Operating and Financial Review
Operating Review
US Distribution
- US electricity and gas distribution
- Background information
- Regulation
- Safety
- Operating performance
- Financial performance
- Investment in the networks
- US stranded cost recoveries
Our US Distribution business comprises two segments: 'US electricity and gas distribution' for our energy delivery businesses operating in the northeastern US and 'US stranded cost recoveries' for the recovery of generation-related costs incurred prior to divestiture. Details of each of these segments are set out below.
US electricity and gas distribution
Background information
We are one of the leading electricity distribution service providers in the northeastern US, as measured by energy delivered, and one of the largest utilities in the US, as measured by the number of electricity distribution customers. US electricity and gas distribution serves approximately 3.3 million electricity customers over a network of 72,000 circuit miles and around 565,000 gas customers over a network of 8,500 miles.
We provide electricity and gas distribution in New York state through our subsidiary Niagara Mohawk Power Corporation. We provide electricity distribution in New England through our subsidiaries Massachusetts Electric Company (operating in Massachusetts), Nantucket Electric Company (operating on Nantucket Island off Massachusetts), The Narragansett Electric Company (operating in Rhode Island) and Granite State Electric Company (operating in New Hampshire).
Regulation
Niagara Mohawk, Massachusetts Electric Company and Narragansett Electric Company together constitute over 98% of our US electricity distribution business, and Niagara Mohawk operates our US gas distribution business. Under their long-term rate plans with state regulators, these subsidiaries can earn and retain certain amounts in excess of traditional regulatory allowed returns. Their incentive returns and shared savings allowances are designed to provide them with an opportunity to use efficiency gains following their respective mergers to more than offset the costs of completing those mergers.
Niagara Mohawk distribution rates
Niagara Mohawk's electricity delivery rates are governed by a 10-year rate plan that began when we acquired it on 31 January 2002. Under the plan, after reflecting its share of savings related to the acquisition, Niagara Mohawk may earn a threshold return on equity for its electricity distribution business of 10.6%, or 12.0% if certain customer education targets are met, and half of any earnings in excess of that amount. The return on equity is measured on a US GAAP basis and calculated cumulatively from inception to 31 December 2005 and on a two-year rolling basis thereafter. The earnings calculation used to determine the regulated returns excludes half of the synergy savings, net of the cost to achieve them, that were assumed in the rate plan. This exclusion effectively offers Niagara Mohawk the potential to achieve a return in excess of the regulatory allowed return of 10.6%.
Under the plan, gas delivery rates were frozen until the end of the 2004 calendar year, and Niagara Mohawk now has the right to request an increase at any time, if needed. Niagara Mohawk may earn a threshold return on equity of up to 10%, or 12% if certain customer migration and education goals are met, and is required to share earnings above this threshold with customers.
Massachusetts Electric distribution rates
Under Massachusetts Electric's 20-year rate plan, there is no cap on earnings and no earnings sharing mechanism until 2010. From May 2000 until February 2005, rates were frozen. In March 2005, a settlement credit in the company's rates expired, which represents an increase of $10 million in pre-tax income through to February 2006. From March 2006, rates will be adjusted each March until 2009 by the annual percentage change in average electricity distribution rates in the northeastern US. In 2010, actual earned savings will be determined and the company will be allowed to retain 100% of annual earned savings up to $70 million and 50% of annual earned savings between $70 million and $145 million (all figures pre-tax). Earned savings represents the difference between calendar year 2008 distribution turnover and the company's cost of providing service, including a regional average authorised return. These efficiency incentive mechanisms provide an opportunity to achieve returns in excess of traditional regulatory allowed returns. Massachusetts Electric will be allowed to include its share of earned savings in demonstrating its costs of providing service to customers from January 2010 until May 2020.
Narragansett Electric distribution rates
Narragansett Electric's distribution rates are governed by a 20-year rate plan. Between May 2000 and the end of October 2004, rates were frozen and it was permitted to retain 100% of its earnings up to an allowed return on equity of 12%. The company kept 50% of earnings between 12% and 13%, and 25% of earnings in excess of 13%. With effect from November 2004 until December 2009, Narragansett Electric has agreed to lower its rates by $10.2 million per year. Beginning in January 2005, it will be able to keep an amount equal to 100% of its earnings up to an allowed return on equity of 10.5%, plus $4.65 million (pre-tax), which represents its share of demonstrated savings subsequent to the acquisition of Eastern Utilities Associates in 2000. Earnings above that amount up to an additional 1% return on equity are to be shared equally between the company and its customers, while additional earnings will be allocated 75% to customers and 25% to the company. The company determines earned return on equity based on a hypothetical capital structure of 50% common equity, 5% preferred equity and 45% debt. This regulatory mechanism offers the potential to achieve returns in excess of traditional regulatory allowed returns.
Safety
The number of employee LTIs in the US electricity and gas distribution business fell from 143 in 2003/04 to 81 in 2004/05, a decrease of 43%. This is a marked improvement in our safety record, after a 14% increase in 2003/04.
Operating performance
We work towards service quality standards that our state regulators expect us to achieve. If we fall below a prescribed standard, we can incur a penalty. If we do better than the standard, we can in some cases achieve an incentive. Although we met or bettered our standards on customer service, we missed targets for reliability in the 2004 calendar year, incurring an aggregate net penalty of £2.2 million. Although the shortfalls were small, we are committed to reducing the frequency and duration of service interruptions. We are therefore increasing our investments in the coming financial year for asset enhancement, replacement and maintenance. Continuation of this programme into future years should improve reliability, reduce inefficient use of resources in responding to outages and create a safer work environment.
Financial performance
The results of the US electricity and gas distribution segment for the years ended 31 March 2005, 2004 and 2003 were as follows.
Years ended 31 March US electricity and gas distribution | 2005 £m | 2004 (restated) constant currency basis £m | 2003 (restated) constant currency basis £m | 2004 (restated) £m | 2003 (restated) £m |
|---|---|---|---|---|---|
| Turnover | 3,114 | 3,139 | 2,811 | 3,494 | 3,306 |
| Operating costs excluding exceptional items and goodwill amortisation | (2,740) | (2,814) | (2,470) | (3,132) | (2,905) |
| Adjusted operating profit | 374 | 325 | 341 | 362 | 401 |
| Exceptional items | (20) | (84) | (25) | (93) | (30) |
| Goodwill amortisation | (68) | (67) | (69) | (75) | (81) |
| Operating profit | 286 | 174 | 247 | 194 | 290 |
The average exchange rates used to translate the results of US operations during 2004/05, 2003/04 and 2002/03 were $1.87:£1, $1.68:£1 and $1.59:£1 respectively. In order to illustrate underlying performance, the impact of exchange rate movements has been separated from other changes by also presenting the operating results for 2003/04 and 2002/03 on a constant currency basis, using the average exchange rate for 2004/05 of $1.87:£1. The 2003/04 and 2002/03 results are discussed below as if the 2004/05 exchange rate had applied.
There was a £25 million decrease in US electricity and gas distribution turnover in 2004/05 compared with 2003/04. Turnover decreased by £33 million as a consequence of the recovery of lower purchased electricity costs, partially offset by the recovery of higher purchased gas costs. The costs of purchased electricity and gas are reflected in turnover because they are collected from customers under our rate plans. This overall decrease in turnover occurred despite a 0.5% increase in deliveries of electricity, or 1.4% weather-normalised. Deliveries to the residential customer class increased by 1.7%, weather-normalised.
The £328 million increase in turnover comparing 2003/04 with 2002/03 resulted from the recovery of increased purchased electricity and gas costs and the transfer of certain FERC-regulated tariff charges previously reported under US electricity transmission. Partially offsetting the increase were a 0.8% decline in electricity deliveries and an 18.9% decline in gas deliveries. After normalising for weather, electricity deliveries increased by 0.8% but gas deliveries fell by 18.5%. Strong residential deliveries contributed to the increase in electricity deliveries. The decline in gas deliveries mainly reflected certain larger customers purchasing gas directly from suppliers.
US electricity and gas distribution operating costs, excluding exceptional items and goodwill amortisation, decreased by £74 million comparing 2004/05 with 2003/04. Purchased electricity and gas costs represent more than one-half of US electricity and gas distribution operating costs. These costs decreased £33 million as compared to the prior year because of lower prices and despite increased deliveries. Most of the remainder of the decrease of £41 million in operating costs can be attributed to a £35 million decrease in controllable costs due primarily to the effects of staffing reductions and lowered bad debt expenses. National Grid USA, the holding company for the Group's US operations, has reduced controllable costs by 20% in real terms since 2001/02.
Operating costs, excluding exceptional items and goodwill amortisation, increased by £344 million comparing 2003/04 with 2002/03. Purchased electricity and gas increased by £248 million for 2003/04 as compared to 2002/03. This was mainly driven by higher prices for electricity and gas, partially offset by a decrease in volumes purchased. Also contributing to the increase was the transfer of £76 million of certain tariff charges as discussed above.
The £49 million increase in US electricity and gas distribution adjusted operating profit comparing 2004/05 with 2003/04 was a consequence of the growth in turnover of £8 million and the £41 million reduction in operating costs discussed above, both after excluding the movement in commodity costs recovered from customers.
The £16 million decrease in adjusted operating profit comparing 2003/04 with 2002/03 was primarily because of the increase in other operating costs discussed above, again after excluding the movement in commodity costs.
Exceptional items and goodwill amortisation explain the difference between adjusted operating profit and operating profit. For 2004/05, all the exceptional items were incurred in connection with restructuring costs. In 2003/04, exceptional items included £57 million in connection with voluntary early retirement offers, restructuring costs of £15 million and £12 million for the non-capitalised costs of a new enterprise resource planning system.
Investment in the networks
Capital investment in the replacement, reinforcement and extension of the US electricity and gas distribution networks in 2004/05 was £234 million, compared with £277 million in 2003/04 and £249 million in 2002/03. These amounts reflect the actual respective average exchange rates for 2004/05, 2003/04 and 2002/03.
US electricity and gas distribution capital investment expenditure decreased by £43 million in 2004/05, of which £28 million is attributable to the impact of exchange rate movements. There was a £45 million decline in spending on automated meter reading and on a large gas pipeline project, both of which were largely completed in 2003/04. This decrease was partially offset by increased other spending of £30 million.
US electricity and gas distribution capital investment expenditure increased by £28 million in 2003/04. This reflected increased spending of £13 million to establish automated meter reading and £28 million for load relief and reliability projects, including £9 million for a large gas pipeline, partially offset by the £13 million impact of exchange rate movements.
US stranded cost recoveries
Background information
The US stranded cost recoveries segment captures the recovery of various generation-related costs that were incurred prior to industry-wide restructuring that deregulated the generation business. These costs consist primarily of the above-market costs associated with the generation assets and with amending or ending purchased power contracts. We recover a large portion of these stranded costs, along with a return, through a special rate charged to customers.
Financial performance
The results of the US stranded cost recoveries segment for the years ended 31 March 2005, 2004 and 2003 were as follows.
Years ended 31 March US stranded cost recoveries | 2005 £m | 2004 (restated) constant currency basis £m | 2003 (restated) constant currency basis £m | 2004 (restated) £m | 2003 (restated) £m |
|---|---|---|---|---|---|
| Turnover | 420 | 455 | 498 | 507 | 586 |
| Operating costs | (299) | (334) | (354) | (373) | (416) |
| Adjusted operating profit* | 121 | 121 | 144 | 134 | 170 |
| * | Operating profit was £2 million higher than adjusted operating profit in both 2003/04 and 2002/03. |
|---|
The average exchange rates used to translate the results of US operations during 2004/05, 2003/04 and 2002/03 were $1.87:£1, $1.68:£1 and $1.59:£1 respectively. In order to illustrate underlying performance, the impact of exchange rate movements has been separated from other changes by also presenting the operating results for 2003/04 and 2002/03 on a constant currency basis, using the average exchange rate for 2004/05 of $1.87:£1. The 2003/04 and 2002/03 results are discussed below as if the 2004/05 exchange rate had applied.
There was a £35 million decrease in US stranded cost recoveries turnover comparing 2004/05 with 2003/04. Turnover decreased by £74 million as a consequence of the recovery of lower purchased power contract costs, partially offset by an increase in recoveries of stranded costs in accordance with Niagara Mohawk's rate plan. Most of the prior year's decrease of £43 million was attributable to lower gross returns on the stranded cost asset, which is diminishing as stranded costs are recovered from customers, as well as the impacts of weaker sales and reduced purchased power contract costs.
Operating costs for US stranded cost recoveries decreased by £35 million and £20 million in 2004/05 and 2003/04 respectively, in each case mainly because of lower purchased power contract costs.
Adjusted operating profit stayed constant at £121 million in 2004/05 and decreased by £23 million comparing 2003/04 with 2002/03. This segment had no goodwill amortisation during the periods presented, and so the differences between adjusted operating profit and operating profit in 2003/04 and 2002/03 related to exceptional items.