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Financial position and financial management

Commodity contracts

Power purchase contracts for normal sale and purchase

In the US, we purchase electricity and gas to supply to our customers. The contracts enable us to provide the electricity purchased by customers who do not choose to purchase their energy from independent suppliers.

Commodity derivatives

In the normal course of business, we are party to commodity derivatives. These have included indexed swap contracts, gas futures, electricity swaps, gas options, gas forwards and gas basis swaps that are principally used to manage commodity prices associated with our gas and electricity delivery operations. This includes the buying back of capacity rights already sold in accordance with our UK gas transporter licences and Uniform Network Code obligations.

These financial exposures are monitored and managed as an integral part of our financial risk management policy. At the core of this policy is a condition that we will engage in activities at risk only to the extent that those activities fall within commodities and financial markets to which we have a physical market exposure in terms and volumes consistent with our core business. We do not issue or intend to hold derivative instruments for trading purposes, and hold such instruments consistent with our various licence and regulatory obligations in the UK and US.

Commodity contracts carried at fair value

A number of power purchase agreements were replaced in 1998 with indexed swap contracts that expire in June 2008. These indexed swap contracts are the subject of regulatory rulings that allow the gains and losses to be passed on to customers.

At 31 March 2007, there were liabilities of £136 million (2006: £309 million) in respect of the above indexed swap contracts. The liability will be amortised over the remaining term of the swaps as nominal energy quantities are settled and will be adjusted as periodic reassessments are made of energy prices. A 10% movement in the market price of electricity would result in a £16 million movement in the value of the indexed swap contracts assuming a US dollar to sterling exchange rate of $1.97: £1.

The fair value of the index-linked swap contracts is based on the difference between projected future market prices and projected contract prices as applied to the notional quantities stated in the contracts and discounted using a US Treasury Bill rate curve to the current present value.

Payments made under indexed swap contracts are affected by the price of natural gas and we use New York Mercantile Exchange (NYMEX) gas futures as hedges to mitigate this impact. The futures contracts are derivative commodity instruments with gains and losses deferred as an offset to the corresponding increases and decreases in the swap payments.

We do not currently use options to hedge gas commodity. Gains relating to gas futures as at 31 March 2007 were not material.

Our rate agreement in New York allows for collection of the commodity cost of natural gas sold to customers. The regulator also requires that actions be taken to limit the volatility in gas prices passed on to customers. We meet this requirement through the use of NYMEX gas futures. These contracts are hedges of our natural gas purchases. Gains and losses are deferred until the month that the hedged contract settles. At 31 March 2007, deferred gains on these contracts were immaterial in the context of National Grid as a whole.

During 2005/06, a number of power purchase contracts reverted back to us as part of the settlement arising from USGen's bankruptcy. The power contracts were originally entered into prior to the restructuring of the electricity industry in New England. The power delivered is not required for our normal activities and is sold in the energy markets at prices which are currently significantly below the amount we are required to pay. The fair value of these contracts amounted to £128 million at 31 March 2007 (2006: £169 million) and this has been recorded as a liability in our balance sheet.

We are also a party to several other power purchase arrangements entered into by the former generating business, the output of which is sold to third parties through back-to-back arrangements. We recover the costs incurred under the contracts, net of proceeds received on sales, from customers as part of the US stranded cost recoveries segment.

As at 31 March 2007, our obligations under all these agreements totalled £389 million (2006: £778 million). The fair value of the difference between our obligations and the expected revenues from sales is recorded in the balance sheet within commodity contract liabilities at a value of £268 million (2006: £488 million).

Commodity trading

In our UK gas transmission operation, we are obliged to offer for sale, through a series of auctions (both short- and long-term), a predetermined quantity of entry capacity for every day in the year at predefined locations. Where, on the day, the gas transmission system's capability is constrained, such that gas is prevented from entering the system for which entry capacity rights have been sold, then UK gas transmission is required to buy back those entry capacity rights sold in excess of system capability. Forward and option contracts are used to reduce the risk and exposure to on-the-day entry capacity prices.

Our UK electricity transmission operations have also entered into electricity options, pursuant to the requirement to stabilise the electricity market in Great Britain through the operation of the British Electricity Trading and Transmission Arrangements (BETTA). The options are for varying terms and have been entered into so that we have the ability to deliver electricity as required to meet our obligations under our UK electricity transmission licence. We have not and do not expect to enter into any significant derivatives in connection with our BETTA role.