Ceramic Fuel Cells Limited FY 2008 ANNUAL REPORT AND ACCOUNTS

29 September 2008

Ceramic Fuel Cells Limited (“CFCL” or “the Company”) FY 2008 ANNUAL REPORT AND ACCOUNTS

Ceramic Fuel Cells Limited (AIM / ASX: CFU), a leading developer of high efficiency and low emission microgeneration products  for homes, has released its audited statutory accounts and Directors' Report for the year ended 30 June 2008. The documents are  also available on the company's website: www.cfcl.com.au. The financial results are the same as the preliminary results released  to the market on 28 August 2008. A notice of the 2008 Annual General Meeting will be sent to shareholders in October.

Overview
Ceramic Fuel Cells Limited is a global leader in developing high efficiency and low emission microgeneration products for homes.  The Company’s solid oxide fuel cell (SOFC) technology converts gas into electricity and heat, without combustion or noise. Fuel cells provide environmental benefits through very high efficiency and low emissions.

The Company’s first product is a 1 - 2kW combined heat and power (m-CHP) unit. The unit replaces existing home heating systems, is connected to the existing natural gas network, providing power and heat for the home and exporting excess power to the electricity network. In the medium term the Company will look to extend its technology into other markets and other applications such as remote area power units and auxiliary power units.

Over the 2007-08 financial year the Company continued to deliver on a clear and focused strategy, by developing mCHP products with leading energy customers and appliance partners in five large markets. In July 2007 the Company signed product development agreements with partners in the United Kingdom and The Netherlands, and in January 2008 the Company entered the Japanese market. During the year the Company also continued its projects with partners in Germany and France.

Significantly, CFCL’s first volume order was secured with Nuon, its partner in The Netherlands, based on meeting agreed targets. During the financial year the Company opened a new plant in the United Kingdom to produce high quality ceramic powders, and entered into partnerships to outsource volume component manufacturing, to increase capacity and reduce unit costs.

The Company confirmed a €12.4 million investment in a new fuel cell manufacturing plant in Heinsberg, Germany. The Company also continued to develop its technology, with further significant advances in fuel cell power density, efficiency and lifetime. In May 2008 ,the Company raised £7 million (A$14.7 million) in a placement of new shares.

Achievements to September 2008

- NetGenPlus units installed with all European appliance partners
- NetGenPlus unit shipped to Japan in August 2008
- Developing fully-integrated units

- Completed Australian plant upgrade

- Fuel cell plant in Germany -- Capital expenditure approved in February 2008, project on track for completion by June 2009

- Long term fuel cell supply agreements signed with HC Starck and CeramTec in early 2008
- Partnerships with commercial suppliers for Balance of Plant components

- UK Powder plant commissioned in October 2007, producing samples for potential customers and identifying other opportunities
- Supplying powder for Fuel Cell production in Australia

- Agreement signed with Paloma in January 2008 to enter the Japanese market. The Paloma Group is a leading global producer of gas appliances.

Strong Policy Support
There is a huge demand for more efficient, more secure and cleaner electricity. Energy demand is forecast to rise, however the European Union (along with many other countries) has committed to reduce greenhouse gas emissions by 20% by 2020. These forces create strong support for low-emission energy technology, like solid oxide fuel cells, which can be deployed quickly, using the existing natural gas and electricity infrastructure.

Governments are setting clear policies that support the uptake of new energy technologies. In addition to the policies announced in 2007, many Governments are providing specific incentives for distributed generation, mCHP and fuel cells. Highlights from some of our initial markets are described below.

The United Kingdom Government has been particularly active in this area over the last year. To reduce household emissions, the Government requires all new UK homes to be zero or low carbon by 2016. New planning regulations require all UK councils to integrate climate change mitigation into all local plans and developments, including by helping to deliver decentralized, low carbon energy.

In November 2007 the UK Carbon Trust released its ‘Micro-CHP Accelerator’ Interim Report. The Report is a detailed analysis of field trials of 70 mCHP units, across a range of technologies. The key conclusions of the Report are that micro CHP can save carbon emissions, and money; to maximise the savings, run the units for longer – not intermittently; and that fuel cell mCHP products with higher electrical efficiency can provide higher savings

The UK Department for Business, Energy and Regulatory Reform (BERR) also released a progress report on the UK Government’s 2006 Microgeneration Strategy. The report outlines the Government’s actions to encourage the uptake of microgeneration. One important action has been the Climate Change and Sustainable Energy Act, which ensures that UK energy suppliers offer a price to microgenerators wishing to sell excess electricity to the network. This Act also changed how the UK’s Energy Efficiency Commitment (EEC) operates, to encourage microgeneration. The EEC requires energy suppliers to increase generating efficiency or reduce carbon emissions, or face a fine. For the third phase of EEC, which runs from April 2008 to March 2011, between 6% and 8% of suppliers’ obligations can be met through promoting and installing microgeneration.

In June 2008 BERR released a detailed report on The Growth Potential for Microgeneration in England, Wales and Scotland. The report forecasts the UK market for technologies like mCHP under a range of policy scenarios. Under the baseline scenario (which assumes current policies continue but no new policies are introduced), the report forecasts approximately 1 million microgeneration units (mostly CHP) by 2020. With additional policy support, such as a feed in tariff orother regulations, the forecasts jump to almost 4 million fuel cell CHP units by 2020.

Germany is also a leading market for mCHP. In addition to the existing mCHP feed in tariff of about 5 Euro cents per kWh, from September 2008 the German Government has introduced a subsidy of up to 3,300 Euros for a 2kW mCHP unit. The subsidy is calculated on a sliding scale to reward maximum electric output and operating hours, and therefore favours mCHP technologies – like CFCL’s - that produce more power and less heat.

The Japanese Government has been a strong supporter of fuel cell technology for many years. Japan has more than 2,100 fuel cell units installed in homes – more than any other market. Almost all of these units use proton exchange membrane (PEM) fuel cells. The Japanese Government has now introduced a demonstration program and subsidies specifically for higher efficiency solid oxide fuel cell (SOFC) units, which runs from 2007 to 2010.

The Company’s technical and financial modelling indicates that widespread deployment of fuel cell mCHP units can create significant value for utilities, appliance partners and homeowners. The main reason is simple: highly efficient fuel cell mCHP units can create power and heat (mainly power) more efficiently than the current mix of generating technologies. It costs utilities less to generate the same amount of power using far less fuel.  This means far lower emissions. The value of these benefits is shared between CFCL, its utility and appliance partners, and the homeowner. So, whilst any additional incentives are welcome to support the transition from product development to commercial sales,Management and the Board believe there is a strong business case for customers to deploy CFCL’s units.

Customers and Products
The first product to be powered by the Company’s fuel cells will be combined heat and power (mCHP) units for homes. The Company is developing mCHP products with leading utility customers and appliance partners in five key markets: Germany, France, the United Kingdom, the Benelux markets and Japan.

In these partnerships, typically the energy company sets the specification for the mCHP product and will introduce the product to each market. Ceramic Fuel Cells makes the fuel cell module and sells this to the appliance manufacturer. The appliance manufacturer develops and manufactures the complete mCHP appliance. The appliance manufacturer or the utility then sells or ‘leases’ the mCHP unit to the homeowner.

The Company’s partners are some of the leading energy utilities and appliance developers in their markets:

Germany:
EWE: Among the largest German utilities. Leader in distributed generation and fuel cells. 5,800 staff, sales of €9B. CFCL has been working with EWE since July 2005. www.ewe.de

Bruns Heiztechnik:  Specialist German boiler maker, with over 40 years experience and 200 staff. Develops and manufactures boilers and storage systems under various brand names. www.brunsheiztechnik.de

France:
Gaz de France:  One of Europe’s largest gas utilities now entering the electricity market. Sales of €27B, 13M customers. Leadingthe EU-DEEP program, a €30M program to evaluate decentralised energy systems. www.gazdefrance.com

De Dietrich Thermique: Leading French boiler manufacturer, with an extensive network of installers throughout France. Part of the Remeha group. www.dedietrich-heating.com

The Netherlands:
Nuon: Leading energy company that serves over 2 million customers in the Netherlands, Belgium and Germany with electricity, gas, heating and related services. Sales of €5.6B. www.nuon.com

Remeha: Large global boiler & heating systems manufacturer, sells into 40 countries. 2,500 staff, sales of €540M. www.remeha.com

United Kingdom:
E.On UK:  One of the UK’s largest integrated power and gas companies, experience with deploying CHP units. 8M customers, sales of €12B. Part of the E.ON group, the world’s largest investorowned power and gas company. www.eon-uk.com

Gledhill Water Storage:  Produces an advanced range of appliances for domestic mains pressure hot water and heating, with extensive boiler and storage vessel expertise. www.gledhill.net

Japan:
Paloma Group Leading global gas appliance company. Based in Japan, operations in Asia, Oceania, Americas. Largest water heater manufacturer in the USA. Sales of US$2.5B, 15,000 staff.  www.palomaglobal.com

In February 2008 the Company announced that its Dutch partner Nuon had agreed to place an order for 50,000 mCHP units, on the achievement of agreed performance targets. These targets encompass physical weight and size, power and heat output, efficiency, lifetime, CO2 savings and selling price of the mCHP unit. This agreement with Nuon is a milestone achievement for the Company, with the potential to deliver significant revenue over many years.

During the financial year the Company continued to make progress with its product development projects.

In late 2007 the Company obtained European ‘CE’ approval for its NetGenPlusTM units, and shipped units to the Company’s appliance partners in Germany and the UK. By the end of the financial year a total of six NetGenPlus units were installed with the Company’s European partners, as follows:

- Two units installed at EWE’s facilities and one unit with Bruns Heiztechnik in
Germany.
- Two units installed with De Dietrich Thermique in France (one each for the projects with Gaz de France and Nuon).
- One unit installed with Gledhill Water Storage Ltd in the UK.

These NetGenPlus units are connected to existing heating units and tested and operated in real world conditions, using existing natural gas, water and telecommunications connections and the local electricity grids. All the Company’s units are monitored and can be remotely controlled over the internet, using software specially developed by Ceramic Fuel Cells. These programs allow the Company and its partners to monitor the performance of the units in order to optimise the design of the fully integrated unit and commercial products.

In January 2008, the Company entered the Japanese market through a product evaluation and development agreement with Paloma Industries Ltd.

Japan is one of the world’s leading and fastest growing markets for fuel cells. The Japanese
Government has a long term funding and strategic program to support the commercialization of residential solid oxide fuel cell (SOFC) CHP units. Japan is also a large market for home heating appliances, with approximately 4.2 million units sold per year into a market of 47 million households. The Paloma Group is a leading global producer of gas appliances for residential and commercial applications, and owns the Rheem, Raypak and Solahart brands. The Group has annual revenues of approximately US$2.5 billion and serves more than 10 million homes in Japan.

Under the agreement, CFCL will supply Paloma with a NetGenPlus™ unit for Paloma to operate at its site in Japan. The unit was shipped to Paloma in August 2008. Using the results of the real-world product operation, which is expected to run for up to 12 months, CFCL and Paloma will design and develop integrated mCHP products for the Japanese market.

The Company also continues to assess a range of opportunities to enter new markets and develop additional products.

Manufacturing and Supply Chain
In February 2008 and in line with CFCL’s strategy, the Company announced that it is investing €12.4 million in the construction of a manufacturing plant in Heinsberg, Germany for the commercial production of its fuel cell systems. The plant will have an initial capacity of 10,000 units per year.

By June 2008 the Company had received full environmental and building permit approvals for the plant from the appropriate German government bodies. The Company had also signed contracts and placed orders for the three largest cost pieces of equipment, comprising furnaces, ink skids and robotic assembly units.

The project is on budget and on schedule for the plant to be operational by June 2009.

During the financial year the Company also developed partnerships with leading global suppliers to establish the supply chain for the Heinsberg plant.

Early in 2008 the Company signed long term fuel cell supply and co-operation agreements with each of H.C. Starck and CeramTec, leading German-based manufacturers of advanced ceramic components. Under each of these agreements, the companies will share relevant intellectual property and technical expertise to continually improve the performance of the supplier’s cells, improve manufacturing processes and reduce unit costs. Each supplier has agreed to supply the Company with fuel cell components at fixed prices through to December 2011. The Company will continue to produce fuel cells at its Melbourne R&D and pilot manufacturing facility to drive continued improvements in cell and stack performance.

The Company also entered commercial relationships with suppliers of ‘balance of plant’ components, which are integrated with the fuel cell stack to create CFCL’s fuel cell module. The Company has developed and sourced compact and highly efficient components from low cost commercial suppliers, with significant cost savings and size reductions.

UK Powder Plant
In late 2007 the Company finished building and commissioning a plant in Bromborough, Merseyside, UK, designed to make high quality ceramic powders using the Company’s proprietary technology. Since then the Company has been optimising the processes and equipment used at the plant to make zirconia powders. Zirconia is a key input into the Company’s fuel cell components and is also used in a wide range of other products and applications.

In early 2008 the first shipment of zirconia powder from the Bromborough plant was received in Noble Park, Victoria. The powder passed all the Company’s quality control and powder characterisation tests and has been used to make the Company’s fuel cells. The Company has also continued to develop powder samples for several potential customers.

The Company believes that the plant is capable of making a range of high quality powders for several large and growing markets, and that the plant and the associated intellectual property can provide a range of options to maximise shareholder value.

Technology
During the year the Company continued to improve the performance of its fuel cell technology to meet commercial targets. In early July 2008 the Company presented its latest technical advances at the 8th annual European Solid Oxide Fuel Cell Forum, including:
- a 50% increase in cell power density from June 2007 to June 2008;
- an increase in fuel cell stack lifetime. Degradation has reduced by 35%, from 1.53% / 1000 hours reported in February 2008 to less than 1% / 1000 hours, when operating a 1kW stack in a test station at 750oC on natural gas.

These results have been achieved through advances made in cells, sealing technology, interconnect metals, protective coatings on metals and contact technology.

In July 2008 the Company was granted a further patent in Europe, for a system of reforming fuels for a fuel cell system. This system allows CFCL to control the proportion of methane and remove all higher hydrocarbons from the fuel used for the fuel cell. The invention allows CFCL to use a wide variety of fuels for its fuel cells, including liquid hydrocarbon fuels and bio-fuels, and also maintain very high system efficiency. It is patented in Australia and China, and applications are in progress in the USA and Japan.

As at September 2008 the Company has a broad patent portfolio, of 31 patent families around its principal inventions, including ceramic powder processing to fuel cells, stacks, balance of plant components and fuel cell systems.

People
Management and the Board recognise the importance of attracting and retaining the Company’s highly skilled staff, and the need to create appropriate incentives for those staff to deliver value to the shareholders. All staff members have formal ‘short term incentive’ and ‘long term incentive’ remuneration plans, linked directly to performance against personal and Company key performance indicators (KPIs). A particularly important aspect of the Company’s remuneration policy is to grant share options to staff, under the options plan approved by shareholders in 2006. The Company also has an Employee Excellence rewards program, to recognise and reward outstanding performance.

During the financial year the Company continued to hire staff to support its European activities, including three Product & Support Engineers to work with the Company’s appliance partners (two engineers based in Germany and one in France), a multi-lingual French national for the role of Account Manager - Continental Europe, and a Development Technician for the UK powder plant. The Company also relocated several engineers from Melbourne to support product development projects in Europe.

The Company continued to invest in staff training and development, including through a Leadership Forum group, comprising the Executive Management Team and key functional managers and future leaders.

During the year the Company developed and implemented a new Occupational Health & Safety system, with advice from external specialists. Under this shared approach to managing safety, departmental safety plans and safety KPIs were integrated into the  performance review process for all managers and staff. The Company progressively updated its compliance documentation such as policies and procedures, and implemented a new chemical management system.

The Company also retained specialists to facilitate staff training sessions on the chemical management system, dangerous goods and hazardous substances, contractor safety management, emergency evacuation, first aid and rehabilitation/return to work coordination.

During the financial year 15 safety incidents were reported at the Company’s Melbourne operations. There were no major injuries. Four incidents resulted in minor injuries (such as bruising and manual handling strains), eight involved identification of hazards or potential hazards and there were three false alarm fire evacuations. No safety incidents were reported at the Company’s operations in the United Kingdom or Germany.

At Board level, at the Annual General Meeting in November 2007 Mr Julian Dinsdale retired from the Board, after having served as Chairman since 2002. The Board recognises and thanks Mr Dinsdale for his significantcontribution to the Company during this time. The Board welcomed Mr Jeffrey Harding as Chairman. Mr Harding has extensive experience in the renewable energy sector in Australia, Asia and Europe.

Risk management
Over the past few years the Company has significantly reduced the key risks facing the Company – however, as with any company that is commercialising new technology, there remain risks for the Company to identify, manage and mitigate. Management and the Board believe it is important for shareholders to understand those risks.

Technical
The key technical risk for the Company (and for all fuel cell companies) is to consistently make fuel cells that work reliably, in real world conditions, for a long time. For CFCL, this means ensuring that we have good quality input materials and that our fuel cells, stack, and systems, perform according to their specifications – particularly over a commercially acceptable lifetime.

During the year the Company continued to make significant progress toward meeting these technical requirements, with a 50% increase in cell power density and a significant increase in cell lifetime.

The Company is mitigating technical risks in several ways:
- We will maintain a supply of high quality powder for our fuel cell components.
- We have entered long term supply and collaboration partnerships with HC Starck and CeramTec, two of the world’s leading advanced ceramics companies.
- We have created separate projects to continue to improve the performance and reliability of our cells, stacks and systemcomponents, with each project having clear targets for the 2009 financial year.
- We have a comprehensive cell and stack testing capability, with more than 50 test stations in our Melbourne facility, using proprietary CFCL software. 

Through our ongoing collaboration with the Jülich research centre and, potentially, other leading fuel cell companies, we will address shared technical challenges, for example by developing ‘accelerated lifetime’ testing and prediction models.

Commercial
One of the Company’s key commercial risks has changed over the last two years. Previously a key risk was that the Company’s target customers and partners - energy utilities and appliance makers – would resist the Company’s technology. The Company has mitigated this risk, with formal product evaluation and development agreements with leading partners in five large markets. The risk in the next stage of commercialisation is that partners take too long to develop products, or customers take too long to buy products in volume. Again, this risk is not unique to the Company, and is faced by many companies thatare developing new products with partners.

The Company is addressing these risks, by:
- Securing a volume order from Nuon, for 50,000 units, based on the Company meeting agreed performance and price targets. The Company is working towards agreeing similar targets with its other customers and partners.
- Continuing to refine its detailed financial models, using external experts, to demonstrate the ‘value’ created for utility customers by deploying mCHP units.
- Developing product development ‘roadmaps’ and agreeing project plans and timelines with its appliance partners and utility customers.
- Successfully installing NetGenPlus units with its appliance partners in Europe and developing and operating semi-integrated mCHP units.
- Progressing quickly to design and build a fully integrated mCHP unit.
- Assessing Government funding programs to support early deployment of mCHP units.
- Identifying additional potential customers and market opportunities.

The Company is also addressing the commercial challenge of reducing costs of its units. During the year the Company achieved significant reductions in the cost, size and complexity of the fuel cell module components, through partnerships with commercial suppliers. In the 2009 financial year the Company will continue to make its product components simpler and cheaper.

Finally, Management and the Board will continue to monitor the Company’s investments and financial position and take appropriate action to ensure the Company has sufficient funding to continue to commercialise its technology.

Manufacturing
Apart from mitigating technical risks and commercial risks, the Company needs to make its products in large numbers at low cost. Increasing the Company’s manufacturing capability is a key area of focus over the 2008 and 2009 financial years.

Some of the specific mitigating actions include:
- Selectively outsourcing manufacturing of volume components to leading suppliers.
- Building a large scale fuel cell plant in Heinsberg, Germany. After a rigorous planning process, including a ‘design freeze’ process and risk review conducted by external consultants, the Company commenced capital works on the German plant in February 2008.

The Company has retained external experts (in the United Kingdom and Germany) to project manage the engineering, procurement and construction activities. The Company has also worked closely with Nuon, as the owner and operator of the Heinsberg site, who has provided local expertise and assistance.

- Maintaining and optimising the Company’s pilot production facilities in Melbourne, as a backup to the Heinsberg plant. Before committing to the Heinsberg investment, the Company tested and validated key manufacturing processes at its existing Melbourne facility.
- Building a plant in the United Kingdom to make high quality ceramic powders, using the Company’s proprietary technology.

For each of these risks, Management has created specific projects, with clear KPIs linked to personal performance reviews and remuneration for the 2009 financial year. Management regularly reports to the Board on progress against these KPIs and on any changes to the Company’s key risks.

For further information please contact:
Ceramic Fuel Cells
Andrew Neilson Tel: +61 419 950 771
Email: investor@cfcl.com.au

Source: Ceramic Fuel Cells Limited