Operating and Financial Review

Financial Review

Critical accounting policies

The accounts are prepared using the Group's accounting policies as shown in the Accounts, in accordance with UK GAAP.

UK GAAP differs in certain significant respects from US GAAP. Information relating to the nature and effect of such differences is summarised in note 32 to the accounts 'Differences between UK and US accounting principles'.

The application of accounting principles, requires us to make estimates, judgements and assumptions that may affect the reported amounts of assets, liabilities, revenue and expenses and the disclosure of contingent assets and liabilities in the accounts. On an ongoing basis, we evaluate our estimates using historical experience, consultation with experts and other methods that we consider reasonable in the particular circumstances to ensure compliance with UK GAAP and with US GAAP. Actual results may differ significantly from our estimates, the effect of which is recognised in the period in which the facts that give rise to the revision become known.

Certain of the Group's UK GAAP accounting policies have been identified as critical accounting policies, as these policies involve particularly complex or subjective decisions or assessments. The discussion of critical accounting policies below should be read in conjunction with the description of the Group's accounting policies set out in Accounts. Where critical accounting policies adopted under US GAAP are significantly different from the ones adopted under UK GAAP, additional information is included in the US GAAP section in US GAAP reporting.

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Estimated asset economic lives

Determining the particular asset economic lives for goodwill and tangible fixed assets involves the exercise of judgement and can materially affect the reported amounts for goodwill amortisation and depreciation of tangible fixed assets.

Under UK GAAP, goodwill is principally being amortised over 20 year periods, while the economic lives of tangible fixed assets are disclosed in Accounting policies - e) Tangible fixed assets and depreciation. For the year ended 31 March 2005, the Group profit and loss account reflected goodwill amortisation and depreciation of tangible fixed assets amounting to £109 million and £860 million (2003/04: £99 million and £866 million) respectively.

In businesses such as ours, which are capital intensive in nature and have long tangible fixed asset lives, goodwill is similarly expected to have a long asset life. Therefore, goodwill is amortised over a long life, typically 20 years. If goodwill were amortised over 10 or 30 years, goodwill amortisation would increase or decrease by approximately £110 million or £40 million per annum respectively. This sensitivity assumes the same average US dollar to sterling exchange rate as applied in 2004/05.

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Impairment of fixed assets

Goodwill, fixed asset investments and tangible fixed assets are reviewed for impairment in accordance with UK GAAP. Future events could cause these assets to be impaired, resulting in an adverse effect on the future results of the Group.

Reviews for impairments are carried out under UK GAAP in the event that circumstances or events indicate the carrying value of fixed assets may not be recoverable. Such circumstances or events could include: a pattern of losses involving the fixed asset; a decline in the market value for a particular fixed asset; and an adverse change in the business or market in which the fixed asset is involved.

When a review for impairment is carried out under UK GAAP, the carrying value of the asset, or group of assets if it is not reasonably practicable to identify cash flows arising from an individual fixed asset, is compared with the recoverable amount of that asset or group of assets. The recoverable amount is determined as being the higher of the expected net realisable value or the present value of the expected cash flows attributable to that asset or groups of assets. The discount rate used to determine the present value is an estimate of the rate the market would expect on an equally risky investment and is calculated on a pre-tax basis. Estimates of future cash flows and the selection of appropriate discount rates relating to particular assets or groups of assets involve the exercise of a significant amount of judgement.

At 31 March 2005, we carried out reviews for impairments in respect of goodwill in general, and other assets relating to interconnectors, LNG, and certain telecom activities. We determined that an impairment of £2 million to goodwill and £2 million to tangible fixed assets relating to a telecoms activity was required but we did not recognise any other impairments.

During the year ended 31 March 2004, we carried out reviews for impairments in respect of goodwill in general, and other assets attributable to Advantica, telecoms, metering, interconnectors and LNG. We determined that the carrying value of goodwill and tangible fixed assets related to Advantica and telecoms were impaired based on estimates of future operating results of the respective asset groups. As a result, we recognised within restructuring costs an impairment charge of approximately £20 million.

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Replacement expenditure

This expenditure represents the cost of planned maintenance on gas mains and services assets, the vast majority of which relates to the Group's UK gas distribution business. This expenditure is principally undertaken to maintain the safety of the gas network in the UK and is written off to the profit and loss account as incurred, as such expenditure does not enhance the economic performance of those assets. If such expenditure in the future were considered to enhance these assets, it would be capitalised and treated as an addition to tangible fixed assets, thereby significantly affecting the reporting of future results.

The total amount charged to the profit and loss account in respect of replacement expenditure during the year ended 31 March 2005 was £474 million (2003/04: £388 million). This accounting policy materially affects only the results of the UK gas distribution segment.

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Regulatory assets

These assets are recorded in the accounts under UK GAAP in accordance with the principles of SFAS 71 'Accounting for the Effects of Certain Types of Regulation', a US GAAP accounting standard. SFAS 71 provides that certain costs may be deferred on the balance sheet (referred to as 'regulatory assets') if it is probable that the costs will be recovered through future increases in regulated revenue rates. An entity applying SFAS 71 does not need absolute assurance prior to capitalising a cost, only reasonable assurance. If the principles of SFAS 71 were not applicable, it is likely that this would result in the full or partial non-recognition of these regulatory assets and thereby materially alter the view given by the accounts.

In applying the principles of SFAS 71, UK GAAP measurement principles are followed in the preparation of the Group's UK GAAP results. Regulatory assets under UK GAAP are only recognised if a US GAAP regulatory asset has already been recognised; furthermore only those regulatory assets arising as a result of a past transaction or event are recorded under UK GAAP. Regulatory assets are only recognised in respect of US activities and primarily relate to the US electricity and gas distribution and US stranded cost segments.

The total carrying value of regulatory assets, under UK GAAP, at 31 March 2005 amounted to £2,771 million (£3,111 million at 31 March 2004).

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Turnover

Turnover includes an assessment of energy and transportation services supplied to customers between the date of the last meter reading and the year end. Changes to the estimate of the energy or transportation services supplied during this period would have an impact on the reported results of the Group.

In our US electricity transmission and US electricity and gas distribution segments, estimates of energy supplied are based on a combination of known energy purchases and the historical pattern of billings information. Our estimate of unbilled revenues for these segments amounted to £97 million, 3% of total annual segmental revenues, at 31 March 2005 (£85 million, 2%, at 31 March 2004).

In our UK electricity and gas transmission and UK gas distribution segments, turnover in respect of transportation services supplied includes an estimate for transportation services supplied but not yet invoiced, which substantially represents the transportation services supplied in respect of the last month of the year. The estimate of unbilled turnover is determined as the total of commodity services supplied, less amounts already billed during the year. Total commodity services supplied is calculated from the actual volume of gas transported at estimated weighted average prices, based on recent history and the value of contracted capacity services supplied. Our estimate of unbilled revenues at 31 March 2005 for these segments amounted to £276 million, 7% of total annual segmental revenues (£287 million, 7%, at 31 March 2004).

Under UK GAAP, the Group is not permitted to recognise and has not recognised any liability for amounts received or receivable from customers in excess of the maximum amount allowed for the year under regulatory agreements that will result in an adjustment to future prices.

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Pensions and other post-retirement benefits

The Group operates a number of defined benefit schemes for its employees. In addition, other post-retirement benefits are provided to employees within the Group's US businesses. The cost of providing pensions and other post-retirement benefits is charged to the profit and loss account on a systematic basis over the service lives of the employees in the scheme in accordance with Statement of Standard Accounting Practice No. 24 (SSAP 24).

Pension and other post-retirement benefits are inherently long term, and future experience may differ from the actuarial assumptions used to determine the net charge for 'pension and other post-retirement charges'. Note 7 to the accounts describes the principal discount rate, earnings increase, and pension/healthcare payment increase assumptions that have been used to determine the pension and post-retirement charges in accordance with current UK GAAP. The calculation of any charge relating to 'pensions and other post-retirement benefits' is clearly dependent on the assumptions used, which reflects the exercise of judgement. The assumptions adopted are based on prior experience, market conditions and the advice of plan actuaries.

Each year, we choose a discount rate for each scheme which reflects yields on high-quality fixed-income investments, which may be increased for SSAP 24 purposes to allow for higher returns expected over the longer term from the schemes' equity holdings. The pension liability and future pension expense both increase as the discount rate is reduced.

At 31 March 2005, the Group's prepaid pension asset was £38 million, compared with £19 million at the end of 2003/04 and the Group's pension and other post-retirement benefits provision was £512 million, compared with £464 million at the end of 2003/04.

For the year ended 31 March 2005, the Group recognised a charge excluding exceptional items for pensions and other post-retirement benefits of £231 million (before tax), lower than the £264 million net charge in 2003/04, both before amounts capitalised and amounts deferred as regulatory assets.

The Group has also provided disclosures in accordance with FRS 17 indicating the significantly different results and balance sheet position that would have resulted had FRS 17 been adopted instead of SSAP 24. These disclosures are in note 7 to the accounts. Applying FRS 17 would have reduced the net charge, excluding exceptional items for 'pensions and other post-retirement benefits' by £83 million before tax and reduced net assets by £1,107 million.

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Restructuring costs

The application of UK GAAP measurement principles results in the recognition of restructuring costs, mainly redundancy related, when the Group is irrevocably committed to the expenditure, with the main features of any restructuring plan being communicated to affected employees. If material, these costs are recognised as exceptional.

Restructuring costs recognised by the Group are referred to in 'Exceptional items' for each year and are discussed earlier in this Financial Review.

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Derivative financial instruments

Derivatives are used by the Group to manage its interest rate, foreign currency, and commodity price risks in respect of expected energy usage. All such transactions are undertaken to provide a commercial hedge of risks entered into by the Group.

UK GAAP applies an 'historical cost' and 'hedge accounting' model to these derivatives. Substantially, this model results in gains and losses arising on derivatives being recognised in the profit and loss account or statement of total recognised gains and losses at the same time as the gain or loss on the item being hedged is recognised. Index-linked swap contracts are carried in the UK GAAP balance sheet within creditors, with a total liability amounting to £327 million at 31 March 2005 (£391 million at 31 March 2004). The best estimate of this liability was the estimated market value of the swaps at the balance sheet date determined on the basis of the technique discussed in Valuation and sensitivity analysis of Treasury policy.

The application of a 'fair value' model would result in derivatives being marked to market. Gains or losses relating to these derivatives may or may not be recognised in the profit and loss account or statement of total recognised gains and losses at the same time as any related gains or losses on underlying economic exposures, depending upon whether the derivatives are deemed to have a hedging relationship.

Note 21 to the accounts gives a significant amount of detail relating to the Group's financial instruments. This includes the identification of the difference between the carrying value and fair value of the Group's financial instruments, including derivatives.

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Environmental liabilities and decommissioning costs

Provision is made for liabilities arising from environmental restoration, remediation and decommissioning costs relating to various sites owned by the Group, as described in note 22 to the accounts. The calculations of these provisions are based on estimated cash flows relating to these costs discounted at an appropriate rate where the impact of discounting is material. The total costs and timing of cash flows relating to environmental and decommissioning liabilities are based on management estimates supported by the use of external consultants.

At 31 March 2005, we have recorded provisions for environmental liabilities and decommissioning costs totalling £596 million. A range of possible recorded provision balances was possible if different assumptions had been used. For example, a 10% increase in the projected net cash outflows would increase the total environmental and decommissioning provision balance by approximately £60 million. The provisions can also be affected by the timing of cash flows and from changes in the discount rates used. A 1% decrease in the discount rates used to calculate the provisions would increase the total balance by approximately £36 million.

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Taxation

The Group's tax charge is based on the profit for the year and tax rates in effect. The determination of appropriate provisions for taxation requires us to take into account anticipated decisions of tax authorities and estimate our ability to utilise tax benefits through future earnings and tax planning. Our estimates and assumptions may differ from future events.

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