Summary of CHINA CLEAN ENERGY INC

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion should be read together with the information contained in the consolidated financial statements, pro forma financial statements and the related notes included elsewhere in this annual report. The following discussion highlights the principal factors that have affected our financial condition and results of operations as well as our liquidity and capital resources for the periods described. This discussion contains forward-looking statements. Please see "Forward-Looking Statements" and "Risk factors" for a discussion of the uncertainties, risks and assumptions associated with these forward-looking statements. The operating results for the periods presented were not significantly affected by inflation.

Company Overview

We were originally incorporated in Delaware under the name "Hurley Exploration Inc." on November 12, 2004 in order to conduct mineral exploration activities. On October 13, 2006, in anticipation of our acquisition of China Clean Energy Resources, Ltd., we abandoned this enterprise and changed our name to China Clean Energy Inc. On October 24, 2006, we acquired China Clean Energy Resources, Ltd., pursuant to the terms of a Share Exchange Agreement. This transaction was accounted for as a reverse acquisition (recapitalization), with China Clean Energy Resources, Ltd. deemed to be the accounting acquirer and us as the legal acquirer. Accordingly, the financial statements are those of China Clean Energy Resources, Ltd. and its subsidiary up until October 24, 2006. The basis of the assets, liabilities and retained earnings of China Clean Energy Resources, Ltd., were carried over in the recapitalization. Upon the closing of this transaction, we became a Chinese renewable resource-based biodiesel and specialty chemicals manufacturer/distributor.

China Clean Energy Resources, Ltd. was incorporated in the British Virgin Islands on February 13, 2006, for the purpose of holding a 100% interest in Fujian Zhongde Technology Co., Ltd. As such, China Clean Energy Resources, Ltd. does not conduct any substantive operations of its own, but rather conducts its primary business operations through Fujian Zhongde Technology Co., Ltd., a Chinese company that was incorporated in the Province of Fujian, China on July 10, 1995. On November 5, 2007, Fujian Zhongde Energy Co., Ltd., was incorporated in the Province of Fujian, China as a 100% owned subsidiary of China Clean Energy Resources, Ltd. for the development and operation of our new 100,000 tons per year biodiesel refinery in Jiangyin Industrial Park, Fuqing City, Fujian Province, China.

Year Ended December 31, 2008 Compared to the Year Ended December 31, 2007

Revenues. During the year ended December 31, 2008, we had net sales of $18,169,835 (7.68% from biodiesel sales and 92.32% from specialty chemicals sales), as compared to net sales of $21,756,010 (26.54% from biodiesel sales and 73.46% from specialty chemicals sales) during the year ended December 31, 2007. This decrease of approximately 16.48% was attributable (i) to a decrease in sales volume and selling prices of specialty chemicals, particularly in the second half of the year, primarily driven by declining demand in the specialty chemicals market caused by the international financial crisis and lower perceived growth in the Chinese and global economies, and (ii) to the significant decrease in our biodiesel production. In March 2008, we temporarily halted the production of biodiesel and shifted our focus to higher value-added specialty chemicals in an effort to mitigate sharp increases in the cost of raw materials and stagnant wholesale diesel pricing in the People's Republic of China. Due to a decline in raw material costs in November 2008, we resumed the production of biodiesel. However, the rapidly declining crude oil prices in the fourth quarter have depressed the selling prices of biodiesel. We will continue to closely monitor the prices of our feedstock raw material, wholesale diesel prices and the conditions in the biodiesel industry in the People's Republic of China in order to reassess our biodiesel production on an ongoing basis.

Gross Profit. The cost of goods sold, which consists of direct labor, feedstock, direct materials, overhead and product costs, and depreciation of production facilities, was $14,310,907 for the year ended December 31, 2008, as compared to cost of goods sold of $15,882,799 for the year ended December 31, 2007. We had a gross profit of $3,858,928 for the year ended December 31, 2008, as compared to a gross profit of $5,873,211for the year ended December 31, 2007, representing gross margins of approximately 21.24% and 27.00%, respectively. The decrease in gross profit is the result of a significant decrease in sales volume of our biodiesel and specialty chemical export business, along with higher raw material costs. Falling selling prices contributed to a loss on carried inventory of $93,838. The decrease in our gross margin percentage is a result of higher commodities costs, lower margins in biodiesel production, and, effective July 1, 2007, a decrease in Chinese government export tax rebates on our exported specialty chemical products from 13% to 5%.

Selling Expenses. Selling expenses, which include advertising and promotion, freight charges, exporting expenses, wages and salaries, totaled $249,583 for the year ended December 31, 2008, as compared to $695,007 for the year ended December 31, 2007. This was a decrease of approximately 64.09%. This decrease is primarily due to our lower specialty chemical product exports (approximately $6,032,472 and $17,352,323 in the year ended December 31, 2008 and the year ended December 31, 2007, respectively), related export and freight charges and wages and salaries.

General and Administrative and Other Operating Expenses. General and administrative and other operating expenses totaled $2,482,971 for the year ended December 31, 2008, as compared to $1,713,438 for the year ended December 31, 2007. This was an increase of approximately 44.91%. This increase is primarily attributable to $903,769 of stock based compensation costs incurred in connection with employee stock options granted in January 2008. The fair value of the option is amortized on a quarterly basis over three years.

Net Income. We had a net income of $596,816 for the year ended December 31, 2008, as compared to a net income of $3,359,894 for the year ended December 31, 2007. This was a decrease of approximately 82.24%. This decrease in net income was due primarily to the $3,586,175 decrease in revenues caused by decline in sales volume and selling prices, the $324,109 increase in total operating expense primarily driven by stock based compensation costs, the $177,905 loss on disposal of assets and the $369,640 increase in income taxes. The decrease in net income was partially offset by a reduction in selling expenses associated with lower specialty chemicals exports and a decrease in cost of goods sold of $1,571,892. We received a full income tax exemption in 2007 and are subject to a 12% income tax rate in 2008, 2009 and 2010.

Liquidity and Capital Resources

Private Placement. On January 9, 2008, we completed a private placement, pursuant to which we issued 10,000,000 shares of common stock and five-year warrants to purchase 5,000,000 shares of common stock at an initial exercise price of $2.00 per share, for aggregate gross proceeds of $15,000,000. In connection with this private placement, we incurred placement agent fees of approximately $1,200,000, and issued the placement agent five-year warrants to purchase an aggregate of 1,200,000 shares of common stock at an initial exercise price of $2.00 per share. In addition, we incurred other professional fees and expenses totaling approximately $90,000. The proceeds from the above financing were used, in part, to construct our second biodiesel facility, as well as for working capital purposes.

General. As of December 31, 2008 and December 31, 2007, we had cash and cash equivalents of $2,913,711 and $1,133,555, respectively. The increase in cash and cash equivalents was primarily due to the net proceeds of $13,627,403 we received from the $15,000,000 private placement. We incurred a $16,503,785 capital expenditure on our Jiangyin plant and a $2,159,868 decrease in our accounts receivables. The decrease in account receivables was primarily attributable to our reduced specialty chemical exports.

The $16,503,785 capital expenditure on our new Jiangyin plant includes $13,835,889 used for construction related activities and purchases and $2,667,896 used for prepaid equipment purchases. As of December 31, 2008, we paid 86% of the total capital required to finish the plant including $2.5 million we paid in 2006 to acquire the land use rights. After the facility commences production, we anticipate that we will require an additional $3 million for working capital uses. We commenced construction on December 19, 2007 and expect to complete construction in June 2009. The new facility is expected to have a production capacity of 100,000 tons of biodiesel per year or 30,000 tons of specialty chemicals per year or a combination of biodiesel and specialty chemicals for a total output of 70,000 tons per year.

The $5,116,806 net cash proceeds provided by operating activities during the year ended December 31, 2008 was primarily due to $596,816 in net income, $932,908 of depreciation and amortization expenses, $903,769 of stock based compensation costs and a $2,696,479 decrease in accounts receivable and inventories.

The $12,332,965 of net cash provided by financing activities during the year ended December 31, 2008 was primarily due to the net proceeds of $13,627,403 we received from our January 2008 $15,000,000 private placement, partially offset by payments on bank loans. We are currently in active negotiations to secure a $4.4 million loan, of which we intend to allocate $3 million for the working capital expenses for our new Jiangyin Plant.

We have historically met our liquidity and capital requirements from a variety of sources. These included internally generated cash, short-term borrowings from both related parties and financial institutions, and sales of common stock.

At the moment, we have only one refinery which produces both specialty chemicals and biodiesel products. The production capacities for specialty chemicals and biodiesel are at 18,000 tons per annum and 10,000 tons per annum, respectively.

Obligations under Material Contracts. We had a capital commitment of approximately $3.0 million for the acquisition of plant equipment and machinery as of December 31, 2008. We had no material capital commitments as of December 31, 2007.

Other than any of the contractual obligations and commercial commitments set forth above, we did not have any other long-term debt obligations, capital commitments, purchase obligations or other long-term liabilities as of December 31, 2008.

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition presented in this section is based upon the consolidated financial statements of ours and our subsidiaries. These have been prepared in accordance with accounting principles generally accepted in the United States. During the preparation of the financial statements we are required to make estimates and judgment that affect the reported amount of assets, liabilities, revenues, expenses and the related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to sales, returns, pricing concessions, bad debts, inventories, investments, fixed assets, intangible assets, income taxes and other contingencies. We based our estimates on historical experience and various other assumptions that we believe are reasonable under the set of current conditions. Actual results may differ from these estimates under a different set of assumptions or set of conditions.

In response to the Securities and Exchange Commission's Release No. 33-8040, "Cautionary Advice Regarding Disclosure About Critical Accounting Policy," we identified the most critical accounting principals upon which our financial status depends. We determined that those critical accounting principles are related to the use of estimates, inventory valuation, revenue recognition, income tax , impairment of intangibles and other long-lived assets. We present these accounting policies in the relevant sections in this management's discussion and analysis, including the Recently Issued Accounting Pronouncements discussed below.

Revenue Recognition. We recognize a sale when the revenue has been realized or realizable and has been earned, in accordance with Securities and Exchange Commission Staff Accounting Bulletin No. 104, "Revenue Recognition in Financial Statements". Our sales are related to the sale of a product. Revenue for a product sale is recognized as risk and title to the product transfer to the customer, which usually occurs at the time shipment is made. Substantially all of our products are sold FOB ("free on board") shipping point. Title to the product passes when the product is delivered to the freight carrier.

Sales revenue represents the invoiced value of goods, net of a value-added tax (VAT). All products that are sold in the People's Republic of China are subject to a local value-added tax at a rate of 17% of the gross sales price, or at a rate that is approved by the local government. This VAT may be offset by a VAT paid on raw materials and other materials included in the cost of producing the finished product.

Accounts Receivable, Trade and Allowance for Doubtful Accounts. Substantial portions on our business operations are conducted in the People's Republic of China. During the normal course of business, we extend unsecured credit to our customers. Accounts receivable and trades outstanding on December 31, 2008 and December 31, 2007 totaled $1,092,768 and $2,795,363, respectively. Management reviews our accounts receivable on a regular basis to determine if the allowance for doubtful accounts is adequate. An estimate for doubtful accounts is recorded when collection of the full amount is no longer likely. As of December 31, 2008 and December 31, 2007, allowances for doubtful accounts totaled $136,389 and $407,593, respectively.

Inventories. Inventories are stated at the lesser of cost (first in, first out method) or market. We review our inventory on a regular basis or determine if any reserves are necessary for potential obsolescence. As of December 31, 2008, our management determined that the carrying amount of raw materials exceeded the prices currently available. Therefore, we wrote down $92,113 and included this amount in the cost of goods sold for 2008.

Impairment of Long-Lived Assets. Management reviews the long-lived tangible and intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may no longer be recoverable. When these events occur, we measure impairment by comparing the carrying value of the long-lived assets to the estimated undiscounted future cash flows expected to result from the use of the assets and their eventual disposition. If the sum of the expected discounted cash flows is less than the carrying amount of the assets, we would recognize an impairment loss based on the fair value of the assets. As of December 31, 2008, we recorded an impairment loss totaling $74,817.

Income Taxes. We adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"). SFAS 109 requires the recognition of deferred income tax liabilities and assets for the expected future tax consequences of temporary differences between income tax basis and financial reporting basis of assets and liabilities. Provision for income taxes consist of taxes currently due plus deferred taxes. Since we had no operations in the U.S., there is no provision for U.S. income tax and there were no deferred tax amounts as of December 31, 2008 and December 31, 2007.

Deferred tax is accounted for by using the balance sheet liability method in respect of temporary differences arising from differences between the carrying amount of assets and liabilities in the financial statements and the corresponding tax basis used in the computation of assessable tax profit. In principal, deferred tax liabilities are recognized for all taxable temporary differences, and deferred tax assets are recognized to the extent that it is probable that taxable profit will be available against which deductible temporary differences can be utilized. Deferred tax is calculated at the tax rate that is expected to apply to the period when the asset is realized or the liability is settled. Deferred tax is charged or credited in the income statement, except when it relates to items credited or charged directly to equity, in which case the deferred tax is also dealt with as equity. Deferred tax assets and liabilities are offset when they relate to income taxes levied by the same taxation authority and we intend to settle current tax assets and liabilities on a net basis.

Our subsidiaries, Fujian Zhongde Technology Co., Ltd. and Fujian Zhongde Energy Co., Ltd., are governed by the Income Tax Law of the People's Republic of China concerning Foreign Investment Enterprises and Foreign Enterprises and various local income tax laws (the "Income Tax Laws"). Under the Income Tax Laws, WOFEs generally are subject to an income tax rate of 25% on income as reported in their statutory financial statements after appropriate tax adjustments, unless the enterprise is located in specially designated regions of cities for which more favorable tax rates apply.

Upon approval by the People's Republic of China tax authorities, WOFEs scheduled to operate for a period of 10 years or more and engage in manufacturing and production may be exempt from income tax for two years, commencing with their first profitable year of operations, after taking into account any losses brought forward from prior years, and thereafter with a 50% exemption for the next three years.

As Fujian Zhongde Technology Co., Ltd. became a WOFE starting February 20, 2006 at the time it merged with China Clean Energy Resources, Ltd., it received the above described WOFE tax benefit upon approval from the People's Republic of China. Fujian Zhongde Technology Co., Ltd. was exempt from income taxes in 2007 and thereafter 50% exempt for the next three years beginning in 2008.

Value Added Tax (VAT). Enterprises or individuals who sell commodities, engage in repair and maintenance or import/export goods in the People's Republic of China are subject to a value added tax in accordance with People's Republic of China laws. The value added tax standard rate is 17% of the gross sales price. A credit is available whereby VAT paid on the purchases of semi-finished products or raw materials used in the production of our finished products can be used to offset the VAT due on sales of the finished product.

Recently Issued Accounting Pronouncements

In March 2008, the Financial Accounting Standards Board ("FASB") issued SFAS 161, "Disclosures About Derivative Instruments and Hedging Activities - an Amendment of FASB Statement No. 133" ("SFAS 161"), which changes the disclosure requirements for derivative instruments and hedging activities. Entities are required to provide enhanced disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for under SFAS 133, "Accounting for Derivative Instruments and Hedging Activities" and its related interpretations, and (c) how derivative instruments and related hedged items affect an entity's financial position, financial performance and cash flows. SFAS 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. We are currently evaluating the impact that adopting SFAS 161 will have on our financial statements.

In April 2008, the FASB issued FSP 142-3, "Determination of the Useful Life of Intangible Assets" ("FSP 142-3"), which amends the factors a company should consider when developing renewal assumptions used to determine the useful life of an intangible asset under SFAS 142, "Goodwill and Other Intangible Assets" ("SFAS 142"). FSP 142-3 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. SFAS 142 requires companies to consider whether renewal can be completed without substantial cost or material modification of the existing terms and conditions associated with the asset. FSP 142-3 replaces the previous useful life criteria with a new requirement-that we consider its own historical experience in renewing similar arrangements. If historical experience does not exist then an entity would consider market participant assumptions regarding renewal, including 1) highest and best use of the asset by a market participant, and 2) adjustments for other entity-specific factors included in SFAS 142. We are currently evaluating the impact that adopting FSP 142-3 will have on our financial statements.

In May 2008, the FASB issued SFAS 162, "The Hierarchy of Generally Accepted Accounting Principles" ("SFAS 162"). SFAS 162 identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles in the United States. It is effective 60 days following the SEC's approval of the Public Company Accounting Oversight Board amendments to AU Section 411, "The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles". The adoption of SFAS 162 is not expected to have a material effect on our financial statements.

In June 2008, the FASB issued FSP Emerging Issues Task Force 03-6-1, "Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities" ("FSP EITF 03-6-1"). FSP EITF 03-6-1 concludes that unvested share-based payment awards that contain rights to receive non-forfeitable dividends or dividend equivalents are participating securities, and thus, should be included in the two-class method of computing earnings per share, or EPS. FSP EITF 03-6-1 is effective for fiscal years beginning after December 15, 2008, and interim periods within those years. Early application of EITF 03-6-1 is prohibited. It also requires that all prior-period EPS data be adjusted retrospectively. The adoption of this statement is not expected to have a material effect on our financial statements.

In June 2008, the FASB issued EITF 07-5, "Determining Whether an Instrument (or Embedded Feature) is Indexed to an Entity's Own Stock" ("EITF 07-5"). EITF 07-5 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. Early application is not permitted. Paragraph 11(a) of SFAS 133 specifies that a contract that would otherwise meet the definition of a derivative but is both
(a) indexed to the Company's own stock and (b) classified in stockholders' equity in the statement of financial position would not be considered a derivative financial instrument. EITF 07-5 provides a new two-step model to be applied in determining whether a financial instrument or an embedded feature is indexed to an issuer's own stock and thus able to qualify for the SFAS 133 paragraph 11(a) scope exception. We believe adopting this statement will have a material impact on the financial statements because among other things, any option or warrant previously issued and all new issuances denominated is U.S. dollars will be required to be carried as a liability and marked to market each reporting period.

On October 10, 2008, the FASB issued FSP 157-3, "Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active" ("FSP 157-3") which clarifies the application of SFAS 157, "Fair Value Measurements" in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. FSP 157-3 became effective on October 10, 2008, and its adoption did not have a material impact on our financial position or results for the year ended December 31, 2008.

In December 2008, the FASB issued FSP FAS 140-4 and FIN 46(R)-8, "Disclosures by Public Entities (Enterprises) about Transfers of Financial Assets and Interests in Variable Interest Entities" ("FSP FAS 140-4 and FIN 46(R)-8"). FSP FAS 140-4 and FIN 46(R)-8 amends FAS 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" and FIN 46(R), "Consolidation of Variable Interest Entities" to require additional disclosures regarding transfers of financial assets and interest in variable interest entities. FSP FAS 140-4 and FIN 46(R)-8 is effective for interim or annual reporting periods ending after December 15, 2008. FSP FAS 140-4 and FIN 46(R)-8 will not have a material impact on our consolidated financial statements because we do not have any variable interest entities.

In January 2009, the FASB issued FSP EITF 99-20-1, "Amendments to the Impairment Guidance of EITF Issue No. 99-20, Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets" ("FSP EITF 99-20-1"). FSP EITF 99-20-1 changes the impairment model included within EITF 99-20, "Recognition of Interest Income and Impairment of Purchased Beneficial Interests and Beneficial Interests that Continue to be Held by a Transferor in Securitized Financial Assets" ("EITF 99-20") to be more consistent with the impairment model of SFAS 115,"Accounting for Certain Investments in Debt and Equity". FSP EITF 99-20-1 achieves this by amending the impairment model in EITF 99-20 to remove its exclusive reliance on "market participant" estimates of future cash flows used in determining fair value. Changing the cash flows used to analyze other-than-temporary impairment from the "market participant" view to a holder's estimate of whether there has been a "probable" adverse change in estimated cash flows allows companies to apply reasonable judgment in assessing whether an other-than-temporary impairment has occurred. The adoption of FSP EITF 99-20-1 did not have a material impact on our consolidated financial statements because all of our investments in debt securities are classified as trading securities.

Item 8. Financial Statements and Supplementary Data.

See our Financial Statements beginning on page F-1.