Notes to the consolidated financial statements - supplementary information
33. Financial risk
Our activities expose us to a variety of financial risks: market risk (including foreign exchange risk; fair value interest rate risk; cash flow interest rate risk; commodity price risk); credit risk and liquidity risk. The overall risk management programme focuses on the unpredictability of financial markets and seeks to minimise potential adverse effects on financial performance. Derivative financial instruments are used to hedge certain risk exposures.
Risk management related to financing activities is carried out by a central treasury department under policies approved by the Board of Directors. This department identifies, evaluates and hedges financial risks in close cooperation with the operating units. The Board provides written principles for overall risk management, as well as written policies covering specific areas, such as foreign exchange risk, interest rate risk, credit risk, use of derivative financial instruments and non-derivative financial instruments, and investment of excess liquidity as discussed further in our treasury policy.
(a) Market risk
(i) Foreign exchange risk
National Grid operates internationally and is exposed to foreign exchange risk arising from various currency exposures, primarily with respect to the US dollar. Foreign exchange risk arises from future commercial transactions, recognised assets and liabilities and investments in foreign operations.
With respect to near term foreign exchange risk, we use foreign exchange forwards to manage foreign exchange transaction exposure. Our policy is to hedge a minimum percentage of known contracted foreign currency flows in order to mitigate foreign currency movements in the intervening period. Where cash forecasts are less certain, we generally cover a percentage of the foreign currency flows depending on the level of agreed probability for those future cash flows.
We also manage the foreign exchange exposure to net investments in foreign operations, within a policy range, by maintaining a percentage of net debt and foreign exchange forwards in the relevant currency. The primary managed foreign exchange exposure arises from the US dollar denominated assets and liabilities held by the US operations, with a further small euro exposure in respect to a joint venture investment.
During 2009 and 2008, derivative financial instruments were used to manage foreign currency risk as follows:
| 2009 | 2008 | ||||||||||
| Sterling £m |
Euro £m |
US dollar £m |
Other £m |
Total £m |
Sterling £m |
Euro £m |
US dollar £m |
Other £m |
Total £m |
||
| Cash and cash | |||||||||||
| equivalents | 632 | 4 | 101 | – | 737 | 168 | 6 | – | – | 174 | |
| Financial investments | 1,377 | 132 | 617 | 71 | 2,197 | 1,063 | 92 | 898 | 42 | 2,095 | |
| Borrowings (i) | (12,424) | (7,214) | (6,435) | (720) | (26,793) | (9,111) | (5,342) | (5,769) | (781) | (21,003) | |
| Pre-derivative position |
(10,415) | (7,078) | (5,717) | (649) | (23,859) | (7,880) | (5,244) | (4,871) | (739) | (18,734) | |
| Derivative effect | 2,040 | 7,116 | (8,622) | 652 | 1,186 | 1,069 | 5,301 | (6,016) | 739 | 1,093 | |
| Net debt position | (8,375) | 38 | (14,339) | 3 | (22,673) | (6,811) | 57 | (10,887) | – | (17,641) | |
- (i)
- Includes bank overdrafts.
The overall exposure to US dollars largely relates to our net investment hedge activities as described and shown in note 32.
The currency exposure on other financial instruments is as follows:
| 2009 | 2008 | ||||||||||
| Sterling £m |
Euro £m |
US dollar £m |
Other £m |
Total £m |
Sterling £m |
Euro £m |
US dollar* £m |
Other £m |
Total* £m |
||
| Trade and other | |||||||||||
| receivables | 138 | – | 1,519 | – | 1,657 | 182 | – | 1,134 | – | 1,316 | |
| Trade and other | |||||||||||
| payables | (1,196) | – | (1,421) | – | (2,617) | (1,290) | – | (1,086) | – | (2,376) | |
| Other non-current | |||||||||||
| liabilities | 1 | – | (553) | – | (552) | (18) | – | (417) | – | (435) | |
- *
- Comparatives have been restated for the finalisation of the fair value exercise on the acquisition of KeySpan Corporation (see note 28)
The carrying amounts of other financial instruments are denominated in the above currencies, which in most instances are the functional currency of the respective subsidiaries. Our exposure to US dollars is due to activities in our US subsidiaries. We do not have any other significant exposure to currency risk on these balances.
(ii) Cash flow and fair value interest rate risk
Interest rate risk arises from our borrowings. Borrowings issued at variable rates expose National Grid to cash flow interest rate risk. Borrowings issued at fixed-rates expose National Grid to fair value interest rate risk. Our interest rate risk management policy as further explained under Interest rate risk management is to minimise the finance costs (being interest costs and changes in the market value of debt). Some of our borrowings issued are inflation-linked; that is, their cost is linked to changes in the UK retail price index (RPI). We believe that these borrowings provide a good hedge for regulated UK revenues and our UK regulatory asset values that are also RPI-linked.
Interest rate risk arising from our financial investments is primarily variable being composed of short dated money funds.
The following table sets out the carrying amount, by contractual maturity, of borrowings that are exposed to interest rate risk before taking into account interest rate swaps:
| 2009 £m |
2008 £m |
|
|---|---|---|
| Fixed interest rate borrowings | ||
| In one year or less | (2,103) | (2,620) |
| In more than one year, but not more than two years | (809) | (906) |
| In more than two years, but not more than three years | (1,398) | (642) |
| In more than three years, but not more than four years | (981) | (1,008) |
| In more than four years, but not more than five years | (1,821) | (900) |
| In more than five years | (8,637) | (5,579) |
| (15,749) | (11,655) | |
| Floating interest rate borrowings (including inflation-linked) | (11,044) | (9,348) |
| Total borrowings | (26,793) | (21,003) |
During 2009 and 2008, net debt was managed using derivative instruments to hedge interest rate risk as follows:
| 2009 | 2008 | ||||||||||
| Fixed- rate £m |
Floating- rate £m |
Inflation- linked(i) £m |
Other(ii) £m |
Total £m |
Fixed- rate £m |
Floating- rate £m |
Inflation- linked(i) £m |
Other(ii) £m |
Total £m |
||
| Cash and cash equivalents |
– | 737 | – | – | 737 | – | 174 | – | – | 174 | |
| Financial investments | 217 | 1,922 | – | 58 | 2,197 | 223 | 1,835 | – | 37 | 2,095 | |
| Borrowings (iii) | (15,749) | (6,001) | (5,043) | – | (26,793) | (11,655) | (4,825) | (4,523) | – | (21,003) | |
| Pre-derivative position |
(15,532) | (3,342) | (5,043) | 58 | (23,859) | (11,432) | (2,816) | (4,523) | 37 | (18,734) | |
| Derivative effect (iv) | 148 | 589 | 345 | 104 | 1,186 | 1,814 | (708) | (2) | (11) | 1,093 | |
| Net debt position | (15,384) | (2,753) | (4,698) | 162 | (22,673) | (9,618) | (3,524) | (4,525) | 26 | (17,641) | |
- (i)
- The post derivative impact represents financial instruments linked to the UK RPI.
- (ii)
- Represents financial instruments which are not directly affected by interest rate risk, such as investments in equity, foreign exchange forward contracts or other similar financial instruments.
- (iii)
- Includes bank overdrafts.
- (iv)
- The impact of 2009/10 maturing short-dated interest rate derivatives is included.
(b) Credit risk
Credit risk is the risk of loss resulting from counterparties’ default on their commitments including failure to pay or make a delivery on a contract. This risk is inherent in the Company’s commercial business activities and is managed on a portfolio basis. Credit risk arises from cash and cash equivalents, derivative financial instruments and deposits with banks and financial institutions, as well as credit exposures to wholesale and retail customers, including outstanding receivables and committed transactions.
Treasury related credit risk
Counterparty risk arises from the investment of surplus funds and from the use of derivative instruments. As at 31 March 2009 the following limits were in place for investments held with banks and financial institutions:
| Maximum limit £m |
Long-term limit £m |
|
|---|---|---|
| Rating | ||
| AAA rated G8 sovereign entities | Unlimited | Unlimited |
| Triple ‘A’ vehicles | 265 | 225 |
| Triple ‘A’ range institutions (AAA) | 905 to 1,365 | 455 to 715 |
| Double ‘A’ range institutions (AA) | 540 to 680 | 275 to 340 |
| Single ‘A’ range institutions (A) | 185 to 265 | 95 to 135 |
As at 31 March 2009 and 2008, we had a number of exposures to individual counterparties. In accordance with our treasury policies and exposure management practices, counterparty credit exposure limits are continually monitored and no individual exposure is considered significant in the ordinary course of treasury management activity. Management does not expect any significant losses from non-performance by these counterparties.
The counterparty exposure under derivative financial contracts as shown in note 17 was £2,126m (2008: £1,526m); after netting agreements it was £1,674m (2008: £1,277m). This exposure is further reduced by collateral received as shown in note 21. Additional information for commodity contract credit risk is in note 34.
Wholesale and retail credit risk
Our principal commercial exposure in the UK is governed by the credit rules within the regulated codes Uniform Network Code and Connection and Use of System Code. These lay down the level of credit relative to the regulatory asset value (RAV) for each credit rating. In the US, we are required to supply electricity and gas under state regulations. Our credit policies and practices are designed to limit credit exposure by collecting prepayments prior to providing utility services. Collection activities are managed on a daily basis. The utilisation of credit limits is regularly monitored. Sales to retail customers are usually settled in cash or using major credit cards. Management does not expect any significant losses of receivables that have not been provided for as shown in note 19.
(c) Liquidity analysis
We determine our liquidity requirements by the use of both short- and long-term cash flow forecasts. These forecasts are supplemented by a financial headroom analysis which is used to assess funding adequacy for at least a 12 month period.
The following is an analysis of the contractual undiscounted cash flows payable under financial liabilities and derivative assets and liabilities as at the balance sheet date:
| At 31 March 2009 | Due within 1 year £m |
Due between 1 and 2 years £m |
Due between 2 and 3 years £m |
Due 3 years and beyond £m |
Total £m |
|---|---|---|---|---|---|
| Non derivative financial liabilities | |||||
| Borrowings, excluding finance lease liabilities | (2,839) | (1,946) | (2,460) | (19,056) | (26,301) |
| Interest payments on borrowings (i) | (1,031) | (982) | (903) | (9,456) | (12,372) |
| Finance lease liabilities | (46) | (60) | (50) | (162) | (318) |
| Other non interest-bearing liabilities | (2,303) | (396) | – | – | (2,699) |
| Derivative financial liabilities | |||||
| Derivative contracts – receipts | 1,057 | 1,109 | 1,686 | 1,674 | 5,526 |
| Derivative contracts – payments | (598) | (889) | (1,588) | (2,154) | (5,229) |
| Commodity contracts | (601) | (314) | (172) | (214) | (1,301) |
| Total at 31 March 2009 | (6,361) | (3,478) | (3,487) | (29,368) | (42,694) |
At 31 March 2008 |
Due within 1 year £m |
Due between 1 and 2 years £m |
Due between 2 and 3 years £m |
Due 3 years and beyond £m |
Total £m |
|---|---|---|---|---|---|
| Non derivative financial liabilities | |||||
| Borrowings, excluding finance lease liabilities | (3,379) | (1,345) | (1,380) | (14,626) | (20,730) |
| Interest payments on borrowings (i) | (822) | (728) | (663) | (7,946) | (10,159) |
| Finance lease liabilities | (266) | (38) | (34) | (147) | (485) |
| Other non interest-bearing liabilities* | (2,226) | (347) | – | – | (2,573) |
| Derivative financial liabilities | |||||
| Derivative contracts – receipts | 990 | 495 | 710 | 5,329 | 7,524 |
| Derivative contracts – payments | (647) | (364) | (587) | (5,538) | (7,136) |
| Commodity contracts | (490) | (257) | (188) | (279) | (1,214) |
| Total at 31 March 2008 | (6,840) | (2,584) | (2,142) | (23,207) | (34,773) |
- *
- Comparatives have been restated for the finalisation of the fair value exercise on the acquisition of KeySpan Corporation (see note 28)
- (i)
- The interest on borrowings is calculated based on borrowings held at 31 March without taking account of future issues. Floating-rate interest is estimated using a forward interest rate curve as at 31 March. Payments are included on the basis of the earliest date on which the Company can be required to settle.
(d) Sensitivity analysis
Financial instruments affected by market risk include borrowings, deposits, derivative financial instruments and commodity contracts. The following analysis, required by IFRS 7, is intended to illustrate the sensitivity to changes in market variables, being UK and US interest rates, the UK retail price index and the US dollar to sterling exchange rate, on our financial instruments.
The analysis also excludes the impact of movements in market variables on the carrying value of pension and other post-retirement obligations, provisions and on the non-financial assets and liabilities of overseas subsidiaries.
The sensitivity analysis has been prepared on the basis that the amount of net debt, the ratio of fixed to floating interest rates of the debt and derivatives portfolio and the proportion of financial instruments in foreign currencies are all constant and on the basis of the hedge designations in place at 31 March 2009 and 31 March 2008, respectively. As a consequence, this sensitivity analysis relates to the positions at those dates and is not representative of the years then ended, as all of these varied.
The following assumptions were made in calculating the sensitivity analysis:
- the balance sheet sensitivity to interest rates relates only to derivative financial instruments and available-for-sale investments, as debt and other deposits are carried at amortised cost and so their carrying value does not change as interest rates move;
- the sensitivity of accrued interest to movements in interest rates is calculated on net floating rate exposures on debt, deposits and derivative instruments;
- changes in the carrying value of derivatives from movements in interest rates designated as cash flow hedges are assumed to be recorded fully within equity;
- changes in the carrying value of derivative financial instruments designated as net investment hedges from movements in interest rates are recorded in the income statement as they are designated using the spot rather than the forward translation method. The impact of movements in the US dollar to sterling exchange rate are recorded directly in equity;
- changes in the carrying value of derivative financial instruments not in hedging relationships only affect the income statement;
- all other changes in the carrying value of derivative financial instruments designated as hedges are fully effective with no impact on the income statement;
- debt with a maturity below one year is floating rate for the accrued interest part of the calculation;
- the floating leg of any swap or any floating-rate debt is treated as not having any interest rate already set, therefore a change in interest rates affects a full 12 month period for the accrued interest portion of the sensitivity calculations; and
- sensitivity to the retail price index does not take into account any changes to revenue or operating costs that are affected by the retail price index or inflation generally.
Using the above assumptions, the following table shows the illustrative impact on the income statement and items that are recognised directly in equity that would result from reasonably possible movements in the UK retail price index, UK and US interest rates and in the US dollar to sterling exchange rate, after the effects of tax.
| 2009 | 2008 | ||||
| Income statement +/- £m |
Other equity reserves +/- £m |
Income statement +/- £m |
Other equity reserves +/- £m |
||
| UK retail price index +/- 0.50% | 17 | – | 16 | – | |
| UK interest rates +/- 0.50% | 67 | 77 | 46 | 57 | |
| US interest rates +/- 0.50% | 63 | 13 | 31 | 7 | |
| US dollar exchange rate +/- 10% (i) | 55 | 880 | 38 | 590 | |
- (i)
- Prior year comparatives have been restated for US dollar exchange rate +/- 10% impact on the income statement to present on a basis consistent with current year.
The income statement sensitivities impact interest expense and financial instrument remeasurements.
The other equity reserves impact does not reflect the exchange translation in our US subsidiary net assets which it is estimated would change by £964m (2008: £718m) in the opposite direction if the US dollar exchange rate changed by 10%.
(e) Capital and risk management
National Grid’s objectives when managing capital are to safeguard our ability to continue as a going concern, to remain within regulatory constraints and to maintain an efficient mix of debt and equity funding thus achieving an optimal capital structure and cost of capital. We regularly review and maintain or adjust the capital structure as appropriate in order to achieve these objectives.
The principal measure of our balance sheet efficiency is our interest cover ratio. Interest cover for the year ended 31 March 2009 decreased to 3.1 from 3.2 for the year ended 31 March 2008. Our long-term target range for interest cover is between 3.0 and 3.5, which we believe is consistent with single A range long-term senior unsecured debt credit ratings within our main UK operating companies, National Grid Electricity Transmission plc and National Grid Gas plc, based on guidance from the rating agencies.
In addition, we monitor the regulatory asset value (RAV) gearing within each of National Grid Electricity Transmission plc and the regulated transmission and distribution businesses within National Grid Gas plc. This is calculated as net debt expressed as a percentage of RAV, and indicates the level of debt employed to fund our UK regulated businesses. It is compared with the level of RAV gearing indicated by Ofgem as being appropriate for these businesses, at around 60%.
Some of our regulatory and bank loan agreements impose lower limits for either the long-term credit ratings that certain companies within the group must hold or the amount of equity within their capital structures. These requirements are monitored on a regular basis in order to ensure compliance.