Regulatory environment

As a result of their position in and importance to the economies they serve, the Group’s transmission and distribution businesses in the UK and US are subject to significant regulation. In the UK they are regulated by the Office of Gas and Electricity Markets (Ofgem). Ofgem operates under the direction and governance of the Gas and Electricity Markets Authority (GEMA), which makes all major decisions and sets policy priorities for Ofgem.

NGC is the sole holder of an electricity transmission licence for England and Wales. Regulation of the company is provided in a number of ways. The transmission licence conditions set the regulatory framework under which NGC operates. Revenues relating to transmission assets are regulated through a price control that is expected to run until 31 March 2007. Annual charges are set out by NGC in a charging statement. The methodology for determining charges is subject to Ofgem’s approval. Finally, System Operator incentives are set by Ofgem, usually on an annual basis. These encourage efficiency in balancing the electricity system in real time.

The Energy Bill, which is currently progressing through the UK Parliament, contains powers to create a Great Britain electricity market. The UK Government announced that when it receives these powers NGC would become System Operator for England, Wales and additionally for Scotland.

Transco is the holder of a gas transporter licence for Britain in respect of the Group’s gas transmission, distribution and metering businesses. The regulatory framework is set out in this licence. Transco is subject to two price controls for transmission activities that both run to 31 March 2007. The Transmission Owner price control covers assets and related expenditure. The System Operation price control covers the operation of the transmission system, including balancing of the transmission system and constraint management, providing incentives to promote efficiency. The actual balancing costs derive from services and actions set out in the Network Code. Distribution activities are also covered by price control regulation. From 1 April 2004, each of Transco’s eight regional networks became subject to separate price controls covering their activities. Although these separate price control formulae were due to run to 31 March 2007, Ofgem has recently announced its intention to extend them by an additional year. The form of the price controls is discussed in more detail under Regulation. The annual transportation charging statement sets out the transportation charges for market participants for both transmission and distribution. Again, Ofgem approves the methodology used to determine transportation charges.

Over the last year and as part of its consultations concerning network monopoly price controls and the electricity distribution price review, Ofgem has proposed changes to the regulatory framework that applies to all energy network monopolies. Proposed developments include the introduction of a five-year retention of benefits from savings in operating costs, capital expenditure efficiencies and asset disposals, irrespective of when they occur during a price control period (currently, the benefits of cost saving initiatives are returned to customers when a price control is reset). In respect of pension costs, Ofgem has indicated that it sees these as a normal operating cost of the business. Furthermore, Ofgem has suggested that, with effect from 1 April 2002, any efficiently incurred over or underfunding of pension schemes as compared to those assumptions made by Ofgem when its price controls were set, will ultimately be passed to consumers. It is expected that the details of how this mechanism will work, together with any adjustments that Ofgem may wish to make in respect of historic pensions issues, will be clarified later in 2004.

The Group’s businesses are also affected by European Union legislation. The Electricity Regulation will mean that the UK will be expected to join the cross-border trading mechanism in 2005. The detailed rules will be adopted through secondary European legislation. This is expected to impact on the charging for transits of electricity and interconnector arrangements. A Directive concerning measures to safeguard security of natural gas supply is due for implementation in May 2006. This will ensure that Member States have in place, and publish, policies and standards on gas security of supply. However, the impact on Transco’s activities is expected to be minimal. There are also a number of European Directives or Regulations in draft form or in development covering many issues including electricity security of supply, harmonisation of access to gas systems and infrastructure development, where the precise impact on the Group in the future is currently uncertain.

In the US, transmission service is generally regulated by the Federal Energy Regulatory Commission and distribution service is regulated by the relevant state’s public utilities authority. Under rates approved by the applicable regulators, we generally recover our costs of providing service and earn a return on our assets. The rates are set based on certain historical or forecasted costs, and we may achieve extra earnings to the extent we outperform those benchmarks. Commodity costs are passed through directly to ratepayers. We earn a return on our investments, including on the ‘stranded costs’ associated with the previous divestiture of our generating assets under deregulation. We may also earn incentives for meeting certain performance targets, such as for reliability and customer service, and are conversely subject to penalties if we miss certain targets.

As a result of our ownership of several US public utility companies, National Grid Transco is a registered public utility holding company under PUHCA – the Public Utility Holding Company Act of 1935. The implications of registration as a holding company include, among other things, various conditions and limitations relating to financing, subsidiary company transactions, ownership of non-utility businesses and the requirement for SEC consent for further US utility acquisitions. The non-US operations of the Group are exempt from full regulation under PUHCA.