<PAGE>
================================================================================
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
(Mark one)
[X] QUARTERLY REPORT UNDER SECTION 13 OR 15 (D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2000
-----------------------------------------------
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
-------------------------
Commission file number 0-15472
------------------------------------------
Environmental Power Corporation
(Exact name of registrant as specified in its charter)
Delaware 04-2782065
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
500 Market Street, Suite 1-E, 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[_]
Number of shares of Common Stock outstanding
-
at May 12, 2000 11,406,783 shares
The Exhibit Index appears on Page 26.
Total number of pages is 26.
================================================================================
<PAGE>
ENVIRONMENTAL POWER CORPORATION
INDEX
<TABLE>
<CAPTION>
PART I. FINANCIAL INFORMATION Page No.
-------
Item 1. Financial Statements:
<S> <C>
Condensed Consolidated Balance Sheets as
of March 31, 2000 (unaudited) and December 31, 1999................................. 2
Condensed Consolidated Statements of Operations (unaudited) for the Three Months
Ended March 31, 2000 and March 31, 1999............................................ 3
Condensed Consolidated Statements of Cash Flows (unaudited) for the Three Months
Ended March 31, 2000 and March 31, 1999............................................. 4
Notes to Condensed Consolidated Financial Statements................................. 5-6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of
Operations.......................................................................... 7-23
Item 3. Quantitative and Qualitative Disclosures About Market Risk.................. 23-24
</TABLE>
PART II. OTHER INFORMATION
<TABLE>
<S> <C>
Item 1. Legal Proceedings........................................................... 24-26
Item 6. Exhibits and Reports on Form 8-K............................................ 26
Signatures ........................................................................ 26
</TABLE>
1
<PAGE>
PART I. FINANCIAL INFORMATION
------------------------------
ITEM 1. FINANCIAL STATEMENTS
ENVIRONMENTAL POWER CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
March 31 December 31
2000 1999
------------ ------------
ASSETS (Unaudited)
CURRENT ASSETS:
<S> <C> <C>
Cash and cash equivalents $ 1,936,300 $ 306,188
Restricted cash 494,263 299,490
Receivable from utility 4,106,154 3,703,922
Other current assets 613,604 645,852
------------ ------------
TOTAL CURRENT ASSETS 7,150,321 4,955,452
PROPERTY, PLANT AND EQUIPMENT, NET 722,996 778,864
DEFERRED INCOME TAX ASSET 876,305 876,305
LEASE RIGHTS, NET 2,422,260 2,459,511
ACCRUED POWER GENERATION REVENUES 50,911,130 49,152,131
OTHER ASSETS 550,431 559,739
------------ ------------
TOTAL ASSETS $ 62,633,443 $ 58,782,002
============ ============
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable and accrued expenses $ 5,195,530 $ 4,751,906
Dividends payable on common stock 0 171,102
Other current liabilities 2,500,077 2,694,619
------------ ------------
TOTAL CURRENT LIABILITIES 7,695,607 7,617,627
DEFERRED GAIN, NET 5,011,674 5,088,776
SECURED PROMISSORY NOTES PAYABLE
AND OTHER BORROWINGS 2,400,462 2,394,237
ACCRUED LEASE EXPENSES 50,911,130 49,152,131
------------ ------------
TOTAL LIABILITIES 66,018,873 64,252,771
------------ ------------
SHAREHOLDERS' DEFICIT:
Preferred Stock ($.01 par value; 1,000,000 shares authorized; no
shares issued at March 31, 2000 and December 31, 1999, respectively) -- --
Preferred Stock (no par value, 10 shares authorized; 10 shares
issued at March 31, 2000 and December 31, 1999, respectively) 100 100
Common Stock ($.01 par value; 20,000,000 shares authorized;
12,525,423 shares issued at March 31, 2000 and
December 31, 1999, respectively; 11,406,783 shares outstanding
at March 31, 2000 and December 31, 1999, respectively) 125,254 125,254
Accumulated deficit (2,244,782) (4,330,121)
------------ ------------
(2,119,428) (4,204,767)
Treasury stock (1,118,640 common shares, at cost, as of
March 31, 2000 and December 31, 1999, respectively) (456,271) (456,271)
Notes receivable from officers and board members (809,731) (809,731)
------------ ------------
TOTAL SHAREHOLDERS' DEFICIT (3,385,430) (5,470,769)
------------ ------------
TOTAL LIABILITIES AND SHAREHOLDERS' DEFICIT $ 62,633,443 $ 58,782,002
============ ============
</TABLE>
See Notes to Condensed Consolidated Financial Statements.
2
<PAGE>
ENVIRONMENTAL POWER CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
<TABLE>
<CAPTION>
Three Months Ended March 31
1999
2000 (Restated)
------------- -----------
<S> <C> <C>
POWER GENERATION REVENUES $ 16,768,555 $12,347,003
------------ -----------
COSTS AND EXPENSES:
Operating expenses 5,239,505 4,826,350
Lease expenses 7,651,398 5,628,452
General and administrative expenses 664,797 679,397
Depreciation and amortization 105,386 63,369
------------ -----------
13,661,086 11,197,568
------------ -----------
OPERATING INCOME 3,107,469 1,149,435
------------ -----------
OTHER INCOME (EXPENSE), NET:
Interest income 634,022 29,605
Interest expense (92,004) (84,883)
Sale of NOx emission credits 0 629,720
Other expense 0 (32)
Amortization of deferred gain 77,102 77,103
------------ -----------
619,120 651,513
------------ -----------
INCOME BEFORE INCOME TAXES 3,726,589 1,800,948
INCOME TAX EXPENSE (1,640,000) (738,000)
------------ -----------
NET INCOME $ 2,086,589 $ 1,062,948
============ ===========
BASIC AND DILUTED EARNINGS PER
COMMON SHARE $ 0.18 $ 0.09
============ ===========
DIVIDENDS:
Common shares $ 0 $ 171,102
Preferred shares 1,250 1,250
------------ -----------
$ 1,250 $ 172,352
============ ===========
DIVIDENDS PER COMMON SHARE $ 0.000 $ 0.015
============ ===========
</TABLE>
See Notes to Condensed Consolidated Financial Statements
3
<PAGE>
ENVIRONMENTAL POWER CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
<TABLE>
<CAPTION>
Three Months Ended March 31
1999
2000 (Restated)
------------- -------------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 2,086,589 $ 1,062,948
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 105,386 63,369
Deferred income taxes 54,000
Amortization of deferred gain (77,102) (77,103)
Accrued power generation revenues (1,758,999) (1,941,405)
Accrued lease expenses 1,758,999 1,941,405
Changes in operating assets and liabilities:
(Increase) decrease in receivable from utility (402,232) 2,979,756
Decrease in other current assets 32,248 118,667
Increase in other assets (2,959) (1,884)
Increase (decrease) in accounts payable and
accrued expenses 443,624 (1,894,804)
Increase in long-term liabilities 2,850 2,850
Increase in long-term debt to supplier 3,375 5,083
------------ -------------
Net cash provided by operating activities 2,191,779 2,312,882
------------ -------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from the collection of notes receivable 13,752
Increase in restricted cash (194,773) (821,981)
Property, plant and equipment expenditures (34,435)
------------ -------------
Net cash used in investing activities (194,773) (842,664)
------------ -------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Dividend payments (172,352) (1,250)
Net repayments of working capital loan (194,542) (621,440)
Repayment of secured promissory notes payable and
other borrowings (671,076)
------------ -------------
Net cash used in financing activities (366,894) (1,293,766)
------------ -------------
INCREASE IN CASH AND CASH EQUIVALENTS 1,630,112 176,452
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 306,188 362,416
------------ -------------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 1,936,300 $ 538,868
============ =============
</TABLE>
See Notes to Condensed Consolidated Financial Statements.
4
<PAGE>
ENVIRONMENTAL POWER CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE A -- BASIS OF PRESENTATION
- -------------------------------
The accompanying unaudited condensed consolidated financial statements of
Environmental Power Corporation ("EPC") and its subsidiaries (collectively the
"Company") 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 accruals)
considered necessary for a fair presentation have been included. The results of
operations for the three months ended March 31, 2000 are not necessarily
indicative of results to be expected for the year ending December 31, 2000. For
further information, refer to the consolidated financial statements and
footnotes included in the Company's Annual Report on Form 10-K for the year
ended December 31, 1999.
Effective January 1, 1999, the Company changed its method of accounting for
major equipment overhauls to a method which is consistent with the viewpoints
recently 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. The Company reported the effect of this
change in accounting principle during the fourth quarter of 1999 by recognizing
an increase in operating expenses of $307,893, a decrease in income tax expense
of approximately $125,000, and an increase in net income of $1,188,989 for the
cumulative effect of the change on years prior to 1999. The Company restated the
results of its operations and cash flows for the three months ended March 31,
1999 in order to conform to the financial presentation for the same period in
2000. As a result of this restatement, the Company decreased its operating
expenses by $88,147 and increased its income tax expense by $36,000 for the
three months ended March 31, 1999.
NOTE B -- NEW ACCOUNTING STANDARD
- ---------------------------------
In June 1999, the Financial Accounting Standards Board issued SFAS No. 137,
which deferred the effective date of SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities". SFAS No. 133 establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts, and for 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. If certain conditions are met, a derivative
instrument may be specifically designated as (a) a hedge of the exposure to
changes in the fair value of an asset or liability or an unrecognized firm
commitment, or (b) a hedge to the exposure to variable cash flows of a
forecasted transaction. The Lessor of the Scrubgrass Project has entered into
certain interest rate swaps with financial institutions that may meet the
definition of derivative instruments under SFAS No. 133. The Company will be
required to adopt SFAS No. 133 by January 1, 2001 and is presently assessing
whether the adoption of SFAS No. 133 will have any impact on its Consolidated
Financial Statements.
5
<PAGE>
NOTE C -- 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 following table outlines the
calculation of basic earnings per share and diluted earnings per share for the
three months ended March 31, 2000 and 1999.
<TABLE>
<CAPTION>
Income SHARES PER SHARE
(Numerator) (DENOMINATOR) AMOUNTS
--------------- ---------------- -------------
<S> <C> <C> <C>
Three Months Ended March 31, 2000:
- ----------------------------------
Income available to shareholders $2,086,589 11,406,783 $.18
Effect of dividends to preferred stockholders (1,250)
----------- ------------- --------
Basic EPS - income available to common shareholders 2,085,339 11,406,783 .18
Effect of dilutive securities:
Assumed exercise of dilutive stock options 543
----------- ------------- --------
Diluted EPS - income available to common shareholders $2,085,339 11,407,326 $.18
=========== ============= ========
Three Months Ended March 31, 1999:
- ----------------------------------
Income available to shareholders $1,062,948 11,406,783 $.09
Effect of dividends to preferred stockholders (1,250)
----------- ------------- --------
Basic EPS - income available to common shareholders 1,061,698 11,406,783 .09
Effect of dilutive securities:
Assumed exercise of dilutive stock options
----------- ------------- --------
Diluted EPS - income available to common shareholders $1,061,698 11,406,783 $.09
=========== ============= ========
</TABLE>
NOTE D - SUBSEQUENT EVENT
- -------------------------
In April 2000, the Scrubgrass Project received 1,077 NOx Credits which pertain
to the ozone seasons in 2000, 2001 and 2002, and received $1,161,888 from its
outstanding sales commitments for 546 projected available NOx Credits.
6
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Overview of the Company
The Company owns a 22 year leasehold interest in an approximately 83 Mw (net)
waste coal-fired electric generating facility (the "Scrubgrass Project") located
in Pennsylvania, the lease for which commenced on June 30, 1994. In recent
years, the Company also held varying ownership interests (100% to 40%) in an
approximately 51 Mw (net) waste coal-fired electric generating facility (the
"Sunnyside Project") located in Utah and owned the development rights to an
existing 43 Mw (net) waste coal-fired electric generating facility (the
"Milesburg Project") located in Pennsylvania which was retired from service in
1984. The Company sold its remaining interest in the Sunnyside Project on
December 31, 1994 and is presently involved in a litigation with the Purchasers
to collect the balance of the Purchaser's obligations for the sale. The Company
sold its development rights for the Milesburg Project on December 5, 1997 to the
utility which had contracted to purchase electricity from such project. The
following Management's Discussion and Analysis of Financial Condition and
Results of Operations compares the Company's results of operations for the three
months ended March 31, 2000 ("2000") with the results of operations for the
three months ended March 31, 1999 ("1999"). Historical results and trends which
might appear should not be taken as indicative of future operations.
The Company's leasehold interest in the Scrubgrass Project is held by EPC's
subsidiary, Buzzard Power Corporation ("Buzzard"). Buzzard leases the Scrubgrass
Project from Scrubgrass Generating Company L.P. (the "Lessor"). Buzzard has a
Management Services Agreement (the "MSA") with PG&E Generating Company (the
"Manager") to manage the Scrubgrass Project and a 15-year Operations and
Maintenance Agreement (the "O&M") with PG&E Operating Services Company (the
"Operator") to operate the Scrubgrass Project. Buzzard sells electric output to
Pennsylvania Electric Company ("PENELEC") pursuant to a 25 year power purchase
agreement (the "PPA") which expires in 2018.
Cautionary Statement
This Quarterly Report on Form 10-Q 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 the Company's 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".
7
<PAGE>
RESULTS OF OPERATIONS
Net income in 2000 amounted to $2,086,589 (18 cents per share) as compared to
net income of $1,062,948 (9 cents per share) in 1999. The increase in net
results during 2000 is primarily attributable to increases in power generation
revenues and interest income. Such increases were offset in part by increases in
operating expenses, lease expenses, income tax expense, and depreciation and
amortization, and the absence in 2000 of income from sales of NOx emission
credits. The reasons for the changes in the Company's net results are discussed
in more detail in the following paragraphs.
Power generation revenues in 2000 amounted to $16,768,555 as compared to
$12,347,003 in 1999 and all pertained to the Scrubgrass Project. The increase in
power generation revenues during 2000 is primarily attributable to additional
revenues of approximately $3,802,000 from the settlement agreement with PENELEC
and a 5% increase in certain rates billed to the utility under the terms of the
PPA. The Scrubgrass Project, which operated at 93.9% of its capacity in 2000 as
compared to 94.1% in 1999, had comparable power generation during each period.
Operating expenses in 2000 amounted to $5,239,505 as compared to $4,826,350 in
1999 and all pertained to the Scrubgrass Project. The increase in operating
expenses is primarily attributable to the following reasons. First, the Company
incurred higher fuel costs primarily as a result of cost escalations in certain
fuel supply agreements and increases in diesel fuel costs. Second, pursuant to
the terms of the O&M, the Operator passed along increases in its labor and
related costs to the Company. Third, the Company performed certain scheduled
maintenance procedures prior to the scheduled annual outage in 2000. Since
these procedures are typically performed in the second quarter, the Company had
an increase in maintenance expenses during 2000 by comparison to 1999.
Lease expenses in 2000 amounted to $7,651,398 as compared to $5,628,452 in 1999
and all pertained to the Scrubgrass Project. The increase in lease expenses
during 2000 is primarily attributable to the following reasons. First, the
Lessor's loan costs that were passed through to the Company in its lease
expenses increased due to higher average interest rates. Second, the Company
incurred scheduled increases in base equity rents. Third, due to increases in
available cash flows from Scrubgrass Project, which included revenues and
interest income from the settlement agreement with PENELEC, the Company incurred
an increase in additional rent paid to the Lessor, which amounts to 50 percent
of the net available cash flows from the Scrubgrass Project. The Company's
overall increase in lease expenses for 2000 was offset in part by a decrease in
lease expense recorded as a result of the straight-line accounting treatment of
certain lease expenses under the Scrubgrass lease which amounted to $1,758,999
and $1,941,405 in 2000 and 1999, respectively.
General and administrative expenses in 2000 amounted to $664,797 as compared to
$679,397 in 1999. While aggregate general and administrative expenses did not
materially change from 1999 to 2000, the following offsetting changes are worthy
of comment. First, pursuant to the terms of the MSA, the Manager passed along
increases in its labor and related costs to the Company. Second, professional
fees increased in 2000 because the Company engaged an investment banker to
consider various sale and restructuring alternatives. The aforementioned
increases were offset by a decrease in legal fees in 2000.
8
<PAGE>
Depreciation and amortization amounted to $105,386 in 2000 as compared to
$63,369 in 1999. Depreciation and amortization increased in 2000 primarily
because the Company's Fiscal 1999 capital expenditures, which were substantially
made during the second quarter, were depreciated during 2000.
Sale of NOx emission credits amounted to $629,720 in 1999 and represented the
aggregate proceeds received in February 1999 from sales of Nitrogen Oxide Ozone
Transport Region Budget Allowances ("NOx Credits"). The Company did not have
sales of NOx Credits during 2000. The sales of NOx Credits are discussed
further under "Liquidity and Capital Resources - Cash Flow Outlook"
Interest income in 2000 amounted to $634,022 as compared to $29,605 in 1999. The
increase in 2000 is primary attributable to approximately $608,000 of interest
income from the settlement agreement with PENELEC.
Income tax expense in 2000 amounted to $1,640,000 as compared to $738,000 in
1999. The increase in income tax expense for 2000 is primarily attributable to
increased pre-tax earnings in 2000. The effective income tax rate for 2000 is
currently projected to be approximately 44% which is consistent with the actual
tax rate realized for Fiscal 1999. During 1999, the Company originally
estimated that its effective income tax rate for Fiscal 1999 would be 41% and
revised its estimates later in the year.
2000 Outlook
The Company expects its net earnings to improve for the year ending December 31,
2000 ("Fiscal 2000") by comparison to the year ended ending December 31, 1999
("Fiscal 1999") and offers the following prospective information concerning
significant components of its results of operations for Fiscal 2000 which are
being compared to historical results of operations for Fiscal 1999:
Power generation revenues - Power generation revenues are expected to increase
materially in Fiscal 2000 primarily as a result of a 5% increase in certain
contracted rates under the PPA and additional revenues from the settlement
agreement with PENELEC. As discussed further in "Part II - Item 1. Legal
Proceedings", the Company settled its legal proceeding with PENELEC and
recognized revenues during 2000 which were earned in prior years. The Company
expects an additional increase in its revenue because PENELEC is expected to pay
full contract rates during Fiscal 2000 for capacity in excess of 80mw.
Operating expenses - Operating expenses are expected to decrease slightly in
Fiscal 2000 primarily due to lower maintenance expenses, the absence of expenses
related to Year 2000 compliance, and improvements in fuel quality. The
aforementioned decreases in operating expenses are expected to be substantially
offset by a 4% average increase in contracted rates for fuel supply agreements,
a 5% increase in contracted rates for the O&M and anticipated increases in the
Operator's labor and related costs.
9
<PAGE>
Lease expenses - Lease expenses are expected to increase significantly in Fiscal
2000 for the following reasons. First, the Company expects that higher interest
rates on the Lessor's tax-exempt bonds and term loans will increase the Lessor's
loan costs that are expected to be passed through to the Company in its facility
lease expenses. Second, the Company expects to incur scheduled increases in
base equity rents in Fiscal 2000. Third, due to projected increases in cash
from Scrubgrass Project operations, which include revenues and interest income
from the settlement agreement with PENELEC, the Company expects its additional
rent paid to the Lessor, which amounts to 50 percent of the net cash flows from
the Scrubgrass Project, would also increase in Fiscal 2000. Fourth, the Lessor
is presently considering changes to the financing structure of the Scrubgrass
Project that could increase the Lessor's loan costs in Fiscal 2000. However, the
Lessor's junior debt obligation was fully satisfied by the end of Fiscal 1999.
The absence of payments on the junior debt obligation is expected to reduce the
Lessor's loan costs in Fiscal 2000 and lessen the impact of the aforementioned
increases in lease expense. The Lessor's additional rent and the potential
changes to the financing structure of the Scrubgrass Project are discussed
further under "Liquidity and Capital Resources - Cash Flow Outlook".
General and administrative expenses - General and administrative expenses are
expected to increase during Fiscal 2000 for the following reasons. First, the
Company expects its casualty insurance costs to increase in Fiscal 2000 due to
changes in the Manager's experience rating for all its facilities. The Manager
insures all of its power plants under one insurance program and is expected to
apportion this overall rate increase to all its facilities. Second, the Company
is anticipating increases in the Manager's labor and related costs. Third, the
Manager has expressed its intention to begin billing the Scrubgrass Project for
certain corporate level support expenses. The Manager, which has improved its
ability to track support expenses by facility, previously absorbed these
expenses at the corporate level. The Company's legal fees and Scrubgrass
Project management costs are also subject to considerable variation each year
due to the demands of legal proceedings and contract matters. As such, the
Company cannot predict the full extent of changes to general and administrative
expenses.
Other income - Other income is expected to materially increase in Fiscal 2000
primarily for the following two reasons. First, the Company expects to report
income of $1,161,888 in Fiscal 2000 from sales of Nitrogen Oxide Ozone Transport
Region Budget Allowances ("NOx Credits"). The sales of NOx credits are discussed
further under "Liquidity and Capital Resources - Cash Flow Outlook". The
Company also reported interest income of approximately $608,000 in 2000 from the
settlement agreement with PENELEC.
Cumulative effect of a change in accounting principle - The Company reported
income in Fiscal 1999 as a result of a change in its method of accounting for
major equipment overhauls. This income will not recur in Fiscal 2000.
Income tax expense - Income tax expense is expected to significantly increase in
light of anticipated increases in income before income taxes. The Company
expects its effective income tax rates for Fiscal 2000 would be comparable to
the actual rates experienced in Fiscal 1999.
10
<PAGE>
Litigation recoveries - As of March 31, 2000, the Company is seeking to recover
approximately $4.5 million owed by the Purchasers of SCA which is the subject of
legal proceeding. See "Part II - Item 1. Legal Proceedings". Should this legal
proceeding resolve or settle in favor of the Company, the Company could also
receive additional financial recoveries which include supplementary interest,
punitive damages and reimbursements for attorney's expenses. The Company would
report any future recoveries from this legal proceeding as additional income in
its Consolidated Statement of Operations.
RECENTLY ISSUED ACCOUNTING STANDARDS
See Note B to the Condensed Consolidated Financial Statements for recently
issued accounting standards which are required to be adopted in the future.
LIQUIDITY AND CAPITAL RESOURCES
Operating Activities
The Company had cash provided by operating activities of $2,191,779 and
$2,312,882 in 2000 and 1999, respectively. During these periods, the Company's
only sources of cash from operating activities were operating profits from the
Scrubgrass Project and investment earnings.
The Company's net income during 2000 and 1999 contributed a significant portion
of the cash provided by operations. The following adjustments, which did not
impact the Company's cash flows, need to be considered in order to reconcile the
Company's 2000 net income to its net cash provided by operating activities.
Depreciation and amortization - During 2000, the Company recognized depreciation
and amortization for its lease rights of $37,251, deferred financing costs of
$12,267, machinery and equipment modifications of $53,592 and equipment and
furniture of $2,276.
Deferred gain, net - The Company's deferred gain, net, amounted to $5,011,674 as
of March 31, 2000 as compared to $5,088,776 as of December 31, 1999. The
decline is due to the amortization of the deferred gain related to the
Scrubgrass Project, which is being amortized on a straight-line basis over 22
years.
The Company also offers the following information to discuss changes in its
operating assets and liabilities which most notably impacted its cash position
during 2000:
Receivable from utility - The Company's receivable from utility relates to the
Scrubgrass Project and amounted to $4,106,154 as of March 31, 2000 as compared
to $3,703,922 as of December 31, 1999. The increase in 2000 is primarily
attributable to a 5% increase in certain contracted rates under the PPA and a
higher capacity rate billed in March 2000 by comparison to December 1999.
11
<PAGE>
Other current assets - The Company's other current assets amounted to $613,604
as of March 31, 2000 as compared to $645,852 as of December 31, 1999. The
decrease in other current assets is largely due to seasonal decreases in prepaid
insurance and the collection of an insurance refund which was receivable as of
December 31, 1999. Such decreases were offset in part by an increase in fuel
inventory which was largely related to higher diesel fuel costs in 2000.
Accounts payable and accrued expenses - The Company's accounts payable and
accrued expenses amounted to $5,195,530 as of March 31, 2000 as compared to
$4,751,906 as of December 31, 1999. The increase in accounts payable and
accrued expenses is primarily attributable to the following reasons. First, due
to the higher capacity rate in March 2000 by comparison to December 1999, the
Company had more variable operating expenses in accounts payable and accrued
expenses as of March 31, 2000. Second, the Company has certain costs which are
paid annually during the first quarter and accrued monthly during the calendar
year. For such costs, the Company's accrued expenses as of March 31, 2000
included only three months of expense as compared to 12 months of expense as of
December 31, 1999. Third, primarily due to the increases in operating expenses
and general and administrative expenses discussed under "Results of Operations"
above, the Company realized an increase in certain accounts payable and accrued
expenses as of March 31, 2000. Fourth, the Company's corporate taxes payable
increased from $539,780 as of December 31, 1999 to $2,179,024 as of March 31,
2000 primarily for the following two reasons. First, as discussed under
"Results of Operations", the Company incurred significant non-recurring taxable
income from a litigation settlement during 2000. Second, the majority of the
corporate taxes payable as of December 31, 1999 were not paid until April 15,
2000. The aforementioned increases in accounts payable and accrued expenses
were offset in part by a decrease in accrued bond interest which amounted to
$1,096,460 and $418,543 as of December 31, 1999 and March 31, 2000,
respectively. The decrease in accrued bond interest occurred primarily because
a significant percentage of the bonds were redeemed and reissued during 2000.
Investing Activities
The Company used $194,773 and $842,664 in investing activities during 2000 and
1999, respectively. The Company's investing activities are concentrated
primarily in the following areas:
Notes receivable - The Company presently has notes receivable related to the
1994 sale of the Sunnyside Project and had a note receivable related to fees
earned for the Scrubgrass Project which was fully satisfied in 1999. The
Company collected $13,752 from notes receivable related to the Scrubgrass
Project in 1999. The notes receivable related to the Sunnyside Project, with a
principal balance of $2,937,500 and outstanding interest balance of $1,176,006
as of March 31, 2000, are the subject of a legal proceeding. Due to
uncertainties surrounding the timing of resolving this legal proceeding, the
Company wrote-off the outstanding balances of these receivables as of December
31, 1998 and is no longer recognizing future interest income on the notes.
"See Part II - Item 1. Legal Proceedings" for further information about this
litigation.
Restricted cash - The Company is presently required to make scheduled deposits
to a restricted major maintenance fund relating to the Scrubgrass Project to
ensure that funds are available in the future for scheduled major equipment
overhauls. The Company is also allowed to spend restricted cash to
12
<PAGE>
fund the cost of major equipment overhauls subject to certain restrictions.
During 2000 and 1999, the Company made scheduled deposits to the restricted
major maintenance fund of $185,052 and $227,424, respectively. During 2000 and
1999, the Company's payments for major equipment overhauls amounted to -0- and
$20,000, respectively. During 1999, the Company received $629,720 from the sale
of a portion of its projected available NOx Credits and designated that $600,000
of such proceeds be used to purchase and install certain machinery related to
the production of NOx Credits. Pending the purchase and installation of this
machinery, the Company had invested such proceeds in restricted cash, which
investments increased restricted cash by $603,049 during 1999. The remaining
changes to restricted cash primarily pertain to investments of available
restricted cash balances.
Property, plant and equipment - The Company invested $34,435 in 1999 primarily
for machinery and equipment modifications made at the Scrubgrass facility.
Financing Activities
The Company used $366,894 and $1,293,766 in financing activities during 2000 and
1999, respectively. The Company's financing activities are concentrated
primarily in the following areas:
Dividends - The Company has a quarterly dividend program which is subject to
review and consideration by the Board of Directors each quarter. In respect of
this dividend program, the Company declared dividends of $171,102 (1.5 cents per
share) during the first quarter of 1999 which were paid on April 17, 1999 and
dividends of $171,102 (1.5 cents per share) during the fourth quarter of 1999
which were paid on January 14, 2000. The Company also paid dividends to its
subsidiary's preferred stockholder of $1,250 during both the first quarter of
2000 and first quarter of 1999. As such, the Company paid total dividends of
$172,352 and $1,250 during the first quarter of 2000 and first quarter of 1999,
respectively. The Company also declared a dividend of $171,102 (1.5 cents per
share) in April 2000 which will be reported in the consolidated financial
statements during the second quarter.
Working Capital Loan - The Company may borrow up to $4 million under a Lessee
Working Capital Loan Agreement with the Lessor for ongoing working capital
requirements of the Scrubgrass Project. During 2000 and 1999, the Company made
net repayments under the Lessee Working Capital Loan Agreement of $194,542 and
$621,440, respectively. Due to the timing of collecting revenues from the
utility, the Company collected two payments from the utility in December 1999
and made an additional repayment under the Lessee Working Capital Loan
Agreement. As such, the net repayments during 2000 were lower by comparison to
1999 since the outstanding borrowings under the Lessee Working Capital Loan
Agreement were lower as of December 31, 1999 by comparison to December 31, 1998.
Term Credit Facility - In June 1997, the Lessor entered into a three year credit
facility with the lenders of the Scrubgrass Project which made $3 million
available to the Scrubgrass Project to cover the cash deficiency which resulted
from the extended annual outage of the Scrubgrass Project and associated costs
and expenses. On July 1, 1998, the maximum allowable borrowings under this
credit facility began reducing in $600,000 increments every six months through
July 3, 2000 when the credit facility will be payable in full. The Company made
aggregate payments of $0 and $650,000 during 2000 and
13
<PAGE>
1999, respectively, under this term credit facility to ensure that the
outstanding borrowings would not exceed the maximum allowable borrowings on the
dates indicated.
Notes payable - In addition to the term credit facility described previously,
the Company has other long-term obligations related to its Sunnyside Project and
Scrubgrass Project in the amounts of $1,211,889 and $1,188,573, respectively as
of March 31, 2000. The Sunnyside Project long-term obligations are payable based
on a schedule which relates directly to the amount of proceeds received from the
collection of the outstanding notes receivable from the sale of the Company's
interest in the Sunnyside Project, which are the subject of a litigation
described in "Part II. - Item 1. Legal Proceedings". The Scrubgrass Project
obligation has scheduled maturities which began in 1998 and continue through
2005. The Company made payments of $-0- and $21,076 for the Scrubgrass Project
obligation in 2000 and 1999, respectively.
Cash Flow Outlook
During Fiscal 2000, the Company expects the principal sources of cash to fund
its business activities will be from available cash balances, investment
earnings and cash which may become available from the Scrubgrass Project. As
discussed in its Annual Report on Form 10-K for Fiscal 1999, the Company is not
able to receive distributions from the Scrubgrass Project until all operating
expenses, base lease payments, certain maintenance reserve payments and other
subordinated payments of the Scrubgrass Project are satisfied. Nevertheless,
the Scrubgrass Project's cash flows in Fiscal 2000 are expected to be sufficient
to satisfy all of these restrictions and provide the Company with a material
increase in distributions by comparison to Fiscal 1999.
As discussed under the caption "Results of Operations - 2000 Outlook", the
Company expects that the Scrubgrass Project's cash flows in Fiscal 2000 will be
enhanced by an increase in the contracted rates under the PPA, sales of NOx
Credits, and additional revenues from the settlement agreement with PENELEC.
However, the Company expects that anticipated increases in lease expenses,
administrative expenses and income taxes would consume a portion of these
additional revenues. The Company also believes that the Scrubgrass Project's
cash flows would continue to be affected by certain debt and maintenance
payments. According to certain agreements, the Scrubgrass Project is expected
to make scheduled payments in Fiscal 2000 of $700,000 for debt and $678,527 for
deposits to restricted cash.
As discussed under the caption "Certain Factors That May Affect Future Results--
Environmental Regulation", the Scrubgrass Project needed to achieve certain
seasonal NOx 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, the Scrubgrass Project met the new Fiscal 1999
requirements without any modifications to the Facility. However, the Company
made capital improvements of $811,568 in Fiscal 1999 to the Facility, which are
expected to enable the Facility to meet the stricter standards in 2003. By
making improvements to the Facility before 2003, the Company anticipated that it
would not require a portion of its future NOx Credits to maintain its compliance
with the applicable regulations. Consequently, the Company sold its anticipated
excess NOx Credits and used the proceeds to finance the capital improvements and
generate additional working capital. The Company expects to comply with all
material
14
<PAGE>
environmental regulations for the foreseeable future without any additional
material modifications to the Scrubgrass facility. The sales of NOx Credits are
discussed further in the Company's Fiscal 1999 Annual Report on Form 10-K.
During Fiscal 1999, the Manager of the Scrubgrass Project commenced long-term
refinancing discussions with the lending agents for the Scrubgrass Project.
Through these discussions, the Manager of the Scrubgrass Project expects to
address several changes in the Scrubgrass Project's financing structure that are
expected to occur over the next few years. First, the tax-exempt bond letter of
credit expires in December 2000 and would need to be replaced or extended.
Second, Buzzard is expected to pay the balance of its Lessee Working Capital
Loan to zero for a minimum of 20 days during 2001 and 2002. Third, Buzzard's
Lessee Working Capital Loan commitment expires in December 2002. Fourth,
PENELEC's contracted payment terms will be extended by 24 days beginning in July
2003, which is expected to create the need for additional working capital.
Fifth, based on recent market trends, the Manager believes there may be better
ways to manage the Scrubgrass Project's interest rate risk. The Company believes
that the Scrubgrass Project has demonstrated its ability to satisfy its existing
financial obligations and expects it could demonstrate an ability to satisfy
proposed changes to its financing structure. As such, the Company expects the
Manager could negotiate favorable terms for the financing structure at the
Scrubgrass Project. However, the Scrubgrass Project might incur additional fees
to extend or originate new financing commitments. At this time, the Company
cannot predict the impact that refinancing discussions would have on its future
results of operations or financial position.
As of March 31, 2000, the Company is seeking to recover approximately $4.5
million owed by the Purchasers of SCA (See "Part II - Item 1. Legal
Proceedings"). The Company is also seeking additional financial recoveries which
include supplementary interest, punitive damages and/or reimbursements for
attorney's expenses. As discussed under "Financing Activities--Notes payable",
the Company would be required to utilize a portion of these recoveries to
satisfy certain obligations of the Sunnyside Project. The Company believes its
position in this litigation is meritorious and, should the litigation resolve or
settle in favor of the Company, the Company's financial position could be
materially enhanced in the future. However, there can be no assurance that the
litigation will resolve or settle in favor of the Company.
The Company's corporate structure is very complicated and includes multiple
entities resulting in several layers of tax for the Company and its
shareholders. Prior to 1998, the Company's cash position was not materially
affected by this corporate structure because of the existence of significant net
operating loss carryforwards. However, the Company's cash position has been
affected in recent years by significant corporate tax payments since the Company
utilized substantially all of its net operating loss carryforwards in 1997.
Presently, the Company is reviewing its corporate tax position and is
considering tax strategies and restructuring alternatives which could mitigate
the effect that corporate taxes are expected to have on its future cash flows.
In the meantime, the Company's cash flows continue to be affected by substantial
corporate tax payments as well as considerable professional fees for the
Sunnyside litigation.
The Company is optimistic about the future performance of the Scrubgrass Project
which is currently expected to achieve significant earnings and cash flows on an
annual basis for the
15
<PAGE>
foreseeable future. The PPA has contracted rate escalations which, assuming the
Scrubgrass Project meets its targeted capacity rates, would ensure a material
increase in revenues in future years. Furthermore, as discussed above, the
additional revenues from the PENELEC legal settlement and the sales of NOx
Credits have also materially enhanced the Company's cash position in 2000.
Notwithstanding, the Company will continue to be affected by its obligations for
scheduled maintenance reserves, term debt repayments, corporate taxes and
professional fees. Nevertheless, the Company believes that the cash flows which
may become available from the Scrubgrass Project, together with existing cash
reserves, would be sufficient to fund the Company's business activities on a
long-term basis. However, the payment of any future dividends will depend on the
Board of Directors' evaluation, made on a quarterly basis, based on its dividend
policy and the Company's then current and projected operating performance and
capital requirements.
YEAR 2000 ISSUE
The Year 2000 Issue related to the potential problems resulting from the
incorrect processing of information using dates or date sensitive data by
computers and other machines utilizing embedded microprocessors. The problem is
attributable to hardware or software recognizing the Year 2000 as a two digit
number "00" as opposed to correctly interpreting the year as "2000". The
Company was adequately prepared for the Year 2000 Issue and did not experience
any meaningful disruptions related to the Company's information technology (IT)
and non-IT systems. Additionally, the Company did not encounter any meaningful
disruptions or communications with its mission critical vendors, its business
partners, or its customer.
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.
Ownership of Single Operating Asset
The Company owns a 22 year leasehold interest in the Scrubgrass Project, an
approximate 83 Mw (net) waste coal-fired electric generating facility located in
Pennsylvania, the lease for which commenced on June 30, 1994. Presently, all
the Company's operating revenues are attributable to power generation from the
Scrubgrass Project. Accordingly, the Company's operations are largely dependent
upon the successful and continued operation of the Scrubgrass Project. In
particular, if the Scrubgrass Project experiences unscheduled shutdowns of
significant duration, the Company's results of operations will be materially
adversely affected.
Dependence Upon Key Employees
The success of the Company is largely dependent upon a staff of three full-time
executive officers and two part-time employees. The loss of any of the Company's
executive officers could adversely effect the Company's operations.
16
<PAGE>
Third Party Project Management
The Company has a management services agreement with PG&E Generating Company to
manage the Scrubgrass Project and a 15-year operations and maintenance agreement
with PG&E Operating Services Company to operate the Scrubgrass Project. Under
the terms of these agreements, there are provisions which limit the Company's
participation in the management and operation of the Scrubgrass Project, and
provisions which provide for recourse against the Manager and the Operator for
unsatisfactory performance. However, the Company does not exercise control over
the operation or management of the Scrubgrass Project. As such, decisions may
be made affecting the Scrubgrass Project, notwithstanding the Company's
opposition, which may have an adverse effect on the Company.
Interest Rates
Buzzard, as a lease cost of the Scrubgrass facility, is required to fund the
Lessor's debt service which consists of variable rate and fixed rate debt
obligations. Buzzard also has a variable rate working capital loan, a variable
rate term loan and a variable rate term credit facility all of which were
advanced from the Lessor under various Scrubgrass Project agreements. The
Company offers the following information about these debt and lease obligations:
<TABLE>
<CAPTION>
BALANCE AT Matures
DESCRIPTION OF THE OBLIGATION 3/31/2000 INTEREST RATE Through
- -------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Lessor debt obligations:
Variable-rate tax exempt bonds $135,600,000 Quoted Tax Exempt Bond Rate 2012
Variable rate term loan 13,901,751 Fixed swap rate of 6.4225% 2005
Variable rate term loan 10,061,427 LIBOR rate plus 1.250% 2004
Buzzard debt obligations:
Variable rate working capital loan 1,800,077 LIBOR rate plus 1.125% Revolving
Variable rate term loan 1,188,573 LIBOR rate plus 1.250% 2004
Variable rate term credit facility 600,000 LIBOR rate plus 1.125% 2000
</TABLE>
The Lessor entered into interest rate swaps which had the effect of fixing the
interest rate for its term loan which matures in 2005 at 6.4225%. As such,
except for the Lessor's term loan which matures in 2005, Buzzard will be
required to fund debt service consisting of rates which will vary with market
conditions. Presently, the Company is not able to predict how future interest
rates will affect these debt or lease obligations. Should market interest rates
rise significantly, the Company's operating results may be significantly
impacted. Notwithstanding, the Company believes the Lessor has good
relationships with the project lenders who would continue to support lending
terms which would not have a material adverse affect on the operating results of
the Scrubgrass Project. However, there can be no assurance that the Lessor
could renegotiate its credit facilities under terms which would ensure
continuing profitable operating results of the Scrubgrass Project. See the
Company's Fiscal 1999 Annual Report on Form 10-K for further information about
the Company's debt and lease obligations.
17
<PAGE>
Scheduled and Unscheduled Shutdowns
The Scrubgrass Project from time to time experiences both scheduled and
unscheduled shutdowns. Periodically, the Scrubgrass Project incurs scheduled
shutdowns in order to perform maintenance procedures to equipment that cannot be
performed while the equipment is operating. Occasionally, the Scrubgrass Project
may also incur unscheduled shutdowns or may be required to operate at reduced
capacity levels following the detection of equipment malfunctions, or following
minimum generation orders received by the utility. During periods when the
Scrubgrass Project is shutdown or operating at reduced capacity levels, the
Company may incur losses due to the loss of its operating revenues and/or due to
additional costs which may be required to complete any maintenance procedures.
It is not possible for the Company to predict the frequency of future
unscheduled shutdowns or to predict the extent of maintenance which may be
required during shutdowns related to equipment maintenance.
Circulating Fluidized Bed Technology
The Company's 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 areas being
explored by the alternative energy market in the last 15 years. Accordingly,
this technology carries greater risk than more established methods of power
generation such as hydropower. As such, the long-term costs and implications of
maintaining this technology have not been established by historical industry
data.
Legal Proceedings
As discussed in "Part II - Item 1. Legal Proceedings", the Company is involved
in a legal proceeding with the purchasers of the Company's interest in the
Sunnyside Project which was sold in 1994. Pending the resolution of the legal
proceeding, the purchasers have withheld scheduled payments of principal and
interest due on the promissory notes since June 1996, which amounted to
$2,937,500 and $1,176,006, respectively as of March 31, 2000. The balance of a
purchase price closing adjustment is also being disputed in the legal proceeding
with the purchasers. To date, the Company's available cash and cash provided by
operating activities has been sufficient to fund the Company's investing and
financing activities. Nevertheless, the professional fees incurred to defend
its position in the litigation and the withholding of scheduled principal and
interest payments on the promissory notes have adversely affected the Company's
financial position. At this time, while management believes the Company's
position in this litigation is meritorious, the Company cannot predict whether
it will prevail in the litigation and to what extent it will continue to incur
professional fees to defend its position in the litigation. An unfavorable
resolution and/or extensive professional fees to defend the litigation could
adversely affect the Company's results of operations and financial position.
Financial Results
To date the Company has incurred substantial losses, primarily due to its
development activities, which have resulted in an accumulated deficit of
$2,244,782 as of March 31, 2000. While the
18
<PAGE>
Company has been profitable from operating activities from 1998 through March
31, 2000, the Company incurred a net loss from the operation of the Scrubgrass
Project during 1997 due to an unforeseen repair to the generator at the
Scrubgrass facility. The Company also had an overall net loss during 1998
largely due to the write-off of the Sunnyside project receivables. Financial
results can be affected by numerous factors, including without limitation
general economic conditions, cyclic industry conditions, the amount and rate of
growth of expenses, transportation and quality of raw materials, inflation,
levels of energy rates, uncertainties relating to government and regulatory
policies, the legal environment and volatile and unpredictable developments like
the generator repair. The Company believes it is well positioned to handle such
matters as they may arise during the course of its future business activities.
However, there can be no assurance that the Company will be profitable in the
future.
Customer Concentration
The Company's power generation revenues are earned under a long-term power
purchase agreement with one customer, Pennsylvania Electric Company. The
Company expects that the concentration of its revenues with this customer will
continue for the foreseeable future.
Competition
The Company generates electricity using alternative energy sources which is sold
on a wholesale basis under long-term contracts to utilities under rates
established in power purchase agreements and approved by regulatory agencies.
The independent power industry has grown rapidly over the past twenty years.
There are a large number of suppliers in the wholesale market and a surplus of
capacity which has led to intense competition in this market. The principal
sources of competition in this market include traditional regulated utilities
who have excess capacity, unregulated subsidiaries of regulated utilities,
energy brokers and traders, energy service companies in the development and
operation or energy-producing projects and the marketing of electric energy,
equipment suppliers and other non-utility generators like the Company.
Competition in this industry is substantially based on price with competitors
discovering lower cost alternatives for providing electricity. The electric
industry is also characterized by rapid changes in regulations which the Company
expects could continue to increase competition. For instance, the electric
industry has been previously affected by legislation such as PURPA and the
Energy Act which have encouraged companies other than utilities to enter the
electric power business by reducing regulatory constraints. More recently, as
discussed under the caption "Energy Regulation", there has been new state
legislation to deregulate the generation component of the electric business.
Furthermore, proposed changes to repeal or modify PUHCA and PURPA could reduce
regulatory restrictions placed on electric utilities and encourage them to seek
new sources of electric power. Any of these regulatory matters, among others,
could increase competition for electric power. Other than the risk that PENELEC
would seek to renegotiate the terms of the PPA (see further discussion under the
caption "Energy Regulation"), the Company does not believe the Scrubgrass
Project would be significantly impacted by competition in the wholesale energy
market since its revenues are subject to contracted rates which are
substantially fixed for several years. However, the contracted rates in the
later years of the PPA switch to rates which vary more closely with existing
market conditions. Should ensuing competition in the
19
<PAGE>
later years of the PPA create downward pressure on wholesale energy rates, the
Company's profitability could be impacted.
In previous years, the Company competed in the market to develop power
generation facilities. The primary bases of competition in this market are the
quality of development plans, the ability of the developer to finance and
complete the project and the price. In certain cases, competitive bidding for a
development opportunity is required. Competition for attractive development
opportunities is expected to be intense as there are a number of competitors in
the industry interested in the limited number of such opportunities. Many of
the companies competing in this market have substantially greater resources than
the Company. The Company believes its project development experience and its
experience in creating strategic alignments with other development firms with
greater financial and technical resources could enable it to continue to compete
effectively in the development market if and when opportunities arise.
Presently, the Company believes there are limited opportunities for additional
project development in the United States for projects similar to those
previously developed by the Company. As a result, the Company is not actively
pursuing new development opportunities at this time.
Presently, there is significant merger and consolidation activity occurring in
the electric industry. Recently, the Company engaged an investment banker to
consider any sale or merger proposals and other strategic alternatives that may
present an opportunity to enhance shareholder value. There can be no assurance
that any transaction will result from this engagement.
Energy Regulation
The Company's projects are subject to regulation under federal and state energy
laws and regulations. The Company's facilities are either self-certified as a
Qualifying Facility under the PURPA, or formally certified as a Qualifying
Facility by the Federal Energy Regulatory Commission ("FERC"). Pursuant to
PURPA, FERC has promulgated regulations which exempt certain Qualifying
Facilities from the Federal Power Act of 1920, PUHCA, and, except under certain
limited circumstances, state laws regulating the rates charged by electric
utilities. In order to qualify under PURPA, the Company's facilities must meet
certain size, fuel and ownership requirements and/or co-generate. In addition
to the regulation of Qualifying Facilities, PURPA requires that electric
utilities purchase electric energy produced by qualifying facilities 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. The Company is not presently subject to
regulation under PUHCA and does not presently intend to engage in any activities
that would cause it to be so regulated.
The Company believes that changes in PURPA, PUHCA and other related federal
statutes could occur in the next several years. The nature and impact of such
changes on the Company's projects is unknown at this time. Presently, there are
several legislative proposals pending in Congress which suggest a comprehensive
restructuring of the electric utility industry. These proposals advocate, among
other things, retail choice for all utility customers, the opportunity for
utilities to recover their prudently incurred stranded costs in varying degrees,
and the repeal of both PURPA and PUHCA. In April 1999, the Clinton
administration also introduced the
20
<PAGE>
Comprehensive Electricity Competition Act, which proposes a flexible mandate for
customer choice by January 1, 2003, reliability standards, environmental
provisions, and the repeal of both PURPA and PUHCA. The flexible mandate gives
individual states the option to seek alternative policies which appear to better
serve their consumers. If PURPA is amended or repealed, the statutory
requirement that electric utilities purchase electricity from Qualifying
Facilities at full avoided cost could be repealed or modified. While current
legislative proposals specify the honoring of existing contracts, the repeal or
modification of these statutory purchase requirements under PURPA in the future
could increase pressure for electric utilities to renegotiate existing
contracts. Should there be changes in statutory purchase requirements under
PURPA, and should these changes result in amendments which reduce the contracted
rates under the PPA, the Company's 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. Although the FERC generally has exclusive jurisdiction over the rates
charged by an independent power project to its wholesale customers, state public
utility commissions have the practical ability to influence the establishment of
such rates by asserting jurisdiction over the purchasing utility's ability to
pass through the resulting cost of purchased power to its retail customers. In
addition, although thought to be unlikely, states may assert jurisdiction over
the siting and construction of independent power projects and, among other
things, the issuance of securities and the sale and transfer of assets. The
actual scope of jurisdiction over independent power projects by state public
utility regulatory commissions varies from state to state. Presently, through
the PPA, the Scrubgrass Project is indirectly subject to state legislation in
the Commonwealth of Pennsylvania.
On December 3, 1996, in response to changes in the electric industry, the
Commonwealth of Pennsylvania passed new legislation known as the Electricity
Generation Customer Choice and Competition Act (Customer Choice Act) which
became effective on January 1, 1997. The Customer Choice Act provides for the
deregulation of the generation portion of electric business by permitting all
Pennsylvania retail electric customers to choose their electric generation
supplier over a phase-in period which expires December 31, 2000. The Customer
Choice Act required that all electric utilities file restructuring plans with
the Pennsylvania Public Utility Commission ("PAPUC") which, among other things,
included unbundled prices for electric generation, transmission and distribution
and a competitive transition charge ("CTC") for the recovery of "stranded costs"
which would be paid by all customers receiving distribution service and certain
customers that increase their own generation of electricity. "Stranded costs"
generally are electric generation-related costs that traditionally would be
recoverable in a regulated environment but may not be recoverable in a
competitive electric generation market. As such, PENELEC filed a proposed
restructuring plan in 1997 with the PAPUC which was heavily contested by a
number of affected parties. Eventually, the litigation resulted in a settlement
which was approved by the PAPUC on October 20, 1998, and which satisfied all but
one of the litigants. This settlement 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 settlement is currently being appealed in the Commonwealth Court of
Pennsylvania by the party which opposed such settlement. However, the Company
presently does not anticipate that such appeal will have a significant effect,
if any, on PENELEC's restructuring plan as far as that plan affects the
Scrubgrass
21
<PAGE>
Project. Most importantly, the restructuring plan, as approved by the PAPUC,
provided for PENELEC to maintain a separate non-utility generator cost recovery
mechanism for accounting purposes. Therefore, the restructuring plan is
designed, in part, 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.
Presently, neither the Customer Choice Act (and PENELEC's restructuring plan
filed thereunder), nor proposed legislation directly impacts the Company, since
the legislation and restructuring plan pertain to the retail market or new
contracts in the wholesale market. However, as discussed above, the Company
could possibly be impacted in the future by, among other things, increases in
competition as a result of deregulation, or the chance that PENELEC would
attempt to renegotiate the existing power contract. The Company is actively
monitoring these developments in energy proceedings in order to evaluate the
impact on its projects.
Environmental Regulation
The Company's projects are subject to various federal, state and local
regulations pertaining to the protection of the environment, primarily in the
areas of water and air pollution. 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. The Company also has
significant administrative responsibilities to monitor its compliance with the
regulations. As regulations are enacted or adopted in any of these
jurisdictions, the Company cannot predict the effect of compliance therewith on
its business. The Company's failure to comply with all the applicable
requirements could require modifications to operating facilities. During
periods of non-compliance, the Company's operating facilities may be forced to
shutdown until the compliance issues are corrected. The Company 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 Company believes the Scrubgrass Project, its
only operating project, is currently in compliance with all material applicable
environmental regulations. The Scrubgrass Project most notably has been
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 (CAA). CAA Title I established National
Ambient Air Quality Standards (NAAQS) 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
NAAQS in the Northeast. Ozone control is facilitated by the control of
pollutant precursors, which are nitrogen oxides (NOx) and volatile organic
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 (PaDEP)
established regulations that required companies with stationery sources of NOx
emissions to establish plans to reduce their NOx emissions. To administer these
regulations, the PaDEP began allocating Nitrogen Oxide Ozone Transport Region
Budget Allowances ("NOx Credits") to facilities based on numerous
22
<PAGE>
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 (OTC) 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 the OTC's 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 requirements beginning on May 1, 1999 without any modifications to the
facility. However, the Company made capital improvements of $811,568 in Fiscal
1999 to the Scrubgrass facility, which are expected to enable the Scrubgrass
facility to meet the stricter standards in 2003. The Company expects to meet the
NAAQS 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 the handling and disposal of hazardous
and non-hazardous wastes. The PaDEP 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 electric generation process, is removed from the Scrubgrass facility and
returned to the original waste site where it is reclaimed 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, the Company's ash disposal costs may
significantly increase which could have material adverse affect on the Company's
results of operations and financial position.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company's most significant market risk exposure is changing interest rates
which may affect its short-term investments, its debt and certain of its lease
expenses. The Company offers the following information about these market risks:
Short-term investments - The Company invests cash balances which are in excess
of its normal operating requirements in short term investments generally with
maturities of three months or less. Because of the short duration of these
investments, the Company does not believe its short-term investments are subject
to material market risk.
Debt - The Company has borrowings which bear interest at variable rates which
are based on the London Interbank Offering Rate (LIBOR). The Company or the
Lessor monitors market conditions for interest rates and, from time to time,
enters into interest rate swaps to manage its interest payments. The interest
rate swaps have the effect of converting the variable rate borrowings to fixed
rate borrowings for specified time periods. For further information on the
23
<PAGE>
Company's interest rate risk, refer to "Item 2. Management's Discussion and
Analysis of Financial Condition and Results of Operations - Certain Factors That
May Impact Future Results -- Interest Rates".
Lease Expense - The Company, as a lease cost of the Scrubgrass facility, is
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 (LIBOR). The Lessor
monitors market conditions for interest rates and, from time to time, enters
into interest rate swaps to manage the interest payments for the Scrubgrass
facility. The interest rate swaps have the effect of converting the variable
rate borrowings to fixed rate borrowings for specified time periods. For
further information on the Company's interest rate risk, refer to "Item 2.
Management's Discussion and Analysis of Financial Condition and Results of
Operations - Certain Factors That May Impact Future Results -- Interest Rates".
PART II. OTHER INFORMATION
--------------------------
ITEM 1. LEGAL PROCEEDINGS
Scrubgrass Project
On October 11, 1995, the Lessor and the Company (collectively, the "Plaintiffs")
filed a complaint against PENELEC in the Court of Common Pleas of Venango
County, Pennsylvania seeking damages for certain alleged breaches of the PPA.
In its complaint, the Plaintiffs allege that PENELEC failed to pay contract
rates for energy produced by the Facility in excess of 80 MW in any hour, that
PENELEC has misused certain automatic regulation equipment, and that PENELEC has
caused the Plaintiffs to incur losses from its late payment for energy purchased
from the Facility. From October 1995 to September 1996, this legal proceeding
was stayed informally by a letter agreement between the parties. Pursuant to
the letter agreement, PENELEC, which had previously not made any payments for
the energy it received in excess of 80 MW in any hour, agreed to pay for all
energy in excess of 80 MW in any hour, both previously received and to be
received in the future, at a rate equal to 90% of a market based rate, subject
to reimbursement based on the ultimate determination of PENELEC's responsibility
to pay for such energy and the applicable rate therefor. In September 1996, the
Plaintiffs elected to resume the litigation in the Court while PENELEC continued
to pay for all energy in excess of 80 MW in any hour at a rate equal to 90% of a
market based rate.
On August 3, 1999 the Plaintiffs jointly entered into a settlement agreement
with PENELEC to terminate the ongoing litigation. The settlement agreement did
not become effective until the date PENELEC obtained a final non-appealable
Order of the PAPUC approving the settlement agreement in form and substance
acceptable to PENELEC (the "Effective Date"). Under the terms of the settlement
agreement, in full settlement of 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 MW 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
24
<PAGE>
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 January 27, 2000, the PAPUC issued an Order adopting the settlement
agreement. After a 30 day period without any appeals, the Order became final and
non-appealable on February 27, 2000, the Effective Date. On March 24, 2000,
PENELEC remitted to the Scrubgrass Project the outstanding balances due under
the settlement agreement for previous net deliveries of electric energy and
interest which amounted to approximately $3,802,000 and $608,000, respectively.
Sunnyside Project
On May 3, 1996, Sunnyside II L.P. (f/k/a B&W Sunnyside L.P.), Babcock & Wilcox
Investment Company, Sunnyside I, Inc. (f/k/a NRG Sunnyside Inc.), NRG Energy
Inc., and Sunnyside Cogeneration Associates (collectively the "Plaintiffs")
filed a complaint, which was amended on September 27, 1996, December 21, 1998,
and March 17, 1999, against EPC and three of its wholly owned subsidiaries
(collectively hereafter "the Company") in Seventh District Court for Carbon
County, State of Utah (the "Court"). The third amended complaint alleges that
the Company breached the purchase and sale agreement by which the Company
transferred all of its interest in Sunnyside Cogeneration Associates ("SCA"), a
joint venture which owned and operated a nominal 51 megawatt waste coal-fired
facility located in Carbon County, Utah. The third amended complaint also
alleges that the Company made certain misrepresentations in connection with the
purchase and sale agreement. As a result of the alleged breaches of contract and
misrepresentations, the Plaintiffs allege that they suffered damages in an
unspecified amount that exceed the aggregate outstanding principal and interest
balances due to the Company by Sunnyside II L.P. and Sunnyside I, Inc. under
certain notes receivable, which amounted to $2,937,500 and $1,176,006,
respectively at March 31, 2000. On April 9, 1999, in response to the
Plaintiffs' third amended complaint, the Company filed an answer and restatement
of its earlier restated counterclaim dated January 21, 1999. In the answer to
the third amended complaint, the Company denied all material allegations and
asserted numerous affirmative defenses. In the restated counterclaim, the
Company alleges numerous causes of action against the Plaintiffs which include
breach of contract, breach of the promissory notes, intentional, malicious and
willful breach of contract, intentional tort, interference and
misrepresentation. Through the restated counterclaim, the Company seeks
remedies which include: (1) compensatory, consequential and punitive damages;
(2) acceleration and immediate payment in full of the promissory notes; and (3)
injunctions to require the Plaintiffs to continue making payments under the
promissory notes during the pendency of this action and until the promissory
notes are paid in full and which enjoin the Plaintiffs from continuing certain
malicious and intentional actions that are alleged in the counterclaim, together
with interest, reasonable attorney's fees, costs and other such relief as the
court deems proper. On May 17, 1999, the Plaintiffs responded to the restated
counterclaim whereby they denied all material allegations of the restated
counterclaim and asserted numerous affirmative defenses. The Company plans to
vigorously defend against the third amended complaint and vigorously pursue the
causes of action in the restated counterclaim.
On April 15, 1998, the Company filed a motion for summary judgment with respect
to claims regarding the power purchase agreement, seeking dismissal of a portion
of the Plaintiffs' claims. On September 5, 1998, the Plaintiffs responded by
stating their opposition to the Company's April 15, 1998 motion. The Company
and the Plaintiffs appeared in Court on November 19, 1998 to present
25
<PAGE>
oral arguments on the Company's April 15, 1998 motion. On December 30, 1999, the
Court denied the Company's April 15, 1998 motion. The Court found that there
were issues of material fact that would warrant further consideration of the
matter.
On February 12, 1999, the Plaintiffs filed a motion for partial summary judgment
wherein the Plaintiffs alleged that the Company misrepresented whether SCA had a
basis to commence legal proceedings as of December 31, 1994 against PacifiCorp,
the utility purchasing energy from the Sunnyside facility. On April 9, 1999,
the Company filed an opposition to the Plaintiffs' February 12, 1999 motion and
also filed a cross motion for partial summary judgment. In its cross motion,
the Company asserted that the claims at issue in the Plaintiffs' February 12,
1999 motion should be dismissed as a matter of law. The Company and the
Plaintiffs appeared in Court on October 6, 1999 to present oral arguments on
these cross motions. On January 12, 2000, the Court granted the Company's
motion for partial summary judgment and denied the Plaintiffs' motion for
partial summary judgment. The Court based its decision on the grounds that (1)
the portion of the purchase and sale agreement allegedly breached is concerned
with legal proceedings against or adverse to SCA and not advantageous legal
proceedings against third parties; (2) the alleged basis for legal proceedings
was not "material", as required by the purchase and sale agreement, because the
Plaintiffs acquired SCA even though the Plaintiffs had prior knowledge of the
alleged basis for legal proceedings; and (3) because the Plaintiffs were aware
of the alleged basis for legal proceedings, any failure by the Company to
disclose such basis for legal proceedings in the purchase and sale agreement was
not the cause of the Plaintiffs' loss, if any. On February 15, 2000, the
Plaintiffs filed a request for the Court to reconsider its January 12, 2000
decision. On February 28, 2000, the Company opposed the Plaintiffs' request for
the Court to reconsider its January 12, 2000 decision. Discovery remains
ongoing.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibit 11 - Computation of Earnings Per Share
(b) Reports on Form 8-K - None
SIGNATURES
----------
Pursuant to the requirements 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.
ENVIRONMENTAL POWER CORPORATION
May 12, 2000 /s/ William D. Linehan
-----------------------------
William D. Linehan
Treasurer and
Chief Financial Officer
(principal accounting officer
and authorized officer)
26
<PAGE>
EXHIBIT 11
----------
ENVIRONMENTAL POWER CORPORATION
COMPUTATION OF EARNINGS PER SHARE
<TABLE>
<CAPTION>
Income SHARES PER SHARE
(Numerator) (DENOMINATOR) AMOUNTS
------------- --------------- ---------
<S> <C> <C> <C>
Three Months Ended March 31, 2000:
- ----------------------------------
Income available to shareholders $2,086,589 11,406,783 $.18
Effect of dividends to preferred stockholders (1,250)
----------- ----------- --------
Basic EPS - income available to common shareholders 2,085,339 11,406,783 .18
Effect of dilutive securities:
Assumed exercise of dilutive stock options 543
----------- ----------- --------
Diluted EPS - income available to common shareholders $2,085,339 11,407,326 $.18
=========== =========== ========
THREE MONTHS ENDED MARCH 31, 1999:
- ----------------------------------
Income available to shareholders $1,062,948 11,406,783 $.09
Effect of dividends to preferred stockholders (1,250)
----------- ----------- --------
Basic EPS - income available to common shareholders 1,061,698 11,406,783 .09
Effect of dilutive securities:
Assumed exercise of dilutive stock options
----------- ----------- --------
Diluted EPS - income available to common shareholders $1,061,698 11,406,783 $.09
=========== =========== ========
</TABLE>
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM CONDENSED
CONSOLIDATED FINANCIAL STATEMENTS FOR THE COMPANY AS OF MARCH 31, 2000 AND MARCH
31, 1999 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL
STATEMENTS.
</LEGEND>
<RESTATED>
<S> <C> <C>
<PERIOD-TYPE> 3-MOS 3-MOS
<FISCAL-YEAR-END> DEC-31-2000 DEC-31-1999
<PERIOD-START> JAN-01-2000 JAN-01-1999
<PERIOD-END> MAR-31-2000 MAR-31-1999
<CASH> 2,430,563<F1> 2,158,771<F2>
<SECURITIES> 0 0
<RECEIVABLES> 4,106,154 3,651,418
<ALLOWANCES> 0 0
<INVENTORY> 592,622 658,661
<CURRENT-ASSETS> 7,150,321 6,512,984
<PP&E> 1,076,716 282,035
<DEPRECIATION> 353,720 159,979
<TOTAL-ASSETS> 62,633,443 54,945,363
<CURRENT-LIABILITIES> 7,695,607 6,854,211<F3>
<BONDS> 2,400,462 2,848,358
0 0
100 100
<COMMON> 125,254 125,254
<OTHER-SE> (3,510,784) (5,793,681)<F3>
<TOTAL-LIABILITY-AND-EQUITY> 62,633,443 54,945,363
<SALES> 16,768,555 12,347,003
<TOTAL-REVENUES> 16,768,555 12,347,003
<CGS> 5,239,505 4,826,350<F3>
<TOTAL-COSTS> 5,239,505 4,826,350<F3>
<OTHER-EXPENSES> 7,651,398 5,628,452
<LOSS-PROVISION> 0 0
<INTEREST-EXPENSE> 92,004 84,883
<INCOME-PRETAX> 3,726,589 1,800,948
<INCOME-TAX> 1,640,000 738,000<F3>
<INCOME-CONTINUING> 2,086,589 1,062,948
<DISCONTINUED> 0 0
<EXTRAORDINARY> 0 0
<CHANGES> 0 0
<NET-INCOME> 2,086,589 1,062,948
<EPS-BASIC> .18 .09
<EPS-DILUTED> .18 .09
<FN>
<F1> Includes cash of $494,263 which is restricted in use.
<F2> Includes cash of $1,619,903 which is restricted in use.
<F3>The Company's financial data as of and for the three months ended
March 31, 1999 has been restated to reflect a change in the method of
accounting for major equipment overhauls.
</FN>
</TABLE>
