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Uil Holdings Corp – ‘10-Q’ for 11/3/06

On:  Friday, 11/3/06, at 10:19am ET   ·   For:  11/3/06   ·   Accession #:  1082510-6-70   ·   File #:  1-15052

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  As Of                Filer                Filing    For·On·As Docs:Size

11/03/06  Uil Holdings Corp                 10-Q       11/03/06    5:2.5M

Quarterly Report   —   Form 10-Q
Filing Table of Contents

Document/Exhibit                   Description                      Pages   Size 

 1: 10-Q        Uil Holdings Form 10Q for Period Ended September    HTML   1.06M 
                          30, 2006                                               
 2: EX-2.4      Uil Exhibit 2.4 - Purchase Agreement                HTML    393K 
 3: EX-31.1     Uil Exhibit 31.1 - Certification                    HTML     15K 
 4: EX-31.2     Uil Exhibit 31.2 - Certification                    HTML     15K 
 5: EX-32       Uil Exhibit 32 - Certification                      HTML      9K 


10-Q   —   Uil Holdings Form 10Q for Period Ended September 30, 2006
Document Table of Contents

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  UIL Holdings Form 10Q For Period Ended September 30, 2006  

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


FORM 10-Q

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

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2006

OR

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

For the transition period from   to            


Commission file number 1-15052

(Exact name of registrant as specified in its charter)

Connecticut
 
06-1541045
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
     
157 Church Street, New Haven, Connecticut
 
06506
(Address of principal executive offices)
 
(Zip Code)

Registrant’s telephone number, including area code: 203-499-2000

None
(Former name, former address and former fiscal year, if changed since last report.)

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 T No  £ 

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. (Check one):
Large accelerated filer [X]
Accelerated filer [ ]
Non-accelerated filer [ ]

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes [ ] No [X]

The number of shares outstanding of the issuer’s only class of common stock, as of November 1, 2006 was 24,687,530.



INDEX

Part I. FINANCIAL INFORMATION

   
Page Number
Financial Statements.
      3
 
Consolidated Statement of Income (Loss) for the three and nine months ended
 
 
      3
 
Consolidated Statement of Comprehensive Income (Loss) for the three and nine months ended
 
 
      3
 
Consolidated Balance Sheet as of September 30, 2006 and December 31, 2005.
      4
 
Consolidated Statement of Cash Flows for the nine months ended September 30, 2006 and 2005.
      6
 
Notes to Consolidated Financial Statements.
      7
 
- Critical Accounting Policies
      7
 
- Capitalization
    14
 
- Regulatory Proceedings
    15
 
- Short-term Credit Arrangements
    17
 
- Income Taxes
    18
 
- Supplementary Information
    20
 
- Pension and Other Benefits
    21
 
- Commitments and Contingencies
    23
 
- Other Commitments and Contingencies
    23
 
- Connecticut Yankee Atomic Power Company
    23
 
- Hydro-Quebec
    27
 
- Environmental Concerns
    27
 
- Claim of Enron Power Marketing, Inc.
    29
 
- Claim of Dominion Energy Marketing, Inc.
    29
 
- Gross Earnings Tax Assessment
    30
 
- Cross-Sound Cable Company, LLC
    30
 
- United Bridgeport Energy, Inc.
    31
 
- Discontinued Operations
    31
 
- Segment Information
    31
 
- Related Party Transactions
    33
 
- Discontinued Operations
    33
 
- Subsequent Event
    36
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations.
    37
 
- Major Influences on Financial Condition 
    37
 
- UIL Holdings Corporation 
    37
 
- The United Illuminating Company 
    37
 
- Discontinued Operations 
    41
 
- United Capital Investments, Inc. 
    42
 
- United Bridgeport Energy, Inc. 
    43
 
- Liquidity and Capital Resources 
    44
 
- Financial Covenants
    45
 
- 2006 Capital Resource Projections
    45
 
- Contractual and Contingent Obligations 
    45
 
- Critical Accounting Policies 
    45
 
- Off-Balance Sheet Arrangements 
    46
 
- New Accounting Standards 
    46
 
- Results of Operations 
    47
Item 3.
Quantitative and Qualitative Disclosures About Market Risk.
    59
Item 4.
Controls and Procedures.
    60



Part II. OTHER INFORMATION

Item 1A.
Risk Factors
    61
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
    61
Item 5.
Other Information
    61
Item 6.
Exhibits
    62
 
SIGNATURES
    63

 
2


PART I. FINANCIAL INFORMATION

Item 1. Financial Statement

UIL HOLDINGS CORPORATION
CONSOLIDATED STATEMENT OF INCOME (LOSS)
AND
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME (LOSS)

(In Thousands except per share amounts)
 
(Unaudited)
 
   
 Three Months Ended
 
Nine Months Ended
 
   
 September 30,
   
     
2005
 
2006
 
2005
 
                    
Operating Revenues (Note F)
                  
   Utility
 
$
261,140
 
$
259,442
 
$
661,154
 
$
632,271
 
   Non-utility businesses
   
4
   
5
   
13
   
14
 
       Total Operating Revenues
   
261,144
   
259,447
   
661,167
   
632,285
 
Operating Expenses
                         
   Operation
                         
     Fuel and energy (Note F)
   
124,699
   
130,919
   
324,416
   
319,997
 
     Operation and maintenance
   
63,071
   
57,805
   
174,127
   
156,164
 
   Depreciation and amortization (Note F)
   
21,065
   
22,024
   
54,562
   
54,713
 
   Taxes - other than income taxes (Note F)
   
12,616
   
12,480
   
33,602
   
32,043
 
       Total Operating Expenses
   
221,451
   
223,228
   
586,707
   
562,917
 
Operating Income
   
39,693
   
36,219
   
74,460
   
69,368
 
                           
Other Income and (Deductions), net (Note F)
   
4,816
   
2,610
   
11,008
   
7,202
 
                           
Interest Charges, net
                         
   Interest on long-term debt
   
5,332
   
5,158
   
16,075
   
15,582
 
   Other interest, net (Note F)
   
374
   
755
   
1,100
   
1,250
 
     
5,706
   
5,913
   
17,175
   
16,832
 
   Amortization of debt expense and redemption premiums
   
393
   
387
   
1,163
   
1,156
 
       Total Interest Charges, net
   
6,099
   
6,300
   
18,338
   
17,988
 
                           
Income Before Gain on Sale of Equity Investments, Income
                         
Taxes, Equity Earnings and Discontinued Operations
   
38,410
   
32,529
   
67,130
   
58,582
 
                           
Gain on Sale of Equity Investments (Note A)
   
-
   
-
   
18,908
   
-
 
                           
Income Before Income Taxes, Equity Earnings and
                         
Discontinued Operations
   
38,410
   
32,529
   
86,038
   
58,582
 
                           
Income Taxes (Note E)
   
9,199
   
14,109
   
29,414
   
24,927
 
                           
Income Before Equity Earnings and Discontinued Operations
   
29,211
   
18,420
   
56,624
   
33,655
 
Gain (Loss) from Equity Investments
   
446
   
65
   
104
   
(4,729
)
Income from Continuing Operations
   
29,657
   
18,485
   
56,728
   
28,926
 
Discontinued Operations, Net of Tax (Note P)
   
(17,858
)
 
(33
)
 
(79,717
)
 
(3,887
)
                           
Net Income (Loss)
 
$
11,799
 
$
18,452
 
$
(22,989
)
$
25,039
 
                           
Average Number of Common Shares Outstanding - Basic
   
24,455
   
24,283
   
24,382
   
24,223
 
Average Number of Common Shares Outstanding - Diluted
   
24,852
   
24,490
   
24,760
   
24,442
 
                           
Earnings Per Share of Common Stock - Basic:
                         
   Continuing Operations
 
$
1.21
 
$
0.76
 
$
2.33
 
$
1.19
 
   Discontinued Operations
   
(0.73
)
 
-
 
$
(3.27
)
 
(0.16
)
   Net Earnings (Loss)
 
$
0.48
 
$
0.76
 
$
(0.94
)
$
1.03
 
                           
Earnings Per Share of Common Stock - Diluted:
                         
   Continuing Operations
 
$
1.19
 
$
0.75
 
$
2.29
 
$
1.18
 
   Discontinued Operations
   
(0.72
)
 
-
   
(3.22
)
 
(0.16
)
   Net Earnings (Loss)
 
$
0.47
 
$
0.75
 
$
(0.93
)
$
1.02
 
                           
Cash Dividends Declared per share of Common Stock
 
$
0.43
 
$
0.43
 
$
1.29
 
$
1.29
 
                           
                           
UIL HOLDINGS CORPORATION
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME (LOSS)
(Thousands of Dollars)
 
(Unaudited)
 
   
 Three Months Ended
 
Nine Months Ended
 
   
 September 30,
   
     
2005
 
2006
 
2005
 
Net Income (Loss)
 
$
11,799
 
$
18,452
 
$
(22,989
)
$
25,039
 
Other comprehensive income, net of tax:
                         
   Interest rate cap mark-to-market
   
(169
)
 
-
   
69
   
-
 
Comprehensive Income (Loss) (Note A)
 
$
11,630
 
$
18,452
 
$
(22,920
)
$
25,039
 
                           
The accompanying Notes to the Consolidated Financial
Statements are an integral part of the financial statements.
 
 
3


UIL HOLDINGS CORPORATION
CONSOLIDATED BALANCE SHEET

ASSETS

(Thousands of Dollars)
 
(Unaudited)
 
   
September 30,
   
     
2005
 
Current Assets
         
   Unrestricted cash and temporary cash investments
 
$
107,806
 
$
28,860
 
   Utility accounts receivable less allowance of $2,600 and $2,600
   
81,836
   
69,547
 
   Other accounts receivable
   
9,001
   
10,440
 
   Unbilled revenues
   
39,097
   
31,956
 
   Current regulatory assets
   
44,262
   
36,961
 
   Loan receivable - Cross-Sound Cable Project
   
-
   
23,787
 
   Materials and supplies, at average cost
   
2,241
   
2,104
 
   Deferred income taxes
   
4,286
   
6,641
 
   Prepayments
   
5,100
   
2,718
 
   Current assets of discontinued operations held for sale
   
103,472
   
126,784
 
       Total Current Assets
   
397,101
   
339,798
 
               
Investments
             
   Investment in United Bridgeport Energy facility
   
-
   
70,344
 
   Other
   
13,536
   
24,753
 
       Total Investments
   
13,536
   
95,097
 
               
Property, Plant and Equipment at original cost
             
   In service
   
815,699
   
788,678
 
   Less, accumulated depreciation
   
287,245
   
272,470
 
     
528,454
   
516,208
 
Construction work in progress
   
79,705
   
65,544
 
   Net Property, Plant and Equipment
   
608,159
   
581,752
 
               
Regulatory Assets (future amounts due from customers
             
                             through the ratemaking process)
             
   Nuclear plant investments-above market
   
359,833
   
375,169
 
   Income taxes due principally to book-tax differences
   
73,046
   
72,951
 
   Long-term purchase power contracts-above market
   
29,627
   
38,242
 
   Connecticut Yankee
   
26,086
   
31,552
 
   Unamortized redemption costs
   
16,315
   
16,919
 
   Other
   
71,252
   
69,116
 
      Total Regulatory Assets
   
576,159
   
603,949
 
               
Deferred Charges and Other Assets
             
   Unamortized debt issuance expenses
   
6,933
   
7,527
 
   Prepaid pension
   
49,856
   
56,532
 
   Other long-term receivable
   
18,712
   
13,799
 
   Other
   
2,318
   
2,300
 
       Total Deferred Charges and Other Assets
   
77,819
   
80,158
 
               
Long-term assets of discontinued operations held for sale
   
10,086
   
98,301
 
               
       Total Assets
 
$
1,682,860
 
$
1,799,055
 
               
The accompanying Notes to the Consolidated Financial
Statements are an integral part of the financial statements.
 
 
4


UIL HOLDINGS CORPORATION
CONSOLIDATED BALANCE SHEET

CAPITALIZATION AND LIABILITIES

(Thousands of Dollars)
 
(Unaudited)
 
   
September 30,
   
     
2005
 
Current Liabilities
         
   Notes payable
 
$
-
 
$
20,000
 
   Current portion of long-term debt
   
4,286
   
4,286
 
   Accounts payable
   
55,275
   
57,023
 
   Dividends payable
   
10,601
   
10,517
 
   Accrued liabilities
   
29,953
   
38,257
 
   Current regulatory liabilities
   
11,277
   
17,430
 
   Interest accrued
   
4,528
   
4,147
 
   Taxes accrued
   
33,047
   
7,962
 
   Current liabilities of discontinued operations held for sale
   
50,363
   
75,572
 
       Total Current Liabilities
   
199,330
   
235,194
 
               
Noncurrent Liabilities
             
   Purchase power contract obligation
   
43,504
   
55,602
 
   Pension accrued
   
9,154
   
8,272
 
   Connecticut Yankee contract obligation
   
34,856
   
40,414
 
   Other
   
21,846
   
23,415
 
       Total Noncurrent Liabilities
   
109,360
   
127,703
 
               
Deferred Income Taxes (future tax liabilities owed
             
                                     to taxing authorities)
   
332,044
   
336,871
 
               
Regulatory Liabilities (future amounts owed to customers
             
                                through the ratemaking process)
             
   Accumulated deferred investment tax credits
   
5,027
   
11,432
 
   Deferred gains on sale of property
   
32,183
   
32,183
 
   Asset removal cost
   
4,624
   
5,828
 
   Other
   
17,671
   
10,621
 
       Total Regulatory Liabilities
   
59,505
   
60,064
 
               
Long-term liabilities of discontinued operations held for sale
   
1,053
   
7,756
 
               
Commitments and Contingencies (Note J)
             
               
Capitalization (Note B)
             
     Net long-term debt
   
482,603
   
486,889
 
               
   Common Stock Equity
             
     Common stock
   
311,014
   
306,699
 
     Paid-in capital
   
14,272
   
10,307
 
     Capital stock expense
   
(2,170
)
 
(2,170
)
     Unearned employee stock ownership plan equity
   
(2,850
)
 
(3,562
)
     Accumulated other comprehensive loss
   
(870
)
 
(940
)
     Retained earnings
   
179,569
   
234,244
 
       Net Common Stock Equity
   
498,965
   
544,578
 
               
       Total Capitalization
   
981,568
   
1,031,467
 
               
       Total Liabilities and Capitalization
 
$
1,682,860
 
$
1,799,055
 
               
The accompanying Notes to the Consolidated Financial
Statements are an integral part of the financial statements.
 
 
5


UIL HOLDINGS CORPORATION
CONSOLIDATED STATEMENT OF CASH FLOWS
 
(Thousands of Dollars)
 
(Unaudited)
 
           
   
Nine Months Ended
 
     
     
2005
 
Cash Flows From Operating Activities
         
   Net Income (Loss)
 
$
(22,989
)
$
25,039
 
   Adjustments to reconcile net income
             
     to net cash provided by operating activities:
             
     Gain on sale of equity investments
   
(18,908
)
 
-
 
     Gain on sale of assets of discontinued operations held for sale
   
(602
)
 
-
 
     Impairment of remaining assets of discontinued operations held for sale
   
24,829
   
-
 
     Goodwill impairment
   
85,004
   
-
 
     Depreciation and amortization
   
40,654
   
43,056
 
     Purchase power contract amortization (Note F)
   
15,992
   
16,268
 
     Purchase power above market fuel expense credit (Note F)
   
(15,992
)
 
(16,268
)
     Investment tax credits (Note C)
   
(6,495
)
 
-
 
     Deferred income taxes
   
(32,282
)
 
3,170
 
     Stock-based compensation expense (Note A)
   
4,581
   
2,577
 
     Excess tax benefits from share-based compensation
   
(490
)
 
-
 
     Deferred investment tax credits - net
   
(6,405
)
 
(338
)
     Allowance for funds used during construction
   
(2,544
)
 
(2,045
)
     Undistributed (earnings) losses of minority interest investments
   
(105
)
 
5,265
 
     Changes in:
             
       Accounts receivable - net
   
1,273
   
(36,171
)
       Materials and supplies
   
1,023
   
(349
)
       Prepayments
   
(4,081
)
 
(4,638
)
      Accounts payable
   
(12,563
)
 
(6,794
)
       Interest accrued
   
338
   
500
 
       Taxes accrued
   
8,198
   
2,121
 
       Other assets
   
17,691
   
7,144
 
       Other liabilities
   
(22,536
)
 
(7,193
)
       Total Adjustments
   
76,580
   
6,305
 
Net Cash provided by Operating Activities
   
53,591
   
31,344
 
               
Cash Flows from Investing Activities
             
   Proceeds from (loan to) Cross-Sound Cable Project
   
23,787
   
387
 
   Proceeds from sale of equity investments
   
100,949
   
-
 
   Proceeds from sale of assets of discontinued operations held for sale
   
9,125
   
-
 
   Deferred payments in prior acquisitions
   
(9,382
)
 
(6,934
)
   Non-utility minority interest investments, net
   
(109
)
 
(2,096
)
   Plant expenditures
   
(45,464
)
 
(33,105
)
   Changes in restricted cash
   
207
   
86
 
Net Cash provided by (used in) Investing Activities
   
79,113
   
(41,662
)
               
Cash Flows from Financing Activities
             
   Issuances of common stock
   
4,410
   
2,744
 
   Excess tax benefits from share-based compensation
   
490
   
-
 
   Payments on long-term debt
   
(4,286
)
 
(4,286
)
   Notes payable - short-term, net
   
(26,219
)
 
13,913
 
   Payments on notes payable - long-term
   
-
   
(786
)
   Proceeds from notes payable - long-term
   
-
   
153
 
   Payment of common stock dividend
   
(31,600
)
 
(41,894
)
   Bank overdraft
   
3,287
   
5,417
 
   Other
   
160
   
(97
)
Net Cash used in Financing Activities
   
(53,758
)
 
(24,836
)
               
Cash and Temporary Cash Investments:
             
Net change for the period
   
78,946
   
(35,154
)
Balance at beginning of period
   
28,860
   
40,165
 
Balance at end of period
 
$
107,806
 
$
5,011
 
               
The accompanying Notes to the Consolidated Financial
Statements are an integral part of the financial statements.
 
 
6

UIL HOLDINGS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED)
 
(A) CRITICAL ACCOUNTING POLICIES

Basis of Presentation

UIL Holdings Corporation (UIL Holdings) operates in two principal lines of business: utility and non-utility. The utility business consists of the electric transmission and distribution operations of The United Illuminating Company (UI). The non-utility business consists of United Capital Investments, Inc. (UCI), which holds minority ownership interests in two investment funds. The non-utility businesses also included a minority ownership interest in Bridgeport Energy, LLC (BE) held by United Bridgeport Energy, Inc. (UBE) until the completion of the sale of that interest to an affiliate of Duke Energy on March 28, 2006, as well as UCI’s minority ownership interest in Cross-Sound Cable Company, LLC (Cross-Sound) until the completion of the sale of that interest to Babcock and Brown Infrastructure Ltd. on February 27, 2006, as well as the operations of Xcelecom, Inc. (Xcelecom). As discussed further in “Note (P) - Discontinued Operations” of this Form 10-Q, on April 26, 2006, UIL Holdings announced its intention to divest its wholly-owned subsidiary, Xcelecom, completing its corporate strategic realignment to focus on its regulated electric utility, UI. UIL Holdings is headquartered in New Haven, Connecticut, where its senior management maintains offices and is responsible for overall planning, operating and financial functions. UIL Holdings’ Consolidated Financial Statements should be read in conjunction with the consolidated financial statements and the notes to the consolidated financial statements included in UIL Holdings’ Annual Report on Form 10-K for the year ended December 31, 2005. Such notes are supplemented below.

The year-end balance sheet data was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America (GAAP). Certain information and footnote disclosures, which are normally included in financial statements prepared in accordance with GAAP, have been condensed or omitted in accordance with Securities and Exchange Commission rules and regulations. UIL Holdings believes that the disclosures made are adequate to make the information presented not misleading. The information presented in the consolidated financial statements reflects all adjustments which, in the opinion of UIL Holdings, are necessary for a fair statement of the financial position and results of operations for the interim periods described herein. All such adjustments are of a normal and recurring nature. The results for the nine months ended September 30, 2006 are not necessarily indicative of the results for the entire fiscal year ending December 31, 2006.

All earnings per share (EPS) amounts and references to common stock share numbers reflect a 5 for 3 common stock split, which occurred on July 3, 2006 for shareowners of record as of June 6, 2006.

Certain amounts previously reported have been reclassified to conform to the current presentation, including the reporting of Xcelecom results as discontinued operations and the impact on EPS and common stock share numbers of the aforementioned stock split.

Restructuring Charges

SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of commitment to an exit or disposal plan. Costs covered by the standard include lease termination costs and certain employee severance costs that are associated with a restructuring, discontinued operation, plant closing, or other exit or disposal activity. In the fourth quarter of 2004, UIL Holdings recorded employee termination costs associated with the reorganization of UIL Holdings’ Finance organization amounting to $2 million and the balance in the restructuring reserve as of September 30, 2006 was approximately $0.9 million. These accrued restructuring costs are expected to be settled throughout the remainder of 2006 and 2007 in accordance with the applicable employee’s severance agreement.
 
 
7

 
UIL HOLDINGS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) (Continued)

A reconciliation of the changes in the restructuring reserve liability balance since December 31, 2005 is presented below.

(In Thousands)
 
 Total
 
Restructuring Accrual December 31, 2005
 
$
1,181
 
Adjustment for final employee severance payout
   
76
 
Severance Payment
   
(341
)
Restructuring Accrual September 30, 2006
 
$
916
 

Goodwill and Other Intangible Assets

Effective January 1, 2002, UIL Holdings adopted SFAS No. 142, “Goodwill and Other Intangible Assets.” This statement modifies the accounting and reporting of goodwill and intangible assets. On April 26, 2006, UIL Holdings announced its intention to divest its wholly-owned subsidiary, Xcelecom, completing its corporate strategic realignment to focus on its regulated electric utility, UI. This event required goodwill to be remeasured for impairment and a pre-tax goodwill impairment charge of $85.0 million was recorded during the first quarter of 2006 based on UIL Holdings’ intent to divest, estimates of fair value as determined by an outside advisory firm and indicative third party bids. In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the impairment is included in discontinued operations as of September 30, 2006. See below “Note (A) - Impairment of Long-Lived Assets and Investments and Discontinued Operations/Assets Held for Sale.”

Impairment of Long-Lived Assets and Investments

SFAS No. 144 requires the recognition of impairment losses on long-lived assets when the book value of an asset exceeds the sum of the expected future undiscounted cash flows that result from the use of the asset and its eventual disposition. If impairment arises, then the amount of any impairment is measured based on discounted cash flows or estimated fair value. To the extent that an asset is held for sale, SFAS 144 requires that the asset be recorded at the lower of carrying value or the asset’s fair value less cost to sell.

A pre-tax impairment charge of $24.8 million was recorded in the third quarter of 2006 to bring the carrying value of the remaining Xcelecom businesses in line with their estimated fair value based on indicative third party bids.

SFAS No. 144 also requires that rate-regulated companies recognize an impairment loss when a regulator excludes all or part of a cost from rates, even if the regulator allows the company to earn a return on the remaining costs allowed. Under this standard, the probability of recovery and the recognition of regulatory assets under the criteria of SFAS No. 71, “Accounting for the Effects of Certain Types of Regulation,” must be assessed on an ongoing basis. At September 30, 2006 and December 31, 2005, UI, as a rate-regulated entity, did not have any assets that were impaired under this standard.

Discontinued Operations/Assets Held for Sale

SFAS No. 144 also addresses the accounting for, and disclosure of, long-lived assets to be disposed of by sale. Under SFAS No. 144, a long-lived asset or group of assets (disposal group) is classified as discounted operations when the company commits to a plan to sell the long-lived asset (disposal group) within a twelve month period, there will be no significant continuing involvement following the sale, and certain other criteria set forth in the statement are satisfied. In such a case:

·  
the long lived-asset (disposal group) will be measured at the lower of its carrying value or fair value, less costs to sell, and will be classified as held for sale on the Consolidated Balance Sheet;
·  
the long-lived asset (disposal group) shall not be depreciated (amortized) while it is classified as held for sale;
·  
the related operations of the long-lived asset (disposal group) will be reported as discontinued operations in the consolidated statement of operations, with all comparable periods restated; and
·  
the operations and cash flows of the disposal group are expected to be eliminated from ongoing operations.

 
8

 
UIL HOLDINGS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) (Continued)
 
UIL Holdings announced on April 26, 2006, its intentions to divest its wholly-owned subsidiary, Xcelecom. With the announcement, Xcelecom meets the criteria set forth in SFAS No. 144 to be classified as held for sale and is reported as such in UIL Holdings’ Form 10-Q for the period ending September 30, 2006. The disposal is expected to be completed within twelve months of the April 26, 2006 announcement.

Major classes of assets and liabilities of Xcelecom consist of current assets of $--103.5 million, property, plant & equipment of $9.1 million, other assets of $1.0 million, current liabilities of $50.4 million and non current liabilities of $1.0 million. When the sale is completed, $28.3 million of net deferred tax assets, including amounts related to the impairment of goodwill will be realized through the filing of UIL Holdings’ consolidated income tax returns.

Earnings per Share

The following table presents a reconciliation of the basic and diluted earnings per share calculations for the three and nine months ended September 30, 2006 and 2005:

   
Income Applicable to
Common Stock
 
Average Number of
Shares Outstanding
 
Earnings
per Share
 
   
(In Thousands, except per share amounts)
 
Nine Months Ended September 30:
             
2006
             
Basic earnings from continuing operations
 
$
56,728
   
24,382
 
$
2.33
 
Basic earnings (loss) from discontinued operations
   
(79,717
)
 
24,382
   
(3.27
)
Basic earnings (loss)
   
(22,989
)
 
24,382
   
(0.94
)
Effect of dilutive stock options (1)
   
-
   
378
   
0.01
 
Diluted earnings (loss)
 
$
(22,989
)
 
24,760
 
$
(0.93
)
     
2005
                   
Basic earnings from continuing operations
 
$
28,926
   
24,223
 
$
1.19
 
Basic earnings (loss) from discontinued operations
   
(3,887
)
 
24,223
   
(0.16
)
Basic earnings
   
25,039
   
24,223
   
1.03
 
Effect of dilutive stock options (1)
   
-
   
219
   
(0.01
)
Diluted earnings
 
$
25,039
   
24,442
 
$
1.02
 
                     
Three Months Ended September 30:
                   
2006
                   
Basic earnings from continuing operations
 
$
29,657
   
24,455
 
$
1.21
 
Basic earnings (loss) from discontinued operations
   
(17,858
)
 
24,455
   
(0.73
)
Basic earnings
   
11,799
   
24,455
   
0.48
 
Effect of dilutive stock options (1)
   
-
   
397
   
(0.01
)
Diluted earnings
 
$
11,799
   
24,852
 
$
0.47
 
                     
2005
                   
Basic earnings from continuing operations
 
$
18,485
   
24,283
 
$
0.76
 
Basic earnings (loss) from discontinued operations
   
(33
)
 
24,283
   
-
 
Basic earnings
   
18,452
   
24,283
   
0.76
 
Effect of dilutive stock options (1)
   
-
   
207
   
(0.01
)
Diluted earnings
 
$
18,452
   
24,490
 
$
0.75
 

(1)  
Reflecting the effect of dilutive stock options, performance shares and restricted stock. Dilutive securities diluted earnings from continuing operations by $0.02 per share and diluted the loss from discontinued operations by $0.01 per share for the three months ended September 30, 2006. Dilutive securities diluted earnings from continuing operations by $0.04 per share and diluted the loss from discontinued operations by $0.05 per share for the nine months ended September 30, 2006. Dilutive securities diluted earnings from continuing operations by $0.01 per share and had no impact on the loss from discontinued operations for the three and nine months ended September 30, 2005.

 
9


UIL HOLDINGS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) (Continued)

There were no stock options to purchase shares of common stock outstanding and not included in the computation of diluted earnings per share for the three and nine months ended September 30, 2006. Stock options to purchase 378,530 and 433,233 shares of common stock were outstanding but not included in the computation of diluted earnings per share for the three and nine months ended September 30, 2005 because the options’ exercise prices were greater than the average market price of the common shares during such periods.

Stock-Based Compensation

On January 1, 2006, UIL Holdings adopted SFAS No. 123 (Revised), “Share-Based Payment” (SFAS No. 123R), which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation” (SFAS No. 123) and supersedes Accounting Principles Board (APB) No. 25, “Accounting for Stock Issued to Employees,” (APB No. 25). Under the modified prospective method of adoption, pursuant to SFAS No. 123R, options granted after December 31, 2005 are expensed based on their fair value at date of grant over the vesting period, following the non-substantive vesting approach. Prior to January 1, 2006, UIL Holdings followed the fair value recognition provisions, under the prospective method, of SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure” (SFAS No. 148), an amendment of SFAS No. 123. Under SFAS No. 148, UIL Holdings recorded compensation expense related to stock options based on the most recently available fair-value estimates calculated by an independent party utilizing the binomial option-pricing model following the nominal vesting approach. No compensation expense was recorded prior to January 1, 2003, as UIL Holdings accounted for employee stock-based compensation in accordance with APB No. 25.

In the first quarter of 2004, UIL Holdings decided to generally cease granting new stock options, other than new grants pursuant to the reload feature of the UIL Holdings 1999 Amended and Restated Stock Plan (Plan). Although new stock options generally will not be granted, compensation expense related to options granted after January 1, 2003, including any new stock options granted under the reload feature of the Plan, will continue to be recorded ratably over the vesting periods associated with such options. For reloads, compensation expense is calculated on the date of the reload, utilizing the binomial option-pricing model described above.  The reload feature provides for an automatic grant of additional stock options whenever the holder exercises previously granted stock options and utilizes shares of UIL Holdings stock, rather than cash, to satisfy the exercise price.

In 2004, UIL Holdings implemented a performance-based long-term incentive arrangement under the Plan pursuant to which certain members of management have the opportunity to earn a pre-determined number of performance shares, the number of which is predicated upon the achievement of various pre-defined performance measures. These performance shares vest over a three-year cycle with the actual issuance of UIL Holdings common stock in respect of such shares following the end of each three-year cycle. A new three-year cycle begins in January of each year. UIL Holdings records compensation expense for these performance shares ratably over the three-year period, except in the case of retirement eligible employees, for whom compensation expense is immediately recognized in accordance with SFAS No. 123R, based on the value of the expected payout at the end of each year relative to the performance measures achieved. An additional $0.8 million of compensation expense was recorded in the first nine months of 2006 in regards to retirement eligible employees based on the adoption of SFAS No. 123R retirement eligible provisions. UIL Holdings records stock compensation expense in the current period based on quarterly projected performance against formal plans over the performance period. A target amount of 81,833 performance shares were granted during the first quarter of 2006; the average of the high and low market price on the date of grant was $30.55 per share.

In January 2006, UIL Holdings granted a total of 16,667 shares of restricted stock to its new President, James P. Torgerson, pursuant to his employment agreement; the average of the high and low market price on the date of grant was $29.10 per share. In March 2006, UIL Holdings granted another 2,578 shares of restricted stock to Mr. Torgerson pursuant to his employment agreement; the high and low market price on the date of grant was $30.55 per share. Such shares were granted pursuant to the Plan. Compensation expense for this restricted stock is recorded ratably over the five-year vesting period for such restricted stock.

In March 2006, UIL Holdings granted a total of 20,000 shares of restricted stock to directors; the average of the high and low market price on the date of grant was $30.55 per share. Such shares were granted pursuant to the Plan.
 
 
10


UIL HOLDINGS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) (Continued)

Compensation expense for this restricted stock is recorded ratably over the three-year vesting period for such restricted stock, except in the case of retirement eligible directors, for whom compensation expense is accelerated in accordance with SFAS No. 123R.

As of December 31, 2005 and September 30, 2006, UIL Holdings had 60,000 and 79,245 shares of restricted stock which had not vested with a weighted average exercise price of $26.25 and $29.53, respectively. In March 2006, 20,000 shares of restricted stock previously granted to directors vested, for which the intrinsic value was $0.3 million.

The following table sets forth information regarding stock option transactions for the year ended December 31, 2005 and the nine months ended September 30, 2006.

   
 
 
Number
of Options
     
 
 
Option Price
per Share
 
Weighted
Average
Exercise
Price
 
   
1,116,088
     
$
21.68-$34.79
 
$
28.37
 
Granted
   
94,452
 
(1
)
$
30.86-$31.44
 
$
30.93
 
Forfeited
   
(54,830
)
   
$
21.68-$34.79
 
$
32.66
 
Exercised
   
(197,163
)
   
$
21.68-$27.25
 
$
22.93
 
   
958,547
     
$
21.68-$34.56
 
$
29.50
 
Granted
   
94,387
 
(1
)
$
32.98
 
$
32.98
 
Forfeited
   
(13,888
)
   
$
21.68
 
$
21.68
 
Exercised
   
(239,099
)
   
$
21.68-$34.56
 
$
25.50
 
   
799,947
                 
                         
Exercisable at December 31, 2005
   
804,028
     
$
21.68-$34.56
 
$
30.88
 
Exercisable at September 30, 2006
   
793,295
 
(2
)
$
21.68-$34.79
 
$
31.24
 

(1)  
One-third of the options granted become exercisable on each of the first three anniversaries of the grant date, with the exception of reload grants, for which the entire grant becomes exercisable six months from the grant date.
(2)  
The intrinsic value of exercisable stock options at September 30, 2006 was $5.0 million.

The fair values of stock options granted have been estimated on the date of grant using the binomial option-pricing model using the weighted average assumptions below. The binomial option-pricing model is appropriate for valuing options on stocks with high dividend yields, such as UIL Holdings.

 
Nine Months Ended September 30, 2006
Nine Months Ended September 30, 2005
Risk-free interest rate
5.08%
4.09%
Expected volatility
19.31%
24.80%
Expected lives
7.06 years
6.75 years
Expected dividend yield
5.65%
6.55%
 
The weighted-average grant date fair value of stock options granted during the first nine months ended September 30, 2006 and 2005 was $8.23 and $8.41, respectively.

Total stock-based compensation expenses were $4.6 million, after-tax of $2.7 million, and $2.6 million, after-tax of $1.5 million, for the nine months ended September 30, 2006 and 2005, respectively. Total shared-based compensation expenses were $2.0 million, after-tax of $1.2 million, and $1.1 million, after-tax of $0.6 million for the three months ended September 30, 2006 and 2005, respectively. No share based compensation costs were capitalized as part of the costs of an asset during the nine months ended September 30, 2006.

 
11


UIL HOLDINGS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) (Continued)

As of September 30, 2006, total stock option compensation costs, performance share costs and restricted stock costs related to non-vested awards not yet recognized was an immaterial amount, $2.1 million and $1.4 million, respectively. The weighted-average period over which the stock option compensation costs, performance-base cost and restricted stock cost will be recognized is 12 months, 11 months and 18 months, respectively.

The non-employee director’s shares issued for services rendered are usually drawn from the Non-Employee Director Common Stock and Deferred Compensation Plan.  Employee performance shares and options are drawn from the 1999 Amended and Restated UIL Holdings Corporation Stock Plan.

The following table illustrates the effect on net income and earnings per share of applying the fair value based method to all outstanding and unvested awards in each period.

   
Three Months Ended
 
Nine Months Ended
 
   
September 30,
   
     
2005
 
2006
 
2005
 
   
(In thousands except per share amounts)
 
Net Income (loss), as reported
 
$
11,799
 
$
18,452
 
$
(22,989
)
$
25,039
 
Add: Stock-based compensation
                         
expense included in reported
                         
net income (loss), net of related tax effects
   
1,184
   
643
   
2,710
   
1,549
 
Deduct: Total stock-based compensation
                         
determined under fair value based
                         
method for all stock grants, net of
                         
related tax effect
   
(1,184
)
 
(643
)
 
(2,710
)
 
(1,681
)
                           
Pro forma net income (loss)
 
$
11,799
 
$
18,452
 
$
(22,989
)
$
24,907
 
                           
Earnings (loss) per share:
                         
Basic - as reported
 
$
0.48
 
$
0.76
 
$
(0.94
)
$
1.03
 
                           
Basic - proforma
 
$
0.48
 
$
0.76
 
$
(0.94
)
$
1.02
 
                           
Diluted - as reported
 
$
0.47
 
$
0.75
 
$
(0.93
)
$
1.02
 
                           
Diluted - proforma
 
$
0.47
 
$
0.75
 
$
(0.93
)
$
1.01
 

Comprehensive Income

Comprehensive income for the three months ended September 30, 2006 was equal to net income less an interest rate cap mark-to-market adjustment of approximately $0.2 million, after-tax, related to the $64.5 million principal amount of Pollution Control Refunding Revenue Bonds. Comprehensive income for the nine months ended September 30, 2006 was equal to net income plus an interest rate cap mark-to-market adjustment of approximately $0.1 million, after-tax, related to the $64.5 million principal amount of Pollution Control Refunding Revenue Bonds. For further information regarding this interest rate cap transaction, see “Note (B) - Long-Term Debt.” Comprehensive income for the three and nine month periods ended September 30, 2005, was equal to net income as reported.

Equity Investment Sales

On February 27, 2006, UCI completed the sale of its ownership interest in Cross-Sound. UCI received proceeds of $29.9 million for its $11.4 million investment in Cross-Sound. Excluding transaction costs, UCI recognized a pre-tax gain on the sale of approximately $18.5 million.

On March 28, 2006, UBE completed the sale of its ownership interest in BE. UBE received proceeds of $71 million for its $70.6 million investment in BE. Excluding transaction costs, UBE recognized a pre-tax gain on the sale of approximately $0.4 million.

 
12


UIL HOLDINGS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) (Continued)

These gains on sale of ownership interests are included in gain on sale of equity investments on the UIL Consolidated Statement of Income (Loss) for the nine months ended September 30, 2006.

New Accounting Standards

In July 2006, the Financial Accounting Standard Board (FASB) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes”, an interpretation of SFAS No. 109, “Accounting for Income Taxes”. This interpretation clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements in accordance with SFAS No. 109. The interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return which has a level of uncertainty of being sustained on audit by the taxing authority. The interpretation provides guidance on derecognition of a previously recognized liability for an uncertain tax position, the classification of liabilities for uncertain tax positions, and the potential recognition of interest and penalties by taxing authorities. In addition, the interpretation prescribes additional disclosure requirements including i) a reconciliation of beginning and ending balances of the total amounts of unrecognized tax benefits from uncertain tax positions for the annual reporting periods presented, ii) a discussion of the nature of the uncertain tax position taken if any of those positions will significantly increase or decrease in the twelve months following the reporting date, iii) the amount of interest and penalties recognized in the statement of operations and the total amount of interest and penalties recognized in the statement of financial position, and iv) a description of the tax years that remain subject to examination by major taxing authorities. The provisions of this interpretation are effective for UIL Holdings as of January 1, 2007. Management is currently evaluating the impact of this statement, but the adoption of this interpretation is not expected to have a material impact on UIL Holdings’ consolidated financial position, results of operations or liquidity.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (SFAS No. 157). This statement defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The statement emphasizes that fair value is a market-based measurement, not an entity-specific measurement and establishes a fair value hierarchy that distinguishes between market participant assumptions and the reporting entity’s own assumptions. This statement is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Earlier application is encouraged, provided the reporting entity has not yet issued financial statements for that fiscal year, including financial statements for an interim period within that fiscal year. This statement is not expected to have a material impact on UIL Holdings’ consolidated financial position or liquidity.

In September 2006, the FASB issued SFAS No. 158 “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Benefits an amendment of FASB No. 87, 88, 106 and 132(R) (SFAS 158). The Statement requires an employer that sponsors one or more defined benefit pension or other postretirement plans to recognize an asset or liability for the overfunded or underfunded status of the plan. For a pension plan, the asset or liability is the difference between the fair value of the plan’s assets and the projected benefit obligation. For any other postretirement benefit plan, the asset or liability is the difference between the fair value of the plan’s assets and the accumulated postretirement benefit obligation. In addition, employers must record all unrecognized prior service costs and credits and unrecognized actuarial gains and losses in accumulated other comprehensive income. Such amounts will then be recognized in earnings as components of net periodic benefit cost/income pursuant to the current recognition and amortization provisions of SFAS No. 87, “Employers’ Accounting for Pensions,” and SFAS No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions.” This statement is effective for fiscal years ending after December 15, 2006. UIL Holdings will adopt SFAS No. 158 effective December 31, 2006 on a prospective basis. In addition, management arranged for an amendment of UIL Holdings’ Note Purchase Agreement to remove the impact of SFAS No. 158 on the financial covenant calculation made quarterly thereunder. See “Note (B) - Long Term Debt.” Management is currently evaluating the impact of this statement, but the adoption of this interpretation is not expected to have a material impact on UIL Holdings’ consolidated financial position or liquidity.

 
13


UIL HOLDINGS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) (Continued)

In September 2006, the U.S. Securities and Exchange Commission (SEC) staff issued Staff Accounting Bulletin No. 108 (SAB 108), “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” SAB 108 was issued in order to eliminate the diversity of practice surrounding how public companies quantify financial statement misstatements. In SAB 108, the SEC staff established an approach that requires quantification of financial statement misstatements based on the effects of the misstatements on each of the company’s financial statements and the related financial statement disclosures. Management is currently evaluating the impact of this statement, but the adoption of this interpretation is not expected to have a material impact on UIL Holdings’ consolidated financial position, results of operations or liquidity.

(B) CAPITALIZATION

Common Stock

UIL Holdings had 24,687,530 shares of its common stock, without par value, outstanding at September 30, 2006. Of those shares, 139,702 were unallocated shares held by UI's 401(k)/Employee Stock Ownership Plan (KSOP) and 43,245 were shares of restricted stock, none of which are recognized as outstanding for the purpose of calculating basic earnings per share.

UI has an arrangement under which it loaned $11.5 million to the KSOP. Prior to the formation of UIL Holdings, the trustee for the KSOP used the funds to purchase 547,167 shares of UI common stock in open market transactions. On July 20, 2000, effective with the formation of a holding company structure, unallocated shares held by the KSOP were converted into shares of UIL Holdings’ common stock. The shares will be allocated to employees’ KSOP accounts, as the loan is repaid, to cover a portion of the required KSOP contributions. Compensation expense is recorded when shares are committed to be allocated based on the fair market value of the stock. The loan will be repaid by the KSOP over a twelve-year period ending October 1, 2009, using employer contributions and UIL Holdings’ dividends paid on the unallocated shares of the stock held by the KSOP. Dividends on allocated shares are charged to retained earnings. As of September 30, 2006, 139,702 shares, with a fair market value of $5.3 million, had been purchased by the KSOP and had not been committed to be released or allocated to KSOP participants.

Long-Term Debt

On March 9, 2006, UI entered into an interest rate cap (rate cap) transaction to mitigate interest rate risk with respect to the $64.5 million principal amount of Pollution Control Refunding Revenue Bonds, 2003 Series, due October  1, 2033, issued by the Business Finance Authority of the State of New Hampshire (the “Bonds”). The Bonds are currently in an auction rate mode by which the interest rate is established at auction every 35 days. As of the last auction on October 30, 2006, the interest rate on the bonds was 3.55%. The rate cap was set at 3.68% and became effective March 30, 2006. The rate cap will terminate on August 5, 2009. The rate cap is tied to the U.S. Dollar - Bond Market Association (USD-BMA) Municipal Swap Index. If the average of the index for the calculation period exceeds the rate cap, UI will be paid an amount based on such difference. At the end of each quarter, changes in the market value of the rate cap are marked-to-market, which resulted in $0.1 million charged to income at September 30, 2006. UI paid $0.6 million to enter into the rate cap transaction which is being amortized over the life of the rate cap based upon quarterly fair market value analysis. As such, the above transaction constitutes hedge accounting and is marked-to-market in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.”
 
UIL Holdings is a party to a Note Purchase Agreement, dated as of February 15, 2001 (the “NPA”). UIL Holdings amended the NPA, effective March 30, 2006, to define consolidated net income without regard to any reduction in net income resulting from any impairment of goodwill in connection with a decision by UIL Holdings to divest of Xcelecom or its subsidiaries.

UIL Holdings amended the NPA a second time, effective October 20, 2006, to exclude the anticipated impact to comprehensive income at December 31, 2006 of SFAS No. 158 from two of the three financial covenants under the Agreement.

 
14


UIL HOLDINGS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) (Continued)

(C) REGULATORY PROCEEDINGS

2005 Rate Case

On January 27, 2006, the DPUC issued a final decision in the 2005 Rate Case proceeding. The DPUC set UI's distribution rates at levels that will increase revenues by $14.3 million in 2006. The DPUC set incremental distribution rate increases for 2007, 2008 and 2009, so that revenues will increase a total of $35.6 million, or 4.9%, by 2009 compared to 2005 rates.

On February 10, 2006, UI filed a Petition for Reconsideration with the DPUC requesting that it reconsider the final decision to correct calculations in the decision with respect to employee compensation and the pension/post-retirement discount rate. On March 1, 2006, the DPUC granted UI’s Petition to reopen the proceeding for the limited purpose of reconsidering the record with regards to employee compensation and denied UI’s request to reconsider the pension/post-retirement discount rate. On July 28, 2006, a settlement was reached between UI and the Prosecutorial unit of the DPUC staff. The settlement agreement allows UI to recover additional distribution revenue requirements of $1.5 million in 2007, $1.8 million in 2008 and $2.3 million in 2009. The settlement agreement had no impact in 2006. The settlement was approved by the DPUC on August 21, 2006 and results in a total revenue increase of $37.9 million or 5.3% by 2009 compared to 2005 rates.

Department of Public Utility Control

UI generally has several regulatory proceedings open and pending at the DPUC at any given time. Examples of such proceedings include an annual DPUC review and reconciliation of UI’s CTA and SBC revenues and expenses, a semi-annual transmission adjustment clause proceeding to adjust retail transmission rates to true up to wholesale transmission revenue requirements, dockets to consider specific restructuring or electricity market issues, consideration of specific rate or customer issues, and review of conservation programs.

On June 16, 2006, UI announced its agreement with the City of Bridgeport and its Redevelopment Authority (the “City”) for the transfer of title to UI’s Steel Point property to the City and settlement of all claims against the City with respect to relocation of a substation and repair/replacement of a bulkhead, in exchange for payment to UI of $14.9 million, which represents the commercial value of the property and cost to replace the bulkhead. Pursuant to a Memorandum of Understanding among UI, the City of Bridgeport, and the City’s selected developer for the property (MOU), the City must also provide to UI, within one year and free of charge, a substation site within a reasonable proximity to the Steel Point property. On July 12, 2006, the DPUC approved the proposed transfer of property and all of the terms of the MOU. The DPUC also accepted the proposed ratemaking treatment submitted by UI with respect to the property, the substation, and the bulkhead, which provides for UI to recover costs related to the Steel Point property through the CTA, subject to DPUC approval in the annual CTA/SBC reconciliation filing. The MOU provides for the filing of a stipulated judgment incorporating the MOU’s terms in the eminent domain proceeding currently pending in the Connecticut Superior Court, and for title to the property to transfer as part of that judgment upon the City’s payment of $10.3 million, with the remaining $4.6 million to be paid by June 30, 2007.

Tax Credits Related to the Sale of Generation

On December 21, 2005, the Internal Revenue Service (IRS) issued proposed regulations that would allow public utilities, in certain circumstances, to return certain tax benefits pertaining to divested or deregulated public utility property to customers. Specifically, these regulations deal with accumulated deferred investment tax credits (ADITC) and excess deferred federal income taxes (EDFIT) associated with public utility property.

UI had been previously ordered by the DPUC to seek a Private Letter Ruling (PLR) from the IRS requesting permission to immediately flow-through to customers $3.3 million of ADITC and $0.2 million of EDFIT relating to fossil-fueled generating stations formerly owned by UI.

 
15


UIL HOLDINGS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) (Continued)

The proposed regulations would only allow public utilities to return ADITC and EDFIT to customers under certain specific and limited circumstances. Under the proposed guidance provided in these new regulations, none of the ADITC or the EDFIT related to the generating stations previously sold could be flowed-through to customers.

On May 17, 2006, UI received the requested PLR from the IRS. The PLR is consistent with the proposed regulations and indicates that none of the ADITC or EDFIT relating to the fossil-fueled generating stations formerly owned by UI could be returned to customers, either directly or indirectly, without violating the normalization provisions of the Internal Revenue Code. On September 8, 2006, the DPUC issued a decision to UI releasing its previously-imposed hold on the accounting and regulatory treatment of the ADITC and EDFIT. Accordingly, UI recorded non-recurring earnings of approximately $6.5 million as a reduction to income tax expense (including $3.0 million related to UI’s former ownership interest in the Millstone Unit 3 nuclear generating facility) representing the balance of ADITC and EDFIT related to the generating stations previously sold. This adjustment had no impact on cash flow.

Regional Transmission Organization for New England

On March 24, 2004, the FERC conditionally approved Independent System Operator - New England’s (ISO-NE’s) joint proposal with the New England Transmission Owners (TOs) for the creation of a Regional Transmission Organization (RTO). The creation of an RTO for New England (RTO-NE) will strengthen the independent oversight of the region’s bulk power system and wholesale electricity marketplace. UI is a party to all of the agreements that establish RTO-NE and a signatory to the joint RTO filing with the FERC. RTO-NE commenced operation effective February 1, 2005. As a member of RTO-NE, UI is eligible for the FERC’s participation incentive adder (50 basis points above the approved transmission base return on equity (ROE)) for joining RTO-NE. The 50 basis point participation adder is applicable to UI’s pool transmission facilities (PTF transmission projects). The base ROE of 12.8% requested by the TOs became effective on February 1, 2005 when RTO-NE commenced operation. All of the TOs, including UI, were able to earn the base ROE of 12.8% plus the 50 basis point participation adder (or 13.3%) on their PTF transmission projects and the base ROE of 12.8% on their non-PTF projects, subject to refund, pending a final FERC decision on the justness and reasonableness of the common base ROE.

On October 31, 2006, the FERC issued a final decision. The order sets a base ROE of 10.20%, based on a proxy group made up of northeast utility companies. In addition, the FERC approved three ROE adders as follows: (i) a 50 basis point incentive for RTO participation; (ii) a 100 basis point incentive for new transmission investment; and (iii) a 74 basis point adjustment reflecting updated bond data, applicable to the period commencing with the date of the order. The new ROEs are effective February 1, 2005, with the exception of the adder related to updated bond data, which is effective prospectively from the date of the decision.

For UI, the ROE will differ depending on whether or not the asset or new investment is a PTF transmission project, which benefits the regional grid, or a non-PTF project, which is primarily a local transmission cost. As an owner of the ISO New England transmission grid, UI qualifies for the 50 basis point adder for its PTF projects. The 100 basis point incentive is available for new PTF transmission projects which are identified as necessary by ISO New England in its regional planning process. Non-PTF projects would not be eligible for either the 50 basis point adder or the 100 basis point adder. A summary of the ROEs for UI’s transmission projects under the guidelines in the FERC order, as it is currently understood, would be as follows:

 
Existing Transmission
New Transmission
 
PTF
Non-PTF
PTF (1)
Non-PTF
2/1/05 to 10/30/06
10.70%
10.20%
11.70%
10.20%
10/31/06 and forward
11.44%
10.94%
12.44%
10.94%
 
(1) ROE available for new PTF transmission projects which are identified as necessary by ISO-NE in its regional planning process.

 
16


UIL HOLDINGS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) (Continued)

With the issuance of this decision, UI’s preliminary analysis indicates that the approved ROEs will result in customer refunds of approximately $3.3 million. This covers the period from February 1, 2005 through September 30, 2006. Correspondingly, these refunds will also result in a reduction to net income of approximately $1.9 million. These entries have been recorded in the third quarter of 2006. UI expects to administer such refunds on a prospective basis. The FERC decision is complex and subject to interpretation and clarification. UI, with its legal counsel, will continue to evaluate the impact of this decision and will revise these entries, if necessary, in the fourth quarter of 2006, depending on the outcome of its final evaluation.

Other Transmission

On May 31, 2006, Northeast Utilities (NU) filed proposed amendments to its local transmission service tariff at the FERC. The proposed revisions would have the effect of charging UI customers a prorated portion of the construction cost of NU’s Bethel to Norwalk 345KV transmission line that ISO-NE deems not justified to be included in the New England regional transmission rate. On June 21, 2006, UI filed a motion at the FERC protesting on the grounds that UI’s customers neither caused nor benefit from these costs. On July 28, 2006, the FERC approved the NU filing. UI has filed to seek rehearing. If the FERC ultimately decides in NU’s favor, and FERC’s decision is ultimately upheld, these costs will be included in UI’s local transmission tariff and, therefore, recovered through rates.

(D) SHORT-TERM CREDIT ARRANGEMENTS
 
UIL Holdings has a money market loan arrangement with JPMorgan Chase Bank. This is an uncommitted short-term borrowing arrangement under which JPMorgan Chase Bank may make loans to UIL Holdings for fixed maturities from one day up to six months. JPMorgan Securities, Inc. acts as an agent and sells the loans to investors. The fixed interest rates on the loans are determined based on conditions in the financial markets at the time of each loan. As of September 30, 2006, UIL Holdings did not have any short-term borrowings outstanding under this arrangement.
 
On July 29, 2004, UIL Holdings entered into a revolving credit agreement with a group of banks that extends to July 28, 2007 (Revolving Credit Agreement). The borrowing limit of this facility is $100 million. The facility permits UIL Holdings to borrow funds at a fluctuating interest rate determined by the prime lending market in New York, and also permits UIL Holdings to borrow money for fixed periods of time specified by UIL Holdings at fixed interest rates determined by the Eurodollar inter-bank market in London (LIBOR). If a material adverse change in the business, operations, affairs, assets or condition, financial or otherwise, or prospects of UIL Holdings and its subsidiaries, on a consolidated basis, should occur, the banks may decline to lend additional money to UIL Holdings under this revolving credit agreement, although borrowings outstanding at the time of such an occurrence would not necessarily then become due and payable. As of September 30, 2006, UIL Holdings did not have any short-term borrowings outstanding under this arrangement. UIL Holdings amended its Revolving Credit Agreement, effective March 30, 2006, to define consolidated net income without regard to any reduction in net income resulting from any impairment of goodwill in connection with a decision by UIL Holdings to divest of Xcelecom or its subsidiaries.

Xcelecom has a revolving credit agreement with a bank that extends to the earlier of June 30, 2007 and the date on which UIL Holdings’ divestiture of Xcelecom is substantially completed. In connection with an amendment of this agreement, dated as of July 28, 2006, UIL Holdings has guaranteed Xcelecom’s obligations under the agreement. This agreement provides for a $20 million revolving loan facility available to meet working capital needs and to support standby letters of credit issued by Xcelecom in the normal course of its business (such amount to be reduced as UIL Holdings’ divestiture of Xcelecom is completed), and to meet capital equipment needs of up to $1 million. Capital equipment loans under this facility can be converted to amortizing term loans with a maturity of up to four years. This agreement also provides for the payment of interest at a rate, at the option of Xcelecom, based on the agent bank’s prime interest rate or LIBOR. As of September 30, 2006, there was $3.0 million outstanding under the revolving working capital balance under this facility. Xcelecom had $0.2 million of capital equipment funding that had been converted to term notes outstanding and standby letters of credit of $3.8 million outstanding at September 30, 2006 under the facility.

 
17


UIL HOLDINGS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) (Continued)

(E) INCOME TAXES

   
Three Months Ended
 
Nine Months Ended
 
   
September 30,
   
     
2005
 
2006
 
2005
 
   
(In Thousands)
 
(In Thousands)
 
Income tax expense for continuing operations consists of:
                 
Income tax provisions (benefit):
                 
Current
                 
Federal
 
$
14,673
 
$
10,648
 
$
35,560
 
$
18,758
 
State
   
2,874
   
2,336
   
8,783
   
4,208
 
Total current
   
17,547
   
12,984
   
44,343
   
22,966
 
Deferred
                         
Federal
   
(7,685
)
 
1,143
   
(12,278
)
 
2,294
 
State
   
(626
)
 
95
   
(2,541
)
 
5
 
Total deferred
   
(8,311
)
 
1,238
   
(14,819
)
 
2,299
 
                           
Investment tax credits
   
(37
)
 
(113
)
 
(110
)
 
(338
)
                           
Total income tax expense
 
$
9,199
 
$
14,109
 
$
29,414
 
$
24,927
 
                           
Income tax components charged as follows:
                         
Operating tax expense
 
$
14,317
 
$
14,826
 
$
26,659
 
$
27,590
 
Non-operating tax expense (benefit)
   
(5,291
)
 
(742
)
 
(5,002
)
 
(777
)
Equity investments tax (benefit)
   
173
   
25
538
)
 
7,757
   
(1,886
)
                           
Total income tax expense
 
$
9,199
 
$
14,109
 
$
29,414
 
$
24,927
 
                           

Legislation enacted in Connecticut in 2005 imposed a 20% surcharge on the corporation business tax for the year 2006. This surcharge effectively increased the statutory rate of Connecticut corporation business tax from 7.5% to 9.0% for the year 2006. Due to this change, the combined statutory federal and state income tax rate for UIL Holdings’ Connecticut-based entities increased from 39.875% for the year 2005 to 40.85% for the year 2006.

Differences in the treatment of certain transactions for book and tax purposes occur which cause the rate of UIL Holdings’ reported income tax expense to differ from the statutory tax rate described above. The effective book income tax rates for the three and nine months ended September 30, 2006 were 23.7% and 34.2%, respectively, as compared to 43.1% and 46.8% for the three and nine months ended September 30, 2005. The decrease in the 2006 effective book income tax rates from the rates for the 2005 periods is primarily due to: (1) the reversal of accumulated deferred investment tax credits (ADITC) and excess deferred federal income taxes (EDFIT) based on the IRS private letter ruling, See “Note (C) - Tax Credits Related to the Sale of Generation.” (2) differences in the amount of book depreciation in excess of non-normalized tax depreciation, and (3) non-recurring adjustments to deferred income tax reserves primarily associated with bond redemption premiums and expenses that were recorded during the first nine months of 2005.

The 2006 nine month effective book income tax rate is lower than the 2006 effective statutory tax rate due primarily to the reversal of $6.5 million in ADITC and EDFIT based on the IRS private letter ruling. See “Note (C) - Tax Credits Related to the Sale of Generation.”

For federal income tax purposes, any capital losses that UIL Holdings may incur associated with the planned divestiture of Xcelecom are expected to be applied against previously incurred capital gains totaling approximately $101 million from the prior sales of American Payment Systems in June 2004, its ownership interest in Cross-Sound in February 2006, and its ownership interest in Bridgeport Energy in March 2006.

 
18


UIL HOLDINGS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) (Continued)

For state income tax purposes, UIL Holdings is not able to recognize any state income tax benefits for capital losses associated with the divestiture of Xcelecom incurred during the first nine months of 2006. As a result, UIL Holdings has recorded a valuation allowance of $3.3 million associated with future state income tax benefits from capital losses in connection with which the realization is uncertain as of September 30, 2006. These future state income tax benefits may be recognized over the course of the next five years to the extent that capital gains are realized by Xcelecom.

 
19

 
UIL HOLDINGS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) (Continued)

(F) SUPPLEMENTARY INFORMATION
 
(In Thousands)
                 
   
Three Months Ended
 
Nine Months Ended
 
   
September 30,
   
     
2005
 
2006
 
2005
 
   
(In Thousands)
 
(In Thousands)
 
Operating Revenues
                 
Utility
                         
Retail
 
$
236,427
 
$
240,692
 
$
597,957
 
$
593,900
 
Wholesale
   
7,469
   
11,311
   
22,266
   
24,066
 
Other
   
17,244
   
7,439
   
40,931
   
14,305
 
Non-utility businesses
                         
Other
   
4
   
5
   
13
   
14
 
Total Operating Revenues
 
$
261,144
 
$
259,447
 
$
661,167
 
$
632,285
 
                           
                           
Fuel and Energy
                         
Fuel and Energy
 
$
130,088
 
$
136,401
 
$
340,408
 
$
336,265
 
Purchase Power above market fuel expense credit (1)
   
(5,389
)
 
(5,482
)
 
(15,992
)
 
(16,268
)
Total Fuel and Energy
 
$
124,699
 
$
130,919
 
$
324,416
 
$
319,997
 
                           
Depreciation and Amortization
                         
Utility property, plant, and equipment depreciation
 
$
7,888
 
$
7,799
 
$
23,342
 
$
22,838
 
Amortization of nuclear plant regulatory assets
   
7,459
   
8,713
   
14,296
   
15,660
 
Amortization of purchase power contracts (1)
   
5,389
   
5,482
   
15,992
   
16,268
 
Amortization of other CTA regulatory assets
   
-
   
-
   
-
   
(156
)
Subtotal CTA Amortization
   
12,848
   
14,195
   
30,288
   
31,772
 
Amortization of intangibles
   
-
   
7
   
4
   
36
 
Amortization of other regulatory assets
   
329
   
23
   
928
   
67
 
Total Amortization
   
13,177
   
14,225
   
31,220
   
31,875
 
Total Depreciation and Amortization
 
$
21,065
 
$
22,024
 
$
54,562
 
$
54,713
 
                           
Taxes - Other than Income Taxes
                         
Operating:
                         
Connecticut gross earnings
 
$
9,126
 
$
8,970
 
$
22,255
 
$
20,848
 
Local real estate and personal property
   
2,498
   
2,477
   
7,692
   
7,567
 
Payroll taxes
   
992
   
1,033
   
3,655
   
3,628
 
Total Taxes - Other than Income Taxes
 
$
12,616
 
$
12,480
 
$
33,602
 
$
32,043
 
                           
Other Income (Deductions), net
                         
Interest income
 
$
1,395
 
$
540
 
$
3,157
 
$
1,555
 
Allowance for funds used during construction
   
902
   
722
   
2,544
   
2,045
 
C&LM incentive
   
289
   
229
   
596
   
646
 
GSC procurement fees
   
943
   
802
   
2,242
   
2,084
 
ISO load response, net
   
1,092
   
405
   
2,017
   
1,021
 
Miscellaneous other income and (deductions) - net
   
195
   
(88
)
 
452
   
(149
)
Total Other Income (Deductions), net
 
$
4,816
 
$
2,610
 
$
11,008
 
$
7,202
 
                           
Other Interest, net
                         
Notes payable
 
$
-
 
$
229
 
$
151
 
$
467
 
Other
   
374
   
526
   
949
   
783
 
Total Other Interest, net
 
$
374
 
$
755
 
$
1,100
 
$
1,250
 
                           
(1) The amortization of this regulatory asset is a cash neutral item, as there is an offsetting liability which is relieved through a credit to fuel and energy expense.
                           
 
 
20

UIL HOLDINGS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) (Continued)

(G) PENSION AND OTHER BENEFITS

The United Illuminating Company Pension Plan (the “Pension Plan”) covers the majority of employees of UIL Holdings and UI and certain management employees of Xcelecom, in each case other than newly hired employees as described below in this Note (G). Xcelecom employees no longer accrue benefits under the Pension Plan, but any benefits accrued to them through December 2003 remain in the Pension Plan. UI also has a non-qualified supplemental pension plan for certain employees and a non-qualified retiree-only pension plan for certain early retirement benefits.

The funding policy for the qualified pension plan is to make annual contributions that satisfy the minimum funding requirements of ERISA but that do not exceed the maximum deductible limits of the Internal Revenue Code. These amounts are determined each year as a result of an actuarial valuation of the qualified pension plan. Based upon preliminary actuarial calculations, UI does not expect to make a contribution to the Pension Plan for the 2006 plan year.

There is potential variability to the pension expense calculation depending on changes in certain assumptions: if there is a 0.25% change in the discount rate used, the pension expense would increase or decrease inversely by $0.9 million; if there is a 1% change in the expected return on assets, the pension expense would increase or decrease inversely by $2.8 million.

In addition to providing pension benefits, UI also provides other post-retirement benefits (OPEB), consisting principally of health care and life insurance benefits, for retired employees and their dependents. Employees who are 55 years of age and whose sum of age and years of service at time of retirement is equal to or greater than 65 are eligible for benefits partially subsidized by UI. The amount of benefits subsidized by UI is determined by age and years of service at retirement. In the first nine months of 2006, UI contributed $1.8 million to a 401(h) account in connection with the Pension Plan to fund OPEB for UI’s non-union employees. In addition, UI expects to contribute approximately $5.3 million to the Voluntary Employees’ Benefit Association (VEBA) in the fourth quarter, to provide additional OPEB funding for non-union employees.

There is potential variability in the calculation of OPEB plan expenses depending on changes in certain assumptions: if there is a 0.25% change in the discount rate used, the OPEB plan expenses would increase or decrease inversely by $0.2 million; if there is a 1% change in the expected return on VEBA assets, the OPEB plan expenses would increase or decrease inversely by $0.2 million.

A new retirement plan became effective on April 1, 2005 for new employees hired into the bargaining unit, and May 1, 2005 for all other new employees. Such new employees will not participate in the Pension Plan or receive retiree medical plan benefits. The new retirement plan is a “defined contribution plan”, and consists of the current provisions of UI's 401(k)/Employee Stock Ownership Plan (KSOP), plus the following benefits:

·  
An additional cash contribution of 4.0% of total annual compensation (as defined in the KSOP Plan) is made to a separate account in the KSOP for new hires.
·  
An additional cash contribution of $1,000 per year (pro rata per pay period) is made to a separate Retiree Medical Fund account within the KSOP for new hires.
·  
New employees do not need to contribute to the KSOP to receive these additional cash contribution amounts; they only need to enroll in the KSOP Plan.
·  
Both types of additional cash contributions to the KSOP vest 100% after 5 years of service.

In the third quarter, certain changes were made to the Pension Plan pursuant to which all employees who are participants in the Pension Plan were given the opportunity to elect whether to continue to earn benefits under the Pension Plan or, instead, to stop earning benefits under the Pension Plan and begin earning additional benefits under the KSOP. If an employee elects to earn benefits under the KSOP, any benefits earned under the Pension Plan will continue to be held in trust, and will be paid when the employee retires or terminates service. The election is available to employees from November 1, 2006 through December 15, 2006.

 
21


UIL HOLDINGS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) (Continued)

The following tables represent the components of net periodic benefit cost for pension and OPEB for the three and nine months ended September 30, 2006 and 2005:

   
Three Months Ended September 30,
 
   
Pension Benefits
 
Other Post-retirement Benefits
 
   
2006
 
2005
 
2006
 
2005
 
   
(In Thousands)
 
Components of net periodic benefit cost:
                 
Service cost
 
$
1,760
 
$
1,582
 
$
319
 
$
245
 
Interest cost
   
4,635
   
4,495
   
864
   
776
 
Expected return on plan assets
   
(5,966
)
 
(5,565
)
 
(409
)
 
(380
)
Amortization of:
                         
Prior service costs
   
263
   
246
   
(32
)
 
(45
)
Transition obligation (asset)
   
-
   
(131
)
 
265
   
265
 
Actuarial (gain) loss
   
1,889
   
1,589
   
564
   
418
 
Net periodic benefit cost
 
$
2,581
 
$
2,216
 
$
1,571
 
$
1,279
 
                           
The following actuarial weighted average assumptions were used in calculating net periodic benefit cost:
                         
Discount rate
   
5.50
%
 
5.75
%*  
5.50
%
 
5.75
%*
Average wage increase
   
4.40
%
 
4.50
%
 
N/A
   
N/A
 
Return on plan assets
   
8.25
%
 
8.00
%
 
8.25
%
 
8.00
%
Pre-65 health care trend rate (current yr)
   
N/A
   
N/A
   
11.00
%
 
12.00
%
Pre-65 health care trend rate (2012+)
   
N/A
   
N/A
   
5.50
%
 
5.50
%
Post-65 health care trend rate (current yr)
   
N/A
   
N/A
   
6.00
%
 
6.50
%
Post-65 health care trend rate (2008+)
   
N/A
   
N/A
   
5.00
%
 
5.00
%

N/A - not applicable.
*5% discount rate used at June 30, 2005 for non-qualified plan.

 
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UIL HOLDINGS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) (Continued)

   
Nine Months Ended September 30,
 
   
Pension Benefits
 
Other Post-retirement Benefits
 
   
2006
 
2005
 
2006
 
2005
 
   
(In Thousands)
 
Components of net periodic benefit cost:
                 
Service cost
 
$
5,282
 
$
4,728
 
$
955
 
$
735
 
Interest cost
   
13,905
   
13,485
   
2,592
   
2,340
 
Expected return on plan assets
   
(17,897
)
 
(16,694
)
 
(1,227
)
 
(1,139
)
Amortization of:
                         
Prior service costs
   
789
   
776
   
(96
)
 
(135
)
Transition obligation (asset)
   
-
   
(393
)
 
794
   
794
 
Actuarial (gain) loss
   
5,665
   
4,748
   
1,691
   
1,249
 
Settlements, curtailments and special
termination benefits
   
-
   
488
   
-
   
37
 
Net periodic benefit cost
 
$
7,744
 
$
7,138
 
$
4,709
 
$
3,881
 
                           
The following actuarial weighted average assumptions were used in calculating net periodic benefit cost:
                         
Discount rate
   
5.50
%
 
5.75
%*  
5.50
%
 
5.75
%*
Average wage increase
   
4.40
%
 
4.50
%
 
N/A
   
N/A
 
Return on plan assets
   
8.25
%
 
8.00
%
 
8.25
%
 
8.00
%
Pre-65 health care trend rate (current yr)
   
N/A
   
N/A
   
11.00
%
 
12.00
%
Pre-65 health care trend rate (2012+)
   
N/A
   
N/A
   
5.50
%
 
5.50
%
Post-65 health care trend rate (current yr)
   
N/A
   
N/A
   
6.00
%
 
6.50
%
Post-65 health care trend rate (2008+)
   
N/A
   
N/A
   
5.00
%
 
5.00
%

N/A - not applicable.
*5% discount rate used at June 30, 2005 for non-qualified plan.

The preceding tables reflect curtailment and special termination benefits charges resulting from the departure of an employee as part of the reorganization of UIL Holdings’ Finance organization. Approximately $0.4 million of these charges were previously recognized as employee termination costs and have now been reclassified to the pension and other post-retirement benefits accounts due to the employee’s election to receive enhanced retirement benefits rather than a lump sum termination payment. See “Note (A) - Statement of Accounting Policies - Restructuring Charges” for additional information.

(J) COMMITMENTS AND CONTINGENCIES

Other Commitments and Contingencies

Connecticut Yankee Atomic Power Company

UI has a 9.5% stock ownership share in the Connecticut Yankee Atomic Power Company (Connecticut Yankee), the carrying value of which was $4.0 million as of September 30, 2006. On December 4, 1996, the Board of Directors of Connecticut Yankee voted unanimously to retire the Connecticut Yankee nuclear plant (the “Connecticut Yankee Unit”) from commercial operation. A decision by the FERC that became effective on August 1, 2000 allows Connecticut Yankee to collect, through the power contracts with the unit’s owners, the FERC-approved decommissioning costs, other costs associated with the permanent shutdown of the Connecticut Yankee Unit, the unrecovered investment in the Connecticut Yankee Unit, and a return on equity of 6%. Connecticut Yankee may recover 9.5% of these costs from UI. As of the end of September 2006, the decommissioning project is approximately 96% complete and the physical component of that work is expected to be completed in the first quarter of 2007.

 
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UIL HOLDINGS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) (Continued)

There are currently two significant unresolved legal and regulatory matters regarding the decommissioning of the Connecticut Yankee Unit which could have an impact on the results of operations and financial condition of UI: (1) the review and approval process by the FERC of the request by Connecticut Yankee to recover increased decommissioning costs, and (2) litigation between the U.S. Department of Energy (DOE) and Connecticut Yankee, together with two other New England-based owners of retired nuclear generating plants, regarding disposal of spent nuclear fuel. Each of these items is discussed in further detail below.

Connecticut Yankee updates its cost to decommission the unit at least annually, and more often as needed, and provides UI with a projected recovery schedule depicting annual costs expected to be billed to UI, including a return on investment over the term of the projected recovery period. The present value of these costs is calculated using UI’s weighted average cost of capital and, after consideration of recoverability, recorded as a Connecticut Yankee Contract Obligation and a corresponding regulatory asset. At September 30, 2006, UI has regulatory approval to recover in future rates (through the CTA) $6.9 million of its regulatory asset for Connecticut Yankee over a term ending in 2007. The remaining portion of the regulatory asset, as of September 30, 2006, was $27.9 million, which consists of costs subject to a regulatory review and approval process and reflects the present value of the revenue requirements to fund the increased costs described in the following paragraphs. The regulatory review and approval process may extend the recovery period beyond 2007. Although UI believes full regulatory recovery is probable, because these costs are similar in nature to the costs for which UI already has regulatory approval to recover in future rates, the actual amounts subject to recovery may be different.

Current Cost Estimate

As part of Connecticut Yankee’s April 2000 rate case settlement with the FERC (2000 FERC Settlement), remaining decommissioning costs were estimated at $436 million. The original estimate was updated in November 2002 to increase the estimated decommissioning costs by approximately $130 million. The $130 million increase stemmed primarily from additional security costs, increased insurance costs and other factors. In December 2003, the estimate was increased by an additional $265 million, reflecting the fact that Connecticut Yankee is now directly managing the work necessary to complete decommissioning of the plant following termination in July 2003 of the contractor that had been managing such work. Consequently, the total current cost estimate of approximately $831 million (2003 Estimate) represents an aggregate increase of approximately $395 million over the 2000 FERC Settlement amount. The above financial information has been adjusted to 2003 dollars. UI’s share of the estimated increased cost of $395 million over the 2000 FERC Settlement amount is approximately $37.5 million. The 2000 FERC Settlement specified that if Connecticut Yankee’s costs for the physical decommissioning of the plant exceeded a specified level, then, subject to certain conditions, Connecticut Yankee would not bill its wholesale purchasers for 10 percent of the overage, up to a maximum of $10 million, even if the higher costs were prudently incurred. Connecticut Yankee has determined that although neither the regulatory proceeding nor the physical decommissioning of the plant are complete, it can no longer conclude that it is probable that it will recover this $10 million portion of the decommissioning costs in its wholesale decommissioning charges. Connecticut Yankee recognized the after-tax impact of $6 million as a reduction in its equity in the second quarter of 2006. UI’s share of this write-off is approximately $0.3 million on an after tax basis. The balance of the increased costs will not impact current period earnings, because the amounts will be deferred on UI’s balance sheet pending resolution of the litigation and regulatory proceedings described herein. Ultimately, if this issue is resolved favorably, the costs will be recovered in rates and therefore would not have a financial impact on UI’s results of operations. If the outcome is not favorable, there could be a material negative impact to UI’s results of operations.

FERC Matters

2004 Rate Case Filing
 
Connecticut Yankee filed the 2003 Estimate with the FERC as part of a July 1, 2004 rate application (the “Filing”) seeking additional funding to complete the decommissioning project and for storage of spent fuel through 2023. The Filing was required as part of the terms of the 2000 FERC Settlement and requests that new rates take effect on January 1, 2005. The Filing includes proposed increased decommissioning charges, based on the 2003 Estimate, as well as $4.0 million and $2.4 million of new charges for pension and post-retirement benefits (other than pensions), respectively. The proposed $93 million annual decommissioning collection represents a significant increase in
 
 
24


UIL HOLDINGS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) (Continued)
 
annual charges compared to the existing FERC-approved decommissioning collection rate of $16.7 million per year that had been approved as part of the 2000 FERC Settlement. The Filing proposes extending the collection period for decommissioning from June 30, 2007 to December 31, 2010.

Notices of intervention or protest were filed in July and August 2004 at the FERC by several utility parties and by non-utility parties, including the DPUC, the Office of Consumer Counsel (OCC), the Massachusetts Attorney General, the Massachusetts Department of Telecommunications and Energy, the Rhode Island Attorney General, and the Maine Public Advocate. Bechtel Power Corporation also filed a motion to intervene and protest.

On August 30, 2004, FERC issued an order: (1) accepting for filing Connecticut Yankee’s proposed new charges for decommissioning, pension expense and post-retirement benefits (other than pensions) expense; (2) suspending the revised charges for a period of five months, to February 1, 2005, at which time the proposed rates went into effect subject to refund; (3) establishing hearing procedures, which commenced with a pre-hearing conference before an administrative law judge (ALJ) in September 2004; (4) denying the request of the DPUC and OCC for an accelerated hearing schedule and for a bond or other security for potential refunds; (5) denying the declaratory ruling requested by the DPUC and OCC (see paragraph below); and (6) granting Bechtel’s motion to intervene as well as allowing the interventions by the other applying parties, including UI and the other Connecticut Yankee power purchasers. The evidentiary hearings concluded on June 22, 2005.

Following post-hearing briefs, the ALJ issued an Initial Decision on November 22, 2005. The Initial Decision found that Connecticut Yankee acted prudently in all respects and denied all prudence-related claims for disallowance of decommissioning costs. The only adjustment to Connecticut Yankee’s decommissioning charges required by the Initial Decision relates to the escalation rate, which is the factor used to translate the 2003 Estimate, which is stated in constant 2003 dollars, into spending projections and decommissioning charges. The Initial Decision found that Connecticut Yankee should recalculate its decommissioning charges to reflect a lower escalation rate. The Initial Decision is subject to review by the FERC.

FERC Order on Request for Declaratory Order

On June 10, 2004, the DPUC and the OCC filed a petition (Petition) with the FERC seeking a declaratory order that Connecticut Yankee can recover all decommissioning costs from its wholesale purchasers, but that those purchasers may not recover in their retail rates any costs that the FERC might determine to have been imprudently incurred. Connecticut Yankee, as well as its wholesale purchasers, responded in opposition to the Petition, indicating that the order sought by the DPUC and OCC would violate the Federal Power Act and decisions of the U.S. Supreme Court, other federal and state courts, and the FERC. As noted above, the ALJ rejected this Petition as part of its initial ruling on Connecticut Yankee’s rate filing. The DPUC and OCC filed a petition for rehearing on the matter which was denied by the FERC on October 20, 2005. On December 12, 2005, the DPUC and OCC filed a petition for review of the FERC’s orders on the Petition with the U.S. Court of Appeals for the D.C. Circuit (D.C. Circuit). On January 12, 2006, FERC responded to the DPUC petition arguing that the D.C. Circuit should dismiss or hold the matter in abeyance until the completion of the FERC proceeding and FERC’s orders become final. The matter remains pending before the D.C. Circuit.

Settlement Agreement

On August 15, 2006, Connecticut Yankee submitted to the FERC a settlement agreement in connection with the above-referenced Connecticut Yankee FERC rate case proceedings. The agreement is jointly sponsored by the DPUC, OCC, the Maine Public Advocate and the Maine Public Utilities Commission. If accepted by the Commission, this Settlement Agreement would resolve all of the issues raised in these proceedings, including, (a) Connecticut Yankee’s filing of increased decommissioning charges and charges for pension and post-employment benefit other than pension (PBOP) expenses; (b) the DPUC’s and OCC’s request for a declaratory order noted above, and the related petition for review; (c) the rights and obligations of the parties under incentive mechanisms contained in the 2000 FERC Settlement that requires the disallowance of $10 million of decommissioning costs (See discussion in “Current Cost Estimate” section above); (d) Connecticut Yankee’s reflection in its decommissioning
 
 
25


UIL HOLDINGS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) (Continued)

trust fund and its wholesale decommissioning charges of the net proceeds it received in the settlement of the civil litigation with Bechtel; (e) Connecticut Yankee’s recovery in its wholesale rates of the costs of completing the decontamination and dismantlement (D&D) phase of the decommissioning of the Plant; and (f) Connecticut Yankee’s payment of dividends and return of equity capital to its shareholders and its right to earn a return on equity on the remaining equity capital. In particular, and without limiting the generality of the foregoing, the Settlement Agreement resolves any claims that Connecticut Yankee incurred D&D costs imprudently. The Commission has not yet responded to the submittal.

DOE Litigation

The new estimates described above relate in part, to spent fuel storage, and could be affected by the outcome of an ongoing dispute between the DOE and several utilities and states. Under the Nuclear Waste Policy Act of 1982 (the “Act”), the DOE is required to design, license, construct and operate a permanent repository for high-level radioactive waste and spent nuclear fuel. The Act requires the DOE to provide for the disposal of spent nuclear fuel and high-level waste from commercial nuclear plants through contracts with the owners. In return for payment of established disposal fees, the federal government was required to take title to and dispose of the utilities’ high-level waste and spent nuclear fuel beginning no later than January 1998. After the DOE announced that its first high-level waste repository will not be in operation earlier than 2010, several utilities and states obtained a judicial declaration that the DOE has a statutory responsibility to take title to and dispose of high-level waste and spent nuclear fuel beginning in January 1998. Although the federal government now concedes that its failure to begin disposing of high-level waste and spent nuclear fuel in January 1998 constituted a breach of contract, it continues to dispute that the entities with which it had contracts are entitled to damages. Connecticut Yankee, together with two other New England-based owners of retired nuclear generating plants, is seeking recovery of damages stemming from the breach by the DOE under the 1983 contracts that were mandated by the U.S. Congress under the High Level Waste Act for purposes of disposal of spent fuel and high-level waste, including greater than class C waste (GTCC).

The amount of the claim for damages incurred through 2010, net of adjustments made as part of the trial record, is approximately $186 to $198 million, depending on the discount rate applied. In addition, incremental continuing damages that will be incurred for periods beyond 2010 are being sought based on an annual dollar value. The 2003 Estimate discussed above does not include an allowance for recovery of damages in this matter. The Department of Justice submitted a motion to the court during the damage trial which raises the issue of whether Connecticut Yankee’s pre-1983 spent fuel fee obligation of approximately $155 million should be treated as an offset to any payment of damages. On October 4, 2006, the Court released a judgment in the amount of $34.2 million.

The decision awards Connecticut Yankee the above stated damages for spent fuel storage related costs that it incurred through 2001. Connecticut Yankee had sought $37.7 million of damages through the same period and is still evaluating whether it will seek an appeal.

Since it is expected that the DOE will seek an appeal, Connecticut Yankee has not recognized the damage award on its books. Connecticut Yankee’s FERC settlement requires such damage awards once realized, net of litigation expenses and taxes, to be applied to decommissioning costs and then credited to ratepayers.

The decision, if upheld, establishes the DOE’s responsibility for reimbursing Connecticut Yankee for its actual costs through 2001 for the construction of the independent spent fuel storage installation (ISFSI). Although the decision leaves open the question regarding damages in subsequent years, the decision does support future claims for the remaining ISFSI construction costs. The decision also awards Connecticut Yankee all costs of re-racking completed in 1996. The decision denies Connecticut Yankee wet fuel storage costs for the period through 2001 and calls into question claims for subsequent operational costs until a future time period. The order bases these conclusions on findings that Connecticut Yankee would have had to incur fuel storage costs for some time period beyond 2001 and therefore did not incur these during the period through 2001 as a result of the Government’s failure to remove fuel.

 
26


UIL HOLDINGS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) (Continued)

Bechtel Litigation

Connecticut Yankee terminated its decommissioning contract with Bechtel Power Corporation (Bechtel) in July 2003, due to Bechtel’s history of incomplete and untimely performance of decommissioning work. In June 2003, Bechtel filed a complaint against Connecticut Yankee in Connecticut Superior Court, asserting a number of claims, including wrongful termination and negligent misrepresentation.

In August 2003, Connecticut Yankee filed a counterclaim, including counts for breach of contract, negligent misrepresentation and breach of duty of good faith and fair dealing. Connecticut Yankee has been managing the decommissioning process and was continuing to prosecute its counterclaims for excess completion costs and other damages against Bechtel in Connecticut Superior Court until completion of the settlement described below.

On March 7, 2006, Connecticut Yankee and Bechtel entered into a binding settlement agreement regarding this litigation. The agreement includes provisions providing that (1) all disputes between the parties are fully and finally settled and the decommissioning contract is deemed to be terminated by agreement, (2) the parties shall exchange a mutual general release of all claims, including any liens, garnishments and attachments, and (3) Bechtel shall pay Connecticut Yankee $15 million. Connecticut Yankee and Bechtel executed more complete implementing documentation relating to this settlement on March 17, 2006. Connecticut Yankee expects to credit net proceeds of the settlement against decommissioning costs recoverable under the power contracts in a superseding rate application at FERC.

Hydro-Quebec

UI is a participant in the Hydro-Quebec (HQ) transmission tie facility linking New England and Quebec, Canada. UI has a 5.45% participating share in this facility, which has a maximum 2000 megawatt equivalent generation capacity value. UI furnished a guarantee for its participating share of the debt financing for one phase of this facility in April 1991, in the amount of $11.7 million. The amount of this guarantee is reduced monthly, proportionate with principal paid on the underlying debt. As of September 30, 2006, the amount of UI’s guarantee for this debt totaled approximately $2.7 million.

Environmental Concerns

In complying with existing environmental statutes and regulations and further developments in areas of environmental concern, including legislation and studies in the fields of water quality, hazardous waste handling and disposal, toxic substances, and electric and magnetic fields, UIL Holdings and its wholly-owned direct and indirect subsidiaries may incur substantial capital expenditures for equipment modifications and additions, monitoring equipment and recording devices, and it may incur additional operating expenses. The total amount of these expenditures is not now determinable. Environmental damage claims may also arise from the operations of UIL Holdings’ subsidiaries. Significant environmental issues known to UIL Holdings at this time are described below.

Site Decontamination, Demolition and Remediation Costs

On June 16, 2006, UI announced its agreement with the City of Bridgeport and its Redevelopment Authority (the “City”) for the transfer of title to UI’s Steel Point property to the City and settlement of all claims against the City with respect to relocation of a substation and repair/replacement of a bulkhead, in exchange for payment to UI of $14.9 million, which represents the commercial value of the property and cost to replace the bulkhead. Pursuant to a Memorandum of Understanding among UI, the City of Bridgeport, and the City’s selected developer for the property (MOU), the City must also provide to UI, within one year and free of charge, a substation site within a reasonable proximity to the Steel Point property. On July 12, 2006, the DPUC approved the proposed transfer of property and all of the terms of the MOU. The DPUC also accepted the proposed ratemaking treatment submitted by UI with respect to the property, the substation, and the bulkhead, which provides for UI to recover costs related to the Steel Point property through the CTA, subject to DPUC approval in the annual CTA/SBC reconciliation filing. The MOU provides for the filing of a stipulated judgment incorporating the MOU’s terms in the eminent domain proceeding currently pending in the Connecticut Superior Court, and for title to the property to transfer as part of that judgment upon the City’s payment of $10.3 million, with the remaining $4.6 million to be paid by June 30, 2007.

 
27


UIL HOLDINGS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) (Continued)

UI may be required to remove additional soil on the Steel Point property to achieve environmental compliance prior to the transfer of title to the property. Under the MOU, the City and developer release UI from any further liability with respect to the Steel Point property after title transfers, and the City and/or developer must indemnify UI for environmental matters related to the Steel Point property once title transfers to the City. The sole exception to the indemnity is for personal injury claims brought against UI by UI employees or contractors hired by UI relating to incidents occurring on the site before title transfers to the City. In addition, the MOU provides that there is no indemnity for liability related to contaminated harbor sediments. UI would seek to recover all costs related to such sediments that are UI’s responsibility, to the extent incurred, through the CTA in accordance with the ratemaking treatment approved in the DPUC’s July 12, 2006 decision.

Subsequent to the demolition of Steel Point Station, the adjacent East Main Street Substation was removed at the request of the City of Bridgeport and UI expanded the Congress Street Substation to replace it. Such removal and expansion costs totaled $10.3 million of which UI was entitled to $8.9 million from the City of Bridgeport. As a result of the approved ratemaking described above, $8.5 million will be added to UI’s distribution rate base and the remaining $0.4 in removal costs will be recovered through the annual CTA/SBC reconciliation filing. The remaining $1.4 million of costs related to the Substation are transmission assets recoverable through regional transmission rates.

A site on the Mill River in New Haven was conveyed by UI to an unaffiliated entity, Quinnipiac Energy LLC (QE), reserving to UI permanent easements for the operation of its transmission facilities on the site. At the time of the sale, a fund of approximately $1.9 million, an amount equal to the then-current estimate for remediation, was placed in escrow for purposes of bringing soil and groundwater on the site into compliance with applicable environmental laws. Approximately $0.5 million of the escrow fund remains unexpended. QE’s environmental consultant reports that approximately $2 million of remediation remains to be performed. QE has entered into a long-term agreement to lease the property to a Long Island developer (Evergreen Power). UI could be required by applicable environmental laws to finish remediating any subsurface contamination at the site if it is determined that QE and/or Evergreen Power have not completed the appropriate environmental remediation at the site.

On April 16, 1999, UI completed the sale of its Bridgeport Harbor Station and New Haven Harbor Station generating plants in compliance with Connecticut’s electric utility industry restructuring legislation. Environmental assessments performed in connection with the marketing of these plants indicate that substantial remediation expenditures will be required in order to bring the plant sites into compliance with applicable minimum Connecticut environmental standards. The purchaser of the plants agreed to undertake and pay for the remediation of the purchased properties.

With respect to the portion of the New Haven Harbor Station site that UI retained, UI has performed an additional environmental analysis, indicating that approximately $3.2 million in remediation expenses will be incurred. Actual remediation costs may be higher or lower than what is currently estimated. The required remediation is virtually all on transmission-related property and UI accrued these estimated expenses during the third quarter of 2002.

UI sold property to Bridgeport Energy LLC (BE) on April 16, 1999. UIL Holdings, through its subsidiary United Bridgeport Energy, Inc. (UBE) held a minority ownership interest in BE at that time and until the sale of that interest to the majority owner in March 2006. In connection with the sale of the property, UI entered into an environmental indemnity agreement with BE to provide indemnification related to certain environmental conditions specific to the site where BE’s generation facilities were constructed. This environmental indemnification remains in place following the sale of UBE’s interest in BE. Because of soil management and other environmental remediation activities that were performed during construction of the generation facilities, UI does not regard its exposure under the environmental indemnity agreement as material.

From 1961 to 1976, UI owned a parcel of property in Derby, Connecticut, on which it operated an oil-fired electric generating unit. For several years, the Connecticut Department of Environmental Protection (CDEP) has been monitoring and remediating a migration of fuel oil contamination from a neighboring parcel of property into the adjacent Housatonic River. Although, based on its own investigation to date, UI believes it has no responsibility for this contamination, if regulatory agencies determine that UI is responsible for the cost of these remediation activities, UI may incur substantial costs, no estimate of which is currently available.

 
28


UIL HOLDINGS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) (Continued)

Electric System Work Center

UI’s January 2004 purchase of its Electric System Work Center property, located in Shelton, Connecticut, caused a review under the CDEP’s Transfer Act Program. Under this review, the CDEP had an opportunity to examine the current environmental conditions at the site and direct remediation, or further remediation, of any areas of concern. At the conclusion of its review, the CDEP elected not to oversee any further site investigation or remediation at the site and directed UI to undertake any necessary evaluation and/or remediation (verification work) using an independent Licensed Environmental Professional (LEP). UI hired a LEP and submitted a schedule to the CDEP for the verification work. The schedule was approved by the CDEP and implementation of the verification work has begun. Implementation of the verification work is not expected to have a material impact on the financial condition of UI.

Claim of Enron Power Marketing, Inc.

UI had a wholesale power agreement and other agreements with Enron Power Marketing, Inc. (EPMI) (the “Agreements”). Following EPMI’s bankruptcy filing on December 2, 2001, UI terminated the Agreements in accordance with their terms, effective January 1, 2002, in reliance upon provisions of the Bankruptcy Code that permit termination of such contracts. The Agreements permitted UI to calculate its gains and losses resulting from the termination, and globally to net these gains and losses against one another, and against any other amounts that UI owed to EPMI under the Agreements, to arrive at a single sum. On January 31, 2003, EPMI commenced an adversary proceeding against UI and UIL Holdings in the EPMI bankruptcy. UIL Holdings was sued as the guarantor of UI’s financial obligations under the Agreements. EPMI contended that UI was not entitled to offset, against any losses UI suffered from the termination of the Agreements, any amounts owing to EPMI for power delivered to UI after the date EPMI filed for bankruptcy. The amount of the allegedly improper setoff that EPMI sought to recover in the adversary proceeding was approximately $8.2 million, plus interest and attorneys’ fees. UI retained a reserve of $8.2 million for this claim.

In June 2006, UI reached a settlement agreement with EPMI under which UI paid $7.9 million to fully settle all of EPMI’s claims, and in return received a claim of $7.9 million as a general-creditor in EPMI’s bankruptcy proceeding. UI then entered into a separate agreement with an investment banking firm to sell UI’s general-creditor claim against EPMI for $5.7 million. The net effect of these two transactions reduced UI’s previously established reserve from $8.2 million to $6.0 million. The remaining balance in the reserve has been applied to the benefit of customers through the CTA.


Claim of Dominion Energy Marketing, Inc.

On December 28, 2001, UI entered into an agreement with Virginia Electric and Power Company, which was subsequently assigned to its affiliate Dominion Energy Marketing, Inc. (DEMI), for the supply of all of UI’s standard offer generation service needs from January 1, 2002 through December 31, 2003, and for the supply of all of UI’s generation service requirements for special contract customers through 2008 (Power Supply Agreement or PSA). In December 2004, UI received a letter from DEMI claiming that under the terms of this agreement, DEMI should not have been responsible for certain “CT Reliability COS” charges related to Reliability Must Run agreements between ISO-NE and NRG (the owner of power plants located in Connecticut that were formerly owned by Northeast Utilities) in an amount currently estimated at $8.2 million, plus interest. DEMI claims that such charges are fixed operation and maintenance costs and not “Transmission Congestion Costs,” for which DEMI would be responsible under the terms of the PSA. DEMI has indicated that it does not intend to terminate the PSA prior to resolution of the dispute, but the parties have not agreed to a dispute resolution process. On February 14, 2005, DEMI filed a complaint in United States District Court for the District of Connecticut (USDC-CT) seeking the court’s interpretation of the PSA and an order to compel UI to pay the claimed damages. On March 14, 2005, UI filed a complaint with the FERC requesting that it exercise jurisdiction under Section 206 of the Federal Power Act and order DEMI to abide by the terms and conditions of the PSA. On May 13, 2005, the FERC issued an order granting UI’s request, noting that DEMI is responsible for the “CT Reliability COS” charges. Subsequently, DEMI filed a notice of voluntary dismissal of the complaint filed with the USDC-CT, which was granted. DEMI also filed a request for rehearing with the FERC, which was granted on September 15, 2005. On May 26, 2006 an initial decision was issued by the FERC administrative law judge denying DEMI’s motion to dismiss UI’s claim and
 
 
29


UIL HOLDINGS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) (Continued)

granting UI’s request, again, noting that DEMI is responsible for the “CT Reliability COS” charges. DEMI has requested reconsideration of the initial decision by the full Commission.

Gross Earnings Tax Assessment

On September 20, 2005, the Appellate Division of the Connecticut Department of Revenue Services (DRS) ruled against UI’s appeal of a gross earnings tax assessment made by the DRS as the result of an audit examination which covered the period July 1, 1998 through December 31, 2000. The assessment, in the amount of $0.1 million (including interest), is entirely attributable to activity within the year 2000 and arose as a result of changes to the gross earnings tax statutes enacted pursuant to Connecticut’s 1998 electric industry restructuring legislation, Public Act 98-28, which became effective on January 1, 2000. UI believes that the DRS has erroneously determined that the gross earnings tax statutes, as amended, apply to the following three specific categories of revenues: (1) late payment fees imposed on customers that do not pay their bills within the time specified in their terms of service; (2) returned check fees imposed on customers whose checks were returned to UI due to insufficient funds; and (3) reconnection fees paid by customers who request to have their premises reconnected to UI’s system.

UI has not paid the assessment on the basis that it believes its claim to be meritorious and, on October 18, 2005, filed a lawsuit with the Superior Court for the State of Connecticut in order to appeal the DRS’s ruling. Because this issue has not been previously adjudicated, UI has recorded a reserve of $1.2 million, of which $0.4 million was recorded in the third quarter of 2006, representing UI’s total estimated liability for additional tax and interest covering: (1) the original audit period of July 1, 1998 through December 31, 2000; (2) a subsequent audit period of July 1, 2001 through June 30, 2004; and (3) the unaudited period of July 1, 2004 through September 30, 2006.

On April 17, 2006, the DRS filed a petition with the DPUC with respect to this matter, specifically seeking a declaratory ruling from the DPUC as to its position regarding the applicability of the gross earnings tax statutes for periods on and after January 1, 2000 to the three specific categories of revenue in question noted above. On August 30, 2006, the DPUC issued its final decision which stated that although the applicable tax statute does not fall within the DPUC’s jurisdiction, the DPUC reads the language of the applicable tax statute as referring to “all income of an electric distribution company that is subject to being regulated by the Department for the purposes of setting rates,” in which the specific categories of revenue would be included as being taxable for gross earnings tax purposes. UI disagrees with this interpretation of the applicable tax statute and, as mentioned above, is contesting the DRS’s ruling vigorously in the Superior Court of the State of Connecticut.

Cross-Sound Cable Company, LLC

On February 27, 2006, UIL Holdings and UCI completed the sale of UCI’s 25% ownership interest in Cross-Sound to Babcock & Brown Infrastructure Ltd. The gross proceeds were approximately $53.2 million in exchange for UCI’s equity interest in Cross-Sound and the repayment of a loan made by UIL Holdings to Cross-Sound.

After completion of the sale transaction, UIL Holdings and UCI continue to provide two guarantees, in original amounts of $2.5 million and $1.3 million, in support of guarantees by Hydro-Quebec (HQ), the former majority owner of Cross-Sound, to third parties in connection with the construction of the project. Babcock & Brown is obligated to indemnify Hydro-Quebec from liabilities incurred under the existing guarantees and post a letter of credit in favor of Hydro-Quebec. Accordingly, in the event Hydro-Quebec is called on to perform on the guarantees, UIL Holdings expects that Hydro-Quebec would first seek recovery from Babcock & Brown before requiring UIL Holdings and UCI to perform under its guarantees.

The $2.5 million guarantee supports an HQ guarantee to the Long Island Power Authority (LIPA) to provide for damages in the event of a delay in the date of achieving commercial operation of the Cross-Sound Cable. There had been a delay in achieving the originally agreed upon date of commercial operation, primarily due to a Connecticut legislative moratorium on installing new gas and utility lines across Long Island Sound, which precluded the CDEP from considering applications related to submarine cables under Long Island Sound. UCI believes action or inaction of governmental, regulatory or judicial bodies qualify as events beyond its control and performance under the guarantee is not required. Further, on June 24, 2004, Cross-Sound executed a settlement agreement allowing for
 
 
30


UIL HOLDINGS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) (Continued)

immediate commercial operation of the cable. Although retaining commercial operating status is contingent upon the satisfaction of certain provisions of the settlement agreement, UIL Holdings expects commercial operating status to be maintained and, accordingly, it has not recorded a liability related to this guarantee in its Consolidated Balance Sheet as of September 30, 2006.

The $1.3 million guarantee supports an agreement under which Cross-Sound is providing compensation to shell fishermen for their losses, including loss of income, incurred as a result of the installation of the cable (Shellfish Agreement). The payments to the fishermen are being made over a 10-year period, and the obligation under this guarantee reduces proportionately with each payment made. As of September 30, 2006, the remaining amount of the guarantee was $1.1 million. UIL Holdings has completed a probability weighted analysis based on the likelihood of certain events occurring that would cause UIL Holdings to be required to perform under this guarantee. This analysis resulted in a liability amount that was inconsequential, and, accordingly, UIL Holdings has not recorded a liability related to this guarantee in its Consolidated Balance Sheet as of September 30, 2006.

United Bridgeport Energy, Inc.

UBE held a 33 1/3% ownership interest in Bridgeport Energy LLC (BE), the owner of a gas-fired 520 MW merchant wholesale electric generating facility located in Bridgeport, Connecticut. On March 28, 2006, UBE sold that interest to the majority owner in exchange for $71 million and a release of all claims by the parties.

Discontinued Operations

Xcelecom has a revolving credit agreement with a bank that extends to the earlier of June 30, 2007 and the date on which UIL Holdings’ divestiture of Xcelecom is substantially completed. In connection with an amendment of this agreement, dated as of July 28, 2006, UIL Holdings has guaranteed Xcelecom’s obligations under the agreement. This agreement provides for a $20 million (reduced to $15 million on September 30, 2006 pursuant to the terms of the agreement) revolving loan facility available to meet working capital needs and to support standby letters of credit issued by Xcelecom in the normal course of its business (such amount to be reduced as UIL Holdings’ divestiture of Xcelecom is completed), and to meet capital equipment needs of up to $1 million. Capital equipment loans under this facility can be converted to amortizing term loans with a maturity of up to four years. This agreement also provides for the payment of interest at a rate, at the option of Xcelecom, based on the agent bank’s prime interest rate or LIBOR. As of September 30, 2006, there was $3.0 million outstanding under the revolving working capital balance under this facility. Xcelecom had $0.8 million of capital equipment funding that had been converted to term notes outstanding and standby letters of credit of $3.8 million outstanding at September 30, 2006 under the facility.

(M) SEGMENT INFORMATION

As described in “Note (P) - Discontinued Operations,” to the Consolidated Financial Statements, Xcelecom has been classified as held for sale and its results of operations have been reported as discontinued operations. Accordingly, UIL Holdings has one segment, UI, its regulated electric utility business engaged in the purchase, transmission, distribution and sale of electricity. All of UIL Holdings’ revenues are derived in the United States. The following measures of segment profit and loss are utilized by management for purposes of making decisions about allocating resources to the segments and assessing performance.

The following table reconciles certain segment information with that provided in UIL Holdings’ Consolidated Financial Statements. In the table, “Other” includes the information for the remainder of UIL Holdings’ non-utility businesses, including minority interest investments, administrative costs, and inter-segment eliminations.

 
31


UIL HOLDINGS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) (Continued)

(M) SEGMENT INFORMATION
                         
(In Thousands)
                         
   
For the three months ended September 30, 2006
 
For the nine months ended September 30, 2006
 
       
Eliminations
         
Eliminations
     
   
UI
 
And Other
 
Total
 
UI
 
And Other
 
Total
 
Operating Revenues
 
$
261,140
 
$
4
 
$
261,144
 
$
661,154
 
$
13
 
$
661,167
 
Fuel and Energy
   
124,699
   
-
   
124,699
   
324,416
   
-
   
324,416
 
Operation and maintenance
   
61,959
   
1,112
   
63,071
   
169,489
   
4,638
   
174,127
 
Depreciation and amortization
   
21,064
   
1
   
21,065
   
54,557
   
5
   
54,562
 
Taxes - other than income taxes
   
12,602
   
14
   
12,616
   
33,587
   
15
   
33,602
 
Operating Income (Loss)
   
40,816
   
(1,123
)
 
39,693
   
79,105
   
(4,645
)
 
74,460
 
                                       
Other Income and (Deductions), net
   
3,591
   
1,225
   
4,816
   
8,298
   
2,710
   
11,008
 
Interest Charges, net
   
5,026
   
1,073
   
6,099
   
14,504
   
3,834
   
18,338
 
                                       
Income (Loss) Before Sale of Equity Investments, Income Taxes, Equity Earnings and Discontinued
Operations
   
39,381
   
(971
)
 
38,410
   
72,899
   
(5,769
)
 
67,130
 
Gain on Sale of Equity Investments
   
-
   
-
   
-
   
-
   
18,908
   
18,908
 
Income (Loss) Before Income Taxes, Equity Earnings and
                                     
Discontinued Operations
   
39,381
   
(971
)
 
38,410
   
72,899
   
13,139
   
86,038
 
Income Taxes
   
9,596
   
(397
)
 
9,199
   
23,854
   
5,560
   
29,414
 
Income (Loss) Before Equity Earnings and Discontinued Operations
   
29,785
   
(574
)
 
29,211
   
49,045
   
7,579
   
56,624
 
Income (Loss) from Equity Investments
   
446
   
-
   
446
   
(369
)
 
473
   
104
 
Income (Loss) from Continuing Operations
   
30,231
   
(574
)
 
29,657
   
48,676
   
8,052
   
56,728
 
Discountinued Operations, Net of Tax
   
-
   
(17,858
)
 
(17,858
)
 
-
   
(79,717
)
 
(79,717
)
Net Income (Loss)
 
$
30,231
 
$
(18,432
)
$
11,799
 
$
48,676
 
$
(71,665
)
$
(22,989
)
                                       
   
For the three months ended September 30, 2005
 
For the nine months ended September 30, 2005
 
       
Eliminations
         
Eliminations
     
   
UI
 
And Other
 
Total
 
UI
 
And Other
 
Total
 
Operating Revenues
 
$
259,442
 
$
5
 
$
259,447
 
$
632,271
 
$
14
 
$
632,285
 
Fuel and Energy
   
130,919
   
-
   
130,919
   
319,997
   
-
   
319,997
 
Operation and maintenance
   
56,612
   
1,193
   
57,805
   
151,760
   
4,404
   
156,164
 
Depreciation and amortization
   
22,016
   
8
   
22,024
   
54,676
   
37
   
54,713
 
Taxes - other than income taxes
   
12,480
   
-
   
12,480
   
32,040
   
3
   
32,043
 
Operating Income (Loss)
   
37,415
   
(1,196
)
 
36,219
   
73,798
   
(4,430
)
 
69,368
 
                                       
Other Income and (Deductions), net
   
2,441
   
169
   
2,610
   
6,571
   
631
   
7,202
 
Interest Charges, net
   
4,688
   
1,612
   
6,300
   
13,332
   
4,656
   
17,988
 
                                       
Income (Loss) Before Sale of Equity Investments, Income Taxes, Equity Earnings and Discontinued
Operations
   
35,168
   
(2,639
)
 
32,529
   
67,037
   
(8,455
)
 
58,582
 
Gain on Sale of Equity Investments
   
-
   
-
   
-
   
-
   
-
   
-
 
Income (Loss) Before Income Taxes, Equity Earnings and
                                     
Discontinued Operations
   
35,168
   
(2,639
)
 
32,529
   
67,037
   
(8,455
)
 
58,582
 
Income Taxes
   
15,169
   
(1,060
)
 
14,109
   
30,266
   
(5,339
)
 
24,927
 
Income (Loss) Before Equity Earnings and Discontinued Operations
   
19,999
   
(1,579
)
 
18,420
   
36,771
   
(3,116
)
 
33,655
 
Income (Loss) from Equity Investments
   
71
   
(6
)
 
65
   
192
   
(4,921
)
 
(4,729
)
Income (Loss) from Continuing Operations
   
20,070
   
(1,585
)
 
18,485
   
36,963
   
(8,037
)
 
28,926
 
Discountinued Operations, Net of Tax
   
-
   
(33
)
 
(33
)
 
-
   
(3,887
)
 
(3,887
)
Net Income (Loss)
 
$
20,070
 
$
(1,618
)
$
18,452
 
$
36,963
 
$
(11,924
)
$
25,039
 
                                       
                                       
       
Eliminations
     
   
UI
 
And Other (1)
 
Total
 
Total Assets at September 30, 2006
 
$
1,470,917
 
$
211,943
 
$
1,682,860
 
                     
Total Assets at December 31, 2005
 
$
1,466,356
 
$
332,699
 
$
1,799,055
 
                     
(1) includes assets of discontinued operations.
                   
UIL HOLDINGS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) (Continued)

(O) RELATED PARTY TRANSACTIONS

Arnold L. Chase, a Director of UIL Holdings since June 28, 1999, holds a beneficial interest in the building located at 157 Church Street, where UI leases office space for its corporate headquarters. UI’s lease payments for this office space for the nine months ended September 30, 2006 and 2005 totaled $7.4 million and $7.1 million, respectively and for the three months ended September 30, 2006 and 2005 totaled $2.5 million and $2.4 million, respectively.

On March 31, 2006, a subsidiary of Xcelecom sold its 52% partnership interest in Government Center Thermal Energy Partnership for $0.7 million to an entity with an indirect affiliation to Arnold L. Chase, a Director of UIL Holdings. The gain on the sale is included in Discontinued Operations. The sale was approved at the Board of Directors meeting in March 2006 at which time Mr. Chase disclosed his interest in the buyer. Mr. Chase stated that he had not participated in negotiations of the transaction, nor did he participate in the Board of Directors’ discussion or vote concerning the sale.

(P) DISCONTINUED OPERATIONS

On April 26, 2006, UIL Holdings announced its intention to divest its wholly-owned subsidiary, Xcelecom, completing its corporate strategic realignment to focus on its regulated electric utility, UI. In accordance with the requirements of SFAS No. 142, this event triggered a review for goodwill impairment based upon a reduction in the estimated fair value of Xcelecom below its carrying amount. As a result, a pretax goodwill impairment charge of $85.0 million was recorded during the first quarter of 2006 based upon UIL Holdings’ intent to divest, estimates of fair value as determined by an outside advisory firm, and indicative third party bids.

A pre-tax impairment charge of $24.8 million was recorded in the third quarter of 2006 to bring the carrying value of the remaining Xcelecom businesses in line with their estimated fair value based on indicative third party bids.

On June 22, 2004, UIL Holdings completed the sale of American Payment Systems, Inc. (APS) to CheckFree Corporation (CheckFree), a leading provider of financial electronic commerce services and products, pursuant to the purchase agreement entered into between the parties on December 16, 2003. In 2005, CheckFree elected to treat its purchase of APS as an asset purchase for tax purposes rather than as a stock purchase. The resulting adjustment from the evaluation of the treatment of this tax election, along with additional third party costs associated with the preparation of the final APS tax returns, lowering the overall gain on the sale of APS by $0.1 million, was recognized in the third quarter of 2005 upon the filing of the final 2004 APS tax returns.

In accordance with the provisions of SFAS No. 144, the results of Xcelecom and APS for the three and nine months ended September 30, 2006 and 2005 have been reported as discontinued operations in the accompanying Consolidated Statement of Income (Loss), and as discontinued operations held for sale in the Consolidated Balance Sheet as of September 30, 2006 and December 31, 2005.

 
33


UIL HOLDINGS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) (Continued)

A summary of the discontinued operations of Xcelecom and APS follows (in thousands):

   
Three Months Ended
 
Three Months Ended
 
Nine Months Ended
 
Nine Months Ended
 
                   
Net operating revenues
 
$
88,537
 
$
109,944
 
$
284,105
 
$
295,533
 
Operating income (loss)
 
$
(3,050
)
$
559
   
(103,802
)
$
(7,655
)
Income (loss) before income taxes
 
$
(26,462
)
$
103
 
$
(127,646
)
$
(6,574
)
Income (taxes) benefit
   
8,031
   
(34
)
 
47,865
   
2,789
 
Income (loss) from discontinued operations,
net of tax, excluding gain (loss) on sale
 
$
(18,431
)
$
69
 
$
(79,781
)
$
(3,785
)
Loss on sale of APS, net of tax
   
-
   
(102
)
 
-
   
(102
)
Gain on sale of Government Center Thermal
Energy Partnership, net of tax
   
-
   
-
   
705
   
-
 
Loss on sale of subsidiary, M.J. Daly & Sons,
Incorporated, net of tax
   
(174
)
 
-
   
(1,388
)
 
-
 
Gain on sale of subsidiary, the Systems
Integration companies, net of tax
   
747
         
747
       
Net loss from discontinued operations
 
$
(17,858
)
$
(33
)
$
(79,717
)
$
(3,887
)

Xcelecom, through one of its subsidiaries, filed suit in New Jersey Superior Court against M. J. Paquet (Paquet), a general contractor doing business in the state of New Jersey, and Paquet’s surety, United States Fidelity & Guaranty Company. Paquet was the general contractor on a completed project for the New Jersey Department of Transportation and one of Xcelecom’s subsidiaries was the electrical subcontractor on the project. Xcelecom alleged in its suit, among other causes of action, breach of contract, failure to comply with New Jersey’s Prompt Pay Act, and breach of trust. Xcelecom sought to recover approximately $2.4 million in overdue payments, plus damages for delay and failure by Paquet to comply with New Jersey state law. Paquet had asserted numerous defenses to the suit, as well as various counterclaims. In June 2006, a settlement agreement was reached in which Xcelecom received $2.2 million for release of all claims, resulting in an immaterial impact on net income.

Xcelecom is contingently liable to sureties with respect to performance and payment bonds issued by sureties, all relating to construction projects entered into in the normal course of business. These bonds provide a guarantee to the customer that Xcelecom will perform under the terms of a contract and that it will pay subcontractors and vendors. If Xcelecom fails to perform under a contract or to pay subcontractors or vendors, the customer may demand that the surety make payments or provide services under the bond. Xcelecom must reimburse the surety for any expenses or outlays it incurs. Xcelecom has maintained a relationship with its primary surety since 1999. To date, Xcelecom has not had any situation in which any of its sureties has been required to incur expenses on Xcelecom’s behalf. As of September 30, 2006, sureties had issued bonds for the account of Xcelecom in the aggregate amount of approximately $203.1 million. The expected cost to complete projects covered by such surety bonds was approximately $61.6 million as of September 30, 2006.

UIL Holdings indemnifies the respective surety bond companies against any exposure under the bonds described above. The purpose of UIL Holdings’ indemnity is to allow Xcelecom to obtain bonding at competitive rates. In the event that Xcelecom does not fulfill its obligations in relation to its bonded contracts or obligations, UIL Holdings may be required to make payments under its indemnification agreements with Xcelecom’s sureties. The majority of these contingent commitments will expire within the next 12 months, but UIL Holdings will continue to enter into surety bond indemnification arrangements for Xcelecom in the future, as necessary. As noted above, since Xcelecom’s inception, sureties have never been required to make payments on Xcelecom’s behalf under the bonds. Accordingly, UIL Holdings concluded that it need not record a liability in connection with these obligations in its Consolidated Balance Sheet as of September 30, 2006.

 
34


UIL HOLDINGS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) (Continued)

Xcelecom has a revolving credit agreement with a bank that extends to the earlier of June 30, 2007 and the date on which UIL Holdings’ divestiture of Xcelecom is substantially completed. This agreement provides for a revolving loan facility available to meet working capital needs and to support standby letters of credit issued by Xcelecom in the normal course of its business, and to meet capital equipment needs. Capital equipment loans under this facility can be converted to amortizing term loans with a maturity of up to four years. This agreement also provides for the payment of interest at a rate, at the option of Xcelecom, based on the agent bank’s prime interest rate or LIBOR. On July 28, 2006, the agreement was amended to reduce the amount of the facility from $30 million to $20 million, with subsequent reductions in the amount of the facility taking effect as UIL Holdings executes on its plans to divest of Xcelecom. The agreement was further amended to reduce the capital equipment loans from an amount of up to $5 million to $1 million and, effective June 30, 2006, to eliminate all financial covenants under the agreement. As of September 30, 2006, there was $3.0 million outstanding under the revolving working capital balance under this facility. Xcelecom had $0.2 million of capital equipment funding that had been converted to term notes outstanding and standby letters of credit of $3.8 million outstanding at September 30, 2006 under the facility.

In connection with certain of the acquisitions of Xcelecom, certain of Xcelecom’s subsidiaries have entered into related party lease arrangements for facilities with the former owners of companies acquired (or persons or entities related thereto), some of whom are current employees of Xcelecom. These lease agreements are for periods generally ranging from three to five years. Xcelecom’s payments related to these lease arrangements totaled $1.1 million for each of the nine months ended September 30, 2006 and 2005, respectively, and $0.4 million for each of the three months ended September 30, 2006 and 2005, respectively.

Xcelecom recognizes certain significant claims for recovery of incurred costs when it is probable that the claim will result in additional contract revenue, when the amount of the claim can be reliably estimated and when it is determined that there is legal basis for the claim. Such amounts are recorded at estimated net realizable value and take into account factors that may affect Xcelecom’s ability to bill unbilled revenues and collect amounts after billing. Costs, related to claims, of approximately $1.2 million are included in current assets of discontinued operations held for sale as of September 30, 2006 and December 31, 2005, respectively.

On March 31, 2006, a subsidiary of Xcelecom, Thermal Energies, Inc. sold its 52% partnership interest in Government Center Thermal Energy Partnership for $0.7 million to an entity with an indirect affiliation to Arnold L. Chase, a Director of UIL Holdings, resulting in an after tax gain on sale of approximately $0.7 million.

On June 30, 2006, Xcelecom entered into an agreement to sell a substantial portion of the assets, including all of the operating assets, of its wholly owned subsidiary, M.J. Daly & Sons, Incorporated. Upon closing, Xcelecom sold assets with a book value of $3.8 million for approximately $1.8 million, resulting in an after tax loss on the sale of approximately $1.2 million. During the third quarter of 2006, Xcelecom booked an additional after tax loss on the sale of approximately $0.2 million due to certain post closing adjustments.

On August 29, 2006, Xcelecom sold all of the capital stock of three companies comprising Xcelecom’s Systems Integration business for approximately $16.5 million, which included $2.6 million in closing adjustments, mainly attributed to changes in cash levels prior to closing. The remaining purchase price consisted of $7.4 million in cash, $4.2 million in notes receivable and $2.3 due upon the collection by the buyer of certain accounts receivable existing as of the closing date. This resulted in an after tax gain of approximately $0.7 million. For state income tax purposes, UIL Holdings is not able to recognize any state income tax benefits for capital losses associated with this sale. As a result, a $1.4 million valuation allowance was recorded during the third quarter of 2006. These future state income tax benefits may be recognized over the course of the next five years to the extent that capital gains are realized by Xcelecom. The System Integration companies are The Datastore, Inc., 4-Front Systems, Inc, and Datanet Services, Inc. In connection with this agreement, UIL Holdings agreed to indemnify the buyer for certain losses arising out of the breach of representations and warranties and certain pre-closing liabilities of the companies.

 
35


UIL HOLDINGS CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) (Continued)

(Q) SUBSEQUENT EVENTS

On October 30, 2006, UIL Holdings and its wholly owned subsidiary Xcelecom, Inc. entered into an agreement to sell all of the outstanding capital stock of Orlando Diefenderfer Electrical Contractors, Inc. to ODEC Holding Corporation for approximately $3.3 million. The $3.3 million sale price includes $1 million in cash and a right to receive approximately $2.3 million of net outstanding receivables. After transaction costs, an additional reserve for potential bad debt, and income taxes, UIL expects to recognize an after-tax loss of approximately $7 million, subject to October operating results. This projected loss has been recognized through an impairment charge recorded in the third quarter of 2006. See “Note (A) - Impairment of Long-Lived Assets and Investments and Discontinued Operations/Assets Held for Sale.”

 
36

 
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.

Certain statements contained herein, regarding matters that are not historical facts, are forward-looking statements (as defined in the Private Securities Litigation Reform Act of 1995). These include statements regarding management’s intentions, plans, beliefs, expectations or forecasts for the future. Such forward-looking statements are based on UIL Holdings’ expectations and involve risks and uncertainties; consequently, actual results may differ materially from those expressed or implied in the statements. Such risks and uncertainties include, but are not limited to, general economic conditions, legislative and regulatory changes, changes in demand for electricity and other products and services, unanticipated weather conditions, changes in accounting principles, policies or guidelines, and other economic, competitive, governmental, and technological factors affecting the operations, markets, products, services and prices of UIL Holdings’ subsidiaries. The foregoing and other factors are discussed and should be reviewed in UIL Holdings’ most recent Annual Report on Form 10-K and other subsequent periodic filings with the Securities and Exchange Commission. Forward-looking statements included herein speak only as of the date hereof and UIL Holdings undertakes no obligation to revise or update such statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events or circumstances.

MAJOR INFLUENCES ON FINANCIAL CONDITION

UIL Holdings Corporation

UIL Holdings’ financial condition and financing capability will be dependent on many factors, including the level of income and cash flow of UIL Holdings’ subsidiaries, conditions in the securities markets, economic conditions, interest rates, legislative and regulatory developments, and its ability to retain key personnel.

The loss of key personnel or the inability to hire and retain qualified employees could have an adverse effect on the business, financial condition and results of operations for UIL Holdings and its operating subsidiaries. These operations depend on the continued efforts of their respective current and future executive officers, senior management and management personnel. UIL Holdings cannot guarantee that any member of management at the corporate or subsidiary level will continue to serve in any capacity for any particular period of time. In an effort to enhance UIL Holdings’ ability to attract and retain qualified personnel, UIL Holdings continually evaluates the overall compensation packages offered to employees at all levels of the organization.

On April 26, 2006, UIL Holdings announced its intention to divest its wholly-owned subsidiary, Xcelecom, completing its corporate strategic realignment to focus on its regulated electric utility, UI. In accordance with the requirements of Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets,” this event triggered a review for goodwill impairment based upon a reduction in the estimated fair value of Xcelecom below its carrying amount. As a result, a pretax goodwill impairment charge of $85.0 million was recorded during the first quarter of 2006 based upon UIL Holdings’ intent to divest, estimates of fair value as determined by an outside advisory firm and indicative third party bids. In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” an additional pretax impairment charge of $24.8 million was recording during the third quarter of 2006 to bring the carrying value of the remaining Xcelecom businesses in line with their estimated fair value, These impairments are included in UIL Holdings’ discontinued operations at September 30, 2006. See Notes to Financial Statements, “Note (A) - Impairment of Long-Lived Assets and Investments and Discontinued Operations.”

The United Illuminating Company

UI is an electric transmission and distribution utility whose structure and operations are significantly affected by legislation and regulation. UI’s rates and authorized return on equity are regulated by the Federal Energy Regulatory Commission (FERC) and the Connecticut Department of Public Utility Control (DPUC). Legislation and regulatory decisions implementing legislation establish a framework for UI’s operations. Other factors affecting UI’s financial results are operational matters such as sales volume and ability to control expenses, major weather disturbances, and capital expenditures. UI expects significant capital investment in transmission and distribution infrastructure. UI has begun to construct its portion of a major transmission line in southwest Connecticut.

 
37


Legislation & Regulation

Background

State legislation has significantly restructured the electric utility industry in Connecticut. The primary restructuring legislation includes Public Act 98-28 (the “1998 Restructuring Legislation”) and Public Act 03-135, as amended in part by Public Act 03-221 (collectively, the “2003 Restructuring Legislation”). Since 2000, UI’s retail customers have been able to choose their electricity suppliers. The 2003 Restructuring Legislation requires that UI offer a “transitional standard offer” rate during the period January 1, 2004 - December 31, 2006 to retail customers who do not choose an alternate electric supplier. UI has begun procuring power to serve its standard service and supplier of last resort service requirements as of January 1, 2007 for retail customers who do not choose an alternate electric supplier. The procurement and availability of these services are undertaken in accordance with statutory and DPUC requirements. The 2003 Restructuring Legislation provides for UI to recover its costs of acquiring and providing generation services, and directs the DPUC to establish each electric distribution company’s transitional standard offer rates, standard service rates, and supplier of last resort rates.

The 2003 Restructuring Legislation provides for UI to collect a fee of $0.0005/kilowatt-hour from transitional standard offer service customers, beginning January 1, 2004, as compensation for providing transitional standard offer service. This fee is included in the GSC amounts charged to transitional standard offer customers, and is excluded by the legislation from determinations of whether UI’s rates are just and reasonable. For 2005, these fees generated approximately $2.8 million in revenue. The 2003 Restructuring Legislation also provides for the DPUC to establish an incentive plan for the procurement of long-term contracts for transitional standard offer service that compares UI’s actual average contract price to a regional average price for electricity, making adjustments as deemed appropriate by the DPUC. If UI’s price is lower than the average, the legislation provides for the plan to allocate $0.00025/kilowatt-hour of transitional standard offer service to the distribution company. The DPUC issued a draft decision on December 8, 2005 approving UI’s proposed methodology for calculating the incentive fee and noting that UI has earned the incentive fee applicable to the year 2004, which amounted to approximately $1.4 million. The draft decision did not address the incentive related to 2005. The hearing was subsequently reopened to consider objections raised by the Office of Consumer Counsel (OCC). A draft decision has not yet been issued.

2005 Rate Case

On January 27, 2006, the DPUC issued a final decision in the 2005 Rate Case proceeding. The DPUC set UI's distribution rates at levels that will increase revenues by $14.3 million in 2006. The DPUC set incremental distribution rate increases for 2007, 2008 and 2009, so that revenues will increase a total of $35.6 million, or 4.9%, by 2009 compared to 2005 rates.

On February 10, 2006, UI filed a Petition for Reconsideration with the DPUC requesting that it reconsider the final decision to correct calculations in the decision with respect to employee compensation and the pension/post-retirement discount rate. On March 1, 2006, the DPUC granted UI’s Petition to reopen the proceeding for the limited purpose of reconsidering the record with regards to employee compensation and denied UI’s request to reconsider the pension/post-retirement discount rate. On July 28, 2006, a settlement was reached between UI and the Prosecutorial unit of the DPUC staff. The settlement agreement allows UI to recover additional distribution revenue requirements of $1.5 million in 2007, $1.8 million in 2008 and $2.3 million in 2009. The settlement agreement had no impact in 2006. The settlement was approved by the DPUC on August 21, 2006 and results in a total revenue increase of $37.9 million or 5.3% by 2009 compared to 2005 rates.

Recent Legislation

On July 6, 2005, An Act Concerning the Department of Transportation, Public Act No. 05-210 (the “2005 Transportation Act”), became law in Connecticut. Section 28 of this legislation, effective from enactment, amends § 13a-126 of the Connecticut statutes to provide that the state shall bear no part of the cost to readjust, relocate or remove an electric transmission line buried within a public highway right-of-way where such action is required by a state highway project, but also provides that the state shall consider such costs in selecting a final project design in order to minimize the overall cost incurred by the state and the electric distribution company. As a result, the electric distribution company’s costs of readjustment, relocation or removal will be included in tariffs, for collection from customers.

 
38


The DPUC has approved a transmission adjustment clause (TAC) for UI, implementing the provisions of Section 30 of the 2005 Transportation Act, which amended § 16-19b of the Connecticut statutes to establish a “transmission tracker” mechanism by which the DPUC adjusts an electric distribution company’s retail transmission rate
periodically to “track” and recover the transmission costs, rates, tariffs and charges approved by the FERC. In accordance with the DPUC’s December 14, 2005 decision in Docket No. 05-08-03, UI has filed TAC tariff revisions with the DPUC. UI makes a semi-annual filing with the DPUC, setting forth its actual transmission revenues, projected transmission revenue requirement, and the required TAC charge or credit so that any under- or over-collections of transmission revenues from prior periods are reconciled along with the expected revenue requirements for the next six months from filing. The DPUC holds an administrative proceeding to approve the TAC charge or credit, and holds a hearing to determine the accuracy of customer billings under the TAC. The TAC tariff and this semi-annual change of the TAC charge or credit mitigates the lag between changes in UI’s FERC-approved transmission revenue requirements and its retail transmission rate, and facilitates the timely matching of transmission revenues and transmission revenue requirements.

On July 22, 2005, An Act Concerning Energy Independence, June Special Session, Public Act No. 05-1 (the “Energy Independence Act”), became law in Connecticut, the general intention of which is to reduce congestion costs in the state. The Energy Independence Act consists of forty sections, all of which became effective by October 1, 2005. The Energy Independence Act: adds to the items included in the definition of Federally Mandated Congestion Charges (FMCCs, formerly known as Federally Mandated Congestion Costs); provides for incentives to promote the development of projects and resources that are intended to reduce FMCCs and for the recovery of the costs of such incentives through the FMCC rate component on retail customers’ bills; makes certain changes to the prior electric restructuring legislation in the state; and makes other changes to the statutes administered by the DPUC. The DPUC has initiated numerous dockets, both uncontested and contested, to implement the many provisions of the Energy Independence Act. Some of these proceedings are currently pending, while others have been concluded. In general, the DPUC is authorized to identify and implement measures intended to reduce FMCCs. These potential measures include “grid-side distributed resources,” “customer-side distributed resources,” new generation, and contracts for capacity rights from generation, conservation and energy efficiency measures, to be entered into by electric distribution companies such as UI after a request for proposal process administered by the DPUC. In addition, the Energy Independence Act establishes Class III renewable energy resources, and related portfolio standards for generation services, in addition to the existing Class I and Class II renewable energy resources and portfolio standards. The Energy Independence Act provides for the waiving of electric back-up rates and gas delivery charges for qualifying customer-side distributed resources, with recovery of electric distribution company costs through the FMCC rate component of bills. In order to encourage electric distribution companies to promote measures to reduce FMCCs, the Energy Independence Act provides for monetary awards to the electric distribution companies in whose service areas such measures are located. There is also provision for the DPUC to determine whether electric distribution companies should have the opportunity to earn an incentive fee for procuring standard service and default service for the period 2007 and beyond; the DPUC has determined in a proceeding that there should be no such opportunity. The DPUC has ordered capital grants for measures to reduce FMCCs, and is developing a request for proposals and draft contracts for capacity and demand resources as long-term measures to reduce FMCCs, expected to be issued in the fourth quarter of 2006. While the ultimate impact of this legislation will be determined through the series of regulatory proceedings described above, and the implementation of the measures approved in the proceedings, UI does not expect this legislation to have a material impact on its results of operations or financial condition, because the Energy Independence Act provides that electric distribution companies will recover their costs and investments resulting from the law through a number of mechanisms, including the FMCC charges on customers’ bills.

In August 2005, President Bush signed the Energy Policy Act of 2005 (Energy Act). The Energy Act repeals the Public Utility Holding Company Act, which will impact UIL Holdings, and includes numerous provisions which may affect UI, some of which include (1) reducing depreciable lives for newly constructed electric transmission lines, (2) establishing an electric reliability organization responsible for reliability standards, subject to FERC jurisdiction, approval and enforcement, (3) authorizing limited FERC backstop siting authority for interstate transmission projects in federally-designated transmission corridors, and (4) requiring the FERC to issue a rule that provides transmission rate incentives to promote capital investment and provides for recovery of all prudent costs of complying with mandatory reliability standards and costs related to transmission infrastructure development. In July 2006, the FERC issued a final ruling which provides transmission rate incentives to promote capital investment and provides for recovery of all prudent costs of complying with mandatory reliability standards and costs related to transmission infrastructure development. Among other items, the ruling includes provisions to allow an incentive return on equity for new infrastructure and 100% construction work-in-process expenditures in rate base and
 
 
39


accelerated book depreciation. Utilities must apply for these incentives and the FERC will make its determinations on a case by case basis. Certain public parties have requested rehearing of the order. UI anticipates filing an application in the near future for appropriate treatment of the Middletown/Norwalk transmission line.

Other Regulation

UI generally has several regulatory proceedings open and pending at the DPUC at any given time. Examples of such proceedings include an annual DPUC review and reconciliation of UI’s CTA and SBC revenues and expenses, a semi-annual transmission adjustment clause proceeding to adjust retail transmission rates to true up to wholesale transmission revenue requirements, dockets to consider specific restructuring or electricity market issues, consideration of specific rate or customer issues, and review of conservation programs.

Competitive Transition Assessment

UI’s CTA collection recovers costs that have been reasonably incurred, or will be incurred, to meet its public service obligations and that will likely not otherwise be recoverable in a competitive market. These “stranded costs” include above-market long-term purchased power contract obligations, regulatory asset recovery and above-market investments in power plants. Based on current conditions, CTA revenues are expected to remain relatively constant, with amortization increasing over time as the earnings trend downward due to the decreasing CTA rate base. A significant amount of UI’s earnings is generated by the authorized return on the equity portion of as yet unamortized stranded costs in the CTA rate base. UI’s after-tax earnings attributable to CTA for the nine months ended September 30, 2006 and 2005 were $8.6 million and $9.6 million, respectively. A significant portion of UI’s cash flow from operations is also generated from those earnings and from the recovery of the CTA rate base. Cash flow from operations related to CTA amounted to $20.6 million and $22.9 million for the nine months ended September 30, 2006 and 2005, respectively. The CTA rate base has declined from year to year for a number of reasons, including: amortization of stranded costs, the sale of UI’s nuclear units, and adjustments made through the annual DPUC review process. The original rate base component of stranded costs, as of January 1, 2000, was $433 million. It has since declined to $413 million at year-end 2000, $373 million at year-end 2001, $303 million at year-end 2002, $279 million at year-end 2003, $267 million at year-end 2004, $254 million at year-end 2005, and $234 million as of September 30, 2006. During the third quarter of 2006, the DPUC issued its final decision regarding UI’s 2005 CTA reconciliation filing with the DPUC. In that decision, the DPUC approved UI’s 2005 reconciliation filing and UI’s request to recover $4.8 million of gross earnings tax. Customer bills were not affected by this recovery. In the future, UI’s CTA earnings will decrease while, based on UI’s current projections, cash flow will remain fairly constant until stranded costs are fully amortized between 2013 and 2015, subject to future regulatory or legislative action, if any, which could affect future rates of stranded cost amortization.

Capital Projects

In order to maintain and improve its electricity delivery system and to provide quality customer service, UI is required to spend a significant amount each year on capital projects in the Distribution and Transmission Divisions. A large portion of the funds required for capital projects is provided by operating activities, and the remainder must be financed externally.

In April 2005, the Connecticut Siting Council (CSC) approved a project to construct a 345-kiloVolt transmission line from Middletown, Connecticut, to Norwalk, Connecticut, which was jointly proposed by UI and The Connecticut Light and Power Company (CL&P). This project is expected to improve the reliability of the transmission system in southwest Connecticut. The two companies have been working together on certain siting and permitting issues, and will each construct, own and operate its respective portion of the transmission line and related facilities.

UI will construct, own, and operate transmission and substation facilities comprising approximately 20% of the total project. UI’s current estimate for its share of the project cost is approximately $230 million to $260 million (excluding allowance for funds used during construction). Based on the current projected schedule of construction, the project is expected to be completed in 2009. Upon project completion, UI’s transmission rate base will have increased by approximately $255 million to $285 million, an increase of more than 200% relative to UI’s current net transmission assets. FERC recently approved UI’s request to include 50% of construction work in progress (CWIP) expenditures in rate base, allowing early recovery on a portion of UI’s investment. UI will commence earning a
 
 
40


return on the remaining 50% of CWIP when it is added to rate base in conjunction with the improvements being placed in service. UI’s costs for the project are expected to be included in and recovered through transmission rates under FERC jurisdiction.

The procurement process for most of the major project components is presently under way. In April 2006, UI executed a major turn-key contract for the construction of Singer Substation, which is the largest 345-kV gas insulated substation (GIS) in North America; and in September, UI executed a contract for the construction of the 345kv underground cable system.

Approvals obtained thus far include: CSC approval of UI’s Singer Substation and 345kV underground transmission line Development and Management (D&M) plans; unanimous approval for the proposed plan application submitted to the Reliability Committee of NEPOOL; and a determination from ISO-NE that implementation of the project will not have a significant adverse effect on the stability, reliability or operating characteristics of the transmission system, subject to certain conditions. Appeals to the Connecticut Superior Court were taken by three groups of entities, each of whom contested the CSC’s decision with respect to the location and construction of the line in two areas along the project route; however, these appeals do not contest the need for the project and do not seek a stay of the CSC decision. The appeal by one group of entities has been resolved and withdrawn. A new appeal, which does not name UI as a defendant, has been recently filed by two homeowners relating to their specific property along one portion of the line. Other governmental permitting, together with additional approvals from ISO-NE, will be required for the project. The total project cost and timing of completion could change depending on other permit requirements.
 
Discontinued Operations

As a result of the divestiture of Xcelceom, Inc., there are now two principal risks affecting the financial condition of Xcelecom: operating risk and disposition risk. Operating risk relates to the risk factors inherent in Xcelecom’s business operations, whereas disposition risk relates to the risk factors that could impact the outcome of the divestiture.

The significant disposition risks related to Xcelecom are described in “Part II, Other Information, Item 1A - Risk Factors,” of this Form 10-Q.

The principal factors affecting the operating results of Xcelecom and its subsidiaries are (1) construction and technology spending in Xcelecom markets; (2) competition; (3) fixed-priced contract estimation and bidding; (4) work-related hazards and insurance; (5) attracting and retaining management expertise; (6) overall liquidity and ability to obtain surety bonding; and (7) risks of attaining required labor productivity levels to meet or exceed contract estimates. Additional risk factors include general economic conditions, the pace of technological changes, recoverability, and collectibility of receivables. These factors are discussed in further detail in UIL Holdings’ Annual Report on Form 10-K for the year ended December 31, 2005.

Xcelecom’s contracts are generally awarded on the basis of competitive bids. The final terms and prices of those contracts are frequently negotiated with the customer. Although contract terms vary considerably, most are made on either a fixed price or unit price basis in which Xcelecom agrees to do the work for a fixed amount for the entire project (fixed price) or for units of work performed (unit price), although services are sometimes performed on a cost-plus or time and materials basis. Xcelecom’s most significant cost drivers are the cost of labor, including employee benefits, the cost of products and materials, and the cost of casualty insurance. These costs may vary from the costs originally estimated. Variations from estimated contract costs along with other risks inherent in performing fixed price and unit price contracts may result in actual revenue and gross profits for a project differing from those originally estimated and could result in losses on projects. Depending on the size of a particular project, variations from estimated project costs could have a significant impact on operating results for any fiscal quarter or year.

During 2006, Xcelecom recognized approximately $13.1 million in after-tax project losses (excluding charges related to the goodwill impairment,) from cost overruns incurred on several large projects at Allan/Briteway Electrical Contractors, Inc. (Allan/Briteway), a New Jersey based subsidiary of Xcelecom. In addition, the current state tax benefit that would result from these project losses at Allan/Briteway cannot be recognized in the financial statements as UIL Holdings has concluded that these state tax benefits, along with previously-recorded state net
 
 
41


operating losses, will not likely be realized through the generation of future taxable income at Allan/Briteway. Contracts in their early stages changed project managers resulting in new estimates based on new experience, which made up the majority of the project losses. The projects in their final completion stages that resulted in losses were from commodity price changes and better estimates from recent project experience due to higher complexity of work and some required rework. Management has taken actions to improve the operational issues at Allan/Briteway including (1) establishing project budgets in sufficient detail to track work categories by task, system or phase, (2) incorporating a turn-over of the awarded job estimate to the project manager with the appropriate detail, scope and schedule in order to manage the project, (3) ensuring adequate levels of management staffing and oversight, and (4) hiring a construction management consultant to assist in the completion of projects. On October 12, 2006, Allan/Briteway entered into a fee agreement with a construction manager in connection with the completion of certain electrical projects for which Allan/Briteway has contracts as of such date. The construction manager will provide among other things, consultation on planning, guidance in the preparation of construction schedules, budgeting and review. Allan/Briteway has the right to terminate the construction manager for convenience up to November 30, 2006. UIL Holdings has guaranteed the performance and payment obligations of Allan/Briteway under this agreement. As a result of UIL’s announcement to divest of Xcelecom, the task of monitoring staffing and management levels will continue to be a challenge. The project losses may be partially offset by pending change orders and claims, for which all costs have been recognized, but which have not been included in projected earnings. There is no assurance that these claims will be recovered.

As discussed previously in the Notes to the financial statements, on April 26, 2006, UIL Holdings announced its intention to divest its wholly-owned subsidiary, Xcelecom, completing its corporate strategic realignment to focus on its regulated electric utility, UI. A pretax goodwill impairment charge of $85.0 million was recorded during the first quarter of 2006 based upon UIL Holdings’ intent to divest, estimates of fair value as determined by an outside advisory firm, and indicative third party bids. In accordance with SFAS No. 144, an additional pre-tax impairment charge of $24.8 million was recorded in the third quarter of 2006 to bring the carrying value of the remaining Xcelecom businesses in line with their estimated fair value based on indicative third party bids. These impairments are included in discontinued operations. See Notes to Financial Statements, “Note (A) - Impairment of Long-Lived Assets and Investments and Discontinued Operations/Assets Held for Sale”.

Cost Drivers

As a service business, Xcelecom’s cost structure is highly variable. Primary costs include labor, materials and insurance. Approximately 35.6% of costs are derived from labor and related expenses. For the nine months ended September 30, 2006 and 2005, labor-related expenses totaled $138.2 million and $149.5 million, respectively.

Approximately 31.7% of Xcelecom’s costs incurred are for materials installed on projects and equipment and other products sold to customers. This component of the expense structure is variable based on the demand for services. Costs are generally incurred for materials once work begins on a project or a customer order is received. Materials are ordered when needed, shipped directly to the jobsite or customer facility, and installed within 30 days. Materials consist of commodity-based items such as conduit, pipe, data cabling, wire and fuses as well as specialty items such as fixtures, switchgear, switches and routers, servers and control panels. For the nine months ended September 30, 2006 and 2005, material and equipment expenses totaled $123.1 million and $111.2 million, respectively.

United Capital Investments, Inc.

UCI had a 25% interest in Cross-Sound Cable Company, LLC (Cross-Sound), which owns and operates a 330-megawatt transmission line (cable) connecting Connecticut and Long Island under the Long Island Sound. On February 27, 2006, UCI, together with the majority owner Hydro-Quebec (HQ), sold Cross-Sound to Babcock & Brown Infrastructure Ltd. (Babcock & Brown). UCI and UIL Holdings received proceeds of $53.2 million in exchange for UCI’s equity interest in Cross-Sound and the repayment of loans made by UIL Holdings to Cross-Sound. After transaction costs and taxes, UCI and UIL Holdings recognized a gain of approximately $10.6 million and net proceeds of approximately $46 million.

UIL Holdings and UCI continue to provide two guarantees, in original amounts of $2.5 million and $1.3 million, in support of HQ guarantees to third parties in connection with the construction of the project. Babcock & Brown is obligated to indemnify Hydro-Quebec from liabilities incurred under the existing guarantees and post a letter of credit in favor of Hydro-Quebec. Accordingly, in the event Hydro-Quebec was called on to perform on the guarantees, UIL
 
 
42


Holdings expects that Hydro-Quebec would first seek recovery from Babcock & Brown before requiring UIL Holdings and UCI to perform under its guarantees.

The $2.5 million guarantee supports an HQ guarantee to the Long Island Power Authority (LIPA) to provide for damages in the event of a delay in the date of achieving commercial operation of the cross sound cable. There had been a delay in achieving the originally agreed upon date of commercial operation, primarily due to a Connecticut legislative moratorium on installing new gas and utility lines across Long Island Sound, which precluded the CDEP from considering applications related to submarine cables under Long Island Sound. UCI believes action or inaction of governmental, regulatory or judicial bodies qualify as events beyond its control and performance under the guarantee is not required. Further, on June 24, 2004, Cross-Sound executed a settlement agreement allowing for immediate commercial operation of the cable. Although retaining commercial operating status is contingent upon the satisfaction of certain provisions of the settlement agreement, UIL Holdings expects commercial operating status to be maintained and, accordingly, it has not recorded a liability related to this guarantee in its Consolidated Balance Sheet as of September 30, 2006.

The $1.3 million guarantee supports an agreement under which Cross-Sound is providing compensation to shell fishermen for their losses, including loss of income, incurred as a result of the installation of the cable (Shellfish Agreement). The payments to the fishermen are being made over a 10-year period, and the obligation under this guarantee reduces proportionately with each payment made. As of September 30, 2006, the remaining amount of the guarantee was $1.1 million. UIL Holdings has completed a probability weighted analysis based on the likelihood of certain events occurring that would cause UIL Holdings to be required to perform under this guarantee. This analysis resulted in a liability amount that was inconsequential, and, accordingly, UIL Holdings has not recorded a liability related to this guarantee in its Consolidated Balance Sheet as of September 30, 2006.

UCI also has passive, minority equity positions in two investment funds. UCI viewed these investments as an opportunity to earn reasonable returns and promote local economic development. In 2006, UCI funded $0.2 million of its remaining $0.3 million commitment to the Ironwood Mezzanine Fund.

United Bridgeport Energy, Inc.

UBE held a 33 1/3% ownership interest in Bridgeport Energy LLC (BE), the owner of a gas-fired 520 MW merchant wholesale electric generating facility located in Bridgeport, Connecticut. On March 28, 2006, UBE sold its interest to the majority owner for $71 million and a release of all claims, and recognized a gain of approximately $0.2 million after-tax.

 
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LIQUIDITY AND CAPITAL RESOURCES

UIL Holdings generates its capital resources primarily through operations. At September 30, 2006, UIL Holdings had $107.8 million of unrestricted cash and temporary cash investments. This represents an increase of $78.9 million from the corresponding balance at December 31, 2005. The components of this increase, which are detailed in the Consolidated Statement of Cash Flows, are summarized as follows:

   
(In Millions)
 
       
 
$
28.9
 
         
Net cash provided by operating activities
   
53.6
 
         
Net cash (used in) investing activities:
       
- Non-utility minority interest investments, net
   
(0.1
)
- Restricted Cash
   
0.2
 
- Cash invested in plant
   
(45.5
)
- Deferred payments in prior acquisitions
   
(9.4
)
- Proceeds from sale of equity investments
   
100.9
 
- Proceeds from sale of assets of discontinued operations held for sale
   
9.2
 
- Repayments from (loan to) loan receivable Cross-Sound Cable Project, net
   
23.8
 
     
79.1
 
         
Net cash used in financing activities:
       
- Financing activities, excluding dividend payments
   
(22.2
)
- Dividend payments
   
(31.6
)
     
(53.8
)
         
Net Change in Cash
   
78.9
 
         
 
$
107.8
 

The unrestricted cash position of UIL Holdings increased by $78.9 million from December 31, 2005 to September 30, 2006, as cash provided by investment activities from proceeds from the sale of minority ownership interests in Cross-Sound and BE as well as the repayment of the UIL Holdings loan to Cross-Sound supplemented cash provided by operations which was partly driven by strong accounts receivable collections at both UI and Xcelecom. Cash used in financing activities during the first nine months included the quarterly dividend payments on UIL Holdings common stock totaling $31.6 million, a $4.3 million principal payment on UIL Holdings’ long-term debt and repayment of UIL short term debt totaling $26.2 million. Cash used in investing activities during the first nine months of 2006 includes capital expenditures of $45.5 million, mainly by UI.

UIL Holdings also accesses capital through both long-term and short-term financing arrangements. Total long-term debt outstanding as of September 30, 2006 was $486.9 million, as compared to $491.2 million at year-end December 31, 2005. UIL Holdings and Xcelecom also have short-term credit facilities totaling $100 million and $20 million, respectively (reduced from $20 million to $15 million on September 30, 2006 pursuant to the terms of the agreement). See Notes to Financial Statements, “Note (P) -- Discontinued Operations.” The following table presents a summary of the amounts available under these credit facilities as of September 30, 2006:

   
UIL Holdings
 
Xcelecom
 
   
(In Millions)
 
           
Credit lines available
 
$
100
 
$
15
 
Less: Credit line advances outstanding
   
-
   
3
 
Less: Credit facility supporting standby letters of credit
   
-
   
4
 
Less: Credit facility supporting capital equipment funding
   
-
   
1
 
Available Credit
 
$
100
 
$
7
 

 
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All capital requirements that exceed available cash will have to be provided by external financing. Although there is no commitment to provide such financing from any source of funds, other than the short-term credit facilities discussed above, future external financing needs are expected to be satisfied by the issuance of additional short-term and long-term debt. The continued availability of these methods of financing will be dependent on many factors, including conditions in the securities markets, economic conditions, and future income and cash flow. See Part I, Item 1, “Financial Statements - Notes to Consolidated Financial Statements - Note (B) - Capitalization and Note (D), Short-Term Credit Arrangements” of this Form 10-Q and UIL Holdings’ Annual Report on Form 10-K for the fiscal year ended December 31, 2005 for a discussion of UIL Holdings’ financing arrangements.

Financial Covenants

UIL Holdings and its subsidiaries are required to comply with certain covenants in connection with their respective loan agreements. The covenants are normal and customary in bank and loan agreements and UIL Holdings and its subsidiaries were in compliance at September 30, 2006. UIL Holdings amended its Note Purchase Agreement and Revolving Credit Agreement, in each case, effective March 30, 2006, to define consolidated net income without regard to any reduction in net income resulting from any impairment of goodwill in connection with a decision by UIL Holdings to divest of Xcelecom or its subsidiaries.

UIL Holdings also amended its Note Purchase Agreement effective October 20, 2006, to exclude the impact to comprehensive income of the recently adopted SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans,” an amendment of SFAS Nos. 87, 88, 106 and 132(R), effective December 2006, from two of the three financial covenants under the Agreement.

Xcelecom has a revolving credit agreement with a bank that extends to the earlier of June 30, 2007 and the date on which UIL Holdings’ divestiture of Xcelecom is substantially completed. In connection with an amendment of this agreement, dated as of July 28, 2006, UIL Holdings has guaranteed the obligations under the agreement. This agreement provides for a $20 million revolving loan facility available to meet working capital needs and to support standby letters of credit issued by Xcelecom in the normal course of its business (such amount to be reduced as UIL Holdings’ divestiture of Xcelecom is completed), and to meet capital equipment needs of up to $1 million. Capital equipment loans under this facility can be converted to amortizing term loans with a maturity of up to four years. This agreement also provides for the payment of interest at a rate, at the option of Xcelecom, based on the agent bank’s prime interest rate or LIBOR. Effective June 30, 2006, all financial covenants were eliminated in connection with the amendment of the agreement. As of September 30, 2006, there was $3.0 million outstanding under the revolving working capital balance under this facility. Xcelecom had $0.2 million of capital equipment funding that had been converted to term notes outstanding and standby letters of credit of $3.8 million outstanding at September 30, 2006 under the facility.

2006 Capital Resource Projections

There have been no material changes in UIL Holdings’ 2006 capital resource projections from those reported in UIL Holdings’ Annual Report on Form 10-K for the fiscal year ended December 31, 2005. UIL holdings will re-evaluate those projections as it proceeds with the divestiture of Xcelecom, the results of which may have a material impact on such projections.

Contractual and Contingent Obligations

At September 30, 2006, there was no material change in contractual and contingent obligations of UIL Holdings and its subsidiaries from those reported in UIL Holdings’ Annual Report on Form 10-K for the fiscal year ended December 31, 2005.

CRITICAL ACCOUNTING POLICIES

UIL Holdings’ Consolidated Financial Statements are prepared based on certain critical accounting policies that require management to make judgments and estimates that are subject to varying degrees of uncertainty. UIL Holdings believes that investors need to be aware of these policies and how they impact UIL Holdings’ financial reporting to gain a more complete understanding of UIL Holdings’ Consolidated Financial Statements as a whole, as well as management’s related discussion and analysis presented herein. While UIL Holdings believes that these
 
 
45


accounting policies are grounded on sound measurement criteria, actual future events can and often do result in outcomes that can be materially different from these estimates or forecasts. The accounting policies and related risks described in UIL Holdings’ Annual Report on Form 10-K for the fiscal year ended December 31, 2005 are those that depend most heavily on these judgments and estimates. At September 30, 2006, there have been no material changes to any of the Critical Accounting Policies described therein, except for the adoption of SFAS No. 123R. See Part I, Item 1, “Financial Statements - Notes to Consolidated Financial Statements“Note (A) - Stock Based Compensation.”

OFF-BALANCE SHEET ARRANGEMENTS

UIL Holdings and its subsidiaries occasionally enter into guarantee contracts in the ordinary course of business. At the time a guarantee is provided, an analysis is performed to assess the expected financial impact, if any, based on the likelihood of certain events occurring that would require UIL Holdings to perform under such guarantee. Subsequent analysis is performed on a periodic basis to assess the impact of any changes in events or circumstances. If such an analysis results in an amount that is inconsequential, no liability is recorded on the balance sheet related to the guarantee. As of September 30, 2006, UIL Holdings had certain guarantee contracts outstanding for which no liability has been recorded in the Consolidated Financial Statements (see Part I, Item 1, “Financial Statements - Notes to Consolidated Financial Statements - Note (J), Commitments and Contingencies,” of this Form 10-Q for further discussion of such guarantees).

NEW ACCOUNTING STANDARDS

In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” an interpretation of SFAS No. 109, “Accounting for Income Taxes”. This interpretation clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements in accordance with SFAS No. 109. The provisions of this interpretation will be effective for UIL Holdings as of January 1, 2007. Management is currently evaluating the impact of this statement, but the adoption of this interpretation is not expected to have a material impact on UIL Holdings’ consolidated financial position, results of operations and liquidity. See “Note (A) - New Accounting Standards.”

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (SFAS No. 157). This statement defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. This statement is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Earlier application is encouraged, provided the reporting entity has not yet issued financial statements for that fiscal year, including financial statements for an interim period within that fiscal year. This statement is not expected to have a material impact on UIL Holdings’ consolidated financial position or liquidity.

In September 2006, the FASB issued SFAS No. 158 “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Benefits an amendment of FASB No. 87, 88, 106 and 132(R) (SFAS 158). The Statement requires an employer that sponsors one or more defined benefit pension or other postretirement plans to recognize an asset or liability for the overfunded or underfunded status of the plan. For a pension plan, the asset or liability is the difference between the fair value of the plan’s assets and the projected benefit obligation. For any other postretirement benefit plan, the asset or liability is the difference between the fair value of the plan’s assets and the accumulated postretirement benefit obligation. In addition, employers must record all unrecognized prior service costs and credits and unrecognized actuarial gains and losses in accumulated other comprehensive income. Such amounts will then be recognized in earnings as components of net periodic benefit cost/income pursuant to the current recognition and amortization provisions of SFAS No. 87, “Employers’ Accounting for Pensions,” and SFAS No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions.” This statement is effective for fiscal years ending after December 15, 2006. UIL Holdings will adopt SFAS No. 158 effective December 31, 2006 on a prospective basis. In addition, management arranged for an amendment of UIL Holdings’ Note Purchase Agreement to remove the impact of SFAS No. 158 on the financial covenant calculation made quarterly thereunder. See “Note (B) - Long Term Debt.” Management is currently evaluating the impact of this statement, but the adoption of this interpretation is not expected to have a material impact on UIL Holdings’ consolidated financial position or liquidity.

 
46


In September 2006, the U.S. Securities and Exchange Commission (SEC) staff issued Staff Accounting Bulletin No. 108 (SAB 108), “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” SAB 108 was issued in order to eliminate the diversity of practice surrounding how public companies quantify financial statement misstatements. In SAB 108, the SEC staff established an approach that requires quantification of financial statement misstatements based on the effects of the misstatements on each of the company’s financial statements and the related financial statement disclosures. Management is currently evaluating the impact of this statement, but the adoption of this interpretation is not expected to have a material impact on UIL Holdings’ consolidated financial position, results of operations or liquidity.

RESULTS OF OPERATIONS

Use of Non-GAAP Measures

Within the “Results of Operations” section of this Form 10-Q, tabular presentations showing a comparison of UIL Holdings’ net income and earnings per share (EPS) for the three and nine months ended September 30, 2006 and 2005 are provided. UIL Holdings believes this information is useful in understanding the fluctuations in earnings per share between the current and prior year periods. The amounts presented show the earnings per share for each of UIL Holdings’ lines of business, calculated by dividing the income from each line of business by the average number of shares of UIL Holdings common stock outstanding for the periods presented. The earnings per share tables presented in “The United Illuminating Company Results of Operations” and “Non-Utility Results of Operations” for all periods presented are calculated on the same basis and reconcile to the amounts presented in the table under the heading “UIL Holdings Corporation Results of Operations.” The total earnings per share from continuing operations and discontinued operations in the table presented under the heading “UIL Holdings Corporation Results of Operations” are presented on a GAAP basis.

In discussing the results of operations, UIL Holdings also believes that a breakdown, presented on a per share basis, of how particular significant items contributed to the change in income by line of business (Item Variance EPS Presentation) is useful in understanding the overall change in the consolidated results of operations for UIL Holdings from one reporting period to another. UIL Holdings presents such per share amounts by taking the dollar amount of the applicable change for the revenue or expense item, booked in accordance with GAAP, and applying UIL Holdings’ combined effective statutory federal and state tax rate (see Item 1, “Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements - Note (E), Income Taxes” of this Form 10-Q for details of UIL Holdings combined effective statutory tax rate) to obtain the after-tax impact of the item. The after-tax amount is then divided by the average number of shares of UIL Holdings common stock outstanding for the period presented. Any amounts provided as Item Variance EPS Presentation are provided for informational purposes only and are not intended to be used to calculate “Pro-forma” amounts.

All EPS amounts and references to common stock share numbers reflect a 5 for 3 common stock split, which occurred on July 3, 2006 for shareowners of record as of June 6, 2006.

Third Quarter 2006 vs. Third Quarter 2005

UIL Holdings Corporation Results of Operations: Third Quarter 2006 vs. Third Quarter 2005

UIL Holdings’ earnings from continuing operations increased by $11.1 million, or $0.45 per share. Net income from discontinued operations decreased by $17.8 million, or $0.73 per share. Total earnings, including discontinued operations, decreased by $6.7 million, or $0.28 per share.

 
47


The increase in earnings from continuing operations was mainly due to the improved results from UI due to non-recurring earnings resulting from final decisions from the DPUC, as well as the absence of losses incurred in the third quarter of 2005 at UBE (due to the sale of Bridgeport Energy, LLC, (BE) in the first quarter of 2006).

   
2006 more (less) than 2005
 
 
   
Quarter Ended
   
Quarter Ended
   
Amount
   
Percent
 
Net Income (In Millions except Percents and Per Share Amounts)
                         
UI
 
$
30.1
 
$
20.1
 
$
10.0
   
50
%
Non-Utility
   
(0.5
)
 
(1.6
)
 
1.1
   
69
%
Total Net Income from Continuing
Operations
 
$
29.6
 
$
18.5
 
$
11.1
   
60
%
Discontinued Operations
   
(17.8
)
 
-
   
(17.8
)
 
-
%
Total Net Income
 
$
11.8
 
$
18.5
 
$
(6.7
)
 
(36
)%
                           
EPS
                         
UI
 
$
1.23
 
$
0.83
 
$
0.40
   
48
%
Non-Utility
   
(0.02
)
 
(0.07
)
 
0.05
   
71
%
Total EPS from Continuing
Operations - Basic
 
$
1.21
 
$
0.76
 
$
0.45
   
59
%
Discontinued Operations
   
(0.73
)
 
-
   
(0.73
)
 
-
%
Total EPS - Basic
 
$
0.48
 
$
0.76
 
$
(0.28
)
 
(37
)%
Total EPS - Diluted (Note A)
 
$
0.47
 
$
0.75
 
$
(0.28
)
 
(37
)%
                           
 
Note A: Reflecting the effect of dilutive stock options, performance shares and restricted stock. Dilutive securities diluted earnings from continuing operations by $0.02 per share and the loss from discontinued operations by $0.01 per share for the three months ended September 30, 2006. Dilutive securities diluted earning from continuing operations by $0.01 per share and did not dilute the loss from discontinued operations for the three months ended September 30, 2005.

 
48


The following table presents a line-by-line breakdown of revenue and expenses from UIL Holdings’ Consolidated Statement of Income by line of business, including comparisons between the third quarter of 2006 and the third quarter of 2005. Significant variances are explained in the discussion and analysis of individual line of business results that follow.

   
Quarter Ended
 
Quarter Ended
 
2006 more (less)
 
(In Millions)
     
than 2005
 
               
Operating Revenues - UI
 
$
261.1
 
$
259.5
 
$
1.6
 
                     
Fuel and energy expenses - UI
 
$
124.7
 
$
130.9
 
$
(6.2
)
                     
Operation and maintenance expenses
                   
UI
 
$
62.0
 
$
56.6
 
$
5.4
 
Minority Interest Investment & Other (1)
   
1.1
   
1.2
   
(0.1
)
Total operation and maintenance expenses
 
$
63.1
 
$
57.8
 
$
5.3
 
                     
Depreciation and amortization expenses
                   
UI
 
$
7.9
 
$
7.8
 
$
0.1
 
Amortization of regulatory assets - UI
   
13.2
   
14.3
   
(1.1
)
Total depreciation and amortization expenses
 
$
21.1
 
$
22.1
 
$
(1.0
)
                     
Taxes - other than income taxes
                   
UI - State gross earnings tax
 
$
9.2
 
$
9.0
 
$
0.2
 
UI - other
   
3.4
   
3.5
   
(0.1
)
Total taxes - other than income taxes
 
$
12.6
 
$
12.5
 
$
0.1
 

 
49


   
Quarter Ended
 
Quarter Ended
 
2006 more (less)
 
(In Millions)
     
than 2005
 
Other Income (Deductions)
             
UI
 
$
3.6
 
$
2.5
 
$
1.1
 
Minority Interest Investment & Other (1)
   
1.2
   
0.1
   
1.1
 
Total Other Income (Deductions)
 
$
4.8
 
$
2.6
 
$
2.2
 
                     
Interest Charges
                   
UI
 
$
4.7
 
$
4.3
 
$
0.4
 
UI - Amortization: debt expense, redemption premiums
   
0.4
   
0.4
   
-
 
Minority Interest Investment & Other (1)
   
1.0
   
1.6
   
(0.6
)
Total Interest Charges
 
$
6.1
 
$
6.3
 
$
(0.2
)
                     
Income Taxes
                   
UI
 
$
9.5
 
$
15.2
 
$
(5.7
)
Minority Interest Investment & Other (1)
   
(0.4
)
 
(1.1
)
 
0.7
 
Total Income Taxes
 
$
9.1
 
$
14.1
 
$
(5.0
)
                     
Income (Loss) from Equity Investments
                   
UI
 
$
0.4
 
$
0.1
 
$
0.3
 
Minority Interest Investment (2)
   
-
   
-
   
-
 
Total Income (Loss) from Equity Investments
 
$
0.4
 
$
0.1
 
$
0.3
 
                     
Net Income
                   
UI
 
$
30.1
 
$
20.1
 
$
10.0
 
Minority Interest Investment & Other (1) (2)
   
(0.5
)
 
(1.6
)
 
1.1
 
Subtotal Net Income from Continuing Operations
   
29.6
   
18.5
   
11.1
 
Discontinued Operations
   
(17.8
)
 
-
   
(17.8
)
Total Net Income
 
$
11.8
 
$
18.5
 
$
(6.7
)

(1)  
The category "Minority Interest Investment and Other" includes amounts recognized at the non-utility businesses in relation to their minority interest investments, as well as unallocated holding company costs.
(2)  
Includes income (losses) recognized at the non-utility businesses in relation to their minority interest investments.

 
50


The United Illuminating Company Results of Operations: Third Quarter of 2006 vs. Third Quarter of 2005

   
2006 more (less) than 2005
 
   
Quarter Ended
 
 
Quarter Ended
 
 
Amount
 
 
Percent
 
EPS from operations
                         
Total UI - basic
 
$
1.23
 
$
0.83
 
$
0.40
   
48
%
Total UI - diluted (Note A)
 
$
1.22
 
$
0.82
 
$
0.40
   
49
%
                           
Retail Sales*
   
1,691
   
1,779
   
(88
)
 
(5
)%
Weather Impact* (Note B)
   
(2
)
 
(90
)
 
88
   
5
%
Retail Sales - Normalized*
   
1,689
   
1,689
   
-
   
-
%
 
* Millions of kilowatt-hours
Note A: Reflecting the effect of dilutive stock options, performance shares and restricted stock. Dilutive securities diluted earnings from operations by $0.01 per share for the three months ended September 30, 2006 and 2005.
Note B: Percentage change reflects impact to total retail sales.

UI’s net income was $30.1 million, or $1.23 per share, in the third quarter of 2006, compared to $20.1 million, or $0.83 per share, in the third quarter of 2005. The increase in earnings was primarily due to non-recurring earnings resulting from final decisions from the DPUC.

Overall, UI’s revenue increased by $1.6 million, from $259.5 million in the third quarter of 2005 to $261.1 million in the third quarter of 2006. Retail revenue decreased $4.3 million due mainly to decreases in volume resulting from milder weather as compared to the third quarter of 2005. Wholesale revenue decreased by $3.8 million as compared to third quarter 2005, primarily due to lower wholesale energy market price. “Other” revenues increased $9.7 million as compared to third quarter 2005, largely due to (1) the net activity of the GSC “working capital allowance,” which increased 2006 “other” revenues by $3.9 million for the third quarter, as compared to a decrease in “other” revenues of $3.5 million in the third quarter 2005, (2) $4.8 million from the DPUC approval of UI’s request to recover amounts related to gross earnings tax in the 2005 SBC/CTA reconciliation filing, and (3) increased transmission revenue of $0.8 million mainly due to higher billings.

Fuel and energy expense decreased by $6.2 million from $130.9 million in the third quarter of 2005 to $124.7 million in the third quarter of 2006. Retail fuel expense in the third quarter of 2006 decreased by $4.6 million compared to the third quarter of 2005, primarily due to lower volume and UI’s portion of costs related to reliability must run agreements between ISO-NE and generators, partially offset by increased costs of transitional standard offer service supply. UI receives electricity to satisfy its transitional standard offer retail customer service requirements through a fixed-price purchased power agreement. These costs are recovered through the GSC and BFMCC portion of UI’s unbundled retail customer rates. UI’s wholesale energy expense in the third quarter of 2006 decreased by $1.6 million compared to the third quarter of 2005, primarily due to decreased volume from the Bridgeport RESCO generating plant.

UI’s operation and maintenance expenses increased by $5.4 million, from $56.6 million in the third quarter of 2005 to $62.0 million in the third quarter of 2006. The increase was primarily attributable to (1) increases in payroll and incentive compensation of $1.9 million, and (2) higher transmission expense of $3.0 million mainly due to increased tariffs.

UI’s amortization of regulatory assets decreased by $1.1 million, from $14.3 million in the third quarter of 2005 to $13.2 million in the third quarter of 2006. The decrease was mainly due to the absence of amortization related to regulatory assets no longer required under the 2005 Rate Case.

UI’s income taxes decreased by $5.7 million, from $15.2 million in the third quarter of 2005 to $9.5 million in the third quarter of 2006. The decrease was primarily due to non-recurring earnings of $6.5 million resulting from a final decision from the DPUC in regards to a Private Letter Ruling (PLR) issued by the IRS associated with accumulated deferred investment tax credits (ADITC) and excess deferred federal income taxes (EDFIT) related to generation assets formerly owned by UI.

 
51


Non-Utility Results of Operations: Third Quarter 2006 vs. Third Quarter 2005

 
2006 more (less) than 2005
 
   
Quarter Ended
 
 
Quarter Ended September 30, 2005
 
 
Amount
 
 
Percent
 
EPS
                         
Minority Interest Investments
                         
UBE
   
-
   
(0.02
)
 
0.02
   
100
%
UCI
   
-
   
-
   
-
   
-
%
Subtotal Minority Interest 
Investments
   
-
   
(0.02
)
 
0.02
   
100
%
                           
UIL Corporate (Note A)
   
(0.02
)
 
(0.05
)
 
0.03
   
60
%
                           
Total Non-Utility EPS from Continuing
Operations
   
(0.02
)
 
(0.07
)
 
0.05
   
71
%
Discontinued Operations
   
(0.73
)
 
-
   
(0.73
)
 
-
%
Total Non-Utility EPS - Basic
 
$
(0.75
)
$
(0.07
)
$
(0.68
)
 
(971
)%
Total Non-Utility EPS - Diluted (Note B)
 
$
(0.75
)
$
(0.07
)
$
(0.68
)
 
(971
)%

Note A:
Includes interest charges and strategic and administrative costs of the non-utility holding company.
Note B:
Reflecting the effect of dilutive stock options, performance shares and restricted stock. Dilutive securities did not dilute earnings from continuing operations or discontinued operations for the three months ended September 30, 2006 or 2005.
 
The consolidated non-utility businesses reported a loss from continuing operations, including unallocated holding company costs, of $0.5 million, or $0.02 per share, in the third quarter of 2006, compared to a loss of $1.6 million, or $0.07 per share, in the same period of 2005. The increase in earnings was mainly due to the absence of losses incurred in the third quarter of 2005 at UBE (due to the sale of Bridgeport Energy, LLC, (BE) in the first quarter of 2006) and lower losses at UIL Corporate due to increased interest income earned on short term investments.

The following is a detailed explanation of the quarterly variances for each of UIL Holdings’ non-utility businesses.

Non-Utility Business

Minority Interest Investments

United Bridgeport Energy, Inc.

UBE owned a 33 1/3% interest in Bridgeport Energy, LLC (BE) until the completion of its sale to an affiliate of Duke Energy on March 28, 2006. With the sale of its interest in BE, no operations were reported at UBE for the third quarter of 2006. UBE lost $0.5 million, or $0.02 per share, in the third quarter of 2005.

United Capital Investments, Inc.

UCI earned an immaterial amount, with no impact on earnings per share, in the third quarter of 2006, compared to a loss of $0.1 million, with no impact on earnings per share in the third quarter of 2005. The improvement from the prior year was primarily due to the absence of negative results from its passive investments in 2005.

UIL Corporate

UIL Holdings retains certain costs at the holding company, or “corporate” level which are not allocated to the various non-utility subsidiaries. UIL Corporate incurred unallocated after-tax costs of $0.5 million, or $0.02 per share in the third quarter of 2006, compared to a loss of $1.0 million, or $0.05 per share in the third quarter of 2005. The improvement was largely due to increased interest income on short term investments.

 
52


Discontinued Operations

Xcelecom, Inc.

Xcelecom lost $17.8 million, or $0.73 per share, in the third quarter of 2006, compared to income of $0.1 million with no impact on earnings per share in the third quarter of 2005. The decrease in earnings was largely due to an after-tax impairment charge of $16.8 million to bring the carrying value of the remaining Xcelecom businesses in line with their estimated fair value based on indicative third party bids, Additionally, the decline in earnings from prior year was largely due to (1) increases in project losses incurred in the third quarter of 2006, partially due to increases in commodity prices and from refinements to previous job costs and project loss estimates as work in progress continues toward completion, and (2) severance and other divestiture-related costs incurred due to the divestiture announcement, partially offset by an after-tax gain of $0.7 million on the sale of Xcelecom’s Systems Integration businesses. In accordance with SFAS No. 144, depreciation of assets classified as “held for sale” was ceased in April 2006. As such, 2006 depreciation and amortization expense was $0.5 million, after tax, lower than it would have been if the assets of Xcelecom had been depreciated during the three months ended September 30, 2006.

American Payment Systems, Inc.

On June 22, 2004, UIL Holdings completed the sale of American Payment Systems, Inc. (APS) to CheckFree Corporation (CheckFree), a leading provider of financial electronic commerce services and products, pursuant to the purchase agreement entered into between the parties on December 16, 2003. In 2005, CheckFree elected to treat its purchase of APS as an asset purchase for tax purposes rather than as a stock purchase. The resulting adjustment from the evaluation of the treatment of this tax election, along with additional third party costs associated with the preparation of the final APS tax returns, lowering the overall gain on the sale of APS by $0.1 million, was recognized in the third quarter of 2005 upon the filing of the final 2004 APS tax returns.

UIL Holdings Corporation Results of Operations: First Nine Months 2006 vs. First Nine Months 2005

UIL Holdings’ earnings from continuing operations increased by $27.7 million, or $1.14 per share. Net income from discontinued operations decreased by $75.8 million, or $3.11 per share. Total earnings, including discontinued operations, decreased by $48.1 million, or $1.97 per share.

The increase in earnings from continuing operations was mainly due to the sale of UIL Holdings’ ownership interest in Cross-Sound, absence of costs related to a scheduled outage in 2005 at Bridgeport Energy, and improved results from UI due to non-recurring earnings resulting from final decisions from the DPUC.

 
53


The table below represents a comparison of UIL Holdings’ Net Income and Earnings per Share (EPS) for the first nine months of 2006 and 2005.

 
2006 more (less) than 2005
 
   
Nine Months Ended 
 
 
Nine Months Ended
 
 
Amount
 
 
Percent
 
Net Income (In Millions except Percents and Per Share Amounts)
                         
UI
 
$
48.6
 
$
37.0
 
$
11.6
   
31
%
Non-Utility
   
8.1
   
(8.0
)
 
16.1
   
201
%
Total Net Income from Continuing
Operations
 
$
56.7
 
$
29.0
 
$
27.7
   
96
%
Discontinued Operations
   
(79.7
)
 
(3.9
)
 
(75.8
)
 
(1,944
)%
Total Net Income (Loss)
 
$
(23.0
)
$
25.1
 
$
(48.1
)
 
(192
)%
                           
EPS
                         
UI
 
$
2.00
 
$
1.53
 
$
0.47
   
31
%
Non-Utility
   
0.33
   
(0.34
)
 
0.67
   
197
%
Total EPS from Continuing
Operations - Basic
 
$
2.33
 
$
1.19
 
$
1.14
   
96
%
Discontinued Operations
   
(3.27
)
 
(0.16
)
 
(3.11
)
 
(1,944
)%
Total EPS - Basic
 
$
(0.94
)
$
1.03
 
$
(1.97
)
 
(191
)%
Total EPS - Diluted (Note A)
 
$
(0.93
)
$
1.02
 
$
(1.95
)
 
(191
)%
                           

Note A: Reflecting the effect of dilutive stock options, performance shares and restricted stock. Dilutive securities diluted earnings from continuing operations by $0.04 per share and diluted the loss from discontinued operations by $0.05 per share for the nine months ended September 30, 2006. Dilutive securities diluted earnings from continuing operations by $0.01 per share and did not dilute the loss from discontinued operations for the nine months ended September 30, 2005.

 
54


The following table presents a line-by-line breakdown of revenue and expenses from UIL Holdings’ Consolidated Statement of Income by line of business, including comparisons between the first nine months of 2006 and the first nine months of 2005. Significant variances are explained in the discussion and analysis of individual line of business results that follow.

   
Nine Months Ended
 
Nine Months Ended
 
2006 more (less)
 
(In Millions)
     
than 2005
 
Operating Revenues
             
               
Operating Revenues - UI
 
$
661.1
 
$
632.3
 
$
28.8
 
                     
Fuel and energy expenses - UI
 
$
324.4
 
$
320.0
 
$
4.4
 
                     
Operation and maintenance expenses
                   
UI
 
$
169.5
 
$
151.7
 
$
17.8
 
Minority Interest Investment & Other (1)
   
4.6
   
4.4
   
0.2
 
Total operation and maintenance expenses
 
$
174.1
 
$
156.1
 
$
18.0
 
                     
Depreciation and amortization expenses
                   
UI
 
$
23.4
 
$
22.8
 
$
0.6
 
Amortization of regulatory assets - UI
   
31.2
   
31.9
   
(0.7
)
Total depreciation and amortization expenses
 
$
54.6
 
$
54.7
 
$
(0.1
)
                     
Taxes - other than income taxes
                   
UI - State gross earnings tax
 
$
22.3
 
$
20.9
 
$
1.4
 
UI - other
   
11.3
   
11.2
   
0.1
 
Total taxes - other than income taxes
 
$
33.6
 
$
32.1
 
$
1.5
 
 
 
55


   
Nine Months Ended
 
Nine Months Ended
 
2006 more (less)
 
(In Millions)
     
than 2005
 
Other Income and (Deductions), net
             
UI
 
$
8.3
 
$
6.6
 
$
1.7
 
Minority Interest Investment & Other (1)
   
2.7
   
0.6
   
2.1
 
Total Other Income and (Deductions), net
 
$
11.0
 
$
7.2
 
$
3.8
 
                     
Interest Charges
                   
UI
 
$
13.4
 
$
12.2
 
$
1.2
 
UI - Amortization: debt expense, redemption premiums
   
1.1
   
1.1
   
-
 
Minority Interest Investment & Other (1)
   
3.8
   
4.7
   
(0.9
)
Total Interest Charges
 
$
18.3
 
$
18.0
 
$
0.3
 
                     
Gain on Sale of Equity Investments - UIL & Other
 
$
18.9
 
$
-
 
$
18.9
 
                     
Income Taxes
                   
UI
 
$
23.8
 
$
30.3
 
$
(6.5
)
Minority Interest Investment & Other (1)
   
5.6
   
(5.4
)
 
11.0
 
Total Income Taxes
 
$
29.4
 
$
24.9
 
$
4.5
 
                     
Income (Loss) from Equity Investments
                   
UI
 
$
(0.4
)
$
0.2
 
$
(0.6
)
Minority Interest Investment (2)
   
0.5
   
(4.9
)
 
5.4
 
Total Income (Loss) from Equity Investments
 
$
0.1
 
$
(4.7
)
$
4.8
 
                     
Net Income
                   
UI
 
$
48.6
 
$
37.0
 
$
11.6
 
Minority Interest Investment & Other (1) (2)
   
8.1
   
(8.0
)
 
16.1
 
Subtotal Net Income from Continuing Operations
   
56.7
   
29.0
   
27.7
 
Discontinued Operations
   
(79.7
)
 
(3.9
)
 
(75.8
)
Total Net Income (Loss)
 
$
(23.0
)
$
25.1
 
$
(48.1
)

(1)  
The category "Minority Interest Investment and Other" includes amounts recognized at the non-utility businesses in relation to their minority interest investments, as well as unallocated holding company costs.
(2)  
Includes income (losses) recognized at the non-utility businesses in relation to their minority interest investments.

 
56


The United Illuminating Company Results of Operations: First Nine Months of 2006 vs. First Nine Months of 2005

           
2006 more (less) than 2005
 
 
 
 
Nine Months Ended 
 
 
Nine Months Ended
 
 
Amount
 
 
Percent
 
EPS from operations
                         
Total UI - basic
 
$
2.00
 
$
1.53
 
$
0.47
   
31
%
Total UI - diluted (Note A)
 
$
1.96
 
$
1.51
 
$
0.46
   
30
%
                           
Retail Sales*     4,529     4,649     (120 )   (3 )%
Weather Impact* (Note B)     24     (98 )   122     3 %
Retail Sales - Normalized*
   
4,553
   
4,551
   
2
   
-
%

* Millions of kilowatt-hours
Note A: Reflecting the effect of dilutive stock options, performance shares and restricted stock. Dilutive securities diluted earnings from operations by $0.04 per share for the nine months ended September 30, 2006 and diluted earnings from operations by $0.02 per share for the nine months ended September 30, 2005.
Note B: Percentage change reflects impact to total retail sales.

UI’s net income was $48.6 million, or $2.00 per share, in the first nine months of 2006, compared to $37.0 million, or $1.53 per share, in the first nine months of 2005. The increase in earnings was primarily due to higher retail rates and non-recurring earnings resulting from final decisions from the DPUC, partially offset by decrease in customer volume and increased outside services, payroll and incentive compensation, and pension expense.

Overall, UI’s revenue increased by $28.8 million, from $632.3 million in the first nine months of 2005 to $661.1 million in the first nine months of 2006. Retail revenue increased $4.1 million due mainly to increases in customer prices, partially offset by lower customer volume resulting from mild weather. The price increase allowed UI to collect certain FMCC charges from customers to offset higher costs of procuring energy (see fuel and energy expense discussion below). Wholesale revenue decreased by $1.8 million as compared to the first nine months of 2005, primarily due to lower wholesale energy market price. “Other” revenues increased $26.5 million as compared to the first nine months of 2005, largely due to (1) the net activity of the GSC “working capital allowance,” which increased 2006 “other” revenues by $9.0 million for the first nine months, as compared to a decrease in “other” revenues of $12.7 million in the first nine months of 2005, (2) $4.8 million from the recovery of amounts related to gross earnings tax in the 2005 SBC/CTA reconciliation filing, and (3) increased transmission revenue of $2.9 million mainly due to higher billings.

Fuel and energy expense increased by $4.4 million from $320.0 million in the first nine months of 2005 to $324.4 million in the first nine months of 2006. Retail fuel expense in the first nine months of 2006 increased by $1.0 million compared to the first nine months of 2005, primarily due to UI’s portion of costs related to reliability must run agreements between ISO-NE and generators as well as increased costs of transitional standard offer service supply, partially offset by lower volume. UI receives electricity to satisfy its transitional standard offer retail customer service requirements through a fixed-price purchased power agreement. These costs are recovered through the GSC and BFMCC portion of UI’s unbundled retail customer rates. UI’s wholesale energy expense in the first nine months of 2006 increased by $3.4 million compared to the first nine months of 2005, primarily due to increased volume from the Bridgeport RESCO generating plant.

UI’s operation and maintenance expenses increased by $17.8 million, from $151.7 million in the first nine months of 2005 to $169.5 million in the first nine months of 2006. The increase was primarily attributable to (1) increases in outside services of $2.8 million mainly due to higher consulting fees, mainly due to upgrades to the customer billing system, (2) increases in payroll and incentive compensation of $3.8 million largely due to expenses related to retirement eligible employees, (3) increases in pension expense of $1.2 million, and (4) higher transmission expense of $4.0 million mainly due to increased tariffs.

 
57


UI’s income taxes decreased by $6.5 million, from $30.3 million in the first nine months of 2005 to $23.8 million in the first nine months of 2006. The decrease was primarily due to non-recurring earnings of $6.5 million resulting from a final decision from the DPUC in regards to a PLR issued by the IRS associated with ADITC and EDFIT related to generation assets formerly owned by UI.

Non-Utility Results of Operations: First Nine Months 2006 vs. First Nine Months 2005

           
2006 more (less) than 2005
 
   
Nine Months Ended
 
 
Nine Months Ended
 
 
Amount
 
 
Percent
 
EPS
                         
Minority Interest Investments
                         
UBE
   
(0.01
)
 
(0.18
)
 
0.17
   
94
%
UCI
   
0.44
   
-
   
0.44
   
-
%
Subtotal Minority Interest 
Investments
   
0.43
   
(0.18
)
 
0.61
   
339
%
                           
UIL Corporate (Note A)
   
(0.10
)
 
(0.16
)
 
0.06
   
38
%
                           
Total Non-Utility EPS from Continuing
Operations
   
0.33
   
(0.34
)
 
0.67
   
197
%
Discontinued Operations
   
(3.27
)
 
(0.16
)
 
(3.11
)
 
(1,944
)%
Total Non-Utility EPS - Basic
 
$
(2.94
)
$
(0.50
)
$
(2.44
)
 
(488
)%
Total Non-Utility EPS - Diluted (Note B)
 
$
(2.89
)
$
(0.49
)
$
(2.40
)
 
(490
)%
                           
 
Note A:
Includes interest charges and strategic and administrative costs of the non-utility holding company.
Note B:
Reflecting the effect of dilutive stock options, performance shares and restricted stock. Dilutive securities did not dilute earnings from continuing operations and diluted the loss from discontinued operations by $0.05 per share for the nine months ended September 30, 2006. Dilutive securities did not dilute earnings from continuing operations or discontinued operations for the nine months ended September 30, 2005.

The consolidated non-utility businesses reported income from continuing operations, including unallocated holding company costs, of $8.1 million, or $0.33 per share, in the first nine months of 2006, compared to a loss of $8.0 million, or $0.34 per share, in the first nine months of 2005. The increase in earnings was mainly due the sale of UIL Holdings’ ownership interest in Cross-Sound in the first quarter of 2006, and the absence of costs related to a scheduled outage in 2005 at Bridgeport Energy.

The following is a detailed explanation of the year-to-date variances for each of UIL Holdings’ non-utility businesses.

Non-Utility Business

Minority Interest Investments

United Bridgeport Energy, Inc.

UBE owned a 33 1/3% interest in Bridgeport Energy, LLC (BE) until the completion of its sale to an affiliate of Duke Energy on March 28, 2006. UBE lost $0.2 million, or $0.01 per share, in the first nine months of 2006, compared to a loss of $4.4 million, or $0.18 per share in the first nine months of 2005. The improvement from the prior year was mainly due to the absence of costs related to a scheduled outage in 2005.

United Capital Investments, Inc.

UCI earned $10.8 million, or $0.44 per share, in the first nine months of 2006, compared to a loss of $0.1 million, with no impact on earnings per share, for the first nine months of 2005. The improvement from the prior year was mainly due to the sale of Cross-Sound which occurred on February 27, 2006.

 
58


UIL Corporate

UIL Holdings retains certain costs at the holding company, or “corporate” level which are not allocated to the various non-utility subsidiaries. UIL Corporate incurred unallocated after-tax costs of $2.5 million, or $0.10 per share in the first nine months of 2006, compared to a loss of $3.5 million, or $0.16 per share in the first nine months of 2005. The improvement was largely due to increased interest income on short term investments.

Discontinued Operations

Xcelecom, Inc.

Xcelecom lost $79.7 million, or $3.27 per share, in the first nine months of 2006, compared to a loss of $3.8 million, or $0.16 per share in the first nine months of 2005. The decrease in earnings was largely due to the announcement of UIL Holdings’ intention to divest its wholly-owned subsidiary, Xcelecom, completing its corporate strategic realignment to focus on its regulated electric utility, UI. An after-tax goodwill impairment charge of $50.5 million was recorded during the first quarter of 2006 based upon UIL Holdings’ intent to divest, estimates of fair value as determined by an outside advisory firm and indicative third party bids. During the third quarter of 2006, an after-tax impairment charge of $16.8 million was recorded to bring the carrying value of the remaining Xcelecom businesses in line with their estimated fair value based on indicative third party bids. Additionally, the decline in earnings from prior year was partially due to (1) increases in project losses incurred in the first nine months of 2006 partially due to increases in commodity prices and from refinements to previous job costs and project loss estimates as work in progress continues toward completion, (2) a recognized loss on the partial asset sale of Xcelecom subsidiary, M.J. Daly & Sons, Incorporated, and (3) severance and other divestiture-related costs incurred due to the divestiture announcement, partially offset by an after-tax gain of $0.7 million on the sale of Xcelecom’s Systems Integration businesses. In accordance with SFAS No. 144, depreciation of assets classified as “held for sale” was ceased in April 2006. As such, 2006 depreciation and amortization expense was $1.1 million, after tax, lower than it would have been if the assets of Xcelecom had been depreciated through September 30, 2006.

American Payment Systems, Inc.

On June 22, 2004, UIL Holdings completed the sale of American Payment Systems, Inc. (A