Operating and Financial Review
Introduction
- History and development of the business
- Regulatory environment
- Regulatory developments
- Business segments
- Financial performance
- Adjusted profit measures
- Other performance measures
- Summary results
- Turnover and operating profit
- Cash flows from operating activities
- Exchange rates
- Acquisitions, disposals and mergers
National Grid Transco is a network utility, based mainly in the UK and the US. Our principal interests are in the transmission and distribution of electricity and gas and in the provision of network infrastructure to the broadcast and telecommunications industries. We also have interests in related markets, including metering services, liquefied natural gas facilities and property in the UK, as well as electricity interconnectors in the UK, US and Australia.
History and development of the business
National Grid Transco originated from the restructurings of the UK gas industry in 1986 and the UK electricity industry in 1990. We entered the US energy delivery market in 2000 and substantially expanded our UK wireless infrastructure activities in 2004.
The UK gas industry was first restructured in 1986 when British Gas was incorporated as a public limited company, British Gas plc. In 1997, Centrica was demerged from British Gas plc which was re-named BG plc. In December 1999, BG plc completed a restructuring programme which resulted in the creation of a new parent company, BG Group plc, and involved separating the UK regulated business, BG plc (re-named Transco plc), from its other businesses. Lattice Group plc was created as the holding company for Transco plc and certain other non-regulated infrastructure service businesses and, in October 2000, it was demerged from BG Group plc and separately listed on the London Stock Exchange.
In 1990 National Grid Company plc took on the ownership and control of the electricity transmission network in England and Wales and certain interests in the interconnectors with Scotland and France from the Central Electricity Generating Board. Originally the predominant shareholders in National Grid Company plc, via a holding company, were the twelve Regional Electricity Companies which owned and operated the local distribution systems, but in 1995, shares in the holding company were listed on the London Stock Exchange and by early 1996 the Regional Electricity Companies had disposed of most of their respective shareholdings.
We entered the US electricity market in 2000 when we acquired New England Electric System and Eastern Utilities Associates. We expanded further into the northeastern US with our acquisition of Niagara Mohawk Power Corporation in January 2002. National Grid USA is the holding company for our US operations.
In October 2002 National Grid Group plc, the holding company for National Grid Company plc and National Grid USA, merged with Lattice Group plc, changing its name to National Grid Transco plc.
In August 2004, we completed the purchase of the UK operations of Crown Castle International Corp. and integrated it with the Group's existing communications business, Gridcom UK, to form a single business, known as Crown Castle UK.
Also in August 2004, we agreed the sales of four of our UK gas distribution networks. These sales are expected to complete on 1 June 2005, after which we will still own the largest gas distribution network in the UK. Further details of these planned sales are included in Network Sales within UK Gas Distribution of the Operating Review.
Regulatory environment
National Grid Transco is listed on the London Stock Exchange and on the New York Stock Exchange and, as a consequence, is subject to regulation by the Financial Services Authority in the UK, and by the Securities and Exchange Commission (SEC) in the US.
As a result of our position in and importance to the economies we serve, our electricity and gas transmission and distribution businesses in the UK and US are subject to UK, European Union and US industry regulation.
In the UK these businesses are regulated by the Office of Gas and Electricity Markets (Ofgem). Ofgem operates under the direction and governance of the Gas and Electricity Markets Authority, which makes all major decisions and sets policy priorities for Ofgem.
In the US our public utilities are regulated by the commissions in the states in which we operate and by the Federal Energy Regulatory Commission. These US regulators set service standards and determine our potential levels of return.
As a result of our ownership of several US public utility companies, National Grid Transco is a registered holding company under the US Public Utility Holding Company Act 1935, for which the regulator is the SEC. This law imposes various conditions and limitations relating to financing, subsidiary company transactions and ownership of non-utility businesses, and the requirement for SEC consent for further US utility acquisitions.
In addition, certain of the UK activities of our Wireless infrastructure business are subject to regulation by the Office of Communications (Ofcom), in particular our UK analogue television and radio transmission networks. We operate two digital multiplexes under the terms of a licence granted by Ofcom. Ofcom is also responsible for regulating the broadcast and telecommunication industries to which Crown Castle UK provides wireless infrastructure.
Regulatory developments
On 1 April 2005, the British Electricity Transmission and Trading Arrangements (BETTA) came into operation and, as the Great Britain System Operator, we became responsible for operating the Scottish electricity transmission network in addition to that of England and Wales. This change is discussed in more detail in Regulation within Transmission of the Operating Review.
The European Union Electricity Regulation requires a mandatory inter-operator compensation scheme to be established in respect of electricity transfers between member states. The scheme may be introduced in the course of 2006, although this is by no means certain. Any receipts from, or payments to, the scheme will have to be set against transmission charges and so the overall impact is expected to be neutral. The scheme could also impact on charging arrangements for the interconnector with France. The Regulation also allows for other changes to be made to transmission tariffs and congestion management across member state borders, although details of these areas will only be developed over the coming year.
A European Union Directive concerning measures to safeguard security of natural gas supply is due for implementation in May 2006. This will ensure that member states have in place, and publish, policies and standards on gas security of supply. In addition, the Gas Regulation on conditions for access to gas networks is expected to be adopted by the European Union in the summer of 2005. We expect the impact of these regulations on our businesses to be minimal.
There are also a number of European Directives and Regulations in development covering many issues including electricity security of supply, harmonisation of access to gas systems and infrastructure development, where the precise impact on our businesses in the future is currently uncertain.
Business segments
We report our operating results by segment, reflecting the management responsibilities and economic characteristics of the Group's business activities. Our business operations are divided into the following segments: UK electricity and gas transmission; US electricity transmission; UK gas distribution; US electricity and gas distribution; US stranded cost recoveries; and Wireless infrastructure; with all other activities of the Group being reported as part of Other activities.
Our UK electricity and gas transmission segment comprises the high-voltage electricity transmission networks and the gas National Transmission System in the UK. Our US electricity transmission segment comprises high-voltage electricity transmission networks in the northeastern US and transmission management operations for other utilities in the midwestern US.
Our UK gas distribution segment comprises the majority of Great Britain's gas distribution system. Information on the planned sales of four regional gas distribution networks, comprising approximately half of this segment, is given in Network Sales within UK Gas Distribution of the Operating Review.
Our US electricity and gas distribution segment delivers electricity and gas in New York State and electricity in New England.
Our US stranded cost recoveries segment represents the recovery of generation-related costs through a special rate charged to electricity customers. We incurred these costs prior to industry-wide restructuring that deregulated the generation business.
Our Wireless infrastructure segment includes our activities in providing network infrastructure to the broadcast and telecommunications industries. It was established as a separate segment in 2004/05, when we acquired the UK operations of Crown Castle International Corp. and integrated it with our existing Gridcom business in the UK. We also operate in the US through Gridcom US.
Other activities not included in the above segments include metering services, property and liquefied natural gas operations in the UK and our electricity interconnector businesses in the UK and Australia.
As described in Segmental Reporting of the Financial Review, these business segments are different from those presented in last year's Annual Report and Accounts, and comparative results for the years ended 31 March 2004 and 2003 have been restated accordingly.
Financial performance
The summary consolidated results of the Group for the years ended 31 March 2005, 2004 and 2003 are discussed in the Summary results in the Introduction of the Operating and Financial Review.
The Operating Review focuses on the performance of individual business segments, including a consideration of the business environment within which each of our business segments operates and the operational and financial performance of each business segment. The Operating Review contains a discussion of changes in segmental financial results during the years under review.
The Financial Review primarily focuses on the financial impact of matters that do not arise from operating performance or are better discussed in the wider Group context rather than on a segment by segment basis. Consequently, it comments on consolidated turnover, adjusted operating profit and operating profit, interest, taxation, exceptional items and cash flows.
The Operating Review and the Financial Review should be read together to obtain a complete understanding of our results of operations and financial condition during the years presented in the financial statements.
Adjusted profit measures
We use 'adjusted' profit measures in considering the performance of the Group's operating segments and businesses. References to 'adjusted operating profit', 'adjusted profit before taxation', 'adjusted earnings' and 'adjusted earnings per share' are stated before exceptional items and goodwill amortisation.
The Directors believe that the use of these adjusted measures better indicates the underlying business performance of the Group than the unadjusted measures. Excluding exceptional items removes their distorting impact in order to provide a clearer comparison from year to year, and excluding goodwill amortisation enhances comparability with other UK companies as this is a standard reporting practice in the UK. These measures are the primary financial performance measures used by the Directors to evaluate our operations.
Other performance measures
The Group uses a number of measures of operational and financial performance relating to its various businesses. The Group's core businesses are regulated utilities and therefore many of our targets are determined by the relevant regulators. Much of the Group's performance depends on meeting and exceeding those regulatory targets. Measures of operational performance include: Lost Time Injuries (LTIs); the management of controllable costs in relation to our UK and US regulated businesses; reliability of our energy delivery networks; and other service quality measures.
The Directors believe that safety is paramount and, as a fundamental part of this, that all work-related injuries and illnesses are preventable. Consequently, we measure the level of LTIs as a key operational performance indicator for the Group. LTIs are injuries that arise from a person's employment and cause that person to be unable to attend the workplace and perform his or her duties for one or more shifts or working days. All our businesses are required to report on LTIs suffered by their respective employees and any contractors.
The level of controllable costs is another critical performance measure in our core utility businesses. Our ability to make a profit depends largely on our ability to manage those of our costs that we can control. Controllable costs include employment costs (excluding pension fund deficits in the UK) and other costs incurred in operating and maintaining transmission and distribution systems. The manner in which we calculate controllable costs varies within the Group as a result of, among other things, different regulatory regimes and the historical treatment of costs by our regulators. However, the underlying principle is the same, and in the event that the definition of controllable costs is changed for any reason, comparatives are amended so that year on year changes are not distorted. Ofgem monitors our performance in a number of areas and our ability to reduce controllable costs is important to this process. We also use controllable costs in our US regulated operations as an additional performance measure.
Certain costs, of course, cannot be controlled and hence are not included within the definition of controllable costs. Some are fixed or semi-fixed and generally cannot be altered by management. These costs include depreciation charges, replacement expenditure, goodwill amortisation and certain pension and pension deficit related costs. Those commodity and other costs incurred by Group businesses that are passed through to our customers in turnover or commodity costs that change as a result of movements in market prices over which we have no control are therefore also excluded from the definition of controllable costs.
Operational reliability is a core measure of our success, and it is fundamental to our relationships with our regulators and the public. We monitor reliability using various methods, relevant to each particular energy delivery network. We also measure service quality in each of those businesses, with various methods relevant to each particular network, to assess the performance of our management and staff in serving our customers.
Summary results
The following tables summarise the turnover, adjusted operating profit and operating profit of the Group by business segment. Comparative figures for the years ended 31 March 2004 and 2003 have been restated to reflect changes in accounting policies and changes in the presentation of segmental information as described in notes 1 and 2 to the accounts.
| Years ended 31 March | |||
|---|---|---|---|
|
Turnover |
2005 £m |
2004 (restated) £m |
2003 (restated) £m |
| UK electricity and gas transmission | 1,930 | 1,867 | 1,893 |
| US electricity transmission | 283 | 318 | 407 |
| UK gas distribution | 2,215 | 2,245 | 2,089 |
| US electricity and gas distribution | 3,114 | 3,494 | 3,306 |
| US stranded cost recoveries | 420 | 507 | 586 |
| Wireless infrastructure | 208 | 72 | 61 |
| Other activities | 844 | 834 | 861 |
| Sales between businesses | (493) | (462) | (370) |
| Continuing operations | 8,521 | 8,875 | 8,833 |
| Discontinued operations | - | 158 | 586 |
| Sales between businesses | - | - | (19) |
| Group turnover | 8,521 | 9,033 | 9,400 |
| Years ended 31 March | |||
|---|---|---|---|
|
Adjusted operating profit |
2005 £m |
2004 (restated) £m |
2003 (restated) £m |
| UK electricity and gas transmission | 809 | 759 | 809 |
| US electricity transmission | 123 | 133 | 128 |
| UK gas distribution | 570 | 716 | 547 |
| US electricity and gas distribution | 374 | 362 | 401 |
| US stranded cost recoveries | 121 | 134 | 170 |
| Wireless infrastructure | 46 | 6 | (23) |
| Other activities | 162 | 96 | 147 |
| Continuing operations | 2,205 | 2,206 | 2,179 |
| Discontinued operations | - | - | (26) |
| Joint ventures | 7 | 7 | (5) |
| Total adjusted operating profit | 2,212 | 2,213 | 2,148 |
Exceptional items, which are not included in the adjusted operating profit and other adjusted measures, are defined as material items arising from the ordinary activities of the Group, requiring separate disclosure on the grounds of size or incidence for the accounts to give a true and fair view. Such exceptional items include, for example, material restructuring costs and impairments. The Financial Review contains a discussion of the nature of these exceptional items for each year.
| Years ended 31 March | |||
|---|---|---|---|
|
Operating profit | 2005 £m | 2004 (restated) £m | 2003 (restated) £m |
| UK electricity and gas transmission | 807 | 745 | 763 |
| US electricity transmission | 102 | 105 | 103 |
| UK gas distribution | 390 | 627 | 436 |
| US electricity and gas distribution | 286 | 194 | 290 |
| US stranded cost recoveries | 121 | 136 | 172 |
| Wireless infrastructure | 10 | (6) | (50) |
| Other activities | 129 | 29 | 52 |
| Continuing operations | 1,845 | 1,830 | 1,766 |
| Discontinued operations | - | - | (194) |
| Joint ventures | 7 | 7 | 124 |
| Total operating profit | 1,852 | 1,837 | 1,696 |
Turnover and operating profit
Movements from year to year in turnover do not necessarily have an impact on the financial condition of the Group as the amounts we charge to customers can vary depending on our costs. In particular, we can pass through certain elements of our costs to customers, and these therefore do not have a significant impact on adjusted operating profit and operating profit.
In addition, there can be timing differences in our UK regulated businesses between when costs are incurred and when these can be recovered from customers. In these cases, turnover, operating costs, adjusted operating profit and operating profit will vary from year to year.
Cash flows from operating activities
The Group generated positive operating cash flows before exceptional items of £3,103 million in 2004/05, compared with £3,058 million and £3,154 million in 2003/04 and 2002/03 respectively. After exceptional items, operating cash inflows were £2,909 million, £2,810 million and £2,826 million in 2004/05, 2003/04 and 2002/03 respectively.
Cash flows from our operations are largely stable over a period of years, but they do depend on the timing of customer payments and exchange rate movements. The Group's electricity and gas transmission and distribution operations in the UK and US are subject to multi-year rate agreements with regulators. In the UK, this results in essentially stable cash flows in local currency terms. However, weather conditions can affect cash flows in those businesses, with abnormally mild or extreme weather driving volumes down or up respectively. In the US, the regulatory mechanisms for recovering costs from customers can result in very significant cash flow swings from year to year.
Exchange rates
As shown in the Summary results tables, adjusted operating profit and operating profit from our US businesses each accounted for some 28% of the totals for Group undertakings for 2004/05. The functional currency for our US operations is US dollars. As a consequence, their results are translated into sterling for Group reporting purposes at the average rate of exchange for the year. Consequently, to the extent that the US dollar to sterling exchange rate moves from year to year, the sterling value of US dollar denominated results will also vary even if the underlying US dollar values remain the same.
The financial impact of the movement in average US dollar to sterling exchange rates between years is discussed in Exchange rates in the Financial Performance of the Financial Review. Although during the periods under review there was a significant impact on operating profit and adjusted operating profit as a result of the movement in this exchange rate, this was substantially offset by the impact of the translation of US dollar denominated interest and taxation. As a consequence, in comparing the adjusted earnings and earnings of 2004/05 with 2003/04 and of 2003/04 with 2002/03, the impact of currency translation was less significant as a result of these offsetting movements not included in adjusted operating profit or operating profit.
Acquisitions, disposals and mergers
As described above under 'History and development of the business', we have agreed the sales of four of our regional gas distribution networks, comprising approximately half of the UK gas distribution segment. Cash proceeds from these planned sales are expected to be £5.8 billion. Further details on the planned sales are included in Network sales in UK Gas Distribution of the Operating Review.
In 2004/05, we acquired the UK operations of Crown Castle International Corp. This acquisition has been accounted for in accordance with acquisition accounting principles (purchase accounting) under UK GAAP. The business was acquired for cash consideration of £1,138 million and gave rise to goodwill amounting to £622 million under UK GAAP. Under US GAAP, goodwill was £510 million, with £220 million ascribed to the value of other intangible fixed assets that are not recognised under UK GAAP.
There were no significant acquisitions, disposals or mergers during 2003/04.
During 2002/03, National Grid Group plc merged with Lattice Group plc and the resulting entity was renamed National Grid Transco plc. In accordance with UK GAAP, this was accounted for using merger accounting principles such that the results of the Group under UK GAAP have been presented as if the combined Group had been in existence for all of the financial years presented. The results for all years are presented on the basis of uniform accounting policies.
Under US GAAP, the business combination of National Grid Group plc with Lattice Group plc was accounted for as an acquisition. Under US GAAP, the purchase consideration for Lattice Group plc was £6,598 million, primarily satisfied by the issuance of shares, which gave rise to goodwill amounting to £3,824 million. The US GAAP accounting of this business combination is described in more detail in US GAAP reporting of the Financial Review.