• Overview of National Grid Transco
• Adjusted profit measures
• Summary results
• Other performance measures
• Turnover
• Cash flows from operating activities
• Exchange rates
• Acquisitions, disposals and mergers
• Delivering integration

Overview of National Grid Transco

National Grid Transco is an international network utility company with electricity and gas transmission and distribution interests in the UK and US. We have also transferred our network skills to related markets in the UK and US, including communications infrastructure, metering and liquefied natural gas, and have interests in electricity interconnectors in the UK, US and Australia.

National Grid Transco reports its operating results by segment, reflecting the management responsibilities and economic characteristics of the Group’s business activities. The designation of segments was informed by the level of materiality of some of the Group’s activities and to ensure that the disclosures are not overly detailed.

The business operations of the Group are divided into the following segments: UK gas distribution; UK electricity and gas transmission; US electricity transmission; US electricity distribution; and US gas distribution, with all other activities of the Group being reported as part of ‘Other activities’. Our Transmission business comprises high-voltage electricity transmission networks in the UK and US and the gas National Transmission System in the UK. Through GridAmerica, we also manage a range of electricity transmission operations for other utilities. Our US Distribution business provides electricity and gas distribution in New York and electricity distribution in New England. Our UK Gas Distribution business comprises the majority of Britain’s gas distribution system.

The Operating Review focuses on the performance of individual business segments, including a consideration of the business environment within which each of our businesses operates, the operational performance of that business and the financial performance of each business segment. In the opinion of management, it is appropriate to consider the financial performance of each business segment in the context of its operational performance and related business issues for the period concerned.

The Financial Review primarily focuses on the financial impact of matters that do not arise from operating performance or are better discussed in the wider Group context and is not intended to duplicate the Operating Review. Consequently, it focuses on items in our Group accounts which we believe are the most material, such as interest, taxation, exceptional items and cash flows.

The Operating Review and the Financial Review should be read together to obtain a complete understanding of our results of operations and financial condition during the years under review.

Adjusted profit measures

Management uses ‘adjusted’ profit measures in considering the performance of the Group’s operating segments and businesses. References to ‘adjusted operating profit’, ‘adjusted profit before taxation’, ‘adjusted earnings’ and ‘adjusted earnings per share’ are stated before exceptional items and goodwill amortisation.

The Directors believe that the use of these adjusted measures better indicates the underlying business performance of the Group than the unadjusted measures because the exclusion of exceptional items and goodwill amortisation provides a clearer comparison of results from year to year for each of the years presented. This is because excluding exceptional items removes their distorting impact in order to enhance comparability from year to year, and excluding goodwill amortisation enhances comparability with the reporting practices of other UK companies.

Exceptional items, which are not included in the adjusted measures referred to above, are defined as material items that derive from events that fall within the ordinary activities of the Group, but that require separate disclosure on the grounds of size or incidence for the accounts to give a true and fair view. Such exceptional items include, for example, material restructuring costs and impairments. Exceptional items – 2003/04 and Exceptional items – 2002/03 contain a discussion of the nature of these exceptional items for each period.

The following tables reconcile the statutory or unadjusted UK GAAP measure to the corresponding adjusted measure.

a) Reconciliation of total operating profit to adjusted operating profit

	Years ended 31 March
	2004	2003	2002
	£m	£m	£m
Total operating profit	1,862	1,736	359
Operating exceptional items – continuing operations	277	308	285
Operating exceptional items – discontinued operations	-	39	1,042
Goodwill amortisation	99	102	97
Operating profit before exceptional items and goodwill
amortisation (adjusted operating profit)	2,238	2,185	1,783

The effect of the above reconciliation can be seen on the face of the profit and loss account, where adjusted operating profit is reconciled to total operating profit.

b) Reconciliation of profit/(loss) before taxation to adjusted profit before taxation

	Years ended 31 March
	2004	2003	2002
	£m	£m	£m
Profit/(loss) before taxation	1,362	667	(284)
Operating exceptional items – continuing operations	277	308	285
Operating exceptional items – discontinued operations	–	39	1,042
Non-operating exceptional items – continuing operations	(96)	31	(125)
Non-operating exceptional items – discontinued operations	(226)	68	(31)
Exceptional financing charge	–	31	142
Goodwill amortisation	99	102	97
Profit before taxation before exceptional items and goodwill
amortisation (adjusted profit before taxation)	1,416	1,246	1,126

A summary of the above reconciliation can be seen in note 11 to the accounts.

c) Reconciliation of earnings or profit/(loss) for the year to adjusted earnings

	Years ended 31 March
	2004	2003	2002
	£m	£m	£m
Earnings or profit/(loss) for the year	1,099	391	(321)
Operating exceptional items – continuing operations	277	308	285
Operating exceptional items – discontinued operations	-	39	1,042
Non-operating exceptional items – continuing operations	(96)	31	(125)
Non-operating exceptional items – discontinued operations	(226)	68	(31)
Exceptional financing charge	-	31	142
Exceptional taxation	(89)	(128)	(166)
Exceptional minority interest	-	28	(50)
Goodwill amortisation	99	102	97
Earnings or profit/(loss) before exceptional items and
goodwill amortisation (adjusted earnings)	1,064	870	873

The effect of the above reconciliation can be seen on the face of the profit and loss account where adjusted earnings are reconciled to earnings or profit/(loss). Note 11 to the accounts shows a reconciliation of earnings to adjusted earnings on a per share basis.

Summary results

The following is a summary of the turnover of the Group by segment:

	Years ended 31 March
Turnover	2004	2003 (restated)	2002 (restated)
	£m	£m	£m
Continuing operations
UK gas distribution	2,245	2,089	2,013
UK electricity and gas transmission	1,867	1,893	1,799
US electricity transmission	318	407	278
US electricity distribution	3,537	3,446	2,282
US gas distribution	464	446	104
Other activities	906	922	892
Sales between businesses	(462)	(370)	(290)
	8,875	8,833	7,078
Discontinued operations
Other activities	158	586	513
Sales between businesses	-	(19)	(37)
	158	567	476
Turnover	9,033	9,400	7,554

The following is a summary of adjusted operating profit and operating profit for Group undertakings by segment:

		Years ended 31 March
	Adjusted operating profit			Operating profit
	2004	2003 (restated)	2002 (restated)	2004	2003 (restated)	2002 (restated)
	£m	£m	£m	£m	£m	£m
Group undertakings –
continuing operations
UK gas distribution	729	554	548	640	443	504
UK electricity and gas	769	820	756	755	774	713
transmission
US electricity transmission	133	128	87	105	103	64
US electricity distribution	449	513	266	294	413	149
US gas distribution	48	58	17	37	49	8
Other activities	103	143	206	24	24	120
	2,231	2,216	1,880	1,855	1,806	1,558
Discontinued operations	-	(26)	(62)	-	(194)	(498)
Operating profit of Group	2,231	2,190	1,818	1,855	1,612	1,060
undertakings

Comparative figures in the above tables have been restated to reflect minor changes to the presentation of segmental information as discussed in note 2 to the accounts.

Other performance measures

The Group uses a number of measures of operational and financial performance relating to its various businesses. The Group’s core businesses are regulated utilities and therefore many of these targets are determined by the relevant regulators. Much of the Group’s performance depends on meeting and exceeding those regulatory targets. Measures of operational performance include the management of ‘controllable costs’ in relation to our UK and US regulated businesses; reliability of our energy delivery networks and other service quality measures; and Lost Time Injuries for the Group.

Our ability to meet or outperform our regulatory targets depends in part on our ability to manage our costs. Of those costs, some are fixed or semi-fixed in nature and generally cannot be altered by management in the ordinary course. Examples of these include depreciation charges, replacement expenditure, goodwill amortisation and pension deficit related costs.

The Group is also allowed under the relevant licence or regulatory settlement to pass through certain costs to our customers. The costs that we pass through are reflected in our turnover, an important example of this being commodity cost. We are allowed to pass through to our customers most of the commodity cost of the gas and electricity to which we are exposed and, consequently, we currently assume only a limited amount of risk in respect of these costs.

Other costs are within management’s ability to control. These include employment costs (excluding pension fund deficits in the UK) and other costs incurred in maintaining transmission and distribution systems. The manner in which we calculate controllable costs varies within the Group as a result of, among other things, different regulatory regimes and the historical treatment of costs by our regulators. However, the underlying principle remains the same in that the expression ‘controllable costs’ represents management’s calculation of the costs that they can control. Moreover, the definition of controllable costs is consistent from year to year within a given part of the business. Our ability to reduce controllable costs is used by Ofgem to measure a number of our activities. We have extended controllable costs to our US regulated operations as an internal performance measure.

The Directors believe that employee and public safety is paramount and, as a fundamental part of this, that all work-related injuries and illnesses are preventable. Consequently, the level of Lost Time Injuries (LTIs) is measured as a key performance indicator of the Group. LTIs are injuries and illnesses that arise from a person’s employment and cause that employee to be unable to attend the workplace and perform his or her duties. All our businesses are required to report on any LTIs suffered by their respective employees and any contractors.

Turnover

As noted above in the discussion of other performance measures, the Group takes very limited commodity risk and certain categories of costs are passed through to customers and, as such, are reflected in turnover. As a result, movements from year to year in turnover do not necessarily have an impact on the financial condition of the Group.

Cash flows from operating activities

Cash flows from our operations are largely stable from year to year, although they do depend on the timing of customer payments and exchange rate movements. The Group’s gas and electricity distribution and transmission operations in the UK and US are subject to multi-year rate agreements with regulators, which results in essentially stable cash flows in local currency terms. However, weather conditions can affect cash flows in those businesses, with abnormally mild or extreme weather driving volumes down or up respectively. In the US, the timing of recovery of commodity costs can influence the timing of cash flows between financial years.

Exchange rates

As shown in the summary results table above, adjusted operating profit and operating profit from our US businesses accounted for some 28% and 24% respectively of Group undertakings for 2003/04. The functional currency for our US operations is US dollars, hence our US results are denominated in US dollars and translated into sterling at the average rate of exchange for the year for Group reporting purposes. Consequently, to the extent that the US dollar to sterling exchange rate moves from year to year, the sterling value of US dollar denominated results will also vary even if the underlying US dollar values remain the same.

The Financial Review explains in more detail the financial impact of the movement in average US dollar to sterling exchange rates between years. In short, although during the periods under review there was a significant impact on operating profit and adjusted operating profit as a result of the movement in this exchange rate, this was substantially offset by the impact of the translation of US dollar denominated interest and taxation. As a consequence, in comparing the results of 2003/04 with 2002/03 and 2002/03 with 2001/02, the impact of currency translation on earnings or adjusted earnings was not significant.

Acquisitions, disposals and mergers

There were no significant acquisitions, disposals or mergers during 2003/04.

In October 2002, National Grid merged with Lattice and National Grid was renamed National Grid Transco. In accordance with UK GAAP, the Merger was accounted for using merger accounting principles such that the results of the Group under UK GAAP have been presented as if the Group had been in existence for all of the financial years presented. The results for all years are presented on the basis of uniform accounting policies.

Under US GAAP, the business combination of National Grid and Lattice was accounted for as an acquisition in accordance with US GAAP acquisition accounting principles (‘purchase accounting’). Under US GAAP, Lattice was acquired for consideration of £6,598 million primarily satisfied by the issuance of shares.

This acquisition gave rise to goodwill amounting to £3,824 million. The US GAAP accounting of this business combination is described in more detail in the Financial Review.

The merger of National Grid and Lattice brought together two companies with substantial UK interests and has delivered significant integration savings. The combined Group has significant balance sheet strength and strong operational cash flows and allows the Group to take advantage of future opportunities as they arise.

In January 2002, the Group acquired Niagara Mohawk for consideration of £2,186 million comprising the issuance of shares which had a fair value at the date of acquisition of £1,270 million (based on the share price on the date of acquisition) and cash of £916 million, including £45 million relating to the costs of acquisition. The net assets acquired had a fair value of £1,294 million resulting in goodwill of £892 million being recognised and amortised over 20 years.

The acquisition of Niagara Mohawk was a further step in the Group’s strategy of securing better returns outside of its UK regulated business. The existence and size of goodwill recognised as a result of this transaction reflects management’s judgement that the returns to be generated from the investment were sufficient to justify paying in excess of the fair value attributable to the net assets of Niagara Mohawk.

In May 2003, we announced our plans to sell up to four of our UK gas distribution networks if this maximises value. Since then, plans have progressed and we are in discussions with a number of parties, with final bids expected this summer. The disposal of these businesses is likely to affect the Group significantly. The actual impact will depend on the number of networks sold, if any, the price received and the use of the proceeds of any sales.

Delivering integration

We continue to develop further integration opportunities across the businesses to streamline our operations. In our Transmission business, we are realising efficiencies in the UK across our electricity and gas operations and in the US across our electricity networks, while we are also sharing best practice between the UK and the US.

In order to maximise the benefits from the Merger, a UK business services organisation was established in Warwick. It provides shared services such as legal, procurement, finance, regulatory, information technology and human resources support to UK Transmission, UK Gas Distribution and the non-regulated businesses in the UK, ensuring a more efficient use of resources.

The information technology service provided to our UK businesses took an important step forward in December 2003 when an outsourcing contract with Computer Sciences Corporation (CSC) for the management and support of the Group’s UK information technology infrastructure was agreed. Under the seven-year outsourcing agreement, CSC will manage and support National Grid Transco’s data centres, desktop, telecommunications and helpdesk activities in the UK.

As a result of this contract, National Grid Transco will be able to benefit from CSC’s skills, experience and best practice processes to drive down costs, to create a more flexible cost base for adapting to business change, to obtain continuous service improvements, and to gain access to technology, innovation and additional technical capability.

Across our US operations, we launched a new Enterprise Resource Planning (ERP) system in May 2004. ERP will address finance and accounting, supply chain and work management. Through automation and improved technology, the system will promote greater consistency in work practices. It will also improve our ability to collect and manage data on our operations, telling us where we are performing well and where we can improve. In the coming year, we will merge the remainder of the information technology systems across our New York and New England operations.

In another initiative that will use technology to synchronise our processes, we are planning a field force automation project for our New York and New England operations. By putting computers into the hands of our field workers, we will be able to distribute work assignments and monitor their status in real time. This will help us to optimise productivity and reduce paperwork while improving customer satisfaction. As we move forward with this project, we are building on the lessons learnt through similar initiatives undertaken across the Group.

In the US, we successfully reached agreement with our New England labour force in May 2003. The four-year labour contract with the New England field workers includes new work processes that will provide multiple benefits: improved employee safety; faster response to outages; improved productivity; and lower costs. In March 2004, we also reached a separate labour agreement in our New England customer service call centre, delivering equivalent benefits and improvements there. The contract with our New York labour force is up for renewal in September 2004.

Also in the US, the Group made voluntary early retirement offers to a subset of union employees and to non-union employees who met certain criteria based on age and length of service. The offers were made in areas including transmission, retail operations (in New England) and corporate administrative functions such as finance, human resources, legal and information technology. Management sets the actual retirement dates for individuals based on operational needs. The majority of those who accepted the offers will retire by 1 November 2004, with the remainder retiring by 1 January 2008. During 2003/04, we incurred approximately £70 million of exceptional costs related to this programme.