WHOLLY-OWNED PIPELINES – FINANCIAL REVIEW

Alberta System Net earnings of $214 million in 2002 are $10 million higher than 2001 and $5 million lower than 2000. The increase over 2001 was primarily due to an interest refund of $4 million relating to a prior year income tax reassessment, and the expiry of TransCanada’s transition support costs with respect to the products and receipt point pricing structure introduced in 2000. Earnings in 2002 and 2001 were both lower than 2000 earnings as a result of a lower implicit rate of return on equity in the ASRS compared to the Cost Efficiency Incentive Settlement (CEIS) that expired at the end of 2000. Under the ASRS, the majority of the Alberta System revenue requirement for 2002 and 2001 was at negotiated amounts of $1.347 billion and $1.390 billion, respectively.

The Alberta System is one of the largest volume carriers of natural gas in North America and delivered 4,146 billion cubic feet (Bcf) of natural gas in 2002, as compared to deliveries of 4,059 Bcf in 2001 and 4,490 Bcf in 2000. The volumes transported by the Alberta System in 2002 represented approximately 17 per cent of total North American natural gas production and about 68 per cent of the natural gas produced in the WCSB.

The Alberta System is regulated by the EUB primarily under the provisions of the Gas Utilities Act (Alberta) (GUA) and the Pipeline Act (Alberta). Under the GUA, the rates, tolls and other charges, and terms and conditions of service are subject to the approval of the EUB.

Canadian Mainline The Canadian Mainline generated net earnings of $307 million in 2002, an increase of $33 million and $26 million compared to 2001 and 2000, respectively. The increase in net earnings in 2002 was primarily due to the Fair Return decision by the NEB in June 2002, which included an increase in the deemed common equity ratio from 30 to 33 per cent effective January 1, 2001. Net earnings in 2002 reflected the impact of the Fair Return decision for both 2001 and 2002. The increase in earnings was partially offset by a decline in the NEB approved rate of return on common equity from 9.90 per cent in 2000 to 9.61 per cent in 2001 to 9.53 per cent in 2002, combined with a lower average investment base.

Annual deliveries of natural gas on the Canadian Mainline totaled 2,630 Bcf in 2002, compared to deliveries of 2,450 Bcf in 2001 and 2,675 Bcf in 2000. In 2002, deliveries to export border points comprised approximately 53 per cent of total deliveries compared to approximately 50 per cent in 2001 and 2000.

The Canadian Mainline is regulated by the NEB. The NEB sets tolls which provide TransCanada the opportunity to recover projected costs of transporting natural gas and also provide a return on the Canadian Mainline average investment base. New facilities are approved by the NEB before construction begins. Changes in investment base, the rate of return on common equity, the level of deemed common equity, and the availability of incentive earnings affect the net earnings of the Canadian Mainline.

WHOLLY-OWNED PIPELINES – DEVELOPMENTS

Regulatory As part of TransCanada’s plan to establish a new regulated business model, the company held extensive discussions with industry stakeholders in early 2002. The new regulated business model proposes changes to TransCanada’s Canadian regulated pipeline business that would enhance the company’s ability to compete for future market demand and gas supply while bringing benefits to customers. This regulated business model is intended to advance the evolution of TransCanada’s rate and service offerings on all three of its wholly-owned pipelines (Alberta System, Canadian Mainline and BC System).

In the 2003 Canadian Mainline Tolls and Tariff Application, TransCanada seeks to increase the existing minimum bid floor price of IT from 80 per cent to 110 per cent of the Firm Transportation (FT) toll. This proposed change will better reflect the value associated with the reliability and flexibility currently inherent with IT, and will enhance the relative value of FT on the Canadian Mainline. TransCanada also proposes to establish a new geographic area in southwestern Ontario for tolling purposes. TransCanada believes the creation of this new tolling zone will increase market liquidity in the area, make TransCanada’s tolls more reflective of actual costs, and ultimately improve TransCanada’s competitiveness.

TransCanada has developed and filed for approval with the EUB proposed rate design changes to its Alberta System. The proposed changes include an intra-Alberta delivery toll, a short-haul transportation service, a price-matching service, and improved cost accountability for capacity expansions. Based on a settlement with its stakeholders, TransCanada applied in February 2003 to the EUB for approval of the 2003 revenue requirement.

Operational Excellence TransCanada continued its commitment to operational excellence in 2002 by advancing initiatives that will improve the company’s ability to provide low-cost, reliable and responsive service to customers. Fundamentally, TransCanada continues to pursue this strategy in order to become the preferred company that customers choose to connect new gas supplies and markets.

Objectives in 2002 that focused on improving levels of customer service to Transmission customers included enhancing TransCanada’s responsiveness to resolving customer issues, building effective relations with customers’ senior management, and consolidating and improving TransCanada’s information systems for managing customer transactions.

Specific 2002 objectives established within TransCanada’s operations and engineering functions included operating and maintenance cost-related targets, per unit capital costs, and maintenance and operating costs per gas volume transported. These objectives were met or exceeded.

Supply Growth In 2002, TransCanada continued to connect incremental gas supply within the WCSB, both in Alberta and British Columbia. The Northwest Mainline Expansion project was completed in early 2002. Located along the western edge of Alberta, this additional pipeline capacity accommodates incremental receipt contract volumes of approximately 415 million cubic feet per day (MMcf/d) to be transported from the Ladyfern area of British Columbia. The Narraway Extension project was also completed in 2002, and resulted in incremental volumes of approximately 100 MMcf/d from the Narraway and Cutbank areas of western Alberta. In addition, TransCanada negotiated a competitive service offering in the Suffield area of Alberta to retain natural gas supply, which would have otherwise bypassed the Alberta System.

The timely connection of these significant volumes has allowed TransCanada’s customers to take advantage of premium gas price environments. TransCanada will continue to grow by seeking new opportunities to connect additional gas supplies.

Market Growth TransCanada continues to pursue growth opportunities within existing and new natural gas markets. In 2002, TransCanada expanded its pipeline system in western Alberta and British Columbia by approximately 350 MMcf/d to meet growing market demand in California and the Pacific Northwest.

TransCanada continues to strengthen business relations with customers in the Fort McMurray area. This market, located in northeastern Alberta, is comprised of oil sands and upgrading plants that are heavily reliant on natural gas as a source of fuel. In 2002, TransCanada experienced steady growth of delivered gas volumes to this market. Looking forward, this market represents one of the largest growth opportunities for natural gas demand in North America. In other geographic regions of Alberta, TransCanada connected both new and expansion projects for existing and smaller markets.

WHOLLY-OWNED PIPELINES – OUTLOOK

TransCanada’s Transmission business has a long history of providing market access and connecting gas supply for its customers. As the marketplace has evolved and competition has grown, the wholly-owned pipelines business has focused on providing market-responsive products and services, a competitive cost structure, and world-class levels of reliability to its customers.

In 2003, the wholly-owned pipelines business will focus on achieving additional efficiency improvements in all aspects of the business, by maintaining focus on operational excellence and leveraging technological advancements. TransCanada will also continue to work collaboratively with all stakeholders on resolving jurisdictional issues, advancing regulated business model changes and addressing fair return challenges.

Looking forward, in order to replace declines in production, producers will continue to explore and develop other fields that are geologically similar to the Ladyfern project and unconventional supply such as the recently connected initial gas production from coal bed methane reserves to the Alberta System. As new reserves are developed in the WCSB, TransCanada will seek to connect these additional natural gas supplies to the Alberta System.

TransCanada’s net income is not directly affected by fluctuations in the commodity price of natural gas, but such fluctuations may influence both production levels and the natural gas basin from which North American users elect to purchase natural gas supplies. Under the current regulatory model, TransCanada’s net income from its wholly-owned pipelines is not materially affected by fluctuations in throughput.

Earnings In 2003, the net earnings from wholly-owned pipelines are expected to be significantly lower than in 2002.

For the Alberta System, the one-year fixed 2003 revenue requirement settlement reached between TransCanada and its stakeholders will negatively impact Alberta System’s 2003 net earnings by approximately $40 million after tax, as compared to 2002.

The 2002 Canadian Mainline earnings included the recognition of the impact of the Fair Return decision on 2001, which will not be repeated in 2003. The 2003 net earnings from the Canadian Mainline will depend on the outcome of the 2003 Tolls and Tariff Application currently before the NEB. Approval of the 2003 Tolls and Tariff Application as filed would significantly increase TransCanada’s revenue and cash flow due to increased depreciation. However, higher depreciation has a negative earnings impact due to the associated reduction of the investment base.

Capital Expenditures Total capital spending for the wholly-owned pipelines during 2002 was $272 million. Capital expenditures in 2002 included approximately $113 million to expand transmission capacity on the Alberta and BC Systems to serve growing markets in California and the Pacific Northwest. Capital spending in 2003 is expected to decrease by approximately $70 million from 2002, primarily due to lower capacity capital spending requirements.

WHOLLY-OWNED PIPELINES – BUSINESS RISKS

Competition and Regulation TransCanada faces competition at both the supply end and the market end of its system. The competition is a result of other pipelines accessing an increasingly mature WCSB. The construction of the Alliance Pipeline, a natural gas pipeline from northeast British Columbia to the Chicago area, and the continuing expiry of transportation contracts have resulted in significant reductions in firm contracted capacity on both the Alberta System and the Canadian Mainline. The Canadian Mainline has effectively become the "swing" pipeline out of the WCSB, absorbing the bulk of any volume swings in the supply area.

Based on TransCanada’s year-end 2001 estimates, the WCSB had remaining discovered reserves of 56 trillion cubic feet and a reserves-to-production ratio of approximately nine years at current levels of production. Additional reserves are continually being discovered to maintain the reserves-to-production ratio at close to nine years. Gas prices in the future are expected to be higher than long-term historical averages due to a tighter supply/demand balance which should stimulate exploration and production in the WCSB.

TransCanada’s Alberta System provides the major natural gas gathering and export transportation capacity for the WCSB. It does so by connecting to most of the gas processing plants in Alberta and then transporting gas to two large mainline systems for domestic and export deliveries. The Alberta System faces competition primarily from the Alliance Pipeline, which connects to some of the same gas plants. The maximum receipt capacity of the Alliance Pipeline is approximately 1.7 Bcf/d compared to TransCanada’s Alberta System average 2002 receipt volumes of 11.2 Bcf/d. Two bypass pipelines in southern Alberta connect to the Canadian Mainline and have a combined capacity of 0.4 Bcf/d. In addition, the Alberta System has faced, and will continue to face, increasing competition from other pipelines.

The Canadian Mainline is TransCanada’s cross-continent pipeline serving mid-western and eastern markets in Canada and the U.S. The demand for gas in TransCanada’s key eastern markets is expected to continue to increase, particularly to meet the expected growth in gas-fired power generation. TransCanada does, however, face competition for its transportation services to eastern Canadian markets and U.S. export points. The main source of this competition is the combination of the Alliance and Vector pipelines. Alliance transports gas from the WCSB to the U.S. Midwest, where Vector connects to Alliance and transports gas to Eastern Canada, essentially allowing a complete bypass of the Canadian Mainline. In addition, there are several smaller pipeline systems that compete with TransCanada for markets in Eastern Canada. TransCanada must also compete to retain and attract customers in the northeastern U.S. market where consumers have access to an array of supply options such as U.S. supplies, imported LNG supplies, and natural gas from the Canadian East Coast offshore supply basin. New market growth customers and existing customers with expiring FT contracts may take advantage of these alternatives.

The increased competitive environment has resulted in contract non-renewals on both the Alberta System and the Canadian Mainline. There are significant quantities of excess firm capacity available for IT service as a consequence of FT service contract non-renewals on the Canadian Mainline. As a result, IT service provides some shippers with flexibility and a level of reliability comparable to FT service. In 2002, IT service pricing for the Canadian Mainline was determined based on bids received by shippers with a floor price of 80 per cent of the FT price. The Canadian Mainline has had reductions in FT contracts for deliveries originating at the Alberta border and in Saskatchewan of approximately 2.1 Bcf/d, or approximately 31 per cent of its capacity. As a result of reduced contracted FT volumes, tolls have increased on the Canadian Mainline. However, the toll increases due to contract non-renewals are somewhat mitigated by higher volumes flowed under IT contracts. Looking forward, there is limited opportunity to reduce tolls by increasing volumes on the Canadian Mainline. The utilization of the Canadian Mainline is not expected to increase in the short to medium term as additional supply from the WCSB is expected to be absorbed by demand growth within Western Canada and higher flows on other pipeline systems.

One of the responses by the Transmission business towards increased competition has been to focus on changes to the regulated business model. TransCanada will continue to work with stakeholders in 2003 to advance various aspects of the company’s competitive business model for the Alberta System, Canadian Mainline and BC System.

For the Canadian Mainline, TransCanada has filed an application with the NEB in the 2003 Tolls and Tariff Application to increase the depreciation rate and further the company’s initiatives on services and pricing. The decisions by the NEB on TransCanada’s 2003 Tolls and Tariff Application may have an impact on TransCanada’s 2003 earnings. In February 2003, the NEB denied TransCanada’s request for a review and variance of the Fair Return decision. As a result, the company has concerns about the long-term implications of a financial return that discourages additional investment in existing Canadian natural gas transmission systems.

The EUB is currently considering holding a generic cost of capital inquiry for all Alberta utilities. TransCanada’s position is that the inquiry should not apply to the Alberta System. Should the EUB proceed with the inquiry and should the Alberta System be subject to the inquiry, TransCanada will fully advance its views on the level of returns that are required to induce investment in pipelines.

Safety TransCanada worked closely with regulators, customers and communities during 2002 to ensure the continued safety of employees and the public. In 2002, two line breaks occurred in relatively remote areas of Manitoba and Alberta resulting in minimal impact. Pipeline integrity expenditures, including increased spending as a result of these line breaks, are anticipated to be approximately $80 million in 2003 compared to $53 million in 2002. TransCanada continues to use a rigorous risk management system that focuses spending on issues and areas that have the largest impact on maintaining or improving the reliability and safety of the pipeline system.

Environment In 2002, TransCanada continued efforts to minimize the impact of operations on the environment through continuous improvements to the leak detection and repair program and blowdown emissions management program. Through the use of innovative technology, TransCanada is able to quantify leaks and prioritize them for repair. TransCanada also tested a new technology for minimizing the impacts from pipeline blowdowns. This technology incinerates gas that would have normally been vented after the use of a portable transfer compressor and, as a result, significantly reduces the amount of greenhouse gases emitted to the atmosphere.

For information on management of risks with respect to the Transmission business, see Risk Management.