Risk and Compliance Management

• Risk management
• Compliance management
• Risk factors

Risk management

We believe that risk management is an essential discipline in our business operations. As an integral part of this, we have established a Group-wide risk management process to ensure a consistent approach to the assessment, recording, consolidation and reporting of our key risks in a visible, structured and continuous manner. This process complies with the Turnbull working party guidance (published September 1999) and the ABI Disclosure Guidelines on Socially Responsible Investment (published October 2001) which focus on social, ethical and environmental risks. In addition, the process supports the Group's compliance with our obligations under the Sarbanes-Oxley Act.

The risk management process continues to be based on both bottom-up and top-down assessments of operational, financial and other business risks. From the bottom up, business units and corporate centre functions must prepare and maintain risk registers that capture their key risks and the actions that are being taken to manage them. These risk registers are primarily management tools for use at an operational level, but are also intended to ensure that risk data is reported on a consistent basis throughout the Group. The key element in the top-down assessment of our risk profile is the involvement of the Executive Directors and other senior management across the Group at critical stages in the review process. Their review of the bottom-up assessment produces an overall evaluation of the risks that are faced by the Group. Graphics that set out the Group's risk profile and the significant changes to this between reporting periods are considered by the Executive Committee, the Risk & Responsibility Committee and the Audit Committee twice a year. The Audit Committee also reviews the risk management process at least once during each year and reports on this to the Board.

In May 2004, we were awarded 'best enterprise-wide risk management programme' by Strategic Risk Magazine. However, we recognise that risk management is a dynamic process and, as a result, risk reporting at Board level was refined during the year to ensure greater visibility and understanding of business specific risks. Similarly, an internal assessment on the extent to which risk management is embedded in the Group was carried out during the latter part of 2004 and further work will be undertaken to drive the embedding of risk management throughout National Grid Transco. An external benchmarking exercise has also begun with other FTSE 100 companies and similar organisations to measure the effectiveness of our own approach and exchange best practice.

The Group's risk management process has identified the risk factors set out below.

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Compliance management

Last year, we reported that we had begun to introduce a compliance management process that seeks to raise awareness of the increasing number of compliance obligations to which the Group is subject. The compliance management procedure is consistent with, and complimentary to, the Group's risk management procedure and is intended to ensure that we take all reasonable steps to comply with our principal legal and regulatory obligations. We are also using the process to ensure compliance with our Group policies and procedures.

Twice during each year the Executive Committee, the Risk & Responsibility Committee and the Audit Committee receive a report setting out the significant obligations across the Group, any material non-compliance with those, together with control opinions and action plans to improve controls where necessary.

Going forward, we aim to implement a procedure to provide assurance that robust compliance programmes are in place or are being developed for all significant obligations.

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Risk factors

Our risk management process has identified the following risk factors that could have a material adverse effect on our business, financial condition, results of operations and reputation, as well as the value and liquidity of our securities. Not all of these factors are within our control. In addition, other factors besides those listed below may have an adverse effect on the Group. Any investment decision regarding our securities and any forwardlooking statements made by us should be considered in the light of these risk factors and the cautionary statement set out on the inside front cover.

Changes in law or regulation in the geographies in which we operate could have an adverse effect on our results of operations.

Many of our businesses are utilities or networks that are subject to regulation by governments and regulatory authorities. Consequently, changes in law or regulation in the countries or states in which we operate could adversely affect the Group. Regulatory decisions concerning, for example, whether licences or approvals to operate are renewed, whether market developments have been satisfactorily implemented, whether there has been any breach of the terms of a licence or approval, the level of permitted revenues for our businesses and proposed business development activities, could have an adverse impact on our results of operations, cash flows, the financial condition of our businesses and the ability to develop those businesses in the future. For further information about this, please see the relevant sections of the Operating Review and Financial Review and, in particular, the Regulatory environment and Regulatory developments sections.

Breaches of environmental or health and safety laws or regulations could expose us to claims for financial compensation and adverse regulatory consequences and could damage our reputation.

Aspects of our activities are inherently dangerous, such as the operation and maintenance of electricity lines and the transmission and distribution of natural gas. Electricity and gas utilities also typically use and generate in their operations hazardous and potentially hazardous products and by-products. In addition, there may be other aspects of our operations that are not currently regarded or proved to have adverse effects but could become so, for example, the effects of electric and magnetic fields. We are subject to laws and regulations relating to pollution, the protection of the environment, and how we use and dispose of hazardous substances and waste materials. We are also subject to laws and regulations governing health and safety matters, protecting both the public and our employees. Any breach of these obligations, or even incidents relating to the environment or health and safety that do not amount to a breach, could adversely affect the results of operations and our reputation. For further information about environmental and health and safety matters relating to our businesses, please see the Responsibility section of our website at www.ngtgroup.com/responsibility.

Network failure or the inability to carry out critical non-network operations may have significant adverse impacts on both our financial position and our reputation.

We may suffer a major network failure or may not be able to carry out critical non-network operations. Risks to operational performance could arise from a failure to maintain the health of the system or network, inadequate forecasting of demand or inadequate record keeping. Any failure could cause us to be in breach of a licence or approval, and even incidents that do not amount to a breach could result in adverse regulatory action and financial consequences, as well as harming our reputation. In addition to these risks, we are subject to other risks that are largely outside of our control such as the impact of weather or unlawful acts of third parties. Weather conditions can affect financial performance, particularly in the US, and severe weather that causes outages or damages infrastructure will adversely affect operational and, potentially, business performance. Terrorist attack, sabotage or other intentional acts may also physically damage our businesses or otherwise significantly affect corporate activities and as a consequence affect the results of operations.

Our results of operations depend on a number of factors relating to business performance including the ability to outperform regulatory targets and to deliver anticipated cost and efficiency savings.

Earnings maintenance and growth from our regulated gas and electricity businesses will be affected by our ability to meet or better regulatory efficiency targets set by Ofgem and other regulators. From time to time, we also publish cost and efficiency savings targets for our businesses in the UK and the US. To meet these targets, we must continue to improve management and operational performance. In the US, under our state rate plans, earnings from our regulated businesses will be affected by our ability to deliver integration and efficiency savings. Earnings from our regulated businesses in both the UK and the US also depend on meeting service quality standards set by regulators. To meet these standards, we must improve service reliability and customer service. If we do not meet these targets and standards, both our results of operations and our reputation may be adversely affected.

Changes to the regulatory treatment of commodity costs may have an adverse effect on the results of operations.

Changes in commodity prices could potentially impact our energy delivery businesses. For example, the costs incurred by our electricity businesses in purchasing electricity are subject to movements in the prices of oil and gas. Current regulatory arrangements in the UK and US provide the ability to pass through virtually all of the increased costs related to commodity prices to consumers. If regulators in the UK or the US were to restrict this ability, it could have an adverse effect on our operating results.

Our reputation may be harmed if consumers of energy suffer a disruption to their supply even if this disruption is outside of our control.

Our energy delivery businesses are responsible for transporting available electricity and gas. We consult with and provide information to regulators, governments and industry participants about future demand and the availability of supply. However, where there is insufficient supply, our role is to manage the relevant system safely, which in extreme circumstances may require us to disconnect consumers.

We are subject to the risk that business development activity, such as significant acquisitions or disposals, will be based on incorrect assumptions or conclusions or that significant liabilities will be overlooked or there may be other unanticipated adverse impacts.

In any acquisition or disposal process we evaluate the projected financial impact of the transaction and conduct due diligence; however, unforeseen circumstances or erroneous assumptions may adversely affect the anticipated financial consequences of that project.

Fluctuations in the value of the US dollar could have a significant impact on our results of operations because we have substantial business interests in the US and because of the proportion of our total debt that is denominated in US dollars.

We have significant operations in the US. These businesses are subject to the risks normally associated with foreign businesses, including the need to translate US assets and liabilities, and income and expenses, into sterling, our primary reporting currency. Our results of operations may be similarly impacted because we hold a significant proportion of our borrowings in US dollars. For further information about this see Foreign exchange risk management under Treasury policy in the Financial Review.

The nature and extent of our borrowings means that an increase in interest rates could have an adverse impact on our financial position and business results.

A significant proportion of our borrowings are subject to variable interest rates that may fluctuate with changes to prevailing interest rates. Increases in these interest rates could therefore increase our costs and diminish our profits. For further information about this see Interest rate risk management under 'Treasury policy' in the Financial Review.

Our overall financial position may be adversely affected by a number of factors including restrictions in borrowing and debt arrangements, changes to credit ratings and effective tax rates.

We are subject to certain covenants and restrictions in relation to our listed debt securities and our bank lending facilities. We are also subject to restrictions on financing that have been imposed by regulators. These restrictions may hinder us in servicing the financial requirements of our current businesses or the financing of newly acquired or developing businesses. The debt issued by the Company and certain of its subsidiaries is rated by credit rating agencies and changes to these ratings may affect both the borrowing capacity of the Group as a whole and the cost of those borrowings. The effective rate of tax paid by the Group may be influenced by a number of factors including changes in law and accounting standards and the Group's overall approach to such matters, the results of which could increase or decrease that rate.

New or revised accounting standards, rules and interpretations by the UK, US or international accounting standard setting boards and other relevant bodies could have an adverse effect on the Group's reported financial results.

With the adoption of International Financial Reporting Standards (IFRS), changes in the accounting treatment of replacement expenditure, regulatory assets and pension and post-retirement benefits will significantly affect the way we report our financial position and results of operations. New standards, rules or interpretations may be issued that could also have significant effects. In addition, as a body of practice develops, the application of accounting principles to our particular circumstances may change.

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