National Grid - Earnings Call - H2 2016

Transcript

Aarti Singhal (Head of IR)

Okay, I think we're going to start. Good morning, everyone. I'm Aarti Singhal, Head of Investor Relations for National Grid, and it is my pleasure to welcome you to our full-year results presentation. As always, we're going to start with safety. If you hear a fire alarm, it's not a test. It's for real. And in case of emergency, please use the front exits, turn left, and go to the end of the hall.

The other important thing to take note of is the cautionary statement, which is included in your packs. And for those of you who are joining on the web, thank you for watching the webcast. All the material is available on the website and on the investor relations app. So thank you very much for your attention, and I'd now like to hand you over to our first speaker, our Chairman, Sir Peter Gershon. Thank you.

Peter Gershon (Chairman)

Thank you, Aarti. At the half-year results presentation last November, I said a few words about CEO succession and said that Steve isn't going yet and still has the second half to deliver. The results we're announcing today mark a strong finish to Steve's leadership of National Grid. Steve stepped down at the end of March as CEO and handed the baton on to John Pettigrew. Steve has made an outstanding contribution to the group over his 15-year career with National Grid, including over nine years as its Chief Executive. The group composition has changed significantly over that time with outstanding total shareholder return delivered during his tenure as Chief Executive. To my mind, the real test of a CEO is the quality of the team and the business that they leave behind.

The results today should give you confidence that the business is in great shape, and the Board and I are delighted with the strength of the leadership team that we have in place to take this business forward. John Pettigrew has spent his whole career at National Grid in key roles throughout the group, both here in the U.K. and in the U.S., and I am confident he will prove to be a great successor to Steve. As you would have seen, we have also announced that Nicola Shaw will be joining to head the U.K. business on the 1st of July. Nicola brings with her enormous experience in the fields of regulation and infrastructure investment, and alongside Andrew and Dean, completes a very strong team of executive directors.

So many thanks to Steve for his hard work, his commitment, his drive, and focus, which have not only created great value for shareholders but also for his leadership, which has made National Grid the trusted and responsible company it is today. And now that's quite enough from me, so over to you, John.

John Pettigrew (CEO)

So thank you, Sir Peter, and good morning, everybody. So let me start by adding my own thanks to what Peter's already said and just recognizing Steve's tremendous contribution to National Grid over the last 10 years. And I'm very proud to be taking over a business that's in such good shape, as demonstrated by the results that we've announced this morning. So let me pick up on the main highlights of those results. So as you can see here, it's been another year of strong performance. Headline operating profit of GBP 4.1 billion is up 6% from last year, driving earnings per share of GBP 0.635, and group return on equity increasing by 50 basis points to 12.3%.

In line with our dividend policy, we're recommending a final dividend of GBP 0.2834 per share, bringing the proposed full-year dividend to GBP 0.4334, an increase of 1.1%, reflecting last year's average inflation. We continue to invest significant CapEx in infrastructure across the U.K. and the U.S. Last year, we had the highest level of capital investment for the group, investing GBP 3.9 billion, up GBP 364 million from the prior year. Looking ahead, we expect to maintain the high level of investment in existing and new assets. Overall, despite a low level of inflation, last year's capital spend resulted in our combined RAV and rate base growing by 4%. Safety and reliability remain our top priorities, and I'm pleased to say we've had one of our best years for safety performance across the group.

In the U.K., we've improved our key measures, including our Employee Incident Frequency Rate, which at 0.07 benchmarks as world-class. In the U.S., we've continued a positive trend. This year, we saw a double-digit improvement of over 20% in most of our key safety metrics, and this has been achieved despite a higher level of operational activity. Moving forward, our aim is to build upon this positive momentum, with safety continuing to be at the heart of every activity we undertake. As for reliability across our networks, this has remained strong throughout the year. In the U.S., our Electricity Distribution business delivered solid performance with continued recognition of our storm response. And in the U.K., despite the ongoing concerns over tightening electricity margins, our system operators manage these challenges extremely well. So let me now review the key achievements and developments across the group, starting with the U.K.

We have successfully maintained our strong track record of operational and financial performance. We reached major milestones on construction projects such as the London Power Tunnels, where we commissioned the first high-voltage substation in London for over 20 years. Financially, the U.K. business has performed very well with another good year of TotEx outperformance. This was achieved by our continued ability to find innovative and less expensive ways of delivering on our commitments. We also earned over GBP 100 million in incentives for outperformance against our key reliability, environmental, and customer service targets. One example I'd like to highlight where innovation has reduced costs for customers is our circuit breaker replacement program, where we piloted a new approach.

Through a combination of lower procurement costs and a new engineering design, we're now able to carry out circuit breaker replacements in half the time and in half the cost, at half the cost. So far, we've successfully completed 10 trials, and overall, we expect to generate future savings in excess of GBP 100 million through this new approach. It's important to note that our achievements benefit our customers as well, as around 50% of those savings are shared with them. To date, under RIIO, the customer share of savings is over GBP 330 million, with 2015-2016 being the first year when customers started to see those benefits. Moving on to our other activities, as we outlined at the half-year results, our Interconnector, Property, and other businesses have performed strongly, demonstrating the growing importance of these businesses for our group.

We've started the construction of new Interconnectors to Belgium and Norway, and we're in advanced stages of considering two further projects with France and with Denmark. I believe these Interconnectors, together with Metering, LNG, and Property, present attractive opportunities for National Grid. So turning now to regulation. As you know, Ofgem recently announced a mid-term review. As expected, the scope of this review was narrow, with no changes to key financial parameters. We welcome Ofgem's continued commitment to the clarity and the certainty offered by the eight-year RIIO framework. Ofgem will run a consultation process this summer, with any changes to be implemented in April next year. The other important area Ofgem is consulting on is the extension of competition in Electricity Transmission. We have been very clear in our responses to Ofgem's consultations that any changes need to be in the interests of customers.

We'll continue to use our experience to inform this debate and strive to ensure that any proposals implemented are robust and can deliver value. And in addition, we've been working with DECC and with Ofgem to consider how we evolve the current system operator model to make it more independent whilst remaining cost-effective. In doing so, we believe it's vital that there's no disruption to the pivotal role that National Grid plays as system operator in balancing the network. And finally, we've started the process of separating the U.K. Gas Distribution business to prepare for the sale of a majority stake. This process is now on track, with completion expected in early 2017, and I'll discuss in more detail in the second part of my presentation. So let me now turn to our U.S. business, which has delivered returns in line with expectations.

Our team is concentrating on efficiency improvements, which will help to manage our cost base ahead of new rates coming into effect. Overall, total investment was a record GBP 1.9 billion, contributing to a U.S. rate base growth of 7.5%, excluding movements in working capital. The high level of investment reflects the strong growth potential of our U.S. business, driven by the need to replace gas mains and reinforce electric systems across our regions. The $100 million Brooklyn-Queens Interconnector is a project that's a great example of a tight investment completed last year. This project addresses long-term gas supply issues in the New York City region. In addition, last year, we started construction of a $115 million Transmission project. This project will connect the first U.S. offshore wind farm to the mainland in Rhode Island and is due to be in service later this year.

As you know, we've also made significant progress with major rate filings and extensions, and currently, we have Massachusetts Electric, KEDLI, KEDNY, and Niagara Mohawk all under review. Improving returns in the U.S. is a key focus area for me, and I'll discuss the specifics of the rate filings in more detail later. Overall, last year was another strong year for National Grid, and I believe we're well positioned for the future. I'll now hand over to Andrew, who'll discuss the financial performance in more detail.

Andrew Bonfield (CFO)

Thank you, John, and good morning, everybody. As John has outlined, our financial performance in 2015-2016 was strong. Our regulated business has delivered solid results, which were enhanced by the strong contribution from other activities. Total operating profit increased by 6% to GBP 4.1 billion, a 4% increase at constant currency, and earnings per share rose by 10% to GBP 0.635 per share.

Importantly, group return on equity, a key measure of performance, increased by 50 basis points to 12.3%. Despite low inflation, our regulated assets grew by 4% with value added of GBP 1.8 billion, and our balance sheet remained strong. Now let me walk you through the performance of each of our segments. Starting with the U.K. Electricity Transmission, which continued to perform well with a return on equity of 13.9%. Overall, the business delivered 370 basis points of outperformance. Through our continued focus on innovation and efficiency, we met our Network Output Measures, and this contributed 210 basis points of TotEx outperformance. Other incentive performance at 80 basis points benefited from the Balancing Services Incentive Scheme, which delivered GBP 27 million of profit. Additional allowances contributed 80 basis points of outperformance, broadly in line with the previous year.

IFRS operating profit was GBP 1.2 billion, slightly down on last year as the business started to return prior-year efficiencies and as last year benefited from a one-off legal settlement. Capital investment totaled GBP 1.1 billion, and the year-end regulated asset value increased by 4% to GBP 11.8 billion. Moving now to U.K. Gas Transmission, which delivered a return on equity of 12.5%. The returns were down from last year, reflecting the expected reduction in additional allowances and the end of the Gas Permit Scheme. Despite the impact of these items, incentive performance was strong and enabled us to outperform the allowed base return by 250 basis points. Operating profit was up 11% on a headline basis, primarily due to timing. Excluding timing, underlying operating profit was down due to the loss of income from gas permits.

Capital investment was similar to last year at GBP 186 million, and the regulated asset value was flat at GBP 5.6 billion. U.K. Gas Distribution delivered another strong performance, achieving return on equity of 13%, 310 basis points above the allowed return. The business earned 200 basis points from TotEx savings, primarily from the Mains Replacement program. Other incentive performance at 100 basis points is ahead of last year, reflecting improved exit capacity incentives. Operating profit of GBP 878 million is up 6%, benefiting from high allowances following a change in the tax treatment of RepEx. Investment increased by GBP 51 million to GBP 549 million, and the regulated asset value increased to GBP 8.7 billion. In the U.S., the return on equity of 8% was lower than last year, but in line with our expectations, whilst we wait for new rates to come into effect.

As normal, our U.S. ROEs are reported on a calendar year basis. In 2015, our New York businesses were impacted by adverse winter weather, which led to higher repair costs and increased bad debt expense. In Massachusetts, the electric business continues to face eroding returns due to increased costs. As you know, we took the first steps to improve returns with the filings we've made for Massachusetts Electric in November and KEDNY and KEDLI in January. John will cover the progress we've made on these rate filings later on. Our Rhode Island and upstate jurisdictions continue to perform well, achieving attractive rates of return. Headline operating profit of GBP 1.2 billion is down 5%, driven by timing, reflecting the warmer end of this year's winter. Excluding timing, operating profit was GBP 45 million higher than the previous year.

We invested $2.7 billion in our U.S. networks, and the rate base grew by 6% to $18.3 billion. Excluding the movements from working capital, the rate base grew by 7.5%. Our portfolio of other activities delivered operating profit of GBP 374 million, almost doubling compared to the previous year. This increase in profitability was led by a strong year for our French Interconnector, significant sales in our Property business, and a favorable one-off gain of GBP 49 million on exchange of the Iroquois investment. We also saw lower costs as we completed the U.S. financial system implementation in the first half of last year. BritNed, our other Interconnector, also performed well, but its results are reflected in the JV line. Total investment in other activities was GBP 271 million. Financing costs were 6% lower than last year at a constant currency at just over GBP 1 billion.

The effective interest rate fell from 4.3% to 3.8% as we refinanced debt at lower interest rates and benefited from lower RPI increases in the U.K. We continue to be innovative in our approach to funding the business. During the year, we raised about GBP 1.8 billion of new financing by issuing nine new bonds, including a cash-settled convertible bond. We also continue to draw down on the EIB loan to fund capital investment. In KEDNY, we've issued $1 billion of debt, securing attractive low-cost financing for 10 and 30 years. Tax was in line with expectations. The effective rate of 24% was 20 basis points lower than the previous year and gave rise to a charge of GBP 753 million. Earnings increased to GBP 2.4 billion, and as you've heard before, earnings per share increased to GBP 0.635.

Operating cash flow was GBP 5.7 billion, around GBP 350 million higher than last year due to increases in profits and favorable movements in working capital. Our key credit metrics are comfortably above the levels expected for an A- rating. RCF to net debt was 11.5% and 10.5% after reflecting a full cash dividend. FFO to net debt was 16.7%, and interest was covered 5.5x. The strengthening of the U.S. dollar had an impact of around GBP 0.5 billion on net debt, but no impact on gearing, which fell by 1% to 62%.

Last year, we invested GBP 3.9 billion, a record for the group. Starting with the U.K., we invested GBP 1.0 billion in our regulated operations. Just over GBP 1 billion of that was in Electricity Transmission, of which over half was non-load related. In Gas Distribution, CapEx increased by GBP 51 million due to a step-up in the Mains Replacement program.

We replaced about 1,900 km of pipes last year, up almost a quarter. In Gas Transmission, most of our capital investment relates to asset health and emissions programs. Both of these are expected to increase next year. Looking now at the U.S., where investment increased significantly to $2.7 billion or GBP 1.9 billion. The majority of the spend was in Gas Distribution, principally on the replacement of leak-prone pipe and, to a lesser extent, on converting new customers from oil to gas. We also made significant investment in Electricity Distribution, where around $900 million was invested, reinforcing the network and connecting to a growing customer base, and $400 million was spent on improving and growing in our U.S. Transmission networks and other non-regulated activity. Finally, the increase in investment in other activities was due to construction starting on the North Sea Link and Nemo Link Interconnectors.

This investment also covered projects such as the Road Tanker Loading Facility at Grain. As John has said, this segment presents the group with interesting new opportunities. As you can see from the chart, our CapEx has risen, reflecting our focus on growing the portfolio through high-quality organic investment. In the U.K., we are currently expected to invest around GBP 16 billion in the RIIO-1 period, with around GBP 10 billion of this being investment in Electricity Transmission. Over the remainder of RIIO, around two-thirds of our investment in Transmission relates to non-load activity. In respect of our load investment, we are in consultation with Ofgem on the introduction of onshore competition. Current proposals relate to Strategic Wider Works, with anticipated capital spend in excess of GBP 100 million. We have two projects within RIIO-1 that could fall within the new arrangements.

These are the connections for Hinkley Point and NuGen Moorside, which together represent about GBP 1 billion of CapEx. If Ofgem decides it is in the best interest of customers to make these important projects contestable, we are well positioned to bid competitively. So, with our U.K. CapEx projections and the growth potential that we see in the U.S., we expect to sustain this significant level of CapEx in the coming years. This supports our long-run growth target to achieve 5%-7% asset growth, assuming U.K. RPI inflation of 3%. Assuming normal levels of U.K. inflation and excluding the U.S. working capital movement, underlying asset growth in this year was 5%. Consistent with our policy, the Board is recommending a 1.1% increase in the dividend. We also brought back last year's scrip, reflecting our strong balance sheet.

As we've said previously, we will continue to manage dilution whilst keeping a close eye on the need to finance growth within our current credit ratings. Value added in the year was strong at GBP 1.8 billion or GBP 0.476 per share. This is built from growth in group assets of GBP 1.1 billion, cash dividends, and the repurchase of scrip, which totaled just over GBP 1.6 billion, less the growth in net debt of around GBP 0.9 billion. Our expectations for value added continue to support our commitment to sustainable dividend growth. Looking ahead to next year, as usual, we've included a technical guidance section to support you with modeling assumptions. A few key points to note: we expect the U.K. to continue to deliver 200 basis points-300 basis points of outperformance, with slight reductions of legacy incentives in our Gas Transmission business, as I flagged previously.

In the U.S., returns are expected to be maintained year on year ahead of rate revisions in Massachusetts and New York. After removal of this year's one-off items and with lower Interconnector revenue, we expect our other activities to return to more normal levels of performance. We also expect to see marginally higher interest costs and a tax rate similar to this year. Let me summarize. The financial performance across the group has been strong. Our capital investment is at record levels, supporting future growth opportunities, and our financial strategy remains robust, with strong operating cash flows and headroom in the balance sheet. With that, I'll hand you back to John.

John Pettigrew (CEO)

Thank you, Andrew. As the new CEO of National Grid, I'd now like to share with you my initial thoughts on our priorities in both the short and the long term.

Maximizing value for our existing businesses has been and will continue to be the key priority, and this year, we have a number of important activities underway, including the sale of a majority stake in our Gas Distribution business and the U.S. rate filings, so let me start by updating you on the progress we've made on each of these, and after that, I'll highlight the key areas that I believe are important for the continued long-term success of National Grid, so starting with the update on our plans to sell a majority stake in the U.K. Gas Distribution business. With regards to the transaction itself, we've seen a good level of buyer interest and have been approached by a range of investors who are in the process of forming bidding consortia.

However, before formally launching the sales process, there's a huge amount of work required to start the separation of the business. U.K. Gas Distribution is not a standalone business. It's fully integrated with the other U.K. businesses and utilizes shared services from finance, HR, and IT. This means that separating out the business is complex. Our goal is to create a standalone business that can operate efficiently whilst maintaining its primary role as a provider of safe and reliable networks. Internally, we're consulting with our employees and with the pension trustees, and externally, we're working closely with Ofgem and the HSE to secure all the necessary regulatory consents prior to separation. I'm pleased to say that this work is progressing well.

The formal sales process will launch in the summer, and we continue to expect the transaction to complete in early 2017, after which our portfolio will be in a strong position in support of higher growth, delivering attractive dividend while ensuring we maintain a healthy balance sheet. As we indicated when we announced our plans, we expect to return substantially all the net proceeds to shareholders following completion of the sale. So, now turning to the second major activity, which is the rate filings in the U.S. As you know, following the completion of the SAP implementation, we've now started more frequent rate filings. Our objective is simple: to improve the performance of the business and consistently earn close to the allowed level of returns. To achieve this, we're focusing on three things.

Firstly, being more efficient, which will help to keep costs down and improve our underlying financial performance. Secondly, we must continue to file for new rates on a regular basis, which we're now much more able to do. And thirdly, we need to extend the mechanisms for CapEx trackers and true-ups to ensure efficient cost recovery. Looking at the specific rate cases filed, starting with KEDNY and KEDLI, which we filed in January, this is the first rate case filing for these entities since 2006. In terms of the timetable and the next steps, we're in the discovery phase, which typically involves responding to a very large number of information requests. The next stage in the process is when we receive PSC staff rebuttal testimony, which we're expecting tomorrow, and this will determine the next stage in the process with a decision due in December this year.

In addition to KEDNY and KEDLI, last November, we also filed the Massachusetts Electric rate case. Since starting the filings, we have completed discovery, and we are now in the hearing phase. This started earlier this month and will continue for the next four weeks, with new rates coming into effect in October 2016. In December 2015, we also filed a CapEx petition for Niagara Mohawk, seeking to provide funding for GBP 1.4 billion of CapEx across the fiscal years 2016-2017 and 2017-2018. The filing is currently being considered by the PSC, and we expect to hear from them shortly, with an extension coming into effect from April 2016. We are working closely with our regulators in each of our jurisdictions, and we are highly focused on ensuring a fair outcome for the significant filings made last year. Looking ahead, I expect the U.S. business to undertake frequent rate filings.

The next will be in 2017, with filings for both Niagara Mohawk businesses and Massachusetts Gas. Our other jurisdictions in Rhode Island and New York are performing well, with no immediate need to file, so this has been a busy year for us, and our teams are highly focused on delivering on our short-term priorities, but we also need to look forward, and I'd now like to share with you my thoughts on the four areas that I believe are absolutely critical to the continued long-term success of National Grid, so first of all, our customers. We take pride in connecting our customers to the energy they need. We want them to receive a service that's safe, reliable, and affordable. However, customers' needs are evolving, with much greater engagement, awareness, and a desire to manage their energy use.

It's vital, therefore, that we remain close to our customers so we can respond to their changing needs and deliver them an outstanding service. As customer requirements evolve, so must National Grid, and this will bring further opportunities to grow and drive value. The next area is performance optimization. National Grid is massively more efficient and agile than the business that I joined 25 years ago, but there's always more that can and must be done. To my mind, the entire organization should regard performance optimization as part of the day job, relentlessly driving efficiency and doing things better. For us to succeed, it's essential that we maintain and strengthen the group's performance culture. Moving to the third area, which is growth. We have a strong growth potential that's underpinned by the need for significant investment in the regions where we operate.

We see plenty of opportunities in our regulated businesses, and we expect to sustain high levels of investment over the coming years. We also see attractive prospects in our Interconnectors, Transmission, and Property businesses. And in addition, from time to time, we'll review acquisition opportunities that arise in our markets. Overall, we have access to multiple sources of growth, but we will only invest in projects that meet our strict investment criteria and represent the best value for our shareholders. This requires strong investment discipline, and I want to ensure this discipline is at the core of every decision that we make. And finally, looking ahead to the future, the use of renewable energy sources today, together with the drive for energy efficiency, are two major objectives that continue to grow in importance for our customers and our regulators.

Steady improvements in the economics of distributed generation and energy storage are both adding pace to this momentum. At National Grid, we support these changes, and we want to play our role in promoting clean energy and energy efficiency. We're working on many exciting projects that position National Grid at the heart of consumer-led developments. For example, in Massachusetts, we have a smart grid pilot which offers 15,000 customers advanced meters and in-home technology that's helping them to manage their energy use in real time, and in the U.K., managing system flexibility, given all the changes in the industry, is a major focus area for us. A good example is a service we call Demand Turn Up, which is part of our Power Responsive program. It essentially creates a market for businesses to earn revenue by shifting consumption to periods of oversupply on the system.

We're actively innovating and developing new products and services that are in sync with the needs of our evolving industry. Over the longer term, there are other trends that will need to become relevant for National Grid, such as electrification of heating and transport. These will result in more interaction between the Transmission and Distribution grids, which in turn will drive further investment in a range of opportunities. Overall, I believe if we concentrate on these four areas, we'll be in a strong position to deliver our long-term commitments for all our stakeholders. Let me summarize. National Grid is a strong business, as demonstrated by the performance that we delivered last year. As I said earlier, maximizing value from our core business is our key priority.

And this year, we're focused on the sale of a majority stake in our U.K. Gas Distribution business and the U.S. rate filings. Looking further out, we have good growth opportunities across the portfolio, and we're well positioned to deliver value for shareholders. So, thank you very much for your attention, ladies and gentlemen. Andrew, Dean, and I will now be happy to take any questions.

Mark Freshney (Director of Equity Research)

Thank you. I have two questions. Just firstly.

Andrew Bonfield (CFO)

Sorry, for the purposes of the transcript, can you identify yourself?

Mark Freshney (Director of Equity Research)

Sorry. It's Mark Freshney from Credit Suisse. I have two questions. Firstly, on the competitive tendering, it seems that the government are very intent on going ahead with this alongside Ofgem. What are some of the infra funds that you're competing against and also looking to sell assets to are taking exceptionally low returns?

If you were to compete against them taking those low returns, it may be dilutive to the overall group performance. In this new world of competitive tendering, what would be your kind of competitive advantage, so to speak? Just secondly, on the sale of U.K. Gas Distribution, I think there's been some press speculation on difficulties with or challenges with novating bonds and also on the pensions liabilities. What kind of structure can we expect to see? Would you prepackage it with debt and make it easy, or would it need a bigger financing package?

John Pettigrew (CEO)

Let me start with the competitive onshore Transmission. Clearly, we're still progressing on that in terms of exactly what the shape of that competition is.

We've been very clear to Ofgem and to other stakeholders that if onshore competition is in the interest of customers, then we're very supportive of it. But there's still a long way to go to make sure that we understand exactly what that onshore competition looks like. The Select Committee last week, you would have seen their findings, which I think were very sensible in setting out that for significant onshore Transmission projects, then there should be an assessment of whether there are actually benefits for customers or not. So, there's a long way to go, Mark, in terms of exactly what it would look like. In RIIO-T1, there are only two projects, Andrew said in his presentation, that would be impacted by competition. It's still not clear whether there will be or not because we don't know exactly what the definitions are.

Back in 2013, Ofgem said the Strategic Wider Works, which is basically Hinkley and Moorside NuGen, could be open to competition. They're incredibly complex projects. We've been at Hinkley for five years and up in the northwest for three. I'm sure Ofgem will need to assess not just the economics, but actually the timeliness of delivery as well. There's only two projects that will be impacted in RIIO-T1, and then further on, there may be further impacts. In terms of competitive advantage, it depends on the definition of competition. National Grid's got a huge amount of experience in developing major infrastructure projects right across the U.K. The whole process of planning, consenting, and getting an agreement with local communities to design and agree the infrastructure is something that National Grid's got a lot of experience, and infra funds certainly haven't.

In terms of the gas sale, let me start, and then I'll hand over to Andrew to talk about the bond issue. So, as I said in my presentation, the process is on track. We're expecting to formally start the process this summer, and we're on track to complete the transaction in early 2017. As I said, it is complex in that we need to separate out the business, but all that work is progressing very, very well. Andrew, did you?

Andrew Bonfield (CFO)

On both from a pensions perspective, we are working with the pension trustees and working very well with them to get to agreement on how we actually separate the liabilities into the different entities. So, that report was actually incorrect from that perspective.

And then, secondly, on the liability management exercise, we actually do have to work through a process of actually putting because don't forget, all the bonds that have been issued in NGG, we would have to get consent from bondholders to switch over. So, we will look to see what's the optimal way of actually putting a mixture of existing debt and new debt into the structure. But effectively, that is an ongoing process. The time issue at the moment for us actually is the separation from a business perspective on the back office and people part. That is actually probably the bigger time constraint than actually liability management or pensions. So, no real issue there.

Mark Freshney (Director of Equity Research)

Thank you.

Bobby Chada (Managing Director)

Thank you. It's Bobby Chada from Morgan Stanley. Can I just follow up on the onshore competition points?

So, specifically, those two examples you quoted of Hinkley and Moorside, National Grid's put a lot of time, effort, organizational skill into those projects already. Would there be any compensation?

John Pettigrew (CEO)

So, actually, Bobby, for the Strategic Wider Works as part of the RIIO funding mechanism, there was a pot of money put aside for the pre-engineering work. So, National Grid's effectively had its costs recovered for that. Where costs aren't recovered, they're a part of pre-engineering, then we look to indemnify with the customer themselves.

Bobby Chada (Managing Director)

So, in a sense, if they force these projects to go into some kind of competitive tender, you could have acted as a effectively, you've sort of facilitated them. But in the next round of competitive tenders, you wouldn't expect to take that facilitation role, would you?

John Pettigrew (CEO)

No, I mean, it's sort of at the heart of what's the definition of competition.

So, are they going to compete for a requirement that the system operator has for an increase in capacity, which they've described as the early model? Or are they going to actually have detailed work done by National Grid or other parties to do all the design work and all the planning, and then only compete out actually a project that's fully engineered and designed? That, I think, is still being discussed and debated. But in a world in which it's early and it was competed out, no, National Grid wouldn't do it.

Bobby Chada (Managing Director)

And when do you expect to have a decision on early versus well-defined?

John Pettigrew (CEO)

Well, the timetable seems to be working through over the next few months. So, Ofgem have been doing the consultations. They've set out some of their preferences and recommendations. So, I suspect it's towards the end of the summer.

Dominic Nash (Head of Utilities, Renewables, and Transport Research)

Hi. Hi, Dominic Nash, Macquarie.

Two questions, please. Firstly, on system operation, when are we expecting the news flow from DSO, and what are the options actually available as to in extremis? Could it be stripped from you into an independent company? And then, sort of following up from Bobby's question, would there be compensation for that sort of role? And secondly, all the action going forward in networks looks like it's getting more local and distributed. And the DSO, the creation of a DSO, when would we expect to hear from a potential creation of a lower voltage system operator? And then just my second question, sorry, on point three then, I guess, which is on storage. I mean, Terna's building a big storage facility in southern Italy as a replacement for Transmission.

When do you start to expect to see sort of large-scale storage in the U.K., and what opportunities and threats does that sort of throw up your way?

John Pettigrew (CEO)

I'm going to go at each of them in turn. So, we'll start with the system operator. So, a bit of context here. So, I mean, this goes right back to Amber Rudd's reset speech where she mentioned she wanted to look at whether there was value in increased separation of the system operator. And it's probably worth just saying that the system operator role has evolved every year over the last 20-odd years, and National Grid has always had to put the right controls and governance and separation in place to make sure that there aren't any perceived or actual conflicts of interest.

But we do recognize that the market needs to have confidence that those separations and those controls are in place. So, there is discussion going on with DECC and with Ofgem about what they might look like. The options are that given that the role has evolved over the last couple of years, there may be a need for further controls to be put in place. That is one option. The second option, which is debated far and wide, is a move to an independent system operator. My personal view is I don't think moving to an independent system operator is the right thing for the U.K. at this time. There's an awful lot going on in the industry with the need for inward investment.

We need stability as we focus on things like balancing the network with a lot of new generation coming on, and it would be a hugely disruptive thing to do, but in terms of the timescales, it's with government, so we're in discussion, so I'm not sure what the exact timescales are. My personal view is it's probably going to be in 2016. The second question was around, I think, just the interaction between Distribution and Transmission networks?

Dominic Nash (Head of Utilities, Renewables, and Transport Research)

And the creation of a DSO itself.

John Pettigrew (CEO)

Yeah. Again, in terms of timing of the DSO, it's unclear to me. You're absolutely right that there is a huge amount of more interaction now between the Transmission networks and the Distribution networks.

And we've done a lot of work over the last 12 months working with the DNOs to be able to make sure that we get the right information flow so that there aren't any inhibitors to distributed generation connecting to the Distribution networks. We are at a point where quite often, reinforcements are now needed on the Transmission system in order to facilitate the flows that we're seeing on the Distribution network. So, the DNOs are becoming more active in the way that they manage their networks. There's been lots of discussion around whether they're going to formally become Distribution System Operators, but that's going to continue to evolve, in my view. And the third question around storage. So, in terms of storage, you're right. As technology prices fall, then storage starts to become an option for a number of different types of service.

In our mind, it can provide an extremely useful balancing service. As we see more intermittent generation on the network, then the need to have fast-acting frequency response, which battery storage is a fantastic provider of, becomes a really valuable service to us. Of course, you could also see it as being an alternative to building infrastructure, depending on what type of flows you have on the network. Of course, it's got the opportunity for energy arbitrage as well. When the National Infrastructure Commission came up with their findings, which I think were very helpful, that said that we need to get the right frameworks in place in the U.K. to make sure that those three tranches of opportunity in storage can be exploited, I think was bang on, in my view.

I think the actions that they put to DECC and Ofgem are going to be important to get the right framework. We are certainly looking at it from a system operator perspective at the moment in terms of potentially seeing if there's an opportunity to have fast-acting frequency response through battery storage.

Deepa Venkateswaran (Managing Director and Head of Utilities and Clean Energy Research)

Thank you. This is Deepa Venkateswaran from Bernstein. I had a couple of questions. The first one is your Interconnectors. I mean, if there were to be a Brexit, would that actually impact any of your existing projects where you've already taken FID or maybe even the future projects? Secondly, could you also explain the working capital movements in the U.S., which I think there was some statement that you wouldn't be seeing a similar working capital move next year? And then I think the rate base growth was different. Could you just explain what that was?

John Pettigrew (CEO)

So, in terms of, I'll give Andrew the working capital one. In terms of the impact on Interconnectors, I think our expectation is that we're not expecting to see a significant impact as a result of Brexit on our Interconnector flows. The economics and the desire to have interconnection between the U.K. and Europe exists. So, there are people on both sides that are keen to trade across that Interconnector. Exactly what form that will take is really dependent on exactly what the exit looks like and what set of rules we get the other side of it in terms of whether we're part of the internal energy market in a world in which we're outside of Europe. So, it's difficult to exactly predict what that will look like. But the desire to have interconnection between the U.K. and Europe is on both sides.

I don't see it having a significant impact. In terms of working capital, Andrew?

Andrew Bonfield (CFO)

Yeah, certainly, Deepa, on working capital. Some jurisdictions in the U.S. do actually put working capital into rate base. And obviously, when you have winter weather fluctuations, you do see. 31st of March 2015, very cold winter, very high level of debtors resulted in very high working capital. Last year, when we talked about underlying growth in the U.S., the headline growth was 9% in rate base. We talked about 5% underlying. This year, obviously, very mild winter in the U.S. On 31st of March 2016, low level of debtors, we actually saw a working capital reduction. Effectively, the underlying rate was 7.5%, but the headline rate was 6%. We just normalized for that just to take it out so you can see what the real underlying expectation is of rate base growth.

John Pettigrew (CEO)

We have one here.

Andrew Bonfield (CFO)

Second one. Ed.

Edmund Reid (Partner)

Thank you very much. I'm Edmund Reid from Lazarus. Three questions. The first on DSR. You're obviously making quite a push for DSR in the U.K. I think DSR is a lot less prevalent in the U.K. than it is in the U.S. I was wondering why that was the case and what you can do to improve it. Secondly, on battery storage, do you think most of the battery storage will be at the Transmission or Distribution level? Do you see it as more of an opportunity for your U.K. or your U.S. business? And then thirdly, on Metering revenues, looks like smart meters are finally being introduced or speeding up. What's that going to do to your legacy Metering business?

John Pettigrew (CEO)

Okay, thank you so much. So, let's start with DSR. And I might ask Dean for his comments on the U.S.

So, certainly in the U.K., over the last 12 months, National Grid actually launched a program called Power Responsive campaign, which was really trying to identify where are the blockers in the U.K. for encouraging increased demand-side response. So, from a system operator perspective, we see demand-side as being a really important part of balancing the network going forward, particularly when you've got increased intermittent generation. So, the Power Responsive campaign was very much about getting people across the industry together to understand where those blockers are and then to try and develop different types of products and services. Over the last year, I think we've had some real successes with that. So, we are seeing increased use of DSR in terms of balancing our network. As I mentioned in my speech, we've introduced new products such as the Demand Turn Up product, and we'll continue to do that.

As an aspiration, we've set out that potentially you could see, from a balancing action perspective in the U.K., about half of our actions being on the demand-side and half on the generation side. Now, that's a long-term aspiration, but one that we think is achievable because of the scale and the capability of the demand-side. In terms of, so why is it not flourishing in the U.K. as much as it perhaps in the U.S.? If you talk to people who are providing those services, then what they're looking for is long-term contracts and certainty. We need to work with the regulators and with the providers themselves to make sure that they have that to be able to make the investments to shift their processes to be able to provide the services. Dean, did you want to mention anything on the U.S. side, demand-side?

Dean Seavers (Executive Director of PLC and President of U.S. Business)

Yeah. Good morning. I mean, I don't have a lot to add to that. I think from the standpoint of both working with our regulators as well as, I'd say, just incentives, we definitely are seeing that in the U.S. I think I did want to pick up on another point too, another question that was asked relative to the storage piece for us and the distributed generation. The reality is a lot of the regulations and incentives are really driving that. It's put a lot of pressure on the system from a peak standpoint. John mentioned the fact that it has some requirements on our network. But in terms of the test that John mentioned in his earlier prepared speech, the reality is we're testing a lot of those from a microgrid standpoint.

If you go from what we're trying to do with our customers from a resiliency and from a reliability standpoint, we're testing microgrids and some of our REV initiatives. So, you'll see a lot more results from that going forward.

Edmund Reid (Partner)

Thanks, Dean.

John Pettigrew (CEO)

And in terms of battery storage in the U.K., so there are opportunities in Transmission. It's quite clear whether they're going to be larger than the people putting the battery on their home, which is what all the adverts show at the moment. I think it's just too early to say, if I'm honest. I mean, there is an issue in the U.K. that actually National Grid couldn't own storage as it's currently defined as an asset class because at the moment it's classed as a generator. Now, there are a lot of people who think that's probably not right in terms of the role that storage plays.

But in terms of potentially providing a service to Transmission or as an alternative to infrastructure, clearly, if prices keep coming down, it's a sensible solution. And on Metering, we did see some reduction in the number of meters, gas meters. Obviously, this year, most of them were prepayment. But actually, we were able to offset the impact of that. So, profits were actually flat year on year. It's been interesting watching the Metering business. I've now been here for five and a half years, and every year it's going to go down. And my budget for next year is slightly down year on year given the change. But we'll obviously just manage the business as best as we can. Ed, obviously, over time, we do expect obviously the rollout of smart to have an impact.

Iain Turner (U.K. Utility Analyst)

Thanks. It's Iain Turner from Exane.

Can I ask a couple of questions? Firstly, could you just go through the change to the tax treatment in RepEx? Explain that a bit more so I didn't get that. And secondly, I think in the statement you give a figure for how much tax you paid in the U.K., but you don't give a figure for how much you paid in the U.S., which I guess means it's probably quite a small number. Is that a liability going forward in terms of the political or the regulatory situation in the U.S.?

Andrew Bonfield (CFO)

Okay. So, first of all, on tax change in RepEx, this was a very technical accounting issue. It effectively relates to adding IFRS accounting to U.K. entities. As a result of that, as a result of the change to IFRS accounting, effectively Mains Replacement expenditure was now capitalized and depreciated.

That results in a change to the tax treatment because the HMRC was going to follow what IFRS accounting was going to do. So, allowances had to change to reflect that because, as you know, we're remunerated on cash taxes. In the U.S., we don't pay any cash tax. It's bonus depreciation, which obviously increases the deferred tax liability. As far as the political climate is concerned, actually, they've just extended bonus depreciation through 2019, although tailed it off. It is about the desire to see investment.

Lakis Athanasiou (Utilities Analyst)

Hi. Lakis Athanasiou from Agency Partners. Three questions for me. You mentioned the IFRS changes. Are you seeing any different treatments in regard to your current tax on derivative with the change to your subsidiaries being accounted as IFRS? Secondly, could I press you on your response on storage and DSR, particularly in the U.K.?

It is a technology that's very good for a system operator, but it's very bad for a Transmission owner. And you seem remarkably relaxed that these activities will cannibalize your growth in assets. And I'm thinking particularly the U.K., where you do get some good returns on your assets going into the RAV. And thirdly, on debt separation in Gas Distribution, Andrew spoke about it. But could I press you on that one a bit more? Because if I was a debt holder in NGG, I certainly wouldn't want my debt ending up in the new Gas Distribution entity with the potential that it gets levered up down the road. And I see that as a problem that, well, I mean, is it surmountable? And how could it be given that bondholders wouldn't want to see their debt going into the new entity?

Andrew Bonfield (CFO)

Do you want me to start?

Okay, start with that one first. Firstly, there is a regulatory reason why you wouldn't actually gear up the entity itself. And that is actually because of the interest deduction on cash taxes. There is a restriction on how much debt you would actually be able to put in. So, that would be one thing that is a thing. You cannot gear these entities up to the level that you're expecting. You will actually have to do it within the structure rather than the actual individual entity.

Lakis Athanasiou (Utilities Analyst)

You get the tax. You don't get the tax credit, but we've seen in the water sector when these things happen, they come in and they gear up. Now, they lose the tax shield, but they still gear up.

Andrew Bonfield (CFO)

But like I said, one of the things we all will still have a 49% ownership. We will not want to lose the tax credit.

We actually do have restrictions. We do have things we'll continue to watch on. As far as actually on the IFRS accounting for derivatives, that doesn't impact because derivatives are for our own account. There was no impact. This was because, obviously, with RepEx, there is a regulatory allowance around whether it was capitalized or not capitalized for IFRS accounting and then for tax purposes. Tax on derivatives or book tax on derivatives is actually as reflected in the accounts. There will be no impact of that just from a book accounting perspective. Sorry. Excuse me.

Lakis Athanasiou (Utilities Analyst)

My third question on cannibalizing Transmission.

John Pettigrew (CEO)

I mean, in terms of investment in the U.K. business, as we look forward, we've got a strong investment profile. We're going to spend GBP 16 billion on our networks in RIIO-T1.

And a large part of that continues to be asset replacement as well as supporting renewables and new generation. There are opportunities for Transmission to use storage, but DSR and storage do impact on the overall profile of demand. So, demand has been flat for a number of years now. How that actually plays out is just too early to say in terms of exactly what it means. We're actually finding at the moment that actually through intermittent generation and distributed generation, that we're identifying projects on our Transmission business that are required in order to support the Distribution networks doing what's happening on their DNO networks. So, it's not one-way is what we're seeing at the moment. Its impact on what we need in terms of reactive power on our networks. We're putting a lot of equipment on reactive on the networks at the moment.

So, I don't see it as a spiral decline.

Any more questions?

Verity Mitchell (Director of Utilities Research)

Hello. Verity Mitchell, HSBC. I've just a couple of questions. One is a technical one about FERC and the complicated moving down and up of returns. Perhaps we get a bit of clarification about that. The FERC businesses. I mean, you earned 11.4% ROE this year, but I know that the FERC is reviewing its allowed returns. That's my question. And the second question is just about your technical guidance on strong Interconnector performance this year. And perhaps you could explain why you think that might not continue in the current year.

John Pettigrew (CEO)

Okay. Dean, would you like to take the first one?

Dean Seavers (Executive Director of PLC and President of U.S. Business)

Yeah. On the FERC, we've had a couple of challenges on the returns. And in a couple of cases, they've been reduced. But in reality, we've had a case that should just been come back.

The decision was in the first year; it was reduced. In the second year, it was actually increased. From our perspective, obviously, in terms of the relationship with the regulator is to make sure we get fair outcomes on that to get the heavyweights stabilized. That's kind of what we're seeing recently.

Andrew Bonfield (CFO)

Thank you. Very few on the technical guidance. What we're pointing out, if you remember the half-year, I did actually point out we saw very strong performance over the summer. Part of that was due to changes with the Climate Change Levy, which did result in a very significant arbitrage opportunity, which boosted auction prices that we don't expect to recur next year. We do expect the profitability to decline as a result of that.

John Pettigrew (CEO)

Okay. We'll just take the last couple of questions. There's one here up front.

James Brand (Director)

James Brand from Deutsche Bank. Two questions. First one is on the U.S. You talked about a desire to get the returns up in the U.S. to close to the base returns, and that's a key focus. Is that something we should expect to happen over the course of the next round of rate filings in the next kind of two to three years, or is that more of a medium-term ambition for the next five to six years? Second question, obviously, a lot of focus on your system operator role and lots of talk about how next winter looks very, very tight, certainly based on the capacity that's going to be available in the market. Obviously, you have the SBR as well.

Just wondering whether you could share some thoughts around next winter, whether you think you have the tools that you need to keep the lights on and keep prices at a reasonable level, and whether there are any levers that you can pull to avoid frequent price spikes next winter?

John Pettigrew (CEO)

So, in terms of the U.S. rate filings, as I said in my presentation, so we've currently got KEDNY and KEDLI and Massachusetts out for rate filings. We expect Massachusetts to conclude in October and KEDNY and KEDLI to conclude in January. So, we will see a small benefit in this fiscal year from those rate filings, which will effectively offset some of the cost pressures we've got in other parts of the business. So, as our outlook sets out, we're expecting returns in the U.S. for this coming year to be similar to what we've seen last year.

However, with those rate filings in place and then with the next tranche of rate filings going in, which will be the Niagara Mohawk and Massachusetts Gas, then we would expect to start to reduce that headroom between the allowed returns and the actual returns. In terms of the system operator role in next winter, part of our role as National Grid, obviously, is to do the assessment in terms of what does the winter look like. We've done that assessment based on what we see and with the closures that we've seen in the last 12 months. Next winter looks tight but manageable, similar to the words that we've used in previous winters. National Grid has already purchased 3.5 GW of Supplemental Balancing Reserve. We've got a tender out at the moment for demand-side Supplemental Balancing Reserve.

Based on where we are today and the analysis that we've done, we feel that we've got the tools that we need. But it's a long way to go till the winter. We continuously assess it, and we'll continue to do that through the summer right up to our Winter Outlook Report in the autumn to make sure that we have the tools to balance the system.

James Brand (Director)

Thank you.

John Pettigrew (CEO)

Peter.

Peter Atherton (Managing Director of Equity Research)

Thanks. Peter Atherton from Jefferies. These are easy ones, I think. In the financial calculations on the return on RAVs, there's a 3% indexation. So, can you just remind me when that gets trued up to actual inflation?

Andrew Bonfield (CFO)

The actual numbers we produce are value-add, and actually what the RAV-based growth we talked about actually are actual rates of inflation. So, they reflect the 1.6% that was there at the 31st of March on RPI.

When we do, for purposes of actually giving out ROE calculations and showing our returns, rather than go to effect, because we have nominal regulation in the U.K., nominal in the U.S., real in the U.K., we just give a nominal, but we use a long-term inflation assumption, which is 3%, which is the Bank of England 2% plus 1% for RPI.

Peter Atherton (Managing Director of Equity Research)

Okay. Thanks. And just final one on sort of managing the system. I mean, we've seen a collapse in coal output in the U.K. in recent weeks and months. And it doesn't look great for the coming months as well on the economics of coal. What sort of challenges does that throw up, if any?

John Pettigrew (CEO)

So, in terms of the it was a lot of media, wasn't it, in the last couple of weeks?

But it was the first time in a hundred-odd years that we've run the network without any coal on it. So, the characteristics of the network have changed, Peter. You're absolutely right. So, we see a lot of solar in the day, a lot of wind, and then the gas coming on in the evening, and a lot less coal on the network. The challenge it throws up is particularly around intermittency, which is why we've been developing products like the Demand Turn Up product and fast frequency response. So, as the network's evolving, we're having to develop new products to make sure that we can manage the system in real time. I'm very pleased, actually, with the way that the system operator's managing that. And the new products we're putting in place seem to be very economic and a good way of meeting those challenges.

We're going to take this as a final question, I think.

Elchin Mammadov (Equity Research Analyst of European Utilities)

Elchin Mammadov of Bloomberg Intelligence. Two questions, please. Can you remind us what the system operator earnings are as a part of your operating profit and net income, please? And the second question is on M&A. Obviously, you said you're trying to grow organically mostly, but you're open for new opportunities. Could you give us a bit more color? What geographies we're talking about? Is it just U.S. and U.K., or are you open to new geographies? And what areas? Is it just a Transmission, Interconnectors, or Distribution?

John Pettigrew (CEO)

So, in terms of the system operator, the operating profits are very modest. They're about 1% of our total operating profit. So, in terms of my comments on M&A, so National Grid's in a very good position in terms of sources of growth.

We've got strong growth in our core business in both the U.K. and the U.S. As Andrew said, we're targeting 5% growth across the group. In addition to that, we've got some exciting development opportunities with things like Interconnectors and Transmission in the U.S. As you'd expect of a company like National Grid, from time to time, we will look to see if there's an opportunity for acquisitions. We will only do that if we believe it aligns with our strategy and that it creates value for our shareholders. Okay. I'm going to conclude the Q&A there. Thank you very much, everybody, for attending today. As you saw last year, strong results for National Grid. Hopefully, as you got a sense from the presentation, the management team is very focused on our short-term priorities and in very good shape for the future.

So, thank you very much, everybody.