<PAGE>

================================================================================

                UNITED STATES SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

--------------------------------------------------------------------------------

                                    FORM 10-Q

(Mark One)

 [X]                  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
                             SECURITIES EXCHANGE ACT OF 1934

                      FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2001

 [ ]                  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
                             SECURITIES EXCHANGE ACT OF 1934

--------------------------------------------------------------------------------


                         Commission file number 0-23634

                                    KFX INC.
             (Exact name of Registrant as specified in its charter)

              Delaware                                     84-1079971
   (State or other jurisdiction of                      (I.R.S. employer
   incorporation or organization)                     Identification number)

          3300 EAST FIRST AVENUE, SUITE 290, DENVER, COLORADO USA 80206
                    (Address of principal executive offices)

                                 (303) 293-2992
               (Registrant's telephone number including area code)

Indicate by check mark whether the Registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months, and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]

On November 7, 2001 there were 26,774,340 shares of the Registrant's common
stock, $.001 par value, outstanding.


================================================================================
<PAGE>

                                    KFX INC.
                           FORM 10-Q QUARTERLY REPORT
                FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2001

                                TABLE OF CONTENTS

                                                                        PAGE NO.
 PART I.  FINANCIAL INFORMATION

     ITEM 1. FINANCIAL STATEMENTS:

        Consolidated Balance Sheets - September 30, 2001
            and December 31, 2000 (Unaudited)................................  3
        Consolidated Statements of Operations - Three Months Ended
            September 30, 2001 and 2000 (Unaudited)..........................  4
        Consolidated Statements of Operations - Nine Months Ended
            September 30, 2001 and 2000 (Unaudited)..........................  5
        Consolidated Statements of Cash Flows - Nine Months Ended
            September 30, 2001 and 2000 (Unaudited)........................... 6
        Notes to Consolidated Financial Statements (Unaudited)................ 8

     ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
             FINANCIAL CONDITION AND RESULTS OF
             OPERATIONS...................................................... 16

     ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES
             ABOUT MARKET RISK............................................... 21

 PART II.  OTHER INFORMATION

     ITEM 1. LEGAL PROCEEDINGS............................................... 23

     ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS....................... 24

     ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K................................ 25

 SIGNATURES ................................................................. 26
<PAGE>

                                    KFX INC.
                           CONSOLIDATED BALANCE SHEETS

                                                           UNAUDITED
                                                   SEPTEMBER 30,   DECEMBER  31,
                                                      2001             2000
                                                   ------------    ------------
ASSETS
Current assets
     Cash and cash equivalents .................   $  1,720,922    $    348,955
     Trade accounts receivable, net ............        518,281         351,909
     Unbilled revenue ..........................        110,647         118,103
     Other receivables .........................        268,923         224,853
     Prepaid expenses ..........................         85,087          34,459
     Debt issue costs ..........................        328,193              --
     Deferred job costs ........................        521,952         216,152
                                                   ------------    ------------
     Total current assets ......................      3,554,005       1,294,431
Property, plant and equipment, net .............        559,044       1,360,430
Patents, net ...................................      1,766,174       1,951,567
Investment in K-Fuel, LLC ......................        431,658         694,135
Goodwill, net ..................................      8,882,824       1,817,731
Intangibles, net ...............................      1,360,033              --
Debt issue costs ...............................             --         679,046
Prepaid royalty ................................        498,000         498,000
Other assets ...................................        177,299         176,030
                                                   ------------    ------------
TOTAL ASSETS ...................................   $ 17,229,037    $  8,471,370
                                                   ============    ============

LIABILITIES AND STOCKHOLDERS' DEFICIT
Current liabilities
     Accounts payable ..........................   $  2,024,017    $  1,817,533
     Accrued expenses ..........................        498,994         625,523
     Interest payable ..........................        266,728         458,265
     Liability to issue stock and warrants .....         23,810         134,458
     Deferred sale of Pegasus common stock .....             --       1,000,000
     Deferred revenue ..........................      1,104,743         523,552
     Deferred income ...........................        232,520              --
     Short term notes payable to directors .....        350,000         827,551
     Obligations to repurchase Pegasus preferred
       stock, net ..............................      1,768,697              --
     Convertible debentures ....................     15,070,309              --
     Current maturities of long-term debt ......      5,485,174         873,476
                                                   ------------    ------------

         Total current liabilities .............     26,824,992       6,260,358
Deferred income ................................             --         499,309
Deferred revenue, less current portion .........        492,051         200,000
Convertible debentures .........................             --      16,339,444
Long-term debt, less current maturities ........      5,047,612         331,150
                                                   ------------    ------------
         Total liabilities .....................     32,364,655      23,630,261
                                                   ------------    ------------
Minority interest ..............................      4,136,327       2,275,040
                                                   ------------    ------------
Stockholders' deficit
   Preferred stock, $.001 par value, 20,000,000
     shares authorized; none issued ............             --              --

   Common stock, $.001 par value, 80,000,000
     shares authorized; and 26,774,340 and
     25,196,280 shares issued and outstanding ..         26,774          25,196
Additional paid-in capital .....................     61,306,335      53,632,177
Accumulated deficit ............................    (80,605,054)    (71,091,304)
                                                   ------------    ------------

         Total stockholders' deficit ...........    (19,271,945)    (17,433,931)
                                                   ------------    ------------
TOTAL LIABILITIES AND STOCKHOLDERS' DEFICIT ....   $ 17,229,037    $  8,471,370
                                                   ============    ============

                   The accompanying notes are an integral part
                   of these consolidated financial statements

                                       3
<PAGE>

                                    KFX INC.
                      CONSOLIDATED STATEMENTS OF OPERATIONS



                                                            UNAUDITED
                                                THREE MONTHS ENDED SEPTEMBER 30,
                                                       2001             2000
                                                   ------------    ------------

OPERATING REVENUES
Pegasus software licenses and services .........   $  1,106,530    $    375,379
K-Fuel demonstration plant and laboratory
  contract revenue .............................             --         129,417
                                                   ------------    ------------
     Total operating revenues ..................      1,106,530         504,796

OPERATING COSTS & EXPENSES
Costs of Pegasus software licenses and services.        551,063         467,564
Marketing, general and administrative expenses .      2,160,347       1,315,585
Pegasus software research and development ......        210,569         189,820
K-Fuel demonstration plant and laboratory ......         81,467         101,080
Depreciation and amortization ..................        651,483         690,702
                                                   ------------    ------------
     Total operating costs and expenses ........      3,654,929       2,764,751
                                                   ------------    ------------

OPERATING LOSS .................................     (2,548,399)     (2,259,955)

Other income (expense) .........................         (7,680)          9,541
Interest expense (including accretion of
  maturity  premiums) ..........................     (1,138,758)       (457,934)
Equity in income (loss) of unconsolidated
  affiliates ...................................          1,303         (23,537)
                                                   ------------    ------------
NET LOSS .......................................   $ (3,693,534)   $ (2,731,885)
                                                   ============    ============

BASIC AND DILUTED NET LOSS PER COMMON SHARE ....   $      (0.14)   $      (0.11)
                                                   ============    ============

Weighted-average common shares outstanding .....     26,552,000      24,998,000
                                                   ============    ============


                   The accompanying notes are an integral part
                   of these consolidated financial statements

                                       4
<PAGE>

                                    KFX INC.
                      CONSOLIDATED STATEMENTS OF OPERATIONS


                                                           UNAUDITED
                                                 NINE MONTHS ENDED SEPTEMBER 30,
                                                       2001           2000
                                                   ------------    ------------

OPERATING REVENUES
Pegasus software licenses and services .........   $  1,883,484    $  1,601,571
K-Fuel demonstration plant and laboratory
  contract revenue .............................             --         229,393
                                                   ------------    ------------
     Total operating revenues ..................      1,883,484       1,830,964

OPERATING COSTS & EXPENSES
Costs of Pegasus software licenses and services       1,159,827       1,265,855
Marketing, general and administrative expenses .      4,399,787       3,804,281
Pegasus software research and development ......        563,426         455,653
K-Fuel demonstration plant and laboratory
  operations ...................................        171,245         277,840
Depreciation and amortization ..................      2,028,671       2,112,865
                                                   ------------    ------------
     Total operating costs and expenses ........      8,322,956       7,916,494
                                                   ------------    ------------


OPERATING LOSS .................................     (6,439,472)     (6,085,530)

Other income (expense) .........................        (45,603)        (28,753)
Interest expense (including accretion of
  maturity premiums) ...........................     (3,032,987)     (2,012,565)

Equity in income of unconsolidated affiliates ..          4,312          22,693
                                                   ------------    ------------

NET LOSS .......................................   $ (9,513,750)   $ (8,104,155)
                                                   ============    ============

BASIC AND DILUTED NET LOSS PER COMMON SHARE ....   $      (0.37)   $      (0.33)
                                                   ============    ============

Weighted-average common shares outstanding .....     25,746,000      24,831,000
                                                   ============    ============



                   The accompanying notes are an integral part
                   of these consolidated financial statements

                                       5
<PAGE>

<TABLE>
<CAPTION>
                                    KFX INC.
                      CONSOLIDATED STATEMENTS OF CASH FLOWS

                                                                     UNAUDITED
                                                          NINE MONTHS ENDED SEPTEMBER 30,
                                                             2001                    2000
                                                          -----------            -----------
<S>                                                       <C>                    <C>
OPERATING ACTIVITIES
     Net loss .........................................   $(9,513,750)           $(8,104,155)
     Adjustments to reconcile net loss to cash
       used in operating activities
            Depreciation and amortization .............     2,028,671              2,112,865
            Equity in loss of unconsolidated affiliates        (4,312)               (22,693)
            Accretion of maturity premiums and
              amortization of debt discount ...........     1,992,264              1,181,389
            Common stock and warrants issued for
              services ................................       313,136                205,313
            Other .....................................       111,287                     --
     Changes in operating assets and liabilities:
         Accounts receivable, unbilled revenue
         and deferred job costs, net ..................      (508,787)               109,072
         Deferred revenue .............................       604,178               (446,672)
         Accounts payable and accrued expenses ........        79,955                921,483
         Interest payable .............................      (191,537)              (311,355)
         Other assets .................................       (53,282)                31,643
                                                          -----------            -----------
Cash used in operating activities .....................    (5,142,177)            (4,323,110)
                                                          -----------            -----------
INVESTING ACTIVITIES
     Purchases of equipment............................       (82,619)               (51,854)
     Pending patent applications ......................       (68,313)              (221,453)
     Purchase of Power Optimization Segment of
       Pavilion Technologies, Inc. assets .............    (2,008,789)                    --
     Deferred sale of subsidiary stock ................            --              1,000,000
     Cash recovery of investment in KFx Fuel
       Partners LP. ...................................            --              1,527,048
                                                          -----------            -----------
Cash (used in) provided by investing activities .......    (2,159,721)             2,253,741
                                                          -----------            -----------
FINANCING ACTIVITIES
     Issuance of common stock and warrants, net .......     3,500,000              1,500,000
     Issuance of preferred stock in subsidiary ........       750,000                     --
     Proceeds from sale of Pegasus preferred stock ....     1,972,331                     --
     Short term note issued to director ...............       300,000                750,000
     Proceeds from convertible long term borrowing ....     3,500,000                     --
     Payments on note payable to directors ............      (600,000)              (400,000)
     Payments on notes payable ........................      (748,466)              (156,167)
                                                          -----------            -----------
Cash provided by financing activities .................     8,673,865              1,693,833
                                                          -----------            -----------

Increase (decrease) in cash and cash equivalents ......     1,371,967               (375,536)
Cash and cash equivalents, beginning of period ........       348,955                654,429
                                                          -----------            -----------
Cash and cash equivalents, end of period ..............   $ 1,720,922            $   278,893
                                                          ===========            ===========


SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
     Cash paid for interest ...........................   $ 1,260,151            $ 1,148,142
                                                          ===========            ===========
</TABLE>

SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES

Nine Months Ended September 30, 2001:

The Company issued 194,500 shares of common stock (70,000 shares of common stock
to a party related to the Chairman and CEO) in exchange for consulting services
during the nine months and to satisfy an obligation that existed at December 31,
2000; a total of $313,136 was charged to general and administrative expense and
$110,648 reduced a liability outstanding at December 31, 2000. In connection
with the sales of Pegasus preferred stock, subject to KFx's obligation to
repurchase, a debt discount of $1,780,256 was recorded, which is being amortized
to

                                       6
<PAGE>

                                    KFX INC.
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                                   (CONTINUED)

interest expense over the one-year term of the repurchase obligation. On March
3, 2001, Kennecott Energy's put option relative to its Pegasus common stock
expired; accordingly, the $1,000,000 sales price has been included in minority
interest as of September 30, 2001. Convertible Debentures with a face value of
$1,400,000 were converted, under the stated terms of $3.65 per share, into
383,561 shares of the Company's common stock resulting in an addition to
stockholders' equity approximating $1,362,980, net of a pro rata portion of
unamortized debt issue costs. Warrants to purchase 285,000 shares of Pegasus
common stock were issued in the second quarter of 2001, resulting in debt
discount of $102,348, which was recognized as interest expense on the issuance
date. During the third quarter of 2001, the Company issued a warrant in
conjunction with a loan agreement to purchase 200,000 shares of KFx common
stock, resulting in debt discount of $369,190 and interest expense of $22,802.

Nine Months Ended September 30, 2000:

   Convertible Debentures with a face value of $1,750,000 were converted, under
the stated terms of $3.65 per share, into 479,445 shares of the Company's common
stock resulting in an addition to stockholders' equity approximating $1,637,000,
net of a pro rata portion of unamortized debt issue costs. Warrants valued at
$2,200,000 to purchase 1.3 million shares of KFx common stock at $3.65 per
share, subject to certain adjustments, were issued in the second quarter of
2000; see Note 3. In July 2000, in connection with obtaining a $400,000
unsecured line of credit from a KFx director, Pegasus issued a warrant valued at
$215,000 to purchase new shares of its common stock equivalent to 1.5% of its
then outstanding common stock; see Note 6. Through September 30, 2000, $83,889
of related expense was recorded. In July 2000, the Company issued 56,250 shares
of its common stock for financial consulting services valued at $205,313.



                   The accompanying notes are an integral part
                   of these consolidated financial statements

                                       7
<PAGE>

                                    KFX INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED)

NOTE 1.   BASIS OF PRESENTATION

   The accompanying unaudited consolidated financial statements include the
accounts of KFX Inc. ("KFx" or the "Company"), its wholly owned subsidiary, KFX
Wyoming Inc., and its majority-owned subsidiaries, Pegasus Technologies, Inc.
("Pegasus"), KFX Technology, Inc. ("KFxT"), and Heartland Fuels Corporation. The
Company's 51% interest in K-Fuel, L.L.C. ("K-Fuel, LLC") is accounted for as an
equity investment since the 49% partner, Kennecott Energy Company ("Kennecott
Energy"), has certain participative rights; accordingly, the Company does not
control K-Fuel, LLC. Until May 2000, the Company's 5% interest in KFx Fuel
Partners, L.P. ("KFP") was accounted for as equity investment since the Company
was a non-controlling investor in KFP. In May 2000, the Company sold its 5%
interest in KFP to Black Hills Corporation, see Note 3.

   The consolidated financial statements at September 30, 2001 and for the three
and nine month periods ended September 30, 2001 and 2000 are unaudited. In the
opinion of the Company's management, all adjustments, consisting of only normal
recurring adjustments, necessary for a fair statement of the results for the
interim periods have been made. Certain reclassifications have been made to the
2000 financial statements to conform to the current year presentation.

   Certain information and footnote disclosures normally included in financial
statements prepared in accordance with generally accepted accounting principles
have been condensed or omitted. These financial statements should be read in
conjunction with the audited financial statements and notes to financial
statements for the year ended December 31, 2000 included in the Company's Form
10-K. The accounting policies used in the preparation of these unaudited
quarterly financial statements are the same as those policies used in the
preparation of the audited annual financial statements. The results of
operations for the three and nine months ended September 30, 2001 are not
necessarily indicative of the results of operations expected for the year ended
December 31, 2001.

   The accompanying financial statements have been prepared on a going concern
basis, which contemplates the realization of assets and the satisfaction of
liabilities in the normal course of business. The Company has incurred net
losses of approximately $12,290,000, $12,730,000 and $6,784,000 and negative
cash flow from operations of $5,151,000, $3,458,000 and $4,642,000 in the years
ended December 31, 2000, 1999 and 1998, respectively, and an additional net loss
of $9,513,750 and negative cash flow from operations of $5,142,177 in the nine
months ended September 30, 2001 and had an accumulated deficit of approximately
$80,605,054 as of September 30, 2001. These factors, coupled with the need for
additional financing to fund operations and planned growth in the business,
raise substantial doubt about whether the Company can continue as a going
concern. The Report of Independent Accountants dated April 13, 2001 covering the
Company's consolidated financial statements for the year ended December 31, 2000
included an explanatory paragraph discussing this going concern uncertainty.

   In order to mitigate this uncertainty, the Company intends to seek further
capital through various means which may include the sale of all or a portion of
its interest in Pegasus, additional sales of debt or equity securities, a
business combination or other means and to further reduce expenditures as
necessary. Should the Company not be successful in achieving one or more of
these actions, it is possible that the Company may not be able to continue as a
going concern. The consolidated financial statements do not include any
adjustments that might result from the outcome of this uncertainty.

   Net loss per common share for the three and nine month periods ended
September 30, 2001 and 2000 are based on the weighted-average number of shares
of common stock outstanding during the period, and excludes approximately
14,185,544 and 9,724,000 of potentially issuable common shares from common stock
options, warrants and convertible debt, as the effect on the Company's net loss
would be anti-dilutive.

                                       8
<PAGE>

NOTE 2.   DEFERRED SALE OF PEGASUS COMMON STOCK, ISSUANCES OF PEGASUS PREFERRED
          STOCK AND SALES OF PEGASUS PREFERRED STOCK

   On March 3, 2000, KFx and Pegasus closed a transaction with Kennecott Energy
that included, among various other elements, (a) the sale of 4% of the common
stock of Pegasus, held by KFx ("Pegasus Common Stock"), to Kennecott Energy for
$1,000,000, (b) the issuance by Pegasus to Kennecott Energy, in exchange for
$500,000, of newly authorized 6% cumulative convertible preferred stock
("Pegasus Preferred Stock") equivalent to an additional 2% interest in Pegasus
on an as converted basis, and (c) the joint development by KFx, Pegasus and
Kennecott Energy of a work plan for enhancements to NeuSIGHT, new product
development and the completion of other tasks designed to improve the
performance of Pegasus and trigger additional purchases of Pegasus Preferred
Stock by Kennecott Energy at its discretion of up to $3,500,000, for an
additional interest in Pegasus up to 14%, on an as converted basis, by December
31, 2004 or earlier. Through September 30, 2001, Kennecott Energy has purchased
$2,250,000 of additional Pegasus Preferred Stock, $750,000 of which was
purchased during the nine months ended September 30, 2001. Through March 3,
2001, Kennecott Energy had the right to sell the Pegasus Common Stock back to
KFx at a price equal to the greater of $1,000,000 or fair market value; such
right was not exercised and expired on March 3, 2001. Accordingly, the
$1,000,000 sale price has been included in minority interest as of September 30,
2001.

   During the nine months ended September 30, 2001, KFx closed transactions with
various parties pursuant to which KFx sold a portion of its Pegasus preferred
stock investment in Pegasus, representing an approximate 11.6% as converted
interest in Pegasus, for $1,972,331. Included in these sales of Pegasus
preferred stock were sales to two directors of KFx and KFx's Chairman, Theodore
Venners, for $222,331 in exchange for an as converted interest in Pegasus of
1.3%. KFx is obligated to repurchase this preferred stock, or any other security
issued with respect to this preferred stock, for $2,787,561 at dates varying
from January 31, 2002 to May 25, 2002, or earlier upon the occurrence of certain
events, such as a change in control. In certain circumstances, the parties can
individually elect to exchange their interest in Pegasus, with an aggregate
value of $2,787,561, and any interest in Pegasus subsequently acquired by
Evergreen Resources, Inc. ("Evergreen"), for common stock of KFx at $3.65 per
share, subject to certain adjustments, including a reduction to the then current
market value upon the conversion or satisfaction of the Company's 6% Convertible
Debentures due July 31, 2002 ("Debentures"). In addition, the parties were
provided with warrants, expiring five years after their issue, to purchase an
aggregate amount of 1,314,888 shares of KFx common stock at $3.65 per share,
subject to certain adjustments including a reduction to a weighted-average price
of $2.34 per share upon the conversion or satisfaction of the Company's
Debentures. The terms of these agreements are substantially the same except that
Evergreen, which paid $1,500,000 for an approximate 8.8% as converted interest,
can elect to defer the repurchase date to January 31, 2003, in which case it
will receive the right to purchase from KFx an additional interest in Pegasus on
similar terms, excluding any additional warrants to purchase KFx common stock.
Evergreen's Chairman is a member of the Board of Directors of KFx.

   Based on the terms and characteristics of the preferred stock sales as
discussed above, the instruments have been classified as debt in the September
30, 2001 balance sheet. Accordingly, the Company valued the related warrants
using a Black-Scholes option pricing model and recorded $843,247 as debt
discount. In addition, the difference between the accounting conversion price of
the preferred stock and the fair value of KFx's common stock on the dates of the
transactions resulted in a beneficial conversion feature in the amount of
$937,009, which was calculated in accordance with EITF 98-5, Accounting for
Convertible Securities with Beneficial Conversion Features or Contingently
Adjustable Conversion Ratios and EITF 00-27, Application of Issue No. 98-5 to
Certain Convertible Instruments. The beneficial conversion feature is reflected
as additional debt discount in the balance sheet at September 30, 2001. In the
nine months and quarter ended September 30, 2001, the Company recorded
$1,576,621 and $647,027, respectively, in interest expense related to the
amortization of the debt discount and the accretion to redemption value.

   At September 30, 2001, as a result of these additional investments of
Kennecott Energy in Pegasus Preferred Stock and KFx's sale of a portion of its
Pegasus Preferred Stock, the ownership, on an as converted basis, of Pegasus is
approximately as follows: KFx--56.7%, Pegasus founders--15.8%, Kennecott
Energy--15.9%, Evergreen Resources, Inc.--8.8% and other private
investors--2.8%.

                                       9
<PAGE>

NOTE 3.   INVESTMENT IN KFP

   On April 12, 2000, the Company executed agreements with various parties that
initiated the redevelopment of the KFP Facility. Pursuant to the agreements (a)
a subsidiary of Black Hills Corporation ("BKH") purchased the KFP Facility and
received 2 million shares of KFx common stock previously held by Thermo Ecoteck
Corporation ("TCK") in exchange for the assumption of the reclamation liability
associated with the KFP Facility, (b) BKH was given the right to one seat on
KFx's board of directors (which to date it has declined to exercise), (c) KFx
granted BKH a fully-exercisable warrant, which expires April 30, 2005, to
purchase 1.3 million shares of KFx common stock at $3.65 per share, subject to
certain adjustments including a reduction to a price of $3.48 per share upon the
conversion or satisfaction of the Company's Debentures, (d) KFx relinquished its
5% interest in KFP to TCK and provided certain releases to TCK in exchange for
cash proceeds approximating $1.5 million and certain real and personal property,
and (e) TCK sold the remaining 2.25 million common shares of KFx it owned to
private investors and canceled the warrant it held to purchase a control
position in KFx's common stock. The carrying value of the Company's investment
in KFP was written down effective December 31, 1999 by $1,800,000, to the
$1,500,000 estimated cash proceeds to KFx from these transactions. In addition,
the estimated $2.2 million value of the warrant issued to BKH, using the
Black-Scholes option pricing model, was charged to expense in 1999.

NOTE 4.   NOTES PAYABLE TO THE STATE OF WYOMING

   Principal and interest under a promissory note ("Note") to the State of
Wyoming ("Wyoming") in the amount of $500,000 was due March 1, 2001, but not
paid. The Company initiated discussions with Wyoming in advance of the maturity
date and paid the interest due under the Note on April 10, 2001. Substantially
identical circumstances arose relative to a promissory note ("Chairman's Note")
for $819,000 due to Wyoming by KFx's Chairman and one of his affiliates. The
Company agreed in 1994 to indemnify its Chairman and his affiliate for any
payments due under such note. In exchange for current interest payments, Wyoming
had previously granted the Company an extension to August 1, 2001. On July 20,
2001, the Company made the final payment to Wyoming in the amount of $1,161,583
for all principal and interest outstanding at that date under the Note and the
Chairman's Note. At the time of the final payment, which fulfilled all
obligations to Wyoming under the Note and the Chairman's Note, Wyoming returned
its 12% interest in the K-Fuel process to the Company. The final payment of
$762,144 to satisfy the Chairman's Note was expensed to marketing, general and
administrative expense in the nine months and the quarter ended September 30,
2001.

NOTE 5.   SEGMENT INFORMATION

   KFx's reportable segments are based on its principal products and services,
which are optimization software and related services, through its Pegasus
subsidiary ("Pegasus" segment), and clean fuels technology, through certain
activities of KFx and certain of its subsidiaries ("K-Fuel" segment). The
accounting policies of these segments are the same as described in the Company's
Annual Report on Form 10-K for the year ended December 31, 2000. In addition,
the goodwill and related amortization resulting from the acquisition of Pegasus
is included in the Pegasus segment. KFx evaluates the performance of its
segments and allocates resources to them primarily based on its view of the
potential for net income and operating cash flow. There are no intersegment
revenues; however, KFx's corporate office charges management and related fees to
the Pegasus segment based on actual costs and estimated time and other resources
devoted to assist with and support the activities of Pegasus.

                                       10
<PAGE>

   The tables below presents information about revenues, certain income and
expense categories, net loss, cash used in operating activities, segment assets
and certain other information used by KFx's Chairman and CEO, its chief
operating decision maker, as of September 30, 2001 and 2000 and for the three
and nine month periods then ended:

<TABLE>
<CAPTION>
                THREE MONTHS ENDED                                                               RECONCILING
                September 30, 2001                    PEGASUS                 K-FUEL               ITEMS (a)          CONSOLIDATED
                ------------------                    -------                 ------          --------------------    ------------
<S>                                                <C>                   <C>                   <C>                   <C>
    Operating Revenues....................         $  1,106,530          $          --         $          --         $   1,106,530

    Net Loss..............................         $   (961,956)         $    (341,166)        $  (2,390,412)        $  (3,693,534)

    Cash Provided by (Used in) Operating
    Activities............................         $   (533,764)         $      35,281         $  (2,183,850)        $  (2,682,333)

    Total Assets                                   $ 12,493,368          $   2,344,118         $   2,391,551         $  17,229,037

               September 30, 2000
               ------------------
    Operating Revenues....................         $    375,379          $     129,417         $          --         $     504,796

    Net Loss..............................         $ (1,150,750)         $    (399,900)        $  (1,181,235)        $   (2,731,885)

    Cash Used in Operating Activities.....         $   (595,541)         $     (88,670)        $  (1,043,910)        $   (1,728,121)

    Total Assets                                   $  2,764,433          $   4,978,093         $   2,205,635         $    9,948,161

<CAPTION>
                NINE MONTHS ENDED                                                                RECONCILING
                September 30, 2001                    PEGASUS                 K-FUEL               ITEMS (a)          CONSOLIDATED
                ------------------                    -------                 ------          --------------------    ------------
<S>                                                <C>                   <C>                   <C>                   <C>
    Operating Revenues....................         $  1,883,484          $          --         $         --          $   1,883,484

    Net Loss..............................         $ (2,921,788)         $  (1,150,686)        $ (5,441,276)         $  (9,513,750)

    Cash Provided by (Used in) Operating
    Activities............................         $ (1,734,319)         $     257,925         $ (3,665,783)         $  (5,142,177)

    Total Assets                                   $ 12,493,368          $   2,344,118         $  2,391,551          $  17,229,037

               September 30, 2000
               ------------------
    Operating Revenues....................         $  1,601,571          $     229,393         $         --          $   1,830,964

    Net Loss..............................         $ (2,953,967)         $  (1,280,228)        $ (3,869,960)         $  (8,104,155)

    Cash Used in Operating Activities.....         $ (1,731,314)         $     (13,237)        $ (2,578,559)         $  (4,323,110)

    Total Assets                                   $  2,764,433          $   4,978,093         $  2,205,635          $   9,948,161
</TABLE>

(a) Consists primarily of KFx corporate office activities and consolidating
    entries.

                                       11
<PAGE>

NOTE 6.  NOTES PAYABLE TO DIRECTORS

   During the nine months ended September 30, 2000, the Company borrowed
$550,000 under an unsecured note payable to a director bearing interest at 11.5%
and personally guaranteed by the Company's Chairman. The note was fully repaid
in August 2001.

   During the nine months ended September 30, 2000, Pegasus also borrowed
$400,000 under an unsecured note payable to another of the Company's directors
bearing interest at prime plus 2%, due on demand. The terms of the agreement
include a warrant to purchase common stock of Pegasus equivalent to 1.5% of its
then currently outstanding common stock. The Company valued the warrant using a
Black-Scholes option pricing model and recorded $215,040 as debt discount, which
was amortized to interest expense over the original term of the note. At
September 30, 2001, the unpaid balance of this note was $200,000 and the warrant
was outstanding and fully exercisable.

   During the nine months ended September 30, 2001, Pegasus borrowed $300,000
under an unsecured note payable to the Company's Chairman and CEO bearing
interest at prime plus 2%, due on demand. The terms of the agreement include a
warrant to purchase common stock of Pegasus equivalent to 1.5% of its then
currently outstanding common stock. The Company valued the warrant using a
Black-Scholes option pricing model and recorded $102,348 as debt discount, which
was immediately amortized to interest expense on the issuance date. At September
30, 2001, the unpaid balance of this note was $150,000 and the warrant was
outstanding and fully exercisable.

NOTE 7.   CONVERTIBLE LONG-TERM DEBT

   On July 25, 2001, Cinergy Corp. ("Cinergy) advanced $3.5 million to Pegasus
against the existing contract between Pegasus and Cinergy, which was signed on
May 1, 2001. The advance bears interest at 7% per annum, payable monthly.
Cinergy may elect to apply future Pegasus invoices against the advance or may
choose to convert the balance of the advance into KFx common stock, at a price
of $3.65 per share, or into Pegasus common stock, at a price of $2.10 per share,
subject to certain adjustments. The note is also putable by Cinergy upon (i) a
change in control of KFx or Pegasus, (ii) the sale of substantially all of
Pegasus' or KFx's assets, (iii) the completion of third party financing for
Pegasus of $12.5 million or for Pegasus and KFx combined of $50 million, or (iv)
termination for cause as set forth in the original contract. Cinergy also
received a warrant, expiring three years after the date of issue, exercisable
for 200,000 shares of KFx common stock, at $3.65 per share, subject to certain
adjustments. The Company valued the warrant using a Black-Scholes option pricing
model and recorded $369,190 as debt discount, which will be amortized to
interest expense over the expected term of the note, which is April 2004. At
September 30, 2001, the original balance of this note was outstanding and all of
the shares granted in the warrant were authorized and exercisable.

NOTE 8.   DEBENTURE PREMIUM

   At June 30, 2000, the Company recorded a cumulative charge of $1,000,000 to
correct previously unrecorded accretion of the 12% premium on its Debentures.
The Company cannot provide any assurance that the Debentures will be converted
prior to maturity on July 31, 2002; accordingly, accretion of this premium is
required under generally accepted accounting principles. The impact of this
correction on each of the quarters since the Debentures were issued in July 1997
was not material. Accordingly, the correction was recorded in the second quarter
of 2000.

NOTE 9.   PURCHASE OF POWER OPTIMIZATION SEGMENT OF PAVILION TECHNOLOGIES, INC.

   Pursuant to an Asset Purchase and License Agreement (the "Purchase
Agreement") between Pavilion, Pegasus Technologies, Inc. ("Pegasus"), a
subsidiary of KFx Inc. ("KFx"), and KFx, dated July 31, 2001, certain assets and
liabilities relating to the Power Optimization Division were acquired by
Pegasus. These purchased assets and acquired liabilities were primarily accounts
receivable, unbilled revenue, deposits, customer list, exclusive rights to
license Pavilion's software, other intangibles and deferred revenue. Pavilion
has retained certain liabilities of the Power Optimization Division, including
but not limited to Pavilion indemnifying Pegasus regarding the intellectual
property of Pavilion's software being licensed. The Purchase Agreement provided
for a base price of $9,500,000 in cash, payable to Pavilion in installments
through July 31, 2003, which is adjusted for the net of assets and liabilities
assumed. Remaining installment payments, net of $777,000 of imputed interest,
total $3,000,000, $2,500,000 and $2,000,000 in 2001, 2002 and 2003,
respectively. Additionally, Pegasus shall pay Pavilion royalties of up to
$5,500,000 between August 1, 2001 and

                                       12
<PAGE>

October 31, 2005, based on Pavilion and Pegasus software licenses sold by
Pegasus. Through September 30, 2001, Pegasus made payments to Pavilion totaling
$1,947,740 against the base purchase price. KFx guarantees the duties and
obligations of Pegasus under the Purchase Agreement. This acquisition expands
the software product offerings, customer installed base, and technical expertise
as well as effectively dismissing the Pavilion Lawsuit, which allows management
to concentrate on the growth of Pegasus. The acquisition has been accounted for
by the purchase method and the results of operations are included in the
Company's financial statements beginning in the third quarter of 2001. The
assets acquired and liabilities assumed were recorded at estimated fair values.
The allocation of the purchase price to net assets acquired, liabilities assumed
and intangible assets based on an independent valuation of those assets follows:

                 (dollars in thousands):

                 Purchase price                                $     8,515
                 Fair value of identifiable intangible
                  assets acquired                                    1,426
                 Deferred revenue                                     (269)
                                                               -----------
                 Excess cost over net assets acquired                7,358
                 Acquisition costs                                     217
                                                               -----------
                 Goodwill                                      $     7,575
                                                               ===========


   The intangible assets acquired consist of order backlog, customer lead list
and maintenance contracts which have estimated useful lives of 18 months, 18
months and seven years, respectively. Goodwill recognized as a result of the
transaction is attributable to Pegasus and all activity relating to the goodwill
was assigned to the Pegasus segment.

   The unaudited pro forma results of operations for the nine months ended
September 30, 2000 and 2001, assuming the consummation of the purchase as of
January 1, 2000 follows. The pro forma results include estimates and
assumptions, which the Company's management believes are reasonable. However,
the pro forma results do not include any cost savings, revenue enhancements or
other effects of the planned integration of the Pegasus and Pavilion and are not
necessarily indicative of the results which would have occurred if the
transaction had been in effect on the dates indicated, or which may result in
the future.

                                                     UNAUDITED PRO FORMA
                                                NINE MONTHS ENDED SEPTEMBER 30,
   (in thousands, except per share amounts)          2001          2000
                                                   --------      --------
Total operating revenues ......................    $  2,619      $  3,344
Net loss ......................................    $(12,156)     $ (9,026)
Basic and diluted net loss per common share ...    $  (0.47)     $  (0.36)

                                                     UNAUDITED PRO FORMA
                                                THREE MONTHS ENDED SEPTEMBER 30,
   (in thousands, except per share amounts)          2001          2000
                                                   --------      --------
Total operating revenues ......................    $  1,325      $  1,121
Net loss ......................................    $ (3,972)     $ (3,095)
Basic and diluted net loss per common share ...    $  (0.15)     $  (0.12)

NOTE 10.   CONTINGENCIES

   On September 8, 2000, Pavilion Technologies, Inc. ("Pavilion"), a competitor
of Pegasus, served Pegasus with a complaint that it had filed on August 14,
2000, in the United States District Court for the Southern District of Texas,
asserting that Pegasus infringed 26 patents allegedly issued to or licensed by
Pavilion (the "Pavilion Lawsuit"). The Pavilion Lawsuit was subsequently
transferred to the United States District Court for the Northern District of
Ohio. The Pavilion Lawsuit seeks injunctive relief, compensatory and treble
damages, as well as attorney's fees, costs and expenses. Pegasus' products
employ its own proprietary computer code as well as

                                       13
<PAGE>

computer code exclusively licensed to Pegasus. On September 15, 2000, the
licensor agreed to defend Pegasus in the Pavilion Lawsuit pursuant to an
indemnification provision of the parties' license agreement. On October 27,
2000, Pegasus filed an answer to the Pavilion Lawsuit denying the patent
infringement claims ("Pegasus Answer"). The Pegasus Answer also asserted various
counterclaims against Pavilion alleging unfair competition, deceptive trade
practices, defamation, tortuous interference with business relationships and
attempted monopolization in violation of Section 2 of the Sherman Antitrust Act
("Pegasus Counterclaims"). After consultation with counsel, KFx and Pegasus
management believe that the infringement allegations in the Pavilion Lawsuit are
objectively baseless and without merit. On April 11, 2001, Pegasus and Pavilion
agreed to dismiss the Pavilion Lawsuit, the Pegasus Answer and the Pegasus
Counterclaim, without prejudice, in order to explore possible business
combinations, cooperative relationships and other alternatives. On August 1,
2001, Pegasus purchased certain assets of the Pavilion power optimization
segment, which effectively resolved the Pavilion Lawsuit, see Note 9.

   On November 4, 1999, Link Resources, Inc., a Georgia corporation, ("Link")
and its two shareholders, Linda E. Kobel ("Kobel") and Gary A. Sanden
("Sanden"), filed a complaint against the Company in US District Court for the
District of Colorado. The complaint alleges that KFX, Link, Kobel and Sanden had
entered into an agreement requiring KFX to acquire Link and that KFX breached
such agreement. The complaint seeks damages in excess of $5.3 million. Although
the ultimate resolution of this matter cannot be predicted with certainty, based
on a review of the underlying facts and discussions with counsel, management
believes that this complaint is without merit. KFX intends to contest this
complaint vigorously. Accordingly, management does not believe that its ultimate
outcome will have a material adverse effect on the Company's consolidated
financial position, its results of operations or its cash flows.

   As part of the restructured bond agreement with the State of Wyoming
("Wyoming") in 1994, Energy Brothers Holding, Inc., an affiliate of the
Company's Chairman; and the Company's Chairman, Theodore Venners, executed a
promissory note to Wyoming for $819,000, with annual interest at 6%. The Company
agreed in 1994 to indemnify its Chairman and his affiliate for any payments made
under such note, upon his demand, since their obligation stemmed from their
personal guarantee of certain obligations of the Company that were renegotiated
in 1994. During 2000, the Company made related principal and interest payments
on behalf of its Chairman totaling $82,150. In addition, similar payments
totaling $158,587 were made during the six months ended June 30, 2001. The
Company's Chairman and his affiliate have agreed to waive their indemnification
rights for 2001, triggering a 10-day cure period. On June 29, 2001, Wyoming
agreed to forebear from collection activities under this note until August 1,
2001. In connection with the 1994 restructured bond agreement, the Company
entered into an agreement that requires the Company to pay Wyoming 12% of its
domestic license and royalty revenue. The rate decreases to 6% when cumulative
payments under this agreement total $5 million. On July 20, 2001, the Company
made a final payment to Wyoming to satisfy these commitments, see Note 4.

   The Company is contingently liable to Ohio Valley Electric Corporation
("OVEC") for an overriding royalty of 0.5% to OVEC on the gross revenues
generated by the sale of fuel produced from any production plant (other than the
current facility owned by BKH) located in the United States in which the
feedstock is coal and which uses the Company's proprietary Series "C" K-Fuel
technology to produce fuel. The Company is contingently liable to Fort Union for
20% of the Company's North American royalty proceeds. No payments or accruals
have been required through September 30, 2001 under these agreements.

   In 1996, the Company entered into a royalty amendment agreement with Edward
Koppelman, the inventor of the K-Fuel Technology. As a result of the agreement,
Mr. Koppelman's royalty is now 25% of the Company's worldwide royalty and
license fee revenue, computed after a State of Wyoming royalty. The royalty to
Mr. Koppelman will cease when the cumulative payments to him reach the sum of
approximately $75,222,000. Mr. Koppelman is now deceased and his estate holds
all royalty rights. The total amount paid under this agreement through September
30, 2001 was $250,000.

   Pegasus is contingently liable to certain of its founding stockholders for a
royalty equivalent to 2% of the license fee revenues derived from the sale of
its NeuSIGHT product through November 30, 2004. This obligation is limited to
the extent of pretax income without regard to such royalty, subject to a maximum
of $2.5 million and subject to certain other limitations. Pegasus has made no
payments or accruals through September 30, 2001 under this agreement.

                                       14
<PAGE>

NOTE 11.   RECENT ACCOUNTING PRONOUNCEMENTS

   In July 2001, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standard No. 141, "Business Combinations"
("FAS 141"). FAS 141 requires that all purchase business combinations must be
accounted for using the purchase method. Under this method, the purchase price
of an acquired business is allocated to the individual tangible and intangible
assets acquired and liabilities assumed based on the estimated fair values at
the date of acquisition. If the purchase price exceeds the amounts assigned to
assets acquired and liabilities assumed, the excess is recognized as goodwill.
Acquired intangible assets that do not meet certain criteria for recognition
apart from goodwill are included in the amount initially recognized as goodwill.
After initial recognition, goodwill and intangible assets acquired in the
business combination must be accounted for under FAS 142. FAS 141 is effective
for the Company for all business combinations initiated after June 30, 2001,
including the acquisition of certain assets and liabilities of Pavilion, see
Note 9.

   In July 2001, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standard No. 142, "Goodwill and Other
Intangible Assets" ("FAS 142"). FAS 142 requires that after a company allocates
the purchase price in accordance with FAS 141, the assets acquired, liabilities
assumed and goodwill must be assigned to one or more reporting units based on
certain criteria outlined in FAS 142. In addition, goodwill will no longer be
amortized. Companies must perform transitional, annual, and, in certain
situations, interim impairment testing of their recorded goodwill, as well as of
their indefinite-lived intangible assets. Indefinite-lived intangible assets
would be tested for impairment by comparing the fair value of the intangible
asset with its carrying amount. FAS 142 is effective for the Company for any
goodwill acquired in a business combination entered into after June 30, 2001,
including the acquisition of certain assets of Pavilion, see Note 9. The
remaining provisions of the Statement are effective beginning in the first
quarter of 2002.

On October 3, 2001, the FASB issued Statement of Accounting Standards No. 144
"Accounting for the Impairment or Disposal of Long-Lived Assets" ("FAS 144").
FAS 144 supercedes FAS 121 "Accounting for the Impairment of Long-Lived Assets
and for Long-Lived Assets to Be Disposed Of." FAS 144 applies to all long-lived
assets (including discontinued operations) and consequently amends Accounting
Principles Board Opinion No. 30 (APB 30), Reporting Results of Operations -
Reporting the Effects of Disposal of a Division of a Business. FAS 144 develops
one accounting model for long-lived assets that are to be disposed of by sale.
FAS 144 requires that long-lived assets that are to be disposed of by sale be
measured at the lower of book value or fair value less cost to sell.
Additionally, FAS 144 expands the scope of discontinued operations to include
all components of an entity with operations that (1) can be distinguished from
the rest of the entity and (2) will be eliminated from the ongoing operations of
the entity in a disposal transaction. FAS 144 is effective for Pavilion's
financial statements issued in fiscal 2003.

NOTE 12.   SUBSEQUENT EVENTS

   On November 6, 2001, Kennecott invested an additional $250,000 in Pegasus
Preferred Stock under the agreement described in Note 2. Pegasus will use the
investment for enhancements to NeuSIGHT, new product development and the
completion of other tasks designed to improve the performance of Pegasus.


                                       15
<PAGE>

                                    KFX INC.

                 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
                  FINANCIAL CONDITION AND RESULTS OF OPERATIONS

   This quarterly report includes forward-looking statements. We have based
these forward-looking statements on our current expectations and projections
about future events based on our knowledge of facts as of the date of this
quarterly report and our assumptions about future events. These forward-looking
statements are subject to various risks and uncertainties that may be outside of
our control, including, but not limited to:

      o  the ability of the Company to continue to as a going concern;
      o  adverse market and various other conditions that could impair the
         Company's ability to obtain needed financing;
      o  actions or the inaction of the Company's strategic partners;
      o  the breadth or degree of protection available to the Company's
         intellectual property;
      o  availability of key management and skilled personnel;
      o  competition and technological developments by competitors;
      o  lack of market interest in the Company's existing products and any new
         products or services;
      o  changes in environmental, electric utility and other governmental
         regulations;
      o  unanticipated problems that could arise in research and development
         activities;
      o  cost overruns, delays and other problems that may occur in developing,
         permitting, financing or constructing K-Fuel production facilities;
      o  the availability of Section 29 or similar tax credits related to any
         future K-Fuel production facilities; and
      o  domestic and international economic and political developments.

   We use words like "believe," "expect," "anticipate," "will," "estimate,"
"project," "plan," and similar expressions to help identify forward-looking
statements in this annual report.

   For additional factors that could affect the validity of our forward-looking
statements, you should read "Risk Factors" contained in Part I, Item 1 of our
annual report on Form 10-K for the year ended December 31, 2000, "Management's
Discussion and Analysis of Financial Condition and Results of Operations"
contained in Part II, Item 7 of our Annual Report on Form 10-K for the year
ended December 31, 2000 and "Notes to Consolidated Financial Statements"
contained in Part II, Item 8 of our annual report on Form 10-K for the year
ended December 31, 2000. The forward-looking statements included in this
quarterly report are subject to additional risks and uncertainties not disclosed
in this quarterly report, some of which are not known or capable of being known
by the Company. The information contained in this quarterly report is subject to
change without notice. Readers should review future reports that we file with
the Securities and Exchange Commission. In light of these and other risks,
uncertainties and assumptions, actual events or results may be very different
from those expressed or implied in the forward-looking statements in this
quarterly report or may not occur. We have no obligation to publicly update or
revise any forward-looking statement, whether as a result of new information,
future events or otherwise.

   The financial statements have been prepared on a going concern basis, which
contemplates the realization of assets and the satisfaction of liabilities in
the normal course of business. The Company has incurred net losses of
approximately $12,290,000, $12,730,000 and $6,784,000 and negative cash flow
from operations of $5,151,000, $3,458,000 and $4,642,000 in the years ended
December 31, 2000, 1999 and 1998, respectively, and an additional net loss of
$9,513,750 and negative cash flow from operations of $5,142,177 in the nine
months ended September 30, 2001 and had an accumulated deficit of approximately
$80,605,054 as of September 30, 2001. These factors, coupled with the need for
additional financing to fund planned growth in the business, raise substantial
doubt about whether the Company can continue as a going concern. The Report of
Independent Accountants dated April 13, 2001 covering the Company's consolidated
financial statements for the year ended December 31, 2000 included an
explanatory paragraph discussing this going concern uncertainty.

   In order to mitigate this uncertainty, the Company intends to seek further
capital through various means which may include the sale of all or a portion of
its interest in Pegasus, additional sales of debt or equity securities, a

                                       16
<PAGE>

business combination or other means and to further reduce expenditures as
necessary. Should the Company not be successful in achieving one or more of
these actions, it is possible that the Company may not be able to continue as a
going concern. The consolidated financial statements do not include any
adjustments that might result from the outcome of this uncertainty.

OVERVIEW

   During the past several months, the Company has been able to establish a
platform to develop and implement a strategic plan to begin to realize the
potential growth of its two energy technology bases.

   A 16-month project of its K-Fuel LLC joint venture with Kennecott Energy
culminated in the demonstration of an improved design for a K-Fuel plant that
was announced in February 2001. K-Fuel LLC is conducting studies concerning
appropriate means to further test the new process and design facilities for
production. In April 2001, Pegasus and Pavilion entered into an agreement to
dismiss the litigation pending between the two companies, without prejudice, in
order to explore possible business combinations.

   On May 9, 2001, KFx retained Raymond James & Associates to assist in all
aspects of strategic and financial planning to take advantage of the rapidly
growing energy market opportunities and determine an optimal course of action
for KFx's shareholders. In addition, it is management's belief there is a far
better understanding in Washington, D.C. today of the importance of coal-fired
power to meet the nation's energy needs, which it believes will facilitate the
Company's development and implementation of a strategic plan to capitalize on
the growth potential of its technologies.

   In May 2001, Cinergy Corp. ("Cinergy"), a Cincinnati, Ohio based energy
company, selected Pegasus to install its NeuSIGHT optimization software on a
system-wide basis. Phase 1 of the Cinergy contract calls for performance-based
incentives measured by actual NOx reductions and is expected to generate
approximately $5-8 million in revenues through May 2004, including potential
revenues from performance provisions in the contract of up to approximately $3
million. On July 25, 2001, Cinergy advanced $3.5 million to Pegasus against the
existing contract between Pegasus and Cinergy. The advance bears interest at 7%
per annum, payable monthly. Cinergy may elect to apply future Pegasus invoices
against the advance or may choose to convert the balance of the advance into KFx
common stock, at a price of $3.65 per share, or Pegasus common stock, at a price
of $2.10 per share, subject to certain adjustments. The note is also putable by
Cinergy upon (i) a change in control of KFx or Pegasus, (ii) the sale of
substantially all of Pegasus' or KFx's assets, (iii) the completion of third
party financing for Pegasus of $12.5 million or for Pegasus and KFx combined of
$30 million, or (iv) termination for cause as set forth in the original
contract. Cinergy also received a warrant, expiring three years after the date
of issue, exercisable for 200,000 shares of KFx common stock, at $3.65 per
share, subject to certain adjustments.

   In July 2001, the Company issued 1 million shares of common stock at a price
of $3.65 per share and a warrant, expiring three years after the date of issue,
exercisable for 500,000 of KFx common stock, at a price of $3.65 per share,
subject to certain adjustments, to an institutional investor, resulting in
proceeds to the Company of $3.65 million.

   Pursuant to an Asset Purchase and License Agreement (the "Purchase
Agreement") between Pavilion, Pegasus Technologies, Inc. ("Pegasus"), a
subsidiary of KFx Inc. ("KFx"), and KFx, dated as of July 31, 2001, certain
assets and liabilities relating to the Power Optimization Division were acquired
by Pegasus. These purchased assets and acquired liabilities were primarily
accounts receivable, unbilled revenue, deposits, customer list, exclusive rights
to license Pavilion's software, other intangibles and deferred revenue. Pavilion
has retained certain liabilities of the Power Optimization Division, including
but not limited to Pavilion indemnifying Pegasus regarding the intellectual
property of Pavilion's software being licensed. The Purchase Agreement provided
for a base price of $9,500,000 in cash, payable to Pavilion in installments
through July 31, 2003, which is adjusted for the net of assets and liabilities
assumed. Additionally, Pegasus shall pay Pavilion royalties of up to $5,500,000
between August 1, 2001 and October 31, 2005, based on Pavilion and Pegasus
software licenses sold by Pegasus. KFx guarantees the duties and obligations of
Pegasus under the Purchase Agreement.

   As disclosed in Note 8 to the Consolidated Financial Statements, the second
quarter of 2000 includes a $1,000,000 non cash, non operational cumulative
charge to correct the previously unrecorded accretion of the 12% premium on its
6% Convertible Debentures. This maturity premium will only be paid if the
Debentures are not converted prior to their maturity in July 2002.

                                       17
<PAGE>

   Pegasus' firm backlog of software license and installation contracts as of
September 30, 2001 was approximately $8,734,000, compared to approximately
$1,771,000 at September 30, 2000, an increase of 393%.

RESULTS OF OPERATIONS-THREE MONTHS ENDED SEPTEMBER 30, 2001 VS. THREE MONTHS
ENDED SEPTEMBER 30, 2000

   Consolidated revenues in the third quarter of 2001 increased as compared to
the third quarter of 2000 by $601,734 (119%) due to a $129,417 decline in K-Fuel
contract revenues in 2001 offset by an increase of $731,151 (195%) in Pegasus
revenues. The decrease in K-Fuel contract revenues is a result of the suspension
of certain contract activities in 2001. The increase in Pegasus revenues
resulted from a significant increase in projects due to the receipt of the
Cinergy order noted above, an increase in installation hours spent on the
projects that generate revenue, recognition of a one-time exclusivity fee for
the China market of $300,000, for which Pegasus incurred no costs. Due to the
recent increase in the Pegasus backlog, mainly due to the Cinergy order and the
Pavilion acquisition, we expect the trend of increasing revenue to continue in
future quarters.

   Consolidated operating costs and expenses in the third quarter of 2001
increased as compared to the third quarter of 2000 by $890,178 (32%) due
primarily to the net effect of (a) an increase of $83,499 (18%) in Pegasus' cost
of software licenses and services triggered by the corresponding revenue
increase, (b) an increase in marketing, general and administrative expense of
$844,763 (64%) caused by an increase in professional fees due to the Pavilion
Lawsuit, increased headcount at Pegasus, expense of $762,144 relating to the
final payment for the Chairman's Note to the State of Wyoming and costs relating
to international market expansion offset by headcount reductions at the
corporate level, (c) an increase of $20,749 (11%) in Pegasus' research and
development costs offset by a decrease of $19,613 (19%) in the costs at the
K-Fuel demonstration plant due to the suspension of certain contract activities
and a decrease in depreciation and amortization expense of $39,219 (6%).

   The factors discussed above combined in the third quarter of 2001 to produce
an operating loss of $2,548,399, which was $288,444 more than for the third
quarter of 2000. Pegasus' portion of the operating loss for the third quarter of
2001 was $739,816, which was a significant improvement over the corresponding
$1,051,276 operating loss for the third quarter of 2000 and was mainly due to an
overall improvement in margins on installation projects. The combined K-Fuel
segment and corporate cost portion of the operating loss for the third quarter
of 2001 was $1,808,583 compared to $1,208,679 in 2000 with the increase in
operating loss resulting from expense of $762,144 relating to the final payment
for the Chairman's Note to the State of Wyoming; see Note 4 to the accompanying
financial statements.

   Non-operating items added $1,145,135 of net expense in the third quarter of
2001, compared to $471,930 in the third quarter of 2000, for an increase of
$673,205 (143%), due to an increase in interest expense of $680,824 (149%).
The increase in interest expense is due mainly to an increase in accruals for
the maturity premium, debt discount and beneficial conversion charges related to
the 2001 sales to third parties of Pegasus Preferred Stock held by KFx and KFx's
related obligation to repurchase and debt discount which was recognized as
interest expense for the issuance of warrants for the Company's common stock.

   As a result of the above factors, the consolidated net loss of $3,693,534
($0.14 per share) for the third quarter of 2001 was $961,649 more than the net
loss for the third quarter of 2000. Included in the third quarter net losses
were non-cash charges approximating $1,486,000 and $1,078,000, respectively.

RESULTS OF OPERATIONS-NINE MONTHS ENDED SEPTEMBER 30, 2001 VS. NINE MONTHS ENDED
SEPTEMBER 30, 2000

   Consolidated revenues in the first nine months of 2001 increased as compared
to the first nine months of 2000 by $52,520 (3%) due to a $229,393 decline in
K-Fuel contract revenues in 2001 because of the suspension of certain contract
activities offset by an increase in Pegasus revenues of $281,913 (18%) due to
the increase in order intake during 2001, increased progress on projects during
the most recent quarter and the revenue contributed by Pavilion projects during
the third quarter. Due to the recent increase in the Pegasus backlog, mainly due
to the Cinergy order and acquisition of the Pavilion power segment as noted
above, we expect the trend of increasing revenues to continue in future
quarters.

                                       18
<PAGE>

   Consolidated operating costs and expenses in the first nine months of 2001
increased as compared to the first nine months of 2000 by $406,462 (5%) due
primarily to the net effect of (a) a $106,028 (8%) decrease in Pegasus' cost of
software licenses and services realized through the completion of problem
projects and efficiencies gained in installations, (b) a decrease of $106,595
(38%) in the costs at the K-Fuel demonstration plant due to the suspension of
certain contract activities during 2001, and (c) a decrease in depreciation
and amortization expense of $84,194 (4%) offset by an increase in marketing,
general and administrative expense of $595,507 (16%) and an increase of $107,773
(24%) in Pegasus' research and development costs. The increase in marketing,
general and administrative expense is due mainly to expense of $762,144 relating
to the final payment for the Chairman's Note to the State of Wyoming (see Note 4
to the accompanying financial statements) offset by headcount reductions at the
corporate level. The increase in Pegasus research and development costs was due
to an increase in headcount.

   The factors discussed above combined in the first nine months of 2001 to
produce an operating loss of $6,439,472, which was $353,942 less than for the
first nine months of 2000. Pegasus' portion of the operating loss for the first
nine months of 2001 was $2,511,407, which was an improvement of $284,788 (10%)
compared to the corresponding $2,796,195 operating loss for the first nine
months of 2000. The improvement in the Pegasus operating loss was due mainly to
the realization of the effect of headcount reductions that occurred in late
2000. The combined K-Fuel segment and corporate cost portion of the operating
loss for the first nine months of 2001 was $3,928,065 compared to $3,289,335 in
2000.

   Non-operating items added $3,074,278 of net expense in the first nine months
of 2001, compared to $2,018,625 in the first nine months of 2000, for an
increase of $1,055,653 (52%), due to an increase in interest expense of
$1,020,422 (51%). The increase in interest expense is due mainly to in accretion
for the maturity premium, debt discount and beneficial conversion charges
related to 2001 sales to third parties of Pegasus Preferred Stock held by KFx
and KFx's related obligation to repurchase, debt discount which was recognized
as interest expense on the issuance date of warrants for KFx and Pegasus common
stock, and an increase in interest on outstanding debt, offset by a decrease of
$828,898 (76%) in the accrual for the maturity premium on the Convertible
Debentures (accretion was $1 million for the first half of 2000).

   As a result of the above factors, the consolidated net loss of $9,513,750
($0.37 per share) for the first nine months of 2001 was $1,409,595 ($0.04 per
share) greater than the net loss for the first nine months of 2000. Included in
the year to date net losses were non-cash charges approximating $4,445,000 and
$3,500,000, respectively.

LIQUIDITY AND CAPITAL RESOURCES

   During the first nine months of 2001, the Company used $5,142,177 of cash for
its operating activities, compared to $4,323,110 in the first nine months of
2000, an increase of $819,067. Included in the 2001 amount is $1,260,151 of
interest payments ($348,772 by Pegasus and $911,379 by KFx), $1,385,547 for
other Pegasus operations and $2,496,479 for the K-Fuel segment and other KFx
corporate activities. Included in the 2000 amount is $1,148,000 of KFx interest
payments, $1,731,314 for Pegasus' operations, $13,237 of cash used by the K-Fuel
segment's demonstration plant and laboratory and $1,430,559 for KFx's corporate
activities.

   Sources of cash during the first nine months of 2001 included the following:

     o   In July 2001, the Company issued 1 million shares of common stock at a
         price of $3.65 per share and a warrant, expiring three years after the
         date of issue, exercisable for 500,000 shares of KFx common stock, at a
         price of $3.65 per share, subject to certain adjustments, to an
         institutional investor, resulting in net proceeds, after financing
         costs, to the Company of $3.5 million.
     o   In July 2001, Cinergy advanced $3.5 million to Pegasus against the
         existing contract between Pegasus and Cinergy. The advance bears
         interest at 7% per annum, payable monthly. Cinergy may elect to apply
         future Pegasus invoices against the advance or may choose to convert
         the balance of the advance into KFx common stock, at a price of $3.65
         per share, or Pegasus common stock, at a price of $2.10 per share,
         subject to certain adjustments. The note is also putable by Cinergy
         upon (i) a change in control of KFx or Pegasus, (ii) the sale of
         substantially all of Pegasus' or KFx's assets, (iii) the completion of
         third party financing for Pegasus of $12.5 million or for Pegasus and
         KFx combined of $30 million, or (iv) termination for cause as set forth
         in the original contract. Cinergy also received a warrant, expiring
         three years after the date of issue, exercisable for 200,000 shares of
         KFx common stock, at $3.65 per share, subject to certain adjustments.
     o   $1,972,331 in proceeds from the sale of Pegasus preferred stock held by
         KFx, which the Company is

                                       19
<PAGE>

         required to repurchase during the first half of 2002, subject to
         certain provisions that could accelerate or defer the required
         repurchase date. Due to KFx's repurchase obligation, these sales are
         accounted for as debt; see Note 2 to the Consolidated Financial
         Statements.
     o   Pegasus issued $750,000 of Pegasus preferred stock to Kennecott Energy
         during the first nine months of 2001.
     o   Pegasus received a $300,000 short-term loan from a director of the
         Company, which bears interest.

Cash raised during the first nine months of 2001 was used for funding of current
operations, repayment of portions of notes payable and installment payments
totaling approximately $2 million for the acquisition of the Pavilion power
optimization segment.

   Pursuant to an Asset Purchase and License Agreement (the "Purchase
Agreement") between Pavilion, Pegasus Technologies, Inc. ("Pegasus"), a
subsidiary of KFx Inc. ("KFx"), and KFx, dated July 31, 2001, certain assets and
liabilities relating to the Power Optimization Division were acquired by
Pegasus. These purchased assets and acquired liabilities were primarily accounts
receivable, unbilled revenue, deposits, customer list, exclusive rights to
license Pavilion's software, other intangibles and deferred revenue. Pavilion
has retained certain liabilities of the Power Optimization Division, including
but not limited to Pavilion indemnifying Pegasus regarding the intellectual
property of Pavilion's software being licensed. The Purchase Agreement provided
for a base price of $9,500,000 in cash, payable to Pavilion in installments
through July 31, 2003, which is adjusted for the net of assets and liabilities
assumed. Additionally, Pegasus shall pay Pavilion royalties of up to $5,500,000
between August 1, 2001 and October 31, 2005, based on Pavilion and Pegasus
software licenses sold by Pegasus. Through September 30, 2001, Pegasus made
payments to Pavilion totaling $1,947,740. KFx guarantees the duties and
obligations of Pegasus under the Purchase Agreement. See note 9 to the
accompanying financial statements.

   The Company engaged Raymond James & Associates, an investment banking firm,
to assist in all aspects of strategic and financial planning. This step was
taken as a part of the Company's ongoing efforts to restructure its balance
sheet in an optimal manner for the benefit of its shareholders and in view of
the rapidly growing energy market opportunities. The Company had begun a similar
effort initially focused on Pegasus in mid 2000, but the Pavilion Lawsuit, which
was filed in the third quarter of 2000, precluded many of the options that were
under consideration at that time. Prior to the filing of the Pavilion Lawsuit
and subsequent to the purchase of the Pavilion power optimization segment, which
effectively resolved the Pavilion Lawsuit, the Company has received strong
interest from numerous industry sources to participate in the acceleration and
development of its products.

   The Company is continuing to work toward its goal of licensing a large
commercial K-Fuel plant. Upon granting a license to construct a commercial scale
K-Fuel production facility, KFx expects to generate significant K-Fuel license
fees and net cash flows.

   From time to time, directors of the Company have provided to the Company
short term unsecured financing and the Company expects that such financing, on
at least a short-term basis, will continue to be available if needed.

   The Company expects its cash requirements over the next fiscal year with
respect to day-to-day operations and debt service requirements to be satisfied
by (a) cash on hand, which as of November 10, 2001 approximated $1.4 million;
(b) potential additional investments in Pegasus and/or KFx from interested
participants in the power generation industry; (c) potential debt and/or equity
offerings of the Company; (d) potential fees from licensing new K-Fuel
facilities; (e) potential partners in connection with opportunities to expand
the Company's product and service offerings to the power industry; and (f)
unsecured short term borrowings for the Company and/or Pegasus from one or more
of its directors and/or other parties.

   Depending on the outcome of various uncertainties, including those discussed
herein, the Company may be required to seek additional debt and/or equity
financing for general operating purposes and/or to meet debt service
requirements. The timing of collection of accounts receivable and payment of
accounts payable could significantly alter the Company's need for at least
temporary financing. Should the Company be required to seek any additional debt
and/or equity financing, its ability to do so will be affected by the terms of
the Debentures, which contain a number of restrictions including (a) limitations
on the Company's ability to incur secured and unsecured debt, (b) limitations on
the Company's ability to sell assets or enter into merger agreements, and (c)
provisions that would reduce the Debenture conversion price from $3.65 per share
if the Company sells KFx common stock at a price below $3.65 per share. In
addition, included in the agreements among KFx and the other shareholders of
Pegasus are provisions governing the terms of investments from any new investors
in Pegasus, limiting the borrowings of Pegasus, and limiting the payment of
dividends by Pegasus. See also Note 1 of the Consolidated Financial Statements.

                                      20
<PAGE>

   There are no assurances that any of these potential funding sources will
materialize, and the Company does not currently have any commitments with
respect to any such funding sources. If the overall outcome of the various
uncertainties affecting the Company is not favorable, the Company may be forced
to seek debt and/or equity financing on terms and conditions that may be
unfavorable to the Company, if available at all. If the Company requires
additional financing and cannot obtain it when needed, the Company may default
on payments when due. Should the Company not be successful in achieving one or
more of the financing alternatives discussed above, the Company may not be able
to continue as a going concern

RECENT ACCOUNTING PRONOUNCEMENTS

   In July 2001, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standard No. 141, "Business Combinations"
("FAS 141"). FAS 141 requires that all purchase business combinations must be
accounted for using the purchase method. Under this method, the purchase price
of an acquired business is allocated to the individual tangible and intangible
assets acquired and liabilities assumed based on the estimated fair values at
the date of acquisition. If the purchase price exceeds the amounts assigned to
assets acquired and liabilities assumed, the excess is recognized as goodwill.
Acquired intangible assets that do not meet certain criteria for recognition
apart from goodwill are included in the amount initially recognized as goodwill.
After initial recognition, goodwill and intangible assets acquired in the
business combination must be accounted for under FAS 142. FAS 141 is effective
for the Company for all business combinations initiated after June 30, 2001,
including the acquisition of certain assets and liabilities of Pavilion, see
Note 9.

   In July 2001, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standard No. 142, "Goodwill and Other
Intangible Assets" ("FAS 142"). FAS 142 requires that after a company allocates
the purchase price in accordance with FAS 141, the assets acquired, liabilities
assumed and goodwill must be assigned to one or more reporting units based on
certain criteria outlined in FAS 142. In addition, goodwill will no longer be
amortized. Companies must perform transitional, annual, and, in certain
situations, interim impairment testing of their recorded goodwill, as well as of
their indefinite-lived intangible assets. Indefinite-lived intangible assets
would be tested for impairment by comparing the fair value of the intangible
asset with its carrying amount. FAS 142 is effective for the Company for any
goodwill acquired in a business combination entered into after June 30, 2001,
including the acquisition of certain assets of Pavilion, see Note 9. The
remaining provisions of the Statement are effective beginning in the first
quarter of 2002.

   On October 3, 2001, the FASB issued Statement of Accounting Standards No. 144
"Accounting for the Impairment or Disposal of Long-Lived Assets" ("FAS 144").
FAS 144 supercedes FAS 121 "Accounting for the Impairment of Long-Lived Assets
and for Long-Lived Assets to Be Disposed Of." FAS 144 applies to all long-lived
assets (including discontinued operations) and consequently amends Accounting
Principles Board Opinion No. 30 (APB 30), Reporting Results of Operations -
Reporting the Effects of Disposal of a Division of a Business. FAS 144 develops
one accounting model for long-lived assets that are to be disposed of by sale.
FAS 144 requires that long-lived assets that are to be disposed of by sale be
measured at the lower of book value or fair value less cost to sell.
Additionally, FAS 144 expands the scope of discontinued operations to include
all components of an entity with operations that (1) can be distinguished from
the rest of the entity and (2) will be eliminated from the ongoing operations of
the entity in a disposal transaction. FAS 144 is effective for Pavilion's
financial statements issued in fiscal 2003.

                      ITEM 3. QUANTITATIVE AND QUALITATIVE
                          DISCLOSURES ABOUT MARKET RISK

   The Company is not currently subject to a significant level of direct market
risk related to interest rates, foreign currency exchange rates, commodity
prices or equity prices. The Company has no derivative instruments and only
$450,000 of floating rate debt and does not expect to derive a material amount
of its revenues or income from interest bearing securities. Currently the
Company has no significant foreign operations. To the extent that the Company
establishes significant foreign operations in the future, it will attempt to
mitigate risks associated with foreign currency exchange rates contractually and
through the use of hedging activities and other means considered appropriate.
The Company is indirectly exposed to fluctuations in fuel commodity prices. To
the extent that fuel prices rise, there may be a tendency for greater demand for
certain of the Company's products and services, since

                                       21
<PAGE>

K-Fuel and NeuSIGHT have been shown to result in lower usage of coal and coal
beneficiated fuel products when used to generate electric power. The Company's
fuel-related products provide various environmental benefits that management
believes significantly mitigate the fuel commodity risk associated with the
Company's business. The Company holds no equity market securities, but does face
equity market risk relative to its own equity securities.

                                       22
<PAGE>

                           PART II - OTHER INFORMATION
                            ITEM 1. LEGAL PROCEEDINGS

   On September 8, 2000, Pavilion Technologies, Inc. ("Pavilion"), a competitor
of Pegasus, served Pegasus with a complaint that it had filed on August 14,
2000, in the United States District Court for the Southern District of Texas
asserting that Pegasus infringed 26 patents allegedly issued to or licensed by
Pavilion (the "Pavilion Lawsuit"). The Pavilion Lawsuit was subsequently
transferred to the United States District Court for the Northern District of
Ohio. The Pavilion Lawsuit sought injunctive relief, compensatory and treble
damages, as well as attorney's fees, costs and expenses. Pegasus' products
employ its own proprietary computer code as well as computer code exclusively
licensed to Pegasus. On September 15, 2000, the licensor agreed to defend
Pegasus in the Pavilion Lawsuit pursuant to an indemnification provision of the
parties' license agreement. On October 27, 2000, Pegasus filed an answer to the
Pavilion Lawsuit denying the patent infringement claims ("Pegasus Answer"). The
Pegasus Answer also asserted various counterclaims against Pavilion alleging
unfair competition, deceptive trade practices, defamation, tortuous interference
with business relationships and attempted monopolization in violation of Section
2 of the Sherman Antitrust Act ("Pegasus Counterclaims"). After consultation
with counsel, KFx and Pegasus management believed that the infringement
allegations in the Pavilion Lawsuit were objectively baseless and without merit.
On April 11, 2001, Pegasus and Pavilion agreed to dismiss the Pavilion Lawsuit,
the Pegasus Answer and the Pegasus Counterclaims, without prejudice, in order to
explore possible business combinations, cooperative relationships and other
alternatives. Pursuant to an Asset Purchase and License Agreement (the "Purchase
Agreement") between Pavilion, Pegasus Technologies, Inc. ("Pegasus"), a
subsidiary of KFx Inc. ("KFx"), and KFx, dated July 31, 2001, certain assets and
liabilities relating to the Power Optimization Division were acquired by
Pegasus. These purchased assets and acquired liabilities were primarily accounts
receivable, unbilled revenue, deposits, customer list, exclusive rights to
license Pavilion's software, other intangibles and deferred revenue. Pavilion
has retained certain liabilities of the Power Optimization Division, including
but not limited to Pavilion indemnifying Pegasus regarding the intellectual
property of Pavilion's software being licensed. The Purchase Agreement provided
for a base price of $9,500,000 in cash, payable to Pavilion in installments
through July 31, 2003, which is adjusted for the net of assets and liabilities
assumed. Additionally, Pegasus shall pay Pavilion royalties of up to $5,500,000
between August 1, 2001 and October 31, 2005, based on Pavilion and Pegasus
software licenses sold by Pegasus. Through September 30, 2001, Pegasus made
payments to Pavilion totaling $1,947,740. KFx guarantees the duties and
obligations of Pegasus under the Purchase Agreement. See note 9 to the
accompanying financial statements.

   On November 4, 1999, Link Resources, Inc., a Georgia corporation, ("Link")
and its two shareholders, Linda E. Kobel ("Kobel") and Gary A. Sanden
("Sanden"), filed a complaint against the Company in US District Court for the
District of Colorado. The complaint alleges that KFX, Link, Kobel and Sanden had
entered into an agreement requiring KFX to acquire Link and that KFX breached
such agreement. The complaint seeks damages in excess of $5.3 million. Although
this matter is still in discovery and its ultimate resolution cannot be
predicted with certainty, based on a preliminary review of the underlying facts
and discussion with counsel, management believes that this complaint is without
merit. KFX intends to contest this complaint vigorously. Accordingly, management
does not believe that this matter will have a material impact on the results of
operation, financial position or cash flows of the Company.

                                       23
<PAGE>

                ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

   During the three months ended September 30, 2001, KFx issued the following
securities in private transactions pursuant to an exemption from the
registration requirements of the Securities Act of 1933, as amended ("Securities
Act") under Section 4(2) of the Securities Act:

<TABLE>
<CAPTION>
                                                                                                 Number
Purchaser / Recipient                           Terms of Exercise,                               Sold or            Consideration
    of Securities            Date                if Convertible             Title of Security    Granted               Received
    -------------            ----                --------------             -----------------    -------               --------
<S>                    <C>              <C>                                <C>                   <C>           <C>
  Venners & Company,      July 2001                    N/A                    Common Stock         20,000      Professional services
         Ltd.                                                                                                    valued at $73,000

   Bayou Fund, LLC      July 16, 2001    Exercisable at $3.65 per share,        Warrants          500,000           $3,650,000 1
                                         subject to certain adjustments.     exercisable for
                                          Expires three years after the       Common Stock
                                                  date of issue

Cinergy Services, Inc   July 25, 2001    Exercisable at $3.65 per share,         Warrant          200,000           $3,500,000 2
                                         subject to certain adjustments.     exercisable for
                                          Expires three years after the       Common Stock
                                                  date of issue

     H.M.R., L.P.       July 28, 2001    Exercisable at $3.65 per share,         Warrant          100,000      Professional services
                                         subject to certain adjustments.     exercisable for                     valued at $365,000
                                          Expires three years after the       Common Stock
                                                  date of issue
</TABLE>

/1/ This sum includes payment for 1,000,000 shares of common stock of KFx Inc.
/2/ This sum includes an advance to Pegasus Technologies, Inc. against the
    existing contract between Pegasus and Cinergy. Cinergy may elect to apply
    future Pegasus invoices against the advance or may choose to convert the
    balance of the advance into KFx common stock, at a price of $3.65 per share,
    or Pegasus common stock, at a price of $2.10 per share, subject to certain
    adjustments.

                                       24
<PAGE>

                    ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(A) EXHIBITS

 EXHIBIT
 NUMBER      DESCRIPTION
 ------      -----------
 4.1         Warrant to Purchase 250,000 Shares of KFx Inc. Common Stock issued
             to Bayou Fund, LLC dated July 16, 2001
 4.2         Warrant to Purchase 250,000 Shares of KFx Inc. Common Stock issued
             to Bayou Fund, LLC dated July 16, 2001
 4.3         Warrant to Purchase 200,000 Shares of KFx Inc. Common Stock issued
             to Cinergy Services, Inc. dated July 24, 2001
 4.4         Warrant to Purchase 100,000 Shares of KFx Inc. Common Stock issued
             to H.M.R., L.P. dated July 28, 2001
 10.1        Common Stock and Warrant Purchase Agreement between the Company and
             Bayou Fund, LLC dated July 16, 2001
 10.2        Registration Rights Agreement Between the Company and Bayou Fund,
             LLC dated July 16, 2001
 10.3        Addendum to Blanket Contract, No. 142072, dated May 1, 2001,
             Project -- Cinergy NOx Compliance Plan, Addendum dated July 24,
             2001
 10.4 *      Asset Purchase and License Agreement, dated as of July 31, 2001, by
             and among Pavilion Technologies, Inc., Pegasus Technologies, Inc.
             and KFx Inc.
 10.5 *      Assignment and Assumption Agreement, dated as of July 31, 2001, by
             and among Pavilion Technologies, Inc. and Pegasus Technologies,
             Inc.
 10.6 *      Guaranty Agreement, dated July 31, 2001, by KFx Inc.
           * Document previously filed with the U.S. Securities and Exchange
             Commission with the Company's Current Report on Form 8-K dated
             August 15, 2001 and incorporated herein by reference.

(B) REPORTS ON FORM 8-K

   During the quarter ended September 30, 2001, the Company filed Current
Reports on Form 8-K dated July 2, 2001, under Item 5, Other Events, and dated
August 15, 2001 (as amended on Form 8-K/A filed on October 15, 2001), under Item
2, Acquisition or Disposition of Assets.

                                       25
<PAGE>

                                   SIGNATURES

   Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.

                                    KFX INC.

                                    /s/ PATRICK S. FLAHERTY
                                    --------------------------------------------
                                    PATRICK S. FLAHERTY
                                    VICE PRESIDENT & CHIEF FINANCIAL OFFICER
                                    (PRINCIPAL FINANCIAL AND ACCOUNTING OFFICER)

                                    DATE: NOVEMBER 14, 2001


                                       26
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================================================================================

                UNITED STATES SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

--------------------------------------------------------------------------------

                                    FORM 10-Q

(Mark One)

 [X]                  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
                             SECURITIES EXCHANGE ACT OF 1934

                      FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2001

 [ ]                  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
                             SECURITIES EXCHANGE ACT OF 1934

--------------------------------------------------------------------------------

                         Commission file number 0-23634

                                    KFX INC.
             (Exact name of Registrant as specified in its charter)

              Delaware                                     84-1079971
   (State or other jurisdiction of                      (I.R.S. employer
   incorporation or organization)                     Identification number)

          3300 EAST FIRST AVENUE, SUITE 290, DENVER, COLORADO USA 80206
                    (Address of principal executive offices)

                                 (303) 293-2992
               (Registrant's telephone number including area code)

Indicate by check mark whether the Registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months, and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]

On November 7, 2001 there were 26,774,340 shares of the Registrant's common
stock, $.001 par value, outstanding.

================================================================================
KFX INC.
                           FORM 10-Q QUARTERLY REPORT
                FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2001

                                TABLE OF CONTENTS

                                                                        PAGE NO.
 PART I.  FINANCIAL INFORMATION

     ITEM 1. FINANCIAL STATEMENTS:

        Consolidated Balance Sheets - September 30, 2001
            and December 31, 2000 (Unaudited)................................  3
        Consolidated Statements of Operations - Three Months Ended
            September 30, 2001 and 2000 (Unaudited)..........................  4
        Consolidated Statements of Operations - Nine Months Ended
            September 30, 2001 and 2000 (Unaudited)..........................  5
        Consolidated Statements of Cash Flows - Nine Months Ended
            September 30, 2001 and 2000 (Unaudited)........................... 6
        Notes to Consolidated Financial Statements (Unaudited)................ 8

     ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
             FINANCIAL CONDITION AND RESULTS OF
             OPERATIONS...................................................... 16

     ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES
             ABOUT MARKET RISK............................................... 21

 PART II.  OTHER INFORMATION

     ITEM 1. LEGAL PROCEEDINGS............................................... 23

     ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS....................... 24

     ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K................................ 25

 SIGNATURES ................................................................. 26
KFX INC.
                           CONSOLIDATED BALANCE SHEETS

                                                           UNAUDITED
                                                   SEPTEMBER 30,   DECEMBER  31,
                                                      2001             2000
                                                   ------------    ------------
ASSETS
Current assets
     Cash and cash equivalents .................   $  1,720,922    $    348,955
     Trade accounts receivable, net ............        518,281         351,909
     Unbilled revenue ..........................        110,647         118,103
     Other receivables .........................        268,923         224,853
     Prepaid expenses ..........................         85,087          34,459
     Debt issue costs ..........................        328,193              --
     Deferred job costs ........................        521,952         216,152
                                                   ------------    ------------
     Total current assets ......................      3,554,005       1,294,431
Property, plant and equipment, net .............        559,044       1,360,430
Patents, net ...................................      1,766,174       1,951,567
Investment in K-Fuel, LLC ......................        431,658         694,135
Goodwill, net ..................................      8,882,824       1,817,731
Intangibles, net ...............................      1,360,033              --
Debt issue costs ...............................             --         679,046
Prepaid royalty ................................        498,000         498,000
Other assets ...................................        177,299         176,030
                                                   ------------    ------------
TOTAL ASSETS ...................................   $ 17,229,037    $  8,471,370
                                                   ============    ============

LIABILITIES AND STOCKHOLDERS' DEFICIT
Current liabilities
     Accounts payable ..........................   $  2,024,017    $  1,817,533
     Accrued expenses ..........................        498,994         625,523
     Interest payable ..........................        266,728         458,265
     Liability to issue stock and warrants .....         23,810         134,458
     Deferred sale of Pegasus common stock .....             --       1,000,000
     Deferred revenue ..........................      1,104,743         523,552
     Deferred income ...........................        232,520              --
     Short term notes payable to directors .....        350,000         827,551
     Obligations to repurchase Pegasus preferred
       stock, net ..............................      1,768,697              --
     Convertible debentures ....................     15,070,309              --
     Current maturities of long-term debt ......      5,485,174         873,476
                                                   ------------    ------------

         Total current liabilities .............     26,824,992       6,260,358
Deferred income ................................             --         499,309
Deferred revenue, less current portion .........        492,051         200,000
Convertible debentures .........................             --      16,339,444
Long-term debt, less current maturities ........      5,047,612         331,150
                                                   ------------    ------------
         Total liabilities .....................     32,364,655      23,630,261
                                                   ------------    ------------
Minority interest ..............................      4,136,327       2,275,040
                                                   ------------    ------------
Stockholders' deficit
   Preferred stock, $.001 par value, 20,000,000
     shares authorized; none issued ............             --              --

   Common stock, $.001 par value, 80,000,000
     shares authorized; and 26,774,340 and
     25,196,280 shares issued and outstanding ..         26,774          25,196
Additional paid-in capital .....................     61,306,335      53,632,177
Accumulated deficit ............................    (80,605,054)    (71,091,304)
                                                   ------------    ------------

         Total stockholders' deficit ...........    (19,271,945)    (17,433,931)
                                                   ------------    ------------
TOTAL LIABILITIES AND STOCKHOLDERS' DEFICIT ....   $ 17,229,037    $  8,471,370
                                                   ============    ============

                   The accompanying notes are an integral part
                   of these consolidated financial statements

                                       3
KFX INC.
                      CONSOLIDATED STATEMENTS OF OPERATIONS

                                                            UNAUDITED
                                                THREE MONTHS ENDED SEPTEMBER 30,
                                                       2001             2000
                                                   ------------    ------------

OPERATING REVENUES
Pegasus software licenses and services .........   $  1,106,530    $    375,379
K-Fuel demonstration plant and laboratory
  contract revenue .............................             --         129,417
                                                   ------------    ------------
     Total operating revenues ..................      1,106,530         504,796

OPERATING COSTS & EXPENSES
Costs of Pegasus software licenses and services.        551,063         467,564
Marketing, general and administrative expenses .      2,160,347       1,315,585
Pegasus software research and development ......        210,569         189,820
K-Fuel demonstration plant and laboratory ......         81,467         101,080
Depreciation and amortization ..................        651,483         690,702
                                                   ------------    ------------
     Total operating costs and expenses ........      3,654,929       2,764,751
                                                   ------------    ------------

OPERATING LOSS .................................     (2,548,399)     (2,259,955)

Other income (expense) .........................         (7,680)          9,541
Interest expense (including accretion of
  maturity  premiums) ..........................     (1,138,758)       (457,934)
Equity in income (loss) of unconsolidated
  affiliates ...................................          1,303         (23,537)
                                                   ------------    ------------
NET LOSS .......................................   $ (3,693,534)   $ (2,731,885)
                                                   ============    ============

BASIC AND DILUTED NET LOSS PER COMMON SHARE ....   $      (0.14)   $      (0.11)
                                                   ============    ============

Weighted-average common shares outstanding .....     26,552,000      24,998,000
                                                   ============    ============

                   The accompanying notes are an integral part
                   of these consolidated financial statements

                                       4
KFX INC.
                      CONSOLIDATED STATEMENTS OF OPERATIONS

                                                           UNAUDITED
                                                 NINE MONTHS ENDED SEPTEMBER 30,
                                                       2001           2000
                                                   ------------    ------------

OPERATING REVENUES
Pegasus software licenses and services .........   $  1,883,484    $  1,601,571
K-Fuel demonstration plant and laboratory
  contract revenue .............................             --         229,393
                                                   ------------    ------------
     Total operating revenues ..................      1,883,484       1,830,964

OPERATING COSTS & EXPENSES
Costs of Pegasus software licenses and services       1,159,827       1,265,855
Marketing, general and administrative expenses .      4,399,787       3,804,281
Pegasus software research and development ......        563,426         455,653
K-Fuel demonstration plant and laboratory
  operations ...................................        171,245         277,840
Depreciation and amortization ..................      2,028,671       2,112,865
                                                   ------------    ------------
     Total operating costs and expenses ........      8,322,956       7,916,494
                                                   ------------    ------------

OPERATING LOSS .................................     (6,439,472)     (6,085,530)

Other income (expense) .........................        (45,603)        (28,753)
Interest expense (including accretion of
  maturity premiums) ...........................     (3,032,987)     (2,012,565)

Equity in income of unconsolidated affiliates ..          4,312          22,693
                                                   ------------    ------------

NET LOSS .......................................   $ (9,513,750)   $ (8,104,155)
                                                   ============    ============

BASIC AND DILUTED NET LOSS PER COMMON SHARE ....   $      (0.37)   $      (0.33)
                                                   ============    ============

Weighted-average common shares outstanding .....     25,746,000      24,831,000
                                                   ============    ============

                   The accompanying notes are an integral part
                   of these consolidated financial statements

                                       5
KFX INC.
                      CONSOLIDATED STATEMENTS OF CASH FLOWS

                                                                     UNAUDITED
                                                          NINE MONTHS ENDED SEPTEMBER 30,
                                                             2001                    2000
                                                          -----------            -----------
OPERATING ACTIVITIES
     Net loss .........................................   $(9,513,750)           $(8,104,155)
     Adjustments to reconcile net loss to cash
       used in operating activities
            Depreciation and amortization .............     2,028,671              2,112,865
            Equity in loss of unconsolidated affiliates        (4,312)               (22,693)
            Accretion of maturity premiums and
              amortization of debt discount ...........     1,992,264              1,181,389
            Common stock and warrants issued for
              services ................................       313,136                205,313
            Other .....................................       111,287                     --
     Changes in operating assets and liabilities:
         Accounts receivable, unbilled revenue
         and deferred job costs, net ..................      (508,787)               109,072
         Deferred revenue .............................       604,178               (446,672)
         Accounts payable and accrued expenses ........        79,955                921,483
         Interest payable .............................      (191,537)              (311,355)
         Other assets .................................       (53,282)                31,643
                                                          -----------            -----------
Cash used in operating activities .....................    (5,142,177)            (4,323,110)
                                                          -----------            -----------
INVESTING ACTIVITIES
     Purchases of equipment............................       (82,619)               (51,854)
     Pending patent applications ......................       (68,313)              (221,453)
     Purchase of Power Optimization Segment of
       Pavilion Technologies, Inc. assets .............    (2,008,789)                    --
     Deferred sale of subsidiary stock ................            --              1,000,000
     Cash recovery of investment in KFx Fuel
       Partners LP. ...................................            --              1,527,048
                                                          -----------            -----------
Cash (used in) provided by investing activities .......    (2,159,721)             2,253,741
                                                          -----------            -----------
FINANCING ACTIVITIES
     Issuance of common stock and warrants, net .......     3,500,000              1,500,000
     Issuance of preferred stock in subsidiary ........       750,000                     --
     Proceeds from sale of Pegasus preferred stock ....     1,972,331                     --
     Short term note issued to director ...............       300,000                750,000
     Proceeds from convertible long term borrowing ....     3,500,000                     --
     Payments on note payable to directors ............      (600,000)              (400,000)
     Payments on notes payable ........................      (748,466)              (156,167)
                                                          -----------            -----------
Cash provided by financing activities .................     8,673,865              1,693,833
                                                          -----------            -----------

Increase (decrease) in cash and cash equivalents ......     1,371,967               (375,536)
Cash and cash equivalents, beginning of period ........       348,955                654,429
                                                          -----------            -----------
Cash and cash equivalents, end of period ..............   $ 1,720,922            $   278,893
                                                          ===========            ===========

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
     Cash paid for interest ...........................   $ 1,260,151            $ 1,148,142
                                                          ===========            ===========
SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES

Nine Months Ended September 30, 2001:

The Company issued 194,500 shares of common stock (70,000 shares of common stock
to a party related to the Chairman and CEO) in exchange for consulting services
during the nine months and to satisfy an obligation that existed at December 31,
2000; a total of $313,136 was charged to general and administrative expense and
$110,648 reduced a liability outstanding at December 31, 2000. In connection
with the sales of Pegasus preferred stock, subject to KFx's obligation to
repurchase, a debt discount of $1,780,256 was recorded, which is being amortized
to

                                       6
KFX INC.
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                                   (CONTINUED)

interest expense over the one-year term of the repurchase obligation. On March
3, 2001, Kennecott Energy's put option relative to its Pegasus common stock
expired; accordingly, the $1,000,000 sales price has been included in minority
interest as of September 30, 2001. Convertible Debentures with a face value of
$1,400,000 were converted, under the stated terms of $3.65 per share, into
383,561 shares of the Company's common stock resulting in an addition to
stockholders' equity approximating $1,362,980, net of a pro rata portion of
unamortized debt issue costs. Warrants to purchase 285,000 shares of Pegasus
common stock were issued in the second quarter of 2001, resulting in debt
discount of $102,348, which was recognized as interest expense on the issuance
date. During the third quarter of 2001, the Company issued a warrant in
conjunction with a loan agreement to purchase 200,000 shares of KFx common
stock, resulting in debt discount of $369,190 and interest expense of $22,802.

Nine Months Ended September 30, 2000:

   Convertible Debentures with a face value of $1,750,000 were converted, under
the stated terms of $3.65 per share, into 479,445 shares of the Company's common
stock resulting in an addition to stockholders' equity approximating $1,637,000,
net of a pro rata portion of unamortized debt issue costs. Warrants valued at
$2,200,000 to purchase 1.3 million shares of KFx common stock at $3.65 per
share, subject to certain adjustments, were issued in the second quarter of
2000; see Note 3. In July 2000, in connection with obtaining a $400,000
unsecured line of credit from a KFx director, Pegasus issued a warrant valued at
$215,000 to purchase new shares of its common stock equivalent to 1.5% of its
then outstanding common stock; see Note 6. Through September 30, 2000, $83,889
of related expense was recorded. In July 2000, the Company issued 56,250 shares
of its common stock for financial consulting services valued at $205,313.

                   The accompanying notes are an integral part
                   of these consolidated financial statements

                                       7
KFX INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED)

NOTE 1.   BASIS OF PRESENTATION

   The accompanying unaudited consolidated financial statements include the
accounts of KFX Inc. ("KFx" or the "Company"), its wholly owned subsidiary, KFX
Wyoming Inc., and its majority-owned subsidiaries, Pegasus Technologies, Inc.
("Pegasus"), KFX Technology, Inc. ("KFxT"), and Heartland Fuels Corporation. The
Company's 51% interest in K-Fuel, L.L.C. ("K-Fuel, LLC") is accounted for as an
equity investment since the 49% partner, Kennecott Energy Company ("Kennecott
Energy"), has certain participative rights; accordingly, the Company does not
control K-Fuel, LLC. Until May 2000, the Company's 5% interest in KFx Fuel
Partners, L.P. ("KFP") was accounted for as equity investment since the Company
was a non-controlling investor in KFP. In May 2000, the Company sold its 5%
interest in KFP to Black Hills Corporation, see Note 3.

   The consolidated financial statements at September 30, 2001 and for the three
and nine month periods ended September 30, 2001 and 2000 are unaudited. In the
opinion of the Company's management, all adjustments, consisting of only normal
recurring adjustments, necessary for a fair statement of the results for the
interim periods have been made. Certain reclassifications have been made to the
2000 financial statements to conform to the current year presentation.

   Certain information and footnote disclosures normally included in financial
statements prepared in accordance with generally accepted accounting principles
have been condensed or omitted. These financial statements should be read in
conjunction with the audited financial statements and notes to financial
statements for the year ended December 31, 2000 included in the Company's Form
10-K. The accounting policies used in the preparation of these unaudited
quarterly financial statements are the same as those policies used in the
preparation of the audited annual financial statements. The results of
operations for the three and nine months ended September 30, 2001 are not
necessarily indicative of the results of operations expected for the year ended
December 31, 2001.

   The accompanying financial statements have been prepared on a going concern
basis, which contemplates the realization of assets and the satisfaction of
liabilities in the normal course of business. The Company has incurred net
losses of approximately $12,290,000, $12,730,000 and $6,784,000 and negative
cash flow from operations of $5,151,000, $3,458,000 and $4,642,000 in the years
ended December 31, 2000, 1999 and 1998, respectively, and an additional net loss
of $9,513,750 and negative cash flow from operations of $5,142,177 in the nine
months ended September 30, 2001 and had an accumulated deficit of approximately
$80,605,054 as of September 30, 2001. These factors, coupled with the need for
additional financing to fund operations and planned growth in the business,
raise substantial doubt about whether the Company can continue as a going
concern. The Report of Independent Accountants dated April 13, 2001 covering the
Company's consolidated financial statements for the year ended December 31, 2000
included an explanatory paragraph discussing this going concern uncertainty.

   In order to mitigate this uncertainty, the Company intends to seek further
capital through various means which may include the sale of all or a portion of
its interest in Pegasus, additional sales of debt or equity securities, a
business combination or other means and to further reduce expenditures as
necessary. Should the Company not be successful in achieving one or more of
these actions, it is possible that the Company may not be able to continue as a
going concern. The consolidated financial statements do not include any
adjustments that might result from the outcome of this uncertainty.

   Net loss per common share for the three and nine month periods ended
September 30, 2001 and 2000 are based on the weighted-average number of shares
of common stock outstanding during the period, and excludes approximately
14,185,544 and 9,724,000 of potentially issuable common shares from common stock
options, warrants and convertible debt, as the effect on the Company's net loss
would be anti-dilutive.

                                       8
NOTE 2.   DEFERRED SALE OF PEGASUS COMMON STOCK, ISSUANCES OF PEGASUS PREFERRED
          STOCK AND SALES OF PEGASUS PREFERRED STOCK

   On March 3, 2000, KFx and Pegasus closed a transaction with Kennecott Energy
that included, among various other elements, (a) the sale of 4% of the common
stock of Pegasus, held by KFx ("Pegasus Common Stock"), to Kennecott Energy for
$1,000,000, (b) the issuance by Pegasus to Kennecott Energy, in exchange for
$500,000, of newly authorized 6% cumulative convertible preferred stock
("Pegasus Preferred Stock") equivalent to an additional 2% interest in Pegasus
on an as converted basis, and (c) the joint development by KFx, Pegasus and
Kennecott Energy of a work plan for enhancements to NeuSIGHT, new product
development and the completion of other tasks designed to improve the
performance of Pegasus and trigger additional purchases of Pegasus Preferred
Stock by Kennecott Energy at its discretion of up to $3,500,000, for an
additional interest in Pegasus up to 14%, on an as converted basis, by December
31, 2004 or earlier. Through September 30, 2001, Kennecott Energy has purchased
$2,250,000 of additional Pegasus Preferred Stock, $750,000 of which was
purchased during the nine months ended September 30, 2001. Through March 3,
2001, Kennecott Energy had the right to sell the Pegasus Common Stock back to
KFx at a price equal to the greater of $1,000,000 or fair market value; such
right was not exercised and expired on March 3, 2001. Accordingly, the
$1,000,000 sale price has been included in minority interest as of September 30,
2001.

   During the nine months ended September 30, 2001, KFx closed transactions with
various parties pursuant to which KFx sold a portion of its Pegasus preferred
stock investment in Pegasus, representing an approximate 11.6% as converted
interest in Pegasus, for $1,972,331. Included in these sales of Pegasus
preferred stock were sales to two directors of KFx and KFx's Chairman, Theodore
Venners, for $222,331 in exchange for an as converted interest in Pegasus of
1.3%. KFx is obligated to repurchase this preferred stock, or any other security
issued with respect to this preferred stock, for $2,787,561 at dates varying
from January 31, 2002 to May 25, 2002, or earlier upon the occurrence of certain
events, such as a change in control. In certain circumstances, the parties can
individually elect to exchange their interest in Pegasus, with an aggregate
value of $2,787,561, and any interest in Pegasus subsequently acquired by
Evergreen Resources, Inc. ("Evergreen"), for common stock of KFx at $3.65 per
share, subject to certain adjustments, including a reduction to the then current
market value upon the conversion or satisfaction of the Company's 6% Convertible
Debentures due July 31, 2002 ("Debentures"). In addition, the parties were
provided with warrants, expiring five years after their issue, to purchase an
aggregate amount of 1,314,888 shares of KFx common stock at $3.65 per share,
subject to certain adjustments including a reduction to a weighted-average price
of $2.34 per share upon the conversion or satisfaction of the Company's
Debentures. The terms of these agreements are substantially the same except that
Evergreen, which paid $1,500,000 for an approximate 8.8% as converted interest,
can elect to defer the repurchase date to January 31, 2003, in which case it
will receive the right to purchase from KFx an additional interest in Pegasus on
similar terms, excluding any additional warrants to purchase KFx common stock.
Evergreen's Chairman is a member of the Board of Directors of KFx.

   Based on the terms and characteristics of the preferred stock sales as
discussed above, the instruments have been classified as debt in the September
30, 2001 balance sheet. Accordingly, the Company valued the related warrants
using a Black-Scholes option pricing model and recorded $843,247 as debt
discount. In addition, the difference between the accounting conversion price of
the preferred stock and the fair value of KFx's common stock on the dates of the
transactions resulted in a beneficial conversion feature in the amount of
$937,009, which was calculated in accordance with EITF 98-5, Accounting for
Convertible Securities with Beneficial Conversion Features or Contingently
Adjustable Conversion Ratios and EITF 00-27, Application of Issue No. 98-5 to
Certain Convertible Instruments. The beneficial conversion feature is reflected
as additional debt discount in the balance sheet at September 30, 2001. In the
nine months and quarter ended September 30, 2001, the Company recorded
$1,576,621 and $647,027, respectively, in interest expense related to the
amortization of the debt discount and the accretion to redemption value.

   At September 30, 2001, as a result of these additional investments of
Kennecott Energy in Pegasus Preferred Stock and KFx's sale of a portion of its
Pegasus Preferred Stock, the ownership, on an as converted basis, of Pegasus is
approximately as follows: KFx--56.7%, Pegasus founders--15.8%, Kennecott
Energy--15.9%, Evergreen Resources, Inc.--8.8% and other private
investors--2.8%.

                                       9
NOTE 3.   INVESTMENT IN KFP

   On April 12, 2000, the Company executed agreements with various parties that
initiated the redevelopment of the KFP Facility. Pursuant to the agreements (a)
a subsidiary of Black Hills Corporation ("BKH") purchased the KFP Facility and
received 2 million shares of KFx common stock previously held by Thermo Ecoteck
Corporation ("TCK") in exchange for the assumption of the reclamation liability
associated with the KFP Facility, (b) BKH was given the right to one seat on
KFx's board of directors (which to date it has declined to exercise), (c) KFx
granted BKH a fully-exercisable warrant, which expires April 30, 2005, to
purchase 1.3 million shares of KFx common stock at $3.65 per share, subject to
certain adjustments including a reduction to a price of $3.48 per share upon the
conversion or satisfaction of the Company's Debentures, (d) KFx relinquished its
5% interest in KFP to TCK and provided certain releases to TCK in exchange for
cash proceeds approximating $1.5 million and certain real and personal property,
and (e) TCK sold the remaining 2.25 million common shares of KFx it owned to
private investors and canceled the warrant it held to purchase a control
position in KFx's common stock. The carrying value of the Company's investment
in KFP was written down effective December 31, 1999 by $1,800,000, to the
$1,500,000 estimated cash proceeds to KFx from these transactions. In addition,
the estimated $2.2 million value of the warrant issued to BKH, using the
Black-Scholes option pricing model, was charged to expense in 1999.

NOTE 4.   NOTES PAYABLE TO THE STATE OF WYOMING

   Principal and interest under a promissory note ("Note") to the State of
Wyoming ("Wyoming") in the amount of $500,000 was due March 1, 2001, but not
paid. The Company initiated discussions with Wyoming in advance of the maturity
date and paid the interest due under the Note on April 10, 2001. Substantially
identical circumstances arose relative to a promissory note ("Chairman's Note")
for $819,000 due to Wyoming by KFx's Chairman and one of his affiliates. The
Company agreed in 1994 to indemnify its Chairman and his affiliate for any
payments due under such note. In exchange for current interest payments, Wyoming
had previously granted the Company an extension to August 1, 2001. On July 20,
2001, the Company made the final payment to Wyoming in the amount of $1,161,583
for all principal and interest outstanding at that date under the Note and the
Chairman's Note. At the time of the final payment, which fulfilled all
obligations to Wyoming under the Note and the Chairman's Note, Wyoming returned
its 12% interest in the K-Fuel process to the Company. The final payment of
$762,144 to satisfy the Chairman's Note was expensed to marketing, general and
administrative expense in the nine months and the quarter ended September 30,
2001.

NOTE 5.   SEGMENT INFORMATION

   KFx's reportable segments are based on its principal products and services,
which are optimization software and related services, through its Pegasus
subsidiary ("Pegasus" segment), and clean fuels technology, through certain
activities of KFx and certain of its subsidiaries ("K-Fuel" segment). The
accounting policies of these segments are the same as described in the Company's
Annual Report on Form 10-K for the year ended December 31, 2000. In addition,
the goodwill and related amortization resulting from the acquisition of Pegasus
is included in the Pegasus segment. KFx evaluates the performance of its
segments and allocates resources to them primarily based on its view of the
potential for net income and operating cash flow. There are no intersegment
revenues; however, KFx's corporate office charges management and related fees to
the Pegasus segment based on actual costs and estimated time and other resources
devoted to assist with and support the activities of Pegasus.

                                       10
The tables below presents information about revenues, certain income and
expense categories, net loss, cash used in operating activities, segment assets
and certain other information used by KFx's Chairman and CEO, its chief
operating decision maker, as of September 30, 2001 and 2000 and for the three
and nine month periods then ended:
THREE MONTHS ENDED                                                               RECONCILING
                September 30, 2001                    PEGASUS                 K-FUEL               ITEMS (a)          CONSOLIDATED
                ------------------                    -------                 ------          --------------------    ------------
Operating Revenues....................         $  1,106,530          $          --         $          --         $   1,106,530

    Net Loss..............................         $   (961,956)         $    (341,166)        $  (2,390,412)        $  (3,693,534)

    Cash Provided by (Used in) Operating
    Activities............................         $   (533,764)         $      35,281         $  (2,183,850)        $  (2,682,333)

    Total Assets                                   $ 12,493,368          $   2,344,118         $   2,391,551         $  17,229,037

               September 30, 2000
               ------------------
    Operating Revenues....................         $    375,379          $     129,417         $          --         $     504,796

    Net Loss..............................         $ (1,150,750)         $    (399,900)        $  (1,181,235)        $   (2,731,885)

    Cash Used in Operating Activities.....         $   (595,541)         $     (88,670)        $  (1,043,910)        $   (1,728,121)

    Total Assets                                   $  2,764,433          $   4,978,093         $   2,205,635         $    9,948,161
NINE MONTHS ENDED                                                                RECONCILING
                September 30, 2001                    PEGASUS                 K-FUEL               ITEMS (a)          CONSOLIDATED
                ------------------                    -------                 ------          --------------------    ------------
Operating Revenues....................         $  1,883,484          $          --         $         --          $   1,883,484

    Net Loss..............................         $ (2,921,788)         $  (1,150,686)        $ (5,441,276)         $  (9,513,750)

    Cash Provided by (Used in) Operating
    Activities............................         $ (1,734,319)         $     257,925         $ (3,665,783)         $  (5,142,177)

    Total Assets                                   $ 12,493,368          $   2,344,118         $  2,391,551          $  17,229,037

               September 30, 2000
               ------------------
    Operating Revenues....................         $  1,601,571          $     229,393         $         --          $   1,830,964

    Net Loss..............................         $ (2,953,967)         $  (1,280,228)        $ (3,869,960)         $  (8,104,155)

    Cash Used in Operating Activities.....         $ (1,731,314)         $     (13,237)        $ (2,578,559)         $  (4,323,110)

    Total Assets                                   $  2,764,433          $   4,978,093         $  2,205,635          $   9,948,161
(a) Consists primarily of KFx corporate office activities and consolidating
    entries.

                                       11
NOTE 6.  NOTES PAYABLE TO DIRECTORS

   During the nine months ended September 30, 2000, the Company borrowed
$550,000 under an unsecured note payable to a director bearing interest at 11.5%
and personally guaranteed by the Company's Chairman. The note was fully repaid
in August 2001.

   During the nine months ended September 30, 2000, Pegasus also borrowed
$400,000 under an unsecured note payable to another of the Company's directors
bearing interest at prime plus 2%, due on demand. The terms of the agreement
include a warrant to purchase common stock of Pegasus equivalent to 1.5% of its
then currently outstanding common stock. The Company valued the warrant using a
Black-Scholes option pricing model and recorded $215,040 as debt discount, which
was amortized to interest expense over the original term of the note. At
September 30, 2001, the unpaid balance of this note was $200,000 and the warrant
was outstanding and fully exercisable.

   During the nine months ended September 30, 2001, Pegasus borrowed $300,000
under an unsecured note payable to the Company's Chairman and CEO bearing
interest at prime plus 2%, due on demand. The terms of the agreement include a
warrant to purchase common stock of Pegasus equivalent to 1.5% of its then
currently outstanding common stock. The Company valued the warrant using a
Black-Scholes option pricing model and recorded $102,348 as debt discount, which
was immediately amortized to interest expense on the issuance date. At September
30, 2001, the unpaid balance of this note was $150,000 and the warrant was
outstanding and fully exercisable.

NOTE 7.   CONVERTIBLE LONG-TERM DEBT

   On July 25, 2001, Cinergy Corp. ("Cinergy) advanced $3.5 million to Pegasus
against the existing contract between Pegasus and Cinergy, which was signed on
May 1, 2001. The advance bears interest at 7% per annum, payable monthly.
Cinergy may elect to apply future Pegasus invoices against the advance or may
choose to convert the balance of the advance into KFx common stock, at a price
of $3.65 per share, or into Pegasus common stock, at a price of $2.10 per share,
subject to certain adjustments. The note is also putable by Cinergy upon (i) a
change in control of KFx or Pegasus, (ii) the sale of substantially all of
Pegasus' or KFx's assets, (iii) the completion of third party financing for
Pegasus of $12.5 million or for Pegasus and KFx combined of $50 million, or (iv)
termination for cause as set forth in the original contract. Cinergy also
received a warrant, expiring three years after the date of issue, exercisable
for 200,000 shares of KFx common stock, at $3.65 per share, subject to certain
adjustments. The Company valued the warrant using a Black-Scholes option pricing
model and recorded $369,190 as debt discount, which will be amortized to
interest expense over the expected term of the note, which is April 2004. At
September 30, 2001, the original balance of this note was outstanding and all of
the shares granted in the warrant were authorized and exercisable.

NOTE 8.   DEBENTURE PREMIUM

   At June 30, 2000, the Company recorded a cumulative charge of $1,000,000 to
correct previously unrecorded accretion of the 12% premium on its Debentures.
The Company cannot provide any assurance that the Debentures will be converted
prior to maturity on July 31, 2002; accordingly, accretion of this premium is
required under generally accepted accounting principles. The impact of this
correction on each of the quarters since the Debentures were issued in July 1997
was not material. Accordingly, the correction was recorded in the second quarter
of 2000.

NOTE 9.   PURCHASE OF POWER OPTIMIZATION SEGMENT OF PAVILION TECHNOLOGIES, INC.

   Pursuant to an Asset Purchase and License Agreement (the "Purchase
Agreement") between Pavilion, Pegasus Technologies, Inc. ("Pegasus"), a
subsidiary of KFx Inc. ("KFx"), and KFx, dated July 31, 2001, certain assets and
liabilities relating to the Power Optimization Division were acquired by
Pegasus. These purchased assets and acquired liabilities were primarily accounts
receivable, unbilled revenue, deposits, customer list, exclusive rights to
license Pavilion's software, other intangibles and deferred revenue. Pavilion
has retained certain liabilities of the Power Optimization Division, including
but not limited to Pavilion indemnifying Pegasus regarding the intellectual
property of Pavilion's software being licensed. The Purchase Agreement provided
for a base price of $9,500,000 in cash, payable to Pavilion in installments
through July 31, 2003, which is adjusted for the net of assets and liabilities
assumed. Remaining installment payments, net of $777,000 of imputed interest,
total $3,000,000, $2,500,000 and $2,000,000 in 2001, 2002 and 2003,
respectively. Additionally, Pegasus shall pay Pavilion royalties of up to
$5,500,000 between August 1, 2001 and

                                       12
October 31, 2005, based on Pavilion and Pegasus software licenses sold by
Pegasus. Through September 30, 2001, Pegasus made payments to Pavilion totaling
$1,947,740 against the base purchase price. KFx guarantees the duties and
obligations of Pegasus under the Purchase Agreement. This acquisition expands
the software product offerings, customer installed base, and technical expertise
as well as effectively dismissing the Pavilion Lawsuit, which allows management
to concentrate on the growth of Pegasus. The acquisition has been accounted for
by the purchase method and the results of operations are included in the
Company's financial statements beginning in the third quarter of 2001. The
assets acquired and liabilities assumed were recorded at estimated fair values.
The allocation of the purchase price to net assets acquired, liabilities assumed
and intangible assets based on an independent valuation of those assets follows:

                 (dollars in thousands):

                 Purchase price                                $     8,515
                 Fair value of identifiable intangible
                  assets acquired                                    1,426
                 Deferred revenue                                     (269)
                                                               -----------
                 Excess cost over net assets acquired                7,358
                 Acquisition costs                                     217
                                                               -----------
                 Goodwill                                      $     7,575
                                                               ===========

   The intangible assets acquired consist of order backlog, customer lead list
and maintenance contracts which have estimated useful lives of 18 months, 18
months and seven years, respectively. Goodwill recognized as a result of the
transaction is attributable to Pegasus and all activity relating to the goodwill
was assigned to the Pegasus segment.

   The unaudited pro forma results of operations for the nine months ended
September 30, 2000 and 2001, assuming the consummation of the purchase as of
January 1, 2000 follows. The pro forma results include estimates and
assumptions, which the Company's management believes are reasonable. However,
the pro forma results do not include any cost savings, revenue enhancements or
other effects of the planned integration of the Pegasus and Pavilion and are not
necessarily indicative of the results which would have occurred if the
transaction had been in effect on the dates indicated, or which may result in
the future.

                                                     UNAUDITED PRO FORMA
                                                NINE MONTHS ENDED SEPTEMBER 30,
   (in thousands, except per share amounts)          2001          2000
                                                   --------      --------
Total operating revenues ......................    $  2,619      $  3,344
Net loss ......................................    $(12,156)     $ (9,026)
Basic and diluted net loss per common share ...    $  (0.47)     $  (0.36)

                                                     UNAUDITED PRO FORMA
                                                THREE MONTHS ENDED SEPTEMBER 30,
   (in thousands, except per share amounts)          2001          2000
                                                   --------      --------
Total operating revenues ......................    $  1,325      $  1,121
Net loss ......................................    $ (3,972)     $ (3,095)
Basic and diluted net loss per common share ...    $  (0.15)     $  (0.12)

NOTE 10.   CONTINGENCIES

   On September 8, 2000, Pavilion Technologies, Inc. ("Pavilion"), a competitor
of Pegasus, served Pegasus with a complaint that it had filed on August 14,
2000, in the United States District Court for the Southern District of Texas,
asserting that Pegasus infringed 26 patents allegedly issued to or licensed by
Pavilion (the "Pavilion Lawsuit"). The Pavilion Lawsuit was subsequently
transferred to the United States District Court for the Northern District of
Ohio. The Pavilion Lawsuit seeks injunctive relief, compensatory and treble
damages, as well as attorney's fees, costs and expenses. Pegasus' products
employ its own proprietary computer code as well as

                                       13
computer code exclusively licensed to Pegasus. On September 15, 2000, the
licensor agreed to defend Pegasus in the Pavilion Lawsuit pursuant to an
indemnification provision of the parties' license agreement. On October 27,
2000, Pegasus filed an answer to the Pavilion Lawsuit denying the patent
infringement claims ("Pegasus Answer"). The Pegasus Answer also asserted various
counterclaims against Pavilion alleging unfair competition, deceptive trade
practices, defamation, tortuous interference with business relationships and
attempted monopolization in violation of Section 2 of the Sherman Antitrust Act
("Pegasus Counterclaims"). After consultation with counsel, KFx and Pegasus
management believe that the infringement allegations in the Pavilion Lawsuit are
objectively baseless and without merit. On April 11, 2001, Pegasus and Pavilion
agreed to dismiss the Pavilion Lawsuit, the Pegasus Answer and the Pegasus
Counterclaim, without prejudice, in order to explore possible business
combinations, cooperative relationships and other alternatives. On August 1,
2001, Pegasus purchased certain assets of the Pavilion power optimization
segment, which effectively resolved the Pavilion Lawsuit, see Note 9.

   On November 4, 1999, Link Resources, Inc., a Georgia corporation, ("Link")
and its two shareholders, Linda E. Kobel ("Kobel") and Gary A. Sanden
("Sanden"), filed a complaint against the Company in US District Court for the
District of Colorado. The complaint alleges that KFX, Link, Kobel and Sanden had
entered into an agreement requiring KFX to acquire Link and that KFX breached
such agreement. The complaint seeks damages in excess of $5.3 million. Although
the ultimate resolution of this matter cannot be predicted with certainty, based
on a review of the underlying facts and discussions with counsel, management
believes that this complaint is without merit. KFX intends to contest this
complaint vigorously. Accordingly, management does not believe that its ultimate
outcome will have a material adverse effect on the Company's consolidated
financial position, its results of operations or its cash flows.

   As part of the restructured bond agreement with the State of Wyoming
("Wyoming") in 1994, Energy Brothers Holding, Inc., an affiliate of the
Company's Chairman; and the Company's Chairman, Theodore Venners, executed a
promissory note to Wyoming for $819,000, with annual interest at 6%. The Company
agreed in 1994 to indemnify its Chairman and his affiliate for any payments made
under such note, upon his demand, since their obligation stemmed from their
personal guarantee of certain obligations of the Company that were renegotiated
in 1994. During 2000, the Company made related principal and interest payments
on behalf of its Chairman totaling $82,150. In addition, similar payments
totaling $158,587 were made during the six months ended June 30, 2001. The
Company's Chairman and his affiliate have agreed to waive their indemnification
rights for 2001, triggering a 10-day cure period. On June 29, 2001, Wyoming
agreed to forebear from collection activities under this note until August 1,
2001. In connection with the 1994 restructured bond agreement, the Company
entered into an agreement that requires the Company to pay Wyoming 12% of its
domestic license and royalty revenue. The rate decreases to 6% when cumulative
payments under this agreement total $5 million. On July 20, 2001, the Company
made a final payment to Wyoming to satisfy these commitments, see Note 4.

   The Company is contingently liable to Ohio Valley Electric Corporation
("OVEC") for an overriding royalty of 0.5% to OVEC on the gross revenues
generated by the sale of fuel produced from any production plant (other than the
current facility owned by BKH) located in the United States in which the
feedstock is coal and which uses the Company's proprietary Series "C" K-Fuel
technology to produce fuel. The Company is contingently liable to Fort Union for
20% of the Company's North American royalty proceeds. No payments or accruals
have been required through September 30, 2001 under these agreements.

   In 1996, the Company entered into a royalty amendment agreement with Edward
Koppelman, the inventor of the K-Fuel Technology. As a result of the agreement,
Mr. Koppelman's royalty is now 25% of the Company's worldwide royalty and
license fee revenue, computed after a State of Wyoming royalty. The royalty to
Mr. Koppelman will cease when the cumulative payments to him reach the sum of
approximately $75,222,000. Mr. Koppelman is now deceased and his estate holds
all royalty rights. The total amount paid under this agreement through September
30, 2001 was $250,000.

   Pegasus is contingently liable to certain of its founding stockholders for a
royalty equivalent to 2% of the license fee revenues derived from the sale of
its NeuSIGHT product through November 30, 2004. This obligation is limited to
the extent of pretax income without regard to such royalty, subject to a maximum
of $2.5 million and subject to certain other limitations. Pegasus has made no
payments or accruals through September 30, 2001 under this agreement.

                                       14
NOTE 11.   RECENT ACCOUNTING PRONOUNCEMENTS

   In July 2001, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standard No. 141, "Business Combinations"
("FAS 141"). FAS 141 requires that all purchase business combinations must be
accounted for using the purchase method. Under this method, the purchase price
of an acquired business is allocated to the individual tangible and intangible
assets acquired and liabilities assumed based on the estimated fair values at
the date of acquisition. If the purchase price exceeds the amounts assigned to
assets acquired and liabilities assumed, the excess is recognized as goodwill.
Acquired intangible assets that do not meet certain criteria for recognition
apart from goodwill are included in the amount initially recognized as goodwill.
After initial recognition, goodwill and intangible assets acquired in the
business combination must be accounted for under FAS 142. FAS 141 is effective
for the Company for all business combinations initiated after June 30, 2001,
including the acquisition of certain assets and liabilities of Pavilion, see
Note 9.

   In July 2001, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standard No. 142, "Goodwill and Other
Intangible Assets" ("FAS 142"). FAS 142 requires that after a company allocates
the purchase price in accordance with FAS 141, the assets acquired, liabilities
assumed and goodwill must be assigned to one or more reporting units based on
certain criteria outlined in FAS 142. In addition, goodwill will no longer be
amortized. Companies must perform transitional, annual, and, in certain
situations, interim impairment testing of their recorded goodwill, as well as of
their indefinite-lived intangible assets. Indefinite-lived intangible assets
would be tested for impairment by comparing the fair value of the intangible
asset with its carrying amount. FAS 142 is effective for the Company for any
goodwill acquired in a business combination entered into after June 30, 2001,
including the acquisition of certain assets of Pavilion, see Note 9. The
remaining provisions of the Statement are effective beginning in the first
quarter of 2002.

On October 3, 2001, the FASB issued Statement of Accounting Standards No. 144
"Accounting for the Impairment or Disposal of Long-Lived Assets" ("FAS 144").
FAS 144 supercedes FAS 121 "Accounting for the Impairment of Long-Lived Assets
and for Long-Lived Assets to Be Disposed Of." FAS 144 applies to all long-lived
assets (including discontinued operations) and consequently amends Accounting
Principles Board Opinion No. 30 (APB 30), Reporting Results of Operations -
Reporting the Effects of Disposal of a Division of a Business. FAS 144 develops
one accounting model for long-lived assets that are to be disposed of by sale.
FAS 144 requires that long-lived assets that are to be disposed of by sale be
measured at the lower of book value or fair value less cost to sell.
Additionally, FAS 144 expands the scope of discontinued operations to include
all components of an entity with operations that (1) can be distinguished from
the rest of the entity and (2) will be eliminated from the ongoing operations of
the entity in a disposal transaction. FAS 144 is effective for Pavilion's
financial statements issued in fiscal 2003.

NOTE 12.   SUBSEQUENT EVENTS

   On November 6, 2001, Kennecott invested an additional $250,000 in Pegasus
Preferred Stock under the agreement described in Note 2. Pegasus will use the
investment for enhancements to NeuSIGHT, new product development and the
completion of other tasks designed to improve the performance of Pegasus.

                                       15
KFX INC.

                 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
                  FINANCIAL CONDITION AND RESULTS OF OPERATIONS

   This quarterly report includes forward-looking statements. We have based
these forward-looking statements on our current expectations and projections
about future events based on our knowledge of facts as of the date of this
quarterly report and our assumptions about future events. These forward-looking
statements are subject to various risks and uncertainties that may be outside of
our control, including, but not limited to:

      o  the ability of the Company to continue to as a going concern;
      o  adverse market and various other conditions that could impair the
         Company's ability to obtain needed financing;
      o  actions or the inaction of the Company's strategic partners;
      o  the breadth or degree of protection available to the Company's
         intellectual property;
      o  availability of key management and skilled personnel;
      o  competition and technological developments by competitors;
      o  lack of market interest in the Company's existing products and any new
         products or services;
      o  changes in environmental, electric utility and other governmental
         regulations;
      o  unanticipated problems that could arise in research and development
         activities;
      o  cost overruns, delays and other problems that may occur in developing,
         permitting, financing or constructing K-Fuel production facilities;
      o  the availability of Section 29 or similar tax credits related to any
         future K-Fuel production facilities; and
      o  domestic and international economic and political developments.

   We use words like "believe," "expect," "anticipate," "will," "estimate,"
"project," "plan," and similar expressions to help identify forward-looking
statements in this annual report.

   For additional factors that could affect the validity of our forward-looking
statements, you should read "Risk Factors" contained in Part I, Item 1 of our
annual report on Form 10-K for the year ended December 31, 2000, "Management's
Discussion and Analysis of Financial Condition and Results of Operations"
contained in Part II, Item 7 of our Annual Report on Form 10-K for the year
ended December 31, 2000 and "Notes to Consolidated Financial Statements"
contained in Part II, Item 8 of our annual report on Form 10-K for the year
ended December 31, 2000. The forward-looking statements included in this
quarterly report are subject to additional risks and uncertainties not disclosed
in this quarterly report, some of which are not known or capable of being known
by the Company. The information contained in this quarterly report is subject to
change without notice. Readers should review future reports that we file with
the Securities and Exchange Commission. In light of these and other risks,
uncertainties and assumptions, actual events or results may be very different
from those expressed or implied in the forward-looking statements in this
quarterly report or may not occur. We have no obligation to publicly update or
revise any forward-looking statement, whether as a result of new information,
future events or otherwise.

   The financial statements have been prepared on a going concern basis, which
contemplates the realization of assets and the satisfaction of liabilities in
the normal course of business. The Company has incurred net losses of
approximately $12,290,000, $12,730,000 and $6,784,000 and negative cash flow
from operations of $5,151,000, $3,458,000 and $4,642,000 in the years ended
December 31, 2000, 1999 and 1998, respectively, and an additional net loss of
$9,513,750 and negative cash flow from operations of $5,142,177 in the nine
months ended September 30, 2001 and had an accumulated deficit of approximately
$80,605,054 as of September 30, 2001. These factors, coupled with the need for
additional financing to fund planned growth in the business, raise substantial
doubt about whether the Company can continue as a going concern. The Report of
Independent Accountants dated April 13, 2001 covering the Company's consolidated
financial statements for the year ended December 31, 2000 included an
explanatory paragraph discussing this going concern uncertainty.

   In order to mitigate this uncertainty, the Company intends to seek further
capital through various means which may include the sale of all or a portion of
its interest in Pegasus, additional sales of debt or equity securities, a

                                       16
business combination or other means and to further reduce expenditures as
necessary. Should the Company not be successful in achieving one or more of
these actions, it is possible that the Company may not be able to continue as a
going concern. The consolidated financial statements do not include any
adjustments that might result from the outcome of this uncertainty.

OVERVIEW

   During the past several months, the Company has been able to establish a
platform to develop and implement a strategic plan to begin to realize the
potential growth of its two energy technology bases.

   A 16-month project of its K-Fuel LLC joint venture with Kennecott Energy
culminated in the demonstration of an improved design for a K-Fuel plant that
was announced in February 2001. K-Fuel LLC is conducting studies concerning
appropriate means to further test the new process and design facilities for
production. In April 2001, Pegasus and Pavilion entered into an agreement to
dismiss the litigation pending between the two companies, without prejudice, in
order to explore possible business combinations.

   On May 9, 2001, KFx retained Raymond James & Associates to assist in all
aspects of strategic and financial planning to take advantage of the rapidly
growing energy market opportunities and determine an optimal course of action
for KFx's shareholders. In addition, it is management's belief there is a far
better understanding in Washington, D.C. today of the importance of coal-fired
power to meet the nation's energy needs, which it believes will facilitate the
Company's development and implementation of a strategic plan to capitalize on
the growth potential of its technologies.

   In May 2001, Cinergy Corp. ("Cinergy"), a Cincinnati, Ohio based energy
company, selected Pegasus to install its NeuSIGHT optimization software on a
system-wide basis. Phase 1 of the Cinergy contract calls for performance-based
incentives measured by actual NOx reductions and is expected to generate
approximately $5-8 million in revenues through May 2004, including potential
revenues from performance provisions in the contract of up to approximately $3
million. On July 25, 2001, Cinergy advanced $3.5 million to Pegasus against the
existing contract between Pegasus and Cinergy. The advance bears interest at 7%
per annum, payable monthly. Cinergy may elect to apply future Pegasus invoices
against the advance or may choose to convert the balance of the advance into KFx
common stock, at a price of $3.65 per share, or Pegasus common stock, at a price
of $2.10 per share, subject to certain adjustments. The note is also putable by
Cinergy upon (i) a change in control of KFx or Pegasus, (ii) the sale of
substantially all of Pegasus' or KFx's assets, (iii) the completion of third
party financing for Pegasus of $12.5 million or for Pegasus and KFx combined of
$30 million, or (iv) termination for cause as set forth in the original
contract. Cinergy also received a warrant, expiring three years after the date
of issue, exercisable for 200,000 shares of KFx common stock, at $3.65 per
share, subject to certain adjustments.

   In July 2001, the Company issued 1 million shares of common stock at a price
of $3.65 per share and a warrant, expiring three years after the date of issue,
exercisable for 500,000 of KFx common stock, at a price of $3.65 per share,
subject to certain adjustments, to an institutional investor, resulting in
proceeds to the Company of $3.65 million.

   Pursuant to an Asset Purchase and License Agreement (the "Purchase
Agreement") between Pavilion, Pegasus Technologies, Inc. ("Pegasus"), a
subsidiary of KFx Inc. ("KFx"), and KFx, dated as of July 31, 2001, certain
assets and liabilities relating to the Power Optimization Division were acquired
by Pegasus. These purchased assets and acquired liabilities were primarily
accounts receivable, unbilled revenue, deposits, customer list, exclusive rights
to license Pavilion's software, other intangibles and deferred revenue. Pavilion
has retained certain liabilities of the Power Optimization Division, including
but not limited to Pavilion indemnifying Pegasus regarding the intellectual
property of Pavilion's software being licensed. The Purchase Agreement provided
for a base price of $9,500,000 in cash, payable to Pavilion in installments
through July 31, 2003, which is adjusted for the net of assets and liabilities
assumed. Additionally, Pegasus shall pay Pavilion royalties of up to $5,500,000
between August 1, 2001 and October 31, 2005, based on Pavilion and Pegasus
software licenses sold by Pegasus. KFx guarantees the duties and obligations of
Pegasus under the Purchase Agreement.

   As disclosed in Note 8 to the Consolidated Financial Statements, the second
quarter of 2000 includes a $1,000,000 non cash, non operational cumulative
charge to correct the previously unrecorded accretion of the 12% premium on its
6% Convertible Debentures. This maturity premium will only be paid if the
Debentures are not converted prior to their maturity in July 2002.

                                       17
Pegasus' firm backlog of software license and installation contracts as of
September 30, 2001 was approximately $8,734,000, compared to approximately
$1,771,000 at September 30, 2000, an increase of 393%.

RESULTS OF OPERATIONS-THREE MONTHS ENDED SEPTEMBER 30, 2001 VS. THREE MONTHS
ENDED SEPTEMBER 30, 2000

   Consolidated revenues in the third quarter of 2001 increased as compared to
the third quarter of 2000 by $601,734 (119%) due to a $129,417 decline in K-Fuel
contract revenues in 2001 offset by an increase of $731,151 (195%) in Pegasus
revenues. The decrease in K-Fuel contract revenues is a result of the suspension
of certain contract activities in 2001. The increase in Pegasus revenues
resulted from a significant increase in projects due to the receipt of the
Cinergy order noted above, an increase in installation hours spent on the
projects that generate revenue, recognition of a one-time exclusivity fee for
the China market of $300,000, for which Pegasus incurred no costs. Due to the
recent increase in the Pegasus backlog, mainly due to the Cinergy order and the
Pavilion acquisition, we expect the trend of increasing revenue to continue in
future quarters.

   Consolidated operating costs and expenses in the third quarter of 2001
increased as compared to the third quarter of 2000 by $890,178 (32%) due
primarily to the net effect of (a) an increase of $83,499 (18%) in Pegasus' cost
of software licenses and services triggered by the corresponding revenue
increase, (b) an increase in marketing, general and administrative expense of
$844,763 (64%) caused by an increase in professional fees due to the Pavilion
Lawsuit, increased headcount at Pegasus, expense of $762,144 relating to the
final payment for the Chairman's Note to the State of Wyoming and costs relating
to international market expansion offset by headcount reductions at the
corporate level, (c) an increase of $20,749 (11%) in Pegasus' research and
development costs offset by a decrease of $19,613 (19%) in the costs at the
K-Fuel demonstration plant due to the suspension of certain contract activities
and a decrease in depreciation and amortization expense of $39,219 (6%).

   The factors discussed above combined in the third quarter of 2001 to produce
an operating loss of $2,548,399, which was $288,444 more than for the third
quarter of 2000. Pegasus' portion of the operating loss for the third quarter of
2001 was $739,816, which was a significant improvement over the corresponding
$1,051,276 operating loss for the third quarter of 2000 and was mainly due to an
overall improvement in margins on installation projects. The combined K-Fuel
segment and corporate cost portion of the operating loss for the third quarter
of 2001 was $1,808,583 compared to $1,208,679 in 2000 with the increase in
operating loss resulting from expense of $762,144 relating to the final payment
for the Chairman's Note to the State of Wyoming; see Note 4 to the accompanying
financial statements.

   Non-operating items added $1,145,135 of net expense in the third quarter of
2001, compared to $471,930 in the third quarter of 2000, for an increase of
$673,205 (143%), due to an increase in interest expense of $680,824 (149%).
The increase in interest expense is due mainly to an increase in accruals for
the maturity premium, debt discount and beneficial conversion charges related to
the 2001 sales to third parties of Pegasus Preferred Stock held by KFx and KFx's
related obligation to repurchase and debt discount which was recognized as
interest expense for the issuance of warrants for the Company's common stock.

   As a result of the above factors, the consolidated net loss of $3,693,534
($0.14 per share) for the third quarter of 2001 was $961,649 more than the net
loss for the third quarter of 2000. Included in the third quarter net losses
were non-cash charges approximating $1,486,000 and $1,078,000, respectively.

RESULTS OF OPERATIONS-NINE MONTHS ENDED SEPTEMBER 30, 2001 VS. NINE MONTHS ENDED
SEPTEMBER 30, 2000

   Consolidated revenues in the first nine months of 2001 increased as compared
to the first nine months of 2000 by $52,520 (3%) due to a $229,393 decline in
K-Fuel contract revenues in 2001 because of the suspension of certain contract
activities offset by an increase in Pegasus revenues of $281,913 (18%) due to
the increase in order intake during 2001, increased progress on projects during
the most recent quarter and the revenue contributed by Pavilion projects during
the third quarter. Due to the recent increase in the Pegasus backlog, mainly due
to the Cinergy order and acquisition of the Pavilion power segment as noted
above, we expect the trend of increasing revenues to continue in future
quarters.

                                       18
Consolidated operating costs and expenses in the first nine months of 2001
increased as compared to the first nine months of 2000 by $406,462 (5%) due
primarily to the net effect of (a) a $106,028 (8%) decrease in Pegasus' cost of
software licenses and services realized through the completion of problem
projects and efficiencies gained in installations, (b) a decrease of $106,595
(38%) in the costs at the K-Fuel demonstration plant due to the suspension of
certain contract activities during 2001, and (c) a decrease in depreciation
and amortization expense of $84,194 (4%) offset by an increase in marketing,
general and administrative expense of $595,507 (16%) and an increase of $107,773
(24%) in Pegasus' research and development costs. The increase in marketing,
general and administrative expense is due mainly to expense of $762,144 relating
to the final payment for the Chairman's Note to the State of Wyoming (see Note 4
to the accompanying financial statements) offset by headcount reductions at the
corporate level. The increase in Pegasus research and development costs was due
to an increase in headcount.

   The factors discussed above combined in the first nine months of 2001 to
produce an operating loss of $6,439,472, which was $353,942 less than for the
first nine months of 2000. Pegasus' portion of the operating loss for the first
nine months of 2001 was $2,511,407, which was an improvement of $284,788 (10%)
compared to the corresponding $2,796,195 operating loss for the first nine
months of 2000. The improvement in the Pegasus operating loss was due mainly to
the realization of the effect of headcount reductions that occurred in late
2000. The combined K-Fuel segment and corporate cost portion of the operating
loss for the first nine months of 2001 was $3,928,065 compared to $3,289,335 in
2000.

   Non-operating items added $3,074,278 of net expense in the first nine months
of 2001, compared to $2,018,625 in the first nine months of 2000, for an
increase of $1,055,653 (52%), due to an increase in interest expense of
$1,020,422 (51%). The increase in interest expense is due mainly to in accretion
for the maturity premium, debt discount and beneficial conversion charges
related to 2001 sales to third parties of Pegasus Preferred Stock held by KFx
and KFx's related obligation to repurchase, debt discount which was recognized
as interest expense on the issuance date of warrants for KFx and Pegasus common
stock, and an increase in interest on outstanding debt, offset by a decrease of
$828,898 (76%) in the accrual for the maturity premium on the Convertible
Debentures (accretion was $1 million for the first half of 2000).

   As a result of the above factors, the consolidated net loss of $9,513,750
($0.37 per share) for the first nine months of 2001 was $1,409,595 ($0.04 per
share) greater than the net loss for the first nine months of 2000. Included in
the year to date net losses were non-cash charges approximating $4,445,000 and
$3,500,000, respectively.

LIQUIDITY AND CAPITAL RESOURCES

   During the first nine months of 2001, the Company used $5,142,177 of cash for
its operating activities, compared to $4,323,110 in the first nine months of
2000, an increase of $819,067. Included in the 2001 amount is $1,260,151 of
interest payments ($348,772 by Pegasus and $911,379 by KFx), $1,385,547 for
other Pegasus operations and $2,496,479 for the K-Fuel segment and other KFx
corporate activities. Included in the 2000 amount is $1,148,000 of KFx interest
payments, $1,731,314 for Pegasus' operations, $13,237 of cash used by the K-Fuel
segment's demonstration plant and laboratory and $1,430,559 for KFx's corporate
activities.

   Sources of cash during the first nine months of 2001 included the following:

     o   In July 2001, the Company issued 1 million shares of common stock at a
         price of $3.65 per share and a warrant, expiring three years after the
         date of issue, exercisable for 500,000 shares of KFx common stock, at a
         price of $3.65 per share, subject to certain adjustments, to an
         institutional investor, resulting in net proceeds, after financing
         costs, to the Company of $3.5 million.
     o   In July 2001, Cinergy advanced $3.5 million to Pegasus against the
         existing contract between Pegasus and Cinergy. The advance bears
         interest at 7% per annum, payable monthly. Cinergy may elect to apply
         future Pegasus invoices against the advance or may choose to convert
         the balance of the advance into KFx common stock, at a price of $3.65
         per share, or Pegasus common stock, at a price of $2.10 per share,
         subject to certain adjustments. The note is also putable by Cinergy
         upon (i) a change in control of KFx or Pegasus, (ii) the sale of
         substantially all of Pegasus' or KFx's assets, (iii) the completion of
         third party financing for Pegasus of $12.5 million or for Pegasus and
         KFx combined of $30 million, or (iv) termination for cause as set forth
         in the original contract. Cinergy also received a warrant, expiring
         three years after the date of issue, exercisable for 200,000 shares of
         KFx common stock, at $3.65 per share, subject to certain adjustments.
     o   $1,972,331 in proceeds from the sale of Pegasus preferred stock held by
         KFx, which the Company is

                                       19
required to repurchase during the first half of 2002, subject to
         certain provisions that could accelerate or defer the required
         repurchase date. Due to KFx's repurchase obligation, these sales are
         accounted for as debt; see Note 2 to the Consolidated Financial
         Statements.
     o   Pegasus issued $750,000 of Pegasus preferred stock to Kennecott Energy
         during the first nine months of 2001.
     o   Pegasus received a $300,000 short-term loan from a director of the
         Company, which bears interest.

Cash raised during the first nine months of 2001 was used for funding of current
operations, repayment of portions of notes payable and installment payments
totaling approximately $2 million for the acquisition of the Pavilion power
optimization segment.

   Pursuant to an Asset Purchase and License Agreement (the "Purchase
Agreement") between Pavilion, Pegasus Technologies, Inc. ("Pegasus"), a
subsidiary of KFx Inc. ("KFx"), and KFx, dated July 31, 2001, certain assets and
liabilities relating to the Power Optimization Division were acquired by
Pegasus. These purchased assets and acquired liabilities were primarily accounts
receivable, unbilled revenue, deposits, customer list, exclusive rights to
license Pavilion's software, other intangibles and deferred revenue. Pavilion
has retained certain liabilities of the Power Optimization Division, including
but not limited to Pavilion indemnifying Pegasus regarding the intellectual
property of Pavilion's software being licensed. The Purchase Agreement provided
for a base price of $9,500,000 in cash, payable to Pavilion in installments
through July 31, 2003, which is adjusted for the net of assets and liabilities
assumed. Additionally, Pegasus shall pay Pavilion royalties of up to $5,500,000
between August 1, 2001 and October 31, 2005, based on Pavilion and Pegasus
software licenses sold by Pegasus. Through September 30, 2001, Pegasus made
payments to Pavilion totaling $1,947,740. KFx guarantees the duties and
obligations of Pegasus under the Purchase Agreement. See note 9 to the
accompanying financial statements.

   The Company engaged Raymond James & Associates, an investment banking firm,
to assist in all aspects of strategic and financial planning. This step was
taken as a part of the Company's ongoing efforts to restructure its balance
sheet in an optimal manner for the benefit of its shareholders and in view of
the rapidly growing energy market opportunities. The Company had begun a similar
effort initially focused on Pegasus in mid 2000, but the Pavilion Lawsuit, which
was filed in the third quarter of 2000, precluded many of the options that were
under consideration at that time. Prior to the filing of the Pavilion Lawsuit
and subsequent to the purchase of the Pavilion power optimization segment, which
effectively resolved the Pavilion Lawsuit, the Company has received strong
interest from numerous industry sources to participate in the acceleration and
development of its products.

   The Company is continuing to work toward its goal of licensing a large
commercial K-Fuel plant. Upon granting a license to construct a commercial scale
K-Fuel production facility, KFx expects to generate significant K-Fuel license
fees and net cash flows.

   From time to time, directors of the Company have provided to the Company
short term unsecured financing and the Company expects that such financing, on
at least a short-term basis, will continue to be available if needed.

   The Company expects its cash requirements over the next fiscal year with
respect to day-to-day operations and debt service requirements to be satisfied
by (a) cash on hand, which as of November 10, 2001 approximated $1.4 million;
(b) potential additional investments in Pegasus and/or KFx from interested
participants in the power generation industry; (c) potential debt and/or equity
offerings of the Company; (d) potential fees from licensing new K-Fuel
facilities; (e) potential partners in connection with opportunities to expand
the Company's product and service offerings to the power industry; and (f)
unsecured short term borrowings for the Company and/or Pegasus from one or more
of its directors and/or other parties.

   Depending on the outcome of various uncertainties, including those discussed
herein, the Company may be required to seek additional debt and/or equity
financing for general operating purposes and/or to meet debt service
requirements. The timing of collection of accounts receivable and payment of
accounts payable could significantly alter the Company's need for at least
temporary financing. Should the Company be required to seek any additional debt
and/or equity financing, its ability to do so will be affected by the terms of
the Debentures, which contain a number of restrictions including (a) limitations
on the Company's ability to incur secured and unsecured debt, (b) limitations on
the Company's ability to sell assets or enter into merger agreements, and (c)
provisions that would reduce the Debenture conversion price from $3.65 per share
if the Company sells KFx common stock at a price below $3.65 per share. In
addition, included in the agreements among KFx and the other shareholders of
Pegasus are provisions governing the terms of investments from any new investors
in Pegasus, limiting the borrowings of Pegasus, and limiting the payment of
dividends by Pegasus. See also Note 1 of the Consolidated Financial Statements.

                                      20
There are no assurances that any of these potential funding sources will
materialize, and the Company does not currently have any commitments with
respect to any such funding sources. If the overall outcome of the various
uncertainties affecting the Company is not favorable, the Company may be forced
to seek debt and/or equity financing on terms and conditions that may be
unfavorable to the Company, if available at all. If the Company requires
additional financing and cannot obtain it when needed, the Company may default
on payments when due. Should the Company not be successful in achieving one or
more of the financing alternatives discussed above, the Company may not be able
to continue as a going concern

RECENT ACCOUNTING PRONOUNCEMENTS

   In July 2001, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standard No. 141, "Business Combinations"
("FAS 141"). FAS 141 requires that all purchase business combinations must be
accounted for using the purchase method. Under this method, the purchase price
of an acquired business is allocated to the individual tangible and intangible
assets acquired and liabilities assumed based on the estimated fair values at
the date of acquisition. If the purchase price exceeds the amounts assigned to
assets acquired and liabilities assumed, the excess is recognized as goodwill.
Acquired intangible assets that do not meet certain criteria for recognition
apart from goodwill are included in the amount initially recognized as goodwill.
After initial recognition, goodwill and intangible assets acquired in the
business combination must be accounted for under FAS 142. FAS 141 is effective
for the Company for all business combinations initiated after June 30, 2001,
including the acquisition of certain assets and liabilities of Pavilion, see
Note 9.

   In July 2001, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standard No. 142, "Goodwill and Other
Intangible Assets" ("FAS 142"). FAS 142 requires that after a company allocates
the purchase price in accordance with FAS 141, the assets acquired, liabilities
assumed and goodwill must be assigned to one or more reporting units based on
certain criteria outlined in FAS 142. In addition, goodwill will no longer be
amortized. Companies must perform transitional, annual, and, in certain
situations, interim impairment testing of their recorded goodwill, as well as of
their indefinite-lived intangible assets. Indefinite-lived intangible assets
would be tested for impairment by comparing the fair value of the intangible
asset with its carrying amount. FAS 142 is effective for the Company for any
goodwill acquired in a business combination entered into after June 30, 2001,
including the acquisition of certain assets of Pavilion, see Note 9. The
remaining provisions of the Statement are effective beginning in the first
quarter of 2002.

   On October 3, 2001, the FASB issued Statement of Accounting Standards No. 144
"Accounting for the Impairment or Disposal of Long-Lived Assets" ("FAS 144").
FAS 144 supercedes FAS 121 "Accounting for the Impairment of Long-Lived Assets
and for Long-Lived Assets to Be Disposed Of." FAS 144 applies to all long-lived
assets (including discontinued operations) and consequently amends Accounting
Principles Board Opinion No. 30 (APB 30), Reporting Results of Operations -
Reporting the Effects of Disposal of a Division of a Business. FAS 144 develops
one accounting model for long-lived assets that are to be disposed of by sale.
FAS 144 requires that long-lived assets that are to be disposed of by sale be
measured at the lower of book value or fair value less cost to sell.
Additionally, FAS 144 expands the scope of discontinued operations to include
all components of an entity with operations that (1) can be distinguished from
the rest of the entity and (2) will be eliminated from the ongoing operations of
the entity in a disposal transaction. FAS 144 is effective for Pavilion's
financial statements issued in fiscal 2003.

                      ITEM 3. QUANTITATIVE AND QUALITATIVE
                          DISCLOSURES ABOUT MARKET RISK

   The Company is not currently subject to a significant level of direct market
risk related to interest rates, foreign currency exchange rates, commodity
prices or equity prices. The Company has no derivative instruments and only
$450,000 of floating rate debt and does not expect to derive a material amount
of its revenues or income from interest bearing securities. Currently the
Company has no significant foreign operations. To the extent that the Company
establishes significant foreign operations in the future, it will attempt to
mitigate risks associated with foreign currency exchange rates contractually and
through the use of hedging activities and other means considered appropriate.
The Company is indirectly exposed to fluctuations in fuel commodity prices. To
the extent that fuel prices rise, there may be a tendency for greater demand for
certain of the Company's products and services, since

                                       21
K-Fuel and NeuSIGHT have been shown to result in lower usage of coal and coal
beneficiated fuel products when used to generate electric power. The Company's
fuel-related products provide various environmental benefits that management
believes significantly mitigate the fuel commodity risk associated with the
Company's business. The Company holds no equity market securities, but does face
equity market risk relative to its own equity securities.

                                       22
PART II - OTHER INFORMATION
                            ITEM 1. LEGAL PROCEEDINGS

   On September 8, 2000, Pavilion Technologies, Inc. ("Pavilion"), a competitor
of Pegasus, served Pegasus with a complaint that it had filed on August 14,
2000, in the United States District Court for the Southern District of Texas
asserting that Pegasus infringed 26 patents allegedly issued to or licensed by
Pavilion (the "Pavilion Lawsuit"). The Pavilion Lawsuit was subsequently
transferred to the United States District Court for the Northern District of
Ohio. The Pavilion Lawsuit sought injunctive relief, compensatory and treble
damages, as well as attorney's fees, costs and expenses. Pegasus' products
employ its own proprietary computer code as well as computer code exclusively
licensed to Pegasus. On September 15, 2000, the licensor agreed to defend
Pegasus in the Pavilion Lawsuit pursuant to an indemnification provision of the
parties' license agreement. On October 27, 2000, Pegasus filed an answer to the
Pavilion Lawsuit denying the patent infringement claims ("Pegasus Answer"). The
Pegasus Answer also asserted various counterclaims against Pavilion alleging
unfair competition, deceptive trade practices, defamation, tortuous interference
with business relationships and attempted monopolization in violation of Section
2 of the Sherman Antitrust Act ("Pegasus Counterclaims"). After consultation
with counsel, KFx and Pegasus management believed that the infringement
allegations in the Pavilion Lawsuit were objectively baseless and without merit.
On April 11, 2001, Pegasus and Pavilion agreed to dismiss the Pavilion Lawsuit,
the Pegasus Answer and the Pegasus Counterclaims, without prejudice, in order to
explore possible business combinations, cooperative relationships and other
alternatives. Pursuant to an Asset Purchase and License Agreement (the "Purchase
Agreement") between Pavilion, Pegasus Technologies, Inc. ("Pegasus"), a
subsidiary of KFx Inc. ("KFx"), and KFx, dated July 31, 2001, certain assets and
liabilities relating to the Power Optimization Division were acquired by
Pegasus. These purchased assets and acquired liabilities were primarily accounts
receivable, unbilled revenue, deposits, customer list, exclusive rights to
license Pavilion's software, other intangibles and deferred revenue. Pavilion
has retained certain liabilities of the Power Optimization Division, including
but not limited to Pavilion indemnifying Pegasus regarding the intellectual
property of Pavilion's software being licensed. The Purchase Agreement provided
for a base price of $9,500,000 in cash, payable to Pavilion in installments
through July 31, 2003, which is adjusted for the net of assets and liabilities
assumed. Additionally, Pegasus shall pay Pavilion royalties of up to $5,500,000
between August 1, 2001 and October 31, 2005, based on Pavilion and Pegasus
software licenses sold by Pegasus. Through September 30, 2001, Pegasus made
payments to Pavilion totaling $1,947,740. KFx guarantees the duties and
obligations of Pegasus under the Purchase Agreement. See note 9 to the
accompanying financial statements.

   On November 4, 1999, Link Resources, Inc., a Georgia corporation, ("Link")
and its two shareholders, Linda E. Kobel ("Kobel") and Gary A. Sanden
("Sanden"), filed a complaint against the Company in US District Court for the
District of Colorado. The complaint alleges that KFX, Link, Kobel and Sanden had
entered into an agreement requiring KFX to acquire Link and that KFX breached
such agreement. The complaint seeks damages in excess of $5.3 million. Although
this matter is still in discovery and its ultimate resolution cannot be
predicted with certainty, based on a preliminary review of the underlying facts
and discussion with counsel, management believes that this complaint is without
merit. KFX intends to contest this complaint vigorously. Accordingly, management
does not believe that this matter will have a material impact on the results of
operation, financial position or cash flows of the Company.

                                       23
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

   During the three months ended September 30, 2001, KFx issued the following
securities in private transactions pursuant to an exemption from the
registration requirements of the Securities Act of 1933, as amended ("Securities
Act") under Section 4(2) of the Securities Act:
Number
Purchaser / Recipient                           Terms of Exercise,                               Sold or            Consideration
    of Securities            Date                if Convertible             Title of Security    Granted               Received
    -------------            ----                --------------             -----------------    -------               --------
Venners & Company,      July 2001                    N/A                    Common Stock         20,000      Professional services
         Ltd.                                                                                                    valued at $73,000

   Bayou Fund, LLC      July 16, 2001    Exercisable at $3.65 per share,        Warrants          500,000           $3,650,000 1
                                         subject to certain adjustments.     exercisable for
                                          Expires three years after the       Common Stock
                                                  date of issue

Cinergy Services, Inc   July 25, 2001    Exercisable at $3.65 per share,         Warrant          200,000           $3,500,000 2
                                         subject to certain adjustments.     exercisable for
                                          Expires three years after the       Common Stock
                                                  date of issue

     H.M.R., L.P.       July 28, 2001    Exercisable at $3.65 per share,         Warrant          100,000      Professional services
                                         subject to certain adjustments.     exercisable for                     valued at $365,000
                                          Expires three years after the       Common Stock
                                                  date of issue
/1/ This sum includes payment for 1,000,000 shares of common stock of KFx Inc.
/2/ This sum includes an advance to Pegasus Technologies, Inc. against the
    existing contract between Pegasus and Cinergy. Cinergy may elect to apply
    future Pegasus invoices against the advance or may choose to convert the
    balance of the advance into KFx common stock, at a price of $3.65 per share,
    or Pegasus common stock, at a price of $2.10 per share, subject to certain
    adjustments.

                                       24
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(A) EXHIBITS

 EXHIBIT
 NUMBER      DESCRIPTION
 ------      -----------
 4.1         Warrant to Purchase 250,000 Shares of KFx Inc. Common Stock issued
             to Bayou Fund, LLC dated July 16, 2001
 4.2         Warrant to Purchase 250,000 Shares of KFx Inc. Common Stock issued
             to Bayou Fund, LLC dated July 16, 2001
 4.3         Warrant to Purchase 200,000 Shares of KFx Inc. Common Stock issued
             to Cinergy Services, Inc. dated July 24, 2001
 4.4         Warrant to Purchase 100,000 Shares of KFx Inc. Common Stock issued
             to H.M.R., L.P. dated July 28, 2001
 10.1        Common Stock and Warrant Purchase Agreement between the Company and
             Bayou Fund, LLC dated July 16, 2001
 10.2        Registration Rights Agreement Between the Company and Bayou Fund,
             LLC dated July 16, 2001
 10.3        Addendum to Blanket Contract, No. 142072, dated May 1, 2001,
             Project -- Cinergy NOx Compliance Plan, Addendum dated July 24,
             2001
 10.4 *      Asset Purchase and License Agreement, dated as of July 31, 2001, by
             and among Pavilion Technologies, Inc., Pegasus Technologies, Inc.
             and KFx Inc.
 10.5 *      Assignment and Assumption Agreement, dated as of July 31, 2001, by
             and among Pavilion Technologies, Inc. and Pegasus Technologies,
             Inc.
 10.6 *      Guaranty Agreement, dated July 31, 2001, by KFx Inc.
           * Document previously filed with the U.S. Securities and Exchange
             Commission with the Company's Current Report on Form 8-K dated
             August 15, 2001 and incorporated herein by reference.

(B) REPORTS ON FORM 8-K

   During the quarter ended September 30, 2001, the Company filed Current
Reports on Form 8-K dated July 2, 2001, under Item 5, Other Events, and dated
August 15, 2001 (as amended on Form 8-K/A filed on October 15, 2001), under Item
2, Acquisition or Disposition of Assets.

                                       25
SIGNATURES

   Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.

                                    KFX INC.

                                    /s/ PATRICK S. FLAHERTY
                                    --------------------------------------------
                                    PATRICK S. FLAHERTY
                                    VICE PRESIDENT & CHIEF FINANCIAL OFFICER
                                    (PRINCIPAL FINANCIAL AND ACCOUNTING OFFICER)

                                    DATE: NOVEMBER 14, 2001

                                       26