CATALYTICA ENERGY SYSTEMS INC - 10-K Annual Report

Catalytica Energy Systems, Inc. (“Catalytica Energy,” the “Company,” “we” or “us”) was incorporated in Delaware in 1995 as a subsidiary of Catalytica, Inc. Catalytica Energy operated as part of Catalytica, Inc.’s research and development group from inception through the date of its incorporation as a separate entity. In December 2000, Catalytica Advanced Technologies, Inc., another subsidiary of Catalytica Inc., was merged into us, and the combined entity was spun out from Catalytica, Inc. as Catalytica Energy Systems, Inc., a separate, stand-alone public company.

We provide innovative emissions solutions to ease the environmental impact of combustion-related applications in the power generation and transportation industries. Through our SCR-Tech subsidiary, we offer a variety of services for coal-fired power plants that use selective catalytic reduction (“SCR”) systems to reduce nitrogen oxides (“NOx”) emissions. These services include SCR catalyst cleaning and regeneration, SCR system management services to optimize efficiency and reduce overall operating and maintenance (“O&M”) costs, and consulting services related to the design of SCR systems (collectively “SCR Catalyst and Management Services”). Our business activities also include the design, development, manufacture and servicing of advanced products based on our proprietary catalyst and fuel processing technologies to offer cost-effective solutions for reducing NOx emissions from diesel engines and natural gas-fired turbines. Our diesel fuel processing technology is designed to facilitate significant NOx reduction from mobile, stationary and off-road diesel engine applications by improving the performance of NOx adsorber catalyst systems. Our commercially-available Xonon Cool Combustion® system offers a breakthrough pollution prevention approach that enables gas turbines to achieve ultra-low NOx emissions through a proprietary catalytic combustion process. Other activities include the development of fuel processing systems for fuel cells used in stationary, auxiliary and back-up power applications.

We are focused on growing our business through a product and market diversification strategy in the area of NOx control. Increasingly stringent air quality regulations have resulted in tighter emissions restrictions being imposed on a variety of combustion-related applications. NOx emissions, which are a precursor to smog formation, have become a primary target of government-imposed emissions regulations, creating a significant opportunity for innovative, cost-effective NOx control solutions. Industry analysts estimate the U.S. market for NOx control represents a greater than $5 billion opportunity annually in the power generation and diesel industries, and we believe this market should experience additional growth as a result of pending Federal and State regulations calling for further reductions in NOx emissions.

As a result of ongoing challenging conditions in the U.S. gas turbine industry, a slow to emerge distributed generation market and the pace of gas turbine original equipment manufacturer (“OEM”) commercialization activities, we completed a rigorous exercise in 2003 to realign our strategic direction and build a stronger business. This has been accomplished through broadening our product and service offerings in the area of NOx control beyond our Xonon Cool Combustion product for gas turbines, pursuing new business activity and expanding our portfolio of NOx-related products and services across new and growing markets. We are committed to solving NOx-related problems by providing the most economically compelling and most effective solutions available, whether it is through prevention or through some form of after-treatment. In addition to intensifying our development of NOx control after-treatment systems for diesel engines which leverage our core Xonon^® technology, we have become more active in identifying strategic opportunities, including business acquisitions that complement our current products, expand the breadth of our markets or build upon our technical capabilities. In particular, we continue to focus on opportunities that offer near-term, profitable product and service offerings.

As part of this strategic initiative, in February 2004 we acquired SCR-Tech, LLC (“SCR-Tech”), the North American leader in catalyst regeneration technologies and management services for selective catalytic reduction systems used by coal-fired power plants to reduce NOx emissions. The addition of SCR-Tech strategically broadened and diversified our product and service offerings to the growing emissions control market for coal-fired power plants and has served to accelerate our penetration into the NOx control marketplace. We believe the acquisition of SCR-Tech has created a foundation for future growth and has strengthened our ability to continue pursuing development and commercialization efforts in other areas of our business, while also targeting additional business opportunities in the area of NOx control.

As a result of our February 2004 acquisition of SCR-Tech, we are now conducting our business through the following two business segments:

1. SCR Catalyst and Management Services (“SCMS”)

2. Catalyst-Based Technology Solutions (“CBTS”)

SCR Catalyst and Management Services

Our SCR-Tech subsidiary is based in Charlotte, North Carolina and offers catalyst cleaning, rejuvenation and regeneration as well as SCR system management and consulting services, to help power plant operators optimize their SCR system operation while reducing O&M costs. SCR-Tech’s customer base has included some of the largest utilities and independent power producers (“IPPs”) in the U.S.

SCR-Tech provides catalyst regeneration services by means of two patented processes that can restore the activity level of used SCR catalyst for significantly less cost than purchasing a new catalyst. SCR-Tech is the only company in North America currently operating a commercial catalyst regeneration facility and offering catalyst regeneration in addition to cleaning and rejuvenation.

SCR-Tech also provides SCR system management and consulting services relating to system design and tuning, efficiency optimization, O&M cost reduction, catalyst specification and performance testing.

History of SCR-Tech

SCR-Tech’s roots go back to the mid-90’s when one of the founders of SCR-Tech, ENVICA GmbH, created a method for cleaning, rejuvenating and regenerating SCR catalyst in Germany. Meanwhile, EnBW, Germany’s third largest energy company and one of SCR-Tech’s former owners, was independently developing an innovative “in-situ” cleaning and rejuvenation process.

In 1997, ENVICA, in partnership with one of Germany’s largest utilities, Hamburgische Electricitätswerke AG (“HEW”), developed an off-site regeneration process based on ENVICA’s core technology, which not only physically cleaned but also chemically regenerated depleted SCR catalyst, began marketing SCR catalyst regeneration services to other SCR plant operators in Germany and built the world’s first full-scale commercial SCR catalyst regeneration facility. This process continues to be marketed in Germany by ENVICA under the ENVICA Kat name. Both HEW and EnBW continue to use ENVICA’s regeneration processes in their coal-fired plants throughout Germany.

In March 2001, ENVICA and Energy & Environmental Consultants GmbH (“E&EC”), a German consulting company, formed SCR-Tech GmbH in Germany for marketing the regeneration process worldwide. In March 2002, EnBW Energy Solutions GmbH became a shareholder of SCR-Tech GmbH together with the two founders—ENVICA and E&EC. EnBW Energy Solutions granted an exclusive license to SCR-Tech for its proprietary and patented in-situ cleaning process that it had independently developed in 1995.

Since 1997, these technologies have been successfully applied commercially throughout Germany by SCR-Tech’s founding owners, leading to the creation of SCR-Tech, LLC in 2001 to begin marketing the technology in the U.S. SCR-Tech initiated commercial operations in its Charlotte regeneration facility in early 2003.

Industry Background and Market Opportunity

SCR systems are used most commonly in large coal-fired and natural gas-fired power plants. SCR technology is based on catalysts that remove NOx from the power plant exhaust by reducing it with ammonia to elemental nitrogen and water vapor. Over time, ash buildup can cause physical clogging or blinding of the catalyst, which can negatively impact the performance of both the SCR system and the power generating facility. In addition, the NOx removal efficiency of SCR systems gradually declines as a result of catalyst deactivation caused by various catalyst poisons present in the flue gas, resulting in the need for some form of catalyst exchange. Historically, the spent catalyst has been replaced with new catalyst, a costly process. Because utilities and IPPs have been facing increasing pressure to lower their O&M costs, plant operators are seeking more cost-effective SCR catalyst management solutions.

NOx is considered to be one of the principal contributors to secondary, ground level ozone, or smog, and energy producers and other industries operating large power plants, particularly in the Eastern half of the U.S, have been required to reduce their NOx emissions by at least 85 percent by 2007 as part of the Environmental Protection Agency’s (“EPA”) NOx SIP Call. The NOx SIP Call requires major NOx reductions during the “ozone season” (May 1-September 30) in 19 Midwestern and Eastern states¹ and the District of Columbia to mitigate the regional transport of ozone, which is contributing to the poor air quality of downwind states. As a result, these areas have been required to revise their SIPs, outlining measures to reduce NOx emissions to a statewide limit determined by the EPA for each affected state. As part of the NOx SIP Call, these areas were required to begin implementing new controls by April 2004 to reduce NOx emissions in an effort to reach compliance with EPA established limits by September 2007. In general, during non-ozone season periods, most operators do not have any requirements to run their SCR systems unless regulations are further tightened.

Coal-fired plants currently account for more than half of the nation’s power generating capacity and are poised to play an even greater role in future power generation. An October 2004 report published by The McIlvaine Company projects that the present coal-fired generating capacity in the U.S. of 329 gigawatts (“GW”) will expand to 356 GW by 2012. Coal-fired plants have also become a primary target for NOx reduction. With NOx removal efficiencies of up to 95 percent, SCR systems are considered to be the most effective and most widely used technology by coal-fired power plant operators to comply with increasingly stringent U.S. emissions regulations. As a result, the installed base of SCR systems has increased dramatically in recent years. It is projected that by the end of 2005, approximately 100 GW of coal-fired generating capacity in the U.S. will be operating with SCR systems to comply with the EPA’s NOx SIP Call, creating a large and growing market for SCR catalyst management services. As a result of this recent growth in new SCR system installations, the market for SCR catalyst services is expected to more fully develop in the 2006-2007 timeframe. We believe the available market for catalyst replacement could reach $100 million by 2010. We also believe catalyst regeneration has the potential to play a significant role in this market, as it offers a more cost-effective approach than the replacement of deactivated catalyst.

¹ Alabama, Connecticut, Delaware, Illinois, Indiana, Kentucky, Massachusetts, Maryland, Michigan, North Carolina, New Jersey, New York, Ohio, Pennsylvania, Rhode Island, South Carolina, Tennessee, Virginia and West Virginia.

In addition, recent Federal emissions mandates and other pending legislation offer significant upside market potential. In April 2004, the U.S. Environmental Protection Agency (“EPA”) announced a new 8-hour standard for the measurement of ground level ozone, or smog. Under this new standard, which took effect in June 2004, the EPA estimated that the number of areas in violation of air quality regulations has grown from 271 to 475 counties, home to 159 million people. As a result, 54% of the U.S. population now lives in areas where the most stringent emissions requirements are now being enforced. According to the EPA, the 8-hour ozone standard is just the first in a series of new air pollution rules expected to be issued, which could result in as much as $50 billion being spent on pollution control equipment at coal-fired power plants over the next 15 years. For example, the EPA’s pending Clean Air Interstate Rule (“CAIR”), signed on March 10, 2005, calls for 28 states in the Eastern U.S. and the District of Columbia to reduce NOx emissions by more than 60% from 2003 levels by 2015. This rule builds on the NOx SIP Call and proposes to cut NOx emissions from power generating facilities by an additional 1.7 million tons annually by 2009 and by 2.0 million tons annually by 2015. Accordingly, we expect substantial additional growth in the number of SCR installations at coal-fired plants over the next decade.

SCR-Tech’s Service Offerings

SCR-Tech offers proprietary and patented processes based on highly sophisticated and advanced technologies that can improve the NOx removal efficiency and extend the useful life of installed SCR catalyst, offering a compelling economic alternative to catalyst replacement.

SCR-Tech’s processes are capable of not only physically cleaning and rejuvenating the most severely plugged, blinded or poisoned catalyst, but of also chemically reactivating deactivated catalyst. Depending upon the state of the installed catalyst, SCR-Tech offers several alternatives for restoring its NOx removal efficiency and extending its life.

For lightly plugged or blinded catalyst that has not yet fully deactivated from catalyst poisons, SCR-Tech offers an “in-situ” cleaning process that can be performed on catalyst at the customer’s plant site without requiring removal of the catalyst from the SCR unit.

For severely plugged or blinded catalyst that may have limited deactivation from catalyst poisons, SCR-Tech offers an off-site cleaning and rejuvenation process that is performed at SCR-Tech’s regeneration facility. In this process, the customer removes the catalyst modules from the SCR unit and ships them to SCR-Tech. The cleaning process physically removes the materials plugging the catalyst to improve its NOx removal efficiency while the rejuvenation process removes catalyst poisons to extend its useful life. Once cleaned and rejuvenated, SCR-Tech returns the catalyst modules to the customer for reinstallation in the SCR unit.

For severely plugged or blinded catalyst that has significantly deactivated, SCR-Tech offers an off-site regeneration process that restores deactivated SCR catalyst back to its original specifications and catalytic activity. In this process, the customer removes the deactivated catalyst modules from the SCR unit and ships them to SCR-Tech’s regeneration facility where the catalyst is both cleaned and chemically reactivated. Once regenerated, SCR-Tech returns the catalyst modules to the customer for reinstallation in the SCR unit. Upon reinstallation, the regenerated catalyst delivers the same level of performance and deactivation rate as the original catalyst. Catalyst regeneration provides SCR operators a significantly lower cost alternative to catalyst replacement and essentially eliminates the need to dispose of deactivated catalyst, which can be considered hazardous waste.

SCR-Tech also provides SCR system management services including ammonia injection grid (“AIG”) tuning to optimize efficiency and reduce overall O&M costs, and consulting services related to the management and design of SCR systems, including catalyst specification, selection and initial performance testing for guarantee verification. These services have principally been performed by, or under the supervision of, Hans Hartenstein, former president of SCR-Tech, whose employment with the Company

terminated in March 2005. Effective March 21, 2005, William J. McMahon, a seasoned executive with more than 25 years of experience in the energy and utility industries, was appointed president of SCR-Tech.

SCR-Tech’s cleaning, rejuvenation and regeneration services have represented, and are expected to continue to represent for the foreseeable future, the substantial majority of SCR-Tech’s revenues.

Customers

Since its founding in May 2001, SCR-Tech has performed SCR Catalyst and Management Services for some of the largest utilities and IPPs, and their equipment suppliers, in the U.S. including AES, Alstom, Duke Power, Englehard, Mirant, National Energy & Gas Transmission, South Carolina Electric & Gas, Southern Company’s subsidiaries, Alabama Power and Georgia Power. In March 2003, SCR-Tech greatly expanded its service offerings when it commenced commercial operation in its regeneration facility.

As part of an ongoing commercialization strategy, SCR-Tech is actively targeting SCR operators throughout North America to broaden its established customer base and is in active negotiations today with several potential new customers.

In 2004, SCR-Tech serviced 17 plant sites for 17 different customers, and secured 23 purchase orders for a variety of SCR services, including three contracts with leading utilities to provide SCR catalyst cleaning and regeneration services.

Competition

We expect SCR-Tech’s cleaning and rejuvenation processes to compete with alternate cleaning and rejuvenation processes currently in the marketplace. We are aware of at least one company, Enerfab, Inc., that offers on-site SCR catalyst cleaning and washing process that requires the removal of the catalyst from the SCR system. We believe that SCR-Tech’s patent-protected cleaning process offers several competitive advantages, including both an off-site process and an “in-situ” process that does not require the removal of the catalyst from the SCR system.

While there is some competition for catalyst cleaning and rejuvenation, we are not aware of any other company in North America offering a regeneration process that can chemically reactivate SCR catalyst back to its original specifications. Accordingly, new catalyst remains the primary competition for SCR-Tech’s regeneration process. The leading SCR catalyst suppliers to the U.S. coal-fired power generation market include Cormetech, Haldor Topsøe and Hitachi America. While we believe that SCR-Tech’s regeneration process offers a significant cost advantage over the purchase of replacement catalyst and essentially eliminates hazardous waste disposal issues associated with spent catalyst, it is possible that these companies and others could eventually develop a solution that may compete with ours. Nonetheless, we believe the strength of SCR-Tech’s intellectual property and patent protection creates a significant barrier for new entrants to the market. In addition, we believe that our first mover advantage in the regeneration marketplace will help us maintain our leading market position.

Catalyst-Based Technology Solutions

Our Catalyst-Based Technology Solutions segment includes our business activities associated with the design, development, and manufacture of advanced products based on our proprietary catalyst and fuel processing technologies to offer cost-effective solutions for reducing NOx emissions from combustion-related applications. These business activities include Emissions Control Solutions for Diesel Engines, NOx Control Solutions for Gas Turbines, and Fuel Processing Solutions for Fuel Cell Applications.

Ø Emissions Control Solutions for Diesel Engines

We are leveraging our catalyst technology expertise with a proven fuel processing competency to offer innovative emissions reduction solutions for mobile, stationary and off-road diesel engine applications, targeted at helping diesel OEMs, government agencies, and power producers meet the growing diesel emissions challenge.

Industry Background

In October 1997, the EPA adopted new NOx emissions standards for heavy-duty diesel truck and bus engines to be phased in through 2010. The first phase of these stricter limits took effect in October 2002 when the requirements for NOx were reduced from 4.0 grams per brake horsepower-hr (“g/bhp-hr”) to 2.5 g/bhp-hr. Non-compliance with the October 2002 deadline resulted in steep fines imposed by the EPA of as much as $12,000 per engine. The most stringent of the EPA’s new emissions standards requires a phased-in 50% reduction by 2007 over the current standards, with another 80% reduction by 2010, resulting in a 0.2 g/bhp-hr limit by the end of the decade for all heavy-duty diesel trucks and buses. The aggregate 90% reduction in NOx required by 2010, in particular, has created a major technological hurdle for diesel engine OEMs for which a single technology path has yet to be adopted. Lighter-duty applications in the U.S., including heavy light-duty diesel trucks and passenger vans, are also facing tighter NOx emissions standards to be phased in through 2009.

Increasingly stringent emissions standards are also being imposed on diesel engine markets in the European Union (“EU”) and Japan. For example, in April 2005 Japan will impose the world’s strictest emissions standards to date for urban heavy-duty trucks and buses, requiring a 41% reduction in NOx emissions to 1.49 g/bhp-hr. Japan’s Central Environment Council subsequently announced in February 2005 that it has drawn up recommendations to further tighten Japan’s diesel emissions standards for all vehicles sold beginning in 2009, which could result in emissions limits that are more closely in-line with those that are scheduled to be imposed in the U.S. in 2010. While current U.S., EU and Japanese emissions reduction mandates remain fragmented, there is a growing demand for the harmonization of tighter standards throughout these markets.

At the same time, mobile and stationary diesel engines in service today along with other off-road diesel-powered equipment are coming under increasingly intense scrutiny by government officials in an attempt to reduce urban smog in emissions-sensitive areas across the country. According to the EPA, existing diesel sources contribute as much as 50% of NOx emitted in many U.S. urban areas, making them a prime target for emissions controls. Government agency funding for diesel retrofits continues to develop in an effort to meet air quality objectives, and, in some cases, to avoid severe EPA sanctions or the loss of Federal Highway Administration funds. In addition, a growing number of federal and state programs to fund school bus retrofits have emerged over the past two years in an effort to reduce asthma and other pediatric respiratory disorders associated with diesel exhaust.

Stationary diesel engines used in both back-up and prime power applications currently face operating restrictions as a result of high emissions levels. If emissions can be brought into compliance, major utilities, municipal power producers and other end-users could benefit from extended operation and increased utilization of their diesel power generating units, even in the most stringent non-attainment areas. Among the many benefits include the creation of emissions credits and reduced electricity costs by running these units during peak pricing periods. With appropriate permitting, these units could be dispatched during peak demand to open up a new option to relieve stress on constrained utility distribution systems, provide grid support, and improve reliability. Another potential emissions control opportunity is diesel engines that drive agricultural water pumps. Due to significant air quality degradation caused by many such pumps, particularly in the Central Valley of California, there is mounting political pressure to re-power the pumps with electric motors using grid electricity. However, this could push electricity demand beyond supply

during hot summer months. An economical diesel emissions reduction solution could provide a new option for continued operation of these pumps.

New stationary diesel engines will soon face even tougher regulations. In 2000, the state of California passed Senate Bill 1298 (“SB 1298”) requiring the California Air Resources Board (“CARB”) to set new emissions standards and provide guidance for the permitting of new electrical generation technologies less than 50 megawatt (“MW”) in size. The first phase of emissions limits under the new CARB certification program and guidance document took effect in January 2003, with even tighter limits scheduled to be imposed beginning in January 2007. In addition, new stationary diesel engines along with other diesel-powered equipment used in construction, agricultural and other off-road applications will soon have to comply with new federal emissions restrictions. In May 2004, the EPA announced the signing of the Bush Administration’s Clean Air Nonroad Diesel Rule that will cut emissions from off-road diesel-powered equipment by more than 90%. The new standards, also known as the U.S. Tier 4 emissions standards, will be phased in between 2008 and 2015 and are expected to result in the widespread introduction of diesel emissions control systems for new nonroad diesel equipment.

Market Opportunity

Diesel engine manufacturers in the U.S., and internationally, continue to seek enabling solutions to meet increasingly stringent emissions standards. In 2004, approximately 1.2 million diesel engines were produced in North America for on-highway applications. U.S. heavy duty diesel (“HDD”) engine manufacturers intend to pursue in-house engine modifications similar to those used in their 2002 compliant engines to meet the initial 2007 step-down in emissions requirements. However, the most severe NOx reduction requirements, which will be phased into various segments of the U.S. HDD market between 2008 and 2010, remain a difficult challenge that we believe will require some form of advanced NOx after-treatment or significant advances in diesel engine technology. We are also exploring opportunities in markets outside of the U.S., including Japan, which produces approximately 200,000 diesel bus and truck engines annually. Other global markets in Europe and Asia, which are considering more stringent emissions regulations similar to those being imposed in the U.S., in addition to heavy light-duty diesel trucks and passenger vans in the U.S. and internationally, could offer promising additional markets for our emissions solutions.

We believe the retrofit market for mobile and stationary diesel engines in the U.S. offers a more near-term opportunity for us than the new engine market. The EPA estimated in 2001 as many as 10 million sources of diesel emissions were in service in the U.S., many operating in emissions-sensitive areas of the country.

Funding sources for diesel retrofits continue to build on both the state and federal level. As a result of a recent growth in funding sources, the total addressable market for diesel retrofits is expanding. On the federal level, a variety of programs have been proposed to reduce emissions from a variety of diesel sources. The Congestion Mitigation and Air Quality (“CMAQ”) Program, sponsored by the Department of Transportation, and administered by the Federal Highway and Federal Transit Administrations, is providing funds totaling more than $1.75 billion per year for states to invest in air quality improvement projects, with diesel retrofit recently added as an acceptable candidate for appropriations. In January 2004, the EPA called for the nation’s fleet of school buses to install pollution control devices in an effort to combat rising health concerns associated with diesel exhaust fumes. To assist in this effort, the EPA has allocated $7.5 million in funding for fiscal 2005 for a cost-shared grant program to school districts to upgrade their diesel fleets under its Clean School Bus USA program.

According to the EPA, the number of states pursuing diesel retrofit programs has grown from 10 states in 2003 to 20 states plus the District of Columbia in 2004. Programs to funnel state or federal dollars to retrofit diesels with emissions control systems are in place today in Alabama, Arizona, California,

Colorado, Connecticut, the District of Columbia, Georgia, Illinois, Indiana, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, North Carolina, Ohio, Pennsylvania, South Carolina, Texas and Washington.

Both California and Texas, in particular, have committed significant annual funding for diesel emissions reduction. California’s Carl Moyer Program has created a dedicated funding source for air pollution reduction. This program is encouraging projects to reduce emissions from heavy-duty diesel engines by offering up to $140 million annually in incentive grants through 2015. As part of the Texas Emissions Reduction Program (“TERP”), the state of Texas announced NOx reduction grants for 2004 totaling in excess of $80 million, and has budgeted in excess of $130 million annually for years 2005 through 2008 to help fund the deployment of diesel NOx reduction solutions to achieve a significant reduction in air pollution and reach compliance with its State Implementation Plan (“SIP”). According to industry reports, retrofit programs are also now emerging in Canada, Japan and in the European Union to address approximately five million HDD engines, as estimated by the 2003 Transportation Industry Data Book.

According to the Northeast States for Coordinated Air Use Management (“NESCAUM”), as many as 350,000 stationary diesel generators are installed throughout the U.S., many of which are restricted in operation as a result of high emissions levels. We have identified more than 35,000 emergency standby diesel generator sets in the 100 kW to 1.5 MW size range permitted throughout the Northeast, California and Texas, areas imposing the strictest emissions regulations, that could be candidates for an emissions reduction retrofit solution. In addition, more than 36,000 new stationary diesel engines are produced annually in North America for power generation applications, many of which are candidates for emissions control today, and many more which will require emissions controls beginning in 2007 and 2008 when the CARB and U.S. Tier 4 emissions standards are phased in, respectively. Further, more than 200,000 additional diesel engines are produced each year in North America for use in construction, agricultural and other industrial equipment that will also have to comply with the U.S. Tier 4 standards.

Diesel Emissions Reduction Applications Development

We have developed a proprietary fuel processing technology that is designed to facilitate a significant reduction in NOx from diesel engine applications by enabling more effective regeneration of NOx adsorber systems. Our unique approach to diesel fuel processing leverages our Xonon® catalyst technology and our extensive work in gasoline and diesel fuel processing for fuel cell applications.

We are focused on bringing the benefits of our diesel fuel processing solutions to the growing diesel emissions reduction market by partnering with diesel OEMs, Tier 1 catalyst providers (direct suppliers to OEMs), system integrators, and other leading companies within the diesel industry.

In an effort to further advance the cost-effective development of our diesel emissions reduction solutions, we completed in the fall of 2003 the construction of a diesel test facility. Since that time, we have completed numerous in-house, full-scale engine tests. These tests are providing us with valuable data that we are using to further optimize our technology solutions for commercial application. This test facility will also enable us to simulate EPA certification and CARB verification protocols as well as advanced durability testing for a broad diesel engine population as we work to accelerate the product development path of our solutions for both new engine and retrofit applications.

We are currently developing our core diesel fuel processing technology for three applications:

1. Diesel OEM solution for new mobile engine applications

2. Diesel retrofit solution for “in service” mobile engine applications

3. Diesel generator set (“genset”) solution for stationary diesel engine applications

1. Diesel OEM Solution

We have developed and are now refining a proprietary diesel fuel processor technology for new mobile engine applications as a means for diesel OEMs to meet the most stringent impending NOx emissions regulations. Our Xonon fuel processor, or XFP, technology is designed to enable a greater than 90% reduction in NOx by improving the performance of NOx adsorber catalyst systems. NOx adsorbers, also referred to as NOx traps, represent one of the approaches believed to have the greatest potential to meet the EPA’s 2010 emissions mandate.

NOx adsorbers adsorb NOx from the exhaust and convert the NOx to non-polluting nitrogen during a regeneration cycle. NOx adsorber technology today offers considerable NOx reduction capabilities, but performance issues related to durability, operating range and fuel economy have limited their viability for some diesel engine applications. In most cases, diesel fuel injected at the engine or in the exhaust system upstream of the NOx adsorber is used for the regeneration cycle. This process can give good performance at high exhaust temperatures, but historically has demonstrated poor performance at lower exhaust temperatures. Low exhaust temperatures (as low as 200 degrees Celsius) represent a large portion of vehicle operating time, particularly for medium and light duty diesel engine applications used in urban areas and for automobiles, light trucks and SUVs. Our XFP is designed to deliver rapid, low-temperature NOx adsorber regeneration with improved fuel utilization and efficient desulfation (elimination of sulfur within the NOx adsorber associated with the sulfur naturally occurring within diesel fuel) to significantly improve NOx adsorber performance and durability. We believe the combination of our XFP with a NOx adsorber can enable diesel OEM implementation of a durable, economical, reasonably sized NOx reduction solution that complies with the most stringent emissions requirements with minimal fuel penalty.

In July 2003, we announced successful completion of the first full-scale test of our prototype XFP on a 7+ liter HDD engine, which demonstrated the rapid regeneration capabilities of our technology and its potential to significantly improve the performance of NOx adsorbers. The tests, which were conducted with a leading HDD engine manufacturer, focused on verifying the performance of our XFP at low exhaust temperatures. Test results demonstrated highly efficient, rapid NOx adsorber regeneration, resulting in NOx conversion in line with the EPA’s mandated emissions requirements for 2010.

These tests provided us with valuable data we have used to further develop and refine our technology to enhance the operating range and fuel economy performance of our XFP system and to facilitate desulfation of the NOx adsorber catalyst at lower temperatures, thus providing increased NOx adsorber durability. According to the EPA, improving the durability of NOx adsorbers, especially as it relates to desulfation, remains a fundamental hurdle to commercial NOx adsorber deployment in HDD applications.

In 2004 we completed a number of additional full-scale engine tests and demonstrations of our XFP technology with other diesel engine manufacturers as well as with Tier 1 system integrators. OEM test activities, in particular, included a focus on verifying operation at low exhaust temperatures as well as demonstrating desulfation strategies. Tests of our XFP combined with a NOx adsorber catalyst were conducted on both 5 and 8 liter diesel engines at two separate OEM facilities, and successfully demonstrated NOx reduction in excess of 90% over a broad range of operating conditions with a total fuel system usage of less than 3%. In addition, both NOx adsorber operation and regeneration were demonstrated at low exhaust temperatures. Our XFP also demonstrated full regeneration of a sulfur-poisoned NOx adsorber catalyst, a critical requirement to enable operation of NOx adsorber systems, even with the ultra-low sulfur diesel (“ULSD”) fuel mandated in the U.S. for 2007 and beyond. Further, we believe that these tests demonstrated the ability of our XFP technology to bring added flexibility for OEM NOx adsorber regeneration and desulfation strategies to accommodate the wide variety of NOx adsorber system designs currently being pursued. For example, our XFP enabled very rapid regeneration cycles that would be required for transient engine operation.

As a result of the favorable performance demonstrated in these OEM tests, we received commitments by both diesel engine manufacturers to conduct additional test activities in 2005. We continue to build on the positive results of our recent test activities to further optimize our XFP technology in connection with NOx adsorber systems with the goal of bringing a high performing NOx reduction solution to diesel engine OEMs for their diesel engine products and ultimately a cost-effective product to the end use customer.

For new engine applications, we are committed to working with diesel OEMs, NOx adsorber providers and/or emissions system integrators to jointly develop and commercialize robust NOx control systems to meet the most stringent U.S. and international emissions requirements. To gain market share and penetrate new markets while maintaining compliance with new emissions standards, OEMs and Tier 1 suppliers seek to differentiate their products with technological advances that benefit their customers. We believe that the combination of our XFP and a third party NOx adsorber has the potential to offer a cost-effective NOx reduction solution with minimal fuel penalty to enhance an OEM’s product line and offer significant competitive advantages. Accordingly, we have taken an active role over the past two years in establishing and building relationships within the diesel industry, both in the U.S. and internationally, in line with our objective to secure partners to further develop and commercialize our XFP for new mobile engine applications.

As a result of these efforts, in December 2004 we signed a Memorandum of Understanding (“MOU”) with a leading company in the diesel industry following our successful completion of a technology demonstration at their facility. The terms of the MOU include a commitment to further evaluate our XFP in 2005 for application to their technology platforms with the intent of entering into a future joint development agreement. We also continue to be in active discussions today with a number of other companies within the diesel industry, including both diesel OEMs and systems integrators, relating to both testing and joint development opportunities in North America and Asia.

2. Diesel Retrofit Solution

We are also developing a retrofit solution for mobile diesel engine applications as a means for government agencies to address growing urban smog issues in emissions-sensitive areas. Our mobile retrofit solution combines a derivative of our XFP technology with a NOx adsorber catalyst and is being designed to offer a scalable, easily integrated solution for diesel engines currently in service.

Successful development and commercialization of this solution will bring three main benefits that could differentiate our technology from current mobile retrofit solutions on the market today:

1. A lower installed cost when compared with alternate solutions,

2. A potential NOx reduction capability of 50% or greater, compared with 25% offered by the only alternate non-SCR solution offered today, and

3. A potential to operate across a broad temperature range, including low temperature conditions, in which a significant portion of urban vehicles such as buses and refuse trucks operate today.

In 2003, we completed initial subscale, in-house rig tests of our retrofit solution demonstrating a 50% NOx reduction while operating on standard U.S. highway diesel fuel with 500 parts per million (“ppm”) sulfur content. Since that time, we have continued to develop a next generation version of our retrofit technology with a focus on increasing the NOx reduction capability of the system and optimizing its use for multiple diesel engine applications. As part of this effort, we evolved our solution during the first of half of 2004 from combining our diesel fuel processor with a lean-NOx catalyst to now combining our diesel fuel processor with a NOx adsorber catalyst. This current approach has enabled us to better leverage the technology synergies of both our OEM and stationary diesel engine applications while providing enhanced performance and cost benefits. We have since assembled full-scale prototypes of our next generation solution and have completed a number of full-scale, in-house engine tests of our modified approach with

favorable results. Most recently, we progressed to an AVL-8 mode test using a full-scale, 7.6 liter heavy-duty diesel engine. An AVL-8 mode test is a steady-state engine test procedure with 8 test points designed to closely correlate with different engine speeds and load factors, and offers a good indication of how our technology might perform in future EPA product verification testing. In this most recent test, we achieved another product development milestone by successfully demonstrating NOx reduction well in excess of our 50% target. We view these results as another positive step toward our commercialization goals.

In recognition of the significant technical progress we made over the past year and the commercial prospects for our technology, we were awarded a $330,000 grant in November 2004 by the Texas Commission on Environmental Quality (“TCEQ”) under its New Technology Research and Development (“NTRD”) Program to help support the first on-vehicle demonstration of our mobile retrofit solution. The field demonstration will evaluate the performance of our diesel fuel processing technology in combination with a NOx adsorber catalyst, and its potential to offer a cost-effective, easy integration solution for the mobile retrofit market. In support of this effort, the City of Denton, Texas has agreed to supply two heavy-duty diesel trucks for the on-road demonstration, which is currently scheduled to commence in the second quarter of 2005.

Although our prospects for this market are exciting, we recognize that we still have significant technical and commercial hurdles to overcome that will be critical to our success. In preparation for a forthcoming on-road demonstration of our technology, we must first complete a variety of integration activities. With successful field demonstration results, we must then advance our technology to an EPA and / or CARB verified retrofit solution before we can introduce the product in the marketplace as most government agencies will only fund verified products. Accordingly, we continue to evaluate our progress in developing a commercially viable retrofit solution and our ability to capitalize on the finite time horizon associated with the diesel retrofit market.

For mobile retrofit applications, we are focused on partnering with system integrators and field service providers to jointly develop and commercialize our product. We believe the scalable, viable integration retrofit solution we are developing could have the potential to achieve maximum NOx reduction in a cost-effective manner to enhance a partner’s product line and offer significant competitive advantages.

In line with this objective, we signed an MOU in January 2005 with a leading retrofit integrator, including a commitment to further evaluate the commercial prospects of our mobile retrofit solution with the intent of entering into a commercialization agreement.

3. Diesel Genset Solution

We are building upon the successful test results we have achieved with our diesel fuel processor in combination with a NOx adsorber catalyst for both new and retrofit mobile diesel engine applications and are now extending application of this technology to stationary diesel engines. The goal of this development effort is to provide a cost-effective, bolt-on solution for widespread commercial application that enables both new and installed stationary diesel generators to significantly reduce NOx emissions.

In June 2004, we were awarded a $480,000 contract by the Electricity Innovation Institute (“E2I”), an affiliate of the Electric Power Research Institute (“EPRI”), and supported by The Public Interest Energy Research (“PIER”) program of the California Energy Commission (“CEC”) and Hawaiian Electric Company, Inc. (“HECO”), for the Phase I development of a greater than 90% NOx reduction system for stationary diesel engines.

Delaware	77-0410420
(State or other jurisdiction of incorporation or organization)	(IRS Employer Identification Number)

		Page No.
PART I
Item 1.	Business	5
Item 2.	Properties	25
Item 3.	Legal Proceedings	25
Item 4.	Submission of Matters to a Vote of Security Holders	25
PART II
Item 5.	Market for the Registrant’s Common Stock and Related Stockholder Matters	26
Item 6.	Selected Consolidated Financial Data	28
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	29
Item 7A.	Quantitative and Qualitative Disclosures about Market Risk	61
Item 8.	Consolidated Financial Statements and Supplementary Data	61
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	61
Item 9A.	Evaluation of Disclosure Controls and Procedures	61
PART III
Item 10.	Directors and Executive Officers of the Registrant	62
Item 11.	Executive Compensation	62
Item 12.	Security Ownership of Certain Beneficial Owners and Management	62
Item 13.	Certain Relationships and Related Transactions	62
Item 14.	Principal Accountant Fees and Services	62
PART IV
Item 15.	Exhibits, Financial Statement Schedules and Reports on Form 8-K	63