The Group and the Company adopted IAS 32 Financial Instruments: Disclosure and Presentationand IAS 39 Financial Instruments: Recognition and Measurementfrom 1 April 2005. No comparative information has been presented under these standards for the year ended 31 March 2005, in accordance with the transition provisions of IFRS 1. The comparative figures have been prepared in accordance with FRS 4 Capital Instrumentsand FRS 13 Derivatives and other financial instruments: disclosures.
Exposure to commodity price and volume risk, counterparty credit risk, interest rate risk, currency risk and liquidity risk arises in the normal course of the Group’s business. Derivative financial instruments are entered into to hedge exposure to risk. The objectives and policies for holding or issuing financial instruments and similar contracts, and the strategies for achieving those objectives that have been followed during the year are explained below. The Risk Committee, a standing committee of the Board comprising three executive directors and senior managers from the Generation and Supply and Finance functions, oversees the control of these activities. This committee is discussed further in the Directors’ Report.
The Group’s Treasury function is responsible for managing the banking and liquidity requirements of the Group, risk management relating to interest rate and foreign exchange exposures, and for managing the credit risk relating to the banking counterparties with which it transacts. The department’s operations are governed by policies determined by the Board and any breaches of these policies are reported to the Risk Committee and Audit Committee.
(i) Risk
Counterparty credit risk and liquidity risk
Credit risk arising from the Group’s normal commercial operations is controlled by individual business units operating in accordance with group policies and procedures. Generally, individual business units enter into contracts or agreements with counterparties having investment grade credit ratings only, or where suitable collateral or other security has been provided. Counterparty credit validation is undertaken prior to contractual commitment.
Credit risk management for the Group’s regulated businesses is performed in accordance with industry standards as set out by the Regulator and is controlled by the individual business units. The Group’s greatest credit risks lie with the non-regulated operations of the Generation and Supply business and the activities carried out by the Group’s Treasury function, for which specific credit risk controls that match the risk profile of those activities, are applied.
Liquidity risk, the risk that the Group will have insufficient funds to meet liabilities, is managed by the Group’s Treasury function.
Generation and Supply
Exposure to credit risk in the supply of electricity and gas arises from the potential of a customer defaulting on their invoiced payables. The financial strength and creditworthiness of business customers is assessed before commencing, and during, their contract of supply. Domestic customers’ creditworthiness is reviewed from a variety of internal and external information.
Exposure to credit risk in the procurement of wholesale energy and fuel is managed by reference to agreed transaction credit limits which are determined by whether the counterparty:
(i) holds an investment grade credit rating; or
(ii) can be assessed as adequately credit worthy in accordance with internal credit rules using information from other external credit agencies; or
(iii) can provide a guarantee from an investment grade rated entity or post suitable collateral or provide other acceptable assurances in accordance with group procedures where they have failed to meet the above conditions; or
(iv) can be allocated a non-standard credit limit approved by the Risk Committee within its authorised limits as delegated by the Group Board.
Credit support clauses or side agreements are typically included or entered into to protect the Group against counterparty failure or non- delivery. Within the Generation and Supply business, increasing volumes of commodity derivative products are now traded through cleared exchanges to further mitigate credit risk. Such exchanges are subject to strict regulation by the UK Financial Services Authority (FSA) and participants in these exchanges are obliged to meet rigorous capital adequacy requirements.
Individual counterparty credit exposures are monitored by category of credit risk and are subject to approved limits. At 31 March 2006, the Group had pledged £100m of cash collateral and letters of credit and had received £660m of cash collateral and letters of credit principally to reduce exposures on commodity price risk.
Treasury
In relation to the Group’s liquidity risk, the Group’s relationship banks (defined as those banks who support the company’s financing activities through their ongoing participation in the committed lending facilities that are maintained by the Group), are each allocated financial limits, subject to the maintenance of a minimum credit rating of “A” or equivalent allocated by a recognised major ratings group. In respect of short- term cash management, counterparties are subject to review and approval according to defined criteria.
Bank credit exposures, which are monitored and reported on daily, are calculated on a formulaic, risk-weighted basis. Any issues relating to these credit exposures are presented for discussion and review by the Risk Committee.
85
29. FINANCIAL INSTRUMENTSContinued
(i) Risk Continued
Energy commodity price risk
The Group’s Generation and Supply business faces exposure to energy commodity price movements as part of its normal course of business. This arises from the Group’s requirement to source gas or electricity to supply customers, or to procure fuel to produce electricity from its generation assets.
The Group’s strategy is to procure gas, electricity and fuel through longer term contracts including forwards and futures contracts and financial instruments which will reduce the volume required to be procured in the short-term market. Alternatively, reduced retail sales activity may be seen as an appropriate strategy in times of rising commodity prices. The contracts entered into are done so primarily for own use or hedging purposes and not for trading purposes.
The capacity to generate electricity beyond the level currently committed to existing customers is also recognised as an exposure to volatile wholesale electricity prices.
The resulting energy commodity price risk is quantified by the use of a Value at Risk (VaR) model which provides an estimate of the potential change to the Group’s forecast profits over a given period and to a given confidence level. The calculated financial risk is controlled through the imposition of a number of risk limits approved by the Risk Committee.
Energy volume risk
Inherently linked to the Group’s energy commodity price risk is the Group’s energy volume risk. This risk arises from the requirement to match volumes of procured gas, electricity and power station fuel with demand for gas and electricity by its customers, which can vary from expectations and result in a requirement to close the resulting positions at unfavourable prices. This risk is managed through the ability to increase or decrease energy production either in the form of flexible purchase contracts or assets such as pumped storage generating plant, flexible hydro generating plant, standby oil plant and gas storage.
The Group has assessed its portfolio of sources of production and supply and has been able to identify contracts which are held for own use (which are not accounted for as financial derivatives) and those which are held to manage commodity price and volume risk. Certain physical contracts are treated as the hedging instrument in documented cash flow hedging relationships where the hedged item is the forecast future purchase requirement to meet production or customer demand.
Currency risk
In addition to spot purchases of foreign currency, the Group uses forward contracts, swaps and options to manage its exposures to foreign exchange risk. All such exposures are transactional in nature, and relate primarily to procurement contracts, commodity purchasing and related freight requirements, commodity hedging, long term plant servicing and maintenance agreements, and the purchase and sale of carbon emission certificates. Significant exposures are reported to, and discussed by, the Risk Committee on an ongoing basis and additionally form part of the bi-annual Treasury report to the Audit Committee.
At the balance sheet date, the total nominal value of outstanding forward foreign exchange contracts that the Group has committed to is:
2006 2005
£m £m
Forward foreign exchange contracts 777.1 521.8
The Group has no subsidiaries outside the UK and therefore has minimal exposure to currency translation risk arising from operations outside the UK.
Interest rate risk
Interest rate risk derives from the Group’s exposure to changes in value of an asset or liability or future cash flows through changes in interest rates.
The Group’s policy is to manage this risk by stipulating that a minimum of 50% of Group borrowings be subject to fixed rates of interest, either directly through the debt instruments themselves or through the use of derivative financial instruments. Such instruments include interest rate swaps and options, forward rate agreements and, in the case of debt raised in currencies other than sterling, cross currency swaps.
Although interest rate derivatives are primarily used to hedge risk relating to current borrowings, under certain circumstances they may also be used to hedge future borrowings. Any such pre-hedging is unwound at the time of pricing the underlying debt, either through cash settlement on a net present value basis or by transacting offsetting trades. The floating rate borrowings mainly comprise commercial paper issued at interest rates less than LIBOR and cash advances from the European Investment Bank (EIB).
Notes on the Financial Statements Continued
for the year ended 31 March 200686
29. FINANCIAL INSTRUMENTSContinued
(i) Risk Continued
Effective interest rate analysis
In respect of income earning financial assets and interest bearing financial liabilities, the following table indicates their effective interest rates as at the balance sheet date and the periods in which they mature:
At 31 March 2006 Effective Within 1-2 2-5 More than
interest rate Total 1 year years years 5 years
% £m £m £m £m £m
Cash and cash equivalents 4.22% (34.4) (34.4) – – –
Bank overdrafts 5.50% 6.1 6.1 – – –
Long term bonds 5.77% 1,186.5 150.0 61.5 – 975.0
Other bank loans – fixed 6.33% 336.3 19.6 46.4 56.6 213.7
Other bank loans – floating 4.52% 385.0 235.0 – – 150.0
Interest rate swaps – fixed 5.81% 340.0 – – 75.0 265.0
Interest rate swaps – floating 4.69% 325.0 125.0 200.0 – –
Convertible debt 3.75% 300.0 – – 300.0 –
Finance lease obligations 8.00% 1.6 0.5 – 0.8 0.3
Non-recourse borrowings 6.44% 26.2 6.5 6.5 13.2 –
(ii) Fair Values
The fair values of the Group’s financial assets and financial derivatives and the carrying amounts in the Group’s consolidated balance sheet are analysed below. Balances included in the analysis of primary financial assets and liabilities include cash and cash equivalents, loans and borrowings, trade and other receivables, trade and other payables and provisions, all of which are disclosed separately. Own use commodity contracts are not considered to be financial instruments.
Summary fair values
The fair values of the primary financial assets and liabilities together with their carrying values are as follows:
2006 2006
Carrying Fair
Value Value
£m £m
Financial Assets
Trade and other receivables 1,672.3 1,672.3
Cash and cash equivalents 2.1 2.1
Other financial assets (i) 32.3 32.3
Financial Liabilities
Trade and other payables (2,231.3) (2,231.3)
Provisions (81.8) (81.8)
Bank loans and overdrafts (ii) (726.8) (747.7)
Long-term bonds (iii) (1,180.5) (1,232.0)
Convertible bond (iii) (280.8) (389.4)
Non-recourse borrowings (26.2) (26.2)
Obligations under Finance Leases (1.6) (1.6)
(i) Represents carrying value of equity in unlisted investments, included at fair value.
(ii) Fair value of overdrafts is equivalent to carrying value due to short-term maturity.
(iii) Fair values have been determined with reference to closing market prices.
87
29. FINANCIAL INSTRUMENTSContinued
(ii) Fair Values Continued
Financial derivative instruments – disclosure
For disclosure purposes, derivative financial instruments are classified into two categories, operating derivatives and financing derivatives. Operating derivatives include all qualifying commodity contracts including those for electricity, gas, oil, coal and carbon. Financing derivatives include all fair value and cash flow interest rate hedges, non-hedge accounted mark to market (MTM) interest rate derivatives, cash flow foreign exchange hedges and non-hedge MTM accounted foreign exchange contracts. Non-hedge accounted contracts are treated as held for trading MTM. The carrying value is the same as the fair value for all instruments. All balances are stated gross of associated deferred taxation.
Movement Movement
At in the year: in the year: At
1 April Income Hedge 31 March
2005 Statement (ii) Reserve (ii) Transfer (i) 2006
£m £m £m £m £m
Operating derivatives
Cash flow hedges – commodity (iii) 49.2 – (32.4) – 16.8
MTM – commodity (iii) 80.9 (14.4) – – 66.5
130.1 (14.4) (32.4) – 83.3
Financing derivatives
Cash flow hedges – interest rate (iv) (13.2) (0.1) 1.5 – (11.8)
Fair value hedges – interest rate (iv) (3.8) 2.3 – – (1.5)
MTM – interest rate (iv) (74.6) (47.8) – 89.5 (32.9)
Cash flow hedges – currency (v) (9.6) – 14.0 – 4.4
MTM – currency (v) (1.0) 4.6 – – 3.6
(102.2) (41.0) 15.5 89.5 (38.2)
Financial assets / (liabilities) 27.9 (55.4) (16.9) 89.5 45.1
Hedged items (vi)
Loans and borrowings (note 21) 3.9 (2.5) – – 1.4
Net balance sheet 31.8 (57.9) (16.9) 89.5 46.5
The net movement reflected in the Income Statement can be analysed thus:
2006 £m Operating derivatives
Total result on operating derivatives (vii) 176.1
Less: amounts settled in the year (viii) (190.5)
Movement in unrealised derivatives (14.4)
Financing derivatives (and hedged items)
Total result on operating derivatives (vii) (47.3)
Less: amounts settled in the year (viii) 3.8
Movement in unrealised derivatives (43.5)
Total (57.9)
(i) Represents previously contingent interest rate swap held and entered into by Scotia Gas Networks plc and transferred at date of acquisition of the gas distribution networks at 1 June 2005 to the investment in the jointly controlled entity (note 14).
(ii) Gains or losses transferred to the hedge reserve represent amounts in respect of mark-to-market movements on effective cash flow hedge relationships which have not matured. Where hedge accounting is discontinued, any cumulative gain or loss on the hedging instrument previously recognised in equity remains in equity until the forecast transaction occurs. If the transaction is no longer expected to occur, the cumulative gain or loss recognised in equity is recognised in the income statement. The movement on the hedge reserve in the year includes the impact of a transfer of an ineffective, loss-making cash flow hedge item to the income statement. See note (v) for policy basis.
(iii) These fair values represent the contracts which have not been designated as own use purchase contracts in line with the provisions of IAS 39. The fair values at the balance sheet date represent the unrealised gains and losses from holding commodity contracts for future delivery. These fair values are subject to change in commodity market prices. The method of determining fair value is described in ‘basis of determining fair value’ below.
(iv) The interest rate derivative instruments outstanding at the balance sheet date had remaining lives of between nine months and 31 years and fixed rates of interest payable ranging from 4.01% to 8.22%. The gross fair value of these instruments was a £46.2m liability. The method of determining fair value is described in ‘basis of determining fair value’ below.
Notes on the Financial Statements Continued
for the year ended 31 March 200688
29. FINANCIAL INSTRUMENTSContinued
(ii) Fair Values Continued
Financial derivative instruments – disclosure Continued
(v) At 31 March 2006, the fair value of the Group’s currency derivatives is estimated to be approximately £8.0m. This amount is based on market values of equivalent instruments at the balance sheet dates. The method of determining fair value is described in ‘basis of determining fair value’ below. For both (iv) and (v), the effective portion of the fair value movement of qualifying cash flow hedges is recorded in the hedge reserve. If the hedged asset or liability no longer exists or the forecast transaction is no longer expected to occur, the previously deferred amount in equity is recycled to the income statement.
(vi) The fair value adjustments to loans and borrowings designated as the hedged item in effective fair value hedge relationships are analysed. This provides a full analysis of the impact of the adoption of IAS 39 in the financial year. This is reflected in note 21 to these financial statements.
(vii) Total result on derivatives (operating or financial) in the income statement represents amounts in respect of realised gains or losses on derivatives, mark-to-market movements on effective fair value hedge relationships which have not matured, mark-to-market movements on other derivatives held or acquired during the year and mark-to-market movements on the ineffective portion of cash flow hedge relationships which have not matured.
(viii) Amounts settled in the year represent the unwind of opening unrealised financial derivative assets or liabilities which have matured or been delivered in the financial year and other derivatives transacted in the year which have matured or been delivered.
The net financial assets / (Iiabilities) have been offset in this note. The following is an analysis of these items for financial reporting purposes.
Consolidated Company 2006 2005 2006 2005 £m £m £m £m Financial Assets Non-current 24.8 – – – Current 157.6 – – – 182.4 – – – Financial liabilities Non-current (77.5) – (20.9) – Current (59.8) – – – (137.3) – (20.9) – Loans (note 21) 1.4 – – – 46.5 – (20.9) –
Basis of determining fair value
Closing rate market values have been used to determine the fair values of the interest rate and foreign currency contracts and denominated long-term fixed rate debt. Commodity contracts fair values are based on published price quotations where liquid markets exist and on future price forecasts where markets are illiquid. The estimates applied reflect the management’s best estimates of these factors.
(iii) Comparatives for the year to 31 March 2005
As set out in the accounting policies on page 53, the financial information provided in respect of financial instruments as at 31 March 2005 is based on the Group’s policies under FRS 4 and does not take into account the requirements of IAS 32 and IAS 39.
Interest rate profile
At 31 March 2005, the Group had fixed interest investments of £218.5m which were part of the financing activities of the Group. After taking into account interest rate swaps and currency swaps, the interest rate profile of the Group’s total borrowings was as follows:
Borrowings Fixed rate borrowings
Weighted average Weighted average period for which Total Floating rate Fixed rate interest rate rate is fixed
£m £m £m % Years
89
29. FINANCIAL INSTRUMENTSContinued
(iii) Comparatives for the year to 31 March 2005 Continued
The floating rate borrowings mainly comprise commercial paper bearing interest rates less than LIBOR at the date of issue and cash advances from the European Investment Bank.
Fair values
Set out below is a comparison of book values and fair values of the Group’s other financial assets and liabilities:
2005
Book value Fair value
£m £m
Primary financial instruments held or issued to finance the Group’s operations
Short-term borrowings 22.4 24.6
Long-term borrowings 1,640.6 1,706.7
Short-term deposits 218.5 218.5
Derivative financial instruments held to manage the interest rate and currency profile
Interest rate swaps and options – (31.1)
Cross currency swaps – (5.5)
Foreign exchange swaps and forward contracts – (10.9)
Oil and coal swaps – 82.7
Market values have been used to determine the fair values of the interest rate swaps and options, foreign currency contracts, oil price contracts and Sterling denominated long-term fixed rate debt. All the other fair values shown above have been calculated by discounting cash flows at prevailing interest rates.