UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-QSB

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2006

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to .

Commission File No. 000-31953

CATALYTICA ENERGY SYSTEMS, INC.

(Exact name of Registrant as specified in its charter)

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

1388 North Tech Boulevard
Gilbert, Arizona 85233
(Address of principal executive offices)

(480) 556-5555
(Registrant’s telephone number, including area code)

Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act during the past 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 o

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o No x

As of August 7, 2006 there were outstanding 18,227,096 shares of the issuer’s common stock, par value $0.001, which is the only class of common stock outstanding.

Transitional Small Business Disclosure Format (check one): Yes o No x

CATALYTICA ENERGY SYSTEMS, INC.

FORM 10-QSB

June 30, 2006

TABLE OF CONTENTS

	Page No.
PART I. FINANCIAL INFORMATION		3

Item 1. Financial Statements		3

Consolidated Statements of Operations for the three and six-months ended June 30, 2006 and 2005 (Unaudited)		3

Consolidated Balance Sheet at June 30, 2006 (Unaudited)		4

Consolidated Statements of Cash Flows for the six-months ended June 30, 2006 and 2005 (Unaudited)		5

Notes to Unaudited Consolidated Financial Statements		6

Item 2. Management’s Discussion and Analysis or Plan of Operation		13

Item 3. Controls and Procedures		39

PART II. OTHER INFORMATION		40

Item 1. Legal Proceedings		40

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		40

Item 3. Defaults Upon Senior Securities		40

Item 4. Submission of Matters to a Vote of Security Holders		40

Item 5. Other Information		40

Item 6. Exhibits		41

Signatures		45

PART I - FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

CATALYTICA ENERGY SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

for the three and six-months ended June 30, 2006 and 2005

(In thousands, except per share amounts)

(Unaudited)

	Three Months Ended June 30,						Six Months Ended June 30,
	2006			2005			2006			2005

Revenues
SCR catalyst & management services	$	957		$	184		$	3,936		$	927
Research and development	—			578			—			1,134
Total revenues	957			762			3,936			2,061

Costs and expenses:
Cost of revenues	845			1,192			2,415			2,362
Research and development	1,443			1,633			3,063			3,681
Selling, general and administrative	1,767			1,591			3,838			3,450
Total costs and expenses	4,055			4,416			9,316			9,493

Operating loss	(3,098		)	(3,654		)	(5,380		)	(7,432		)

Interest and other income	257			325			863			724
Interest expense	(49		)	(161		)	(98		)	(320		)

Net loss	$	(2,890	)	$	(3,490	)	$	(4,615	)	$	(7,028	)

Basic and diluted net loss per share	$	(0.16	)	$	(0.19	)	$	(0.25	)	$	(0.39	)

Weighted average shares used in computing basic and diluted net loss per share	18,171			17,996			18,164			17,963

See accompanying notes.

CATALYTICA ENERGY SYSTEMS, INC.

CONSOLIDATED BALANCE SHEET

at June 30, 2006

(In thousands)

(Unaudited)

ASSETS
Current assets:
Cash and cash equivalents	$	1,334
Short-term investments	16,397
Accounts receivable, net	514
Inventory	780
Prepaid expenses and other assets	327
Total current assets	19,352
Property and equipment:
Leasehold improvements	3,876
Equipment	7,003
Less accumulated depreciation and amortization	(9,157		)
Total property and equipment	1,722

Goodwill	4,257
Land and building held for sale, net	3,887
Other intangible assets	1,324
Other assets	289
Total assets	$	30,831

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	583
Accrued payroll and benefits	904
Accrued liabilities and other	1,708
Current portion of long-term debt and other long-term liabilities	48
Total current liabilities	3,243

Long-term debt and other long-term liabilities	2,977
Total liabilities	6,220

Stockholders’ equity:
Common stock	18
Additional paid-in capital	167,746
Accumulated deficit	(143,099		)
Accumulated other comprehensive loss	(54		)
Total stockholders’ equity	24,611
Total liabilities and stockholders’ equity	$	30,831

See accompanying notes.

CATALYTICA ENERGY SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

for the six-months ended June 30, 2006 and 2005

(In thousands)

(Unaudited)

	Six Months Ended June 30,
	2006			2005
Cash flows from operating activities:
Net loss	$	(4,615	)	$	(7,028	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation of property and equipment	475			579
Amortization of investments premium	(9		)	33
Amortization of intangible assets	86			86
Accretion of interest on long-term debt	—			219
Forgiveness of notes receivable from related parties	—			20
Stock based compensation	144			3
Remeasurement of present value of long-term debt	—			(62		)
Loss on sale of property and equipment	50			4
Credit for uncollectible accounts	—			(192		)
Changes in:
Trade accounts receivable	920			645
Inventory	206			(30		)
Prepaid expenses and other assets	(11		)	215
Accounts payable	298			74
Accrued payroll and benefits	(123		)	(94		)
Accrued liabilities and other	(894		)	(272		)
Net cash used in operating activities	(3,473		)	(5,800		)

Cash flows from investing activities:
Purchases of investments	(2,405		)	(33,627		)
Maturities of investments	5,870			15,382
Sale of property and equipment	2			10
Additions to property and equipment	(155		)	(277		)
Net cash provided by (used in) investing activities	3,312			(18,512		)

Cash flows from financing activities:
Collection of notes receivable from employees	—			187
Repayments of long-term debt	(21		)	(32		)
Proceeds from issuance of capital lease obligations	—			25
Repayments of capital lease obligations	(2		)	(2		)
Proceeds from the exercise of stock options	3			68
Proceeds from issuance of common stock through stock plans	25			104
Net cash provided by financing activities	5			350

Net decrease in cash and cash equivalents	(156		)	(23,962		)
Cash and cash equivalents at beginning of period	1,490			26,901
Cash and cash equivalents at end of period	$	1,334		$	2,939

Additional disclosure of cash flow information:
Deferred compensation for issuance and revaluation of stock options to non-employees	$	—		$	(2	)
Interest paid	$	94		$	96

See accompanying notes.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Note 1. Description of Business and Significant Accounting Policies

Description of Business. Catalytica Energy Systems, Inc. (“Catalytica Energy,” “the Company,” “we,” “us” or “our”) provides innovative products and services to meet the growing demand for emissions control solutions in the power generation and transportation industries. Through our SCR-Tech subsidiary, we offer a variety of services for coal-fired power plants that use selective catalytic reduction (“SCR”) systems to reduce nitrogen oxides (“NOx”) emissions. These services include SCR catalyst management, cleaning and regeneration, as well as consulting services to help power plant operators optimize efficiency and reduce overall NOx compliance costs (collectively “SCR Catalyst and Management Services”). Our business activities also include the design, development, manufacture and servicing of advanced products based on our proprietary catalyst and fuel processing technologies to offer cost-effective solutions for reducing diesel engine emissions. Our Xonon® Diesel Fuel Processing technology is designed to facilitate a significant reduction in NOx and particulate matter (“PM”) emissions from mobile and stationary diesel engine applications by improving the performance of NOx adsorber catalyst systems and diesel particulate filters.

We are currently conducting our business through the following two business segments (see Note 6 in Notes to Unaudited Consolidated Financial Statements for business segment disclosures):

· Catalyst regeneration, rejuvenation, cleaning and management services for SCR systems used by coal-fired power generation facilities to reduce NOx emissions – our SCR Catalyst and Management Services segment (“SCMS”); and

· Designing, developing and manufacturing advanced products based on our proprietary catalyst and fuel processing technologies, primarily focused on cost-effective solutions for reducing emissions from diesel engine applications – our Catalyst-Based Technology Solutions segment (“CBTS”).

Included in our CBTS segment is our Xonon Cool Combustion® catalytic combustion technology for gas turbines. In 2005, we ceased development and commercialization activities associated with this technology. On June 30, 2006, we entered into a definitive agreement with Kawasaki Heavy Industries, Ltd. (“Kawasaki”) for the sale of the technology and associated gas turbine assets for $2.1 million. This transaction is expected to be completed by the end of August 2006, subject to customary closing conditions, the delivery of assets, and the securing of certain consents. The book value at June 30, 2006 of the assets being sold was approximately $230,000.

Unaudited Interim Financial Information. The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles for interim financial information generally accepted in the United States and with the instructions to Form 10-QSB and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. For further information, refer to the financial statements and footnotes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2005, filed with the Securities and Exchange Commission on March 30, 2006. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and six-month periods ended June 30, 2006 are not necessarily indicative of the results that may be expected for the full fiscal year ending December 31, 2006.

Use of Estimates. The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.

Reclassifications. Certain amounts in the prior periods’ financial statements have been reclassified to conform to the current presentation.

SCR Catalyst and Management Services Revenues. As prescribed in Staff Accounting Bulletin (“SAB”) 101 and 104, “Revenue Recognition in Financial Statements”, the Company recognizes revenue from SCR Catalyst and Management Services when persuasive evidence of an arrangement exists, services have been rendered, the price is fixed or determinable, and collectibility is reasonably assured.

Revenues related to SCR catalyst regeneration and cleaning services are recognized when the service is completed for each catalyst module. Customer acceptance is not required for regeneration and cleaning services in that SCR-Tech’s contracts currently provide that services are completed upon receipt of testing results by independent third parties confirming compliance with contract requirements. Testing generally occurs three times during a particular customer project – at the beginning of the processing, when approximately one-half of the project has been processed, and upon completion of processing. A typical customer project may take 30 to 90 days to complete. Once a successful test result is received from an independent third party, revenue is recognized for each catalyst module processed prior to the receipt of such test results, and revenue is subsequently recognized for each catalyst module as its processing is completed. As the Company utilizes a consistent methodology and formula for each project, it is unlikely that subsequent testing would not be successful. Nonetheless, if a subsequent test result were to indicate failure, the Company would cease recognizing revenue on any subsequent modules until new testing evidence confirms successful processing. We maintain a revenue allowance to provide for any deficient test results that may occur after our initial test.

From time to time, SCR-Tech purchases spent catalyst modules, regenerates them and subsequently sells them to customers as refurbished units. In such cases, revenues are not recognized until the units are delivered to the customer.

Due to the nature of the demand for SCR regeneration and cleaning services, some of our contracts provide for extended payment terms. In a situation where the project for a customer is complete, but the customer is not contractually committed to receive an invoice within the succeeding six months (and subsequent payment is due within 30 days of invoice date), revenues are deferred until the six month criterion is met. If the customer contract provides for a deposit or progress payments, we recognize revenue up to the amount invoiced. No rights of return exist. The customer is responsible for the removal, transportation and subsequent installation of the catalyst. Our revenue arrangements do not have any material multiple deliverables as defined in Emerging Issues Task Force (“EITF”) 00-21, “Accounting for Multiple Element Revenue Arrangements”.

Costs associated with performing SCR catalyst regeneration and cleaning services are expensed as incurred because of the close correlation between the costs incurred, the extent of performance achieved and the revenue recognized. In the situation where revenue is deferred due to collectibility uncertainties, the Company does not defer costs due to the uncertainties related to payment for such services.

We recognize revenue from our management and consulting services as work is performed. Costs associated with management and consulting services are expensed as incurred.

SCR Catalyst and Management Services revenue is project-based, and as such, the timing of those revenues varies from period-to-period. Accordingly, period-to-period comparisons of those revenues are not necessarily meaningful and should not be relied upon as an indication of future performance.

Research and Development (“R&D”) Revenues. Research and development (“R&D”) revenues are recognized as contractual services are performed and are recognized in accordance with contract terms, principally based on reimbursement of total costs and expenses incurred. Revenues from government funded R&D programs are often multi-year, cost reimbursement or cost-share types of contracts. We are reimbursed for reasonable and allocable costs up to the reimbursement limits set by the contract. In many cases, we are reimbursed for only a portion of the costs incurred under the contract. The Company generally shares in the cost of these programs with cost-sharing percentages between 30% and 50%. We rely on general revenue recognition guidance, as prescribed in SAB 104, to determine whether persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price is fixed and determinable, and collection is reasonably assured.

While government research and development contracts may extend over multiple years, funding is generally provided incrementally on an annual basis with authorization of funds by Congress. Should funding be temporarily delayed or if the Company’s strategic objectives change, we may choose to devote resources to other activities, including internally funded R&D programs.

No amounts recognized as revenue are refundable. In return for funding, collaborative partners may receive certain rights in the commercialization of any resulting technology, including royalty payments on future sales (see “-Other Commitments”). Most of our R&D contracts are also subject to periodic review by our funding partners, which could result in schedule delays or modifications to project scope, including reduction or termination of funding.

We enter into contracts with government agencies as funding sources to help defray costs of commercializing our emissions control-related technologies. The federal government is not the sole or principal expected end-use customer for the research and development or for products directly resulting from the R&D activity funded by the contract. We believe the funding derived from those sources is incidental to our anticipated costs of bringing the technologies we develop, with government funding support, to the marketplace. As such, we believe it is appropriate to present R&D revenues on a gross, rather than net, basis in the statement of operations.

Accounts Receivable. Accounts receivable consists of trade receivables generated from research and development contracts, trade receivables from SCR Catalyst and Management Services and revenues in excess of billings from SCR Catalyst and Management Services. Trade receivables are recorded at the invoiced amount. Payment terms for SCR catalyst regeneration and cleaning services are typically defined in the contract for services rendered. Revenues may be earned for those services in advance of amounts billable to the customer and are recognized when the service is complete, unless the contract terms will not result in invoice generation within six months from the date of completion of those services. Revenues recognized in excess of amounts billed are recorded as accounts receivable. Revenues in excess of billings represented $185,000 and $0 of net accounts receivable as of June 30, 2006 and 2005, respectively.

Inventory. Raw materials inventory consists of chemicals used in the regeneration of SCR catalyst modules and precious metals used in research and development. Production hardware inventory consists of finished Xonon® modules which are subject to the pending sale to Kawasaki. The components of inventory at June 30, 2006 were as follows:

Raw Materials	$	549,000
Production Hardware	231,000
	$	780,000

Land and Building Held For Sale. On April 18, 2006, the Company entered into an agreement for the sale of its Gilbert, Arizona facility. In accordance with SFAS No. 144, the Company ceased depreciating the building on that date. As of June 30, 2006, the combined cost of the land and building was $4,438,000 and the accumulated depreciation was $551,000. The sale was completed on July 19, 2006 at a price of $4,815,000.

Goodwill and Other Intangible Assets. The Company accounts for goodwill and other intangible assets in accordance with the provisions of SFAS No. 141, “Business Combinations”, and SFAS No. 142, “Goodwill and Other Intangible Assets”. Purchase prices of acquired businesses that are accounted for as purchases have been allocated to the assets and liabilities acquired based on the estimated fair values on the respective acquisition dates. Based on these values, the excess purchase prices over the fair value of the net assets acquired were allocated to goodwill. Pursuant to SFAS No. 142, goodwill and other intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but instead tested for impairment at least annually in accordance with the provisions of SFAS No. 142. SFAS No. 142 also requires that intangible assets with estimable useful lives be amortized over their respective estimated useful lives to their estimated residual values and reviewed for impairment in accordance with SFAS No. 144, “Accounting for Impairment or Disposal of Long-Lived Assets.”

Goodwill represents the excess of costs over fair value of acquired net assets, including other intangible assets. Other intangible assets that have finite useful lives, including patents, trademarks, trade secrets and other purchased technology, are recorded at fair value at the time of the acquisition, and are carried at such value less accumulated amortization. The Company amortizes these intangible assets on a straight-line basis over their useful lives, estimated at ten years.

Goodwill and other intangible assets relate only to the SCMS business segment. The carrying amounts and related accumulated amortization of goodwill and other intangible assets at June 30, 2006 were as follows (in thousands):

	June 30, 2006
	Carrying		Accumulated
	Amount		Amortization

Goodwill	$	4,257

Other Intangible Assets
Intellectual property	$	1,727	$	(403	)

Amortization expense of other intangible assets was $86,000 during both the six-month periods ended June 30, 2006 and 2005. The Company expects amortization expense will approximate $87,000 for the remainder of the fiscal year. For fiscal years 2007 through 2010, the Company estimates amortization expense will approximate $173,000 per year.

Accrued Warranty Liability. The Company warrants its Xonon Cool Combustion® catalytic modules for a period of 8,000 hours of operation or five years from first firing, whichever comes first. The Company’s obligations under this warranty are limited to repair or replacement of any defective Xonon Cool Combustion module(s). Warranties provided for the Company’s SCR catalyst cleaning and regeneration services vary by contract, but typically provide limited performance guarantees and complete structural warranties. Estimated warranty obligations related to Xonon Cool Combustion modules are based on the number of modules in operation and are recorded as a cost of revenues.

Estimated warranty obligations related to SCR catalyst cleaning and regeneration services are provided for as cost of revenues in the period in which the related revenues are recognized. Adjustments are made to accruals as warranty claim data and historical experience warrant. Our warranty obligation may be materially affected by product or service failure rates and other costs incurred in correcting a product or service failure. Should actual product or service failure rates or other related costs differ from our estimates, revisions to the estimated warranty liability would be required.

The accrued warranty liability balance was $175,000 at June 30, 2006.

Revenue Cost Reserves. Revenues from our funded research and development contracts are recorded as work is performed and billable hours are incurred by us, in accordance with each contract. Since these programs are subject to government audits, we maintain a revenue cost reserve for our government-funded programs in the event any of these funded costs, including overhead, are disallowed. We estimate this reserve by applying a percentage to the revenues recorded under contracts still subject to audit by those funding agencies.

The revenue cost reserve balance was $106,000 at June 30, 2006.

Income Taxes. Financial Accounting Standards Board (“FASB”) SFAS No. 109, “Accounting for Income Taxes”, requires that a valuation allowance be established when it is more likely than not that all or a portion of a deferred tax asset will not be realized. SFAS No. 109 further states that it is difficult to conclude that a valuation allowance is not needed when there is negative evidence such as cumulative losses in recent years. As a result we have recorded a full valuation allowance against our deferred tax assets and expect to continue to record a full valuation allowance on future tax benefits until we reach sustained profitability.

Recent Accounting Standards. In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections” (“SFAS No. 154”), which replaces APB Opinion No. 120, “Accounting Changes,” and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statements”. SFAS No. 154 changes the requirements for accounting and reporting a change in accounting principle, and applies to all voluntary changes in accounting principles. Specifically, SFAS No. 154 requires retrospective application to prior periods’ financial statements. When it is impracticable to determine the effects of the change, the new accounting principle must be applied to the balances of assets and liabilities as of the beginning of the earliest period for which retrospective application is practicable and a corresponding adjustment must be made to the opening balance of retained earnings for that period

rather than being reported in an income statement. SFAS No. 154 became effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. No events which would be subject to the provisions of SFAS No. 154 occurred during the periods presented, however, should such an event occur in the future, our financial statements would be affected.

Note 2. Net Loss per Share

Basic and diluted net loss per share is presented in accordance with SFAS No. 128, “Earnings Per Share.” The Company’s potentially dilutive securities (stock options) were anti-dilutive for the three and six-months ended June 30, 2006 and 2005 because the Company incurred a net loss for each of those periods. Therefore, such potentially dilutive securities have been excluded from the computation of weighted-average shares outstanding used in computing diluted net loss per share. Total potentially dilutive securities outstanding as of June 30, 2006 and 2005 were approximately 2,710,000 and 3,102,000, respectively.

Note 3. Stock Based Compensation

The Company has a Stock Option Plan, which allows for the granting of restricted stock units (“RSUs”), and an Employee Stock Purchase Plan (the “ESPP”), which are both considered stock-based compensation plans. Prior to January 1, 2006, the Company accounted for those plans under the recognition and measurement provisions of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations, as permitted by SFAS No. 123, “Accounting for Stock-based Compensation.” No stock-based employee compensation cost was recognized in the Consolidated Statements of Operations for the three and six-month periods ended June 30, 2005 as all options granted under the Stock Option Plan had exercise prices equal to the market value of the underlying common stock on the date of grant and no RSUs had yet been granted. The ESPP was considered non-compensatory under APB No. 25. Total compensation for share-based compensation arrangements recognized in the three and six-month periods ended June 30, 2006 was $126,000 and $144,000, respectively.

Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS No. 123(R), Share-Based Payment, using the modified prospective method. Compensation cost recognized in the three and six-month periods ended June 30, 2006, therefore, includes compensation cost for all stock options granted subsequent to December 31, 2005, based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123(R). Results for prior periods have not been restated. The Company had no granted but not yet exercisable stock options outstanding at December 31, 2005. The Company continues to amortize the fair value at the date of grant of RSUs over their related vesting periods, however, pursuant to SFAS No. 123(R), the amount amortized is reduced by an estimated forfeiture rate. The ESPP includes a provision which allows for purchases of the Company’s common stock at a 15% discount which causes it to be considered compensatory under SFAS No. 123(R).

Adoption of SFAS No. 123(R) had the effect of increasing net loss for the six-month period ended June 30, 2006 by $121,000 or $.01 per share. Had the Company applied the fair value recognition provisions of SFAS No. 123(R) to options granted under the Stock Option Plan and share purchases pursuant to the ESPP in the six-month period ended June 30, 2005, the Company’s net loss would have increased by $311,000 or $.02 per share for that period. For purposes of this comparison, the value of the options was estimated using a Black-Scholes option pricing formula and amortized to expense over the options’ original vesting periods. The ESPP valuation used a Black-Scholes model and amortized the expense over the 6-month subscription period. The adoption of SFAS No. 123(R) had no effect on cash flow.

The following tables summarize stock option plan activity since the adoption of SFAS No. 123(R):

					Weighted
			Weighted		Average
			Average		Contractual	Aggregate
	Number		Exercise		Term	Intrinsic
	of Shares		Price		(Years)	Value
Outstanding at December 31, 2005	2,415,337		$	5.21
Granted	634,200		1.15
Exercised	(15,000	)	0.40
Expired	(365,228	)	6.48
Outstanding at June 30, 2006	2,669,309		$	4.10	7.32	$	209,994
Vested or expected to vest at June 30, 2006	2,450,637		$	4.36	7.06	150,953
Exercisable at June 30, 2006	2,148,813		$	4.82	6.74	69,460

The weighted-average fair value of options granted during the six-month period ended June 30, 2006 was $.7234. The total intrinsic value of options exercised during the period was $17,000. The fair value of each stock option award is estimated using a Black-Scholes option pricing formula with the following assumptions:

	Six Months
	Ended
	June 30, 2006
Expected dividend yield	0.0	%
Expected stock price volatility	66.8	%
Risk-free interest rate	4.72	%
Expected life of options	4.0 years

The following table summarizes RSU activity during the six-month period ended June 30, 2006:

	Number		Grant-Date
	of Shares		Fair Value
Nonvested at December 31, 2005	46,875		$	1.50
Granted	—
Vested	(6,250	)	1.50
Forfeited	—
Nonvested at June 30, 2006	40,625		1.50

As of June 30, 2006, there was $364,000 of total unrecognized compensation cost related to nonvested share-based compensation arrangements under the plan. That cost is expected to be recognized over a period of 1.74 years. The total fair value of shares vested during the three and six-month periods ended June 30, 2006 was $4,000 and $8,000, respectively.

The issuance of shares pursuant to the exercise of stock options is done through a third party broker who acquires the shares on the open market. Issuances in connection with the vesting of RSUs or ESPP purchases are accomplished with new shares.

Note 4. Debt Agreements. In March 2002, we received a term loan of $3,010,000 from the Arizona State Compensation Fund. Proceeds of this loan were applied to the purchase of a 43,000 square foot manufacturing and administrative facility in Gilbert, Arizona. In August 2004, the remaining $2,940,254 principal balance on this loan was refinanced with a five-year term loan, which bears interest at a fixed annual rate of 6.5% and matures in April 2009. Under the terms of this new loan, payments of principal and interest totaling $19,105 are due monthly with a final principal payment of $2,737,228 due at maturity. This loan is secured by a deed of trust in the acquired real property.

On July 19, 2006, the Company sold the Gilbert, Arizona facility and repaid the remaining balance of the loan along with prepayment penalties totaling $90,000.

Note 5. Comprehensive Loss. The components of comprehensive loss are as follows (in thousands):

	Three Months Ended June 30,						Six Months Ended June 30,
	2006			2005			2006			2005

Net loss	$	(2,890	)	$	(3,490	)	$	(4,615	)	$	(7,028	)
Other comprehensive loss:
Change in unrealized loss on available-for-sale securities recognized in other comprehensive loss	7			16			10			(42		)
Comprehensive loss	$	(2,883	)	$	(3,474	)	$	(4,605	)	$	(7,070	)

The components of accumulated other comprehensive loss at June 30, 2006 are as follows (in thousands):

Unrealized loss on available-for-sale securities	$	(54	)

Accumulated other comprehensive loss	$	(54	)

Note 6. Segment Disclosures. SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information”, requires disclosures of certain information regarding operating segments, products and services, geographic areas of operation and major customers. The method for determining what information to report under SFAS No. 131 is based upon the “management approach,” or the way that management organizes the operating segments within the Company, for which separate financial information is available that is evaluated regularly by the Chief Operating Decision Maker (“CODM”) in deciding how to allocate resources and in assessing performance. Our CODM is our Chief Executive Officer.

We have the following two reportable operating segments:

· Catalyst regeneration, rejuvenation, cleaning and management services for SCR systems used by coal-fired power generating facilities to reduce NOx emissions – our SCR Catalyst and Management Services segment (“SCMS”).

· Designing, developing and manufacturing advanced products based on our proprietary catalyst and fuel processing technologies primarily focused on cost-effective solutions for reducing emissions from diesel engine applications – our Catalyst-Based Technology Solutions segment (“CBTS”).

All intercompany transactions are eliminated in consolidation and there are no differences between the accounting policies used to measure profit and loss for our operating segments and on a consolidated basis. The Company evaluates performance of segments based on profit or loss from operations before interest and income taxes. Segment costs and expenses considered in deriving segment operating income include cost of revenues, depreciation and amortization, research and development, and selling, general and administrative expenses. The Company does not allocate corporate general and administrative expenses (“corporate SG&A”) on a segment basis for internal management reporting; corporate SG&A is reported within the CBTS segment. Financial performance of the segments is evaluated primarily on operating income.

The following table presents information about our reportable operating segments (in thousands):

	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2006			2005			2006			2005
Total revenue
CBTS	$	—		$	578		$	—		$	1,134
SCMS	957			184			3,936			927
Consolidated	$	957		$	762		$	3,936		$	2,061

Operating income/(loss)
CBTS	$	(2,825	)	$	(3,075	)	$	(5,999	)	$	(6,635	)
SCMS	(273		)	(579		)	619			(797		)
Consolidated	$	(3,098	)	$	(3,654	)	$	(5,380	)	$	(7,432	)

Depreciation and amortization (1)
CBTS	$	140		$	266		$	315		$	453
SCMS	135			107			246			212
Consolidated	$	275		$	373		$	561		$	665

Capital expenditures
CBTS	$	—		$	79		$	68		$	175
SCMS	57			61			87			102
Consolidated	$	57		$	140		$	155		$	277

(1) Depreciation of fixed assets and amortization of intangible assets. Operating loss, excluding this depreciation and amortization, constitutes EBITDA by segment which is the basis of evaluation used by the Chief Operating Decision Maker.

Total assets classified by the Company’s two reportable segments are shown below (in thousands):

	June 30,
	2006
Total assets
CBTS	$	22,364
SCMS	8,467
Consolidated	$	30,831

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION

This Management’s Discussion and Analysis and other parts of this Report on Form 10-QSB contain forward-looking statements that involve risks and uncertainties. The words “anticipates,” “believes,” “expects,” “intends,” “will” and similar expressions identify forward-looking statements, which are based on information available to us on the date hereof. We assume no obligation to update any such forward-looking statements.

Forward-looking statements in this report may include, but are not limited to statements regarding:

· our market opportunities and the growth of the market for our product and service offerings

· our ability to identify opportunities to streamline our operations and reduce overhead

· our ability to capitalize on any long-term commercial prospects and maintain financial viability

· the long-term commercial prospects for our Company;

· the outcome of any strategic initiatives that we may decide to take, including additional headcount reductions, discontinuing other business activities and downsizing our facilities

· the nature of our asset and technology base

· our business strategies and plan of operations

· our competitive advantage in the marketplace

· the nature and level of competition for our product and service offerings

· the efficiency and efficacy of our product and service offerings

· the cost-effectiveness of our product and service offerings

· our commitment to funded research programs

· the level of research and development by original equipment manufacturer (“OEM”) partners

· our ability to integrate our products with OEM solutions

· the availability and expense of resources and raw materials necessary for production and manufacturing

· the timing of our testing activities, our development programs, and the commercialization of our products

· the future research, development and commercialization costs of our products

· the value of our intellectual property and effectiveness of our patent portfolio

· the ability of our management to adapt to changing circumstances

· our relations with employees

· the cost of emissions reduction technology and its effects

· the applicability of our solutions to different diesel engine applications

· the successful development and market potential of our diesel products

· the existing and proposed emissions restrictions on power generating sources and diesel engines used in transportation applications due to environmental concerns

· the likelihood of downsizing, discontinuing or pursuing other strategic alternatives related to our diesel emissions reduction business and the financial effect of any such actions

· the effects of our decision to discontinue development and commercial activities associated with our Xonon Cool Combustion product for gas turbines

· the value of our Xonon-equipped gas turbine business in a sale transaction

· the uniqueness, potential and market for our SCR catalyst and management services

· our ability to manage SCR-Tech

· the role of catalyst regeneration in the catalyst replacement market

· the effect of the acquisition of SCR-Tech

· the adequacy of SCR-Tech’s facilities

· our forecast of revenues and results of operations

· the nature and amount of concentration of customers for SCR-Tech

· the effectiveness of testing of regenerated and cleaned SCR modules by independent third parties and the effect of such testing on revenue recognition

· our investment in research and development

· sources and amounts of our revenues and the timing of revenue recognition

· the level, amount and consistency of our revenues

· our use of earnings

· our ability to generate cash and the sufficiency of existing cash and cash equivalents

· our funding requirements and potential sources of funding

· predictions as to the amount and nature of anticipated losses and whether we will achieve profitability

· our anticipated SG&A and capital expenditures

· our liquidity and the effect or our actions on our liquidity

· the impact of interest income and expense

· the level and amount of our expenses

· predictions as to when we may incur material income taxes

· the financial effect of the sale of our Gilbert, Arizona facility

· the likelihood or effect of any claims arising out of our spin-off from Catalytica, Inc.

· the likelihood of completing the sale of our Xonon Cool Combustion technology and gas turbine assets to Kawasaki.

· the likelihood or effect of any litigation with Kawasaki

· critical accounting policies and the effect of such policies on our financial statements

Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth in “Risks That Could Affect Our Financial Condition and Results of Operations” and elsewhere in this Quarterly Report on Form 10-QSB.

Overview

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

We provide innovative products and services for emissions control in the power generation and transportation industries. Our business is focused on the emissions control market, with a primary focus on nitrogen oxides (“NOx”). Increasingly stringent air quality regulations have resulted in tighter emissions restrictions being imposed on a variety of combustion-related applications. NOx emissions, which are a precursor to smog formation, have become a key target of government-imposed emissions regulations, creating a significant opportunity for innovative, cost-effective NOx control solutions.

Through our SCR-Tech subsidiary, we offer a variety of services for coal-fired power plants that use SCR systems to reduce NOx emissions. These services include SCR catalyst management, cleaning and regeneration, as well as consulting services to help power plant operators optimize efficiency and reduce overall NOx compliance costs (collectively “SCR Catalyst and Management Services”). Our business activities also include the design, development, manufacture and servicing of advanced products based on our proprietary catalyst and fuel processing technologies to offer cost-effective solutions for reducing diesel engine emissions. Our Xonon® Diesel Fuel Processing technology is designed to facilitate a significant reduction in NOx and PM emissions from mobile and stationary diesel engine applications by improving the performance of NOx adsorber catalyst systems and diesel particulate filters.

In September 2005, we discontinued development of our diesel retrofit product. In October 2005, we completed work on our Department of Energy-funded development of a compact fuel processor that sought to convert conventional fuels to hydrogen to power proton exchange membrane fuel cells and we are no longer conducting research or development activities associated with fuel processing for fuel cell applications. In February 2006, we announced that we are no longer conducting development or commercial activities associated with our Xonon Cool Combustion product for gas turbines. On June 30, 2006 we entered into a definitive agreement with Kawasaki for the sale of our Xonon Cool Combustion® catalytic combustion technology and associated gas turbine assets for $2.1 million. This transaction is expected to be completed by the end of the third quarter of 2006, subject to customary closing conditions, the delivery of assets, and the securing of certain consents.

We plan to continue evaluating our business in 2006 to identify opportunities to further streamline our operations and reduce overhead as we seek to enhance our ability to capitalize on the longer-term commercial prospects we anticipate for the Company and maintain financial viability. The outcome of this evaluation could include additional headcount reductions, discontinuing other business activities, downsizing our facilities, and other strategic initiatives to seek to realize value from our diverse asset and technology base and reduce cash consumption.

We are currently conducting our business through the following two business segments:

1. Catalyst regeneration, rejuvenation, cleaning and management services for SCR systems used by coal-fired power generation facilities to reduce NOx emissions – our SCR Catalyst and Management Services (“SCMS”) segment; and

2. Designing, developing and manufacturing advanced products based on our proprietary catalyst and fuel processing technologies, primarily focused on cost-effective solutions for reducing emissions from diesel engine applications – our Catalyst-Based Technology Solutions (“CBTS”) segment.

Critical Accounting Policies and Estimates

Our discussion and analysis of financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of

contingent liabilities. On an on-going basis, we evaluate our estimates and judgments, including those related to contract terms, equity investments, bad debts, inventories, investments, goodwill and other intangible assets, warranty reserves, income taxes, financing operations, contingencies and litigation. We base our estimates and judgments on historical experience and on various other factors that we believe to be reasonable under the circumstances, the results of which form the basis of our judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results would differ from these estimates under different assumptions or conditions.

Our significant accounting policies are disclosed in Note 1 to our consolidated financial statements. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition

We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price is fixed or determinable and collection is reasonably assured.

Revenues from SCR Catalyst and Management Services

Due to the nature of the demand for SCR catalyst regeneration and cleaning services, some of our contracts provide for extended payment terms. In a situation where the project for a customer is complete, but the customer is not contractually committed to receive an invoice within the succeeding six months (and subsequent payment is due within 30 days of invoice date), revenue is deferred until the six month criterion is met. If the customer contract provides for a deposit or progress payments, we recognize revenue up to the amount invoiced. Because we perform a service for a customer, no rights of return exist. The customer is responsible for the removal, transportation and subsequent installation of the catalyst. Our revenue arrangements do not have any material multiple deliverables as defined in Emerging Issues Task Force (“EITF”) 00-21, “Accounting for Multiple Element Revenue Arrangements”.

We recognize revenue from our management and consulting services as work is performed. Costs associated with management and consulting services is expensed as incurred.

Revenues from Research and Development Contracts

Research and development revenues are earned as contractual services are performed and are recognized in accordance with contract terms, principally based on reimbursement of total costs and expenses incurred. Since

research and development revenues from government-funded programs are subject to government audits, we maintain a revenue cost reserve in the event any of these funded costs, including overhead, are disallowed. We estimate this reserve by applying a percentage to the revenue recorded under contracts still subject to audit by those funding agencies based on historical experience. If we underestimate the amount of disallowed funding for a particular program, we will have to reduce our revenue in a subsequent period by the amount by which actual disallowed funding exceeds our estimate. No amounts recognized as revenue are refundable. In return for funding, collaborative partners may receive certain rights in the commercialization of the resulting technology. The contracts are also subject to periodic review by the funding partner, which could result in modifications to program scope, including reduction or termination of funding.

Goodwill and Other Intangible Assets

We account for goodwill and other intangible assets in accordance with the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 141, “Business Combinations”, and SFAS No. 142, “Goodwill and Other Intangible Assets”. Purchase prices of acquired businesses that are accounted for as purchases have been allocated to the assets and liabilities acquired based on the estimated fair values on the respective acquisition dates. Based on these values, the excess purchase prices over the fair value of the net assets acquired were allocated to goodwill. Pursuant to SFAS No. 142, goodwill and other intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but instead tested for impairment at least annually in accordance with the provisions of SFAS No. 142. SFAS No. 142 also requires that intangible assets with estimable useful lives be amortized over their respective estimated useful lives to their estimated residual values and reviewed for impairment in accordance with SFAS No. 144, “Accounting for Impairment or Disposal of Long-Lived Assets.” Other intangible assets that have finite useful lives, including patents, trademarks, trade secrets and other purchased technology, were recorded at fair value at the time of the acquisition, and are carried at such value less accumulated amortization. We amortize these intangible assets on a straight-line basis over their useful lives, estimated at ten years.

Accounts Receivable Reserves

We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers or funding partners to make required payments. This allowance is based on specific customer account reviews and historical collections experience. If the financial condition of any of our customers or funding partners were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances would be required.

Income Taxes

Financial Accounting Standards Board (“FASB”) SFAS No. 109, “Accounting for Income Taxes”, requires that a valuation allowance be established when it is more likely than not that all or a portion of a deferred tax asset will not be realized. SFAS No. 109 further states that it is difficult to conclude that a valuation allowance is not needed when there is negative evidence such as cumulative losses in recent years. As a result we have recorded a full valuation allowance against our deferred tax assets and expect to continue to record a full valuation allowance on future tax benefits until we reach sustained profitability.

Results of Operations

The following summary presents the results of operations by comparable period for the three and six-months ended June 30, 2006 and 2005 (in thousands):

	Three Months Ended June 30,									Six Months Ended June 30,
	2006			2005			Change			2006			2005			Change

Revenues
SCR catalyst & management services	$	957		$	184		$	773		$	3,936		$	927		$	3,009
Research and development	—			578			(578		)	—			1,134			(1,134		)
Total revenues	957			762			195			3,936			2,061			1,875

Costs and expenses:
Cost of revenues	845			1,192			(347		)	2,415			2,362			53
Research and development	1,443			1,633			(190		)	3,063			3,681			(618		)
Selling, general and administrative	1,767			1,591			176			3,838			3,450			388
Total costs and expenses	4,055			4,416			(361		)	9,316			9,493			(177		)

Operating loss	(3,098		)	(3,654		)	556			(5,380		)	(7,432		)	2,052

Interest and other income	257			325			(68		)	863			724			139
Interest expense	(49		)	(161		)	112			(98		)	(320		)	222

Net loss	$	(2,890	)	$	(3,490	)	$	600		$	(4,615	)	$	(7,028	)	$	2,413

Comparison of the three and six-month periods ended June 30, 2006 and 2005

Revenues. SCR Catalyst and Management Services revenues result primarily from catalyst cleaning and regeneration services. Additionally, the Company provides SCR catalyst management and consulting services, including catalyst inspection, performance testing and analysis, catalyst specification, and computer simulation to help power plant operators improve their SCR system performance and achieve cost-effective NOx compliance. We expect SCR Catalyst and Management Services to continue to be the most significant component of revenue for the foreseeable future. However, this revenue is project-based, and as such, the timing of those revenues varies from period-to-period.

Research and Development revenues include revenues generated from research and development (“R&D”) contracts funded by gas turbine manufacturers and government sources for fuel processor, diesel and gas turbine technology development. These R&D contracts provide for partial recovery of our direct and indirect costs. Most of our R&D contracts are subject to periodic review by our funding partners, which could result in modifications to project scope, termination of funding, or schedule delays. We expect to continue to pursue funded research programs, however, we received no such funding in the six-month period ended June 30, 2006 and cannot ensure we will receive R&D funding in the future. In return for funding development, collaborative partners may receive certain rights in the commercialization of any resulting technology, including royalty payments on future sales. The timing of revenues from R&D contracts varies from year to year, and from contract to contract, based on the terms agreed upon by us and the customer or funding party. Due to the nature of R&D funding, period-to-period comparisons of R&D revenues are not necessarily meaningful and should not be relied upon as indications of future performance. We expect that 2006 funding will continue to be significantly below 2005 levels due to the completion in 2005 of several revenue producing R&D contracts.

The increase in SCR Catalyst and Management Services revenue during the three-month period ended June 30, 2006, compared to the corresponding period of 2005, results from the completion of two contracts for the rejuvenation of spent SCR catalyst during the second quarter of 2006 as compared with no such contracts in the

second quarter of 2005. The increase is reflective of increased sales activity and staffing during the second half of 2005, as evidenced by the increase in backlog at December 31 from $775,000 in 2004 to $3,100,000 in 2005.

SCR Catalyst and Management Services revenues for the six-month period ended June 30, 2006 represent a 325% increase over such revenues for the corresponding period of 2005. The magnitude of the increase is reflective of increased sales activity and staffing during the second half of 2005, but is also due to the timing of individual projects and, therefore, should not be relied upon as an indication of performance for the remainder of 2006. Further, during the six-month period ended June 30, 2006, one customer represented 56% of our revenue. We do believe, however, that 2006 revenues from SCR Catalyst and Management Services will increase more than three-fold, when compared with 2005 revenues from SCR Catalyst and Management Services. Revenue backlog as of June 30, 2006 for SCR Catalyst and Management Services was approximately $2,100,000, compared with revenue backlog as of June 30, 2005 of approximately $729,000, including $49,500 of deferred revenue. Although a significant portion of the 2006 backlog may not be recognized as revenue until 2007, due to delays in delivery and billing resulting from customer scheduling requirements, it is anticipated that additional revenues will be recognized in 2006 from additional orders received or to be received in the second half 2006.

We believe our full-year revenues will be in the range of $6.0 to $7.0 million, based upon the current level of sales activity for SCR Catalyst and Management Services. However, such expectations are subject to the timing of revenue recognition associated with various projects at SCR-Tech and the other uncertainties regarding our business as described herein. With respect to revenues generated from R&D contracts, however, it is likely that 2006 funding will continue to be significantly below 2005 levels due to the completion in 2005 of all revenue producing R&D contracts. Accordingly, we anticipate that SCR Catalyst and Management Services revenues will constitute the vast majority of our revenues in 2006. We have identified potential funding sources for our diesel programs; however, we have not yet secured funding from those sources and the availability of such funding is not certain.

Cost of Revenues. Cost of revenues attributable to SCR Catalyst and Management Services is comprised largely of fixed costs and includes direct labor, plant management wages, fringe benefits, the cost of replacement modules sold, facility rent, chemicals, depreciation, supplies and third party consulting services, and are expensed as incurred.

Expenses relating to government and OEM funded R&D programs are also classified as cost of revenues. Expenses relating to internally funded programs are classified as R&D expenses. Accordingly, shifts in effort between government and OEM funded programs, versus internally funded programs, produce period-to-period variances in cost of revenues and R&D expenses. Cost of revenues relating to R&D contracts consists of direct expenses including direct labor, fringe benefits, travel, consulting and other third party professional services, supplies and R&D overhead, and are expensed as incurred. R&D overhead is applied to government and OEM funded programs based on total non-direct program expenses incurred as a percentage of direct program expenses.

The decrease in cost of revenues during the three-month period ended June 30, 2006, compared to the corresponding period of 2005, resulted from $714,000 of expenses relating to government and OEM funded R&D programs being included in 2005 while no such expenses were included in 2006 due to the absence of any such programs in 2006. Cost of sales for SCR Catalyst and Management Services increased in the second quarter of 2006 over the corresponding period of 2005 from $478,000 to $845,000 due to increased sales in 2006.

The increase in cost of revenues during the six-month period ended June 30, 2006, compared to the corresponding period of 2005, resulted from $1,167,000 of expenses relating to government and OEM funded R&D programs being included in 2005 while no such expenses were included in 2006 due to the absence of any such programs in 2006, which were more than offset by an increase in cost of sales for SCR Catalyst and Management Services from $1,195,000 to $2,415,000 due to increased sales in 2006.

Research and Development Expenses. R&D expenses relate solely to our Catalyst-Based Technology Solutions segment and include compensation and benefits for engineering and manufacturing staff, fees for contract engineers, materials to build prototype units, amounts paid to outside suppliers for subcontracted components and services, supplies, facilities and information technology costs. We expense all R&D costs as incurred.

The decrease in R&D expenses during the three-month period ended June 30, 2006 compared to the corresponding period of 2005 resulted from the overall reduction in R&D activity and staffing due to the termination of the Company’s diesel retrofit and Department of Energy (“DOE”) fuel processor programs along with the

cessation of development efforts associated with our Xonon Cool Combustion product for gas turbines in the second half of 2005. The decrease included approximately $650,000 of personnel-related costs and $153,000 of supplies. Further, depreciation decreased $115,000 due to impairment write-downs taken in 2005 in connection with the termination of the aforementioned mentioned programs. These decreases were partially offset by the existence of government and OEM-funded R&D programs in 2005, which resulted in $714,000 of R&D expenditures being reported as cost of revenues in 2005 versus none in 2006 due to the absence of any such programs in 2006, and a $163,000 increase in patent-related legal costs largely incurred in connection with the pending sale of the Company’s gas turbine technology in 2006.

The decrease in R&D expenses during the six-month period ended June 30, 2006, compared to the corresponding period of 2005, resulted from the overall reduction in R&D activity and staffing due to the termination of the Company’s diesel retrofit and Department of Energy (“DOE”) fuel processor programs along with the cessation of development efforts associated with our Xonon Cool Combustion product for gas turbines in the second half of 2005. The decrease included approximately $895,000 of personnel-related costs and $237,000 of supplies. Further, depreciation decreased $188,000 due to impairment write-downs taken in 2005 in connection with the termination of the aforementioned programs. These decreases were partially offset by the existence of government and OEM funded R&D programs in 2005, which resulted in $1,167,000 of R&D expenditures being reported as cost of revenues in 2005 versus none in 2006 due to the absence of any such programs in 2006, and a $168,000 increase in patent-related legal costs largely incurred in connection with the pending sale of the Company’s gas turbine technology in 2006.

We expect total R&D expenses, including those classified as cost of revenues, will remain well below 2005 levels for the balance of 2006 due to reduced staffing and fewer active research programs. The significant majority of our current research and development efforts are focused on diesel programs.

Selling, General and Administrative (“SG&A”) Expenses. SG&A includes compensation, benefits and related costs of corporate functions, which include management, business development, marketing, human resources, sales and finance, and un-allocated facilities and IT costs.

The increase in SG&A expenses during the three-month period ended June 30, 2006, compared to the corresponding period of 2005, results from the collection in the 2005 period of a previously written-off note in the amount of $186,000 plus accrued interest costs, an increase in stock compensation expense of $111,000 resulting primarily from the adoption of SFAS No. 123(R) in 2006 and a $128,000 increase in SCR-Tech personnel-related costs resulting from increased staffing levels in 2006. These increases were partially offset by a $168,000 decrease in salaries resulting from staffing reductions in our Catalyst-Based Technology Solutions segment and an $85,000 reduction in legal fees due to personnel-related issues, primarily at SCR-Tech, in 2005.

The increase in SG&A expenses during the six-month period ended June 30, 2006, compared to the corresponding period of 2005, results from a $338,000 increase in SCR-Tech personnel-related costs resulting from increased staffing levels in 2006, the collection in the 2005 period of a previously written-off note in the amount of $186,000 plus accrued interest costs and an increase in stock compensation expense of $140,000 resulting primarily from the adoption of SFAS No. 123(R) in 2006. These increases were partially offset by a $342,000 decrease in salaries resulting from staffing reductions in our Catalyst-Based Technology Solutions segment.

We expect SG&A expenses for the remainder of 2006 to remain near current levels as cost reductions in our Catalyst-Based Technology Solutions segment are offset by increases in our SCR Catalyst and Management Services segment to support continued growth.

Interest and Other Income. Interest income is generated from money market and short-term investments. Other income consists of rental income generated from leasing certain portions of our Gilbert, Arizona building.

The decrease in interest and other income during the three-month period ended June 30, 2006, compared to the corresponding period of 2005, results from lower invested cash balances partially offset by improved yields on money market and short-term investments.

The increase in interest and other income during the six-month period ended June 30, 2006, compared to the corresponding period of 2005, results from a $182,000 increase in proceeds from the recovery of precious metals

from scrap in 2006, partially offset by lower interest income resulting from lower invested cash balances partially offset by improved yields on money market and short-term investments.

We expect interest income to increase in the second half of 2006 due to higher invested cash balances resulting from investment of the proceeds from the sale of our Gilbert, Arizona facility in July 2006 and the pending sale of our small gas turbine technology. We expect other income to decline by approximately $80,000 in the second half of 2006 as a result of the sale of the Gilbert, Arizona building.

Interest Expense. Interest expense reflects amounts incurred under long-term debt and capital lease obligations.

The decrease in interest expense during the three and six-month periods ended June 30, 2006, compared to the corresponding periods of 2005, results from the settlement of our remaining SCR-Tech acquisition liability in December 2005.

Interest expense in the first half of 2006 relates to the mortgage on our Gilbert, Arizona building which was sold in July 2006. Accordingly, interest expense for the remainder of 2006 is expected to be insignificant.

Income Taxes. No benefit from income taxes was recorded on the losses incurred during the three or six-month periods ended June 30, 2006 and 2005 because the expected benefit, computed by applying statutory tax rates to the net loss, was offset by an increase in the valuation allowance for deferred tax assets due to the uncertainty of future taxable income that would allow us to realize deferred tax assets generated from our losses. We do not believe we will incur any material income taxes in the foreseeable future.

Liquidity and Capital Resources

Historical Capital Position and Usage

Prior to our spin-off in December 2000, Catalytica, Inc. made a $50.0 million cash investment in the Company. Additionally, in August 2001, we received net proceeds of $47.7 million from a public offering of our common stock. Through June 30, 2006, approximately 82% of the proceeds from the capital contribution and our public offering have been used to fund our ongoing research and development efforts associated with our diesel emissions reductions solutions and the commercialization of our Xonon Cool Combustion technology for gas turbine applications, the purchase of our commercial manufacturing and administrative facility in Gilbert, Arizona and other capital expenditures, the purchase of SCR-Tech, funding our continuing losses, and for general corporate purposes. The remaining funds are invested in commercial and government short-term paper.

The following table presents balances and changes in cash, cash equivalents and short-term investments for the six-month periods ended June 30, 2006 and 2005(in thousands):

	Six months ended June 30,
	2006			2005

Ending balance of cash, cash equivalents and short-term investments	$	17,731		$	29,800

Net decrease in cash, cash equivalents and short-term investments	$	(3,601	)	$	(5,792	)

Our net decrease in cash, cash equivalents and short-term investments (“Cash Consumption”) was approximately $3.6 million for the six-months ended June 30, 2006. The following amounts comprised the decrease of $3.6 million, or 16.9%, in cash, cash equivalents and short-term investments during the six-months ended June 30, 2006:

· $4.4 million related to loss before interest, taxes, depreciation and amortization (“EBITDA”), summarized in the following table (in thousands). We elect to use EBITDA in our analysis of Cash Consumption as we believe it approximates cash generated from our operations.

Net loss		$	(4,615	)

Plus:	Interest expense	98
	Depreciation of property and equipment	475
	Amortization of intangible assets	86

Less:	Interest income	(428		)

	EBITDA	$	(4,384	)

· ($0.3) million of net interest income

· $0.2 million related to capital expenditures

· ($0.1) million non-cash charge for stock based compensation; and

· ($0.6) million changes in working capital and other.

Our Cash Consumption was approximately $5.8 million for the six-months ended June 30, 2005. The following amounts comprised the decrease of $5.8 million, or 16.3%, in cash, cash equivalents and short-term investments during the six-months ended June 30, 2005:

· $6.6 million related to loss before interest, taxes, depreciation and amortization (“EBITDA”), summarized in the following table (in thousands). We elect to use EBITDA in our analysis of Cash Consumption as we believe it approximates cash generated from our operations:

Net loss		$	(7,028	)

Plus:	Interest expense	320
	Depreciation of property and equipment	579
	Amortization of intangible assets	86

Less:	Interest and other income	(568		)

	EBITDA	$	(6,611	)

· ($0.1) million interest paid in cash

· $0.2 million proceeds from issuance of stock

· ($0.3) million related to capital expenditures

· ($0.6) million changes in working capital and other.

Capital Requirements

In general, our current and near-term capital requirements depend on numerous factors, including but not limited to our product development and commercialization activities, the timing and level of third-party research and development funding, market acceptance of our products and our rate of sales growth. We face substantial uncertainties with respect to our business operations and we may not be able to achieve positive cash flow from our operations. Our current operating plans through fiscal 2006 are continually under review and may or may not include further development of our diesel emissions reduction business and expanding our SCR Catalyst and Management Services business.

industry demands and requirements, and the cost of required regulatory reviews and approvals. Further, our SG&A expenses have been in excess of $6.0 million per year and are expected to continue to be significant under our current business strategy. Thus, any delay in product development or commercial product launches will result in us continuing to incur significant SG&A expenses without corresponding revenues. In addition, because we are a public company subject to the compliance requirements and corresponding costs relating to federal securities laws, it is difficult to reduce such expenses without substantially curtailing our operations. Our liquidity will continue to be impacted by these expenses as long as we are subject to such requirements.

Our net decrease in cash, cash equivalents and short-term investments (“Cash Consumption”) was $3,601,000 in the six-month period ended June 30, 2006, compared to Cash Consumption of $5,792,000 in the comparable period of 2005. We estimate that our total Cash Consumption for 2006, assuming the successful consummation of the pending sale of our gas turbine technology and assets to Kawasaki, will range between $4.5 million and $6.0 million. We believe our available cash, cash equivalents and short-term investments (“Cash”) in the amount of $17.7 million as of June 30, 2006 will provide sufficient capital to fund operations as currently conducted until at least December 31, 2007. However, if our overall Cash Consumption in 2006 exceeds our current expectations because of higher capital expenditures, increased costs of development or commercialization, lower than anticipated revenues from SCR-Tech, lower government and third-party funding, higher SG&A expenditures or for any other reason, we may be required to raise additional funds to continue our operations as currently conducted, significantly curtail our business operations and/or change our strategic direction. In particular, we currently estimate that the total remaining development costs for continuing to pursue our diesel OEM NOx and PM solutions for new, over-the-road diesel engines will be in excess of $10.0 million, and potentially substantially in excess of such sum. Our belief that we have sufficient funds through December 31, 2007 is significantly dependent on these costs not materially exceeding $10.0 million during this period. In addition, we may enter into mergers, acquisitions or other strategic arrangements which could require the use of cash, reducing our available capital prior to December 31, 2007, or which could require additional equity or debt financing. Moreover, the integration and operation of any business acquired could require significant expenditures that could materially and adversely impact our liquidity and capital resources. In this regard, our 2004 acquisition of SCR-Tech required significant cash outlays for acquisition-related payments and may potentially require future cash outlays to fund continued operations or to support growth through an expansion of our production capacity. However, we are currently exploring and evaluating strategic alternatives for our diesel emissions reduction solutions business. If we were to downsize, discontinue or sell our diesel emissions reduction solutions business in 2006, our capital requirements will be significantly reduced and we likely would have sufficient capital to fund our SCR Catalyst and Management Services business through at least 2008.

Any additional funding requirements, whether for operations, acquisitions or otherwise, may be significant, may not be available when required, or may be available only on terms unsatisfactory to us. Furthermore, if we issue equity securities, the ownership percentage of our then existing stockholders may be reduced, and the holders of new equity securities may have rights senior to those of our existing holders of common stock. If we issue debt securities, these securities would be senior in priority to any equity securities, including our common stock, and would subject us to the risks inherent in issuing debt, including ongoing payment and maturity obligations. Funding requirements satisfied through strategic relationships with industry participants could result in substantial dilution of our then existing equity holders and could require us to limit our potential return from our products by making significant business or financial concessions to such participants.

Beyond December 31, 2007, our cash requirements will depend on many factors, including but not limited to the market acceptance of our products, the ability of our diesel emissions reduction products to achieve market acceptance and commitments from significant industry participants, whether or not we downsize, discontinue or sell our diesel emissions reduction solutions business, the timing and level of development funding from private and government sources, the ability of SCR-Tech to generate significant cash flow, the rate of expansion of our sales and marketing activities, the rate of expansion of our production capacity, and the timing and extent of research and development projects. Most significantly, since we do not expect any significant revenues from our diesel OEM NOx or PM solutions until 2009, even if we are successful in such programs, if we continue to incur significant development expenditures for such programs beyond 2007, we almost certainly will require significant additional capital to continue our operations. Further, if our SCR Catalyst and Management Services business expands significantly, we may require substantial additional capital expenditures beyond 2007, including additional plant expansion or location of a second regeneration facility at a different geographic location. Our ability to fund SCR-Tech’s future capital requirements would be favorably impacted by a decision to discontinue, downsize or sell our diesel emissions reduction business.

Other Capital Commitments

In March 2002, we received a term loan of $3,010,000 from the Arizona State Compensation Fund. Proceeds of this loan were applied to the purchase of a 43,000 square foot manufacturing and administrative facility in Gilbert, Arizona. In August 2004, the remaining $2,940,254 principal balance on this loan was refinanced with a five-year term loan which bears interest at a fixed annual rate of 6.5% and matures in April 2009. Under the terms of this new loan, payments of principal and interest totaling $19,105 are due monthly with a final principal payment of $2,737,228 due at maturity. This loan is secured by a deed of trust in the acquired real property.

On July 19, 2006, the Company sold the Gilbert, Arizona facility and repaid the remaining balance of the loan along with prepayment penalties totaling approximately $90,000.

Dividend Policy

We have never paid cash dividends on our common stock or any other securities. We anticipate that we will retain any future earnings for use in the expansion and operation of our business and do not anticipate paying cash dividends in the foreseeable future.

Other Commitments

We have entered into research collaboration arrangements that may require us to make future royalty payments. These payments would generally be due once specified milestones, such as the commencement of commercial sales of a product incorporating the funded technology, are achieved. Currently we have four such arrangements, with Tanaka Kikinzoku Kogyo K.K. (“Tanaka”), Gas Technology Institute (“GTI”) (formally known as Gas Research Institute), the California Energy Commission (“CEC”) and Woodward Governor Company (“WGC”).

A significant amount of the development effort related to our catalytic combustion technology for gas turbines was funded by Tanaka under a January 1995 development agreement which divides commercialization rights to the technology between the parties along product market lines. We have exclusive rights to manufacture and market catalytic combustion systems for gas turbines of greater than 25 megawatt (“MW”) power output and non-exclusive rights for gas turbines of 25 MW power output or less. Tanaka has reciprocal exclusive rights to manufacture and market catalytic combustors for use in automobiles and non-exclusive rights for gas turbines of 25 MW power output or less. In each case, the manufacturing and marketing party will pay a royalty of 5% of net sales to the other party. Each party is responsible for its own development expenses, and any invention made after May 1, 1995 is the sole property of the party making the invention, while the other party has a right to obtain a royalty-bearing, non-exclusive license to use the invention in its areas of exclusivity. As commercialized, the Xonon system contains significant technology developed by us after May 1, 1995 and no technology developed by Tanaka after this date. Our development agreement with Tanaka expired in 2005, and we have no further royalty obligations to Tanaka after 2005.

In September 1998, we entered into a funding arrangement with the CEC under which they agreed to fund a portion of our Xonon engine test and demonstration facility located in Santa Clara, California. Under this agreement, we are required to pay a royalty of up to 1.5% of the sales price on the sale of each product or right developed under this project for fifteen years upon initiation of the first commercial sale of a Xonon-equipped engine greater than 1 MW.

In January 2000, we entered into a funding arrangement with GTI to fund the development of our Xonon combustor and demonstrate its performance. We will be required to make royalty payments to GTI of $243,000 per year for seven years beginning with the sale, lease or other transfer of the twenty-fifth catalyst module for gas turbines rated greater than 1 MW, up to a maximum of $1,701,000. Since we are no longer conducting development or commercialization activities associated with our Xonon Cool Combustion product for gas turbines, we do not believe we will reach the level of module production to trigger the GTI payments.

On December 19, 2001, we entered into a Control Patent Assignment and Cross License Agreement (“Patent Assignment Agreement”) with WGC pursuant to which WGC assigned a patent to us, and we and WGC cross-licensed certain intellectual property to each other. Under the Patent Assignment Agreement, we must pay WGC between $5,000 and $15,000 upon each shipment of a Xonon commercial unit. Additionally, as part of an April 2002 settlement agreement with WGC (the “Settlement Agreement”), we agreed to increase royalties by $2,500 per unit on

our shipment of the first 100 gas turbines greater than 10 MW. These increased royalties are guaranteed, and we must pay them on 100 units even if we do not ship any units of this size. We prepaid $50,000 of these royalties to WGC in April 2002. We paid WGC $100,000 in January 2003 and an additional $100,000 in January 2004. These guaranteed payments totaling $250,000 were recorded as a component of SG&A expenses during the three months ended March 2002 and are in addition to the $5,000 we must pay to WGC under the Patent Assignment Agreement upon each shipment of a Xonon commercial unit in a gas turbine of this size.

The Patent Assignment Agreement also provides that each time we sublicense the WGC technology to a gas turbine manufacturer or third party control manufacturer; we will pay WGC a control technology license fee of $50,000, as well as a $3,000 additional license fee for each sale of a Xonon control system sold by such manufacturer. As a part of the Settlement Agreement, we paid $200,000 in April 2002, representing a pre-payment of the control technology license fees for our first four $50,000 sublicenses of the WGC control technology. We are obligated to make the foregoing license payments to WGC through December 31, 2014 or until our cumulative payments and license fees to WGC total $15,250,000, whichever occurs first.

WGC must pay us a fee of 1% of the sale price of each WGC control system installed in conjunction with Xonon catalytic modules for new and retrofit turbines. WGC is obligated to make these payments through December 31, 2014 or until we have received total payments of $2,000,000, whichever occurs first.

Off-Balance Sheet Arrangements

The Company has no off-balance sheet arrangements that are required to be disclosed pursuant to Item 303(c) of Regulation S-B.

RISKS THAT COULD AFFECT OUR FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following risk factors could materially and adversely affect our future operating results, financial condition, the value of our business, and the price of our common stock and also could cause actual events to differ materially from those predicted in the forward-looking statements we make about our business. Investors are encouraged to carefully consider the risks described below before making decisions related to buying, holding or selling our common stock.

GENERAL RISKS RELATING TO OUR FINANCIAL CONDITION AND OPERATING RESULTS

The following risks could negatively impact our operating results, financial condition, the value of our business and the price of our common stock. These risks also apply to and may adversely affect our specific business programs, products and opportunities, as more specifically described below.

We have incurred significant continuing losses since inception, and we may never achieve profitability.

We incurred losses of $4,615,000, $13,466,000 and $13,269,000 for the six-month period ended June 30, 2006 and for the years ended December 31, 2005 and 2004, respectively. As of June 30, 2006, we had an accumulated deficit of $143,099,000 and had not yet recorded significant revenues from commercial sales apart from revenues contributed by SCR-Tech, a business we acquired in 2004. Unless we significantly curtail or successfully secure third-party funding for our diesel emissions reduction solutions development activities, we expect to continue to incur net losses for the foreseeable future and these losses are likely to be significant.

We exited our mobile diesel retrofit program in September 2005 and in June 2006 we entered into an agreement to sell our Xonon Cool Combustion gas turbine technology and associated gas turbine assets to Kawasaki Heavy Industries after a decade of development work and expense in this business. We incurred significant losses in both businesses. There can be no assurance that our remaining active development activities will be successful or that our SCR Catalyst and Management Services business will be profitable. Further, there can be no assurance that Catalytica Energy will ever reach or sustain profitability.

We are actively exploring alternatives for our diesel emissions reduction business and we may elect to downsize, discontinue or sell our remaining diesel development activities and focus solely on SCR-Tech as our principal business.

We have significant remaining business, technical and financial hurdles to overcome to develop a commercially viable emissions control solution for diesel engines, as described in greater detail below under “Additional Risks Relating to Emissions Control Solutions for Diesel Engines”. In particular, we likely will not have sufficient capital to complete necessary development and commercialization work for our diesel development programs without a significant financial or equivalent commitment from diesel OEM’s or industry suppliers, especially since we would be unlikely to receive any significant commercial revenues from a product until 2009. We recorded no revenues for our Catalyst-Based Technology Solutions segment (“CBTS”) for the first half of 2006. As a result of these considerations, we are actively exploring and evaluating alternatives for this business, including downsizing, discontinuing or selling this business. In light of the early stage of our development activities relating to diesel engines and the long-term nature of any significant revenues, we are unlikely to realize any significant value from a sale of this business at present. If we elect to discontinue our diesel development activities, we likely will incur significant shut-down related costs, such as severance and other personnel expenses, facility-related expenses such as potential environmental clean-up costs at our California facility and equipment disposal costs. If we discontinue or sell our diesel emissions reduction solutions business, our sole remaining line of business would be that of SCR-Tech. In such case, the entire success or failure of the Company would depend on the performance of this business.

We may need significant additional capital to operate our business or achieve profitability, and we may be unable to raise additional capital.

In general, our current and near-term capital requirements depend on numerous factors, including but not limited to our product development and commercialization activities, the timing and level of third-party research and development funding, market acceptance of our products and our rate of sales growth. We face substantial uncertainties with respect to our business operations and we may not be able to achieve positive cash flow from our operations. Our current operating plans through fiscal 2006 are continually under review and may or may not include further development of our diesel emissions reduction solutions and expanding our SCR Catalyst and Management Services business.

The amount of capital required to complete our development programs is highly uncertain and depends on numerous factors, including technical issues associated with our ongoing development of Catalyst-Based Technology Solutions, the nature of partner participation and the amount and timing of any capital or technical contributions from such partners, the ability of third party suppliers to develop certain components in a timely manner, market and industry demands and requirements, and the cost of required regulatory reviews and approvals. Further, our selling, general and administrative (“SG&A”) expenses have been in excess of $6 million per year and are expected to continue to be significant under our current business strategy. Thus, any delay in product development or commercial product launches will result in us continuing to incur significant SG&A expenses without corresponding revenues.

We believe that our available cash, cash equivalents and short-term investments (collectively “Cash”) in the amount of $17.7 million as of June 30, 2006 will provide sufficient capital to fund operations as currently conducted until at least December 31, 2007. However, if our overall Cash usage in 2006 or 2007 exceeds our current expectations because of higher capital expenditures, increased costs of development or commercialization, lower than anticipated revenues from SCR-Tech, lower government and third-party funding, higher SG&A expenditures or for any other reason, we may be required to raise additional funds to continue our operations as currently conducted, significantly curtail our business operations and/or change our strategic direction. In particular, we currently estimate that the total remaining development costs for continuing to pursue our diesel OEM NOx and PM solutions for new, over-the-road diesel engines will be in excess of $10 million, and potentially substantially in excess of such sum. Our belief that we have sufficient funds through December 31, 2007, is significantly dependent on these costs not materially exceeding $10 million during this period. In addition, we may enter into mergers, acquisitions or other strategic arrangements which could require the use of cash, reducing our available capital prior to December 31, 2007, or which could require additional equity or debt financing. Moreover, the integration and operation of any business acquired could require significant expenditures that could materially and adversely impact our liquidity and capital resources. In this regard, our 2004 acquisition of SCR-Tech required significant cash outlays for acquisition-related payments and may potentially require future cash outlays to fund operations.

Beyond December 31, 2007, our cash requirements will depend on many factors, including but not limited to the market acceptance of our products and services, the ability of our diesel emissions reduction products to achieve market acceptance and commitments from significant industry participants, a decision to discontinue or sell our diesel emissions reduction solutions business, the timing and level of development funding from private and government sources, the ability of SCR-Tech to generate significant cash flow, the rate of expansion of our sales and marketing activities, the rate of expansion of our manufacturing capacity, and the timing and extent of research and development projects.

Risk of changes in government regulation.

Our business is significantly dependent on the nature and level of government regulation of emissions. Without government regulation of coal-fired power generation, SCR catalyst would not be used by utilities, there would be no need for utilities to acquire, clean or regenerate SCR catalyst, and SCR-Tech would have no business purpose. Further, changes in or adverse interpretations of governmental accounting or rate-based emissions regulations also could have a material adverse effect on our business. Without government regulation of diesel emissions, there would be no demand for our potential diesel emissions reduction products. Further, the level of this regulation will determine the required level of emission solutions required, and the rate of increase, if any, in regulation, will determine the potential growth in our target markets. Additionally, without the continued support of federal government agencies, such as the Environmental Protection Agency (“EPA”), for the technology approach we are pursuing to reduce NOx emissions from mobile diesel engine applications, competing technology approaches could gain momentum in the U.S. marketplace as the technology path that will be pursued for meeting the 2010 emissions mandate. Although government regulation of emissions has become increasingly stringent in recent years, the growing costs associated with such regulations may limit the level of increase and scope of emissions requirements, which could limit the potential growth of our target markets. Any easing of governmental emissions requirements or the growth rate of such requirements could have a material adverse effect on our business.

Any significant transaction we may undertake could disrupt our business and harm our financial condition.

We regularly evaluate the status of our research and development activities, product and service offerings and associated market opportunities, and consider sales or discontinuation of businesses or product or service offerings, as well as strategic activities or opportunities, including business acquisitions or other strategic transactions that could positively impact shareholder value. We have limited experience in these types of transactions. We acquired SCR-Tech in February 2004, and there can be no assurance this acquisition will prove to be successful or ultimately beneficial to us. See “Additional Risks Relating to SCR Catalyst and Management Services.” The SCR-Tech acquisition and any future transactions, including mergers, acquisitions or similar transactions, entail a number of risks that could materially and adversely affect our business and operating results, including but not limited to:

· issues associated with integrating the acquired operations, technologies or products with our existing business and products;

· changes in control or management;

· dilution of existing stockholders;

· potential disruption of our ongoing business activities and distraction of our management;

· difficulties in retaining business relationships with suppliers and customers of the acquired companies;

· difficulties in coordinating and integrating overall business strategies, sales and marketing, and research and development efforts;

· difficulties associated with the maintenance of corporate cultures, controls, procedures and policies;

· risks associated with entering markets in which we lack prior experience;

· the potential loss of key employees; and

· the potential for write-offs of goodwill and other acquired intangibles.

The market price of our common stock is highly volatile, has significantly declined and may decline further. Our common stock could be de-listed by NASDAQ.

The market price of our common stock is highly volatile and has declined significantly since our stock began trading in December 2000. Factors that could cause fluctuation and further declines in our stock price may include, but are not limited to:

· the nature, amounts and trends with respect to our net losses and cash consumption;

· the amount of our capital resources and our potential need to seek additional funding;

· announcements or cancellations of orders or research and development arrangements;

· conditions or trends in our industry;

· changes in the market valuations of other companies in our industry;

· the effectiveness and commercial viability of products and services offered by us or our competitors;

· the results of our research and development or test activities;

· announcements by us or our competitors of technological innovations, new products or services, significant acquisitions or mergers, strategic partnerships, divestitures, joint ventures or other strategic initiatives;

· changes in environmental regulations; and

· additions or departures of key personnel.

Many of these factors are beyond our control. These factors may cause the market price of our common stock to decline regardless of our operating performance. In addition, stock markets have experienced extreme price volatility in recent years. This volatility has had a substantial effect on the market prices of securities issued by many companies for reasons that may be unrelated to the operating performance of the specific companies. These broad market fluctuations may adversely affect the market price of our common stock.

We expect our revenues and operating results to vary significantly from quarter to quarter. As a result, quarterly comparisons of our financial results are not necessarily meaningful and investors should not rely on them as an indication of our future performance. In addition, due to our stage of development, we cannot predict our future revenues or results of operations accurately. As a consequence, our operating results may fall below the expectations of securities analysts and investors, which could cause the price of our common stock to decline. Factors that may affect our operating results include:

· the status of development of our technology, products and services and manufacturing capabilities;

· the volume of sales activity in our SCR Catalyst and Management Services business;

· the cost of our raw materials and key components;

· warranty and service costs for products in the field;

· the introduction, timing and market acceptance of new products or services introduced by us or our competitors;

· the development of our customer relationships;

· the development of our strategic relationships and distribution channels;

· general economic conditions, which can affect our customers’ capital investments and the length of our sales cycle;

· the market acceptance of SCR catalyst regeneration

· the development and/or market acceptance of NOx adsorbers; and

· government regulations.

Our stock has traded below $1 in the recent past. If the price of our common stock declines and remains below $1 for 30 consecutive trading days, our common stock will be subject to de-listing by NASDAQ. In such event, if we are unable to regain compliance within a period of time specified by NASDAQ, our common stock could be moved to the OTC Bulletin Board, and the liquidity and value of our common stock likely would be negatively impacted.

If we are unable to attract or retain key personnel, our ability to manage our business could be harmed.

Currently our management team is responsible for the operations of our SCR services business, our diesel programs, exploring and evaluating potential acquisitions or divestitures and other strategic opportunities. In light of employee headcount reductions over the past few years, including management level employees, and the increasing number of Federal and NASDAQ securities regulatory requirements, substantial additional burdens have been placed on our management. If Robert Zack, our CEO and CFO, were to depart, we would be required to find both a CEO and CFO to assume his duties. It may prove difficult for current management to successfully operate these differing areas and meet the demands and requirements of our diverse business activities. Our future success will therefore depend on attracting and retaining additional qualified management and technical personnel. No assurance can be given that management resources will be sufficient to address current and future business activities or that we will not be required to incur substantial additional expenses to add to our management capabilities. Further, our inability to hire qualified personnel on a timely basis, or the departure of any key employee, could harm our expansion and commercialization plans.

We have historically focused on research and development activities and have limited experience in marketing, selling and servicing our products.

Other than sales of SCR Catalyst and Management Services by SCR-Tech, a business we acquired in February 2004, we have primarily focused on research and development activities to date. Prior to ceasing development and commercialization activities associated with our Xonon Cool Combustion systems, we had only limited experience marketing, selling and servicing these systems, and experienced significant financial losses. Further, we have no experience marketing, selling or servicing our diesel emissions reduction systems. We will have to expand our marketing and sales organization, as well as our maintenance and support capability as our products become commercially available. We may not be successful in our efforts to market and service our products, which could compromise our ability to increase our revenues.

If we are unable to attract or retain key personnel, our ability to adapt our technology to diesel engines or other products, to continue to develop and commercialize our technology, to effectively market our products and to manage our business could be harmed.

Our business requires a highly skilled management team and specialized workforce, including scientists, engineers, researchers, and manufacturing and marketing professionals who have developed essential proprietary skills. Our future success will therefore depend on attracting and retaining qualified management and technical personnel. We do not know whether we will be successful in hiring or retaining these qualified personnel. Our inability to hire qualified personnel on a timely basis, or the departure of key employees, could harm our existing business as well as our expansion and commercialization plans.

Certain of our processing and manufacturing equipment is unique to our business and would be difficult and expensive to repair or replace.

Certain of the capital equipment used in the manufacture of our products has been developed and made specifically for us and would be difficult to repair or replace if it were to become damaged or stop working. In addition, certain of our manufacturing equipment is not readily available from multiple vendors. Consequently, any damage to or breakdown of our manufacturing equipment at a time we are manufacturing commercial quantities of our products may have a material adverse impact on our business.

Significant price increases in key materials may reduce our gross margins and profitability of our NOx reduction products.

The prices of rhodium, palladium, platinum, molybdenum and vanadium, all of which are used in various components or our business, can be volatile. If the long-term costs of these materials were to increase significantly, we would attempt to reduce material usage or find substitute materials. If these efforts were not successful or if these cost increases could not be reflected in our price to customers, then our gross margins and profitability would be reduced and our ability to commercialize a product at a competitive cost could be compromised.

We are subject to significant potential environmental and product liability exposure.

Since our business relates to NOx and related emissions controls, solutions and services, we are subject to significant potential environmental and product liability risks. These include risks relating to the chemicals and other materials used to manufacture our products and provide our services; risks relating to hazardous waste and hazardous waste disposal; potential environmental damage caused in the manufacture, sale, distribution or operation of our products and services relating thereto; employee and third party injuries from the manufacture, sale, distribution or operation of our products and services relating thereto, including claims by our customers and their end users, including in certain cases, consumers; the inability of our products to meet environmental or other standards imposed by federal, state or local law or by our customers; and other claims relating to our products and services. Because of our very limited experience and the limited distribution of our products and services, we do not have any experience with the nature or type of claims which may arise from our business. Only limited insurance is available for environmental and product liability claims, and any such claims could have an adverse impact on our business and financial condition. This could be the case even if we ultimately had no liability on any particular claim, since the costs of defending any environmental or product liability claim could be prohibitive. To date, the Company has not been identified as a potential responsible party to such environmental or product liability risks, nor have any amounts been recorded to accrue for these potential exposures.

Many of the risks of our business have only limited insurance coverage and many of our business risks are uninsurable.

Our business operations are subject to potential environmental, product liability, employee and other risks. Although we have insurance to cover some of these risks, the amount of this insurance is limited and includes numerous exceptions and limitations to coverage. Further, no insurance is available to cover certain types of risks, such as acts of god, war, terrorism, major economic and business disruptions and similar events. In the event we were to suffer a significant environmental, product liability, employee or other claim in excess of our insurance or a loss or damages relating to an uninsurable risk, our financial condition could be negatively impacted. In addition, the cost of our insurance has increased substantially in recent years and may prove to become prohibitively expensive, thus making it impractical to obtain insurance. This may result in the need to abandon certain business activities or subject ourselves to the risks of uninsured operations.

If we are unable to protect our intellectual property, or our intellectual property protection efforts are unsuccessful, others may duplicate our technology.

We rely on a combination of patents, copyrights and trade secret laws and restrictions on disclosure to protect our intellectual property rights. Our ability to compete effectively will depend, in part, on our ability to protect our proprietary technology, systems designs and manufacturing processes. In this regard, we recently entered into new emissions control solution markets with respect to diesel emissions technology and SCR Catalyst and Management Services in which we do not have as broad of intellectual property protection as we do in the NOx control solutions area for small gas turbines. Consequently, our ability to compete effectively in such new emission control solution markets may be adversely affected by our inability to exclude competitors based on our intellectual property position. The ability of others to use our intellectual property could allow them to duplicate the benefits of our products and reduce our competitive advantage. We do not know whether any of our pending patent applications will issue or, in the case of patents issued, that the claims allowed are or will be sufficiently broad to protect our technology or processes. Further, a patent issued covering one use of our technology may not be broad enough to cover uses of that technology in other business areas. Even if all our patent applications are issued and are sufficiently broad, they may be challenged or invalidated. We could incur substantial costs in prosecuting patent and other intellectual property infringement suits and defending the validity of our patents and other intellectual property. While we have attempted to safeguard and maintain our property rights, we do not know whether we have been or will be completely successful in doing so. These actions could place our patents, trademarks and other intellectual property rights at risk and could result in the loss of patent, trademark or other intellectual property rights protection for the products, systems and services on which our business strategy partly depends.

We rely, in part, on contractual provisions to protect our trade secrets and proprietary knowledge. These agreements may be breached, and we may not have adequate remedies for any breach. Our trade secrets may also be known without breach of such agreements or may be independently developed by competitors.

Third parties may claim that we are infringing their intellectual property, and we could suffer significant litigation or licensing expenses or be prevented from selling products and services if these claims are successful.

Our competitors may independently develop or patent technologies or processes that are equivalent or superior to ours. In recent years, there has been significant litigation involving patents and other intellectual property rights in many technology-related industries and we believe our industry has a significant amount of patent activity. Third parties may claim, that the technology or intellectual property that we incorporate into or use to develop or manufacture our current and future products, systems or services infringe, induce or contribute to the infringement of their intellectual property rights, and we may be found to infringe, induce or contribute to the infringement of those intellectual property rights and require a license to use those rights. We may also be required to engage in costly efforts to design our products, systems and services around the intellectual property rights of others. The intellectual property rights of others may cover some of our technology, products, systems and services. In addition, the scope and validity of any particular third party patent may be subject to significant uncertainty.

Litigation regarding patents or other intellectual property rights is costly and time consuming, and could divert the attention of our management and key personnel from our business operations. The complexity of the technology involved and the uncertainty of intellectual property litigation increase these risks. Claims of intellectual property infringement might also require us to enter into costly royalty or license agreements or indemnify our customers. However, we may not be able to obtain royalty or license agreements on terms acceptable to us or at all. Any inability on our part to obtain needed licenses could delay or prevent the development, manufacture and sale of our products, systems or services. We may also be subject to significant damages or injunctions against development, manufacture and sale of our products, systems or services.

We incur substantial costs as a result of being a public company.

As a public company, we incur significant legal, accounting, and other expenses. In addition, both the Sarbanes-Oxley Act of 2002 and the rules subsequently implemented by the Securities and Exchange Commission and NASDAQ, have required changes in corporate governance practices of public companies. These new rules and regulations have already increased our legal and financial compliance costs and the amount of time and effort we devote to compliance activities. We expect these rules and regulations to further increase our legal and financial compliance costs and to make compliance and other activities more time-consuming and costly. In addition, we incur costs associated with our public company reporting requirements. Further, due to increased regulations, it may be more difficult for us to attract and retain qualified persons to serve on our board of directors or as executive officers. We have attempted to address some of these attraction and retention issues by offering contractual indemnification agreements to our directors and executive officers, but this may not be sufficient. We continue to regularly monitor and evaluate developments with respect to these new rules with our legal counsel, but we cannot predict or estimate the amount of additional costs we may incur or the timing of such costs.

Because a small number of stockholders own a significant percentage of our common stock, they may exert significant influence over major corporate decisions, and our other stockholders may not be able to do so.

As of March 31, 2006, our executive officers, directors and greater than 5% stockholders controlled 60.5% of our outstanding common stock. If these parties were to act together, they could significantly influence the election of directors and the approval of actions requiring the approval of a majority of our stockholders. The interests of our management or these investors may not always be aligned with the interests of our other stockholders.

Based on shares outstanding as of June 30, 2006, the funds managed by Metalmark Capital LLC on behalf of Morgan Stanley Capital Partners and their affiliates own 18.6% of our outstanding common stock. The Morgan Stanley Capital Partners funds also have stockholder rights, including rights to appoint directors and registration rights. As a result, Morgan Stanley Capital Partners and its affiliates hold a substantial voting position in us and may be able to significantly influence our business.

Provisions in our charter documents, our Shareholder Rights Plan and Delaware law may prevent or delay an acquisition of us, which could decrease the value of our securities.

Our certificate of incorporation and bylaws and Delaware law contain provisions that could make it more difficult for a third party to acquire us without the consent of our board of directors. Furthermore, we have adopted a Shareholder Rights Plan with anti-takeover provisions which are triggered if any stockholder acquires 20% or more (or 21.5% in the case of Morgan Stanley Capital Partners III, L.P. and its affiliates) of our outstanding common stock, resulting in significant dilution of the shares owned by such stockholder unless such stockholder obtains consent of our Board of Directors to purchase shares in excess of the threshold. Thus, the plan could substantially impede the ability of public stockholders to benefit from a change in control or change in our management and board of directors.

Liabilities we acquired as a result of our spin-off may have a negative effect on our financial results.

We incurred additional liabilities as a result of our spin-off from Catalytica, Inc. For example, when the business of Catalytica Advanced Technologies, Inc. (“CAT”) was combined with ours, we became responsible for the liabilities of CAT. Additionally, we have obligations under the separation agreements we entered into with Catalytica, Inc., Synotex and DSM Catalytica Pharmaceuticals, Inc., the successor corporation to Catalytica, Inc. For example, we agreed to indemnify DSM for liabilities arising out of our business, the business of CAT and other liabilities of DSM not associated with the pharmaceuticals business it purchased from Catalytica, Inc., which could include, for example, potential environmental liabilities. We are also responsible for specified potential liabilities arising out of the distribution of our common stock by Catalytica, Inc. To date, no claims have been made against us pursuant to these indemnification provisions and, at June 30, 2006, we believe the likelihood of any material claim being made against us is remote. However, if any additional liabilities materialize, our financial results could be harmed.

ADDITIONAL RISKS RELATING TO SCR CATALYST AND MANAGEMENT SERVICES

In addition to the risks discussed elsewhere, any of which also could adversely impact our SCR-Tech subsidiary and its business, the following additional risks specifically relate to SCR-Tech and could negatively impact SCR-Tech and the entire Company.

SCR-Tech has not been profitable in periods prior to the six months ended June 30, 2006 and there can be no assurance SCR-Tech will remain profitable in future periods.

Although SCR-Tech generated a profit for the six-month period ended June 30, 2006, it has historically not been profitable. No assurance can be given that SCR-Tech will be able to generate significant SCR management services revenues or SCR catalyst cleaning and regeneration services revenues or that SCR-Tech will be profitable for the full year of 2006 or in any future period.

We have limited experience with the operations of SCR-Tech.

We completed the acquisition of SCR-Tech in February 2004. SCR-Tech was a privately-held company, which commenced commercial operations in the U.S. in March 2003. At the time we acquired SCR-Tech, we had no experience in the SCR-related business and we have just begun to integrate our management, technology and systems with SCR-Tech. In addition, SCR-Tech did not previously have audited financial statements. Thus, there is a risk that unknown financial or other liabilities could negatively impact SCR-Tech and us.

SCR-Tech has very limited operating experience in North America. SCR-Tech may not be able to profitably operate its business.

SCR-Tech commenced commercial operations in its U.S. regeneration facility in March 2003 and has completed only a limited number of SCR cleaning and regeneration projects. Thus SCR-Tech does not have a substantial operational history in this facility to determine whether it can successfully operate its business under differing environments and conditions or at any level of sustained profitability.

The size of the market for SCR-Tech’s business is uncertain.

SCR-Tech offers SCR catalyst cleaning, rejuvenation and regeneration, as well as SCR system management and consulting services. The size and growth rate for this market will ultimately be determined by a number of factors, including environmental regulations, the growth in the use of SCR systems to reduce NOx and other pollutants, the length of operation of SCR systems without the need for cleaning, the differences, if any, in the accounting and rate-base effect of using regenerated SCR catalyst as compared to new SCR catalyst as adopted or approved by applicable federal and state regulatory authorities, rejuvenation or regeneration, the expansion of warranty coverage from SCR catalyst OEMs, the cost of new SCR catalyst, and other factors, most of which are beyond the control of SCR-Tech. There is limited historical evidence in North America as to the cycle of replacement, cleaning and regeneration of SCR catalyst so as to accurately estimate the potential growth of the business. In addition, the number of times a catalyst can be regenerated is unknown, which also may affect the demand for regeneration in lieu of purchasing new catalyst. Any delay in the development of the market could significantly and adversely affect the value of SCR-Tech and the nature of any return on our acquisition of SCR-Tech.

SCR-Tech may be subject to vigorous competition with very large competitors that have substantially greater resources and operating histories.

Although there does not appear to be a direct competitor in the business of SCR catalyst regeneration in North America, we are aware of at least one other company, Enerfab, Inc. (which uses a process developed by Envirgy/Integral), providing SCR catalyst management, rejuvenation and cleaning services. There also are a number of SCR catalyst manufacturers with substantial parent companies that may seek to maintain market share by significantly reducing or even eliminating all profit margins. These companies include Cormetech Inc. (owned by Mitsubishi Heavy Industries and Corning, Inc.), Argillon GmbH (formerly Siemens), BASF / CERAM, Haldor-Topsoe, Inc. and Hitachi America. Further, if the SCR catalyst regeneration market expands, competitors could emerge. If the intellectual property protection acquired by us becomes weakened, competition could more easily develop.

SCR-Tech’s business is subject to potential seasonality.

Because some utilities and independent power producers (“IPPs”) currently operate their SCR units only during the “ozone season” (May 1 – September 30), SCR-Tech’s business may be more limited than if SCR units were required to operate on a continual basis. The NOx State Implementation Plan (“SIP”) Call was configured to impose a summer ozone season NOx limitation over 19 states and the District of Columbia. During this period, utilities and IPPs seek to operate their SCR catalyst at maximum capacity so as to reduce NOx emissions during this period. During non-ozone season periods, most operators currently have limited (if any) requirements to run their SCR systems. Unless and until such regulations are tightened, much of SCR-Tech’s business may be concentrated outside the ozone season each year. This will likely result in less business than if SCR units were required to be operated throughout the year and this also may result in quarters of relatively higher cash flow and earnings and quarters where cash flow and earnings may be minimal. These potential fluctuations in revenues and cash flow during a year may be significant and could materially impact our quarterly earnings and cash flow. This may have a material adverse effect on the perception of our business and the market price for our common stock.

SCR-Tech may be subject to warranty claims from its customers.

SCR-Tech typically provides limited warranties to its customers relating to the level of success of its catalyst cleaning and regeneration services. In the event SCR-Tech is unable to perform a complete regeneration of an SCR catalyst, SCR-Tech may be required to re-perform a regeneration or repay a portion of the fees earned for the regeneration efforts. SCR-Tech also may be required to provide warranties with respect to its other SCR catalyst services provided to its customers. Since SCR-Tech has only a limited operating history in North America, it is not possible to determine the amount or extent of any potential warranty claims that SCR-Tech may incur. There is a risk that any such claims could be substantial and could affect the profitability of SCR-Tech and the financial condition of the Company.

SCR-Tech is dependent on third parties to perform certain testing required to confirm the success of its regeneration.

In connection with the regeneration of SCR catalyst, SCR-Tech generally must have an independent company provide testing services to determine the level of success of regeneration. Currently there are a limited number of companies providing this service. If SCR-Tech is unable to obtain this service on a cost-effective basis, SCR-Tech may not be able to perform its regeneration services.

SCR-Tech’s business may be subject to customer concentration.

SCR-Tech offers SCR catalyst cleaning, rejuvenation and regeneration, as well as SCR system management and consulting services to coal-fired power plants. Some of the utilities operating these plants are exceptionally large and operate a number of such power plants. Thus, one or more large utilities could provide a very large order or orders to SCR-Tech which likely would result in one or more such utilities providing most of the orders and revenues for SCR-Tech for a particular quarterly or annual period. In the first half of 2006, one customer represented 56% of our revenue for such period. Although such large orders could prove extremely beneficial to SCR-Tech by providing a large and consistent source of orders and revenues without the expense of marketing to a number of smaller customers, SCR-Tech could become highly dependent on a small number of large utilities for its business. In such event, the loss of a particular customer would have a much greater adverse effect on SCR-Tech than the loss of a smaller customer. This also may result in significant swings in orders and revenues on a quarterly basis. SCR-Tech cannot at this time determine the likelihood or extent of such customer concentration.

SCR-Tech is still dependent on ENVICA.

SCR-Tech has required assistance of an affiliate of one of the former owners of SCR-Tech, ENVICA Kat GmbH, to successfully complete certain contracts. In addition, SCR-Tech has been relying to a limited extent on the assistance of ENVICA on various technical and support matters relating to its business. There can be no assurance that SCR-Tech and its current employees will be ultimately able to successfully operate the business or expand the business without the continued assistance of ENVICA. Further, there can be no assurance that SCR-Tech will not incur significant unanticipated technical problems and costs which could adversely affect SCR-Tech’s business.

SCR-Tech is highly dependent upon the strength of its intellectual property to protect its business.

In addition to the intellectual property risks relating to ongoing dealings with ENVICA, there can be no assurance the intellectual property acquired by us as part of the acquisition of SCR-Tech will prove sufficient or enforceable or that our activities will not infringe the rights of competitors or other third parties. Further, much of the intellectual property used by SCR-Tech is in the form of trade secrets, for which patent protection is not available or being sought.

SCR-Tech does not own its regeneration facilities and it is subject to risks inherent in leasing the site of its operations.

SCR-Tech does not own its regeneration site; instead it leases it from Clariant Corporation, the U.S. subsidiary of a Switzerland-based public company. Although we believe the lease terms are favorable, the dependence on Clariant and the site could subject SCR-Tech to increased risk in the event Clariant experiences financial setbacks or loses its right to operate the site upon which SCR-Tech leases property. This risk is heightened because of the fact the site is a Federal Superfund site (under the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (“CERCLA”), which increases the risks the site ultimately could be shut down or that Clariant will be financially unable to continue its ownership of the site. It may be difficult to relocate to another site on a cost-effective basis, and SCR-Tech’s business could be negatively impacted by any problems with continuing to conduct its operations at its current site.

SCR-Tech may require unexpected capital expenditures to expand its production facilities.

SCR-Tech does not own its regeneration site; instead it leases it from Clariant Corporation. We believe this site is sufficient to meet SCR-Tech’s anticipated production requirements for 2006 and 2007. However, orders for SCR regeneration services have increased significantly in recent months, and it is possible that SCR-Tech’s currently

facilities may prove inadequate to meet unanticipated increased demand for regeneration services. Although we believe SCR-Tech’s current site allows for building additional regeneration facilities, including a doubling of current capacity, such construction could require significant capital expenditures, necessary permitting and time for construction. There can be no assurance that SCR-Tech could meet the demands of a rapid increase in orders in a timely manner. Any failure to timely fulfill such orders could have an adverse impact on SCR-Tech’s business.

SCR-Tech could be subject to environmental risks as a result of the operation of its business and the location of its facilities.

The operation of SCR-Tech’s business and the nature of its assets create various environmental risks. SCR-Tech leases its site for operations at a property listed on the National Priority List as a Federal Superfund site. Five CERCLA Areas (those areas of concern identified under the CERCLA program) are identified on the property, and while SCR-Tech does not lease any property identified as a CERCLA Area, one such Area has resulted in contamination of groundwater flowing underneath one of the buildings leased by SCR-Tech. Although SCR-Tech has indemnification from Clariant Corporation for any environmental liability arising prior to the operation of SCR-Tech’s business at the site, there can be no assurance that such indemnification will be sufficient or that SCR-Tech could be protected from an environmental claim from the nature of the site. In addition, the operation of SCR-Tech’s business involves removal of hazardous wastes from catalyst and the use of significant chemical materials. As a result, SCR-Tech could be subject to potential liability from such operations. To date, the Company has not been identified as a potential responsible party to such environmental risks, nor have any amounts been recorded to accrue for these potential exposures.

Risks of Purchasing Used SCR Catalyst

SCR-Tech’s primary business involves the cleaning and regenerating of customer-owned SCR catalyst. In certain instances, however, SCR-Tech may purchase used or “spent” catalyst from utilities for regeneration. This may occur, for example, when a utility wishes to avoid the costs and potential hazardous waste issues associated with the disposal of used or “spent” catalyst. SCR-Tech may purchase SCR catalyst for a nominal sum and then regenerate such catalyst for immediate sale, or may purchase spent SCR catalyst on an opportunistic basis for future regeneration and sale. The purchase of spent SCR catalyst involves additional potential risks to SCR-Tech. First, spent SCR catalyst includes significant hazardous waste. Unlike the regeneration of customer-owned SCR catalyst, the purchase of spent SCR catalyst requires SCR-Tech to take ownership or “title” to the SCR catalyst, which may potentially increase SCR-Tech’s environmental risk exposure. Further, if SCR-Tech cannot find a customer to purchase the regenerated catalyst, then SCR-Tech will be required to either store the spent catalyst, with all of the risk inherent in holding catalyst which has not been regenerated and contains hazardous waste, or incur significant costs to dispose of the spent catalyst in a manner which complies with the strict requirements to dispose of potentially hazardous wastes. It is unclear as to the amount of SCR catalyst which SCR-Tech may purchase, but it is possible such purchases ultimately may be substantial, which would potentially significantly increase the risk profile of SCR-Tech’s business.

ADDITIONAL RISKS RELATING TO EMISSIONS CONTROL SOLUTIONS FOR DIESEL ENGINES

In addition to the risks discussed elsewhere, any of which could adversely impact our efforts to develop emissions control solutions for diesel engines, the following additional risks particularly relate to our efforts to develop emissions control solutions for diesel engines and could negatively impact our entire company.

We may never complete the research and development of commercially viable emissions control solutions for diesel engines.

We are in the very early development stage associated with emissions control solutions for diesel engines. We do not know when or whether we will successfully complete research and development of a commercially viable product in the diesel OEM or stationary diesel generator set (“genset”) markets. Economic and technical difficulties may prevent us from completing development of products for diesel engines or commercializing those products. Furthermore, a viable market for our product concept may never develop. If demand for our emissions control solutions were to develop in the diesel OEM or stationary genset markets using our emissions control solutions, we likely would face intense competition from various competitors, including large diesel engine OEMs, and we may be unable to compete successfully. In addition, diesel engine OEMs and other competitors may create technology

alternatives that could render our systems obsolete prior to commercialization. Moreover, we may conclude that the potential return from our investment in the diesel OEM or stationary diesel genset markets does not justify our continued investment in these opportunities, and thus decide to shut-down this program. In this regard, we recently terminated our diesel retrofit program, which resulted in the loss of our investment in such program. Further, no assurance can be given that we will not incur substantial expenses to discontinue these remaining business programs, including personnel reduction costs, environmental clean-up and equipment disposal costs, lease termination expenses and other shut-down related costs.

We may not have sufficient capital to complete development of a commercially viable emissions control solution for diesel engines.

Even if we ultimately overcome all the technical and business hurdles described herein to develop a commercially viable diesel emissions reduction product, we may never have the opportunity to fully undertake the necessary development because of the significant financial requirements to develop a commercial product. We currently estimate that the total remaining development costs for continuing to pursue our diesel OEM NOx and PM solutions for new, over-the-road diesel engines will be in excess of $10 million, and potentially substantially in excess of such sum. We likely will not have sufficient capital to complete necessary development and commercialization work without a significant financial or equivalent commitment from diesel OEM’s or suppliers, especially since we would be unlikely to receive any significant commercial revenues from a product until 2009. If we determine that we do not have the financial capability to complete the necessary development and commercialization work, then we may determine not to continue pursuing some or all of our diesel-related programs even if we believe we ultimately could solve all technical and business problems related to a product launch and even if we believe that the financial benefits of completing such a product would be significant. If we reach such a conclusion, then we likely would find it necessary or desirable to discontinue our efforts in the diesel emission reduction solutions business and seek to sell such business. In such event, we likely would realize little if any significant value from our investment in the diesel emissions reduction solution market. Further, the costs of discontinuing our diesel emissions reduction solutions business may exceed any value from a sale of this business as a result of shut-down related costs, such as personnel expenses and any environmental clean-up and equipment disposal costs.

We will be heavily dependent on developing relationships with diesel industry companies, including large diesel OEMs or suppliers to OEMs, and their commitment to adopt and market our diesel emissions reduction technology for their or their customers’ diesel engines in order to enter the diesel OEM marketplace; any agreements with these diesel industry companies may limit our market opportunities.

In order to take advantage of the opportunities for NOx control solutions in the diesel OEM market, we must develop a solution that results in significant NOx reduction (approximately 90%) to meet impending United States, European Union or Japanese requirements for diesel engines. This will require us to partner with one or more diesel industry companies, including large diesel OEMs or suppliers to OEMs. Until we can demonstrate the viability of our diesel fuel processor for the diesel OEM market, it is unlikely we can develop the necessary OEM or OEM supplier relationships. Our failure to commercialize a diesel retrofit solution could adversely impact our ability to develop the necessary credibility with diesel OEMs or suppliers with respect to our diesel OEM solutions.

Even if we are successful in entering into agreements with a diesel OEM or OEM supplier, the agreements may provide the OEM with the right to be the exclusive market channel for distribution of our technology and may otherwise limit our ability to enter into other OEM or OEM supplier agreements. An agreement may provide for exclusivity for particular engine sizes and for limited periods of time. The agreements also may provide that either party can terminate the agreement, but not necessarily the exclusivity provision. A decision by an OEM or OEM supplier to discontinue the commercialization of our technology in certain engines could significantly limit or foreclose our access to the market for those engines or prevent us from entering into agreements with other OEMs or OEM suppliers regarding the application of our technology to some of their competing engines.

We may incur significant costs in developing our diesel technology with OEMs or suppliers to OEMs; if any OEM or OEM supplier does not complete development for any reason, we may not be able to recover costs incurred for the development with that OEM or OEM supplier.

We may incur significant costs in developing our diesel technology with OEMs or suppliers to OEMs for the diesel OEM market. Further, the technological development required to meet the requirements for this decade may

be significant, and the capital required to be invested in such a development is likely to be substantial. Moreover, there can be no assurance that any solution developed by us will be technically feasible, cost-effective or acceptable to OEMs or OEM suppliers. We are not likely to recover any significant portion of these costs through contractual reimbursement from the OEMs or OEM suppliers. Thus, we will likely bear the majority of the development costs ourselves. If OEMs or OEM suppliers do not complete development work for any reason, we will not be able to recover our development costs through product sales.

We will be dependent on third party development of NOx adsorbers for our diesel products.

Even if our diesel fuel processor is accepted in the diesel markets, if NOx adsorbers for heavy-duty diesel engine applications do not evolve to a state of commercial viability, OEMs will not ultimately adopt our technology. While NOx adsorbers are in limited commercial use today in medium and light-duty diesel engine applications, a variety of technical hurdles associated with the use of NOx adsorbers in heavy-duty diesel engine applications remain. Although our diesel fuel processor has the benefit of lessening certain NOx adsorber limitations, significant technological hurdles, including cost, size, durability, operating range and the level of NOx reduction from NOx adsorbers must be overcome to ensure the feasibility of commercializing our diesel fuel processor in combination with a NOx adsorber for heavy-duty diesel engine applications. The failure of third parties to develop solutions to current NOx adsorber limitations in a timely manner will effectively eliminate our diesel fuel processor from market consideration. We may not have any ability to significantly influence the resolution of NOx adsorber issues. Further, a supplier’s failure to develop and supply components in a timely manner or at all, or to develop or supply components that meet our quality, quantity or cost requirements, or our inability to obtain substitute sources of these components on a timely basis or on terms acceptable to us, could harm our ability to manufacture our products. In addition, to the extent that our supply partners use technology or manufacturing processes that are proprietary, we may be unable to obtain comparable components from alternative sources.

We will be dependent on third party suppliers for the supply of key components for our diesel products.

We have not entered into commercial arrangements with suppliers of the key components which may be required for our diesel emissions reduction solutions. We do not know when or whether we will secure arrangements with suppliers of required materials and components for our diesel products, even if they are successfully developed, or whether these arrangements will be on terms that will allow us to achieve our objectives. Even if we can develop a commercially viable diesel OEM or stationary diesel genset solution, if we are unable to obtain suppliers of all the required materials and components for our systems, our business could be harmed. A supplier’s failure to supply materials or components in a timely manner, its failure to supply materials or components that meet our quality, quantity or cost requirements, or our inability to obtain substitute sources of these materials and components on a timely basis or on terms acceptable to us, could harm our ability to manufacture our diesel solutions.

We may be subject to significant competition from companies including those that may have substantially greater resources and market credibility.

The size of the diesel OEM and stationary diesel genset markets has attracted a number of significant participants. In the diesel OEM market, there are a number of significant competitors, including Arvin Meritor, Eaton Corporation and Delphi Corporation and the major diesel OEMs such as Cummins, Caterpillar, Detroit Diesel, ITEC and Volvo. Some of these competitors have announced solutions for the 2007 NOx regulations. Further, these competitors also have substantially greater resources and a more established presence than we do in this market. There can be no assurance that we can successfully compete in either the diesel OEM or diesel genset markets, even if we were to develop a technologically feasible emissions solution in these markets.

Alternate technologies may provide a more effective solution than our diesel NOx reduction technology.

Even if we are able to develop and commercialize a NOx reduction solution for diesel engines, there can be no assurance that any such solution will be either practical or cost-effective. Currently, a number of competitors have developed verified NOx control solutions in the diesel retrofit market and a number of competitors have developed announced solutions in the diesel OEM market to comply with the United States 2007 regulations. These solutions are based on different technology than the basis for our proposed NOx solution, including exhaust gas recirculation (“EGR”) and other advanced engine controls. An additional potential competitive threat may come from proven SCR technology. We are aware that some European diesel engine OEMs have implemented SCR for heavy-duty diesel engine applications in Europe to meet the Euro IV emissions standards that took effect in October 2005.

Furthermore, a representative from the EPA recently acknowledged that diesel engine manufacturers have officially selected SCR as an option for meeting the 2010 U.S. emissions regulations, but are continuing to consider alternate paths for at least another year. Although we believe our proposed solution, if successful, will constitute a cost-effective and competitive solution in the diesel OEM market, no assurance can be given that alternate technologies will not prove to be more reliable or otherwise more successful in the market.

Failure to successfully demonstrate our technology in field tests could negatively impact demand for our products.

We have recently encountered technical problems associated with our diesel retrofit product, specifically related to the performance and integration of various third-party components and have terminated this program. We also may encounter technical problems in connection with our other diesel products for a number of reasons, including the failure of our technology or the technology of third parties, or our failure to maintain and service our products properly. Many of these potential problems and any resulting commercial delays are beyond our control. Any problem or perceived problem with our field tests could materially harm our reputation and impair market acceptance of, and demand for, our products.

We may not meet our product development and commercialization milestones, which could have a material adverse effect on our operations.

We have established product development and commercialization milestones that we use to assess our progress toward developing commercially viable emissions control solutions for our diesel engine applications. These milestones relate to technology and design improvements as well as to dates for achieving product development goals. To gauge our progress, we operate, test and evaluate our diesel products under various testing conditions. If our systems exhibit technical defects or are unable to meet cost or performance goals, including targeted levels of NOx or PM reduction, temperature variability, durability and fuel economy, our commercialization schedule could be delayed and potential purchasers of our initial commercial products may decline to purchase them or choose to purchase alternative technologies. We have in the past failed to achieve announced technical milestones and we cannot be sure that we will successfully achieve our milestones in the future or that any failure to achieve these milestones will not result in potential competitors gaining advantages in our target market. Failure to meet publicly announced milestones could also have a material adverse effect on our operations.

Significant warranty and product liability risks could arise from our diesel emissions reduction solutions.

Even if we are able to successfully develop and commercialize emissions control solutions for the diesel OEM, or stationary diesel genset markets, we will be required to provide product warranties. It is unclear as to the nature of these warranties at this time, but the warranties may include specified levels of reforming activity, hydrocarbon emissions levels and/or low temperature startup activity for substantial time and/or mileage requirements in order to activate necessary NOx or PM reduction during such periods. If we are unable to satisfy these warranties, we could incur significant liability to diesel OEMs and potentially end users, including consumers. In addition, the manufacture, sale and distribution of our diesel fuel processor could expose us to potential product liability to customers and end users, including consumers. Any such liability could be significant and may not be insurable.

We have no experience manufacturing our diesel products on a commercial basis.

To date, we have focused primarily on research and development and have no experience manufacturing diesel products on a commercial scale. We may not be able to develop efficient, low-cost manufacturing capability and processes that will enable us to meet the quality, price, engineering, design and production standards or production volumes required to manufacture our diesel products on a commercial scale. We may also encounter difficulty purchasing components and materials, particularly those with long lead times. Even if we are successful in developing our manufacturing capability and processes, we do not know whether we will do so in time to meet our product commercialization schedules or to satisfy the requirements of our customers.

ADDITIONAL RISKS RELATING TO RESTRUCTURING ACTIVITIES AND RECENT DEVELOPMENTS

In addition to the risks discussed elsewhere, any of which could adversely impact our operations, the following additional risks particularly relate to our restructuring activities and recent developments and could negatively impact our entire company.

Although we have entered into an agreement to sell our Xonon Cool Combustion technology for gas turbines and associated gas turbine assets to Kawasaki Heavy Industries, we are involved in a contract dispute with Kawasaki that could result in adverse financial consequences and a diversion of resources and management time and attention from business operations if the transaction does not close.

In September 2005 we announced our election to terminate our Xonon Module Supply Agreement with Kawasaki Gas Turbines-Americas (“Kawasaki”), effective December 13, 2005, having determined that there was no business or financial justification to continue the agreement on its current terms. After receiving notice of such termination, but prior to December 13, 2005, Kawasaki purported to place an order for 27 Xonon modules at a total price of approximately $1 million, which we rejected. Kawasaki has disputed our rejection of the purchase order and has indicated it may seek arbitration of the dispute pursuant to the Supply Agreement. We do not believe we have any obligation to fill this order upon the terms proposed by Kawasaki or on any other terms. Further, we do not believe we have the manufacturing capabilities to fill such an order, and even if we did, we believe the cost of completing such order would be substantially in excess of the $1 million order price. Thus, if Kawasaki were to seek arbitration and an arbitrator were to order us to complete the order, we would suffer significant losses. However, the Supply Agreement contains a maximum limit on damages in the amount of the order price, which we believe should limit any potential damages in arbitration. There can be no assurance, however, as to the result of any arbitration or the amount of damages which could occur if Kawasaki were to prevail in such an arbitration or other litigation. In addition, resolution of this dispute, whether by litigation, arbitration or otherwise, could divert the attention of our management and key personnel from our business operations. On June 30, 2006, we entered into a definitive agreement to sell our Xonon Cool Combustion catalytic combustion technology and associated gas turbine assets to Kawasaki Heavy Industries for a purchase price of $2.1 million. The definitive agreement provides that if the transaction closes, all of our claims with Kawasaki and its affiliates would be resolved. However, the closing of the transaction is subject to, among other things, certain closing conditions and the securing of certain consents, and there can be no assurance that all such closing conditions will be met, that all such consents will be obtained or that the transaction will otherwise close.

We likely will never complete the research and development of a commercially viable fuel processor to be utilized with PEM fuel cell applications.

In October 2005, we completed work on a $11,658,000 DOE cost-shared contract initiated in October 2001 associated with the development of a compact fuel processor that could convert conventional fuels, such as gasoline, to hydrogen to power proton exchange membrane (“PEM”) fuel cells, with applications in automotive, stationary, auxiliary and back-up power. Due to a lack of continued funding or partner commitments and our efforts to rationalize our ongoing operations, we are no longer conducting research or development activities associated with fuel processing for fuel cell applications.

We do not believe that our PEM fuel cell business has any significant value at this stage of development, and thus we do not believe we could realize any significant value from a sale of this business.

ITEM 3. CONTROLS AND PROCEDURES

(a) Evaluation of disclosure controls and procedures. Our management evaluated, with the participation of our Chief Executive Officer and our Chief Financial Officer, the effectiveness of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as of the end of the period covered by this Quarterly Report on Form 10-QSB. Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures are effective as of June 30, 2006 to ensure that information we are required to disclose in reports that we file or submit under the Exchange Act is (i) recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms and (ii) accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

(b) Changes in internal control over financial reporting. There was no change in our internal control over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-QSB that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II - OTHER INFORMATION

Item 1. LEGAL PROCEEDINGS

Although we may be subject to routine litigation that is incidental to our business from time to time in the ordinary course of our business, we are not currently a party to any material legal proceeding.

Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None

Item 3. DEFAULTS UPON SENIOR SECURITIES

None

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

On June 8, 2006, at the Company’s Annual Meeting of Stockholders, a quorum of stockholders of the Company approved the following proposals: (1) the election of two Class III Directors to each serve a three-year term, and (2) the ratification of the appointment of Ernst & Young LLP to serve as the Company’s independent registered public accountants for the 2006 fiscal year.

The Company’s Board of Directors is divided into three classes, with Directors in each class serving for three-year terms. Accordingly, not all Directors are elected at each Annual Meeting of Stockholders. Ricardo B. Levy and Robert W. Zack were elected during this year’s Annual Meeting. The Directors whose terms of office continued after the meeting were Richard A. Abdoo, William B. Ellis, Howard I. Hoffen, David F. Merrion and Susan F. Tierney.

The proposals listed below were voted on at the Annual Meeting of Stockholders, and the number of votes cast with respect to each matter and the election of each Director, were as follows:

Proposal No. 1– Election of Directors

Nominee	For	Withheld
Ricardo B. Levy	17,311,316	451,368
Robert W. Zack	17,520,748	241,936

Proposal No. 2 – Ratification of Appointment of Independent Registered Public Accountants

For		Against		Abstain
17,739,966		21,183		1,535

In addition, subsequent to the Annual Meeting, we decreased the number of members on our Board of Directors from nine to seven, following the resignations from the Company’s Board of Directors of Frederick M. O’Such and John A. Urquhart, effective as of the Annual Meeting.

Item 5. OTHER INFORMATION

None

Item 6. EXHIBITS

(a) Exhibits

Exhibit Number	Notes	Description

2.1	(5)	Assignment and Assumption Agreement between Catalytica, Inc. and the Registrant, effective as of July 25, 1995.
2.1A	(28)	Membership Interests and Asset Purchase Agreement dated as of January 21, 2004 by and among EnBW Energy Solutions GmbH, with respect to Articles VII and X only, ENVICA GmbH, ENVICA Kat GmbH, E&EC Energy & Environmental Consultants GmbH, SCR-Tech GmbH, CESI-SCR, Inc. and, with respect to Section 11.18 and Articles VI and IX only, Catalytica Energy Systems, Inc., filed as Exhibit 2.1, dated as of January 21, 2004.
2.2	(11)	Employee Matters Agreement between Catalytica, Inc. and the Registrant, effective as of December 15, 2000.
2.2A	(28)	Amendment No. 1 to Membership Interests and Asset Purchase Agreement by and among EnBW Energy Solutions GmbH, ENVICA GmbH, ENVICA Kat GmbH, E&EC Energy & Environmental Consultants GmbH, SCR-Tech GmbH, SCR-Tech LLC, CESI-SCR, Inc., filed as Exhibit 2.2, dated as of February 20, 2004.
2.3	(11)	Form of Master Trademark Ownership and License Agreement between Catalytica, Inc. and the Registrant, effective as of December 15, 2000.
2.4	(11)	Tax Sharing Agreement between Catalytica, Inc., Synotex, Inc. and the Registrant, dated as of December 15, 2000.
2.5	(11)	Master Confidential Disclosure Agreement between Catalytica, Inc. and the Registrant, effective as of December 15, 2000.
2.6	(5)	Cross-License Agreement between Catalytica, Inc. and the Registrant, effective as of July 1995.
2.7	(5)	Cross-License Agreement between Catalytica Advanced Technologies, Inc. and Catalytica, Inc., dated July 1995.
2.8	(5)	Tax Sharing Agreement between Catalytica, Inc., Catalytica Bayview, Inc., Catalytica Advanced Technologies, Inc. and the registrant, dated March 4, 1999.
2.8A	(11)	Indemnification Agreement between Catalytica, Inc. and the Registrant, filed as Exhibit 2.8, dated December 15, 2000.
2.9	(11)	Transition Services Agreement between Catalytica, Inc. and the Registrant, dated December 15, 2000.
2.10	(11)	Real Estate Matters Agreement between Catalytica, Inc. and the Registrant, dated December 15, 2000.
2.11	(11)	Master Separation Agreement between Catalytica, Inc. and the Registrant, dated December 15, 2000.
3.1	(11)	Amended and Restated Certificate of Incorporation of Catalytica Energy Systems, Inc., dated December 13, 2000.
3.1A	(18)	Certificate of Designation, the form of Rights Certificate and the Summary of Rights attached thereto as Exhibits A, B and C, respectively, filed as Exhibit 4.1, dated January 29, 2002.
3.2	(8)	Form of Amended and Restated Bylaws.
4.1	(11)	Stock Specimen of the Registrant.
4.1A	(18)	Preferred Stock Rights Agreement between the Registrant and Mellon Investor Services LLC, including the Certificate of Designation, the form of Rights Certificate and the Summary of Rights attached thereto as Exhibits A, B, and C, respectively, filed as Exhibit 4.1, dated January 29, 2002.
4.1B	(35)	Amended and Restated Preferred Stock Rights Agreement with Mellon Investor Services LLC, filed as Exhibit 4.1, dated November 22, 2004.
10.4	(5)*	Promissory Notes from Peter B. Evans issued to Registrant, both dated July 20, 1999.
10.6	(3)	Limited Liability Company Operating Agreement of GENXON Power Systems,

		LLC, dated October 21, 1996.
10.7	(4)	Amendment No. 1 to the Operating Agreement of GENXON Power Systems, LLC, dated December 4, 1997.
10.8	(1)+	Agreement between Catalytica, Inc. and Tanaka Kikinzoku Kogyo K.K, dated as of July 18, 1988.
10.9	(2)+	Agreement between Catalytica, Inc. and Tanaka Kikinzoku Kogyo K.K, dated as of January 31, 1995.
10.11	(5)	Omnibus Agreement by and among Catalytica, Inc., Sundance Assets, L.P., Enron North America Corp. and the Registrant, dated August 29, 2000.
10.12	(5)+	Collaborative Commercialization and License Agreement among General Electric Co., GENXON Power System, LLC and the Registrant, dated as of November 19, 1998.
10.17	(8)	Registration Rights Agreement between Morgan Stanley Capital Partners III and its affiliates and the Registrant, dated September 2000.
10.18	(7)*	2000 Employee Stock Purchase Plan of the Registrant.
10.20	(12)*	Catalytica Energy Systems, Inc. (formerly Catalytica Combustion Systems, Inc.) 1995 Stock Plan, as amended and restated October 26, 2000.
10.23	(12)	Share Transfer Agreement between the Registrant and JSB Asset, LLC, dated December 15, 2000.
10.24	(12)	Stock Purchase Warrant Agreement between the Registrant and GlaxoWellcome, Inc., dated December 15, 2000.
10.26	(16)+	Technology Development and Transfer Agreement between Kawasaki Heavy Industries, Ltd. and Registrant, dated December 13, 2000.
10.27	(16)+	Xonon Module Supply Agreement by and among Kawasaki Heavy Industries, Ltd. and Registrant, dated December 13, 2000.
10.28	(14)*	Change of Control Severance Agreements between Patrick T. Conroy and the Registrant dated April 5, 2001, Dennis S. Riebe and the Registrant dated April 5, 2001, Craig N. Kitchen and the Registrant dated April 5, 2001, and Ralph A. Dalla Betta and the Registrant, dated April 17, 2001.
10.30	(19)+	Amendment No. 1 to the Collaborative Commercialization and License Agreement between Catalytica Combustion Systems, Inc. and GENXON Power Systems, LLC and General Electric Company, dated January 3, 2002.
10.32	(19)	GENXON Membership Transfer and Settlement Agreement between the Registrant, Woodward Governor Company, and GENXON Power Systems, LLC, dated December 19, 2001.
10.33	(19)	Control Patent Assignment and Cross-License Agreement between the Registrant and Woodward Governor Company, dated December 19, 2001.
10.43	(26)	Third Amendment and Extension to Lease Agreement between Jack Dymond Associates and Catalytica Energy Systems, Inc., dated June 20, 2003.
10.46	(29)	Lease Agreement dated December 16, 2002 between Clariant Corporation and SCR-Tech, LLC, dated December 16, 2002, and First Amendment to Lease Agreement between Clariant Corporation and SCR-Tech, LLC., dated February 18, 2004.
10.47	(34)	Loan Modification Agreements between the Arizona State Compensation Fund and the Registrant, as amended, dated August 9, 2004.
10.48	(36)*	Form of Indemnification Agreement between the Registrant and executive officers and directors of the Registrant.
10.49	(36)*	Consulting Agreement between the Registrant and David Merrion, dated February 1, 2005
10.50	(37)*	Retention Agreement by and between the Registrant and Ralph Dalla Betta, dated as of September 27, 2005
10.51	(37)	Retention Agreement by and between the Registrant and Joe Barry, dated as of September 27, 2005
10.52	(37)*	Severance Consulting and Release Agreement by and between the Registrant and Dominic Geraghty, dated as of September 27, 2005
10.53	(38)*	Employment Agreement by and between the Registrant and Robert W. Zack, dated as of September 27, 2005
10.54	(39)	Settlement Agreement and Mutual Release among the Registrant, EnBW Energy

		Solutions GmbH, ENVICA Kat GmbH, E&EC Energy & Environmental Consultants GmbH, SCR-Tech GmbH, SCR-Tech LLC, CESI-SCR, Inc., ENVICA GmbH, CESI-Tech Technologies, Inc., Hans-Ulrich Hartenstein, and Brigitte Hartenstein
10.55	(40)	Form of Option Acceleration Agreement
10.56	(43)*	Employment Letter and Change of Control Agreement between the Registrant and William McMahon
10.57	(41)	Termination Agreement between the Registrant and General Electric Company
10.58	(44)	Purchase and Sale Agreement dated April 18, 2006 between the Registrant and Wilshire Property Company, LLC
10.59	(45)	First Amendment to Purchase and Sale Agreement dated May 18, 2006 between the Registrant and Wilshire Property Company, LLC
10.60	(46)	Second Amendment to Purchase and Sale Agreement dated July 14, 2006 between the Registrant, Wilshire Property Company, LLC and 1388 North Tech Boulevard Partners LP
10.61	(46)	Lease between the Registrant and 1388 North Tech Boulevard Partners LP effective July 20, 2006
10.62	(47)	Asset Purchase Agreement dated June 30, 2006 between the Registrant, Kawasaki Heavy Industries, Ltd. and Kawasaki Gas Turbines-Americas
10.63	**	Form of Stock Option Agreement
14.1	(42)	Code of Ethics
21.1	(43)	Subsidiaries of Registrant.
23.1	(43)	Consent of Independent Registered Public Accounting Firm.
24.1	(43)	Power of Attorney (see Signature page).
31.1	**	Certification of Chief Executive Officer pursuant to Rule 13a-14(a) / 15d-14(a) of the Securities Exchange Act of 1934, as amended.
31.2	**	Certification of Chief Financial Officer pursuant to Rule 13a-14(a) / 15d-14(a) of the Securities Exchange Act of 1934, as amended.
32.1	**	Certification of Chief Executive Officer pursuant to 18 U.S.C. 1350.
32.2	**	Certification of Chief Financial Officer pursuant to 18 U.S.C. 1350.

+ Confidential treatment has been granted for portions of these agreements.

* Represents management contracts or compensatory plans for executive officers and directors.

** Filed herewith.

(1)		Incorporated by reference to exhibits filed with Catalytica, Inc.’s Registration Statement on Form S-1 (Registration Statement No. 33-55696).
(2)		Incorporated by reference to exhibits filed with Catalytica, Inc.’s Form 10-K (File No. 0-20966) for the year ended December 31, 1994.
(3)		Incorporated by reference to exhibits filed with Catalytica, Inc.’s Form 10-K (File No. 0-20966) for the year ended December 31, 1996.
(4)		Incorporated by reference to exhibits filed with Catalytica, Inc.’s Form 10-K (File No. 0-20966) for the year ended December 31, 1997.
(5)		Incorporated by reference to exhibits filed with our Registration Statement on Form S-1 (File No. 333-44772), filed on August 29, 2000.
(7)		Incorporated by reference to exhibits filed with our Amendment No. 2 to Form S-1 (File No. 333-44772), filed on October 16, 2000.
(8)		Incorporated by reference to exhibits filed with our Amendment No. 3 to Form S-1 (File No. 333-44772), filed on November 1, 2000.
(11)		Incorporated by reference to exhibits filed with our Post-Effective Amendment No. 1 to Form S-1 (File No. 333-44772), filed on January 12, 2001.
(12)		Incorporated by reference to exhibits filed with our Form 10-K for the year ended December 31, 2000, filed on March 15, 2001.
(14)		Incorporated by reference to exhibits filed with our Registration Statement on Form S-1

		(File No. 333-64682), filed on July 6, 2001.
(16)		Incorporated by reference to exhibits filed with our Amendment No. 2 to Form S-1 (File No. 333-64682), filed on August 6, 2001.
(18)		Incorporated by reference to exhibits filed with our Amendment No. 1 to Form 8-A12G/A, filed on February 6, 2002.
(19)		Incorporated by reference to exhibits filed with our Form 10-K for the year ended December 31, 2001, filed on April 01, 2002.
(26)		Incorporated by reference to exhibits filed with our Form 10-Q for the quarter ended June 30, 2003, filed on August 5, 2003.
(28)		Incorporated by reference to exhibits filed with our Form 8-K, filed on March 4, 2004.
(29)		Incorporated by reference to exhibits filed with our Form 10-K for the year ended December 31, 2003, filed on March 30, 2004.
(34)		Incorporated by reference to exhibits filed with our Form 10-Q for the quarter ended September 30, 2004, filed on November 12, 2004.
(35)		Incorporated by reference to exhibits filed with our Amendment No. 1 to Form 8-A12G/A, filed on November 22, 2004.
(36)		Incorporated by reference to exhibits filed with our Form 8-K, filed on February 4, 2005.
(37)		Incorporated by reference to exhibits filed with our Form 8-K, filed on September 28, 2005
(38)		Incorporated by reference to exhibit filed with our amended Form 8-K, filed on September 28, 2005
(39)		Incorporated by reference to the exhibit filed with our Form 8-K, filed on December 22, 2005
(40)		Incorporated by reference to the exhibit filed with our Form 8-K, filed on November 21, 2005
(41)		Incorporated by reference to the exhibit filed with our Form 8-K, filed on March 15, 2006
(42)		Incorporated by reference to exhibits filed with our Form 10-K for the year ended December 31, 2004, filed on March 30, 2005
(43)		Incorporated by reference to exhibits filed with our Form 10-K for the year ended December 31, 2005, filed on March 30, 2006
(44)		Incorporated by reference to exhibit filed with our Form 8-K, filed on April 24, 2006
(45)		Incorporated by reference to exhibit filed with our Form 8-K, filed on May 23, 2006
(46)		Incorporated by reference to exhibits filed with our Form 8-K, filed on July 24, 2006
(47)		Incorporated by reference to the exhibit filed with our Form 8-K, filed on July 5, 2006

CATALYTICA ENERGY SYSTEMS, INC.

SIGNATURES

In accordance with 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.

Date: August 10, 2006

	CATALYTICA ENERGY SYSTEMS, INC.
	(Registrant)


	By:	/s/ Robert W. Zack
		Robert W. Zack

		Chief Financial Officer
		(Duly Authorized Officer, and Principal Financial and Accounting Officer)

Catalytica Energy Systems Inactive 10QSB2006 Q2 Quarterly report (small business)

FORM 10-QSB

Critical Accounting Policies and Estimates

Comparison of the three and six-month periods ended June 30, 2006 and 2005

Liquidity and Capital Resources

Many of the risks of our business have only limited insurance coverage and many of our business risks are uninsurable.

ADDITIONAL RISKS RELATING TO EMISSIONS CONTROL SOLUTIONS FOR DIESEL ENGINES