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Financial position and financial management

Liquidity and treasury management

Cash flows from our operations are largely stable over a period of years, but they do depend on the timing of customer payments and exchange rate movements. Our electricity and gas transmission and distribution operations in the UK and US are subject to multi-year rate agreements with regulators. Significant changes in volumes, for example as a consequence of weather conditions, can affect cash inflows in particular, with abnormally mild or extreme weather driving volumes down or up respectively. Subject to this, we have essentially stable cash flows in the UK, while in the US, the regulatory mechanisms for recovering costs from customers can result in very significant cash flow swings from year to year.

Cash flow forecasting

Both short- and long-term cash flow forecasts are produced frequently to assist in identifying our liquidity requirements.

These forecasts, supplemented by a financial headroom position, are supplied to the Finance Committee of the Board regularly to demonstrate funding adequacy for at least a 12 month period. We also maintain a minimum level of committed facilities in support of that objective.

Credit facilities and unutilised Commercial Paper and Medium Term Note Programmes

We have both committed and uncommitted facilities that are available for general corporate purposes.

At 31 March 2007, we had the following committed and uncommitted facilities:

Facility	Amount	Status
National Grid plc
US commercial paper programme	$3.0 billion	Unutilised
National Grid Electricity Transmission plc
US commercial paper programme	$1.0 billion	Unutilised
Euro commercial paper programme	$1.0 billion	Unutilised
National Grid plc and National Grid Electricity Transmission plc
Euro medium term note programme	€12.0 billion	€3.2 billion unissued
National Grid Gas plc
US commercial paper programme	$2.5 billion	Unutilised
Euro commercial paper programme	$1.25 billion	Unutilised
National Grid Gas plc and National Grid Gas Holdings plc
Euro medium term note programme	€10 billion	€5.9 billion unissued
National Grid plc and certain UK subsidiaries
Long-term committed facilities	£1.29 billion	Undrawn
Short-term committed facilities	$1.5 billion	Undrawn
Uncommitted borrowing facilities	£0.9 billion	Undrawn
National Grid’s US subsidiaries
Committed facilities	$680 million	Undrawn
US commercial paper programme	$2.0 billion	Unutilised

The short-term (364 day) committed facilities include an option to extend these facilities. The US committed facilities provide liquidity support for New England Power Company's tax-exempt debt programme.

In addition to the above facilities, National Grid Gas plc has signed a loan agreement for £370 million with the European Investment Bank. Of this, £190 million remains to be drawn and can be drawn before August 2008.

Note 27 to the accounts shows the maturity profile of undrawn committed borrowing facilities in sterling as at 31 March 2007.

Regulatory restrictions

As part of our regulatory arrangements, our operations are subject to a number of restrictions on the way we can operate. These include regulatory ‘ring-fences’ that require us to maintain adequate financial resources within certain parts of our operating businesses and restrict our ability to transfer funds or levy charges between certain subsidiary companies.

Treasury policy

Funding and treasury risk management for National Grid is carried out under policies and guidelines approved by the Board. The Finance Committee, a committee of the Board (for further details see page 80), is responsible for regular review and monitoring of treasury activity and for approval of specific transactions, the authority for which may be delegated. There is a Treasury function that raises funding and manages interest rate and foreign exchange rate risk.

Financing programmes exist for each of the main companies within National Grid. The Finance Committee of the Board and the finance committee or board of the appropriate subsidiary undertaking approve all funding programmes.

The Treasury function is not operated as a profit centre. Debt and treasury positions are managed in a non-speculative manner, such that all transactions in financial instruments or products are matched to an underlying current or anticipated business requirement.

The use of derivative financial instruments is controlled by policy guidelines set by the Board. Derivatives entered into in respect of gas and electricity commodities are used in support of the business's operational requirements and the policy regarding their use is explained below.

We had borrowings outstanding at 31 March 2007 amounting to £15,711 million (31 March 2006: £13,126 million).

Appropriate committed facilities are in place, such that we believe that the maturing amounts in respect of its contractual obligations as shown in ‘Commitments and Contingencies’ in note 35 to the accounts can be met from existing cash and investments and these facilities, operating cash flows and other financings that we reasonably expect to be able to secure in the future. Our financial position and expected future operating cash flows are such that we can borrow on the wholesale capital and money markets and most of our borrowings are through public bonds and commercial paper.

We place surplus funds on the money markets, usually in the form of short-term fixed deposits that are invested with approved banks and counterparties. Details relating to cash, short-term investments and other financial assets at 31 March 2007 are shown in notes 21 and 26 to the accounts.

As of 31 March 2007, the long-term senior unsecured debt and short-term debt credit ratings respectively provided by Moody's, Standard & Poor's (S&P) and Fitch were as follows:

Facility	Moody’s	S&P	Fitch
National Grid plc	Baa1/P2	A-/A1	A-/F2
National Grid Electricity Transmission plc	A2/P1	A/A1	A/F2
National Grid Holdings One plc	–	A-/A1	–
National Grid Gas plc	A2/P1	A/A1	A+/ F1
National Grid Gas Holdings plc	A3	A-	A
National Grid USA	P2	A-/A1	–
Niagara Mohawk Power Corp.	Baa1	A-	–
Massachusetts Electric Co.	P1	A/A1	–
New England Power Co.	A1/P1	A/A1	–

In connection with the proposed acquisition of KeySpan Corporation, our ratings have been moved to ‘creditwatch with negative implications’ by S&P. Moody's have placed the majority of our ratings on to review for downgrade, National Grid plc on to developing outlook and National Grid Gas Holdings plc to stable. We expect the long-term credit ratings of National Grid plc from S&P and Fitch to reduce by one notch as a direct result of the KeySpan acquisition.

It is a condition of the regulatory ring-fences around National Grid Electricity Transmission plc, National Grid Gas plc and National Grid Gas Holdings plc that they use reasonable endeavours to maintain an investment grade credit rating. At these ratings, the principal borrowing entities within National Grid should have good access to the capital and money markets for future funding when necessary.

The main risks arising from our financing activities are set out below, as are the policies for managing these risks, which are agreed and reviewed by the Board and the Finance Committee.

Refinancing risk management

The Board controls refinancing risk mainly by limiting the amount of financing obligations (both principal and interest) arising on borrowings in any financial year. This policy is intended to prevent us from having an excessively large amount of debt to refinance in any given time-frame. During the year, a mixture of short-term and long-term debt was issued.

Note 23 (c) to the accounts sets out the contractual maturities of our borrowings over the next three years, with the remaining contracted borrowings maturing over a further 47 years in compliance with our refinancing risk policy.

Interest rate risk management

Our interest rate exposure arising from borrowings and deposits is managed by the use of fixed- and floating-rate debt, interest rate swaps, swaptions and forward rate agreements. Our interest rate risk management policy is to seek to minimise total financing costs (being interest costs and changes in the market value of debt) subject to constraints so that, even with large movements in interest rates, neither the interest cost nor the total financing cost can exceed pre-set limits. Some of the bonds in issue from National Grid Electricity Transmission plc, National Grid Gas Holdings plc and National Grid Gas plc are index-linked, that is their cost is linked to changes in the UK Retail Price Index (RPI). We believe that these bonds provide a good hedge for revenues and our regulatory asset values that are also RPI-linked under our price control formulae in the UK.

The performance of the Treasury function in interest rate risk management is measured by comparing the actual total financing costs of its debt with those of a passively-managed benchmark portfolio.

Pie chart showing the interest rate profile in pounds billion for net debt both pre and post derivatives

More information on the interest rate profile of our debt is included in note 23 to the accounts.

Foreign exchange risk management

We have a policy of hedging certain contractually committed foreign exchange transactions over a prescribed minimum size. This covers a minimum of 75% of such transactions expected to occur up to 6 months in advance and a minimum of 50% of transactions 6 to 12 months in advance. Cover generally takes the form of forward sale or purchase of foreign currencies and must always relate to underlying operational cash flows.

The principal foreign exchange risk to which we are exposed arises from assets and liabilities denominated in US dollars. In relation to these risks, the objective is to manage the US dollar proportion of our financial liabilities, by using debt and derivatives, to match the proportion of our cash flows that arise in US dollars and is available to service those liabilities.

In addition, we are exposed to currency exposures on borrowings in currencies other than sterling and the US dollar, principally the euro. This currency exposure is managed through the use of derivative financial instruments.

Pie chart showing the currency profile of net debt both pre and post derivatives in pounds billion

The currency compositions of financial liabilities and assets are shown in note 23 to the accounts.

Counterparty risk management

Counterparty risk arises from the investment of surplus funds and from the use of derivative instruments. The Finance Committee has agreed a policy for managing such risk, which is controlled through credit limits, approvals and monitoring procedures. Further information is provided in note 23 (b) to the accounts. Where multiple transactions are entered into with a single counterparty, a master netting arrangement can be put in place to reduce our exposure to credit risk of that counterparty. At the present time, we use standard International Swap Dealers Association (ISDA) documentation, which provides for netting in respect of all transactions governed by a specific ISDA with a counterparty, when transacting interest rate and exchange rate derivatives.

Derivative financial instruments held for purposes other than trading

As part of our business operations, we are exposed to risks arising from fluctuations in interest rates and exchange rates. We use financial instruments, including derivatives, to manage exposures of this type and they are a useful tool in reducing risk. Our policy is not to use derivatives for trading purposes. Derivative transactions can, to varying degrees, carry both counterparty and market risk.

We enter into interest rate swaps to manage the composition of floating- and fixed-rate debt and so hedge the exposure of borrowings to interest rate movements. In addition, we enter into bought and written option contracts on interest rate swaps. These contracts are known as swaptions. We also enter into foreign currency swaps to manage the currency composition of borrowings and so hedge the exposure to exchange rate movements. Certain agreements are combined foreign currency and interest rate swap transactions. Such agreements are known as cross-currency swaps.

We enter into forward rate agreements to hedge interest rate risk on short-term debt and money market investments. Forward rate agreements are commitments to fix an interest rate that is to be paid or received on a notional deposit of specified maturity, starting at a future specified date.

Cross-currency and foreign exchange contracts are used to manage the foreign exchange risk arising from the investment in non-sterling subsidiaries.

More details on derivative financial instruments are provided in note 22 to the accounts.

Valuation and sensitivity analysis

We calculate the fair value of debt and derivative instruments by discounting all future cash flows by the market yield curve at the balance sheet date. The market yield curve for each currency is obtained from external sources for interest and foreign exchange rates. In the case of instruments that include options, the Black's variation of the Black-Scholes model is used to calculate fair value.

The valuation techniques described above for interest rate swaps and currency swaps are a standard market methodology. These techniques do not take account of the credit quality of either party but this is not considered to be a significant factor unless there is a material deterioration in the credit quality of either party.

In relation to swaptions, we only use swaptions for hedging purposes with a European style exercise. As a consequence, the Black's variation of the Black-Scholes model is considered to be sufficiently accurate for the purpose of providing fair value information in relation to these types of swaptions. More sophisticated valuation models exist but we do not believe it is necessary to employ these models, given the extent of our activities in this area.

For debt and derivative instruments held, we utilise a sensitivity analysis technique to evaluate the effect that changes in relevant rates or prices will have on the market value of such instruments.

At 31 March 2007, the potential change in the fair value of the aggregation of long-term debt and derivative instruments, assuming an increase or decrease of 10% in the level of interest rates and exchange rates, was £138 million and £145 million for interest rates and £794 million and £971 million for exchange rates respectively (2006: £44 million and £46 million for interest rates and £427 million and £521 million for exchange rates respectively).

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