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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

(Mark one)

For the quarterly period ended September 30, 2004

OR

For the transition period from              to             

Commission file number 0-15472

Environmental Power Corporation

(Exact name of registrant as specified in its charter)

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

(Address of principal executive offices)

(Zip code)

(603) 431-1780

Registrant’s telephone number, including area code

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

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange

Act).    Yes  ¨    No  x

Number of shares of Common Stock outstanding at September 30, 2004 34,107,949 shares

The Exhibit Index appears on Page23

Total number of pages is 28.

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PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

ENVIRONMENTAL POWER CORPORATION AND SUBSIDIARIES

Condensed Consolidated Balance Sheets (unaudited) as of September 30, 2004 & December 31, 2003

See Notes To Consolidated Financial Statements.

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ENVIRONMENTAL POWER CORPORATION AND SUBSIDIARIES

Condensed Consolidated Statements of Operations (unaudited) for the Three and Nine Months Ended September 30, 2004 and September 30, 2003

See Notes to Consolidated Financial Statements.

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ENVIRONMENTAL POWER CORPORATION AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows (unaudited) for Nine Months Ended September 30, 2004 and September 30, 2003

See Notes to Consolidated Financial Statements.

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Notes to Condensed Consolidated Financial Statements

NOTE A — BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements of Environmental Power Corporation (“EPC”) and our subsidiaries have been prepared in accordance with the instructions to Form 10-Q and do not include all of the information and footnotes required by generally accepted accounting principles for annual financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. The results of operations for the nine months ended September 30, 2004 are not necessarily indicative of results to be expected for the year ending December 31, 2004. For further information, refer to the consolidated financial statements and footnotes included in our Annual Report on Form 10-K for the year ended December 31, 2003.

NOTE B — EARNINGS PER COMMON SHARE

We compute basic earnings per share by dividing net income (loss) for the period by the weighted average number of shares of common stock outstanding during the period. We compute our diluted earnings per common share using the treasury stock method. For purposes of calculating diluted earnings per share, we consider our shares issuable in connection with stock options to be dilutive common stock equivalents when the exercise price is less than the average market price of our common stock for the period. We excluded 7,981,662 anti-dilutive common stock equivalents from the calculation of diluted earnings per share for the nine months ended September 30, 2004, and 3,577,329 and 5,072,329 anti-dilutive common stock equivalents from the calculation of diluted earnings per share for the three and nine months ended September 30, 2003. The following table outlines the calculation of basic earnings per share and diluted earnings per share for the three and nine months ended September 30, 2004 and 2003.

NOTE C —STOCK OPTIONS AND STOCK-BASED COMPENSATION

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

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

During the three months ended September 30, 2004, no options or warrants were issued. During the nine months ended September 30, 2004, we issued 2,020,000 options under the 2001 Stock Incentive Plan, 400,000 options under the 2002 Director Option Plan, and 6,619,700 options and warrants outside of any plan. During the nine months ended September 30, 2003, we issued 1,515,000 options under the 2001 Stock Incentive Plan and 450,000 options under the 2002 Director Option Plan.

We issued 1,000,000 performance-based options each to Joseph E. Cresci, Chairman, and Donald A Livingston, Executive Vice President, as part of their executive compensation packages that also included a reduction in their base salaries to $225,000 each. In March 2004, we reduced the options granted to Kam Tejwani, Chief Executive Officer by 1,000,000 and amended his remaining options to have performance-based vesting criteria, including raising additional equity. There is no future liability related to this transaction. After the successful completion of the 2004 Private Placement, 2,820,000 of Mr. Tejwani’s options vested. The 1,000,000 options of Mr. Cresci and the 1,000,000 options of Mr. Livingston vested completely on September 23, 2004 upon the successful completion of specific milestones related to the development of our Microgy subsidiary.

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Because there is uncertainty regarding several key assumptions that are required to value performance-based options, including vesting, stock price, volatility, and discount rate, we apply variable accounting treatment to these options. When options vest or if it is highly likely that they will vest, we expense the options based upon the current stock price. These options are re-evaluated quarterly.

We recorded a $450,572 of stock-based compensation income in the three months ended September 30, 2004 and stock based compensation expense of $1,987,737 for the nine months ended September 30, 2004. The following table shows the composition of the non-cash, stock-based compensation.

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

NOTE D – GOODWILL AND INTANGIBLE ASSETS

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

Accumulated amortization of licensed technology rights was $592,329 as of September 30, 2004 and $453,204 as of December 31, 2003. Amortization expense for licensed technology rights was $46,375 and $139,125 for the three and nine months ended September 30, 2004, respectively. The future estimated amortization expense for licensed technology rights is as follows:

NOTE E – RECENT ACCOUNTING PRONOUNCEMENTS

In January and December 2003, the FASB issued FASB Interpretation No. 46 (FIN 46) and No. 46, revised (FIN 46R), “Consolidation of Variable Interest Entities.” These statements, which address perceived weaknesses in accounting for entities commonly known as special-purpose or off-balance-sheet, require consolidation of certain interests or arrangements

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by virtue of holding a controlling financial interest in such entities. On January 1, 2004 we adopted FIN 46R. Adoption of this new method of accounting for variable interest entities did not have a material impact on our consolidated results of operations and financial position.

NOTE F – RETIREMENT PLAN

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

Plan Assets – Pension costs and cash funding requirements are expected to increase in future years. The following table sets out the market value of out retirement plan as of September 30, 2004 and December 31, 2003.

Employer Contributions – We made no contributions to the pension plan in the first or second quarter of 2004. In the third quarter we made total contributions of $403,401, comprised of $29,901 in cash and the officer notes, with a face value of $597,000 and an estimated fair value of $373,500. The officer notes are secured by 2,322,739 shares of our common stock held by Joseph Cresci and Donald A. Livingston, as well as personally guaranteed by them.

The notes contributed to the plan are replacements for existing notes which were demand notes with interest payable monthly. The amended notes with Mr. Cresci and Mr. Livingston require constant principal payments over a ten year term with interest calculated at a rate of 4.92%.

We are neither the guarantor nor the primary obligor on the notes, but a cosigner. We are obligated to pay any dishonored portion of the Notes, including any and all accrued interest.

The Plan will hold the notes until the earlier of the following occur: (1) the Plan has received principal repayments under the Notes that total $373,750, after which the Plan shall indorse, assign and transfer the Notes back to us or, if a Note has been repaid in its entirety, cancel the Note; or (2) the Independent Fiduciary determined that the investment in the Notes is no longer in the best interests of the Plan, in which case the Plan may either call the Notes or demand the Notes be paid off by us.

We have been in discussions with the Department of Labor and have made steps to get approval for this transaction, which is normally prohibited and requires an exemption. Based on preliminary discussions with counsel and the DOL, management believes the Company will receive the exemption for the prohibited transaction.

Since we are in substance a guarantor on the notes, we have calculated a guarantee accrual in accordance with Interpretation No. 45, Guarantor’s Accounting and Disclosure requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, and this amount is included in the accompanying balance sheet as of September 30, 2004. The accompanying statement of income for the three month and nine month period ended September 30, 2004 includes a charge to operating expense of $223,873 for the loss on the extinguishment of the Company’s current pension liability and the above guarantor accrual.

NOTE G – LONG TERM LIABILITIES

Long Term Liabilities & Commitments

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

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

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

The following table describes our debt obligations as of September 30, 2004 and December 31, 2003:

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 September 30, 2004 and December 31, 2003:

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

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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 $48,575 and $645,948 as of September 30, 2004 and December 31, 2003, respectively. These notes, secured by the underlying shares of stock, are payable upon demand and bear interest at a floating rate which is payable monthly. In accordance with company policy and applicable law, we no longer make loans to our officers or directors. In September 2004, an independent accounting firm performed an appraisal of two of these notes and provided a fair market valuation of $373,500. We contributed the fair market value of two of these notes to the pension plan as discussed above. The plan will hold the notes until it receives principal repayments totaling $373,500, with interest at 4.92%. The notes are secured by 2,322,739 shares of common stock. After the plan has received all the principal and interest due, the remaining value of the notes, if any, will be returned to Environmental Power Corporation.

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

Because of the terms of this settlement agreement, which terms represented a substantial compromise of our previous claims against the purchasers of Sunnyside, we are presently considering our rights and obligations with respect to the remaining contingent obligations of $583,030. The unsettled contingent obligations will remain recorded in our consolidated financial statements until the statute of limitations for any legal action runs out after 2004.

NOTE H – SEGMENT INFORMATION

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

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NOTE I - PRIVATE PLACEMENT

On May 19, 2004 we successfully completed a private placement of securities, raising $5,640,000 in gross proceeds. We issued 7,050,000 shares of common stock and warrants to purchase 3,525,000 shares of common stock as a result of this private placement. The proceeds have been allocated to the common stock and warrants based on relative fair values. The value assigned to the warrants is included in paid in capital in the balance sheet as of September 30, 2004.

We were required to register all the securities by September 19, 2004. Since the registration statement did not go effective on that date, we were required to pay a penalty equal to 1% of the gross proceeds received for each month that the securities remain un-registered. The payment can be in cash or in the issuance of additional shares whose value would equal 1% of the gross proceeds for each month. We have elected to pay this penalty in cash and expect to pay more penalties until the registration statement goes effective.

NOTE J – SUBSEQUENT EVENTS

We have applied for the listing of our common stock on the American Stock Exchange (“AMEX”). In order to meet its listing requirements, we have filed definitive proxy materials for a special meeting at which shareholders would vote on a seven-to-one reverse split of our common stock. After the reverse split, we expect to meet the listing requirements of AMEX. However, we cannot assure you that AMEX will agree to list our common stock.

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

Overview of the Company

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

Buzzard Power Corporation

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

Microgy Cogeneration Systems, Inc

Microgy Cogeneration Systems, Inc. (“Microgy”) holds an exclusive license in North America for the development and deployment of a proprietary technology for the extraction of methane gas from animal wastes. This biogas can be used to generate electricity or it can be used in other industrial applications. Microgy’s product is expected to provide certain farms, known as concentrated animal feeding operations, or CAFOs, with a potentially profitable means of mitigating an existing waste management problem that affects both water and air quality. Federal and State agencies either have or may be in the process of passing regulations that require CAFOs to implement changes to their current waste management practices.

While Microgy is seeking to help farmers meet their waste management needs, we are also seeking to put the biogas produced to use in the generation of electricity or other valuable applications, such as the production of thermal energy to power animal feed production facilities. Many states have either passed or may be in the process of promulgating legislation

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requiring utilities to obtain a certain percentage of their power from renewable sources. This trend positions Microgy as a potentially profitable solution to farmers’ waste management problems, while at the same time providing a new renewable energy source for utilities. We believe that Microgy represents a substantial portion of the future potential growth of EPC and, as such, we are investing substantially all of our available resources, including both our financial and human capital, to take advantage of Mircogy’s potential.

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations compares the results of operations for the three and nine months ended September 30, 2004 with the results of operations for the three and nine months ended September 30, 2003. Unless otherwise indicated, all references to 2004 pertain to the nine months ended September 30, 2004 and all references to 2003 pertain to the nine months ended September 30, 2003. Historical results and trends that might appear should not be taken as indicative of future operations.

Cautionary Statement

This Quarterly Report on Form 10-Q contains forward-looking statements in order to provide investors with prospective information about us. For this purpose, any statements that 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 that 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.” Such forward-looking statements represent management’s current expectations and are inherently uncertain. Investors are warned that actual results may differ from management’s expectations.

Results of Operations

For the nine months ended September 30, 2004, we had a net loss of $2,467,911, or a loss of $0.08 per common share, compared to a net loss of $404,633, or a loss of $0.02 per common share, for the nine months ended September 30, 2003. The decrease in net income was primarily attributable to a $1,730,706 pre-tax loss in Microgy and a $2,916,776 pre-tax loss in All Other Segments compared to pre-tax losses in 2003 of $1,233,585 and $1,044,928, respectively. These decreases were due to increased operating expenses at Microgy and at the home office that are tied to the construction of the first three Microgy plants. Buzzard provided pre-tax income of $1,641,987 for 2004, compared to pre-tax income $1,975,975 for 2003. This decrease was due primarily to increased operating and maintenance expenses. The decrease in earnings per common share was partially offset by the increase in the weighted average common shares outstanding due to the issuance of additional shares of common stock in connection with our private placement concluded in the second quarter of this year (the “2004 Private Placement”).

For the three months ended September 30, 2004, we had net income of $2,233,221, or $0.07 per common share, compared to net loss of $748,392, or a loss of $0.03 per common share, for the same period in 2003. The increase in net income was primarily attributable to pre-tax income of $2,706,555 at Buzzard, an increase from a pre-tax loss of $46,189 for the three months ended September 30, 2003. The increase was due to increased operating capacity. In 2003, there was an unexpected outage that sharply reduced operating capacity. Pre-tax losses at Microgy increased to $725,726 from $427,720 for the third quarters of 2004 and 2003, respectively, due to increased project-related costs. Pre-tax losses for All Other Segments decreased to $52,802 from $727,164 for the three months ending September 30, 2004 and 2003, respectively, due to the variable accounting of performance based stock options for key executives, described in Note C. Offsetting the increase in earnings per common share was an the increase in the weighted average common shares outstanding due to the issuance of additional shares of common stock in connection with the 2004 Private Placement.

Revenues increased 9% to $42,713,408 from $39,012,266 for the nine months ending September 30, 2004 and 2003, respectively. For the three months ending September 30, 2004, revenues increased 41% to $15,101,828 from $11,923,173 in the same period in 2003. For both periods, the increases were due to increases in revenues at both Buzzard and Microgy. At Buzzard, operating capacity increased due to the absence of any unexpected outages as had occurred in 2003. In addition, Microgy recognized its first revenues in the sale of the first three projects, based upon the percentage completion method, as discussed in more detail below.

Costs and expenses increased by 15% and 12% for the nine and three months ended September 30, 2004 compared to the same periods in 2003. These increases were primarily attributable to operating expenses at Buzzard and Microgy. Buzzard expenses increased due primarily to increased maintenance expenses. Microgy expenses increased as a result of the growth of the business and construction of its first projects. Furthermore, we recorded an additional $1,472,327 in non-cash compensation expense in 2004 related to non-employee stock and option grants and employee options that are subject to variable accounting treatment.

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We had other expenses of $529,998 in 2004 compared to other income of $117,926 in 2003. For the three months ended September 30, 2004 and 2003, other expenses increased to $313,812 from $3,943. These decreases are primarily due to increased interest expenses related to the Arclight loan, described in Note G – Long Term Liabilities and Commitments and to the $223,873 loss on the write-off of the officer notes.

For the nine months ended September 30, 2004, we reported a tax benefit of $537,584 compared to an expense of $98,345 for the same period in 2003. For the three months ended September 30, 2004 and 2003, we recorded a tax benefit of $305,195 and $452,681, respectively. Our tax rate is based upon forecasts for a full year of operations. Currently, we expect to have a federal tax benefit and a state tax obligation, resulting in a combined tax benefit of $716,779 for the full year. However, we have not recognized any deferred taxes and the benefit that has been and will be recorded is only related to realized carry-backs.

The results of operations for the business segments are discussed below.

Buzzard

Pre-tax income at Buzzard decreased to $1,641,987 for the nine months ended September 30, 2004 compared to $1,975,975 for the nine months ended September 30, 2003. This decrease was primarily attributable to an increase in operating and maintenance expenses and was offset by an increase in operating capacity this period, leading to a 12% increase in total energy sales. Buzzard provided pre-tax income of $2,706,555 for the three months ended September 30, 2004, up from pre-tax loss of $46,189 for the same period in 2003. This increase was attributable to increased power generation revenues for the third quarter 2004.

For the nine months ended September 30, 2004, power generation revenues increased to $41,043,102 from $39,012,266 in the same period last year. This increase is principally due to a 5% increase in billable rates to Penelec, the purchaser of power from this facility. Directly contributing to the increase in power generation revenues was an increase in operating capacity to 90% for the nine months ended September 30, 2004 from 84% for the same period in 2003 when we suffered an unexpected outage caused by an electrical storm. For the three months ended September 30, 2004 and 2003, power revenues increased 27% to $15,101,828 from $11,923,173 due to an increase in operating capacity from 75% to 99% and the 5% increase in billable rates.

Accrued power generation revenues decreased to $1,606,228 from $3,841,299 and to $535,413 from $1,280,433 for the nine and three months ended September 30, 2004 and 2003, respectively. The decreases result from the FASB 13 accounting treatment of the Scrubgrass lease. In accordance with accounting principles generally accepted in the United States, we are required to treat the power sales agreement as a lease, aggregate the minimum lease payments expected to be received over its life, and recognize it on a straight-line basis over the 22-year lease term. However, we have limited the recognition of accrued power revenues to the recognition of the deemed minimum payments of the facility lease so that we do not recognize any profits early related to executory costs or payment for goods and services other than solely for the right to use the facility. This minimum lease payment component is higher in the early years, decreases in the subsequent years, and reverses itself in the later years of the power purchase agreement. This adjustment has no effect on pre-tax income because it is completely offset by an accrued lease expense.

Total operating expenses for 2004 increased 15% to $22,527,867 from $19,699,118 for 2003. The increase is primarily attributed to a 19% increase in total maintenance expense to $5,418,433 for the nine months ended September 30, 2004 from $ 4,555,847 for the same period in 2003. This increase was related to major maintenance items that will increase the length of time between major maintenances. Further contributing to the increase in total operating expenses was a 26% increase in fuel expense to $8,316,086 for the nine months ended September 30, 2004, up from $6,606,639 for the nine months ended September 30, 2003. The increase in the capacity factor directly contributed to the increase in operating expenses. Because the plant was online 6% longer for the nine months ended September 30, 2004 as compared to the same period in 2003, the plant required more fuel and greater maintenance in the nine months ended September 30, 2004.

Operating expenses for the three months ended September 30, 2004 increased 17% to $7,042,739 as compared to $6,020,393 for the same period in 2003. The increase was due primarily to increased fuel expenses of $1,002,370 and labor expenses of $93,955. These increases were partially offset by decreases in plant maintenance of $162,032.

Lease expenses for 2004 decreased by $66,227 to $14,373,121 for the nine months ended September 30, 2004 as compared to $14,439,348 for the same period in 2003. This decrease was primarily due to decreases in senior debt principal repayments and senior debt interest that were offset by an increase in equity rents to $4,256,838 from $1,382,322. For the three months ended September 30, 2004, lease expenses increased to $4,759,718 from $4,755,928 in the same period in 2003. The increase was due to a $1,300,678 increase in equity rents that was offset by decreases in senior debt principal and interest payments. All of the increases in equity rents are due to scheduled payments.

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Microgy

Pre-tax losses at Microgy increased to $1,730,706 for the nine months ended September 30, 2004, compared to a pre-tax loss of $1,233,585 for the nine months ended September 30, 2003. For the three months ended September 30, 2004, pre-tax losses increased to $725,726 from $427,720 for the same period in 2003. These increases resulted from increases in operating expenses associated with the growth of our Microgy subsidiary and beginning construction on three plants.

For the nine and three months ended September 30, 2004, Microgy recognized its first revenues of $1,670,306. We are recognizing revenues associated with the construction of three of the five farms projects that we signed under the Dairyland agreement, Five Star, Wild Rose, and Norswiss, using the percentage of completion method. However, due to the uncertainty of the projects, we are currently limiting our percentage complete revenue recognition to an amount equal to our cost of construction, thereby not recognizing any gross profit until the project sale process is complete. Once we have a proven track record of successfully completing projects of this kind, we will move to the standard percentage of completion revenue recognition and recognize a prorated share of gross profit each period we record revenue. We began billing Dairyland Power Cooperative for construction costs on these farms in August 2004.

For the nine and three months ended September 30, 2004, we recognized $1,670,306 in costs of construction. There were no such expenses for the same periods in 2003.

Operating expenses for the nine months ended September 30, 2004 increased to $2,377,136 from $1,088,666 for the nine months ended September 30, 2003. The increase is primarily attributed to increases in project expenses of $775,283, payroll expenses of $354,543, insurance expenses of $28,448, and professional services of $27,963. Operating expenses for the three months ended September 30, 2004 increased to $1,454,772 from $379,174 for the same period in 2003. This increase is attributed to increases in project-related expenses of $775,283, payroll of $197,469, and travel and entertainment expenses of $9,941. The increase in operating expenses for both periods is due to the growth of Microgy and to the expenses related to the construction of its first facilities.

All Other Segments

All other segments are comprised of corporate expenses and non-current business segments. For the nine months ended September 30, 2004, we had a pre-tax loss of $2,916,776 compared to a pre-tax loss of $1,044,928 for the same period in 2003. Pre-tax losses decreased to $52,802 from $727,164 for the three months ending September 30, 2004 and 2003, respectively. These losses are all attributable to general and administrative expenses at our corporate offices (see discussion below). We do not have any revenues in these segments.

General and administrative expenses increased to $2,389,907 for the nine months ended September 30, 2004 from $1,170,953 for the same period 2003. This increase is primarily due to a $1,472,327 increase in non-cash stock compensation. These expenses are related to stock and options granted to non-employees for services rendered and to the variable accounting of performance based stock options for key executives. Please see Note C —Stock Options and Stock-Based Compensation for more information.

For the three months ended September 30, 2004, we had general and administrative income of $37,297 compared to an expense of $732,162 for the same period in 2003. The $769,460 change in expenses was due to the variable accounting of performance based stock options for key executives, described in Note C. This decrease was primarily a result in the change in the price of our common stock from $1.07 per share to $0.92 per share on June 30, 2004 and September 30, 2004, the respective measurement dates.

We had other expenses of $512,947 and $296,761 for the nine and three months ended September 30, 2004 compared to other income of $139,551 and $17,682 in same periods in 2003. These decreases are primarily due to increased interest expenses related to the Arclight loan, described in Note G – Long Term Liabilities and Commitments and to the $223,873 loss on the write-off of the officer notes.

2004 Outlook

The following forward-looking information concerning our results of operations for 2004 is being compared to our historical results of operations for 2003:

Power generation revenues are expected to increase slightly in 2004 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. We also expect to operate the facility at a capacity factor of 90% or greater. Pursuant to the terms of the ArcLight loan (see Note G – Long Term Liabilities), all distributions from Buzzard are required to be used to repay the ArcLight loan. Therefore, performance at Buzzard should not have an effect on our liquidity in 2004. See “Cash Flow Outlook” for more information.

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We have signed Digester Purchase and Management Agreements with 5 farms under our relationship with Dairyland Power Cooperative. These agreements represent backlog of approximately $12.6 million. We have recorded $1.6 million of this backlog as revenue for 2004 based upon the percent completion method, representing a portion of the sales for three of the five facilities. However, we have limited the recognition of revenues to the actual associated expenses.

Operating expenses for the full year of 2004 are expected to increase primarily due to:

Lease expenses for the full year of 2004 are expected to decrease by approximately $1,450,000 primarily due to:

General and administrative expenses for the full year of 2004 are expected to increase by approximately $1,800,000, primarily because we plan to increase expenses to further implement Microgy’s business plan. These expenses would include:

Interest expense is expected to increase for the full year of 2004 because we should pay and accrue interest on the ArcLight loan for a full twelve-month period.

We expect our weighted average common shares outstanding to increase in 2004 as result of additional financing activities and issuances of stock compensation and stock awards. In 2003, we issued 4,853,456 new shares of common stock and expect to issue more shares in 2004. In our 2004 Private Placement, we issued over 7,050,000 new shares of common stock and warrants to purchase 3,525,000 additional shares of common stock.

Liquidity and Capital Resources

Operating Activities

For the nine months ended September 30, 2004, cash used for operating activities was $4.8 million, compared to cash used for operations of $3.6 million for the 2003 period. The only source of cash from operating activities for the nine months ended September 30, 2004 was power generation revenues from Buzzard, which as discussed above is used to repay the Arclight loan.

We reported a net loss of $2,471,661 for the nine months ended September 30, 2004. The following adjustments need to be considered in order to reconcile our net income for the period to our net cash provided by operating activities:

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Investing Activities

Our cash provided by investing activities was $21,036 for the nine months ending September 30, 2004 compared to cash used by investing activities of $789,684 for the same period in 2003. Our investing activities were concentrated primarily in the following areas:

Financing Activities

Our cash provided by financing activities was $4,873,193 for the nine months ended September 30, 2004, as compared to $6,081,008 for the nine months ended September 30, 2003. We offer the following information concerning the financing activities for our business:

Cash Flow Outlook

During 2004, we expect to fund our business activities principally from available cash balances, investment earnings, equity funding, raising additional debt at Microgy, and the sale of the first products based upon Microgy’s technology. We do not expect to receive cash from the operations of Buzzard (because such cash, if any, will be used to repay interest and principal on the ArcLight loan), nor proceeds from the sale of NOx emission credits, nor from any pending litigation, as we have in the past. These sources of cash should be sufficient to cover all of our operating expenses and current contractual obligations for 2004.

On May 19, 2004 we successfully completed a private placement of our equity securities, raising gross proceeds of $5,640,000. After commissions and fees, the proceeds from this private placement should be sufficient to cover all of our operating expenses and current contractual obligations for 2004. Additionally, we should be able to finance the construction of some of the Microgy projects that are in our sales backlog.

On September 30, 2004, our unrestricted cash balance was $1,518,469 as compared to $1,444,870 as of December 31, 2003. Our restricted cash balances were $1,528,208 and $1,554,308 at the respective dates. 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 nine months ended September 30, 2004, we received distributions of $997,500 from Scrubgrass, which is less than our distributions of $1,710,000 during the same period in 2003. This decrease is due to the repayment of working capital at Scrubgrass and increased operating costs. All of the distributions, managed by J.P. Morgan, have been used to repay interest of $367,361 and principal of $453,001 on the ArcLight loan, described above. We expect that all distributions in 2004 will be used to satisfy the same debt obligation.

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Our present business strategy generally anticipates the outright sale of facilities; however, in some circumstances, we expect that Microgy may own 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. We cannot assure you that Microgy or any other prospective project owner will be able to secure project financing in the amount required to fulfill any development or construction requirements, that project financing will be obtained in time to meet such requirements, or that any such proposed project financing, if obtained, will be on terms acceptable to Microgy or any other prospective project owner. 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.

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 was also required to achieve reduced emission standards by May 2002. Due to the efficient design of the Scrubgrass facility, Scrubgrass met the 1999 requirements without any modifications to the facility. During 1999, we made capital improvements of $811,568 to the Scrubgrass facility, which enabled Scrubgrass to meet the stricter standards in 2002. By making improvements to the facility before 2002, 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 2002 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. We did not have such sales in 2003 and do not anticipate the sale of NOx Credits in 2004.

Loss of Status as a QF Facility – The Scrubgrass plant operates as a qualifying facility or QF. The loss of the QF status could trigger defaults in the project’s power sales agreement. Therefore, Buzzard would most likely have to sell power at the prevailing market rates that are much lower than the rate outlined in the power sales agreement. This event would not affect our liquidity in 2004 because all of the distributions in 2004 will be required to repay the ArcLight loan. However, it would have an effect on future years. Nevertheless, our exposure would be limited to the assets of EPC Corporation, our wholly-owned subsidiary, and its subsidiary, Buzzard Power.

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 Quarterly Report on Form 10-Q.

Microgy 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 that 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 expected to involve Microgy’s anaerobic digester projects and Microgy is an unproven enterprise with very little operating history, we are unable to determine whether our investment in Microgy will prove to be profitable.

Microgy has experienced losses to date and we anticipate it will continue to experience losses in 2004.

Microgy had accumulated losses due primarily to expenses of business development of approximately $12,726,016 through September 30, 2004. We expect our Microgy subsidiary to continue to incur losses, reduce our earnings or, as the case may be, add to our earnings deficit as we seek to further develop its business. These ongoing losses would adversely affect our financial condition into 2004.

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

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

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

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

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

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

We currently rely on the Scrubgrass plant for all of our operating revenues.

We own a 22-year leasehold interest that commenced in 1994 in our Scrubgrass plant, a waste coal fired electric generating facility in Pennsylvania. Because all of our operating revenue currently results from the Scrubgrass plant, we are dependent on its successful and continued operations. Increased working capital requirements of the Scrubgrass plant, significant unscheduled shutdowns or large increases in interest rates at Scrubgrass would reduce our cash flow. 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.

On September 4, 2003, we entered into a Note Purchase Agreement with Crystal Creek Coalpower Funding, LLC, an affiliate of ArcLight Energy Partners Fund I, L.P., referred to as ArcLight, pursuant to which our subsidiary, EPC Corporation, which holds as its sole asset the stock of Buzzard, agreed to issue and sell to ArcLight up to $5,400,000 original principal amount of its 20.0% Senior Secured Notes due December 31, 2012, consisting of Note A in the original principal amount of $3,700,000 and Note B in the original principal amount of $1,700,000. ArcLight purchased Note A on September 4, 2003, as a result of which EPC Corporation received gross proceeds of $3.7 million. We do not expect to satisfy the conditions to the purchase of Note B. The aggregate minimum principal and interest to be paid by EPC Corporation on Note A over the term of Note A is $4.8 million. Distributions from Scrubgrass are required to be used to repay Note A. After it is paid in full, we will keep the next $1.4 million of distributions. Thereafter, future distributions will be shared equally through December 31, 2012.

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

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

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

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

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

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

Our current Scrubgrass plant power generation revenue is earned under a long-term power purchase agreement for all output with one customer, Pennsylvania Electric Company, or Penelec, a subsidiary of FirstEnergy Corporation. This concentration of our revenue with this customer will continue for the foreseeable future. If this customer goes out of business or defaults on its payments to us, our financial condition will be adversely affected.

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

Our Buzzard and EPC Corporation subsidiaries are leveraged with variable rate and fixed rate debt obligations. Additionally, Buzzard has lease expenses that are based on the principal, interest and fees of the debt obligations of the lessor of the

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Scrubgrass facility, most of which carries variable rate interest. The following table shows that over 90% of our debt obligations and lease obligations have variable interest rates. Therefore, significant increases in market interest will adversely affect our operating results since we are required to pay the Scrubgrass lessor’s debt obligations as a base lease expense. For example, a 1% increase in LIBOR and our Quoted Bond Rates would result in a $1.4 million increase in our lease expense.