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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

(Mark one)

For the quarterly period ended March 31, 2005

OR

For the transition period from              to             

Commission file number 001-32393

Environmental Power Corporation

(Exact name of registrant as specified in its charter)

One Cate Street 4^th Floor, Portsmouth, New Hampshire 03801

(Address of principal executive offices)

(Zip code)

(603) 431-1780

Registrant’s telephone number, including area code

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

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

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

Number of shares of Common Stock outstanding at March 31, 2005: 7,417,558 shares

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PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

ENVIRONMENTAL POWER CORPORATION AND SUBSIDIARIES

Condensed Consolidated Balance Sheets (unaudited) as of March 31, 2005 and December 31, 2004

See Notes to Condensed Financial Statements.

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ENVIRONMENTAL POWER CORPORATION AND SUBSIDIARIES

Condensed Consolidated Statements of Operations (unaudited) for the Three Months Ended March 31, 2005 and March 31, 2004

See Notes to Condensed Financial Statements.

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ENVIRONMENTAL POWER CORPORATION AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows (unaudited) for Three Months Ended March 31, 2005 and March 31, 2004

See Notes to Condensed Financial Statements.

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ENVIRONMENTAL POWER CORPORATION AND SUBSIDIARIES

Condensed Consolidated Statement of Equity for Three Months Ended March 31, 2005

See Notes to Condensed Financial Statements.

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Notes to Condensed Consolidated Financial Statements

NOTE A — BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements of Environmental Power Corporation (“we”, “us”, “EPC”, or the “Company”) and our subsidiaries have been prepared in accordance with the instructions to Form 10-Q and include all of the information and footnotes required by generally accepted accounting principles for annual financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. The results of operations for the three months ended March 31, 2005 are not necessarily indicative of results to be expected for the year ending December 31, 2005. For further information, refer to the consolidated financial statements and footnotes included in our Annual Report on Form 10-K for the year ended December 31, 2004.

NOTE B — EARNINGS PER COMMON SHARE

We compute basic earnings per share by dividing net income (loss) for the period by the weighted average number of shares of common stock outstanding during the period. We compute our diluted earnings per common share using the treasury stock method. For purposes of calculating diluted earnings per share, we consider our shares issuable in connection with stock options to be dilutive common stock equivalents when the exercise price is less than the average market price of our common stock for the period. The following table outlines the calculation of basic earnings per share and diluted earnings per share for the three months ended March 31, 2005 and 2004. We excluded 333,066 and 100,280 anti-dilutive common stock equivalents from the calculation of diluted earnings per share for the three months ended March 31, 2005 and 2004, respectively.

NOTE C —STOCK OPTIONS AND STOCK-BASED COMPENSATION

We have elected to account for stock options in accordance with Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” which uses the intrinsic value method of accounting. Accordingly, the Company has not recognized compensation expense for the fair value of its stock-based awards in its condensed consolidated statements of operations.

We account for non-employee stock compensation under SFAS 123 and EITF 96-18. We record the compensation expense over the period of service at the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more reliably measurable. The fair value of the options or warrants is calculated using a Black-Scholes option model.

During the three months ended March 31, 2005, we issued 301,790 options under the 2001 Stock Incentive Plan. During the three months ended March 31, 2004, we issued 10,000 options under the 2001 Stock Incentive Plan. In March 2004, we issued 142,858 performance-based options each to Joseph E. Cresci, Chairman, and Donald A Livingston, Executive Vice President, as part of their executive compensation packages that also included a reduction in their base salaries to $225,000 each. These options are vested completely on September 23, 2004 upon the successful completion of specific milestones related to the development of our Microgy subsidiary. In March 2004, we reduced the options granted to Kamlesh Tejwani, Chief Executive Officer by 142,858 and amended his remaining options to have performance-based vesting criteria, including raising additional equity. On February 3, 2005, all of Mr. Tejwani’s remaining options vested upon the successful completion of our recent public offering. There is no future liability related to this transaction.

Because there is uncertainty regarding the vesting of performance-based options, we apply variable accounting treatment to these options. When options vest or if it is highly likely that they will vest, we expense the options based upon the current stock price. These options are re-evaluated quarterly.

We recorded $587,558 of stock-based compensation income in the three months ended March 31, 2005 and $231,822 of stock based compensation expense for the three months ended March 31, 2004. The following table shows the composition of the non-cash, stock-based compensation for the three months ended March 31, 2005.

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The following table reflects pro forma net income and earnings per share had the Company elected to record expense for employee stock options under Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock Based Compensation.”

NOTE D – GOODWILL AND INTANGIBLE ASSETS

Intangible assets are recorded at cost and consist of licensed technology rights and goodwill. Licensed technology rights are being amortized using the straight-line method over a useful life of 20 years. Goodwill represents the excess of cost over the fair value of tangible and identifiable intangible assets and liabilities acquired in a business combination and are not being amortized pursuant to SFAS No. 142 “Goodwill and Other Intangible Assets.”

Accumulated amortization of licensed technology rights was $685,079 as of March 31, 2005 and $638,704 as of December 31, 2004. Amortization expense for licensed technology rights was $46,375 for the three months ended March 31, 2005. The future estimated amortization expense for licensed technology rights is as follows:

Estimated Amortization Expense for Licensed Technology Rights

NOTE E – RECENT ACCOUNTING PRONOUNCEMENTS

SFAS No. 151, Inventory Costs - An amendment of ARB No. 43, Chapter 4 (SFAS 151) was issued in November 2004. SFAS 151 reinforces the requirement that abnormal levels of idle facility expense, freight, handling costs and spoilage are required to be expensed as incurred and not included in overhead. The statement also requires fixed production overheads be allocated to conversion costs based on the production facility’s normal capacity. The provisions in Statement 151 are effective prospectively for inventory costs incurred during fiscal years beginning after June 15, 2005. The adoption of SFAS 151 is not expected to have a material impact on our consolidated financial statements.

FASB Statement No. 123 (Revised 2004), Share-Based Payment (SFAS 123(R)) was issued in December 2004. SFAS 123(R) replaces SFAS No. 123, Accounting for Stock-Based Compensation (SFAS 123), and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees. SFAS 123(R) requires companies to recognize the compensation cost related to share-based payment transactions with employees in the financial statements. The compensation cost is measured based upon the fair value of the instrument issued. Share-based compensation transactions with employees covered within SFAS 123(R) include stock options, restricted share plans, performance-based awards, share appreciation rights, and employee stock purchase plans. SFAS 123 included a fair-value-based method of accounting for share-based payment transactions with employees, but allowed companies to continue to apply the guidance in APB 25 provided that they disclose in the footnotes to the financial statements the pro forma net income if the fair-value-based method been applied. SFAS 123(R) requires the use of the modified prospective application transition method. The modified prospective application transition method requires the application of this standard to:

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For unvested awards, the compensation cost related to the remaining ‘requisite serve’ that has not been rendered at the effective date will be determined by the compensation cost calculated currently for either recognition under SFAS 123. We will be adopting the modified prospective application of SFAS 123(R). Based on the current options outstanding, we do not anticipate the adoption of this statement to result in the recognition of material additional compensation cost in the first quarter of 2006.

NOTE F – RETIREMENT PLAN

Net Periodic Benefit Costs - Our net periodic pension costs are comprised of the following components:

Plan Assets – Pension costs and cash funding requirements are expected to increase in future years. The following table sets out the market value of out retirement plan as of March 31, 2005 and December 31, 2004.

Employer Contributions – We made contributions to the pension plan of $380,866 in the first quarter of 2005.

NOTE G – LONG TERM LIABILITIES

Long Term Liabilities & Commitments

The following table shows all of our long term liabilities and commitments:

EPC Corporation Debt Obligations – On September 4, 2003, we entered into a Note Purchase Agreement with Crystal Creek Coalpower Funding, LLC, an affiliate of ArcLight Energy Partners Fund I, L.P., referred to as ArcLight, pursuant to which our subsidiary, EPC Corporation, which holds as its sole asset the stock of Buzzard, agreed to issue and sell to ArcLight up to $5,400,000 original principal amount of its 20.0% Senior Secured Notes due December 31, 2012, consisting of Note A in the original principal amount of $3,700,000 and Note B in the original principal amount of $1,700,000. ArcLight purchased Note A on September 4, 2003, as a result of which EPC Corporation received gross proceeds of $3.7 million. We do not expect ArcLight to purchase Note B. The aggregate minimum principal and interest to be paid by EPC Corporation on Note A over the term of Note A is $4.8 million. Distributions from Scrubgrass are held by an agent bank, J.P. Morgan. Payments are made first to any outstanding interest, second to fees to the agent bank, third to the management fee to us, and fourth to the outstanding principal. Distributions from Scrubgrass are required to be used to repay Note A. After it is paid in full, we will keep the next $1.4 million of distributions. Thereafter, future distributions will be shared equally through December 31, 2012. Any unpaid interest that has accrued on the 15^th of each month shall be added to the balance of the note.

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We are only required to make payments to the extent that we receive distributions from Scrubgrass with the exception of making at least one payment in any 24 month period. We are prohibited from incurring additional debt at the EPC Corporation subsidiary level. Additionally, we are required to provide ArcLight with financial statements and other related information in a timely manner, for which we are paid an annual management fee of $75,000. As of March 31, 2005, we are in full compliance with our covenants.

The following table describes our debt obligations as of March 31, 2005 and December 31, 2004:

Scrubgrass Debt Obligations - Buzzard and the lessor have various debt obligations related to Scrubgrass. Under the terms of the Scrubgrass lease, Buzzard is required to pay the principal, interest and fees for the lessor’s debt obligations as a base lease payment. As such, Buzzard is committed to pay all of the Scrubgrass debt obligations as either a debt or lease obligation. Scrubgrass had the following debt obligations as of March 31, 2005 and December 31, 2004:

Because we are not required to fund Buzzard’s operating losses, including payments to lease obligations, or otherwise invest further from sources outside of the Scrubgrass plant, Buzzard’s lease obligations for the lessor’s debt are not reported in our consolidated financial statements. As these debt obligations mature, they will be billed by the lessor to Buzzard and reported as a lease expense in our consolidated financial statements.

Notes Receivable from Officers – We have outstanding notes receivable from officers and directors for shares purchased in connection with stock option plans which amounted to $638,219 and $640,110 as of March 31, 2005 and December 31, 2004, respectively. These notes, secured by the underlying shares of stock, are payable upon demand and bear interest at a floating rate which is payable monthly. In accordance with company policy and applicable law, we no longer make loans to our officers or directors.

Sunnyside Contingent Obligations – We had contingent obligations of $1,218,078 on our consolidated balance sheet as of December 31, 2000. The contingent obligations were principally expenses for the sale of Sunnyside which were payable upon collection of certain obligations from the purchasers of Sunnyside. On April 10, 2001, we received aggregate proceeds of $1,500,000 from the purchasers of Sunnyside and resolved litigation by executing a Binding Settlement Agreement. In this agreement, we were formally released from contingent obligations of $177,962. We have also been released by the statute of limitations or the terms of the underlying agreements from additional contingent obligations of $457,086. We reported the settlement proceeds of $1,500,000 and the released liabilities of $635,048 as other income in our consolidated financial statements for 2001.

Because of the terms of this settlement agreement, which terms represented a substantial compromise of our previous claims against the purchasers of Sunnyside, we are presently considering our rights and obligations with respect to the remaining contingent obligations of $583,030. The unsettled contingent obligations will remain recorded in our consolidated financial statements until the statute of limitations for any legal action runs out after 2007.

NOTE H – SEGMENT INFORMATION

We manage and evaluate our operations in two reportable business segments: the Scrubgrass project (Buzzard) and Microgy. “All Other Segments” is comprised of corporate items that are not directly tied to either operating entity. These segments have been classified separately because of the different technologies used in the generation of energy and the future growth prospects of the businesses. Financial data for reportable business segments is as follows:

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NOTE I – CONTRACTS

Revenues and profits from our contracts, referred to as product sales, are generally recognized by applying percentages of completion for the period to the total estimated profits for the respective contracts. Percentage of completion is determined by relating the actual cost of the work performed to date to the current estimated total cost of the respective contracts. However, due to our relative inexperience with construction projects of this kind, we are currently limiting our revenue recognition to an amount equal to our cost of construction, thereby not recognizing any gross profit until the project is complete. When the estimate on a contract indicates a loss, our policy is to record the entire loss during the accounting period in which it is estimated. In the ordinary course of business, at a minimum on a quarterly basis, we prepare updated estimates of the total forecasted revenue, cost and profit or loss for each contract. The cumulative effect of revisions in estimates of the total forecasted revenue and costs, including unapproved change orders and claims, during the course of the work is reflected in the accounting period in which the facts that caused the revision become known. The financial impact of these revisions to any one contract is a function of both the amount of the revision and the percentage of completion of the contract. An amount equal to the costs incurred is included in the total estimated revenue when realization is probable. Profit from unapproved change orders and claims is recorded in the period such amounts are resolved.

In accordance with normal practice in the construction industry, we include in current assets and current liabilities amounts related to construction contracts realizable and payable over a period in excess of one year. Deferred contract revenue represents the excess of billings to date over the amount of contract costs and profits (or contract revenue) recognized to date on the percentage of completion accounting method on certain contracts. Unbilled work represents the excess of contract costs and profits (or contract revenue) recognized to date on the percentage of completion accounting method over billings to date on the remaining contracts. Unbilled work results when the appropriate contract revenue amount has been recognized in accordance with the percentage of completion accounting method, but a portion of the revenue recorded cannot be billed currently due to the billing terms defined in the contract, and/or costs, recorded at estimated realizable value, related to unapproved change orders or claims are incurred. Unbilled work related to our contracts at March 31, 2005 and December 31, 2004, consisted of the following:

NOTE J – PUBLIC OFFERING

On February 3, 2005, we successfully completed a public offering of our common stock, raising $12,409,375 in net proceeds. We issued 2,500,000 shares of common stock as a result of this offering.

NOTE K – SUBSEQUENT EVENTS

On May 5, 2005, the Board of Directors voted to terminate our pension plan. Plan participants will be given at least 60 days written notice. Participants will receive distributions from the plan based upon the credited years of service at the date of the plan’s termination. The Company may have to make additional contributions to the plan of approximately $400,000 to $600,000 to meet any outstanding obligations.

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

You should read the following discussion together with our financial statements and accompanying notes included in this quarterly report and our audited financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2004, which is on file with the Securities and Exchange Commission. In addition to historical information, the following discussion contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results could differ materially from those anticipated by the forward-looking statements due to important factors including, but not limited to, those set forth under “Certain Factors That May Affect Future Results” below.

Overview

Our mission is to be a leading company in resource management and energy production technologies that serve multiple socially responsible markets. Since inception, we have been an independent developer and owner of non-commodity, renewable and alternative energy facilities that produce biofuels or electricity by utilizing fuel derived from our agricultural waste management processes or alternative fuel sources such as waste coal. Such fuel sources generally are not subject to the pricing and market fluctuations of commodity fuels and, in some instances, are considered renewable energy fuels. We have developed seven hydroelectric plants, two municipal waste projects, and three waste coal-fired generating facilities. We sold or transferred all of these projects either in development or after completion. We currently have two principal business units, Buzzard Power Corporation and Microgy, Inc., which are described below.

Buzzard Power Corporation

Buzzard Power Corporation, referred to as Buzzard, is a subsidiary of our wholly owned subsidiary, EPC Corporation. Buzzard leases its generating facility from Scrubgrass Generating Company, L.P. The Scrubgrass plant, referred to as Scrubgrass, located on a 600-acre site in Venango County, Pennsylvania, is an approximate 83 megawatt waste coal-fired electric generating station.

Microgy, Inc.

Microgy, Inc., formerly Microgy Cogeneration Systems, Inc., referred to as Microgy, holds an exclusive license in North America for the development and deployment of a proprietary technology for the extraction of methane gas from animal wastes and other organic wastes. This biogas can be used to generate electricity or thermal energy that can be used in other applications. The biogas can also be refined to pipeline-grade methane and sold as a commodity. Microgy’s technology is expected to provide certain farms, known as animal feeding operations, or AFOs, with a potentially profitable means of mitigating an existing waste management problem that affects both water and air quality. Federal and state agencies either have or may be in the process of passing regulations that require AFOs to implement changes to their current waste management practices.

While Microgy is seeking to help farmers meet their waste management needs, we are also seeking to put the biogas produced to use in the generation of electricity or other valuable applications, such as the production of thermal energy to power animal feed production facilities. Many states have either passed or may be in the process of promulgating legislation requiring utilities to obtain a certain percentage of their power from renewable sources. This trend, along with increases in the costs of conventional energy, positions Microgy as a potentially profitable solution to farmers’ waste management problems, while at the same time providing a new renewable energy source for utilities. We believe that Microgy represents a substantial portion of our future potential growth and, as such, we currently are investing most of our available resources, including both our financial and human capital, to take advantage of Mircogy’s potential.

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations compares the results of operations for the three months ended March 31, 2005 with the results of operations for the three months ended March 31, 2004. Unless otherwise indicated, all references to 2005 pertain to the three months ended March 31, 2005 and all references to 2004 pertain to the three months ended March 31, 2004. Historical results and trends that might appear should not be taken as indicative of future operations.

Cautionary Note Regarding Forward-Looking Statements

The Private Securities Litigation Reform Act of 1995, referred to as the PSLRA, provides a “safe harbor” for forward-looking statements. Certain statements contained in this Report, such as statements concerning planned manure-to-energy systems, our sales pipeline, our backlog, our projected sales and financial performance, statements containing the words “may,” “assumes,” “forecasts,” “positions,” “predicts,” “strategy,” “will,” “expects,” “estimates,” “anticipates,” “believes,” “projects,” “intends,” “plans,” “budgets,” “potential,” “continue,” “target” and variations thereof, and other statements contained in this Report regarding matters that are not historical facts are forward-looking statements as such term is defined in the PSLRA. Because such statements involve risks and uncertainties, actual results may differ materially from those expressed or implied by such forward-looking statements. Factors that could cause actual results to differ materially include, but are not limited to:

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and other factors, including those described in this Report under the heading “Certain Factors Which May Affect Future Results,” as well as other filings we make with the Securities and Exchange Commission. If one or more of these factors materialize, or if any underlying assumptions prove incorrect, our actual results, performance or achievements may vary materially from any future results, performance or achievements expressed or implied by these forward-looking statements. In addition, any forward-looking statements in this quarterly report represent our views only as of the date of this quarterly report and should not be relied upon as representing our views as of any subsequent date. We anticipate that subsequent events and developments will cause our views to change. However, while we may elect to update these forward-looking statements publicly at some point in the future, we specifically disclaim any obligation to do so, whether as a result of new information, future events or otherwise.

RESULTS OF OPERATIONS

For the three months ended March 31, 2005, we had net income of $406,441, or earnings per common share of $0.06, compared to net income of $1,428,851, or earnings per common share of $0.37, for the three months ended March 31, 2004. The decrease in net income was primarily attributable to a $1,969,384 increase in costs and expenses for the first quarter of 2005 as compared to the same periods in 2004, partially offset by an $832,626 increase in revenues during the period, as compared to the same period in 2004. These changes are described in greater detail below.

Revenues increased by $832,626, or 6%, to $15,171,014 for the quarter ended March 31, 2005, as compared to $14,338,388 for the quarter ended March 31, 2004. The increase is due principally to recognition of revenues at Microgy, which did not recognize any revenues in the first quarter of 2004. In the quarter ended March 31, 2005, Microgy recognized $1,256,502 in product sales revenues relating to its first three projects, based upon the percentage completion method, compared to no such revenues in the same period in 2004. At Buzzard, revenues decreased by $423,876 due to decreases in accrued power generation revenues of $504,931 that were partially offset by an increase in billed power generation revenues of $80,673.

Costs and expenses increased by $1,969,384, or 15%, to $14,725,666 for the quarter ended March 31, 2005, as compared to $12,756,282 for the quarter ended March 31, 2004. This increase was attributable to an increase in cost of goods sold at Microgy of $1,545,670, a $773,112 increase in lease expenses related to Scrubgrass, and a $526,301 increase of general and administrative expenses for the first quarter of 2005 as compared to the same period last year. These increases were partially offset by a decrease in non-cash compensation expense of $819,380 for the first quarter of 2005 as compared to the same period last year. Non-cash compensation expense is related to non-employee stock and option grants and employee options that are subject to variable accounting treatment.

In the quarter ended March 31, 2005, other expenses decreased to $34,611, as compared to $124,582 in the quarter ended March 31, 2004. This decrease was primarily attributable to a $79,789 decrease in interest expense related to the Arclight loan for the first quarter of 2005 as compared to the same quarter last year.

For the quarter ended March 31, 2005, we reported a tax expense of $4,296, as compared to a tax expense of $28,673 for the quarter ended March 31, 2004. Our tax rate is based upon forecasts for a full year of operations. Currently, we expect to have a federal tax benefit and a state tax obligation. However, we have deferred any federal tax benefits.

We have two primary business segments, Buzzard and Microgy. The results of operations for these business segments, and All Other Segments, which is comprised of parent company expenses and non-current business segments, are discussed below.

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Buzzard

Buzzard provided pre-tax income of $977,079 for the quarter ended March 31, 2005, compared to pre-tax income of $2,525,520 for the quarter ended March 31, 2004. This decrease in pre-tax income was caused by a decrease in revenues of $ 423,876, an increase in lease expenses of $773,112 and a $320,736 increase in fuel expenses for the first quarter of 2005 as compared to the same period last year. These increases were partially offset by decreases in routine maintenance expenses of $125,224 for the first quarter of 2005 as compared to the same period last year.

Power generation revenues decreased to $13,914,512 in the quarter ended March 31, 2005 from $14,338,388 in the quarter ended March 31, 2004. This decrease was principally due to a $504,931 decrease in accrued power generation revenues for the first quarter of 2005 as compared to the same period last year, partially offset by an increase in billed power generation revenues of $80,673. This decrease resulted from the effects of FASB 13 on the accounting treatment of the Scrubgrass lease. In accordance with generally accepted accounting principles in the United States, we are required to treat our power sales agreement with Penelec as a lease, aggregate the minimum lease payments expected to be received over its life, and recognize it on a straight-line basis over the 22-year lease term. However, we have limited the recognition of accrued power revenues to the recognition of the deemed minimum payments of the facility lease so that we do not recognize any profits early related to executory costs or payment for goods and services other than solely for the right to use the facility. This minimum lease payment component is higher in the early years, decreases in the subsequent years, and reverses itself in the later years of the power purchase agreement. This adjustment has no effect on pre-tax income because it is completely offset by an accrued lease expense.

The decrease in accrued power generation revenues for the first quarter of 2005 was offset by an increase in billed power generation revenues of $80,673. In the first quarter of 2005, the operating capacity of the plant was 98.52%, compared to 95.17% in the first quarter of 2004. The effect of the increase in operating capacity was offset by a 2% decrease in the billing rate under our power sales agreement with Penelec.

Total operating expenses for the three months ended March 31, 2005 decreased slightly to $6,232,239, from $6,281,122 for the three months ended March 31, 2004. This decrease was a result of decreases in routine maintenance costs of $125,224 and labor costs of $73,883 for the first quarter of 2005 as compared to the same period last year. These decreases were partially offset by increases in chemical expenses of $105,855 for the first quarter of 2005 as compared to the same period last year.

Lease expenses for the three months ended March 31, 2005 increased by $773,112 to $5,569,796, as compared to $4,796,684 for the three months ended March 31, 2004. This increase resulted from increases of $1,781,721 in scheduled equity rent payments and $224,260 in bond interest for the first quarter of 2005 as compared to the same period last year, partially offset by decreases in scheduled principal payments of $719,033 and in deferred lease expenses of $504,931 for the first quarter of 2005 as compared to the same period last year.

Microgy

Pre-tax losses at Microgy increased to $1,109,242 for the three months ended March 31, 2005, from $533,719 for the three months ended March 31, 2004. This increase resulted from increases in operating expenses associated with the construction of Microgy’s first three projects, as well as increased development efforts in California and the southwestern United States.

Microgy recognized revenues of $1,256,502 for the three months ended March 31, 2005. No revenues were recognized in the same period in 2004. We are recognizing revenues associated with the construction of the first three of the projects on which we have commenced construction under our relationship with Dairyland using the percentage of completion method. However, due to the uncertainty associated with the projects, we are currently limiting our revenue recognition to an amount equal to our cost of construction, thereby not recognizing any gross profit until the project sale process is complete. When the estimate on a contract indicates a loss, our policy is to record the entire loss during the accounting period in which it is estimated. Once we have a proven track record of successfully completing projects of this kind, we will move to the standard percentage of completion revenue recognition method and recognize a prorated share of gross profit in each period that we record revenue. We began billing Dairyland for construction costs on the generator portion of these farms in August 2004.

Cost of goods sold increased to $1,545,670 in the three months ended March 31, 2005, as compared to $0 in the three months ended March 31, 2004. These expenses represent the construction costs related to the first three Dairyland projects, which had not yet commenced construction in the first quarter of 2004.

General and administrative expenses for Microgy increased by $267,609 to $767,387 for the three months ended March 31, 2005, as compared to $499,778 for the three months ended March 31, 2004. This increase is primarily due to increases during the first quarter of 2005 in payroll expenses of $234,669, due to the additional staff needed for the growth of Microgy, $51,967 in consulting fees and $20,638 in travel and entertainment expenses, in each case as compared to the same period in 2004.

All Other Segments

All other segments are comprised of corporate expenses and non-current business segments. We did not have any revenues in these segments for the three months ended March 31, 2005. We had pre-tax income of $542,902 in this segment for the first quarter of 2005, compared to a pre-tax loss of $534,277 for the same period in 2004. This income is attributable to the variable accounting of performance-based options, as discussed below.

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The accounting for performance-based options resulted in income of $642,857 for the first quarter of 2005, as the closing price of our common stock decreased to $5.20 on March 31, 2005 from $7.00 on December 31, 2004. Please see Note C for more information. This income was partially offset by expenses related to options issued to non-employees of $55,299, by increases in professional fees of $143,677 and in business development expenses of $144,224 for the first quarter of 2005. For the same period in 2004, we did not have variable accounting related to performance-based options

We had total other expenses of $25,802 for the first quarter of 2005, compared to expenses of $119,274 for the same period in 2004. The decrease in other expenses is primarily due to decreases in interest expenses of $79,789 for the first quarter of 2005, due to the fact that we have continued to make repayments on the principal balance of the Arclight loan, as described in Note G.

LIQUIDITY AND CAPITAL RESOURCES

Operating Activities

Our cash used in operating activities was $2,010,046 in the three months ended March 31, 2005, compared to cash provided by operating activities of $389,827 for the same period in 2004. During these periods, our only sources of cash from operating activities were operating profits from Scrubgrass and product sales at Microgy. We reported net income of $406,441 during the three months ended March 31, 2005 which was offset entirely by cash used in operating activities. The following adjustments, which did not impact our cash flows, need to be considered in order to reconcile our net income in the first quarter of 2005 to our net cash used in operating activities:

Depreciation and amortization - During the first quarter of 2005, we recognized depreciation and amortization for lease rights of $37,251, licensed technology rights of $46,375, and property plant and equipment of $32,927.

Deferred gain, net – Our deferred gain, net, decreased to $3,469,620 as of March 31, 2005 from $3,546,723 as of December 31, 2004. The decrease is due to the amortization of the deferred gain related to Scrubgrass, which is being amortized on a straight-line basis over 22 years.

Interest expense, accrued and added to the balance of borrowing – In the first quarter of 2005, we had $118,999 of interest expense that was added to the outstanding principal balance of the Arclight loan.

Stock-based compensation – The accounting for performance-based options resulted in income of $642,857 for the first quarter of 2005. This income was partially offset by expenses related to options issued to non-employees of $55,299 for the first quarter of 2005.

We also offer the following information regarding changes in operating assets and liabilities which most notably impacted our cash position during the first quarter of 2005:

Receivables – Receivables at Buzzard decreased to $13,875,518 on March 31, 2005 from $14,466,924 on December 31, 2004. This decrease was due to a 2% decrease in billable power rates and a decrease in operating capacity to 98.52% at March 31, 2005 compared to 98.98% at December 31, 2004. Microgy and EPC receivables decreased to $1,703,392 from $1,844,194 for the first quarter of 2005 at March 31, 2005 due primarily to lower product revenues sales at Microgy

Fuel Inventory – Fuel inventory at Buzzard decreased to $1,186,163 on March 31, 2005 from $1,269,297 on December 31, 2004.

Unbilled Revenues – Unbilled revenues at Microgy decreased to $173,401 on March 31, 2005 from $624,683 on December 31, 2004.

Accounts payable and accrued expenses – Our accounts payable and accrued expenses decreased to $8,897,742 on March 31, 2005 from $12,119,212 on December 31, 2004 due primarily to payments of $1,778.379 of operating and lease expenses at Buzzard, payments of $726,057 of construction expenses at Microgy, and payments of $444,709 of corporate expenses.

Investing Activities

Our cash used for investing activities was $781,413 in the first quarter of 2005 as compared to $394,778 in the first quarter of 2004. Our investing activities were concentrated primarily in the following areas:

Restricted cash - We are contractually required to make scheduled deposits to a restricted maintenance fund for Scrubgrass to ensure that funds are available in the future for scheduled major equipment overhauls. We are allowed to use restricted cash for major equipment overhauls subject to certain restrictions. We made scheduled deposits to the restricted major maintenance fund of $710,199 in the three months ended March 31 2005.

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Property, plant and equipment - Property, plant and equipment expenditures were $71,214 for the three months ended March 31, 2004. There were no such expenditures in the same period in 2004.

Financing Activities

Our cash provided by financing activities was $12,609,766 in the three months ended March 31, 2005, compared to cash used in financing activities of $1,164,501 in the three months ended March 31, 2004. We offer the following information concerning the financing activities for our business:

Dividend payments to preferred stock of subsidiary - Buzzard paid dividends of $1,250 to its preferred stockholder during the three months ended March 31, 2005 and 2004.

Public Offering of Common Stock - On February 3, 2005, we successfully completed a public offering of our common stock, raising $12,409,375 in net proceeds. We issued 2,500,000 shares of common stock in connection with this offering.

Repayments of Notes Receivable from Officers and Board Members – In the three months ended March 31, 2005, we received principal repayments of $1,891 on notes receivable from officers and board members.

Exercise of Stock Options – We received $141,750 of gross proceeds from the exercise of stock options in the three months ended March 31, 2005.

Working Capital Loan and Current Notes Payable for Scrubgrass - Buzzard may borrow up to $4 million under a Lessee Working Capital Loan Agreement with the lessor of Scrubgrass for ongoing working capital requirements of this project. The outstanding borrowings under this loan were $2,711,000 and $2,653,000 as of March 31, 2005 and December 31, 2004, respectively. Under the existing terms of this loan, we were required to pay the outstanding balance to zero for a minimum of twenty days during each calendar year. We have met the pay down requirement for this loan for 2005.

2005 Outlook

Operations

The following forward-looking information concerning our results of operations for the full year 2005 is being compared to our historical results of operations for 2004:

Buzzard

Power generation revenues are expected to decrease in 2005 due to a decrease in power rates based upon a contracted change in 2005 and a decrease in revenue recorded as a result of the straight-line accounting treatment of revenue under the power sales agreement. We also expect to operate the facility at a capacity factor of 90% or greater. Pursuant to the terms of the Arclight loan, all distributions from Buzzard are required to be used to repay the loan. Therefore, performance at Buzzard will not have an affect on our liquidity in 2005.

Operating expenses are expected to increase in 2005 primarily due to:

Lease expenses are expected to increase slightly in 2005. Lower payments on interest expenses will be offset by increased payments of scheduled principal payments.

Microgy

We expect increased revenues from our Microgy subsidiary in 2005. We have signed digester purchase and management agreements with five farms under the Dairyland relationship. These deals represent backlog of approximately $6.8 million. We expect to be able to record this backlog as revenue in 2005. Additionally, we have signed agreements with several farms in California and a farm in Idaho. These agreements are not included in our backlog figures, as they remain subject to further definitive agreement.

Cost of goods sold is expected to increase as we recognize the revenue from these projects. Additionally, as we complete these projects, we expect to recognize the gross profits that have not been recognized during construction.

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General and administrative expenses are expected to increase by approximately $4 million during 2005 primarily because we plan to grow our business to further implement Microgy’s business plan. These expenses would include:

All Other Segments

We do not expect significant changes in general and administrative expenses related to All Other Segments. However, interest expense is expected to decrease in 2005 due to lower principal balances on the Arclight loan.

Cash Flow Outlook

During 2005, we expect to fund our business activities principally from available cash balances, investment earnings, raising additional debt at Microgy or equity funding, and the sale of the first products based upon Microgy’s technology. As described above, we have a backlog of approximately $6.8 million in sales that would be offset by expenses incurred for construction and development. We do not expect to receive cash from the operations of Buzzard insofar as any available cash will be used to repay interest and principal on the Arclight loan, nor do we expect to receive proceeds from the sale of NOx emission credits nor from any pending litigation, as we have in the past.

On February 3, 2005, we completed an underwritten public offering of our common stock. We issued 2,500,000 new shares of common stock at a price of $5.50 per share and raised $12,409,375 in net proceeds.

On March 31, 2005, our unrestricted cash balance was $10,199,268, as compared to $382,961 as of December 31, 2004. Our restricted cash balances were $2,627,086 and $1,916,887 at March 31, 2005 and December 31, 2004, respectively. As discussed further under investing activities, we are allowed to spend restricted cash to fund the cost of major equipment overhauls at Scrubgrass subject to certain restrictions.

Accordingly, our cash flow from operations for 2005 will be sufficient to fund:

However, these cash flows will not be sufficient to fund the construction of projects included in our backlog in the absence of obtaining project debt and/or equity.

In the event that the recorded Microgy backlog is delayed or not realized in 2005, we may have to modify Microgy’s plans to continue the sale, development and construction of anaerobic digester projects. Our present business strategy generally anticipates the outright sale of facilities as well as direct or indirect participation in the ownership of projects. We anticipate that project financing may be obtained in the form of a credit facility with one or more lenders, the sale of tax exempt or taxable bonds to investors or equity or other financing or a combination of the foregoing. However, we cannot assure you that Microgy or any other prospective project owner will be able to secure project financing in the amount required to fulfill any development or construction requirements, that project financing will be obtained in time to meet such requirements, or that any such proposed project financing, if obtained, will be on terms favorable to Microgy or any other prospective project owner. Furthermore, to the extent Microgy is an owner of projects, Microgy will need to obtain substancial additional financing to allow it to develop and construct such projects.

Project development activities – We expect to continue the development and construction of facilities using Microgy’s licensed technology during 2005. We will require substantial additional financing to complete the development and construction of these facilities.

CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS

The following important factors, among others, could cause actual results to differ materially from those indicated by the various forward-looking statements made in this Quarterly Report on Form 10-Q.

Risks Relating to Microgy

Microgy has very little operating history from which to evaluate its business and products.

Our subsidiary, Microgy, Inc., referred to as Microgy, was formed in 1999 and is still in the development stage. Microgy intends to develop facilities that use environmentally friendly anaerobic digestion and other technologies to produce biogas from animal and organic wastes. Because a large part of our future business is expected to involve Microgy’s anaerobic digester projects and Microgy is an unproven enterprise with very little operating history, we are unable to determine whether our investment in Microgy will prove to be profitable.

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Microgy has experienced losses to date and we anticipate it will continue to experience losses in 2005.

We expect our Microgy subsidiary to continue to incur losses, reduce our earnings or, as the case may be, add to our earnings deficit as we seek to further develop its business. These ongoing losses will adversely affect our financial condition into 2005.

The marketplace for Microgy’s anaerobic digester technology is complex, still developing and subject to change and, therefore, we cannot predict how all projects will be developed, what Microgy’s costs will be or, consequently, Microgy’s outlook for profitability.

Microgy markets its anaerobic digester technology in a complicated and changing environment. Due to the many possible applications for Microgy’s technology, and the many possible ways in which projects deploying Microgy’s technology might be structured, Microgy may decide to develop and own facilities, sell and operate facilities or some combination of the foregoing, either alone or in conjunction with others. We expect to make these determinations on a case-by-case basis. As a result, despite the revenue potential, we are unable to project with certainty Microgy’s organizational, structural, staffing or other overhead costs, or whether any facility, or Microgy as a whole, will generate a profit. If Microgy fails to generate a profit, your investment in our common stock will be adversely affected.

If we are unable to obtain needed financing for Microgy’s anaerobic digester projects, the value of our Microgy investment may be reduced significantly.

We are seeking and will require corporate, project or group financing to fund the cost of any development we may decide to pursue for our anaerobic digester projects. This financing may be difficult or impossible for us to obtain. If we are unable to obtain such financing, the value of our Microgy investment may be reduced significantly, and we may be required to substantially curtail our business or completely cease construction or operation of any anaerobic digester projects. This financing will depend on prospective lenders’ or investors’ review of our financial capabilities as well as specific projects and other factors, including assessment of our ability to successfully construct and manage each project.

The market for anaerobic digester technology is crowded, and our market share may not be sufficient to be profitable.

There are many companies that offer anaerobic digester systems. We believe that at least 60 companies offer complete systems or components to these systems in the U.S. market. Competition from these companies may constrain our market share to a degree that we are not profitable. Although we are unaware of any competitors pursuing a business strategy similar to Microgy’s, a number of competitors have more mature businesses and have successfully installed anaerobic digester systems.

The composition of effluents from our anaerobic digester facilities is not certain and may expose us to liability.

In some cases, we may be responsible for handling the wastes that will be produced by some of our anaerobic digester facilities. We do not have experience in handling or disposing of such wastes. Handling and disposing of such wastes could result in unpredictable regulatory compliance costs, related liabilities and unwanted materials in waste effluents and co-products, all of which could harm our financial condition.

Our products and services involve long sales cycles that result in high costs and uncertainty.

The negotiation of the large number of agreements necessary to sell, develop, install, operate and manage any of our facilities, as well as to market the energy and other co-products and to provide necessary related resources and services, involves a long sales cycle and decision-making process. Delays in the parties’ decision-making process are outside of our control and may have a negative impact on our cost of sales, receipt of revenue and sales projections. We expect that, in some cases, it may take a year or more to obtain decisions and to negotiate and close these complex agreements, which could harm our operating results and financial condition.

Because the market for renewable energy and waste management is unproven, it is possible that we may expend large sums of money to bring our offerings to market and the revenue that we derive may be insufficient to fund our operations.

Our business approach to the renewable energy and waste management industry may not produce results as anticipated, be profitable or be readily accepted by the marketplace. We cannot estimate whether demand for facilities based on our technology will materialize at anticipated prices, or whether satisfactory profit margins will be achieved. If such pricing levels are not achieved or sustained, or if our technologies and business approach to our markets do not achieve or sustain broad acceptance, our business, operating results and financial condition will be materially and negatively impacted.

We are a small company and the entrance of large companies into the alternative fuels and renewable energy business will likely harm our business.

Competition in the traditional energy business from electric utilities and other energy companies is well established with many substantial entities having multi-billion dollar, multi-national operations. Competition in the alternative fuels and renewable energy business is expanding with the growth of the industry and the advent of many new technologies. Larger companies, due to their better capitalization, will be better positioned to develop new technologies and to install existing or more advanced renewable energy generators, which could harm our market share and business.

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If we are unable to obtain sufficient waste resources for our Microgy renewable energy technologies, Microgy will not likely operate profitably.

The performance of our renewable energy technologies is dependent on the availability of animal or other organic waste resources to produce the raw energy and meet performance standards in the generation of power or biogas. Lack of these waste resources or adverse changes in the nature or quality of such waste resources would seriously affect our ability to develop and finance projects and to operate efficiently and generate income. As a result, our revenue and financial condition would be materially and negatively affected. We cannot assure you that waste resources will be available in the future for free or at a price that makes them affordable for our waste-to-energy technologies.

Because we have not filed patents to protect Microgy’s intellectual property, we might not be able to prevent others from employing competing products. Conversely, others who have filed for patent or other protection might be able to prevent us from employing our products.

Neither we nor, we believe, our licensor have filed any patent applications on the intellectual property Microgy plans to use. Should we or our licensor decide to file patent applications, we cannot assure you that any patent applications relating to our existing or future products or technologies will result in patents being issued, that any issued patents will afford adequate protection to us, or that such patents will not be challenged, invalidated, infringed or circumvented. Furthermore, we cannot assure you that others have not developed, or will not develop, similar products or technologies that will compete with our products without infringing upon, or which do not infringe upon, our intellectual property rights.

Third parties, including potential competitors, may already have filed patent applications relating to the subject matter of our current or future products. In the event that any such patents are issued to such parties, such patents may preclude our licensors from obtaining patent protection for their technologies, products or processes. In addition, such patents may hinder or prevent us from commercializing our products and could require us to enter into licenses with such parties. We cannot assure you that any required licenses would be available to us on acceptable terms, or at all.

We rely heavily on confidentiality agreements and licensing agreements to maintain the proprietary nature of our base of technologies relating to currently licensed technologies. To compete effectively, we may have to defend the rights to our intellectual property from time to time. Such defense costs may be significant. As a result, we may lack the financial resources to adequately defend our intellectual property.

If our relationship with the licensor of our technology were terminated for any reason, such licensor ceased doing business, our Microgy subsidiary likely could not continue to operate.

Microgy licenses its anaerobic digester technology from Danish Biogas Technology, A.S., referred to as DBT, a Danish company. The license agreement grants to Microgy a perpetual, exclusive license to develop projects based on this technology in North America. Pursuant to the license agreement, Microgy is required to pay one-time licensing fee per project and engineering and design fees to DBT in connection with the development of projects. Microgy relies upon DBT for technical advice and engineering assistance. Therefore, if DBT were to cease doing business, Microgy’s business may be materially and negatively impacted.

The large number of tasks that need to be accomplished for the development of power projects and other projects based on our anaerobic digester technology increases the possibility that such projects will incur costly delays.

In our development of power projects and other projects based on our anaerobic digester technology for ourselves or on behalf of our customers, we are required to enter into or obtain some or all of the following:

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Our failure to accomplish any of these objectives could materially increase the cost or prevent the successful completion of development projects and incur the loss of any investment made. These events could adversely affect our business and results of operations.

Because all of the cash flow we receive from Buzzard is currently dedicated to the repayment of our loan with Arclight, we are entirely dependent upon the capital we raise to fund the continuing development of Microgy.

We do not expect to receive cash from the operations of Buzzard, because such cash, if any, will be used to repay interest and principal on our loan from an affiliate of Arclight. As a result, if we are not able to raise additional capital, including by means of this offering, to fund Microgy’s operations and our corporate expenses until Microgy’s operations begin to generate positive cash flow, we will not be able to continue to fund Microgy’s operations at their current levels, and our business will be materially and adversely affected.

Risks Relating to Buzzard

We currently rely on the Scrubgrass plant for almost all of our operating revenues, and the cash distributions resulting from the Scrubgrass operations have been dedicated to the repayment of the Arclight loan.

We own a 22-year leasehold interest that commenced in 1994 in our Scrubgrass plant, a waste coal-fired electric generating facility in Pennsylvania. Because almost all of our operating revenue currently results from the Scrubgrass plant, we are dependent on its successful and continued operations. Increased working capital requirements of the Scrubgrass plant, significant unscheduled shutdowns or large increases in interest rates at Scrubgrass would reduce our cash flow. In addition, we will not receive any distributions from Buzzard until our loan from Arclight is repaid. Thereafter, we will receive the next $1,400,000 of distributions, after which we will share distributions equally with Arclight through December 31, 2012. As a result, unless we are able to raise additional capital or generate operating income from other sources, we would have to substantially curtail our operations.

If we default on our obligations under our loan agreement with Arclight, we will lose ownership of our subsidiary, EPC Corporation, and, thereby, the leasehold interest in the Scrubgrass facility.

Our loan from Arclight is secured by a pledge of all of the outstanding stock of our subsidiary, EPC Corporation, which in turns holds our interest in Buzzard Power Corporation as its sole asset, the entity that maintains the Scrubgrass facility. If we were to default on our obligations under our agreement with Arclight, Arclight would have the right to foreclose on this pledge and take ownership of EPC Corporation. As a result, we would lose our interest in the Scrubgrass facility, which is currently our most significant operating asset and revenue source.

The events of default under our agreements with Arclight are narrowly defined. The most significant default is related to non-payment. We are only required to make payments when there is a distribution from Scrubgrass. Nevertheless, if we do not make any payments in a 24-month period, a default under our agreements with Arclight would be triggered.

We do not control the management of the Scrubgrass plant, our primary revenue-generating asset.

We have a management services agreement with Cogentrix, formerly PG&E National Energy Group, to manage the Scrubgrass plant and a 15-year operation and maintenance agreement with PG&E Operating Services to operate the facility. These agreements contain provisions that limit our participation in the management and operation of the Scrubgrass plant. Because we do not exercise control over the operation or management of the Scrubgrass plant, decisions may be made, notwithstanding our opposition, which may have an adverse effect on our business.

Our current power generation revenue is derived from only one customer, the loss of which would severely harm our financial condition and the value of your investment.

Our Scrubgrass plant power generation revenue is earned under a long-term power purchase agreement for all output with one customer, Pennsylvania Electric Company, or Penelec, a subsidiary of FirstEnergy Corporation. This concentration of our revenue with this customer will continue for the foreseeable future. If this customer goes out of business or defaults on its payments to us, our financial condition will be adversely affected. Furthermore, the Scrubgrass plant operates as a qualifying facility, or QF, under PURPA. The loss of QF status could trigger defaults in the project’s PSA. Therefore, Buzzard would most likely have to sell power at prevailing market rates that are much lower than the rate outlined in the PSA.

A large increase in interest rates may adversely affect our operating results.

Our Buzzard and EPC Corporation subsidiaries are leveraged with variable rate and fixed rate debt obligations. Additionally, Buzzard has lease expenses that are based on the principal, interest and fees of the debt obligations of the lessor of our Scrubgrass facility, most of which carries variable rate interest. The table appearing under the heading “Scrubgrass Debt Obligations” included in Note G to our financial statements included in this Report shows that over 90% of our debt obligations and lease obligations have variable interest rates. Therefore, significant increases in market interest rates will adversely affect our operating results since we are required to pay the Scrubgrass lessor’s debt obligations as a base lease expense. For example, a one percent increase in the London Interbank Offering Rate, referred to as LIBOR, and our quoted bond rates would result in a $1,391,880 increase in our lease expense.

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Our Scrubgrass plant’s long-term power purchase agreement is subject to a change in rates in 2005 and market conditions in its later years that may affect our profitability.

The Scrubgrass plant generates electricity that is sold at rates established under a long-term power purchase agreement with Penelec, which has been approved by the Pennsylvania Public Utility Commission. For years 2005 through 2012, the agreement provides for a rate determined based on a scheduled rate adjusted for actual inflation during prior contract years compared to the automatic 5% adjustment in such prior years. Contracted rates in the later years of the agreement are determined with reference to then existing market conditions. Therefore, the existence of inflation less than 5% in years prior to 2005 will negatively impact our revenue and profitability. Low wholesale energy rates during the later years of the power purchase agreement would also negatively impact our revenue and profitability and could adversely affect our financial position.

Poor fuel and other materials quality may expose us to environmental liability and reduce our operating results.

For our Scrubgrass facility, we obtain waste coal primarily from coal mining companies on a long-term basis because waste coal is plentiful and generally creates environmental hazards, such as acid drainage, when not disposed of properly. The waste coal is burned in the Scrubgrass facility using a circulating fluidized bed combustion system. During the circulating fluidized bed combustion process, the waste coal is treated with other substances such as limestone. Depending on the quality of the waste coal and the limestone, the facility operator may need to add additional waste coal or other substances to create the appropriate balance of substances in order to produce the best fuel or sorbent consistency for power generation and compliance with air quality standards. Therefore, the cost of generating power is directly impacted by the quality of the waste coal, which supplies the Scrubgrass power generation facility. Certain conditions, such as poor weather, can create situations where the facility operator has less control over the quality of the waste coal. Poor fuel quality may impact our future operating results.

If we violate performance guarantees granted to Penelec, we will be required to provide them with an incentive payment.

Our agreement for the sale of power to Penelec contains a provision that requires our Scrubgrass facility to provide Penelec with a minimum output of 85% based on a rolling 3-year average. If we do not comply with this performance guarantee, we will be required to compensate Penelec with an incentive payment. The payment of an incentive payment would have an adverse effect on our financial condition.

Risks Relating to Both Microgy and Buzzard

Our products and services may be subject to numerous governmental regulations.

We expect to provide services that may be subject to various government regulations, including regulations covering air and water quality and related pollution issues. These regulations are mandated by the United States Environmental Protection Agency, or EPA, and various state and local governments and are usually implemented through a permitting process, with ongoing compliance requirements thereafter. In addition, our activities will fall under a number of health and safety regulations and laws and regulations relating to farms and zoning. Compliance with these regulations and permitting requirements could delay the development of projects and could be costly and harm our financial condition.

Furthermore, there are from time to time various legislative proposals that would amend or comprehensively restructure the Public Utility Regulatory Policies Act of 1978, or PURPA, and the electric utility industry. If PURPA is amended or repealed, the statutory requirement that electric utilities purchase electricity from qualifying facilities, or QFs, at full-avoided cost could be repealed or modified. While we expect that existing contracts would be honored, the repeal or modification of these statutory purchase requirements under PURPA in the future could, among other things, increase pressure from electric utilities to renegotiate existing contracts. Should there be changes in statutory purchase requirements under PURPA, and should these changes result in amendments to our current power purchase agreement with Penelec for our Scrubgrass facility that reduce the contract rates, our results of operations and financial position could be negatively impacted.

Our power producing activities could be subject to costly regulations and tariffs.

Our Scrubgrass facility produces power for sale to the local electrical grid, as will many of our planned bio-energy projects. The sale of this power may come under the regulations of various state public utility commissions, although such sales are currently exempt. These commissions set the price tariffs under which energy can be sold or purchased and they set the design standards for the interconnection of power producing equipment with the electrical power grid. Many of our power projects where electricity is sold to the grid may come under regulation by these commissions. These regulations may impede or delay the process of approving and implementing our projects. Substantial delays may materially affect our financial condition.

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