Item 1. Business

General

Thermal Energy Storage, Inc. (TESI) is an innovator in the application of a var- iety of thermal storage mechanisms, and in the application of one of these mech- anisms to the production of potable water from seawater. The Company has de- signed, developed, and installed systems for reducing the peak load on air con- ditioning systems. This is accomplished by "cool storage" a term for describing the creation of an ice-like media that can absorb peak air conditioning loads. "Cool storage" produces economies by reducing the size and cost of the air con- ditioning equipment, and by shifting air conditioning electrical loads from peak periods to off-peak periods when electricity is cheaper.

The company's systems make use of patented technology that induces water to form ice-like crystals (a "clathrate") by adding certain chemicals to the water. A system using the foaming agent CCl2FCH3 (monofluorodichloroethane or R141b) in- duces crystal formation at 47.5F. The heat of fusion of the clathrate is close to that of water, and provides the required heat sink mechanism.

Recently the company has been engaged in developing systems for the desalination of seawater using similar technology and has designed built, and tested small capacity experimental systems that have provided proof of concept for the de- salt-ing process. The desalination systems take advantage of the phenomenon observed in ordinary ice; that it excludes the salt when it freezes and the ice produced is nearly pure water. Clathrate crystals are used in this process to produce crystals at temperatures well above the normal ice freezing temperature in sea-water. Crystals may be produced from cold seawater available at ocean depths of about 2000 feet without mechanical refrigeration, thus reducing the energy required to obtain potable water.

Products Background

Thermal Energy Storage Systems

The Company has developed a unique system to create a heat sink for thermal energy as a means of reducing the initial and operating cost of large central air conditioning units. The system absorbs energy by melting "clathrate" crys- tals. The clathrates used by the company are formed of water mixed with certain materials having a small molecular structure which, when combined, promotes crystallization at higher freezing temperature than water alone. In recent experiments the Company used the clathrate forming compound R141b, or hydro- chlorofluorocarbon (HCFC) 141b. The clathrate crystals and water produce a slurry that is stored in a tank and pumped through a heat exchanger to absorb heat when the air conditioning load increases above the nominal capacity of the air conditioner.

The clathrate crystal slurry has several advantages over the more conventional, ordinary water-ice systems in use for this purpose:

(i) the clathrate freezes at approximately 45F to 64F instead of 32F as with water-ice and thus provides desalination at lower cost than reverse osmosis;
(ii) the clathrate requires less energy to achieve storage at this higher temperature as compared to ordinary ice; and

(iii) the clathrate does not expand as does ordinary ice, thereby simplifying equipment design and minimizing the risk of damage that can occur with ordinary ice.

The U.S. Environmental Protection Agency (EPA) has determined that R141b de- pletes ozone in the upper atmosphere and that it has an Ozone Depletion Poten- tial (ODP) of 0.11. This is substantially lower than a chlorofluorocarbon

used by the Company earlier, (trichloromono-fluoromethane, also known as CFC 11 or R11). The EPA has banned the production of R11 because it had an ODP of 1.0. Although the ODP of R141b is almost a factor of ten lower, the EPA has ruled that the manufacture of R141b must cease this year (2003). This ruling, coupled with the uncertainty of finding a suitable replacement, has effectively elim- inated the Company's ability to sell its product in its prime marketplace.

Since this clathrate-forming material is being phased out of production because of EPA requirements the Company is investigating the use of non-Chlorine com- pounds like hydrocarbons for use in the desalination system. Through work per- formed in the development of a freeze desalination system the Company has ident- ified several alternative clathrate formers that have freezing temperatures that may be suitable for the thermal storage application. Although the freezing temperature is important in this application, other characteristics of the crystals are also important in determining the feasibility of their use. Never- theless, the search for a suitable clathrate former for desalination may also yield a substitute clathrate former, with zero ODP, for the purposes of thermal energy storage.

Freeze Desalination Systems

Since 1995 the Company has done research and development on the applica- tion of clathrate technology to the desalination of seawater. This work was funded by the Company's president through his solely owned engineering consult- ing company, RAMCO, Inc., and support agreements with the Bureau of Reclamation (BuRec), Department of Interior.

In this process, the clathrate former R141b is mixed with cold seawater from a depth of approximately 2,000 feet, forming a slurry of the clathrate-crystals. The slurry is pumped to a device known as a wash column where the clathrate crystals are separated from and washed of surface brine. The crystals are then melted producing fresh water and the R141b is recovered for reinjection in a continuous cycle. The initial studies and subsequent experiments show that, if certain problems can be resolved, this process could compete economically with desalination systems now in use.

Since the manufacture of R141b was to cease in the US this year (2003), an effort was initiated to find a suitable substitute clathrate-former for desalination purposes.

For this service a higher temperature clathrate former is desirable because it would either make increased production efficiency possible where cold water is available or would broaden the geographic applicability of the process. A fol- low-on contract was received from the Bureau of Reclamation in 1999 to identify possible replacement clathrate formers suitable for desalination. During 1999 the work under this agreement identified clathrate formers that have a zero ozone depletion potential, and that form clathrate crystals at higher tempera- tures than R141b, at pressures deemed feasible by the Company for the

desalination process. Additionally, some of the clathrate formers identified for the purpose of desalination may be useful in certain thermal energy storage applications.

Company Business Outlook

Since 1989 the Company's existence has been threatened by serious financial difficulties as a result of circumstances that made the Company unable to mar- ket its products. These circumstances have been noted in prior 10-K reports and are briefly reviewed under History below. In fact, as early as 1989, the Company's Directors were required to consider terminating the Company's business when it became unclear that the Company could meet its obligations for operating funds. However, certain of the Directors, including the President pledged per- sonal funds to attempt to keep the Company in operation, principally to explore the possibility of a merger or acquisition with or by a stronger company, and more recently to help advance the desalination technology. With this financial support the Company was able to continue.

After 1992, substantial contributions from the President were a major source of funding, combined with supplementary support from other Directors. In 1994, dollar contributions from the other Directors ceased although these Directors continue to provide services. Continued efforts from 1994 to present have prod- uced some positive results and the Company has received funds from the Bureau of Reclamation for its desalination program. These funds from the Bureau have also carried with them an obligation for the Company to contribute on a participatory basis and this latter obligation was met in major part by continued funding of the Company by RAMCO, Inc.

Competition

Because of the delay created by the elimination of R11 and R141b, the Company still has not entered the thermal energy storage (TES) market, which exacerbates the financial constraints under which the Company had been operating. Manage- ment is aware of at least eight companies currently competing in the off-peak storage air conditioning market. Seven of these companies produce systems based on water ice, or water, as the storage media. Management believes its clathrate storage technology is unique and, as noted earlier, offers technical advantages over systems presently marketed by competitors.

Management is not aware of any manufacturer currently producing or developing a clathrate-based cool storage system; however, other firms with greater resources than the Company are interested in the utilization of phase-change materials for thermal energy storage. Some of these firms have the technical capability of developing a thermal energy storage system along the lines of the Company's product should they decide to do so, subject to constraints imposed by our patent position.

Both the technology and the utility perception as to the requirements for energy storage and electric power load management are experiencing many new develop- ments. There can be no assurance that the Company's products will not be made uncompetitive or obsolete in the future.

The clathrate former (R141b) used in the Company's storage medium is no longer being manufactured in the U.S. The uncertainty surrounding the Company's ability to find a suitable replacement has stalled the Company's entrance into

the market place. Should the price of a replacement be significantly higher than that of R141b the Company's system could be rendered uncompetitive. An alternate clathrate former will have to be used after 2003. The Company continues to seek R&D funds to meet this need.

The company is aware of other makers of thermal storage systems for air con- ditioning applications. The primary market for the Company's systems is for large central air conditioning systems such as those employed in office build- ings, shopping malls, and high-technology manufacturing facilities. The Com- pany believes that its systems have significant advantages, including higher efficiency, over competing thermal storage systems. The company is aware of another patent on clathrate desalination, but does not believe that the clath- rate desalination technology embodied in that patent offers the advantages in- herent in the company's technology. The Company anticipates that competition from makers of distillation and reverse osmosis desalination systems will be significant because of their current presence in the marketplace.

Marketing

The company's sales and marketing efforts at present are directed toward obtaining additional support for research and development testing of clathrate forming chemicals thus far identified.

History

Thermal Energy Storage, Inc. (the Company) was incorporated under the laws of Colorado on December 8, 1978. Initially the Company's business was the manu- facture and marketing of thermal energy storage systems to the solar industry. In fact, the great majority of the Company's existing shareholders trace their participation to the 1979-1983 period.

By the end of 1984 consumer demand for solar energy systems declined and the Company directed its efforts into the growing commercial demand for off-peak cool thermal storage in large central air conditioning systems. The TES system first developed by the Company relied on the use of the refrigerant labeled R11 (monofluorotrichloromethane), a chlorofluorocarbon (CFC) that was subsequently (in 1989) identified with the depletion of the earth's ozone layer. The U.S. government placed a heavy tax on the use of CFC R11 in 1990 and the U.S. En- vironmental Protection Agency (EPA) ordered the termination of manufacture of all CFC products at the end of 1995.

Under a contract with Consolidated Edison of New York, the Company was success- ful in identifying the R141b as a suitable replacement to R11. However, the expenditures made by the Company to accomplish the development of the 'SnoPeak' (a contraction of "there's no peak") thermal energy storage system depleted the Company's resources so that it was unable to sustain a marketing effort. The Company then began to seek merger partners to promote the product line.

In 1993 an effort was begun to pursue clathrate desalination technology. This work led to a sharing contract with the Bureau of Reclamation (BuRec) to design, build, and test a small-scale pilot plant at the Natural Energy Laboratory of Hawaii, on the Big Island of Hawaii. As part of this endeavor a search for a new clathrate former for use with the desalination technology was made and that work is ongoing. In order to obtain this contract, RAMCO met the financial sharing obligations required by the BuRec.

In January, 1995 the Company's President filed for a patent on a clathrate desalination system, which patent has subsequently been issued. All costs incurred up to the time of issuance of the patent and thereafter, for develop- ing, obtaining and supporting the patent were paid by RAMCO. The Company's Board of Directors has proposed, and the Company's president has agreed, that RAMCO cross-license the technology, as embodied in the patent application and developments through the completion of the aforementioned BuRec contract, to the Company in perpetuity, on a worldwide, royalty-free basis. Additionally, RAMCO has agreed to assign all its rights to the desalination technology to the Company upon reimbursement of expenditures and amounts owed RAMCO by the Company.

In 1995 the EPA dealt the company another blow when it ruled that the manufact- ure of R141b must also be terminated and established the year 2003 as the date after which no new material can be produced. This ruling by EPA effectively removed the Company from both the thermal energy storage and desalination markets.

Over the long and difficult period, from 1989 to present, while the Company was developing its 'Snopeak' product line and searching for a suitable replacement for its clathrate-forming chemical, many fundamental and structural changes were occurring in the traditional electric utility industry leading up to the current restructuring of the industry. Having lost its ability to market its 'Snopeak' product line because of EPA rulings, the Company sought to align with a financially strong company with comparable business interests that would continue to fund the search for new a clathrate-former as well as to develop the desalination technology. However management judges that the best opportun- ity to find an appropriate partner is to find a suitable replacement clathrate former and also to develop a working system for its desalination technology for a demonstration plant.

In an approach to revitalize itself the Company was able to obtain two cost- sharing desalination contracts from the Bureau of Reclamation amounting to $553,000. In order for the Company to obtain these contracts it was necessary for RAMCO to agree to fund in kind the major part of the cost-sharing amount of $241,000.

The testing showed that four of the five subsystems making up the desalination system operate satisfactorily. The fifth subsystem did not work as required for the overall system to be deemed successful. Follow on funding was sought from BuRec to modify the design of this subsystem and to perform further testing.

This funding was held back by BuRec because of an incident at NELH in Septem- ber, 1998 whereby certain parties accused, falsely as it turns out, NELH and the Company of causing a fish kill through the release of R141b into the out- fall tide pool from the company's test facility. The company's subsequent investigation determined that the most likely cause of the alleged fish kill would have been thermal shock caused by the release of very cold water into the warm water that collects in the outfall tide pool during periods when the company's system is not operating. Further it was shown that for R141b to be toxic to humans, fish or plant life it would have to be in concentrations on the order of magnitude of 1000 times greater than the amounts reportedly detected. It was concluded that the most likely cause of there being R141b in the outfall was through the efforts of one or more disgruntled defendants

in a suit brought by NELH to eject them from the land to which they claim ownership, which land is part of NELH's facility.

The Company received the follow on contract from BuRec in March 1999 and had intended to continue experiments with the pilot plant at NELH. However the changed requirements by the Hawaii Department of Health made further work at the site financially infeasible. As a consequence, the Company dismantled the pilot plant in 1999 and vacated the NELH facility.

Instead of experiments at the pilot plant, the Company contracted for the construction of a small-scale test facility in San Diego near the company offices. A small-scale system, designed to permit observation during operation, was constructed and evaluated with the test facility.

The project was completed in June 2000 and successfully demonstrated the abil- ity of the process to produce water meeting EPA salinity standards. The exper- iments with the scale model system reduced the salinity from 35,000 parts per million (ppm) in seawater to less than the 500-ppm salinity limit on drinking water established by the EPA. Several alternative clathrate formers that have zero ozone depletion potential were identified in the second quarter. Experi- ments with those alternative clathrates are planned for 2002.

The results to date have provided management with optimism that its desalina- tion efforts may lead to a marketable product in the future.

Research and Development

In October 1993 the Company was awarded a $103,000 participatory contract from the U.S. Department of Interior, Bureau of Reclamation (BuRec), to perform a feasibility study to determine if clathrate technology is suitable for the de- salination of seawater. Known as "Freeze Desalination" a clathrate system, theoretically, has the potential to be a more efficient desalination system than reverse osmosis systems currently in use. The study was completed in April 1995 and verified the technical feasibility of the clathrate desalination system and showed that there is potential for this system to compete with other desalination systems now in commercial use.

In October 1995, the Company received a follow-on, $450,000, participatory contract to build a small demonstration plant to be located at the Natural Energy Laboratory of Hawaii. Certain costs associated with obtaining the fol- low-on contract and funding needed for the $178,000 participatory share, were paid by RAMCO, the Company not having sufficient funds to meet the funding requirements.

In October 1996, the company was awarded a $250,000 contract by the Center of Excellence for Research in Ocean Sciences (CEROS) to evaluate the effects of greater pressures at ocean depths on crystal formation, and to design, con- struct, and test a subsystem module for the removal and recovery of trace quantities of the clathrate from the product water stream. This work was completed in March 1999.

In March 1999, the company was awarded a $100,000 financial assistance agree- ment by the Bureau of Reclamation. The agreement, which supported participa- tion by the company at a somewhat higher level, was for research into higher

temperature clathrate formers and experimentation with the wash column. RAMCO provided funds on behalf of the Company in support of this work.

During the first quarter, 2000 the Company accepted a proposal for engineering services from Innovative Engineering Services, Inc. (IES) in which IES proposed that the services be paid either in cash or in stock, at the Company's option. The Board of Directors established a price of $0.03 per share as reasonable in light of the recent volatility in share price and IES accepted that price as the basis for the contract. The work was completed in February 2000 and the sale of 202,833 restricted common shares to IES via a private placement was anticipated in the second quarter to fund payment for the engineering services. After further discussions with IES, the Company and IES agreed that a total of 200,000 shares would be issued for the services provided by IES. The private placement to issue these restricted common shares was completed in the third quarter.

In accordance with generally accepted accounting principles, all costs assoc- iated with research and development incurred by the Company were expensed.

The company has also received significant support in its research from the Department of Interior, Bureau of Reclamation and from CEROS. The Company has published three technical reports on the work supported by these agencies, and a paper presented at the International Desalination Association's 1999 World Congress. These technical reports, listed below, are available from those agencies.

1. Richard A. McCormack and Richard K. Andersen, Thermal Energy Storage, Inc., "Clathrate Desalination Plant Preliminary Research Study," Bureau of Rec- lamation Contract Number 1425-3-CR-81-19520, Water Treatment Technology Program Report Number 5, June 1995

2. Richard A. McCormack and Glenn A. Niblock, Thermal Energy Storage, Inc., Build and Operate a Clathrate Desalination Pilot Plant, Final Technical Report, Bureau of Reclamation Assistance Agreement Number 1425-5-FC-81- 20690, Water Treatment Technology Program Report Number 31, May 1998

3. Richard A. McCormack, Thermal Energy Storage, Inc., Development and Test- ing of a Clathrate Desalination Research Facility, DARPA Grant Number MDA 972-94-1-0010, Final Technical Report, January 1999.

4. Richard A. McCormack, Thermal Energy Storage, Inc. and Glenn A. Niblock, Vertex Associates Inc.; "Clathrate Freeze Desalination Progress," IDA Log No: SD99165 presented at the International Desalination Association 1999 World Congress, August 29-September 4, 1999.

Intellectual Property Rights

Patents

The Company has patented its clathrate phase-change technology based on the concept of freezing the clathrate mix in a range of 42F to 48F while maintain- ing high thermal storage capacity. Mixing certain compounds with water using off-the-shelf mechanical and chemical components produces clathrates, also known as gas-hydrates. At certain temperatures and pressures, depending on the chemistry of the mixture, molecules of the clathrate forming compound are com-

pletely enclosed with a group of water molecules in a solid crystalline struct- ure to form the clathrate heat sink medium. The Company was issued U.S. Patent Number 4,696,338 on September 29, 1987 covering the formation of a clathrate under specific physical and chemical conditions. This patent was for a warm temperature (118F) heat storage medium that the Company no longer considers commercially valuable. The Company's second clathrate patent, number 4,821,794 that was issued on April 18, 1989 covers different methods and chemicals for forming its clathrate heat sink medium.

In January 1995, Richard McCormack, the Company's President filed for a patent on a clathrate desalination system. U.S. Patent 5,553,456 was issued to RAMCO as the originator of the basic patent applications on freeze desalination that is used by the Company in its desalination development work. All costs of obtain- ing the patent have been, and are being, paid by RAMCO. The Company's Board of Directors has proposed, and the Company's president has agreed, that RAMCO cross-license the technology, as embodied in the patent application and develop- ments through the completion of aforementioned BuRec contract, to the Company in perpetuity, on a worldwide, royalty-free basis. Additionally, RAMCO has agreed to assign all its rights to the desalination technology to the Company upon reimbursement of expenditures and amounts owed RAMCO by the Company.

Work completed under the financial assistance agreement received in 1999, and work funded by RAMCO may lead to additional patents. No evaluation of the po- tential for patent protection has yet been done and there is no assurance that additional patents will be granted.

Trademark

In 1981 the Company was granted a federal trademark for the name, Thermal Energy Storage, Inc., as well as the acronym, "TESI", and the Company's logo. A state trademark registration has been granted by the State of California. The Company believes its name is an asset as it reflects the name for thermal energy storage (TES) commonly used in the literature and in the industry.

Material Customers

In 2000, as in 1999, 100 percent of the Company's revenues were derived from research supported by contracts with the U.S. Department of Interior, Bureau of Reclamation (BuRec). In 1998, and 1997, 100 percent of the Company's revenues were derived from research supported by contracts with the BuRec and the Cent- ers of Excellence for Research in Ocean Sciences. The failure of the Company to contract with additional new customers is having a material adverse effect on the Company.

Manufacturing and Assembly

The Company's production of storage systems consists primarily of engineering, procurement and final assembly of components produced by other manufacturers to Company specifications, and charging the system with its storage medium. Man- agement believes that all major equipment components of its system are, and will remain, readily obtainable from numerous suppliers to the extent necessary to meet the Company's production needs. The Company has not entered into any long-term contract for the supply of any component. The Company does not in- tend to build any manufacturing facilities in the foreseeable future.

Employees

As of December 31, 2003 the Company had no full time employees. Part time employees, consultants and contractors are hired as needed in engineering, marketing, manufacturing and administration.