**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-K**

**x**                               ANNUAL REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**Forthe fiscal year ended December 31, 2006**

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

**Forthe transition period form                      to                     **

**Commission file number:**** 001-14176**

**EVERGREEN ENERGY INC.**

(Exact Name of Registrantas specified in its Charter)

| **Delaware**                                                     | **84-1079971**                     |
|------------------------------------------------------------------|------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) | (IRS Employer  Identification No.) |
| **55 Madison Street, Suite 500  Denver, Colorado**          | **80206**                          |
| (Address of  Principal Executive Offices)                        | (Zip Code)                         |

 

Registrant’s Telephone Number,including area code:** (303) 293-2992**

Securities registeredpursuant to Section 12(b) of the Act:

| Title of Each Class                | ** ** | **Name of Exchange on Which Registered** |
|------------------------------------|------------|------------------------------------------|
| **Common  Stock, $.001 par value** | ** ** | **NYSE  Arca**                           |

 

Securities registered pursuantto Section 12(g) of the Act:** None**

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

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

Indicate by check markwhether registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days. Yes x  No o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K. o

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

Large accelerated filer  x   Acceleratedfiler   ̈   Non-acceleratedfiler  o

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

The aggregate market valueof the common stock held by non-affiliates of the registrant was $1,094,602,633computed by reference to the closing price of the common stock on June 30,2006, the last trading day of the registrant’s most recently completed secondfiscal quarter.

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

| Class                              | ** ** | **Outstanding at  February 23, 2007** |
|------------------------------------|------------|--------------------------------------------|
| **Common  Stock, $.001 par value** |       | **83,600,061  shares**                     |

 

**DOCUMENTS INCORPORATED BYREFERENCE**

| Document                                         | ** ** | **Parts Into Which Incorporated** |
|--------------------------------------------------|------------|-----------------------------------|
| **Proxy  Statement for the 2007 Annual Meeting** |       | **Part III**                 |

 

 

----

**TABLEOF CONTENTS**

|                | ** ** | ** **                                                                                       | ** ** | **Page No.** |
|----------------|------------|--------------------------------------------------------------------------------------------------|------------|-------------------|
|           | ** ** | **PART I**                                                                                  |       |              |
| Item 1.        |       | Business                                                                                         |       | 3                 |   |
| Item 1A.       |       | Risk Factors                                                                                     |       | 10                |   |
| Item 1B.       |       | Unresolved Staff Comments                                                                        |       | 19                |   |
| Item 2.        |       | Properties                                                                                       |       | 19                |   |
| Item 3.        |       | Legal Proceedings                                                                                |       | 20                |   |
| Item 4.        |       | Submission of Matters to a Vote of Security Holders                                              |       | 20                |   |
|           | ** ** | **PART II**                                                                                 |       |              |   |
| Item 5.        |       | Market for Common Stock, Related Stockholder Matters  and Issuer Purchases of Equity Securities  |       | 21                |   |
| Item 6.        |       | Selected Financial Data                                                                          |       | 23                |   |
| Item 7.        |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations |       | 24                |   |
| Item 7A.       |       | Quantitative and Qualitative Disclosures About Market  Risk                                      |       | 39                |   |
| Item 8.        |       | Financial Statements and Supplementary Data                                                      |       | 39                |   |
| Item 9.        |       | Changes in and Disagreements with Accountants on  Accounting and Financial Disclosures           |       | 39                |   |
| Item 9A.       |       | Controls and Procedures                                                                          |       | 39                |   |
| Item  9B.      |       | Other  Information                                                                               |       | 44                |   |
|           | ** ** | **PART III**                                                                                |       |              |   |
| Item 10.       |       | Directors, Executive Officers and Corporate Governance                                           |       | 44                |   |
| Item 11.       |       | Executive Compensation                                                                           |       | 44                |   |
| Item 12.       |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters  |       | 44                |   |
| Item 13.       |       | Certain Relationships and Related Transactions, and  Director Independence                       |       | 44                |   |
| Item 14.       |       | Principal Accountant Fees and Services                                                           |       | 44                |   |
|           | ** ** | **PART IV**                                                                                 |       |              |   |
| Item 15.       |       | Exhibits and Financial Statement Schedules                                                       |       | 45                |   |
| **SIGNATURES** |       | 49                                                                                               |       |

 

1

----

**CAUTIONARYSTATEMENT ABOUT FORWARD-LOOKING STATEMENTS**

This Annual Report on Form 10-K containsforward-looking statements that are not statements of historical fact andmay involve a number of risks and uncertainties. These statements relate toanalyses and other information that are based on forecasts of future resultsand estimates of amounts not yet determinable. These statements may also relateto our future prospects, developments and business strategies.

We have used thewords “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “will,”“plan,” “predict,” “project” and similar terms and phrases, includingreferences to assumptions, in this Annual Report on Form 10-K toidentify forward-looking statements. These forward-looking statementsare made based on expectations and beliefs concerning future events affectingus and are subject to uncertainties and factors relating to our operations andbusiness environment, all of which are difficult to predict and many of whichare beyond our control, that could cause our actual results to differmaterially from those matters expressed in or implied by these forward-lookingstatements. The following factors are among those that may cause actual resultsto differ materially from our forward-looking statements:

·       generaleconomic and industry conditions;

·       ourhistory of losses, deficits and negative operating cash flows;

·       oursubstantial capital requirements and dependence on the sale of our equitysecurities to provide capital to fund our operations;

·       ourlimited operating history;

·       technicaland operational problems at K-Fuel facilities;

·       uncertainmarket for our K-Fuel refined coal;

·       industrycompetition;

·       environmentaland government regulation;

·       protectionand defense of our intellectual property rights;

·       relianceon, and the ability to attract, key personnel;

·       inabilityto implement our acquisition strategy; and

·       otherfactors including those discussed under “Risk Factors” in Item 1A of thisAnnual Report on Form 10-K.

You should keep in mind that any forward-lookingstatement made by us in this Annual Report on Form 10-K or elsewherespeaks only as of the date on which we make it. New risks and uncertaintiesarise from time to time, and it is impossible for us to predict these events orhow they may affect us. We have no duty to, and do not intend to, update orrevise the forward-looking statements in this Annual Report on Form 10-Kafter the date of this filing, except as may be required by law. In light ofthese risks and uncertainties, you should keep in mind that any forward-lookingstatement made in this Annual Report on Form 10-K or elsewhere mightnot occur.

2

----

**PART I**

**ITEM 1.**                BUSINESS

**Overview**

In this Annual Report on Form 10-K, we usethe terms “Evergreen Energy,” “we,” “our,” and “us” to refer to EvergreenEnergy Inc. and its subsidiaries. All references to K-Fuel refined coal andK-Fuel® refer to our patented process and technology explained in detailthroughout this Annual Report on Form 10-K. All references to years,unless otherwise noted, refer to our fiscal year, which ends on December 31st.

We are leveraging a vertically integrated, coal-basedplatform to deliver combined energy, environmental and economic solutions,producing clean, efficient and affordable energy. We intend to meet thespecific needs of industrial, international and public utility market customers.We provide economical solutions to environmental emission standards compared toother emission standard alternatives. Our proprietary K-Fuel process uses heatand pressure to physically and chemically transform high moisture, low-Btucoals, such as subbituminous coal and lignite, into a more energy efficient,lower-emission fuel. The pre-combustion refinement of raw coal intoK-Fuel refined coal reduces mercury content up to 70 percent and uponcombustion, sulfur dioxide and nitrous oxides by significant amounts. Studiesshow that the increased efficiency of K-Fuel refined coal will reduce carbondioxide emissions by beneficial amounts.

Throughout the United States and internationally,there are abundant reserves of high moisture, low-Btu coals with heatvalues of less than 9,000 Btus per pound. However, many coal-fired powergenerating facilities, including industrial and institutional facilities, burncoal that is 11,000 Btus or greater. The current K-Fuel process applies heatand pressure to Powder River Basin coal with a high water content to reducemoisture from approximately 30% in the low-Btu coal to 8% to 14% in our K-Fuelrefined coal. As a result, the heat value is boosted by 30% to 40%, resultingin its increased efficiency for use in power generating facilities, includingindustrial and institutional facilities. Further, the K-Fuel process removes asignificant amount of impurities from the low-Btu coal allowing for the powergenerating industry to economically comply with increasingly stringent airemission standards and environmental regulations. We have and will continue totest other low Btu coals and lignites in our lab and study the results in orderto increase the potential number of plant sites. Our research has shown coalsources other than coal from the Powder River Basin have produced similarresults when subjected to the K-Fuel process.

As supplies of affordable eastern coals aretightening, emissions standards are strengthening, and public support for cleanenergy is building, we will continue becoming fully integrated, allowing us toengage in all different aspects of production, from mining our own coal, tomanufacturing, transporting, marketing and retailing our end product. To date,we have executed our business strategy by owning coal reserves and a refiningplant, maintaining our own marketing and distribution team and entering intodistribution agreements with coal transporters.

On September 26,2006, in keeping with our strategy to use technology to create cleaner coal forgenerating power, we began doing business as Evergreen Energy Inc. The namechange received formal stockholder approval on November 9, 2006. The nameof Evergreen Energy Inc. captures our key attributes, namely our commitment todelivering clean energy and our strategy to vertically integrate ouroperations.

We have completed the initial construction and enteredthe start-up phase for our Fort Union plant and mine site in Wyoming’s PowderRiver Basin, which is our first plant implementing the K-Fuel process. We arein the process of modifying and improving the design and efficiency of theequipment used in the K-Fuel process. In September 2006, we hired BechtelPower Corporation to assist with the completion and 

3

----

optimization of our FortUnion plant and to assist with the future designs of K-Direct and K-Fuel plants.We have shipped K-Fuel refined coal to utilities and other industrial customersduring 2006. Initial test burns of the K-Fuel refined coal provided us withpositive results regarding the characteristics and quality of the K-Fuelrefined coal.

On December 27, 2006,we received the test burn results of blending K-Fuel refined coal withhigh-sulfur Ohio coal. The test burns were conducted with the city ofPainesville, Ohio Department of Utilities. The results indicated compliancewith a new federal clean air standard for industrial coal-fired boilers,effective in 2007. Emissions included 0.07 pounds of particulate matter permillion Btus generated, 0.09 pounds of hydrogen chloride per million Btusgenerated and nine pounds of mercury per trillion Btus generated.

On February 7, 2007,we received the results of test burns conducted at the University of NotreDame. These test burns were conducted and monitored by an independent thirdparty. We blended 50 percent and 75 percent of K-Fuel refined coal withhigh-sulfur, low-fusion eastern Ohio bituminous coal. Test burns using 100 percentof our K-Fuel refined coal were also conducted. Blended results indicatedimprovements in emissions that could help coal-fired boilers comply with thenew Federal Industrial Boiler Maximum Achievable Control Technologyrule for emissions while maintaining load capacities through higher Btuvalues. Using only K-Fuel refined coal resulted in reduced chloride emission by75 percent, sulfur dioxide emissions by 90 percent and reduced the mercurycontent by 75 percent when compared to the high-sulfur, low-fusion eastern Ohiobituminous coal.

**Segments**

On April 3, 2006, wecompleted the acquisition of Buckeye Industrial Mining Company for a totalpurchase price of $39.1 million, including cash paid, stock issued, liabilitiesassumed and costs incurred in the acquisition. Buckeye’s primary business is tomine, process, blend and sell high quality coal to electric utilities,industrial and institutional end users. Buckeye also operates one of thelargest ash disposal facilities in the state of Ohio, disposing of up to onemillion tons of dry and conditioned ash per year**.**Theacquisition of Buckeye complements our strategy to transition from an energytechnology company into an energy production company.

With the acquisition ofBuckeye, we have expanded our segments and our segment presentation. We haveidentified three segments: our Plant and Licensing segment, Mining segment and Operatingsegment. Our results of operations are evaluated and allocations of capitalresources are based upon the vertical integration and operation of thesesegments. The Plant and Licensing segment represents revenue and costs relatedto the use and application of our proprietary, patented K-Fuel process and ourmine site in Gillette, Wyoming. The Mining segment represents our operations atour Buckeye location and includes certain marketing personnel, the ash disposalfacility, the blending facility and mines. The Operating segment is comprisedof all other operations.

We incorporate theacquisition of Buckeye into our overall strategy and therefore, we do notoperate or evaluate it as other stand-alone coal mining operations might. Asignificant value of Buckeye is its marketing team and strategic location, railroad loading facility, port dock loading facility on the Ohio River, blendingfacility and mines and coal reserves. This Form 10-K is presented ina view consistent with our vertical integration strategy and, unless otherwisespecifically addressed, represents our overall business strategy and goals.

4

----

**Business Strategy**

**Theprincipal elements of our long-term strategy are to construct K-Directfacilities, K-Fuel facilities and license our K-Fuel technology to thirdparties. In the next year, we plan to primarily focus on construction ofK-Direct facilities and the following:**

·       ***Expand Production through the Construction ofK-Direct Facilities***   K-Direct facilities are K-Fuelprocessing plants located at coal-fired power generating plants. K-Directplants co-located with new or existing power generating plants offer the addedadvantages of using secondary steam to refine raw low-Btu coal feedstocks. Witha K-Direct plant at a generating site, coal users can shop the world market forabundant low-Btu coal, process it on site and feed it directly into theirboilers. We have signed a letter of intent with TXU Generation DevelopmentCompany LLC, for detailed engineering, design integration and tests of theK-Direct facilities. Should the results from the engineering, design andtesting be successful, we could enter into one or more definitive agreementsfor the construction of K-Direct facilities at new or existing TXU powerplants. In addition to this letter of intent, we have signed an agreement withanother major utility to advance the integration of another K-Direct coalrefinery.

K-Direct plants offerpublic utilities a unique opportunity to boost efficiency and meet emissionsstandards. The advantages of a K-Direct facility compared to a K-Fuel facilityare: (i) less capital outlay; (ii) less construction time tocomplete; (iii) shorter permitting time; and (iv) accelerated productdelivery as K-Fuel refined coal is transported from our processor directly intothe coal-fired boilers at the power generating plants.

·       ***Expand Production through theConstruction of K-Fuel Facilities.****  *In the long-term, we intend to construct K-Fuelfacilities at coal mine sites to process abundant reserves of subbituminouscoal and lignite into K-Fuel refined coal. In the future we will pursueconstruction at sites, both within the Powder River Basin and throughout othercoal-producing regions of the United States, focusing on sites that havereadily available access to rail and barge transportation.

·       ***Continue to Pursue VerticalIntegration through Acquisitions and Joint Ventures.****  *We believe we are well-positionedto pursue selected acquisitions and attract industry joint venture partners tocontinue our vertical integration strategy. In the second quarter of 2006, wepurchased Buckeye Industrial Mining Co., which provided us with established markets,infrastructure, blending facilities, rail and barge transportation access andcoal supply. We expect to pursue additional acquisitions of companies with businessescomplementary to our business model and strategy. Additional acquisitions willhelp us ensure quality refined coal for our customers and help us extractmaximum rents from the coal value chain.

·       ***Enter into Licensing Agreements*.  **Weare developing K-Fuel production plants domestically and internationallythrough the licensing of our K-Fuel technology to third parties. We believethat there are a number of opportunities to license our technology to operatorsin other regions that have access to transportation infrastructure and highmoisture, low-Btu coal supplies.

Coal is the largest source of power for America’selectricity generation. At about one-third the cost of natural gas, manyutilities and industrial users are dependent upon coal. While the United Statesenjoys cheap and plentiful reserves of low-grade coal, the reserves ofhigh-grade coals are dwindling, and environmental issues are a concern. It’sclear that we need to make those low-grade coals better.

The total annual coal consumption in the United Statesis approximately 1 billion tons per year. Our goal is to produce50 million tons of K-Fuel refined coal per year in the next five years. OurFort Union plant in Gillette, Wyoming, is shipping K-Fuel refined coal toutility and industrial customers. To further support our growth strategy, weare negotiating K-Direct co-location options with utilities that have coal-

5

----

fired power plants, we arepermitting and developing additional K-Fuel processing plants and we areworking towards international licensing agreements.

We plan to achieve ourgoals through a combination of organic growth, acquisitions and partnerships.

**CompetitiveStrengths**

As a result of thefollowing strengths, we believe we are well positioned to execute our businessstrategy:

·       ***Technical Expertise*.  **Ouremployees have a wide range of technical expertise and experience includingexpertise in refining coal, coal thermal upgrading, thermal processing, coalgasification, coal liquidification, chemical engineering, civil engineering,mechanical engineering and power engineering. We have exclusive licensingagreements with Sasol-Lurgi Technology Company and Lurgi (Pty) Limited who havebrought over 70 years of experience in designing and building coal processingplants for the implementation of the K-Fuel process. In addition we haveagreements with professional engineering firms for engineering services in theareas of architecture, civil/structural, mechanical, electrical, and controls,including subsystems engineering and design for our K-Direct and K-Fuelstandard commercial plants.

·       ***Proprietary Process*.**   TheK-Fuel refined coal process uses heat and pressure to refine coal. The processalso reduces mercury, and lowers emissions, upon combustion, of sulfur dioxide,nitrogen oxide and carbon dioxide, which helps coal consumers meet emissionsstandards. Our processes are patent-protected with global worldwide exclusivityon key equipment technology.

·       ***High BTU, Low Emission K-Fuel Refined Coal.  ***Weconvert low-BTU sub-bituminous coals and lignites into K-Fuel refined coal, ahigh Btu, low emission coal that is a replacement for rapidly dwindling easterncoals. Current Federal and in some cases even tougher state emissionsregulations will soon begin requiring significant reductions in sulfur dioxide,nitrous oxides and mercury levels. Some states are enacting carbon dioxidelimits as well. Coal-fired power plants and industrial customers that use ourK-Fuel refined coal can cost-effectively boost efficiency and may reduce theseemissions without adding new, expensive, post-combustion cleanup equipment.Coal-fired power plants and industrial users with post-combustion controls maysee improved pollution control performance. Power generating facilities burningour K-Fuel refined coal realize lower emissions and experience significantsavings as a result of reducing the need to purchase carbon dioxide, sulfurdioxide, nitrogen oxide and mercury credits. In addition, coal-fired industrialboilers are required to meet stringent emissions standards beginning inSeptember 2007 and are currently developing compliance strategies.

·       ***Established Marketing and SalesTeam.****  *TheBuckeye acquisition has added value through access to its established markets,infrastructure and coal reserves. Over the years Buckeye has shipped product toover 70 coal customers, including utilities and industrial users. Buckeye’smarketing team brings considerable logistical expertise and longstandingrelationships in the coal-fired industry, that enhance our ability to get ourK-Fuel refined coal to a wide variety of customers.

·       ***Favorable Price Differentials.  ***Wehave uniquely positioned ourselves in the energy market to capture a portion ofthe price differential between high- and low-Btu coals.

·       ***Key Industry Relationships*.**   Aswe expand our production, we benefit from agreements such as our logistics andmarketing agreement with DTE Coal Services Inc., and our technical servicesagreement with Bechtel Power Corporation. The Bechtel agreement providesengineering services in the areas of architecture, civil/structural,mechanical, electrical and controls, including subsystems engineering anddesign for future K-Direct and K-Fuel commercial plants. Bechtel is aglobal engineering, construction and project company with more than a centuryof experience on 

6

----

complex projects inchallenging locations. Effective February 15, 2007, this agreement wasamended and restated to include engineering, procurement and constructioncontracts for building several K-Direct Plants that are currently beingevaluated by us.

·       ***VerticallyIntegrated.****  *We arepositioned to capture maximum value in the refined coal value chain, frommining to refining, transportation, marketing and distribution. Our verticalintegration strategy helps us capture the considerable spread between low-gradewestern coal and high-grade eastern coal.

**Business Historyand Patents**

Over the past 20 years, we have obtained multiplepatents for different versions of the K-Fuel technology using a variety ofmethods to apply heat and pressure to process high moisture coal feedstocks. Wehave patents or patent applications for the K-Fuel technology issued or pendingin the United States and various foreign countries. As we continue to developand make enhancements to K-Fuel, we intend to continue to file for new patentapplications.

During the yearsended December 31, 2006, 2005 and 2004, our research and development costswere approximately $1.4 million, $1.6 million and $696,000, respectively. Thefollowing historical events have contributed to the development and improvementof our technology:

·       During2006, we identified certain inefficiencies in the design and operation of ourFort Union plant. We, with the assistance of Bechtel, are currently optimizingthis plant and incorporating the changes into the design of future K-Direct andK-Fuel facilities. Additionally, during the shipment of K-Fuel refined coal toFirst Energy in August of 2006, we identified certain dusting issuesrelating to the off load and transfer of K-Fuel refined coal. We have adjustedour process to address this issue and believe that it is resolved.

·       Between 2000 and 2005, wecompleted evaluations of our K-Fuel refined coal and process and commissionednumerous independent combustion studies to test and improve our K-Fuel refinedcoal. Through these efforts we believe we have enhanced the K-Fuel process andresolved previously identified technical and operational issues.

We were founded in 1984 asa clean coal company focused on developing our K-Fuel process. We incorporatedunder the laws of the state of Delaware in 1988. Our principal executiveoffices are located at 55 Madison Street, Suite 500, Denver, Colorado80206, and our telephone number is (303) 293-2992.

**Acquisitions**

On April 3, 2006, we completed the acquisition ofBuckeye, for a total purchase price of $39.1 million, consisting of $35.0million in cash and our common stock valued at approximately $2.2 million. Weincurred approximately $1.0 million in acquisition costs and reimbursed Buckeye’sformer parent approximately $900,000 for costs incurred relating to capitalprojects. Buckeye’s primary business is to mine, process, blend and sell coalto electric utilities and to industrial and institutional end users. Buckeyealso operates one of the largest ash disposal facilities in the state of Ohio,disposing of up to one million tons of dry and conditioned ash per year. Theacquisition of Buckeye continues our strategy to transition from an energytechnology company into an energy production company. We believe theacquisition will add value through access to Buckeye’s established markets,infrastructure and coal reserves. The expected benefits of the acquisitioninclude the addition of an experienced coal marketing and mining team and cashflow. Their operations have been included in our consolidated financialstatements, for the nine months ended December 31, 2006, as of theeffective purchase date of April 3, 2006.

7

----

On May 21, 2004, weacquired all of the outstanding stock of Landrica Development Company fromWyodak Development Corporation for cash of $523,000 and the assumption of anasset retirement obligation of $2.7 million. The results of Landrica have beenincluded in the consolidated financial statements from the date of acquisition.Landrica owns a coal mine and related assets that include land, buildings, coalhandling equipment, a railroad loop and other pieces of equipment and property.

**Competition**

Our K-Fuel refined coal is a coal characterized bylow-moisture, high-Btu content and low sulfur dioxide, nitrogen oxides andmercury emissions. As such, the known direct competitors for K-Fuel refinedcoal include other coal upgrading processes, other high Btu coal, low sulfurcoal and advanced pollution control technologies. The indirect competition toK-Fuel refined coal includes electrical generation from natural gas, nuclearfuel, oil, wind, bio-fuels, and other renewable energy sources. Over the pasttwo years, pricing trends for a number of these alternatives have enhanced thecompetitive position of K-Fuel.

Potential customers couldchoose to install pollution equipment instead of using our K-Fuel refined coaland/or choose to inject additives to reduce emissions. These alternativesinclude low-nitrogen oxide burners, over-fire air systems, selective catalyticreduction systems, sulfur scrubbers, fabric filters, electrostaticprecipitators, mercury control technology, or other equipment and addinglimestone or other chemicals to combustion and waste stream. In contrast to ourK-Fuel refined coal, most of these technologies require a significantinvestment of capital by the customer and impose a parasitic load on the plant,thereby reducing the salable electricity produced from the affected unit.

**Customers**

As of December 31,2006, three customers from our mining segment accounted for 26%, 14% and 11% oftotal accounts receivables, respectively, while one customer in our miningsegment, accounted for 12% of total revenues. We believe the loss of any one ofthese customers would not have a material adverse effect on our financialposition.

**Environmental Regulation Affecting our Market**

We believe that existingand proposed legislation and regulations could impact fossil fuel-fired, and specificallycoal-fired, power generating facilities. According to the U.S. EnvironmentalProtection Agency, or EPA, power generation emits substantial levels of sulfurdioxide, nitrogen oxides and mercury into the environment. Regulation of theseemissions can affect the market for our K-Fuel refined coal by imposing limitsand caps on these emissions. The most significant national legislation andregulations affecting our market include the Clean Air Act, the Clean AirInterstate Rule and the Clean Air Mercury Rule, which are describedfurther below. In addition, the K-Fuel market will be affected by additionalnational policies including the EPA’s Nitrogen Oxide State Implementation PlanCall, which requires 22 eastern states and the District of Columbia toreduce summertime ozone formation by controlling nitrogen oxide emissions; theEPA’s National Ambient Air Quality Standards for ozone and fine particulatematter, which requires that approximately 700 counties across the United Statesachieve attainment of ozone and particulate matter standards; and the RegionalHaze Rules, which requires emission controls for industrial facilities emittingair pollutants that reduce visibility by causing or contributing to regionalhaze.

State and regional policieswill also impact our market. The Regional Greenhouse Gas Initiative requiresreduction in carbon dioxide, starting in 2009 in 7 northeastern states. Thestate of California has adopted a stringent greenhouse gas policy that willaffect coal-fired electricity generated in and imported into the state. Otherstates or regions may take similar actions in the coming years. Additionally,states are implementing emission reduction policies more stringent thannational policy, such as, the approximately 10 states are requiring morestringent mercury reduction than the EPA’s Clean Air Mercury Rule.

8

----

Thefollowing briefly describes the most significant national laws and regulationsaffecting the market for our K-Fuel refined coal.

·       **The Clean Air Act and Acid Rain Program.  **TheClean Air Act of 1970, as amended, is currently the primary mechanism forregulating emissions of sulfur dioxide and nitrogen oxide from coal-fired powergenerating facilities. A key component of the act regulates sulfur dioxide andnitrogen oxide emissions. Specifically, title IV set a goal of reducing sulfurdioxide emissions by 10 million tons below 1980 levels and imposed a two-phasedtightening of restrictions on fossil fuel-fired power plants. Phase I began in1995 and focused primarily on coal-burning electric utility plants in the eastand midwest. In 2000, Phase II began and this phase tightened the annualemissions’ limits on larger higher emitting plants and set restrictions onsmaller, cleaner plants fired by coal, oil, and gas. The Acid Rain Programcalls for a 2 million ton reduction in nitrogen oxide emission and focuses onone set of sources that emit nitrogen oxide: coal-fired electric utilityboilers. Beginning in January 2000, nitrogen oxide emissions are to bereduced 900,000 tons per year beyond the 1.2 million per year reduction set bythe EPA in 1995.

·       **Clean Air Interstate Rule.  **The CleanAir Interstate Rule was finalized by the EPA in March 2005. Oncefully implemented, this rule will reduce sulfur dioxide emissions in 28states and District of Columbia by more than 70% and nitrogen oxide emissionsby more than 60% from the 2003 levels. Through the use of a cap-and-tradeapproach, the rule promises to achieve substantial reduction of sulfurdioxide and nitrogen oxide emissions. The rule will be fully implementedby 2015.

·       **Clean Air Mercury Rule.  **The Clean Air MercuryRule will impose mandatory mercury emissions reduction on electric utilitycoal-fired power plants for the first time. The EPA finalized the rule inMay 2005. The mercury rule is based on the EPA’s finding thatapproximately 75 tons of mercury is found in coal delivered to power plantseach year and about 2¤3rdsof this mercury is emitted to the air. As currently formulated, therule allows coal-fired power plants to cap emissions in two phases, in2010 and 2018, and trade mercury allowances. However, many states are implementingmore stringent state standards, resulting in various timelines and caps acrossthe country.

**EnvironmentalRegulation Affecting the Construction and Operation of our Plants and Mining ofCoal**

As a general matter, we are subject to a number of stateand federal regulations that (i) seek to limit the amounts of certainemissions into the environment, (ii) regulate the disposal of certainpotentially hazardous materials, and (iii) impose certain employee safetyrequirements upon us. As we expand our operations we may become subject to moreregulation. For example, if we build additional plants we may installcoal-fired boilers, which are subject to more permitting requirements and moreenvironmental regulation than gas-fired boilers. As we have begun to mine coalfrom our open pit in Wyoming and as a result of the Buckeye acquisition, we aresubject to additional regulations including the Coal Mine Health and Safety Actof 1969, the Federal Mine Safety and Health Act of 1977, the Black LungBenefits Revenue Act of 1977 and other regulations that seek to protect thehealth and safety of employees.

In the United States, K-Fuel refined coal is notexpected to be subject to unusual levels of local, state or federal regulationwith respect to its transportation and distribution. However, any futureproduction plants will require numerous permits, approvals and certificatesfrom appropriate federal, state and local governmental agencies beforeconstruction of each facility can begin and will be required to comply withapplicable environmental laws and regulations (including obtaining operatingpermits) once facilities begin production. The most significant types ofpermits that are typically required for commercial production facilitiesinclude an operating and construction permit under the Clean Air Act, awastewater discharge permit under the Clean Water Act, and a treatment, storageand disposal permit under the Resource Conservation and Recovery Act. Somefederal programs have delegated regulatory authority to the states and, as aresult, facilities may be required to secure state permits. Finally, theconstruction of new facilities 

9

----

may require review underthe National Environmental Policy Act, or a state equivalent, which requiresanalysis of environmental impacts and, potentially, the implementation ofmeasures to avoid or minimize these environmental impacts.

Any international K-Direct or K-Fuel plants will alsobe subject to various permitting and operational regulations specific to eachcountry. International initiatives, such as the Kyoto Protocol, are expected tocreate increasing pressures on the electric power generation industry on aworld-wide basis to reduce emissions of various pollutants, which managementexpects will create additional demand for our products and services.

In 2004, Congress passedtax credits for refined coal within the American Jobs Creation Act. To qualifyfor the tax credit, the refined coal must realize a reduction of at least 20%in nitrogen oxide emissions and at least 20% in either sulfur dioxide ormercury emissions and have an increase in market value over the comparable coalof at least 50%. Based upon our testing to date, we believe that K-Fuel refinedcoal meets these requirements and that our future K-Fuel plants will beeligible for the credit if they are operational by January 1, 2009. Generally,the refined coal credit, escalated annually, will be earned for each tonproduced over a ten-year period from the date the plant is placed in service.

**Employees**

At January 31, 2007,we had 216 full-time employees.

**Access toInformation**

Our web site address iswww.evgenergy.com. We make available, free of charge, on the Investor Infosection of our web site our Annual Report on Form 10-K, QuarterlyReports on Form 10-Q, Current Reports on Form 8-K, andall amendments to those reports, as soon as reasonably practicable after thesereports are electronically filed with or furnished to the Securities andExchange Commission. We also make available through our web site other reportselectronically filed with the SEC under the Securities Exchange Act of 1934,including our proxy statements and reports filed by officers and directorsunder Section 16(a) of that Act. Additionally, we make availablepress releases, presentation material including slides and other investorinformation. We do not intend for information contained in our web site to bepart of this Annual Report on Form 10-K

**ITEM1A.**        RISKFACTORS

In addition to risk anduncertainties in the ordinary course of business that are common to allbusinesses, important factors that are specific to our industry and our companycould materially impact our future performance and results. We have providedbelow a list of these risk factors that should be reviewed when considering ourbusiness and securities. These are not all the risks we face, and other factorscurrently considered immaterial or unknown to us may impact our futureoperations.

**Business Risks**

***We have a history of losses,deficits, and negative operating cash flows and will likely continue to incurlosses in the future. Such losses may impair our ability to pursue our businessplan.***

Weexpect to incur operating losses and continued negative cash flows fromoperations for the foreseeable future. We have made, and will continue to make,substantial capital and other expenditures before we will have sufficientoperating income and cash flow to recover our investments. We are not able toaccurately estimate when, if ever, our operating income will increasesufficiently to cover these investments. Further, we may not achieve ormaintain profitability or generate cash from operations in 

10

----

future periods. Our working capital (the amount ourcurrent assets exceed our current liabilities), accumulated deficit, net lossand cash (used in) provided by operating activities are as follows:

| ** **                                       | ** ** | **December 31,**   | ** ** |
|--------------------------------------------------|------------|-------------------------|------------|
| ** **                                       | ** ** | **2006**                | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                       | ** ** | **(in thousands)** | ** ** |
| Working capital                                  |       | $                       | 79,156     |   | $ | 19,910 |   | $ | 73,603 |   |
| Accumulated  deficit                             |       | (203,397                | )          | (151,870 | ) | (128,557 | ) |
| Net loss                                         |       | (51,527                 | )          | (23,313 | ) | (10,555 | ) |
| Cash (used in)  provided by operating activities |       | $                       | (30,435    | ) | $ | (12,071 | ) | $ | 2,042 |   |

 

***We have substantial capital requirements and, as aresult, we have been and continue to be dependent on sales of our equitysecurities to fund our operating costs.***

As a result of negativecash flows from operations, we have been and continue to be dependent on salesof our equity securities to fund the operating and substantial capital costsassociated with our business. Our business strategy to become fully verticallyintegrated may further increase our needs for additional capital. Our successis dependent on our ability to utilize existing resources and to generatesufficient cash flows to meet our obligations on a timely basis, to obtainfinancing or refinancing as may be required, to attain profitability, or acombination thereof. Depending on our future operations and the conditions ofthe equity capital markets, we may not be able to continue to raise additionalequity capital on terms acceptable to us or at all. A lack of adequate financingmay adversely affect our ability to pursue our business strategy, respond tochanging business and economic conditions and competitive pressures, absorbnegative operating results and fund our continuing operations, capitalexpenditures or increased working capital requirements.

***We have a limited operating history as an energysolutions company, and our business and prospects should be considered in lightof the risks and difficulties typically encountered by a company with a limitedoperating history.***

You should considerour business and prospects in light of the risks and difficulties typicallyencountered by a company with a limited operating history. The specific risksinclude whether we will be able to:

·       enterinto agreements for the purpose of building K-Direct and K-Fuel plants orlicensing the technology;

·       enterinto or maintain strategic partnerships with vendors and other parties tomaximize our K-Fuel process;

·       raiseadditional capital;

·       accuratelyassess potential markets and effectively respond to competitive developments;

·       attractand retain customers for product sales;

·       attractand retain credit-worthy customers;

·       effectivelymanage expanding operations;

·       successfullymarket our products;

·       executeour business strategy; and

·       attractand retain key personnel.

11

----

We may not be successfulin addressing these and other risks. As a result, our financial condition andresults of operations may be adversely affected.

***We rely on key personnel and if we are unable toretain or attract qualified personnel, we may not be able to execute ourbusiness plan.***

Our success is currentlydependent on the performance of a small group of senior managers and keytechnical personnel that have a wide range of technical expertise and experienceincluding coal refining, coal thermal upgrading, thermal processing, coalgasification and coal liquification. In addition, our business strategy willrequire us to attract and retain a substantially greater number of qualifiedpersonnel. The inability to retain key managerial and technical personnel orattract and retain additional highly qualified managerial or technicalpersonnel in the future could harm our business or financial condition.

***Ouracquisition activities may not be successful.***

As part of ourvertical integration business strategy, we may make acquisitions of businessesand properties. However, suitable acquisition candidates may not be availableon terms and conditions we find acceptable. Further, acquisitions posesubstantial risks to our financial condition and results of operations. Inpursuing acquisitions, we compete with other companies, many of which havegreater financial and other resources to acquire attractive companies andproperties. Even if future acquisitions are completed, the following are someof the risks associated with acquisitions:

·       theacquired businesses or properties may not produce revenues, earnings or cashflow at anticipated levels;

·       wemay be unable to integrate acquired businesses successfully and realizeanticipated economic, operational and other benefits in a timely manner;

·       acquisitionscould disrupt our ongoing business, distract management, divert resources andmake it difficult to maintain our current business standards, controls andprocedures;

·       wemay finance future acquisitions by issuing common stock for some or all of thepurchase price, which could dilute the ownership interests of our stockholders;and

·       we may incur additionaldebt related to future acquisitions.

**K-Fuel ProcessRisks**

***Technical and operational problems may adverselyimpact our ability to operate or develop K-Fuel facilities, resulting in delaysin the production of our K-Fuel refined coal.***

Problems we mayencounter in current and future plants include:

·       constructionproblems including cost overruns, delays, damage, technical issues,availability of raw material, availability of workers or contractors andweather;

·       unforeseenproblems in the commissioning, start-up or operation of our current or futureplants; and

·       K-Fuelrefined coal produced may not meet our specifications or customer requirements.

Our ability to effectivelyoperate and develop K-Direct and K-Fuel facilities may be harmed to the extentthese and other technical or operational problems materialize. Should we beunable to effectively operate and develop K-Fuel facilities, our ability togenerate revenues and profits may be negatively impacted.

12

----

***Any negativeresults from the continuing evaluation of K-Fuel refined coal produced at ourFort Union plant site or future plant sites by us or third parties could have amaterial adverse effect on the marketability of K-Fuel refined coal and futureprospects.***

We and certain thirdparties are continuing to evaluate K-Fuel refined coal produced at our FortUnion plant. There can be no assurance that this evaluation will result inpositive findings concerning the moisture content, heat value, emission-levels,burn qualities or other aspects of our K-Fuel refined coal. Furthermore, evenshould current evaluations indicate that our K-Fuel refined coal performs todesign specifications, there can be no assurance that later tests will confirmthese current results or that our K-Fuel refined coal will be readilyaccepted by the market. The process of introducing our K-Fuel refined coal intothe market may be further delayed if these test results are negative or ifpotential customers conduct their own tests of the K-Fuel refined coal todetermine whether it meets their individual requirements and the results arenot acceptable. If this continuing process of evaluation and marketintroduction results in negative findings concerning the K-Fuel process, thiscould have a material adverse effect on the marketability of K-Fuel refinedcoal and on our financial condition, results of operations and futureprospects.

***Due to the uncertain market for, and commercialacceptance of, our K-Fuel refined coal, we may not be able to realizesignificant revenues from the sale of K-Fuel refined coal.***

While we believethat a commercial market is developing both domestically and internationallyfor cleaner coal products such as K-Fuel refined coal, we may face thefollowing risks due to the developing market for our cleaner coal technology:

·       limitedpricing information;

·       changesin the price differential between low- and high-Btu coal;

·       unknowncosts and methods of transportation for bringing  K-Fuel market;

·       alternativefuel supplies available at a lower price;

·       theavailability of emissions-reducing equipment and other technologies that may bemore desirable than the K-Fuel refined coal;

·       themarket viability of K-Fuel refined coal; and

·       sufficientmarket interest for us to continue in business.

If we are unable todevelop markets for our K-Fuel refined coal, our ability to generate revenuesand profits may be negatively impacted.

***If we are unable to construct and operate commercialK-Fuel production plants profitably, our ability to generate revenue from thisprocess will be impaired.***

The commercialproduction of our K-Fuel refined coal is relatively new. Our future successdepends on our ability to locate, develop and construct future commercialK-Fuel production plants at a profit. A number of different variables, risksand uncertainties affect our successful construction of future K-Fuelproduction plants and our ability to operate such plants at a profit including:

·       thecomplex, lengthy and costly regulatory permit and approval process;

·       localopposition to development of projects, which can increase cost and delaytimelines;

·       increasesin construction costs such as contractors, workers and raw materials;

·       transportationcosts and availability of transportation;

13

----

·       thepossible price fluctuations of low-Btu coal, which could impact K-Fuel refinedcoal’s profitability; and

·       expendituresrelated to researching and investigating future K-Fuel production sites, whichwe may not be able to recover.

If we are unable tosuccessfully address these risks, our results from operations and financialcondition may be adversely affected.

***Competition from other companies in the clean coal andalternative fuel technology industries could adversely affect our market share.***

Competition in the cleancoal, alternative fuel and emission-reducing equipment industries couldimpact our ability to generate revenue from our K-Fuel process. Many of thesecompanies in the clean coal, alternative fuel technology and emission-reducingequipment industries have financial resources greater than ours. Due to thesecompetitive advantages, our competition may be able to offer products morecompetitively priced and more widely available than ours. These companies mayalso have the resources to create new technologies and products that could makeour process and products obsolete. Evergreen Energy’s future revenues maydepend on our ability to address competition in these industries.

***Deregulationin the United States power generating industry may result in increasedcompetition, which could result in lower margins for our product.***

We expect thatderegulation in the United States power generating industry will result inutilities and other power generating facilities placing a high emphasis onreducing costs in their operations. This situation may, in turn, result inincreased competition from other producers of energy-efficient coalproducts, other clean fuel sources, and other products, services andtechnologies designed to provide environmental and operating cost benefitssimilar to those which we believe are available from our K-Fuel refined coal.

***Regulationof the K-Fuel process and K-Fuel refined coal may adversely affect ourfinancial condition and results of operations and cash flows.***

Our K-Fuel refined coalwill be subject to federal, local, and foreign laws and regulations. Inaddition, as products are introduced into the market commercially, governmentsmay impose new regulations. Any regulation of our K-Fuel refined, whether atthe federal, state, local or foreign level, including any regulations relatingto the development or sale of our product, may increase our costs and the priceof our product. If the cost of compliance with applicable laws and regulationsincreases past that forecasted, our ability to profitably market and sellK-Fuel refined coal may be jeopardized.

***Compliance with environmental laws and regulationsmay increase our costs and reduce our revenues.***

Our operations are subjectto stringent and complex federal, state and local environmental laws andregulations. Failure to comply with these laws and regulations may trigger avariety of administrative, civil and criminal enforcement measures, includingthe assessment of monetary penalties, the imposition of remedial requirements,and the issuance of orders enjoining future operations. Certain environmentalstatutes impose strict, joint and several liabilities for costs required toclean up and restore sites where hazardous substances have been disposed orotherwise released. Moreover, it is not uncommon for neighboring landowners andother third parties to file claims for personal injury and property damageallegedly caused by the release of substances or other waste products into theenvironment.

14

----

***Future changes in the law may adversely affect ourability to sell our products and services.***

A significant factor inexpanding the potential U.S. market for K-Fuel refined coal is the numerousfederal and state environmental regulations, which provide various air emissionrequirements for power generating facilities and industrial coal users. Webelieve that the use of clean-burning fuel technologies, like K-Fuelrefined coal, helps utility companies comply with the air emission regulationsand limitations. We are unable to predict future regulatory changes and theirimpact on the demand for our products. While more stringent laws andregulations, including mercury emission standards, limits on sulfur dioxide emissionsand nitrogen oxide emissions, may increase demand for our products, suchregulations may result in reduced coal use and increase reliance on alternativefuel sources. Similarly, amendments to the numerous federal and stateenvironmental regulations that relax emission limitations would have a materialadverse effect on our prospects.

***Ourinability to adequately protect and defend our proprietary process could harmour business, increase our costs and decrease the sales volume of our productsand services.***

Our success depends uponour proprietary process. We rely on a combination of patent, trademark andtrade secret rights to establish and protect our proprietary rights. Wecurrently have a series of patents and patent applications on our K-Fuel process.However, competitors may successfully challenge the validity or scope of one ormore of our patents, or any future patents. These patents alone may not provideus with any significant competitive advantage.

Further, while our currentissued patent protection covers what we believe are certain unique aspects ofour K-Fuel process as it is currently conducted, not all of the claims we filedwere allowed. While we continue our efforts regarding these claims there can beno assurance that we will be able to obtainpatent protection in the United States or abroad to protect these or any otheraspects of our intellectual property, or that, in the absence of any suchpatent protection, that the combination of additional methods that we currentlyemploy to maintain the confidentiality of our processes will adequatelysafeguard our proprietary processes and information. If our intellectualproperty is not adequately protected, this may have a material adverse impacton our financial condition, results of operations, cash flows and futureprospects.

Third parties could copyor otherwise obtain and use our technology without authorization or developsimilar technology independently. The protection of our proprietary rights maybe inadequate and our competitors could independently develop similartechnology, duplicate our solutions, or design around any patents or otherintellectual property rights we hold.

Any actions taken by us toenforce our patents or other property rights could result in significantexpense as well as the diversion of management time and resources. In addition,detecting infringement and misappropriation of patents or intellectual propertycan be difficult, and there can be no assurance that we would detect anyinfringement or misappropriation of our proprietary rights. Even if we are ableto detect infringement or misappropriation of our proprietary rights,litigation to enforce our rights could cause us to divert significant financialand human resources from our business operations, and may not ultimately besuccessful. If we are required to divert significant resources and time to theenforcement of our proprietary rights, even if the enforcement is successful,our business could be materially adversely affected.

***Oursuccess will depend on our ability to operate without infringing on ormisappropriating the proprietary rights of others.***

We may be sued forinfringing or misappropriating the proprietary rights of others. Intellectualproperty litigation is costly, and, even if we prevail, the cost of suchlitigation could adversely affect our business. In addition, litigation is timeconsuming and could divert management attention and resources away from ourbusiness. If we do not prevail in any litigation, we could be required to stopthe infringing activity and/or pay substantial damages. Under somecircumstances, these damages could be triple the 

15

----

actualdamages the patent holder incurs. If we have supplied infringing products tothird parties for marketing or licensed third parties to manufacture, use ormarket infringing products, we may be obligated to indemnify these thirdparties for any damages they may be required to pay to the patent holder andfor any losses the third parties may sustain themselves as the result of lostsales or damages paid to the patent holder.

If a third party holdingrights under a patent successfully asserts an infringement claim with respectto any of our products or processes, we may be prevented from manufacturing ormarketing our infringing product in the country or countries covered by thepatent we infringe, unless we can obtain a license from the patent holder. Anyrequired license might not be available to us on acceptable terms, or at all. Somelicenses may be non-exclusive, and therefore, our competitors may have accessto the same technology licensed to us. If we fail to obtain a required licenseor are unable to design around a patent, we may be unable to market some of ouranticipated products, which could have a material adverse effect on ourbusiness.

***Any overseasdevelopment of our business is subject to international risks, which couldadversely affect our ability to license, construct or operate profitableoverseas plants.***

We believe a portion ofthe growth opportunity for our business lies outside the United States. Doingbusiness in foreign countries may expose us to many risks that are not presentdomestically. We lack significant experience dealing with such risks, includingpolitical, military, privatization, technology piracy, currency exchange and repatriationrisks, and higher credit risks associated with customers. In addition, it maybe more difficult for us to enforce legal obligations in foreign countries, andwe may be at a disadvantage in any legal proceeding within the localjurisdiction. Local laws may also limit our ability to hold a majority interestin the projects that we develop.

**Coal Mining Risks**

***Asubstantial or extended decline in coal prices could reduce our revenues andthe value of our coal reserves.***

The results ofoperations in our Mining segment are substantially dependent upon the prices wereceive for our coal. The prices we receive for coal depend upon factors beyondour control, including:

·       thesupply of and demand for domestic and foreign coal;

·       thedemand for electricity;

·       theproximity to, capacity of, and cost of transportation facilities;

·       airemission standards for coal-fired power plants;

·       regulatory,administrative, and judicial decisions; and

·       theeffect of worldwide energy conservation measures.

Declines in the prices wereceive for our coal could adversely affect our operating results and ourability to generate the cash flows we require to improve our productivity andinvest in our operations.

16

----

***Our coalmining production and delivery is subject to conditions and events beyond ourcontrol, which could result in higher operating expenses and/or decreasedproduction and sales and adversely affect our operating results.***

Our coal miningoperations are conducted in underground mines and at surface mines. The levelof our production at these mines is subject to operating conditions and eventsbeyond our control that could disrupt operations, affect production and thecost of mining at particular mines for varying lengths of time and have asignificant impact on our operating results. Adverse operating conditions andevents that we may experience are:

·       delaysand difficulties in acquiring, maintaining or renewing necessary permits formining or surface rights;

·       changesor variations in geologic conditions, such as the seam thickness of the coaldeposits and the amount of rock embedded in or overlying the coal deposit;

·       miningand processing equipment failures and unexpected maintenance problems;

·       limitedavailability of mining and processing equipment and parts from suppliers;

·       interruptionsdue to transportation availability and delays;

·       adverseweather and natural disasters, such as heavy rains and flooding;

·       accidentalmine water discharges;

·       theunavailability of qualified labor; and

·       unexpectedmine safety accidents, including fires and explosions.

The occurrence of any ofthese conditions or events in the future may affect deliveries of coal tocustomers, increase our cost of mining and delay or halt production atparticular mines or sales to our customers either permanently or for varyinglengths of time, which could adversely affect our operating results.

***Ourbusiness will be adversely affected if we are unable to develop or acquireadditional coal reserves that are economically recoverable.***

Our profitability dependssubstantially on our ability to mine coal reserves possessing qualitycharacteristics desired by our customers in a cost-effective manner. We havenot yet applied for the permits required, or developed the mines necessary, tomine all of our reserves. Permits are becoming increasingly more difficult andexpensive to obtain and the review process continues to lengthen. In addition,we may not be able to mine all of our reserves as profitably as we do at ourcurrent operations.

Because our reserves aredepleted as we mine our coal, our future success and growth depend, in part,upon our ability to acquire additional coal reserves that are economicallyrecoverable. If we are unable to replace or increase our coal reserves onacceptable terms, our production and revenues will decline as our reserves aredepleted. Exhaustion of reserves at particular mines also may have an adverseeffect on our operating results that is disproportionate to the percentage ofoverall production represented by such mines.

***We facenumerous uncertainties in estimating our recoverable coal reserves, andinaccuracies in our estimates could result in decreased profitability fromlower than expected revenues or higher than expected costs.***

Forecastsof our future performance are based on, among other things, estimates of ourrecoverable coal reserves. We base our estimates of reserve information onengineering, economic and geological data assembled and analyzed by ourinternal engineers and periodically reviewed by third-party consultants. Thereare numerous uncertainties inherent in estimating the quantities and qualitiesof recoverable 

17

----

reserves and costs to mine, including many factorsbeyond our control. Estimates of economically recoverable coal reserves and netcash flows necessarily depend upon a number of variable factors andassumptions, any one of which may, if incorrect, result in an estimate thatvaries considerably from actual results. These factors and assumptions include:

·       futurecoal prices, operating costs, capital expenditures, severance and excise taxes,royalties and development and reclamation costs;

·       futuremining technology improvements;

·       theeffects of regulation by governmental agencies; and

·       geologicand mining conditions, which may not be fully identified by availableexploration data and may differ from our experiences in areas we currentlymine. As a result, actual coal tonnage recovered from identified reserve areasor properties, and costs associated with our mining operations, may vary fromestimates.

Any inaccuracy in our estimates related to ourreserves could result in decreased profitability from lower than expectedrevenues or higher than expected costs.

**Risks Relating to Our Common Stock and Other Risks**

***Our stockprice has been volatile, and your investment in our common stock could suffer adecline in value.***

An investment in ourcommon stock is risky, and stockholders could suffer significant losses andwide fluctuations in the market value of their investment. The market price ofour common stock has been extremely volatile over the last twelve months; ourstock price has declined approximately 65%. During 2006, the sale prices of ourcommon stock on The American Stock Exchange and the NYSE Arca ranged from a lowclose of $7.65 to a high close of $22.16. We expect our common stock tocontinue to be subject to fluctuations. Broad market and industry factors mayadversely affect the market price of our common stock, regardless of our actualoperating performance. Volatility in the market price of shares may preventinvestors from being able to sell their shares of common stock at prices theyview as attractive. In the past, securities class action litigation has oftenbeen instituted against companies following periods of volatility in theirstock price. This type of litigation could result in substantial costs anddivert our management’s attention and resources.

***Provisionsin our articles of incorporation, bylaws and Delaware law may make it moredifficult to effect a change in control, which could adversely affect the priceof our common stock.***

Provisions of our articlesof incorporation, bylaws and Delaware law could make it more difficult for athird party to acquire us, even if doing so would be beneficial to our stockholders.We may issue shares of preferred stock in the future without stockholderapproval and upon such terms as our board of directors may determine. Ourissuance of this preferred stock could have the effect of making it moredifficult for a third party to acquire, or of discouraging a third party fromacquiring, a majority of our outstanding stock and potentially prevent thepayment of a premium to stockholders in an acquisition.

Ourarticles of incorporation and bylaws contain provisions that could delay, deferor prevent a change in control. These provisions include:

·       givingthe board the exclusive right to fill all board vacancies;

·       providingthat special meetings of stockholders may be called by the chair of the board,by the board, or by the holders of shares entitled to cast not less than 10% ofthe votes at the Meeting;

·       aclassified board of directors; and

·       permittingremoval of directors only for cause and with a majority vote of thestockholders.

18

----

These provisions alsocould discourage proxy contests and make it more difficult stockholders toelect directors and take other corporate actions. As a result, these provisionscould make it more difficult for a third party to acquire us, even if doing sowould benefit our stockholders, and may limit the price that investors arewilling to pay in the future for shares of our common stock.

We are also subject toprovisions of the Delaware General Corporation Law that prohibit businesscombinations with persons owning 15% or more of the voting shares of acorporation’s outstanding stock for three years following the date that personbecame an interested stockholder, unless the combination is approved by theboard of directors prior to the person owning 15% or more of the stock, afterwhich the business combination would be subject to special stockholder approvalrequirements. This provision could deprive our stockholders of an opportunityto receive a premium for their common stock as part of a sale of our company ormay otherwise discourage a potential acquirer from attempting to obtain controlfrom us, which in turn could have a material adverse effect on the market priceof our common stock.

***Asubstantial number of shares we have issued in exempt transactions are, or arebeing made, available for sale on the open market, and the resale of thesesecurities might adversely affect our stock price.***

We have on file with theSEC effective registration statements for a substantial number of shares forresale. The selling stockholders under our effective registration statementswill be permitted to sell their registered shares in the open market from timeto time without advance notice to us or to the market and without limitationson volume.

The sale of a substantialnumber of shares of our common stock under our registration statements, or theanticipation of such sales, could make it more difficult for us to sell equityor equity-related securities in the future at a time and at a price thatwe might otherwise wish to effect sales.

***We havenot paid cash dividends on our common stock and do not anticipate paying anydividends on our common stock in the foreseeable future.***

We anticipate that we willretain all future earnings and other cash resources for the future operationand development of our business. Accordingly, we do not intend to declare orpay any cash dividends on our common stock in the foreseeable future. Paymentof any future dividends will be at the discretion of our board of directorsafter taking into account many factors, including our operating results,financial conditions, current and anticipated cash needs and plans forexpansion.

**ITEM1B.**       UNRESOLVED STAFF COMMENTS

None.

**ITEM2.**                PROPERTIES

We previously entered intoa lease through May 2010 for office space to accommodate our headquarters,which is located in Denver, Colorado. Due to our rapid growth, it is necessaryto move our headquarters from the current location to a new larger location. Wehave leased 32,727 square feet of office space in Denver, Colorado for a tenyear term and anticipate moving into our new headquarters in April 2007. Ournew headquarters will allow us to improve office efficiency per square foot andwill also accommodate future employees. We believe this new space will besufficient for our near-term goals and growth projections.

In April 2006, wepurchased Buckeye Industrial Mining Co. Through the purchase we own the rightsto approximately 25 million tons of surface and underground coal reserves, infour Ohio counties. In addition to the coal reserves, we own one of the largestash monofills in Ohio, disposing of over one million tons of dry andconditioned ash per year.

19

----

In May 2004, wepurchased Landrica Development Company, or Landrica. Through Landrica, we ownapproximately 1,000 acres of land located in Campbell County, Wyoming (nearGillette, Wyoming), on which our Fort Union plant is located. The land alsoincludes various coal processing equipment, certain industrial buildings, wasteinjection wells, producing water wells, a coal-mining pit and a railroad spur. Theseassets occupy only a portion of the total acreage of the site. As a result,there is acreage available for expansion or use for other purposes, subject tocertain restrictions.

**ITEM3.**                LEGAL PROCEEDINGS

We are not engaged in anymaterial legal proceedings to which we or any of our subsidiaries are a party.

**ITEM4.**                SUBMISSION OFMATTERS TO A VOTE OF SECURITY HOLDERS

A special meeting of thestockholders was held on November 9, 2006 for the principal purpose ofapproving our name change from KFx Inc. to Evergreen Energy Inc.

Thefollowing votes were cast by the stockholders with respect to the approval ofour name change:

| **Proposal**                                             | ** ** | ** ** | ** ** | **Shares Voted For** | ** ** | **Shares Voted Against** | ** ** | **Shares Abstained** | ** ** |
|----------------------------------------------------------|------------|------------|------------|--------------------------------|------------|------------------------------------|------------|---------------------------|------------|
| Name change from  KFx Inc. to Evergreen Energy Inc. |       |       | 67,300,786 |                           |       |                               | 26,601     |                      |       |   | 62,686 |   |   |
|                                                          |            |            |            |                                |            |                                    |            |                           |            |  |  |  |  |  |  |

 

 

20

----

**PART II**

**ITEM 5.**                MARKETFOR COMMON STOCK, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITYSECURITIES

**Principal Marketand Price Range of Common Stock**

Ourcommon stock has been listed on the NYSE Arca exchange under the market symbol “EEE”since September 29, 2006. Prior to that date, our common stock was listedon the American Stock Exchange under the market symbol “KFX.”  The following table sets forth the range ofhigh and low sales prices per share of common stock for the periods indicated.

| Year       | ** ** | ** **      | ** ** | **Period** | ** ** | **High** | ** ** | **Low** | ** ** |
|------------|------------|-----------------|------------|------------|------------|----------|------------|---------|------------|
| 2006       |       | Fourth  Quarter |       | $          | 14.13      |     | $          | 7.65    |       |
|            |       | Third  Quarter  |       | $          | 16.50      |     | $          | 10.95   |       |
|            |       | Second  Quarter |       | $          | 19.52      |     | $          | 11.62   |       |
|            |       | First  Quarter  |       | $          | 22.16      |     | $          | 16.50   |       |
|  2005 |       | Fourth  Quarter |       | $          | 17.50      |     | $          | 12.41   |       |
|       |       | Third  Quarter  |       | $          | 18.48      |     | $          | 13.98   |       |
|       |       | Second  Quarter |       | $          | 14.90      |     | $          | 10.32   |       |
|       |       | First Quarter   |       | $          | 18.00      |     | $          | 12.24   |       |

 

As of February 23,2007, we had approximately 254 holders of record of our common stock. This doesnot include holdings in street or nominee names. On February 23, 2007, theclosing price of our common stock was $8.84 per share.

21

----

**ComparativePerformance Graph**

The Securities andExchange Commission requires that we include in this Form 10-K aline-graph presentation comparing cumulative, five-year stockholder returns(assuming reinvestment of dividends) for our common stock with a broad-basedmarket index and either a nationally recognized industry standard or an indexof peer companies selected by us. The following graph assumes $100 invested on December 31,2001 in our common stock, a Peer Group of companies and the S&P 500. Thestock price performance shown on the following graph is not necessarilyindicative of future price performance.

**Comparison of 5Year Cumulative Total ReturnAssumes Initial Investment of $100December 2006**

****

Our Peer Group is comprised of the following companies:ADA-ES Inc.; Alliance Resource Partners, LP; Arch Coal, Inc.; ConsolEnergy, Inc.; Foundation Coal Holdings, Inc.; Headwaters, Inc.;International Coal Corp.; James River Coal Corp.; Massey Energy Company;Natural Resource Partners LP; Penn Virginia Resource Partners LP;Rentech Inc.; Suncor Energy, Inc.; U.S. Energy Systems, Inc.;and Westmoreland Coal Company. All companies in the Peer Group are listed onU.S. stock exchanges or the NASDAQ system.

We are excluded from thePeer Group for purposes of the comparative performance graph.

**Dividend Policy**

We have never paid cashdividends and do not anticipate paying dividends in the foreseeable future. Weexpect that we will retain all available earnings generated by our operationsfor the development and growth of our business. Payment of any future dividends will be at the discretion of our boardof directors after taking into account many factors, including our operatingresults, financial conditions, current and anticipated cash needs and plans forexpansion.

**Recent Sales ofUnregistered Securities**

None.

22

----

**ITEM6.**                SELECTEDFINANCIAL DATA

Thefollowing selected consolidated financial data should be read in conjunctionwith our Consolidated Financial Statements and related notes thereto in Item 8of this report and Management’s Discussion and Analysis of Financial Conditionand Results of Operations included in Item 7 of this report. The selectedconsolidated results of operations and cash flow data for each of the threeyears in the period ended December 31, 2006 and the selected balance sheetdata as of December 31, 2006 and 2005 are derived from, and qualified byreference to, our audited Consolidated Financial Statements, in Item 8 of thisreport. The selected consolidated results of operations and cash flow datarelated to 2003 and 2002 and selected consolidated balance sheet data relatedto 2004, 2003 and 2002, have been derived from audited financial statements notincluded in this report and have been revised from prior filings for ourdiscontinued operations unless otherwise noted.

| ** **                                                                                     | ** ** | **Year ended December 31,**                            | ** ** |
|------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                                                     | ** ** | **2006**                                                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                                     | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Statement of  operations data:                                                                 |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Operating revenues                                                                             |       | $                                                                     | 36,710     |   | $ | 984 |   | $ | 28 |   | $ | 72 |   | $ | 6 |   |
| Operating expenses                                                                             |       | 94,918                                                                |       | 26,144 |   | 11,375 |   | 9,590 |   | 6,491 |   |
| Operating loss                                                                                 |       | (58,208                                                               | )          | (25,160 | ) | (11,347 | ) | (9,518 | ) | (6,485 | ) |
| Loss from continuing operations                                                                |       | (51,527                                                               | )          | (23,313 | ) | (10,555 | ) | (10,245 | ) | (18,385 | ) |
| Net gain (loss) from discontinued operations                                                   |       | —                                                                |       | — |   | — |   | 1,962 |   | (5,066 | ) |
| Net loss                                                                                       |       | (51,527                                                               | )          | (23,313 | ) | (10,555 | ) | (8,283 | ) | (39,987 | ) |
| Basic and diluted loss from continuing operations                                              |       | (0.66                                                                 | )          | (0.35 | ) | (0.18 | ) | (0.22 | ) | (0.52 | ) |
| Basic and diluted net loss per share                                                           |       | $                                                                     | (0.66      | ) | $ | (0.35 | ) | $ | (0.18 | ) | $ | (0.18 | ) | $ | (1.14 | ) |
| Weighted average shares of common stock outstanding                                            |       | 77,783                                                                |       | 66,399 |   | 57,928 |   | 46,569 |   | 35,088 |   |
| Balance sheet  data:                                                                           |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Cash, cash equivalents and marketable   securities                                             |       | $                                                                     | 84,276     |   | $ | 28,793 |   | $ | 79,381 |   | $ | 23,701 |   | $ | 2,758 |   |
| Property, plant and equipment, mineral rights net,  including plant construction in   progress |       | 151,727                                                               |       | 76,291 |   | 23,521 |   | 6,649 |   | 126 |   |
| Total assets(1)                                                                                |       | 252,319                                                               |       | 114,172 |   | 112,304 |   | 35,005 |   | 15,782 |   |
| Deferred rent and other long-term liabilities,  including current portion(2)                   |       | 646                                                                   |       | 535 |   | 213 |   | 170 |   | 415 |   |
| Stockholders’ equity                                                                      |       | 224,984                                                               |       | 93,641 |   | 94,260 |   | 31,098 |   | 1,735 |   |
| Working capital (deficit)                                                                      |       | $                                                                     | 79,156     |   | $ | 19,910 |   | $ | 73,603 |   | $ | 21,204 |   | $ | (756 | ) |
| Cash flow data:                                                                                |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Cash (used in) provided by continuing operating  activities                                    |       | $                                                                     | (30,435    | ) | $ | (12,071 | ) | $ | 2,042 |   | $ | (8,220 | ) | $ | (3,993 | ) |
| Cash used in continuing investing activities                                                   |       | (92,940                                                               | )          | (49,984 | ) | (16,285 | ) | (5,669 | ) | (5,500 | ) |
| Cash provided by continuing financing activities                                               |       | $                                                                     | 169,100    |   | $ | 11,467 |   | $ | 69,923 |   | $ | 32,061 |   | $ | 15,077 |   |

----

(1)          Total assets for 2002include assets held for disposal related to our discontinued operations ofapproximately $10.2 million.

(2)          The current portion oflong-term debt as of December 31, 2006, 2005, and 2004, was $0, $160,000and $180,000, respectively. 

23

----

**ITEM 7.**                MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussionand analysis of our financial condition and results of operations should beread in conjunction with, and are qualified by reference to, our ConsolidatedFinancial Statements and related notes thereto in Item 8 of this report andSelected Financial Data included in Item 6 of this report. Certainreclassifications have been made to prior year amounts to conform to currentyear presentation. Certain statements set forth below under this captionconstitute “forward-looking statements” within the meaning of the PrivateSecurities Litigation Reform of 1995. Refer to the “Cautions About ForwardLooking Statements” preceding Item 1 of this report. Also, for a discussion ofcertain risk factors applicable to our business and operations see “RiskFactors” in Item 1A of this report.

**Overview**

We are leveraging a vertically integrated, coal-basedplatform to deliver combined energy, environmental and economic solutions,producing clean, efficient and affordable energy. We intend to meet thespecific needs of industrial, international and public utility market customers.We provide economical solutions to environmental emission standards compared toother emission standard alternatives. Our proprietary K-Fuel process uses heatand pressure to physically and chemically transform high moisture, low-Btucoals, such as subbituminous coal and lignite, into a more energy efficient,lower-emission fuel. The pre-combustion refinement of raw coal into K-Fuelrefined coal reduces mercury content up to 70 percent and upon combustion,sulfur dioxide and nitrous oxides by significant amounts. Studies show that theincreased efficiency of K-Fuel refined coal will reduce carbon dioxideemissions by beneficial amounts.

The followingdiscussion is focused on the recent events that we believe have the mostsignificant impact on our business.

·       OnFebruary 7, 2007, we received the results of test burns conducted at theUniversity of Notre Dame. These test burns were conducted and monitored by anindependent third party. We blended 50 percent and 75 percent of K-Fuel refinedcoal with high-sulfur, low-fusion eastern Ohio bituminous coal. Test burnsusing 100 percent of our K-Fuel refined coal were also conducted. Blendedresults indicated improvements in emissions that could help coal-fired boilerscomply with the new Federal Industrial Boiler Maximum Achievable ControlTechnology rule for emissions while maintaining load capacities throughhigher Btu values. Using only K-Fuel refined coal resulted in reduced chlorideemission by 75 percent sulfur dioxide emissions by 90 percent and reduced themercury content by 75 percent when compared to the high-sulfur, low-fusioneastern Ohio bituminous coal.

·       OnDecember, 27 2006, we received the test burn results of blending K-Fuel refinedcoal with high-sulfur Ohio coal. The test burns were conducted with the city ofPainesville, Ohio Department of Utilities. The results indicated compliancewith a new federal clean air standard for industrial coal-fired boiler thatgoes into effect in 2007. Emissions included 0.07 pounds of particulate matterper million Btu’s generated, 0.09 pounds of hydrogen chloride per million Btu’sgenerated and nine pounds of mercury per trillion Btus generated.

·       OnDecember 27, 2006, we signed agreements with two major utilities toadvance the integration of several K-Direct coal refineries in both existingand new coal power plants.

·       Wecompleted the initial construction and are in the start-up phase for our FortUnion K-Fuel plant and mine site project in Wyoming’s Powder River Basin, whichis our first plant implementing the K-Fuel process.

24

----

·       OnSeptember 29, 2006, we listed our common stock on the NYSE Arca platformunder the new ticker symbol “EEE.”

·       OnSeptember 26, 2006, in keeping with our strategy to use technology tocreate cleaner coal for generating power, we began doing business as EvergreenEnergy Inc.

·       OnSeptember 21, 2006, we signed an agreement with Bechtel Power Corporationfor plant engineering, standardization and design optimization for our K-Fuelrefined coal plants. The agreement provides for engineering services in theareas of architecture, civil/structural, mechanical, electrical, and controls,including subsystems engineering and design for our future K-Fuel andK-Direct commercial plants. Effective February 15, 2007, this agreementwas amended and restated to include engineering, procurement and constructioncontracts for building several K-Direct Plants that are currently beingevaluated by us.

·       OnAugust 4, 2006, we shipped our first unit train of K-Fuel refined coal.

·       OnJune 28, 2006, we purchased a 700,000 pound per hour Circulating FluidizedBed coal-fired boiler island. We have unexercised options to purchase two more coal-firedboiler islands. The fixed price for this first coal-fired boiler island is $76million. As we are primarily focused on the construction of K-Direct facilitiesin the near term, we are evaluating alternatives for this boiler, includingpotentially selling it to a third party.

·       OnJune 14, 2006, we entered into a long term Marketing, Distribution andTransportation Logistics Services Agreement with DTE Coal Services, Inc.

·       OnApril 3, 2006, we completed the acquisition of Buckeye Industrial MiningCo., which continues our strategy to transition from an energy technologycompany into an energy production company.

·       InFebruary 2006, we sold approximately 8.1 million shares of common stock ata price to the public of $18.75 per share pursuant to a follow-on commonstock offering, resulting in net proceeds of approximately $144.6 million.

Our consolidated financial statements include all ofour wholly owned subsidiaries, including the nine months ended December 31,2006, for Buckeye Industrial Mining Co. (acquisition date of April 3,2006). 

With the acquisition of Buckeye, we have expanded oursegments and our segment presentation. We have identified three segments: ourPlant and Licensing segment, Mining segment and Operating segment. Our resultsof operations are evaluated and allocations of capital resources are based uponthe vertical integration and operation of these segments. The Plant andLicensing segment represents revenue and costs related to the use andapplication of our proprietary, patented K-Fuel process and our mine site inGillette, Wyoming. The Mining segment represents our mining operations at ourBuckeye location and includes certain marketing personnel, the ash disposalfacility, the blending facility and mines. The Operating segment is comprisedof all other operations.

We incorporate the acquisition of Buckeye into ouroverall strategy and therefore, we do not operate or evaluate it as otherstand-alone coal mining operations might. The value of Buckeye to us is its marketingteam and strategic location, rail road loading facility, port dock loadingfacility on the Ohio River, blending facility and mines and coal reserves. 

Our analysis presentedbelow is organized in a way that provides the information required, whilehighlighting the information that we believe will be instructive for understandingthe results of our operations and relevant trends. Discussions of our resultsrelated to our segments are presented in the context of our overall resultsand, unless otherwise indicated, relate to our Operating segment. We willcontinue to evaluate how we manage our business and, as necessary, adjust oursegment reporting accordingly.

25

----

**Significant Trends**

For the last severalyears, our operations have been focused on developing our technology and theconstruction of the Fort Union plant. As a result, we have limited revenuesfrom K-Fuel refined coal and, historically most of our costs are related togeneral and administrative expenses. With the addition of Buckeye, we havebegun to generate revenue and incurred more substantial mining costs. In thefuture, we plan to construct, own and operate K-Direct and K-Fuel productionfacilities domestically, both wholly owned and through joint ventures, as wellas to license the K-Fuel technology to third parties, primarily internationally.As our operations expand, we expect our revenue and cost structure will alsoincrease. The following discussion and analysis is focused on the events andtrends that we believe have or will in the future have the most significantimpact on our business.

**Revenue Trends**

In the future weexpect to generate revenue from the following sources:

·       revenuesfrom production facilities including K-Direct and K-Fuel plants;

·       coalsales from blending our K-Fuel refined coal with other mined coal;

·       coalsales from our Buckeye operations;

·       licensingof our technology, including license fees for constructing a plant and royaltyfees for operating a plant; and

·       consultingservices to parties who license our technology.

The value andpricing of our K-Fuel refined coal is evolving. Over time, as the market forour product develops, we will adjust the price at which we sell our refinedcoal. We may be able to charge a premium for K-Fuel refined coal in certainindustries and different geographic regions of the United States. Conversely,we may be required to sell K-Fuel refined coal to customers at substantiallydiscounted rates so customers can test combustion, emissions and coal handlingthrough their own systems. Additionally, we may process raw coal provided bypotential customers through our Fort Union plant to assess the removal ofmercury and reductions in the emission of carbon dioxide, sulfur dioxide,nitrogen oxides and various product handling aspects at little or no cost tothe potential customers. 

In addition, to the extent that we execute on ourvertical integration strategy and acquire companies that conform to ourbusiness strategy, we anticipate revenues from those sources as well. 

We have granted certainrights and limited licenses for the use of certain K-Fuel technology, which maylimit our revenue from production of K-Fuel refined coal to the extent that therights are exercised. 

26

----

**Expense Trends**

***Plant costs***

We have completedthe initial construction and entered the plant start-up phase of our Fort Unionplant in Gillette, Wyoming. Plant start-up costs were higher than anticipatedand production was less than anticipated due to general start-up issues withthis first-of-a-kind plant and the acceleration of initial production runs. Thecommissioning of the facility at this accelerated pace resulted in a number ofplant operating inefficiencies. To eliminate these inefficiencies and optimizethe facility, we are continuously modifying, testing, reconfiguring andimproving the plant. We believe that the start-up costs incurred are notindicative of future continuous operations and that start-up costs will trenddownward in future periods. As our Fort Union plant begins continuous operationand future potential K-Direct and K-Fuel plants are constructed, we willincur additional expenses, the most significant on a per ton basis are:

·       rawmaterial costs;

·       coaltransportation costs;

·       outsourcedengineering and technical support;

·       fluidprocessing costs;

·       by-productand water disposal costs;

·       royaltycosts, relating to fees we owe to parties who own certain rights that supportour patents and proprietary technology, primarily the Koppelman estate.

See further discussion ofthe royalty owed to the estate of Edward Koppelman in Note 6—Deferred RoyaltyCosts in Item 8 of this report

***Coal mining operating expenses***

With the acquisition ofBuckeye we expect to incur mine operating expenses including all costsassociated with the mining of saleable coal and costs relating to our coal ashdisposal facility. Additionally, as our Fort Union plant obtains continuousproduction, we expect to blend our K-Fuel refined coal with prepared and rawcoal at Buckeye’s facility and incur the associated shipping and blendingcosts.

***General and administrative expenses***

As we continue topursue vertical integration through acquisitions and joint ventures andgenerally expand our business including hiring additional personnel at ourcorporate and plant locations and outsourced professional services, we willincur additional expenses, the most significant of which are:

·       non-cash,share-based compensation;

·       payrolland related burdens;

·       rentand utilities; and

·       professionalsupport fees.

We anticipate thataccounting for non-cash, share-based compensation will add approximately $11 millionto $13 million per year in the foreseeable future to our expenses. In the eventwe should achieve certain performance goals, we would significantly acceleraterecognition of these costs. Costs such as payroll and related burdens,professional support fees and utilities are variable costs that increase withsize and the location. As we expand our vertical integration strategy we expectthese costs increase in future periods.

27

----

**RESULTS OFOPERATIONS**

**Revenue**

Revenues for theyear ended December 31, 2006 were $36.7 million compared to $984,000 forthe same period ended December 31, 2005. Substantially all the increasewas due to our acquisition of Buckeye, which resulted in $35.8 million ofrevenue in our Mining segment for the nine months ended December 31, 2006(acquisition date of April 3, 2006). The fluctuations are as follows;

·       Coalrevenue includes mined raw and prepared coal sales within our Buckeyeoperations. Buckeye coal sales, including transportation costs charged tocustomers, were $30.4 million or $56.32 sales realization per ton sold for thenine months ended December 31, 2006 (acquisition date of April 3,2006).

·       Brokeredcoal sales net, include the revenues reduced by costs associated with thepurchase of coal from other coal producers, which we ship directly tocustomers. We recognized $695,000 of net revenue for the nine months endedDecember 31, 2006 (acquisition date of April 3, 2006) in our Miningsegment.

·       Ashdisposal revenue includes revenue generated from the disposal of coalcombustion bi-products at our ash pit in Ohio. Ash disposal revenues were $4.7million for the nine months ended December 31, 2006 (acquisition date ofApril 3, 2006), in our Mining segment.

·       Duringthe year ended December 31, 2006, we recognized $420,000 of revenuerelated to shipments of K-Fuel refined coal in our Plant and Licensing segment.K-Fuel refined coal sales were less than expected primarily due to lessproduction at our Fort Union Plant. In addition, we sold a portion of ourK-Fuel refined coal at discounted rates.

·       In2000, we entered into a licensing and royalty agreement related to a previousversion of our proprietary technology with a third party. During 2005, theequipment relating to the licensing agreement was placed into service. As aresult of the equipment being placed into service, we received a cash royaltypayment for 2005, in the first quarter 2006. We recognized $150,000 of royaltyrevenue for 2005 in the first quarter of 2006 in our Plant and Licensingsegment. During the second quarter of 2006, we received an annual cash royaltypayment for 2006 in the amount of $150,000. We anticipate that we will onlyrecognize future revenue as circumstances dictate, including the receipt ofcash payments. This licensing agreement expires in 2007.

·       Werecognized revenue of $768,000 from the $7.5 million up-front licensing feereceived in December 2004 from Cook Inlet Coal LLC in our Plant andLicensing segment for the year ended December 31, 2005. To date we havecompleted all of our contractual deliverables for the licensing fee and arewaiting for Cook Inlet Coal to provide specific site information before thenext phase of revenue recognition can commence.

Revenues for the yearsended December 31, 2005 and 2004 were $984,000 and $28,000. For the yearended December 31, 2005, we recognized $768,000 on the $7.5 millionup-front licensing fee received in December 2004 in our Plant andLicensing segment as discussed above. Revenues for the period ended December 31,2004 were insignificant to our operations.

**Coal MiningOperating Expenses**

Our coal mining operatingexpenses include all costs associated with the mining of saleable coal andcosts relating to our coal ash disposal facility at Buckeye, which representsour mining segment. 

28

----

***Coal mining operating expenses***

Coal mining operating expenses includeemployee-related costs, outside contracted mining for our underground mines,internal and external coal transportation costs, blasting, drilling, heavyequipment costs, blending costs, coal purchases from others used to blend withour coal and other mining related costs. Coal mining operating expenses**were $28.9 million for the nine months ended December 31,2006 (acquisition date of April 3, 2006). The increase in mining costs isattributed to the acquisition of Buckeye in the second quarter of 2006.

SFAS No. 141 requiresunder purchase price accounting that finished goods inventory be valued atestimated selling prices less a reasonable profit allowance for the sellingeffort and that raw materials be valued at current replacement costs. Wedetermined that the book value for Buckeye’s raw material inventory as of April 1,2006 was equal to current replacement cost. For finished goods, we increasedthe inventory to fair value from a book value of $1.7 million to a fair valueof $2 million, for a total increase of $364,000. As a direct result of thispurchase price adjustment, the sales of Buckeye’s inventory resulted in a 3%reduction in operating income in our mining operation for the nine months endedDecember 31, 2006 (acquisition date of April 3, 2006).

***Ash disposal***

Ash disposal expensesinclude employee-related costs, consulting, repairs and maintaining culvertsand drainage ponds, transportation, heavy equipment costs and other costsassociated with the ash disposal facility. Ash disposal expenses were $3.4million for the nine months ended December 31, 2006 (acquisition date of April 3,2006).

**General andAdministrative**

Thefollowing table summarizes our general and administrative costs for the yearsended December 31, 2006, 2005 and 2004. 

| ** **                                   | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                   | ** ** | **(in thousands)**                    | ** ** |
| Employee  non-cash, share-based compensation |       | $                                          | 9,803      |   | $ | 2,239 |   | $ | 157 |   |
| Employee-related  costs                      |       | 8,045                                      |       | 6,319 |   | 2,090 |   |
| Non-cash, Arch  warrants                     |       | 1,692                                      |       | 5,803 |   | — |   |
| Professional fees                            |       | 4,113                                      |       | 3,418 |   | 5,315 |   |
| Travel and office  costs                     |       | 2,260                                      |       | 1,468 |   | 708 |   |
| Insurance and  other                         |       | 2,929                                      |       | 1,341 |   | 517 |   |
| Total general and  administrative            |       | $                                          | 28,842     |   | $ | 20,588 |   | $ | 8,787 |   |

 

Employee non-cash, share-based compensation expenseswere $9.8 million and $2.2 for the year ended December 31, 2006 and 2005,respectively. The expenses for 2006 relate to (i) stock optionsoutstanding, (ii) restricted stock grants, and (iii) the discount andthe fair value calculation for the “look back” provision for employee stockpurchases under our Employee Stock Purchase Plan. The increase in non-cash,share-based compensation was in direct correlation with the adoption of SFAS123(R) as of January 1, 2006. See Note 9—Stock Options, Stock Grantsand Employee Benefit Plans for further discussion in Item 8 of this report.Non-cash, share based compensation in 2006 primarily related to restrictedstock and option grants to our Chief Executive Officer, Chief Operating Officerand our Chief Technology Officer.

Employee-related costs primarily include salaries andwages, bonuses, benefits, employer payroll taxes and education and training. Employee-relatedcosts were $8.0 million and $6.3 million for the years ended 

29

----

December 31, 2006 and2005, respectively. The increases for the year ended December 31, 2006were primarily related to an increase in the number of employees, whichincreased salaries and related burdens. During 2006, we added personnel in manyareas, including engineering and business development. In addition, the numberof employees increased as a result of the Buckeye acquisition.

During 2005, we entered into two agreements with ArchCoal, Inc. which allowed us to evaluate the potential of constructing andoperating a plant at their Coal Creek mine site and required us to issuewarrants. In 2006, we extended these agreements to allow additional time forthe evaluation of the project. In connection with the extension, the expirationdate of the warrants was also extended and, pursuant to SFAS 123R, we wererequired to recognize an additional $1.7 million of non-cash expense for theyear ended December 31, 2006. Basedon discussions with Arch Coal, it was mutually agreed not to further extendthese agreements. The first agreement expired on September 30, 2006 andthe warrant agreement expired on October 31, 2006. As market conditionsand other circumstances change we may enter into new agreements with Arch Coal.

Professional fees include legal, audit and accounting,public relations, governmental relations and similar costs. Professional feeswere $4.1 million and $3.4 million for the period ended December 31, 2006and 2005, respectively. The increases can be attributed to a general overallincrease in legal and accounting fees when compared to the same period ended2005.

Travel and office costs include airfare, lodging,meals, office rent, office supplies, phone and utilities. Travel and officeexpenses were $2.3 million as compared to $1.5 for the year ended December 31,2006 and 2005, respectively. The majority of the increase is attributed to our increasein the number of employees at our corporate office and as a result of ouracquisition of Buckeye. The increase in the number of employees at our corporateoffice led to our office expansion in June 2005 and the related increasesin rent and utilities. In addition, we increased our travel related to ourexpanded business development efforts, including travel to our Ohio subsidiaryand travel to identify potential sites for future plants. We also saw anincrease in travel to our Fort Union plant site by non-plant related employeesand management in 2006, as the plant entered the startup phase.

Insurance and other costs primarily include costsrelated to our property and commercial liability, other insurance and all coststhat cannot be categorized elsewhere and include, among other costs, variousbusiness and franchise taxes, repair and maintenance, director fees anddirector expenses. Insurance and other costs for the year ended December 31,2006 were $2.9 million compared to $1.3 million for the same period ended 2005.The increase can be attributed primarily to an overall increase in property andcommercial liability premiums for our Fort Union plant, and our Buckeyeoperations.

Employee non-cash, share-based compensation expenseswere $2.2 million and $157,000 for the years ended December 31, 2005 and2004, respectively. Non-cash, share based compensation in 2005 primarilyrelated to restricted stock and option grants to our current Chief ExecutiveOfficer, Chief Operating Officer and our Chief Technology Officer. 

Employee-related costs were $6.3 million and $2.1million for the years ended December 31, 2005 and 2004, respectively. Theincrease was primarily related to an increase in the number of employees andrelated burdens as we hired more employees at our corporate and plant office.

Pursuant to agreements we entered into with Arch Coal,previously described, we issued 2.5 million warrants in 2005 to Arch topurchase our common stock at prices ranging from $15.69 to $20.69. Werecognized $5.8 million of general and administrative expense during the yearended December 31, 2005 related to the warrants.

30

----

Professional feeswere $3.4 million, and $5.3 million for the years ended December 31, 2005and 2004, respectively. We experienced fluctuations in professional fees due tothe following:

·       In 2005, we recognized $3.0 million of non-cash expense related to theissuance of stock to a consultant in exchange for services performed.

·       In 2004 there was a $2.2 million non-cash charge for consulting feesrelating to assistance with regulatory issues.

Travel and office costs were $1.5 million and $708,000for the years ended December 31, 2005 and 2004, respectively. The increasein 2005 was due to additional non-plant related employees and managementtraveling to our Fort Union plant site and increased international travel relatedto visits to Lurgi South Africa’s facilities and other business developmentopportunities. Additionally, we experienced increases in all aspects of officeexpense due to the expansion of our business and the increase in the number ofemployees.

Insurance and otherexpenses were $1.3 million and $517,000 for the years ended December 31,2005 and 2004, respectively. Increases were attributed to an overall increasein general and commercial liability premiums for our Fort Union plant.

**Plant start-up costs**

Plant start-up costs include purchased raw materials,coal transportation, outsourced engineering and technical support, fluidprocessing, by-products and water disposal, and employee-related costs whichare reflected in our Plant and Licensing segment.

Plant start-up costs were$26.3 million and $1.5 million for the years ended December 31, 2006 and2005, respectively. Plant start-up costs were higher than anticipated due togeneral start up issues with this first-of-a-kind plant and the acceleration ofinitial production runs. The commissioning of the facility at this acceleratedpace resulted in a number of plant operating inefficiencies. We incurred higherfeed stock costs as we chose to purchase coal from a nearby mine and incurredtrucking costs for the transportation of that purchased coal. Outsourcedengineering and employee-related costs were incurred to assist with theacceleration of the initial production. The water handling system was limitedin its ability to process water from the production process. Disposal of thisexcess water required utilizing third parties to transport water to approveddisposal sites. This resulted in higher water disposal costs.

**Depreciation, Depletion and Amortization**

Depreciation, depletionand amortization are comprised of depreciation on our Fort Union plant usingthe units-of-production method, based on actual tons processed and depreciationon other fixed assets using the straight-line method, depletion, based onactual tons mined at our mine sites in Ohio and Wyoming, and amortizationrelated to our patents. Depreciation, depletion and amortization expenses were$5.5 million for the year ended December 31, 2006 compared to $773,000during the same period ended 2005. The increases are primarily attributable tothe acquisition of Buckeye in the second quarter of 2006.

Depreciation, depletionand amortization expenses were $773,000 for the year ended December 31,2005 compared to $420,000 during the same period ended 2004.

**Research and Development**

Research and developmentcosts include costs incurred to advance, test, or otherwise modify ourproprietary technology or develop new technologies and primarily include costsincurred to operate and maintain our laboratory facilities and professionalengineering fees related to off-site testing of our K-Fuel refined coal. Researchand development costs were $1.4 million and $1.6 million for the years ended2006 

31

----

and2005, respectively. The decrease is primarily a result of our Fort Union plantentering the start-up phase of operation, which resulted in costs that werepreviously classified as research and development now being classified as plantstart-up costs.

Research and developmentcosts were $1.6 million and $696,000 for the years ended 2005 and 2004,respectively. The majority of the increase can be attributed to an increase inthe number of employees and related overhead at our laboratory facilities andincreases in new technology development and feasibility studies for futurelarge-scale plant sites. The increased activity at our laboratory facilitieswas indicative of internal coal testing of our K-Fuel refined coal.

**Cost of License and Consulting Revenue**

Cost of license andconsulting revenue includes costs to transfer our technology related tolicensing and royalty agreements, including amortization of deferred royaltycosts, salaries and wages of certain personnel and professional fees. Cost oflicensing and consulting revenue was $134,000 and $401,000 for the years ended December 31,2006 and 2005, respectively. The decreases in these costs were in directcorrelation to the revenue recognized in 2005 on the licensing agreement weentered into in 2004.

Cost of licensing andconsulting revenue was $401,000 and $5,000 for the years ended December 31,2005 and 2004, respectively. The increases in these costs were in directcorrelation to the revenue recognized in 2005 on the licensing agreement weentered into in 2004.

**Bad Debt and Asset Impairment Charges**

Bad debt and assetimpairment charges were $335,000 and $1.3 million for the years ended December 31,2006 and 2005, respectively. In 2006, we wrote off $295,000 of certain sitespecific costs, which we were evaluating for a future K-Fuel facility.

Through a series of transactions, Pegasus becameindebted to us for $2.7 million. We have rights to collect payments under thisnote from Pegasus and to demand payment upon certain events of default. Duringthe year ended December 31, 2005, we determined that Pegasus might nothave sufficient contracts to continue to meet this obligation. Therefore, wehave recorded an allowance for bad debt for the note receivable of $1.3 million.Despite this allowance, we retain all of our rights to collect payments underthis note from Pegasus and to demand payment upon certain events of default.

Bad debt and asset impairment charges were $1.3 millionfor each of the years ended December 31, 2005 and 2004.

In 2004, we incurred $1.3million plant development impairment primarily related to certain site-specificand plant size-specific costs incurred associated with evaluating three otherlocations for our Fort Union plant. 

**Other IncomeExpense**

***Interest income, net***

Interest income, net was $5.6 million and $1.9 millionfor the years ended December 31, 2006 and 2005, respectively. The increaseis attributed to interest earned on our cash balance, which was significantlyhigher compared to the same period in 2005, primarily as a result of our publicstock offering in February of 2006.

Interest income, net was$1.9 million and $569,000 for the years ended December 31, 2005 and 2004,respectively. The increase is attributed to interest earned on our cashbalance, which was significantly higher compared to the same period in 2005.

32

----

***Other income (expense), net***

Other income (expense), net was $1.1 million for theyear ended December 31, 2006.

In 2003, we completed anequity exchange transaction pursuant to which we transferred our interest inPegasus Technologies, Inc. for full ownership of K-Fuel LLC, now part of awholly owned subsidiary named KFx Technology, LLC. As a part of thisexchange transaction, we exchanged an intercompany working capital loan withPegasus with an outstanding balance of $9.4 million for a contingent earn-out agreementof up to $9.4 million in the aggregate, plus accrued interest (prime rateplus 500 basis points), payable out of a portion of future cash flows generatedby Pegasus. Due to the contingent nature of this potential stream of futurecash flows, we did not recognize an asset or any associated income at the timeof the exchange transaction. As a result of a transfer of ownership interests,the earn-out provisions were triggered and we received a payment of $1.1million from Pegasus as a payment in full satisfaction of the $9.4 millionobligation. 

**Deferred TaxBenefit**

We have not reflected a deferred tax benefit,primarily from net operating loss carryforwards, since based on the weight ofavailable evidence, both positive and negative, management has determined thatit is more likely than not that our deferred tax assets may not be realized.The primary evidence was our history of net operating losses. As we begin toearn revenue and realize net income, we will continue to evaluate our valuationallowance and at such time as there is sufficient evidence that we will utilizeat least some portion of our deferred tax assets, we will reverse a relatedportion of our valuation allowance.

Certain limitations applyto the annual amount of net operating losses that can be used to offset taxableincome due to certain ownership changes, as defined in Section 382 of theInternal Revenue Code.

**Liquidity andCapital Resources**

In February 2006, we sold approximately 8.1million shares of common stock at a price to the public of $18.75 pershare pursuant to a follow-on common stock offering, resulting in net proceedsof approximately $144.6 million after deducting the underwriting discounts andcommissions and estimated offering expenses. We used part of the proceeds fromthis offering to fund the acquisition of Buckeye and the construction of ourFort Union plant. We plan on using the remaining funds for new K-Direct andK-Fuel facility construction costs and general corporate purposes.

Our cash will primarily be used to fund operations andfor capital expenditures. The capital expenditure budget for 2007 isapproximately $25 million to $30 million which will be used for FortUnion completion costs, Buckeye mining and development costs and costsassociated with initial K-Direct facilities. After completion of the next phaseand upon initiation of definitive agreements, future capital costs will beadjusted to reflect the construction of two new K-Direct facilities.

We believe our cash levelis sufficient to support our operations, including the Fort Union plant, startpreliminary site investigation, design, permitting and similar long-lead-timeactivities related to K-Direct plants located on site at coal-fired powergenerating and industrial facilities and other large-scale K-Fuel plants for atleast the next twelve months. However, as we identify strategic opportunitiesto accelerate construction of K-Direct and large-scale commercial plants, orother agreements such as joint ventures, we will need to obtain additionalfunding. We plan to seek additional capital from time to time as neededthrough: (1) equity offerings or the exercise of outstanding options andwarrants; (2) debt offerings; (3) partnering with third parties inthe construction and operation for some of our large-scale commercial plantsthrough the formation of joint ventures, and (4) fees from additionallicensing of our K-Fuel technology. While we believe we will obtainadditional capital through one or more of the alternatives 

33

----

described,we can provide no assurance that any of the alternatives will be available tous or be on terms acceptable to us.

**Payment Obligations**

Thefollowing table summarizes our future commitments as of December 31, 2006:

| ** **                           | ** ** | **Payments due by period** | ** ** |
|--------------------------------------|------------|-------------------------------------------|------------|
| ** **                           | ** ** | **2007**                                  | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
| ** **                           | ** ** | **(in thousands)**                   | ** ** |
| Operating leases                     |       | $                                         | 1,183      |   | $ | 1,421 |   | $ | 1,437 |   | $ | 1,301 |   | $ | 1,105 |   |   | $ | 26,060 |   |   | $ | 32,507 |   |
| Capital lease and  other obligations |       | 100                                       |       | 16 |   | 16 |   | 8 |   | — |   |   | — |   |   | 140 |   |
| Purchase  commitment obligations     |       | 25,268                                    |       | 26,637 |   | 9,459 |   | — |   | — |   |   | — |   |   | 61,364 |   |
| Consulting and  service commitments  |       | 4,020                                     |       | 3,045 |   | 240 |   | 240 |   | — |   |   | — |   |   | 7,545 |   |
| Total commitments                    |       | $                                         | 30,571     |   | $ | 31,119 |   | $ | 11,152 |   | $ | 1,549 |   | $ | 1,105 |   |   | $ | 26,060 |   |   | $ | 101,556 |   |

 

This table does not include accounts payable, accruedexpenses nor asset retirement obligations, which are reported in our December 31,2006 Consolidated Balance Sheets. We generally have not included any obligationin which either party has the right to terminate except as discussed below. Additionally,we have not included royalty payments, as we cannot presently determine whensuch payments will be made as such payments are based upon our receipt of cashfor licensing and royalties.

We are obligatedunder non-cancelable operating leases with initial terms exceeding one year. Rentexpense in the years ended December 31, 2006, 2005 and 2004 was $415,000,$242,000 and $226,000, respectively. Included in operating leases is a 50 yearport dock lease on the Ohio River, we have the right to cancel this lease uponsix months written notice, if we cancelled this lease as of December 31,2006, we would be obligated to pay only $250,000 of the $25.0 million includedin the table.

Purchase commitments include our 700,000 pound perhour Circulating Fluidized Bed coal-fired boiler island that is beingconstructed. We have the right to cancel this at any time with a 17.5% penalty,if we cancelled this as of December 31, 2006, we would be obligated to payonly $10.7 million of the $61.1 million included in the table.

Consulting and servicecommitments include agreements with consultants to advise us on proposedlegislation and regulations and advocate our interests before the U.S. Congressand regulatory agencies, these agreements are for 18 months. Also included inconsulting and service agreements is an agreement for technical and engineeringservice in which we have the right to cancel upon six months written notice, ifwe cancelled this agreement as of December 31, 2006, we would be obligatedto pay only $1.8 million of the $6.3 million include in the table. Effective February 15,2007, we amended and restated a service agreement with Bechtel, as a result ofthis amendment, if we were to cancel early we would be required to pay up to a$5 million termination fee.

**Historical View**

***Cash (Used in) Provided by Operating Activities***

Cash used in operating activities was $30.4 millionand $12.1 million for the years ended December 31, 2006 and 2005,respectively. The majority of the cash used in operating activities for theyear ended December 31, 2006, relates to cash utilized in our on-goingoperations, as adjusted for non-cash items and changes in operating assets andliabilities. The most significant adjustment to net loss to arrive at cash usedin operating activities for the year ended December 31, 2006, werenon-cash expense related to the 

34

----

adoption of SFAS 123R andthe issuance of stock and warrants for services resulting in a $11.5 millioncharge and depreciation, depletion and amortization of $5.5 million, primarilyfrom the acquisition of Buckeye.

The most significant adjustments to net loss for theyear ended December 31, 2005 were non-cash expense related to the issuanceof warrants and options to employees, directors and consultants of $11.0 million,and a $1.3 million non-cash charge to establish and an allowance for a notereceivable. 

Cash used inoperating activities was $12.1 million and cash provided by operatingactivities was $2.0 million for the years ended December 31, 2005 and2004, respectively. For the year ended December 31, 2004, we had cashprovided by operations primarily due to a cash receipt of $7.5 million relatedto the license agreement we entered into in December 2004. We received theup-front cash payment but are required to defer and amortize the underlyingrevenue in our financial statements. The most significant adjustments to netloss to arrive at cash used in operating activities were:

·       Non-cashexpense related to the issuance of warrants and options to employees, directorsand consultants of $11.0 million and $3.8 million for the years endedDecember 31, 2005 and 2004, respectively.

·       In2005, we recorded a $1.3 million non-cash charge to establish an allowance fora note receivable.

·       In 2004, we recorded assetimpairments of $1.3 million.

***Cash Used in Investing Activities***

Cash used ininvesting activities was $92.9 million and $50.0 million for the years ended December 31,2006 and 2005, respectively. The majority of the uses of cash relate to thefollowing:

·       Wepaid $36.9 million to consummate the Buckeye acquisition in 2006.

·       Wepurchased $17.7 million of marketable securities and received $8.0 million inproceeds from the maturity of marketable securities in 2006.

·       Wespent $41.5 million primarily on our Fort Union plant and future plant sites in2006.

·       Wespent $47.1 million primarily on our Fort Union plant in 2005.

·       Wehad capital expenditures related to other purchases of property and equipmentof $5.1 million, and $851,000 for the years ended December 31, 2006 and2005, respectively, and $1.0 million for purchases of mineral rights and minedevelopment for the year ended December 31, 2006.

·       Wewere required to restrict cash to serve as collateral of $1.8 million in 2005,to collateralize other contractual obligations and our asset retirement obligation;$1.3 million of restricted cash was released in 2006.

Cash used ininvesting activities were $50.0 million and $16.3 million for the years ended December 31,2005 and 2004, respectively. The majority of the uses of cash related to thefollowing;

·       Wespent $47.1 million and $12.6 million on our Fort Union plant for the yearsended December 31, 2005 and 2004, respectively.

·       Wehad capital expenditures related to other purchases of property and equipmentof $851,000 and $44,000 for 2005 and 2004, respectively.

·       We were required torestricted cash to serve as collateral of $1.8 million and $3.4 million in 2005and 2004, respectively, to collateralize other contractual obligations and ourasset retirement obligation.

35

----

***Cash Provided by Financing Activities***

Cash provided by financing activities for the yearended December 31, 2006 was $169.1 million compared to $11.5 million forthe same period ended 2005, an increase of $157.6 million. The increase isattributable to the $144.6 million of cash received from our public offering inFebruary 2006 and an increase of $12.9 million of cash proceeds fromthe exercise of warrants and options.

Cash provided by financingactivities for the year ended December 31, 2005 was $11.5 million comparedto $69.9 million compared to the same period ended 2004. The majority of ourfinancing activities related to the exercise of options and warrants and theissuance of common stock in private placements. We received cash related to theexercise of options and warrants of $11.7 million and $22.6 million forthe years ended December 31, 2005 and 2004, respectively. In addition, in2004, we generated cash from the issuance of common stock from privateplacements of $47.4 million.

**Critical AccountingPolicies and Estimates**

We have identified the policies and estimates below ascritical to our current and future business operations and the understanding ofour results of operations. For a detailed discussion on the application ofthese and other significant accounting policies, see the notes to ourConsolidated Financial Statements in Item 8 of this Annual Report. Thesepolicies and estimates are considered “critical” because they either had amaterial impact or they have the potential to have a material impact on ourfinancial statements, and because they require significant judgments,assumptions or estimates. The preparation of our financial statements in thisAnnual Report on Form 10-K requires us to make estimates and judgmentsthat affect both the results of operations as well as the carrying values ofour assets and liabilities. Some of our accounting policies require us to makedifficult and subjective judgments, often as a result of the need to makeestimates of matters that are inherently uncertain. We base estimates onhistorical experience and/or on various other assumptions that we believe to bereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities as of thedate of the financial statements that are not readily apparent from othersources. Actual results may differ from these estimates under differentassumptions or conditions, making it possible that a change in these estimatescould occur in the near term. Set forth below is a summary of our most criticalaccounting policies.

***Revenue recognition.******  ***We recognizerevenue when there is persuasive evidence of an arrangement, generally when anagreement has been signed, all significant obligations have been satisfied, thefee is fixed or determinable, and collection is reasonably assured. Anyup-front fees received are deferred and recognized over the provision ofspecific deliverables as defined in the agreements. As our history related tocustomer relationships is limited, we may be required to change the estimatedperiod over which we recognize our revenue as more information becomesavailable. Arrangements that include multiple deliverables are evaluated todetermine whether the elements are separable based on objective evidence. Ifthe elements are deemed separable, total consideration is allocated to eachelement and the revenue associated with each element is recognized as earned. Ifthe elements are not deemed separable, total consideration is deferred andrecognized ratably over the longer of the contractual period or the expectedcustomer relationship period. We believe that the accounting estimates relatedto customer relationship periods and to the assessment of whether bundledelements are separable are “critical accounting estimates” because: (1) theyrequire management to make assumptions about how long we will retain customers,for which we have limited history; (2) the assessment of whether bundledelements are separable can be subjective; and (3) the impact of changes inactual retention periods versus these estimates on the revenue amounts reportedin our consolidated statements of operations could be material.

36

----

***Accounts and notesreceivable and allowances.******  ***Receivablesare recorded at their estimated net realizable value. The allowance fordoubtful accounts is determined through an analysis of the past-due status ofreceivables and assessments of risk regarding collectability. If the financialcondition of the customers were to deteriorate, resulting in an impairment oftheir ability to make payments, additional allowances may be required. As of December 31,2006, we had a $1.3 million recorded allowance for doubtful accounts relatingprimarily to a note receivable.

***Capitalization ofCosts.******  ***Generally, we expense plant start-upcosts as incurred that do not extend the life of the plant or increaseproduction volumes. In addition, we expense mine exploration costs as incurred.Once it has been determined that it is economically feasible to extract coal,we begin to capitalize these costs as premining costs. We have identified thecommencement of permitting as the point to begin capitalizing premining costs.Judgment is exercised in determining (i) if costs extend the life of theplant; (ii) if costs increase plant production volumes; and (iii) thefeasibility of extracting coal. If these judgments are incorrect, we maycapitalize more costs than we otherwise should.

***Mineral rights andmine development.******  ***Asignificant portion of our coal reserves are controlled through leasingarrangements. Costs to obtain coal lands and leased mineral rights, includingcapitalized premining costs, are capitalized and depleted to operations usingthe units-of-production method based on tons produced utilizing only proven andrecoverable reserves in the depletion base and are assumed to have no residualvalue. Premining costs include drilling, permitting, county and state filingfees and the initial overburden removal. We used assumptions such as sellingprice of coal, costs to mine and a discount rate to value our mines at Buckeye.If the assumptions used to value the proven and recoverable reserves change inthe future, we may be required to record impairment charges for these assets. 

***Useful lives of ourlong-lived assets.******  ***Selecting the useful lives oflong-lived assets to be depreciated, depleted or amortized requires asignificant amount of judgment. We placed our Fort Union plant into service inthe third quarter of 2006. As this is the first-of-its-kind plant, assumptionswere made in order to estimate the total expected production for the life ofthe plant. These assumptions were primarily based upon research and inquiry ofour engineers and out-source engineers. As there is no history on which to basethe economic life of the equipment and as we used a number of assumptions andestimates in determining the production of the plant, we may periodically needto re-evaluate the economic life of and production our Fort Union plant and maybe required to take additional depreciation expense.

***Valuation of long-lived assets.  ***The valuation of our long-livedand intangible assets, including our Fort Union plant, mineral rights andpatents, have significant impact on our results of operations and financialcondition. We must assess the realizable value of these assets for potentialimpairment whenever events or changes in circumstances indicate that thecarrying value may not be recoverable. In assessing the recoverability of theseassets, we must make assumptions regarding estimated future cash flows andother factors to determine the fair value of the respective assets. Theestimates and assumptions related to our Fort Union plant are particularlydifficult to determine as it is a first-of-its-kind facility. In addition, wemust make assumptions regarding the useful lives of these assets. If theseestimates or their related assumptions change in the future, we may be requiredto record impairment charges for these assets.

***Asset retirementobligations.******  ***We are required to record the fairvalue of legally required removal costs and retirement obligations as aliability and we also recorded an offsetting asset. Initially, our assetretirement obligations were recorded at their fair value using an expected cashflow approach, in which multiple cash flow scenarios that reflected the rangeof possible outcomes and a credit-adjusted risk-free rate were applied. Theliability is then accreted over time by applying the interest method ofallocation. In determining the initial liability, we must make assumptionsregarding estimated future cash flows and other factors. In addition, the rateof accretion is based upon our best estimate of the rate at which cost tocomplete the reclamation will increase. If these estimates and their related assumptionsare incorrect or change in the future, we may be required to increase ourobligation.

37

----

***Accounting forstock grants, options and warrants.***   We issuestock grants, options and warrants to employees, board of directors andconsultants in connection with our various business activities. In accountingfor these awards we are required to make estimates of the fair value of therelated instruments, the periods benefited and forfeiture rates. Theseestimates may affect such financial statement categories as stockholders’equity and general and administrative expense. If these estimates areincorrect, we may be required to incur additional expense in the future.

***Accounting for acquisitions.******  ***The acquisition of businessesis an important element of our strategy. We are required to record the netassets acquired at the estimated fair value at the date of acquisition. Thedetermination of the fair value of the assets acquired and liabilities assumedrequires us to make significant estimates and assumptions that affect ourfinancial statements. For example, the value and estimated life of assets mayaffect the amount of future period depletion and depreciation expense for theassets as well as possible impairment charges that may be incurred.

**Recent AccountingPronouncements**

In September 2006, the Financial AccountingStandards Board issued SFAS No. 157, “Fair Value Measurement”. ThisStatement defines fair value, establishes a framework for measuring fair valuein generally accepted accounting principles and expands disclosures about fairvalue measurements. SFAS No. 157 applies under other accountingpronouncements that require or permit fair value measurements, the FinancialAccounting Standards Board having previously concluded in those accountingpronouncements that fair value is the relevant measurement attribute.Accordingly, this statement does not require any new fair value measurements.However, for some entities, the application of this statement will changecurrent practice. SFAS No. 157 is effective for financial statementsissued for fiscal years beginning after November 15, 2007 and interimperiods within those fiscal years. We are in the process of evaluating theimpacts, if any, of adopting this pronouncement. 

In September 2006, the U.S. Securities andExchange Commission released Staff Accounting Bulletin No. 108, “FinancialStatement Misstatements.” SAB No. 108 expresses the staff’s view regardingthe process of quantifying financial statement misstatements. Theinterpretations in SAB No. 108 are being issued to address diversity inpractice in quantifying financial statement misstatements and the potentialunder current practice for the build-up of improper amounts on the balance sheet.SAB No. 108 is effective for annual financial statements covering thefirst fiscal year ending after November 15, 2006. The adoption of thisstatement did not have a material impact on our financial position or resultsour operations. 

In July 2006, the Financial Accounting StandardsBoard issued Interpretation No. 48, “Accounting for Uncertainty in IncomeTaxes-an Interpretation of FASB Statement No. 109,” which clarifies theaccounting for uncertainty in tax positions. This Interpretation requires thatwe recognize, in our financial statements, the impact of a tax position if thatposition is more likely than not of being sustained on audit, based on thetechnical merits of the position. The provisions of FIN 48 are effective as of January 1,2007. We are in the process of evaluating the impacts, if any, of adopting thispronouncement.

In May 2005, theFinancial Accounting Standards Board, as part of an effort to conform tointernational accounting standards, issued SFAS No. 154, “AccountingChanges and Error Corrections,” which was effective for us beginning on January 1,2006. SFAS No. 154 requires that all voluntary changes in accountingprinciples be retrospectively applied to prior financial statements as if thatprinciple had always been used, unless it is impracticable to do so. When it isimpracticable to calculate the effects on all prior periods, SFAS No. 154requires that the new principle be applied to the earliest period practicable. Sinceadoption, SFAS No. 154 has not had a material effect on our financialposition or results of operations.

38

----

**ITEM 7A.**        QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

In addition to risks inherent in operations, we areexposed to the following market risks in our business:

We are exposed to market risk due to changes innatural gas prices. Natural gas is used in our K-Fuel process at our Fort Unionplant. There has been a generally increasing trend in natural gas prices duringthe last few years due to various supply factors, including the increasing overalldemand for natural gas from industrial users, which is affected, in part, bythe general conditions of the United States economy, and other factors.Seasonal fluctuations exist each year resulting from various supply and demandfactors, such as the severity of winters affecting consumer consumption forheating and the severity of, summers affecting industrial demand for electricalgeneration, among other factors. A hypothetical increase of $1.00 per MMBTU ofnatural gas prior to the installation of a reboiler and other plantmodifications could increase the cost per ton by approximately $2.00 per ton ofK-Fuel or approximately $1.5 million annually, assuming the plant isoperating at near full design utilization.

Some of the products used in our mining activities,such as diesel fuel and explosives, are subject to commodity price risk. Weexpect to consume 1.6 million to 1.8 million gallons of fuel per year. On a pergallon basis, based on this usage, a change in fuel prices of one cent pergallon would result in an increase in our operating costs of approximately$18,000 per year. Alternatively, a one dollar per barrel change in the price ofcrude oil would increase or decrease our annual fuel costs by approximately $720,000.

We are indirectly exposedto fluctuations in fuel commodity prices. To the extent that fuel prices riseor fall, there may be greater or lesser demand for our K-Fuel refined coal. Weown (or hold) no derivative instruments or floating rate debt and do not expectto derive a material amount of our revenues from such interest bearingsecurities. Currently, we have no significant foreign operations. We wererequired to establish an irrevocable standby letter of credit in Euros, whichwill be adjusted to account for the change in foreign currency rates. As theseadjustments are made we will either increase or decrease our restricted cashbalance. At this time we are still evaluating our exposure to these foreigncurrency rate adjustments. However, to the extent that we establish significantforeign operations in the future, we may attempt to mitigate risks associatedwith foreign currency exchange rates contractually and through the use ofhedging activities and other means considered appropriate. We hold no equitymarket securities, which are subject to equity market risk relative to our ownequity securities.

**ITEM 8.**                FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA

The financial statementsrequired pursuant to this item are included in Item 15 of this Annual Report onForm 10-K and begin on page F-1. The supplementary financialinformation required by this item is included in “Item 7. Management’sDiscussion and Analysis of Financial Condition and Results of Operations.”

**ITEM 9.**                CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES

None.

**ITEM 9A.**        CONTROLSAND PROCEDURES

**ConclusionRegarding the Effectiveness of Disclosure Controls and Procedures**

We maintain disclosure controls and procedures thatare designed to ensure that information required to be disclosed in ourExchange Act reports is recorded, processed, summarized and reported within thetime periods specified in the Securities and Exchange Commission’s rules andforms, and that such information is accumulated and communicated to management,including the Chief Executive Officer and 

39

----

Chief Financial Officer,as appropriate, to allow timely decisions regarding required disclosure.Management necessarily applied its judgment in assessing the costs and benefitsof such controls and procedures, which, by their nature, can provide onlyreasonable assurance regarding management’s control objectives.

With the participation ofmanagement, our Chief Executive Officer and Chief Financial Officer evaluatedthe effectiveness of the design and operation of our disclosure controls andprocedures at the conclusion of the period ended December 31, 2006. Basedupon this evaluation, the Chief Executive Officer and Chief Financial Officerconcluded that our disclosure controls and procedures were effective inensuring that material information required to be disclosed is included in thereports that we file with the Securities and Exchange Commission.

**Management’s AnnualReport on Internal Control over Financial Reporting**

Our management is responsible for establishing andmaintaining adequate internal control over financial reporting for the company.Internal control over financial reporting is a process to provide reasonableassurance regarding the reliability of our financial reporting for externalpurposes in accordance with accounting principles generally accepted in theUnited States of America. Internal control over financial reporting includesmaintaining records that in reasonable detail accurately and fairly reflect ourtransactions; providing reasonable assurance that transactions are recorded asnecessary for preparation of our financial statements; providing reasonableassurance that receipts and expenditures of company assets are made inaccordance with management authorization; and providing reasonable assurancethat unauthorized acquisition, use or disposition of company assets that couldhave a material effect on our financial statements would be prevented ordetected on a timely basis. Because of the inherent limitations of internal controlover financial reporting, misstatements may not be prevented or detected on atimely basis. Also, projections of any evaluation of the effectiveness of theinternal control over financial reporting to future periods are subject to therisk that the controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

Management, with the participation of the ChiefExecutive Officer and Chief Financial Officer, assessed the effectiveness ofour internal control over financial reporting as of December 31, 2006. Inmaking this assessment, management used the criteria set forth by the Committeeof Sponsoring Organizations of the Treadway Commission (COSO) in InternalControl—Integrated Framework. Based on this assessment, management, with theparticipation of the Chief Executive Officer and Chief Financial Officer,believes that, as of December 31, 2006, our internal control overfinancial reporting is effective based on those criteria.

Deloitte & ToucheLLP, our independent registered public accounting firm, has issued anattestation report on management’s assessment of our internal control overfinancial reporting. That attestation report is set forth below in this Item9A.

**Changes in InternalControl over Financial Reporting**

During the third quarter of 2006, we began toimplement a new enterprise-wide software system. During the year ended December 31,2006, we commenced using the general ledger, accounts payable and procurementapplications of the software to record, allocate and report financialtransactions. This new system resulted in certain material changes to ourinternal controls over financial reporting. Pre-implementation testing andpost-implementation reviews were conducted by management to ensure thatinternal controls surrounding the system implementation process, theapplications, and the closing process were properly designed to preventmaterial financial statement errors. We have tested and evaluated theeffectiveness of the key controls over financial reporting related to thegeneral ledger, accounts payable 

40

----

and procurement anddetermined that they are operating effectively. We plan on implementingadditional modules of the enterprise-wide software through the first quarter of2007. As we implement other modules, our internal control structure will bemodified as appropriate.

The implemented and planned system changes wereundertaken primarily to improve management reporting and were not undertaken inresponse to any actual or perceived significant deficiencies in our internalcontrol over financial reporting. Other than the changes related to this newsystem, no other changes in our internal control over financial reporting (asdefined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act)occurred during the quarter ended December 31, 2006 that have materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting.

On April 3, 2006, we completed the acquisition ofBuckeye Industrial Mining Co., which represents a material acquisition for us. Ourconsolidated financial statements as of December 31, 2006 include theBuckeye operations. In recording the Buckeye acquisition, we followed ournormal accounting procedures and internal controls. Our management alsoreviewed the nine months of operations of Buckeye that are included in ourfinancial statements for the year ended December 31, 2006. In addition, wesolicited disclosure information from Buckeye employees using our Section 302procedures regarding the current business environment in which Buckeye operates.We are continuing to integrate our internal controls into the Buckeyeoperations and it is contemplated that this effort will continue through thefirst quarter of 2007. In accordance with SEC guidance, we have not completedour evaluation of the internal controls of Buckeye and, as a result, ourconclusion regarding the effectiveness of our internal control over financialreporting does not extend to the internal controls of Buckeye, whose financialstatements constitute 18% of total assets and 98% of revenues.

41

----

**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

To the Board of Directors and Stockholders ofEvergreen Energy Inc. Denver, Colorado

We have audited management’s assessment, included inthe accompanying Management’s Report on Internal Control over FinancialReporting, that Evergreen Energy Inc. and subsidiaries (the “Company”)maintained effective internal control over financial reporting as of December 31,2006, based on criteria established in *InternalControl—Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission. As described in Management’s Reporton Internal Control over Financial Reporting, management excluded from itsassessment the internal control over financial reporting at Buckeye IndustrialMining Company, which was acquired on April 3, 2006 and whose financialstatements constitute 17 percent and 18 percent of net and total assets,respectively, 98 percent of revenues, and 3 percent of net loss of theconsolidated financial statement amounts as of and for the year ended December 31,2006. Accordingly, our audit did not include the internal control overfinancial reporting at Buckeye Industrial Mining Company. The Company’smanagement is responsible for maintaining effective internal control overfinancial reporting and for its assessment of the effectiveness of internalcontrol over financial reporting. Our responsibility is to express an opinionon management’s assessment and an opinion on the effectiveness of the Company’sinternal control over financial reporting based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides areasonable basis for our opinions.

A company’s internal control over financial reportingis a process designed by, or under the supervision of, the company’s principalexecutive and principal financial officers, or persons performing similarfunctions, and effected by the company’s board of directors, management, andother personnel to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

Because of the inherent limitations of internalcontrol over financial reporting, including the possibility of collusion orimproper management override of controls, material misstatements due to erroror fraud may not be prevented or detected on a timely basis. Also, projectionsof any evaluation of the effectiveness of the internal control over financialreporting to future periods are subject to the risk that the controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that theCompany maintained effective internal control over financial reporting as of December 31,2006, is fairly stated, in all material respects, based on the 

42

----

criteria established in *Internal Control—Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission.Also in our opinion, the Company maintained, in all material respects,effective internal control over financial reporting as of December 31,2005, based on the criteria established in *InternalControl—Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission.

We have also audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the Consolidated Financial Statements as of and for the yearended December 31, 2006 of the Company and our report dated February 28,2007 expressed an unqualified opinion on those financial statements andincludes an explanatory paragraph relating to the change in method ofaccounting for stock-based compensation.

DELOITTE & TOUCHE LLPDenver, ColoradoFebruary 28, 2007

43

----

**ITEM 9B.**       OTHERINFORMATION

**None.**

**PART III**

**ITEM 10.**         DIRECTORS,EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

The required information for this item is incorporatedby reference to our Proxy Statement for the 2007 Annual Meeting ofStockholders, since such Proxy Statement will be filed with the Securities andExchange Commission not later than 120 days after the end of our fiscal yearpursuant to Regulation 14A.

Our board of directors hasadopted a Code of Business Conduct and Ethics that applies to our directors,executives, officers and employees. Our Code of Business Conduct and Ethics canbe found on our web site, which is located at www.evgenergy.com. We intend tomake all required disclosures concerning any amendments to, or waivers from,our Code of Business Conduct and Ethics on our web site. Any person may requesta copy of the Code of Business Conduct and Ethics, at no cost, by writing to usat the following address: Evergreen Energy Inc, 55 Madison Street, Suite 500,Denver, Colorado, 80206, Attention: Investor Relations.

**ITEM 11.**         EXECUTIVECOMPENSATION

The required informationfor this item is incorporated by reference to our Proxy Statement for the 2007Annual Meeting of Stockholders, since such Proxy Statement will be filed withthe Securities and Exchange Commission not later than 120 days after the end ofour fiscal year pursuant to Regulation 14A.

**ITEM 12.**         SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS

The required informationfor this item is incorporated by reference to our Proxy Statement for the 2007Annual Meeting of Stockholders, since such Proxy Statement will be filed withthe Securities and Exchange Commission not later than 120 days after the end ofour fiscal year pursuant to Regulation 14A.

**ITEM 13.**         CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

The required informationfor this item is incorporated by reference to our Proxy Statement for the 2007Annual Meeting of Stockholders, since such Proxy Statement will be filed withthe Securities and Exchange Commission not later than 120 days after the end ofour fiscal year pursuant to Regulation 14A.

**ITEM 14.**         PRINCIPALACCOUNTANT FEES AND SERVICES

The required information for this item is incorporatedby reference to our Proxy Statement for the 2007 Annual Meeting ofStockholders, since such Proxy Statement will be filed with the Securities andExchange Commission not later than 120 days after the end of our fiscal yearpursuant to Regulation 14A.

44

----

**PART IV**

**ITEM 15.**         EXHIBITSAND FINANCIAL STATEMENT SCHEDULE

**15(a)(1)  **The followingdocuments are filed as part of this Annual Report on Form 10-K:

Thefollowing consolidated financial statements of Evergreen Energy Inc. are filedas part of this report:

| Report of Independent  Registered Public Accounting Firm         |   | F-1             |   |
|------------------------------------------------------------------|--------|-----------------|--------|
| Consolidated Balance Sheets                                      |   | F-2             |   |
| Consolidated Statements of Operations                            |   | F-3             |   |
| Consolidated Statements of Changes in Stockholders’  Equity |   | F-4             |   |
| Consolidated Statements of Cash Flows                            |   | F-5             |   |
| Notes to Consolidated Financial Statements                       |   | F-6 – F-31 |   |

 

**15(a)(2)   FinancialStatement Schedules.  **Schedules are omitted because theyare not required or because the information is provided elsewhere in thefinancial statements. The financial statements of unconsolidated subsidiariesare omitted because, considered in the aggregate, they would not constitute asignificant subsidiary.

**15(a)(3)   Exhibits.**

| EXHIBIT   NUMBER | ** ** | **DESCRIPTION**                                                                                                                                                                                                                                                                   |
|------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1              |       | Restated Certificate of Incorporation of the Company  (incorporated by reference to Exhibit 2.1 to our Form 10-KSB for  the year ended December 31, 1993).                                                                                                         |
| 3.2              |       | Certificate of Amendment  to Certificate of Incorporation of the Company (incorporated by reference to  Exhibit 2.2 to our Form 10-KSB for the year ended December 31,  1993).                                                                                     |
| 3.3              |       | Second Amended and  Restated Bylaws of the Company (incorporated by reference to Exhibit 3.4  to our Form 10-KSB, as amended, for the year ended December 31,  1995).                                                                                              |
| 3.4              |       | Certificate of Amendment  to Restated Certificate of Incorporation of the Company.*                                                                                                                                                                                               |
| 3.5              |       | Certificate of Amendment  to Restated Certificate of Incorporation of the Company (incorporated by  reference to Exhibit 3.4 to our Form 10-Q for the quarter ended  June 30, 2006).                                                                               |
| 3.6              |       | Certificate of Amendment  to Restated Certificate of Incorporation of the Company.*                                                                                                                                                                                               |
| 3.7              |       | Third Amended and  Restated Bylaws of the Company (incorporated by reference to Exhibit 3.1  to our Form 8-K filed February 27, 2007).                                                                                                                             |
| 10.1             |       | Amendments to Agreements  Between Theodore Venners, S.A. Wilson, Koppelman Fuel Development Company,  and the Koppelman Group dated December 29, 1992 (incorporated by  reference to Exhibit 6.1 to our Form 10-KSB for the year ended  December 31, 1993).** |
| 10.2             |       | Royalty Agreement dated  December 29, 1992 between the Company and the Koppelman Group  (incorporated by reference to Exhibit 6.7 to our Form 10-KSB for  the year ended December 31, 1993).                                                                  |
| 10.3             |       | Stock Option Plan dated December 16, 1993  (incorporated by reference to Exhibit 6.19 to our Form 10-KSB for  the year ended December 31, 1993).**                                                                                                            |
| 10.4             |       | Gross Royalty Share  Agreement dated August 17, 1995 between the Company and Fort Union, Ltd.  (incorporated by reference to Exhibit 10.51 to our Registration  Statement on Form SB-2 (File No. 33-97418)).                                                  |

45

----

 

| 10.5  |   | Letter of Agreement  dated August 15, 1995 between the Company and Edward Koppelman  (incorporated by reference to Exhibit 10.53 to our Registration  Statement on Form SB-2 (File No. 33-97418)).                                                       |
|-------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.6  |   | Royalty Amendment  Agreement dated June 3, 1996 between the Company, Edward Koppelman and  Theodore Venners (incorporated by reference to Exhibit 10.1 to our  Form 10-Q for the quarter ended June 30, 1996).**                                         |
| 10.7  |   | Non-qualified Stock  Option Agreement dated October 1, 1998 between the Company and Seth L.  Patterson (incorporated by reference to Exhibit 10.43 to our  Form 10-K for the year ended December 31, 1998).                                              |
| 10.8  |   | Stock Purchase Agreement  dated March 26, 1997 between the Company and Theodore Venners  (incorporated by reference to Exhibit 10.1 to our Form 10-Q for the  quarter ended March 31, 1999).**                                                           |
| 10.9  |   | 1999 Stock Incentive  Plan (incorporated by reference from Annex A-1 of the Company’s Proxy  Statement filed May 4, 1999).**                                                                                                                                       |
| 10.10 |   | 1996 Stock Option and  Incentive Plan of KFx Inc. (incorporated by reference to Exhibit 10.1 to  our Form 10-K for the year ended December 31, 2000).**                                                                                                       |
| 10.11 |   | Addendum to Blanket  Contract, No. 142072, dated May 1, 2001, Project—Cinergy NOx  Compliance Plan, Addendum dated July 24, 2001 (incorporated by reference  to Exhibit 10.3 to our Form 10-Q for the quarter ended  September 30, 2001). |
| 10.12 |   | Common Stock and Warrant  Purchase Agreement dated as of March 28, 2002 (incorporated by reference  to Exhibit 10.1 to our Form 8-K filed April 2, 2002).                                                                                                |
| 10.13 |   | Common Stock and Warrant  Purchase Agreement between KFx Inc. and the Investors dated April 30,  2002 (incorporated by reference to Exhibit 10.1 to our Form 8-K  filed May 7, 2002).                                                                    |
| 10.14 |   | Common Stock and Warrant  Purchase Agreement between KFx Inc. and the Investors dated July 1, 2002  (incorporated by reference to Exhibit 10.1 to our Form 8-K filed  July 3, 2002).                                                                     |
| 10.15 |   | Common Stock and Warrant  Purchase Agreement between KFx Inc. and the Investors dated July 19,  2002 (incorporated by reference to Exhibit 10.1 to our Form 8-K  filed July 24, 2002)                                                                    |
| 10.16 |   | Common Stock and Warrant  Purchase Agreement between KFx Inc. and the Investors dated August 21,  2002 (incorporated by reference to Exhibit 10.1 to our Form 8-K  filed August 28, 2002).                                                               |
| 10.17 |   | Waiver of Penalty  Warrants dated September 25, 2002 (incorporated by reference to  Exhibit 10.1 to our Form 8-K filed September 27, 2002).                                                                                                              |
| 10.18 |   | KFx Inc. 2004 Equity  Incentive Plan (incorporated by reference to Exhibit 10.1 to our  Form 8-K filed December 17, 2004).**                                                                                                                                  |
| 10.19 |   | Waiver Agreement dated  December 17, 2004 between KFx Inc. and Theodore Venners (incorporated by  reference to Exhibit 10.60 to our Form 10-K for the year ended  December 31, 2004).**                                                                  |
| 10.20 |   | Employment Agreement  between KFx Inc. and William G. Laughlin (incorporated by reference to  Exhibit 10.61 to our Form 8-K filed March 15, 2005).**                                                                                                          |
| 10.21 |   | Employment Agreement  between KFx Inc. and Robert I. Hanfling (incorporated by reference to  Exhibit 10.62 to our Form 10-Q for the quarter ended March 31,  2005).**                                                                                         |
| 10.22 |   | K-Fuel Projects  Participation and Development Agreement Dated May 5, 2005 (incorporated  by reference to Exhibit 10.63 to our Form 10-Q for the quarter  ended March 31, 2005).                                                                         |

46

----

 

| 10.23 |   | First Amendment to  Fourth Amended and Restated Investors’ Rights Agreement (incorporated by  reference to Exhibit 10.64 to our Form 10-Q for the quarter ended  March 31, 2005).                                                  |
|-------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.24 |   | Employment Agreement  between KFx Inc. and Mark S. Sexton (incorporated by reference to  Exhibit 10.65 to our Form 8-K filed October 25, 2005).**                                                                                       |
| 10.25 |   | Employment Agreement  between KFx Inc. and Kevin R. Collins (incorporated by reference to  Exhibit 10.66 to our Form 8-K filed October 25, 2005).**                                                                                     |
| 10.26 |   | KFx Inc. 2005 Employee  Stock Purchase Plan (incorporated by reference to Exhibit 10.67 to our  Form S-8 filed November 4, 2005).**                                                                                                     |
| 10.27 |   | Option Agreement dated  September 28, 2005 between Buckskin Mining Company and KFx Plant III,  LLC (incorporated by reference to Exhibit 10.68 to our Form 10-Q  for the quarter ended September 30, 2005).                        |
| 10.28 |   | Employment Agreement  between KFx Inc. and Theodore Venners (incorporated by reference to  Exhibit 10.69 to our Form 8-K filed December 22, 2005).**                                                                                    |
| 10.29 |   | Business Development and  Intellectual Property Rights Agreement, dated January 2, 2003  (incorporated by reference to Exhibit 99.1 to our Form 8-K filed January 31,  2006).                                                      |
| 10.30 |   | Addendum to Business  Development and Intellectual Property Rights Agreement, dated January 8,  2004 (incorporated by reference to Exhibit 99.2 to our Form 8-K  filed January 31, 2006).                                          |
| 10.31 |   | First Amendment to the  Business Development and Intellectual Property Rights Agreement, dated  May 21, 2004 (incorporated by reference to Exhibit 99.3 to our  Form 8-K filed January 31, 2006).                                  |
| 10.32 |   | Professional Services  Agreement, dated July 16, 2003 (incorporated by reference to  Exhibit 99.4 to our Form 8-K filed January 31, 2006).                                                                                         |
| 10.33 |   | Master Agreement between  KFx Plant II, LLC and Arch Coal, Inc. dated October 5, 2005  (incorporated by reference to Exhibit 10.74 to our Form 10-K for  the year ended December 31, 2005).                                   |
| 10.34 |   | Stock Purchase and  Warrants Agreement between KFx Inc. and Arch Coal, Inc. dated  October 5, 2005 (incorporated by reference to Exhibit 10.75 to our  Form 10-K for the year ended December 31, 2005).                       |
| 10.35 |   | Marketing, Distribution  and Transportation Logistics Service Agreement with DTE Coal  Services, Inc. dated June 6, 2006 (incorporated by reference to  Exhibit 10.79 to our Form 10-Q for the quarter ended  June 30, 2006). |
| 10.36 |   | Amendment to Master  Agreement Between KFx Plant II, LLC and Arch Coal, Inc. dated  June 29, 2006 (incorporated by reference to Exhibit 10.80 to our  Form 10-Q for the quarter ended June 30, 2006).                         |
| 10.37 |   | Net lease agreement  between Company and Seventeenth Street Plaza Realty Holding Company dated  November 17, 2006.*                                                                                                                               |
| 21.1  |   | Subsidiaries.*                                                                                                                                                                                                                                         |
| 23.1  |   | Consent of Deloitte & Touche LLP.*                                                                                                                                                                                                            |
| 24.1  |   | Powers of Attorney,  incorporated by reference to Signature page attached hereto.                                                                                                                                                                 |

47

----

 

| 31.1 |   | Certification Pursuant  to Rule 13a-14(a) or 15d-14(a) of the Exchange Act, as Adopted  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.* |
|------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.2 |   | Certification Pursuant  to Rule 13a-14(a) or 15d-14(a) of the Exchange Act, as Adopted  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.* |
| 32.1 |   | Certification Pursuant  to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002.*                                    |
| 32.2 |   | Certification Pursuant  to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002.*                                    |

----

*                    Filed herewith.

**             Management contractsand compensatory plans.

48

----

**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.

|                                | **EVERGREEN  ENERGY INC.** |
|--------------------------------|----------------------------|
| Date:  March 1, 2007 | By:                        | /s/ MARK S. SEXTON |
|                           |                       | Mark S. Sexton *Chief Executive Officer* |

 

**POWER OF ATTORNEY**

Know all persons by these presents, that each personwhose signature appears below constitutes and appoints Mark S. Sexton or KevinR. Collins as his true and lawful attorney-in-fact and agent, with full powerof substitution and resubstitution, for him and in his name, place, stead, inany and all capacities, to sign any and all amendments to this Report on Form 10-K,and to file the same, with all exhibits thereto, and other documents inconnection therewith, including all amendments thereto, with the Securities andExchange Commission, granting unto said attorney-in-fact and agent full powerand authority to do and perform each and every act and thing requisite andnecessary to be done in connection therewith, as fully to all intents andpurposes as he might or could do in person, hereby ratifying and confirming allthat said attorney-in-fact and agent or his substitute or substitutes, maylawfully do or cause to be done by virtue hereof.

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated.

| Date: March 1, 2007 |   | /s/ MARK S.  SEXTON                                                                                          |
|------------------------------------|--------|-------------------------------------------------------------------------------------------------------------------|
|                               |   | Mark S. Sexton, *Chief Executive Officer  and  Chairman of the Board of Directors  (Principal Executive Officer)* |
| Date: March 1, 2007 |   | /s/ THEODORE VENNERS                                                                                         |
|                               |   | Theodore Venners, *Chief  Technology Officer and Director*                                                        |
| Date: March 1, 2007           |   | /s/ DIANA L. KUBIK                                                                                           |
|                               |   | *Chief Financial Officer  (Principal Financial and Accounting Officer)*                                           |
| Date: March 1, 2007           |   | /s/ STANFORD M. ADELSTEIN                                                                                    |
|                               |   | Stanford M. Adelstein, *Director*                                                                                 |
| Date;  March 1, 2007          |   | /s/ ROBERT J. CLARK                                                                                               |
|                               |   | Robert J. Clark, *Director*                                                                                       |
| Date: March 1, 2007           |   | /s/ MANUEL H. JOHNSON                                                                                        |
|                               |   | Manuel H. Johnson, *Director*                                                                                     |

49

----

 

| Date: March 1, 2007 |   | /s/ ROBERT  S. KAPLAN       |
|--------------------------|--------|----------------------------------|
|                     |   | Robert S. Kaplan, *Director*     |
| Date: March 1, 2007 |   | /s/ JOHN V. LOVOI           |
|                     |   | John V. Lovoi, *Director*        |
| Date: March 1, 2007 |   | /s/ JACK C. PESTER          |
|                     |   | Jack C. Pester, *Director*       |
| Date: March 1, 2007 |   | /s/ JAMES S. PIGNATELLI     |
|                     |   | James S. Pignatelli, *Director*  |
| Date: March 1, 2007 |   | /s/ W. GRADY ROSIER         |
|                     |   | W. Grady Rosier, *Director*      |
| Date: March 1, 2007 |   | /s/ JAMES R. SCHLESINGER         |
|                     |   | James R. Schlesinger, *Director* |

 

50

----

**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

To the Board of Directors and Stockholders ofEvergreen Energy Inc.Denver, Colorado

We have audited the accompanying consolidated balancesheets of Evergreen Energy Inc. and subsidiaries (the “Company”) as of December 31,2006 and 2005, and the related consolidated statements of operations,stockholders’ equity, and cash flows for each of the three years in the periodended December 31, 2006. These financial statements are the responsibilityof the Company’s management. Our responsibility is to express an opinion onthese financial statements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statementspresent fairly, in all material respects, the financial position of EvergreenEnergy Inc. and subsidiaries as of December 31, 2006 and 2005, and theresults of their operations and their cash flows for each of the three years inthe period ended December 31, 2006, in conformity with accountingprinciples generally accepted in the United States of America.

As discussed in note 1 to the financial statements,the Company changed its method of accounting for stock-based compensation in2006.

We have also audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the effectiveness of the Company’s internal control overfinancial reporting as of December 31, 2006, based on the criteriaestablished in *Internal Control—Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commissionand our report dated February 28, 2007 expressed an unqualified opinion onmanagement’s assessment of the effectiveness of the Company’s internal controlover financial reporting and an unqualified opinion on the effectiveness of theCompany’s internal control over financial reporting.

Deloitte & Touche LLPDenver, ColoradoFebruary 28, 2007

F-1

----

**EVERGREEN ENERGY INC.Consolidated Balance Sheets**

| ** **                                                                                                               | ** ** | **December 31,**                                            | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------|------------|
| ** **                                                                                                               | ** ** | **2006**                                                         | ** ** | **2005** | ** ** |
| ** **                                                                                                               | ** ** | **(in thousands, except  per share amount)** | ** ** |
| **Assets**                                                                                                               |       |                                                             |       |   |   |
| Current:                                                                                                                 |       |                                                             |       |   |   |
| Cash and cash equivalents                                                                                                |       | $                                                                | 74,518     |   | $ | 28,793 |   |
| Accounts receivable                                                                                                      |       | 6,011                                                            |       | — |   |
| Marketable securities                                                                                                    |       | 9,758                                                            |       | — |   |
| Inventory                                                                                                                |       | 1,260                                                            |       | 64 |   |
| Prepaid and other assets                                                                                                 |       | 2,351                                                            |       | 900 |   |
| Total current assets                                                                                                     |       | 93,898                                                           |       | 29,757 |   |
| Property, plant  and equipment, net of accumulated depreciation                                                          |       | 106,432                                                          |       | 4,679 |   |
| Construction in  progress                                                                                                |       | 23,508                                                           |       | 71,612 |   |
| Mineral rights  and mine development, net of accumulated depletion                                                       |       | 21,787                                                           |       | — |   |
| Restricted cash                                                                                                          |       | 3,910                                                            |       | 5,198 |   |
| Deferred royalty  cost, less current portion                                                                             |       | 1,435                                                            |       | 1,461 |   |
| Patents, net of  accumulated amortization                                                                                |       | 1,134                                                            |       | 1,123 |   |
| Other assets                                                                                                             |       | 215                                                              |       | 342 |   |
|                                                                                                                     |       | $                                                                | 252,319    |   | $ | 114,172 |   |
| **Liabilities and Stockholders’  Equity**                                                                           |       |                                                             |       |   |   |
| Current  liabilities:                                                                                                    |       |                                                             |       |   |   |
| Accounts payable                                                                                                         |       | $                                                                | 7,695      |   | $ | 1,303 |   |
| Accrued liabilities                                                                                                      |       | 6,572                                                            |       | 8,365 |   |
| Other current liabilities                                                                                                |       | 475                                                              |       | 179 |   |
| Total current liabilities                                                                                                |       | 14,742                                                           |       | 9,847 |   |
| Deferred revenue,  less current portion                                                                                  |       | 6,732                                                            |       | 6,751 |   |
| Asset retirement  obligations                                                                                            |       | 5,626                                                            |       | 3,558 |   |
| Other  liabilities, less current portion                                                                                 |       | 235                                                              |       | 375 |   |
| Total liabilities                                                                                                        |       | 27,335                                                           |       | 20,531 |   |
| Commitments and contingencies (note—11)                                                                             |       |                                                             |       |   |   |
| Stockholders’  equity:                                                                                              |       |                                                             |       |   |   |
| Preferred stock, $.001 par value, shares authorized  20,000; none outstanding                                            |       | —                                                           |       | — |   |
| Common stock, $.001 par value, shares authorized  280,000; 82,690 and 68,143 shares issued and outstanding, respectively |       | 83                                                               |       | 68 |   |
| Additional paid-in capital                                                                                               |       | 428,298                                                          |       | 245,443 |   |
| Accumulated deficit                                                                                                      |       | (203,397                                                         | )          | (151,870 | ) |
| Total stockholders’ equity                                                                                          |       | 224,984                                                          |       | 93,641 |   |
|                                                                                                                     |       | $                                                                | 252,319    |   | $ | 114,172 |   |

 

See accompanying notes to the consolidated financial statements.

F-2

----

**EVERGREEN ENERGY INC.Consolidated Statements of Operations**

| ** **                                  | ** ** | **Years Ended December 31,**                                      | ** ** |
|---------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                                  | ** ** | **      2006      ** | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                  | ** ** | **(in thousands, except per share amounts)**            | ** ** |
| Operating revenues:                         |       |                                                                             |       |   |   |   |   |   |   |
| Mining                                      |       |                                                                             | $          | 35,937 |   |   | $ | — |   | $ | — |   |
| K-Fuel refined coal                         |       |                                                                             | 420        |   |   | — |   | — |   |
| Licensing                                   |       |                                                                             | 319        |   |   | 787 |   | 20 |   |
| Consulting and other                        |       |                                                                             | 34         |   |   | 197 |   | 8 |   |
| Total operating revenue                     |       |                                                                             | 36,710     |   |   | 984 |   | 28 |   |
| Operating  expenses:                        |       |                                                                             |       |   |   |   |   |   |   |
| Coal mining operating costs                 |       |                                                                             | 32,311     |   |   | — |   | — |   |
| General and administrative                  |       |                                                                             | 28,842     |   |   | 20,588 |   | 8,787 |   |
| Plant start-up costs                        |       |                                                                             | 26,332     |   |   | 1,522 |   | 154 |   |
| Depreciation, depletion and amortization    |       |                                                                             | 5,526      |   |   | 773 |   | 420 |   |
| Research and development                    |       |                                                                             | 1,438      |   |   | 1,605 |   | 696 |   |
| Cost of licensing and consulting revenue    |       |                                                                             | 134        |   |   | 401 |   | 5 |   |
| Bad debt and asset impairment               |       |                                                                             | 335        |   |   | 1,255 |   | 1,313 |   |
| Total operating expenses                    |       |                                                                             | 94,918     |   |   | 26,144 |   | 11,375 |   |
| Operating loss                              |       |                                                                             | (58,208    | ) |   | (25,160 | ) | (11,347 | ) |
| Other income (expense):                     |       |                                                                             |       |   |   |   |   |   |   |
| Other income (expense), net                 |       |                                                                             | 1,080      |   |   | (16 | ) | 223 |   |
| Interest income, net                        |       |                                                                             | 5,601      |   |   | 1,863 |   | 569 |   |
| Total other income                          |       |                                                                             | 6,681      |   |   | 1,847 |   | 792 |   |
| Net loss                                    |       |                                                                             | $          | (51,527 | ) |   | $ | (23,313 | ) | $ | (10,555 | ) |
| Basic and diluted net loss per share        |       |                                                                             | $          | (0.66 | ) |   | $ | (0.35 | ) | $ | (0.18 | ) |
| Weighted-average common  shares outstanding |       |                                                                             | 77,783     |   |   | 66,399 |   | 57,928 |   |

 

See accompanying notes to the consolidated financial statements.

F-3

----

**EVERGREEN ENERGY INC. Consolidated Statements of Stockholders’ EquityFor the Years ended December 31, 2006, 2005 and 2004**

| ** **                                                                  | ** ** | **Common Stock**   | ** ** | **Additional  Paid-in** | ** ** | **Accumulated** | ** ** | ** **  | ** ** |
|-----------------------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|-----------------|------------|-------------|------------|
| ** **                                                                  | ** ** | **Shares**              | ** ** | **Amounts**             | ** ** | **Capital**     | ** ** | **Deficit** | ** ** | **Total** | ** ** |
| ** **                                                                  | ** ** | **(in thousands)** | ** ** |
| Balance  January 1, 2004                                               |       | 52,952                  |       | $                       | 53         |            | $          | 149,047     |       |   | $ | (118,002 | ) |   | $ | 31,098 |   |
| Common stock issued on exercise of options and  warrants               |       | 7,649                   |       | 8                       |       | 22,566          |       |        | —     |   |   | 22,574 |   |
| Sale of common  stock                                                       |       | 4,245                   |       | 4                       |       | 47,351          |       |        | —     |   |   | 47,355 |   |
| Common stock and  warrants issued for services                              |       | 16                      |       | —                  |       | 3,631           |       |        | —     |   |   | 3,631 |   |
| Compensation  expense for directors, employees and other                    |       | (25                     | )          | —                  |       | 157             |       |        | —     |   |   | 157 |   |
| Net loss                                                                    |       | —                  |       | —                  |       | —          |       |        | (10,555    | ) |   | (10,555 | ) |
| Balance,  December 31, 2004                                            |       | 64,837                  |       | 65                      |       | 222,752         |       |        | (128,557   | ) |   | 94,260 |   |
| Common stock sold or issued on exercise of options and  warrants       |       | 3,239                   |       | 3                       |       | 11,696          |       |        | —     |   |   | 11,699 |   |
| Common stock and  warrants issued for services                              |       | 39                      |       | —                  |       | 8,756           |       |        | —     |   |   | 8,756 |   |
| Compensation  expense for directors and employees                           |       | 28                      |       | —                  |       | 2,239           |       |        | —     |   |   | 2,239 |   |
| Net loss                                                                    |       |                    |       |                    |       |            |       |        | (23,313    | ) |   | (23,313 | ) |
| Balance,  December 31, 2005                                            |       | 68,143                  |       | 68                      |       | 245,443         |       |        | (151,870   | ) |   | 93,641 |   |
| Common stock  issued on exercise of options and warrants               |       | 4,258                   |       | 4                       |       | 24,615          |       |        | —     |   |   | 24,619 |   |
| Common stock  issued in public offering, net of offering costs         |       | 8,050                   |       | 8                       |       | 144,551         |       |        | —     |   |   | 144,559 |   |
| Restricted stock  issued to escrow agent (related to certain executives)    |       | 2,000                   |       | 2                       |       | —          |       |        | —     |   |   | 2 |   |
| Common stock  issued related to acquisition                                 |       | 119                     |       | —                  |       | 2,194           |       |        | —     |   |   | 2,194 |   |
| Warrant extension                                                           |       | —                  |       | —                  |       | 1,692           |       |        | —     |   |   | 1,692 |   |
| Share-based  compensation expense related to employees and consultants |       | 120                     |       | 1                       |       | 9,803           |       |        | —     |   |   | 9,804 |   |
| Net loss                                                                    |       | —                  |       | —                  |       | —          |       |        | (51,527    | ) |   | (51,527 | ) |
| Balance,  December 31, 2006                                            |       | 82,690                  |       | $                       | 83         |            | $          | 428,298     |       |   | $ | (203,397 | ) |   | $ | 224,984 |   |

 

See accompanying notes to the consolidated financial statements.

F-4

----

**EVERGREEN ENERGY INC.Consolidated Statements of Cash Flows**

| ** **                                                                             | ** ** | **Years ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                             | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                             | ** ** | **(in thousands)**                     | ** ** |
| Operating activities:                                                                  |       |                                        |       |   |   |   |   |
| Net loss                                                                               |       | $                                           | (51,527    | ) | $ | (23,313 | ) | $ | (10,555 | ) |
| Adjustments to  reconcile net loss to cash (used in) provided by operating activities: |       |                                        |       |   |   |   |   |
| Share-based compensation expense to employees and  others                              |       | 11,498                                      |       | 10,995 |   | 3,788 |   |
| Depreciation, depletion and amortization                                               |       | 5,526                                       |       | 773 |   | 420 |   |
| Asset impairment and bad debt                                                          |       | 335                                         |       | 1,255 |   | 1,313 |   |
| Asset retirement obligation accretion                                                  |       | 229                                         |       | 103 |   | — |   |
| Other                                                                                  |       | (64                                         | )          | 2 |   | (35 | ) |
| Changes in  operating assets and liabilities:                                          |       |                                        |       |   |   |   |   |
| Accounts receivable                                                                    |       | (1,402                                      | )          | — |   | — |   |
| Accounts receivable from related party                                                 |       | —                                      |       | 750 |   | — |   |
| Inventory                                                                              |       | 941                                         |       | (64 | ) | — |   |
| Prepaids and other assets                                                              |       | (808                                        | )          | (327 | ) | (1,732 | ) |
| Deferred revenue and other current obligations                                         |       | 278                                         |       | (718 | ) | 7,481 |   |
| Accounts payable and accrued expenses                                                  |       | 4,559                                       |       | (1,527 | ) | 1,362 |   |
| Cash (used in)  provided by operating activities                                       |       | (30,435                                     | )          | (12,071 | ) | 2,042 |   |
| Investing activities:                                                                  |       |                                        |       |   |   |   |   |
| Purchases of construction in progress                                                  |       | (41,455                                     | )          | (47,084 | ) | (12,570 | ) |
| Purchases of property, plant and equipment                                             |       | (5,172                                      | )          | (851 | ) | (44 | ) |
| Cash paid for acquisition, net of cash received                                        |       | (36,913                                     | )          | (573 | ) | (523 | ) |
| Purchases of marketable securities                                                     |       | (17,733                                     | )          | — |   | — |   |
| Proceeds from marketable securities                                                    |       | 7,974                                       |       | — |   | — |   |
| Purchases of mineral rights and mine development                                       |       | (1,026                                      | )          | — |   | — |   |
| Restricted cash                                                                        |       | 1,287                                       |       | (1,798 | ) | (3,400 | ) |
| Other                                                                                  |       | 98                                          |       | 322 |   | 252 |   |
| Cash used in  investing activities                                                     |       | (92,940                                     | )          | (49,984 | ) | (16,285 | ) |
| Financing Activities:                                                                  |       |                                        |       |   |   |   |   |
| Proceeds from sale or exercise of options and  warrants                                |       | 24,619                                      |       | 11,699 |   | 22,574 |   |
| Proceeds from issuance of common stock, net of offering  costs                         |       | 144,559                                     |       | — |   | — |   |
| Issuance of common stock and warrants from private placement,  net of issuance cost    |       | —                                      |       | — |   | 47,355 |   |
| Payments on capital leases and note payable                                            |       | (78                                         | )          | (232 | ) | (6 | ) |
| Cash provided by  financing activities                                                 |       | 169,100                                     |       | 11,467 |   | 69,923 |   |
| Increase  (decrease) in cash and cash equivalents                                      |       | 45,725                                      |       | (50,588 | ) | 55,680 |   |
| Cash and cash  equivalents, beginning of year                                          |       | 28,793                                      |       | 79,381 |   | 23,701 |   |
| Cash and cash  equivalents, end of year                                                |       | $                                           | 74,518     |   | $ | 28,793 |   | $ | 79,381 |   |

 

See accompanying notes to the consolidated financial statements.

F-5

----

**EVERGREENENERGY INC.Notes to Consolidated Financial StatementsYears ended December 31, 2006, 2005 and 2004**

Unless the contextrequires otherwise, the terms “Evergreen,” “we,” “our,” and “us” refer toEvergreen Energy Inc. and its subsidiaries. All references to K-Fuel refer toour patented process and technology.

**(1) Business and Summary of SignificantAccounting Policies**

We are leveraging avertically integrated, coal-based platform to deliver combined energy,environmental and economic solutions, producing clean, efficient and affordableenergy. We intend to meet the specific needs of industrial, international andpublic utility market customers. We provide economical solutions toenvironmental emission standards compared to other emission standardalternatives. Our proprietary K-Fuel process uses heat and pressure tophysically and chemically transform high moisture, low-Btu coals, such assubbituminous coal and lignite, into a more energy efficient, lower-emissionfuel. The pre-combustion refinement of raw coal into K-Fuel refined coalreduces mercury content up to 70 percent and upon combustion, sulfurdioxide and nitrous oxides by significant amounts. Studies show that theincreased efficiency of K-Fuel refined coal will reduce carbon dioxideemissions by beneficial amounts.

On September 26,2006, in keeping with our strategy to use technology to create cleaner coal forgenerating power, we began doing business as Evergreen Energy Inc. The namechange received formal stockholder approval on November 9, 2006. The nameof Evergreen Energy Inc. captures our key attributes, namely our commitment todelivering clean energy and our strategy to vertically integrate our operations.

On April 3, 2006, wecompleted the acquisition of Buckeye Industrial Mining Company for a totalpurchase price of $39.1 million, including cash paid, stock issued, liabilitiesassumed and costs incurred in the acquisition. Buckeye’s primary business is tomine, process, blend and sell high quality coal to electric utilities and toindustrial and institutional end users. Buckeye also operates one of thelargest ash disposal facilities in the state of Ohio, disposing of up to onemillion tons of dry and conditioned ash per year**.**Theacquisition of Buckeye complements our strategy to transition from an energytechnology company into an energy production company.

We have completed theinitial construction and entered the start-up phase for our Fort Union plantand mine site in Wyoming’s Powder River Basin, or PRB, which is our first plantimplementing the K-Fuel process. In the third quarter of 2006, we beganshipping K-Fuel refined coal. Initial test burns of K-Fuel refined coalprovided us with positive results regarding the characteristics and quality ofthe K-Fuel refined coal.

***Consolidation.*****  **The accompanying consolidatedfinancial statements include the accounts of Evergreen Energy Inc. and ourwholly owned subsidiaries. All significant intercompany account balances,transactions and profits (loss) have been eliminated.

***Estimates.******  ***The preparationof financial statements in conformity with accounting principles generallyaccepted in the United States of America, or GAAP, requires us to makeestimates, assumptions and judgments that affect the reported amounts of assetsand liabilities and disclosure of contingent assets and liabilities as of thedate of the financial statements and the reported amounts of revenue andexpenses during the periods presented. We believe that the significantestimates, assumptions and judgments when accounting for items and matters suchas asset retirement obligations, mineral reserves, capitalized premining costs,capitalized plant costs, depletion, depreciation, amortization, assetvaluations, asset life, 

F-6

----

revenue,acquisitions, stock option and restricted stock grants and warrants, allowancefor bad debts for receivables, taxes, recoverability of assets, impairments,customer retention, reserves and other provisions are reasonable, based uponinformation available at the time they are made. Actual results could differfrom these estimates, making it possible that a change in these estimates couldoccur in the near term.

***Reclassifications.******  ***Certain prioryear balances have been reclassified to conform to the current yearpresentation.

***Fair value of financial instruments.******  ***The carryingamount of cash and cash equivalents, accounts receivable, marketablesecurities, other current assets, accounts payable, accrued liabilities andother current liabilities in the consolidated financial statements approximatefair value because of the short-term nature of the instruments.

***Cash and cash equivalents.*****  **Cash and cash equivalents consist ofhighly liquid investments that consist primarily of short-term money marketinstruments and overnight deposits with insignificant interest rate risk andoriginal maturities of three months or less at the time of purchase. We utilizeand invest with financial institutions that are sound and of high creditquality. Our investments are in low-risk instruments and we limit our creditexposure in any one institution or type of investment instrument based uponcriteria including creditworthiness.

***Marketable securities.******  ***Marketablesecurities consist of short-term commercial paper and Federal Government Agencyreset bonds with original maturities greater than three months but less thantwelve months. We have classified our marketable securities as held-to-maturityas we have the intent and ability to hold those securities to maturity. Suchsecurities are recorded at cost, which approximates fair value.

***Receivables and allowance for doubtful accounts.******  ***Accounts receivable and notereceivable, which is reflected in prepaids and other assets, are recorded attheir estimated net realizable value. As of December 31, 2006, threecustomers from our Mining segment accounted for 26%, 14% and 11% of totalaccounts receivable, respectively, while one customer from our Mining segment accountedfor 12% of total revenues from operations. The allowance for doubtful accountsis determined through an analysis of the past-due status of accounts receivableand assessments of risk regarding collectability. If the financial condition ofour customers were to deteriorate, resulting in an impairment of their abilityto make payments, additional allowances may be required. As of December 31,2006 and 2005, we have an allowance for doubtful accounts of $1.3 million, primarilyrelating to a note receivable.

***Inventory.***   Inventory,which includes washed or prepared coal, raw coal and inventory in transit aswell as consumable parts, materials and supplies, are stated at the lower ofcost or market. Our practice is to value coal based on the average cost methodby the applicable type of coal. Inventory consisted of $1.2 million ofwashed or prepared coal and $104,000 of spare parts and supplies as of December 31,2006 and $64,000 of spare parts and supplies as of December 31, 2005, allclassified as finished goods.

***Plant, property and equipment.******  ***Plant,property and equipment consists of our Fort Union plant, wash plant facility,buildings, furniture and fixtures, computers, vehicles, leasehold improvements,coal handling system, water treatment equipment, injection wells and land. Expendituresthat extend the useful lives of the assets or increase production capacity arecapitalized. Repairs and maintenance that do not extend the useful lives of theassets are expensed as incurred. We begin depreciation on property, plant andequipment assets once the assets are placed into service. Depreciation expenseis computed using the straight-line method over the estimated useful lives ofthe property and equipment or units-of-production method using total processedtonnage for our Fort Union plant.

***Construction in progress.****  *All costs that are directly relatedto the engineering, design, purchase or fabrication of plant equipment and areexpected to be used in a commercial K-Direct or K-Fuel plant project arecapitalized. All costs that are directly related to, or allocable to,developing a specific K-Direct or K-Fuel plant site are capitalized andseparately identified as belonging to that site. Costs incurred to develop coalmines or to expand the capacity of operating mines are capitalized. Costsincurred to 

F-7

----

maintain currentproduction capacity at a mine and exploration expenditures are charged tooperating costs as incurred. Employee-related costs directly related toconstruction are also capitalized during the construction phase. Any cost thatis not directly related to specific equipment or development of a specific siteis expensed.

***Mineral rights and mine development.******  ***A significant portion of ourcoal reserves are controlled through leasing arrangements. Costs to obtain coallands and leased mineral rights, including capitalized premining costs, aredepleted to operations using the units-of-production method based on tonsproduced utilizing only proven and recoverable reserves in the depletion baseand are assumed to have no residual value. Premining costs include drilling,permitting, county and state filing fees and the initial overburden removal. Also,included in mineral rights are the costs to establish the related assetretirement obligations. The leases have primary terms ranging from 3 to10 years and substantially all of the leases contain provisions that allowfor automatic extension once mining commences and for as long as some miningactivity continues.

***Restricted cash.******  ***We haverestricted cash set aside as collateral pledged toward our asset retirementobligation and to secure certain other obligations. Until the asset retirementobligation is relieved and our other obligations are fulfilled, the cash willremain restricted.

***Patents.******  ***All costsincurred to the point when a patent application is to be filed are expensed asincurred as research and development. Patent application costs, generally legalcosts, thereafter incurred are capitalized. The costs of defending andmaintaining patents are expensed as incurred. Patents are amortized over theexpected useful lives of the patents, which is generally 17 to 20 years fordomestic patents and 5 to 20 years for foreign patents.

***Health care costs.***   Weare self-insured, subject to a stop-loss policy, for individuals and allparticipants as a group, for our employee’s health care costs. The liabilityfor outstanding medical costs has been estimated based on historical claims andis included in accrued liabilities in our consolidated balance sheet.

***Asset retirement obligations.******  ***We value allasset retirement costs, for which we have a legal obligation, and record allsuch costs as liabilities with an equivalent amount added to the asset cost anddepreciated over an appropriate period or depleted using actual tons mined oractual tons produced. The liability is then accreted over time by applying aninterest method of allocation to increase the liability. We have identifiedlegal retirement obligations related to our project site near Gillette, Wyomingand our surface and deep mines in Ohio.

***Exploration costs.***   Mineralexploration costs are expensed as incurred. When it has been determined that itis economically feasible to extract coal and the permitting process has beeninitiated, the costs incurred to further delineate and develop the mine areconsidered premining costs and are included in construction in progress in ourconsolidated balance sheets.

***Long-lived assets.******  ***We evaluatelong-lived assets based on estimated future undiscounted net cash flowswhenever significant events or changes in circumstances occur that indicate thecarrying amount may not be recoverable. If that evaluation indicates that animpairment has occurred, a charge is recognized to the extent the carryingamount exceeds the discounted cash flows or fair values of the asset, whicheveris more readily determinable. In addition, we capitalized certain costs relatedto investigating potential sites for future facilities. We evaluate the statusof these potential sites and if any site has been abandoned or we anticipatethat it will be abandoned, we write-off all associated costs.

***Revenue.******  ***We recognizerevenue when there is persuasive evidence of an arrangement, generally when anagreement has been signed, all significant obligations have been satisfied, thefee is fixed or determinable, and collection is reasonably assured. Anyup-front fees received are deferred and recognized over the provision ofspecific deliverables as defined in the agreements. As our history related tocustomer relationships is limited, we may be required to change the estimatedperiod over which we recognize our revenue as more information becomesavailable. Arrangements that include multiple deliverables are 

F-8

----

evaluated todetermine whether the elements are separable based on objective evidence. Ifthe elements are deemed separable, total consideration is allocated to eachelement and the revenue associated with each element is recognized as earned. Ifthe elements are not deemed separable, total consideration is deferred andrecognized ratably over the longer of the contractual period or the expectedcustomer relationship period.

We recognize revenue fromcoal sales at the time risk of loss passes to the customer, either at ourshipping point or upon delivery, depending on contractual terms. When salesinclude delivery to the customer, transportation costs are billed by us to ourcustomers. We had $5.9 million of transportation costs included in cost ofsales and $5.9 million of revenue included in mining revenue for the year endedDecember 31, 2006. Ash disposal revenue is recognized when coal combustionbi-products are received at our ash disposal facility.

***Brokered coal.***   We act as an agent in certaintransactions involving the brokering of coal produced by others. As wegenerally do not take title to the coal or bear the risk of loss, we haverecognized the net amount of profit related to the transactions in ourconsolidated statements of operations in mining revenue.

***Research and development.******  ***Costs incurredto advance, test, or otherwise modify our proprietary technology or develop newtechnologies are considered research and development costs until such time asthe modification or new technology is ready for protection through patent andare expensed when incurred. These costs are primarily comprised of costsassociated with the operation of our laboratories, pilot plants and operationsof certain of our subsidiaries, including salaries and wages, supplies, repairand maintenance, general office expenses and professional fees. Once patentsare applied for, certain of these costs were capitalized as a cost of obtainingthe patents. Additionally, as our Fort Union plant has been placed intoservice, certain of these costs are now considered plant start-up costs and areexpensed as incurred.

***Income taxes.******  ***We follow theliability method of accounting for income taxes under which deferred tax assetsand liabilities are recognized for future tax consequences. A deferred taxasset or liability is computed for both the expected future impact ofdifferences between the financial statement and tax basis of assets andliabilities and for the expected future tax benefit to be derived from tax lossand tax credit carryforwards. Valuation allowances are established whennecessary to reduce deferred tax assets to the amount expected to be realized,based upon an assessment of both negative and positive evidence, in future taxreturns. Tax rate changes are reflected in the period such changes are enacted.

***Deferred income taxes.***   Wehave provided a full valuation reserve related to our substantial deferred taxassets. In the future, if sufficient evidence of our ability to generate futuretaxable income becomes apparent, we may be required to reduce this valuationallowance, resulting in income tax benefits in our consolidated statement ofoperations. We evaluate the deferred tax assets annually and assess the needfor the valuation allowance.

***Comprehensive income.******  ***Comprehensiveincome includes all changes in equity during a period from non-owner sources. Duringeach of the three years ended December 31, 2006, 2005 and 2004, we had notransactions that were required to be reported as adjustments to determinecomprehensive income.

***Advertising costs.******  ***We recognize advertising expense whenincurred. Advertising expense was $116,000, $3,000 and $0 for the years ended December 31,2006, 2005 and 2004, respectively.

***Accounting for stock grants, options and warrants.***   OnJanuary 1, 2006, we adopted Statement of Financial Accounting Standards123R, “Share-Based Payments”, or SFAS 123R. We issue stock grants, options andwarrants to employees, board of directors and consultants in connection withour various business activities. These are accounted for in accordance with theprovisions of SFAS 123R and Emerging Issues Task Force Abstract No. 96-18,“Accounting for Equity Instruments That are Issued to Other Than Employees forAcquiring or in Conjunction with Selling, Goods or Services” as well as otherauthoritative 

F-9

----

accountingpronouncements. We are required to make estimates of the fair value of therelated instruments and the period benefited.

***Stock-based compensation.******  ***Prior to theadoption of SFAS 123R, we accounted for share-based payment awards inaccordance with Accounting Principals Board 25 “Accounting for Stock Issued toEmployees”, which generally provided that no compensation expense was recordedin connection with the granting of employee and non-employee directors stockoptions if the options were granted at prices at least equal to the fair valueof the common stock at date of grant. Stock options granted to employees andnon-employee directors were measured using the Black-Scholes option pricingmodel and reflected in our proforma disclosures pursuant to Statement ofFinancial Accounting Standard 123 “Accounting for Stock-Based Compensation.”Stock options and other share-based payments granted to non-employees wereaccounted for in accordance with SFAS No. 123, and Emerging Issues TaskForce Abstract No. 96-18, “Accounting for Equity Instruments Thatare Issued to Other Than Employees for Acquiring, or in Conjunction withSelling Goods or Services.” Accordingly, stock options granted to non-employeeswere measured using the Black Scholes option pricing model and reflected in theconsolidated financial statements under guidance of SFAS 123 over the expectedservice period.

Hadcompensation expense for our stock options granted to employees and directorsbeen recognized based on the fair value over the vesting period for the awardsconsistent with the method of SFAS 123, our pro forma net loss and net loss pershare would have been reported as follows:

| ** **                                                                                  | ** ** | **Year ended  December 31, 2005**                      | ** ** | **Year ended  December 31, 2004** | ** ** |
|---------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                  | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Net loss, as  reported                                                                      |       |                                                                  | $          | (23,313                                          | )          |   |   | $ | (10,555 | ) |   |
| Less: Share-based  employee compensation expense included in reported net loss              |       |                                                                  | 1,230      |                                             |       |   | 229 |   |   |
| Total share-based  employee compensation expense determined under a fair value based method |       |                                                                  | (7,338     | )                                                |       |   | (2,781 | ) |   |
| Pro forma net  loss                                                                         |       |                                                                  | (29,421    | )                                                |       |   | (13,107 | ) |   |
| Basic and diluted  net loss per share, as reported                                          |       |                                                                  | $          | (0.35                                            | )          |   |   | $ | (0.18 | ) |   |
| Pro forma basic and  diluted net loss per share                                             |       |                                                                  | $          | (0.44                                            | )          |   |   | $ | (0.23 | ) |   |

 

Forpro forma calculations, the fair value of each stock option grant is estimatedon the date of the grant using the Black-Scholes option-pricing model with thefollowing weighted-average assumptions used for the grants:

| ** **                   | ** ** | **Year ended  December 31, 2005** | ** ** | **Year ended  December 31, 2004** | ** ** |
|------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|
| Weighted-average:            |       |                                             |       |                                             |       |   |   |   |   |
| Risk free interest rate      |       |                                             | 3.89       | %                                                |       |   | 4.08 | % |   |
| Expected option life (years) |       |                                             | 6.7        |                                             |       |   | 7.0 |   |   |
| Expected volatility          |       |                                             | 67         | %                                                |       |   | 70 | % |   |
| Expected  dividends          |       |                                             | None       |                                             |       |   | None |   |   |

 

The pro forma amountsreflected above may not be representative of the effects on our reported netincome or loss in future years because the number of future shares to be issuedis not known and assumptions used to determine fair value vary significantly.

***Net loss per commonshare.******  ***Basic net loss per common share isbased on the weighted-average number of common shares actually outstandingduring each respective period and reduced by shares that are subject to acontingency. During the fourth quarter of 2005, we granted 2 million shares ofrestricted stock to our Chief Executive Officer, or CEO, Chief TechnologyOfficer, or CTO, and Chief Operating Officer, or COO, which immediately vestupon the attainment of certain performance or market criteria, 

F-10

----

but no later than theseventh anniversary of the date of the agreement. Such shares were transferredto an escrow agent during the first quarter of 2006. As a result of thetransfer, such shares are reflected as outstanding in the ConsolidatedFinancial Statements. However, as the vesting criteria have not yet beenattained, they are excluded from the net loss per share calculations due to thecontingent status of the shares.

The calculation of diluted net earnings per commonshare adds the weighted-average number of potential common shares outstandingto the weighted-average common shares outstanding, as calculated for basic lossper share, except for instances in which there is a net loss. Our totalincremental potential common shares outstanding as of December 31, 2006,2005 and 2004 were 16.1 million, 22.9 million and 19.4 million, respectively,and are comprised of outstanding stock options, restricted stock grants andwarrants to purchase our common stock. All potential common shares outstandinghave been excluded from diluted net loss per common share because the impact ofsuch inclusion on a net loss would be anti-dilutive.

***Recently adoptedaccounting pronouncements.******  ***InSeptember 2006, the U.S. Securities and Exchange Commission, or SEC,released Staff Accounting Bulletin No. 108, or SAB No. 108, “FinancialStatement Misstatements.” SAB No. 108 expresses the SEC staff’s viewregarding the process of quantifying financial statement misstatements. TheInterpretations in SAB No. 108 are being issued to address diversity inpractice in quantifying financial statement misstatements and the potentialunder current practice for the build up of improper amounts on the balancesheet. SAB No. 108 is effective for annual financial statements coveringthe first fiscal year ending after November 15, 2006. The adoption of thispronouncement did not have a material impact on our financial position orresults our operations.

In May 2005, the Financial Accounting StandardsBoard, or FASB, as part of an effort to conform to international accountingstandards, issued SFAS No. 154, “Accounting Changes and Error Corrections,”which was effective for us beginning on January 1, 2006. SFAS No. 154requires that all voluntary changes in accounting principles be retrospectivelyapplied to prior financial statements as if that principle had always beenused, unless it is impracticable to do so. When it is impracticable tocalculate the effects on all prior periods, SFAS No. 154 requires that thenew principle be applied to the earliest period practicable. The adoption ofthis pronouncement did not have a material impact on our financial position orresults of operations.

***Recently issuedaccounting pronouncements.******  ***In September 2006,the Financial Accounting Standards Board issued SFAS No. 157, “Fair ValueMeasurement”. This Statement defines fair value, establishes a framework formeasuring fair value in generally accepted accounting principles, and expandsdisclosures about fair value measurements. SFAS No. 157 applies underother accounting pronouncements that require or permit fair value measurements,the FASB having previously concluded in those accounting pronouncements thatfair value is the relevant measurement attribute. Accordingly, this statementdoes not require any new fair value measurements. However, for some entities,the application of this statement will change current practice. SFAS No. 157is effective for financial statements issued for fiscal years beginning after November 15,2007, and interim periods within those fiscal years. We are in the process ofevaluating the impacts, if any, of adopting this pronouncement.

In July 2006, theFASB issued Interpretation No. 48, “Accounting for Uncertainty in IncomeTaxes-an Interpretation of FASB Statement No. 109,” (“FIN 48”) whichclarifies the accounting for uncertainty in tax positions. This Interpretationrequires that we recognize, in our financial statements, the impact of a taxposition if that position is more likely than not of being sustained on audit,based on the technical merits of the position. The provisions of FIN 48 areeffective as of January 1, 2007. We are in the process of evaluating theimpacts, if any, of adopting this pronouncement.

F-11

----

**(2) Acquisitions**

***Buckeye Acquisition***

On April 3,2006, we completed the acquisition of Buckeye, for a total purchase price of$39.1 million, consisting of $35.0 million in cash and our common stock valuedat $2.2 million. We incurred $1.0 million in acquisition costs and reimbursedBuckeye’s former parent $900,000 for cost incurred relating to capitalprojects. Buckeye’s primary business is to mine, process, blend and sell coalto electric utilities and to industrial and institutional end users. Buckeye alsooperates one of the largest ash disposal facilities in the state of Ohio,disposing of up to one million tons of dry and conditioned ash per year. Webelieve the acquisition will add value through access to Buckeye’s establishedmarkets, infrastructure and coal reserves. The expected benefits of theacquisition include the addition of an experienced coal marketing and miningteam and cash flow. Their operations have been included in our consolidatedfinancial statements for the nine months ended December 31, 2006, as ofthe effective purchase date of April 3, 2006.

Theacquisition of Buckeye has been accounted for as a purchase in accordance withStatement of Financial Accounting Standards No. 141, “BusinessCombinations, or SFAS 141, with us being treated as the acquirer. Following isa summary of the estimated fair values of the assets acquired and liabilitiesassumed as of the effective date of the acquisition (in thousands):

| Cash                                                                                |   | $      | — |   |
|-------------------------------------------------------------------------------------|--------|--------|--------|--------|
| Accounts  receivable                                                                |   | 4,649  |   |
| Inventory                                                                           |   | 2,138  |   |
| Other current and  long-term assets                                                 |   | 743    |   |
| Property, plant  and equipment                                                      |   | 7,812  |   |
| Ash disposal  facility                                                              |   | 7,557  |   |
| Mineral rights  and mine development                                                |   | 20,720 |   |
| Construction in  progress                                                           |   | 1,442  |   |
| Total assets  acquired                                                              |   | 45,061 |   |
| Less: Current liabilities assumed                                              |   | 4,182  |   |
|          Asset  retirement obligations |   | 1,772  |   |
| Net purchase  price                                                                 |   | $      | 39,107 |   |

 

Proforma acquisition information represents our unaudited results of operations asif the acquisition had occurred on January 1, 2005.

| ** **                            | ** ** | **December 31,**   | ** ** |
|---------------------------------------|------------|-------------------------|------------|
| ** **                            | ** ** | **2006**                | ** ** | **2005** | ** ** |
| ** **                            | ** ** | **(in thousands)** | ** ** |
| Revenue                               |       | $                       | 49,766     |   | $ | 50,751 |   |
| Net loss                              |       | $                       | (51,284    | ) | $ | (18,342 | ) |
| Basic and diluted  net loss per share |       | $                       | (0.66      | ) | $ | (0.28 | ) |

 

***MR&E Acquisition***

MR&E LLC, a research and engineering firm focusedon thermal process engineering, including the upgrading and processing of cleancoal, was acquired due to its significant expertise in thermal processengineering. We acquired all of the outstanding membership interests effective March 1,2005 for cash of $656,000, including cash received of $83,000. Their operationshave been included in our financial statements as of the effective purchasedate of March 1, 2005.

F-12

----

The operating results,including revenue and net income for the years ended December 31, 2005 and2004 were insignificant. Therefore, pro-forma results as if the acquisition hadoccurred at the beginning of the period are not presented. As of August 1,2006, MR&E was legally merged into KFx Operations, a wholly ownedsubsidiary. 

***Landrica Acquisition***

On May 21, 2004, we acquired all of the outstandingstock of Landrica Development Company from Wyodak Development Corporation forcash of $523,000 and assumption of an asset retirement obligation of $2.7million. The results of Landrica have been included in the consolidatedfinancial statements from the date of acquisition. Landrica owns a coalmine andrelated assets that include land, buildings, coal handling equipment, arailroad loop and other pieces of equipment and property. See furtherdiscussion of our asset retirement obligation in Note—3 Construction inProgress, Mineral Rights and Mine Development and Property, Plant &Equipment.

Since Landrica was notoperating the mine during 2004 the operating results, including revenue and netincome were immaterial. Therefore, proforma results as if the acquisition hadoccurred at the beginning of the respective period are not presented.

**(3) Constructionin Progress, Mineral Rights and Mine Development and Property, Plant &Equipment**

Constructionin progress consisted of the following:

| ** **                                | ** ** | **December 31,**   | ** ** |
|-------------------------------------------|------------|-------------------------|------------|
| ** **                                | ** ** | **2006**                | ** ** | **2005** | ** ** |
| ** **                                | ** ** | **(in thousands)** | ** ** |
| Fort Union plant  and operating equipment |       | $                       | 4,478      |   | $ | 67,889 |   |
| Train loadout  silo                       |       | —                  |       | 2,410 |   |
| Future plant  sites and equipment         |       | 13,981                  |       | — |   |
| Mine and site  improvements               |       | 2,597                   |       | — |   |
| Mining equipment  refurbishment           |       | 2,307                   |       | 1,313 |   |
| Other                                     |       | 145                     |       | — |   |
| Total  construction in progress           |       | $                       | 23,508     |   | $ | 71,612 |   |

 

Total constructionin progress includes: 

·       $2.6million and $7.6 million of accrued costs as of December 31, 2006 and2005, respectively, and

·       $726,000of capitalized asset retirement cost as of December 31, 2005.

In 2006, we impaired assets of $295,000 relating tocertain sites specific costs, which we were evaluating for a future K-Fuel facility.

In 2004, we impaired assets of $1.3 million related tocertain site-specific and plant size-specific costs incurred associated withevaluating three other locations for our Fort Union plant. 

F-13

----

Propertyplant and equipment consisted of the following:

| ** **                                                      | ** ** | ** **          | ** ** | **December 31,**   | ** ** |
|-----------------------------------------------------------------|------------|---------------------|------------|-------------------------|------------|
| ** **                                                      | ** ** | **Lives**           | ** ** | **2006**                | ** ** | **2005** | ** ** |
| ** **                                                      | ** ** | **(in years)** | ** ** | **(in thousands)** | ** ** |
| Fort Union plant  and equipment                                 |       |                | —     |                    |       | $ | 84,093 |   | $ | — |   |
| Machinery and  equipment                                        |       |                | 3-15       |                    |       | 12,189 |   | 4,355 |   |
| K-Fuel  demonstration facility                                  |       |                | —     |                    |       | 10,924 |   | 10,924 |   |
| Ash facility and  wash plant                                    |       |                | 5-10       |                    |       | 8,526 |   | — |   |
| Other                                                           |       |                | 3-30       |                    |       | 6,792 |   | 1,541 |   |
| Total                                                           |       |                |       |                    |       | 122,524 |   | 16,820 |   |
| Less accumulated  depreciation                                  |       |                |       |                    |       | (16,092 | ) | (12,141 | ) |
| Property, plant and  equipment, net of accumulated depreciation |       |                |       |                    |       | $ | 106,432 |   | $ | 4,679 |   |

 

During the third quarter 2006, we placed our FortUnion plant into service and as a result moved $84.1 million of costs fromconstruction in progress to property, plant and equipment. We are depreciatingall Fort Union plant assets on a units-of-production method, based on actualtonnage processed through the plant. We are depreciating all other property,plant and equipment on the straight line method over the estimated useful lifeof the assets. Our K-Fuel demonstration facility is fully depreciated. 

Property,plant and equipment includes:

·       $919,000of accounts payable and accrued liabilities as of December 31, 2006.

·       $794,000of capitalized asset retirement cost as of December 31, 2006.

Mineral rights are comprised of leases and minedevelopment from the acquisition of Buckeye and our mine site in Wyoming. Costsare capitalized during the premining phase and are depleted using theunits-of-production method based on actual tons mined. We entered theproduction phase in a portion of our Gillette mine site and mined and sold rawcoal in the second quarter of 2006. As we have entered the production phase, wehave placed a portion of our Gillette mine site into service and are depletingthe mine site using the units-of-production method based on tonnage mined. Aportion of our Gillette mine site was moved from mine and site improvements inconstruction in progress to mineral rights and mine development in ourconsolidated balance sheet in the second quarter of 2006. As we are incurringcosts to continue developing a new site at our Gillette mine, we arecapitalizing these new costs as mine and site improvements and they arerecorded in construction in progress on our consolidated balance sheet.

Depreciation and depletionexpense was $5.3 million, $563,000, and $268,000 in 2006, 2005 and 2004,respectively

F-14

----

**Asset Retirement Obligation**

Ourasset retirement obligations relate to our surface and deep mines in Ohio, ourGillette, Wyoming mine site, and the improvements we have made at the site onwhich our Fort Union plant and train loadout silo are located. The followingtable reconciles the change in the asset retirement obligation during the year:

| ** **                         | ** ** | **Changes in  Asset  Retirement  Obligations** | ** ** |
|------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                         | ** ** | **(in thousands)**                             | ** ** |
| Balance at  January 1, 2006   | ** ** |                                                | $          | 3,558 |   |   |
| Liability incurred                 |       |                                                | 1,818      |   |   |
| Liability settled                  |       |                                                | —     |   |   |
| Accretion                          |       |                                                | 250        |   |   |
| Balance at  December 31, 2006 | ** ** |                                                | $          | 5,626 |   |   |

 

The liability incurred in2006 primarily relates to the acquisition of Buckeye, for which we haveallocated the asset retirement cost to the underlying assets based the fairvalue using an expected cash flow approach, in which multiple cash flowscenarios that reflected the range of possible outcomes and a credit-adjustedrisk-free rate were applied. The liabilities are then accreted over time byapplying an interest method of allocation. As the assets are placed intoservice we are depreciating and depleting the related assets on aunits-of-production method based on actual tonnage processed and actual tonnagemined. 

**(4) Patents**

Patentsconsisted of the following:

| ** **                            | ** ** | ** **          | ** ** | **December 31,**   | ** ** |
|---------------------------------------|------------|---------------------|------------|-------------------------|------------|
| ** **                            | ** ** | **Lives**           | ** ** | **2006**                | ** ** | **2005** | ** ** |
| ** **                            | ** ** | **(in years)** | ** ** | **(in thousands)** | ** ** |
| Domestic and  foreign patents granted |       |                | 5 to 20    |                    |       | $ | 1,944 |   | $ | 1,880 |   |
| Domestic and  foreign patents pending |       |                | —     |                    |       | 350 |   | 274 |   |
| Total patents                         |       |                |       |                    |       | 2,294 |   | 2,154 |   |
| Less accumulated  amortization        |       |                |       |                    |       | (1,160 | ) | (1,031 | ) |
| Net book value                        |       |                |       |                    |       | $ | 1,134 |   | $ | 1,123 |   |

 

Patent amortizationexpense, including amortization of existing patents, was $178,000, $210,000 and$152,000 in 2006, 2005 and 2004, respectively. We estimate amortization expenseof approximately $130,000 for each of the years ending December 31, 2007,2008, and 2009.

Most of our early patentsare near their expiration dates. Our laterpatents will not expire until 2018 through 2021. While our currentissued patent protection covers what we believe are certain unique aspects ofour K-Fuel process as it is currently conducted, not all of the claims we filedwere allowed. The application has been re-filed to conform to the examiner’scomments and we expect some of the claims to be granted as re-filed.

**(5) Note Receivable**

Through a series of transactions Pegasus Technologies Inc.became indebted to us for $2.7 million. The note receivable bears interest at7% and payments are due pursuant to an assignment of certain cash paymentsreceived by Pegasus. We have rights to collect payments under this note fromPegasus and to demand payment upon certain events of default. As of December 31,2006 and 2005 the net balance of this note receivable was $87,000 and $463,000,respectively.

F-15

----

During the year ended December 31, 2005, wedetermined that Pegasus might not have sufficient contracts to continue to meetthis obligation. Therefore, we recorded an allowance for bad debt for the notereceivable of $1.3 million. Despite this allowance, we retain all of our rightsto collect payments under this note from Pegasus and to demand payment uponcertain events of default. As of December 31, 2006, we believe the netremaining balance of $87,000 is collectible.

In 2003, we completed anequity exchange transaction pursuant to which we transferred our interest inPegasus for full ownership of K-Fuel LLC, now part of a wholly owned subsidiarynamed KFx Technology, LLC. As a part of the exchange transaction, anintercompany working capital loan from us to Pegasus with an outstandingbalance of $9.4 million was exchanged for a contingent earn-out agreement of upto $9.4 million in the aggregate, plus accrued interest (prime rate plus 500basis points), payable out of a portion of future cash flows generated byPegasus. Due to the contingent nature of this potential stream of future cashflows, we did not recognize an asset or any associated income at the time ofthe exchange transaction. As a result of a transfer of ownership interests in 2006,the earn-out provisions were triggered and we received a payment of $1.1million from Pegasus as a payment in full satisfaction of the $9.4 millionobligation, which is reflected in other income.

**(6) DeferredRoyalty Costs**

Deferredroyalty costs were comprised of deferred costs related to the issuance oflicense for K-Fuel and a one-time payment made to Mr. Edward Koppelman,the inventor of the K-Fuel process.

| ** **                                                         | ** ** | **December 31,**   | ** ** |
|--------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                         | ** ** | **2006**                | ** ** | **2005** | ** ** |
| ** **                                                         | ** ** | **(in thousands)** | ** ** |
| Deferred royalty  costs related to issuance of licenses for K-Fuel |       | $                       | 1,015      |   | $ | 1,019 |   |
| Payment to Mr. Koppelman                                      |       | 425                     |       | 447 |   |
| Total deferred  royalties                                          |       | 1,440                   |       | 1,466 |   |
| Less current  portion                                              |       | (5                      | )          | (5 | ) |
| Deferred royalty costs                                             |       | $                       | 1,435      |   | $ | 1,461 |   |

 

The deferred royalty costs associated with theissuances of licenses for K-Fuel represent the licensing fees paid to theKoppelman estate, described below. Such costs are amortized over the sameperiod as the deferred revenue related to the underlying contracts.

In 1996, we entered into a royalty amendment agreementwith Mr. Koppelman, or subsequent to his death, the Koppelman estate, thatreduced the cap for payments by $500,000 to $75.2 million and set the royaltypercentage at 25% of our worldwide licensing and royalty revenue, as defined inthe agreement. In addition, Mr. Koppelman provided us an indemnificationagainst potential claims made by certain parties if we licensed the technology.We paid Mr. Koppelman a total of $500,000 pursuant to the agreement as aprepayment. The $500,000 has no specified expiration date and recognition issolely dependent upon the issuance of licenses. As a result, the payment hasbeen reflected in deferred royalty costs in our Consolidated Balance Sheets. Weare amortizing the $500,000 payment as license revenue is generated. As of December 31,2006, there is $73.0 million remaining under the cap. Also, see discussion inNote 11—Commitments and contingencies—Royalties and Other Rights.

Mr. Theodore Venners,our CTO, is entitled to 50% of net royalties paid to the Koppelman estate. In December 2004,Mr. Venners entered into a waiver agreement with us, under which he agreedto assign his right to payments that became due to him from the estate inconnection with the license arrangement entered into in 2004. Pursuant to thewaiver, Mr. Venners was obligated to remit any proceeds he receivedrelated to this license agreement to us. In February 2005, we paid thepreviously accrued $1.9 million due to the estate and the estate remitted Mr. Venners’portion directly back to us.

F-16

----

**(7) Accruedliabilities**

Accruedliabilities consist of:

| ** **                                | ** ** | **December 31,**   | ** ** |
|-------------------------------------------|------------|-------------------------|------------|
| ** **                                | ** ** | **2006**                | ** ** | **2005** | ** ** |
| ** **                                | ** ** | **(in thousands)** | ** ** |
| Employee-related                          |       | $                       | 2,402      |   | $ | 1,315 |   |
| Services or goods  received, not invoiced |       | 2,240                   |       | 6,129 |   |
| Use tax                                   |       | 889                     |       | 802 |   |
| Other                                     |       | 1,041                   |       | 119 |   |
| Total accrued  liabilities                |       | $                       | 6,572      |   | $ | 8,365 |   |

 

Employee-related includespaid time off, payroll and bonuses. Services or goods received not invoicedprimarily consists of goods and services at our Fort Union plant. Use taxrepresents accrued sales and use tax primarily related to our Fort Union plant.

**(8) Stockholders’Equity**

On February 1, 2006, we filed a shelfregistration statement on Form S-3 with the SEC. Under thisuniversal shelf registration statement, we have the capacity to offer and sellsecurities from time to time, including common stock, preferred stock, debtsecurities, warrants and units. Again on February 1, 2006, we filed apreliminary prospectus supplement to the shelf registration statement to sell 5million shares in a public offering. On February 3, 2006, we filed anamendment increasing the number of shares to 7 million (plus an over allotmentof 1,050,000). The final prospectus was declared effective on February 3,2006.

On February 8, 2006, we sold 7 million shares ofcommon stock at a price to the public of $18.75 per share pursuant to afollow-on common stock offering. On February 27, 2006, the underwritersexercised in full their over allotment option, purchasing an additional 1.1million shares of common stock. Including the over-allotment, the offeringtotaled approximately 8.1 million shares of common stock at a price of $18.75,resulting in net proceeds of $144.6 million after deducting the underwritingdiscounts and commissions and estimated offering expenses. We used the proceedsfrom this offering to fund the acquisition of Buckeye, the completion of ourFort Union plant and general corporate purposes.

On April 3, 2006, we completed the acquisition ofBuckeye, for a total purchase price of $39.1 million, consisting of $35.0million in cash and our common stock valued at approximately $2.2 million. Weincurred $1.0 million in acquisition costs and reimbursed Buckeye’s formerparent $900,000 for cost incurred relating to capital projects.

During the fourth quarter of 2005, we sold 191,000shares of our common stock to Arch Coal Inc. for proceeds of $3 million, whichwere used for general corporate purposes. The shares were sold in connectionwith the execution of two agreements with Arch, which (1) allowed us toevaluate the potential of constructing and operating a plant at their CoalCreek mine site located in the Powder River Basin and (2) required us toissue warrants. We issued 2.5 million warrants to Arch to purchase our commonstock. See further discussion of the warrants in Note 10—Warrants.

Based on discussions with Arch Coal, we mutuallyagreed not to further extend these agreements. The first agreement expired on September 30,2006 and the warrant agreement expired on October 31, 2006. As marketconditions and other circumstances change we may enter into new agreements withArch Coal.

During the second quarter of 2004, we sold 245,400shares of common stock to Arch Coal for gross proceeds of $2 million andincurred $5,000 in placement costs. We used these proceeds for generalcorporate purposes. On November 24, 2004, we sold 4 million shares of ourcommon stock, in a private placement to a limited number of accreditedinvestors, at $12.00 per share, resulting in net proceeds of 

F-17

----

$45.4 million. We used$39.2 million of the proceeds for future plant and project development and $6.2 millionfor working capital needs.

During 2002, weentered into a series of transactions with three investor groups whereby weissued a total of 6.8 million shares of our common stock and 14.4 millionwarrants. The investors have certain rights pursuant to an investor rightsagreement, including the right for one group to select two persons to serve onour Board of Directors. As a result, Richard Spencer, manager of WestcliffCapital Management LLC, was added to our Board of Directors. In the thirdquarter of 2006, Mr. Spencer resigned from the board of directors topursue other business opportunities with us. He has not yet been replaced. Thisprovision remains in force until the investors hold less than 400,000 shares ofour common stock. During 2005, we renegotiated the investor rights agreementexecuted in connection with the issuance of the shares in 2002 to provide usgreater flexibility in constructing and operating plants. Subsequent to therenegotiation, we and the investors have the following rights:

·       Oneinvestor group continues to have the right to select two persons to serve onour Board of Directors.

·       Allinvestors may develop or participate, with up to a 15% interest, in the greaterof K-Fuel commercial projects with an annual output capacity of 50 million tonsper year or six commercial plants. Such right will not be in effect until wehave plants in operation or have binding contracts to construct plants forwhich the aggregate designed or projected annual output is at least 25 milliontons per year.

·       Wecan participate in projects developed by the investors, other than in India, upto a 50% interest.

·       Theinvestors retain the right to develop in India as long as certain conditionsare met.

·       Theinvestors are obligated to pay certain royalty and license fees for theseplants, if constructed.

The rights expire 20 yearsafter the 25 million tons annual capacity threshold is reached or earlier, ifthe investors exercise their rights to 50 million tons of annual capacity.

**(9) Stock Options,Stock Grants and Employee Benefit Plans**

We have five qualified stock plans, under which 12.5million shares were reserved and 4.2 million shares are available for grant asof December 31, 2006. Pursuant to these plans we granted stock options,restricted stock and stock appreciation rights to directors, employees andoutside consultants. In the past, we have also issued stock related to variouscompensation and fee agreements with certain employees that were not issuedfrom our five plans. These grants were made pursuant to certain American StockExchange Rules. All but one of the five qualified plans has been registeredwith the Securities and Exchange Commission. The non-plan awards are generallyregistered with other registration statements that we periodically file. Thefive qualified stock plans and the non-plan awards are collectively referred toas “the plans.”

These plans are administered by the CompensationCommittee of our Board of Directors, or the Committee, which has the authorityto determine the specific terms of awards under these plans, including exerciseprice and vesting term, subject to certain restrictions of the Internal RevenueCode regarding incentive stock options. The Committee can accelerate thevesting of an outstanding award at its sole discretion. Certain of the planscontain provisions requiring the acceleration of vesting of all outstandingawards in the event of a change in control, as defined in those plans. Stockoptions granted under the plans generally expire not more than ten years fromthe date of grant

In the future we plan togrant restricted stock to our employees and stock options to our non-employeedirectors.

F-18

----

***Stock-Based Compensation***

Effective January 1, 2006, we adopted Statementof Financial Accounting Standards No. 123R, or SFAS 123R, which requiresthe measurement and recognition of compensation expense for all share-basedpayment awards to non-employee directors and employees including stock options,restricted stock grants and stock purchases related to our employee stockpurchase plan, or ESPP, based on estimated fair values. SFAS 123R supersedesour previous accounting under Accounting Principles Board Opinion No. 25and related interpretations for periods beginning January 1, 2006. In March 2005,the SEC issued Staff Accounting Bulletin No. 107, or SAB 107, relating toSFAS 123R; we have applied the provisions of SAB 107 in our adoption ofSFAS 123R.

We adopted SFAS 123R, using the modified prospectivetransition method, which requires the application of the accounting standard asof January 1, 2006. Share-based compensation expense recognized under SFAS123R for the year ended December 31, 2006 was $9.8 million, which relatedto (i) stock options, (ii) restricted stock grants and (iii) thediscount and the fair value calculation for our “look back” provision foremployee stock purchases under our ESPP. In accordance with the modifiedprospective transition method, our Consolidated Financial Statements for priorperiods, including the years ended December 31, 2005 and 2004, have notbeen restated to reflect the impact of SFAS 123R.

Under the guidance of SFAS 123R we are required toestimate the fair value of share-based payment awards on the grant date. We usethe Black-Scholes option pricing model to calculate the fair value of stockoptions. Restricted stock is valued based upon the closing price of our commonstock on the date of grant. The fair value is recognized as expense andadditional paid-in capital over the requisite service period, which is usuallythe vesting period, if applicable, in our consolidated financial statements. Priorto the adoption of SFAS 123R, we accounted for share-based payment awards inaccordance with APB 25, which generally provided that no compensation expensewas recorded in connection with the granting of employee and non-employeedirectors stock options if the options were granted at prices at least equal tothe fair value of the common stock at date of grant. Stock options granted toemployees and non-employee directors were measured using the Black-Scholesoption pricing model and reflected in our pro-forma disclosures pursuant toSFAS 123. Stock options and other share-based payments granted to non-employeeswere accounted for in accordance with SFAS No. 123 and Emerging IssuesTask Force Abstract No. 96-18. Accordingly, stock options granted tonon-employees were measured using the Black Scholes option pricing model andreflected in the consolidated financial statements under guidance of SFAS 123over the expected service period.

Share-based compensation expense recognized during thecurrent period is based on the value of the portion of share-based paymentawards that are ultimately expected to vest. SFAS 123R also requires us toestimate forfeitures at the time of grant in order to estimate the amount ofshare-based awards that will ultimately vest. Historically, the majority ofoption grants outstanding were to executives, consultants and to our CTO. Wehave estimated the forfeiture rate on each of these groups based uponhistorical data. We granted restricted stock awards to non-executive employeesduring the year ended December 31, 2006. We have based the forfeiture ratefor this stratification on the historical data of the executive stratification,as we have no historical data for non-executive employees. Lastly, during thefourth quarter of 2005, we granted restricted stock awards to our CEO, CTO andto our COO, which contain accelerated vesting provisions. Our best estimate offorfeitures for these grants is that they all will vest and, as a result, wehave not reduced our expense by estimated forfeitures. In prior periods, ourpro-forma disclosure under SFAS 123 did not include an estimate offorfeitures and, instead, accounted for forfeitures as they occurred.

We usethe Black-Scholes option-pricing model to value stock options. The Black-Scholesmodel requires the use of a number of assumptions including volatility of ourstock price, the weighted average risk-free rate, and the weighted averageexpected life of the options. As we do not pay dividends, the 

F-19

----

dividend rate variable in the Black-Scholes model iszero. The following table summarizes the assumptions used to value stockoptions grant in 2006:

| ** **                   | ** ** | **Year Ended   December 31, 2006** | ** ** |
|------------------------------|------------|--------------------------------------------------------|------------|
| Weighted-average:            |       |                                                   |       |   |   |
| Risk free interest rate      |       |                                                   | 4.78       | % |   |
| Expected option life (years) |       |                                                   | 3          |   |   |
| Expected volatility          |       |                                                   | 57         | % |   |
| Expected  dividends          |       |                                                   | None       |   |   |

 

The volatility assumption is based on the historicalweekly price data of our stock over a period equivalent to the expected life ofthe options. We evaluated whether there were factors during the period whichwere unusual and which would distort the volatility figure used to estimatefuture volatility and concluded that there were no such factors.

The risk-free interest rate assumption is based uponthe note principal U.S. Treasury Strips rates determined at the date of grant. Theexpected life of the stock options represents the life of the option up to theexpiration date. This is based upon an analysis of the historical exercisepattern of our employees and directors.

Thefollowing table reflects our recorded share-based compensation for the yearended December 31, 2006 under SFAS 123(R):

| ** **                                                      | ** ** | **Year Ended  December 31, 2006** | ** ** |
|-----------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                      | ** ** | **(in thousands)**                     | ** ** |
| Share-based  compensation expense included in reported net loss |       |                                        | $          | 9,803 |   |   |
| Earnings per share  effect of share-based compensation expense  |       |                                        | $          | (0.13 | ) |   |

 

We have recognized $9.8 million, $2.2 million and$157,000 in non-cash compensation expense related to our employees anddirectors for the years ended December 31, 2006, 2005 and 2004, respectively,which are reflected in general and administrative expenses. We have recognized$0, $3.0 million and $3.6 million in stock-based compensation expense relatedto non-employees for the years ended December 31, 2006, 2005 and 2004,respectively, which are reflected in general and administrative expenses andrelated to services performed. The more significant transactions and expensesare described below.

On November 10, 2005, the Financial AccountingStandards Board issued FASB Staff Position No. SFAS 123R-3, “TransitionElection Related to Accounting for Tax Effects of Share-Based Payment Awards.”The alternative transition method includes simplified methods to establish thebeginning balance of the additional paid-in capital pool, or APIC pool, relatedto the tax effects of employee share-based compensation, and to determine thesubsequent impact on the APIC pool and Consolidated Statements of Cash Flows ofthe tax effects of employee share-based compensation awards that areoutstanding upon adoption of SFAS 123(R). We have calculated a winfall of $4.0million, which represents the excess of stock-based compensation taken on taxreturns over what we had recorded in the proforma disclosure in ourConsolidated Financial Statements. Since we have fully allowed for our deferredtax asset, we were not required to record this difference in our ConsolidatedFinancial Statements

F-20

----

***Stock Option Grants***

Stockoptions granted under the plans to employees generally vest over five yearsfrom the grant date until fully vested. Stock options granted to directorsusually vest 100% on date of grant. All stock options granted during each of thethree years ended December 31, 2006 were at exercise prices that wereequal to or greater than the fair market value of our common stock on the dateof grant. The following table summarizes our stock option activity, includingboth plan and non-plan options, for the three-year period ended December 31,2006:

| ** **                                                             | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                             | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                             | ** ** | **Total**                                   | ** ** | **Weighted-  Average  Exercise  Price  Per Share** | ** ** | **Total** | ** ** | **Weighted-  Average  Exercise  Price  Per Share** | ** ** | **Total** | ** ** | **Weighted-  Average  Exercise  Price  Per Share** | ** ** |
| ** **                                                             | ** ** | **(shares in thousands)**         | ** ** |
| Outstanding, beginning of period                        |       | 4,678                                       |       |   | $ | 10.36 |   |   | 4,771 |   |   | $ | 5.26 |   |   | 4,453 |   |   | $ | 3.16 |   |   |
| Granted                                                                |       | 50                                          |       |   | 12.31 |   |   | 2,200 |   |   | 11.50 |   |   | 1,800 |   |   | 9.18 |   |   |
| Exercised                                                              |       | (555                                        | )          |   | 5.91 |   |   | (1,813 | ) |   | 3.65 |   |   | (1,395 | ) |   | 3.48 |   |   |
| Expired and forfeited                                                  |       | (129                                        | )          |   | 9.40 |   |   | (480 | ) |   | 7.75 |   |   | (87 | ) |   | 2.75 |   |   |
| Outstanding, end of period                                        |       | 4,044                                       |       |   | $ | 10.86 |   |   | 4,678 |   |   | $ | 10.36 |   |   | 4,771 |   |   | $ | 5.26 |   |   |
| Options exercisable and expected to vest as of  December 31, 2006 |       | 3,667                                       |       |   | $ | 10.51 |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Options exercisable,  end of period                               |       | 2,115                                       |       |   | $ | 8.49 |   |   | 2,033 |   |   | $ | 6.52 |   |   | 3,251 |   |   | $ | 3.73 |   |   |

 

Planand non-plan stock options outstanding and exercisable as of December 31,2006 are summarized below:

| ** **                                  | ** ** | **Stock Options Outstanding** | ** ** | **Stock Options Exercisable** | ** ** |
|---------------------------------------------|------------|-----------------------------------------|------------|-----------------------------------------|------------|
| **Range of Exercise Prices** | ** ** | ** **                              | ** ** | **Number of  Shares**              | ** ** | **Weighted  Average  Remaining  Contractual  Life (Years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| ** **                                  | ** ** | **(in thousands)**                 | ** ** | ** **                              | ** ** | ** ** | ** ** | **(in thousands)** | ** ** | ** ** | ** ** |
| $2.75 - $3.00                               |       |                                    | 293        |                                    |       |   | 3.2 |   |   |   | $ | 2.75 |   |   |   | 283 |   |   |   | $ | 2.75 |   |   |
| $3.01 - $6.00                               |       |                                    | 720        |                                    |       |   | 2.6 |   |   |   | 4.06 |   |   |   | 660 |   |   |   | 4.07 |   |   |
| $6.01 - $9.00                               |       |                                    | 250        |                                    |       |   | 3.8 |   |   |   | 8.13 |   |   |   | 250 |   |   |   | 8.13 |   |   |
| $9.01 - $12.00                              |       |                                    | 280        |                                    |       |   | 4.2 |   |   |   | 9.55 |   |   |   | 100 |   |   |   | 9.90 |   |   |
| $12.01 - $15.00                             |       |                                    | 2,091      |                                    |       |   | 5.1 |   |   |   | 13.71 |   |   |   | 732 |   |   |   | 13.52 |   |   |
| $15.01-  $18.71                             |       |                                    | 410        |                                    |       |   | 5.1 |   |   |   | 16.58 |   |   |   | 90 |   |   |   | 16.77 |   |   |
|                                        |       |                                    | 4,044      |                                    |       |   | 4.4 |   |   |   | 10.86 |   |   |   | 2,115 |   |   |   | 8.46 |   |   |
|                                             |            |                                         |            |                                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

F-21

----

Thefollowing table summarizes the grant date fair value of our stock optionactivity, including both plan and non-plan options, during the year ended December 31,2006:

| ** **                                     | ** ** | **Total**                           | ** ** | **Weighted-Average  Grant Date   Fair Value** | ** ** |
|------------------------------------------------|------------|-------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                     | ** ** | **(shares in thousands)** | ** ** |
| Non-vested, beginning of period |       | 2,645                               |       |                                                         | $          | 12.10 |   |   |
| Granted                                        |       | 50                                  |       |                                                         | 5.14       |   |   |
| Vested                                         |       | (637                                | )          |                                                         | 12.62      |   |   |
| Expired and  forfeited                         |       | (129                                | )          |                                                         | 9.72       |   |   |
| Non-vested, end of  period                |       | 1,929                               |       |                                                         | $          | 13.53 |   |   |

 

The aggregate intrinsic value of stock options is thedifference between our closing stock price on December 31, 2006 and theexercise price multiplied by the number of options. The total intrinsic valueof options exercised were $4.6 million, $21.8 million and $7.6 million for theyears ended December 31, 2006, 2005 and 2004, respectively.

Of the 4.0 million options outstanding1.5 million had exercise prices less than the closing price of our commonstock at December 31, 2006. These options had an aggregate intrinsic valueof $6.9 million at December 31, 2006.

Of the 2.1 million options exercisable 1.2 millionhad exercise prices less than the closing price of our common stock atDecember 31, 2006. These options had an aggregate intrinsic value of$6.2 million at December 31, 2006.

Of the 3.7 million options exercisable andexpected to vest 1.5 million options had exercise prices less than theclosing price of our common stock at December 31, 2006. These options had anaggregate intrinsic value of $6.9 million at December 31, 2006.

We have granted 50,000, 2.2 million and 1.8 millionshares of stock options to our employees, directors and consultants for theyears ended December 31, 2006, 2005 and 2004, respectively. Theweighted-average grant date fair value of options granted during the yearsended December 31, 2005 and 2004 were $14.32 and $9.18, respectively.

The total fair value of stock options vested duringthe years ended December 31, 2006, 2005 and 2004 were $5.4 million, $3.4 millionand $5.7 million, respectively

As of December 31, 2006, total unrecognizedcompensation expense related to nonvested stock options was $12.4 million.This expense is expected to be recognized over a weighted-average period of 2.88 years.

During the year ended December 31, 2005, wegranted 250,000 stock options to our CTO that vested upon achievement ofcertain operational criteria related to our Fort Union plant. The operationalcriteria for our Fort Union plant were achieved in March 2006, at which time20% vested and 20% vest annually thereafter on the anniversary date of thegrant. We recorded $543,000 and $281,000 of non-cash expense related to thisaward during the years ended December 31, 2006 and 2005, respectively

In February 2005, we granted a total of 1 millionoptions to our President. All of the options qualified as inducement options asdefined by the American Stock Exchange, were not issued pursuant to a plan andvest 20% per year beginning in January 2006.

In November 2004 andagain in February 2005, the Committee voted to extend the exercise periodsfor vested options for a period of 90 days after the resignation of a directorand our former President and Chief Operating Officer, respectively. As a resultof these extensions, we recorded general and 

F-22

----

administrativeexpense of $136,000 in 2004 related to the extension of 40,000 options and$906,000 in 2005 related to the extension of 120,000 options. The expenserepresents the difference between the fair value of the options on the date theextension was granted and the exercise price.

***Restricted StockGrants***

In the fourth quarter of2005, the committee began to grant restricted stock, rather than stock options,to employees and officers. Restricted stock grants issued to employees underthe plans generally vest over three years from grant date until fully vested. Restrictedstock grants to certain executive officers, contain accelerated vestingcriteria and are more fully described below. In the fourth quarter of 2006, webegan to grant restricted stock awards to employees that contain time andperformance vesting criteria. These grants usually vest over a three yearperiod with one-third vesting each year, only if the agreed upon performancecriteria have been achieved. In the future, we plan to continue to grant acombination of time-based and time-and-performance-based restricted stockawards.

Thefollowing table summarizes our restricted stock grant activity for the yearsended December 31, 2006, 2005 and 2004:

| ** **                                                     | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                     | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                     | ** ** | **(in thousands)**                     | ** ** |
| Outstanding  beginning of period                               |       |                                        | 2,100      |   |   |   | — |   |   |   | — |   |   |
| Granted                                                        |       |                                        | 296        |   |   |   | 2,240 |   |   |   | — |   |   |
| Vested                                                         |       |                                        | (20        | ) |   |   | (140 | ) |   |   | — |   |   |
| Expired and forfeited                                          |       |                                        | (12        | ) |   |   | — |   |   |   | — |   |   |
| Outstanding end  of the period                                 |       |                                        | 2,364      |   |   |   | 2,100 |   |   |   | — |   |   |
| Outstanding and  expected to vest as of December 31, 2006 |       |                                        | 2,303      |   |   |   |   |   |   |   |   |   |   |

 

The aggregate intrinsicvalue of restricted stock outstanding at December 31, 2006 was $23.5 million.

The aggregate intrinsicvalue of restricted stock outstanding and expected to vest at December 31,2006 was $22.9.

The weighted-averageremaining contractual term of restricted stock outstanding at December 31,2006 was 5.37 years.

We have granted 296,000and 2.2 million shares of restricted stock to our employees, directors andconsultants for the years ended December 31, 2006 and 2005, respectively. Theweighted-average grant date fair value of restricted stock granted during theyears ended December 31, 2006 and 2005 were $15.43 and $15.28,respectively.

The total fair value ofrestricted stock vested during the years ended December 31, 2006 and 2005were $358,000 and $2.4 million, respectively

As of December 31,2006, total unrecognized compensation expense related to outstanding restrictedstock grants was $28.4 million. This expense is expected to be recognizedover a weighted-average period of 5.37 years.

F-23

----

Duringthe fourth quarter of 2005, we granted 2.0 million shares of restricted stockto our CEO, COO and our CTO. The 1.4 million issued to the new CEO and COOwere not issued pursuant to a plan as they qualified as inducement awards underthe American Stock Exchange rules. The 600,000 issued to our CTO were grantedfrom one of our plans. Full vesting of the stock will occur upon attainment ofany of the following:

·       theaverage closing price of our common stock for the trading days within any 90consecutive calendar day period equals or exceeds $45.05 per share;

·       annualgross revenues increase to $1 billion;

·       annualnet operating cash flow increases to $250 million; or

·       changein control, as defined in the agreement occurs after the two-year anniversaryof the agreement.

Further, partial vesting, as defined in the agreement,may occur if certain lesser targets are achieved. Unless sooner vested pursuantto the incentive targets described above, the restricted stock shares willfully vest on the seventh anniversary of the date of the agreement so long asthe individual is continually employed. Related to these awards, we recognized$4.4 million and $679,000 of non-cash expense during the years ended December 31,2006 and 2005, respectively. Pursuant to the employment agreements, we wererequired to transfer the 2 million shares to an escrow agent; such transferoccurred in February 2006.

During the year ended December 31,2005, we granted 140,000 shares of restricted stock to a consultant forservices rendered. As a result, we recorded $2.4 million of non-cashcompensation during the year ended December 31, 2005. These restrictedshares vested immediately upon grant, however at the request of the consultant100,000 shares were issued in January 2006 and the remaining 40,000 sharewere issued in January 2007. Additionally, in March 2005, theCommittee approved the grant of 100,000 shares of restricted stock to ourPresident, vesting 20% per year beginning January 2006. We recognized$331,000 of non-cash compensation expense related to the restricted stock ineach of the years ended December 31, 2006 and 2005.

***Employee Stock Purchase Plan***

During the third quarterof 2005, the Committee and shareholders approved the establishment of anEmployee Stock Purchase Plan. We have reserved 100,000 shares of our commonstock that are eligible for issuance to employees. Until June 30, 2006,employees were able contribute to the plan, subject to certain maximumcontributions, and be eligible for a 15% discount from the lower of the marketprice on November 1, 2005 or June 30, 2006, the first purchase datepursuant to the plan. After June 30, 2006, our employees are eligible formonthly purchases at the month end market price less the employer 15% match.

F-24

----

**(10) Warrants**

Associatedwith various financing and other transactions and professional serviceagreements, we have issued transferable warrants to purchase common stock,which generally immediately vest. The following table summarizes theoutstanding warrant activity for years ended December 31, 2006, 2005, and2004:

| ** **                             | ** ** | **Year Ended December 31,**               | ** ** |
|----------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                             | ** ** | **2006**                                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                             | ** ** | **Number of  Potentially  Exercisable Shares** | ** ** | **Number of  Potentially  Exercisable Shares** | ** ** | **Number of  Potentially  Exercisable Shares** | ** ** |
| Outstanding,  beginning of period |       |                                                     | 15,856     |   |   |   | 14,564 |   |   |   | 18,903 |   |   |
| Granted                                |       |                                                     | —     |   |   |   | 2,547 |   |   |   | 1,915 |   |   |
| Exercised                              |       |                                                     | (3,703     | ) |   |   | (1,255 | ) |   |   | (6,254 | ) |   |
| Expired and cancelled        |       |                                                     | (2,547     | ) |   |   | — |   |   |   | — |   |   |
| Outstanding, end of period   |       |                                                     | 9,606      |   |   |   | 15,856 |   |   |   | 14,564 |   |   |
| Expiration                             |       |                                                     | 2007-2010  |   |   |   | 2006-2010 |   |   |   | 2005-2010 |   |   |
| Exercise price  per share              |       |                                                     | $          | 2.75 - $8.52 |   |   |   | $ | 2.64 - $20.69 |   |   |   | $ | 2.64 - $11.00 |   |   |
|                                        |            |                                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

As discussed above, we issued 2.5 million warrants in2005 to Arch Coal to purchase our common stock at prices ranging from $15.69 to$20.69. We recognized $5.8 million of general and administrative expense duringthe year ended December 31, 2005 related to the warrants. The expense wasestimated using a Black-Scholes option-pricing model using an expected life of10 months, a dividend yield of zero, expected volatility of 56% and a risk freeinterest rate of 4.1%.

In the second quarter of 2006, we extended these agreementswith Arch Coal, to allow additional time for the evaluation of the project,including the underlying agreements. In connection with the extension, theexpiration date of the warrants was also extended and, pursuant to SFAS 123R,we were required to recognize an additional $1.7 million of non-cash expensefor the year ended December 31, 2006. The expense was estimated using a Black-Scholes option pricingmodel using an expected life of four months, a dividend yield of zero, expectedvolatility of 55% and a risk free interest rate of 5.22%.

On June 25, 2004, weentered into agreements to raise capital proceeds from two of our warrantholders. In return for 1.3 million additional warrants at an exercise price of$11.00 per share, these warrant holders agreed to exercise 3.9 million of theirwarrants before their contractual expiration date. On June 28, 2004, wereceived $7.2 million of proceeds from the exercise of 2.6 million of thesewarrants. On July 22, 2004, we received $3.4 million of proceeds from theexercise of the remaining 1.3 million warrants from the other warrant holder. Asof December 31, 2006, all of these warrants were exercised.

F-25

----

**(11) Commitmentsand Contingencies**

**Payment Obligations**

Thefollowing table summarizes our future commitments as of December 31, 2006:

| ** **                           | ** ** | **Payments due by period** | ** ** |
|--------------------------------------|------------|-------------------------------------------|------------|
| ** **                           | ** ** | **2007**                                  | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
| ** **                           | ** ** | **(in thousands)**                   | ** ** |
| Operating leases                     |       | $                                         | 1,183      |   | $ | 1,421 |   | $ | 1,437 |   | $ | 1,301 |   | $ | 1,105 |   |   | $ | 26,060 |   |   | $ | 32,507 |   |
| Capital lease and  other obligations |       | 100                                       |       | 16 |   | 16 |   | 8 |   | — |   |   | — |   |   | 140 |   |
| Purchase  commitment obligations     |       | 25,268                                    |       | 26,637 |   | 9,459 |   | — |   | — |   |   | — |   |   | 61,364 |   |
| Consulting and  service commitments  |       | 4,020                                     |       | 3,045 |   | 240 |   | 240 |   | — |   |   | — |   |   | 7,545 |   |
| Total commitments                    |       | $                                         | 30,571     |   | $ | 31,119 |   | $ | 11,152 |   | $ | 1,549 |   | $ | 1,105 |   |   | $ | 26,060 |   |   | $ | 101,556 |   |

 

This table does not include accounts payable, accruedexpenses nor asset retirement obligations, which are reported in our December 31,2006 Consolidated Balance Sheet. We generally have not included any obligationin which either party has the right to terminate except as discussed below. Additionally,we have not included royalty payments, as we cannot presently determine whensuch payments will be made as such payments are based upon our receipt of cashfor licensing and royalties.

We are obligatedunder non-cancelable operating leases with initial terms exceeding one yearrelating to office space. Rent expense in the years ended December 31,2006, 2005 and 2004 was $415,000, $242,000 and $226,000, respectively. Includedin operating leases is a 50 year port dock lease on the Ohio River, we have theright to cancel this lease upon six months written notice, if we cancelled thislease as of December 31, 2006, we would be obligated to pay only $250,000of the $25.0 million included in the table.

Purchase commitments include our 700,000 pound perhour Circulating Fluidized Bed coal-fired boiler island that is beingconstructed. We have the right to cancel this at any time with a 17.5% penalty,if we cancelled this as of December 31, 2006, we would be obligated to payonly $10.7 million of the $61.1 million included in the table.

Consulting and servicecommitments include agreements with consultants to advise us on proposedlegislation and regulations and advocate our interests before the U.S. Congressand regulatory agencies, these agreements are for 18 months. Also included inconsulting and service agreements is an agreement for technical and engineeringservices in which we have the right to cancel upon six months written notice. Ifwe cancelled this agreement as of December 31, 2006, we would be obligatedto pay only $1.8 million of the $6.3 million included in the table. Effective February 15,2007, we amended and restated a service agreement for technical and engineeringservices, as result of this, if we were to cancel early we would be required topay up to a $5 million termination fee.

***Litigation***

Except as provided below, we are not engaged in anymaterial legal proceedings to which we or any of our subsidiaries are a party.

On April 14, 2005, wewere notified that we were named in a Demand for Arbitration by Ohio basedUltramax Corporation and its affiliate, Decision Control Analysis Corporation (“Ultramax”).In April 2002, Ultramax granted a License Agreement to PegasusTechnologies, Ltd., which we owned at the time, for certain software which wasto be used for the optimization of industrial and other processes, 

F-26

----

includingprocesses used in the electric power generation industry. In May, 2006, a settlementwas reached to resolve the dispute. We did not incur any of the settlementcosts.

***Royalties and Other Rights***

We owe royalty payments to parties related to certainrights that support our patents and our proprietary technology, primarilyrelated to Mr. Edward Koppelman the inventor of the K-Fuel process. Asdescribed in further detail in Note 6—Deferred Royalty Costs.

Wehave granted certain rights and limited licenses for the use of certain K-Fueltechnology. The following is a summary of the significant parties and therights:

·       Pursuantto an exchange transaction in 2003, we gave licenses for up to three plants,with certain limitations on the location of the plants, each plant having amaximum annual capacity of three million tons per year. The counterparty isobligated to pay certain royalty and license fees for these three plants, ifconstructed.

·       Asdescribed in further detail in Note 8—Stockholders’ Equity, certain investorshave the right to, among other things, develop or participate in the greater ofK-Fuel commercial projects with an annual output capacity of 50 million tonsper year or six commercial projects, subject to certain qualifications.

F-27

----

**(12) Segments**

Withthe acquisition of Buckeye, we have expanded our segments and our segmentpresentation. We have identified three segments: our Plant and Licensingsegment, Mining segment and Operating segment. Our results of operations areevaluated and allocations of capital resources are based upon the overalloperations of these segments. The Plant and Licensing segment representsrevenue and costs related to the use and application of our proprietary,patented K-Fuel process and our mine site in Gillette, Wyoming. The Miningsegment represents our mining operations at our Buckeye location and includescertain marketing personnel, the ash disposal facility and the blendingfacility. The Operating segment is comprised of all other operations, primarilyour headquarters and related operations. Our operations are principallyconducted in the United States

| ** **                                         | ** ** | **Year ended December 31, 2006** | ** ** |
|----------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                         | ** ** | **Plant and  Licensing**                        | ** ** | **Mining** | ** ** | **Operating** | ** ** | **Total** | ** ** |
| Operating revenues:                                |       |                                                 |       |   |   |   |   |   |   |
| Mining coal sales                                  |       | $                                                    | —     |   | $ | 31,207 |   | $ | — |   | $ | 31,207 |   |
| Mining ash sales                                   |       | —                                               |       | 4,730 |   | — |   | 4,730 |   |
| K-Fuel refined coal                                |       | 420                                                  |       | — |   | — |   | 420 |   |
| Licensing                                          |       | 319                                                  |       | — |   | — |   | 319 |   |
| Consulting and other                               |       | —                                               |       | — |   | 34 |   | 34 |   |
| Total operating revenue                            |       | 739                                                  |       | 35,937 |   | 34 |   | 36,710 |   |
| Operating  expenses:                               |       |                                                 |       |   |   |   |   |   |   |
| Coal mining operating costs                        |       | —                                               |       | 32,311 |   | — |   | 32,311 |   |
| General and administrative                         |       | —                                               |       | — |   | 28,842 |   | 28,842 |   |
| Plant start-up costs                               |       | 26,332                                               |       | — |   | — |   | 26,332 |   |
| Cost of license and consulting revenue             |       | 102                                                  |       | — |   | 32 |   | 134 |   |
| Total segment operating expense                    |       | 26,434                                               |       | 32,311 |   | 28,874 |   | 87, 619 |   |
| Segment operating loss income                      |       | $                                                    | (25,695    | ) | $ | 3,626 |   | $ | (28,840 | ) | $ | (50,909 | ) |
| Total assets                                       |       | $                                                    | 98,349     |   | $ | 46,675 |   | $ | 107,046 |   | $ | 252,070 |   |
| Reconciliation to  net loss:                       |       |                                                 |       |   |   |   |   |   |   |
| Total Segment operating loss                       |       |                                                 |       |   |   |   |   | $ | (50,909 | ) |
| Depreciation, depletion and amortization |       |                                                 |       |   |   |   |   | (5,526 | ) |
| Research and development                           |       |                                                 |       |   |   |   |   | (1,438 | ) |
| Bad debt and asset impairment                      |       |                                                 |       |   |   |   |   | (335 | ) |
| Other income (expense)                             |       |                                                 |       |   |   |   |   | 6,681 |   |
| Net loss                                           |       |                                                 |       |   |   |   |   | $ | (51,527 | ) |

 

F-28

----

 

| ** **                                         | ** ** | **Year ended December 31, 2005** | ** ** |
|----------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                         | ** ** | **Plant and  Licensing**                        | ** ** | **Mining** | ** ** | **Operating** | ** ** | **Total** | ** ** |
| Operating  revenues:                               |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Licensing                                          |       |                                                 | $          | 787 |   |   |   | $ | — |   |   | $ | — |   | $ | 787 |   |
| Consulting and other                               |       |                                                 | —     |   |   |   | — |   |   | 197 |   | 197 |   |
| Total operating revenue                            |       |                                                 | 787        |   |   |   | — |   |   | 197 |   | 984 |   |
| Operating expenses:                                |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| General and administrative                         |       |                                                 | —     |   |   |   | — |   |   | 20,588 |   | 20,588 |   |
| Plant start-up costs                               |       |                                                 | 1,522      |   |   |   | — |   |   | — |   | 1,522 |   |
| Cost of license and consulting revenue             |       |                                                 | 259        |   |   |   | — |   |   | 142 |   | 401 |   |
| Total segment operating expense                    |       |                                                 | 1,781      |   |   |   | — |   |   | 20,730 |   | 22,511 |   |
| Segment operating loss                             |       |                                                 | $          | (994 | ) |   |   | $ | — |   |   | $ | (20,533 | ) | $ | (21,527 | ) |
| Total assets                                       |       |                                                 | $          | 71,710 |   |   |   | $ | — |   |   | $ | 42,462 |   | $ | 114,172 |   |
| Reconciliation to net loss:                        |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total Segment operating loss                       |       |                                                 |       |   |   |   |   |   |   |   |   | $ | (21,527 | ) |
| Depreciation, depletion and amortization |       |                                                 |       |   |   |   |   |   |   |   |   | (773 | ) |
| Bad debt                                           |       |                                                 |       |   |   |   |   |   |   |   |   | (1,255 | ) |
| Research and development                           |       |                                                 |       |   |   |   |   |   |   |   |   | (1,605 | ) |
| Other income (expense)                             |       |                                                 |       |   |   |   |   |   |   |   |   | 1,847 |   |
| Net loss income                                    |       |                                                 |       |   |   |   |   |   |   |   |   | $ | (23,313 | ) |

 

| ** **                                         | ** ** | **Year ended December 31, 2004** | ** ** |
|----------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                         | ** ** | **Plant and  Licensing**                        | ** ** | **Mining** | ** ** | **Operating** | ** ** | **Total** | ** ** |
| Operating revenues:                                |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Licensing                                          |       |                                                 | $          | 20 |   |   |   | $ | — |   |   |   | $ | — |   |   | $ | 20 |   |
| Consulting and other                               |       |                                                 | —     |   |   |   | — |   |   |   | 8 |   |   | 8 |   |
| Total operating revenue                            |       |                                                 | 20         |   |   |   | — |   |   |   | 8 |   |   | 28 |   |
| Operating  expenses:                               |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| General and administrative                         |       |                                                 | —     |   |   |   | — |   |   |   | 8,787 |   |   | 8,787 |   |
| Plant start-up costs                               |       |                                                 | 154        |   |   |   | — |   |   |   | — |   |   | 154 |   |
| Cost of license and consulting revenue             |       |                                                 | —     |   |   |   | — |   |   |   | 5 |   |   | 5 |   |
| Total segment operating expense                    |       |                                                 | 154        |   |   |   | — |   |   |   | 8,792 |   |   | 8,946 |   |
| Segment operating loss                             |       |                                                 | $          | (134 | ) |   |   | $ | — |   |   |   | $ | (8,784 | ) |   | $ | (8,918 | ) |
| Reconciliation to  net loss:                       |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total Segment operating loss                       |       |                                                 |       |   |   |   |   |   |   |   |   |   |   | $ | (8,918 | ) |
| Depreciation, depletion and amortization |       |                                                 |       |   |   |   |   |   |   |   |   |   |   | (420 | ) |
| Research and development                           |       |                                                 |       |   |   |   |   |   |   |   |   |   |   | (696 | ) |
| Bad debt and asset impairment                      |       |                                                 |       |   |   |   |   |   |   |   |   |   |   | (1,313 | ) |
| Other income (expense)                             |       |                                                 |       |   |   |   |   |   |   |   |   |   |   | 792 |   |
| Net loss income                                    |       |                                                 |       |   |   |   |   |   |   |   |   |   |   | $ | (10,555 | ) |

 

F-29

----

**(**13) IncomeTaxes

Ouroperations are principally domestic, with income taxable at the federalstatutory rate of 34% plus applicable state rates. Deferred tax assets(liabilities) were comprised of the following:

| ** **                               | ** ** | **2006**                | ** ** | **2005** | ** ** |
|------------------------------------------|------------|-------------------------|------------|----------|------------|
| ** **                               | ** ** | **(in thousands)** | ** ** |
| Gross deferred tax  assets:              |       |                    |       |     |       |
| Net operating  loss carryforwards        |       | $                       | 61,781     |     | $          | 41,676 |   |
| Depreciation and  amortization           |       | (1,143                  | )          | 81       |       |
| Accrued  liabilities                     |       | 2,166                   |       | 525      |       |
| Stock options and  warrants              |       | 4,417                   |       | 4,655    |       |
| Deferred revenue                         |       | 2,535                   |       | 2,525    |       |
| Deferred royalty  costs                  |       | —                  |       | (380     | )          |
| Reserve on note  receivable              |       | 469                     |       | 468      |       |
| Other                                    |       | 164                     |       | 164      |       |
| Gross deferred  tax assets               |       | 70,389                  |       | 49,714   |       |
| Deferred tax  assets valuation allowance |       | (70,389                 | )          | (49,714  | )          |
| Net deferred tax assets                  |       | $                       | —     |     | $          | — |   |

 

We have recorded a valuation allowance for the fullamount of our net deferred asset because, based upon an assessment of bothnegative and positive evidence, it is more likely than not that we will notrealize such benefits in future tax returns. Our tax return net operating losscarryforwards of approximately $166 million expire in various amounts beginningin 2007. Certain limitations apply to the annual amount of net operating lossesthat can be used to offset taxable income due to certain ownership changes, asdefined in Section 382 of the Internal Revenue Code.

Ourtotal provision for income taxes in 2006, 2005 and 2004 were different from theamount expected by applying the statutory federal income tax rate to our netloss as reported in our Consolidated Statement of Operations. The approximatedifferences are as follows:

| ** **                                        | ** ** | **2006**                | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **                                        | ** ** | **(in thousands)** | ** ** |
| Expected tax  benefit on loss before income taxes |       | $                       | (17,519    | )        | $          | (7,926   | )          | $ | (3,589 | ) |
| Expected state  tax benefit, net                  |       | (1,700                  | )          | (769     | )          | (348     | )          |
| Stock options and  warrant exercises              |       | (910)                   |       | (12,032  | )          | (264     | )          |
| Non-deductible  items and other                   |       | (546                    | )          | 1,070    |       | 3,449    |       |
| Expiring net  operating loss                      |       | —                  |       | 1,655    |       | —   |       |
| Increase in  valuation allowance                  |       | 20,675                  |       | 18,002   |       | 752      |       |
|                                              |       | $                       | —     |     | $          | —   |       | $ | — |   |

 

**(14) RelatedParty Transactions**

On December 7, 2006, we entered into a memorandumof understanding and real estate lease with Hills Products Group, Inc, or HillsProducts. Hills Products is owned by Mr. Stanford Adelstein who serves onour Board of Directors. We have leased certain real estate and facilities,including a train load-out facility, for the sole purpose of trans-loading ourK-Fuel refined coal from over-the-road truck into railcars. Prior to theexecution of this agreement our independent Board members approved thistransaction. We believe the terms and contracted amounts would be similar if wehad entered into this agreement with a third party. Per the agreement, we havecommitted to a monthly payment in the amount of $1,500, plus an additional feebased on tonnage of K-Fuel refined coal loaded after agreed upon monthlytonnages are exceeded.

F-30

----

We have a consulting agreement with Venners &Company, Ltd. for governmental affairs services, primarily for advice onproposed legislation and regulations and to advocate our interests before theU.S. Congress and regulatory agencies. Venners & Company, Ltd. iscontrolled by John P. Venners, the brother of Theodore Venners, our CTO. Priorto April 1, 2004, the agreement provided for monthly consulting fees of$12,000, reimbursement of expenses related to our business and certainperformance-based bonuses. Effective April 1, 2004, we negotiated arevised agreement with Venners & Company, Ltd. for the provision ofthese services at a fixed cost of $18,000 per month, which either party canterminate the agreement upon written notice. In January 2005, this amountwas increased to $25,500. The additional $7,500 per months is non-cancellableand expires on July, 2008. During the years ended December 31, 2006, 2005and 2004, we paid Venners & Company $306,000, $346,000 and $198,000respectively, in cash for consulting fees and $0, $10,000 and $58,000,respectively, for reimbursement of expenses, excluding certain bonuses.

In 2004, Venners & Company, Ltd. was entitledto bonus compensation as a result of the passage of legislation establishingcertain tax credits. We were required to (i) make cash payments ofapproximately $25,000, (ii) extend the consulting agreement for a periodof 43 months, (iii) issue 4,800 shares of common stock for servicesprovided, and (iv) issue warrants for the purchase of 150,000 shares at anaverage exercise price of $7.35 per share with a term of three years. We paid$25,000 in cash which, was reflected in general and administrative expensesrelated to the issuance of common stock. Based on the Black-Scholesoption-pricing model (assuming a weighted average risk free interest rate of2.83%, expected option life of 3 years, expected volatility of 46.6% and nodividends) we expensed $519,000 for issuing these warrants. In addition, werecognized $25,000 of expense related to the issuance of common stock. As aresult, we recognized a total of $544,000 of general and administrative expenserelated to this success-based fee for the year ended December 31, 2004.

In December 2004, we, entered into a licensingagreement with Cook Inlet Coal, an affiliate of Kanturk Partners LLC, underwhich we agreed to license to Cook Inlet Coal our proprietary coal processingtechnology for use at a coal processing plant to be operated by Cook Inlet Coal.Kanturk Partners owns approximately a 12% interest in Cook Inlet Coal.Mr. John Venners, brother of our CTO, Mr. Theodore Venners, has anapproximately 4.5% interest in Kanturk Partners.

In addition, we areobligated to make licensing and royalty payments to a party related to TheodoreVenners, our CTO. See further discussion in Note 6—Deferred Royalty Costs andNote 11—Commitments and Contingencies.

**(15) SelectedQuarterly Financial Data (Unaudited)**

Thefollowing table presents selected unaudited quarterly financial data for theyears ended December 31, 2006 and 2005:

| ** **                                   | ** ** | **First  Quarter**                                                    | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** | **Total** | ** ** |
|----------------------------------------------|------------|-----------------------------------------------------------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|-----------|------------|
| ** **                                   | ** ** | **(in thousands, except per share amounts)** | ** ** |
| **2006**                                     |       |                                                                  |       |                |       |               |       |                |       |      |       |
| Revenues                                     |       | $                                                                     | 185        |                | $          | 11,499             |       | $                   | 12,097     |      | $          | 12,929 |   | $ | 36,710 |   |
| Operating loss                               |       | (7,338                                                                | )          | (12,195             | )          | (18,907            | )          | (19,768             | )          | (58,208   | )          |
| Net loss                                     |       | (6,228                                                                | )          | (9,539              | )          | (17,363            | )          | (18,397             | )          | (51,527   | )          |
| Basic and diluted  net loss per common share |       | (0.09                                                                 | )          | (0.12               | )          | (0.22              | )          | (0.23               | )          | (0.66     | )          |
| **2005**                                     |       |                                                                  |       |                |       |               |       |                |       |      |       |
| Revenues                                     |       | 799                                                                   |       | 54                  |       | 100                |       | 31                  |       | 984       |       |
| Operating loss                               |       | (3,611                                                                | )          | (4,194              | )          | (5,355             | )          | (12,000             | )          | (25,160   | )          |
| Net loss                                     |       | (3,210                                                                | )          | (3,659              | )          | (4,856             | )          | (11,588             | )          | (23,313   | )          |
| Basic and diluted net  loss per common share |       | $                                                                     | (0.05      | )                   | $          | (0.06              | )          | $                   | (0.07      | )         | $          | (0.17 | ) | $ | (0.35 | ) |

 

F-31

----

***Fourth Quarter 2006 Discussions***

We recognized non-cashcompensation expense of $2.4 million related to non-cash compensation toemployees.

***Fourth Quarter 2005 Discussions***

We recognized non-cash compensation expense of $2.7million related to certain restricted stock grants to employees and consultantsduring the fourth quarter of 2005. In addition, we recognized $5.8 millionrelated to the issuance of warrants to Arch in October 2005.

F-32

----