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Financial Statements

23. Financial risk factors

Our activities expose us to a variety of financial risks: market risk (including currency risk; fair value interest rate risk; cash flow interest rate 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 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 the period out to 6 months and also in the period 6 to 12 months in order to mitigate foreign currency movements in the intervening period. Where cash forecasts are uncertain, we generally cover a percentage of the foreign currency flows depending on the certainty of the 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, and a small Australian dollar foreign exchange exposure with respect to our operations in Australia.

During 2007 and 2006, derivative financial instruments were used to manage foreign currency risk as follows:

	Sterling £m	Euro £m	US dollar £m	Other £m	Total £m
	2007
Cash and cash equivalents	733	2	858	-	1,593
Financial investments	1,663	61	345	29	2,098
Bank overdrafts	(6)	-	-	-	(6)
Borrowings	(8,024)	(4,677)	(2,443)	(567)	(15,711)
Pre-derivative position	(5,634)	(4,614)	(1,240)	(538)	(12,026)
Derivative effect	(1,709)	4,693	(2,972)	226	238
Net debt position	(7,343)	79	(4,212)	(312)	(11,788)

See results for 2007 | 2006

The exposure to US dollars largely relates to our net investment hedge activities as described and shown in note 22.

(ii) Cash flow and fair value interest rate risk

Except for the investments held pending the proposed acquisition of KeySpan, which receive floating rate interest, there are no significant interest-bearing assets maintained on an ongoing basis. The income and operating cash flows are substantially independent of changes in market interest rates.

Interest rate risk arises from long-term 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 is to minimise the finance costs (being interest costs and changes in the market value of debt). Some of our borrowings issued are index-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 revenues and our regulatory asset values that are also RPI-linked.

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:

	2007 £m	2006 £m
Fixed interest rate borrowings
In one year or less	(619)	(2,028)
In more than one year, but not more than two years	(1,525)	(364)
In more than two years, but not more than three years	(569)	(1,232)
In more than three years, but not more than four years	(263)	(870)
In more than four years, but not more than five years	(901)	(261)
In more than five years	(4,886)	(4,573)
	(8,763)	(9,328)
Floating interest rate borrowings (including RPI)	(6,948)	(3,798)
Total borrowings	(15,711)	(13,126)

During 2007 and 2006, net debt was managed using derivative instruments to hedge interest rate risk as follows:

	Fixed- rate £M	Floating- rate £m	RPI(i) £m	Other(ii) £m	Total £m
	2007
Cash and cash equivalents	-	1,593	-	-	1,593
Financial investments	-	1,872	-	226	2,098
Bank overdrafts	-	(6)	-	-	(6)
Borrowings	(8,763)	(3,301)	(3,647)	-	(15,711)
Pre-derivative position	(8,763)	158	(3,647)	226	(12,026)
Derivative effect	2,747	(2,501)	-	(8)	238
Net debt position	(6,016)	(2,343)	(3,647)	218	(11,788)

(i) Represents financial instruments which are linked to the UK retail price index.

(ii) Represents financial instruments which are not directly affected by interest rate risk, such as investments in equity or other similar financial instruments.

See results for 2007 | 2006

(b) Credit risk

Credit risk 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 2007 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	140	140
Triple ‘A’ range institutions (AAA)	620 to 965	310 to 505
Double ‘A’ range institutions (AA)	345 to 450	175 to 225
Single ‘A’ range institutions (A)	80 to 140	40 to 70

As at 31 March 2007 and 2006, 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 22 was £657m (2006: £665m), after netting agreements it was £364m (2006: £524m). This exposure is further reduced by collateral received as shown in note 27.

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 provide electricity and gas under state regulations. Our credit policies and practices are designed to limit credit exposure by collecting deposits 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 25.

(c) Liquidity analysis

We manage our liquidity requirements by the use of both short- and long-term cash flow forecasts. These forecasts are supplemented by a financial headroom position which is used to demonstrate 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 2007	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	(776)	(1,865)	(1,013)	(12,283)	(15,937)
Interest payments on borrowings (i)	(686)	(612)	(548)	(6,489)	(8,335)
Finance lease liabilities	(17)	(17)	(12)	(113)	(159)
Other non interest-bearing liabilities	(1,525)	(214)	-	-	(1,739)

Derivative financial liabilities
Derivative contracts - receipts	382	608	299	2,116	3,405
Derivative contracts - payments	(443)	(571)	(318)	(1,910)	(3,242)
Commodity contracts	(56)	(55)	(38)	(240)	(389)
Total at 31 March 2007	(3,121)	(2,726)	(1,630)	(18,919)	(26,396)

At 31 March 2006	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	(2,569)	(404)	(1,317)	(8,948)	(13,238)
Interest payments on borrowings (i)	(572)	(488)	(439)	(3,982)	(5,481)
Finance lease liabilities	(20)	(26)	(22)	(124)	(192)
Other non interest-bearing liabilities	(1,582)	(324)	-	-	(1,906)

Derivative financial liabilities
Derivative contracts - receipts	1,170	87	248	1,225	2,730
Derivative contracts - payments	(1,046)	(122)	(209)	(1,011)	(2,388)
Commodity contracts	(113)	(114)	(112)	(439)	(778)
Total at 31 March 2006	(4,732)	(1,391)	(1,851)	(13,279)	(21,253)

(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 future interest rate curve as at 31 March.

(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. We have excluded from this analysis the impact of movements in market variables on the carrying value of our commodity contracts as we are able to substantially recover the costs of these contracts from customers in future periods.

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 2007 and 31 March 2006, 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 effect on the income statement and items that are recognised directly in equity that would result from reasonably possible movements in changes in the UK retail price index, UK and US interest rates and in the US dollar to sterling exchange rate, before the effects of tax.

	Income statement -/+ £m	Equity -/+ £m	Income statement -/+ £m	Equity -/+ £m
	2007		2006
UK retail price index +/- 0.50%	18	-	7	-
UK interest rates +/- 0.50%	50	62	63	70
US interest rates +/- 0.50%	37	11	30	10
US dollar exchange rate +/- 10%	52	194	52	228

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