Item 1. Business

Introduction

FuelCell Energy, Inc. (the "Company") is a leading developer of electrochemical technologies for electric power generation and has developed a proprietary patented fuel cell which it believes has significant advantages in terms of fuel efficiency and cost over competing fuel cells for stationary power generation. A fuel cell is a device which electrochemically converts the chemical energy of a fossil fuel into electricity without the combustion of fuel. The fuel cell system feeds a fuel, such as natural gas, into the fuel cell where the fuel and air undergo an electrochemical reaction to produce electricity.

From its founding in 1969, the Company focused on developing fuel cells and specialized batteries. These efforts resulted in the Company obtaining various patents and expertise in these electrochemical technologies. For the last sixteen years the Company has concentrated on developing products availing itself of substantial funding from the United States Department of Energy ("DOE"), the United States Department of Defense ("DOD"), and other outside sources such as the MTU division of DaimlerChrysler.

The Company's patented fuel cell technology is known as the Direct FuelCell(TM) ("DFC") because it introduces the hydrocarbon fuel, such as pipeline natural gas, directly into the fuel cell without requiring external reforming for producing hydrogen. This "one-step" operation results in a significantly more efficient, simpler and more cost-effective energy system compared with most other fuel cells which utilize complex external reforming equipment to convert the fuel to hydrogen. The Company is currently concentrating its efforts on the commercialization of its carbonate fuel cell, the Direct FuelCell(TM). The Direct FuelCell(TM) has demonstrated grid-connected operation at Santa Clara in 1996, and most recently in Danbury since March of 1999, and in Bielefeld, Germany since November of 1999.

The Company has licensed its fuel cell internationally to several major corporations, including MTU-Friedrichshafen GmbH ("MTU"), a subsidiary of DaimlerChrysler.

On February 22, 1999, the Company effected a spin-off to its stockholders of 100% of the shares of Evercel, Inc. ("Evercel"), a wholly-owned subsidiary of the Company. In connection with this transaction, the Company transferred to Evercel the principal assets, liabilities, and intellectual property related to its battery operations.

Following the transfer, the Company distributed to its stockholders in a tax-free distribution one share of Evercel common stock for every three shares of common stock of the Company.

Recent Developments -- Three for Two Stock Dividend

On November 16, 1999, the Company paid a stock dividend of one additional share of common stock for every two shares of the Company's common stock held on November 1, 1999, the record date. All per share data and the number of shares of common stock have been adjusted retroactively to give effect to the stock dividend.

Business

Industry Background

According to the U.S. Department of Energy's ("DOE"), "Energy Information Administration Energy Outlook 1999" report, a projected 363 gigawatts (363,000 MWs) of new capacity generation will be needed by 2020 to meet the growing demand for electricity and to offset planned retirements of generating capacity. This is approximately $300 to $500 billion of new generating capacity. Approximately 81% of this new capacity is projected to be fueled by natural gas which is well suited to the Company's technology.

The U.S. electric utility industry has been changing for several years triggered in part by the Energy Policy Act of 1992, which called for open access for consumers. In 1994, a major upheaval in the industry began as a result of significant moves toward direct access and deregulation of the electric utility industry in various states. As a result, a heightened atmosphere of competition, as well as uncertainty, exists in the industry. Furthermore, some electric utilities have already decided to phase out of the power generation aspect of the business, leaving it to independent power producers and non-utility generators. Others have merged with either other electric utilities or gas supply companies. A number of significant mergers of this type have taken place and further major reorganizations are anticipated. Regardless of the reorganization of the electric utility industry, substantial generation equipment will be required. The Company believes utility deregulation along with the prospects of wholesale and retail wheeling of electric power (the sharing of electricity from multiple sources) create uncertainty as to the future which will discourage utilities from adding substantial new centralized generation during the next several years. Even the wheeling of power over long distances will result in additional energy losses over transmission lines, thus offsetting some of the gains achieved by balancing power usage and keeping pressure on capacity margins. These factors, together with tougher environmental laws, the need to relicense nuclear plants which may not be economically feasible in some cases, and the aging of U.S. power plants result in market opportunities at the time the Company is bringing its products to market.

The Distributed Power Coalition of America defines distributed generation as "any small-scale power generation technology that provides electric power at or closer to the customer's site than centrally sited generation stations." This concept, while simple, has been very difficult to cost-effectively implement in practice. The most cost-effective electrical generation equipment has historically been oil or coal-fired power plants. Because of the laws of thermodynamics, these plants are most efficient at large (greater than 500 MW) sizes. Also, due to the noxious emissions they produce, power plants are generally situated away from population centers with extensive transmission and distribution systems being used to deliver power to end users. While this centralized generation / transmission system of electricity production has worked well for a century, new technological advances coupled with increasing concern for environmental protection are enabling the initial promise of distributed generation to become a reality.

The case for why distributed generation will play a growing role in electricity generation in the US and around the world is supported by three related, global trends. The first and most important trend is electricity deregulation and privatization as described above, which will allow new entrants into the electricity generation sphere, as customers will be free to choose power producers and marketers. The second trend accelerating distributed generation is the rapid improvement of electricity generation technology, especially fuel cells. The final trend is an increasing worldwide awareness that environmental issues, especially air pollution, should be addressed and resolved.

Currently in the US, approximately 86% of the 811 gigawatts ("GW") of installed power generating capacity is in the form of traditional, centralized generating facilities. While distributed generation accounts for approximately 14% of this installed power generation capacity in the US, an energy consulting firm, Frost & Sullivan, forecasts that distributed generation applications will account for at least 20% of capacity added through the year 2003. Other industry predictions range as high as 40% capture by distributed generation technology throughout the next decade. As a result of this study and other consultant reports, the Company believes that the combined available US and European market for distributed generation will reach approximately 5,400 MW per year by 2001 and approximately 7,600 MW per year by 2004.

In their 1999 report on Small-Scale Power Generation, Business Communications Co., Inc. states that fuel cells have emerged as one of the most promising technologies for meeting the growing worldwide energy needs well into the next century. They project that during the period between 1998 and 2003, small-scale power generation will grow at an average annual rate of 14.9% in the U.S. and 28.4% worldwide, and that the total annual market in 2003 for fuel cells can be expected to reach $1.3 billion. The Company expects this trend to grow rapidly beyond 2003 as fuel cells gain market acceptance and fuel cell product cost begins to challenge the product cost of traditional generating technologies.

The Company believes that the restructuring of the utility industry and the growth of the distributed generation market discussed above, greatly enhance its market opportunities. Newly formed entities are working to find the best market solution for the customer. Increasing demands are being put on efficiency, power quality, power reliability, lifetime, low maintenance and environmental compatibility and cost. The use of highly efficient and flexible heat and power generating systems is being investigated by every potential energy company in the world. The Company's fuel cells have the capability to meet these demands in a wide variety of settings offer an excellent enabling technology to energy services companies.

The Company's Direct FuelCell(TM)

The Company concentrates its efforts on the development, demonstration, and commercialization of the Company's patented carbonate fuel cell for generating electricity. Different types of fuel cells are distinguished generally by the electrolyte medium they use. The Company's Direct FuelCell(TM) system employs metal carbonates as the electrolyte, hence the term "carbonate fuel cell". The Company's fuel cell system feeds a fuel, such as natural gas, directly into the fuel cell where the fuel and air undergo an electrochemical reaction to produce electricity without the need for complex reforming equipment to create hydrogen gas from the fuel. A fuel cell power plant can be thought of as having two basic segments: the fuel cell stack module, which is the part that actually produces the electricity, and the "balance of plant", which includes various fuel handling and processing equipment, including requisite pipes and blowers, computer controls, inverters to convert the DC output of the fuel cell to AC, and other related equipment.

Conventional non-nuclear power plants burn a hydrocarbon such as coal, oil or natural gas, to create heat. The heat boils water, converting it to steam, which rotates a turbine, which produces the electricity. Some power plants use a combined cycle approach where the heat is sent to gas turbines, and then to raise steam, which produces additional power in steam turbines. Each step in these processes consumes some of the potential energy in the fuel, and the combustion process typically creates emissions of sulfur and nitrogen oxides, carbon monoxide, soot and other air pollutants. Because of the non-combustion, non-mechanical power generation process, the Company's fuel cell is much more efficient than the conventional power plants. Emissions of sulfur and nitrogen oxides are nearly zero, and other pollutants are minimal or non-existent. With the only moving parts being the air blower, in contrast to large rotating turbines, fuel cells are extremely quiet. In addition, fuel cells achieve high efficiency at extremely small sizes, allowing fuel cells to satisfy market needs for distributed generation, such as providing electrical power to a hospital or a retail store.

The Company's patented Direct FuelCell(TM) uses hydrocarbon fuel without the intermediate step (reforming) of creating hydrogen fuel, which is more efficient, simpler and less costly as compared with other external-reforming type fuel cells. The Direct FuelCell(TM) has been successfully demonstrated using a variety of hydrocarbon fuels including natural gas, methanol, ethanol, bio-gas, diesel, and coal gas. The Direct FuelCell(TM) operates at higher temperatures than most other fuel cells. As a result, less expensive electrocatalysts can be used and high quality heat energy is available for cogeneration. Even though fuel cells are believed to be superior to conventional generators in terms of efficiency, environmental characteristics, and flexibility of size, commercial sales of fuel

cells have been minimal to date. The Company, as well as most potential competitors in the field, has not yet completed development and commercial release of their products. In addition, at such an early stage of the technology's development, the selling price of a fuel cell is high, reflecting the initial low production volume. The Company recognizes that achieving a significant share of the power generation equipment market will require that the Company offer its products at competitive prices, which can be accomplished when production costs are reduced substantially from current levels.

Cost Reduction Progress

The Company has made significant progress in reducing the costs of its DFC(TM). The total installed cost for the Santa Clara demonstration project in 1996 (discussed under Fuel Cell Development Program), was approximately $20,000 per kW of capacity. The Company expects its next mega-watt ("MW") class field trial will cost $8,000 per kW generating electricity at a cost of 17 cents per kWh. Within five years, the Company expects to reduce the total installed cost to less than $1,200 per kW resulting in a cost of electricity of approximately 5 cents per kWh.

These kWh cost estimates are fully inclusive, accounting for the cost of fuel, installation, etc. The Company recognizes the need to educate end-users on the true costs of its technology. The DFC(TM) generates power economically at similar costs on a per kWh basis when compared to other distributed generation technologies because the somewhat higher initial capital costs of the DFC(TM) are offset by fuel savings from its higher efficiency. From a cost per kWh standpoint, the DFC(TM) will be an economically attractive source of energy in many places in the U.S. According to the DOE, electricity prices today vary substantially depending on the region of the country. Prices in the highest cost region (New York, with an average price of over 10 cents per kWh in 1998) are almost 2.3 times as expensive as in the lowest cost region (the Northwest U.S.). The DOE predicts that, even in a competitive environment, electricity prices in New York will be 8.88 cents per kWh in 2005 and 8.84 cents per kWh in 2012. The DFC(TM) will be a viable alternative as transmission and distribution costs, as well as losses in efficiency due to transmission and distribution, will be substantially lessened or eliminated.

The Company continues to achieve its cost goals through a combination of factors including manufacturing process improvements, volume economies of scale, completion or elimination of first time or one of a kind costs, and through technology maturation that increases power output without additional product cost as described below:

Manufacturing cost reduction: Manufacturing costs are being reduced by a multi-faceted effort including supplier management, material and labor utilization, vertical integration, and engineering for manufacturing efficiencies.

Volume economies of scale: Volume directly affects purchased material cost and reduces fixed cost allocation. Volume also has a secondary effect on direct labor by providing justification to invest in capital projects for improved productivity

First time costs: The elimination of first time development and engineering costs is a large and rather straightforward element of the cost reduction plan. At commercial volumes, power plant installations are expected to be virtually identical. Furthermore, indirect costs associated with developing the initial field trial projects will not exist.

Improved performance: Power plant performance is a critical factor. Power output has a direct impact on capital cost as measured in cost per kilowatt ($/kW), and efficiency, decay rate and availability all impact the cost of electricity which is the best measure of the value of the Company's product. The Company's research and development activities have made substantial progress in these areas (see "Fuel Cell Development Program").

The Company regularly reviews and revises its cost reduction plans. In addition, the DOE has on several occasions assigned an independent outside auditor to examine the Company's present and projected cost figures to determine if the DOE's continued support of the Company through development contracts will achieve its intent of creating commercially viable fuel cell power generation technology in the U.S. The most recent such audit, completed in 1999, verified that the Company's commercial design fuel cell is capable of being manufactured, delivered and installed at a cost per kW of $1,196 assuming production of 400 MW per year. The Company believes that this cost would be low enough to be competitive in the marketplace.

Fuel Cell Development Program

During 1996 and 1997, the Company operated its "proof-of-concept" fuel cell plant (the "Santa Clara Plant" or "SCDP") at a site in Santa Clara, California. The demonstration involved the largest carbonate fuel cell power plant in the world and the largest fuel cell of any type operated in the United States. The Santa Clara Plant was initially designed to provide 1.8 megawatts. Following its start up, the Santa Clara Plant achieved a peak power output of 1.93 megawatts, adjusting for supplemental fuel achieved an electrical efficiency level of 50%, a record for a single cycle fossil fuel cell power plant, and also achieved record low emissions of sulfur and nitrogen oxides.

The Santa Clara Plant operated at various electrical outputs for almost one year, half of such time being connected to the utility grid. Despite encountering equipment problems unrelated to the basic fuel cell technology, the Santa Clara Plant achieved most of the goals set by the Company for the project and established new milestones. After the end of the operation of the Santa Clara Plant in March 1997, all of the fuel cell stacks were returned to the Company for comprehensive analysis. The Company used the results of this analysis, along with the results of ongoing development activities, to develop a commercial fuel cell design significantly more compact, reliable and cost-effective than the Santa Clara Plant design. Based on data and analysis from the SCDP and continued progress by company researchers, the Company continues to advance the DFC(TM) design. A new generation of stack hardware has been developed with cells which are 50% larger in area, 40% lighter per unit area and 30% thinner than the SCDP design. These improvements have doubled the power output from a full-height stack. The low-cost advanced cell design incorporating these improvements has been refined through subscale stack tests, which have shown the new cells to be more tolerant of load and thermal changes, with no loss of performance in up to 10 thermal cycles.

In further efforts to develop the DFC(TM) for commercialization, the Company built an integrated power plant facility that can operate DFC(TM) stacks up to 400 kW. A long-term endurance test on a 10 cell stack with the new cell hardware has completed over 13,000 hours of operational testing. The stack has met the performance stability goal for the Company's market entry product. In addition, an internally insulated stack enclosure has been designed and fabricated. The enclosure eliminates the need for inert stack environment gas, and provides for a much more compact arrangement of each stack within the multistack modules.

To date, the Company has operated two full height stack demonstrations. Power conversion efficiencies from pipeline natural gas to DC electricity of up to 47% has been achieved. Since the test facilities are optimized for flexibility instead of efficiency, this achieved efficiency level should translate to more than 50% electrical efficiency in commercial operation, and more than 75% employing cogeneration. This is well above most conventional means of producing electricity in this size range.

Ruggedness of the product design was demonstrated in planned stress tests, such as rapid ramp-up and thermal cycle tests. Another test simulated emergency fuel loss, verifying that the DFC(TM) stack can be maintained in the field cost-effectively despite fuel supply or power failures, without hampering performance. To date, a total of more than 1,250,000 kWh have been produced using a stack, which began operation in March of 1999. Total operation time has exceeded 7,500 hours, including four thermal cycles.

The Company's current fuel cell power plant design will be capable of producing the same output as the Santa Clara Plant with a footprint one ninth as large. This reduction in size and increase in power per stack results in substantial manufacturing cost savings. The Company anticipates a demonstration of a commercial 1 MW fuel cell stack design in 2001, followed by further complete power plant demonstrations.

Recent market research has indicated that the demand for fuel cell power plants from early commercial adopters of the technology may be greater in the sub-MW size than the larger sizes. To meet that demand, the Company plans to take advantage of its license rights to the "Hot Module" fuel cell developed by MTU. See "Partnerships, Joint Ventures and Licenses". This nominal 250kW design, which incorporates the Company's fuel cell stacks, uses an innovative integration of some of the elements of the balance-of-plant with the fuel cell stack module, with the expectation of reducing costs to the power plant as a whole. The design is very compact and specially suited for cogeneration applications. During 1999, the Company delivered fuel cell assemblies to MTU for a field demonstration of the Hot Module design at Bielefeld a municipal utility in Germany. The cogeneration plant was successfully commissioned in November 1999, providing up to 225 kW of electricity and the by-product of high quality heat, at an overall thermal efficiency exceeding 75% feeding 80,000 kWh to the grid as of December 1999.

An additional demonstration of a hot module cogeneration plant is planned in Germany during 2000. This plant, as before, will use Company supplied fuel cell assemblies. The Company also plans to conduct its own field trials of a 250 kW unit at a host site selected by Los Angeles Department of Water and Power. Additional U.S. field trials are planned for late 2000. The Company is currently revising MTU's design to comply with U.S. codes and standards.

Principal Development Contracts

The Company's revenues have been principally derived from U.S. government and industry research and development contracts and license fee income. Government funding provided approximately 87%, 97%, and 92% of revenues in fiscal 1999, 1998, and 1997 respectively, principally by the DOE.

The Company performs its services under contracts or agreements that usually require performance over a period of one to five years. However congressional budget limits could prolong the contracts. In general, the Company's contracts or agreements may be terminated, in whole or in part, at the convenience of the Government. Virtually all government contracts are funded annually based on administrative recommendations and annual congressional appropriations. Regardless of the terms of the Company's government contracts, the Company can only receive up to the appropriated funds made available to the Company.

The Company has been working on the development of its Direct FuelCell(TM) technology under contracts since 1977, with various government agencies in addition to the DOE, including the Department of Defense, the Defense Advanced Research Projects Agency ("DARPA"), and the National Aeronautics and Space Administration ("NASA").

The Company currently receives its government funding primarily under a long-term Cooperative Agreement with the DOE. The original agreement covered a 5-year project which commenced in the first fiscal quarter of 1995 and had an estimated value of $78 million, excluding cost-share funding by the Company and other private sector sources. The DOE Cooperative Agreement covers the design, scale up, construction and testing of direct carbonate fuel cells operating on natural gas. Major development emphasis under this agreement focuses on fuel cell and total power plant cost reduction and improved endurance.

The present estimated value of the DOE Cooperative Agreement is $95 million, excluding cost share funding. The term of this contract has been extended to December 2000. The Company has requested additional funds from DOE and an extension of the term of the contract in order to complete the development and conduct planned field trials of its commercial fuel cell stack design products. The Company and its partners have been providing significant cost-share funding for the project covered by this contract. The Company is also seeking additional funding from potential customers and other private sector organizations, which may be necessary to complete the commercialization process as planned. The Company expects its main contract with the DOE to be supported through 2003.

In addition to the activities listed above, the Company has been active in soliciting other business from industry and government organizations. The Company has been working on Direct FuelCell(TM) power plants for marine applications under contracts with the U.S. Navy and U.S. Coast Guard. These power plants are required to operate on liquid fuels such as diesel. Initial feasibility of using diesel in Direct FuelCell(TM) has been demonstrated. Under this contract, the Company has already produced clean fuel-cell compatible fuel from marine diesel in a compact fuel processing system. In 1999, a subscale fuel cell stack was tested on this clean fuel under conditions simulating marine requirements. The Company also passed required shock and vibration tests, and was selected (subject to final negotiation of a contract) by the Navy to continue development work under Phase II, leading to a 500 kW land based demonstration. In 1999, the Company formed a partnership with Bath Iron Works, a General Dynamics Company to develop an advanced carbonate-based energy plant for defense marine applications. In addition to satisfying marine applications, a stationary market opportunity for islands, such as Bermuda, Hawaii etc., exists which are primarily dependent on diesel fuel to generate electricity.

In late 1999, DOE transferred a long standing Clean Coal project to Global Energy; a Cincinnati based independent power producer. The objective of the project is to demonstrate an innovative gasification technology. The clean, low cost fuel generated in this process will be used to fire gas turbines and to demonstrate the operation

of a MW class fuel cell power plant. The Company is named in the contract as the fuel cell developer. Sub-contract negotiations with Global are in progress.

In 1999, the Company received an award from the DOE to develop a high temperature membrane to overcome some of the shortcomings of present generation polymer electrolyte membrane fuel cells (PEM).

The Company also has received several Small Business Innovation Research grants and research contracts from various organizations to explore advanced concepts or new applications of fuel cells.

Partnerships, Joint Ventures and Licenses

The Company has entered into international licensing agreements with major corporations. Generally, the Company has reserved for itself the exclusive rights to manufacture and sell carbonate fuel cells in North America. The licensees pay annual license fees to the Company and royalties on equipment sales.

The Company has benefited from its licenses and has received valuable technical and manufacturing information from its licensees. By coordinating its own development program with the extensive effort of its partners, it has leveraged its own efforts substantially.

DaimlerChrysler subsidiary MTU-Friedrichshafen GmbH ("MTU"). In 1989, the Company entered into a license agreement (the "MTU Agreement") with DASA, a German aerospace and aircraft equipment manufacturer and a subsidiary of Daimler Benz Corporation, one of the largest industrial companies in Europe. That agreement was transferred to a subsidiary of DASA, MTU Friedrichshafen, which manufactures ship propulsion and power generation equipment in 1993. In 1994, MTU became a subsidiary of AEG Daimler Benz Industries, now DaimlerChrysler.

In 1992, MTU, formed a European consortium (ARGE) including RWE AG, the largest electric utility in Germany, Ruhrgas AG, the largest natural gas supplier in Germany, Elkraft Power Co. Ltd. (Elkraft), a large Danish utility, and Haldor Topsoe A/S, a Danish industrial company. The intent of the consortium is to spend approximately 130 million Deutsche Marks ($68 million), over a nine year period on further development, demonstration and commercialization of the Company's carbonate fuel cell technology. Certain individual members of the consortium, including MTU, Elkraft and Haldor Topsoe A/S, have conducted carbonate fuel cell activities on their own utilizing the Company's technology. The activities of this group complement the Company's efforts to design and manufacture natural gas and coal gas fueled carbonate fuel cell systems based on the Company's designs.

During 1998, MTU designed and built a 250 kW cogeneration fuel cell unit (the "Hot Module"), which incorporates the Company's fuel cell assemblies, uses an innovative integration of a portion of the balance-of-plant into the fuel cell stack module itself, with the expectation of reducing costs to the power plant as a whole. The design is very compact and especially suitable for cogeneration applications. In July 1998, the Company entered into a Cross-Licensing and Cross-Selling Agreement with MTU pursuant to which MTU and the Company have granted to each other the right to manufacture and sell each other's stationary power fuel cell products in their respective regions. The Company therefore has the right to manufacture and sell fuel cell power plants based on MTU's Hot Module design in North America, while, MTU has the right to sell fuel cell power plants based on the Company's larger 1.5 MW base module in Europe. Each company will pay royalties based upon sales.

The 1989 MTU Agreement was replaced in December of 1999 with a revised MTU Agreement. Pursuant to the terms of the new MTU Agreement, the Company has granted to MTU an exclusive license to use, develop and sell carbonate fuel cells in Europe and the Middle East, and a non-exclusive license in South America, and Africa, subject to certain rights of the Company and others. MTU has agreed to conduct research, development, manufacturing and marketing programs in the area of carbonate fuel cell technology and to make the results available to the Company . In addition, MTU has agreed to pay to the Company a royalty based on kilowatts of electrical generating capacity using carbonate fuel cells made or sold by MTU or its permitted licensees, including a minimum annual royalty commencing in 2000.

During 1999, the Company delivered a fuel cell stack to MTU for a field demonstration of the Hot Module design at the municipal utility in Bielefeld, Germany. In calendar 2000, the Company expects to demonstrate a Hot

Module unit, using a Company-manufactured fuel cell stack, in the United States at a site to be determined. MTU buys its fuel cell assemblies from the Company and has ordered fuel cell assemblies from the Company for three other power plants to be delivered in 2000. The Company anticipates that MTU will continue to purchase fuel cell assemblies from it for the foreseeable future.

Mitsubishi Electric Corporation ("MELCO"). In November 1981, the Company and MELCO, a Japanese electronics and electric equipment manufacturer entered into a license agreement relating to carbonate fuel cell technology. MELCO designed and constructed a 200 kW power plant at a Japanese utility site incorporating Direct FuelCell(TM) technology, which was operational in 1999. MELCO has notified the Company that based upon Japanese Government direction it intends to reduce its efforts to internal research and cancel the agreement by January 31, 2000. The Company is in discussion with potential partners interested in commercializing DFC(TM) technology in Asia.

Electric Power Research Institute ("EPRI"). In 1988, the Company entered into a license agreement with EPRI, granting the Company the right to use carbonate fuel cell proprietary data developed under certain EPRI contracts with the Company. The Company has agreed to pay EPRI a one-time fee of approximately $50,000 upon the Company's first commercial sale of a carbonate fuel cell stack of one megawatt or larger in size, and a royalty of 0.5% to 1% upon commercial sales of carbonate fuel cell stacks.

Santa Clara. In 1993, the Company obtained an exclusive license with rights to sublicense through the year 2005 to use the balance of plant design for the Santa Clara Plant. The license becomes non-exclusive after 2005 or earlier, at the option of Santa Clara, if the Company does not meet certain commercialization milestones. In addition, beginning three years after commencement of production of fuel cells at a commercial scale manufacturing plant, the Company is required to make royalty payments of up to $15 per kilowatt subject to consumer price index and other adjustments on sales of fuel cell power plant stacks of capacities of 100 kilowatts or more.

U.S. Department of Energy. In connection with certain contracts and grants from DOE, the Company has agreed to pay DOE 10% of the annual license and royalty income received from MTU, up to $500,000.

Fuel Cell Markets

The Company expects to grow its commercial markets in three phases. Initial orders will come from premium priced applications, the second phase will involve commercial and light industrial users in a more competitive, sustaining market and finally, the achievement of manufacturing economies of scale and the introduction of next generation products will allow the penetration of highly competitive distributed generation markets.

The Company is targeting its initial commercialization efforts for niche stationary power applications. This is because the Company will not yet have gained the cost advantages of mass production. Therefore, the Company expects initial adopters to include those in regions where air pollution requirements are particularly strict, industrial and commercial users who can make use of the high quality waste heat for cogeneration purposes, customers with opportunity fuels such as landfill or digester gas, customers with a requirement for premium power quality or 24X7 reliability, those seeking grid independence or those trying to solve grid transmission shortages and especially those customers who combine several of the above characteristics. The Company also expects to have early purchases from utility and non-utility power producers who will purchase fuel cells to improve their knowledge of the technology with the intention of purchasing or leasing and servicing the equipment in the future. The Company is in active discussions with various utilities, other power producers and equipment suppliers regarding the purchase of its fuel cell products for applications such as those described above.

End users such as hospitals, data processing centers, military bases, schools, shopping centers and office buildings have already emerged as early adopters of distributed generation mainly in the form of cogeneration, the combined utilization of heat and electricity generated by the power plant. The high operating temperature of the Company's Direct FuelCell(TM) provides an advantage in these applications. The Company believes that its sustaining market will come from commercial and light industrial customers following this initial trend. The Company, using a consultant (ERI Services, of Hartford, Connecticut), has identified cogeneration markets where credits for waste heat could be used to reduce the cost of electricity produced. Markets in 11 states were characterized as a function of selling price from $1,000 to $3,000/kW for units for applications of between 1 and 5 MW. The study indicated

a potential market in these states of $15 billion at $1,500/kW and $7 billion at $3,000/kW. Furthermore, in a study completed in February, 1999, EPRI identified 24,000 MW of potential business among commercial and light industrial customers who could self-generate using the Company's products at a savings compared to their current electric rates The Company expects to serve these customers through energy service providers. These retail companies selling energy services to end-users are expected to emerge as the result of deregulation of the electric utility industry. As markets open and customer's expectations increase, retail companies will offer a comprehensive slate of services. Distributed generation technologies offer a flexible tool for this purpose and industry experts expect that within 10 years energy retailers will purchase up to 60% of all new distributed generation equipment.

Many utilities are interested in fuel cell power plant technology primarily as an efficient, low pollution and cost-effective dispersed generator. Since the Company's fuel cells can be located at, or in place of, distribution and transformer stations, they may provide greater flexibility in the transmission and distribution of electricity. The modular aspects of the Company's fuel cells may also allow larger utilities to introduce phased capacity construction into their generation system. In this approach, the utilities could expand electricity generation capacity to keep pace with demand by adding blocks of fuel cells on a periodic basis as required, thereby improving cash flow as compared with building a single large plant.

The company is developing turbine hybrid power plants as its next generation technology. The Company believes that due to the very high electric efficiencies which can be achieved in these power plants (greater than 70%), and the availability of configurations in excess of 20 MWs, they could provide an attractive cost-effective means for large scale distributed power generation for utilities.

Fuel Cell Competition

Several companies in the United States are involved in fuel cell development. One of these companies, M-C Power Corporation is engaged in the development of carbonate fuel cells but uses a different technical approach, which involves complex auxiliary equipment to convert fuel to hydrogen. In Japan, at least six manufacturers have demonstrated interest in developing and marketing carbonate fuel cells. One of these, Mitsubishi Electric Company, is a licensee of the Company (see Partnerships, Joint Ventures and Licenses). Some have larger marketing and sales departments than the Company and a history of producing and selling electric generation equipment. Two Japanese companies have demonstrated extended operation of 100kW carbonate fuel cells and jointly tested a 1MW plant in 1999. One of these companies is expected to concentrate on 700-800 kW modules for dispersed power generation.

In Europe, companies in Germany, Holland, Spain and Italy are actively engaged in carbonate fuel cell development and are potential competitors, although these efforts are not as well advanced as the progress of the United States and Japanese companies. The German activity through the Company's licensee MTU and its partners is by far the largest effort. Almost all of these companies are also significantly larger than the Company, possess greater financial resources and have established product lines in electric generation equipment and in other fields.

In addition to the carbonate fuel cell, other types of fuel cells are also being developed by different companies worldwide. These fuel cells, generally referred to by the electrolyte medium they use, include phosphoric acid, polymer electrolyte and solid oxide systems. These fuel cells are in various stages of development and aim at different applications including stationary power, transportation and portable power. Only the phosphoric acid fuel cell system, developed by United Technology's ONSI Corporation is in advanced stages of development and has limited commercial sales. This system is significantly less efficient and is expected to be more expensive compared to the Company's Direct FuelCell(TM). More recently, Ballard Power Systems has announced plans to test 250 kW polymer electrolyte units for stationary applications. Plug Power Corporation has also announced plans to test models of its 5-10 kW fuel cells for residential applications. The Company believes that polymer electrolyte membrane (PEM) based fuel cells are less efficient than the DFC(TM) and therefore have higher fuel costs. The Company believes that the PEM developers are primarily focused on transportation fuel cells and small residential units. The Company believes that these will not directly compete with the Company's targeted stationary power markets in the 250kW size and larger.

The Company must also compete with companies manufacturing more established combustion equipment, including various engines and turbines, which are currently in use and have established operating and cost features. The greatest competition comes from the gas turbine industry which recently has made good progress in improving fuel efficiency and reducing pollution in large size combined cycle natural gas fueled generators. Efforts are underway to extend these advantages to small size machines. The Company believes that in the small size units, under 5 MW, gas turbines will not be able to match its fuel cell efficiency or environmental characteristics.

Nuclear power is expected to experience a decline in its share of the electricity market. Social and political hurdles make it virtually impossible to site new nuclear power plants in the U.S. at this time. Further, some of the nuclear plants operating today will not be economical in a competitive market due to high operating and maintenance costs. There are currently 110 nuclear units licensed, providing about 20% of electricity in the United States. DOE projects that, by 2020, 45 nuclear units will remain in service supplying about 8% of electricity in the United States.

While hydroelectric power is not forecast to shrink as dramatically as nuclear power as a share of the market, it faces limited growth. The best domestic hydro opportunities have been exploited, and there is growing pressure from conservationists to remove some existing dams due to environmental concerns. The DOE's forecast projects slightly under 3% growth in hydroelectric capability by 2020.

The Company is competing primarily on the basis of fuel efficiency, environmental considerations and cost. The Company believes that the carbonate fuel cell enjoys competitive advantages over other fuel cells including higher efficiency, ease of operation, environmental quality and expected low cost. The Company believes it is more advanced in the development of carbonate fuel cells than other manufacturers.

Fuel Cell Manufacturing

The Company manufactures fuel cells at its facility located in Torrington, CT. At present, the capacity of the plant is approximately 5 MW per year on a single shift basis. The Company is planning to increase the capacity of this plant by purchasing equipment to replace certain elements of the manufacturing process which currently restrict the overall output of the facility. The Company expects to raise funds for this purpose. The first stage in this process is to raise the output capability to 50 MW per year. The Company estimates that the cost of this expansion will be approximately $16 million. Meanwhile, the Company is using existing funds to expand production capacity incrementally and to implement cost reduction and process improvement projects.

The Company believes that virtually all of the raw materials used in its products are readily available from a variety of vendors in the United States and Canada. However, certain manufacturing processes which are necessary to transform the raw materials into component parts for fuel cells are presently available only through a small number of foreign manufacturers. The Company believes that these manufactured products eventually will be obtainable from the United States suppliers as demand for these items increases.

Other Agreements

Research and Development

A significant portion of the Company's research and development has been funded by government contracts and therefore, a substantial amount of the Company's total research and development expense has been included in "cost of revenues" and not in its "research and development expense" in the Consolidated Financial Statements. In addition, the Company has incurred discretionary research and development expense under its government contracts for fuel cell and battery development which has been included in "research and development expense" although it, too, has been reimbursed fully under the government contracts. During fiscal 1999, 1998 and 1997, 100% of the Company's research and development was funded by customers, including approximately $1.81 million, $2.26 million and $1.27 million, respectively, of discretionary independent research and development expense.

During 1998 the Company also formed a joint venture with the City of Xiamen, China called Xiamen-ERC Technology Company, Limited. This Joint Venture has been formed to fund other entities, such as Xiamen University, to conduct research in advanced electrochemical technologies, which will benefit the Company and

Xiamen. The Company has invested $400,000 of capital into this joint venture, which is currently two-thirds owned by the Company. In 2000, the Company intends to transfer one third ownership in the joint venture to Evercel, Inc.

Proprietary Rights

The Company relies primarily on a combination of copyright and trademark laws, trade secrets, patents, confidentiality procedures (including, in some instances, the encryption of certain technical information) and contractual provisions to protect its proprietary rights. The Company has obtained patents and will continue to make efforts to obtain patents, when available, in connection with its technologies. The Company can give no assurance that any patent obtained will provide protection or be of commercial benefit to the Company, or that its validity will not be challenged. The Company also seeks to protect its software, documentation and other written materials under trade secret and copyright laws, which may afford only limited protection. The Company presently has 53 United States patents including 1 obtained in 1999, and 7 pending United States patent applications, including 4 filed in 1999, as well as 105 patents in certain foreign jurisdictions,, and 15 pending patent applications, including 1 filed in 1999, in certain other jurisdictions, principally in Europe, South America, and Japan. Despite the Company's efforts to protect its proprietary rights, unauthorized parties may attempt to copy aspects of the Company's technology or to obtain and use information that the Company regards as proprietary. The laws of some foreign countries do not protect the Company's proprietary rights to as great an extent as do the laws of the United States and, because of the Company's significant international presence, the Company can give no assurance that the Company will be able to protect its proprietary rights in the jurisdictions in which it conducts business or into which it licenses its technology or in which products incorporating its technology are manufactured and sold.

Many of the Company's United States patents were the result of government-funded research programs. The Government does not impose significant restrictions on the Company's use of government-sponsored patents, except that military and national security applications of technology remain the property of the United States Government. Patents of the Company that were the result of government-funded research prior to January 1988 (the date the Company qualified as a small business under applicable government regulations) belong to the Government unless the Government waives its rights to these patents. In most cases, what the Company has obtained is owned by the United States Government. The Company has received a license to use these patents, which is revocable only in the limited circumstances where it has been demonstrated that the Company is not making an effort to commercialize the invention. Patents resulting from government-funded research after January 1988 automatically belong to the Company because of its small business status. In both instances, however, the Government retains a royalty free right to use the patents for government purposes. In addition, the Government may take title to the patents and may license the patented technology to others if the Government believes that the Company is not utilizing the patents. A number of the Company's patents are subject to such rights. The Company believes, however, that the likelihood of the Government exercising these rights is very small and would only occur if the Company ceased its commercialization efforts.

Government Regulation

The Company presently is, and its fuel cell power plants will be, subject to various federal, state and local laws and regulations relating to, among other things, land use, safe working conditions, handling and disposal of hazardous and potentially hazardous substances and emissions of pollutants into the atmosphere. To date, the Company believes that it has obtained all necessary government permits and has been in substantial compliance with all of these applicable laws and regulations.

Pursuant to the National Environmental Protection Act (NEPA), since 1991, each local Department of Energy procurement office must file and have approved by the Department of Energy in Washington, DC, appropriate documentation for environmental, safety and health impacts with respect to procurement contracts entered into by that local office. The costs associated with compliance with environmental regulations are generally recoverable under the Company's cost reimbursable contracts. In certain cases, contract work may be delayed until the approval is received.

Employees

As of December 31, 1999, the Company had 114 full-time employees, of which approximately 30 were engineers, scientists, and other degreed professionals and 84 were professional, technical, administrative and manufacturing support personnel. The Company considers relations with its employees to be good. The loss of key employees could cause delays in completing contracted work and development and commercialization activities.

      NAME                  AGE               POSITION WITH THE COMPANY
      ----                  ---               -------------------------

Jerry D. Leitman            57         President and Chief Executive Officer
Dr. Hansraj C. Maru         55         Executive Vice President and Director
Christopher R. Bentley      57         Executive Vice President and Director
Joseph G. Mahler            47         Vice President,  Chief Financial Officer,
                                         Treasurer & Corporate Secretary

Jerry D. Leitman has been President, Chief Executive Officer and a Director of the Company since August 1997. Mr. Leitman was previously President of ABB Asea Brown Boveri's global air pollution control businesses from 1992 to 1995. Prior to joining ABB Mr. Leitman was Group Executive Vice President of FLAKT AB, a Swedish multinational, responsible for FLAKT`s worldwide industrial businesses from 1989 to 1992. Mr. Leitman is also a Director and a member of the Audit Committee of Esterline Technologies Inc. Mr. Leitman obtained both a BS and MS in Mechanical Engineering from Georgia Institute of Technology in 1965 and 1967, respectively.

Dr. Hansraj C. Maru has been Executive Vice President and a director of the Company since December 1992. Dr. Maru was Chief Operating Officer of the Company from December 1992 to December 1997. Prior to that he was Senior Vice President-Research and Development of the Company. Dr. Maru joined the Company in 1977. Prior to joining the Company, Dr. Maru was involved in fuel cell development at the Institute of Gas Technology. Dr. Maru received a Ph.D. in Chemical Engineering from the Illinois Institute of Technology in 1975.

Christopher R. Bentley has been a director of the Company since June 1993 and Executive Vice President of the Company since September 1990. Mr. Bentley was President of Fuel Cell Manufacturing Corporation, a subsidiary of the Company, from September 1990 to December 1997. From 1985 through 1989 he was Director of Manufacturing (1985), Vice President and General Manager (1985-1988) and President (1988-1989) of the Turbine Airfoils Division of Chromalloy Gas Turbine Corporation, a major manufacturer of gas turbine hardware. Mr. Bentley received a BSME from Tufts University in 1966.

Joseph G. Mahler joined the Company in October 1998 as Vice President, Chief Financial Officer, Corporate Secretary and Treasurer. Prior to joining the Company, Mr. Mahler was Vice President-Chief Financial Officer at Earthgro, Inc. from 1993 to 1998 and prior to that, he was a partner at Ernst & Young. Mr. Mahler received a B.S. in Accounting from Boston College in 1974.

Risk Factors

The risk that the Company's products are not cost competitive

The Company recognizes that achieving a significant share of the power generation equipment market will require that the Company offer its products at very competitive prices, which can only be accomplished when production costs are cut substantially from current levels. There is no guarantee that the Company will be able to achieve the required volume production levels to make its products cost-effective. The failure of the Company to achieve a lower cost structure through volume economies of scale and/or other expected changes and improvements in the manufacturing process would have a material effect on the business. In addition, the Company has no control over

the commodity prices of several types of competitive energy sources such as oil, gas or coal. Significant decreases in the price of these inputs could also have a material adverse effect on the business.

The Distributed Generation market may not develop as anticipated

Although many distributed generation products have been under development for a number of years, commercial prospects for these products are at an early stage of development and rapidly evolving. If the market fails to develop or develops more slowly than the Company expects, the Company may not be profitable in the future. As is typical in a rapidly evolving industry, demand and market acceptance for recently introduced products and services are subject to a high level of uncertainty and risk. Since the market is new and evolving, it is difficult to predict with certainty the size of this market and its growth rate. A market for carbonated fuel cells may not develop and demand for the Company's services may not emerge or be sustainable. If the market fails to develop or develops more slowly than expected, the Company's business would be materially adversely affected.

The Company is affected by governmental regulation and legal uncertainty

The retail electricity industry is undergoing the process of deregulation throughout the US. Although FuelCell Energy is not currently subject to direct regulation by any domestic or foreign governmental agency, it is possible that industry specific laws and regulations will be adopted covering issues such as environmental standards, transmission scheduling, distribution and characteristics and quality of the Company's products and services. Such regulation could limit the growth in the use of carbonated fuel cells and decrease the acceptance of fuel cells as a commercial product. Moreover, the applicability of existing laws in various jurisdictions governing issues such as stranded cost recovery and product liability may take years to resolve. Any such new legislation or regulation, the application of laws and regulations from jurisdictions whose laws do not currently apply to the Company's business, or the application of existing laws and regulations to the energy industry could have a material adverse effect on the Company's business.

The Company is subject to possible capital constraints

FuelCell Energy believes that cash reserves and cash flows from operations will be adequate to fund operations at least for the next twelve months. However, there can be no assurance that such sources will be adequate or that additional funds will not be required either during or after such period. Future capital requirements are dependent upon many factors, including, but not limited to, the rate at which the Company expands production volume capabilities, the amount used to fund demonstration projects, the level of government funding provided to the Company and the Company's investment in new technology. The Company expects to need additional funding to expand its manufacturing capability to the level where volume efficiencies can be achieved. Additional financing may not be available and, if available, it may not be available on terms favorable to the Company or its stockholders. If additional funds are raised through the issuance of equity securities, the percentage ownership of the Company's then current stockholders will be reduced. If adequate funds are not available to satisfy either short or long-term capital requirements, the Company may be required to limit operations significantly.

Intellectual property rights offer only limited protection

The Company's proprietary technology is protected by trademark laws, patents, trade secrets, confidential procedures and contractual provisions. The steps the Company has taken to protect its intellectual property may not prevent misappropriation of this technology and intellectual property agreements entered into by the Company may not be enforceable. It might be possible for a third party to copy or otherwise obtain and use the Company's technology or other proprietary information without authorization, or to develop similar technology independently. Policing unauthorized use of the Company's technology is difficult due in large part to the global nature of the power generation market. The laws of other countries may not adequately protect the Company's intellectual property.

The Company is dependent on key personnel

The Company's performance is substantially dependent on the continued services and on the performance of its executive officers and other key personnel, particularly Jerry Leitman, the President and Chief Executive Officer. The loss of the services of any executive officer or other key personnel could materially adversely affect the Company's business. Although some executive officers and key personnel have entered into employment agreements, these agreements do not prevent them from leaving the Company. Also, the Company does not maintain "key person" life insurance policies.

The power generation industry is competitive

The power generation industry is highly competitive. Failure to compete successfully would have a material adverse effect on the Company's business, results of operations and financial condition. The Company competes not only with other fuel cell manufacturers, but also with makers of alternative energy sources such as wind, solar power and hydropower as well as power producers using more established sources such as oil, gas and coal. Some of the Company's current and potential competitors have significantly greater financial, marketing, technical and other competitive resources than the Company. These resources may enable competitors to adapt more quickly to new technologies, or to devote greater resources to the development, promotion and sale of their products. In addition, other companies could develop new products and services that could directly compete with FuelCell Energy. If the market becomes saturated with competitors, the Company's business would be materially adversely affected.

The Company is reliant on Government contracts and a few other customers

Historically, the Company's major source of revenue has come from government contracts, as well as from licensees of the Company's technology. The Company has no control over these parties and cannot guarantee the ability to maintain satisfactory relationships with any of them on acceptable commercial terms. In addition, the Company's government funding is subject to changes in government agency procurement policies, reductions in expenditures for the services provided by the Company, government agency budget shortfalls, annual congressional appropriations and other risks generally associated with government contracts. The Company cannot guarantee that these contracts will continue to be an integral source of revenue in the future. Failure to retain this customer base or receive government funds would have a material adverse effect on the Company's business. In addition, to achieve projected revenue levels, it will be necessary to expand the current customer base. There can be no assurance that the Company will find additional customers or markets for its products. Failure to expand the customer base would also have a material adverse effect on the Company's business.

The Company concentrates on one product; and market acceptance is uncertain

Since beginning its operations, the Company has derived all of its revenue from R & D contracts as well as from licensees of its electrochemical technologies. The Company expects that its carbonate fuel cell products will continue to account for all of its revenue in the foreseeable future. As a result, the Company's future results of operations are dependent upon continued market acceptance as well as enhancements to the fuel cell products.

The Company cannot guarantee that potential customers will accept fuel cells as a replacement for traditional power sources. Market acceptance of fuel cells will depend upon continued growth in distributed generation technology. Fuel cells may not prove to be a viable medium for power generation due to the inadequate development of the necessary infrastructure or to delays in the development or adoption of new standards and protocols. The acceptance of fuel cells will require a broad acceptance of new methods of power generation. Failure of fuel cell products to gain market acceptance would have a material adverse effect on the Company's business.

The Company has limited experience in marketing its products

The Company has traditionally sold its products to government entities and a select few large industrial entities. Neither customer base has required the use of an extensive sales or marketing force. Going forward, the Company's ability to compete effectively will have to rely on greater use of the sales and marketing functions in order to deliver the Company's products to a wider customer base. Future results will depend on the ability of the Company's executive team to attract and maintain the sales and marketing force. The Company cannot guarantee

that it will be able to increase the size of its sales and marketing team on a timely basis to provide a higher level of support required by a wider customer base. Failure to add qualified sales and marketing representatives would have a material adverse effect on the Company's business.

The risk that the Company's management is unable to manage growth effectively

The Company expects that the availability of additional capital will permit it to expand its manufacturing capabilities, accelerate the commercialization of its product and to enter a period of rapid growth which will place a significant strain on the Company's financial and other resources. The proposed expansion will expose the Company to increased competition, greater overhead, marketing and support costs and other risks associated with the commercialization of a new product. The Company's ability to manage its growth effectively will require it to continue to improve its operations, its financial and management information systems and to train, motivate and manage its employees. If the Company's management is unable to manage growth effectively, the Company's results of operations could be adversely affected.

The risk that commercialization is delayed

The Company believes that its fuel cell commercialization program is dependent upon the Company conducting one or more additional commercial field trials of its power plants. The failure of the Company to site these power plants and complete these commercial field trials as it currently plans could delay the timetable in which the Company believes it can begin to commercially sell its product. The failure of these commercial field trials to perform as well as the Company anticipates could also have a material adverse effect on the Company's commercialization plans. Any such delay or performance failure would have a material adverse effect on the Company's business.

The Company faces the risk of product obsolescence and technology concerns

Future results will depend on the ability of the Company's products to maintain a technological edge with regards to being an efficient and environmentally friendly means of power generation. Given the intense competition within the industry and the ability of some of the Company's competitors to maintain cutting-edge research and development capabilities, it is possible that the competition could develop a product that proves to be more efficient as a means of power generation. The risk of product obsolescence would have a material adverse effect upon the Company's business.

The Company has lengthy sales cycles

Given the Company's dependence on government contracts and the necessity of providing government entities with substantial amounts of information, the sales process has historically been long and time-consuming. Additional time is also needed to build demonstration models to gauge the effectiveness of the product at different stages of development. The time from initial contact to delivery of product can take several months and in some cases, several years. The Company will need to shorten the time from initial contact to final product delivery if it hopes to expand production, reach a wider customer and forecast revenue with any degree of certainty. As new competitors and products enter the industry, failure to shorten the sales cycle could have a material adverse effect on the Company's business.

The Company has a large and influential shareholder

MTU currently has an 11% percent equity stake in the Company and is also a licensee of its technology. Therefore, it would be in MTU's interest to possess substantial influence over matters concerning the Company's overall strategy and technological development. Such influence could make it difficult for a third party to acquire stock or have input into the decisions made by the Board of Directors. In addition, MTU's equity stake could put itself into a conflict of interest if MTU is experimenting with competing technologies for its other products.