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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.

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