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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-K
(Mark one)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2001
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OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE OF 1934
For the transition period from _________________ to _________________
Commission File Number 0-15472
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Environmental Power Corporation
(Exact name of registrant as specified in its charter)
Delaware 04-2782065
(State or other jurisdiction of (IRS Employer Identification No.)
incorporation or organization)
One Cate Street, Fourth Floor, Portsmouth, New Hampshire 03801
(Address of principal executive offices)
(Zip code)
(603) 431-1780
Registrant's telephone number, including area code
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $.01 par value
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes [X] No [_]
Indicate by check mark 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 the
Form 10-K. [X]
State the aggregate market value for the voting stock held by non-affiliates of
the registrant: The aggregate market value, computed by reference to the closing
price of such stock on March 27, 2002, was $3,134,952.
Indicate the number of shares outstanding of each of the registrant's classes of
common stock, as of the last practicable date: On March 27, 2002 there were
20,251,653 outstanding shares of Common Stock, $.01 par value, of the
registrant.
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DOCUMENTS INCORPORATED BY REFERENCE
Portions of the definitive Proxy Statement to be filed with the Securities and
Exchange Commission and delivered to shareholders in connection with the 2002
Annual Meeting of Shareholders are incorporated by reference into Part III of
this Annual Report filed on Form 10-K. The portions of the Proxy Statement under
the headings "Audit Committee Report", "Report of the Compensation Committee"
and the "Stock Performance Graph" are not incorporated by reference and are not
a part of this Form 10-K Report.
TABLE OF CONTENTS
Description of Contents Page #
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PART I:
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Item 1. Business 3
Item 2. Properties 14
Item 3. Legal Proceedings 15
Item 4. Submission of Matters to a Vote of Security Holders 15
PART II:
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Item 5. Market for Registrant's Common Equity and Related Shareholder Matters 16
Item 6. Selected Financial Data 17
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 19
Item 7A. Quantitative and Qualitative Disclosures About Market Risk 39
Item 8. Financial Statements and Supplementary Data 39
Item 9. Disagreements on Accounting and Financial Disclosure 39
PART III:
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Item 10. Directors and Executive Officers 40
Item 11. Executive Compensation 40
Item 12. Security Ownership of Certain Beneficial Owners and Management 40
Item 13. Certain Relationships and Related Transactions 40
PART IV:
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Item 14. Index to Financial Statements, Exhibits, and Reports on Form 8-K 41
Signature Page 47
CAUTIONARY STATEMENT
This Annual Report on Form 10-K contains "forward-looking statements", as
defined by the Private Securities Litigation Reform Act of 1995, in order to
provide investors with prospective information about us. For this purpose, any
statements which are not statements of historical fact may be deemed to be
forward-looking statements. Without limiting the foregoing, the words
"believes", "anticipates", "plans", "expects" and similar expressions are
intended to identify forward-looking statements. There are a number of important
factors which could cause our actual results to differ materially from those
indicated by the forward-looking statements. These factors include, without
limitation, those set forth below under the caption "Item 7. - Certain Factors
That May Affect Future Results".
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ITEM 1. BUSINESS
Environmental Power Corporation, known as EPC, is an independent developer and
owner of electrical generating facilities powered by non-commodity fuels and
renewable energy sources. Our power generating facilities use alternative fuels,
most of which are wastes, which are generally not subject to the same cost
fluctuations as traditional fuels. Our power generating facilities have also
been able to exceed air quality emission standards and to assist with the
clean-up of wastes that are sources of water pollution. Accordingly, we have
realized financial benefits, such as tax-exempt financing and sales of pollution
allowances from the pollution control benefits of our facilities.
Since our founding in 1982, we have partially or fully developed seven
hydroelectric plants, two municipal waste projects and three waste-coal fired
generating facilities. We sold all but one of these projects as follows:
. We sold four hydropower projects during their development phases;
. We transferred rights to two municipal waste projects during their
development phases;
. We sold three hydropower facilities after completion;
. We sold, during development, a 43 megawatt (net) waste-coal fired
facility located in Pennsylvania known as the Milesburg Project. This
project was involved in protracted litigation with, among others, West
Penn Power Company. We settled the litigation in 1997 and sold the
project to West Penn.
. We sold, after completion in 1994, a 51 Megawatt (net) waste-coal
fired facility located in Utah known as the Sunnyside Project. After
the sale, the purchasers sued us claiming breach of certain
obligations in connection with the sale. We counterclaimed for payment
of certain obligations of the purchasers. These matters were settled
by a payment to us of $1,500,000 and the release of certain contingent
liabilities.
Buzzard Power Corporation, our subsidiary, currently owns a 22-year leasehold
interest in an approximate 83 megawatt (net) waste-coal fired facility located
in Pennsylvania known as the Scrubgrass Project.
In 2001, we acquired all of the common stock of Microgy Cogeneration Systems
Inc., a privately held Colorado company. We operate Microgy as a subsidiary.
Microgy holds an exclusive license in North America for development and
deployment of a proprietary technology for extraction of methane gas from animal
wastes and its use to fuel generation of energy. EPC is currently in the process
of developing its strategies for pursuing the opportunities which result from
this acquisition.
Our ongoing business activities are discussed further in the following sections.
Buzzard Power Corporation
Buzzard leases the Scrubgrass facility from Scrubgrass Generating Company, L.P.
The Scrubgrass facility, located on a 600-acre site in Venango County,
Pennsylvania, is an approximate 83 megawatt waste coal-fired electric generating
station.
Buzzard's lease commenced on June 30, 1994 and provides for a term of 22 years
with a renewal option for up to 3 years. Under the lease, Scrubgrass Generating
Company assigned to Buzzard all principal project agreements and its rights and
obligations under such contracts including:
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.. the power purchase agreement
.. management services agreement
.. operating and maintenance agreement
.. limestone supply agreements
.. ground lease agreements
.. fuel agreements
.. transportation
.. materials handling agreements.
We have pledged Buzzard's common stock to the Scrubgrass Generating Company as
security for Buzzard's performance of its obligations as lessee. PG&E National
Energy Group, a wholly owned indirect subsidiary of NEG, Inc., which in turn is
a wholly owned indirect subsidiary of PG&E Corporation, manages the Scrubgrass
facility under a Management Services Agreement.
PG&E Operating Services Company, also a wholly owned indirect subsidiary of NEG,
Inc., operates the plant under a 15-year Operating and Maintenance Agreement.
PG&E OSC prepares a budget for all operating expenses, including a fixed
management fee, and certain targeted output performance levels, which is
approved annually. Under the operating agreement, PG&E OSC may be liable for an
amount not to exceed its management fee if it does not achieve certain targeted
output performance levels.
Buzzard sells all of its electric output to Pennsylvania Electric Company, known
as Penelec, under a twenty-five year power sales agreement, which commenced in
June 1993. Under this contract, except for amounts sold above certain hourly and
annual limits, all power is sold at fixed rates which initially averaged 4.68
cents per kilowatt hour and escalated by 5% annually through 1999. For years
2000 through 2012, the agreement provides for a rate equal to the greater of a
scheduled rate or a rate based on the PJM Billing Rate. The PJM Billing Rate is
the monthly average of the hourly rates for purchases by the General Public
Utilities Group from, or sale to, the Pennsylvania-New Jersey-Maryland
Interconnection. For years 2013 through 2015 and 2016 through 2018, if we
exercise the renewal term option, the agreement provides for a rate equal to the
lower of the average monthly PJM Billing Rate or the rate paid for calendar year
2012 adjusted annually by the percentage change in the Gross National Product
Deflator less one percent.
In early 2000, we resolved a protracted legal proceeding with Penelec. The
proceeding, among other issues, involved Penelec's unwillingness to pay contract
rates for power in excess of 80 megawatts produced by the Scrubgrass facility.
On March 24, 2000, Penelec paid the outstanding balances due under a settlement
agreement of $3,687,000 for previous deliveries of electric energy plus $608,000
in interest. We reported these revenues in our 2000 financial statements.
Penelec also agreed to pay for all future net deliveries of electric energy at
the rates set forth in the power sales agreement, subject to, among other
conditions, certain annual and hourly limits, with energy purchased in excess of
such limits paid for at a market based rate. To date, these limits have not
materially affected our revenues.
Buzzard deposits all revenues earned under the power sales agreement into an
account administered by a disbursement agent. Before Buzzard can receive cash
from the operation of the Scrubgrass facility, Buzzard must first satisfy all
operating expenses, base lease payments, restricted cash deposits, and other
subordinated obligations. Buzzard's base lease payments consist of Scrubgrass
Generating Company's debt service, equity repayment, base return on equity and
related expenses. Buzzard must also pay to Scrubgrass Generating Company
additional rent of 50 percent of the net cash flows Buzzard receives from the
operation of the Scrubgrass facility. We are not required to fund Buzzard's
operating losses, or otherwise invest further from sources outside of the
Scrubgrass Project.
The debt obligations for Scrubgrass Generating Company and Buzzard are described
below:
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Balance at Balance at Matures
Description of the Obligation 12/31/01 12/31/00 Interest Rate Through
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Lease obligations:
Variable rate tax-exempt bonds $135,600,000 $135,600,000 Quoted Bond Rates 2012
Swap rate term loan 10,669,663 12,541,087 7.5475% (through 2000) 2005
7.6725% (thereafter)
Variable rate term loan 8,344,479 10,061,427 LIBOR + 1.250% 2004
Buzzard's debt obligations:
Variable rate term loan 985,747 1,188,573 LIBOR + 1.250% 2004
Working capital loan 1,116,905 2,742,961 LIBOR + 1.125% (through 2000) 2002
LIBOR + 1.250% (thereafter)
Scrubgrass Generating Company or Buzzard pays interest on these obligations at
either quoted rates for tax exempt debt, rates fixed by swap agreements for
taxable debt, or rates for taxable debt which are based on the London Interbank
Offering Rate, or LIBOR. On December 22, 1995, Scrubgrass Generating Company
entered into an interest rate swap arrangement that fixed the LIBOR component
for the life of its swap rate term loan at 6.4225%. As a result, the interest
rate for the swap rate term loan was fixed at 7.5475% through 2000 and at
7.6725% for its remaining. Under the terms of the loan agreements, we are
subject to various customary financial and operating covenants. As of December
31, 2001 and 2000, we complied with all such covenants.
The Environmental Protection Agency and the Pennsylvania Department of
Environmental Protection granted Nitrogen Oxide Ozone Transport Region Budget
Allowances, or NOx Credits, to Buzzard based on factors that primarily pertain
to the design and operation of the Scrubgrass facility. Buzzard is required
annually to maintain NOx Credits that equal or exceed the quantity of its
nitrogen oxide emissions during a seasonal period known as an ozone season. If
the Scrubgrass plant's nitrogen oxide emissions exceed its available NOx
Credits, Buzzard would be subject to fines by such agencies. During 1999,
Buzzard installed machinery, costing $811,568, which has significantly reduced
our nitrogen oxide emissions. Accordingly, we anticipate that Buzzard may not
require a portion of its future NOx Credits to comply with the applicable
regulations. NOx Credits are transferable and marketable. Buzzard has sold and
may sell, from time to time, its projected excess NOx Credits or purchase
additional NOx credits, that are necessary to meet the applicable regulations.
To date, we have entered into several agreements to sell and purchase, when
necessary, NOx credits. We recognized net proceeds from these NOx Credit
transactions of $0 in 2001, $1,156,338 in 2000 and $606,960 in 1999, which were
reported as other income in our accompanying consolidated financial statements.
During February 2002, the Company received $2,428,200 from sales of anticipated
excess NOx emission credits for the 2002 through 2007 ozone seasons. The income
from these sales was reported during the first quarter of 2002.
Microgy Cogeneration Systems
In the second half of 2001, we acquired Microgy Cogeneration Systems, Inc., a
development stage company based in Golden, Colorado. The acquisition is
described in Item 5 of this Report and in our consolidated financial statements.
Microgy intends to market and operate in the renewable energy and distributed
generation sectors of the electric energy industry and the pollution mitigation
area of the agricultural industry. Microgy has an exclusive license to an
anaerobic digestion technology that is designed to provide efficient conversion
of certain agricultural and other wastes into combustible biogas and an
environmentally improved waste effluent. Microgy also has a license for a
microturbine technology and possible rights to other technologies which we are
currently evaluating.
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Anaerobic Digester License Agreement
The licensor of the anaerobic digester technology is Danish Biogas Technology
A/S, or DBT. DBT is 50% owned by Schouw & Co., a Danish public company. On May
12, 2000, Microgy entered into a revised licensing agreement with DBT which
granted Microgy a perpetual and exclusive license in certain territories,
specifically North America, for use of certain proprietary technologies in its
cogeneration facilities, including the anaerobic digestion technology. This
agreement superseded previous license agreements.
As part of the agreement, DBT will own a 5% minority equity stake in any legal
entity that owns any project developed by Microgy using the enhanced anaerobic
digester technology in which Microgy holds an equity position. The agreement
also specifies a fixed payment amount per project to DBT for engineering work
and construction drawings and a licensing fee that is based on a percentage of
the total cost for each project facility where the licensed technology is
installed and operating. A monthly consulting fee will be paid to DBT upon
commercial operation of proposed projects.
Currently, we are developing plans for deployment of the anaerobic digester
technology. Consultants with expertise in the agriculture industries, renewable
energy, finance, engineering and technical and related legal disciplines have
been working with members of EPC's board of directors and our management in this
effort. We expect that this planning process will assist Microgy in recognizing
and pursuing the best short and long term strategies for developing our
anaerobic digestion and renewable energy business.
Proposed Projects
Microgy plans to develop projects based upon the anaerobic digestion technology
license. Our present business strategy anticipates the outright sale of
facilities; however, we expect that, in some circumstances, we may own some or
even a majority of projects. In addition to any ownership position Microgy may
have, it presently plans to manage and may operate any such proposed facilities.
We anticipate these facilities will deliver renewable energy for supply to the
utility grid and will provide pollution control benefits to the agricultural
markets. The ultimate opportunity to develop such projects and/or to sell these
facilities to others, as well as to manage and/or operate them profitably,
depend on factors including the value which can be derived from the energy and
agricultural markets discussed below.
Power Contracts
In December 2000, Microgy entered into an agreement with a California-based
irrigation district that provides water and electric services to its customers
located primarily in the California central valley. This agreement is currently
being renegotiated and may be modified substantially from its current form.
Under the agreement, Microgy may sell up to 15 megawatts of power to the
irrigation district once it has developed facilities to generate such power. The
term of the agreement is ten years from the date of commercial operation of each
proposed facility. The facilities would provide renewable energy created by
Microgy's licensed process and would source their wastes principally from the
farms that are customers of the irrigation district.
On March 21, 2002, Microgy entered into a power sales agreement with Wisconsin
Public Service Corporation. Under the agreement, Microgy may sell up to 15
megawatts of peak power to Wisconsin Public Service from numerous biogas
cogeneration facilities. The agreement also provides for the sale to Wisconsin
Public Service of a portion of the environmental credits derived from the
generation of energy at the facilities. The term of the agreement is 15 years
from the date of the agreement with a five year option to extend by Wisconsin
Public Service. The yet-to-be developed facilities would be located at various
dairy farms and other agricultural facilities and provide renewable energy
created from agricultural waste.
Energy Markets
We generate revenue from the sale of electric energy and derive or expect to
derive some additional revenues and other benefits from our present and proposed
involvement with environmentally friendly power generating
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facilities. There are three segments of the energy markets, as well as the
markets for "green" energy benefits, pollution offsets, and the agricultural
markets, all of which affect our current or planned activities.
PURPA Qualified Facilities (QFs)
The energy crisis of the 1970's led to the enactment of the Federal Public
Utility Regulatory Policies Act of 1978, or PURPA. PURPA encouraged companies
other than utilities to enter the electric energy business by reducing
regulatory constraints. In addition, PURPA requires utilities to purchase
electricity produced by facilities using alternative fuels or from cogeneration
facilities that meet the Federal Energy Regulatory Commission's, or FERC's,
requirements for certification as qualifying facilities, or QF's. The
requirements are described below. This obligation upon utilities to purchase the
output from QFs requires that utilities purchase all power produced at the
utilities' avoided cost. Generally, the avoided cost is the price at which the
utility could purchase or produce the same amount of power from sources other
than the QF.
Scrubgrass is a QF. All of the electricity produced at the Scrubgrass facility
is sold under a contract with Penelec, entered into pursuant to PURPA. Except
for output in excess of certain annual and hourly limits, the contract has a
fixed price with fixed escalations through 2004 and minimum prices from 2005
through 2012. However, after 2004 prices may be influenced by the prices for
electricity in the traditional commodity power markets for the Western PJM
(Pennsylvania-New Jersey-Maryland) Interconnection.
We believe that the facilities we would build using Microgy's licensed
technology would meet the qualifications required to be a QF.
Commodity Electricity
The market for traditional commodity electricity, while national in scope, has
regional variations in pricing. Variations are due to generating and
transmission capacity, regional production costs, and demand within those
regions. In general, however, prices were generally flat or declining over the
period between 1990 and 2000. Further, as the market has moved increasingly
toward trading electricity as a commodity, it has been marked by increased
volatility. In many markets during 2000, there were very high prices during
certain times for peak period electricity. Peak periods are customarily defined
as the sixteen-hour period encompassing the daytime hours, Monday through
Friday. During 2001, the slower economy and lower cost of conventional fuels
used for power generation have brought prices substantially lower. We expect the
near-term market for commodity electricity to remain very price competitive with
upward pressure on prices dependent upon increased costs of fuels used for
electric generation. If and when the economy becomes more robust and consumption
of energy increases, there are likely to be increases in conventional fuel
prices as well as geographical areas within the United States which will need
increased capacity to service demand and prices will likely increase
accordingly.
For 2002 and 2003, the U.S. Department of Energy, or DOE, projects increasing
prices for natural gas, which is considered the most influential fuel in
determining the trading price of commodity electricity. If such projections
prove to be accurate and commodity electricity prices increase, the output from
any facilities developed by Microgy, will be increasingly price competitive and
potentially more profitable. This should also make it easier for us to attract
and execute new opportunities to develop these projects.
Renewable Peak Period Electricity
We plan to develop facilities that serve the market for renewable energy
delivered during peak usage periods. We believe that such renewable energy will
result in "green" benefits as described below. We intend this combination of
renewable energy and peak period delivery to position our output into the
highest priced segments of the electricity markets. During peak periods there is
the greatest use and demand for electricity. Natural gas is the principal fuel
source for generating commodity electricity on a peaking basis. Except for oil,
which is seldom now used, generation from most other fuels is not readily
adaptable to peak period operation. Microgy's anaerobic digestion technology
produces biogas from the processed manure that, like natural gas, can be stored
and used to
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generate power during peak periods. We believe that Microgy's technology offers
us a valuable generating capability, namely, the ability to produce renewable,
peak energy.
The demand for renewable power in the energy markets is driven largely by
consumer desire for such power and by state legislation. Surveys of electric
customers throughout the United States have shown that a large percentage of
individuals would be willing to pay premiums to purchase renewable energy. These
preferences have resulted in green pricing programs in many local energy
markets. Many states and local governments have further encouraged the growth of
renewables through tax incentives and by requiring utilities to offer customers
electricity derived from renewable sources and/or to generate or purchase a
small portion of their electricity from renewable energy providers. Presently,
the United States Congress is considering proposed legislation which would add
significant tax benefits to the generation of electricity produced from biomass.
Further, many states and the Federal government require a portion of the power
consumed in their own facilities to be provided from renewable generating
sources. These Renewable Portfolio Standards, or RPS, have increased over the
last several years. The DOE foresees significant growth in the generation
capacity of renewables - from 357 billion kilowatt hours of generation from
non-hydroelectric renewable energy sources in 2000 to 464 billion in 2020.
Green Tags and Pollution Offset Credits
As a potential producer of renewable energy, we expect to be able to sell
separately electricity and "green" energy credits, also called "green tickets"
or "green tags". Green tags can be defined in many ways. We define them as the
marketable bundle of benefits derived from the environmentally friendly
generation of power. In some instances, we may include all or some portion of
the green tags in wholesale electricity purchase agreements. However, we may
also separately trade these green tags or some of their unbundled components in
a growing trading market.
Buzzard has been able to sell pollution offset credits based upon NOx emissions
which were discussed previously. Our future facilities may also be able to sell
NOx, greenhouse gases, and other pollution offset credits in addition to
electricity and other green credits. The market for these and similar credits is
projected to grow as stricter environmental regulations and emission standards
are adopted.
We expect that trends in the energy and green trading markets will play an
important role in our ability to develop future facilities and our potential
profitability. However, there are many competitors in these markets and, in
addition, the local characteristics of each market, such as installed renewable
generating capacity or local legislation, could create impediments to our plans
and progress.
Agricultural Markets
We plan to provide anaerobic digester equipment and services to help control
pollution in agricultural markets, specifically Animal Feeding Operations, or
AFOs.
Runoff from animal wastes presents significant water pollution problems. In
1998, state reports of water quality conditions indicated that:
. of the rivers and streams surveyed, (53% of all perennial stream
miles) 36% were partially or fully impaired and another 8% were
threatened;
. of the surveyed lakes, (40% of all lake acres) 39% were partially or
fully impaired and another 10% were threatened;
. of the estuaries surveyed by coastal states (72% of all estuarine
waters), 38% were impaired and another 4% were threatened; and
. of the Great Lakes shore miles surveyed (94% of all shore miles), 97%
were impaired and another 1% were threatened.
The Clean Water Act identified polluted runoff as the most important remaining
source of water pollution and provided for a coordinated effort to reduce
polluted runoff from a variety of sources. As part of this effort, the
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Clean Water Act called for the USDA and EPA to take steps to minimize the water
quality and public health impacts of AFOs.
Large and medium AFOs are responsible for the greatest contribution to the
problem of excess manure nutrients. For example:
. 72% of these farms are estimated to have inadequate capacity to
utilize all nitrogen produced on-farm.
. As nutrients produced by AFOs increased from 1982 to 1997, crop
acreage associated with those farms declined. Additional crop acreage
can be used to spread excess animal waste to reduce the concentration
of water polluting nitrogen.
. The 73 million acres of cropland and permanent pasture associated with
AFOs is estimated to have capacity to assimilate for only 38% of the
calculated available nitrogen from those farms.
. Total recoverable manure nitrogen from medium and large animal
operations almost doubled between 1982 to 1997. They contribute almost
70% of the total excess nitrogen in the U.S.:
. On medium farms - excess nitrogen increased by 83% from 1982 to 1997
. On large farms - excess nitrogen increased by 104% from 1982 to 1997
There are over 7,000 AFOs in the United States in the over 500 head dairy and
over 1000 head hog markets alone. These numbers are expected to increase as the
industry continues its trend of consolidation. Based upon this information, the
government has created a new designation for these larger farms, Concentrated
Animal Feeding Operations, or CAFOs. CAFOs will be subject to stricter
permitting and licensing standards. The EPA is expected to regulate these
operations closely. Nevertheless, it is believed that farmers realize many
benefits from consolidation.
We believe that the pollution control benefits of Microgy's technologies should
help CAFOs meet the stricter guidelines and permitting requirements and, as a
result, many farms would be able to address existing pollution problems over
time and to increase land application of less-pollutant manure and, in some
instances, support a larger herd on the same amount of land. Alternatively, in
critical pollution areas, or where uses for residual products can be identified,
the land application of manure could be substantially curtailed.
Competition
We face several types of competitors including:
. commodity power producers
. renewable power producers
. peak power producers
. pollution control providers
. "opportunity" competitors
Commodity Power Producers
We plan to develop and own or sell power generating facilities that provide
wholesale electricity to the utility grid. Our competitors include all other
producers of electricity, such as:
. traditional utilities
. other independent power producers
. coal-fired plants
. nuclear plants, and
. facilities fueled by natural gas, wind-energy, hydro-electric,
geo-thermal, and various other fuels.
As described, this market is very price competitive. Many of our competitors are
well established, more experienced and better capitalized than EPC.
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We believe that we have identified a market niche that will enable us to serve
multiple market segments. We believe that providing pollution control benefits
along with green, peaking electric energy, may afford us an opportunity to avoid
direct competition with a large segment of the commodity power market. We will,
however, be heavily influenced by that market.
Renewable Power Producers
Several other technologies exist to provide "green" renewable energy, including
wind, solar, geo-thermal, biomass, and landfill gas extraction. Producers using
these sources of renewable power compete with us in the sale of renewable energy
and Green Tags. They also compete for participation in green pricing programs,
RPS programs and state mandates for renewables. Many of these competitors are
experienced, well financed, and established in our markets.
We believe that our facilities will compete by seeking to provide benefits that
some of these organizations cannot. The Microgy technology will allow us to
store biogas so that we can provide firm power at peak periods. We believe that
most renewable power sources, other than biogas from a highly controlled source,
cannot consistently produce and/or store their energy and cannot easily provide
firm peak power which usually has the greatest market value. We expect that the
pollution control benefits of Microgy's technology, as well as its anticipated
ability to generate green energy during peak periods, will allow us to serve
multiple markets and to compete.
Pollution Control Providers
Farmers have several options to handle the pollution problems described in the
Agricultural Markets section. They range from acquiring additional land for
spreading, to reducing herd sizes, to employing other technologies such as
plug-flow digesters.
These pollution control options may limit the number of potential sites for
future Microgy facilities and, to the extent that tradeable pollution control
allowances are created, such alternatives are likely to affect Microgy's
opportunities in these markets.
However, we believe that our solution may offer farmers the potential to
realize similar pollution control benefits as some or all of these other
solutions and at the same time to, receive additional financial incentives.
"Opportunity" Competitors
We define opportunity competitors in two ways: First, there is the competitor
for farm sites and the competition resulting from other sources of pollution
mitigation as discussed above. Second, there may become competition for the
various resources which affect our operations or potential profitability. For
example, the market to obtain organic byproducts digested in the planned Microgy
projects may become subject to competition. Presently, we believe there is
little competition for these byproducts. However, in the future, the situation
may change.
The following sections describe the competition facing our subsidiaries.
Buzzard Power Corporation
Buzzard generates electricity using waste coal, an alternative energy source.
Buzzard sells all of its electricity at rates established under a long-term
power purchase agreement. With the exception of the risk that Penelec would seek
and achieve judicial determination that it has a right to renegotiate the terms
of the power purchase agreement the sale of power from our existing facility is
not subject to competition during the term of the power purchase agreement.
However, since our contracted rates in the later years of the agreement are
determined with reference to current consumer price indices and future market
conditions, the rate at which such power is sold after 2004 is influenced
by competitive power rates in the region. Therefore, low wholesale energy rates
during the later years of the power
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purchase agreement would adversely affect our profitability and could affect our
results of operations and financial position.
Microgy Cogeneration Systems
Microgy plans to generate revenue from the development, sale, and/or ownership
of facilities that market renewable, "green" energy in addition to providing
pollution control features to the agricultural markets. In the energy market,
its competitors include traditional regulated utilities, unregulated
subsidiaries of regulated utilities, energy brokers and traders, energy service
companies in the development and operation of energy-producing projects as well
as the marketers of electric energy, equipment suppliers, providers of pollution
control products or services, and other non-utility generators like EPC.
Microgy's "green" competitors include other energy producers using biomass
combustion, biomass anaerobic digestion, geothermal, solar, wind, new hydro, and
other renewable sources. These companies represent a significant class of
competitors because they will compete with Microgy for sale of "green tags" and
participation in various Renewable Portfolios and other programs.
In the agricultural markets, Microgy faces many forms of competition from other
providers of pollution control. The most significant among these entities may
include environmental engineers, providers of pollution control systems, and
other developers of anaerobic digesters or plug-flow digesters. Competition
includes private companies, public companies, associations, cooperatives,
government programs, such as AgStar, foreign companies, and educational pilot
programs.
Energy Regulation
Our Scrubgrass facility is certified as a QF by the FERC. Scrubgrass is and any
of our future facilities or projects will be subject to federal and state laws
and regulations. Pursuant to PURPA, FERC has promulgated regulations that exempt
QFs from the Federal Power Act of 1935, Public Utility Holding Company Act, or
PUHCA, and, except under certain limited circumstances, state laws regulating
the rates charged by electric utilities. In order to be a QF under PURPA, any
facilities that we might acquire or develop will be required to meet certain
size, fuel and ownership requirements and/or co-generate. In addition to
regulating QFs, PURPA requires that electric utilities purchase electric energy
produced by QFs at negotiated rates or at a price equal to the incremental or
avoided cost that would have been incurred by the utility if it were to generate
the power itself or purchase it from another source. We are not presently
subject to regulation under PUHCA and do not presently intend to engage in any
activities that would cause us to be so regulated.
The nature and impact of potential future changes of laws or regulations on our
projects is unknown at this time. Presently, there are numerous pending
legislative proposals and recent laws, which suggest a comprehensive
restructuring of the electric utility industry. If PURPA is amended or repealed,
the statutory requirement that electric utilities purchase electricity from QFs
at full-avoided cost could be repealed or modified. While existing contracts are
expected to be honored, the repeal or modification of these statutory purchase
requirements under PURPA in the future could 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 for Scrubgrass which reduce
the contracted rates, our results of operations and financial position could be
negatively impacted.
State public utility commissions, pursuant to state legislative authority, may
have jurisdiction over how any new federal initiatives are implemented in each
state. The actual scope of jurisdiction over independent power projects by state
public utility regulatory commissions varies from state to state. Presently,
through its power purchase agreement with Penelec, the Scrubgrass plant is
affected by state legislation in Pennsylvania.
On December 3, 1996, in response to changes in the electric industry,
Pennsylvania passed legislation known as the Electricity Generation Customer
Choice and Competition Act, or Customer Choice Act, which became effective
on January 1, 1997. The Customer Choice Act regulates the generation portion of
the electric business by
11
permitting a Pennsylvania retail electric customers to choose their electric
generation supplier over a phase-in period which expired December 31, 2000. The
Customer Choice Act required that all electric utilities file restructuring
plans with the PUC. Penelec filed its proposed restructuring plan during 1997.
The plan was subsequently litigated by numerous parties, and later settled by an
agreement which was approved by the PUC on October 20, 1998. The settlement
agreement set forth a comprehensive plan for restructuring Penelec's service and
for ensuring there would be competition for electric generation for all of
Penelec's customers beginning on January 1, 1999. The restructuring plan, as
approved by the PUC, provided for Penelec to maintain a separate non-utility
generator cost recovery mechanism for accounting purposes. The restructuring
plan is designed to enable Penelec to recover all of its costs from non-utility
generators such as the Scrubgrass plant and should serve to decrease the
pressure on Penelec to renegotiate existing power contracts with non-utility
generators.
On November 21, 2000, the shareholders of General Public Utilities Group and
First Energy Corp. approved a merger of these two companies. First Energy and
GPU have applied for approval of their merger to Federal Energy Regulatory
Commission, New Jersey Board of Public Utilities, Pennsylvania Public Utility
Commission, Nuclear Regulatory Commission, Federal Communications Commission,
Securities and Exchange Commission, and the Department of Justice under the
Hart-Scott-Rodino Act. We have been monitoring these merger activities to
determine whether such activities would have an unfavorable impact on the
Scrubgrass Project.
Presently, except as discussed above, neither the Customer Choice Act nor
Penelec's restructuring plan directly impacts us, since the legislation and
restructuring plan pertain to the retail market or new contracts in the
wholesale market. Nevertheless, we continue to monitor regulatory developments
in order to evaluate any impact on the Scrubgrass Project and possible new
business opportunities for Microgy.
Environmental Regulation
Our present and any future projects are and will be subject to various federal,
state and local regulations pertaining to the protection of the environment,
primarily in the areas of water and air pollution. Microgy intends to build
plants in various states. These facilities will be subject to federal, state and
local regulatory requirements in all the locations where they may operate.
In many cases, these regulations require a lengthy and complex process of
obtaining and maintaining licenses, permits and approvals from federal, state
and local agencies. We also have and will have significant administrative
responsibilities to monitor our compliance with the regulations. As regulations
are enacted or adopted in any of these jurisdictions, we cannot predict the
effect of compliance therewith on our business. Our failure to comply with all
the applicable requirements could require modifications to operating facilities.
During periods of non-compliance, our operating facilities may be forced to
shutdown until the compliance issues are resolved. EPC is responsible for
ensuring the compliance of its facilities with all the applicable requirements
and, accordingly, attempts to minimize these risks by dealing with reputable
contractors and using appropriate technology to measure compliance with the
applicable standards. The cost of environmental regulation does and will
continue to affect our profitability.
Buzzard Power Corporation
We believe the Scrubgrass Project, EPC's only operating project, is currently in
compliance with all material applicable environmental regulations. Our
Scrubgrass Project is most notably affected by the following environmental
regulations:
Air Quality -- The Scrubgrass Project is subject to air quality regulations
under the Federal Clean Air Act of 1970. This Act established National Ambient
Air Quality Standards for certain pollutants including ozone, sulfur dioxide,
nitrogen dioxide, particulate matter, carbon monoxide and lead. In particular,
CAA Title I established the Northeast Ozone Transport Region, which includes 12
northeast states and the District of Columbia, to address the transport of these
pollutants which may lead to the non-attainment of the ozone standards in the
Northeast. Ozone control is facilitated by the control of pollutant precursors,
which are nitrogen oxides, or NOx, and volatile organic
12
compounds. Electric generating facilities that use fossil fuels, including the
Scrubgrass facility, are considered major sources of NOx emissions.
In recent years, the Pennsylvania Department of Environmental Protection
established regulations that required companies with stationary sources of NOx
emissions to establish plans to reduce their NOx emissions. To administer these
regulations, the Department began allocating Nitrogen Oxide Ozone Transport
Region Budget Allowances, or NOx Credits, to facilities based on numerous
factors including the design and operation of each facility. A market-based
trading system was established to allow companies with excess NOx Credits to
trade with companies that required additional NOx Credits to meet the stricter
requirements. More recently, an Ozone Transport Commission established certain
inner and outer zones with seasonal NOx emission reductions that required the
Scrubgrass Project to achieve certain targeted NOx emission levels beginning on
May 1, 1999. Under such requirements, the Scrubgrass Project will also be
required to achieve reduced emission standards by May 2003. Due to the efficient
design of the Scrubgrass facility, the Scrubgrass Project met the new 1999
requirements without any modifications to the facility. However, we made capital
improvements of $811,568 in 1999 to the Scrubgrass facility, which are expected
to enable the Scrubgrass facility to meet the stricter standards in 2003. We
expect to meet the air quality standards for sulfur dioxide, nitrogen dioxide,
particulate matter, carbon monoxide and lead for the foreseeable future without
any additional material modifications to the Scrubgrass facility.
Waste Disposal -- The Scrubgrass Project must also comply with various
environmental regulations pertaining to water discharge as well as the handling
and disposal of hazardous and non-hazardous wastes. The Pennsylvania's
Department establishes classifications for wastes and requires companies to
follow certain handling and disposal procedures for each waste classification.
Currently, the Scrubgrass Project employs special handling procedures for the
transportation of its fuel, which is classified as a waste, from the waste sites
to the Scrubgrass facility. The fuel is burned in the Scrubgrass facility where
it is treated with various substances such as limestone during the electric
generation process. Ash, which is a byproduct of the waste-coal combustion
process, is removed from the Scrubgrass facility and returned to the original
waste site, which is reclaimed in part by deposit of the ash along with the
soil. Under existing regulations, ash is not classified as a hazardous waste.
However, various environmental organizations have recently been lobbying for
changes to the applicable regulations for the classification of ash. If there
are changes to the waste classification of ash, our ash disposal costs may
significantly increase which could have material adverse affect on the results
of operations and financial position.
Microgy Cogeneration Systems
Microgy has no projects currently in operation. Depending on the location of
each individual plant, state implementation plans of the Clean Air and Clean
Water Acts as described above may apply. The state permitting process could
involve lengthy delays for fact and law source reviews and to purchase of
offsets in order to counter-balance emissions. Microgy's projects may be subject
to the following additional regulations:
Current Regulations
The major Federal law affecting manure management on animal operations is the
Clean Water Act, under which the National Pollutant Discharge Elimination
System, or NPDES, program covers Concentrated Animal Feeding Operations, or
CAFOs. Federal NPDES permits may be issued by EPA or any state authorized by EPA
to implement the NPDES program. Forty-three states are certified by the EPA to
issue their own NPDES permits. Of note, EPA materials published in 1999
indicated that 32 states have a requirement covering application rates of manure
on the land, and 27 states require at least some animal operations to develop
and use waste management plans.
In addition, each distributed generation site with an installed reciprocating
engine and generator is regulated under a state implementation plan (SIP)
developed in accordance with the Federal Clean Air Act. The engine emissions at
each site will be covered under a general statewide permit or a point source
permit. The engine emissions are considered a minor point source for both the
general and specific permit and no other emission control devices are required.
13
Anticipated Changes to Current Regulations
In 1999, the US Department of Agriculture, or USDA, and EPA announced the
Unified National Strategy for Animal Feeding Operations, which sets forth a
framework of actions USDA and EPA plan to take under existing legal and
regulatory authority to minimize impacts to water quality and public health from
animal feeding operations and to establish a national performance expectation
for animal feeding operations.
Under the Unified Strategy, all CAFO owners and operators will be expected to
develop and implement comprehensive nutrient management plans for properly
managing the animal wastes produced at their facilities. Inclusion of such plans
as part of the NPDES permit means that for the first time, the application of
manure on land will be a part of a required Federal permit.
Proposed nutrient management plans rely on the Natural Resources Conservation
Service Field Office Technical Guide as the primary technical reference. This
guide limits manure application on land to the level determined by the more
limiting of the two major nutrients: nitrogen or phosphorus. In the past, manure
management has focused on managing manure nitrogen. Shifting to a
phosphorus-based standard will require more land on which to spread the same
amount of manure. Studies indicate that soil phosphorus levels can be rapidly
built up in the soil by the application of manure, but may take years to deplete
to levels enabling additional manure applications. Therefore, basing nutrient
management on phosphorus has significant implications for animal operations with
excess manure by increasing
. the acreage needed for spreading
. manure application costs, and
. the number of farms that will need alternative ways to dispose of
manure.
Impact of Microgy System
While digesting the raw manure and burning the resulting biogas to make
electricity does not eliminate the nutrients from the manure slurry, the process
does change their chemical makeup. In the anaerobic digestion process, many of
the nutrients that were previously bound in organic molecules are mineralized,
or reduced to the inorganic forms of the nutrients. These are the forms that are
usable by crops. The organic forms in undigested manure must first be broken
down before they can be used. Because this natural breaking down process usually
takes several years, there are residual nutrients in the soil left over from
previous years' manure applications. These residuals must be taken into account
when calculating current manure application rates, resulting in less manure
being spread on the same amount of cropland. By providing the nutrients in
readily usable forms, digested manure has lower potential to produce a residual.
Therefore, more of it can be spread on an acre of cropland, thus reducing manure
spreading costs.
In addition, further environmental benefits can be achieved by subjecting the
digested manure slurry to other nutrient extraction techniques, such as chemical
precipitation. By digesting the manure, these nutrients are in a form that is
more easily extracted in such techniques.
Employees
At the time of this filing, we had nine employees, including three EPC executive
officers and other marketing, finance, engineering and administrative personnel.
The loss of any executive officer could have a material adverse effect on our
business. Our employees are not represented by a collective bargaining agreement
and we consider relations with our employees to be good.
Item 2. PROPERTIES
Buzzard leases an approximate 83 megawatt waste coal-fired electric generating
facility located on approximately 600 acres in Venango County, Pennsylvania. The
payment terms of the lease are described in Item 1.
14
We leased 1,028 square feet of office space in Portsmouth, New Hampshire from
February 1996 until March 2002. In March 2002, we began leasing 2,818 square
feet of office space for our new corporate headquarters in Portsmouth, New
Hampshire under a five year lease with monthly payments of $5,520.
Microgy is a tenant-at-will for office space located in Colorado and Wisconsin
with aggregate rents of $3,728 per month.
Item 3. LEGAL PROCEEDINGS
We are currently not involved in any legal proceedings.
Item 4. SUBMISSIONS OF MATTERS TO A VOTE OF SECURITY HOLDERS
At our 2001 Annual Meeting of Stockholders, held on November 1, 2001, the
following actions were submitted to a vote of security holders:
1. Our stockholders elected a Board of Directors to serve for the ensuing year
until their respective successors have been duly elected and qualified. The
results of the voting were as follows:
Number of Shares
----------------
Elected Director For Withheld
---------------- --- --------
Joseph E. Cresci 13,999,022 45,600
Donald A. Livingston 14,034,022 10,600
Peter J. Blampied 14,031,822 12,800
Edward B. Koehler 14,031,822 12,800
Robert I. Weisberg 14,034,022 10,600
George A. Kast 14,031,822 12,800
Benjamin J. Brant 14,031,822 12,800
Thomas M. Matthews 14,034,022 10,600
2. Our stockholders approved an amendment to our Certificate of Incorporation to
increase the number of authorized shares of common stock, from 20,000,000 to
50,000,000 and the number of authorized shares of preferred stock, from
1,000,000 to 2,000,000. The results of the voting were as follows:
Result Number of Shares
------ ----------------
For 13,994,101
Against 49,021
Abstain 1,500
3. Our stockholders approved the adoption of a 2001 Stock Incentive Plan. The
results of the voting were as follows:
Result Number of Shares
------ ----------------
For 13,958,322
Against 86,200
Abstain 100
4. Our stockholders ratified the selection of the firm Deloitte & Touche LLP as
auditors for the fiscal year ending December 31, 2001. The results of the voting
were as follows:
15
Result Number of Shares
------ ----------------
For 14,041,622
Against 2,000
Abstain 1,000
PART II
Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS
Stock Market Trading:
Our common stock trades on the NASD OTC Bulletin Board under the symbol "POWR".
As of March 20, 2002 there were approximately 251 record holders and
approximately 970 beneficial holders of our common stock.
The following table shows the quarterly high and low bid prices during 2000 and
2001 as reported by the OTC Bulletin Board:
Year Period High Low
---- ------ ---- ---
2000 First Quarter $0.81 $0.44
Second Quarter 0.69 0.50
Third Quarter 0.75 0.47
Fourth Quarter 0.69 0.41
2001 First Quarter 0.56 0.44
Second Quarter 0.86 0.22
Third Quarter 0.70 0.40
Fourth Quarter 0.54 0.40
These over-the-counter quotations reflect inter-dealer prices without retail
mark-up, mark-down or commission and may not necessarily represent actual
transactions.
Changes in Securities and Use of Proceeds:
During 2001, we acquired 100% of the common stock of Microgy in two related
transactions. On July 23, 2001, we exchanged our securities for approximately
87.7% of the outstanding common stock of Microgy under a June 20, 2001 agreement
with Microgy and certain principal Microgy shareholders. Under the agreement, we
agreed to offer the remaining Microgy shareholders the opportunity to exchange
their Microgy securities for our securities. On December 28, 2001, we completed
the exchange of our securities for the remaining outstanding securities of
Microgy. The details of the two exchange transactions are discussed in the
following paragraphs.
On July 23, 2001, we issued an aggregate of 5,521,549 shares of common stock and
197,760.7 shares of our newly designated Series B Convertible Preferred Stock to
certain principal stockholders of Microgy in exchange for 15,919,147 shares of
Microgy common stock. Each share of our preferred stock, which voted with our
common stock on an as-converted basis, was automatically converted into ten
shares of common stock as of November 9, 2001 upon an increase in the authorized
common stock to an amount sufficient to allow conversion of the preferred stock.
The exchange ratio of 0.4711 shares of our common stock for each share of
Microgy common stock was determined by negotiations among us, Microgy and the
primary principal Microgy shareholders. The exchange ratio is based on all of
the fully diluted equity of Microgy being exchanged for 45% of our fully diluted
equity and assumes exercise or conversion of all derivative securities. The
exchange ratio may be increased to reflect certain issuances of equity by us to
generate funds to be available for financing Microgy. However, holders of
approximately 94% of the Microgy common stock agreed to waive their right
16
to adjustments in the exchange ratio, other than any adjustment resulting from
400,000 options and warrants issued in September 2001. One of the principal
Microgy shareholders exchanged a warrant to purchase 800,000 shares of Microgy
common stock for a warrant to purchase our securities based on the exchange
ratio. In connection with our issuance of 400,000 options and warrants in
September 2001, we adjusted the exchange ratio to 0.4873 shares of our common
stock for each share of Microgy common stock. We issued 258,884 additional
shares of common stock to the principal Microgy shareholders on December 28,
2001 and amended the warrant issued to the principal Microgy shareholder to
reflect the new exchange ratio.
On October 17, 2001, we offered the remaining security holders of Microgy, who
owned an aggregate of 2,230,126 shares of Microgy common stock, warrants to
purchase 885,000 shares of Microgy common stock and options to purchase 290,000
shares of Microgy common stock, an opportunity to exchange their Microgy
securities for our securities based on the adjusted exchange ratio. On December
28, 2001, we issued 1,086,830 shares of common stock and exchanged warrants to
purchase 431,298 shares of our common stock and options to purchase 141,329
shares of our common stock for the remaining Microgy securities pursuant to
Regulation D. The warrants to purchase 431,298 shares are exercisable through
September 30, 2002 at an exercise price of $2.05 per share. The options to
purchase 141,329 shares were issued under our 2001 Stock Incentive Plan at an
exercise price of $3.08 per share, with scheduled expiration dates of September
18, 2006, subject to earlier termination upon termination of employment or
consultancy. An option for 116,962 of the shares vested one-third immediately,
and vests one-third on October 1, 2002 and the final one-third on October 1,
2003. An option for the other 24,367 shares vested immediately.
Under a July 23, 2001 Registration Rights Agreement, we were required to file a
resale registration statement for the former Microgy security holders by
November 30, 2001. In November 2001, the deadline for filing the registration
statement was extended to March 31, 2002.
Dividends:
We declared dividends on common stock during 1999 and 2000 as follows:
Dividends
Dividends Declared
Year Period Declared per Share
---- ------ -------- ---------
1999 First Quarter $ 171,102 $ .015
Second Quarter 171,102 .015
Third Quarter 171,102 .015
Fourth Quarter 171,102 .015
---------- ------
$ 684,408 $ .060
========== ======
2000 First Quarter $ 171,102 $ .015
Second Quarter 171,102 .015
Third Quarter 171,102 .015
Fourth Quarter 171,102 .015
---------- ------
$ 684,408 $ .060
========== ======
Since March 2001, the Board of Directors has not declared any dividends on our
common stock. Due to the recent acquisition of Microgy and anticipated expansion
of our business, the Board of Directors has concluded that available cash flows
should be used for operating and investing activities for the foreseeable
future.
Item 6. SELECTED FINANCIAL DATA
The following selected financial data for the five years ended December 31, 2001
is derived from our audited consolidated financial statements. The data should
be read in conjunction with the consolidated financial statements and other
financial information included elsewhere herein. Dollars are shown in thousands
except per share data.
17
Year Ended December 31
--------------------------------------------------------
2001 (1) 2000 1999 1998 1997
-------- -------- -------- -------- --------
Results of Operations Data:
Power generation revenues $ 53,518 $ 54,303 $ 48,268 $ 45,721 $ 43,763
-------- -------- -------- -------- --------
Costs and expenses:
Operating expenses 23,681 22,291 21,931 19,215 17,756
Lease expenses 24,706 26,416 23,111 22,971 24,488
General and administrative expenses 3,973 3,603 2,455 2,197 1,995
Reversal of provision for nonrecovery of
project development costs --- --- --- --- (940)
Depreciation and amortization 441 415 363 285 258
-------- -------- -------- -------- --------
52,801 52,725 47,860 44,668 43,557
-------- -------- -------- -------- --------
Operating income 717 1,578 408 1,053 206
Other income (expense):
Other income 2,135 --- --- 8 622
Interest income 78 737 111 156 581
Interest expense (185) (320) (375) (461) (424)
Sale of NOx emission credits --- 1,156 607 --- ---
Amortization of deferred gain 308 308 308 308 308
Write-off of receivables in litigation --- --- --- (3,508) ---
Gain on sale of project --- --- --- --- 7,424
-------- -------- -------- -------- --------
2,336 1,881 651 (3,497) 8,511
-------- -------- -------- -------- --------
Income (loss) before income taxes 3,053 3,459 1,059 (2,444) 8,717
Income tax (expense) benefit (1,374) (1,632) (470) 795 (4,103)
-------- -------- -------- -------- --------
Income (loss) before cumulative effect of a
change in accounting principle 1,679 1,827 589 (1,649) 4,614
Cumulative effect of a change in accounting
principle (3) --- --- 1,189 --- ---
-------- -------- -------- -------- --------
Net income (loss) $ 1,679 $ 1,827 $ 1,778 $ (1,649) $ 4,614
======== ======== ======== ======== ========
Basic earnings (loss) per common share $ 0.12 $ 0.16 $ 0.16 $ (0.14) $ 0.41
Diluted earnings (loss) per common share $ 0.11 $ 0.16 $ 0.16 $ (0.14) $ 0.41
Dividends declared per common share $ --- $ 0.06 $ 0.06 $ 0.09 $ 0.99
Weighted average number of common shares
outstanding on a fully diluted basis 14,746 11,409 11,407 11,407 11,260
Balance Sheet Data:
Total assets $ 85,566 $ 69,284 $ 58,782 $ 55,163 $ 61,362
Working capital (1,499) (1,176) (2,662) (1,190) 536
Deferred gain (2) 4,472 4,780 5,089 5,397 5,706
Long-term obligations (3) 65,216 58,304 51,546 46,511 40,032
Shareholders' (deficit) equity 4,383 (3,970) (5,471) (6,559) (3,878)
--------
(1) The Results of Operations Data for 2001 includes Microgy from July 23, 2001
to December 31, 2001.
(2) See Note B of the Consolidated Financial Statements.
(3) See Note O of the Consolidated Financial Statements and the Consolidated
Statements of Operations for further disclosures pertaining to a change in
accounting principle.
18
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Overview of the Company
We are an independent developer and owner of electrical generating facilities
powered by non-commodity fuels and renewable energy sources. Since 1994, we have
owned a 22 year leasehold interest in an approximately 83 megawatt (net)
waste-coal fired facility located in Pennsylvania known as Scrubgrass.
Scrubgrass sells electricity to Penelec under a 25 year power sales agreement.
In 2001, we acquired all of the common stock of Microgy, a privately held
Colorado company. Microgy holds an exclusive license in North America for
development and deployment of a proprietary technology for extraction of methane
gas from animal wastes and its use thereof to fuel generation of energy.
In recent years, we also held ownership positions in a 43 megawatt (net)
waste-coal fired project in development located in Pennsylvania, known as
Milesburg, and a 51 Megawatt (net) waste-coal fired facility located in Utah,
known as Sunnyside. Milesburg was involved in protracted litigation with, among
others, West Penn Power Company. We settled the Milesburg litigation in 1997 and
sold Milesburg to West Penn. We sold Sunnyside in 1994 and, after the sale, the
purchasers sued us claiming breach of certain obligations in connection with the
sale. We counterclaimed for payment of certain obligations of the purchasers.
The Sunnyside matters were settled by a payment to us of $1,500,000 and the
release of certain contingent liabilities.
Our business activities are discussed further in Item 1. The following
Management's Discussion and Analysis of Financial Condition and Results of
Operations compares our results of operations for the years ended December 31,
2001, 2000 and 1999 and should be read in conjunction with the consolidated
financial statements and notes thereto, and the comparative summary of selected
financial data appearing elsewhere in this report. Historical results and trends
which might appear should not be taken as indicative of future operations.
Cautionary Statement
This Annual Report on Form 10-K contains "forward-looking statements", as
defined by the Private Securities Litigation Reform Act of 1995, in order to
provide investors with prospective information about the Company. For this
purpose, any statements which are not statements of historical fact may be
deemed to be forward-looking statements. Without limiting the foregoing, the
words "believes", "anticipates", "plans", "expects" and similar expressions are
intended to identify forward-looking statements. There are a number of important
factors which could cause our actual results and events to differ materially
from those indicated by the forward looking statements. These factors include,
without limitation, those set forth below under the caption "Certain Factors
That May Affect Future Results".
CRITICAL ACCOUNTING POLICIES
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that effect the reported amounts of assets and
liabilities at the date of the financial statements, the reported amounts of
revenues and expenses during the reporting period, and the disclosure of
contingent assets and liabilities at the date of the financial statements.
Actual results could differ from those estimates. Management believes the
following critical accounting policies, among others discussed in Note B to our
consolidated financial statements, involve more significant judgments and
estimates used in the preparation of our consolidated financial statements.
Sale and Lease-Back Accounting
Our 1990 sale of Scrubgrass Power Corporation, the original developer of the
Scrubgrass facility, was not treated as a sale for financial accounting
purposes. This was originally due to the existence of an option which enabled us
to reacquire Buzzard, then a wholly-owned subsidiary of Scrubgrass Power
Corporation, and lease the Scrubgrass
19
facility for a substantial portion of its commercial operation. We exercised our
option and reacquired Buzzard in 1991 so that we would have the right to lease
the Scrubgrass facility. The then-proposed lease provided Buzzard with a fair
market value purchase option to acquire the Scrubgrass facility as the end of
the lease. This option meant that we had retained substantial risks or rewards
of ownership of Scrubgrass. Therefore, we were not permitted to recognize the
sale until 1993, when we agreed to a modification to the proposed form of lease
and relinquished the fair market value purchase option. Accordingly, we removed
from our consolidated financial statements the gross assets and liabilities of
the Scrubgrass facility and reported a gain of $6,785,035 arising from the sale
of Scrubgrass. However, due to our anticipated involvement with the lease, we
were required to defer our gain over the 22 year minimum lease term, which
commenced on June 30, 1994. In connection with the operating lease, we incurred
aggregate costs of $3,279,060 to reacquire Buzzard, the lessee of Scrubgrass,
and capitalized these costs as the value of our lease rights. The value of our
lease rights is also being amortized over the 22 year minimum lease term, which
commenced on June 30, 1994.
Lease Expense Recognition
We have a long-term lease agreement for Scrubgrass, which commenced on June 30,
1994, and continues for a 22 year minimum lease term. Under the terms of the
lease, Buzzard, as lessee, is required to pay the lessor, in addition to a
specified base rent, which consists of all of the lessor's debt service, equity
repayment, base return on equity and related expenses, an additional rent of 50
percent of the net cash flows Buzzard receives from the operation of Scrubgrass.
The lessor's specified base rent increases over time and is based on schedule
which follows the expected receipt of revenues. In accordance with accounting
principles generally accepted in the United States of America, we are required
to aggregate the estimated lease payments over the life of the lease and
recognize them on a straight-line basis over the 22-year lease term. As such,
during the earlier years of the lease agreement, a portion of our lease expenses
will be paid in cash and a portion will be recorded to a liability. As of
December 31, 2001, we have an accrued lease expense of $63,648,995 recorded on
our consolidated balance sheet. This liability represents accumulated lease
expenses recorded on a straight-line basis in previous years which have not been
paid to the lessor. In the later years of the lease, we expect that our cash
payments to the lessor will exceed the lease expenses recorded on a
straight-line basis and the accrued lease expense will be decreased and reach
zero by the end of the lease term.
As of December 31, 2001, without regard to straight-line lease accounting, we
estimate the future minimum lease payments over the remaining base term of the
Scrubgrass lease are as follows:
2002 15,301,000
2003 16,723,000
2004 19,703,000
2005 21,715,000
2006 26,058,000
Thereafter 278,149,000
-------------
Total $ 377,649,000
=============
Our lease expense components, which are discussed in the following paragraphs,
consist of:
. specified base rent payments calculated on a straight-line basis;
. additional rent; and
. current period adjustments resulting from differences between actual
lease billings and projected lease billings.
Buzzard, as lessee, is required to pay the lessor a specified base rent, which
consists of all of the lessor's debt service, equity repayment, base return on
equity and related expenses. The lessor's debt service largely consists of debt
obligations with variable interest rates. Therefore, in order to calculate
future minimum lease payments, we estimate an average interest rate which will
be payable in the future for each variable rate debt obligation. Since
20
actual interest rates will differ from these estimates, our actual lease expense
reported in future periods will differ from these estimates and the differences
may be material.
In order to calculate the straight-line lease expense, we take the total
estimated future minimum lease payments over the lease term and divide it by the
lease term to get an annual lease expense. The annual lease expense is then
compared to the total amount projected to be billed by the lessor in each
period, and the difference is reported as a straight-line lease expense in our
consolidated financial statements. Any differences between actual lease billings
and projected lease billings, which principally result from variances between
actual interest rates and projected interest rates, are reported as a lease
expense in the current period.
We are also required to pay the lessor an additional rent, in addition to the
specified base rent, which additional rent represents 50 percent of the net cash
flows Buzzard receives from the operation of Scrubgrass. We estimate and accrue
additional rent in the accounting period when we believe the cash flows were
generated from operations. However, because additional rent is based on cash
flows and not earnings, it is more subjective to determine when the cash flows
were generated from operations. Lease expenses may also cause large fluctuations
between accounting periods in our reported earnings since the specified base
rent and additional rent are not directly related to our earnings. Additional
rent is not part of the straight-line lease expense calculation.
Revenue Recognition
We record power generation revenues when electricity is transmitted to the
utility under the terms of the underlying power sales agreement. However, under
the terms of our long-term power sales agreement with Penelec, the same annual
generation of electricity is expected to result in significant increases in
revenues over the life of this agreement. For various reasons, including the
requirement that all the power generated by the Scrubgrass facility be sold to
one customer, we account for power generation revenues under the lease
accounting rules as if the power sales agreement was a sublease to this
customer. In accordance with accounting principles generally accepted in the
United States of America, we are therefore required to aggregate the expected
revenue to be received over the life of the power sales agreement and recognize
it on a straight-line basis over the 22-year lease term. As such, during the
early years of the power sales agreement with Penelec, a portion of our power
generation revenues will be received in cash and a portion will be recorded to
an asset. However, since we cannot predict whether revenues would be collected
over the entire life of the power sales agreement, and absent revenues, whether
Buzzard would be able to perform under the lease, the recognition of revenue on
a straight-line basis was limited to the recognition of lease expense on a
straight-line basis. As a result, net income is not affected by straight-line
lease and revenue accounting and our financial statements are presented more
conservatively. As of December 31, 2001, we have an accrued power generation
revenue of $63,648,995 recorded on our consolidated balance sheet which is equal
in amount to the accrued lease expense. This asset represents accumulated
revenue recorded on a straight-line basis in previous years which has not been
collected from Penelec. In the later years of the power sales agreement, when
the power rates are expected to increase, we expect that our cash receipts from
Penelec will exceed the revenues recorded on a straight-line basis and the
accrued power generation revenue will be decreased and reach zero by the end of
the lease term.
Accounting for Income Taxes
As part of the process of preparing our consolidated financial statements we are
required to estimate our income taxes in each of the jurisdictions in which we
operate. This process involves us estimating our actual current tax exposure
together with assessing temporary differences resulting from differing treatment
of items, such as our deferred gain and lease rights, for tax and accounting
purposes. These differences result in deferred tax assets and liabilities, which
are included within our consolidated balance sheet. We must then assess the
likelihood that our deferred tax assets will be recovered from future taxable
income and to the extent we believe that recovery is not likely, we must
establish a valuation allowance. To the extent we establish a valuation
allowance or increase this allowance in a period, we must include an expense
within the tax provision in the statement of operations.
Significant management judgment is required in determining our provision for
income taxes, our deferred tax assets and liabilities and any valuation
allowance recorded against our deferred tax assets. As of December 31,
21
2001, we have recorded a net deferred income tax liability of $146,396 on our
consolidated balance sheet. We have also recorded a valuation allowance of
$148,377 against our gross deferred income tax assets as of December 31, 2001,
due to uncertainties related to our ability to utilize some of our net operating
loss carryforwards before they expire. The valuation allowance is based on our
estimates of taxable income by jurisdiction in which we operate and the period
over which our deferred tax assets will be recoverable. In the event that actual
results differ from these estimates or we adjust these estimates in future
periods we may need to establish an additional valuation allowance which could
materially impact our financial position and results of operations.
Intangible Assets
In June 2001, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 141, "Business Combinations" and SFAS No.
142, "Goodwill and Other Intangible Assets". SFAS No. 141 requires the purchase
method of accounting for all business combinations and that certain acquired
intangible assets in a business combination be recognized as assets separate
from goodwill. SFAS No. 142 requires that goodwill and other intangibles
determined to have an indefinite life are no longer to be amortized but are to
be tested for impairment at least annually. We have applied SFAS No. 141 in our
accounting for the acquisition of Microgy. Accordingly, we identified and
allocated a value of $3,710,000 to Microgy's licensed technology rights and a
value of $4,912,866 to goodwill. The valuation of these intangible assets
required us to use significant judgment. On January 1, 2002, we adopted SFAS No.
142, which will require us to perform an initial impairment test during 2002 on
our acquired intangible assets and goodwill. The impairment testing required by
SFAS No. 142 will require us to use significant judgment and could require us to
write down the carrying value of our goodwill and other intangible assets in
future periods. We are currently evaluating whether SFAS No. 142 would have an
impact on our financial position.
Results of Operations
Year ended December 31, 2001 compared with the year ended December 31, 2000
Our net income decreased to $1,679,331, or 12 cents per share, for 2001 from
$1,826,808, or 16 cents per share, in 2000. The decrease in net income was
primarily due to:
. decreases in power generation revenues and interest income;
. the absence of revenues from sales of NOx emission credits; and
. increases in operating expenses and general and administrative expenses.
The effect of these changes was partially offset by an increase in other income
and decreases in lease expenses, interest expense and income tax expense.
Earnings per common share decreased to $0.12 per common share in 2001 from $0.16
per common share in 2000. The decrease was primarily due to a decrease in net
income and an increase in the weighted average common shares outstanding. The
weighted average common shares outstanding increased in 2001 due to the issuance
of additional shares for the acquisition of Microgy.
Power generation revenues decreased to $53,518,000 for 2001 from $54,303,222 in
2000 and all pertained to Scrubgrass. The decrease in power generation revenues
was primarily due to the absence in 2001 of revenues of approximately $3,687,000
from the settlement with Penelec. This decrease was partially offset by:
. greater output from the Scrubgrass facility;
. a 5% increase in certain rates billed to Penelec under the terms of the
power sales agreement; and
. an increase in revenue recorded as a result of the straight-line
accounting treatment of revenues under the power sales agreement which
amounted to $7,460,852 in 2001 and $7,036,012 in 2000.
22
Scrubgrass operated at 91.2% of its capacity in 2001 as compared to 90.2% for
2000. The improvement in the capacity rate occurred primarily because of fewer
unplanned shutdowns to respond to equipment malfunctions and utility
curtailments.
Operating expenses increased to $23,681,081 for 2001 from $22,291,069 in 2000
and all pertained to Scrubgrass. The increase in operating expenses was
primarily due to:
. higher fuel expense from cost escalations in certain fuel supply
agreements;
. higher fuel expense from changes in fuel mix and the quality of fuel
sources;
. higher fuel expense from the improvement in facility output;
. increases in labor, labor related costs and operator fees pursuant to
the terms of the operations and maintenance agreement; and
. increases in planned maintenance because of differences in the scope of
procedures performed during the 2001 and 2000 annual maintenance
outages.
These increases were partially offset by a decrease in expensed facility
modifications because of differences in the nature of procedures performed in
2001 versus 2000.
Lease expenses decreased to $24,705,813 for 2001 from $26,415,897 in 2000. The
decrease was primarily due to:
. decreases in the lessor's loan costs, which are passed along to us as a
lease expense, due to lower average interest rates on the tax exempt
bonds and variable rate term loans and reduced outstanding balances on
the Scrubgrass debt;
. decreases in scheduled base equity rents; and
. a decrease in additional rent paid to the lessor, which amounts to 50
percent of the net available cash flows from Scrubgrass, as a result of
decreases in available cash flows from Scrubgrass. During 2000, such
cash flows included revenues and interest income from the settlement
with Penelec and income from sales of NOx emission credits.
These decreases in lease expenses were partially offset by:
. an increase in lease expenses recorded as a result of the straight-line
accounting treatment of lease expenses under the Scrubgrass lease which
amounted to $7,460,852 in 2001 and $7,036,012 in 2000; and
. increases in scheduled principal payments and fees for the Scrubgrass
debt which were billed to us under the terms of the lease.
General and administrative expenses increased to $3,973,025 for 2001 from
$3,602,960 in 2000. The increase was primarily due to:
. Microgy overhead expenses following its acquisition on July 23, 2001;
. significant expenses related to the Microgy acquisition for
post-acquisition integration, business development, and strategic
planning;
. increases in our labor force for planned business expansion; and
. an increase in Scrubgrass insurance expense due to changes in the
insurance market for power generation facilities.
These increases were partially offset by lower Scrubgrass management expenses
and executive compensation during 2001. Scrubgrass had incurred significant
professional fees, travel expenses and labor related costs during 2000 to
address certain non-recurring business matters including the settlement with
Penelec and the replacement of the letter of credit.
Interest income decreased to $78,203 for 2001 from $736,867 in 2000. The
decrease was primarily due to:
. the absence of approximately $608,000 of interest income from the
settlement with Penelec;
23
. lower average interest rates for investments; and
. reductions in the average outstanding balances of notes receivable from
officers.
Interest expense decreased to $185,547 for 2001 from $320,641 in 2000. The
decrease was primarily due to lower variable interest rates and reduced average
outstanding balances for Scrubgrass debt. The decrease was partially offset by
interest incurred on the $750,000 loan made by Alco Financial Services, LLC in
September 2001, which loan is discussed further under Financing Activities.
We had other income of $2,135,048 in 2001 from the settlement of the Sunnyside
litigation which is discussed further under Liquidity and Capital Resources.
We earned net proceeds of $1,156,338 from the sale of NOx emissions credits in
2000. Our NOx emission credits are discussed further under Liquidity and Capital
Resources.
Income tax expense decreased to $1,373,454 for 2001 from $1,632,233 in 2000. The
decrease was primarily due to a decrease in income before taxes and a lower
effective tax rate in 2001. The decrease in the effective tax rate was largely
due to lower state income taxes.
Year ended December 31, 2000 compared with the year ended December 31, 1999
Our net income in 2000 increased to $1,826,808, or 16 cents per share, from
$1,777,562, or 16 cents per share, in 1999. This increase was primarily due to
increases in power generation revenue, interest income and income from sales of
NOx emission credits. Such increases were offset in part by the absence of
income from the cumulative effect of a change in accounting principle and
increases in operating expenses, lease expenses, general and administrative
expenses, depreciation and amortization, and income tax expense.
Power generation revenues in 2000 increased to $54,303,222 from $48,268,311 in
1999 and all pertained to Scrubgrass. The increase in power generation revenues
during 2000 was primarily due to:
. the $3,687,000 payment from the settlement with Penelec;
. greater output from the Scrubgrass facility;
. a 5% increase in rates billed to Penelec under the terms of the power
sales agreement; and
. increases in the rates charged for power generation in excess of 80
megawatts pursuant to the terms of the settlement agreement with
Penelec.
These increases were offset in part by a decrease in revenue recorded as a
result of the straight-line accounting treatment of revenue under the power
sales agreement which amounted to $7,036,012 in 2000 and $7,765,631 in 1999.
Scrubgrass operated at 90.2% of its capacity in 2000 as compared to 89.5% for
1999. The improvements in the capacity rate occurred primarily due to shorter
planned maintenance outages and fewer unplanned shutdowns to respond to
equipment malfunctions and utility curtailments.
Operating expenses in 2000 increased to $22,291,069 from $21,931,318 in 1999 and
all pertained to Scrubgrass. The increase in operating expenses was primarily
due to:
. higher fuel costs from cost escalations in fuel supply agreements and
improvements in output at the Scrubgrass facility;
. increases in diesel fuel costs; and
. increases in labor and related costs, operator fees and operator
bonuses under the terms of the operations and maintenance agreement.
These increases were partially offset by lower maintenance expenses and the
absence in 2000 of expenses related to Year 2000 compliance. Maintenance
expenses decreased during 2000 primarily because of differences in the scope
24
of procedures performed during the 1999 and 2000 annual maintenance outages and
fewer unplanned maintenance shutdowns.
Lease expenses in 2000 increased to $26,415,897 from $23,110,677 in 1999 and all
pertained to Scrubgrass. The increase in lease expenses was primarily due to:
. increases in the lessor's loan costs, which are passed along to us as a
lease expense, due to higher average interest rates on the tax exempt
bonds and variable rate term loans and loan origination costs from the
replacement letter of credit;
. increases in scheduled base equity rents; and
. an increase in additional rent paid to the lessor, which amounts to 50
percent of the net available cash flows from Scrubgrass, due to
increases in available cash flows from Scrubgrass. Cash flows in 2000
included revenues and interest income from the settlement with Penelec
and income from increased sales of NOx emission credits.
Our overall increase in lease expenses during 2000 was partially offset because:
. the lessor's junior debt obligations were fully satisfied during 1999,
so our lease expense did not include principal and interest on these
obligations in 2000; and
. we had a decrease in lease expense recorded as a result of the
straight-line accounting treatment of lease expenses under the
Scrubgrass lease which amounted to $7,036,012 in 2000 and $7,765,631 in
1999.
General and administrative expenses in 2000 increased to $3,602,960 from
$2,455,095 in 1999. The increase in general and administrative expenses during
2000 was primarily due to:
. higher Scrubgrass management costs for refinancing matters, salary
raises and the potential sale of the Scrubgrass project;
. increases in professional fees because we engaged several consultants
to consider various sale and restructuring alternatives;
. bonuses aggregating $710,000 to executive officers; and
. increases in Scrubgrass insurance premiums.
The aforementioned increases were offset in part by a decrease in legal fees
during 2000.
Depreciation and amortization increased to $415,230 in 2000 from $363,234 in
1999. Depreciation and amortization increased in 2000 primarily because our 1999
capital expenditures, which were substantially made during the third quarter,
were depreciated for the entire year in 2000.
Interest income increased to $736,867 in 2000 from $110,975 in 1999. The
increase was primary attributable to approximately $608,000 of interest income
from the settlement with Penelec and higher average interest rates on short-term
investments.
Interest expense decreased to $320,641 in 2000 from $375,208 in 1999. The
decrease was primarily attributable to reductions in the outstanding borrowings
under the Scrubgrass term credit facility which reduced in $600,000 increments
every six months through July 2000. This decrease was partially offset by
increases in average interest rates on borrowings.
Sale of NOx emission credits increased to $1,156,338 in 2000 from $606,960 in
1999. Sales of NOx emission credits are discussed further under Liquidity and
Capital Resources.
Income tax expense increased to $1,632,233 in 2000 from $470,552 in 1999. The
increase in income tax expense for 2000 was largely due to an increase in
earnings before income taxes and an increase in the effective tax rate. During
2000,
25
we had significant earnings from Scrubgrass which are taxed in Pennsylvania. Due
to the high tax rate in Pennsylvania, we had a material increase in state income
taxes which increased our effective tax rate for 2000.
Cumulative effect of a change in accounting principle increased our earnings by
$1,188,989 in 1999 and pertained to a change in our method of accounting for
major equipment overhauls. The cumulative effect of a change in accounting
principle did not affect 2000 operating results.
2002 Outlook
The following forward-looking information concerning our results of operations
for 2002 is being compared to our historical results of operations for 2001:
Power generation revenues are expected to increase in 2002 primarily due to a 5%
increase in rates billed to Penelec under the Scrubgrass power sales agreement.
This increase is expected to be partially offset by a decrease in revenue
recorded as a result of the straight-line accounting treatment of revenue under
the power sales agreement.
Operating expenses are expected to increase in 2002 primarily due to:
. an approximate 4% average escalation in rates for fuel supply
agreements;
. changes in the scope of planned maintenance procedures and facility
modifications; and
. a 5% escalation in operator fees under the terms of the operations and
maintenance agreement
Lease expenses are expected to increase in 2002 primarily because:
. we have scheduled increases in base equity rent payments; and
. we expect additional rents paid to the lessor, which amount to 50
percent of the net cash flows from Scrubgrass, will increase due to
projected increases in cash flows from Scrubgrass operations.
However, these increases may be partially offset because:
. we expect lower interest rates on the lessor's tax-exempt bonds and
variable rate term loans to lessen the lessor's loan costs that would
be billed to us under the terms of the lease;
. we expect lower outstanding balances for term loans to lessen the
lessor's interest costs that would be billed to us under the terms of
the lease;
. we expect the lessor to bill us lower scheduled term loan principal
payments pursuant to the terms of the lease; and
. we expect to have a decrease in the lease expense recorded as a result
of the straight-line accounting treatment of lease expenses under the
lease agreement.
General and administrative expenses are expected to increase during 2002
primarily because:
. we expect to make changes in our work force to seek to develop and
accomplish our Microgy business plan;
. we continue to employ consultants for technical, financial, legal,
marketing, public and investor relations and other strategic advice;
. Microgy corporate overhead would be included in our results of
operations for all of 2002 versus approximately five months in 2001;
and
. we expect numerous corporate expenses like insurance, office supplies,
rent, legal, and travel to increase due to business expansion efforts.
26
Other income is expected to increase slightly in 2002. During 2002, we expect to
report sales of NOx emission credits of approximately $2.4 million. In 2001, we
had other income of approximately $2.1 million from the settlement of the
Sunnyside litigation.
Assuming no additional share issuances and no repurchases, our weighted average
common shares outstanding is expected to increase from 14,144,222 shares in 2001
to 20,251,653 shares in 2002. We expect this increase because our shares issued
for the acquisition of Microgy, which were weighted from the date they were
issued in 2001, are expected to be outstanding for all of 2002. This increase is
expected to significantly dilute our basic and diluted earnings per common share
during 2002.
Recently Issued Accounting Standards
There are four recently issued accounting standards which are required to be
adopted in the future which are described in Note B to the Consolidated
Financial Statements.
Liquidity and Capital Resources
Operating Activities
Our cash provided by operating activities was $2,687,504 in 2001, $469,770 in
2000 and $2,752,441 in 1999. During these periods, our only sources of cash from
operating activities were operating profits from Scrubgrass, proceeds from the
settlement of the Sunnyside litigation, proceeds from sales of NOx emission
credits and investment earnings.
We reported net earnings of $1,679,331 during 2001 which contributed
significantly to the cash provided by operating activities. The following
adjustments, which did not impact our cash flows, need to be considered in order
to reconcile our net income in 2001 to our net cash provided by operating
activities:
Depreciation and amortization - During 2001, we recognized depreciation and
amortization for lease rights of $149,004, licensed technology rights of
$81,823, deferred financing costs of $43,580, machinery and equipment
modifications of $154,405 and equipment and furniture of $12,598.
Deferred income taxes - We had a net deferred income tax liability of $146,396
as of December 31, 2001 versus a net deferred income tax asset of $755,193 as of
December 31, 2000. On July 23, 2001, we acquired a significant deferred tax
liability from Microgy related to licensed technology rights which was the
primary reason we changed to a net deferred income tax liability position as of
December 31, 2001. This change was partially offset by the acquired tax benefits
from Microgy's net operating loss carryforwards. The individual components of
our deferred income tax expense, which amounted to $104,425 in 2001, are
outlined in the notes to our consolidated financial statements.
Deferred gain, net - Our deferred gain, net, decreased to $4,471,955 as of
December 31, 2001 from $4,780,365 as of December 31, 2000. The decrease is due
to the amortization of the deferred gain related to Scrubgrass, which is being
amortized on a straight-line basis over 22 years.
Release of Sunnyside liabilities - We reported other income of $635,048 from the
release of contingent liabilities related to Sunnyside. These liabilities are
discussed further in Liquidity and Capital Resources.
Stock-based compensation - We issued stock options with a fair market value of
$113,600 to a director for services performed for us.
We also offer the following information to discuss changes in operating assets
and liabilities which most notably impacted our cash position during 2001:
27
Receivable from utility - Our receivable from utility increased to $7,905,864 as
of December 31, 2001 from $7,336,408 as of December 31, 2000. The increase was
primarily due to more output at the Scrubgrass facility and a 5% increase in
rates billed to Penelec under the terms of the power sales agreement.
Other current assets - Our other current assets decreased to $607,590 as of
December 31, 2001 from $760,980 as of December 31, 2000. The decrease was
largely due to planned reductions in fuel inventory quantities at Scrubgrass.
Accounts payable and accrued expenses - Our accounts payable and accrued
expenses increased to $9,382,471 as of December 31, 2001 from $6,952,054 as of
December 31, 2000. The increase was primarily because:
. our corporate taxes payable increased by $413,858 primarily due to the
deferral of tax payments for 2001 taxable earnings until 2002;
. our additional rent accrual increased by $272,000 primarily due to
increases in cash flows from Scrubgrass operations;
. we had numerous increases in expenses which are discussed in more
detail under Results of Operations; and
. our lease payable for the lessor's bond interest increased by $806,420
due to longer bond maturities. The effect of the longer bond
maturities was partially offset by lower interest rates.
Long-term debt to supplier - We financed the 1997 rewind of the Scrubgrass
generator with an installment note from the generator manufacturer which had
outstanding balances of $97,893 as of December 31, 2001 and $190,446 as of
December 31, 2000. The decrease is due to an installment payment made in May
2001. The last installment for this obligation is due in May 2002.
Investing Activities
Our cash used in investing activities was $1,071,915 in 2001, $291,009 in 2000
and $284,623 in 1999. Our investing activities were concentrated primarily in
the following areas:
Restricted cash - We are contractually required to make scheduled deposits to a
restricted maintenance fund for Scrubgrass to ensure that funds are available in
the future for scheduled major equipment overhauls. We are allowed to use
restricted cash for major equipment overhauls subject to certain restrictions.
We made scheduled deposits to the restricted major maintenance fund of $808,936
in 2001, $678,524 in 2000 and $739,128 in 1999. Our payments for major equipment
overhauls amounted to $415,460 in 2001, $418,670 in 2000 and $1,271,141 in 1999.
The remaining changes to restricted cash primarily pertain to investment
earnings on available cash balances. Major equipment overhauls are subject to
certification by an independent engineer and are performed on a pre-established
schedule which can differ widely from year to year. The selection of equipment
for service and/or replacement each year depends on factors such as the
condition of the equipment, expected wear and tear, and recommendations made by
equipment manufacturers. Beginning in February 2002, we are required to make
deposits to the restricted major maintenance fund of $92,331 per month through
April 2005. The required monthly payment is subject to possible recalculation
after each annual maintenance outage to ensure that funds are sufficient to
cover the long-term schedule of major equipment overhauls.
Acquisitions - We made expenditures of $412,120 in 2001 for contract
negotiations and due diligence activities related to the acquisition of Microgy.
These expenditures were capitalized in the purchase price of Microgy in the
accompanying consolidated financial statements.
Property, plant and equipment - Property, plant and equipment expenditures were
$232,691 in 2001, $3,023 in 2000 and $829,117 in 1999. During 1999, we made
machinery and equipment modifications of $811,568 to improve the air quality
emission systems at the Scrubgrass facility which are discussed further in the
next section. During 2001, we made machinery and equipment modifications of
$227,295 to improve the raw water pre-treatment systems at the Scrubgrass
facility. The remaining capital expenditures in each period were primarily
purchases of office equipment for our corporate headquarters.
28
Sale of NOx Credits - Under applicable environmental laws and regulations,
Scrubgrass needed to achieve certain seasonal nitrogen oxide emission levels
beginning on May 1, 1999, and will also be required to achieve reduced emission
standards by May 2003. Due to the efficient design of the Scrubgrass facility,
Scrubgrass met the 1999 requirements without any modifications to the facility.
However, as discussed in the previous section, we made capital improvements of
$811,568 during 1999 to the Scrubgrass facility, which are expected to enable
Scrubgrass to meet the stricter standards in 2003. By making improvements to the
facility before 2003, we anticipated that we would not require a portion of our
future NOx Credits to maintain our compliance with the applicable regulations.
Consequently, we sold our anticipated excess NOx Credits in recent years and
used the proceeds to finance the capital improvements and generate additional
cash flows for operations. We expect to comply with all material environmental
regulations for the foreseeable future without any additional material
modifications to the Scrubgrass facility. Recently, we received our next award
of NOx Credits for the ozone seasons in 2003 through 2007. Similar to prior
years, we expected that we may not require a portion of these future NOx Credits
to maintain our compliance with the applicable regulations and sold the
anticipated excess NOx Credits in 2002 for $2,428,200.
Project development activities - We expect to begin sale and/or development and
construction of facilities using Microgy's licensed technology during 2002. To
the extent we are the owner of these facilities, we will require financing to
complete the development and construction of the facilities which is discussed
under financing activities.
Financing Activities
Our cash used in financing activities was $1,454,984 in 2001, $177,283 in 2000
and $2,524,046 in 1999. We offer the following information concerning the
financing activities for our business:
Related Party Loan - On September 14, 2001, we borrowed $750,000 from Alco
Financial Services LLC, or Alco, to fund certain expenses related to the
acquisition of Microgy and provide additional working capital for our expansion
efforts. Robert Weisberg, one of our directors, is the President, Director and a
member of Alco. The loan is evidenced by a one-year promissory note which bears
interest at the prime rate plus 3.5%. We also pay an administrative fee of 0.6%
per month. The loan is secured by all of EPC's assets, except for the stock of
Buzzard, which is already pledged to the lessor of Scrubgrass. In connection
with the loan, we granted Alco five year warrants to purchase 50,000 shares of
common stock at $0.60 per share.
Working Capital Loan for Scrubgrass - Buzzard may borrow up to $4 million under
a Lessee Working Capital Loan Agreement with the lessor of Scrubgrass for
ongoing working capital requirements of this project. The outstanding borrowings
under this loan were $1,116,905 as of December 31, 2001 and $2,742,961 as of
December 31, 2000. As discussed below, the Lessee Working Capital Loan Agreement
expires in December 2002 and is in the process of being refinanced. Under the
existing terms of this loan, we were required to pay the outstanding balance to
zero for a minimum of twenty days during 2001 and 2002. Awaiting the
refinancing, we have been keeping the outstanding balance of this loan at
reduced levels to meet the existing paydown requirements of the original
facility, which requirements have already been met for 2001 and 2002. The
outstanding balance of this loan was also reduced as of December 31, 2001 in
anticipation of paying the higher balances in accounts payable and accrued
expenses.
Refinancing at Scrubgrass - NEG, the manager of Scrubgrass, continues to be in
long-term refinancing discussions with the lending agent for the project. NEG is
addressing the following financing matters:
. Buzzard's Lessee Working Capital Loan commitment expires in December
2002.
. Buzzard is expected to require additional working capital beginning in
July 2003, when Penelec's contracted payment terms will be extended by
20 days.
NEG presently has a letter of intent with the lending agent to provide a new
working capital facility which is expected to address these financing matters.
Under the terms of the proposed working capital facility, the available
borrowings would be increased from $4 million to $10 million through 2005 with
annual paydown
29
requirements to $8 million in 2003 through 2005. After 2005, the available
working capital facility and annual paydown requirements would reduce
incrementally until the expiration of the proposed working capital facility in
2008. Due to its credit constraints, the lending agent is expected to transfer a
portion of its existing Scrubgrass loan commitments to another financial
institution in order to provide the proposed working capital facility. At this
time, we anticipate the provisional agreement would eventually be finalized.
However, present uncertainties in the financial markets have caused delays in
locating a suitable financial institution for the lending agent's transferable
loan commitments. Should there be continued delays in finalizing the working
capital facility, our distributions from Scrubgrass may be delayed or reduced.
As time passes, there can also be no assurance that the terms of the provisional
agreement would not be amended to reflect changes in market conditions.
Scrubgrass Debt Obligations
Buzzard and the lessor have various debt obligations related to Scrubgrass.
Under the terms of the Scrubgrass lease, Buzzard is required to pay the
principal, interest and fees for the lessor's debt obligations as a base lease
payment. As such, Buzzard is committed to pay all of the Scrubgrass debt
obligations as either a debt or lease obligation. Scrubgrass had the following
debt obligations as of December 31, 2001 and 2000:
Balance at Balance at Matures
Description of the Obligation 12/31/01 12/31/00 Interest Rate Through
----------------------------------------------------------------------------------------------------------------------
Buzzard's lease obligations:
Variable rate tax-exempt bonds $135,600,000 $135,600,000 Quoted Bond Rates 2012
Swap rate term loan 10,669,663 12,541,087 7.5475% (through 2000) 2005
7.6725% (thereafter)
Variable rate term loan 8,344,479 10,061,427 LIBOR + 1.250% 2004
Buzzard's debt obligations:
Variable rate term loan 985,747 1,188,573 LIBOR + 1.250% 2004
Working capital loan 1,116,905 2,742,961 LIBOR + 1.125% (through 2000) 2002
LIBOR + 1.250% (thereafter)
Buzzard's lease obligations for the lessor's debt are not reported in our
consolidated financial statements. As these debt obligations mature, they will
be billed by the lessor to Buzzard and reported as a lease expense in our
consolidated financial statements.
Notes Receivable from Officers - We have outstanding notes receivable from
officers and directors for shares purchased in connection with stock option
plans which amounted to $645,948 as of December 31, 2001 and $445,948 as of
December 31, 2000. These notes, which are secured by the underlying shares of
stock, are payable upon demand and bear interest at a floating rate which is
payable monthly. During 2000, we received aggregate note repayments of $363,783
from executive officers. During 2001, executive officers borrowed an aggregate
of $200,000 from us.
Term Credit Facility for Scrubgrass - In June 1997, Buzzard borrowed an
additional $3 million from the lessor under a three year agreement to cover the
cash deficiency which resulted from an extended annual outage at Scrubgrass and
associated costs and expenses. We made payments for this obligation of $600,000
in 2000 and $1,550,000 in 1999.
Dividends - We declared dividends on common stock of $684,408, or 6 cents per
share, in each of 2000 and 1999. Since March 2001, the Board of Directors has
not declared any dividends on our common stock. Due to the recent acquisition of
Microgy and anticipated expansion of our business, the Board of Directors has
concluded that available cash flows should be used for operating and investing
activities for the foreseeable future. We also paid dividends of $5,000 per year
to Buzzard's preferred stockholder during 2001, 2000 and 1999. Since we declared
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dividends of $171,102 in each of 2000 and 1999 that were paid in the following
years, our dividend payments were $176,102 in 2001, $689,408 in 2000 and
$518,306 in 1999.
Sunnyside Contingent Obligations
We had contingent obligations of $1,218,078 on our consolidated balance sheet as
of December 31, 2000. The contingent obligations were principally expenses for
the sale of Sunnyside which were payable upon collection of certain obligations
from the purchasers of Sunnyside. On April 10, 2001, we received aggregate
proceeds of $1,500,000 from the purchasers of Sunnyside and resolved a
litigation by executing a Binding Settlement Agreement. In this agreement, we
were formally released from contingent obligations of $177,962. We have also
been released by the statute of limitations or the terms of the underlying
agreements from additional contingent obligations of $457,086. We reported the
settlement proceeds of $1,500,000 and the released liabilities of $635,048 as
other income in our consolidated financial statements for 2001.
Because of the terms of this settlement agreement, which terms represented a
substantial compromise of our previous claims against the purchasers of
Sunnyside, we are presently considering our rights and obligations with respect
to the remaining contingent obligations of $583,030. Until we resolve these
remaining issues, the unsettled contingent obligations will remain recorded in
our consolidated financial statements.
Cash Flow Outlook
During 2002, we expect to principally fund our business activities from
available cash balances, investment earnings, proceeds from sales of NOx Credits
and additional cash which may become available from Scrubgrass. As discussed in
Item 1, we are not able to receive distributions from Scrubgrass until all
operating expenses, base lease payments, restricted cash deposits and other
subordinated payments of Scrubgrass are satisfied. Nevertheless, Scrubgrass cash
flows in 2002 are expected to be sufficient to satisfy all of these restrictions
and provide us with continuing distributions for the foreseeable future.
On December 31, 2001, our unrestricted cash balance increased to $468,271 from
$307,666 as of December 31, 2000. On December 31, 2001, our restricted cash
balance increased to $1,014,580 from $587,476 as of December 31, 2000. As
discussed further under investing activities, we are allowed to spend restricted
cash to fund the cost of major equipment overhauls at Scrubgrass subject to
certain restrictions.
During the three months ended March 31, 2002, we received distributions of
$1,555,506 from Scrubgrass which significantly exceeded our distributions of
$298,750 from the same period in 2001. Scrubgrass has been operating favorably
with annual capacity rates in excess of 90% for the last two years. Since
Scrubgrass is so highly leveraged with variable rate debt, the recent trend of
low interest rates and favorable operations has allowed Scrubgrass to generate
unprecedented cash flows from its operations. Further, we received a partial
distribution of our revenues from 2002 sales of NOx Credits from Scrubgrass
during the three months ended March 31, 2002. Assuming the continuing trends of
favorable operations and low interest rates, and distribution of our remaining
revenues from 2002 sales of NOx Credits, we expect to receive record levels of
distributions from Scrubgrass in 2002. Therefore, for the next twelve months, we
expect that distributions from Scrubgrass, combined with our current cash
balances, would likely be sufficient to fund:
. EPC's corporate overhead requirements;
. Microgy's corporate overhead requirements prior to the development or
construction of power projects;
. repayment of the Alco loan to the extent the loan is not refinanced or
replaced.
However, in case Scrubgrass distributions are less than anticipated, or
corporate overhead expenses are greater than anticipated, we are engaging in
discussions with various potential sources of loans or equity. We may also need
to expand our business, including our staff and internal systems, more quickly
if market response to our Microgy products are greater than our current
expectations. Therefore, we believe it is necessary to explore these
possibilities for additional financing in case further expansion of our business
is restricted by our available
31
resources. There can be no assurance that such financing would be obtained or,
if obtained, would be on terms acceptable to us.
During 2002, Microgy plans to commence the sale, development and construction of
projects based upon the anaerobic digestion technology license. Our present
business strategy generally anticipates the outright sale of facilities;
however, in some circumstances, we expect that Microgy may own some or even a
majority of the projects. We anticipate that, to the extent Microgy is the owner
of projects, project financing may be obtained in the form of a credit facility
with one or more lenders, the sale of tax exempt or taxable bonds to investors
or equity or other financing. Microgy can offer no assurance that it will be
able to secure project financing in the amount required to fulfill any
development or construction requirements, that project financing will be
obtained in time to meet such requirements, or that any such proposed project
financing, if obtained, will be on terms acceptable to Microgy. However, to the
extent Microgy is the owner of projects, Microgy will need to obtain financing
to allow it to develop and construct such projects.
CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS
The following important factors, among others, could cause actual results to
differ materially from those indicated by forward-looking statements made in
this Annual Report on Form 10-K.
Microgy, a company that we recently acquired, has very little operating history
from which to evaluate its business and products.
Microgy was formed in 1999 and is still in the development stage. Microgy
intends to develop facilities which use environmentally friendly anaerobic
digestion and other technologies to produce bio-energy from animal and organic
wastes. Because a large part of our future business is anticipated to involve
Microgy's bio-energy projects, your investment decision will likely be based in
large part on an enterprise with very little operating history upon which to
judge. We are unable to determine whether our investment in Microgy will prove
to be financially advantageous.
Microgy has experienced losses to date and we anticipate it will continue to
experience losses in the foreseeable future.
Microgy had accumulated losses of approximately $2.3 million through December
31, 2001. 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
develop its business. These ongoing losses will likely adversely affect our
financial condition into the foreseeable future.
We have not completed our plans for deployment of our anaerobic digester
technology and therefore, cannot predict its related costs or outlook for
profitability.
The strategic implementation planning necessary to determine our course of
action for deployment of our anaerobic digester technology has not been
completed. Accordingly, no decision has been made as to whether we will sell,
install and operate, or develop and own the related facilities. In addition, we
do not have experience in, or a basis for, predicting the general and
administrative and other costs associated with developing anaerobic digester
facilities. Because of this we are unable to determine when or if these
facilities will generate a profit. If the organizational, structural, staffing
and other overhead costs associated with the anaerobic digester facilities
outstrip any profits, the value of your investment will be adversely affected.
If we are unable to obtain needed financing for Microgy's anaerobic digestion
bioenergy projects, the valuation of our Microgy investment may be reduced
significantly.
We are considering corporate, project and group financing to fund the cost of
development for our anaerobic digestion bioenergy projects. We are likely to
require financing with more favorable rates and terms than are generally
available and such financing may be difficult to obtain. If we are unable to
obtain such financing, our initial valuation of our Microgy investment may be
reduced significantly, and we may be required to substantially curtail our
business or close
32
any anaerobic digester projects. This financing will depend on the
lender's or investor's review of the financial capabilities of us as well as
specific project or projects and other factors, including their assessment of
our ability to successfully construct and manage the projects.
Microgy's technologies could become obsolete before commercial deployment,
reducing the value of your investment.
We do not expect to commercially deploy Microgy's licensed anaerobic digestion
bioenergy technologies until we further develop Microgy's business plan, decide
on project structures and arrange necessary financing. Current solutions or
solutions that may be developed in the future by competitors could make our
anaerobic digestion bioenergy technologies obsolete before they are commercially
deployed. Accordingly, we cannot guarantee that our technologies will ensure a
competitive position within the marketplace in the future. If we are unable to
obtain a competitive position in the agricultural and alternative power
generation markets, the value of your investment will be reduced.
If we experience delays in obtaining the technical information and specifics
needed to build our licensed anaerobic digester technologies, our business could
be harmed and the value of your investment could be reduced.
The company from which we license intellectual property regarding our anaerobic
digestion bioenergy products still holds trade secret and other proprietary
information that is important to us. In the past, Microgy has experienced delays
in obtaining and completing information necessary to successfully develop
anaerobic digester projects. The inability to readily obtain this information
from our licensor could delay our product offerings, make them more expensive to
bring to market and reduce the value of your investment.
The market for anaerobic digester bioenergy technology is crowded and our market
share may not be sufficient to be profitable.
There are many companies that offer anaerobic digester systems. We believe that
at least 60 companies offer complete systems or components to these systems in
the U.S. market. The presence of these companies may dilute our market share to
a degree that we are not profitable.
We currently rely on the Scrubgrass project for all of our operating revenue.
We own a 22 year leasehold interest that commenced in 1994 in our Scrubgrass
project, a waste coal fired electric generating facility in Pennsylvania.
Because all of our operating revenue currently results from the Scrubgrass
project, we are dependent on its successful and continued operation. Significant
unscheduled shutdowns or large increases in interest rates at Scrubgrass could
reduce our cash flows. This may necessitate a substantial curtailment of our
operations and require the termination of any anaerobic digester projects and
would have an adverse effect on our results of operations.
We do not control the management of the Scrubgrass project, our primary revenue
generating asset.
We have a management services agreement with PG&E National Energy Group, or NEG,
to manage our Scrubgrass project and a 15-year operations and maintenance
agreement with PG&E Operating Services Company to operate the facility. Under
the terms of these agreements, there are provisions that limit our participation
in the management and operation of our Scrubgrass project. Because we do not
exercise control over the operation or management of our Scrubgrass project,
decisions may be made, notwithstanding our opposition, that may have an adverse
effect on our business.
33
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 current Scrubgrass project power generation revenue is earned under a
long-term power purchase agreement with one customer, Pennsylvania Electric
Company, or Penelec. We expect that the 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.
A large increase in interest rates may adversely affect our operating results.
Our Buzzard subsidiary is leveraged with variable rate and fixed rate debt and
lease obligations. Should market interest rates rise significantly, our
operating results will be adversely impacted.
Our long term Scrubgrass project power sales agreement is subject to market
conditions in its later years which may affect our profitability.
Our Scrubgrass project generates electricity that is sold at rates established
under a long-term power sales agreement with Penelec, approved by the
Pennsylvania Public Utility Commission. Contracted rates in the later years of
the agreement are determined with reference to then existing market conditions.
Therefore, low wholesale energy rates during the later years of the power sales
agreement would negatively impact our profitability and could affect our
financial position.
Payment terms with our Scrubgrass project customer will change in 2003 and, if
our working capital is not increased to accomodate the change, our cash
available for other uses will be significantly limited.
In 2003, the payment schedule on our Scrubgrass power sales agreement will be
modified to allow Penelec more time to pay us for the power that we produce.
This will reduce our working capital and could limit our ability to service our
debt or allocate resources to other projects.
Our technology for generating power from waste coal at our Scrubgrass project is
relatively new and unproven and its effectiveness and efficiency cannot be
anticipated.
Our Scrubgrass project employs circulating fluidized bed technology to produce
electricity. Certain aspects of this technology, as well as the conversion of
waste products into electricity, are relatively new concepts and have only been
in existence in the United States over approximately the last 20 years. In
addition, the long-term costs and implications of maintaining this technology
have not been established by historical industry data. Accordingly, this
technology carries greater risk of failure than proven power generation
technologies with more established histories.
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 growth of the industry and
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.
If we are unable to obtain sufficient waste resources our renewable energy
technologies will not likely operate profitably.
The performance of our renewable energy technologies is dependent on the
availability of certain waste resources to produce the raw energy and meet
performance standards in the generation of power or fuel. Lack of these waste
resources
34
or adverse changes in the nature or quality of such waste resources would
seriously affect our ability to develop and finance projects and to efficiently
operate and generate income. In such circumstances, our revenue and financial
condition will be materially and negatively affected. We cannot be sure that
waste resources will be available in the future for free or at a price that make
them affordable for our waste-to-energy technologies.
Our reliance on licenses, agreements and business alliances links our fate to
the fate of these businesses, of which we cannot predict or control.
We intend to rely on a network of various licenses, agreements and alliances
with other businesses to provide important technologies and services for our
businesses. Specifically, we rely on third party companies for the operation and
maintenance of our Scrubgrass project and for the technology upon which we base
our proposed anaerobic digester projects. The termination of any of these or
other material license, agreement or business alliance will have a detrimental
impact on the success of one or all projects or categories of projects and
negatively impact our revenue. We cannot predict or control the fate of these
other businesses on which we rely.
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, it is believed, our primary licensor have filed any patent
applications on the intellectual property Microgy plans to use. Should we or our
primary licensor decide to file patent applications, there can be no assurance
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, there can be no assurance
that others have not developed, or will not develop, similar products or
technologies that will compete with our products without infringing upon, or
which do not infringe upon, our intellectual property rights.
Third parties, including potential competitors, may already have filed patent
applications relating to the subject matter of our current or future products.
In the event that any such patents are issued to such parties, such patents may
preclude our licensors from obtaining patent protection for their technologies,
products or processes. In addition, such patents may hinder or prevent us from
commercializing our products and could require us to enter into licenses with
such parties. There can be no assurance 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. The defense costs can
be significant. As such, we may lack the financial resources to adequately
defend our intellectual property.
Our license for microturbine technology is from a small company that has not
completed the development of the technology and is therefore of an uncertain
value.
Our Microgy subsidiary has entered into a license agreement for applications of
microturbine technology which is owned and being developed by Electric Power
International, Inc., which itself is a small company with limited resources.
Electric Power International has not yet completed development of the
microturbine technology and may not have the resources available to do so. As a
result, the value of this license agreement is of uncertain value.
The large amount of obstacles necessary to overcome for the development of power
projects increases the possibility that such projects will incur costly delays.
In our development of power projects for ourselves or on behalf of our
customers, we will be required to enter into or obtain some or all of the
following:
35
. site agreements;
. supply contracts;
. design/build or other construction related agreements;
. 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
development projects.
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 and the value of your investment.
System failure of our power generation projects will reduce our revenue.
Whether we have sold our facilities to customers or continue to own them, our
revenue and our performance under various agreements will depend on the
efficient and uninterrupted operation of our bioenergy plants and systems,
including automated control systems. Any system failure that causes
interruptions in our operations could have a material adverse effect on our
business, results of operations and financial condition. As we expand our
operations, there will be increased stress placed upon hardware and information
traffic management systems. There can be no assurance that we will not
experience system failures. In addition, our systems and operations are
vulnerable to damage or interruption from fire, flood, power loss,
telecommunications failure, break-ins and similar events. Our systems and
operations will also face contamination due to the actions of farmers and others
who may have access to our sites. We do not presently have redundant systems or
a formal disaster recovery plan to mitigate the risk of losses that may occur.
There can also be no assurance that any business interruption or property and
casualty insurance that we would carry in the future would be sufficient to
compensate for any losses that may occur.
Scheduled and unscheduled shutdowns of our power generation projects will reduce
our revenue.
Our Scrubgrass Project and any future power generation projects we develop will
experience both scheduled and unscheduled shutdowns. Periodically, power
generation projects incur scheduled shutdowns in order to perform maintenance
procedures to equipment that cannot be performed while the equipment is
operating. Occasionally, our power generation projects may also incur
unscheduled shutdowns and be required to temporarily cease operation or to
operate at reduced capacity levels following the detection of equipment
malfunctions, or following minimum generation orders received by the utility.
During periods when these projects shutdown or operate at reduced capacity
levels, we may incur losses due to reduced operating revenue and due to
additional costs that may be required to complete any maintenance procedures.
Our power generation activities expose us to significant liability that our
insurance cannot cover.
Our power generation activities involve significant risks to us for
environmental damage, equipment damage and failures, personal injury and fines
and costs imposed by regulatory agencies. In the event a liability claim is made
against us, or if there is an extended outage or equipment failure or damage at
our power plant for which it is inadequately insured or subject to a coverage
exclusion, and we are unable to defend such claim successfully or obtain
indemnification or warranty recoveries, there may be a material adverse effect
on our financial condition.
36
Poor fuel and other materials quality will expose us to environmental liability
and reduce our operating results.
For our Scrubgrass project 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 project 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 which would result in 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 project. 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.
The composition of effluents from our anaerobic digester facilities is not
certain and may expose us to liability.
We do not have experience in blending the wastes that will occur in our
anaerobic digester facilities. Such blends could result in unpredictable
regulatory compliance costs, related liabilities and unwanted materials in waste
effluents and coproducts, all of which could harm our financial condition.
Our sale of power into unregulated and retail markets will likely subject our
revenue to large swings or a prolonged depression of prices.
Electricity is a commodity available from a large amount of sources with no
pricing control. When we sell power under long term supply contracts or into the
unregulated wholesale and retail markets, we will be subject to very competitive
pricing pressures and market risks. Low energy rates would negatively impact our
profitability and could adversely affect our financial condition.
Our products and services involve long sales cycles that result in high costs
and uncertainty.
The negotiation of the large number of agreements necessary to sell, develop,
install, operate and manage any of our facilities, as well as to market the
energy and other co-products and to provide necessary related resources and
services, involves a long sales cycle and decision-making process. Delays in the
parties' decision-making process are outside of our control and may have a
negative impact on our cost of sales, receipt of revenue and sales projections.
We estimate that it can take from six months to a year or more to obtain
decisions and to negotiate and close these complex agreements.
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 offering 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 our bio-energy products 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 the energy industry do not achieve or
sustain broad market acceptance, our business, operating results and financial
condition will be materially and negatively impacted.
37
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 project to provide Penelec a certain percentage of its
average output over a given period of time. 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.
Our products and services will be subject to numerous governmental regulations.
We expect to provide services involving government regulation, which will
subject us to certain regulatory policies and procedures. Compliance with these
regulations could be costly and harm our financial condition. Many of these
regulations cover air and water quality and related pollution issues. These
regulations are mandated by the United States Environmental Protection Agency
and various state and local governments. More specifically, our activities in
anaerobic digestion and/or nutrient management related to animal manure, and
other wastes, as well as the air emissions and waste effluent control from our
facilities will involve a permitting process and other forms of scrutiny from
these agencies. In addition, our activities will fall under a number of health
and safety regulations and laws and regulations relating to farms and zoning.
Our power producing activities could be subject to costly regulations and
tariffs.
Our Scrubgrass project and many of our planned bio-energy projects may or do
produce power for sale to the electric grid. As such, the sale of this power may
come under the regulations of various state public utility commissions. These
commissions set the price tariffs under which energy can be sold or purchased
and they set the design standards for the interconnection of power producing
equipment with the electric power grid. Most of our power projects where
electricity is sold to the grid will come under regulation by these commissions.
These regulations may impede or delay the process of approving and implementing
our projects. Substantial delays may materially affect our financial condition.
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 which could harm our
financial condition.
We depend on a small number of key executives and our business could suffer if
they were to leave.
We employ a small group of skilled individuals to accomplish our goals. We
believe our performance is substantially dependent on the continued employment
and performance of our senior management. Many of these individuals are not
currently subject to employment agreements or employee non-compete agreements.
If we fail to retain the services of one or more of these persons, our business
could suffer significantly. We do not maintain key-man insurance on the life of
any of our officers at this time.
Our plans to enter into the anaerobic digester market will require the retention
of skilled employees and contractors, the success of which cannot be assured.
In order for us to enter into the anaerobic digester market we will be required
to hire and retain highly skilled employees and independent contractors. It is
anticipated that such persons will be difficult to locate and engage. If we are
not successful in hiring and retaining qualified persons, our entrance into the
anaerobic digester market will not likely be successful and the value of your
investment will be impaired.
38
Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our most significant market risk exposure is changing interest rates which may
affect our short-term investments, debt and certain of our lease expenses. We
offer the following information about these market risks:
Short-term investments - We invest cash balances which are in excess of our
normal operating requirements in short term investments generally with
maturities of 3 months of less. Because of the short duration of these
investments, we do not believe our short-term investments are subject to
material market risk.
Debt - We have borrowings which bear interest at variable rates which are based
on the London Interbank Offering Rate. We monitor market conditions for interest
rates and, from time to time, enter into interest rate swaps to manage our
interest payments. The interest rate swaps have the effect of converting the
variable rate borrowings to fixed rate borrowings for specified time periods.
Lease Expense - As a lease cost of the Scrubgrass facility, we are required to
fund the lessor's debt service which consists of fixed rate borrowings and
borrowings which bear interest at variable rates based on either quoted bond
rates or the London Interbank Offering Rate. The manager of Scrubgrass monitors
market conditions for interest rates and, from time to time, enters into
interest rate swaps to manage the interest payments for Scrubgrass. The interest
rate swaps have the effect of converting the variable rate borrowings to fixed
rate borrowings for specified time periods.
As of December 31, 2001, the aggregate outstanding balance of our variable rate
debt obligations was $2,852,652. As of December 31, 2001, the aggregate
outstanding balance of the lessor's variable rate debt obligations, which are
passed along to us as a lease expense, was $143,944,479. Based on these
balances, an immediate change of one percent for the variable interest rates
would cause a change in interest expense of $28,527 and lease expense of
$1,439,445. Our objective in maintaining these variable rate borrowings is to
achieve a lower overall cost when compared to fixed-rate borrowings. We believe
the lessor has the same objective for maintaining their variable rate
borrowings.
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements listed in the following Index to Financial Statements
are filed as a part of this annual report under Item 14 - Exhibits, Index to
Financial Statements, and Reports on Form 8-K.
Index to Financial Statements
Page
----
ENVIRONMENTAL POWER CORPORATION AND SUBSIDIARIES
Independent Auditors' Report F-1
Consolidated Balance Sheets as of December 31, 2001 and 2000 F-2
Consolidated Statements of Operations and Other Comprehensive Income for the Years Ended December
31, 2001, 2000 and 1999 F-3
Consolidated Statements of Shareholders' Equity (Deficit) for the Years Ended
December 31, 2001, 2000 and 1999 F-4
Consolidated Statements of Cash Flows for the Years Ended December 31, 2001, 2000 and 1999 F-5
Notes to Consolidated Financial Statements F-6
Item 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None
39
PART III
Item 10. DIRECTORS AND EXECUTIVE OFFICERS
Information with respect to our directors may be found in the section captioned
"Occupations of Directors" appearing in the definitive Proxy Statement to be
delivered to shareholders in connection with the 2002 Annual Meeting of
Shareholders. Such information is incorporated herein by reference.
Item 11. EXECUTIVE COMPENSATION
Information with respect to this item may be found in the section captioned
"Compensation and Other Information Concerning Directors and Officers" appearing
in the definitive Proxy Statement to be delivered to shareholders in connection
with the 2002 Annual Meeting of Shareholders. Such information is incorporated
herein by reference.
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information with respect to this item may be found in the sections captioned
"Principal Holders of Voting Securities" and "Election of Directors" appearing
in the definitive Proxy Statement to be delivered to shareholders in connection
with the 2002 Annual Meeting of Shareholders. Such information is incorporated
herein by reference.
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information with respect to this item may be found in the section captioned
"Compensation and Other Information Concerning Directors and Officers" appearing
in the definitive Proxy Statement to be delivered to shareholders in connection
with the 2002 Annual Meeting of Shareholders. Such information is incorporated
herein by reference.
40
PART IV
Item 14. INDEX TO FINANCIAL STATEMENTS, EXHIBITS, AND REPORTS ON FORM 8-K
The following documents are filed as part of this annual report:
(a) 1. Consolidated Financial Statements
Page
----
ENVIRONMENTAL POWER CORPORATION AND SUBSIDIARIES
Independent Auditors' Report F-1
Consolidated Balance Sheets as of December 31, 2001 and 2000 F-2
Consolidated Statements of Operations and Other Comprehensive Income for the Years Ended December
31, 2001, 2000 and 1999 F-3
Consolidated Statements of Shareholders' Equity (Deficit) for the Years Ended
December 31, 2001, 2000 and 1999 F-4
Consolidated Statements of Cash Flows for the Years Ended December 31, 2001, 2000 and 1999 F-5
Notes to Consolidated Financial Statements F-6
(a) 2. Financial Statement Schedules
The following consolidated financial statement schedule is required to be filed
with this annual report:
Schedule II - Valuation and Qualifying Accounts
-----------------------------------------------
----------------------------------------------------------------------------------------------------------------------
Column A Column B Column C Column D Column E
----------------------------------------------------------------------------------------------------------------------
Additions Additions
Balance at (resulting from (charged to
beginning of acquisition of income tax Balance at
Description period subsidiary) expense) Deductions end of period
----------------------------------------------------------------------------------------------------------------------
Year Ended December 31, 2000:
-----------------------------
Valuation reserve for net
operating loss carryforwards $ ----- $ ----- $ ----- $ -----
Year Ended December 31, 2001:
-----------------------------
Valuation reserve for net
operating loss carryforwards $ ----- $ 139,521 $ 8,856 $ 148,377
41
(a) 3. Exhibits
The following Exhibits are included in this report:
Exhibit Incorporation
Number Description Reference
------ ----------- ---------
3.01 Certificate of Incorporation, as amended.
3.02 Certificate of Designations related to the Company's newly designated, $.01 J
par value, Series B Convertible Preferred Stock.
3.03 Amendment to Certificate of Incorporation effective November 9, 2001.
3.04 Bylaws of the Registrant, as amended. F
10.01 Share Exchange Agreement dated June 20, 2001 among the Company, Microgy and H
the Principal Microgy Shareholders.
10.02 Stockholders' Agreement dated July 23, 2001 among the Company, the Principal H
Microgy Shareholders, Joseph E. Cresci and Donald A. Livingston.
10.03 Registration Rights Agreement dated July 23, 2001 among the Company, the H
Principal Microgy Shareholders, Joseph E. Cresci, Donald A. Livingston and
future exchanging Microgy security holders who become a party thereto.
10.04 Form of Joinder Agreement related to Share Exchange Agreement. H
10.05 Form of Waiver Agreement dated July 23, 2001 executed by certain Microgy H
Shareholders.
10.06 Warrant Agreement dated July 23, 2001 between the Company and Daniel J. I
Eastman.
10.07 Technology Licensing Agreement dated May 12, 2000 between K
Microgy and Danish K Biogas Technology, A.S. (portions of this
exhibit have been omitted and filed separately with the
Securities and Exchange Commission pursuant to a request for
confidential treatment).
10.08 Promissory Note dated September 14, 2001 between the Company and Alco K
Financial Services, LLC.
10.09 Security Agreement dated September 14, 2001 between the Company and Alco K
Financial Services, LLC.
10.10 Warrant to purchase 50,000 shares of common stock issued to Alco Financial K
Services, LLC.
10.11 Services Agreement dated September 13, 2001 between the Company and PG&E
Energy Trading Power, L.P. pertaining to the sale and purchase of Nitrogen
Oxide Ozone Transport Region (NOx) Budget Allowances completed in 2002.
10.12 Agreement for Power Purchases between Microgy and Wisconsin Public Service
Corporation dated March 21, 2002.
10.13 Environmental Power Corporation Retirement Plan, as restated,
effective as of January 1, 1998 and dated as of December 23,
1998.
10.14 Trust Agreement for Environmental Power Corporation Retirement
Plan, as amended and restated, effective as of January 1, 1998
and dated as of December 23, 1998.
10.15 Indemnification Agreement dated February 12, 2002 between the
Company and Joseph Cresci, Donald Livingston, William Linehan,
and their successors.
42
10.16 Office Building Lease Agreement dated December 21, 2001 between
the Company and Merkle, Soupcoff, & Fiorentino, Inc.
10.17 Form of Warrant Agreement executed by certain Microgy warrant
holders.
10.18 Agreement for the Sale of Electric Energy from the Scrubgrass B
Generating Plant by and between Pennsylvania Electric Company
and Scrubgrass Power Corporation dated August 7, 1987 which was
assigned by Scrubgrass Power Corporation to Scrubgrass
Generating Company, L.P. on December 15, 1990 and assigned by
Scrubgrass Generating Company, L.P. to Buzzard Power
Corporation on June 17, 1994.
10.19 Supplemental Agreement for the Sale of Electric Energy from the B
Scrubgrass Generating Plant by and between Pennsylvania
Electric Company and Scrubgrass Power Corporation dated
February 22, 1989, as amended by letter agreement dated March
28, 1989, which was assigned by Scrubgrass Power Corporation to
Scrubgrass Generating Company, L.P. on December 15, 1990 and
assigned by Scrubgrass Generating Company, L.P. to Buzzard
Power Corporation on June 17, 1994.
10.20 Second Supplemental Agreement for the Sale of Electric Energy B
from the Scrubgrass Generating Plant by and between
Pennsylvania Electric Company and Scrubgrass Power Corporation
dated September 27, 1989 which was assigned by Scrubgrass Power
Corporation to Scrubgrass Generating Company, L.P. on December
15, 1990 and assigned by Scrubgrass Generating Company, L.P. to
Buzzard Power Corporation on June 17, 1994.
10.21 Third Supplemental Agreement for the Sale of Electric Energy B
from the Scrubgrass Generating Plant by and between
Pennsylvania Electric Company and Scrubgrass Power Corporation
dated August 13, 1990 which was assigned by Scrubgrass Power
Corporation to Scrubgrass Generating Company, L.P. on December
15, 1990 and assigned by Scrubgrass Generating Company, L.P. to
Buzzard Power Corporation on June 17, 1994.
10.22 Amendment to the Third Supplemental Agreement for the Sale of B
Electric Energy from the Scrubgrass Generating Plant by and
between Pennsylvania Electric Company and Scrubgrass Power
Corporation dated November 27, 1990 which was assigned by
Scrubgrass Power Corporation to Scrubgrass Generating Company,
L.P. on December 15, 1990 and assigned by Scrubgrass Generating
Company, L.P. to Buzzard Power Corporation on June 17, 1994.
10.23 Letter Agreement dated December 20, 1990 amending the Agreement B
for the Sale of Electric Energy from the Scrubgrass
Generating Plant by and between Pennsylvania Electric Company
and Scrubgrass Power Corporation dated August 7, 1987, as
amended and supplemented from time to time through November 27,
1990, which was assigned by Scrubgrass Power Corporation to
Scrubgrass Generating Company, L.P. on December 15, 1990 and
assigned by Scrubgrass Generating Company, L.P. to Buzzard
Power Corporation on June 17, 1994.
10.60 Management Services Agreement by and between Scrubgrass B
Generating Company, L.P. and PG&E-Bechtel Generating Company
dated December 15, 1990 which was assigned by Scrubgrass
Generating Company, L.P. to Buzzard Power Corporation on June
17, 1994. PG&E-Bechtel Generating Company has assigned its
rights to this agreement ultimately to U.S. Gen. (now PG&E
National Energy Group). Exhibit A to this agreement was omitted
because it was previously filed as Exhibit 10.67.
43
10.61 Agreement for Operation and Maintenance of the Scrubgrass B
Cogeneration Plant between Scrubgrass Generating Company, L.P.
and Bechtel Power Corporation dated December 21, 1990 which was
assigned by Scrubgrass Generating Company, L.P. to Buzzard
Power Corporation on June 17, 1994. Bechtel Power Corporation
has assigned its rights to this agreement ultimately to U.S.
Operating Services Company (now PG&E Operating Services
Company).
10.62 First Amendment to the Agreement for Operation and Maintenance B
of the B Scrubgrass Cogeneration Plant between Buzzard Power
Corporation and, ultimately, U.S. Operating Services Company
(now PG&E Operating Services Company) dated December 22, 1995.
10.67 Appendix I to the Amended and Restated Participation Agreement, G
dated as of G December 22, 1995, among Buzzard Power
Corporation, Scrubgrass Generating Company, L.P., Environmental
Power Corporation, Bankers Trust Company and Credit Lyonnais,
which Appendix defines terms used and not otherwise defined in
other contracts.
10.70 Stock Pledge Agreement, dated December 19, 1991, between D
Environmental Power Corporation and Scrubgrass Generating
Company, L.P.
10.71 Amended and Restated Participation Agreement, dated as of G
December 22, 1995, among Buzzard Power Corporation, Scrubgrass
Generating Company, L.P., Environmental Power Corporation,
Bankers Trust Company and Credit Lyonnais.
10.72 Amendment No. 1, dated as of May 22, 1997, to the Amended and C
Restated Participation Agreement, dated as of December 22,
1995, among Buzzard Power Corporation, Scrubgrass Generating
Company, L.P., Environmental Power Corporation, Bankers Trust
Company and Credit Lyonnais.
10.73 Director Option Plan. F
10.80 Amended and Restated Lease Agreement between Scrubgrass B
Generating Company, L.P., a Delaware limited partnership, as
Lessor, and Buzzard Power Corporation, a Delaware corporation,
as Lessee, dated as of December 22, 1995. Schedules and similar
attachments listed in the Lease have been omitted and the
Company agrees to furnish supplementally a copy of any omitted
schedule or attachment to the Securities and Exchange
Commission upon request.
10.83 Amended and Restated Disbursement and Security Agreement B
between Scrubgrass Generating Company, L.P., as Lessor, Buzzard
Power Corporation, as Lessee, Bankers Trust Company as
Disbursement Agent and Credit Lyonnais acting through its New
York Branch as Agent, dated as of December 22, 1995. Schedules
and similar attachments listed in this agreement have been
omitted and the Company agrees to furnish supplementally a copy
of any omitted schedule or attachment to the Securities and
Exchange Commission upon request.
10.84 Amended and Restated Lessee Working Capital Loan Agreement B
between Scrubgrass Generating Company, L.P., as Lender, and
Buzzard Power Corporation, as Lessee, dated as of December 22,
1995.
10.85 Amendment No. 1, dated as of May 22, 1997, to the Amended and C
Restated Disbursement and Security Agreement between Scrubgrass
Generating Company, L.P., as Lessor, Buzzard Power Corporation,
as Lessee, Bankers Trust Company as Disbursement Agent and
Credit Lyonnais acting through its New York Branch as Agent,
dated as of December 22, 1995.
44
10.91 Amendment No. 2, dated as of September 2, 1998, to the Amended and Restated E
Participation Agreement, dated as of December 22, 1995, among Buzzard Power
Corporation, Scrubgrass Generating Company, L.P., Environmental Power
Corporation, Bankers Trust Company and Credit Lyonnais.
10.92 Amendment No. 1, updated as of October 9, 1998, to the Amended and Restated E
Disbursement and Security Agreement between Scrubgrass Generating Company,
L.P., as Lessor, Buzzard Power Corporation, as Lessee, Bankers Trust Company
as Disbursement Agent and Credit Lyonnais acting through its New York Branch
as Agent, dated as of December 22, 1995.
10.93 Amendment No. 1, dated as of June 1, 1996, but not executed until July 24, E
1998, to the Amended and Restated Lease Agreement between Scrubgrass
Generating Company, L.P., a Delaware limited partnership, as Lessor, and
Buzzard Power Corporation, a Delaware corporation, as Lessee, dated as of
December 22, 1995.
10.94 Lease between Adams Realty Trust and Environmental Power Corporation, dated E
January 26, 1999.
10.95 Settlement Agreement and Release between GEC Alsthom International, Inc. and E
Buzzard Power Corporation dated May 28, 1998.
10.96 Purchase and Sale Agreements, dated as of December 16, 1998, January 4, E
1999 E and January 8, 1999, between PG&E Energy Trading - Power, L.P. and
Buzzard Power Corporation pertaining to Nitrogen Oxide Ozone Transport
Region (NOx) Budget Allowances.
10.97 Environmental Power Corporation Medical Expense Reimbursement Plan E
effective E as of September 1, 1998 and dated as of December 18, 1998.
10.98 Environmental Power Corporation Defined Benefit Pension Plan effective as E
of E January 1, 1998 and dated as of December 23, 1998.
10.99 Settlement Agreement, dated August 3, 1999 and effective February 27, 2000, F
among Buzzard Power Corporation, Scrubgrass Generating Company L.P. and
Pennsylvania Electric Company.
11 Computation of Earnings per Share.
21 Subsidiaries of the Registrant.
23.1 Consent of Deloitte & Touche LLP.
Incorporation References:
A Intentionally omitted
B Previously filed as part of the Company's Report on Form 10-K for
the year ended December 31, 1996 (Commission File No. 0-15472).
C Previously filed as part of the Company's Report on Form 10-Q for
the period ended June 30, 1997 (Commission File No. 0-15472).
D Previously filed as part of the Company's Report on Form 10-K for
the year ended December 31, 1997 (Commission File No. 0-15472).
E Previously filed as part of the Company's Report on Form 10-K for
the year ended December 31, 1998 (Commission File No. 0-15472).
F Previously filed as part of the Company's Report on Form 10-K for
the year ended December 31, 1999 (Commission File No. 0-15472).
45
G Previously filed as part of the Company's Report on Form
10-K for the year ended December 31, 2000 (Commission
File No. 0-15472).
H Previously filed as part of Amendment No. 7 to Schedule 13D
filed by Joseph E. Cresci on August 2, 2001
I Previously filed as part of Schedule 13D filed by Daniel J.
Eastman on August 2, 2001
J Previously filed as part of the Company's Report on Form 8-K
dated as of August 7, 2001 (Commission File No. 0-15472).
K Previously filed as part of the Company's Report on Form
10-Q for the period ended September 30, 2001 (Commission
File No. 0-15472).
(b) Reports on Form 8-K
i). On December 28, 2001, the Registrant disclosed that William
D. Linehan returned to EPC following a leave of absence and
was named Acting Chief Financial Officer and Acting
Treasurer effective November 20, 2001.
ii). On December 28, 2001, the Registrant disclosed pursuant to
Regulation FD the Letter to Shareholders dated November 30,
2001, which was included in its Third Quarter 2001 Quarterly
Brochure to Shareholders.
46
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.
Dated: ENVIRONMENTAL POWER CORPORATION
April 1, 2002 By /s/ Joseph E. Cresci
------------------------------------
Joseph E. Cresci, Chairman
and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act 1934, this report
has been signed below by the following persons on behalf of registrant and in
the capacities and on the dates indicated.
Signature Title Date
/s/ Joseph E. Cresci Chairman, Chief April 1, 2002
----------------------------------
Joseph E. Cresci Executive Officer,
& Director (Principal
Executive Officer)
/s/ Donald A. Livingston President & Chief April 1, 2002
---------------------------
Donald A. Livingston Operating Officer
/s/ William D. Linehan Acting Treasurer and Chief April 1, 2002
---------------------------
William D. Linehan Financial Officer
(Principal Financial and
Accounting Officer)
/s/ Peter J. Blampied Director April 1, 2002
----------------------------------
Peter J. Blampied
/s/ Benjamin Brant Director April 1, 2002
----------------------------------
Benjamin Brant
/s/ Edward B. Koehler Director April 1, 2002
----------------------------------
Edward B. Koehler
/s/ George Kast Director April 1, 2002
----------------------------------
George Kast
/s/ Tom W. Matthews Director April 1, 2002
----------------------------------
Tom W. Matthews
/s/ Robert I. Weisberg Director April 1, 2002
----------------------------------
Robert I. Weisberg
47
INDEPENDENT AUDITORS' REPORT
Board of Directors and Shareholders of
Environmental Power Corporation
We have audited the accompanying consolidated balance sheets of Environmental
Power Corporation (the "Corporation") and subsidiaries as of December 31, 2001
and 2000 and the related consolidated statements of operations and comprehensive
income, shareholders' equity (deficit), and cash flows for each of the three
years in the period ended December 31, 2001. Our audits also included the
financial statement schedule listed in the index at Item 14, (a)2. These
consolidated financial statements and financial statement schedule are the
responsibility of the Corporation's management. Our responsibility is to express
an opinion on the consolidated financial statements and financial statement
schedule based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of Environmental Power Corporation and
subsidiaries as of December 31, 2001 and 2000, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2001 in conformity with accounting principles generally accepted in
the United States of America. Also, in our opinion, such financial statement
schedule, when considered in relation to the basic consolidated financial
statements taken as a whole, presents fairly in all material respects the
information set forth therein.
As discussed in Notes B and O to the consolidated financial statements, the
Corporation changed its method of accounting for major equipment overhauls in
1999.
/s/ Deloitte & Touche LLP
Boston, Massachusetts
March 1, 2002
F-1
ENVIRONMENTAL POWER CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31 December 31
2001 2000
------------- -------------
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 468,271 $ 307,666
Restricted cash 1,014,580 587,476
Receivable from utility 7,905,864 7,336,408
Other current assets 607,590 760,980
------------- -------------
TOTAL CURRENT ASSETS 9,996,305 8,992,530
PROPERTY, PLANT AND EQUIPMENT, NET 652,830 558,015
DEFERRED INCOME TAX ASSET 0 755,193
LEASE RIGHTS, NET 2,161,503 2,310,507
ACCRUED POWER GENERATION REVENUES 63,648,995 56,188,143
GOODWILL 4,912,866 0
LICENSED TECHNOLOGY RIGHTS, NET 3,628,177 0
OTHER ASSETS 565,570 479,786
------------- -------------
TOTAL ASSETS $ 85,566,246 $ 69,284,174
============= =============
LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT)
CURRENT LIABILITIES:
Accounts payable and accrued expenses $ 9,382,471 $ 6,952,054
Dividends payable on common stock 0 171,102
Secured promissory note payable to related party 750,000 0
Other current liabilities 1,363,108 3,045,787
------------- -------------
TOTAL CURRENT LIABILITIES 11,495,579 10,168,943
DEFERRED GAIN, NET 4,471,955 4,780,365
SECURED PROMISSORY NOTES PAYABLE
AND OTHER BORROWINGS 1,420,467 2,116,309
DEFERRED INCOME TAX LIABILITY 146,396 0
ACCRUED LEASE EXPENSES 63,648,995 56,188,143
------------- -------------
TOTAL LIABILITIES 81,183,392 73,253,760
------------- -------------
SHAREHOLDERS' EQUITY (DEFICIT):
Preferred Stock ($.01 par value; 2,000,000 and 1,000,000 shares authorized
as of December 31, 2001 and 2000, respectively;
no shares issued) 0 0
Preferred Stock (no par value, 10 shares authorized; 10 shares
issued as of December 31, 2001 and 2000, respectively) 100 100
Common Stock ($.01 par value; 50,000,000 and 20,000,000 shares
authorized; 21,370,293 and 12,525,423 shares issued; and
20,251,653 and 11,406,783 shares outstanding as of
December 31, 2001 and 2000, respectively.) 213,702 125,254
Additional paid-in capital 6,850,046 0
Accumulated deficit (1,518,390) (3,192,721)
Accumulated other comprehensive loss (60,385) 0
------------- -------------
5,485,073 (3,067,367)
Treasury stock (1,118,640 common shares, at cost, as of
December 31, 2001 and 2000, respectively) (456,271) (456,271)
Notes receivable from officers and board members (645,948) (445,948)
------------- -------------
TOTAL SHAREHOLDERS' EQUITY (DEFICIT) 4,382,854 (3,969,586)
------------- ------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT) $ 85,566,246 $ 69,284,174
============= =============
See Notes to Consolidated Financial Statements.
F-2
ENVIRONMENTAL POWER CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
Year Ended December 31
2001 2000 1999
------------ ------------ ------------
POWER GENERATION REVENUES $ 53,518,000 $ 54,303,222 $ 48,268,311
COSTS AND EXPENSES:
Operating expenses 23,681,081 22,291,069 21,931,318
Lease expenses 24,705,813 26,415,897 23,110,677
General and administrative expenses 3,973,025 3,602,960 2,455,095
Depreciation and amortization 441,410 415,230 363,234
------------ ------------ ------------
52,801,329 52,725,156 47,860,324
------------ ------------ ------------
OPERATING INCOME 716,671 1,578,066 407,987
------------ ------------ ------------
OTHER INCOME (EXPENSE):
Interest income 78,203 736,867 110,975
Interest expense (185,547) (320,641) (375,208)
Amortization of deferred gain 308,410 308,411 308,411
Sales of NOx emission credits --- 1,156,338 606,960
Settlement of the Sunnyside Project litigation 2,135,048 --- ---
------------ ------------ ------------
2,336,114 1,880,975 651,138
------------ ------------ ------------
INCOME BEFORE INCOME TAXES 3,052,785 3,459,041 1,059,125
INCOME TAX EXPENSE (1,373,454) (1,632,233) (470,552)
------------ ------------ ------------
INCOME BEFORE CUMULATIVE EFFECT OF A
CHANGE IN ACCOUNTING PRINCIPLE 1,679,331 1,826,808 588,573
CUMULATIVE EFFECT OF A CHANGE IN ACCOUNTING
PRINCIPLE, NET OF $812,440 IN INCOME TAXES --- --- 1,188,989
------------ ------------ ------------
NET INCOME 1,679,331 1,826,808 1,777,562
OTHER COMPREHENSIVE LOSS:
Minimum pension liability adjustment, net of
income tax benefit of $39,606 (60,385) --- ---
------------ ------------ ------------
COMPREHENSIVE INCOME $ 1,618,946 $ 1,826,808 $ 1,777,562
============ ============ ============
DIVIDENDS DECLARED:
Common shares $ 0 $ 684,408 $ 684,408
Preferred shares $ 5,000 $ 5,000 $ 5,000
Dividends declared per common share $ 0.00 $ 0.06 $ 0.06
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING:
Basic 14,144,222 11,406,783 11,406,783
Diluted 14,745,695 11,408,809 11,407,076
BASIC EARNINGS PER COMMON SHARE:
Income before cumulative effect of a change in
accounting principle $ 0.12 $ 0.16 $ 0.05
Cumulative effect of a change in accounting principle --- --- 0.11
------------ ------------ ------------
Net income $ 0.12 $ 0.16 $ 0.16
============ ============ ============
DILUTED EARNINGS PER COMMON SHARE:
Income before cumulative effect of a change in
accounting principle $ 0.11 $ 0.16 $ 0.05
Cumulative effect of a change in accounting principle --- --- 0.11
------------ ------------ ------------
Net income $ 0.11 $ 0.16 $ 0.16
============ ============ ============
PRO FORMA AMOUNTS ASSUMING THE CHANGE IN
ACCOUNTING WAS APPLIED RETROACTIVELY:
Net income $ 588,573
Basic and diluted earnings per common share $ 0.05
See Notes to Consolidated Financial Statements.
F-3
ENVIRONMENTAL POWER CORPORATION
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (DEFICIT)
YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
Preferred
Preferred Stock Stock Common Stock
($.01 Par Value) (No Par; 10 ($.01 Par Value)
Shares Amount shares issued) Shares Amount
----------------------------- --------------- -----------------------------
BALANCE AT JANUARY 1, 1999 0.0 $ 0 $ 100 12,525,423 $ 125,254
Dividends paid
Net income
--------------------------- --------------- -----------------------------
BALANCE AT DECEMBER 31, 1999 - 0 100 12,525,423 125,254
Dividends paid
Notes receivable repayments
Net income
--------------------------- --------------- -----------------------------
BALANCE AT DECEMBER 31, 2000 - 0 100 12,525,423 125,254
Issuance of stock options for services
Issuance of warrant to lender
Dividends paid
Borrowings under notes receivable
Exchange of convertible preferred stock
and common stock for 87.7% of
outstanding equity of Microgy 197,760.7 1,528,690 5,521,549 55,215
Issuance of additional common stock
to holders of 87.7% of outstanding
equity in Microgy 258,884 2,589
Conversion of preferred stock to
common stock (197,760.7) (1,528,690) 1,977,607 19,776
Exchange of common stock for 12.3%
of outstanding equity of Microgy 1,086,830 10,868
Exchange of options and warrants for
options and warrants of Microgy
Stock issuance and registration costs
Net income
Minimum pension liability adjustment, net
--------------------------- --------------- -----------------------------
BALANCE AT DECEMBER 31, 2001 - $ 0 $ 100 21,370,293 $ 213,702
=========================== =============== =============================
Accumulated Receivable
Additional Other from Officers
Paid-in Accumulated Comprehensive Treasury and Board
Capital Deficit Loss Stock Members
-------------- ---------------- -------------- ------------ ------------
BALANCE AT JANUARY 1, 1999 $ 0 $ (5,418,275) $ 0 $ (456,271) $(809,731)
Dividends paid (689,408)
Net income 1,777,562
------------ ---------------- -------------- ------------ ------------
BALANCE AT DECEMBER 31, 1999 0 (4,330,121) 0 (456,271) (809,731)
Dividends paid (689,408)
Notes receivable repayments 363,783
Net income 1,826,808
------------ ---------------- -------------- ------------ ------------
BALANCE AT DECEMBER 31, 2000 0 (3,192,721) 0 (456,271) (445,948)
Issuance of stock options for services 113,600
Issuance of warrant to lender 14,398
Dividends paid (5,000)
Borrowings under notes receivable (200,000)
Exchange of convertible preferred stock
and common stock for 87.7% of
outstanding equity of Microgy 4,212,942
Issuance of additional common stock
to holders of 87.7% of outstanding
equity in Microgy 197,528
Conversion of preferred stock to
common stock 1,508,914
Exchange of common stock for 12.3%
of outstanding equity of Microgy 829,252
Exchange of options and warrants for
options and warrants of Microgy 55,697
Stock issuance and registration costs (82,285)
Net income 1,679,331
Minimum pension liability adjustment, net (60,385)
------------ ---------------- -------------- ------------ ------------
BALANCE AT DECEMBER 31, 2001 $ 6,850,046 $ (1,518,390) $ (60,385) $ (456,271) $(645,948)
============ ================ ============== ============ ============
Total
------------
BALANCE AT JANUARY 1, 1999 $(6,558,923)
Dividends paid (689,408)
Net income 1,777,562
------------
BALANCE AT DECEMBER 31, 1999 (5,470,769)
Dividends paid (689,408)
Notes receivable repayments 363,783
Net income 1,826,808
------------
BALANCE AT DECEMBER 31, 2000 (3,969,586)
Issuance of stock options for services 113,600
Issuance of warrant to lender 14,398
Dividends paid (5,000)
Borrowings under notes receivable (200,000)
Exchange of convertible preferred stock
and common stock for 87.7% of
outstanding equity of Microgy 5,796,847
Issuance of additional common stock
to holders of 87.7% of outstanding
equity in Microgy 200,117
Conversion of preferred stock to
common stock 0
Exchange of common stock for 12.3%
of outstanding equity of Microgy 840,120
Exchange of options and warrants for
options and warrants of Microgy 55,697
Stock issuance and registration costs (82,285)
Net income 1,679,331
Minimum pension liability adjustment, net (60,385)
------------
BALANCE AT DECEMBER 31, 2001 $ 4,382,854
============
F-4
ENVIRONMENTAL POWER CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Year Ended December 31
2001 2000 1999
----------- ----------- -----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 1,679,331 $ 1,826,808 $ 1,777,562
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 441,410 415,230 363,234
Deferred income taxes 104,425 121,112 137,816
Cumulative effect of a change in accounting principle --- --- (1,188,989)
Amortization of deferred gain (308,410) (308,411) (308,411)
Release of Sunnyside Project liabilities (635,048) --- ---
Stock-based compensation 113,600 --- ---
Accrued power generation revenues (7,460,852) (7,036,012) (7,765,631)
Accrued lease expenses 7,460,852 7,036,012 7,765,631
Changes in operating assets and liabilities:
(Increase) decrease in receivable from utility (569,456) (3,632,486) 2,894,942
Decrease (increase) in other current assets 164,510 (115,128) 175,610
(Increase) decrease in other assets (20,730) 37,599 (9,268)
Increase (decrease) in accounts payable and
accrued expenses 1,810,425 2,200,148 (1,021,783)
Increase in long-term liabilities --- 11,400 11,400
Decrease in long-term debt to supplier (92,553) (86,502) (79,672)
----------- ----------- -----------
Net cash provided by operating activities 2,687,504 469,770 2,752,441
----------- ----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from the collection of notes receivable --- --- 46,062
Cash paid for acquisition of Microgy, net of cash acquired (412,120) --- ---
(Increase) decrease in restricted cash (427,104) (287,986) 498,432
Property, plant and equipment expenditures (232,691) (3,023) (829,117)
----------- ----------- -----------
Net cash used in investing activities (1,071,915) (291,009) (284,623)
----------- ----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Dividend payments (176,102) (689,408) (518,306)
Net (repayments) borrowings under working capital loan (1,626,056) 748,342 (395,045)
Borrowings under secured promissory note payable to
related party 750,000 --- ---
Repayment of secured promissory notes payable and
other borrowings (202,826) (600,000) (1,610,695)
(Borrowings under) proceeds from officer notes receivable (200,000) 363,783 ---
----------- ----------- -----------
Net cash used in financing activities (1,454,984) (177,283) (2,524,046)
----------- ----------- -----------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 160,605 1,478 (56,228)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 307,666 306,188 362,416
----------- ----------- -----------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 468,271 $ 307,666 $ 306,188
=========== =========== ===========
See Notes to Consolidated Financial Statements.
F-5
ENVIRONMENTAL POWER CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE A--BUSINESS AND ORGANIZATION
Environmental Power Corporation (individually "EPC" or consolidated "the
Company") is an independent developer and owner of generating facilities powered
by non-commodity fuels and renewable energy sources. The Company's operations
are discussed further in the following sections.
Scrubgrass Project
The Scrubgrass Project, located on a 600 acre site in Venango County,
Pennsylvania, is an approximately 83 Megawatt waste coal-fired electric
generating station (the "Facility") which was constructed by Bechtel Power
Corporation. On June 30, 1994, Buzzard Power Corporation ("Buzzard"), a
subsidiary of EPC, entered into an agreement to lease the Facility from
Scrubgrass Generating Company, L.P. (the "Lessor"), a joint venture of certain
wholly owned indirect subsidiaries of PG&E Corporation and Bechtel Generating
Company, Inc. On October 20, 1998, Bechtel Generating Company, Inc. transferred
its interest in the Lessor to a wholly owned subsidiary of Cogentrix Energy,
Inc. The lease provides for an initial term of 22 years with a renewal option
for up to 3 years. Pursuant to the lease, the Lessor assigned to Buzzard all
principal project agreements and its rights and obligations thereunder
including, but not limited to, the power purchase agreement, management services
agreement, operations and maintenance agreement, limestone supply agreements,
ground lease agreements, fuel agreements and transportation and materials
handling agreements. EPC has pledged Buzzard's common stock to the Lessor as
security for Buzzard's performance of its obligations as lessee. PG&E National
Energy Group ("NEG"), a wholly owned indirect subsidiary of NEG, Inc., which in
turn is a wholly owned indirect subsidiary of PG&E Corporation, manages the
Scrubgrass Project.
PG&E Operating Services Company (the "Operator"), a wholly owned indirect
subsidiary of NEG, Inc., operates the Facility pursuant to a 15-year Operating
and Maintenance Agreement (the "O&M"). The Operator prepares a budget for all
operating expenses, including a fixed management fee, and certain targeted
output performance levels, which is approved annually. Under the terms of the
O&M, the Operator can incur a liability not to exceed its management fee if the
Operator does not achieve certain targeted output performance levels.
Buzzard maintains a long-term supply agreement with Quality Aggregates, Inc. to
supply the Scrubgrass Project with limestone which, in September 1999, was
extended through the year 2008 and which may be extended up to 10 additional
years. Buzzard also maintains a 15-year agreement with Savage Industries, Inc.
for the transportation of fuel, ash and limestone which expires in 2005. The
costs established under these agreements will escalate at partially fixed and
partially indexed rates.
Buzzard sells electric output to Pennsylvania Electric Company ("Penelec"),
pursuant to a twenty-five year Power Sales Agreement ("PSA") which commenced in
June 1993, at fixed rates initially averaging 4.68 cents per kwh and which
escalated at five percent per year through calendar year 1999. For the years
2000 through 2012, the PSA provides for a rate equal to the greater of a
scheduled rate or a rate based on the PJM Billing Rate (the monthly average of
the hourly rates for purchases by the General Public Utilities Group ("GPU")
from, or sale by GPU to, the Pennsylvania-New Jersey-Maryland Interconnection).
For the years 2013 through 2015 and 2016 through 2018, if the renewal term
option is exercised, the PSA provides for a rate equal to the lower of the
average monthly PJM Billing Rate or the rate paid for the calendar year 2012
adjusted annually by the percentage change in the Gross National Product
Deflator less one percent. The Facility achieved commercial operation on June 8,
1993.
The Company was involved in a legal proceeding with Penelec whereby, among other
complaints, the Company alleged that Penelec failed to pay the Lessor and
Buzzard contract rates for power in excess of 80 Megawatts produced by the
Facility. On August 3, 1999, the Lessor and Buzzard jointly entered into a
settlement agreement with Penelec to terminate the ongoing litigation. Under the
terms of the settlement agreement, in full settlement of
F-6
all alleged claims, Penelec agreed to pay the Plaintiffs for all previous net
deliveries of electric energy from the Scrubgrass facility in excess of 80
Megawatt at rates set forth in the PSA, minus the total payments Penelec
previously made at 90% of a market based rate, plus interest at the legal rate
of 6%. Penelec also agreed in the settlement agreement to pay for future net
deliveries of electric energy at the rates set forth in the PSA subject to,
among other conditions, certain annual and hourly limits, with energy purchased
in excess of such limits paid for at a market based rate. On March 24, 2000,
Penelec remitted the outstanding balances due under the settlement agreement for
previous net deliveries of electric energy and interest which amounted to
approximately $3,687,000 and $608,000, respectively. The Company reported these
revenues in its consolidated statement of operations for 2000.
Buzzard deposits all revenues earned under the PSA into an account administered
by a disbursement agent. Before Buzzard can receive cash generated by the
Scrubgrass Project, all operating expenses, base lease payments (which are
described below), restricted cash deposits and other subordinated payments must
be satisfied. Buzzard, as lessee, is required to pay the Lessor, in addition to
a specified base rent, which consists of all of the Lessor's debt service,
equity repayment, base return on equity and related expenses, an additional rent
of 50 percent of the net cash flows Buzzard receives from the Scrubgrass
Project's operations. Buzzard is not required to fund operating losses, or
otherwise invest further, from sources outside of the Scrubgrass Project.
Buzzard and the Lessor have various debt obligations related to the Scrubgrass
Project. As discussed above, Buzzard is required to pay the principal, interest
and fees for the Lessor's debt obligations as a base lease payment. As such,
Buzzard is committed to pay all of the Scrubgrass debt obligations as either a
debt or lease obligation. The Scrubgrass Project had the following debt
obligations as of December 31, 2001 and 2000:
Balance at Balance at Matures
Description of the Obligation 12/31/01 12/31/00 Interest Rate Through
-----------------------------------------------------------------------------------------------------------------------
Lessor's debt obligations:
Variable rate tax-exempt bonds $135,600,000 $135,600,000 Quoted Bond Rates 2012
Swap rate term loan 10,669,663 12,541,087 7.5475% (through 2000) 2005
7.6725% (thereafter)
Variable rate term loan 8,344,479 10,061,427 LIBOR + 1.250% 2004
Buzzard's debt obligations:
Variable rate term loan 985,747 1,188,573 LIBOR + 1.250% 2004
Working capital loan 1,116,905 2,742,961 LIBOR + 1.125% (through 2000) 2002
LIBOR + 1.250% (thereafter)
The Lessor's debt obligations and Buzzard's debt obligation incur interest at
either quoted rates, rates fixed by swap agreements, or variable rates which are
based on the London Interbank Offering Rate ("LIBOR"). On December 22, 1995, the
Lessor entered into an interest rate swap arrangement which fixed the LIBOR
component for the life of its swap rate term loan at 6.4225%. As a result, the
interest rate for the swap rate term loan was fixed at 7.5475% (LIBOR + 1.125%)
through December 31, 2000 and 7.6725% (LIBOR + 1.25%) for the remaining term of
the obligation. The Lessor's tax-exempt bonds incurred interest at floating
rates ranging from 2.00% to 4.50% and 3.35% to 6.15% during 2001 and 2000,
respectively. Under the terms of the Lessor's loan agreements, the Company is
subject to various customary financial and operating covenants. As of December
31, 2001 and 2000, the Company was in compliance with these covenants.
The Environmental Protection Agency and the Pennsylvania Department of
Environmental Protection (the "Regional Authorities") granted Nitrogen Oxide
Ozone Transport Region Budget Allowances ("NOx Credits") to the Company based on
numerous factors that primarily pertain to the design and operation of the
Facility. The Company is required annually to maintain sufficient NOx Credits
which equal or exceed the quantity of its nitrogen oxide emissions during a
specified seasonal period (the "ozone season"). If the Company's nitrogen oxide
emissions exceed its available NOx Credits, the Company would be subject to
fines by the Regional Authorities.
F-7
During 1999, the Company installed machinery, costing $811,568, which has
significantly reduced its nitrogen oxide emissions. Accordingly, the Company
anticipates that it may not require a portion of its future NOx Credits to
maintain its compliance with the applicable regulations. Because NOx Credits are
transferable and marketable, the Company has sold and may sell, from time to
time, its available NOx Credits or purchase additional NOx credits that are
necessary to meet the applicable regulations. The Company received net proceeds
from NOx Credit transactions of $0, $1,156,338 and $606,960 in 2001, 2000, and
1999 respectively, which have been reported as other income in the accompanying
consolidated statements of operations.
Microgy Cogeneration Systems
In the second half of 2001, the Company acquired Microgy Cogeneration Systems,
Inc., a development-stage company based in Golden, Colorado. The acquisition is
described in Note C to our consolidated financial statements. Microgy intends to
market and operate in the renewable energy and distributed generation sectors of
the electric energy industry and the pollution mitigation area of the
agricultural industry. Microgy has an exclusive license to an anaerobic
digestion technology that is designed to provide efficient conversion of certain
agricultural wastes into combustible biogas and an environmentally improved
waste effluent. Microgy also has a license for a microturbine technology and
possible rights to other technologies which it is currently evaluating.
The licensor of the anaerobic digester technology is Danish Biogas Technology
A/S ("DBT"). DBT is 50% owned by Schouw & Co., a Danish public company. On May
12, 2000, Microgy entered into a revised licensing agreement with DBT which
granted Microgy a perpetual and exclusive license in certain territories,
specifically North America, for use of certain proprietary technologies in its
cogeneration facilities, including the anaerobic digestion technology. This
agreement superseded previous license agreements.
As part of the agreement, DBT will own a 5% minority equity stake in any legal
entity that owns any project developed by Microgy using the enhanced anaerobic
digester technology in which Microgy holds an equity position. The agreement
also specifies a fixed payment amount per project to DBT for engineering work
and construction drawings and a licensing fee that is based on a percentage of
the total cost for each project facility where the licensed technology is
installed and operating. A monthly consulting fee will be paid to DBT upon
commercial operation of proposed projects.
Microgy plans to develop projects based upon the anaerobic digestion technology
license and may hold various interests in these facilities. Microgy's present
business strategy anticipates the outright sale of facilities, however, in some
instances, Microgy may own some or a portion of the projects. In addition,
Microgy may or may not operate and/or manage the facilities. These facilities
are expected to deliver renewable energy for supply to the utility grid and
provide pollution control benefits to the agricultural markets.
Sunnyside Project
The Sunnyside Project is an approximately 51 Megawatt (net) waste coal-fired
facility located at a site adjacent to the Sunnyside Coal Mine in Carbon County,
Utah. The Company sold its remaining interest in the Sunnyside Project on
December 31, 1994 to B&W Sunnyside, L.P. and NRG Sunnyside, Inc. (the
"Purchasers"). From May 1996 to April 2001, the Company had been involved in a
legal proceeding to collect the Purchasers' remaining obligations from the sale.
On April 10, 2001, the Company received aggregate proceeds of $1,500,000 from
the Purchasers and resolved the litigation by executing a Binding Settlement
Agreement dated April 9, 2001 ("the Settlement"). At the time of making the
Settlement, the Company had contingent obligations of $1,218,078 recorded on its
consolidated balance sheet. The contingent obligations were principally expenses
for the sale of the Sunnyside Project which were payable upon collection of the
Purchasers' obligations. In the Settlement, the Company was formally released
from contingent obligations of $177,962. The Company has also been released as a
result of the statute of limitations or by the terms of the underlying
agreements from additional contingent obligations of $457,086. The
F-8
Company reported the settlement proceeds of $1,500,000 and the released
liabilities of $635,048 as other income in its consolidated statement of
operations for 2001.
Because of the terms of the Settlement, which terms represented a substantial
compromise of its previous claims against the Purchasers, the Company is
presently considering its rights and obligations with respect to the remaining
contingent obligations. Until the Company resolves these remaining issues, the
unsettled contingent obligations will remain recorded on its consolidated
balance sheet.
NOTE B -- SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation: The consolidated financial statements include the
accounts of Environmental Power Corporation and its wholly owned or majority
owned subsidiaries. All significant intercompany accounts and transactions have
been eliminated in consolidation. The consolidated financial statements include
the accounts of Microgy from the date of acquisition (July 23, 2001) until
December 31, 2001 (See Note C).
Use of Estimates: The preparation of financial statements in conformity with
accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that effect the reported
amounts of assets and liabilities at the date of the financial statements, the
reported amounts of revenues and expenses during the reporting period, and the
disclosure of contingent assets and liabilities at the date of the financial
statements. Actual results could differ from those estimates.
Cash Equivalents: The Company considers all highly liquid investments with
maturities of three months or less when purchased to be cash equivalents.
Concentrations of Credit Risk: The Company's financial instruments that are
exposed to concentrations of credit risk consist primarily of cash equivalents
and receivable from utility. The Company's cash equivalents represent short-term
financial instruments which are issued from reputable financial institutions.
Receivable from utility represents amounts due from the Company's sole customer
Penelec, a public utility with a credit rating of BBB by Standard & Poors,
pursuant to the terms of the 25 year power sales agreement.
Restricted Cash: Restricted cash includes all cash held by the disbursement
agent for the Scrubgrass Project pursuant to project agreements which require
requisition and/or certification by the Lessor or bank to withdraw (See Note A).
The Company makes scheduled deposits to restricted cash accounts which are
restricted primarily for scheduled maintenance procedures.
Non-Cash Activities: The Company had the following non-cash investing and
financing activities during 2001:
Fair value of a warrant for 50,000 shares issued to secure financing
(deferred as a cost of the financing) $ 14,398
=============
Fair value of Microgy assets acquired $ 8,775,655
Liabilities assumed (1,432,127)
-------------
Acquisition price - fair value of securities issued and direct
acquisition costs (including direct acquisition costs of $102,606
that are included in accounts payable and accrued expenses as of
December 31, 2001) $ 7,343,528
=============
Fuel Inventory: Fuel inventory consists primarily of handling and hauling costs
and is recorded on a lower of cost or market basis with cost determined on a
monthly weighted average basis.
Property, Plant and Equipment: Property, plant and equipment are stated at cost
less accumulated depreciation. The Company capitalizes significant renewals and
betterments that increase the useful lives of assets while repairs and
maintenance are expensed when incurred. The cost and accumulated depreciation
for property, plant and equipment disposals are removed from the balance sheet
and any resulting gains or losses are reported in the
F-9
statement of operations at the time of the asset disposition. The Company
depreciates its property plant and equipment using straight-line and accelerated
methods over the estimated useful lives of the assets. The Company records
depreciation for office equipment and furniture using the straight-line method
over periods ranging from three to five years and for machinery and equipment
modifications using the double declining balance method over seven years. The
Company evaluates the impairment of long-lived assets based on the projection of
undiscounted cash flows whenever events or changes in circumstances indicated
that the carrying amounts of such assets may not be recoverable. In the event
such cash flows are not expected to be sufficient to recover the recorded value
of the assets, the assets are written down to their estimated fair values.
Investment in Projects (Note F): Investment in projects is recorded at cost and
consists primarily of engineering work related to Microgy's future power
generating projects.
Goodwill and Intangible Assets: Intangible assets are recorded at cost and
consist of licensed technology rights and goodwill. Licensed technology rights
are being amortized using the straight-line method over a useful life of 20
years. Goodwill represents the excess of cost over the fair value of tangible
and identifiable intangible assets and is not being amortized pursuant to
Statement of Financial Accounting Standards ("SFAS") No. 142 "Goodwill and Other
Intangible Assets". The Company periodically reviews the carrying value of
goodwill and other intangible assets against the operating performance and
future undiscounted net cash flows of the related businesses and recognizes
impairment losses whenever circumstances indicate that the carrying values may
not be recoverable. The Company did not have acquired goodwill or intangible
assets recorded on its balance sheet prior to the Microgy acquisition.
Accumulated amortization of licensed technology rights was $81,823 at December
31, 2001.
Deferred Financing Costs: In 1997 and 1995, the Company incurred deferred
financing costs of $139,925 and $300,000, respectively, in connection with
restructuring debt related to the Scrubgrass Project. Deferred financing costs
are being amortized over the lives of the related debt which range from three to
nine years. Accumulated amortization of deferred financing costs was $353,795
and $318,155 at December 31, 2001 and 2000, respectively.
Lease Rights: Lease rights are recorded at cost and are being amortized over the
22-year lease term for the Scrubgrass facility. Accumulated amortization of
lease rights was $1,117,557 and $968,553 at December 31, 2001 and 2000,
respectively.
Accrued Power Generation Revenue and Accrued Lease Expense: As discussed in Note
A, the Company has entered into a long-term agreement, to provide electricity to
PENELEC, which provides for scheduled rate increases. In accordance with
accounting principles generally accepted in the United States of America,
revenue has been recorded on the straight-line basis over the 22-year lease
term. The accrual for power generation revenue is limited to the amount of
accrued lease expense, as described below. Therefore, no amount for the
straight-lining of future revenues, which would result in profits, has been
provided for in the consolidated financial statements. Accrued power generation
revenue was $63,648,995 and $56,188,143 at December 31, 2001 and 2000,
respectively, and represents the portion of revenue earned that has not yet been
received.
As discussed in Note A, the Company has entered into a long-term lease agreement
for the Scrubgrass Project which provides for scheduled lease expense increases.
In accordance with accounting principles generally accepted in the United States
of America, the scheduled lease expense has been recorded on the straight-line
basis over the 22 year lease term. Accrued lease expense was $63,648,995 and
$56,188,143 at December 31, 2001 and 2000, respectively, and represents the
portion of lease expense that has not yet been paid.
Deferred Gain: The Company's sale of the Scrubgrass Project on December 28, 1990
was not treated as a sale for financial accounting purposes. This was originally
due to the existence of an option which enabled the Company to reacquire Buzzard
and to lease the Scrubgrass Project for a substantial portion of its commercial
operation. This option constituted a significant continuing involvement by the
Company which provided evidence that it had retained substantial risks or
rewards of ownership of the Scrubgrass Project. In December 1993, the Company
agreed to a modification to the proposed form of lease thereby relinquishing the
fair market value purchase option. Accordingly, the Company removed from the
Consolidated Balance Sheet the gross assets and liabilities of the
F-10
Scrubgrass Project and recorded a deferred gain of $6,785,035 arising from the
original sale of the Scrubgrass Project in 1990. The deferred gain is being
amortized over the 22 year minimum lease term, which commenced on June 30, 1994.
Accumulated amortization of the deferred gain was $2,313,080 and $2,004,670 at
December 31, 2001 and 2000, respectively.
Maintenance Reserve: Prior to 1999, the Company recorded the expense of major
equipment overhauls on a straight-line basis using management's best estimate of
the future cash outlays. Management's estimates were charged to expense and
credited to a major maintenance reserve in anticipation of the future outlays
for major overhauls. Beginning January 1, 1999, the Company recorded the expense
of major equipment overhauls as incurred. The Company's change in accounting
principle is discussed further in Note O.
Interest Payments: The Company classifies interest payments according to the
nature of its contractual obligations. The Company's base lease payments for
interest on the Lessor's debt obligations are reported as lease expense. The
Company's interest payments on its own debt obligations are reported as interest
expense. The Company paid interest on its own debt obligations of $196,811,
$289,116 and $391,857 during the years ended December 31, 2001, 2000 and 1999,
respectively.
Income Taxes: The Company accounts for income taxes in accordance SFAS No. 109,
"Accounting for Income Taxes". Under SFAS No. 109, deferred tax assets and
liabilities are determined based on differences between the financial reporting
and tax reporting bases of assets and liabilities and are measured by applying
the enacted tax rates and laws to taxable years in which the differences are
expected to reverse. The Company recognizes a deferred tax asset for the tax
benefit of net operating loss carryforwards when it is more likely than not that
the tax benefits would be realized and reduces the deferred tax asset with a
valuation reserve when it is more likely than not that some portion of the tax
benefits would not be realized.
Earnings Per Common Share: The Company computes its earnings per common share
using the treasury stock method in accordance with SFAS No. 128, "Earnings per
Share". The Company computes basic earnings per share by dividing net income for
the period by the weighted average number of shares of common stock outstanding
during the period. For purposes of calculating diluted earnings per share, the
Company considers its shares issuable in connection with stock options to be
dilutive common stock equivalents when the exercise price is less than the
average market price of the Company's common stock for the period. The Company
excludes antidilutive common stock equivalents from the calculation of diluted
earnings per share. The following table outlines the calculation of basic
earnings per share and diluted earnings per share for the years ended December
31, 2001, 2000 and 1999.
Income Shares Per Share
(Numerator) (Denominator) Amounts
---------------- ----------------- -----------
Year Ended December 31, 2001:
-----------------------------
Income available to shareholders $ 1,679,331 14,144,222 $ .12
Effect of dividends to preferred stockholders (5,000)
--------------- ----------------- -----------
Basic EPS - income available to common shareholders 1,674,331 14,144,222 .12
Effect of dilutive securities:
Assumed conversion of preferred stock 585,155
Assumed exercise of dilutive stock options 16,318
--------------- ----------------- -----------
Diluted EPS - income available to common shareholders $ 1,674,331 14,745,695 $ .11
=============== ================= ===========
Year Ended December 31, 2000:
-----------------------------
Income available to shareholders $ 1,826,808 11,406,783 $ .16
Effect of dividends to preferred stockholders (5,000)
--------------- ----------------- -----------
Basic EPS - income available to common shareholders 1,821,808 11,406,783 .16
Effect of dilutive securities:
Assumed exercise of dilutive stock options 2,026
--------------- ----------------- -----------
Diluted EPS - income available to common shareholders $ 1,821,808 11,408,809 $ .16
=============== ================= ===========
F-11
Year Ended December 31, 1999:
-----------------------------
Income available to shareholders $ 1,777,562 11,406,783 $ .16
Effect of dividends to preferred stockholders (5,000)
--------------- ----------------- -----------
Basic EPS - income available to common shareholders 1,772,562 11,406,783 .16
Effect of dilutive securities:
Assumed exercise of dilutive stock options 293
--------------- ----------------- -----------
Diluted EPS - income available to common shareholders $ 1,772,562 11,407,076 $ .16
=============== ================= ===========
As of December 31, 2001, there were outstanding options and warrants to purchase
1,442,499 shares of the Company's common stock which were antidilutive and not
included in the computation of diluted EPS. The options and warrants expire at
various dates through 2011.
Stock Options: As permitted by SFAS 123, "Accounting for Stock-Based
Compensation," the Company accounts for employee and director stock compensation
plans under Accounting Principles Board (APB) Opinion No. 25, "Accounting for
Stock Issued to Employees." Accordingly, the Company records compensation
expense in an amount equal to the excess of the quoted market price on the grant
date over the option price for options issued under its option plans for
employees and directors. As required by SFAS 123, the Company has disclosed in
Note L of its consolidated financial statements the pro forma net income and per
share amounts as if the Company had accounted for its employee and director
plans under SFAS 123. During 2001, the Company recognized $113,600 in
stock-based compensation expense for options issued outside of its option plans
for employees and directors.
Derivative Instruments and Hedging Activities: On January 1, 2001, the Company
adopted SFAS No. 133, "Accounting for Derivative Instruments and Hedging
Activities", which established accounting and reporting standards for derivative
instruments, derivative instruments embedded in other contracts, and hedging
activities. SFAS No. 133 requires that entities recognize all derivative
instruments as either assets or liabilities in the statement of financial
position and measure those instruments at fair value. The Company does not have
any derivative instruments which should be recognized in its financial
statements. However, the Lessor has certain interest rate swap arrangements with
financial institutions that meet the definition of derivative instruments under
SFAS No. 133. Since Buzzard funds the Lessor's debt obligations as a base lease
payment, the Company has disclosed in Note M certain information about the
Lessor's derivative instruments.
Recent Accounting Pronouncements: In June 2001, the Financial Accounting
Standards Board ("FASB") issued SFAS No. 141, "Business Combinations". SFAS 141
requires the purchase method of accounting for business combinations initiated
after June 30, 2001 and eliminates the pooling of interest method of accounting.
SFAS 141 also broadens the criteria for recording intangibles separate from
goodwill and revises certain financial statement disclosures. The Microgy
acquisition was accounted for in accordance with SFAS 141 (see Note C).
In June 2001, The FASB issued SFAS No. 142, "Goodwill and Other Intangible
Assets". The most significant changes made by SFAS No. 142 are: 1) goodwill and
indefinite-lived intangible assets will be tested for impairment at least
annually; 2) goodwill and indefinite-lived intangible assets will no longer be
amortized to income; and 3) the amortization period of intangible assets with
finite lives will no longer be limited to forty years. SFAS No. 142 also
requires the completion of a transitional impairment test within six months of
adoption, with any identified impairments treated as a cumulative effect of a
change in accounting principle. The provisions of SFAS 142 have been applied to
the goodwill and intangible assets acquired in the Microgy acquisition (see Note
C). The Company did not have acquired goodwill or intangible assets recorded on
its balance sheet prior to the Microgy acquisition. The Company adopted SFAS No.
142 on January 1, 2002 and is still evaluating the impact of SFAS No. 142 on its
consolidated financial statements.
In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement
Obligations," which is effective January 1, 2003. SFAS 143 addresses the
financial accounting and reporting for obligations and retirement costs
F-12
related to the retirement of tangible long-lived assets. The Company does not
expect that the adoption of SFAS 143 will have a significant impact on its
consolidated financial statements.
In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets," which is effective January 1, 2002. SFAS 144
supersedes FASB Statement No 121, "Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to Be Disposed Of," and the accounting and
reporting provisions relating to the disposal of a segment of a business of
Accounting Principles Board Opinion No. 30. The Company adopted SFAS No. 144 on
January 1, 2002 and is still evaluating the impact of SFAS No. 144 on its
consolidated financial statements.
NOTE C - ACQUISITION
During 2001, the Company acquired 100% of the common stock of Microgy in two
related transactions. On July 23, 2001, the Company exchanged its securities for
approximately 87.7% of the outstanding common stock of Microgy under a June 20,
2001 agreement with Microgy and certain principal Microgy shareholders. Under
the agreement, the Company agreed to offer the remaining Microgy shareholders
the opportunity to exchange their Microgy securities for its securities. On
December 28, 2001, the Company completed the exchange of its securities for the
remaining outstanding securities of Microgy. The details of the two exchange
transactions are discussed in the following section.
Transaction Details
On July 23, 2001, the Company issued, an aggregate of 5,521,549 shares of common
stock and 197,760.7 shares of newly designated Series B Convertible Preferred
Stock to certain principal stockholders of Microgy in exchange for 15,919,147
shares of Microgy common stock. Each share of preferred stock, which voted with
the common stock on an as-converted basis, was automatically converted into ten
shares of common stock as of November 9, 2001 upon an increase in the authorized
common stock to an amount sufficient to allow conversion of the preferred stock.
The exchange ratio of 0.4711 shares of the Company's common stock for each share
of Microgy common stock was determined by negotiations among the Company,
Microgy and the primary principal Microgy shareholders. The exchange ratio is
based on all of the fully diluted equity of Microgy being exchanged for 45% of
the Company's fully diluted equity and assumes exercise or conversion of all
derivative securities. The exchange ratio may be increased to reflect certain
issuances of equity by the Company to generate funds to be available for
financing Microgy. However, holders of approximately 94% of the Microgy common
stock agreed to waive their right to adjustments in the exchange ratio, other
than any adjustment resulting from 400,000 options and warrants issued in
September 2001. One of the principal Microgy shareholders exchanged a warrant to
purchase 800,000 shares of Microgy common stock for a warrant to purchase the
Company's securities based on the exchange ratio. In connection with the
Company's issuance of 400,000 options and warrants in September 2001, the
Company adjusted the exchange ratio to 0.4873 shares of the Company's common
stock for each share of Microgy common stock. The Company then issued 258,884
additional shares of common stock to the principal Microgy shareholders on
December 28, 2001 and amended the warrant issued to the principal Microgy
shareholder to reflect the adjusted exchange ratio.
On October 17, 2001, the Company offered the remaining security holders of
Microgy, who owned an aggregate of 2,230,126 shares of Microgy common stock,
warrants to purchase 885,000 shares of Microgy common stock and options to
purchase 290,000 shares of Microgy common stock, an opportunity to exchange
their securities of Microgy for the Company's securities based on the adjusted
exchange ratio. On December 28, 2001, the Company issued 1,086,830 shares of its
common stock and exchanged warrants to purchase 431,298 shares of its common
stock and options to purchase 141,329 shares of its common stock for the
remaining Microgy securities.
Under the terms of a Registration Rights Agreement dated July 23, 2001, the
Company was required to file a resale registration statement for the former
Microgy security holders by November 30, 2001. In November 2001, the deadline
for filing the registration statement was extended to March 31, 2002.
F-13
Purchase Accounting and Valuation
The Company acquired Microgy to pursue a prospective growth opportunity in the
area of environmentally sound power generation. The Company believes that trends
in the power and agricultural markets create an opportunity to develop power
generation projects using Microgy's exclusive licensed technology. The Company
paid $7,343,528 for Microgy and accounted for the transaction using the purchase
method of accounting as required by SFAS No. 141. The purchase price represents
the fair value of the securities issued and the direct costs of the acquisition.
The fair value of the common stock was determined using available market
information and appropriate valuation methodologies. The fair value of the
common stock options and warrants were determined using an option pricing model
(See Note L). The following table outlines the components of the purchase price:
Number Fair
Of Shares Value
------------------------------
Common stock 8,844,870 $ 6,837,084
Common stock options 141,329 11,967
Common stock warrants 821,170 43,730
Acquisition costs 450,747
------------------------------
Total purchase price 9,807,369 $ 7,343,528
==============================
The purchase price was allocated to the assets acquired and liabilities assumed
based on their fair values as of July 23, 2001. The fair values of the assets
acquired and liabilities assumed are summarized as follows:
Cash $ 18,306
Other current assets 4,662
Property plant, and equipment 29,127
Investment in projects 100,694
Licensed technology rights 3,710,000
Goodwill 4,912,866
---------------
8,775,655
Less: Liabilities assumed (1,432,127)
---------------
Total Purchase Price $ 7,343,528
===============
At the time of the acquisition, the Company believed that Microgy held numerous
elements of value which could not be separated from the value of the overall
business. These elements of value were assigned to goodwill and included: 1)
technology rights for products and processes which currently do not have a
commercial application; 2) preliminary business relationships; 3) an established
workforce; 4) a proprietary market analysis; and 5) strategic business plans to
capitalize on future market opportunities.
On July 23, 2001, the Company commenced accounting for 100% of Microgy's
operations since the minority interest shareholders were no longer at risk for
Microgy's losses.
Pro forma Information
The following summarized unaudited pro forma information assumes the acquisition
of Microgy occurred on January 1, 2000. The unaudited pro forma results are not
necessarily indicative of the results which might actually have been obtained
had the acquisition occurred as of January 1, 2000, nor are they intended to be
indicative of future results of operations. The amounts below do not include any
amortization of goodwill or indefinite-lived intangible assets.
F-14
Year Ended Year Ended
December 31, 2001 December 31, 2000
-------------------------- ----------------------------
Power generation revenues $ 53,518,000 54,303,222
Net income 1,131,696 1,038,323
Basic earnings per common share 0.06 0.05
Diluted earnings per common share 0.06 0.05
NOTE D -- OTHER CURRENT ASSETS
Other current assets consists of the following as of December 31, 2001 and 2000:
2001 2000
---------------- --------------
Fuel inventory $ 455,907 $ 630,039
Prepaid expenses 123,670 126,845
Deferred financing costs (Note P) 18,894 ----
Deposits and other current assets 9,119 4,096
---------------- --------------
$ 607,590 $ 760,980
================ ==============
NOTE E -- PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment is recorded at cost less accumulated depreciation
and consists of the following as of December 31, 2001 and 2000:
2001 2000
---------------- --------------
Power generating facilities:
Machinery and equipment modifications - Scrubgrass $1,163,863 $ 936,568
Less: Accumulated depreciation (555,081) (400,676)
---------------- --------------
608,782 535,892
---------------- --------------
Office:
Equipment and furniture 83,067 143,171
Less: Accumulated depreciation (39,019) (121,048)
---------------- --------------
44,048 22,123
---------------- --------------
$ 652,830 $ 558,015
================ ==============
During 2001, the Company retired from service and removed from its balance sheet
fully depreciated property, plant and equipment with an original cost of
$94,628. Depreciation expense for the years ended 2001, 2000 and 1999 was
$167,003, $223,872 and $145,008, respectively.
NOTE F -- OTHER ASSETS
Other assets consists of the following as of December 31, 2001 and 2000:
2001 2000
---------------- --------------
Scrubgrass Project deposits $ 367,706 $ 358,016
Deferred financing costs (See Note B) 86,130 121,770
Investment in projects 100,694 ----
Security deposits 11,040 ----
---------------- --------------
$ 565,570 $ 479,786
================ ==============
F-15
Scrubgrass Project deposits represent performance bonds required by state and
local governing authorities for excess highway maintenance and reclamation of
fuel sites.
NOTE G -- ACCOUNTS PAYABLE AND ACCRUED EXPENSES
Accounts payable and accrued expenses consists of the following as of December
31, 2001 and 2000:
2001 2000
-------------- ---------------
Accounts payable $ 4,124,390 $ 3,306,614
Accrued expenses 4,101,015 2,902,232
Corporate taxes payable 1,157,066 743,208
-------------- ---------------
$ 9,382,471 $ 6,952,054
============== ===============
Accounts payable at December 31, 2001 and 2000 includes $3,936,058 and
$3,076,183, respectively, which are related to Scrubgrass Project operations.
Accrued expenses at December 31, 2001 and 2000 includes $3,796,008 and
$2,749,343, respectively, which are related to Scrubgrass Project operations.
NOTE H - RETIREMENT PLAN
Effective January 1, 1998 the Company established a non-contributory defined
benefit pension plan (the "Plan") covering all of its employees who are at least
21 years of age and who have completed at least one year of service. Under the
Plan, the benefits payable to each employee at normal retirement age are based
on years of service and compensation during the three consecutive years of the
latest 10 years immediately preceding retirement which would yield the highest
monthly benefit payment. Employees who have at least 20 years of service at the
time of their retirement would receive the maximum retirement benefit. The
Company's general funding policy is to contribute annually to the Plan the
maximum amount that can be deducted for Federal income tax purposes.
As of January 1, 1998, the commencement date for the Plan, the Company had a
projected benefit obligation of $871,130. The projected benefit obligation as of
January 1, 1998 is being amortized as a prior service cost over 18 years which
represents the average future years of service for the participants in the Plan
at that date.
The following table sets forth the changes during 2001 and 2000 in the projected
benefit obligation for the Plan:
2001 2000
-------------- --------------
Projected benefit obligation, beginning of the year $1,438,313 $1,139,624
Service cost 96,914 97,079
Interest cost 100,682 68,377
Actuarial loss 58,202 133,233
-------------- --------------
Projected benefit obligation, end of the year $1,694,111 $1,438,313
============== ==============
The following table sets forth a reconciliation of the funded status of the Plan
to the amounts recognized in the consolidated balance sheets as of December 31,
2001 and 2000:
2001 2000
-------------- -------------
Projected benefit obligation $ 1,694,111 $1,438,313
Fair market value of Plan assets (599,577) (347,400)
-------------- -------------
Unfunded projected benefit obligation 1,094,534 1,090,913
Unrecognized actuarial loss (424,901) (254,612)
Unrecognized prior service cost (687,734) (733,583)
-------------- -------------
(Prepaid) accrued pension cost $ (18,101) $ 102,718
============== =============
F-16
The amounts recognized in the consolidated balance sheets as of December 31,
2001 and 2000 consist of:
2001 2000
-------------- --------------
Accrued benefit liability $ 769,624 $ 683,815
Intangible asset (687,734) (581,097)
Other comprehensive income (99,991) ---
-------------- --------------
Net amount recognized $ (18,101) $ 102,718
============== ==============
The accrued benefit liability and intangible asset are reported in accounts
payable and accrued expenses on the consolidated balance sheets. Other
comprehensive income is reported, net of tax, in stockholders' equity on the
consolidated balance sheet.
The following table sets forth the changes during 2001 and 2000 in the fair
market value of Plan assets:
2001 2000
-------------- --------------
Fair market value of Plan assets, beginning of the period $ 347,400 $ 396,164
Contributions by the Company to the Plan 346,879 163,130
Benefits paid (8,401) ---
Return on Plan assets (86,301) (211,894)
-------------- -------------
Fair market value of Plan assets, end of the period $ 599,577 $ 347,400
============== ==============
The Company has invested the Plan assets in a portfolio of mutual funds which
consist primarily of growth stocks. The Company expects to make an additional
contribution of $382,890 to the Plan prior to the due date for filing its 2001
Federal income tax return.
The Company's net periodic pension cost for 2001 and 2000 are comprised of the
following components:
2001 2000
-------------- --------------
Service cost $ 96,914 $ 97,079
Interest cost 100,682 68,377
Expected return on assets (27,456) (31,693)
Amortization of actuarial gain 10,071 (589)
Amortization of prior service cost 45,849 45,849
-------------- --------------
Net periodic pension cost $ 226,060 $ 179,023
============== ==============
The actuarial assumptions used in 2001 and 2000 to determine the pension
benefits for the Plan were:
2001 2000
-------------- --------------
Weighted average discount rate 6.75% 7.0%
Expected long-term return on Plan assets 8.0% 8.0%
Weighted average rate of increase in compensation levels 5.0% 5.0%
NOTE I -- OTHER CURRENT LIABILITIES
Other current liabilities consists of the following as of December 31, 2001 and
2000:
2001 2000
-------------- --------------
Scrubgrass Project working capital loan $ 1,116,905 $2,742,961
Scrubgrass Project note payable-current portion (See Note J) 148,310 202,826
Scrubgrass Project long-term debt to supplier-current portion (See Note J) 97,893 100,000
-------------- --------------
$ 1,363,108 $3,045,787
============== ==============
F-17
The Scrubgrass Project working capital loan represents outstanding borrowings
due to the Lessor under a Lessee Working Capital Loan Agreement. Under the terms
of this agreement, which expires in December 2002, Buzzard may borrow up to $4
million for the ongoing working capital requirements of the Scrubgrass Project.
Buzzard paid interest on the outstanding borrowings under this agreement at
LIBOR plus 1.125% through December 31, 2000 and LIBOR plus 1.25% during 2001.
(3.33% as of December 31, 2001 and ranging from 3.33% to 8.23% during 2001 and
7.02% to 7.93% during 2000).
NOTE J -- SECURED PROMISSORY NOTES PAYABLE AND OTHER BORROWINGS
Secured promissory notes payable and other borrowings as of December 31, 2001
and 2000 consists of:
2001 2000
------------- -------------
Scrubgrass Project note payable (See Note I) $ 837,437 $ 985,747
Scrubgrass Project long-term debt to supplier (See Note I) --- 90,446
Sunnyside Project obligations (See Note A) 583,030 1,040,116
------------- -------------
$1,420,467 $2,116,309
============= =============
The Scrubgrass Project note payable represents an installment obligation which
was incurred as part of the Lessor's debt restructuring in December 1995, when
Buzzard extended the term of certain current liabilities through 2004. Buzzard
paid interest on the outstanding borrowings under the Scrubgrass Project note
payable at LIBOR plus 1.25% (3.33% as of December 31, 2001 and ranging from
3.33% to 8.23% during 2001 and 7.14% to 8.05% during 2000). The scheduled
aggregate annual repayments for the Scrubgrass Project note payable are $148,310
in 2002, $447,902 in 2003 and $389,535 in 2004.
The Scrubgrass Project long-term debt to supplier represents the present value
of the long-term installments due to GEC Alsthom, the manufacturer of the
Facility's generator, under a non-interest bearing financing agreement. Under
the terms of the agreement, the Company financed the cost of repairs to the
generator with five installments payable as follows: $50,000 in May 1998;
$100,000 in May 1999, $100,000 in May 2000; $100,000 in May 2001 and $100,000 in
May 2002. As of December 31, 2001 and 2000, the Company has recorded on its
balance sheet the present value of the remaining installments, discounted at the
Facility's incremental borrowing rate (6.75%), which amounted to $97,893 and
$190,446, respectively.
NOTE K -- INCOME TAXES
Income tax expense consists of the following for the years ended December 31,
2001, 2000 and 1999:
2001 2000 1999
------------ ------------ -----------
Current:
Federal $ 788,843 $ 853,791 $ 193,035
State 480,186 657,330 139,701
------------ ------------ -----------
Total current tax expense 1,269,029 1,511,121 332,736
------------ ------------ -----------
Deferred:
Federal 90,530 99,245 121,292
State 13,895 21,867 16,524
------------ ------------ -----------
Total deferred tax expense 104,425 121,112 137,816
------------ ------------ -----------
$1,373,454 $1,632,233 $ 470,552
============ ============ ===========
In 1999, the Company reported deferred income tax expense of $812,440 in its
Consolidated Statement of Operations as a reduction of the cumulative effect of
a change in accounting principle (See Note O).
F-18
Income taxes paid during the years ended December 31, 2001, 2000 and 1999
amounted to $855,363, $1,273,280 and $267,104, respectively.
A reconciliation between the actual income tax expense and the income tax
expense computed by applying the statutory federal income tax rate to the income
before income taxes for the years ended December 31, 2001, 2000 and 1999 is as
follows:
2001 2000 1999
------------ ------------ ------------
Federal tax expense at 34% $1,037,947 $1,176,074 $ 360,103
State tax expense, net of federal tax benefit 320,249 448,270 103,116
State tax valuation allowance, net of federal tax benefit 8,856 --- ---
Nondeductible portion of meals and entertainment 5,141 5,970 5,626
Other 1,261 1,919 1,707
------------ ------------ ------------
$1,373,454 $1,632,233 $ 470,552
============ ============ ============
The components of the net deferred income tax asset (liability) as of December
31, 2001 and 2000 are as follows:
2001 2000
------------- -------------
Deferred tax assets:
Accrued lease expense $25,837,291 $22,808,678
Deferred tax effect of the sale of the Scrubgrass Project for which
the net gain was deferred for financial reporting purposes 893,914 939,814
Capital loss carryforwards 99,025 98,200
Expenses deferred for tax reporting purposes 46,684 ---
Other comprehensive income 39,606 ---
Pre-acquisition net operating loss carryforward of Microgy 622,374 ---
State net operating loss carryforwards 8,856 20,509
------------- -------------
27,547,750 23,867,201
------------- -------------
Deferred tax liabilities:
Accrued power generation revenue 25,837,291 22,808,678
Defined benefit pension plan contribution 158,833 95,907
Licensed technology rights 1,344,450
Other 205,195 207,423
------------- -------------
27,545,769 23,112,008
------------- -------------
1,981 755,193
Less: valuation allowances 148,377 ---
------------- -------------
$ (146,396) $ 755,193
============= =============
As of December 31, 2001, the Company has Federal and state net operating loss
carryforwards of $1,666,094 and $1,829,386, respectively, which are available to
reduce future taxable income. These net operating loss carryforwards relate to
the acquisition of Microgy and expire at various dates through 2020. Due to the
change of ownership provisions in Section 382 of the Internal Revenue Code, the
Company's utilization of Microgy's pre-acquisition net operating loss
carryforwards is limited to $367,911 per year.
As of December 31, 2001, the Company established a $148,377 valuation reserve
for the tax benefit of net operating loss carryforwards which may not be
realized in the future. The Company expects that future taxable income would be
sufficient to realize the tax benefits of the remaining net operating loss
carryforwards.
F-19
NOTE L -- SHAREHOLDERS' EQUITY
Stock Options
In November 2001, the Company's Board of Directors and stockholders approved the
2001 Stock Incentive Plan ("the 2001 Plan"), which provides for the award of up
to 3,000,000 shares of common stock to eligible employees, consultants and
directors of the Company. The Company's awards under the 2001 Plan may consist
of incentive stock options, nonqualified stock options, restricted stock, stock
appreciation rights and other stock awards. The 2001 Plan provides that stock
options and similar awards may be issued with exercise periods of up to 10 years
and minimum option prices equal to 100 percent of the fair market value of the
common stock on the date of grant (110 percent of the fair market value in the
case of individuals holding 10% or more of the Company's common stock). During
2001, the Company granted options for 141,329 shares under the 2001 Plan. As of
December 31, 2001, there were 2,858,671 shares available for grant under the
2001 Plan.
The Company has reserved 405,000 shares of common stock for issuance upon
exercise of stock options which are outstanding or may be granted under the
Company's 1993 Director Plan. The options granted under the 1993 Director Plan
were principally intended to constitute non-qualified options with an option
price of 100 percent of the fair market value of the common stock on the date of
the grant. The options vest at the date of grant and expire 10 years from the
date of grant. The Company granted options for 20,000 shares under the 1993
Director Plan during each of the years 1999, 2000 and 2001. As of December 31,
2001, there were 325,000 shares available for grant under the 1993 Director
Plan.
During 2001, the Company granted options for 450,000 shares of common stock and
warrants for 50,000 shares of common stock to related parties outside of stock
plans. These stock options and warrants are discussed in Note P.
Stock option transactions during 2001, 2000 and 1999 are summarized as follows:
Options Outstanding
----------------------------------------
Shares Price
-------------- -------------------
Balance at January 1, 1999 20,000 $1.50 - 1.688
Options granted 20,000 .625 - .75
-------------- -------------------
Balance at December 31, 1999 40,000 .625 - 1.688
Options granted 20,000 .50 - .688
-------------- -------------------
Balance at December 31, 2000 60,000 .50 - 1.688
Options granted 611,329 .43 - 3.08
-------------- -------------------
Balance at December 31, 2001 671,329 $ .43-3.08
============== ===================
The following table summarizes information about the Company's options
outstanding as of December 31, 2001:
------------Options Outstanding--------------- -----Options Exercisable----
Weighted Weighted Weighted
Average Average Average
Range of Number Exercise Remaining Number Exercise
Option Prices Of Shares Price Contractual Life Of Shares Price
----------------------------------------------------------------------------------------------------
$ 0.43 - 0.625 130,000 $ 0.46 5.28 years 130,000 $ 0.46
0.688 - 0.83 380,000 0.72 5.05 years 380,000 0.72
1.50 - 1.688 20,000 1.59 6.46 years 20,000 1.59
3.08 141,329 3.08 3.97 years 63,354 3.08
----------------------------------------------------------------------------------
671,329 $ 1.19 4.91 years 593,354 $ 0.95
==================================================================================
F-20
Under the provisions of Accounting Principles Board Opinion ("APB") No. 25, the
Company does not recognize compensation expense for stock option awards under
the 2001 Plan and 1993 Director Plan since the underlying options have exercise
prices equal to 100 percent of the fair market value of the common stock on the
date of grant (110 percent of the fair market value in the case officers or
other employees holding 10% or more of the Company's common stock for the 2001
Plan). However, pursuant to the provisions of SFAS No. 123, the Company is
required to calculate the fair market value of its stock options using different
criteria from the provisions of APB No. 25. Using the fair market value criteria
required by SFAS No. 123 to calculate compensation expense on stock options
granted during 2001, 2000 and 1999, the Company would have recognized pro forma
net income of $1,676,213 and pro forma basic earnings per share of $.12 in 2001,
pro forma net income of $1,824,944 and pro forma basic earnings per share of
$.16 in 2000, and pro forma net income of $1,775,050 and pro forma basic
earnings per share of $.16 in 1999.
The estimated fair market values of the Company's options granted during 2001,
2000 and 1999 were $.28 per share, $.18 per share and $.23 per share,
respectively. The fair market values were calculated using an option pricing
model with the following assumptions:
2001 2000 1999
----------------------------------------
Dividend yield 0% 6% 10%
Risk free rate of return 3.73% 5.99% 5.99%
Expected useful life 2 years 5 years 5 years
Expected stock volatility rate 88.04% 42.03% 57.38%
Dividends
The Company declared aggregate dividends of $684,408 (6 cents per share) and
$684,408 (6 cents per share) during 2000 and 1999, respectively. Since March
2001, the Company's Board of Directors has not declared dividends on its common
stock. Due to the recent acquisition of Microgy and anticipated expansion of its
business, the Company's Board of Directors has concluded that available cash
flows should be redirected to operating and investing activities for the
foreseeable future.
The Company paid dividends of $5,000 per year to a preferred stockholder during
2001, 2000 and 1999. The preferred stockholder is entitled to cumulative
dividends of $5,000 per year and has a liquidation preference to receive $500
per share, plus any cumulative unpaid dividends, prior to the distribution of
any remaining assets to common shareholders. There were no dividends in arrears
to the preferred stockholder as of December 31, 2001.
Exchange of Microgy Stock Options and Warrants
Under the terms of the Exchange Agreement, various parties exchanged Microgy
options and warrants for options and warrants to purchase securities of the
Company based on the Exchange Ratio, as adjusted. The fair value of these
options and warrants were calculated using an option pricing model with the
following assumptions:
50,000 240,000 800,000 885,000
Microgy Microgy Microgy Microgy
Options Options Warrants Warrants
-----------------------------------------------------------
Calculated fair value $ 0 $ 11,967 $ 41,451 $ 2,279
Options/Warrants for EPC common shares 24,367 116,962 389,872 431,298
Exercise price per share (EPC share basis) $ 3.08 $ 3.08 $ 1.03 $ 2.05
Dividend yield 0% 0% 0% 0%
Risk free rate of return 1.711% 4.336% 2.182% 1.811%
Expected useful life 3 months 4.75 years 1 year 9 months
Expected stock volatility rate 88.04% 88.04% 72.28% 88.04%
F-21
Other Equity Transactions
The Company has outstanding notes receivable from officers and directors for
shares purchased in connection with the 1990 Stock Plan and 1993 Director Plan
which amounted to $645,948 and $445,948 as of December 31, 2001 and 2000,
respectively. The notes, which are classified as a reduction of shareholders'
equity, are payable upon demand and bear interest at a floating rate which is
payable monthly. The notes are also secured by the shares purchased by the
officers and directors. As of December 31, 2001, the Company has interest
receivable from officers of $5,209.
NOTE M -- COMMITMENTS
Corporate
The Company is obligated under various non-cancelable operating leases for
office space and automotive vehicles. As of December 31, 2001, the future
minimum payments due under these leases are as follows:
2002 $ 77,788
2003 75,383
2004 70,050
2005 66,240
2006 66,240
Thereafter 11,040
-----------
Total $ 366,741
===========
Rent expense for these operating leases was $46,800, $46,689 and $44,230 in
2001, 2000 and 1999, respectively.
Scrubgrass Project
The Company is obligated under a facility lease related to the Scrubgrass
Project. As of December 31, 2001, the estimated minimum lease payments over the
remaining 14.5 year base term of the Scrubgrass lease are as follows:
2002 15,301,000
2003 16,723,000
2004 19,703,000
2005 21,715,000
2006 26,058,000
Thereafter 278,149,000
---------------
Total $ 377,649,000
===============
The Company's Scrubgrass Project lease expense was $24,705,813, $26,415,897 and
$23,110,677 in 2001, 2000 and 1999, respectively. As discussed in Note A, in
addition to scheduled base rent and additional rent payments, the Scrubgrass
Project lease expense includes principal, interest and related fees on the
Lessor's debt obligations. Since a portion of the Lessor's debt obligations have
variable interest rates, the Company has estimated its future minimum lease
payments using average interest rates of 3.12% for the tax-exempt bonds and
7.795% for the variable rate term loan.
As discussed in Notes A and B, the Lessor has an interest rate swap arrangement
for one of its term debt obligations which is considered a derivative
instrument. Beginning July 1, 2000, the Lessor was required to recognize the
interest rate swap as either an asset or liability in its statement of financial
position in accordance with SFAS No. 133. As of December 31, 2001, the Lessor
had a liability of $504,064 in its statement of financial position for the
estimated fair market value of the interest rate swap.
F-22
The Company has also been assigned various long-term noncancelable obligations
under contractual agreements for fuel handling and excavation, limestone supply,
and waste disposal. The contractual terms are generally for 5 to 15 years and
provide for renewal options. The estimated future minimum payments due under
these noncancelable obligations at December 31, 2001 are as follows (See
Note A):
2002 2,334,000
2003 2,413,000
2004 2,496,000
2005 2,581,000
2006 2,668,000
Thereafter 13,868,000
--------------
Total $26,360,000
==============
NOTE N -- DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS
The Company's financial instruments primarily consist of cash and cash
equivalents, restricted cash, receivable from utility, accounts payable, Lessee
working capital loan, short-term debt obligations and long-term debt
obligations. As of December 31, 2001 and 2000, the carrying amounts for cash and
cash equivalents, restricted cash, receivable from utility, accounts payable,
Lessee working capital loan and short-term debt obligations approximate fair
value because of the short maturity of these instruments. As of December 31,
2001 and 2000, the carrying amounts for the long-term debt obligations also
approximate fair value because such obligations incur interest at variable
rates.
NOTE O -- CUMULATIVE EFFECT OF A CHANGE IN ACCOUNTING PRINCIPLE
Effective January 1, 1999, the Company changed its method of accounting for
major equipment overhauls to a method which is consistent with the viewpoints
expressed by the Securities and Exchange Commission. Previously, the Company
recorded the expense of major equipment overhauls on a straight-line basis to a
major maintenance reserve in anticipation of future outlays for the major
overhauls. Beginning in 1999, the Company recorded the expense of major
equipment overhauls when incurred. As a result of this change, the Company
realized an increase in operating expenses of $307,893 and a decrease in income
tax expense of approximately $125,000 during 1999. The Company also recognized
the effect of this change on years prior to 1999 with an increase to net income
of $1,188,989 in 1999. This increase in net income consists of an elimination of
the Company's major maintenance reserve, with a balance of $2,001,429 at
December 31, 1998, and the reversal of $812,440 in deferred income tax benefits.
NOTE P -- RELATED PARTY TRANSACTIONS
In September 2001, the Company paid $150,000 to George Kast, a principal
shareholder of the Company and previously a Principal Microgy Shareholder, in
full satisfaction of a pre-acquisition Microgy obligation.
On September 14, 2001, the Company borrowed $750,000 from Alco Financial
Services, LLC ("Alco"). Robert Weisberg, a Director of the Company, is the
President, Director and a member of Alco. The loan is evidenced by a one-year
promissory note which bears interest at the prime rate plus 3.5%. The Company
also pays an administrative fee of 0.6% per month and paid a commitment fee of
$7,500 to secure the loan. The loan is secured by all of the Company's assets
(other than the stock of its subsidiary, Buzzard Power Corporation). In
connection with the loan, the Company granted Alco five year warrants to
purchase 50,000 shares of common stock at $0.60 per share. During 2001, the
Company recognized interest expense and administrative fees of $20,792 and
$16,050, respectively for this loan.
F-23
In May 2001, the Company granted Mr. Weisberg five-year options to purchase
100,000 shares of common stock at $.43 per share. In September 2001, the Company
granted Mr. Weisberg five-year options to purchase 350,000 shares of common
stock at $0.72 per share. The options were issued in exchange for Mr. Weisberg's
services performed for the Company.
The fair value of the securities granted to Alco and Mr. Weisberg were
calculated using an option pricing model with the following assumptions:
100,000 350,000 50,000
Options Options Warrants
------------------------------------------
Calculated fair value $ 17,869 $95,731 $14,398
Dividend yield 0% 0% 0%
Risk free rate of return 3.73% 3.73% 3.73%
Expected useful life 2 years 2 years 2 years
Expected stock volatility rate 71.57% 85.51% 85.51%
The Company reported the fair value of the securities granted to Mr. Weisberg as
stock-based compensation in its general and administrative expenses for 2001.
The fair value of the securities granted to Alco, along with the commitment fee
and related legal expenses, were reported as deferred financing costs and are
being amortized over the life of the loan. As of December 31, 2001, the Company
has deferred financing costs of $18,894 in other current assets, which will be
amortized during 2002.
NOTE Q - SEGMENT INFORMATION
The Company manages and evaluates its operations in two reportable business
segments: Scrubgrass Project and Microgy. These segments have been classified
separately by the chief operating decision maker because of the different
technologies used in the generation of energy and the future growth prospects of
those technologies. The Company's reportable business segments, which are
described in Note A, follow the same significant accounting policies discussed
in Note B. Financial data for reportable business segments is as follows:
Scrubgrass
Project Microgy Other Consolidated
----------------------------------------------------------
Year Ended December 31, 2001:
-----------------------------
Power generation revenues 53,518,000 ---- ---- 53,518,000
Interest income 40,969 ---- 37,234 78,203
Interest expense 164,252 4,604 16,691 185,547
Depreciation and amortization 339,049 85,446 16,915 441,410
Income tax expense (benefit) 1,273,000 (112,600) 213,054 1,373,454
Net income (loss) 1,754,625 (379,408) 304,114 1,679,331
Identifiable assets 76,358,553 8,668,675 539,018 85,566,246
Year Ended December 31, 2000:
-----------------------------
Power generation revenues 54,303,222 ---- ---- 54,303,222
Interest income 656,024 ---- 80,843 736,867
Interest expense 309,241 ---- 11,400 320,641
Depreciation and amortization 405,723 ---- 9,507 415,230
Income tax expense (benefit) 2,045,062 ---- (412,829) 1,632,233
Net income (loss) 2,812,717 ---- (985,909) 1,826,808
Identifiable assets 68,181,102 ---- 1,103,072 69,284,174
F-24
Year Ended December 31, 1999:
-----------------------------
Power generation revenues 48,268,311 ---- ---- 48,268,311
Interest income 51,199 ---- 59,776 110,975
Interest expense 363,770 ---- 11,438 375,208
Depreciation and amortization 356,062 ---- 7,172 363,234
Cumulative effect of a change in accounting
principle, net of income taxes of $812,440 1,188,989 ---- ---- 1,188,989
Income tax expense (benefit) 812,000 ---- (341,448) 470,552
Net income (loss) 2,331,473 ---- (553,911) 1,777,562
Identifiable assets 57,427,454 ---- 1,354,548 58,782,002
There were no transactions between reportable business segments. Excluding
reportable business segments, the Company had income from the settlement of the
Sunnyside Project litigation, general corporate assets and operating activities
for its corporate office. General corporate assets primarily consist of cash and
equivalents, office equipment, prepaid expenses and a deferred income tax asset.
Since the Sunnyside Project is no longer an operating business, this income was
not included in a reportable business segment.
NOTE R - SUBSEQUENT EVENT
During February 2002, the Company received $2,428,200 from sales of anticipated
excess NOx emission credits for the 2002 through 2007 ozone seasons. The income
from these sales was reported during the first quarter of 2002.
F-25