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

 

Form 10-K

 

 

Commission File Number: 001-32576

 

 

 

 

ITC HOLDINGS CORP.

(Exact Name of Registrant as Specified in Its Charter)

 

39500 Orchard Hill Place, Suite 200

Novi, Michigan 48375

(Address Of Principal Executive Offices, Including Zip Code)

(248) 374-7100

(Registrant’s Telephone Number, Including Area Code)

Securities registered pursuant to Section 12(b) of the Act:

 

Securities registered pursuant to Section 12(g) of the Act:

None

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act of 1933.  Yes þ     No  o

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Securities Exchange Act of 1934.  Yes o     No þ

 

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 (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information, statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o     Accelerated Filer þ     Non-accelerated filer o

 

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

The aggregate market value of the registrant’s common stock held by non-affiliates on June 30, 2006 was approximately $400.4 million, based on the closing sale price as reported on the New York Stock Exchange. For purposes of this computation, all executive officers, directors and 10% beneficial owners of the registrant are assumed to be affiliates. Such determination should not be deemed an admission that such officers, directors and beneficial owners are, in fact, affiliates of the registrant.

 

The number of shares of the Registrant’s Common Stock, without par value, outstanding as of March 1, 2007 was 42,382,893.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the Registrant’s definitive Proxy Statement for the Registrant’s 2007 Annual Meeting of Shareholders (the “Proxy Statement”) filed pursuant to Regulation 14A are incorporated by reference in Part III of this Form 10-K.

 

 

ITC Holdings Corp.

 

Form 10-K for the Fiscal Year Ended December 31, 2006

 

INDEX

 

DEFINITIONS

 

Unless otherwise noted or the context requires, all references in this report to:

 

ITEM 1.  BUSINESS.

 

Overview

 

In 2002, ITC Holdings was incorporated in the State of Michigan for the purpose of acquiring ITCTransmission. Our business consists primarily of the operations of ITCTransmission and METC, our regulated operating subsidiaries, which were acquired in 2003 and 2006, respectively. ITCTransmission was originally formed as a subsidiary of The Detroit Edison Company (“Detroit Edison”), an electric utility subsidiary of DTE Energy Company (“DTE Energy”) in 2001. METC was originally formed as a subsidiary of Consumers Energy Company (“Consumers Energy”), an electric and gas utility subsidiary of CMS Energy Corporation (“CMS Energy”) in 2001.

 

Through our regulated operating subsidiaries, ITCTransmission and METC, we are engaged in the transmission of electricity in the United States. Our business strategy is to operate, maintain and invest in our transmission infrastructure in order to enhance system integrity and reliability and to reduce transmission constraints. By pursuing this strategy, we seek to reduce the overall cost of delivered energy for end-use consumers by providing them with access to electricity from the lowest cost electricity generation sources. ITCTransmission and METC operate contiguous, high-voltage systems that transmit electricity to local electricity distribution facilities from generating stations throughout Michigan and surrounding areas. The local distribution facilities connected to our systems serve an area comprising substantially all of the lower peninsula of Michigan, which had an estimated population of 9.8 million people at December 31, 2006.

 

As transmission utilities with rates regulated by the FERC, ITCTransmission and METC earn revenues through tariff rates charged for the use of their electricity transmission systems by our customers, which include investor-owned utilities, municipalities, co-operatives, power marketers and alternative energy suppliers. As independent transmission companies, ITCTransmission and METC are subject to rate regulation only by the FERC. The rates charged by ITCTransmission and METC are established using a formulaic cost-of-service model, referred to as “Attachment O” and re-calculated annually, allowing for the recovery of actual expenses and income taxes and a return of and on invested capital.

 

Development of Business

 

In July 2006, ITC Holdings formed two new subsidiaries — ITC Grid Development and ITC Great Plains. As an extension of our existing strategy, ITC Grid Development was formed to focus on bringing improvements to the U.S. electricity transmission infrastructure by partnering with entities in regions where we believe significant investment is needed to improve reliability and address local energy needs. ITC Great Plains, which has opened an office in Topeka, Kansas, was formed to focus on opportunities for transmission investment in Kansas and the Great Plains region. In Kansas, and in other states or regions where we may engage in operations through our two new subsidiaries, we expect to partner with local experts, such as firms that specialize in design and engineering, and other entities in order to achieve our objectives of enhancing the U.S. transmission grid and providing the framework for lower electric energy costs. These subsidiaries are working to identify and are expected to eventually undertake projects consisting of upgrades to existing electricity transmission systems as well as the construction of new electricity transmission systems or portions of systems. We expect to pursue only development opportunities that are consistent with ITCTransmission’s and METC’s business model, such as those that are anticipated to result in the creation of a FERC-regulated entity using formula-based rates.

 

On October 10, 2006, ITC Holdings acquired indirect ownership of all the partnership interests in MTH, the sole member of METC (the “METC Acquisition”). The former indirect owners of the MTH partnership interests received $484.4 million in cash and 2,195,045 shares of our common stock valued at $72.5 million. In addition, we assumed approximately $307.7 million of MTH and METC debt and other long term interest bearing obligations. As part of the METC Acquisition, ITC Holdings acquired the

partnership interests of other subsidiaries, including subsidiaries that contributed federal income tax net operating loss carryforwards (“NOLs”).

 

On January 19, 2007, we announced that our newly formed subsidiary, ITC Midwest had signed a definitive agreement to acquire for cash the transmission assets of Interstate Power and Light Company (“IP&L”) in a transaction valued at approximately $750.0 million, excluding expenses.

 

Segments

 

We have a reportable operating segment consisting of our regulated operating subsidiaries, ITCTransmission and METC. Additionally, we have other subsidiaries focused primarily on business development activities and holding companies whose activities include corporate debt and equity financing and general corporate activities. A more detailed discussion of our business segments including financial information about the segments is included in Note 17 to the Consolidated Financial Statements.

 

Operations

 

As transmission-only companies, ITCTransmission and METC function as conduits, moving power from generators to local distribution systems either entirely through its own system or in conjunction with neighboring transmission systems. Third parties then transmit power through these local distribution systems to end-use consumers. The transmission of electricity by ITCTransmission and METC is a central function to the provision of electricity to residential, commercial and industrial end-use consumers. The operations performed by our regulated operating subsidiaries fall into the following categories:

 

 

Currently, Consumers Energy performs some of the engineering, design and construction and all of the maintenance activities and real time operations for METC under a services contract described below. The services provided under the services contract will cease by the end of April 2007, at which time METC will perform all aspects of its operations.

 

Asset Planning

 

Asset Planning uses detailed system models and long-term load forecasts to develop our system expansion capital plans. The expansion plans identify projects that address potential future reliability issues and/or produce economic savings for customers by eliminating constraints.

 

Asset Planning works closely with MISO in the development of our annual system expansion capital plans by performing technical evaluations and detailed studies. As the regional planning authority, MISO reviews regional system improvement projects by its members, including ITCTransmission and METC.

 

Engineering, Design and Construction

 

Our Engineering, Design and Construction group is responsible for design, equipment specifications, maintenance plans and project engineering for capital, operation and maintenance work. We work with outside contractors to perform some of our engineering and design and all of our construction, but retain internal technical experts that have experience with respect to the key elements of the transmission system such as substations, lines, equipment and protective relaying systems. This internal expertise allows us to effectively manage outside contractors.

 

Maintenance

 

We develop and track the preventive maintenance plan to promote a safe and reliable system. By performing preventive maintenance on our assets, we can minimize the need for reactive maintenance, resulting in improved reliability. ITCTransmission contracts with Utility Lines Construction, which is a division of Asplundh Tree Expert Co., to perform the bulk of its maintenance. The agreements provide us with access to an experienced and scalable workforce with knowledge of our system at an established rate until June 30, 2007. The agreement continues until August 29, 2008 and renews on continuous five year terms until terminated by either party. We are in the process of negotiating an amendment to the maintenance agreements to apply the terms of those agreements to all utility affiliates of ITCTransmission.

 

Real Time Operations

 

Joint Control Area Operator.  Under the functional control of MISO, ITCTransmission and METC operate their electricity transmission systems as a combined control area under the Michigan Electric Coordinated System (“MECS”) Control Area Agreement. The operation is performed at the Michigan Electric Power Coordination Center (“MEPCC”), where our employees perform the functions as the control area operator which include balancing loads and generation in order to ensure a supply of electricity to customers, maintaining voltage, coordinating the use of ITCTransmission and METC transmission facilities and monitoring the flow on critical facilities to avoid exceeding operating security limits.

 

System Operations.  As part of day-to-day operations in our operations control room located in Ann Arbor, Michigan, transmission system coordinators analyze system conditions at all times, allowing them to react quickly to changing conditions. Transmission system coordinators must also work with maintenance and construction crews in the field to ensure the safe and reliable operation of the grid. A key component of this work involves scheduling outages on system elements to allow crews to safely perform maintenance and construction while maintaining reliability for our customers.

 

Operating Contracts

 

ITCTransmission

 

Detroit Edison operates the electricity distribution system to which ITCTransmission’s transmission system connects. A set of three operating contracts sets forth the terms and conditions related to Detroit Edison’s and ITCTransmission’s ongoing working relationship. These contracts include the following:

 

Master Operating Agreement.  The Master Operating Agreement (the “MOA”) governs the primary day-to-day operational responsibilities of ITCTransmission and Detroit Edison and will remain in effect until terminated by mutual agreement of the parties (subject to any required FERC approvals) unless earlier terminated pursuant to its terms. The MOA identifies the control area coordination services that ITCTransmission is obligated to provide to Detroit Edison. The MOA also requires Detroit Edison to provide certain generation-based support services to ITCTransmission.

 

Generator Interconnection and Operation Agreement.  Detroit Edison and ITCTransmission entered into the Generator Interconnection and Operation Agreement (the “GIOA”) in order to establish, re-establish and maintain the direct electricity interconnection of Detroit Edison’s electricity generating assets with ITCTransmission’s transmission system for the purposes of transmitting electric power from and to the electricity generating facilities. Unless otherwise terminated by mutual agreement of the parties (subject to any required FERC approvals), the GIOA will remain in effect until Detroit Edison elects to terminate the agreement with respect to a particular unit or until a particular unit ceases commercial operation.

 

Coordination and Interconnection Agreement.  The Coordination and Interconnection Agreement (the “CIA”) governs the rights, obligations and responsibilities of ITCTransmission and Detroit Edison regarding, among other things, the operation and interconnection of Detroit Edison’s distribution system and ITCTransmission’s transmission system, and the construction of new facilities or modification of existing facilities. Additionally, the CIA allocates costs for operation of supervisory,

communications and metering equipment. The CIA will remain in effect until terminated by mutual agreement of the parties (subject to any required FERC approvals).

 

METC

 

Consumers Energy operates the electricity distribution system to which METC’s transmission system connects. METC is party to a number of operating contracts with Consumers Energy that govern the operations and maintenance of its transmission system. These contracts include the following:

 

Amended and Restated Easement Agreement.  Under the Amended and Restated Easement Agreement (the “Easement Agreement”), dated as of April 29, 2002 and as further supplemented, Consumers Energy provides METC with an easement to the land, which we refer to as premises, on which METC’s transmission towers, poles, lines and other transmission facilities used to transmit electricity at voltages of at least 120 kV are located, which we refer to collectively as the facilities. Consumers Energy retained for itself the rights to, and the value of activities associated with, all other uses of the premises and the facilities covered by the Easement Agreement, such as for distribution of electricity, fiber optics, telecommunications, gas pipelines and agricultural uses. Accordingly, METC is not permitted to use the premises or the facilities covered by the Easement Agreement for any purposes other than to provide electric transmission and related services, to inspect, maintain, repair, replace and remove electric transmission lines and to alter, improve, relocate and construct additional electric transmission lines. The easement is further subject to the rights of any third parties that had rights to use or occupy the premises or the facilities prior to April 1, 2001 in a manner not inconsistent with METC’s permitted uses.

 

METC pays Consumers Energy annual rent of approximately $10.0 million, in equal quarterly installments, for the easement and related rights under the Easement Agreement. Although METC and Consumers Energy share the use of the premises and the facilities covered by the Easement Agreement, METC pays the entire amount of any rentals, property taxes, inspection fees and other amounts required to be paid to third parties with respect to any use, occupancy, operations or other activities on the premises or the facilities and is generally responsible for the maintenance of the premises and the facilities used for electricity transmission at its expense. METC also must maintain commercial general liability insurance protecting METC and Consumers Energy against claims for personal injury, death or property damage occurring on the premises or the facilities and pay for all insurance premiums. METC is also responsible for patrolling the premises and the facilities by air at its expense at least annually and to notify Consumers Energy of any unauthorized uses or encroachments discovered. METC indemnifies Consumers Energy for all liabilities arising from the facilities covered by the Easement Agreement.

 

METC must notify Consumers Energy before altering, improving, relocating or constructing additional transmission lines on the facilities covered by the Easement Agreement. Consumers Energy may respond by notifying METC of reasonable work and design restrictions and precautions that are needed to avoid endangering existing distribution facilities, pipelines or communications lines, in which case METC must comply with these restrictions and precautions. METC has the right at its own expense to require Consumers Energy to remove and relocate these facilities, but Consumers Energy may require payment in advance or the provision of reasonable security for payment by METC prior to removing or relocating these facilities, and Consumers Energy need not commence any relocation work until an alternative right-of-way satisfactory to Consumers Energy is obtained at METC’s expense.

 

The term of the Easement Agreement runs through 2050 and is subject to 10 automatic 50-year renewals after that time unless METC provides one year’s notice of its election not to renew the term. Consumers Energy may terminate the easement agreement 30 days after giving notice of a failure by METC to pay its quarterly installment if METC does not cure the non-payment within the 30-day notice period. At the end of the term or upon any earlier termination of the easement agreement, the easement and related rights terminate and revert to Consumers Energy.

 

Amended and Restated Operating Agreement.  Under the Amended and Restated Operating Agreement (the “Operating Agreement”), dated as of April 29, 2002, METC agrees to operate its transmission system to provide all transmission customers with safe, efficient, reliable and non-discriminatory transmission service pursuant to its tariff. Among other things, METC is responsible under the Operating Agreement for maintaining and operating its transmission system, providing Consumers Energy with information and access to its transmission system and related books and records, administering and performing the duties of control area operator (that is, the entity exercising operational control over the transmission system) and, if requested by Consumers Energy, building connection facilities necessary to permit interaction with new distribution facilities built by Consumers Energy. Consumers Energy has corresponding obligations to provide METC with access to its books and records and to build distribution facilities necessary to provide adequate and reliable transmission services to wholesale customers. Consumers Energy must cooperate with METC as METC performs its duties as control area operator, including by providing reactive supply and voltage control from generation sources or other ancillary services and reducing load. The Operating Agreement is effective through 2050 and is subject to 10 automatic 50-year renewals after that time, unless METC provides one year’s notice of its election not to renew.

 

Amended and Restated Services Contract.  Under the Amended and Restated Services Contract (the “Services Contract”), dated as of April 29, 2002, Consumers Energy provides contract services, under METC’s direction, for METC’s transmission assets for an initial five-year period. The Services Contract provides METC with labor for the following:

 

 

Under the Services Contract, METC paid Consumers Energy, excluding amounts for capital work, approximately $21.7 million for the year ended December 31, 2006, which includes amounts paid prior to our acquisition of METC. Payments are made in monthly installments. METC pays Consumers Energy for the other services at escalating fixed annual fees or agreed-upon rates.

 

The Services Contract limits Consumers Energy’s total liability arising out of its performance under the Services Contract to $1.0 million. The parties also agreed to maintain certain insurance coverage under the Services Contract. Any disputes between the parties under the services contract will be brought to the administrative committee established under the Operating Agreement.

 

By its terms, the Services Contract is in effect through April 29, 2007. After that time, the Services Contract renews automatically every three years unless notice is given by either party at least 365 days prior to the expiration of the then-current term. In addition, any services may be removed from the Services Contract after the initial five-year term upon 365 days’ notice by either party.

 

METC gave Consumers Energy written notice of termination of the system control and system optimization portions of the Services Contract on November 2, 2004. METC gave Consumers Energy written notice of termination of the remainder of the services provided by Consumers Energy under the Services Contract on February 6, 2006. Each of these notices is effective in May 2007. METC has already arranged for services such as field operations, maintenance, construction work, inventory management and forestry work, which are currently provided by Consumers Energy under the Services Contract. We have nearly completed the process of hiring staff and procuring services to replace those provided under the Services Contract for control room operations and are contracting with qualified parties who can provide these services starting in May 2007.

 

Amended and Restated Purchase and Sale Agreement for Ancillary Services.  The Amended and Restated Purchase and Sale Agreement for Ancillary Services (the “Ancillary Services Agreement”) is dated as of April 29, 2002 and effective May 1, 2002. Since METC does not own any generating facilities, it must procure ancillary services from third party suppliers, such as Consumers Energy. Currently, under the Ancillary Services Agreement, METC pays Consumers Energy for providing certain generation-based services necessary to support the reliable operation of the bulk power grid, such as voltage support and generation capability and capacity to balance loads and generation. METC is not precluded from procuring these ancillary services from third party suppliers when available. The Ancillary Services Agreement is subject to rolling one-year renewals starting May 1, 2003, unless terminated by either METC or Consumers Energy with six months prior written notice.

 

Amended and Restated Distribution-Transmission Interconnection Agreement.  The Amended and Restated Distribution-Transmission Interconnection Agreement (the “DT Interconnection Agreement”), dated April 29, 2002, provides for the interconnection of Consumers Energy’s distribution system with METC’s transmission system and defines the continuing rights, responsibilities and obligations of the parties with respect to the use of certain of their own and the other party’s properties, assets and facilities. METC agrees to provide Consumers Energy interconnection service at agreed-upon interconnection points, and the parties have mutual responsibility for maintaining voltage and compensating for reactive power losses resulting from their respective services. The DT Interconnection Agreement is effective so long as any interconnection point is connected to METC, unless it is terminated earlier by mutual agreement of METC and Consumers Energy.

 

Amended and Restated Generator Interconnection Agreement.  The Amended and Restated Generator Interconnection Agreement (the “Generator Interconnection Agreement”), dated as of April 29, 2002, specifies the terms and conditions under which Consumers Energy and METC maintain the interconnection of Consumers Energy’s generation resources and METC’s transmission assets. The Generator Interconnection Agreement is effective either until it is replaced by any MISO-required contract, or until mutually agreed by METC and Consumers Energy to terminate, but not later than the date that all listed generators cease commercial operation.

 

Regulatory Environment

 

Regulators and public policy makers have seen the need for further investment in the transmission grid. The growth in electricity generation, wholesale power sales and consumption versus transmission investment have resulted in significant transmission constraints across the United States and increased stress on aging equipment. These problems will continue without increased investment in transmission infrastructure. Transmission system investments can also increase system reliability and reduce the frequency of power outages. Such investments can reduce transmission constraints and improve access to lower cost generation resources, resulting in a lower overall cost of delivered electricity for end-use consumers. After the 2003 blackout that affected sections of the northeastern and midwestern United States and Ontario, Canada, the Department of Energy (the “DOE”) established the Office of Electric Transmission and Distribution, focused on working with reliability experts from the power industry, state governments, and their Canadian counterparts to improve grid reliability and increase investment in the country’s electric infrastructure. In addition, the FERC has signaled its desire for substantial new investment in the transmission sector by implementing financial incentives, such as increasing the return on equity for transmission-only companies to a level that is greater than that of traditional utilities.

 

The FERC has issued orders to promote non-discriminatory transmission access for all transmission customers. In the United States, electricity transmission assets are predominantly owned, operated and maintained by utilities that also own electricity generation and distribution assets, known as vertically integrated utilities. The FERC has recognized that the vertically integrated utility model inhibits the provision of non-discriminatory transmission access and, in order to alleviate this discrimination, the FERC has mandated that all transmission systems over which it has jurisdiction, must be operated in a comparable, non-discriminatory manner such that any seller of electricity affiliated with a transmission

owner or operator is not provided with preferential treatment. The FERC has also indicated that independent transmission companies can play a prominent role in furthering its policy goals and has encouraged the legal and functional separation of transmission operations from generation and distribution operations.

 

In 2005, the federal government enacted the Energy Policy Act of 2005 (the “Energy Policy Act”). In part, the Energy Policy Act required the FERC to implement rules to encourage investment in electricity transmission infrastructure and authorized the FERC to implement mandatory transmission reliability standards. In addition, the Energy Policy Act directed the DOE to investigate and designate corridors along which the construction of electricity transmission infrastructure is in the national interest, and authorizes the FERC to determine siting of transmission facilities in such corridors in certain circumstances. The FERC and the DOE are currently engaged in or have completed regulatory proceedings designed to implement the Energy Policy Act. As a result, we anticipate that we will assess our transmission system against standards established by the North American Electric Reliability Corporation, as the nation’s Electric Reliability Organization approved by the FERC in July 2006. In addition, the FERC has finalized rules under which ITCTransmission and METC may qualify for rate incentives to invest in transmission infrastructure. ITC Transmission and METC may also be eligible for federal assistance in siting of such infrastructure. Finally, the Energy Policy Act repealed the Public Utility Holding Company Act of 1935, which was replaced by the Public Utility Holding Company Act of 2005. It also subjected utility holding companies to regulations of the FERC related to access to books and records, and amended Section 203 of the Federal Power Act (the “FPA”) to provide explicit authority for the FERC to review mergers and consolidations involving utility holding companies in certain circumstances.

 

Federal Regulation

 

As electricity transmission companies, ITCTransmission and METC are regulated by the FERC. The FERC is an independent regulatory commission within the DOE that regulates the interstate transmission and certain wholesale sales of natural gas, the transmission of oil and oil products by pipeline, and the transmission and wholesale sale of electricity in interstate commerce. The FERC also administers accounting and financial reporting regulations and standards of conduct for the companies it regulates. In 1996, in order to facilitate open access transmission for participants in wholesale power markets, the FERC issued Order No. 888. The open access policy promulgated by the FERC in Order No. 888 was upheld in a United States Supreme Court decision issued on March 4, 2002. To facilitate open access, among other things, FERC Order No. 888 encouraged investor owned utilities to cede operational control over their transmission systems to Independent System Operators (“ISOs”), which are not-for-profit entities.

 

As an alternative to ceding operating control of their transmission assets to ISOs, certain investor owned utilities began to promote the formation of for-profit transmission companies, which would assume control of the operation of the grid. In December 1999, the FERC issued Order No. 2000, which strongly encouraged utilities to voluntarily transfer operational control of their transmission systems to Regional Transmission Organizations (“RTOs”). RTOs, as envisioned in Order No. 2000, would assume many of the functions of an ISO, but the FERC permitted greater flexibility with regard to the organization and structure of RTOs than it had for ISOs. RTOs could accommodate the inclusion of independently owned, for-profit companies that own transmission assets within their operating structure. Independent ownership would facilitate not only the independent operation of the transmission systems but also the formation of companies with a greater financial interest in maintaining and augmenting the capacity and reliability of those systems.

 

MISO was formed in 1996 as a voluntary association of electricity transmission owners consistent with the principles in FERC Order No. 888. Later, in response to FERC Order No. 2000, MISO evolved into a FERC-approved RTO with an open architecture framework capable of accommodating a variety of business models including independently owned, for-profit transmission companies. MISO, in its role as an RTO, monitors electric reliability throughout much of the Midwest. MISO is responsible for

coordinating the operation of the wholesale electricity transmission system and ensuring fair, non-discriminatory access to the transmission grid.

 

State Regulation

 

The Michigan Public Service Commission does not have jurisdiction over ITCTransmission’s or METC’s rates or terms and conditions of service, but it has jurisdiction over siting of transmission facilities. Pursuant to Michigan Public Acts 197 and 198 of 2004, ITCTransmission and METC have the right as independent transmission companies to condemn property in the state of Michigan for the purposes of building or maintaining transmission facilities.

 

ITCTransmission and METC are also subject to the regulatory oversight of the Michigan Department of Environmental Quality for compliance with all environmental standards and regulations.

 

Sources of Revenue

 

See Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” under “Significant Components of Results of Operations — Revenues” for a discussion of our principal sources of revenue.

 

Seasonality

 

Our results of operations for periods through December 31, 2006 were subject to significant seasonal variations since demand for electricity, and thus transmission load, is largely dependent on weather conditions. Our historical revenues recognized were dependent on the monthly peak loads and regulated transmission rates. Our historical revenues and operating income were typically higher in the summer months when cooling demand and network load are higher. A particularly warm or cool summer may increase or reduce demand for electricity above or below that expected, causing an increase or decrease in our historical revenues from the same period of the previous year.

 

Under Forward-Looking Attachment O which became effective for ITCTransmission and METC on January 1, 2007, as discussed in Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Rate Setting and Attachment O — Forward-Looking Attachment O,” much of the seasonality in our results of operations is mitigated. The true-up mechanism contained in Forward-Looking Attachment O allows ITCTransmission and METC to accrue or defer revenues to the extent that the actual net revenue requirement for the reporting period is higher or lower, respectively, than the amounts billed relating to that reporting period. Based on our revenue recognition under Forward-Looking Attachment O, we expect to recognize more consistent operating revenues and net income, compared to the historical Attachment O method for each quarterly period within a given year beginning January 1, 2007. Monthly peak loads continue to be used for billing purposes, which will continue to have a seasonal effect on our cash flows.

 

Principal Customers

 

Our principal transmission service customers are Detroit Edison and Consumers Energy, which accounted for approximately 90% and 84%, respectively, of ITCTransmission’s and METC’s total operating revenues for the year ended December 31, 2006, which includes METC’s revenue amounts prior to the acquisition of METC. ITCTransmission’s and METC’s remaining revenues were generated from providing service to other entities such as alternative electricity suppliers, power marketers and other wholesale customers that provide electricity to end-use consumers and from transaction-based capacity reservations on ITCTransmission’s and METC’s transmission system. All of our revenues are from transmission customers in the United States.

 

Billing

 

MISO is responsible for billing and collection for transmission services and administers the transmission tariff in the MISO service territory. As the billing agent for ITCTransmission and METC, MISO bills Detroit Edison, Consumers Energy and other customers on a monthly basis and collects fees for the use of ITCTransmission’s and METC’s transmission system. MISO has implemented strict credit policies for its members, which include customers using ITCTransmission’s and METC’s transmission system. In general, if these customers do not maintain their investment grade credit rating or have a history of late payments, MISO may require them to provide MISO with a letter of credit or a cash deposit equal to the highest monthly invoiced amount over the previous 12 months.

 

Competition

 

ITCTransmission and METC each is the only transmission system in its respective service area and, therefore, effectively has no competitors.

 

Employees

 

As of December 31, 2006, we had 223 employees. We consider our relations with our employees to be good.

 

The certifications of the Chief Executive Officer and Chief Financial Officer required by Securities and Exchange Commission (“SEC”) rules have been filed as exhibits to this report. The unqualified certification of the Chief Executive Officer as to compliance with New York Stock Exchange (“NYSE”) corporate governance requirements was filed with the NYSE on September 27, 2006.

 

Environmental Matters

 

ITCTransmission’s and METC’s operations are subject to federal, state, and local environmental laws and regulations, which impose limitations on the discharge of pollutants into the environment, establish standards for the management, treatment, storage, transportation and disposal of hazardous materials and of solid and hazardous wastes, and impose obligations to investigate and remediate contamination in certain circumstances. Liabilities to investigate or remediate contamination, as well as other liabilities concerning hazardous materials or contamination, such as claims for personal injury or property damage, may arise at many locations, including formerly owned or operated properties and sites where wastes have been treated or disposed of, as well as at properties currently owned or operated by us. Such liabilities may arise even where the contamination does not result from noncompliance with applicable environmental laws. Under a number of environmental laws, such liabilities may also be joint and several, meaning that a party can be held responsible for more than its share of the liability involved, or even the entire share. Environmental requirements generally have become more stringent and compliance with those requirements more expensive. We are not aware of any specific developments that would increase our costs for such compliance in a manner that would be expected to have a material adverse effect on our results of operations, financial position or liquidity.

 

Our assets and operations also involve the use of materials classified as hazardous, toxic or otherwise dangerous. Many of the properties ITCTransmission and METC own or operate have been used for many years, and include older facilities and equipment that may be more likely than newer ones to contain or be made from such materials. Some of these properties include aboveground or underground storage tanks and associated piping. Some of them also include large electrical equipment filled with mineral oil, which may contain or previously have contained polychlorinated biphenyls (PCBs). Our facilities and equipment are often situated close to or on property owned by others so that, if they are the source of contamination, other’s property may be affected. For example, aboveground and underground transmission lines sometimes traverse properties that we do not own, and, at some of our transmission stations, transmission assets (owned or operated by us) and distribution assets (owned or operated by our transmission customers) are commingled.

 

Some properties in which we have an ownership interest or at which we operate are, and others are suspected of being, affected by environmental contamination. We are not aware of any claims pending or threatened against us with respect to environmental contamination, or of any investigation or remediation of contamination at any properties, that entail costs likely to materially affect us. Some facilities and properties are located near environmentally sensitive areas such as wetlands.

 

Claims have been made or threatened against electric utilities for bodily injury, disease or other damages allegedly related to exposure to electromagnetic fields associated with electricity transmission and distribution lines. While we do not believe that a causal link between electromagnetic field exposure and injury has been generally established and accepted in the scientific community, if such a relationship is established or accepted, the liabilities and costs imposed on our business could be significant. We are not aware of any claims pending or threatened against us for bodily injury, disease or other damages allegedly related to exposure to electromagnetic fields and electricity transmission and distribution lines that entail costs likely to have a material adverse effect on our results of operations, financial position or liquidity.

 

Filings Under the Securities Exchange Act of 1934

 

Our internet address is www.itc-holdings.com. You can access free of charge on our web site all of our reports filed pursuant to Section 13(a) or 15(d) of the Exchange Act, including our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports. These reports are available as soon as practicable after they are electronically filed with the SEC. Also on our web site are our:

 

 

We will also provide this information in print to any shareholder who requests it.

 

You may also read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington DC, 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC also maintains an internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. The address is http://www.sec.gov.

 

Risks Related to Our Business

 

ITC Holdings is a holding company with no operations, and unless we receive dividends or other payments from ITCTransmission, METC or our other subsidiaries, we will be unable to pay dividends to our shareholders and fulfill our cash obligations.

 

As a holding company with no business operations, ITC Holdings’ material assets consist only of the common stock of ITCTransmission, indirect ownership interests in METC, ownership interests of our other subsidiaries, deferred tax assets relating primarily to NOLs and cash. Our material cash inflows are only from dividends and other payments received from ITCTransmission, METC or our other subsidiaries and the proceeds raised from the sale of debt and equity securities. We may not be able to access cash generated by ITCTransmission or METC or any other subsidiaries in order to fulfill cash commitments or to pay dividends to shareholders. The ability of ITCTransmission and METC to make dividend and other payments to us is subject to the availability of funds after taking into account ITCTransmission’s and METC’s respective funding requirements, the terms of ITCTransmission’s and METC’s respective indebtedness, the regulations of the FERC under the FPA, and applicable state laws. Each of ITCTransmission, METC and each other subsidiary, however, is legally distinct from us and has no obligation, contingent or otherwise, to make funds available to us.

 

The FERC’s December 2005 rate order authorizing METC’s current rates will be subject to a hearing and possible judicial appeals unless the FERC approves the settlement agreement filed by the interested parties. In any such proceedings, METC could be required to refund revenues to customers and the rates that METC charges for services could be reduced, thereby materially and adversely impacting our results of operations, financial condition, cash flows and future earning capacity.

 

On January 19, 2007, METC, ITCTransmission, MISO, Consumers Energy, Michigan Public Power Agency, Michigan South Central Power Agency and Wolverine Power Supply Cooperative, Inc. entered into a settlement agreement resolving all pending matters in METC’s pending rate case before the FERC, including those set for hearing in the FERC’s December 30, 2005 rate order, which authorized METC, beginning on January 1, 2006, to charge rates for its transmission service using the rate setting formula contained in Attachment O. On December 5, 2006, METC and other parties to the rate case jointly filed a motion to suspend the procedural schedule and the FERC chief administrative law judge approved the suspension. The terms of this settlement agreement have been filed with the FERC and remain subject to its approval.

 

Under the filed settlement terms, METC would be required to make payments totaling $20.0 million to various transmission customers within 30 days after there is a final FERC order approving the settlement. METC’s payment pursuant to this settlement would be in lieu of any and all refunds and/or interest payment requirements in this proceeding in connection with METC’s rates in effect on and after January 1, 2006. METC would have no other refund obligation or liability beyond this payment in connection with this proceeding. Additionally, the settlement would establish the balances and amortization to be used for ratemaking for the Regulatory Deferrals and ADIT Deferrals, as defined in the settlement.

 

If the FERC rejects the settlement agreement, contested issues in the pending rate case may be resolved through a contested hearing process, and interested parties may seek a rehearing or judicial review of any order issued as a result thereof. Although we cannot predict if any subsequent requests for rehearing or appeals will be filed, the FERC, in an order following a contested hearing or in response to requests for rehearing or on remand after a successful appeal, could modify the terms of its authorization of METC’s current rates, including reducing those rates retroactively to January 1, 2006 and ordering refunds. This could result in a significant reduction in METC’s earnings from what we currently expect and, accordingly, our financial condition, cash flows and results of operations could be materially and adversely affected.

 

Certain elements of ITCTransmission’s and METC’s cost recovery through rates can be challenged, which could result in lowered rates and/or refunds of amounts previously collected and thus have an adverse effect on our business, financial condition, results of operations and cash flows.

 

ITCTransmission and METC provide transmission service under rates regulated by the FERC. The FERC has approved ITCTransmission’s and METC’s use of the rate setting formula under Attachment O, but it has not expressly approved the amount of ITCTransmission’s or METC’s actual capital and operating expenditures to be used in that formula. In addition, all aspects of ITCTransmission’s or METC’s rates approved by the FERC, including the Attachment O rate mechanism, ITCTransmission’s and METC’s respective allowed 13.88% and 13.38% rates of return on the actual equity portion of their respective capital structures, and the data inputs provided by ITCTransmission and METC for calculation of each year’s rate, are subject to challenge by interested parties at the FERC in a Section 206 proceeding under the FPA. If a challenger can establish that any of these aspects are unjust, unreasonable, imprudent or unduly discriminatory, then the FERC will make appropriate prospective adjustments to them and/or disallow ITCTransmission’s or METC’s inclusion of those aspects in the rate setting formula. This could result in lowered rates and/or refunds of amounts collected after the date that a Section 206 challenge is filed. In addition, the FERC’s order approving our acquisition of METC is conditioned upon ITCTransmission and METC not recovering acquisition-related costs in their rates unless a separate informational filing is submitted to the FERC. The informational filing, which could be challenged by interested parties,

would need to identify those costs and show that such costs are outweighed by the benefits of the acquisition. Determinations by ITCTransmission or METC that expenses included in Attachment O for recovery are not acquisition-related costs are also subject to challenge by interested parties at the FERC. If challenged at the FERC and ITCTransmission or METC fail to show that costs included for recovery are not acquisition-related, this also could result in lowered rates and/or refunds of amounts collected. Such events could have an adverse effect on our business, financial condition, results of operations and cash flows.

 

ITCTransmission’s or METC’s actual capital investments may be lower than planned, which would decrease expected rate base and therefore our revenues.

 

Each of ITCTransmission’s and METC’s rate base is determined in part by additions to property, plant and equipment when placed in service. If ITCTransmission’s or METC’s capital investments and the resulting in-service property, plant and equipment are lower than anticipated for any reason, including, among other things, the impact of weather conditions, union strikes, labor shortages, material and equipment prices and availability, our ability to obtain financing for such expenditures, if necessary, limitations on the amount of construction that can be undertaken on our system at any one time or regulatory approvals for reasons relating to environmental, siting or regional planning issues or as a result of legal proceedings and variances between estimated and actual costs of construction contracts awarded, ITCTransmission or METC will have a lower than anticipated rate base thus causing its revenue requirement and future earnings to be potentially lower than anticipated.

 

The regulations to which we are subject may limit our ability to raise capital and/or pursue acquisitions, development opportunities or other transactions or may subject us to liabilities.

 

Each of ITCTransmission and METC is a “public utility” under the FPA and, accordingly, is subject to regulation by the FERC. Approval of the FERC is required under Section 203 of the FPA for a disposition or acquisition of regulated public utility facilities, either directly or indirectly through a holding company. Such approval also is required to acquire securities in a public utility. Under the Energy Policy Act, Section 203 of the FPA also provides the FERC with explicit authority over utility holding companies’ purchases or acquisitions of, and mergers or consolidations with, a public utility. Finally, each of ITCTransmission and METC must also seek approval by the FERC under Section 204 of the FPA for issuances of its securities.

 

In addition, we are subject to local regulations relating to, among other things, facility siting. If we fail to comply with these local regulations, we may incur liabilities for such failure.

 

Changes in federal energy laws, regulations or policies could impact cash flows and could reduce the dividends we may be able to pay our shareholders.

 

Attachment O, the rate formula mechanism used by ITCTransmission and METC to calculate their respective annual revenue requirements, will be used by ITCTransmission and METC for that purpose until and unless it is determined by the FERC to be unjust and unreasonable or another mechanism is determined by the FERC to be just and reasonable. Such determinations could result from challenges initiated at the FERC by interested parties or the FERC in a proceeding under Section 206 of the FPA, or by an application initiated by ITCTransmission or METC under Section 205 of the FPA. We cannot predict whether the approved rate methodologies will be changed.

 

End-use consumers and entities supplying electricity to end-use consumers may attempt to influence government and/or regulators to change the rate setting methodologies that apply to ITCTransmission and METC, particularly if rates for delivered electricity increase substantially.

 

Each of ITCTransmission and METC is regulated by the FERC as a “public utility” under the FPA and is a transmission owner in MISO. The FERC could propose new policies and regulations concerning transmission services or rate setting methodologies. In addition, the U.S. Congress periodically considers enacting energy legislation that could shift new responsibilities to the FERC, modify provisions of the FPA

or provide the FERC or another entity with increased authority to regulate transmission matters. ITCTransmission and METC cannot predict whether, and to what extent, ITCTransmission and METC may be affected by any such changes in federal energy laws, regulations or policies in the future.

 

If the network load or point-to-point transmission service on either ITCTransmission’s or METC’s transmission system is lower than expected, the timing of collection of our revenues would be delayed.

 

If the network load on either ITCTransmission’s or METC’s transmission system is lower than expected due to weather, a weak economy, changes in the nature or composition of the transmission grid in Michigan or surrounding regions, poor transmission quality of neighboring transmission systems, or for any other reason, the timing of the collection of our revenue requirement would be delayed until such circumstances are adjusted through the true-up mechanism in ITCTransmission’s or METC’s formula rate mechanism.

 

Each of ITCTransmission and METC depends on its primary customer for a substantial portion of its revenues, and any material failure by those primary customers to make payments for transmission services would adversely affect our revenues and our ability to service ITCTransmission’s and METC’s and our debt obligations.

 

ITCTransmission derives a substantial portion of its revenues from the transmission of electricity to Detroit Edison’s local distribution facilities. Payments from Detroit Edison, billed by MISO, constituted approximately 90% of ITCTransmission’s total operating revenues for the year ended December 31, 2006 and are expected to constitute the majority of ITCTransmission’s revenues for the foreseeable future. Detroit Edison is rated BBB/stable and Baa1/stable by Standard & Poor’s Ratings Services and Moody’s Investors Services, Inc., respectively. Similarly, Consumers Energy accounted for approximately 84% of METC’s revenues for the year ended December 31, 2006, which includes a period prior to the acquisition of METC, and is expected to constitute the majority of METC’s revenues for the foreseeable future. Consumers Energy is rated BB/watch positive and Baa2/positive by Standard & Poor’s Ratings Services and Moody’s Investors Service, Inc., respectively. Any material failure by Detroit Edison or Consumers Energy to make payments for transmission services would adversely affect our revenues and our ability to service ITCTransmission’s, METC’s and our debt obligations.

 

We may be materially and adversely affected by the termination of METC’s services contract with Consumers Energy.

 

Consumers Energy provides METC with operating, maintenance, inspection and other services relating to METC’s transmission assets pursuant to a services contract. For the year ended December 31, 2006, including amounts paid prior to our acquisition of METC, METC paid approximately $21.7 million to Consumers Energy for these services. METC gave Consumers Energy notice of termination of the system control and system optimization portions of the services contract on November 2, 2004 and of the remainder of the services provided by Consumers Energy under the services contract on February 6, 2006. Each of these notices is effective in May 2007. We have nearly completed the process of hiring staff and procuring services to replace those provided under the services contract and will contract with qualified parties on the most economically attractive terms available to METC. However, METC may not be able to fully replace these services in a timely manner or on terms and conditions, including service levels and costs, as favorable as those METC has received from Consumers Energy.

 

As discussed above, Consumers Energy also provides system control and optimization functions for METC at an integrated transmission and distribution control center in Jackson, Michigan. Effective upon the termination of the services contract in May 2007, METC will be performing these functions. METC may not be able to hire all of the qualified staff required to operate the new operations and control center or the new operations and control center may not be fully functional by the anticipated transition date, in which event METC will be required to continue to rely on Consumers Energy for the performance of those services even after the termination of the services contract.

 

METC does not own the majority of the land on which its transmission assets are located and, as a result, it must comply with the provisions of an easement agreement with Consumers Energy.

 

METC does not own the majority of the land on which the transmission assets it acquired from Consumers Energy are located. Instead, under the provisions of an easement agreement with Consumers Energy, METC pays annual rent of approximately $10.0 million to Consumers Energy in exchange for rights-of-way, leases, fee interests and licenses which allow METC to use the land on which its transmission lines are located. Under the terms of the easement agreement, METC’s easement rights could be eliminated if METC fails to meet certain requirements, such as paying contractual rent to Consumers Energy in a timely manner.

 

Deregulation and/or increased competition may adversely affect ITCTransmission’s and METC’s customers, or Detroit Edison’s and Consumers Energy’s customers, which in turn may reduce our revenues.

 

The business of ITCTransmission’s and METC’s primary customers is subject to regulation that has undergone substantial change in accordance with Michigan Public Act 141 of 2000, which mandates the implementation of retail access, as well as changes in federal regulatory requirements. The utility industry has also been undergoing dramatic structural change for several years, resulting in increasing competitive pressures on electric utility companies, such as Detroit Edison and Consumers Energy. The manufacturing sector in Detroit Edison’s and Consumers Energy’s service territories has also been subject to increasing competitive pressures. As a result, demand for electricity transmission service by manufacturing companies in ITCTransmission’s and METC’s service territories may be negatively impacted. These factors may create greater risks to the stability of Detroit Edison’s and Consumers Energy’s revenues and may affect Detroit Edison’s and Consumers Energy’s ability to make payments for transmission service to MISO and thus to ITCTransmission and METC, which would adversely affect our financial condition and results of operations.

 

On April 1, 2005, MISO began centrally dispatching generation resources throughout much of the Midwest with the launch of its Midwest Energy Markets. Because of this restructuring of power markets throughout the Midwest, the risk profile of some of our customers may have changed, which may affect their ability to pay for the services provided by ITCTransmission and METC.

 

Hazards associated with high-voltage electricity transmission may result in suspension of ITCTransmission’s or METC’s operations or the imposition of civil or criminal penalties.

 

ITCTransmission’s and METC’s operations are subject to the usual hazards associated with high-voltage electricity transmission, including explosions, fires, inclement weather, natural disasters, mechanical failure, unscheduled downtime, equipment interruptions, remediation, chemical spills, discharges or releases of toxic or hazardous substances or gases and other environmental risks. The hazards can cause personal injury and loss of life, severe damage to or destruction of property and equipment and environmental damage, and may result in suspension of operations and the imposition of civil or criminal penalties. We maintain property and casualty insurance, but we are not fully insured against all potential hazards incident to our business, such as damage to poles, towers and lines or losses caused by outages.

 

ITCTransmission and METC are subject to environmental regulations and to laws that can give rise to substantial liabilities from environmental contamination.

 

ITCTransmission’s and METC’s operations are subject to federal, state and local environmental laws and regulations, which impose limitations on the discharge of pollutants into the environment, establish standards for the management, treatment, storage, transportation and disposal of hazardous materials and of solid and hazardous wastes, and impose obligations to investigate and remediate contamination in certain circumstances. Liabilities to investigate or remediate contamination, as well as other liabilities concerning hazardous materials or contamination such as claims for personal injury or property damage,

may arise at many locations, including formerly owned or operated properties and sites where wastes have been treated or disposed of, as well as at properties currently owned or operated by ITCTransmission or METC. Such liabilities may arise even where the contamination does not result from noncompliance with applicable environmental laws. Under a number of environmental laws, such liabilities may also be joint and several, meaning that a party can be held responsible for more than its share of the liability involved, or even the entire share. Environmental requirements generally have become more stringent in recent years, and compliance with those requirements more expensive.

 

ITCTransmission and METC have incurred expenses in connection with environmental compliance, and we anticipate that each will continue to do so in the future. Failure to comply with the extensive environmental laws and regulations applicable to each could result in significant civil or criminal penalties and remediation costs. ITCTransmission’s and METC’s assets and operations also involve the use of materials classified as hazardous, toxic, or otherwise dangerous. Some of ITCTransmission’s and METC’s facilities and properties are located near environmentally sensitive areas such as wetlands and habitats of endangered or threatened species. In addition, certain properties in which ITCTransmission has an ownership interest or at which ITCTransmission or METC operates are, and others are suspected of being, affected by environmental contamination. Compliance with these laws and regulations, and liabilities concerning contamination or hazardous materials, may adversely affect our costs and, therefore our business, financial condition and results of operations.

 

In addition, claims have been made or threatened against electric utilities for bodily injury, disease or other damages allegedly related to exposure to electromagnetic fields associated with electricity transmission and distribution lines. We cannot assure you that such claims will not be asserted against us or that, if determined in a manner adverse to our interests, would not have a material adverse effect on our business, financial condition and results of operations.

 

Acts of war, terrorist attacks and threats or the escalation of military activity in response to such attacks or otherwise may negatively affect our business, financial condition and results of operations.

 

Acts of war, terrorist attacks and threats or the escalation of military activity in response to such attacks or otherwise may negatively affect our business, financial condition and results of operations in unpredictable ways, such as increased security measures and disruptions of markets. Strategic targets, such as energy related assets, including, for example, ITCTransmission’s and METC’s transmission facilities and Detroit Edison’s and Consumers Energy’s generation and distribution facilities, may be at risk of future terrorist attacks. In addition to the increased costs associated with heightened security requirements, such events may have an adverse effect on the economy in general. A lower level of economic activity could result in a decline in energy consumption, which may adversely affect our business and financial condition.

 

Risks Related to the Recent Acquisition of METC

 

We may encounter difficulties consolidating METC into our business and may not fully attain or retain, or achieve within a reasonable time frame, expected strategic objectives, cost savings and other expected benefits of the acquisition.

 

We expect to realize strategic and other benefits as a result of our acquisition of the indirect ownership interests in METC. Our ability to realize these benefits or successfully consolidate METC’s business with ours, however, is subject to certain risks and uncertainties, including, among others:

 

 

 

In addition, METC may incur costs relating to the termination of contracts for engineering and other services performed on behalf of METC prior to the acquisition. We may choose not to utilize these services following the consummation of our acquisition of METC. We are in the process of identifying such contracts, and METC has received invoices from one of its vendors for aggregate termination payments of approximately $2.8 million, which we are disputing. Any such termination payments made by METC may have an adverse impact on our financial position, results of operations and cash flows.

 

Our failure to manage these risks, or other risks related to the acquisition that are not presently known to us, could prevent us from realizing the expected benefits of the acquisition and also may have a material adverse effect on our results of operations and financial condition.

 

Risks Related to the Pending Acquisition of IP&L Transmission Assets

 

The proposed IP&L acquisition may not occur on a timely basis or at all, and the required governmental approvals may not be obtained on a timely basis or at all.

 

On January 19, 2007, we announced that ITC Midwest LLC had signed a definitive agreement to acquire for cash the transmission assets of IP&L, an Alliant Energy Corporation subsidiary, in a transaction valued at approximately $750.0 million, excluding expenses. The consummation of the proposed IP&L acquisition may not occur on a timely basis or at all. A number of governmental approvals will be required in order to complete the proposed acquisition. These approvals may not be obtained in the time required under the asset sale agreement or at all. A delay in obtaining or failure to obtain these approvals may prevent the proposed acquisition from being completed. Under certain circumstances, if we terminate the asset sale agreement, we may be liable for liquidated damages of approximately $24.0 million or $45.0 million depending on the facts of the situation.

 

The purchase price for the assets is subject to adjustment and, therefore, the final purchase price cannot be determined at this time.

 

Under the asset sale agreement, the purchase price for the purchase of the assets to be acquired is $750.0 million. However, the purchase price is subject to adjustment both upward and downward depending on the occurrence of specified events. As a result, it is not possible to ascertain the final purchase price at this time.

 

The proposed IP&L acquisition may not be as financially or operationally successful as originally contemplated.

 

In agreeing to the terms and conditions of the asset sale agreement, we made certain business assumptions and determinations based on our investigation of IP&L’s assets and business, as well as other information then available. However, these assumptions and determinations involve certain risks and uncertainties that may cause these assumptions and determinations to be inaccurate. As a result, we may not realize the full benefits that we are expecting from the proposed acquisition.

 

We may encounter difficulties consolidating IP&L’s transmission assets into our business and may not fully attain or retain, or achieve within a reasonable time frame, expected strategic objectives, cost savings and other expected benefits of the proposed acquisition.

 

We expect to realize strategic and other benefits as a result of ITC Midwest’s acquisition of IP&L’s transmission assets. Our ability to realize these benefits or successfully consolidate IP&L’s transmission assets into our business, however, is subject to certain risks and uncertainties, including, among others:

 

 

Our failure to manage these risks, or other risks related to the acquisition that are not presently known to us, could prevent us from realizing the expected benefits of the acquisition and also may have a material adverse effect on our results of operations and financial condition.

 

Risks Related to Our Capital Structure and Leverage

 

We are highly leveraged and our dependence on debt may limit our ability to pay dividends and/or obtain additional financing.

 

As of December 31, 2006, we had approximately $1.3 billion of consolidated indebtedness. ITC Holdings had outstanding $267.0 million aggregate principal amount of 5.25% Senior Notes due July 15, 2013, $255.0 million aggregate principal amount of 5.875% Senior Notes due September 30, 2016 and $255.0 million aggregate principal amount of 6.375% Senior Notes due September 30, 2036. ITCTransmission had outstanding $185.0 million aggregate principal amount of 4.45% First Mortgage Bonds, Series A, due July 15, 2013 and $100.0 million aggregate principal amount of 6.125% First Mortgage Bonds, Series C, due March 31, 2036. METC had outstanding $175.0 million aggregate principal amount of 5.75% Senior Secured Notes due December 10, 2015. Additionally, at December 31, 2006, we had total revolving credit facility commitments at ITCTransmission, ITC Holdings, and METC of $75.0 million, $50.0 million and $35.0 million, respectively, with $12.5 million, $0.0 million, and $14.0 million outstanding, respectively.

 

This capital structure can have several important consequences, including, but not limited to, the following:

 

 

 

We may incur substantial indebtedness in the future. The incurrence of additional indebtedness would increase the leverage-related risks described herein.

 

Certain provisions in our debt instruments limit our capital flexibility.

 

Our debt instruments include senior notes, secured notes, first mortgage bonds and revolving credit facilities containing numerous financial and operating covenants that place significant restrictions on, among other things, our ability to:

 

 

The revolving credit facilities and METC’s Senior Secured Notes also require us to meet certain financial ratios. Our ability to comply with these and other requirements and restrictions may be affected by changes in economic or business conditions, results of operations or other events beyond our control. A failure to comply with the obligations contained in any of our debt instruments could result in acceleration of the related debt and the acceleration of debt under other instruments evidencing indebtedness that may contain cross acceleration or cross default provisions.

 

Adverse changes in our credit ratings may negatively affect us.

 

Our ability to access capital markets is important to our ability to operate our business. Increased scrutiny of the energy industry and the impacts of regulation, as well as changes in our financial performance could result in credit agencies reexamining our credit rating. A downgrade in any of our credit ratings could restrict or discontinue our ability to access capital markets at attractive rates and increase our borrowing costs. A rating downgrade could also increase the interest we pay under our revolving credit facilities.

 

Our recent public offering caused us to undergo an “ownership change” for purposes of Section 382 of the Internal Revenue Code which will limit the amount of our NOLs that we may use to reduce our tax liability in a given period .

 

As of December 31, 2006, we had estimated NOLs of $100.4 million. These NOLs may be used to offset future taxable income and thereby reduce our U.S. federal income taxes otherwise payable. Section 382 of the Internal Revenue Code of 1986, as amended, imposes an annual limit on the ability

of a corporation that undergoes an “ownership change” to use its NOLs to reduce its tax liability. In the event of an ownership change, we would not be able to use our pre-ownership change NOLs in excess of the limitation imposed by Section 382 for each annual period. Our recent public offering caused us to experience an ownership change.

 

Included in the total estimated NOLs above, we estimate that we acquired approximately $35.0 million of NOLs when we acquired all of the indirect ownership interests in METC in October 2006. We will be subject to annual limitations on the use of such NOLs as a result of the acquisition of all of the indirect ownership interests in METC by us, as well as limitations resulting from prior transactions by the acquired entities.

 

While our NOLs may be subject to an annual limitation as a result of the ownership changes described above, we expect that our ability to use the NOLs over time will not be materially affected by such limitation, although we cannot assure you in this regard.

 

We may not be able to pay dividends, and the reduction or elimination of dividends would negatively affect the market price of our common stock.

 

While we currently intend to continue to pay quarterly dividends on our common stock, we have no obligation to do so. Dividend payments are within the absolute discretion of our board of directors and will depend on, among other things, our results of operations, working capital requirements, capital expenditure requirements, financial condition, contractual restrictions, anticipated cash needs and other factors that our board of directors may deem relevant. For example, we may not generate sufficient cash from operations in the future to pay dividends on our common stock in the intended amounts or at all. In addition, ITC Holdings is a holding company and our ability to pay dividends may be limited by restrictions upon transfer of funds applicable to its subsidiaries (including, for example, those which are contained in ITCTransmission’s revolving credit facility, METC’s Senior Secured Notes and METC’s revolving credit facility). As a holding company without any specific operations, ITC Holdings is dependent on receiving dividends from its operating subsidiaries, such as ITCTransmission, METC and its other subsidiaries, in order to be able to make dividend distributions of its own. Any reduction or elimination of dividends could adversely affect the market price of our common stock.

 

Provisions in our Articles of Incorporation and bylaws and Michigan corporate law may prevent efforts by our shareholders to change the direction or management of our company.

 

Our Articles of Incorporation and bylaws contain provisions that might enable our management to resist a proposed takeover. These provisions could discourage, delay or prevent a change of control or an acquisition at a price that our shareholders may find attractive. These provisions also may discourage proxy contests and make it more difficult for our shareholders to elect directors and take other corporate actions. The existence of these provisions could limit the price that investors might be willing to pay in the future for shares of our common stock. These provisions include:

 

 

Provisions in our Articles of Incorporation restrict market participants from voting or owning 5% or more of the outstanding shares of our capital stock.

 

ITCTransmission was granted favorable rate treatment by the FERC based on its independence from market participants. The FERC defines a “market participant” to include any person or entity that, either directly or through an affiliate, sells or brokers electricity, or provides ancillary services to MISO. An affiliate, for these purposes, includes any person or entity that directly or indirectly owns, controls or holds with the power to vote 5% or more of the outstanding voting securities of a market participant. To help ensure that we and our subsidiaries will remain independent of market participants, our Articles of Incorporation impose certain restrictions on the ownership and voting of shares of our capital stock by market participants. In particular, the Articles of Incorporation provide that we are restricted from issuing any shares of capital stock or recording any transfer of shares if the issuance or transfer would cause any market participant, either individually or together with members of its “group” (as defined in SEC beneficial ownership rules), to beneficially own 5% or more of any class or series of our capital stock. Additionally, if a market participant, together with its group members, acquires beneficial ownership of 5% or more of any series of the outstanding shares of our capital stock, such market participant or any shareholder who is a member of a group including a market participant will not be able to vote or direct or control the votes of shares representing 5% or more of any series of our outstanding capital stock. Finally, to the extent a market participant, together with its group members, acquires beneficial ownership of 5% or more of the outstanding shares of any series of our capital stock, our Articles of Incorporation allow our board of directors to redeem any shares of our capital stock so that, after giving effect to the redemption, the market participant, together with its group members, will cease to beneficially own 5% or more of that series of our outstanding capital stock.

 

Future sales of our shares could depress the market price of our common stock.

 

The market price of our common stock could decline as a result of sales of a large number of shares of our common stock in the market or the perception that these sales could occur. These sales, or the possibility that these sales may occur, also might make it more difficult for us to sell equity securities in the future at a time and at a price that we deem appropriate.

 

As of March 1, 2007, we had approximately 42,382,893 shares of common stock outstanding. Of those shares, 39,458,031 shares, were freely tradable. Approximately 2,924,862 shares outstanding as of March 1, 2007 are eligible for resale from time to time, subject to the contractual restrictions on sales referred to above and to the volume, manner of sale and other conditions of Rule 144.

 

In addition, as of March 1, 2007, 4,358,334 shares were available for future issuance under our 2003 Stock Purchase and Option Plan, Employee Stock Purchase Plan and 2006 Long Term Incentive Plan, including 2,633,023 shares issuable upon the exercise of outstanding stock options, of which 1,526,125 were vested. In the future, we may issue our common stock in connection with investments or repayment of our debt. The amount of such common stock issued could constitute a material portion of our then outstanding common stock.

 

None.

 

Our regulated operating subsidiaries’ transmission facilities are located in the lower peninsula of Michigan. ITCTransmission and METC have agreements with other utilities for the joint ownership of specific substations and transmission lines. See Note 15 to the Consolidated Financial Statements.

 

ITCTransmission owns the assets of a transmission system that consist of:

 

 

 

ITCTransmission’s First Mortgage Bonds are issued under ITCTransmission’s First Mortgage and Deed of Trust, and therefore the bondholders have the benefit of a first mortgage lien on substantially all of ITCTransmission’s property.

 

METC owns the assets of a transmission system that consist of:

 

 

Amounts borrowed under METC’s revolving credit facility are secured by a first priority security interest on all of METC’s assets through the issuance of senior secured bonds, collateral series, under METC’s first mortgage indenture and the second supplemental indenture thereto.

 

METC does not own the majority of the land on which its assets are located, but under the provisions of its easement agreement with Consumers Energy, METC has an easement to use the land, rights-of-way, leases and licenses in the land on which its transmission lines are located that are held or controlled by Consumers Energy. See Item 1 “Business — Operating Contracts, — METC, — Amended and Restated Easement Agreement.”

 

The assets of our regulated operating subsidiaries are suitable for electricity transmission and adequate for the electricity demand in our service territory. We prioritize capital spending based in part on meeting reliability standards within the industry. This includes replacing and upgrading existing assets as needed.

 

We are involved in certain legal proceedings before various courts, governmental agencies, and mediation panels concerning matters arising in the ordinary course of business. These proceedings include certain contract disputes, regulatory matters, and pending judicial matters. We cannot predict the final disposition of such proceedings. We regularly review legal matters and record provisions for claims that are considered probable of loss. The resolution of pending proceedings is not expected to have a material effect on our operations or financial statements in the period they are resolved.

 

Refer to Note 5 to the Consolidated Financial Statements for a discussion of the METC rate case and Note 16 to the Consolidated Financial Statements for other pending litigation.

 

None.

 

Stock Price and Dividends

 

Our common stock has traded on the NYSE since July 26, 2005 under the symbol “ITC”. Prior to that time, there was no public market for our stock. As of March 1, 2007, there were approximately 325 shareholders of record of our common stock.

 

The following tables set forth the high and low sales price per share of the common stock for each full quarterly period in 2006 and from July 26, 2005 through December 31, 2005, as reported on the NYSE and the cash dividends per share paid during the periods indicated.

 

 

 

The declaration and payment of dividends is subject to the discretion of ITC Holdings’ board of directors and depends on various factors, including our net income, financial condition, cash requirements, future prospects and other factors deemed relevant by our board of directors. As a holding company with no business operations, ITC Holdings’ material assets consist only of the common stock of ITCTransmission, indirect ownership interests in METC, ownership interests of our other subsidiaries, deferred tax assets relating primarily to NOLs and cash. Our material cash inflows are only from dividends and other payments received from time to time from ITCTransmission, METC or our other subsidiaries and the proceeds raised from the sale of debt and equity securities. We may not be able to access cash generated by ITCTransmission or METC or any other subsidiaries in order to pay dividends to shareholders. The ability of ITCTransmission and METC to make dividend and other payments to ITC Holdings is subject to the availability of funds after taking into account ITCTransmission’s and METC’s respective funding requirements, the terms of ITCTransmission’s and METC’s respective indebtedness, the regulations of the FERC under FPA, and applicable state laws. The debt agreements to which ITC Holdings, ITCTransmission and METC are parties contain numerous financial covenants that could limit our ability to pay dividends, as well as covenants that prohibit us from paying dividends if we are in default under our revolving credit facilities. Further, each of ITCTransmission, METC and each other subsidiary is legally distinct from us and has no obligation, contingent or otherwise, to make funds available to us.

 

If and when we pay a dividend on our common stock, pursuant to our special bonus plans for executives and non-executive employees, amounts equivalent to the dividend may be paid to the special bonus plan participants, if approved by the compensation committee. We currently expect these amounts to be paid upon the declaration of dividends on our common stock. The board of directors intends to increase the dividend rate from time to time as necessary for the yield to remain competitive, subject to

prevailing business conditions, applicable restrictions on dividend payments and the availability of capital resources.

 

The transfer agent for the common stock is Computershare Trust Company, N.A., P.O. Box 43078 Providence, RI 02940-3078.

 

Equity Compensation Plans

 

At December 31, 2006 we had an Amended and Restated 2003 Stock Purchase and Option Plan for Key Employees of ITC Holdings Corp. and its subsidiaries (the “2003 Stock Purchase and Option Plan”) and a 2006 Long-Term Incentive Plan (“LTIP”) pursuant to which we grant stock options and restricted stock and other equity based compensation to employees, officers, and directors. We also have an Employee Stock Purchase Plan that we expect to implement during the first quarter of 2007. Each of these plans has been approved by shareholders.

 

The following table sets forth certain information with respect to our equity compensation plans at December 31, 2006 (shares in thousands):

 

 

 

 

Stock Repurchases

 

The following table sets forth, the repurchases of common stock for the quarter ended December 31, 2006:

 

 

 

 

Recent Sales of Unregistered Securities

 

None.

 

The following table sets forth selected historical financial data of ITC Holdings and subsidiaries and the selected historical financial data of ITCTransmission’s business prior to its acquisition by ITC Holdings

from DTE Energy on February 28, 2003 (“Predecessor ITCTransmission”) for the periods indicated. On July 19, 2005, ITC Holdings affected an approximately 3.34-for-one stock split. All amounts and values of common shares and options and per share data in the accompanying financial information have been retroactively adjusted to give effect to the stock split.

 

From June 1, 2001 until February 28, 2003, Predecessor ITCTransmission was operated as a subsidiary of DTE Energy. We acquired the outstanding ownership interests of Predecessor ITCTransmission from DTE Energy on February 28, 2003 and accounted for the acquisition as a purchase. We adopted certain accounting policies and methods which differ from those followed by Predecessor ITCTransmission prior to the acquisition.

 

The selected financial data presented on the following pages for ITC Holdings and subsidiaries as of December 31, 2006 and 2005 and for the years ended December 31, 2006, 2005 and 2004 have been derived from our audited consolidated financial statements included elsewhere in this Form 10-K. The selected financial data presented for ITC Holdings and subsidiaries as of December 31, 2004 and 2003 and for the period from February 28, 2003 through December 31, 2003, and the selected financial data presented for Predecessor ITCTransmission as of December 31, 2002 and for the two-month period ended February 28, 2003 and year ended December 31, 2002 have been derived from audited financial statements not included in this Form 10-K. Neither Predecessor ITCTransmission’s two-month period ended February 28, 2003 nor the period from February 28, 2003 through December 31, 2003 is reflective of the twelve-month year of operations and, accordingly, neither of such periods individually is directly comparable to the results of operations for the years ended December 31, 2006, 2005, 2004 or 2002.

The selected financial data presented below should be read together with our consolidated financial statements and the notes to those statements and Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” included elsewhere in this Form 10-K.

 

 

 

 

 

 

Safe Harbor Statement Under The Private Securities Litigation Reform Act of 1995

 

Our reports, filings and other public announcements contain certain statements that describe our management’s beliefs concerning future business conditions and prospects, growth opportunities and the outlook for our business and the electricity transmission industry based upon information currently available. Such statements are “forward-looking” statements within the meaning of the Private Securities Litigation Reform Act of 1995. Wherever possible, we have identified these forward-looking statements by words such as “anticipates,” “believes,” “intends,” “estimates,” “expects,” “projects” and similar phrases. These forward-looking statements are based upon assumptions our management believes are reasonable. Such forward-looking statements are subject to risks and uncertainties which could cause our actual results, performance and achievements to differ materially from those expressed in, or implied by, these

statements, including, among other things the risks and uncertainties disclosed under Item 1A “Risk Factors.”

 

Because our forward-looking statements are based on estimates and assumptions that are subject to significant business, economic and competitive uncertainties, many of which are beyond our control or are subject to change, actual results could be materially different and any or all of our forward-looking statements may turn out to be wrong. They speak only as of the date made and can be affected by assumptions we might make or by known or unknown risks and uncertainties. Many factors mentioned in our discussion in this report will be important in determining future results. Consequently, we cannot assure you that our expectations or forecasts expressed in such forward- looking statements will be achieved. Actual future results may vary materially. Except as required by law, we undertake no obligation to publicly update any of our forward-looking or other statements, whether as a result of new information, future events, or otherwise, unless required by law.

 

Overview

 

Through our regulated operating subsidiaries, ITCTransmission and METC, we are engaged in the transmission of electricity in the United States. Our business strategy is to operate, maintain and invest in our transmission infrastructure in order to enhance system integrity and reliability and to reduce transmission constraints. By pursuing this strategy, we seek to reduce the overall cost of delivered energy for end-use consumers by providing them with access to electricity from the lowest cost electricity generation sources. ITCTransmission and METC operate contiguous, high-voltage systems that transmit electricity to local electricity distribution facilities from generating stations throughout Michigan and surrounding areas. The local distribution facilities connected to our systems serve an area comprising substantially all of the lower peninsula of Michigan, which had an estimated population of 9.8 million people at December 31, 2006.

 

As transmission utilities with rates regulated by the FERC, ITCTransmission and METC earn revenues through tariff rates charged for the use of their electricity transmission systems by our customers, which include investor-owned utilities, municipalities, co-operatives, power marketers and alternative energy suppliers. As independent transmission companies, ITCTransmission and METC are subject to rate regulation only by the FERC. The rates charged by ITCTransmission and METC are established using a formulaic cost-of-service model, referred to as “Attachment O” and re-calculated annually, allowing for the recovery of actual expenses and income taxes and a return of and on invested capital.

 

ITCTransmission’s and METC’s primary operating responsibilities include maintaining, improving and expanding its transmission system to meet its customers’ ongoing needs, scheduling outages on system elements to allow for maintenance and construction, balancing electricity generation and demand, maintaining appropriate system voltages and monitoring flows over transmission lines and other facilities to ensure physical limits are not exceeded.

 

We derive nearly all of our revenues from providing (1) network transmission service, (2) point-to-point transmission service, and (3) scheduling, control and dispatch services over our system. Substantially all of our operating expenses and assets support our transmission operations. ITCTransmission’s principal transmission service customer is Detroit Edison and METC’s principal transmission service customer is Consumers Energy. Our remaining revenues are generated from providing service to other entities such as alternative electricity suppliers, power marketers and other wholesale customers that provide electricity to end-use consumers, from transaction-based capacity reservations on ITCTransmission’s and METC’s transmission system and from providing ancillary services to customers. ITCTransmission’s and METC’s network rates are established on a cost-of-service model allowing for the recovery of expenses, including depreciation and amortization, and a return on invested capital.

 

Significant items that influenced our financial position and results of operations and cash flows for the year ended December 31, 2006 or may affect future results are:

 

 

These items are discussed in more detail throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

The disclosure throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses certain relevant aspects of MTH’s and METC’s business prior to the consummation of the METC Acquisition, which was completed on October 10, 2006. MTH’s and METC’s results of operations and cash flows are included in our consolidated results of operations and cash flows for the period from October 11, 2006 through December 31, 2006.

 

Rate Setting and Attachment O

 

Network Transmission Rates

 

ITCTransmission and METC operate in two different rate zones, in each of which a different transmission service rate is charged. The rates of these utility subsidiaries are determined using a FERC-approved formulaic rate setting mechanism known as Attachment O. Attachment O is a rate template used by members of MISO and is completed with financial and load information to calculate a transmission rate. Under Attachment O, these subsidiaries’ rates adjust annually to account for year-to-year changes in network load, expenses and a return of and on invested capital, among other items. These annual adjustments occur under Attachment O without the need to file a rate case at the FERC.

 

ITCTransmission’s FERC-approved rate allows it to earn a return of 13.88% on the actual equity portion of its capital structure in calculating rates. ITCTransmission’s current network transmission rate is $2.099 per kW/month, which became effective beginning on January 1, 2007.

 

Until December 31, 2005, METC’s billed network transmission rate was subject to a rate freeze of $0.98 per kW/month. On December 30, 2005, the FERC issued an order that authorized METC to bill rates determined using Attachment O, subject to specified adjustments. The December 2005 rate order also authorized METC to earn a return of 13.38% on the actual equity portion of its capital structure in calculating rates. Pursuant to the December 2005 rate order, METC began to charge a network transmission rate of $1.567 per kW/month effective as of January 1, 2006, subject to refund based on the outcome of METC’s current rate proceeding. METC began to charge a network transmission rate of $1.524 per kW/month on June 1, 2006, subject to refund, based primarily on data from METC’s 2005 FERC Form No. 1.

 

The following table presents network transmission rates (per kW/month) relevant to our results of operations since January 1, 2004:

 

 

 

 

Forward-Looking Attachment O

 

On July 14, 2006 and December 21, 2006, the FERC authorized ITCTransmission and METC, respectively, to modify the implementation of their Attachment O formula rates so that, beginning January 1, 2007, ITCTransmission and METC recover expenses and earn a return on and recover investments in property, plant and equipment on a current rather than a lagging basis, which is expected to result in higher revenues and cash flows in the initial years after implementation. In periods of capital expansion and increasing rate base, ITCTransmission and METC will recover the costs of these capital investments on a more timely basis than under the historical Attachment O method.

 

Under the Forward-Looking Attachment O formula, ITCTransmission and METC will use forecasted expenses, additions to in-service property, plant and equipment, point-to-point revenues, network load and other items for the upcoming calendar year to establish rates for service on the ITCTransmission and METC systems from January 1 to December 31 of that year. The Forward-Looking Attachment O formula includes a true-up mechanism, whereby ITCTransmission and METC compare their actual net revenue requirements to their billed revenues for each year after the end of the year. ITCTransmission’s and METC’s rate-setting method for network transmission rates in effect through December 31, 2006 primarily used 2005 FERC Form No. 1 data to establish a rate.

 

Monthly peak loads continue to be used for billing network revenues. Under Forward-Looking Attachment O, in the event billed revenues in a given year are more or less than its actual net revenue requirement, which is calculated primarily using that year’s FERC Form No. 1, ITCTransmission and METC will refund or collect additional revenues, with interest, such that customers pay only the amounts that correspond to ITCTransmission’s and METC’s actual net revenue requirement. Revenue amounts billed that differ from actual net revenue requirements are subject to the true-up provisions of Forward-Looking Attachment O, and ITCTransmission and METC accrue or defer revenues to the extent that the actual net revenue requirement for the reporting period is higher or lower, respectively, than the amounts billed relating to that reporting period. Therefore, network load continues to have an impact on cash flows from transmission service, but will not impact revenues recognized from transmission service beginning in 2007. For historical periods through December 31, 2006, there was no adjustment recognized for billed amounts that differed from actual net revenue requirement.

 

Network Transmission Rate Calculation

 

ITCTransmission and METC separately calculate a tariff rate under Attachment O based on the financial information and load data specific to each company. The following steps illustrate ITCTransmission’s and METC’s rate-setting methodology under Forward-Looking Attachment O:

 

 

Rate base is projected using the average of the 13 month-end balances for the months beginning with December 31 of the current year and ending with December 31 of the upcoming year and consists

primarily of in-service property, plant and equipment, net of accumulated depreciation. Rate base also includes an accumulated deferred income tax adjustment, certain regulatory assets and amounts deferred for recovery, as well as other items.

 

Projected rate base is multiplied by the projected weighted average cost of capital to determine the projected allowed return on rate base. The weighted average cost of capital is calculated using a projected 13 month average capital structure, the forecasted pre-tax cost of the debt portion of the capital structure and a FERC-approved return of 13.88% and 13.38% for ITCTransmission and METC, respectively, on the common equity portion of the forecasted capital structure.

 

 

The projected gross revenue requirement is calculated beginning with the projected allowed return on rate base, as calculated in Step One above, and adding projected recoverable operating expenses, including depreciation and amortization and taxes.

 

 

After calculating the projected gross revenue requirement in Step Two above, the projected gross revenue requirement is reduced for certain revenues, other than network revenues, such as projected point-to-point and rental revenues. This net amount represents projected revenues to be billed to network and point-to-point transmission customers through transmission rates. The monthly transmission rate is calculated by dividing the projected net revenue requirement by the sum of the projected 12 coincident peak network loads.

 

 

Upon finalizing FERC Form No. 1, the actual transmission revenues billed for the previous year will be compared to actual net revenue requirement which is based on amounts from the completed FERC Form No. 1. The difference between the actual revenue billed and actual net revenue requirement (the “True-up Adjustment”), will be added to the upcoming year’s projected net revenue requirement used to determine the upcoming year’s rate. For example, the True-up Adjustment relating to 2007 will be calculated in 2008 upon completion of the 2007 FERC Form No. 1 and will be included in the projected net revenue requirement that is used to establish the rate that will be effective commencing January 1, 2009. Interest is also applied to the True-up Adjustment.

 

Illustration of Attachment O Rate Setting.  Set forth below is a simplified illustration of the calculation of ITCTransmission’s monthly network and point-to-point rates under the Attachment O rate setting mechanism for the period from January 1, 2007 through December 31, 2007, that will be based primarily upon projections of ITCTransmission’s 2007 FERC Form No. 1 data. Amounts below are approximations of the amounts used in the 2007 Attachment O filing.

 

 

 

 

 

Trends and Seasonality

 

Network Revenues

 

We expect a general trend of increases in network transmission rates and revenues for ITCTransmission and METC over the next few years under Attachment O, although we cannot predict a specific year-to-year trend due to the variability of factors beyond our control. The expected increase is partially a result of the implementation of Forward-Looking Attachment O, which will allow ITCTransmission and METC to recover their expenses and investments in transmission on a current rather than a lagging basis. ITCTransmission’s network transmission rate is $2.099 per kW/month, which became effective beginning on January 1, 2007, based on ITCTransmission’s implementation of Forward-Looking Attachment O.

METC’s Forward-Looking Attachment O is also effective beginning January 1, 2007, however METC’s network transmission rate of $1.524 per kW/month in effect beginning June 1, 2006 will continue to be the rate used for network transmission service billing through December 31, 2007, and the rate will be updated effective January 1, 2008. The rates used during 2007 are subject to a True-Up Adjustment under Forward-Looking Attachment O based on actual net revenue requirement for 2007.

 

The other factor that is expected to continue to increase our rates in future years is our anticipated capital investment in excess of depreciation as a result of our seven-year capital investment program which began January 1, 2005 for ITCTransmission and January 1, 2007 for METC. ITCTransmission and METC strive for high reliability for their systems and low delivered costs of electricity to end-use consumers. We continually assess our transmission systems against standards established by the North American Electric Reliability Council and ReliabilityFirst Corporation, which are electric industry organizations that, in part, develop standards for reliability and monitor compliance with those standards. Analysis of the transmission systems against these voluntary reliability standards has become more focused and rigorous in recent years, primarily as a reaction to the August 2003 electrical blackout that affected sections of the northeastern and midwestern United States and Ontario, Canada. Moreover, on August 8, 2005 the Energy Policy Act was enacted, which requires the FERC to implement mandatory electricity transmission reliability standards to be enforced by an Electric Reliability Organization. We also assess our transmission system against our own planning criteria that are filed annually with the FERC. Projects that are undertaken to meet the reliability standards may have added benefits of increasing throughput and reducing transmission congestion in ITCTransmission’s and METC’s systems, which in turn reduces the delivered cost of energy to end-use customers.

 

For the seven-year period from January 1, 2005 through December 31, 2011, based on our planning studies, we see needs within the ITCTransmission service territory alone to spend approximately $600.0 million to rebuild existing transmission property, plant and equipment. There may be additional investment of up to approximately $400.0 million over the same period to upgrade the system to address demographic changes in southeastern Michigan that have impacted transmission load and the changing role that transmission plays in meeting the needs of the wholesale market. This additional investment may be needed to accommodate the siting of new generation or to increase import capacity to meet expected growth in peak electrical demand. Approximately $100.0 million may be invested over this period for the primary benefit of relieving congestion in the transmission system in southeastern Michigan, but the total of all these investments is not expected to exceed $1.0 billion for the ITCTransmission system. In 2006, ITCTransmission completed the second year of its capital investment program, and invested $171.5 million in property, plant and equipment. We expect ITCTransmission’s total investments in property, plant and equipment in 2007 to be approximately $190.0 million, based on projects currently planned or being considered.

 

We expect METC to invest approximately $600.0 million in its system over the seven-year period from January 1, 2007 through December 31, 2013, with METC investing $50.0 million and $32.6 million in 2006 and 2005, respectively. We expect that investments in property, plant and equipment at METC in 2007 will be approximately $25.0 million, based on projects currently planned or being considered.

 

Investments in property, plant and equipment at ITCTransmission and METC could vary due to, among other things, the impact of weather conditions, union strikes, labor shortages, material and equipment prices and availability, our ability to obtain financing for such expenditures, if necessary, limitations on the amount of construction that can be undertaken on ITCTransmission’s or METC’s system at any one time, regulatory approvals for reasons relating to environmental, siting or regional planning issues or as a result of legal proceedings and variances between estimated and actual costs of construction contracts awarded. Additions to property, plant and equipment, when placed in service upon completion of a capital project, are added to rate base each year. Property, plant and equipment additions in excess of depreciation and amortization expense result in an expansion of rate base when these additions are placed in service. In 2006, ITCTransmission had $143.3 million of property, plant and equipment additions placed in service and added to rate base and METC had $38.4 million of property, plant and equipment additions placed in service and added to rate base, which includes periods prior to its

2006 acquisition. The following table shows additions to property, plant and equipment in excess of depreciation and amortization expense during the last three years for ITCTransmission.

 

 

 

Our capital investment strategy is aligned with the FERC’s policy objective to promote needed investment in transmission infrastructure, improve reliability and reduce transmission constraints. We assess our performance based in part on the levels of prudent and necessary capital investment and maintenance spending on our transmission system.

 

In addition to an increase in rate base as a result of investments in property, plant and equipment, there were other specific items that caused the increase in the rate at June 1, 2006 to $1.744 per kW/ month at ITCTransmission. Beginning June 1, 2006, one-fifth, or $11.9 million, of the revenue that was deferred during the rate freeze that ended on December 31, 2004 is included in ITCTransmission’s rates in each of the following five 12-month periods. Additionally, operating expenses in 2005 were higher due primarily to higher maintenance expenses as a result of the acceleration of multi-year maintenance initiatives.

 

Point-to-Point Revenue

 

Our point-to-point revenue for the year ended December 31, 2006 was negatively impacted by the elimination of certain types of point-to-point revenues and decreases in other types of point-to-point revenues. The decrease in point-to-point revenues in 2006 compared to 2005 was $13.3 million. Under Forward-Looking Attachment O, the amount of point-to-point revenues is factored into actual net revenue requirement and will not have an impact on net income beginning in 2007.

 

Seasonality

 

Prior to January 1, 2007, the network revenues recognized by ITCTransmission and METC were dependent on monthly peak loads. Revenues and net income varied between periods based on monthly peak loads, among other factors. To the extent that actual conditions during an annual period varied from the data on which the Attachment O rate was based, ITCTransmission and METC earned more or less revenue during that annual period and therefore recovered more or less than its net revenue requirement.

 

As discussed above under “Rate Setting and Attachment O, — Forward-Looking Attachment O,” beginning January 1, 2007, the monthly peak loads continue to be used for billing network revenues.

However, ITCTransmission and METC accrue or defer revenues to the extent that the actual net revenue requirement for the reporting period is higher or lower, respectively, than the amounts billed relating to that reporting period. Therefore, ITCTransmission and METC will recognize more revenues in periods where recoverable expenses are higher, and less revenues in periods where recoverable expenses are lower.

 

ITCTransmission’s total of monthly peak loads for 2006 was down 3.0% compared to the corresponding total for 2005, and was up 1.6% compared to the corresponding totals for 2004, as shown in the table below.

Monthly Peak Load (in MW)

 

 

Recent Developments

 

Pending Acquisition of Transmission Assets

 

On January 19, 2007, we announced that ITC Midwest had signed a definitive agreement to acquire for cash the transmission assets of IP&L in a transaction valued at approximately $750.0 million, excluding expenses.

 

IP&L’s transmission assets currently consist of approximately 6,800 miles of transmission lines at voltages of 34.5kV and above and associated substations, predominantly located in Iowa with some assets in Minnesota, Illinois and Missouri. The rate base being acquired is expected to be in a range between $400.0 million and $425.0 million, subject to the elimination of accumulated deferred taxes. The purchase price is subject to several purchase price adjustments relating to liabilities actually assumed by ITC Midwest and the actual rate base and construction work in progress actually transferred to ITC Midwest by IP&L.

 

The transaction is subject to customary closing conditions and regulatory approvals, including approval from the FERC, the Iowa Utilities Board, the Minnesota Public Utilities Commission and the Illinois Commerce Commission, as well as expiration of the required waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended. The parties must also seek approval of the Missouri Public Service Commission to assign IP&L’s Certificate of Public Convenience and Necessity to ITC Midwest. Our FERC application will seek approval of a rate construct for ITC Midwest that is similar to the rate constructs of ITCTransmission and METC. It is a condition to closing that each party receives regulatory approvals on terms and conditions substantially equivalent to those requested in the parties’ applications for such approvals. If closing of the transaction has not occurred on or before December 31, 2007, in most cases either party may terminate the agreement at any time after that date.

 

ITC Midwest expects to finance the transaction through a combination of cash on hand, the proceeds from a sale of common stock of ITC Holdings and the issuance of debt by ITC Holdings and/or ITC Midwest to maintain ITC Holdings’ targeted capital structure of 70% debt and 30% equity. The transaction is expected to close in the fourth quarter of 2007. ITC Midwest and IP&L have agreed that in the event that either party terminates the acquisition agreement as a result of a breach by the other party of its covenants, agreements or representations, made as of the date of the acquisition agreement, which would cause the closing conditions contained in the acquisition agreement not to be satisfied, the terminating party shall be entitled as its sole and exclusive remedy to liquidated damages equal to approximately $24.0 million, or $45.0 million solely in the event that such breach is ITC Midwest’s failure to pay IP&L the purchase price at closing of the transaction. The closing of the IP&L acquisition is not subject to any condition that ITC Holdings or ITC Midwest have completed any financing prior to consummation of the transaction. ITC Holdings has received a commitment letter, dated January 18, 2007, from Lehman Brothers Inc., Lehman Commercial Paper Inc. and Lehman Brothers Bank to provide to ITC Holdings, subject to the terms and conditions therein, financing in an aggregate amount of up to $765.0 million in the form of a 364-day senior unsecured bridge term loan facility. ITC Holdings does not intend to draw down on this bridge financing unless funds from the contemplated common equity offering and debt offerings are unavailable at the time of closing. The availability of the bridge financing is subject to the satisfaction of customary conditions to consummation, including the consummation of the acquisition and the execution of definitive financing documents. The bridge financing commitment expires upon the earlier of December 31, 2007 and the date ITC Holdings notifies Lehman Brothers Inc. that the acquisition has been abandoned.

 

In connection with the acquisition, ITC Holdings has executed a guaranty, pursuant to which it has agreed to unconditionally guarantee the payment and performance of the obligations of ITC Midwest under the acquisition agreement.

 

There can be no assurance that our acquisition of IP&L’s transmission assets will be consummated. We may not successfully complete our acquisition of the transmission assets of IP&L as a result of our failure, or IP&L’s failure, to obtain the necessary regulatory approvals or other approvals on a timely basis. In addition, both we and IP&L must comply with a number of closing conditions in order to consummate the acquisition and, in addition, we must obtain financing to pay the purchase price for the transmission assets. If we do successfully acquire the transmission assets of IP&L, we may not realize the strategic and other benefits that we currently expect. See Item 1A “Risk Factors — Risks Related to the Pending Acquisition of IP&L’s Transmission Assets.” in this report.

 

The METC Acquisition

 

On October 10, 2006, ITC Holdings acquired indirect ownership of all the partnership interests in MTH, the sole member of METC. The former indirect owners of the MTH partnership interests received approximately $484.4 million in cash and 2,195,045 shares of our common stock valued at $72.5 million. In addition, we, MTH or METC assumed approximately $307.7 million of MTH and METC debt and other long term interest bearing obligations. As part of the METC Acquisition, ITC Holdings acquired the remaining partnership interests in MTH and other subsidiaries, including subsidiaries that contributed NOLs. Based on the preliminary purchase price allocation, METC has recorded goodwill of $450.1 million. No value was assigned to certain METC construction projects that we do not expect to be used subsequent to the METC Acquisition. We may pursue authorization from the FERC to recover METC’s cost of approximately $14.5 million for these items.

 

METC Rate Case Settlement Agreement

 

On January 19, 2007, METC, MISO, Consumers Energy, Michigan Public Power Agency, Michigan South Central Power Agency, Wolverine Power Supply Cooperative, Inc. and ITCTransmission entered into a settlement agreement resolving all pending matters in METC’s pending rate case before the FERC, including those set for hearing in the FERC’s December 30, 2005 rate order, which authorized METC, beginning on January 1, 2006, to charge rates for its transmission service using the rate setting formula contained in Attachment O. On December 5, 2006, METC and other parties to the rate case had jointly filed

a motion to suspend the procedural schedule and the FERC chief administrative law judge had approved the suspension. The terms of this settlement agreement have been filed with the FERC and remain subject to its approval.

 

Under the filed settlement terms, METC would be required to make payments totaling $20.0 million to various transmission customers within 30 days after there is a final FERC order approving the settlement. METC’s payment pursuant to this settlement would be in lieu of any and all refund and/or refund with interest requirements in this proceeding in connection with METC’s rates in effect on and after January 1, 2006. METC shall have no other refund obligation or liability beyond this payment in connection with this proceeding. Additionally, the settlement would establish the balances and amortization to be used for ratemaking for the Regulatory Deferrals and ADIT Deferrals, as defined in the settlement.

 

The METC rate case matter is accounted for as a preacquisition contingency under the provisions of Statement of Financial Accounting Standards No. 141, Business Combinations. The expected settlement payment of $20.0 million is accounted for as a liability at the acquisition date and the adjustments to the Regulatory Deferral and ADIT Deferral balances are treated as adjustments to the carrying amounts of assets acquired. If the METC rate case settlement is approved by the FERC as expected, we will recognize annual amortization expense associated with the Regulatory Deferral and ADIT Deferral totaling $6.2 million beginning in 2007. There was no effect on depreciation and amortization expense for the year ended December 31, 2006.

 

ITC Grid Development, LLC and ITC Great Plains, LLC Company

 

In July 2006, ITC Holdings formed two new subsidiaries — ITC Grid Development and ITC Great Plains. As an extension of our existing strategy, ITC Grid Development was formed to focus on bringing improvements to the U.S. electricity transmission infrastructure by partnering with entities in regions where we believe significant investment is needed to improve reliability and address local energy needs. ITC Great Plains, which has opened an office in Topeka, Kansas, was formed to focus on opportunities for transmission investment in Kansas and the Great Plains region. In Kansas, and in other states or regions where we may engage in operations through our two new subsidiaries, we expect to partner with local experts, such as firms that specialize in design and engineering, and other entities in order to achieve our objectives of enhancing the U.S. transmission grid and providing the framework for lower electric energy costs. These subsidiaries are working to identify and are expected to eventually undertake projects consisting of upgrades to existing electricity transmission systems as well as the construction of new electricity transmission systems or portions of systems. We expect to pursue only development opportunities that are consistent with ITCTransmission’s business model, such as those that are anticipated to result in the creation of a FERC-regulated entity using formula-based rates. We currently anticipate incurring approximately $3.0 million in expenses at ITC Grid Development and ITC Great Plains in 2007. We do not currently have any commitments that would result in additional expenses being incurred if we elect to discontinue these activities.

 

Michigan Public Power Agency Receivable and Revenues

 

The Michigan Public Power Agency (the “MPPA”) has an ownership interest in ITCTransmission’s Greenwood-St. Clair-Jewell-Stephens Transmission Line and Monroe-Wayne-Coventry-Majestic Transmission Line. Under an Ownership and Operating Agreement between the MPPA and ITCTransmission, ITCTransmission is authorized to operate, maintain, and make capital improvements to the transmission lines, while the MPPA is responsible for the capital and operation and maintenance costs allocable to its ownership interest. We had $4.9 million of accounts receivable as of September 30, 2006 for amounts billed to the MPPA under the Ownership and Operating Agreement for the period from March 2003 through September 30, 2006 for which the MPPA had not remitted any payment to us. ITCTransmission commenced litigation in June 2005 in state court to recover the full amount billed to the MPPA. In January 2006, the state court determined that under the Ownership and Operating Agreement the claim must be arbitrated, which ITCTransmission was pursuing. Although we believed we had appropriately billed the MPPA under the terms of the Ownership and Operating Agreement, we had reserved an amount of

$1.0 million relating to this matter resulting in a net amount of accounts receivable from the MPPA of $3.9 million prior to the settlement of this loss contingency as described below.

 

Additionally, prior to the settlement agreement described below, the MPPA had counterclaimed that ITCTransmission breached a 2003 letter agreement by not previously executing a revenue distribution agreement, under which the MPPA would receive revenue from MISO through ITCTransmission. The MPPA contended that amounts it owed to ITCTransmission under the Ownership and Operating Agreement should be set off by revenue the MPPA would have received from MISO if ITCTransmission had executed the revenue distribution agreement. The MPPA also alleged that ITCTransmission had improperly retained the MPPA’s revenue, totaling $3.3 million at September 30, 2006, which MISO has remitted to ITCTransmission on the MPPA’s behalf beginning January 1, 2005. We have not recognized these revenue amounts in our results of operations and expected to remit these retained amounts in the event we executed a revenue distribution agreement and collected the accounts receivable from the MPPA. The amount payable to the MPPA had not been netted against the $4.9 million of accounts receivable from the MPPA as it did not meet the criteria to set off the balances in our statement of financial position.

 

In October 2006, ITCTransmission and the MPPA finalized a settlement agreement for all matters in dispute as described above as well as for a related matter for capital costs allocable to the MPPA’s ownership interest. ITCTransmission received a net settlement amount of $3.2 million from the MPPA, which consisted of $4.6 million for operation and maintenance costs allocable to the MPPA’s ownership interest, $1.7 million for capital costs allocable to the MPPA’s ownership interest and $0.2 million for carrying charges for these capital costs, partially offset by $3.3 million for amounts MISO has remitted to ITCTransmission on the MPPA’s behalf beginning January 1, 2005. ITCTransmission and the MPPA executed a revenue sharing agreement which provides terms and conditions for timely payment of the amounts MISO remits to ITCTransmission on the MPPA’s behalf.

 

The settlement resulted in the recognition of income before income taxes of $0.6 million ($0.4 million net income after tax) in the third quarter of 2006 and $1.0 million ($0.7 million net income after tax) in the fourth quarter of 2006. The amount recognized in the third quarter of 2006 was for the resolution of the loss contingency, whereby we reversed the reserve previously recorded for the operation and maintenance costs allocable to the MPPA’s ownership interest by reducing operating expenses in the amount of $1.0 million, partially offset by a reduction in interest income of $0.4 million for carrying charges on the operation and maintenance costs allocable to the MPPA’s ownership interest, which were waived in the settlement. The amount recognized in the fourth quarter of 2006 results from an additional gain relating to the settlement of the MPPA capital costs allocable to their ownership interest in the amount of $0.8 million and related carrying charges of $0.2 million.

 

Public Securities Offerings

 

On July 29, 2005, ITC Holdings completed an initial public offering of its common stock pursuant to a registration statement on Form S-1, as amended (File No. 333-123657). ITC Holdings sold 2,500,000 newly-issued common shares through the offering, which resulted in proceeds received from the offering of $53.9 million (net of the underwriting discount of $3.6 million and before issuance costs). ITC Holdings paid $7.1 million in 2005 for professional services and other costs in connection with the initial public offering which were recorded in the consolidated statements of financial position as a reduction in stockholders’ equity. IT Holdings Partnership, our largest shareholder at the time, sold 11,875,000 common shares through the offering, from which ITC Holdings received no proceeds. The offering was approved by the FERC under Section 203 of the FPA on May 5, 2005 in Docket Nos. EC05-65 and EL05-94. The FERC also authorized us to complete further public offerings of ITC Holdings’ common stock, so long as such offerings occur before May 5, 2007.

 

On October 10, 2006, ITC Holdings completed an equity offering of its common stock pursuant to a registration statement on Form S-1, as amended (File No. 333-135137). ITC Holdings sold 6,580,987 newly issued shares of common stock through the offering, which resulted in proceeds of $200.5 million (net of underwriting discounts of $9.5 million), before issuance costs estimated at $2.4 million. The

proceeds from this offering were partially used to finance the METC Acquisition. IT Holdings Partnership sold 6,356,513 shares of common shares through the offering, from which sale ITC Holdings received no proceeds.

 

In February 2007, IT Holdings Partnership sold or distributed its remaining 11,390,054 common shares through a secondary offering of 8,149,534 common shares and through distributions of 3,240,520 to its general and limited partners, from which ITC Holdings received no proceeds. ITC Holdings incurred estimated offering costs of $0.7 million relating to this transaction, which was recorded to other expense in the first quarter of 2007.

 

Prior to the February 2007 sale and distribution, the ability of our shareholders, other than the IT Holdings Partnership, to influence our management and policies was limited, including with respect to our acquisition or disposition of assets, the approval of a merger or similar business combination, the incurrence of indebtedness, the issuance of additional shares of common stock or other equity securities and the payment of dividends or other distributions on our common stock. In addition, we could not take certain actions that would adversely affect the limited partners of the IT Holdings Partnership without their approval. Because the IT Holdings Partnership has divested itself of all remaining common shares and is in the process of being dissolved, it is not expected that it will participate further in Company management.

 

Management Agreements

 

On February 28, 2003, we entered into agreements with Kohlberg Kravis Roberts & Co. L.P. (“KKR”), Trimaran Fund Management, L.L.C. and the IT Holdings Partnership for management, consulting and financial services in exchange for annual fees. We incurred general and administrative expenses under these agreements of $0.8 million in 2005 and $1.3 million in 2004, excluding out-of-pocket costs. In connection with ITC Holdings’ initial public offering that was completed on July 29, 2005, these agreements were amended to terminate further annual fees in exchange for payment of fees to KKR, Trimaran Fund Management, L.L.C. and the IT Holdings Partnership of $4.0 million, $1.7 million and $1.0 million, respectively. The total amount of $6.7 million was paid and recorded in operating expenses in 2005.

 

Redirected Transmission Service

 

In January and February 2005 in FERC Docket Nos. EL05-55 and EL05-63, respectively, transmission customers filed complaints against MISO claiming that MISO had charged excessive rates for redirected transmission service for the period from February 2002 through January 2005. In April 2005, the FERC ordered MISO to refund, with interest, excess amounts charged to all affected transmission customers for redirected service within the same pricing zone. ITCTransmission earns revenues based on an allocation from MISO for certain redirected transmission service and is obligated to refund the excess amounts charged to all affected transmission customers. In September 2005, MISO completed the refund calculations and ITCTransmission refunded $0.5 million relating to redirected transmission service, which was recorded as a reduction in operating revenues in the three months ended September 30, 2005.

 

With respect to the April 2005 order requiring refunds, certain transmission customers filed requests for rehearing at the FERC claiming additional refunds based on redirected transmission service between different pricing zones and redirected transmission service where the delivery point did not change. In November 2005, the FERC granted the rehearing requests, which required additional refunds to transmission customers. In December 2005, MISO filed an emergency motion seeking extension of the refund date until May 18, 2006, which was granted in January 2006. In December 2005, ITCTransmission and other transmission owners filed requests for rehearing of the November 2005 order on rehearing and clarification challenging the retroactive refunds and the rates used to price redirected transmission service between different pricing zones. The FERC has not yet acted on the rehearing requests filed in December 2005. We had previously reserved an estimated refund of redirected transmission service revenues by reducing operating revenues by $0.7 million in the fourth quarter of 2005 and an additional $0.6 million in the first quarter of 2006. In May 2006, ITCTransmission refunded $1.3 million relating to redirected services through January 2005. In the second quarter of 2006, we reduced operating revenues by

$0.1 million to reserve for estimated refunds of redirected transmission services revenue received subsequent to January 2005.

 

Long-Term Pricing

 

In November 2004 in FERC Docket No. EL02-111 et al., the FERC approved a pricing structure to facilitate seamless trading of electricity between MISO and PJM Interconnection, a regional transmission organization that borders MISO. The order established a Seams Elimination Cost Adjustment (“SECA”), as set forth in previous FERC orders, that took effect December 1, 2004, and remained in effect through March 31, 2006 as a transitional pricing mechanism. Prior to December 1, 2004, ITCTransmission earned revenues for transmission of electricity between MISO and PJM Interconnection based on a regional through-and-out rate for transmission of electricity between MISO and PJM Interconnection administered by MISO. SECA revenue and through-and-out revenue are both accounted for as point-to-point revenues.

 

From December 1, 2004 through March 31, 2006, we recorded $2.5 million of gross SECA revenues based on an allocation of these revenues by MISO as a result of the FERC order approving this transitional pricing mechanism. We no longer earn SECA revenues subsequent to the first quarter of 2006. The SECA revenues are subject to refund as described in the FERC order and this matter was litigated in a contested hearing before the FERC that concluded on May 18, 2006. An initial decision was issued by the Administrative Law Judge presiding over the hearings on August 10, 2006, which generally indicated that the SECA revenues resulted from unfair, unjust and preferential rates. The judge’s decision is subject to the FERC’s final ruling on the matter which could differ from the initial decision. Notwithstanding the judge’s initial decision, ITCTransmission and other transmission owners who collected SECA revenues are participating in settlement discussions with certain counterparties that paid the SECA amounts. Based on the ongoing settlement discussions, we reserved $0.4 million in the second quarter of 2006 for our estimate of the amount to be refunded to the counterparties that are participating in settlement discussions. As of December 31, 2006, ITCTransmission and METC have reserves recorded of $0.4 million and $0.3 million, respectively. For the counterparties who are not participating in the settlement discussions, we are not able to estimate whether any refunds of amounts earned by ITCTransmission or METC will result from this hearing or whether this matter will otherwise be settled, but we do not expect the amounts to be material. We have not accrued any refund amounts relating to these counterparties.

 

Financial Systems

 

In May 2006, we implemented new financial system modules for fixed assets, inventory, procurement, accounts payable and general ledger. It is anticipated that this implementation will provide operational and internal control benefits including system security and automation of previously manual controls. The new systems have resulted in changes to the overall internal control over financial reporting that were evaluated as part of management’s annual assessment of internal control over financial reporting as of December 31, 2006.

 

Significant Components of Results of Operations

 

Revenues

 

We derive nearly all of our revenues from providing network transmission service, point-to-point transmission service and other related services over our regulated operating subsidiaries’ systems to Detroit Edison and Consumers Energy and to other entities such as alternative electricity suppliers, power marketers and other wholesale customers that provide electricity to end-use consumers and from transaction-based capacity reservations on our transmission systems. MISO is responsible for billing and collection of transmission services in the MISO service territory. MISO, as the billing agent for ITCTransmission and METC, collects fees for the use of ITCTransmission’s and METC’s transmission system, invoicing Detroit Edison and Consumers Energy and other customers on a monthly basis. MISO has implemented credit policies for its members, which include ITCTransmission’s and METC’s customers.

 

Network Revenues are generated from fees charged to network customers for their use of our electricity transmission systems during the one hour of monthly peak usage and accounted for 92.4% of total operating revenues for the year ended December 31, 2006. For periods through December 31, 2006, the network revenues we billed and recognized were dependent on monthly peak loads and regulated transmission rates. Refer to our Critical Accounting Policies- “Revenue Recognition under Forward-Looking Attachment O” below for a discussion of network revenues recognized beginning January 1, 2007.

 

Network revenues are determined using rates regulated by the FERC. The monthly network revenues billed to customers using our transmission facilities are the result of a calculation which can be simplified into the following:

 

(1) multiply the network load measured in kWs achieved during the one hour of monthly peak usage for ITCTransmission’s and METC’s transmission system by the appropriate monthly tariff rate as calculated under Attachment O by 12 by the number of days in that month; and

 

(2) divide the result by 365.

 

Point-to-Point Revenues consist of revenues generated from a type of transmission service for which the customer pays for transmission capacity reserved along a specified path between two points on an hourly, daily, weekly or monthly basis and accounted for 3.1% of total operating revenues for the year ended December 31, 2006. Point-to-point revenues also include other components pursuant to schedules under the MISO transmission tariff.

 

The rates approved by the FERC in connection with our acquisition of ITCTransmission from DTE Energy included specific treatment of point-to-point revenues received during 2004 and the period from February 28, 2003 through December 31, 2003. Based on FERC orders as part of the acquisition of ITCTransmission from DTE Energy, ITCTransmission refunded 100% of point-to-point revenues earned during the period from February 28, 2003 through December 31, 2003 in March 2004 and refunded 75% of 2004 point-to-point revenues in March 2005. Point-to-point revenues collected for periods after December 31, 2004 are no longer refunded. Point-to-point revenues collected for the year ended December 31, 2004 that were not refunded (25% of total point-to-point revenues for 2004) and point-to-point revenues collected subsequent to December 31, 2004 were deducted from ITCTransmission’s revenue requirement in determining the annual network transmission rates.

 

Scheduling, Control and Dispatch Revenues also are approved by the FERC and are allocated to ITCTransmission and METC by MISO as compensation for the services ITCTransmission and METC jointly perform in operating MECS control area and accounted for 3.7% of total operating revenues for the year ended December 31, 2006. Such services include processing energy schedule requests utilizing the MECS system, monitoring of reliability data, implementation of emergency procedures, and coordination of the MECS operation.

 

Other Revenues consist of rental revenues received from METC, prior to the acquisition of METC, for the use of the MEPCC building as well as property easement revenues, and accounted for 0.8% of total operating revenues for the year ended December 31, 2006. Other revenues also includes amounts from providing ancillary services to customers.

 

Operating Expenses

 

Operation and Maintenance Expenses consist primarily of the costs of contractors to operate and maintain our transmission systems and salary-related expenses for our personnel involved in operation and maintenance activities.

 

Operation expenses include activities related to the MECS control area which involve balancing loads and generation and operations control room activities which include analyzing transmission system conditions and monitoring the status of our transmission lines and stations, as well as operation-related Services Contract expenses.

 

Maintenance expenses include preventive or planned maintenance, such as vegetation management, tower painting and equipment inspections, as well as reactive maintenance for equipment failures. Maintenance expenses also includes maintenance-related Services Contract expenses.

 

ITCTransmission Operating Agreements

 

Service Level Agreement.  Subsequent to February 28, 2003 and through April 2004, ITCTransmission operated under a construction and maintenance, engineering, and system operations service level agreements, (the “SLA”), with Detroit Edison whereby Detroit Edison performed maintenance, asset construction, and certain aspects of transmission operations and administration (the “SLA Activities”), on behalf of ITCTransmission. ITCTransmission entered into the SLA to provide an orderly transition from being a subsidiary of an integrated utility to a stand-alone independent transmission company. Under the terms of the SLA, ITCTransmission’s SLA Activities were jointly managed by ITCTransmission and Detroit Edison and therefore ITCTransmission did not have exclusive control over its expenditures relating to the SLA Activities through the term of the SLA. The terms of the SLA included an agreed upon pricing mechanism whereby Detroit Edison was paid an amount to compensate it for its fully allocated costs.

 

In August 2003, ITCTransmission entered into an Operation and Maintenance Agreement with its primary maintenance contractor and a Supply Chain Management Agreement with its primary purchasing and inventory management contractor to perform these services subsequent to the term of the SLA. In order to facilitate the transition from Detroit Edison, the new contractors performed work in parallel with Detroit Edison prior to the termination of the SLA. The agreements reduce uncertainty with regard to ITCTransmission’s cost structure through August 29, 2008. Additionally, the new operating agreements allow ITCTransmission to exclusively manage and control operating expenditures. We are in the process of negotiating an amendment to these agreements to apply the terms of those agreements to all affiliates of ITCTransmission.

 

METC Operating Agreements

 

Amended and Restated Easement Agreement.  Under the Easement Agreement, Consumers Energy provides METC with an easement to the land, which we refer to as premises, on which METC’s transmission towers, poles, lines and other transmission facilities used to transmit electricity at voltages of at least 120 kV are located, which we refer to collectively as the facilities. METC pays Consumers Energy annual rent of approximately $10.0 million, in equal quarterly installments, for the easement and related rights under the Easement Agreement. The term of the Easement Agreement runs through 2050 and is subject to 10 automatic 50-year renewals after that time unless METC provides one year’s notice of its election not to renew the term.

 

Amended and Restated Services Contract.  Under the Services Contract, Consumers Energy provides contract services, under METC’s direction, for METC’s transmission assets for an initial five-year period. The Services Contract provides METC with labor for the following:

 

 

Under the Services Contract, METC paid Consumers Energy, excluding amounts for capital work, $21.7 million for the year ended December 31, 2006, which includes amounts for a period prior to the acquisition of METC. Payments are made in monthly installments. METC pays Consumers Energy for the other services at escalating fixed annual fees or agreed-upon rates.

 

METC gave Consumers Energy written notice of termination of the system control and system optimization portions of the Services Contract on November 2, 2004. METC gave Consumers Energy written notice of termination of the remainder of the services provided by Consumers Energy under the Services Contract on February 6, 2006. Each of these notices is effective in May 2007. METC has already arranged for services such as field operations, maintenance, construction work, inventory management and forestry work, which are currently provided by Consumers Energy under the Services Contract. We have nearly completed the process of hiring staff and procuring services to replace those provided under the Services Contract for control room operations and are contracting with qualified parties who can provide these services starting in May 2007.

 

Amended and Restated Purchase and Sale Agreement for Ancillary Services.   Since METC does not own any generating facilities, it must procure ancillary services from third party suppliers, such as Consumers Energy. Currently, under the Ancillary Services Agreement, METC pays Consumers Energy for providing certain generation-based services necessary to support the reliable operation of the bulk power grid, such as voltage support and generation capability and capacity to balance loads and generation. METC is not precluded from procuring these ancillary services from third party suppliers when available.

 

General and Administrative Expenses consist primarily of compensation and benefits costs for personnel in our finance, human resources, regulatory, information technology and legal organizations, and fees for professional services. Professional services are principally composed of outside legal, audit and information technology consulting.

 

We capitalize to property, plant and equipment certain general and administrative expenses such as compensation, office rent, utilities, and information technology support. These expenses are included in property, plant and equipment on our Consolidated Statements of Financial Position.

 

Depreciation and Amortization Expenses consist primarily of depreciation of property, plant and equipment using the straight-line method of accounting. Additionally, this consists of amortization of various regulatory and intangible assets.

 

Taxes other than Income Taxes consist primarily of property tax expenses. Additionally, Michigan Single Business Taxes and payroll taxes are recorded here.

 

Other items of income or expense

 

Interest Expense consists primarily of interest on long term debt at ITC Holdings, ITCTransmission and METC. Additionally, the amortization of debt financing expenses is recorded to interest expense. An allowance for borrowed funds used during construction is included in property, plant and equipment accounts and is a reduction to interest expense.

 

Allowance for Equity Funds Used During Construction (“AFUDC Equity”) is recorded as an item of other income and is included in property, plant and equipment accounts. The allowance represents a return on stockholders’ equity used for construction purposes in accordance with FERC regulations. Assuming all other factors are constant, if construction work in progress balances increase, the allowance amount capitalized will also increase. The capitalization rate applied to the construction work in progress balance is based on the proportion of equity to total capital (which currently includes equity and long-term debt) and the allowed return on equity for ITCTransmission (currently 13.88%) and METC (currently 13.38%).

 

Results of Operations

 

The following table summarizes historical operating results for the periods indicated:

 

 

Operating Revenues

 

Year Ended December 31, 2006 compared to Year Ended December 31, 2005

 

The following table sets forth the components of and changes in operating revenues for the years ended December 31, 2006 and 2005:

 

 

Network revenue increased $10.3 million due to increases in ITCTransmission’s rate used for network revenues of $1.594 kW/month in January through May 2006 and $1.744 kW/month in June through December 2006 as compared to $1.587 kW/month in January through May 2005 and $1.594 kW/month in June through December 2005. In addition, network revenues increased $24.9 million due to the acquisition

of METC in 2006. These increases were partially offset by a $5.2 million decrease due to a 3.0% decrease in ITCTransmission’s total monthly peak loads for the year ended December 31, 2006 as compared to the same period in 2005.

 

Point-to-point revenue decreased $6.6 million due to lower utilization of the Michigan-Ontario Independent Electric System Operator interface, $2.9 million due to the elimination of the Sub-Regional Rate Adjustment in October 2005, $1.8 million due to a decrease in SECA revenues described in Note 5 to the Consolidated Financial Statements under “— Long Term Pricing,” and $0.7 million due to additional refunds recognized for redirected transmission service revenue as discussed in Note 5 to the Consolidated Financial Statements under “—Redirected Transmission Service.” In addition, a $4.2 million decrease resulted from reduced demand for long-term point-to-point reservations because of the emergence of the MISO energy market in 2005. These decreases were partially offset by an increase of $2.4 million due to the acquisition of METC in 2006.

 

Scheduling, control and dispatch revenue increased $1.7 million primarily due to revenues recognized at METC as a result of the acquisition of METC during 2006.

 

Year Ended December 31, 2005 compared to Year Ended December 31, 2004

 

The following table sets forth the components of and changes in operating revenues for the years ended December 31, 2005 and 2004: