Note Regarding Forward Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements concerning, among other things, our expected future revenues, operations and expenditures, and estimates of the potential markets for our products and services. Such statements made may fall within the meaning of the Private Securities Litigation Reform Act of 1995, as amended. All such forward-looking statements are necessarily only estimates of future results and the actual results we achieve may differ materially from these projections due to a number of factors as discussed in the section entitled "Risk Factors" of this Form 10-Q. New risks can arise and it is not possible for management to predict all such risks, nor can management assess the impact of all such risks on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statement. Given these risks and uncertainties, investors should not place undue reliance on forward-looking statements as a prediction of actual results. All forward-looking statements speak only as of the date of this Quarterly Report on Form 10-Q. We undertake no obligation to revise or update publicly any forward-looking statement in order to reflect any event or circumstance that may arise after the date of this Quarterly Report on Form 10-Q, other than as required by law.

Critical Accounting Policies and Estimates

The preparation of financial statements requires management to make estimates and judgments that may significantly affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures. On an ongoing basis, management evaluates our estimates and assumptions including, but not limited to, those related to revenue recognition, asset impairments, inventory valuation, warranty reserves and other assets and liabilities. Management bases its estimates on historical experience and various other assumptions that it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Revenue Recognition

Although we have sold photovoltaic inverters and recorded revenues for flywheel development contracts, our operations have not yet reached a level that would qualify us to emerge from the development stage. Therefore we continue to be accounted for as a development stage company under Statement of Financial Accounting Standards No. 7 "Accounting and Reporting by Development Stage Enterprises."

† Inverter Sales

We recognize revenue in accordance with accounting principles generally accepted in the United States of America. Generally, revenue is recognized on transfer of title, typically when products are shipped and all related costs are estimable. For sales to distributors, we make an adjustment to defer revenue until our products are subsequently sold by distributors to their customers.

† Government Contract Revenue Recognized on the Percentage-of-Completion Method

We recognize contract revenue using the percentage-of-completion method. We use labor hours as the basis for the percentage of completion calculation, which is measured principally by the percentage of labor hours incurred to date for each contract to the estimated total labor hours for each contract at completion. Changes to total estimated contract costs or losses, if any, are recognized in the period in which they are determined. Revenues recognized in excess of amounts billed are classified as current assets, and included in "Unbilled costs on contracts in process" in our balance sheets. Amounts billed to clients in excess of revenues recognized to date are classified as current liabilities under "Advance billings on contracts." Changes in project performance and conditions, estimated profitability, and final contract settlements may result in future revisions to construction contract costs and revenue.

Some of our research and development contracts are subject to cost review by government agencies. Our reported results from these contracts could change adversely as a result of these reviews.

Loss on Contract Commitments

Our contracts have been primarily for the development of demonstration units of new products and the design of a frequency regulation plant. As such, the work has supported our core research and development efforts. We establish reserves for anticipated losses on contract commitments if, based on our cost estimates to complete the commitment, we determine that the cost to complete the contract will exceed the total expected contract revenue. Most of our contracts have been granted on a cost-share basis, for which the expected cost-share is recorded as a contract loss. Additionally, each quarter we perform an evaluation of expected costs to complete our in-progress contracts and adjust the contract loss reserve accordingly.

Warranty Reserves

The solar inverters we have sold carry warranties that require us to repair or replace defective products returned to us during the applicable warranty period at no cost to the customer. We record an estimate for warranty-related costs based on actual historical return rates, anticipated return rates and repair costs at the time of sale.

Income Taxes

Deferred tax assets and liabilities are determined based on differences between the financial reporting and income tax basis of assets and liabilities as well as net operating loss and tax credit carryforwards, and are measured using the enacted tax rates and laws that will be in effect when the differences reverse. Deferred tax assets are reduced by a 100% valuation allowance to reflect the uncertainty associated with their ultimate realization.

Significant management judgment is required in determining the provision for income taxes, the deferred tax assets and liabilities and any valuation allowance recorded against deferred tax assets. The valuation allowance is based on our estimates of taxable income and the period over which our deferred tax assets will be recoverable. In the event that actual results differ from these estimates or we adjust these estimates in future periods, we may need to establish an additional valuation allowance or reduce our current valuation allowance, which could materially impact our tax provision. We classify interest and penalties relating to uncertain tax position in income tax expense.

Fixed Assets

Fixed assets are defined as tangible items with unit costs exceeding our capitalization threshold that are used in the operation of the business, are not intended for resale and which have a useful life of one year or more. The cost of fixed assets is defined as the purchase price of the item, as well as all of the costs necessary to bring it to the condition and location necessary for its intended use. Repair and maintenance costs are expensed as incurred. Capital assets are classified as "Construction in Progress" (CIP) when initially acquired, and reclassified to the appropriate asset account when placed into service. Depreciation expense is not recorded on assets not yet placed into service. Materials purchased to build flywheels for use in company-owned frequency regulation facilities are classified as CIP, along with the related labor and overhead costs. No overhead is generally applied for other internally-constructed projects not directly related to our core business (e.g., leasehold improvements.)

Impairment of Long-Lived Assets

In accordance with Statement of Financial Accounting Standards No. 144 "Accounting for the Impairment or Disposal of Long-Lived Assets" long-lived assets we hold and use are reviewed to determine whether any events or changes in circumstances indicate that the carrying value of the asset may not be recoverable. The conditions to be considered include whether or not the asset is in service, has become obsolete, is damaged, or whether external market circumstances indicate that the carrying amount may not be recoverable. When appropriate we recognize a loss for the difference between the estimated fair value of the asset and the carrying amount. The fair value of the asset is measured using either available market prices or estimated discounted cash flows.

Overview

We design, develop, configure and expect to begin operating flywheel-based frequency regulation facilities that will provide services to support more reliable and cost-effective electricity grid operation. The focus of our research and development has been to establish commercially viable flywheel-based energy storage technologies that can provide highly reliable energy solutions for the worldwide electricity grid at competitive costs. Initially, we expect to generate revenues from the commercialization of our flywheel energy storage systems to supply frequency regulation services to the electricity grid in North America. We believe that as we expand our production capabilities we can become a provider of frequency regulation services to grid operators on a global basis. In addition we believe that as the commercialization of our technologies continues, we will develop other cost-effective applications for our flywheel systems that will provide additional revenue opportunities.

Our market focus is on the geographic regions of the domestic grid that provide open bid markets for regulation services. These regions and their Independent System Operator (ISO) or Regional Transmission Organization (RTO) designations are: New England (ISO New England or ISO-NE); California (California ISO or CAISO); New York (New York ISO or NYISO); Mid-Atlantic (PJM Interconnect) and Texas (ERCOT). In addition, per its updated schedule, Midwest Independent Transmission System Operator, Inc. (Midwest ISO or MISO) is expected to begin operating its open-bid ancillary services market for frequency regulation before the end of January 2009. We have been proactive in this emerging market and have added it to our initial target markets. Because ERCOT is not regulated by FERC, we are not able to encourage beneficial market rule changes in ERCOT by leveraging FERC Order 890. This limitation will likely slow our entry into the ERCOT market.

These regional ISOs/RTOs or grid operators purchase frequency regulation services from independent providers in open bid markets that they manage and maintain. We are seeking to become one such provider. We believe our technology will offer grid operators the benefits of greater reliability; faster response time; cleaner operation, including zero direct emissions of carbon dioxide (CO2), nitrogen oxide, sulfur dioxide and mercury; and lower maintenance costs compared to conventional power generation facilities that also provide frequency regulation services. We believe that we will have lower operating costs and faster response time than the majority of other entities that provide frequency regulation services, which we believe will allow us to have sufficient margins to make our services economically viable.

In North America, the frequency regulation market in areas that were accessible via open-bid auction mechanisms was valued at approximately $800 million in 2007. Before the end of January, 2009 (by which time Midwest ISO's regulation market is expected to be in operation) the addressable annualized open-bid regulation market is expected to exceed $1 billion per year. Based on global electricity production, we believe that the worldwide frequency regulation market is several times this amount. Significant growth in the US open-bid market is expected due to a combination of factors, including:

†          Greater use of renewable energy sources - especially wind generation
and solar

†          Anticipated expansion of the open-bid market method to additional
regions, such as the Midwest ISO

†          Increased demand for electricity

†          Increased fossil fuel prices

†          Government and market forces aimed at reducing carbon dioxide
emissions.

Under the open-bid market, grid operators forecast the need for frequency regulation as a percentage of expected power demand, and approved suppliers submit bids for these services. Bids are stacked from lowest to highest prices until the cumulative amount of bids is sufficient to meet the calculated need. The price submitted by the highest selected bidder determines the price paid to every bidder that has been scheduled to provide service.

To fully exploit this regulatory-driven open-bid market, we are finalizing our design and expect to build, own and operate a number of frequency regulation facilities. Our business model, which is a sale-of-services model, is similar to that of independent power producers who also design, build, own and operate their own power plants. Each Smart Energy Matrix™ frequency regulation facility will be up to 20 megawatts (MW) in size. A Smart Energy Matrix™ is a multi-flywheel energy storage system designed to provide reliable and sustainable frequency regulation services for utility grids. A Smart Energy Matrix™ can be scaled to any size to provide one or more megawatts of frequency regulation capacity. Smart Energy Matrix™ frequency regulation plants that are 20 MW or less in size offer the advantage of being eligible to use fast-track interconnection regulations that allow plants of this capacity or smaller to be approved more quickly in accordance with streamlined regulatory rules. A key aspect of our business model is that we are not dependant on the lengthy procurement cycles typically associated with the marketing and sale of capital equipment to the utility sector. Instead, our business model is to become a merchant provider of frequency regulation

services to the deregulated open bid markets. We will be bidding the output of our plants into multiple open-bid markets for regulation services on a daily basis.

A key qualification for our participation in these markets is the ability to demonstrate that our technology can deliver the regulation services required by each grid operator. To attain this qualification and accelerate market entry we installed two scale-power 100-kilowatt-hour (kWh) demonstration models of our Smart Energy Matrix™ for evaluation by two large grid operators. Both of our scale-power systems were comprised of multiple flywheels. In 2005, we were awarded contracts for these systems by the California Energy Commission (CEC) and the New York State Energy Research and Development Authority (NYSERDA), in cooperation with the U.S. Department of Energy (DOE), to test the viability of our flywheel technologies for frequency regulation by these grid operators. The demonstration systems were scale-power prototypes of the Smart Energy Matrix™ multi-flywheel system. As a result of the success of the pilot programs, we have focused on the design of full scale Smart Energy Matrix™ systems.

Both the California and New York systems were installed and evaluated in formal field trials. The demonstration units contained fully functional control, communication and interconnection elements similar or identical to the elements of our design for 20 MW frequency regulation facilities. The purpose of these pilot systems was twofold: 1) to demonstrate the ability of our flywheel technology to provide frequency regulation services consistent with the technical requirements of the grid operators, including the California ISO and New York ISO, and 2) to obtain certification or other approval from these system operators that, from a technical perspective, our technology is approved to provide commercial frequency regulation services in their respective states and territories.

The California system completed its field trial on January 31, 2007, earning a positive evaluation from both the CEC and the CAISO. On December 26, 2006, the California ISO certified our flywheel technology for use as a frequency regulation resource in California.

The New York demonstration unit incorporated technology improvements as a result of field testing in California and the system contained additional voltage support and power quality capabilities. The added capabilities were designed to demonstrate the technical efficacy of two entirely new applications for our core technology.

On March 22, 2007, the New York State Energy Research and Development Authority (NYSERDA) and the U.S. DOE confirmed the successful outcome of technical field trial testing of our scale-power flywheel frequency regulation system in New York. At the same time, the New York ISO determined that our technology is a viable technology for frequency regulation on its grid and is acceptable for provision of commercial frequency regulation in the State of New York. Our New York-based flywheel system field trial reached this significant milestone after the U.S. DOE (through Sandia National Laboratories, which co-monitored the demonstration with NYSERDA) concluded that the unit's performance had been successfully demonstrated and that additional testing of the technology was not required. During the first quarter of 2008, the New York demonstration unit was retrieved for potential future use in supporting other demonstration programs and/or R&D activities.

The location of our regulation plants and the sequence in which they will be constructed depend on a number of factors, including but not limited to the availability and cost of land, the cost of power plant construction, technical grid interconnection requirements, comparative market pricing available for frequency regulation in the various regional markets, approval of environmental and related permits required to build plants, and our ability to receive appropriate revenues and payments within the Market Rules of each regional market.

During the third quarter of 2008, we exercised an option to purchase approximately seven acres of land at a site in Stephentown, New York. This site is served by two transmission companies: National Grid and New York State Electric and Gas (NYSEG). National Grid owns a 115 KVA transmission line that abuts the site, and NYSEG owns a substation that also abuts the site. Our interconnection request for a 20 MW plant includes National Grid as the transmission provider. We also submitted a separate interconnection application for a 1 MW facility with NYSEG that would connect directly to its substation. On October 10, 2008, we executed with NESEG a standardized contract for interconnection of new distributed generation units with a capacity of 2 MW or less connected in parallel with utility distributions systems. Pending finalization of certain engineering details with NYSEG and application and receipt of a building permit for a 1 MW resource from the town of Stephentown, we will have the right to build and operate a 1 MW resource connected to the NYSEG substation.

On July 17, 2008, we received a land-use permit we had requested from the town of Stephentown, New York. Pending approval of our active interconnection request to NYISO and any other implementation requirements of the NYISO, a possible location for our first 20 megawatt frequency regulation plant will be in Stephentown. We are aggressively pursuing completion of the

required interconnection processes for the Stephentown plant. This includes completion by NYISO of a System Impact Study, currently underway, the purpose of which is to ensure that our plant can safely interface with the grid, and to identify any utility upgrades or other equipment that may be needed before operation of the plant can be approved.

Our application to the DOE for a loan guarantee identifies Stephentown, New York, as the planned location for our first 20 MW plant. The satisfactory completion of NYISO's System Impact Study and clear resolution of Market Rule issues (described below) that affect our ability to enter and operate in the NYISO market could impact the timing or success of our DOE loan guarantee application. Lengthy delays or negative outcomes in any of the factors identified above could potentially require us to select another location for our first 20 MW plant. While we are working to bring matters related to the 20 MW plant in Stephentown to the earliest possible successful conclusion, we also are actively developing alternate plant sites in multiple ISOs as a hedge against these location-based risks.

Due to uncertainty and volatility in the equity markets, we are modifying our business plan to ensure sufficient cash reserves into the first quarter of 2009. This will result in a reduction in the number of megawatts we will deploy in New England ISO by the end of 2008 to three megawatts (MW). We now expect a delay in deploying the additional two megawatts from the fourth quarter of 2008 to the first quarter of 2009. In volume production, we expect a 20 MW facility to cost approximately $25 million, while the first 20 MW plant will cost approximately twice that amount. In 2009 our business plan is to deploy our first 20MW plant; however the number of megawatts we will be able to deploy is dependent on obtaining sufficient funding for these capital outlays. We expect to fund the construction of our first 20 MW plant from a combination of debt and equity. Our ability to obtain sufficient funding will pace our ability to produce flywheel systems and deploy them. In 2010 and 2011, we will continue to have capital needs that will require additional equity and debt to fund the ongoing deployment of frequency regulation facilities.

In addition to obtaining sufficient funding, our deployment schedule is conditional upon the following additional factors and activities:

† Component development and quality:

† Complete testing of certain components to ensure highly durable operation at commercial operating speeds.

† Development of multiple sources for our key components. We are working to expand our supplier base to qualify their components to our designs and specifications so that we may complete the initial production run of Smart Energy 25 flywheel units.

† Continuing to work closely with our suppliers to refine their manufacturing processes and ensure quality results.

† Market rules and participation:

† To participate in and be paid for regulation services in our target markets, certain conditions must be met. The technology must be demonstrated and accepted by the Independent System Operators (ISOs). We accomplished this through our successful demonstration projects in California and New York. Prior to plant construction, we must also file an interconnection application with the ISO. Our interconnect application for the Stephentown NY site was filed at the end of 2007. New York ISO is currently in the process of completing a System Impact Study for our 20 MW plant. The purpose of the impact study is to ensure the seamless integration of our plant to the grid. Following the completion of this study we expect to be granted an interconnection agreement. In ISO New England we have received approval to interconnect one MW in Tyngsboro to the grid and to start receiving revenue on November 18, 2008. We are in the process of obtaining interconnection approval for up to an additional four MWs in New England.

† We must become a member of each ISO and confirm that market rules specific to each ISO are compatible with our technology. We have been a member of the PJM Interconnection since 2004 and we have found no restrictions to market participation there. More recently, we have been accepted as a member of ISO New England and approved as a member of New York ISO.

† The need to conform some market rules to be compatible with our technology within our target markets is requiring more time to complete than we had previously thought. In some cases market rule changes are needed which also require time to complete. Some ISOs (other than PJM) have not yet fully updated their market rules

to comply with the Federal Energy Regulatory Commission's 2007 mandate that non-generation resources (such as ours) be allowed equal access to enter the market for regulation services. It is believed that these ISOs will require a number of months to come into compliance, and we have committed adequate resources to accelerate the process.

Regulatory and Market Affairs

Within each ISO there is a market tariff and set of market rules that determine who is allowed to bid into regulation markets, how much regulation providers are paid for their services, and what costs providers must pay to participate in markets. While three ISOs have certified or otherwise approved our flywheel technology for commercial deployment, each ISO has its own market rules that will govern the pace at which markets are opened and the degree to which our technology is allowed to participate. Historically, the market rules for regulation were written to conform to traditional generators' abilities to provide regulation. This is understandable, because until the advent of our technology, the capabilities and limitations of traditional generators defined how regulation could be technically implemented. In the markets in which we intend to compete, most of the ISO market rules still contain legacy terms, performance characteristics and other requirements that do not align with our newer technology. The impact of this mismatch varies from market to market. Our ability to foster beneficial changes to ISO market rules will determine our timing for entering these markets and building regulation facilities, as well as the revenues and costs associated with each market.

Of considerable importance and benefit to us, on February 16, 2007, the Federal Energy Regulation Commission (FERC) issued a landmark ruling, Order 890, Preventing Undue Discrimination and Preference in Transmission Service. This FERC ruling seeks to promote greater competition in electricity markets and strengthen the reliability of the grid. Included in Order 890 was a mandate by FERC that all ISOs must change their market tariffs to allow non-generation resources (such as ours) capable of providing frequency regulation the ability to bid and sell into these markets. The ruling also stated that market rule changes must be implemented in a completely non-discriminatory manner.

We believe that FERC Order 890 will accelerate the pace of market rule changes and we have already made progress with several of the ISOs by working with them directly to implement changes to market rules. We are already experiencing positive effects of Order 890 in the form of heightened commitments by ISOs to work collaboratively with us to integrate our technology to their grids. To ensure that we have the right resources to properly address the timely opportunity represented by FERC Order 890, we obtained expert regulatory and legal counsel and have put a vigorous regulatory affairs program in place.

As a result of FERC Order 890, all ISOs were required to submit a compliance filing with FERC in October 2007 to define their degree of compliance with this mandate. Once the ISO compliance filings were published, we became an active participant in reviewing these ISO filings and providing input to FERC. We determined that most of the ISOs were deficient in some way with respect to full Order 890 compliance. In November 2007 we intervened with FERC and submitted comments on each of the ISOs' Order 890 compliance filings in an effort to . . .