | - | ------ | -
|                                                           |  | December 31, 2006 |        |   | December 31, 2005 |  
|Currency Exchange Rate at Loan Origination, April 8, 2004  |  | $                 | 1.331  |   |                   | $ | 1.331  |  
|Currency Exchange Rate at December 31, 2005                |  | $                 | 1.166  |   |                   | $ | 1.166  |  
|Currency Exchange Rate at November 29, 2006                |  | $                 | 1.1343 |   |                   | $ | 1.1343 |  
|Cumulative Translation Adjustments Beginning               |  |                   |        |   |                   |   |        |  
|Of Reporting Period                                        |  | $                 | 9,764  |   |                   | $ | 6,989  |  
|Cumulative Translation Adjustments End                     |  |                   |        |   |                   |   |        |  
|Of Reporting Period                                        |  | $                 | 12,256 |   |                   | $ | 9,764  |  
|Aggregate Adjustment for the Current                       |  |                   |        |   |                   |   |        |  
|Reporting Period Expense                                   |  | $                 | (2,492 | ) |                   | $ | (2,775 | )
|Deferred Taxes Allocated to Adjustment in Reporting Period |  | $                 | 947    |   |                   | $ | 1,054  |  

NOTE O  INCOME TAXES

The provisions (benefits) for federal and state income taxes are as follows:



|                                   |  |      |     |   |      |   |      |  |   |        |  
|---------------------------------- |  | ---- | --- | - | ---- | - | ---- |  | - | ------ | -
|(Dollars in
thousands)             | 
|                                   |  | 2006 |     |   | 2005 |   | 2004 | 
|Current:                           |  |      |     |   |      |   |      |  |   |        |  
|Federal                            |  | $    |    |   |      | $ |     |  | $ |       |  
|State                              |  |      | 81  |   |      |   | 103  |  |   | 240    |  
|                                   |  |      |     |   |      |   |      |  |   |        |  
|Total Current Provision            |  |      | 81  |   |      |   | 103  |  |   | 240    |  
|                                   |  |      |     |   |      |   |      |  |   |        |  
|Deferred                           |  |      |     |   |      |   |      |  |   |        |  
|Federal                            |  |      | (51 | ) |      |   | 646  |  |   | (5,839 | )
|State                              |  |      | (9  | ) |      |   | 121  |  |   | (1,095 | )
|                                   |  |      |     |   |      |   |      |  |   |        |  
|Total Deferred Provision (Benefit) |  |      | (60 | ) |      |   | 767  |  |   | (6,934 | )
|                                   |  |      |     |   |      |   |      |  |   |        |  
|Total Provision (Benefit)          |  | $    | 21  |   |      | $ | 870  |  | $ | (6,694 | )
|                                   |  |      |     |   |      |   |      |  |   |        |  



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U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004



The provision (benefit) for income taxes differs from the Federal statutory rate for the following reasons:



|                                            |  |      |         |   |      |   |        |      |  |   |        |  
|------------------------------------------- |  | ---- | ------- | - | ---- | - | ------ | ---- |  | - | ------ | -
|(Dollars in
thousands)                      | 
|                                            |  | 2006 |         |   | 2005 |   |        | 2004 | 
|Provision (Benefit) at Statutory Rate       |  | $    | (10,281 | ) |      | $ | (3,375 | )    |  | $ | (9,809 | )
|State Income Tax                            |  |      | (1,209  | ) |      |   | (308   | )    |  |   | 240    |  
|Increase in Valuation Allowance             |  |      | 11,752  |   |      |   | 4,409  |      |  |   | 2,665  |  
|Permanent Differences                       |  |      | (365    | ) |      |   | (390   | )    |  |   | 14     |  
|Other                                       |  |      | 124     |   |      |   | 534    |      |  |   | 196    |  
|                                            |  |      |         |   |      |   |        |      |  |   |        |  
|Actual Provision (Benefit) for Income Taxes |  | $    | 21      |   |      | $ | 870    |      |  | $ | (6,694 | )
|                                            |  |      |         |   |      |   |        |      |  |   |        |  

Provisions have been made for deferred taxes based on differences between the financial statements
and the tax basis of assets and liabilities using currently enacted rates and regulations. The components of the net deferred tax assets and liabilities are as follows:



|                                |  |      |         |   |      |   |         |  
|------------------------------- |  | ---- | ------- | - | ---- | - | ------- | -
|                                |  | 2006 |         |   | 2005 |  
|Deferred Tax Assets:            |  |      |         |   |      |   |         |  
|NOL and Credit Carry Forward    |  | $    | 39,230  |   |      | $ | 26,981  |  
|Property, Plant & Equipment     |  |      | 2,886   |   |      |   | 3,100   |  
|Deferred Revenue                |  |      | 898     |   |      |   | 1,086   |  
|Foreign Currency Translation    |  |      | 4,657   |   |      |   | 3,290   |  
|Allowance for Doubtful Accounts |  |      | 1,626   |   |      |   | 532     |  
|                                |  |      |         |   |      |   |         |  
|Total Deferred Tax Assets       |  |      | 49,297  |   |      |   | 34,989  |  
|                                |  |      |         |   |      |   |         |  
|Deferred Tax Liabilities:       |  |      |         |   |      |   |         |  
|Subsidy Revenue                 |  |      | (9,925  | ) |      |   | (9,364  | )
|Derivative Mark to Market Loss  |  |      | (1,030  | ) |      |   |        |  
|Investments                     |  |      | (1,112  | ) |      |   | (407    | )
|                                |  |      |         |   |      |   |         |  
|Total Deferred Tax Liabilities  |  |      | (12,067 | ) |      |   | (9,771  | )
|                                |  |      |         |   |      |   |         |  
|Net Deferred Tax Assets         |  |      | 37,230  |   |      |   | 25,218  |  
|Valuation Allowance             |  |      | (23,092 | ) |      |   | (11,340 | )
|                                |  |      |         |   |      |   |         |  
|Total Deferred Taxes            |  | $    | 14,138  |   |      | $ | 13,878  |  
|                                |  |      |         |   |      |   |         |  

Realization of the deferred tax assets is dependent on generating sufficient taxable income prior
to the expiration of the loss carryforwards. Although realization is not assured, management believes it is more likely than not that a significant portion of the deferred tax asset will be realized. The amount of the deferred tax asset considered
realizable, however, could be reduced in the near term if estimates of future taxable income are reduced. The Company has established a 100% reserve towards the deferred tax assets for two of the companies that are included in the consolidated
financial statements. USEB deferred tax assets are expected to be utilized in 2007 as the result of the settlement gain associated with the Illinois Retail Rate program. Such gain is expected to be recorded during the second quarter of 2007.

The Companys Consolidated Net Operating Loss Carryforwards (NOLs) expire as follows:



|             |  |      |        
|------------ |  | ---- | -------
|             |  | NOLs
|             |  |      |        
|2007         |  | $    |       
|2008         |  |      | 18     
|2009 to 2012 |  |      | 5,313  
|Thereafter   |  |      | 97,905 
|             |  |      |        
|Totals       |  | $    | 103,236
|             |  |      |        



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##### Table of Contents

U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004



NOTE P  STOCKHOLDERS EQUITY

Effective on March 31, 2006, the Company caused the conversion of each share of its Series D Convertible Preferred Stock into four shares of common
stock. A total of 916,666 shares of the Series D Convertible Preferred Stock were converted into 3,666,664 shares of common stock. The conversion resulted in a decrease in preferred stock equity of $9,000, a decrease in additional paid in capital of
$28,000 and an increase in common stock of $37,000.

During 2006, stockholders owning 73,266 of the Companys Series C Convertible
Preferred Stock exchanged such shares for 586,128 shares of common stock.

During 2006, stockholders owning 127.272 of the Companys
Series B Convertible Preferred Stock exchanged such shares for 35,027 shares of common stock.

As of December 31, 2006, the Company
had 7,274,000 warrants, issued as part of the UK acquisition, outstanding for the purchase of its common stock as follows:



|          |  |                |       |                 |                 
|--------- |  | -------------- | ----- | --------------- | ----------------
|Shares    |  | Exercise Price |       | Expiration Date
|6,174,000 |  | $              | 0.01  |                 | February 7, 2014
|600,000   |  |                | 4.37  |                 | February 7, 2014
|166,667   |  |                | 8.00  |                 | February 7, 2014
|166,667   |  |                | 9.00  |                 | February 7, 2014
|166,666   |  |                | 10.00 |                 | February 7, 2014

As of December 31, 2006, the Company had issued 1,900,000 Class B Membership Units of
Overseas associated with the UK Transaction with each unit convertible into one share of the Companys common stock. The Class B Membership Units are convertible after the earlier of August 2009 or when the market price of USEYs common
stock exceeds $11 for 20 consecutive trading days. The value ascribed to the Class B Membership Units were determined by an independent valuation which amounted to $13,500,000. Such amount has been recorded as minority interest in the accompanying
financial statements.

As of December 31, 2006, the Company had preferred stock outstanding as summarized below:



|                                   |  |                                                                     |  |                                                                    
|---------------------------------- |  | ------------------------------------------------------------------- |  | -------------------------------------------------------------------
|                                   |  | Series B                                                            |  | Series C                                                           
|Number of Shares                   |  | 238                                                                 |  | 24,067                                                             
|Annual Dividend per Share          |  | $90                                                                 |  | $1.80                                                              
|Convertible Into USEY Common Stock |  | Yes                                                                 |  | Yes                                                                
|Conversion Price per Share         |  | $3.625                                                              |  | $8.00                                                              
|Forced Conversion by Company       |  | If stock trades at 150% of conversion price for 20 consecutive days |  | If stock trades at 120% of conversion price for 30 consecutive days
|Voting Rights to One Common Share  |  | None                                                                |  | 6:1                                                                

As of December 31, 2006, the Company had issued restricted stock units as summarized below:



|                                       |  |                              |  |                                        |      |       |         |                                        |   |     
|-------------------------------------- |  | ---------------------------- |  | -------------------------------------- | ---- | ----- | ------- | -------------------------------------- | - | ----
|                                       |  | Year Ended December 31, 2006 |  | Year Ended December 31, 2005          
|                                       |  | Units                        |  | Weighted Average Priceon Date of Grant |      | Units |         | Weighted Average Priceon Date of Grant
|Units Outstanding at Beginning of Year |  | 601,015                      |  | $                                      | 1.12 |       | 471,015 |                                        | $ | 0.89
|Granted                                |  | 375,000                      |  |                                        |     |       | 130,000 |                                        |   | 1.95
|Exercised                              |  |                             |  |                                        |     |       |        |                                        |   |    
|Forfeited                              |  |                             |  |                                        |     |       |        |                                        |   |    
|                                       |  |                              |  |                                        |      |       |         |                                        |   |     
|Units Outstanding at End of Year       |  | 976,015                      |  | $                                      | 0.69 |       | 601,015 |                                        | $ | 1.12
|                                       |  |                              |  |                                        |      |       |         |                                        |   |     

These restricted stock units granted in 2006 vest one-third on the later of December 13, 2007 or
when the average trading price for one share of US Energys common stock (the Price) is greater than $15, one-third on the later of December 13, 2008 or when the Price is greater than $20 and one-third on the later of December 13,
2009 or when the Price is greater than $25. The Company has not ascribed any value to these units due to the spread between the Price and the market price of the stock at the date of grant.

There are restricted stock units granted in 2004 and 2005 which vest over a four year period equally on the anniversary of the date of grant. The fair
value of these restricted stock units have been measured at the market value of the underlying stock at the date of the grant.

Following
is a summary of the vesting and the unrecorded compensation costs for the vesting of restricted stock units.



|                              |  |         |  |                             |        
|----------------------------- |  | ------- |  | --------------------------- | -------
|                              |  | Units   |  | UnrecordedCompensationCosts
|Restricted Stock Units Issued |  | 976,015 |  |                             |        
|Shares Vested:                |  | 485,399 |  |                             |        
|Shares Vesting:               |  |         |  |                             |        
|2007                          |  | 166,558 |  | $                           | 163,000
|2008                          |  | 166,558 |  |                             | 202,000
|2009                          |  | 157,500 |  |                             |       
|                              |  |         |  |                             |        
|Totals                        |  | 490,616 |  | $                           | 365,000



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##### Table of Contents

U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004



Restricted stock unit grants are valued based on the closing market value on the date of grant and
expensed over the vesting period of the units.

2000 Executive Incentive Compensation Plan. The 2000 Executive Incentive Compensation
Plan (the 2000 Plan) provides for the granting of stock options, stock appreciation rights, restricted stock, and other stock related awards and incentive awards that may be settled in cash, stock or property. The total number of shares
that may be issued under the 2000 Plan equals the sum of 10,000,000 shares plus the number of shares that are surrendered in payment of any award or any tax withholding requirements.

The Board of Directors or a committee thereof administers the 2000 Plan. The Board is permitted to impose performance conditions with respect to any
award, thereby requiring forfeiture of all or any part of any award if performance objectives are not met, or to link the time of exercisability or settlement of an award to the achievement of performance conditions. For awards intended to qualify
as performance-based compensation within the meaning of Section 162(m) of the Internal Revenue Code, such performance objectives shall be based upon the achievement of a performance goal based upon business criteria described in or
determined pursuant to the 2000 Plan. As such performance based compensation may be tied to the Companys stock price, the intention of the compensation plan is to focus the attention of management on managing the Company from the prospective
of an owner with an equity stake.

Other Executive Incentive Compensation Plans.Prior to the 2000 Executive Incentive Compensation
Plan the Company had three other plans that provided for the granting of stock options and other stock related awards and incentive awards. These plans, entitled the 1996, 1997 and 1998 Plans, have been terminated and no additional awards will be
issued under the plans.

Stock option activity is summarized as follows:

Stock Option Activity



|                                         |  |                              |   |                              |                               |                              |        |           |   |                               |   |        |  |           |                               |  |   |     
|---------------------------------------- |  | ---------------------------- | - | ---------------------------- | ----------------------------- | ---------------------------- | ------ | --------- | - | ----------------------------- | - | ------ |  | --------- | ----------------------------- |  | - | ----
|                                         |  | Year Ended December 31, 2006 |   | Year Ended December 31, 2005 |                               | Year Ended December 31, 2004
|                                         |  | Shares                       |   |                              | WeightedAverageExercise Price |                              | Shares |           |   | WeightedAverageExercise Price |   | Shares |  |           | WeightedAverageExercise Price
|Options Outstanding at Beginning of Year |  | 7,156,425                    |   |                              | $                             | 3.67                         |        | 6,138,925 |   |                               | $ | 3.84   |  | 6,118,925 |                               |  | $ | 3.84
|Granted                                  |  | 73,333                       |   |                              |                               | 4.53                         |        | 1,620,000 |   |                               |   | 2.79   |  | 120,000   |                               |  |   |    
|Forfeited                                |  | (34,000                      | ) |                              |                               | 5.41                         |        | (602,500  | ) |                               |   | 2.97   |  | (100,000  | )                             |  |   | 3.64
|Exercised                                |  | (65,000                      | ) |                              |                               | 1.70                         |        |          |   |                               |   |       |  |          |                               |  |   |    
|                                         |  |                              |   |                              |                               |                              |        |           |   |                               |   |        |  |           |                               |  |   |     
|Options Outstanding at End of Year       |  | 7,130,758                    |   |                              |                               | 3.69                         |        | 7,156,425 |   |                               |   | 3.67   |  | 6,138,925 |                               |  |   | 3.84
|                                         |  |                              |   |                              |                               |                              |        |           |   |                               |   |        |  |           |                               |  |   |     
|Options Exercisable at End of Year       |  | 6,470,738                    |   |                              | $                             | 3.75                         |        | 5,716,425 |   |                               | $ | 3.84   |  | 6,138,925 |                               |  | $ | 3.84
|                                         |  |                              |   |                              |                               |                              |        |           |   |                               |   |        |  |           |                               |  |   |     



|                        |  |                     |  |                                |      |                                        |    
|----------------------- |  | ------------------- |  | ------------------------------ | ---- | -------------------------------------- | ---
|                        |  | Options Outstanding |  |                               
|Range of Exercise Price |  | Shares              |  | Weighted AverageExercise Price |      | Weighted AverageRemaining Life inYears
|$0.65 - $ 2.50          |  | 986,000             |  | $                              | 1.84 |                                        | 4.9
|$2.85 - $3.00           |  | 1,537,425           |  |                                | 2.95 |                                        | 3.0
|$3.50 - $3.63           |  | 1,040,000           |  |                                | 3.51 |                                        | 7.2
|$4.00 - $ 5.15          |  | 2,871,333           |  |                                | 4.22 |                                        | 3.7
|                        |  |                     | 
|$6.00 - $ 7.00          |  | 696,000             |  |                                | 6.09 |                                        | 4.1
|                        |  |                     |  |                                |      |                                        |    
|                        |  | 7,130,758           |  | $                              | 3.69 |                                        | 4.1
|                        |  |                     |  |                                |      |                                        |    

Forfeitures are the result of an option holders termination of employment with the company.



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##### Table of Contents

U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004



The intrinsic value (or the amount by which the market price of the Companys stock exceeds the
exercise price of an option) for options are summarized as follows:



|                                    |  |   |           
|----------------------------------- |  | - | ----------
|Outstanding as of December 31, 2006 |  | $ | 11,093,000
|Exercisable as of December 31, 2006 |  | $ | 9,697,000 
|Exercised during 2006               |  | $ | 225,000   

Unrecorded compensation for unvested options is $400,000 to be recorded in 2007.

The weighted average fair value of options at date of grant for grants during the years ended December 31, 2006, 2005 and 2004 were $2.85, $1.31 and
$0.21, respectively. The fair value of the options at date of grant was estimated using the Black-Scholes option-pricing model utilizing the following assumptions:



|                                |  |                                      |   |  |                                      |   |  |                                     |  
|------------------------------- |  | ------------------------------------ | - |  | ------------------------------------ | - |  | ----------------------------------- | -
|                                |  | For the year ended December 31, 2006 |   |  | For the year ended December 31, 2005 |   |  | For the year endedDecember 31,
2004 |  
|Risk-free Interest Rates        |  | 4.625                                | % |  | 4.77                                 | % |  | 4.20                                | %
|Expected Option Life in Years   |  | 5.00                                 |   |  | 8.50                                 |   |  | 10.00                               |  
|Expected Stock Price Volatility |  | 0.77                                 |   |  | 0.45                                 |   |  | 0.26                                |  
|Expected Dividend Yield         |  | 0.00                                 | % |  | 0.00                                 | % |  | 0.00                                | %

The Risk-Free Interest Rates are based upon an average of the 5 and 10 year treasury bills. The
Expected Option Life is based upon the expected life of the option. The Expected Stock Price Volatility is based upon the standard deviation of the change in the Companys stock price over the last year, based upon managements assessment
of the change in operating characteristics of the Company.

Shares Reserved

The following table summarizes shares of common stock reserved for issuance at December 31, 2006:



|                                    |  |                |               |                          |           
|----------------------------------- |  | -------------- | ------------- | ------------------------ | ----------
|Reserved for:                       |  | Exercise Price |               | Number of SharesIssuable
|Warrants                            |  | $              | 0.01 - $10.00 |                          | 7,274,000 
|Stock Conversions                   |  | $              | 3.63 - $11.00 |                          | 3,134,381 
|2000 Executive Incentive Comp. Plan |  | $              | 0.65 - $7.00  |                          | 7,130,758 
|                                    |  |                |               |                          |           
|Totals                              |  |                |               |                          | 17,539,139

As of December 31, 2006, the Company had dilutive shares, including vested restricted stock units,
warrants and options totalling 16,839,086 shares.

NOTE Q  COMMITMENTS AND CONTINGENCIES

The Company and its subsidiaries have various financial commitments under office and equipment leases. The office leases include leases in New York,
Connecticut and London. Financial commitments for the next five years are:



|      |  |             |          
|----- |  | ----------- | ---------
|Year  |  | Commitments
|2007  |  | $           | 622,000  
|2008  |  |             | 471,000  
|2009  |  |             | 379,000  
|2010  |  |             | 345,000  
|2011  |  |             |         
|      |  |             |          
|Total |  | $           | 1,817,000

Lease expenses for the Company for 2006, 2005 and 2004 were $219,000, $226,000 and $253,000
respectively.

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



F-34



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##### Table of Contents

U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004



For 2006, 2005 and 2004, the amounts of additional contingent consideration paid to YESCO under this
agreement were $45,000, $39,000 and $78,000, respectively. The consideration is treated as an operating expense in the Companys financial statements.

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

On or about March 20, 2007, Marathon Capital Holdings (UK), LLC (Marathon) and Richard T. Brandt II,
as director, filed suit in the Supreme Court of the State of New York against the Company, one of its subsidiaries and certain officers and directors of the Company. The suit asserts causes of action seeking permanent injunctive relief directing the
defendants to provide the plaintiffs with access to the books and records of the Company and to allow the plaintiffs to more fully participate in the management and affairs of the Company. The suit seeks an award of attorneys fees and costs in
connection with the litigation, but does not otherwise seek monetary damages. The defendants intend to vigorously defend against the suit.

NOTE R
 RETIREMENT AND PROFIT SHARING PLAN

Pursuant to the Companys 401(k) plan, employees may defer up to 15% of their salaries
up to the maximum contribution allowed under the Internal Revenue Code. The Company matches 100% of the first 3% of salary contributed and 50% of the next 2% of salary contributed to the plan. For the years ended December 31, 2006, 2005 and
2004, the Companys total contributions were $35,000, $42,000 and $63,000, respectively. Total contributions related to the UK plan since August 7, 2006 were $35,120 based upon the exchange rate at December 31, 2006.

NOTE S  RELATED PARTY TRANSACTIONS

In 2004,
certain legal costs were incurred by us and paid to an entity with which a former member of our executive management was affiliated. The amounts paid were $220,000 in 2004.

AJG Subordinated Loan

On September 30, 2004, USEB purchased the
subordinated note owed by USEB to AJG. The outstanding principal amount of $5,729,000 plus outstanding accrued interest was purchased for $3,000,000. Funds for the acquisition were provided by equity contributions to USEB from the USEB shareholders;
$1,629,000 contributed by the Company and $1,371,000 contributed by Cinergy. The purchase resulted in a gain of $2,729,000. The gain represents the amount of the acquisition price below the notes face value.

NOTE T  MAJOR CUSTOMERS

During 2006, 2005 and
2004, one customer accounted for 33%, 39% and 42% of our revenues (excluding revenues from discontinued operations), respectively.

NOTE U 
QUARTERLY INFORMATION



|                                                  |  |               |        |   |                |   |        |               |  |   |                |   |  |   |         |  
|------------------------------------------------- |  | ------------- | ------ | - | -------------- | - | ------ | ------------- |  | - | -------------- | - |  | - | ------- | -
|2006 (Dollars in thousands, except share amounts) |  |               |        |   |                |   |        |               |  |   |                |  
|                                                  |  | First Quarter |        |   | Second Quarter |   |        | Third Quarter |  |   | Fourth Quarter |  
|Net Loss Applicable Common Stock                  |  | $             | (2,166 | ) |                | $ | (2,925 | )             |  | $ | (7,636         | ) |  | $ | (15,108 | )
|Loss per Common Stock  Basic and Diluted         |  | $             | (0.15  | ) |                | $ | (0.17  | )             |  | $ | (0.47          | ) |  | $ | (0.93   | )



|                                                  |  |               |       |   |                |   |        |               |  |   |                |   |  |   |        |  
|------------------------------------------------- |  | ------------- | ----- | - | -------------- | - | ------ | ------------- |  | - | -------------- | - |  | - | ------ | -
|2005 (Dollars in thousands, except share amounts) |  |               |       |   |                |   |        |               |  |   |                |  
|                                                  |  | First Quarter |       |   | Second Quarter |   |        | Third Quarter |  |   | Fourth Quarter |  
|Net Loss Applicable Common Stock                  |  | $             | (888  | ) |                | $ | (1,049 | )             |  | $ | (6,474         | ) |  | $ | (1,881 | )
|Loss per Common Stock  Basic and Diluted         |  | $             | (0.07 | ) |                | $ | (0.09  | )             |  | $ | (0.52          | ) |  | $ | (0.15  | )



|                                                  |  |               |        |   |                |   |        |               |  |   |                |   |  |   |        |  
|------------------------------------------------- |  | ------------- | ------ | - | -------------- | - | ------ | ------------- |  | - | -------------- | - |  | - | ------ | -
|2004 (Dollars in thousands, except share amounts) |  |               |        |   |                |   |        |               |  |   |                |  
|                                                  |  | First Quarter |        |   | Second Quarter |   |        | Third Quarter |  |   | Fourth Quarter |  
|Net Loss Applicable Common Stock                  |  | $             | (4,181 | ) |                | $ | (1,952 | )             |  | $ | (883           | ) |  | $ | (3,056 | )
|Loss per Common Stock  Basic and Diluted         |  | $             | (0.35  | ) |                | $ | (0.17  | )             |  | $ | (0.07          | ) |  | $ | (0.26  | )



F-35



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##### Table of Contents

U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004



NOTE V  SEGMENT INFORMATION

The Companys results by operating segment were as follows:



|                    |  |                          |             |   |                  |             |             |      |  |   |             |  
|------------------- |  | ------------------------ | ----------- | - | ---------------- | ----------- | ----------- | ---- |  | - | ----------- | -
|                    |  | Years Ended December 31, |            
|                    |  | 2006                     |             |   | 2005             |             |             | 2004 | 
|                    |  |                          | (Unaudited) |   |                  | (Unaudited) |            
|Operating Revenues: |  |                          |             |   |                  |             |             |      |  |   |             |  
|USEB                |  | $                        | 18,860,000  |   |                  | $           | 19,620,000  |      |  | $ | 19,901,000  |  
|UK Operations       |  |                          | 2,384,000   |   |                  |             |            |      |  |   |            |  
|Corporate           |  |                          |            |   |                  |             |            |      |  |   | 207,000     |  
|                    |  |                          |             |   |                  |             |             |      |  |   |             |  
|Total               |  | $                        | 21,244,000  |   |                  | $           | 19,620,000  |      |  | $ | 20,108,000  |  
|                    |  |                          |             |   |                  |             |             |      |  |   |             |  
|Net Loss:           |  |                          |             |   |                  |             |             |      |  |   |             |  
|USEB                |  | $                        | (11,575,000 | ) |                  | $           | (2,882,000  | )    |  | $ | (10,708,000 | )
|UK Operations       |  |                          | (9,137,000  | ) |                  |             |            |      |  |   |            |  
|Corporate           |  |                          | (7,123,000  | ) |                  |             | (7,410,000  | )    |  |   | 636,000     |  
|                    |  |                          |             |   |                  |             |             |      |  |   |             |  
|Total               |  | $                        | (27,835,000 | ) |                  | $           | (10,292,000 | )    |  | $ | (10,072,000 | )
|                    |  |                          |             |   |                  |             |             |      |  |   |             |  
|                    |  |                          |            
|                    |  | December 31,2006         |             |   | December 31,2005 |             |             |      | 
|                    |  |                          | (Unaudited) |   |                  |             |            
|Identifiable Assets |  |                          |             |   |                  |             |             |      |  |   |             |  
|USEB                |  | $                        | 148,739,000 |   |                  | $           | 157,597,000 |      |  |   |             |  
|UK Operations       |  |                          | 161,878,000 |   |                  |             |            |      |  |   |             |  
|Corporate           |  |                          | 36,313,000  |   |                  |             | 11,432,000  |      |  |   |             |  
|                    |  |                          |             |   |                  |             |             |      |  |   |             |  
|Total               |  | $                        | 346,930,000 |   |                  | $           | 169,029,000 |      |  |   |             |  
|                    |  |                          |             |   |                  |             |             |      |  |   |             |  

The USEB segment is comprised of the operations of USEBs landfill gas to energy projects.
The UK segment relates to the operations of the UK Assets. The Company may in the future, based upon changes in the operating structure, create an additional segment related to the UK operations. The Corporate segment relates to the executive
management of the Company.

NOTE W  ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)

The Accumulated Other Comprehensive Income (Loss) for 2006 and 2005 is as follows:



|                              |  |                  |           |                  |   |           |  
|----------------------------- |  | ---------------- | --------- | ---------------- | - | --------- | -
|                              |  | December 31,2006 |           | December 31,2005 |  
|Foreign Currency Translation  |  | $                | 3,391,000 |                  | $ | (442,000  | )
|Mark to Market of Investments |  |                  | 2,380,000 |                  |   | 2,619,000 |  
|                              |  |                  |           |                  |   |           |  
|Total                         |  | $                | 5,771,000 |                  | $ | 2,177,000 |  
|                              |  |                  |           |                  |   |           |  



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##### Table of Contents

U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004



NOTE X  SUBSEQUENT EVENTS

Subsequent to December 31, 2006, the following transactions were entered into:



| |  |  | 19,713 shares of Series C Convertible Preferred Stock were converted into 157,704 shares of common stock;
| | - |  | ---------------------------------------------------------------------------------------------------------



| |  |  | 434,783 restricted stock units granted in 2004 vested and were converted into 434,783 shares of common stock;
| | - |  | -------------------------------------------------------------------------------------------------------------



| |  |  | USEB entered into an agreement with the Illinois Commerce Commission in which it was agreed upon that USEB would satisfy its approximately $65,000,000 obligation to
the State of Illinois for payments received under the Illinois Retail Rate Program for a payment of $5,250,000. The final agreement has been approved by the Court and the amounts were paid on May 31, 2007;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | U.S. Energy sold 1,280,000 shares of common stock for $5.00 per share and issued 652,000 warrants with each warrant convertible into one share of common stock for
an exercise price of $0.01 per share. A total of $6,400,000 was received from the sale of the common stock. Pursuant to the financing agreement with Silver Point Capital Finance, LLC (Silver Point) related to the financing they provided
for the UK Transaction, the Company was required to pay Silver Point, as a payment against the financing liability, 50% of the proceeds from the sale of equity above the first $3,000,000 in proceeds received. The Company made a payment of $1,700,000
against the UK financing as the result of this sale of common stock;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Holders of 1,632,000 options to acquire the Companys common stock exercised those options and were issued 1,632,000 shares of common stock. The total exercise
price for the options exercised was $5,100,000; and
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Pursuant to the terms of the Countryside settlement, a former executive of the Company who owned 1,810,000 options to acquire the Companys common stock at
various exercise prices was granted a cashless exercise of those options resulting in the issuance of 523,423 shares of common stock. The remaining balance of 1,286,577 options were cancelled.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | On May 31, 2007, USEB closed on $80,000,000 in financing with a private equity fund thereby allowing it to fully satisfy its remaining $66,000,000 obligation to
Countryside, the $5,250,000 obligation to the Illinois Commerce Commission per its settlement agreement with USEB, the payment, in full, of all undisputed, unsecured pre-petition claims and the establishment of certain reserves for future
obligations. With the completion of the financing and the subsequent payment of the various obligations, USEB has completed its plan of reorganization and emerged from the Chapter 11 proceedings which commenced on November 29, 2006.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

NOTE YACCOUNTING CORRECTIONS

The Companys accounting policy pertaining to gains associated with the note receivable issued as consideration for the sale of certain partnership interests was adjusted in 2004 to reflect the application of
Staff Accounting Bulletin No. 30, Accounting for Divesture of a Subsidiary or Other Business Operation and Staff Accounting Bulletin No. 81, Gain Recognition on the Sale of a Business to a Highly Leveraged Entity. The application of these
bulletins resulted in the recognition of gains associated with the note as payments are received as such payments are dependent upon future operations of assets sold. The adjustment had no impact on consolidated cash flows.

The Companys accounting policy related to the accounting for a foreign currency loan and related hedge arrangement was adjusted in 2004 to reflect
the application of the Statement of Financial Accounting Standard No. 52, Foreign Currency Translation and No. 133, Accounting for Derivative Instruments and Hedging Activities. The Company states the outstanding principal amount related
to the Countryside debt using the foreign currency exchange rate in effect at the end of the applicable period and to record changes in the fair value of the hedge arrangements.



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##### Table of Contents

U.S. ENERGY SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004



The following table isolates the change in the Companys Consolidated Statement of Operations
and Other Comprehensive for the year ended December 31, 2004 resulting from the restatement. The change had no effect on the Companys cash flows.



|                                                                                     |  |             |         |   |                       |   |        |  
|------------------------------------------------------------------------------------ |  | ----------- | ------- | - | --------------------- | - | ------ | -
|STATEMENT OF OPERATIONS FOR THE TWELVE MONTHS ENDED DECEMBER 31, 2004 (in thousands) |  | As Restated |         |   | As OriginallyReported |  
|Foreign Currency Translation Expense                                                 |  | $           | (6,989  | ) |                       | $ |       |  
|Gain on Sale of Subsidy                                                              |  | $           | 6,560   |   |                       | $ | 9,944  |  
|Minority Interest                                                                    |  | $           | 5,857   |   |                       | $ | 2,061  |  
|Income Tax Benefit                                                                   |  | $           | 6,694   |   |                       | $ | 10,003 |  
|Net Income (Loss)                                                                    |  | $           | (9,244  | ) |                       | $ | 495    |  
|Net Loss Applicable to Common Stock                                                  |  | $           | (10,072 | ) |                       | $ | (185   | )
|Loss per Share of Common Stock                                                       |  | $           | (0.85   | ) |                       | $ | (0.02  | )

NOTE Z  VALUATION ALLOWANCES

The Companys activity in its allowance for doubtful accounts is a summarized as follows:



|                             |  |                  |           |   |                  |   |          
|---------------------------- |  | ---------------- | --------- | - | ---------------- | - | ---------
|                             |  | December31, 2006 |           |   | December31, 2005
|Balance  Beginning of Year: |  | $                | 1,399,000 |   |                  | $ | 46,000   
|Additions                    |  |                  | 3,595,000 |   |                  |   | 1,353,000
|Recovery                     |  |                  | (729,000  | ) |                  |   |         
|                             |  |                  |           |   |                  |   |          
|Balance  End of Year        |  | $                | 4,265,000 |   |                  | $ | 1,399,000
|                             |  |                  |           |   |                  |   |          



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##### Table of Contents

SUPPLEMENTARY OIL AND GAS DATA

(Unaudited)

The supplementary gas data that follows is presented in accordance
with FAS No. 69, Disclosures About Oil and Gas Producing Activities(FAS No. 69), and includes (1) costs incurred, capitalized costs and results of operations relating to gas producing activities, (2) net
proved gas reserves, and (3) a standardized measure of discounted future net cash flows relating to proved gas reserves, including a reconciliation of changes therein.

The Company produces natural gas in the United Kingdom. The Company is the majority owner of a consolidated subsidiary that conducts all business in the
United Kingdom. A total of 21% of all United Kingdom activity, and therefore natural gas activity, is attributable to a minority interest holder.

Costs
Incurred in Gas Producing Activities



|                                 |  |      |        |      |   |      |  
|-------------------------------- |  | ---- | ------ | ---- | - | ---- | -
|(Dollars in thousands)          
|For the Years Ended December 31, |  | 2006 |        | 2005 |   | 2004
|Property acquisitions            |  |      |        |      |   |      |  
|Unproved                         |  | $    | 28,029 |      |  |      | 
|Proved                           |  |      | 54,778 |      |  |      | 
|Exploration                      |  |      |       |      |  |      | 
|Production and development       |  |      | 994    |      |  |      | 
|Accrual for Asset Retirement     |  |      | 6,089  |      |  |      | 

Capitalized Costs Relating to Gas Producing Activities



|                                                                             |  |      |        |   |      |   |      |  
|---------------------------------------------------------------------------- |  | ---- | ------ | - | ---- | - | ---- | -
|(Dollars in thousands)                                                      
|For the Years Ended December 31,                                             |  | 2006 |        |   | 2005 |   | 2004
|Unproved properties                                                          |  | $    | 24,887 |   |      |  |      | 
|Proved properties                                                            |  |      | 48,638 |   |      |  |      | 
|Wells, equipment and related facilities                                      |  |      | 17,953 |   |      |  |      | 
|                                                                             |  |      |        |   |      |   |      |  
|Total Costs                                                                  |  |      | 91,478 |   |      |  |      | 
|Less: Reserve for depreciation, depletion, amortization and lease impairment |  |      | (165   | ) |      |  |      | 
|                                                                             |  |      |        |   |      |   |      |  
|Net capitalized costs                                                        |  | $    | 91,313 |   |      |  |      | 
|                                                                             |  |      |        |   |      |   |      |  



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##### Table of Contents

Results of Operations for Gas Producing Activities

The results of operations shown below excluded gas producing activities, including gains on sales of oil and gas properties, interest expense and gains
and losses resulting from foreign exchange translations. Therefore, these results are on a different basis than the net income from Exploration and Production operations reported in managements discussion and analysis of results of operations
and in Note V  Segment Information, in the notes to the consolidated financial statements.



|                                                               |  |      |       |   |      |   |      |  
|-------------------------------------------------------------- |  | ---- | ----- | - | ---- | - | ---- | -
|(Dollars in
thousands)                                        
|For the Years Ended December 31,                               |  | 2006 |       |   | 2005 |   | 2004
|Sales and other operating revenues                             |  |      |       |   |      |   |      |  
|Unaffiliated customers                                         |  | $    |      |   |      |  |      | 
|Inter-company                                                  |  |      | 1,513 |   |      |  |      | 
|                                                               |  |      |       |   |      |   |      |  
|Total revenues                                                 |  |      | 1,513 |   |      |  |      | 
|                                                               |  |      |       |   |      |   |      |  
|Costs and expenses                                             |  |      |       |   |      |   |      |  
|Production expenses, including related taxes                   |  |      | 1,381 |   |      |  |      | 
|Exploration expenses, including dry holes and lease impairment |  |      |      |   |      |  |      | 
|General, administrative and other expenses                     |  |      | 352   |   |      |  |      | 
|Depreciation, depletion and amortization                       |  |      | 161   |   |      |  |      | 
|                                                               |  |      |       |   |      |   |      |  
|Total costs and expenses                                       |  |      | 1,894 |   |      |  |      | 
|                                                               |  |      |       |   |      |   |      |  
|Results of Operations                                          |  | $    | (381  | ) |      |  |      | 
|                                                               |  |      |       |   |      |   |      |  

Intercompany sales represent sales between subsidiaries used in the production of electricity output.

Gas Reserves

The Companys gas reserves are
calculated in accordance with SEC regulations and interpretations and the requirements of the FASB. For reserves to be booked as proved they must be commercially producible, government approvals must be obtained and depending on the amount of the
project cost, senior management or the board of directors, must commit to fund the project. The Companys gas reserve estimation and reporting process involves an annual independent third party reserve determination as well as internal
technical appraisals of reserves. The Company maintains its own internal reserve estimates that are calculated by technical staff that work directly with the gas properties. The Companys technical staff updates reserve estimates throughout the
year based on evaluations of new wells, performance reviews, new technical data and other studies. To provide consistency throughout the Companys standard reserve estimation guidelines, definitions, reporting reviews and approval practices are
used. The internal reserve estimates are subject to internal technical audits and senior management reviews the estimates.

The gas reserve
estimates reported on the following page are determined independently by the consulting firm of Gaffney, Cline & Associates Inc. (GCA) and are consistent with internal estimates. Periodically, but not less then annually, the
Company provides GCA with engineering, geological and geophysical data, actual production histories and other information necessary for the reserve determination. The Companys and GCAs technical staffs meet to review and discuss the
information provided. Senior management and the board of directors review the final reserve estimates issued by GCA.



F-40



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##### Table of Contents

SUPPLEMENTARY OIL AND GAS DATA

(Unaudited)



|                                            |  |      |   |  |      |  |     
|------------------------------------------- |  | ---- | - |  | ---- |  | ----
|(bcf)                                      
|For the Years Ended December 31,            |  | 2006 |   |  | 2005 |  | 2004
|Net Proved Developed and Undeveloped        |  |      |   |  |      |  |     
|At August 7, 2006 (date of acquisition)     |  |     |   |  |     |  |    
|Purchases of minerals in place              |  | 42.8 |   |  |     |  |    
|Revisions of previous estimates             |  | (1.2 | ) |  |     |  |    
|Extensions, discoveries and other additions |  |     |   |  |     |  |    
|Sales of minerals in place                  |  |     |   |  |     |  |    
|Production                                  |  | (0.4 | ) |  |     |  |    
|                                            |  |      |   |  |      |  |     
|Net Proved Developed & Undeveloped          |  | 41.2 |   |  |     |  |    
|                                            |  |      |   |  |      |  |     
|Net Proved Developed  August, 2006         |  |     |   |  |     |  |    
|Purchased  Net Proved Developed            |  | 4.7  |   |  |     |  |    
|Net Proved Developed  December, 2006       |  | 20.4 |   |  |     |  |    
|                                            |  |      |   |  |      |  |     

Standardized Measure of Discounted Future Net Cash Flows Relating to Proved Gas Reserves

Future net cash flows are calculated by applying year-end gas selling prices (adjusted for price changes provided by contractual arrangements) to
estimated future production of proved gas reserves, less estimated future development and production costs, which are based on year-end costs and existing economic assumptions. Future income tax expenses are computed by applying the appropriate
year-end statutory tax rates to the pre-tax net cash flows relating to the Companys proved gas reserves. Future net cash flows are discounted at the prescribed rate of 10%. The discounted future net cash flow estimates required by
FAS No. 69 do not include exploration expenses, interest expense or general corporate and administrative expenses. The selling prices of natural gas are highly volatile. The year-end prices, which are required to be used for the discounted
future net cash flows and do not include the effects of hedges, may not be representative of future selling prices. The future net cash flow estimates could be materially different if other assumptions were used.



|                                                         |  |      |         |   |      |   |      |  
|-------------------------------------------------------- |  | ---- | ------- | - | ---- | - | ---- | -
|(Dollars in
thousands)                                  
|As of December 31,                                       |  | 2006 |         |   | 2005 |   | 2004
|Future revenues                                          |  | $    | 195,569 |   |      |  |      | 
|Less:                                                    |  |      |         |   |      |   |      |  
|Future production costs                                  |  |      | (27,031 | ) |      |  |      | 
|Future development costs                                 |  |      | (23,617 | ) |      |  |      | 
|Future income tax expenses                               |  |      |        |   |      |  |      | 
|                                                         |  |      |         |   |      |   |      |  
|Future net cash flows                                    |  |      | 144,921 |   |      |  |      | 
|Less: Discount at 10% annual rate                        |  |      | (56,453 | ) |      |  |      | 
|                                                         |  |      |         |   |      |   |      |  
|Standardized measure of discounted future net cash flows |  | $    | 88,468  |   |      |  |      | 
|                                                         |  |      |         |   |      |   |      |  



F-41