UPDATE 1-Entergy, ITC call off grid sale, citing states' opposition
* Failure highlights state-federal tension over rate setting
* Entergy says it will keep transmission operation
HOUSTON, Dec 13 (Reuters) - New Orleans-based Entergy Corp on Friday called off a $1.78 billion plan to divest its transmission operations to ITC Holdings Corp, three days after utility regulators in Mississippi rejected the plan.
The transaction - first announced in 2011 - had received federal and ITC shareholder approval, but was unable to get the necessary support from state and local regulators who were concerned about rising transmission costs and the loss of control over rates.
An unanimous rejection by the Mississippi Public Service Commission on Tuesday effectively killed the deal.
"It's disappointing to have the transaction end the way that is has after over two years of working on it," said Cameron Bready, ITC's chief financial officer.
The deal would have included a spinoff and merger of Entergy's 15,000-mile (24,000-km) transmission network serving parts of Arkansas, Louisiana, Mississippi and Texas with Michigan-based ITC Holdings.
"While we strongly believe that the transaction would be in the best interests of our customers and all stakeholders, it is clear we don't have the necessary regulatory support to close the transaction," Leo Denault, Entergy's chairman and chief executive, said in a statement.
The ITC deal was part of Entergy's larger effort to leave the transmission business to help resolve a U.S. Justice Department (DOJ) investigation into alleged anti-competitive behavior.
Entergy's initial move was to join the Midcontinent Independent System Operator (MISO), which is set to be completed next week.
Federal and state regulators have since 2009 urged Entergy to relinquish day-to-day control of its grid assets after a decade of complaints from independent power producers.
State regulators approved Entergy's move to MISO in 2012, although not before obtaining additional representation.
But state regulators balked at the ITC deal which would have transferred authority to set transmission rates from the state level to the Federal Energy Regulatory Commission (FERC), which allows companies like ITC - the country's largest independent transmission owner - to earn higher rates of return than allowed by states.
Rejection of the ITC transaction "highlights the tension that exists between federal regulation over interstate transmission and state regulation as it relates to the rates customers pay within the bounds of individual states," said Bready in an interview.
"The ITC deal was like a brick wall," said analyst Paul Patterson of Glenrock Associates. "MISO (membership) will allow for independent operation of the system, but changing ownership is a different story."
State opposition came as a "something of a surprise" to ITC officials, said Bready who was active in state negotiations.
"Going into this transaction, we felt there was a burning platform for change in this region, given the history," Bready said. "We felt like our business model was the ideal solution for the concerns they had."
The Mississippi PSC saw it otherwise, however, calling the transaction "an attempt by Entergy and its shareholders to monetize its transmission assets and extract the excess value of the assets under the more generous FERC rate construct available to ITC," according to the commission order.
NARUC, a group which represents state utility commissioners, has asked FERC to review the rate incentives given to independent transmission companies which it claims have "transferred hundreds of millions of dollars from consumers to transmission investors without any clear showing of need or benefit."
"I am truly sorry that customers in this region will not realize the benefits that this transaction would have brought and that they so deserve," said Joseph Welch, ITC chief executive, said in a statement.
Entergy's Denault said the company now views transmission "as an integral part of the significant growth opportunities" ahead as the U.S. Gulf Coast prepares for a period of major industrial investment that will boost electricity needs.
Entergy declined to comment on the ongoing federal investigation, but it has said its practices and policies satisfy applicable regulation and are subject to FERC review.
The DOJ did not respond immediately to a request for comment.