ANNUAL REPORT AND FINANCIAL STATEMENTS
FOR THE YEAR ENDED 31 MARCH 2010

The regulated business requires significant capital expenditure, particularly in relation to new and replacement plant and equipment for water and wastewater networks and treatment facilities. Historically, the group has financed this capital expenditure from operating cashflow and from external debt and equity financing. There can be no assurance that operating cashflows will not decline or that external debt financing and other sources of capital will be available, at similar cost to that assumed by Ofwat, in order to meet these capital expenditure requirements. Delivery of capital investment programmes could also be affected by a number of factors including adverse legacy effects of earlier capital investments (such as increased maintenance or enhancement costs) or amounts funded in regulatory capital investment programmes proving insufficient to meet the actual amount required. This may affect the group’s ability to meet regulatory and other environmental performance standards, which may result in fines imposed by UUW’s regulators of an amount of up to 10 per cent of regulated business turnover or other sanctions.

For the 2010-15 period, Ofwat has introduced a new comparative incentive mechanism to reward or penalise water companies’ service performance, replacing the overall performance assessment (OPA). The service incentive mechanism (SIM) compares companies’ performance in terms of the number of ‘unwanted’ contacts received from customers and how well they deal with those contacts. Depending upon UUW’s relative performance under the SIM it could receive a revenue penalty or reward when price limits are next reset in 2014.

The group is required to maintain the serviceability of its water and wastewater assets, ensuring they continue to deliver a level of service and performance at least as good as in the past. Where serviceability falls below required reference levels of performance Ofwat may impose a penalty in revenue at the next price-setting. Or, if performance were to decline, the group may incur additional operating or capital expenditure to restore performance.

In preparation for the change, systems and processes are being developed and enhanced, where necessary, to allow the company to report accurately on the volume of ‘unwanted’ contacts it receives. The company’s focus is on ensuring right first time service delivery to its customers, thus avoiding the need for ‘unwanted’ contacts. Where ‘unwanted’ contacts do arise, then there is a clear focus on identifying the root causes. These actions are intended to ensure that the company’s performance under the SIM is optimised and thereby mitigating the risk of a penalty at the next price-setting.

The various indicators of performance are closely and routinely monitored by management. The company’s capital investment programme is targeted to seek to maintain stable serviceability of the company’s water and wastewater assets. Similarly, operational practice is intended to ensure stable serviceability. Where adverse trends develop and there is a risk of serviceability deviating from stable, then corrective action can be taken.

In 2008, the government announced its intention to transfer sewers and pumping stations currently owned by private individuals and businesses to sewerage undertakers. The precise date and nature of the transfer is yet to be determined but could occur as soon as 2011. No allowance has been made in price limits for the costs associated with the transfer. Therefore, any costs incurred will represent an unbudgeted increase in operating and capital expenditure.

Although there are costs associated with the transfer, as long as they are incurred efficiently they are expected to be largely recoverable when price limits are next reset, either at an interim determination or the next periodic review, but there can be no guarantee of full cost recovery at this stage.

In recent years, the global banking crisis and economic downturn have impacted the bank lending environment, as well as the debt and equity capital markets. This has resulted in the cost of capital increasing and has made the arranging of finance and issuance of new equity and debt capital more expensive and difficult to secure.

A compounding challenge arises from the relationship between the regulatory capital value (RCV) of the regulated business and the Retail Prices Index (RPI). The RCV is adjusted annually for inflation so, if RPI decreases, the RCV would be adjusted downward to reflect this. This may lead to pressure on gearing (and other key financial ratios), credit ratings of the regulated business (and the group as a whole), and increase the cost or limit the availability of credit. In the extreme, the group may be required to increase its equity base by either reducing its dividend payments or raising new equity capital. The global economic downturn continues to present difficult trading and financing conditions for customers, contractors and suppliers of materials and/or services to the group.

The group monitors closely its liquidity headroom within the parameters approved by the board, the impact of trends in inflation or deflation on its capital position as well as the potential impact of wider changes in the credit markets. Where possible, the group has sought to issue debt linked to RPI to minimise the extent of its exposure to deflationary (or low inflationary) conditions. The group also monitors the financial position of its key contractors and suppliers and seeks to use its procurement processes to ensure that alternative suppliers can be sourced quickly and, where possible, on similar terms.

The group participates in a number of pension arrangements, predominantly in the UK. The principal schemes are defined benefit schemes, although these have been closed to new employees since October 2006. The assets of these schemes are held in trust funds independent of group finances, with the funds being well diversified and professionally managed. The group’s current schemes had a combined IAS 19 deficit of £271 million as at 31 March 2010, compared with a deficit of £213 million as at 31 March 2009 and a deficit of £359 million as at 30 September 2009.

Increases to pension fund deficits may result in an increased liability for the group, the size of the liability depending upon the extent to which additional deficits are recoverable through the regulatory price determination process. In the 2009 water price review, Ofwat took account of broadly 50 per cent of the pension deficit shown in UUW’s final business plan for the regulated business when setting its overall price controls. In response to the size of its ongoing pension risks and pension costs the group has recently been consulting on a series of changes for employees in its defined benefit schemes. These changes, which came into force on 31 March 2010, will result in reduced costs and risks, including deficit, associated with defined benefit liabilities in future. In conjunction with the trustees, the group continues to monitor the investment strategy for the pension schemes, including the group’s exposure to investment risks.

The group is subject to various laws and regulations in the UK and internationally. Regulatory authorities may, from time to time, make enquiries of companies within their jurisdiction regarding compliance with regulations governing their operations. In addition to regulatory compliance proceedings, the group could become involved in a range of third party proceedings relating to, for example: land use, environmental protection and water quality. Amongst others, these may include civil actions by third parties for infringement of rights or nuisance claims relating to odour or other matters. Furthermore, the impact of future changes in laws or regulations or the introduction of new laws or regulations that affect the business cannot always be predicted and, from time to time, interpretation of existing laws or regulations may also change or the approach to their enforcement may become more rigorous. If the group fails to comply with applicable law or regulations, in particular in relation to its water and wastewater licences, or has not successfully undertaken corrective action, regulatory action could be taken that could include the imposition of a financial penalty (of up to 10 per cent of relevant regulated turnover) or the imposition of an enforcement order requiring the group to incur additional capital or operating expenditure to remedy its noncompliance. In the most extreme cases, non-compliance may lead to revocation of a licence or the appointment of a special administrator.

The group endeavours to comply with all legal requirements in accordance with its business principles and robust processes are in place to seek to mitigate against non-compliance. The group continually monitors legislative and regulatory developments and, where appropriate, participates in consultations to seek to influence their outcome, either directly or through industry trade associations for wider issues. The group seeks appropriate funding for any additional compliance costs in the regulated business as part of the price determination process.

The Cave review of competition and innovation in water markets was published in April 2009 and in September 2009 the government consulted on legislation to implement a number of the review’s proposals. If its recommendations are implemented, this could eventually expand the competitive market allowing retail competition to all non-household customers. Ofwat and the Environment Agency are considering the introduction of reforms to the regulation of water abstraction licences that would allow trading of licences. Ofwat is also examining the scope for ‘upstream’ competition in treated water supply.

Ofwat has taken steps to introduce competition into the water supply market through inset appointments and the water licensing supply regime. Prior to 2007 (with one exception), inset appointees had all been granted to existing regulated companies. Since 2007, Ofwat has granted more inset appointments, one of which is within UUW’s region. Further inset appointments may be made in the future, resulting in increased competition.

The group has been fully engaged in the government and Ofwat consultations on the Cave review and other aspects of competition. A relatively small proportion of the group’s profits derive from the retailing of water and wastewater services to non-household customers. However, United Utilities recognises that reforms to the pricing rules that govern access to the group’s water network and greater upstream competition could put at risk a greater proportion of the group’s profits. If competition is expanded, there would also be opportunities for the group to participate in a wider market in England and Wales.

The group controls and operates utility networks and maintains the associated assets with the objective of providing a continuous service. In exceptional circumstances, a significant interruption of service provision or catastrophic damage could occur resulting in: significant loss of life; and/or environmental damage; and/or economic and social disruption. Such circumstances might arise, for example, from electricity, gas or water shortages; the failure of an asset or an element of a network or supporting plant and equipment; human error; an individual’s malicious intervention; or unavoidable resource shortfalls. The group could be fined for breaches of statutory obligations or held liable to third parties, or be required to provide an alternative water supply of equivalent quality, which could increase costs. The group is also dependent upon the ability to access, utilise and communicate remotely via electronic software applications mounted upon corporate information technology hardware and communicating through internal and external networks. The ownership, maintenance and recovery of such applications, hardware and networks are not wholly under the group’s control.

The group operates long-standing, well tested and appropriately resourced incident response and escalation procedures. The processes continue to be refined, alongside related risk management and business continuity procedures. These recognise that possible events can have varying causes, impacts and likelihoods. While the group seeks to ensure that it has appropriate processes in place, there can be no certainty that such measures will be effective in preventing or, when necessary, managing large-scale incidents to the satisfaction of customers, regulators, government and the wider stakeholder community. The group also maintains insurance cover in relation to losses and liabilities likely to be associated with such significant risks, although potential liabilities arising from a catastrophic event could exceed the maximum level of insurance cover that can be obtained cost-effectively. The licence of the regulated business also contains a ‘shipwreck’ clause that, if applicable, may offer a degree of recourse to Ofwat in the event of a catastrophic incident.

Outside the regulated business, the group provides services relating to the operation and management of assets for other utility clients in the UK and overseas. These services include the maintenance and operation of utility networks, the design and construction of new assets, the design and construction of new connections to the relevant network and the provision of ancillary services. The delivery of contracts, both existing and future, will be achieved by exploiting the group’s core infrastructure management skills and may also require capital expenditure. The overstretching of such skills could lead to a loss of customers or the inability to meet contractual commitments, or to the incurrence of penalties.

The costs and risks associated with these new projects are subject to internal reviews before approval is given to commit to them. The group aims to comply with its contractual commitments or operating performance targets and any requirements to maintain service continuity or achieve specified operating efficiencies in relation to those clients. Within the non-regulated business, the focus is on deploying the group’s core skills on an asset-light basis, whilst continually monitoring contract performance, together with programme and project management.

NOSS Consortium (NOSS) (of which North West Water International Limited, a wholly owned subsidiary of United Utilities Group PLC, is a member and the sole remaining active participant) is party to arbitration proceedings in Thailand in relation to a design and construction contract dated 1 November 1993 between NOSS and the Bangkok Metropolitan Administration (BMA) to build a wastewater treatment plant and network in central Bangkok. Following disagreements with the engineer (Dorsch Consult) and disputes with the BMA, NOSS terminated the contract with the BMA and served a notice of arbitration. NOSS has total claims against the BMA of approximately six billion baht. The BMA has counterclaimed for approximately three billion baht; however, based upon the facts and matters currently known, the counterclaim appears to lack substance. Although there have been some delays in the arbitral process, the arbitration now appears set to proceed.

In February 2009, the group was served with notice of a multiparty ‘class action’ in Argentina into which United Utilities International Limited (UUIL) was enjoined in 2007. The class action is related to the issuance and payment default of a US$230 million bond by Inversora Eléctrica de Buenos Aires S.A. (IEBA), an Argentine project company set up to purchase one of the Argentine electricity distribution networks, which was privatised in 1997. UUIL had a 45 per cent shareholding in IEBA which it sold in 2005. The class action is being pursued against various parties, including the original direct and indirect shareholders of IEBA, the banks which advised IEBA and the rating agencies of the bonds. The bonds, which were issued in 1997, were defaulted in March 2002 and IEBA entered an insolvency process in 2003. The claim is for a non-quantified amount of unspecified damages, and purports to be pursued on behalf of unidentified consumer bondholders in IEBA. UUIL has filed a defence to the action and will vigorously resist the proceedings, given the robust defences that UUIL has been advised that it has on procedural and substantive grounds.

In March 2010, Manchester Ship Canal Company (MSCC), owners of the Manchester Ship Canal (the ‘canal’), issued proceedings, seeking, amongst other relief, damages alleging trespass against UUW in respect of UUW’s discharges of water and treated effluent into the canal. The respective legal rights of MSCC and UUW relating to the discharges are unclear. Accordingly, the relevant legal principles need to be tested through court process. UUW will be filing a defence and counterclaim in support of its believed entitlement to make discharges into the canal without charge and MSCC’s claim will be vigorously defended thereafter.

The group faces the general risk of litigation in connection with its businesses. In most cases, liability for litigation is difficult to assess or quantify; recovery may be sought for very large and/or indeterminate amounts and the existence and magnitude of liability may remain unknown for substantial periods of time. The group robustly defends litigation where appropriate and seeks to minimise its exposure to such claims by early identification of risks and compliance with its legal and other obligations. Based upon the facts and matters currently known and the provisions carried in the group’s consolidated statement of financial position, the directors are of the opinion that the possibility of the disputes referred to in this risk section having a material adverse effect on the group’s financial position is remote.