Risk management
All of the group’s activities involve analysis, management and, in some cases, acceptance of risk or a combination of risks. The most important types of financial risk are credit risk, liquidity risk, market risk and capital risk. Market risk includes interest rate, foreign exchange and inflation risks.
The group’s risk management policies are designed to identify and analyse these risks, to set appropriate risk limits and controls and to monitor the risks and limits continually by means of reliable and up-to-date systems. The group modifies and enhances its risk management policies and systems to reflect changes in markets and products. The board formulates the high level group risk management policy. The treasury committee is responsible for monitoring the implementation of the policy. The board has approved all of the classes of financial instruments used by the group. The group’s treasury function, which is authorised to conduct the day-to-day treasury activities of the group, reports annually to the board and quarterly to the treasury committee.
The group’s exposure to risk and its objectives, policies and processes for managing risk and the methods used for measuring risk have not materially changed since the prior year.
Credit risk
Credit risk is the risk that financial loss arises from the failure of a customer or counterparty to meet its obligations under a contract. It arises principally from trade finance (the supply of services to the public and other businesses) and treasury activities (the investment of essential liquidity). The group has policies and procedures to control and monitor credit risk. The group does not believe it is exposed to any material concentrations of credit risk.
The group looks to manage its risk from trade finance through the effective management of customer relationships. The Water Industry Act 1991 (as amended by the Water Industry Act 1999) prohibits the disconnection of a water supply for non-payment and the limiting of a supply with the intention of enforcing payment for certain premises including domestic dwellings. However, allowance is made by the water regulator in the price limits at each price review for a proportion of debt deemed to be irrecoverable. Concentrations of credit risk with respect to trade receivables are limited due to the group’s customer base consisting of a large number of unrelated households and businesses. Due to this, the directors believe there is no further credit risk provision required in excess of the allowance for doubtful receivables (see note 16).
The counterparties in respect of treasury activities consist of financial institutions and other bodies considered to have good credit ratings. Although the group is potentially exposed to credit loss in the event of non-performance by counterparties, such credit risk is measured and controlled through regular review of the credit ratings assigned to the counterparties by credit rating agencies, and by limiting the total amount of exposure to any one party. Management does not expect any counterparty to fail to meet its obligations, and there has not been any such failure during the year, or in the preceding year.
The maximum exposure to credit risk is represented by the carrying amount of each financial asset in the statement of financial position. At 31 March, the maximum exposure to credit risk for the group and the company was as follows:
Cash and short-term deposits and trade and other receivables are measured at amortised cost. Derivative financial instruments are measured at fair value.
The credit exposure on derivatives is disclosed gross of any collateral received from the respective counterparties. As at 31 March 2010 the group held £53.3 million (2009: £84.1 million) as collateral in relation to swap contracts.
Liquidity risk
Liquidity risk is the risk that the group will not have sufficient funds to meet the obligations or commitments arising from its business operations and its financial liabilities. The group manages the liquidity profile of its assets, liabilities and commitments so that cashflows areappropriately balanced and all funding obligations are met when due. The board approves a liquidity framework within which the business operates. Performance against this framework is actively monitored and reported monthly.
At 31 March the headroom was as follows:
Short-term deposits mature within three months. Bank overdrafts are repayable on demand.
Short-term debt includes £53.3 million (2009: £84.1 million) collateral liability pledged in relation to a particular swap contract.
Medium-term committed bank facilities excludes £100.0 million (2009: £335.0 million) of facilities expiring within one year.
The group had available committed borrowing facilities as follows:
Note:
(1)£nil million of these were facilities expiring within one year (2009: £15.0 million) and £nil million were facilities expiring after more than two years (2009: £40.0 million).
In addition to the committed facilities available, the group uses its €2 billion euro-commercial paper programme to help it manage its liquidity position.
The company does not have any committed facilities available.
Maturity analysis
Concentrations of risk may arise if large cashflows are concentrated within particular time periods. The maturity profile in the following table represents the forecast future contractual principal and interest cashflows in relation to the group’s financial liabilities and derivatives on an undiscounted basis. Derivative cashflows have been shown net where there is a contractual agreement to settle on a net basis; otherwise the cashflows are shown gross.
Notes:
(1) Forecast future cashflows are calculated, where applicable, utilising forward interest rates based upon the interest environment at year end and are, therefore, susceptible to changes in market conditions. For index-linked debt it has been assumed that RPI will be 2.65 per cent over the life of each bond.
(2) The carrying value of debt is calculated following various methods in accordance with IAS 39 ‘Financial Instruments: Recognition and Measurement’ and, therefore, this adjustment reconciles the undiscounted forecast future cashflows to the carrying value of debt in the statement of financial position.
The company has a total liability of £1,507.4 million (2009: £1,502.2 million), which is payable within one year.
Market risk
Market risk is the risk that movements in market rates, including foreign exchange rates, interest rates and inflation will affect the group’s results. The management of market risk is undertaken within risk limits approved by the board.
The group borrows in the major global debt markets in a range of currencies at fixed and floating rates of interest, using derivatives, where appropriate, to generate the desired effective currency profile and interest basis.
The group uses a variety of financial instruments, including derivatives, when raising finance for its operations in order to manage any exposure arising from funding activity.
Interest rate risk
The group’s fixed rate borrowings are exposed to a risk of change in their fair value due to changes in interest rates. The group’s floating rate borrowings are exposed to a risk of change in cashflows due to changes in interest rates. The group uses interest rate swap contracts to hedge these exposures. Investments in equity securities and short-term receivables and payables are not exposed to interest rate risk.
The group’s policy is to structure debt in a way that best matches its underlying assets and cashflows. The regulated business earns an economic return on its regulatory capital value (RCV) asset, comprising a real return through revenues, determined by the real cost of capital fixed by the regulator for each five-year regulatory pricing period, and an inflation return as an uplift to its RCV.
The preferred form of debt, therefore, is sterling index-linked debt which incurs fixed interest, in real terms, and forms a natural hedge of regulatory assets and cashflows.
Where conventional long-term debt is raised in a fixed-rate form, to manage exposure to long-term interest rates, the debt is generally swapped at inception to create a floating rate liability for the term of the liability through the use of interest rate swaps.
To manage the exposure to medium-term interest rates, the group fixes interest costs for a substantial proportion of the group’s debt for the duration of each five-year regulatory pricing period at around the time of that price control determination.
Sensitivity analysis
As required by IFRS 7 ‘Financial Instruments: Disclosures’, the sensitivity analysis has been prepared on the basis of the amount of net debt and the interest rate hedge positions in place as at 31 March 2010 and 31 March 2009, respectively. As a result, this analysis relates to the position at the reporting date and is not indicative of the years then ended, as these factors would have varied throughout the year.
The following assumptions were made in calculating the interest sensitivity analysis:
- all fair value hedge relationships, including associated swaps classified as held for trading, are fully effective and therefore there is no sensitivity in the statement of financial position to interest rates with regard to these designated debt and swaps instruments;
- all borrowings designated at fair value through profit or loss are effectively hedged by associated swaps and therefore there is no sensitivity in the statement of financial position to interest rates (excluding the effect of accrued interest) with regard to the associated debt and swap instruments;
- the main sensitivity in the statement of financial position to interest rates (excluding the effect of accrued interest) is in relation to the regulatory swaps which swap the majority of the floating rate exposure to fixed rate for the five-year regulatory period;
- the sensitivity of net finance expense to movements in interest rates is calculated on net floating rate exposures on debt and derivatives; and on deposits. The floating leg of a swap or any floating rate debt is treated as not having any interest rate already set; therefore, a change in interest rates will have a full 12-month impact on interest;
- the standard requires that a change in the relevant risk variable be applied to the risk exposures in existence at the reporting date; therefore, deposits at the reporting date are taken and any debt or swaps maturing during the year are disregarded;
- index-linked debt is carried at amortised cost and therefore the statement of financial position is not exposed to movements in interest rates.
It is assumed that inflation is held constant;
- the analysis excludes the impact of movements in market variables on the carrying value of pensions and other post-retirement obligations;
- management has assessed 100bp as a reasonably possible movement in UK interest rates; and
- all other factors are held constant.
Brackets denote a reduction in profit.
The exposure largely relates to the fair value exposure on the group’s fixed rate financing. Management assesses the net interest exposure and determines whether to mitigate this risk further by entering into financial futures contracts. At 31 March 2010 and 31 March 2009, the group had no financial futures contracts in place.
Repricing analysis
The following tables categorise the group’s borrowings, derivatives and cash deposits on the basis of when they reprice or, if earlier, mature. The repricing analysis demonstrates the group’s exposure to floating rate risk.
Currency risk
The group’s assets are principally sterling denominated; however, the group has access to various international debt capital markets and raises foreign currency denominated debt. Where debt is denominated in a currency which is not sterling, the group’s policy is generally to swap the foreign currency denominated cashflows into sterling through the use of foreign currency swaps. As a result, for the majority of foreign currency denominated borrowings, the group has no material exposure to movements in exchange rates.
The company has no material exposure to currency risk.
Inflation risk
The group’s index-linked borrowings and interest liabilities are exposed to a risk of change in carrying value due to changes in the UK RPI. This form of liability is a good match for the group’s regulated assets, which are also linked to RPI due to the revenue price cap imposed by the regulator. This price cap is linked to RPI and limits management’s ability to change prices. By matching liabilities to assets, index-linked debt hedges the exposure to changes in RPI and delivers a cashflow benefit, as compensation for the inflation risk is provided through adjustment to the principal rather than in cash.
The carrying value of index-linked debt held by the group is as follows:
As required by IFRS 7, the sensitivity analysis has been prepared on the basis of the amount of index-linked debt in place as at 31 March 2010 and 31 March 2009, respectively. As a result, this analysis relates to the position at the reporting date and is not indicative of the years then ended, as these factors would have varied throughout the year. The following table details the sensitivity of profit before taxation to changes in the RPI, excluding the hedging aspect of the group’s regulatory assets, which are not financial assets as defined by IAS 32 ‘Financial Instruments: Disclosure and Presentation’:
Brackets denote a reduction in profit.
The analysis assumes a one per cent change in RPI having a corresponding one per cent impact on this position over a 12-month period. It should be noted, however, that there is a time lag by which current RPI changes impact on the profit and loss and the analysis does not incorporate this factor. The portfolio of index-linked debt is either calculated on a three or eight-month lag basis. Therefore, at the reporting date the index-linked interest and principal adjustments impacting the income statement are fixed and based upon either the previous three or eight-month RPI.
The company has no material exposure to inflation risk.
Capital risk management
The group’s objective when managing capital is to maintain a capital structure that enables its primary subsidiary, United Utilities Water PLC, to retain a credit rating of A3 from Moody’s Investors Services, which the group believes best mirrors the Water Services Regulation Authority’s (Ofwat) assumptions in relation to capital structure. The strategy of targeting a credit rating of A3 has been consistently maintained since 2007.
One of Ofwat’s primary duties is to ensure that water companies are able to finance their functions, in particular by securing a reasonable return on their capital. Therefore, mirroring Ofwat’s assumptions for credit ratings (and hence capital structure) should safeguard the group’s ability to earn a reasonable return on its capital, securing access to finance at a reasonable cost and enabling the group to continue as a going concern in order to provide returns for shareholders and credit investors, and benefits for other stakeholders.
In order to maintain a credit rating of A3 the group needs to manage its capital structure with reference to the ratings methodology and measures used by the relevant rating agencies. The ratings methodology is normally based upon a number of key ratios (such as regulatory capital value (RCV) gearing and adjusted interest cover) and threshold levels as updated and published from time to time by the rating agencies.
Further detail on the precise measures and methodologies used to assess water companies’ credit ratings can be found in the methodology papers published by the rating agencies.
Fair values
The fair values of financial assets and liabilities, together with the carrying amounts shown in the statement of financial position, are as follows:
Notes:
(1) The fair values quoted include £nil interest receivable (2009: £nil, 2008: £2.8 million). This interest receivable is also included within the fair value of trade and other receivables. The impact on the total fair value of financial instruments has been removed in the adjustment for accrued interest.
(2) Fair values quoted include accrued interest of £40.8 million (2009: £41.5 million, 2008: £37.5 million) in respect of the associated borrowings. This accrued interest is also included in the fair value of trade and other payables. The impact on the total fair value of financial instruments has been removed in the adjustment for accrued interest.
(3) Derivatives forming an economic hedge of the currency exposure on borrowings included in these balances were £100.3 million (2009: £182.8 million, 2008: £59.5 million).
In order to determine the fair values in the previous table, all borrowings and derivatives are valued using a discounted cashflow valuation model as described within the accounting policies. In determining fair values, assumptions are made with regard to credit spreads based upon indicative pricing data.
In respect of the total change during the year in the fair value of financial liabilities designated as at fair value through profit or loss for continuing operations of £7.9 million loss (2009: £56.6 million loss), £48.2 million loss (2009: £76.6 million gain) is attributable to changes in credit risk. The cumulative impact of changes in credit spread was £59.0 million profit (2009: £107.2 million profit). The difference between the carrying amount and the amount contracted to settle on maturity was a carrying amount increase of £63.4 million (2009: a carrying amount increase of £55.5 million).
The following table provides an analysis of financial instruments that are measured subsequent to initial recognition at fair value, grouped into levels 1 to 3 based on the degree to which the fair value is observable.
- Level 1 fair value measurements are those derived from quoted prices (unadjusted) in active markets for identical assets or liabilities;
- Level 2 fair value measurements are those derived from inputs other than quoted prices included within level 1 that are observable for the asset or liability, either directly (i.e. as prices) or indirectly (i.e. derived from prices); and
- Level 3 fair value measurements are those derived from valuation techniques that include inputs for the asset or liability that are not based upon observable market data (unobservable).
There were no transfers between level 1 and 2 during the year. No comparatives are required in the first year of adoption of the amendments to IFRS 7.
The company does not hold any financial instruments that are measured subsequent to initial recognition at fair value.