| ENVIRONMENTAL POWER CORP Item 1A Risk Factors An investment in our common stock is speculative and involves a high degree of risk |
| You should purchase the common stock only if you are sophisticated in financial matters and business investments |
| You should carefully consider the following factors before purchasing our common stock |
| 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 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 |
| If our investment in Microgy is not profitable, your investment in our common stock will be adversely affected |
| Microgy has experienced losses to date and we anticipate it will continue to experience losses into at least 2006 |
| 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 at least 2006, which could have a material adverse effect on the value of your investment in our common stock |
| Microgy has little experience in project development, and the marketplace for Microgy’s systems is complex, still developing and subject to change; therefore, we cannot predict how all projects will be developed, what Microgy’s costs will be or, consequently, whether Microgy or any project undertaken by Microgy will be profitable |
| Microgy has very limited experience in project development, including project assessment, construction and operation |
| In addition, Microgy markets its systems in a complicated and changing environment |
| Microgy also has no experience in the design, construction and operation of multiple digester projects of the kind on which its business plan is now focused |
| 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 of Microgy’s inexperience and the dynamic nature of its market, we are unable to project with certainty Microgy’s organizational, structural, staffing or other overhead costs, the construction or operating costs associated with any project, 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 materially adversely affected |
| If we are unable to obtain needed financing for Microgy’s projects, the value of our Microgy investment may be reduced significantly |
| We do not have adequate funds on hand to complete construction of the projects we currently have planned |
| 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 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 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 |
| If we are unable to obtain the required financing, your investment in our common stock will be materially adversely affected |
| 17 ______________________________________________________________________ [45]Table of Contents If we are unable to obtain sufficient manure and other waste resources for use as substrate for Microgy’s renewable energy projects, Microgy will not likely operate profitably |
| The performance of our renewable energy technologies is dependent on the availability of large quantities of animal manure and substrates derived from animal and other organic waste resources to produce raw energy and meet performance standards in the generation of power or biogas |
| While we often have agreements relating to the supply of manure, these agreements may not cover all of our requirements |
| Furthermore, we do not currently have any binding agreements relating to the supply of substrate to our projects |
| Lack of manure or substrate or adverse changes in the nature, quality or cost of such waste resources would seriously affect the ability of our projects to produce gas at profitable levels and, consequently, 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 the waste resources we require will be available in the future for free or at prices that make them affordable for our waste-to-energy technologies |
| As Microgy focuses a significant portion of its development efforts on projects devoted to the sale of gas as a commodity, we will be increasingly exposed to volatility in the commodity price of natural gas, which could have a material adverse impact on our profitability |
| As Microgy begins to focus a significant portion of its development efforts on multi-digester projects for the production of gas for sale as a commodity, we will become increasingly exposed to market risk with respect to the commodity pricing applicable to our gas production |
| Realized commodity prices received for such production are expected to be primarily driven by spot prices applicable to natural gas |
| Historically, natural gas prices have been volatile, and we expect such volatility to continue |
| Fluctuations in the commodity price of natural gas may have a materially adverse impact on the profitability of some of our projects, particularly where we do not have a long-term contract for the sale of the project’s output at a fixed or predictable price |
| At such time as Microgy’s projects begin to produce commercial quantities of gas for sale as a commodity, we intend to explore various strategies, including hedging transactions and long-term sale agreements, in order to mitigate the associated commodity price risk |
| However, we cannot assure you that any such risk management strategies will be successful |
| As a result, many of Microgy’s projects may become unprofitable, which would have a negative impact on your investment in our common stock |
| Our projects involve long development 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 development 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 development costs, 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 |
| Such delays could harm our operating results and financial condition |
| 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 US market |
| Competition from these companies may constrain our market share to a degree that will not allow us to be 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 |
| Competition from any of these sources could harm our business |
| 18 ______________________________________________________________________ [46]Table of Contents 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 |
| 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, or the gas produced by such facilities, 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 |
| 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 or those of our licensor |
| 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 was terminated for any reason or such licensor ceased doing business, our Microgy subsidiary would be negatively impacted |
| Microgy licenses its anaerobic digester technology from Danish Biogas Technology, AS, 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 negatively impacted |
| 19 ______________________________________________________________________ [47]Table of Contents The large number of tasks that need to be accomplished for the development of projects based on our system increases the possibility that such projects will incur costly delays |
| In our development of projects based on our anaerobic system for ourselves or on behalf of our customers, we are required to enter into or obtain some or all of the following: • Site agreements; • Supply contracts; • Design/build or other construction-related agreements; • Off-take agreements for gas produced; • Power sales contracts; • Various co-product sales agreements; • Waste disposal agreements; • Licenses; • Environmental and other permits; • Local government approvals; and • Financing commitments required for the successful completion of projects under consideration |
| 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 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 |
| The composition of effluents from our 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 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 |
| 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 dlra1cmam400cmam000 of distributions, after which we will 20 ______________________________________________________________________ [48]Table of Contents 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 the Public Utility Regulatory Policy Act of 1975, or 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 in Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations under the heading “Liquidity and Capital Resources—Long-Term Liabilities and Commitments—Scrubgrass Debt Obligations” appearing elsewhere in this report, shows that over 90prca 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 dlra1cmam301cmam760 increase in our lease expense |
| 21 ______________________________________________________________________ [49]Table of Contents Poor quality fuel and other materials 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 85prca of capacity 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, solid waste disposal 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 PURPA and the electric utility industry |
| Most recently, these proposals resulted in the enactment of the Energy Policy Act of 2005, which eliminates the PURPA obligation of electric utilities to enter into new contracts with qualifying facilities, or QFs |
| While the Energy Policy Act does not affect existing contracts, if PURPA is amended again or repealed in the future, the statutory requirement that electric utilities purchase electricity at full-avoided cost from QFs could be repealed or modified |
| While we expect that existing contracts would continue 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 and the Federal Energy Regulatory Commission or FERC, although such sales are currently exempt |
| These commissions set the price tariffs under which energy can be sold or purchased, they regulate the 22 ______________________________________________________________________ [50]Table of Contents sale of some generation assets 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 and our ability to sell these assets |
| Substantial delays may materially affect our financial condition |
| Government regulations can be burdensome and may result in delays and expense |
| In addition, modifications to regulations could adversely affect our ability to sell power or to implement our chosen strategy for the sale of power |
| Subsequent changes in the applicable regulations could also affect our ability to sell or install new facilities or develop and install facilities in an efficient manner or at all |
| Failure to comply with applicable regulatory requirements can result in, among other things, operating restrictions and fines that could harm our financial condition |
| Risks Relating to Our Common Stock We have numerous outstanding options and warrants which may adversely affect the price of our common stock |
| As of December 31, 2005, we had outstanding options, both vested and unvested, and warrants to acquire up to approximately 3cmam469cmam346 shares of our common stock at prices ranging from dlra1dtta40 to dlra21dtta56 per share |
| For the term of such options and warrants, the holders thereof will have an opportunity to profit from a rise in the market price of our common stock without assuming the risk of ownership |
| This may have an adverse effect on the price of our common stock and on the terms upon which we could obtain additional capital |
| It should be expected that the holders of such options and warrants would exercise them at a time when we would be able to obtain equity capital on terms more favorable then those provided by the options and warrants |
| The issuance of preferred stock may adversely affect the price of our common stock, which could cause a reduction in the value of your investment |
| We are authorized to issue up to 2cmam000cmam000 shares of preferred stock |
| The preferred stock may be issued in series from time to time with such designations, rights, preferences and limitations as our board of directors may determine by resolution without shareholder approval |
| No shares of preferred stock are currently outstanding |
| However, we may issue preferred stock that would enjoy dividend and liquidation preferences over our common stock, thereby diminishing the value of our common stock |
| The sale of a substantial number of shares could cause the market price of our common stock to decline |
| Our sale, or the resale by our stockholders, of shares of our common stock could cause the market price of our common stock to decline |
| A significant portion of our outstanding shares of common stock had been restricted from immediate resale, but are now available for sale in the market pursuant to Rule 144 under the Securities Act of 1933 |
| As of December 31, 2005, we had approximately 2cmam134cmam067 shares of restricted common stock outstanding, all of which shares are eligible for resale in accordance with Rule 144 |
| Furthermore, we currently have on file with the Securities and Exchange Commission an effective registration statement that permits the resale by certain of our shareholders of up to 1cmam677cmam688 shares of our restricted common stock, of which 1cmam017cmam712 shares are currently issued and outstanding and 659cmam976 shares are subject to outstanding warrants that are currently exercisable at a price of dlra7dtta02 per share |
| We also currently have on file with the Securities and Exchange Commission an effective registration statement that permits the resale of up to 100cmam000 shares of our common stock subject to warrants exercisable at a price of dlra6dtta33 per share by the holders of such warrants |
| 23 ______________________________________________________________________ [51]Table of Contents As of December 31, 2005, we had outstanding options to acquire up to approximately 2cmam709cmam370 shares of our common stock at prices ranging from dlra1dtta40 to dlra21dtta56 per share |
| The shares of common stock issuable upon exercise of these options will be freely transferable without restriction, except to the extent that they are held by our affiliates |
| Any shares held by our affiliates may only be sold in compliance with the volume limitations of Rule 144 |
| These volume limitations restrict the number of shares that may be sold by an affiliate in any three-month period to the greater of 1prca of the number of shares then outstanding, which equals approximately 95cmam000 shares as of December 31, 2005, or the average weekly trading volume of our common stock during the four calendar weeks preceding the filing of a notice on Form 144 with respect to the sale |
| Our management and directors will continue to exercise significant control over our management and affairs |
| As of December 31, 2005, management and directors, including Joseph E Cresci, Donald A Livingston, Kamlesh R Tejwani, Robert I Weisberg, Jessie J Knight, Jr, John R Cooper, August Schumacher, Jr, Lon Hatamiya, Steven Kessner, John F O’Neill and Randall Hull beneficially owned approximately 27prca of our outstanding common stock |
| While there are no voting agreements among them, such persons, as a group, may be able to control the outcome of matters submitted for stockholder action, including the election of members to our board of directors and the approval of significant change in control transactions |
| This may have the effect of delaying or preventing a change in control of our company and, therefore, your opportunity to sell your shares in such a transaction |
| The lack of a developed trading market may make it difficult for you to sell your common stock |
| Prior to December 27, 2004, our common stock was traded on the OTC Bulletin Board |
| While our common stock is now listed for trading on the American Stock Exchange, trading activity in our common stock has fluctuated and has at times been limited |
| We cannot guarantee that a consistently active trading market will develop in the future |
| As a result, a holder of our common stock may find it difficult to dispose of our common stock |
| The market price for our common stock may be volatile |
| The market price for our common stock could be subject to significant fluctuations in response to variations in quarterly operating results, announcements of technological innovations or new projects and products by us or our competitors, or our failure to achieve operating results consistent with any securities analysts’ projections of our performance |
| The stock market has experienced extreme price and volume fluctuations and volatility that have particularly affected the market price of many emerging growth and development stage companies |
| Such fluctuations and volatility have often been unrelated or disproportionate to the operating performance of such companies |
| We will require and are actively seeking significant additional financing, which may result in our issuing a significant number of shares of our common stock or preferred stock, which in turn may dilute your investment |
| We require and are seeking corporate and project financing to fund our ongoing operations and growth plans as well as and the cost of any development we may decide to pursue for our projects |
| Any such financing could be in the form of debt or equity instruments or a combination of debt and equity instruments |
| To the extent any such financing involves equity, we may issue a significant number of shares of our common stock or preferred stock, which will dilute your investment in our common stock, and we may issue such shares at prices that may be lower than the price you paid for our common stock |
| In addition, if we issue shares of our preferred stock, such preferred stock will have rights and preferences that are superior to those of the shares of common stock offered hereby |