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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

(Mark One)

For the Fiscal Year Ended December 31, 2002

Commission file number 0-23634

KFX INC.

(Exact Name of Registrant As Specified In Its Charter)

3300 EAST FIRST AVENUE, SUITE 290, DENVER, COLORADO USA 80206

(Address of Principal Executive Offices)

(303) 293-2992

(Registrant’s Telephone Number Including Area Code)

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

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

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days.  Yes  x  No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

Indicate by check mark whether the registrant is an accelerate filer (as defined in Rule 12b-2 of the Act).  Yes  ¨  No  x

The aggregate market value of the voting and non-voting common equity held by non-affiliates of KFx Inc. as of June 28, 2002, the last business day of KFx Inc.’s most recently completed second fiscal quarter was $71,547,671 computed by reference to the price at which KFx Inc.’s Common Stock was last traded on that date, as reported on the American Stock Exchange.

At April 9, 2003, 46,713,012 shares of common stock of the Registrant were outstanding.

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DOCUMENTS INCORPORATED BY REFERENCE

Portions of the definitive Proxy Statement for the 2003 Annual Meeting of Shareholders are incorporated by reference in Part III of this Form 10-K Report.

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PART I

ITEM 1. BUSINESS

Overview

We are a “clean energy” technology company with two principal business lines. We developed a patented process, which we refer to as K-Fuel^® Technology, that transforms low grade, high moisture content coal into high grade, low moisture content coal. We also provide an advanced software package for utility boiler optimization through our majority-owned subsidiary Pegasus Technologies, Inc. (“Pegasus”). Our technology and service solutions are marketed to the electric power generation industry to facilitate the industry’s compliance with air emission standards, as well as its transformation to intensive competition as the domestic power industry undergoes deregulation and restructuring.

Our patented K-Fuel^® Technology is a process which uses heat and pressure to physically and chemically transform low grade (or low BTU), high moisture content coal into a high grade (or high BTU), low-moisture content solid clean fuel. We plan to own and operate K-Fuel^® production facilities, as well as license K-Fuel^® Technology domestically and internationally to third parties. We recently announced the completion of a series of private equity financings, and a portion of the proceeds of these financings will be used to construct a commercial K-Fuel^® production facility. In January 2003, we completed a feasibility study for the construction and operation of a commercial K-Fuel^® plant. This study was prepared under the guidelines of the K-Fuel LLC Agreement. The feasibility study evaluated the construction cost and economic returns of a potential K-Fuel^® plant at three locations in Wyoming. Kennecott Energy Company (together with its affiliates, “Kennecott”) has informed us that they will not participate in constructing and operating a commercial K-Fuel^® plant under the guidelines in the feasibility study. We are currently working on the design and engineering phases of a potential K-Fuel^® plant to be constructed in Wyoming.

We also offer, through our Pegasus subsidiary, NeuSIGHT^®, a leading combustion optimization software product for coal-fired electric utility boilers, which, in addition to improving boiler efficiency, helps reduce nitgrogen oxide emissions. NeuSIGHT^® is a “neural network-based” (i.e., artificial intelligence) software, and was developed by Pegasus. Pegasus continues to enhance NeuSIGHT^® and develop related products and market NeuSIGHT^® licenses and related implementation services. Pegasus also markets and installs Power Perfecter^™, a complementary neural network-based combustion optimization software product licensed exclusively to us by the Power Optimization Division of Pavilion Technologies, Inc.

Recent Developments

Agreement with Arch Mineral Corporation

On January 28, 2003, we announced a preliminary agreement with Arch Mineral Corporation (“Arch”) to develop a 700,000 ton-per-year K-Fuel^® plant. Under this agreement, we will finance, construct, permit, and operate the plant at Arch’s Black Thunder mine, located near Gillette, Wyoming. Arch will supply waste coal as feedstock and dispose of reject material. KFx will have the right to expand the plant to a maximum output of 3,000,000 tons per year, with Arch’s consent. Arch will purchase all of the initial K-Fuel Plus^™ produced (up to the 700,000 tons per year output of the plant) at a price to be agreed upon, and will have the exclusive right to provide marketing services with respect to all of the output from any plant expansion.

Recent Equity Financing

In March 2003 we completed two equity financing transactions with several institutional investors. We sold a total of 7,745,000 shares of common stock at a price of $2.50 per share, for an aggregate purchase price of $19,400,000. Under the terms of the

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agreements, the investors also received warrants to purchase an aggregate of 1,549,000 shares of common stock at a purchase price of $2.75 per share (subject to adjustment) which expire five years after the date of the grant. We will use the proceeds from the sale of these securities for general corporate purposes and to partially fund the development of a K-Fuel^® plant. We also agreed with the investors to file a registration statement with the Securities and Exchange Commission to register all of the common stock and warrants issued as part of these financing transactions.

Potential Asset Transfer of Pegasus Technologies

On March 14, 2003, we signed a non-binding letter of intent with Kennecott, providing that Kennecott will transfer to us all of its membership interest in K-Fuel, LLC and the full ownership of certain related technology developed by Kennecott. In return, we will transfer to Kennecott preferred and common stock, in Pegasus, having the equivalent of $8 million in value at a value per share to be agreed by us and Kennecott, provided that such equivalent value shall result in the acquisition by Kennecott of a majority interest in, and control of, Pegasus. The contemplated transaction is subject to due diligence, definitive documentation, to board approval by Kennecott and its parent company, and by us, and to other conditions. In the absence of unanticipated delay, the transaction could be completed in the second or third quarter of 2003.

Summary financial information

Summary financial information about each of our segments for 2002, 2001 and 2000 follows (for additional segment information see Note 19 to the consolidated financial statements):

We do not believe that there are any seasonal effects to the business of our segments.

We will continue to consider various options to expand our business by adding other solutions (including technologies, products and services) to meet the needs of the electric power industry as it is transformed by deregulation into a highly competitive industry and the increasingly stringent environmental standards triggered by indications of global warming and other environmental concerns.

We are pursuing various international opportunities in both segments. During each of the three years ended December 31, 2002, the majority of our operating activities were conducted domestically. However, Pegasus generated revenues from customers in Canada, China and Poland approximating $397,000, $833,000, and $119,000 in 2002, 2001, and 2000, respectively.

OTHER INFORMATION

Our common stock is traded on the American Stock Exchange under the symbol “KFX.” Our principal executive office is located at 3300 East First Avenue, Suite 290, Denver, Colorado 80206 and our

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telephone number is (303) 293-2992. Our website can be found at www.kfx.com. We make our filings with the Securities and Exchange Commission available through a link to the Securities and Exchange Commission’s EDGAR website at www.sec.gov.

INDUSTRY OVERVIEW

Domestic Market

There are two primary market drivers for the K-Fuel^® Technology and the Pegasus software solutions offered by us. For a number of years various regulations and other requirements have placed increasingly stringent standards on the air emissions generated by the electric power generation industry and others. In addition, as the power industry undergoes deregulation and is transformed into a market-driven highly competitive industry, there will be increasing pressure to meet such air emission standards in more cost effective ways to improve the overall cost efficiency of electric power generation.

Air Emission Standards. The Clean Air Act of 1970, as amended in 1990 (the “Clean Air Act”), has been the primary historical stimulus for the developing United States market for beneficiated clean coal fuel products, such as K-Fuel^®, and for combustion optimization products, such as NeuSIGHT^® and Power Perfecter^™. A number of regulations issued under the Clean Air Act have the potential for driving the demand for our products. Among other things, the Clean Air Act requires reductions in acid rain precursor emissions (sulfur dioxide (“SO₂”) and nitrogen oxide (“NOx”)) from existing sources, particularly large, older power plants that were exempted from certain requirements of the Clean Air Act. Other provisions of the Clean Air Act relate to the reduction of ozone precursor emissions and have resulted in the imposition by various U.S. states of “reasonably available control technology” requirements to reduce those emissions.

NOx SIP Call. In 1998, the United States Environmental Protection Agency (“EPA”) issued a final rule, as amended in 2000, requiring twenty-two states and the District of Columbia to revise there state implementation plans in order to achieve a significant reduction in emissions of “NOx” (the “SIP Call”). NOx is a primary component in ground-level smog and is also a contributor to acid rain. The SIP Call established NOx “budgets” for each of the affected states, which would limit the amount of NOx that could be emitted by regulated sources in those states during each “ozone season” (May 1 through September 30). Although the SIP Call did not mandate precisely how the affected states were to comply with the regulation, the budget developed by the EPA relied to a great extent on reductions from coal-fired electric utility power plants. The EPA also recommended that the affected states could achieve compliance by implementing an interstate NOx emissions trading program. State plans developed to date have also relied on achieving significant reductions from coal-fired electric utility power plants and through the use of emissions trading. The SIP Call has survived a number of legal challenges, although such challenges have delayed the date affected sources must comply with the rule to May 30, 2004, and have also reduced the number of states subject to the rule to 19 (although the EPA has proposed a rule to require sources in Georgia and Missouri to achieve NOx reductions by May 1, 2005). Compliance with the SIP Call requirements is generally expected to require a significant investment in emission control technologies.

Pegasus software has been demonstrated to typically reduce NOx by 10% to 40%. K-Fuel^® Technology can also reduce NOx emissions (when using Powder River Basin (“PRB”) coal as the feedstock) as compared to typical eastern coals by levels approximating 25%, as indicated in the February 1999 commercial burn. Through the combination of Pegasus software and K-Fuel^®, we believe that we are in a unique position to assist the electric power generation industry in achieving required reductions in NOx more cost effectively than various other solutions, some of which are highly capital intensive and also can add significant operating costs.

Acid Rain Program. Title IV of the Clean Air Act established an innovative emissions trading program (the “Acid Rain Program”) to achieve reductions of SO₂ from fossil-fuel fired electric utility boilers. This program was the forerunner of the NOx emissions trading program discussed above. Under this program, existing electric generating units subject to the program are allocated “allowances”; each allowance equals a right to emit one ton of SO₂ . New units generally must acquire allowances from the market. Each year, facilities are required to hold allowances equal to their SO₂ emissions. Phase I of the program commenced in 1995 and affected 110 mostly coal-burning generating plants in 21 states (primarily in the industrial Midwest). Phase II of the Acid Rain Program, which commenced January 1, 2000, covers all existing electric generating units serving generators with an output capacity of greater than 25 megawatts and all new utility generating units. Phase II encompasses over 2,000 fossil-fuel fired electric generating units. The total number of allowances issued in connection with Phase II was based on (i) the average heat input (during specified years) of units in operation prior to November 15, 1990 and (ii) an emissions rate of 1.2 lbs SO₂ per million British Thermal Units (“mmBtu”) heat input. When using Wyoming PRB coal as feedstock material, the K-Fuel^® Technology produces a fuel product that

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has an SO₂ emission rate of approximately 0.7 to 1.0 lbs. SO₂ per mmBtu. NeuSIGHT^® also produces reductions in SO₂ as a byproduct of heat rate improvements and combustion optimization. Although the ultimate impact of the implementation of Phase II of the Acid Rain Program on the demand for K-Fuel^®, NeuSIGHT^® and Power Perfecter^™ is not clearly determinable, management believes it will create demand for these and other related technologies, as well as products and services that we may offer in the future.

Our United States marketing emphasis is directed primarily at electric utilities under EPA scrutiny located in the industrial Midwest and Eastern states. In these states there are approximately 300 utility-operated coal-fired boiler units with each having a power generation capacity of 200 MW or greater. The combustion characteristics of cyclone furnace boilers, a common boiler type used by Midwestern utilities, are particularly well suited to the K-Fuel^® product manufactured from PRB coal.

In addition to marketing our products to the electric utility industry, we believe K-Fuel^® and Pegasus software could be marketed to manufacturers and other large-scale industrial coal users that are either subject to the NOx and SO₂ provisions of the Clean Air Act or that desire to improve their fuel combustion performance. Fuel combustion performance is becoming more important because of the need to cut costs and become more efficient in an increasingly competitive market environment.

Revised National Ambient Air Quality Standards. In 1997, the EPA adopted a new national ambient air quality standard (“NAAQS”) to address emissions of fine particulate matter and also tightened the NAAQS for ozone. Although the revised fine particulate matter and ozone NAAQS were ultimately upheld, legal challenges to the standards have delayed their implementation. EPA is now drafting new schedules for implementing the ozone and fine particulate matter NAAQS. Pursuant to a negotiated settlement, the EPA has agreed to designate attainment and nonattainment areas under the ozone standard in 2004. The EPA has announced that it also intends to designate attainment and nonattainment areas under the fine particulate matter standard in 2004. Once these designations are published, states will be required to revise their implementation plans to achieve attainment with the revised standards, which plans are likely to require additional emission reductions from facilities that are significant emitters of ozone precursors (such as NOx) and fine particulates (including NOx and SO2).

Greenhouse Gases. Carbon dioxide (“CO2”) is widely considered to be a primary component of greenhouse gases that have given rise to worldwide concerns of global warming. Global warming continues to be a concern and remains a policy issue that is regularly considered for possible government regulation. The December 1997 Kyoto Protocol to the United Nations Framework Convention on Climate Change (“Kyoto Protocol”), if ratified by the requisite number of signatory countries, would require the signatory countries to make substantial reductions in greenhouse gas emissions, which include CO2, in the years 2008 to 2012. In addition, the Kyoto Protocol identifies electric power generation as one of the specific industry sectors that should be reviewed to achieve the targeted reductions. A very important by-product of the efficiency gains at electric power generation boiler units achievable through the use of Pegasus software and/or K-Fuel^® is a corresponding reduction in the level of CO₂. As of March 13, 2003, the Kyoto Protocol had been ratified by most of the signatories, although the Protocol will not go into effect until it is ratified by industrialized countries representing 55% of the total greenhouse gas emissions of all industrialized countries combined. It is expected that this figure will be reached in 2003 when Russia ratifies the treaty. Although the United States signed the Kyoto Protocol, it has not been ratified by the United States Senate, as would be required to be applicable in the United States. In addition, the Bush Administration has indicated that it does not support signing the Kyoto Protocol or the regulation of emissions of CO₂ in the near term. We are not able to predict the impact that the United States’ ratification of the Kyoto Protocol, or lack thereof, could have on the demand for K-Fuel^®, NeuSIGHT^® and Power Perfecter^™. Nevertheless, initiatives such as the Kyoto Protocol, targeted at reducing CO₂ and other greenhouse gases, are expected to continue to progress and create additional demand for alternatives to achieve significant reductions in these emissions.

Hazardous Air Pollutants. On December 20, 2000, the EPA determined that it would regulate emissions of hazardous air pollutant emissions from coal and oil-fired electric utility steam generating units. The EPA intends to propose regulations regarding mercury and to the extent necessary, other hazardous air pollutant emissions from electric utility steam generating units by December 15, 2003. Final regulations are supposed to be promulgated by December 15, 2004. According to a March 2003 report by Black & Veatch, K-Fuel^® provides an effective pre-combustion mercury reduction technology. According to independent research, a significant level of mercury is removed from run-of-mine coal during the K-Fuel^® production process. These tests indicate that any mercury contained in K-Fuel^® is below detectable levels of .05 parts per million (“ppm”), compared to mercury levels of typical Eastern bituminous coals of .15 ppm to .20 ppm. Based on these test results, if the EPA adopts regulations to restrict the level of mercury emissions, K-Fuel^® may offer significant competitive advantages over other high-energy value coals.

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Clear Skies Act. Under the Bush Administration’s proposed Clear Skies Act, new strict mandatory emissions caps would be established on SO₂, NOx and mercury, three of the most harmful air pollutants from power generators. Under the proposed Clear Skies Act:

As reported by the U.S. Department of Energy, the total domestic market for coal fuel is approximately 1.1 billion tons per year, of which electric utility companies use the majority of the tonnage (approximately 91%). Coal-fired electricity generation currently accounts for approximately 51% of the nation’s total electricity supply. The impact of more stringent laws and regulations, such as the SIP Call, more stringent particulate matter and ozone national ambient air quality standards, regulation of mercury emissions and potential amendments to the Clean Air Act such as the Clear Skies Act, on the demand for K-Fuel and Pegasus software, are not clearly determinable. Although we believe that such regulations will create demand for these and other related technologies, as well as related products and services that we may offer in the future, it is also possible that such regulations may cause power generators or other industrial users of coal to switch to other fuels, thus reducing the potential size of our market and our domestic growth opportunities. We believe that it is too soon to evaluate whether the Clear Skies Act or a compromise based on the Clear Skies Act (or similar legislation that has also been introduced during the current session of congress) will be passed by congress.

Deregulation of the United States Power Industry

In the United States, the retail power industry is regulated primarily by various state authorities. With the passage of the Energy Policy Act of 1992, deregulation of the power industry began approximately nine years ago in an effort to introduce market discipline in a manner similar to the deregulation of the telecommunications industry, both of which had previously been considered to be monopolies requiring a high degree of regulation in order to protect retail consumers. Approximately 24 states and the District of Columbia have deregulated or are in the process of deregulating their power industry with other additional states considering deregulation. With the exception of California, deregulation has generally proceeded without significant disruptions of supply or unfavorable impacts on power rates.

Deregulation of the electric power industry is expected to result in intensified price competition, increased price volatility, shorter-term wholesale electricity transactions and industry consolidation and structural changes. The electric power industry is moving toward retail competition while the wholesale market has already been established as full-scale open competition. While the electric power industry is experiencing consolidation through mergers and acquisitions, much of the industry is concurrently unbundling generation, transmission and distribution services from the traditionally integrated structure.

This restructuring is expected to cause some electricity generators to operate as merchant plants without a guaranteed market for their production output. In such an environment these businesses will be

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under constant competition for the sales of their products and services. As a result, plant operators will be expected to look to cut costs and improve operating efficiencies wherever possible.

We believe competition in a deregulated power industry will require further reductions in the cost of power generation. To further reduce the cost of power generation, savings must begin to come from areas other than personnel reductions, such as more effective fuel purchase practices and efficiency gains in the core processes in the generation of power.

The need for these expense reductions by power generating companies to remain competitive in the deregulated market comes at a time when EPA regulations are causing the power generation industry to consider further capital investment in plants to achieve emissions compliance. Management believes that power-generating companies will look for solutions, such as Pegasus software and K-Fuel, to reduce these capital investments, cut operating costs and run their plants more efficiently.

These developments are expected to produce a strong incentive for electricity generators to become low cost producers and expand market share in order to remain profitable in the deregulated environment. In a fully competitive retail electricity market, only those generators with costs low enough to produce electricity at market acceptable prices, not simply low enough to meet regulatory oversight, will be able to sell electricity profitably and remain viable.

Foreign Markets

The international coal-fired power generation industry is approximately four times the size of the United States coal-fired power generation industry. Our objective, with respect to international opportunities for K-Fuel^®, is to concentrate on markets where there is either a significant need for more energy efficient and environmentally responsible fuel products, or where abundant coal reserves can be utilized in conjunction with the K-Fuel^® Technology to develop a value-added export product. The principal benefit of the K-Fuel^® Technology in foreign markets is that low-rank indigenous coal reserves can be upgraded to provide a more cost effective and less environmentally damaging fuel source for power producers, manufacturers and households, either in internal markets or for export. We have international commercialization opportunities related to K-Fuel^® in Indonesia and Turkey, although they are not currently active.

Although we expect to initially concentrate our marketing and sales efforts with respect to Pegasus’ products domestically, we believe there is significant market potential for Pegasus software and related products internationally. Pegasus currently derives certain revenues from Canada, China and Poland and has a value-added reseller agreement in place for sales into South Africa. See “Pegasus – Strategic Relationships” below. Further we believe that initiatives such as the Kyoto Protocol, targeted at reducing CO₂ and other greenhouse gases, will continue to progress and create additional demands for alternative to achieve significant reductions in these emissions.

K-FUEL

The K-Fuel^® Technology is a “beneficiating process” which uses heat and pressure to transform low BTU, high moisture content coal into high BTU, low moisture content coal. The principal benefit of the K-Fuel^® Technology in the United States is that the beneficiated coal produced from the K-Fuel production process can facilitate the efforts of electric power producers, manufacturers and other large-scale users of coal to meet the clean air standards imposed by the Clean Air Act. Based on analyses, the environmental benefits of burning K-Fuel^® compared to most other coals appear to include significant reductions in emissions of NOx, SO₂, CO₂, mercury and chlorine.

We have three series of primary patents related to the K-Fuel^® Technology. The initial series, Series “A” and Series “B” Technology patents, were based on hot gas and steam heat-transfer media, respectively, in direct contact with the feedstock for heat transfer and beneficiation. The Series “C” Technology patents are based on a nitrogen gas atmosphere combined with an indirect hot-oil heat transfer

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system medium and use a simplified design with respect to the manufacturing equipment and facilities, resulting in lower capital costs. Our joint venture with Kennecott and K-Fuel, LLC has developed further improvements to coal beneficiary technology, including continuous operations and lower processing temperature and pressure during the process. We refer to these improvements as K-Fuel Plus^™, which is expected to be used in future K-Fuel manufacturing facilities. Further research may result in viable improvements to one or more of the three patent series. We are currently focusing our commercialization efforts on the development of projects for the manufacture of coal fuel product using the Series “C” Technology.

In the Series “C” Technology process, raw coal is crushed and screened before it is introduced into a steel alloy processing vessel that is then pressurized and heated indirectly using vertical tube heat exchangers. Nitrogen, serving as an inert, non-oxidizing heat-transfer medium, is admitted to the tube side of the processing vessel at a pressure of approximately 125 pounds per square inch (“psi”). After the nitrogen is inserted, it picks up heat from the walls of the tube and gradually expands to approximately 800 psi. Water is released from the coal during this expansion period. When the temperature in the tubes exceeds 520 degrees Fahrenheit, any water remaining in the coal turns to steam. When the temperature of the coal reaches approximately 650 to 740 degrees Fahrenheit, the process is complete. The process takes 30 to 40 minutes to complete from initial loading of the raw coal into the processing vessels to final discharge of finished K-Fuel product.

In late 2000, we demonstrated an improved K-Fuel process, K-Fuel Plus^™. The principal differences from the K-Fuel Series “C” Technology process previously used and the K-Fuel Plus^™ product production process are continuous operations and lower processing temperature and pressure. This demonstration used Powder River Basin (“PRB”) coal, which typically has the lowest mercury content of any naturally available coal. Analysis of the K-Fuel Plus^™ product produced during the demonstration indicated that the K-Fuel Plus^™ process produced lower amounts of SO₂, NO_X, mercury and chlorine than was produced by untreated PBR coal. Analysis of this demonstration also indicates that an improved process could be designed to produce improved K-Fuel^® within potentially attractive economic constraints, with improved reliability and have lower capital and operating costs than any previous K-Fuel plant design. The BTU value of the K-Fuel Plus^™ product tested was approximately 11,200 to 11,600 BTU’s per pound. Upon combustion, the K-Fuel Plus^™ product produce approximately 20% lower NO_X emissions and lower mercury emissions, as compared to untreated PRB coal and SO₂ emissions, well below the 1.0 lb per million BTU limit contained in Phase II of the Clean Air Act.

We are pursuing the possible advantages of blending the K-Fuel Plus^™ product and untreated PRB coal. The dust and self-heating behaviors of this blend of K-Fuel Plus^™ product and untreated PRB coal appear to be similar to untreated PRB coal, without the need for oil or other treatment, as was the case in the Series C product. The NO_X, SO₂ and mercury reduction benefits of this blend can be adjusted by moderating the amount of K-Fuel Plus^™ product added to the blend. Therefore, a commercial plant for the new product may be leveraged to provide considerably higher volumes of blended product for the market place.

During the years ended December 31, 2002, 2001 and 2000 KFX research and development costs were approximately $230,000, $221,000 and $925,000, respectively.

The KFP Facility

In August 1995, we and Thermo Ecotek Corporation, acting through respective wholly-owned subsidiaries, formed KFx Fuel Partners, L.P., a Delaware limited partnership and began the construction of a 500,000 ton per year K-Fuel^® production facility (the “KFP Facility”) near Gillette, Wyoming, using our Series “C” Technology. We owned a 5% interest in KFx Fuel Partners, with the remaining 95% owned by Thermo Ecotek. The KFP Facility operated and produced commercially salable K-Fuel in 1998 and 1999. The KFP Facility experienced certain problems relating to tar and fines residue build-up within the system during production and product quality issues related to product dusting. On May 24, 1999, Thermo Ecotek announced that in connection with certain strategic restructuring decisions it had decided to sell its interest in the KFP Facility. In June 1999, Thermo Ecotek suspended all K-Fuel^® production at the KFP Facility. We have sold our interest in the KFP facility to Thermo Ecotek Corporation and accordingly, we have no ownership interest in the KFP Facility and have no obligation to fund any capital or other costs necessary for its restart. We would, however, be entitled to royalty payments upon the successful restart of the plant and production of K-Fuel^®.

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K-Fuel, LLC

In April 1996, we entered into a joint venture agreement (the “K-Fuel LLC Agreement”) with a wholly-owned subsidiary of Kennecott. The joint venture, a Delaware limited liability company named K-Fuel, LLC (“K-Fuel, LLC”), is intended to be the vehicle for further technical advancement and the commercialization of business opportunities arising out of the K-Fuel Technology, including research and development, sublicensing, marketing and consulting, but not including the construction of facilities to produce K-Fuel products on a commercial basis (“Commercial Projects”). Commercial Projects will be constructed by separate entities in which Kennecott, KFx, both or third parties will have an equity interest and which will be granted a sublicense from K-Fuel, LLC for the K-Fuel Technology.

Under the K-Fuel LLC Agreement, as amended, with respect to future Commercial Projects to be licensed by K-Fuel, LLC to entities wholly or partially owned by Kennecott, we are entitled to a one-time license fee approximating $3 per ton of annual design capacity of each project, times Kennecott’s percentage of beneficial ownership, to be paid one-half at the time the license is granted, with the remaining one-half paid over a period of three years beginning when the project begins commercial operations. We will also receive a production royalty, to be paid each calendar quarter, depending on certain levels of the project’s selling price per ton of coal product. With respect to the non-Kennecott portion of production capacity and production of Commercial Projects in which Kennecott has less than 100% beneficial ownership, we are entitled to similar, but higher, license fees and royalty payments. Such higher license fees and royalty payments will also apply to 100% of the production capacity and production of Commercial Projects in which Kennecott has no beneficial ownership. In addition, we will be entitled to additional payments based on a percentage of the excess of annual cash revenue from each project, or annual pre-tax cash operating costs of each project plus an annual capital charge related to each project. Kennecott has the right to fund 100% of Commercial Projects that it approves, subject, to our right to fund up to 50% of such projects on the same economic terms as Kennecott. We have no obligation to fund any Commercial Project.

Agreement with Lurgi

On December 9, 2002, we announced a preliminary, worldwide, exclusive agreement with Lurgi South Africa (Pty) Limited (“Lurgi”) to combine the K-Fuel^® Technology with Lurgi’s technical services and equipment to beneficiate low-grade coal into clean, high-BTU K-Fuel Plus^™. We expect this relationship to accelerate the commercialization of K-Fuel^® and significantly improves the economics of future plants. Existing Lurgi gasification equipment will be modified to produce K-Fuel^®. We believe that Lurgi’s 50 years of experience in designing and building coal processing plants, including more than 450 process plants and equipment installations since the first unit was constructed in 1927, add significant expertise to the commercial implementation of the K-Fuel^® process.

Patents, Licenses, and Royalty Agreements

We have patents or patent applications for the K-Fuel^® Technology registered in the United States and in over 40 foreign countries. These include applications for patents developed by us and seven patents and patent applications developed by K-Fuel, LLC. We have assigned the seven United States counterparts to K-Fuel, LLC. All licensing rights to the K-Fuel^® Technology are property of K-Fuel LLC.

The only licenses we have granted for use of the K-Fuel^® Technology are to the KFP Facility (Series “C” Technology), K-Fuel, LLC (Series “C” Technology), and Heartland Fuels Corporation (Series “A” and “B” Technologies). We own 85% of the common stock of Heartland Fuels, and as a condition of the K-Fuel LLC Agreement, we caused Heartland Fuels to grant K-Fuel, LLC an exclusive sublicense to the Series “A” and “B” Technologies. In September 2002, the KFP Facility license was transferred to a third party and we received a fee of $100,000. A predecessor entity of the Company acquired the Series “A” and “B” Technologies from Mr. Edward Koppelman, the inventor of the K-Fuel^® Technology, and other

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investors (the “Koppelman Group”) in 1984 for $10 million in cash and a royalty agreement. In June 1996, we entered into a royalty amendment agreement with Mr. Edward Koppelman. As a result of the amended agreement, Mr. Koppelman’s estate is now entitled to a royalty of 25 percent of our worldwide royalty and license fee revenue. The royalty to Mr. Koppelman’s estate will cease when the cumulative payments to him reach the sum of approximately $75,222,000. As consideration for the royalty amendment agreement, in June 1996, we paid Mr. Koppelman $300,000 cash and issued a promissory note for $200,000; see Note 8 to the consolidated financial statements. The resulting $500,000 prepaid royalty is amortized as licenses to K-Fuel^® Technology are sold. Also as part of the royalty agreement, Mr. Koppelman indemnified us for any claims made by the Koppelman Group. During 2001, we reacquired the 12% patent interest held by the State of Wyoming for a cash payment approximating $1,162,000.

Although the Series “A” and “B” Technology patents are approaching expiration, because these patents covered earlier versions of the technology, we do not believe that expiration of the patents will have a material adverse effect on us or the value of the Series “C” Technology due to the superior performance observed by employing the Series “C” Technology and the K-Fuel, LLC improvements.

The following table summarizes our royalty obligations with respect to the K-Fuel^® Technology to various third parties:

Competition

We believe that there are no competitors producing significant commercial quantities of beneficiated clean coal fuel products either in the United States or international markets. However, there are other clean coal technology (“CCT”) companies, primarily in the United States, that are developing fuel combustion and product technologies that would reduce emission pollutants and/or increase the heat value of coal feedstock fuel sources. Many of these CCT competitors have greater financial, technical and operational resources than us. We believe of these other efforts have yet resulted in an economically viable and commercially acceptable beneficiated coal product with the economic and commercial potential of K-Fuel^®.

PEGASUS

General

In March 1998, we purchased a 60% interest in Pegasus Technologies Limited (“Pegasus Limited”), an Ohio limited liability company. Pegasus Limited had developed a software technology that optimizes the performance of coal-fired electric utility boilers. Pegasus’ flagship product, NeuSIGHT, provides two primary benefits: improved combustion performance, and reduction in NO_X emissions. NO_X is a primary component of ground level smog. Additional benefits of NeuSIGHT include improvements in

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boiler efficiency (heat rate), which translate into lower fuel costs, as well as lower emissions of SO₂ and CO₂; an increase in gross generating capacity; lower carbon in the ash waste by-product, which can convert a related waste product disposal cost into a marketable ash product; and improvements in opacity, which refers to the visible exhaust discharged from an emissions stack.

In August 1998, KFx formed Net Power Solutions, LLC (“NPS”), a Delaware limited liability company, primarily to provide marketing and sales services to Pegasus Limited. From late 1998 through November 30, 1999, NPS hired and trained a marketing and sales staff, developed marketing programs and generally performed the sales and marketing for Pegasus Limited. Pursuant to an agreement dated December 13, 1999, the members of Pegasus Limited and NPS including KFx, exchanged their membership interests in Pegasus Limited and NPS for shares of common stock of a new company, Pegasus Technologies, Inc., effective November 30, 1999. Hereafter, references to Pegasus include the activities of Pegasus Limited and NPS prior to this exchange, as well as the subsequent activities of Pegasus Technologies, Inc. and its subsidiaries.

NeuSIGHT dynamically models in real time the operating conditions of the electric utility boiler combustion process and makes alterations to operating variables. Maximum benefits are achieved by allowing NeuSIGHT to operate in closed loop mode, where its alterations to operating variables are automatically invoked.

In July 2001, Pegasus entered into an Asset Purchase and License Agreement with Pavilion Technologies, Inc (“Pavilion”), under which Pegasus received the exclusive right to license Pavilion’s Power Perfecter, Continuous Emission Monitoring (“CEM”) and Environmental Portfolio Manager (“EPM”) software to the electric utility industry. Power Perfecter is a universal, non-linear control and optimization solution that uses model-predictive control to monitor multiple variables and provide a proactive response. Power Perfecter uses a different methodology to determine optimum performance in boilers, but is considered to be a technology that is complementary to NeuSIGHT. CEM applications are customized to meet state and federal emissions monitoring using predictive emissions monitoring systems. These applications return data identical to a hardware-based analyzer but with less manual processing by the user. EPM simplifies the retrieval, collation, processing and formatting of environmental monitoring data for submittal to regulatory agencies and allows data from disparate sources to be reported in a consistent manner. Pegasus is currently developing a marketing plan for the CEM and EPM software. On March 28, 2002, the Asset Purchase and License Agreement (“Purchase Agreement”) between Pavilion, Pegasus and us was amended to decrease the total base cash payment to $7.5 million, from $9.5 million, subject to certain adjustments for the value of assets and liabilities acquired and transaction costs. The amendment also increased the future royalty payments on licenses sold to a total of $9 million with no expiration date on the royalty payment period. Future royalty payments are considered contingent purchase price and will result in additions to goodwill as the royalties become due. Per the terms of this amendment, Pegasus paid Pavilion $4.4 million on March 28, 2002 as the final base purchase price payment for the acquisition.

During the years ended December 31, 2002, 2001and 2000 Pegasus research and development costs were approximately $559,000, $655,000 and $614,000, respectively.

Potential Assets Transfer of Pegasus

On March 14, 2003, we and Kennecott signed a non-binding letter of intent with respect to a potential transaction pursuant to which Kennecott will transfer to us all of its membership interest and other rights in K-Fuel, L.L.C. and the full ownership of certain related technology developed by Kennecott, in consideration for preferred and common stock, having the equivalent of $8 million in value, in Pegasus, at a value per share to be agreed by us and Kennecott, provided that such equivalent value shall result in the acquisition by Kennecott of a majority interest in and control of Pegasus.

In connection with this transaction, an intercompany loan from us to Pegasus, in the outstanding principal amount of approximately $7.7 million at December 31, 2002, will either be retired upon closing or remain outstanding under commercial terms to be determined prior to closing. If the loan remains outstanding, it will become convertible, at our option, into common stock of Pegasus at the same value per share as agreed with respect to Kennecott’s acquisition of such common stock, provided that such conversion does not result in Kennecott not having majority control of Pegasus.

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The contemplated transaction is subject to due diligence, negotiation of and agreement on definitive documentation, to board approval by Kennecott, by its parent company, and by us, and to other conditions. In the absence of unanticipated delay, such a transaction could be completed in the second or third quarter of 2003.

During 2002, the following individual Pegasus clients accounted for greater than 10% each of consolidate revenues: Cinergy Corporation—32% and TXU Generation Company LP—26%. During 2001, the following individual Pegasus clients accounted for greater than 10% each of consolidated revenues: Cinergy Corporation—39%, Ameren/Union Electric—11% and BITCO Enterprises (China)—10%. During 2000, the following individual Pegasus clients accounted for greater than 10% each of consolidated revenues: Ameren/Union Electric—30%, Dairyland Power Cooperative—18% and American Electric Power—12%.

Material Relationships

During the first quarter of 2000, Pegasus entered into value added reseller agreements with Babcock & Wilcox and ABB Centrum providing for certain minimum purchases of NeuSIGHT licenses from Pegasus and providing Babcock & Wilcox and ABB Centrum certain resale rights. Later in 2000, the Babcock & Wilcox agreement was amended to provide only for joint marketing activities and the provision of Babcock & Wilcox installation personnel at preferred rates. In addition, in connection with the final testing of an installation for ABB Centrum at the Jawarzno power station in Poland, various previous agreements with ABB Centrum were revised to provide ABB Centrum with the exclusive resale rights in Poland and $500,000 of minimum purchases of NeuSIGHT by February 27, 2002. Revenue recognized under these agreements totals approximately $308,000 in 2002.

Late in 2000, Pegasus took two steps to enter the market in the People’s Republic of China (“China”). During the third quarter of 2000, Pegasus signed a letter of intent for the installation of its flagship NeuSIGHT product at four coal-fired boiler units, with a total generating capacity of 1,200 megawatts, at the Xibaipo power station in China, near Beijing. In late November 2000, a firm order was received for the first of these installations, which was initiated in 2002. During the fourth quarter of 2000, Pegasus entered into a license agreement with BITCO Enterprises (“BITCO”), providing BITCO and certain affiliates with the exclusive right to market Pegasus’ NeuSIGHT technology in China in exchange for a nonrefundable $300,000 fee and future license fees. Pegasus and BITCO finalized an exclusive agreement in 2001 for BITCO to license NeuSIGHT in China, provided BITCO meets certain minimum license sales during 2001 and 2002. The agreement resulted in recognized revenue of approximately $59,000 during 2002.

During 2001, Pegasus was selected as the neural network system provider for the Department of Energy (“DOE”) project awarded to Tampa Electric. The DOE’s funding will be from its “Power Plant Improvement Initiative”, a congressionally directed effort. This project is one of eight “showcase” projects selected from 24 proposals submitted to the DOE in early 2001. The intent of this project is to test and demonstrate a leading edge, artificial intelligence based, soot-blowing system in conjunction with state-of-the-art controls and instrumentation, to reduce NOx and PM emissions while concurrently optimizing the operation of a utility boiler. Pegasus’ research and development efforts with respect to developing this sootblowing system will be partially reimbursed through this DOE initiative.

In September 2001, Pegasus entered into an agreement with Alstom Power Customer Services China (“Alstom China”) for Alstom China to have the exclusive right to license Power Perfecter in China. In October 2001, Alstom China sold the first Power Perfecter installation project under this agreement. Revenue recognized under this agreement during 2002 was $187,000.

In early 2002, Pegasus and ABB Inc. entered into a value-added reseller agreement for Pegasus’ combustion optimization solutions in the United States. ABB Inc. will offer integrated Pegasus applications with their Industrial ITTM solutions for combustion management optimization, including carbon-in-ash sensors, performance monitoring, coal flow monitoring, and ABB Inc. distributed control systems.

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Pegasus will pursue additional value-added reseller and similar arrangements with appropriate parties as a means to quickly and cost effectively gain access to potential customers, particularly in foreign countries.

As of April 9, 2003, Pegasus has firm unfilled sales commitments (backlog) for software licenses and related installations at an estimated contract value of $7,467,000, which are generally expected to be filled within approximately the next 3-24 months. At April 12, 2002, such backlog approximated $7,694,000.During the year ended December 31, 2002, Pegasus’ top two customers were Cinergy Corporation and TXU Generation Company LP accounting for approximately 32% and 26% of Pegasus’ revenues, respectively, or approximately 58% in the aggregate.

Intellectual Property

NeuSIGHT utilizes a technology licensed from a wholly-owned subsidiary of Computer Associates, Inc. under an agreement which, among other terms, grants Pegasus a perpetual, irrevocable, world-wide, exclusive right and license for use in process monitoring and control applications in the electric utilities industry. Payments are made to Computer Associates for each neural network license sold, one of which is required for each NeuSIGHT installation. The programming code that constitutes NeuSIGHT is a trade secret.

Pegasus received the exclusive right to license Pavilion’s Power Perfecter under an Asset Purchase and License Agreement with Pavilion dated July 31, 2001.

Competition

Pegasus faces direct competition from approximately three companies that offer software products providing combustion optimization benefits to the electric power industry. In addition, Pegasus faces indirect competition from a similar number of companies that offer control systems used to operate utility boiler units, which contain certain combustion optimization features. We believe the NeuSIGHT and Power Perfecter software solutions offer several competitive advantages over competitors’ offerings. NeuSIGHT and Power Perfecter have demonstrated an ability to operate in closed-loop supervisory mode for extended time periods without intervention.

NeuSIGHT’s neural network model is considerably more extensive and effective than competing products, through its ability to manage higher volumes of input variables (up to 7 times the level of competing products). While NeuSIGHT’s neural network models are sophisticated and complex, the software has a unique capability to retrain the model automatically as operating conditions change in the plant. Competing product models are generally static and require periodic retuning, making them more costly to maintain and less effective over time. We believe these and other features provide a much greater ability for the software to adapt to changing environmental conditions, equipment degradation, instrument calibration drift, and operating variances.

GOVERNMENT AND ENVIRONMENTAL REGULATION

Generally, environmental permitting and operating regulations in countries outside the United States that we are currently pursuing for international development are not as stringent as those which are within the United States. Nevertheless, international initiatives, such as the Kyoto Protocol, are expected to create increasing pressures on the electric power generation industry on a world-wide basis to reduce emissions of various pollutants, which management expects will create additional demand for its products and services.

K-Fuel^® Technology

In the United States, the K-Fuel^® product is not expected to be subject to unusual levels of local, state or federal regulation with respect to its transportation and distribution. However, any future United States production plants will require numerous permits, approvals and certificates from appropriate federal,

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state and local governmental agencies before construction of each facility can begin, and will be required to comply with applicable environmental laws and regulations (including obtaining operating permits once facilities begin production. The types of permits that are typically required for commercial production facilities include air quality, wastewater discharge, land use, and hazardous waste treatment, storage and disposal. Future international K-Fuel^® production plants will also be subject to various permitting and operational regulations specific to each country.

Pegasus

The operations of Pegasus are not significantly impacted by governmental regulation with respect to the development and delivery of NeuSIGHT, Power Perfecter, CEM, EPM and related software products and services.

EMPLOYEES

We currently have approximately 43 full-time employees, six of whom work in the areas of corporate and K-Fuel marketing, finance and administration, and the operation of the K-Fuel demonstration plant and laboratory and 37 of whom work at Pegasus in the areas of sales and marketing, software development, software implementation, finance, and administration. We consider our relations with all employees to be good.

FORWARD-LOOKING INFORMATION MAY PROVE INACCURATE

Some of the information presented in this Annual Report on Form 10-K constitutes “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include, but are not limited to, statements that include terms such as “may,” “will,” “intend,” “anticipate,” “estimate,” “expect,” “continue,” “believe,” “plan,” or the like, as well as all statements that are not historical facts. Forward-looking statements are inherently subject to risks and uncertainties that could cause actual results to differ materially from current expectations. Although we believe our expectations are based on reasonable assumptions within the bounds of our knowledge of our business and operations, there can be no assurance that actual results will not differ materially from expectations.

RISK FACTORS

We have a history of losses, deficits, working capital deficits and negative operating cash flows.

At December 31, 2002, we had a working capital deficit of $2,554,728 and an accumulated deficit of approximately $109,719,000. At December 31, 2002, after giving effect to the termination of a put option previously granted to some of our stockholders, we had a stockholders’ equity of approximately $1,735,000. We incurred net losses of approximately $39,987,000, $15,177,000 and $12,290,000 in 2002, 2001 and 2000, respectively, and of approximately $23,850,000, net of accretion of redeemable common stock, at December 31, 2002. We have experienced negative operating cash flow of approximately $3,994,000, $6,738,000 and $5,151,000 in 2002, 2001 and 2000, respectively. Further, the report from our former independent accountants to our consolidated financial statements for the years ended December 31, 2001 and 2000 contained an explanatory paragraph regarding our ability to continue as a going concern. We and our predecessors have not achieved significant K-Fuel^® licensing, royalty or product sales revenue.

We expect to incur significant additional operating losses and continued negative cash flows from operations for the foreseeable future. We have made, and will continue to make, very significant expenditures well before our revenues increase sufficiently to cover these additional costs. We are not able to estimate when, if ever, our revenue will increase sufficiently to cover these costs. Further, we may not achieve or maintain profitability or generate cash from operations in future periods.

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As a result, we have been and continue to be very dependent on strategic relationships, sales of our debt and equity securities and short-term loans from our directors and third parties to fund the operating costs associated with our business. Our continuation is dependent on our ability to generate sufficient cash flows to meet our obligations on a timely basis, to comply with the terms of our financing agreements, to obtain financing or refinancing as may be required, to attain profitability, or a combination thereof. A lack of adequate financing may adversely affect our ability to make necessary interest and principal payments on our indebtedness, respond to changing business and economic conditions and competitive pressures, absorb negative operating results, and fund capital expenditures or increased working capital requirements.

We have contractual limitations on our ability to secure additional funding.

Our ability to secure additional financing is limited by the terms of a common stock this and warrant purchase agreement for the sale of 6.76 million shares of common stock in 2002. Under the terms of this agreement and a related investors rights agreement we are prohibited from selling and issuing any of our preferred stock until the investors no longer hold any shares of common stock or warrants, or obtain a waiver to sell and issue preferred stock from at least two-thirds of these investors. The terms of this agreement have subsequent dilutive offering protections that are triggered if we sell common stock at a price below $2.50 per share. The investors under this common stock and warrant purchase agreement also have the first right of purchase related to potential sales of our common stock until August 21, 2004.

Technical and operational problems may adversely impact our ability to develop K-Fuel^® projects or facilities.

There have been past significant technical and operational problems with the construction of the K-Fuel^® facility. The construction of the first commercial-scale K-Fuel^® production facility (the “ KFP” Facility”) began in 1995, which was completed and began operations in April 1998. The facility experienced a series of construction problems during and after it began operations, including a 1996 fire at the facility and issues relating to the flow of materials within the facility and the design and operation of pressure release equipment. Following the commencement of operations, the KFP Facility experienced problems relating to tar and residue build-up within the system during production and product quality issues related to product dusting. As a result of these problems, operations at the KFP Facility were suspended. In 2000, we tested an improved K-Fuel^® production process using Powder River Basin (“PRB”) coals, which resulted in an improved K-Fuel^® product which is low in SO₂, NO_x, mercury and chlorine. Analysis of this improved K-Fuel^® product indicated that this improved K-Fuel^® production process can be more reliable than the process used by the KFP Facility. Additionally, the improved K-Fuel^® production facilities would require less capital and have lower operating costs than previous K-Fuel^® plant designs. However, there can be no assurance that any future K-Fuel^® production facilities will not experience technical or operational problems similar to or in addition to those experienced at the KFP Facility. To the extent that other technical or operational problems materialize, our ability to develop other K-Fuel^® projects or facilities would be jeopardized.

The K-Fuel^® Technology has not yet shown economic viability.

We have only recently finished the development of the K-Fuel^® Technology, and we will need to raise additional capital to build the first commercial K-Fuel^® production facility. Our future success depends upon our ability to successfully construct and operate commercial K-Fuel^® production facilities.

The process of developing, financing and constructing K-Fuel^® production facilities, including obtaining necessary regulatory permits and approvals, is complex, lengthy and costly and subject to numerous risks, uncertainties and factors beyond our control, including cost overruns, delays, damage and technical delays. In addition, local opposition to a particular project can substantially increase the cost and time associated with developing the project, and can, potentially, render a project unfeasible or

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uneconomical. Future projects for the development of K-Fuel^® production facilities may incur substantial costs or delays or may be unsuccessful as a result of such opposition.

Only a small percentage of the projects that are considered and pursued may ultimately result in operating projects that are sufficiently successful to provide us with license fee income, royalty fee income and equity participation income. As a result, we may not be able to recover any expenses that we incur in the evaluation and development of certain projects.

The market for the K-Fuel^® Technology is unclear.

Although we believe that a substantial market will develop both domestically and internationally for clean coal fuel products, no established market for beneficiated fuel products exists. As a result, the availability of accurate and reliable pricing information and transportation alternatives is not fully known. The future success of our K-Fuel^® Technology will depend on our ability to establish a market for clean coal fuel products among potential customers such as electrical utility companies and industrial coal users. Further, potential users of our fuel products may be able to choose among alternative fuel supplies. The market viability for the K-Fuel^® Technology will not be known until we complete construction of one or more commercial-scale production facilities, either in the United States or internationally, that produce, on a consistent basis, commercial quantities of fuel that meet certain minimum performance specifications. There is a risk that commercial-scale production facilities when completed will be unable to generate sufficient market interest to continue in business. Further, there can be no assurance that a commercial-scale K-Fuel^® facility will be economically successful. If we are unable to complete construction and successfully operate a commercial K-Fuel^® production facility, we will not be able to sustain our operations or achieve future growth.

There are risks related to sale of Pegasus or transfer of assets.

On March 14, 2003 we and Kennecott signed a non-binding letter of intent with respect to a potential transaction pursuant to which Kennecott will transfer to us all of Kennecott’s membership interest in K-Fuel, LLC and the full ownership of certain related technology developed by Kennecott, in consideration for which we will transfer to Kennecott preferred and common stock in Pegasus, having the equivalent of $8 million in value, at a value per share to be agreed by us and Kennecott, provided that such equivalent value shall result in the acquisition by Kennecott of a majority interest in and control of Pegasus.

In the absence of unanticipated delay, such a transaction could be completed in the second or third quarter of 2003. If such transaction were to consummate, our business will change significantly, and we will be dependent to a large extent on the K-Fuel^® technology, which has not yet proved to be commercially viable. As a result of the reduction of our interest in Pegasus, our revenues may significantly decline. These changes may have a material adverse effect on us.

The market for NeuSIGHT^® and related software is new and uncertain and will depend upon successful sales and marketing strategies and product improvement strategies.

Pegasus, which sells our NeuSIGHT^® products, had revenues of approximately $5.2 million in 2002 and $3.0 million in 2001. These revenues are for the sale of licenses for NeuSIGHT^® and Power

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Perfecter^™, installation services, maintenance and other revenue. The market for Pegasus products is new and uncertain. Combustion and other optimization software such as NeuSIGHT^®, Power Perfecter^™, and other similar products have only been used by the electric power business for a few years. We believe that market pressures caused by the developing deregulation of the electric power industry and the Clean Air Act will accelerate demand for, and market acceptance of, combustion optimization products.

We believe that increased market acceptance of Pegasus software is dependent, in part, on our ability to simplify and streamline its installation process. Product improvements directed at this objective have been made and new versions of NeuSIGHT^® were released to the market in late 1999, late 2000 and in early 2002. There can be no assurance that our efforts to further improve Pegasus software products to more fully meet our objectives will be successful. If the market for Pegasus’ NeuSIGHT^® software products fails to develop or if we are unable to successfully market or improve our products, our results of operation and financial condition will be materially adversely affected.

Pegasus’ operating results depend on a limited number of customers, and the loss of customers or Pegasus’ inability to attract new customers would seriously harm our operating results.

Pegasus has in the past derived, and may in the future derive, a significant portion of its net revenues from a limited number of customers. During the year ended December 31, 2002, Pegasus’ top two customers were Cinergy Corporation and TXU Generation Company LP, accounting for approximately 32% and 26% of Pegasus’ revenues, respectively, or approximately 58% in the aggregate. We expect that these two customers will continue to account for a substantial portion of Pegasus’ revenue for the duration of their contracts, which are expected to continue through July 2004. Pegasus will need to establish business relationships with new customers to replace existing customers as contracts with existing customers are completed, expired, terminated or otherwise discharged. We cannot guarantee that Pegasus will be able to increase its customer base. If Pegasus were to lose Cinergy Corporation or TXU Generation Company LP as customers, if either of these customers were to significantly reduce their volume of business with Pegasus, or if Pegasus is unable to increase its customer base, our business, results of operations and financial condition would be materially adversely affected.

Deregulation in the United States power industry may result in increased competition for our products.

We expect that deregulation in the United States power industry will result in utilities and other power generators placing a high emphasis on reducing costs in their operations. This situation may, in turn, result in increased competition from other producers of beneficiated coal products, other clean fuel sources, other developers of combustion optimization software and other products, services and technologies designed to provide environmental and operating cost benefits similar to those which we believe are available from our K-Fuel^® Technology and Pegasus’ combustion optimization technology and related software.

Our markets are competitive.

We face competition from other companies in the clean coal and alternative fuel technology industries as well as the emission control equipment industry. Many of these companies have financial and managerial resources much greater than ours and, therefore, may be able to offer products more competitively priced and more widely available than ours. Also, competitors’ products may make our technology and products obsolete or non-competitive. Our future success may depend on our ability to adapt to such changing technologies and competition.

We are subject to risks of changing laws.

A significant factor driving the creation of the United States market for K-Fuel^®, other beneficiated coal products, Pegasus combustion optimization and related software products is the Clean Air Act, as amended, which specifies various air emission requirements for electrical utility companies and

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industrial coal users. We believe that compliance with the air emission regulations by these coal users can be fully or partially met through the use of clean-burning fuel technologies, like K-Fuel^®, and combustion optimization software, like NeuSIGHT^® and Power Perfecter^™. We are unable to predict future regulatory changes and their impact on the demand for our products. While more stringent laws and regulations, including, without limitation, new mercury emission standards that are expected to be proposed by December 15, 2003, may increase demand for our products. Such laws and regulations could also result in reduced use of coal if utilities switch to other sources of fuel. Similarly, amendments to the Clean Air Act that would have the effect of relaxing emissions limitations, or a repeal of the Clean Air Act would have a material adverse effect on our prospects.

Our inability to adequately protect and defend our proprietary technology could harm our business.

Our success depends upon our proprietary technology. We rely on a combination of patent, copyright, trademark and trade secret rights to establish and protect our proprietary rights. We currently have a series of patents on our K-Fuel^® technology, however, competitors may successfully challenge the validity or scope of one or more of our patents or any future allowed patents. These patents alone, our trade secret rights with respect to NeuSIGHT^® and indemnification by the licensors of various Pegasus software products may not provide us with any significant competitive advantage.

Third parties could copy or otherwise obtain and use our products or technology without authorization or develop similar technology independently. We cannot easily police unauthorized use of our technologies. The protection of our proprietary rights may be inadequate and our competitors could independently develop similar technology, duplicate our solutions or design around any patents or other intellectual property rights we hold.

As is common in the software industry, we may, from time to time receive notices from third parties claiming infringement by our software products of third party patent and other property rights.

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

We rely on key personnel and must be able to retain or attract qualified personnel.

We believe that our performance is substantially dependent on the performance of a small group of senior managers and key technical personnel. The inability to retain key managerial and technical personnel or attract and retain additional highly qualified managerial or technical personnel in the future could harm our business or financial condition.

Local opposition to K-Fuel^® projects could substantially delay or prevent development of new K-Fuel facilities.

Development, construction and operation of K-Fuel^® production facilities require numerous environmental and other permits. The process of obtaining these permits can be lengthy and expensive. In addition, local opposition to a particular project can substantially increase the cost and time associated with developing a project, and can, potentially, render a project unfeasible or uneconomical. We may incur substantial costs or delays or may be unsuccessful in developing K-Fuel^® production facilities as a result of such opposition.

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A significant portion of the potential of the K-Fuel and Pegasus businesses is subject to international risks.

Although our current operations are primarily in the United States, we believe a significant portion of the growth opportunity for both our Pegasus and K-Fuel businesses lies outside the United States. Doing business in foreign countries exposes us to many risks that are not present in the United States and with which we lack significant experience, including political, military, privatization, technology piracy, currency exchange and repatriation risks, and higher credit risks associated with customers. In addition, it may be more difficult for us to enforce legal obligations in foreign countries and we may be at a disadvantage in any legal proceeding within the local jurisdiction. Local laws may also limit our ability to hold a majority interest in the projects that we develop.

Our ability to take advantage of net operating losses if we achieve profitability could be limited.

Under Section 382 of the Internal Revenue Code (“IRC”), the use of prior net operating losses is limited after an “ownership change,” as defined in Section 382. The limitation, if applicable, is equal to the value of the loss corporation’s outstanding stock immediately before the date of the ownership change multiplied by a long-term interest rate specified by the IRC. The quoted market value of a stock is a factor to consider, but not necessarily a conclusive factor, in determining the fair value of a corporation’s stock. Additional issuances of equity interests by us, or on the exercise of outstanding warrants or options to purchase our common stock may result in an ownership change that is large enough to trigger the Section 382 limitations. In the event we achieve profitable operations and taxable income, any significant limitation on the use of our net operating losses to offset taxable income would have the effect of increasing our tax liability and reducing net income and available cash resources.

We are required to pay third parties a significant portion of licensing and royalty revenues with respect to K-Fuel^® technology.

We anticipate that a significant portion of our future revenues with respect to K-Fuel^® will be in the form of licensing and royalty payments from third party licensees operating commercial-scale production facilities of K-Fuel^®. Pursuant to various agreements we have executed, we are required to pay third parties a substantial portion of licensing and royalty revenues that we receive. The Estate of Edward Koppelman is entitled to 25 percent of all license fees and royalties, with a maximum of approximately $75.2 million; Fort Union Ltd. is entitled to 20 percent of royalties from K-Fuel^® production in the United States, Canada and Mexico, not to exceed $1.5 million; and Ohio Valley Electric is entitled to 0.5 percent of royalties derived from the sale of K-Fuel^®. As of December 31, 2002, the Estate of Edward Koppelman has received $275,000 in licensing fees and royalties. Amounts due under these agreements will decrease our revenues from the commercialization of the K-Fuel^® Technology.

We must maintain compliance with the American Stock Exchange (“Amex”) continued listing standards.

Our common stock is listed on the Amex and to maintain our listing we must meet certain continued listings standards. Specifically, pursuant to Section 1003(a)(iii) of the Amex Company Guide, the Amex will consider delisting a company that has stockholders’ equity of less than $6 million if such company has sustained losses from continuing operations and/or net losses in its five most recent fiscal years. In the past we have failed to comply with Amex’s listing standards. On April 10, 2003 we received notification from the Amex that we are currently in compliance with Amex’s listing standards. Going forward, we will continue to be subject to the Amex’s listing standards. There can be no assurance that our common stock will remain listed on the Amex. If our common stock were delisted from the Amex for any reason, it would reduce our liquidity and could seriously reduce the value of our common stock, reduce our ability to raise additional financing, limit our use of equity instruments to satisfy outstanding obligations and limit our ability to attract qualified employees. If our common stock is delisted it may, be deemed to be “penny stock” as that term is defined in Rule 3a51-1 of the Exchange Act of 1934 and would be subject to additional disclosure requirements for penny stocks mandated by the Securities Enforcement Remedies and Penny Stock Reform Act of 1990.

We do not pay cash dividends.

We have never paid any cash dividends and do not anticipate paying cash dividends in the foreseeable future.

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ITEM 2. PROPERTIES

Our principal executive offices consist of approximately 2,600 square feet of office space leased under a sublease through August 31, 2004, located at 3300 East First Avenue, Suite 290, Denver, Colorado 80206. The current base rent under the lease is $4,200 per month, increasing to $4,310 per month by the final year of the lease. We are also obligated to pay, as additional rent, allocable operating costs.

We are parties to the lease relating to our former principal executive offices which consisted of approximately 5,900 square feet of office space located at 1999 Broadway, Suite 3200, Denver, Colorado 80202. The lease for this office space expires in September 2004. The current base rent under the lease is $11,100 per month, escalating gradually to $11,593 per month by the final year of the lease. Effective October 1, 2000 to September 30, 2004, we subleased this office space to a third party for an average of $11,100 per month. We are also obligated to pay, as additional rent, allocable operating costs, most of which will also trigger additional rental income from the sublessee.

We have leased approximately 2,300 square feet of office space through June 30, 2003, located at 2300 Clarendon Boulevard, Suite 401, Arlington, Virginia 22201. The current base rent under the lease is approximately $5,600 per month. We are also obligated to pay, as additional rent, an allocable share of increases in certain operating costs. We have the option to renew the lease for one additional five-year term. A majority of this office space is sublet under short-term leases to third parties.

Pegasus has leased approximately 7,600 square feet of office space through October 2004, located at 5970 Heisley Road, Suite 300, Mentor, Ohio 44060. The current base rent under the lease is approximately $8,515 per month, increasing gradually to $9,146 per month by the final year of the lease. Pegasus is also obligated to pay, as additional rent, allocable operating costs. Pegasus has options to renew the lease for two additional 3-year terms, at a base rent escalated by the Consumer Price Index from the final base rent in the current term.

We, through our KFx Technology, Inc. (“KFxT”) subsidiary, own a demonstration plant and leases from a subsidiary of Black Hills Corporation (for nominal rental payments), a research and development laboratory adjacent to the KFP Facility. This facility is located on approximately 80 acres of land, inside the rail loop of Fort Union Mine, in Campbell County, Wyoming, approximately 5 miles northeast of Gillette, Wyoming. The facility is comprised of three buildings totaling approximately 7,100 square feet.

ITEM 3. LEGAL PROCEEDINGS

Leon S. Segen, derivatively on behalf of KFx v. Westcliff Capital Management, LLC, Richard S. Spencer III, KFx, Inc. and others, United States District Court Southern District of New York, filed March 7, 2003. A stockholder suing derivatively on our behalf has filed a civil complaint against Westcliff Capital Management, LLC, Richard S. Spencer, a member of our Board, us and others pursuant to Section 16(b) of the Securities Exchange Act of 1934 for disgorgement of alleged short-swing profits of at least $5.3 million purported to have arisen in connection with a series of transactions between us and Westcliff Capital Management, LLC completed in 2002. The action seeks disgorgement of profits, interest, attorneys’ fees and costs. Such litigation is not expected to have an economic adverse effect on us.

In addition, we are a party to potential lawsuits incidental to our business, none of which are anticipated to have a material adverse impact on our financial position, results of operations, liquidity or cash flows.

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

Not applicable.

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ITEM 5. MARKET FOR COMMON STOCK AND RELATED STOCKHOLDER MATTERS

Our common stock trades on the American Stock Exchange under the trading symbol “KFX.” The following table presents the reported sales prices on the American Stock Exchange for the two-year period ended December 31, 2002:

As of April 9, 2003, we had 236 holders of record of the common stock. This does not include holdings in street or nominee names. On April 9, 2003, the closing price of the common stock on the American Stock Exchange was $2.80 per share.

We have never paid cash dividends and do not anticipate paying dividends in the foreseeable future.

During 2002, we issued or granted the following securities in private transactions pursuant to an exemption from the registration requirements of the Securities Act of 1933, as amended (“Securities Act”) under Section 4(2) of the Securities Act:

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ITEM 6. SELECTED FINANCIAL DATA

The following selected consolidated financial data should be read in conjunction with the Company’s consolidated financial statements and related notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in Item 7. The consolidated statement of operations data for each of the three years in the period ended December 31, 2002 and the consolidated balance sheet data at December 31, 2002 and 2001 are derived from the audited consolidated financial statements, beginning on page F-1. The consolidated statement of operations data for each of the two years in the period ended December 31, 1999, and the consolidated balance sheet data at December 31, 2001, 1999 and 1998 are derived from audited consolidated financial statements not included in this Annual Report on Form 10-K.

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ITEM 7 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis explains our general financial condition, changes in financial condition and results of operations for KFx Inc, as a whole and each of our operating segments including:

The following discussion contains, in addition to historical information, forward-looking statements that involve risks and uncertainties. Our actual results may differ significantly from the results discussed in the forward-looking statements. As you read this section, you should also refer to our consolidated financial statements and accompanying notes. These consolidated financial statements provide additional information regarding our financial activities and condition. This analysis may be important to you in making decisions about your investment in KFx Inc.

Introduction

We are a “clean energy” technology company with two principal business segments. We have developed a patented process, which we refer to as K-Fuel^® Technology, that transforms low-grade high moisture content coal into high BTU low moisture coal. We also provide an advanced software package for utility boiler optimization through our majority-owned subsidiary Pegasus Technologies, Inc. (“Pegasus”). Our technology and service solutions are marketed to the electric power generation industry to facilitate the industry’s compliance with air emission standards and transformation to intensive competition, as the domestic power industry undergoes deregulation.

Our patented K-Fuel^® Technology is a process which uses heat and pressure to physically and chemically transform high-moisture, low-energy value coal and other organic feedstocks into a low-moisture, high-energy solid clean fuel. We plan to own and operate K-Fuel^® production facilities, as well as license K-Fuel^® Technology domestically and internationally to third parties.

During 2000, we sold 4% of our interest in Pegasus to Kennecott Energy for $1,000,000, we converted $3.6 million of debt Pegasus owed to it into convertible preferred stock and Kennecott Energy invested $2,500,000 into Pegasus in the form of convertible preferred stock.

During 2001, we closed transactions with various parties pursuant to which we sold all of our Pegasus Preferred Stock, representing an approximate 16.0% as converted interest in Pegasus, for $2,722,330 which represents an approximate 16% interest in Pegasus on an as converted basis. Included in these sales of Pegasus preferred stock were sales to Evergreen Resources, Inc. (“Evergreen”), whose Chairman is a director of KFx, for $1,500,000, two directors of KFx and KFx’s Chairman, Theodore Venners, for $100,000 each, and a related party of KFx’s Chairman for $100,000. These sales to related parties represent an as converted interest in Pegasus of approximately 11.2%.

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On April 30, 2002, we satisfied our obligation to repurchase the preferred stock of Pegasus for $3,846,049. In connection with purchase of Pegasus preferred stock, the parties were provided with warrants, expiring five years after their issue, to purchase an aggregate amount of 1,814,887 shares of our common stock at an exercise price of $3.65 per share, subject to certain adjustments including a reduction to a weighted-average price of $2.52 per share upon the conversion or redemption of our Convertible Debentures.

During 2002 Kennecott Energy purchased an additional $1,000,000 of Pegasus Preferred Stock. Also during 2002, we received 919,416 shares of Pegasus Common Stock in exchange for our guarantee of Pegasus’ obligations relating to the Pavilion acquisition and warrants issued in conjunction with the Cinergy advance to Pegasus.

As a result of the additional investments of Kennecott Energy in Pegasus Preferred Stock and the grant of Pegasus Common Stock to us in 2002, the ownership of Pegasus at April 9, 2003 is approximately as follows: KFx—66%, Pegasus founders—14% and Kennecott Energy—20%.

As of April 9, 2003, Pegasus has firm unfilled sales commitments (backlog) for software licenses and related installations at an estimated contract value of $7,467,000 which are generally expected to be filled within approximately the next 3-24 months. At April 12, 2002, such backlog approximated $7,694,000.

We operate in two principal segments of the clean energy industry:

Critical Accounting Policies and Estimates

The Company’s discussion and analysis of its financial condition and results of operations are based upon consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Company to make estimates and judgments that affect both the results of operations as well as the carrying values of our assets and liabilities. Some of our accounting policies require us to make difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. The Company bases estimates on historical experience and on various other assumptions that it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities as of the date of the financial statements that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Our significant accounting policies are described in Note 1 of the Notes to Consolidated Financial Statements. Set forth below is a summary of our most critical accounting policies.

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guidelines of Staff Accounting Bulletin (“SAB”) 101 “Revenue Recognition in Financial Statements” in recognizing revenue related to the sale of software licenses and services. Where products are essential to the functionality of the delivered software, the license fee and product revenue is generally recognized using the percentage-of-completion method of accounting, as prescribed by SOP 81-1 “Accounting for Percentage of Construction -Type and Certain - Production Type Contracts”.

Results of Operations

Year Ended December 31, 2002 vs. Year Ended December 31, 2001

The consolidated operating loss in 2002 of $9,418,879, which includes $4,685,438 of non-cash charges was $201,307, or 2.1%, less than the 2001 operating loss. Pegasus’ portion of the operating loss in 2002 was $2,688,955, which was $800,754, or 22.9%, less than the 2001 Pegasus operating loss. The improvement in the Pegasus operating loss was due to a) an increase of $904,274 (89%) in the gross profits generated by Pegasus as a result of higher levels of installation projects, b) a decrease of $96,041 (15%) in research and development costs because of lower spending levels and c) an increase of $196,350 (7%) in marketing, general and administrative and management fees. The combined K-Fuel segment and corporate cost portion of the operating loss for 2002 was $6,729,924 compared to $6,130,477, an increase of $599,447 or 9.8%. The increase is due to a) the recognition of $1,822,424 for the appreciation of the outstanding stock appreciation rights, b) higher consulting and legal fees associated with the sale of 6.76 million shares of common stock in 2002, c) lower depreciation and amortization expense of $1,297,095 in 2002 because of lower patent amortization and no depreciation expense recorded at the K-Fuel demonstration plant in 2002 and d) a reduction of a $762,144 payment recorded in 2001 relating to the final payment for our Chairman’s note to the State of Wyoming in return for a 12% royalty interest held by the state.

Consolidated operating revenues increased $2,156,972, or 71.8%, from 2001 to 2002. Pegasus’ revenues for 2002 are $5,154,008, an increase of $2,150,951, or 71.6% due to an increase in Pegasus installation projects (approximately $2.2 million of the increase) and an increase in maintenance revenue of approximately $129,000. These increases were partially offset by revenue from a one-time exclusivity payment recorded in 2001 of $300,000. While Pegasus revenues increased significantly in 2002, potential customers of Pegasus have been adversely impacted by the economic downturn in the power generation industry and might delay or cancel future sales orders. Further, a continued weakening United States economy could cause longer sales cycles or delays in closing new business opportunities.

Consolidated operating costs and expenses in 2002 exceeded 2001 by $1,955,665, or 15.5%. Pegasus’ operating costs for 2002 are $7,842,963, an increase of $1,350,197, or 20.8% compared to 2001. The increase can be attributed to a) an increase in cost of software licenses and services of $1,246,677 because of higher levels of software licenses and installations and b) an increase of $196,350 in marketing, general and administrative and management fees for Pegasus. The operating costs for the K-Fuel segment and corporate cost portion for 2002 are $6,735,945, an increase of $605,468, or 9.9%, compared to 2001. The increase is primarily due to a) the recognition of $1,822,424 for the appreciation of the outstanding stock appreciation rights, b) higher consulting and legal fees associated with the sale of 6.76 million shares of common stock in 2002, c) lower depreciation and amortization expense of $1,297,095 in 2002 because

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of lower patent amortization and no depreciation expense recorded at the K-Fuel demonstration plant in 2002 and d) a reduction of a $762,144 payment recorded in 2001 relating to the final payment for our Chairman’s note to the State of Wyoming in return for a 12% royalty interest held by the state.

Non-operating items added $14,032,024 to the Company’s net loss in 2002, an increase of $8,475,134, or 152.5%, compared to $5,556,890 in 2001. The increase is primarily due to a) a decrease of interest expense of $783,415 (14%) because of the debenture payoff/conversion and b) an increase of other expense of $9,253,654. Other expense increased a) $2,797,739 due to the recognition of the warrant penalty incurred as part of private equity investments, b) $10,574,095 due to the recognition of expense relating to the grant of the warrants pursuant to the July 19, 2002 and August 21, 2002 private equity transactions and c) $4,230,405 in other income resulting from the revaluation of warrants at June 30, 2002 and again at August 30, 2002.

As a result of the above factors, the net loss of $23,450,903 ($.67 per share) for 2002 was $8,273,827 ($.09 per share), or 54.5%, greater than the net loss in 2001. Included in the year to date net losses were non-cash charges $17,924,648 and $8,391,179, respectively. Non-cash charges for 2002 included depreciation and amortization, accretion of maturity premium, amortization of debt discount and the cost of common stock and warrants issued for services. Non-cash charges for 2001 included depreciation and amortization, accretion of maturity premium, amortization of debt discount and the cost of common stock and warrants issued for services.

Additional non-cash expense of $16,536,417 was recognized during 2002 to accrete the redeemable common stock, pursuant to the put options, to its redemption value and to recognize expense relating to the reduction of the exercise price and extension of the term of an outstanding warrant. This non-cash expense increased the net loss available to common shareholders to $39,987,320 ($1.14 per share).

The Company has not recorded a deferred tax benefit from KFx’s and Pegasus’ net operating loss carryforwards, which approximate $79.2 million and $13.5 million, respectively, at December 31, 2002, since, based on the weight of available evidence, both positive and negative, management has determined that it is more likely than not that the Company’s deferred tax assets will not be realized. Certain limitations apply to the annual amount of net operating losses that can be used to offset taxable income, after certain ownership changes, as defined in Section 382 of the Internal Revenue Code (“Section 382”). Although management does not believe Section 382 places significant limitations on the use of the Company’s net operating loss carryforwards presently, transactions that may be consummated in order to obtain needed financing may result in ownership changes that are large enough to trigger the Section 382 limitations. In the event the Company achieves profitable operations and taxable income, any significant Section 382 limitation would have the effect of increasing the Company’s income tax liability and reducing available cash resources.

Year Ended December 31, 2001 vs. Year Ended December 31, 2000

The consolidated operating loss in 2001 of $9,620,186, which includes $4,172,650 of non-cash charges, was $621,781, or 6.9%, greater than the 2000 operating loss. Pegasus’ portion of the operating loss in 2001 was $3,489,709, which was an improvement of $641,585, or 15.5%, compared to the corresponding $4,131,294 operating loss in 2000. The improvement in the Pegasus operating loss was due mainly to a significant increase in customer orders and efficiencies gained in installations during 2001. The gross margin for Pegasus’ installations increased to 34% from 6% in the prior year. The combined K-Fuel segment and corporate cost portion of the operating loss for 2001 was $6,130,477 compared to $4,867,111, an increase of $1,263,366, or 26.0%. The increased loss can be attributed to the increase in marketing, general and administrative expenses of $1,860,129, or 83.3%, from the prior year. The increase is primarily due to increased professional fees for legal and consulting services, relating to various financing arrangements that took place during 2001, in addition to $762,144 relating to the final payment for our Chairman’s note to the State of Wyoming in return for a 12% royalty interest held by the state.

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Consolidated operating revenues increased $878,287, or 41.3%, from 2000 to 2001. Pegasus’ revenues for 2001 are $3,003,057, an increase of $1,108,063, or 58.4% due to increased executed orders during 2001 mainly from the Cinergy Fleetwide Agreement along with recognition of the revenue from the installation completed in Poland and the Gateway license fee. The increase in consolidated revenues was offset by the decline in K-Fuel contract revenues in 2001 because there were no contract projects during 2001. The K-Fuel contract revenues are derived from contracts negotiated with a third party who funds individual research projects. Each contract with this third party is negotiated separately as research projects arise. These contracts occur intermittently and there may not be a new project each year. The absence of such a contract in 2001 resulted in a decrease of $229,776 compared to 2000.

Consolidated operating costs and expenses in 2001 exceeded 2000 by $1,500,068, or 13.5%. Pegasus’ operating costs for 2001 are $6,492,766, an increase of $466,478, or 7.7% compared to 2000. The increase can be attributed to a) an increase in amortization expense of $198,110 mainly due to the amortization of intangibles purchased from Pavilion, b) an increase in research and development costs of $40,176, and c) an increase in headcount primarily to support the increase in contracts entered into during 2001. At December 31, 2001, Pegasus had 32 full time employees compared to 23 full time employees at December 31, 2000. The increases in costs were offset by a reduction in professional fees primarily due to the reduction in legal fees incurred during the Pavilion lawsuit and the realization of reduced sales and marketing expenses due to headcount reductions in those areas in 2000. The operating costs for the K-Fuel segment and corporate cost portion for 2001 are $6,130,477, an increase of $1,033,590, or 20.3%, compared to 2000. The increase is primarily due to the increase in professional fees for legal and consulting services, relating to various financing arrangements that took place during 2001, in addition to $762,144 relating to the final payment for our Chairman’s note to the State of Wyoming. These increases were offset by a decrease in depreciation and amortization expense of $265,984 primarily due to the full amortization of most Series “A” and “B” patents by the end of 2000 and the decrease of $560,555 in the costs at the K-Fuel demonstration plant due to the suspension of certain contract activities during 2001.

Non-operating items added $5,556,890 to the Company’s net loss in 2001, an increase of $2,265,123, or 68.8%, compared to $3,291,767 in 2000. The increase is primarily due to an increase in interest expense of $2,822,061, or 106.3%, offset by a reduction in the impairment loss recognized in 2000 of $629,000. Interest expense increased due mainly to the accretion for the maturity premium of $1,063,520 relating to the Company’s convertible debentures and the sales of Pegasus preferred stock and the amortization of the debt discount of $2,998,352 relating to the Cinergy convertible debt, the Company’s convertible debentures and the Evergreen Resources, Inc. preferred stock transaction.

As a result of the above factors, the consolidated net loss of $15,177,076 ($.58 per share) for 2001 was $2,886,904 ($.09 per share), or 23.5%, greater than the net loss in 2000. Included in the year to date net losses were non-cash charges approximating $8,391,179 and $5,814,864, respectively. Non-cash charges for the current year included depreciation and amortization, accretion of maturity premium, amortization of debt discount and the cost of common stock and warrants issued for services. Non-cash charges for the prior year included depreciation and amortization, impairment losses, accretion of maturity premium, amortization of debt discount and the cost of common stock and warrants issued for services.

Liquidity and Capital Resources

At December 31, 2002, our working capital deficit was $2,554,728 compared to a working capital deficit at December 31, 2001 of $17,402,398. The decrease in the working capital deficit of $14,847,670 is attributable to the $19.1 million received from the issuance of stock during 2002 together with the $4.4 million of the proceeds used to satisfy the outstanding amount due on the Pavilion Power Optimization Division acquisition obligation, and approximately $3.8 million of the proceeds was used to satisfy the entire outstanding obligation to repurchase the Pegasus preferred stock. The decrease is also attributable to the retirement of convertible debentures in 2002 of $3,371,200. As of December 31, 2002, we had cash and cash equivalent of $3,341,909 compared to $604,252 at December 31, 2001.

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Cash Used in Operating Activities

Cash used in operating activities decreased to $3,993,900 in 2002 from $6,737,717. The decrease of $2,743,817 was due to: a) higher net loss in 2002 of $8,273,827, b) lower depreciation and amortization in 2002 of $1,293,884, c) higher amortization of debt discount of $423,103, d) lower accretion of maturity premium of $609,486, e) an increase in Stock Appreciation Rights issued for services of $1,822,424, f) an increase in liabilities to issue stock warrants of $9,141,429 g) an increase in the change in accounts receivable, unbilled revenue and deferred job costs of $587,809, h) an increase in deferred revenue of $1,269,125, i) a decrease in accounts payable and accrued expenses of $146,081 and j) a decrease in interest payable of $335,548.

Cash Used in Investing Activities

Cash used in investing activities totaled $5,499,797 in 2002, compared to $2,701,150 in 2001. The increase was primarily due approximately $2.7 million of higher acquisition costs in 2002 as compared to 2001.

Future capital expenditures are anticipated to be, primarily for the development and construction of a K-Fuel^® production facility. The estimated capital expenditures for a K-Fuel production facility are approximately $20 million to $25 million. Such expenditures will be financed with existing cash balances and potential future debt or equity offerings.

Cash Provided by Financing Activities

Cash provided by financing activities totaled $12,231,354 in 2002, compared to $9,694,164 in 2001. The increase was due to a) the $19.6 million received from the issuance of common stock and warrants, b) the repayment of approximately $3.4 million of convertible debentures, c) approximately $3.8 million repurchase of Pegasus preferred stock, d) sale of Pegasus preferred stock in 2001, approximately $2.7 million, e) proceeds of $3.5 million in convertible long-term borrowings in 2001, f) repayment of approximately $1.0 million on convertible long-term borrowings in 2002, g) an increase in short-term borrowing in 2002 of $700,000, i) a reduction in payments on short-term notes to directors in 2002 of $700,000 and j) higher payments on notes payable of approximately $500,000 in 2002.

During 2002, we engaged Jefferies & Co., Inc., an investment banking firm, to assist in all aspects of strategic and financial planning. This step was taken as a part of our ongoing efforts to restructure our balance sheet in an optimal manner for the benefit of our shareholders and in view of the rapidly changing energy market opportunities and challenges. We will require significant funds to finance our proposed K-Fuel^® plant.

In addition, we are considering the potential for debt and/or equity offerings by us and/or Pegasus and has had related discussions with investment banking firms. At this stage, discussions with all of these parties are preliminary, but we intend to continue such discussions and negotiate definitive agreements if acceptable terms can be reached. There is no assurance that any such discussions will result in the consummation of any such transaction.

As discussed above in March 2003 we completed two equity financing transactions. We sold a total of 7,745,000 shares of common stock at a price of $2.50 per share, for an aggregate purchase price of $19.4 million, in a series of private placements to several institutional investors. Under the terms of the agreements, the investors also received warrants for the purchase of an aggregate of 1,549,000 million shares of common stock at a purchase price of $2.75 per share (subject to adjustment) which expire five years after the date of the grant. The proceeds from the sale of these securities will be used for general corporate purposes and to partially fund the development of a K-Fuel^® production facility.

On April 10, 2003 we received notification from the American Stock Exchange that we are now in compliance with their listing standards.

We are continuing to work toward our goal of licensing a large commercial K-Fuel^® plant. Upon granting a license to construct a commercial scale K-Fuel^® production facility, we expect to generate K-Fuel^®

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license fees and net cash flows. Through December 31, 2002, there were no commitments to build a K-Fuel^® plant. It is estimated that construction of a K-Fuel^® production facility will take approximately nine to twelve months, thus no royalty payment would begin until at least nine to twelve months after a license agreement is signed. We will require further funds to construct this production facility.

From time to time, our directors have provided us short term unsecured financing and we expect that such financing, on at least a short-term basis, will continue to be available if needed. Such short term financing will not, however, cover the cash needs we require on an ongoing basis.

We will seek to meet our cash requirements over the next fiscal year with respect to day-to-day operations and debt service requirements through (a) cash on hand, which as of April 9, 2003 approximated $20.4 million; (b) potential additional investments in Pegasus and/or KFx from interested participants in the power generation industry; (c) potential debt and/or equity offerings; (d) potential fees from licensing new K-Fuel facilities; (e) potential partners in connection with opportunities to expand our product and service offerings to the power industry; and (f) unsecured short term borrowings for us and/or Pegasus from one or more of their directors and/or other parties.

Depending on the outcome of various uncertainties, including those discussed herein, we may be required to seek additional debt and/or equity financing for general operating purposes and/or to meet debt service requirements. The timing of collection of accounts receivable and payment of accounts payable could significantly alter our need for at least temporary financing. Should we be required to seek any additional debt and/or equity financing, our ability to do so will be affected by the agreements among KFx and the other shareholders of Pegasus related to the provisions governing the terms of investments from any new investors in Pegasus, limiting the borrowings of Pegasus, limiting the payment of dividends by Pegasus, and precluding us from issuing, selling, transferring or pledging any of our interest in Pegasus and precluding Pegasus from transferring any rights with respect to its equity and assets without approval of at least two-thirds of the investors (see also Note 2 of the consolidated financial statements).

There are no assurances that any of these potential funding sources will materialize, If the overall outcome of the various uncertainties affecting us is not favorable, we may be forced to seek debt and/or equity financing on terms and conditions that may be unfavorable to us, if available at all. If we require additional financing and cannot obtain it when needed, we may default on payments when due. Our former independent accountants report on the Company’s consolidated 2001 and 2000 financial statements contained an explanatory paragraph related to the Company’s ability to continue as a going concern.

Below is the detail of our obligations and the maturity of those obligations as of December 31, 2002:

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NEW ACCOUNTING PRONOUNCEMENTS

In July 2001, the FASB issued FASB Statement No. 143, Accounting for Asset Retirement Obligations (Statement 143). Statement 143 requires that the fair value of a liability for an asset retirement

obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset. The asset retirement liability will be allocated to operating expense by using a systematic and rational method. Statement 143 is effective for financial statement for fiscal years beginning after June 15, 2002. Management is currently assessing what impact Statement 143 may have on its financial position or results of operations.

In June 2002, the FASB issued FASB Statement No. 146, Accounting for Costs Associated with Exit or Disposal Activities (Statement 146). Statement 146 requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. Statement 146 is required to be applied prospectively to exit or disposal activities initiated after December 31, 2002; the Company will adopt FAS 146 on January 1, 2003.

In December 2002, the FASB issued FASB Statement No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure – an amendment of FASB Statement No. 123. Statement 148 requires more prominent disclosure for companies that account for Stock Based Compensation under Accounting Principal Board No. 25, Accounting for Stock Issued to Employees. Statement 148 amends the disclosure required under Statement 123 to require prominent disclosure in both the annual and interim financial statements about the methods of accounting for stock-based employee compensation and the effect of the method used on reported results. Statement 148 is effective for financial statements for fiscal years ending after December 15, 2002.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company is not currently subject to a significant level of direct market risk related to interest rates, foreign currency exchange rates, commodity prices or equity prices. The Company has no derivative instruments and only $450,000 of floating rate debt and does not expect to derive a material amount of its revenues from interest bearing securities. Currently the Company has no foreign operations. To the extent that the Company establishes significant foreign operations in the future, it will attempt to mitigate risks associated with foreign currency exchange rates contractually and through the use of hedging activities and other means considered appropriate. The Company is indirectly exposed to fluctuations in fuel commodity prices. To the extent that fuel prices rise, there may be a tendency for greater demand for certain of the Company’s products and services, since K-Fuel and Pegasus’ combustion optimization products have been shown to result in lower usage of coal and coal beneficiated fuel products when used to generate electric power. The Company’s fuel-related products provide various environmental benefits that management believes significantly mitigate the fuel commodity risk associated with the Company’s business. The Company holds no equity market securities, but does face equity market risk relative to its own equity securities.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA

The financial statements required pursuant to this item are included in Item 15 of this Annual Report on Form 10-K and are beginning on page F-1. The supplementary financial information required by this item is included in “Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations” under the subsection titled “Quarterly Results of Operations/Supplementary Financial Information.”

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES

On February 5, 2003, PricewaterhouseCoopers LLP (“PwC”) was dismissed as independent accountants for the Company. On that same date, Deloitte & Touche LLP was recommended as the new independent accountants for the Company for the year ended December 31, 2002. The decision to change independent accountants was recommended and approved by the Audit Committee of the Board of Directors of the Company and was also approved by the Board of Directors of the Company.

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PwC’s reports on our financial statements for the two fiscal years ended December 31, 2001 and 2000 did not contain an adverse opinion or a disclaimer of opinion, nor were qualified or modified as to uncertainty, audit scope or accounting principle, except that PwC’s opinion on our 2001 and 2000 financial statements included an explanatory paragraph expressing substantial doubt regarding our ability to continue as a going concern.

During the Company’s two most recent fiscal years and the period from January 1, 2002 through February 5, 2003, there were no disagreements between the Company and PwC on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure, which disagreements, if not resolved to the satisfaction of PwC, would have caused it to make reference to the subject matter of the disagreements in connection with its report.

We provided both PwC and Deloitte & Touche LLP with a copy of the foregoing disclosures.

During the year ended December 31, 2001 and 2000 and through the date hereof, the Company did not consult Deloitte & Touche LLP regarding any matters or events set forth in Item 304(a) (2) (i) and (ii) of Regulation S-K.

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS

The required information for this item is incorporated by reference to the Company’s Proxy Statement for the 2003 Annual Meeting of Shareholders.

ITEM 11. EXECUTIVE COMPENSATION

The required information for this item is incorporated by reference to the Company’s Proxy Statement for the 2003 Annual Meeting of Shareholders.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The required information for this item is incorporated by reference to the Company’s Proxy Statement for the 2003 Annual Meeting of Shareholders.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The required information for this item is incorporated by reference to the Company’s Proxy Statement for the 2003 Annual Meeting of Shareholders.

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ITEM 14. CONTROLS AND PROCEDURES

(a) Evaluation of disclosure controls and procedures

Based on an evaluation carried out under the supervision, and with the participation of the management of the Company, including the Chief Executive Officer and the Chief Financial Officer, during the 90 day period prior to the filing of this report, the Company’s Chief Executive Officer and Chief Financial Officer believe the Company’s disclosure controls and procedures, as defined in the Securities Exchange Act Rules 13a-14 and 15d-14, are, to the best of their respective knowledge, effective.

(b) Changes in internal controls

Subsequent to the date of this evaluation, the Chief Executive Officer and Chief Financial Officer are not aware of any significant changes in the Company’s internal controls, including any corrective actions with regard to significant deficiencies and material weaknesses, or in other factors that could significantly affect these controls to ensure that information required to be disclosed by the Company, in reports that it files or submits under the Securities Act of 1934, is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and regulations.

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

(a) The following documents are filed as part of this Annual Report on Form 10-K:

(1) Consolidated Financial Statements

The following consolidated financial statements of KFx, Inc. are filed as part of this report:

(2) List of Financial Statement Schedules

None

(3) Exhibits

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(b) Reports on Form 8-K

During the quarter ended December 31, 2002, the Company filed Current Reports on Form 8-K dated October 4, 2002 under Item 5, Other Events and December 20, 2002 under Item 5, Other Events.

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SIGNATURES

PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED.

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POWER OF ATTORNEY

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Theodore Venners and Jerry A. Mitchell, and each of them, as his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution, for him and in his name, place, stead, in any 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 in connection therewith, including all amendments thereto, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection therewith, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof.

PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED.

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CERTIFICATION OF CHIEF EXECUTIVE OFFICER

Section 302 Certification

I, Theodore Venners, certify that:

April 14, 2003

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CERTIFICATION OF CHIEF FINANCIAL OFFICER

Section 302 Certification

I, Jerry A. Mitchell, certify that:

April 14, 2003

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INDEPENDENT AUDITORS’ REPORT

To the Stockholders and Board of Directors of KFx Inc.

Denver, Colorado

We have audited the accompanying consolidated balance sheet of KFx Inc. and subsidiaries (the Company) as of December 31, 2002, and the related consolidated statements of operations, stockholders’ equity (deficit), and cash flows for the year then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.