Operating and Financial Review

Operating Review

UK Gas Distribution

Background information

Our UK Gas Distribution business currently comprises almost all of Great Britain's gas distribution system. The gas distribution system consists of approximately 170,000 miles of distribution pipelines. Gas is transported on behalf of approximately 70 active gas shippers from the NTS through the eight regional distribution networks to around 21 million consumers.

Following the planned sales of four of our regional gas distribution networks (Scotland, Wales and West, North of England and South of England), which are expected to be completed on 1 June 2005, our retained gas distribution system will consist of approximately 82,000 miles of distribution pipeline.

We are and will continue to be responsible for the safety, development, maintenance and daily operation of our UK Gas Distribution system.

Following completion of the network sales the national emergency number (0800 111 999) will remain the same, which we will continue to manage on behalf of all gas transporters.

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Regulation

We are regulated through our subsidiary Transco plc, which owns and operates our UK Gas Distribution business under the terms of our gas transporter licence.

The price control that applies to the UK Gas Distribution business takes into account Ofgem's estimates of operating expenditure, capital expenditure, replacement expenditure and allowed rate of return (which is currently set at a real pre-tax rate of 6.25% on our regulatory asset value). As at 31 March 2005, our regulatory asset value is estimated as approximately £11 billion.

On 1 April 2002, the activities of the UK Gas Distribution business became subject to a separate five-year price control formula ('distribution price control formula'), as distinct from the gas transmission price control. With effect from 1 April 2004, this single price control formula was disaggregated into eight separate price control formulae ('networks price control formulae') to cover the activities of the eight regional gas distribution networks.

The networks price control formulae take the same form as the distribution price control formula, with a maximum allowed revenue assigned to each network. Each formula retains a 65% fixed, 35% variable revenue associated with transportation volume changes, a mains replacement incentive mechanism and the pass-through of prescribed rates and gas transporter licence fees.

Each network was allocated a regulatory asset value associated with its distribution assets using an estimate of the UK Gas Distribution business's regulatory asset value as at 1 April 2002. The allocation was aimed to minimise unnecessary regional differentials in transportation charges. The networks price control formulae also incorporates the same allowed return assumptions at a real pre-tax rate of 6.25%.

Each network is subject to its own mains replacement incentive mechanism and retains 33% of any outperformance against Ofgem's annual cost targets as additional return or, alternatively, bears 50% of any overspend if it underperforms. In 2004/05, it is estimated that we earned a small additional return from the operation of the incentive mechanism for mains replacement, which is lower than the previous year. The lower return is primarily due to a reduction in Ofgem allowances compared with the previous year, together with inflationary pressures acting in our labour and contract costs.

Ofgem has indicated that it will extend the existing five-year gas distribution price control for a further year, with a mini price control review taking place to set revenue for 2007/08, followed by a full price control review.

New incentive schemes are being designed which will apply to both the sold networks and our retained networks following completion of the network sales.

With effect from 1 May 2005, our UK Gas Distribution business (and each of the networks which we plan to sell) and UK gas transmission business each hold a gas transporter licence. These licences are derived from the original integrated transmission and distribution licence, but have been substantially amended in order to distinguish between the separate activities of transmission and distribution gas transportation, and to facilitate the post sales environment with multiple gas distribution transporters.

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Safety

UK Gas Distribution has continued to make progress towards our Group goal of zero injuries and work-related ill-health. Over the last year, we have achieved an 18% reduction in LTIs to our employees, from 119 in 2003/04 to 97 in 2004/05.

We continue to make progress in our management of occupational illness with a comprehensive health surveillance programme for our industrial employees monitoring issues such as Hand Arm Vibration Syndrome.

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Operating performance

Gas demand was 697 TWh in 2004/05, compared with 706 TWh in 2003/04 and 708 TWh in 2002/03. The decrease was due to the very mild weather experienced. If the weather had corresponded to seasonal normal temperatures, it is estimated that gas demand would have been 729 TWh in 2004/05, compared with 732 TWh in 2003/04 and 730 TWh in 2002/03.

While there has been underlying growth of 0.4% in demand from small users (2003/04: 1.9% demand growth), 2004/05 saw a 2.6% reduction in underlying demand from business and other large users (2003/04: 3.5% reduction), which can be attributed to higher gas prices.

We again exceeded our safety-related standards of service targets with more than 98% of 'uncontrolled' gas escapes (where the gas leak cannot be controlled by turning the gas supply off at the meter) attended within one hour, and more than 99% of 'controlled' gas escapes (where the gas leak can be controlled at the meter) attended within two hours.

Over the year, we have seen a significant improvement in performance against all of our connections-related standards of service, meeting all but two of our performance targets. Low levels of performance in the early part of the year against these two standards adversely affected our overall performance for the year. Ofgem is currently investigating our performance in relation to standards of service associated with connections activities for 2003/04.

We have been working with Ofgem and the wider industry to develop new connections-related standards of service which came into effect on 1 May 2005. These standards better reflect the current connections market and provide more comprehensive protection to consumers requiring a gas connection service.

Furthermore, it has become increasingly apparent that the prospects for competition in the domestic connections market are limited. Therefore, we have decided to deliver this element of the service from within our UK Gas Distribution business to improve service to domestic customers further.

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Financial performance
Operating profit

Text-only version – Operating profit

The results of the UK Gas Distribution segment for the years ended 31 March 2005, 2004 and 2003 were as follows.

Years ended 31 March
 
UK Gas Distribution
2005
 
£m		2004
(restated)
£m		2003
(restated)
£m
Turnover2,2152,2452,089
Operating costs excluding exceptional items(1,645)(1,529)(1,542)
Adjusted operating profit570716547
Exceptional items(180)(89)(111)
Operating profit390627436

The £30 million reduction in UK Gas Distribution turnover comparing 2004/05 with 2003/04 was primarily due to a £53 million reduction in revenue recovered under the distribution price control formula. This arose from a 3.5% price cut implemented in April 2004, which reduced income by £43 million, and a £14 million reduction because of the relatively mild weather, partially offset by a £4 million increase from growth in underlying volumes. This net reduction in income was partially offset by a £17 million increase in work undertaken by Transco plc's workforce on behalf of the Group's regulated and non-regulated Metering businesses.

The £156 million increase in turnover comparing 2003/04 with 2002/03 was primarily due to an increase in revenue recovered under the distribution price control formula of £84 million, mainly because of a 5% price increase implemented in October 2003 which added £79 million, combined with an increase in underlying volumes which added £21 million, but offset by an £11 million reduction because of relatively mild weather. In addition, there was an increase of £72 million in other income primarily because of increased work for the Group's other businesses.

The £116 million increase in UK Gas Distribution operating costs, excluding exceptional items, comparing 2004/05 with 2003/04 was principally because of a planned £86 million increase in expenditure associated with the iron mains replacement programme. The other main factors behind the increase were higher controllable costs (£18 million, discussed below) and increased work for the Group's other businesses (£29 million), partly offset by a lower charge for UK Gas Distribution's share of the Lattice pension deficit (£17 million).

The £13 million reduction in operating costs, excluding exceptional items, comparing 2003/04 with 2002/03 was as a result of a £97 million reduction in controllable costs (discussed below) offset inter alia by higher costs associated with the increased work for the Group's other businesses (£65 million) and a first-time charge in respect of the Lattice pension deficit (£23 million).

Further cost efficiencies have been achieved against the backdrop of substantial organisational change and the significant volume of work required to design and implement a new industry structure as a result of the planned network sales. Controllable costs, which exclude increases in ongoing pension costs and gas commodity prices, decreased by 3% in real terms during the year and have now decreased by 23% in real terms since March 2002.

The £97 million reduction in controllable operating costs comparing 2003/04 with 2002/03 was the result of restructuring plans announced in September 2002, together with the effects of investment in technology and the centralisation of activities, and aided by synergies achieved since the merger of National Grid Group plc and Lattice Group plc.

The £86 million increase in replacement expenditure comparing 2004/05 with 2003/04 was in line with the planned increase in the iron mains replacement programme agreed with the Health and Safety Executive (HSE).

The £17 million reduction in replacement expenditure comparing 2003/04 with 2002/03 was associated with the completion of the medium pressure ductile iron replacement programme in 2002/03 and the commencement of the iron mains replacement programme, with 2003/04 representing the lowest year of expenditure planned until 2007.

The £146 million reduction in UK Gas Distribution adjusted operating profit comparing 2004/05 with 2003/04 was the result of the factors referred to above, with the increased replacement expenditure and lower price controlled income being the two main factors.

The £169 million increase in adjusted operating profit comparing 2003/04 with 2002/03 was the result of higher price controlled income and lower controllable costs, as described above.

Exceptional items explain the difference between adjusted operating profit and operating profit. UK Gas Distribution exceptional items in 2004/05 comprised £62 million in connection with the network sales process, £109 million in respect of internal restructuring initiatives and a £9 million charge reflecting a revised estimate of environmental liabilities.

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Investment in the networks
Capital investment

Text-only version – Capital investment

Growth capital expenditure in the reinforcement and extension of the UK Gas Distribution network was £272 million in 2004/05, compared with £293 million in 2003/04 and £380 million in 2002/03.

During the year ended 31 March 2005, we made around 120,000 new connections to our network.

Capital expenditure reduced from £293 million in 2003/04 to £272 million in 2004/05 because of a lower level of investment in high pressure pipeline projects, such projects being dependent on forecasts of future demand.

During 2004/05 we spent £474 million on replacement expenditure. Ofgem treats 50% of projected replacement expenditure as recoverable during the price control period and 50% as recoverable over future years, as another form of capital investment in the network.

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Network sales

The process to implement the planned sales of four of our eight gas distribution networks (Scotland, Wales and West, North of England and South of England), announced in August 2004, has progressed steadily over the past year. In January of this year, Ofgem gave its conditional approval to the sale of the four gas distribution networks. This was followed by Department of Trade and Industry consent later that month.

Since then, we have developed a network code with the industry that will be suitable for us and independent distribution gas transporters. This revised code has become the Uniform Network Code.

A Joint Office of Gas Transporters (an unincorporated association) has been established in order to administer and coordinate certain functions that result from common licence obligations imposed on both transmission and distribution gas transporters. The role of the Joint Office will include, for example, the coordination of transportation charge changes and the administration of the Uniform Network Code modification procedures.

We have established xoserve ltd, which will act as the common service provider ('agency') envisaged by the licences of transmission and distribution gas transporters. The company was formed from the internal departments previously known as shipper services. The initial role of xoserve ltd is to continue to provide essential services and systems on a common basis to network gas transporters. These services include the key roles of transportation invoice production, supply point administration services, data processing and, in relation to the NTS, managing the financial consequences of energy imbalances. The key objective in creating xoserve ltd was to minimise the changes shippers would need to make as a result of network sales and to improve industry efficiency by providing common commercial interfaces between shippers and multiple distribution gas transporters.

Ofgem has also completed a number of public consultations concerning the establishment of the appropriate industry frameworks. Ofgem's impact assessments and detailed cost benefit analysis concluded that the sales will potentially generate approximately £225 million net benefit to customers.

On 1 May, having received Ofgem approval, we transferred the four sold networks into four new wholly-owned subsidiaries of National Grid Transco. On the same date, the Uniform Network Code became effective and the Joint Office and xoserve commenced operations.

Submissions have been made to the HSE to seek their acceptance of the safety cases for the new independent gas networks, which we expect to receive before 31 May 2005. Ofgem's final consent to allow the sales to complete on 1 June is also expected by the end of May.

With anticipated cash proceeds of £5.8 billion, the planned sales represent a major step in value creation. Completion will enable both a £2 billion return of value to our shareholders and repayment of around £2.3 billion of debt.

We remain committed to operating a substantial gas distribution business in Great Britain and we will continue to be the largest operator of gas distribution assets in the country. The retained system will consist of approximately 82,000 miles of distribution pipelines, distributing gas to around 11 million consumers.

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The 'Way Ahead' for our retained distribution networks

The 'Way Ahead' restructuring programme in the West Midlands, London, North West and East of England networks (the networks that we will retain) is advanced. A number of offices have closed and more are set to close over the coming months as we move to a new unified structure which is supported by two key centres, one in Hinckley and the other at our new office in Northampton. This will enable us to place increased emphasis on safety and efficiency, and share best practice across the organisation. It should also enable the delivery of further reductions in controllable costs. This is particularly focused on bringing overheads into line with the smaller size of the retained business. In addition, we have entered into eight year alliances with key contractors to ensure the safe, efficient and sustainable delivery of the iron mains replacement programme.

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