A4 Financial risk management

Risk management

The board is responsible for treasury strategy and governance, which is reviewed on an annual basis. The annual treasury strategy review covers (as applicable) the group's funding, liquidity, capital management and interest rate management strategies, along with the delegation of specific funding and hedging authorities to the treasury committee.

The treasury committee, a subcommittee of the board, has responsibility for setting and monitoring the group's adherence to treasury policies, along with oversight in relation to the activities of the treasury function.

Treasury policies cover the key financial risks: liquidity risk, credit risk, market risk (inflation, interest rate, electricity price and currency) and capital risk. These policies are reviewed by the treasury committee for approval on at least an annual basis, or following any major changes in treasury operations and/or financial market conditions.

Day-to-day responsibility for operational compliance with the treasury policies rests with the treasurer. An operational compliance report is provided monthly to the treasury committee, which details the status of the group's compliance with the treasury policies and highlights the level of risk against the appropriate risk limits in place.

The group's treasury function does not act as a profit centre and does not undertake any speculative trading activity.

Liquidity risk

The group looks to manage its liquidity risk by maintaining liquidity within a board approved duration range. Liquidity is actively monitored by the group's treasury function and is reported monthly to the treasury committee through the operational compliance report.

At 31 March 2016, the group had £888.6 million (2015: £1,244.0 million) of available liquidity, which comprised £213.6 million (2015: £244.0 million) of cash and short-term deposits, £600.0 million (2015: £600.0 million) of undrawn committed borrowing facilities, and £75.0 million (2015: £400.0 million) of undrawn term loan facilities. Short-term deposits mature within three months.

The group had available committed borrowing facilities as follows:

Group2016
£m
2015
£m
Expiring within one year150.050.0
Expiring after one year but in less than two years150.0150.0
Expiring after more than two years300.0400.0
Undrawn borrowing facilities600.0600.0

These facilities are arranged on a bilateral rather than a syndicated basis, which spreads the maturities more evenly over a longer time period, thereby reducing the refinancing risk by providing several renewal points rather than a large single refinancing point.

Company

The company did not have any committed facilities available at 31 March 2016 or 31 March 2015.

Maturity analysis

Concentrations of risk may arise if large cash flows are concentrated within particular time periods. The maturity profile in the following table represents the forecast future contractual principal and interest cash flows in relation to the group's financial liabilities with agreed repayment periods and derivatives on an undiscounted basis. Derivative cash flows have been shown net where there is a contractual agreement to settle on a net basis; otherwise the cash flows are shown gross.

Group
At 31 March 2016
Total(1)
£m
Adjust-
ment(2)
£m
1 year
or less
£m
1–2
years
£m
2–3
years
£m
3–4
years
£m
4–5
years
£m
More
than
5 years
£m
Bonds9,620.9146.4178.9707.4535.9103.77,948.6
Bank and other term borrowings3,148.8505.889.8107.4109.7656.91,679.2
Adjustment to carrying value(2)(5,791.7)(5,791.7)
Borrowings6,978.0(5,791.7)652.2268.7814.8645.6760.69,627.8
Derivatives:
Payable1,154.694.7117.1393.2411.126.4112.1
Receivable(1,671.3)(128.1)(196.2)(700.0)(485.4)(8.0)(153.6)
Adjustment to carrying value(2)12.812.8
Derivatives – net assets(503.9)12.8(33.4)(79.1)(306.8)(74.3)18.4(41.5)
At 31 March 2015Total(1)
£m
Adjust-
ment(2)
£m
1 year
or less
£m
1–2
years
£m
2–3
years
£m
3–4
years
£m
4–5
years
£m
More
than
5 years
£m
Bonds10,067.1593.3143.4173.3691.1502.87,963.2
Bank and other term borrowings2,536.9184.5348.984.285.886.91,746.6
Adjustment to carrying value(2)(5,958.6)(5,958.6)
Borrowings6,645.4(5,958.6)777.8492.3257.5776.9589.79,709.8
Derivatives:
Payable1,039.689.370.7101.3369.9383.025.4
Receivable(1,534.2)(124.2)(101.4)(176.9)(626.9)(502.3)(2.5)
Adjustment to carrying value(2)17.217.2
Derivatives – net assets(477.4)17.2(34.9)(30.7)(75.6)(257.0)(119.3)22.9

Notes:

  1. Forecast future cash flows are calculated, where applicable, using forward interest rates based on 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 three per cent over the life of each instrument.
  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 cash flows to the carrying value of debt in the statement of financial position.

Company

The company has total borrowings of £0.5 million (2015: £0.4 million), which are payable within one year, and £1,636.9 million (2015: £1,609.4 million), which are payable within one to two years.

Credit risk

Credit risk arises principally from trading (the supply of services to customers) and treasury activities (the depositing of cash and holding of derivative and foreign exchange instruments). The group does not believe it is exposed to any material concentrations of credit risk.

The group manages its risk from trading through the effective management of customer relationships. 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. The Water Industry Act 1991 (as amended by the Water Industry Act 1999) prohibits the disconnection of a water supply and the limiting of 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. In addition, under the group's revenue recognition policy, revenue is only recognised when collection of the resulting receivable is reasonably assured. Considering the above, the directors believe there is no further credit risk provision required in excess of the allowance for doubtful receivables (see note 14).

The group manages its risk from treasury activities by establishing a total credit limit by counterparty, which comprises a counterparty credit limit and an additional settlement limit to cover intra-day gross settlement cash flows. In addition, potential derivative exposure limits are also established to take account of potential future exposure which may arise under derivative transactions. These limits are calculated by reference to a measure of capital and credit ratings of the individual counterparties and are subject to a maximum single counterparty limit. A control mechanism to trigger a review of specific counterparty limits, irrespective of credit rating action, is in place. This entails daily monitoring of counterparty credit default swap levels and/or share price volatility. Credit exposure is monitored daily by the group's treasury function and is reported monthly to the treasury committee through the operational compliance report.

At 31 March 2016 and 31 March 2015, the maximum exposure to credit risk for the group and company is represented by the carrying amount of each financial asset in the statement of financial position:

GroupCompany
2016
£m
2015
£m
2016
£m
2015
£m
Cash and short-term deposits (see note 16)213.6244.0
Trade and other receivables (see note 14)369.9355.862.561.2
Investments (see note 12)8.78.6
Derivative financial instruments765.6682.6
1,357.81,291.062.561.2

The credit exposure on derivatives is disclosed gross of any collateral held. At 31 March 2016, the group held £127.5 million (2015: £117.5 million) as collateral in relation to derivative financial instruments (included within borrowings in note A3).

Market risk

The group's exposure to market risk primarily results from its financing arrangements and the economic return which it is allowed on the regulatory capital value (RCV).

The group uses a variety of financial instruments, including derivatives, in order to manage the exposure to these risks.

Inflation risk

The group earns an economic return on its RCV, comprising a real return through revenues and an inflation return as an uplift to its RCV. To the extent that nominal debt liabilities finance a proportion of the RCV, there is an asset-liability mismatch which potentially exposes the group to the risk of economic loss where actual inflation is lower than that implicitly locked-in through nominal debt.

The group's index-linked borrowings, which are linked to RPI inflation, form an economic hedge of the group's regulatory assets, which are also linked to RPI inflation. In particular, index-linked debt delivers a cash flow benefit compared to nominal debt, as the inflation adjustment on the index-linked liabilities is a deferred cash flow until the maturity of each financial instrument, providing a better match to the inflation adjustment on the regulated assets, which is recognised as a non-cash uplift to the RCV.

In addition, the group's pension obligations also provide an economic hedge of the group's regulatory assets. The pension schemes' inflation funding mechanism (see note A5) ensures that future contributions will be flexed for movements in RPI and smoothed over a rolling five-year period, providing a natural hedge against any inflationary uplift on the RCV.

The group seeks to manage this risk by identifying opportunities to amend the economic hedge currently in place where deemed necessary and subject to relative value. Inflation risk is reported monthly to the treasury committee in the operational compliance report.

The carrying value of index-linked debt held by the group was £3,447.3 million at 31 March 2016 (2015: £3,083.8 million).

Sensitivity analysis

The following table details the sensitivity of profit before tax to changes in the RPI on the group's index-linked borrowings. The sensitivity analysis has been based on the amount of index-linked debt held at the reporting date and, as such, is not indicative of the years then ended. In addition, it excludes the hedging aspect of the group's regulatory assets and post-retirement obligations described above.

Increase/(decrease) in profit before tax and equity2016
£m
2015
£m
1 per cent increase in RPI(35.0)(31.4)
1 per cent decrease in RPI35.031.4

The sensitivity 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 income statement, and the analysis does not incorporate this factor. The portfolio of index-linked debt is calculated on either 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 on the annual RPI change either three or eight months earlier.

Company

The company had no material exposure to inflation risk at 31 March 2016 or 31 March 2015.

Interest rate risk

The group's policy is to structure debt in a way that best matches its underlying assets and cash flows. The group earns an economic return on its RCV, 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 cash flows.

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. These instruments are typically designated within a fair value accounting hedge.

To manage the exposure to medium-term interest rates, the group fixes underlying interest rates on nominal debt out to ten years in advance on a reducing balance basis. This is supplemented by managing residual exposure to interest rates within the relevant regulatory price control period by fixing substantively all residual floating underlying interest rates on projected nominal debt across the immediately forthcoming regulatory period at around the time of the price control determination.

The group seeks to manage its risk by maintaining its interest rate exposure within a board approved range. Interest rate risk is reported monthly to the treasury committee through the operational compliance report.

Sensitivity analysis

The following table details the sensitivity of the group's profit before tax and equity to changes in interest rates. The sensitivity analysis has been based on the amount of net debt and the interest rate hedge positions in place at the reporting date and, as such, is not indicative of the years then ended.

GroupCompany
Increase/(decrease) in profit before tax and equity2016
£m
2015
£m
2016
£m
2015
£m
1 per cent increase in interest rate175.6174.2(16.4)(16.1)
1 per cent decrease in interest rate(183.0)(190.9)16.416.1

The sensitivity analysis assumes that both fair value hedges and borrowings designated at fair value through profit or loss are effectively hedged and it excludes the impact on post-retirement obligations.

The exposure largely relates to fair value movements on the group's fixed interest rate swaps which manage the exposure to medium-term interest rates. Those swaps are not included in hedge relationships.

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 interest rate risk.

Group
At 31 March 2016
Total
£m
1 year
or less
£m
1–2
years
£m
2–3
years
£m
3–4
years
£m
4–5
years
£m
More than
5 years
£m
Borrowings in fair value hedge relationships
Fixed rate instruments2,373.0617.4455.11,300.5
Effect of swaps2,373.0(617.4)(455.1)(1,300.5)
2,373.02,373.0
Borrowings designated at fair value through profit or loss
Fixed rate instruments338.0338.0
Effect of swaps338.0(338.0)
338.0338.0
Borrowings measured at amortised cost
Fixed rate instruments156.2127.70.50.50.60.626.3
Floating rate instruments663.5663.5
Index-linked instruments3,447.33,447.3
4,267.04,238.50.50.50.60.626.3
Effect of fixed interest rate swaps(3,006.3)(125.0)(50.0)1,127.1325.01,729.2
Total borrowings6,978.03,943.2(124.5)(49.5)1,127.7325.61,755.5
Cash and short-term deposits(213.6)(213.6)
Net borrowings6,764.43,729.6(124.5)(49.5)1,127.7325.61,755.5
At 31 March 2015Total
£m
1 year
or less
£m
1–2
years
£m
2–3
years
£m
3–4
years
£m
4–5
years
£m
More than
5 years
£m
Borrowings in fair value hedge relationships
Fixed rate instruments2,252.1615.8424.11,212.2
Effect of swaps2,252.1(615.8)(424.1)(1,212.2)
2,252.12,252.1
Borrowings designated at fair value through profit or loss
Fixed rate instruments333.7333.7
Effect of swaps333.7(333.7)
333.7333.7
Borrowings measured at amortised cost
Fixed rate instruments572.7543.80.40.50.50.626.9
Floating rate instruments403.1403.1
Index-linked instruments3,083.83,083.8
4,059.64,030.70.40.50.50.626.9
Effect of fixed interest rate swaps(2,656.3)(250.0)(125.0)(50.0)1,127.11,954.2
Total borrowings6,645.43,960.2(249.6)(124.5)(49.5)1,127.71,981.1
Cash and short-term deposits(244.0)(244.0)
Net borrowings6,401.43,716.2(249.6)(124.5)(49.5)1,127.71,981.1
CompanyTotal
£m
2016
1 year
or less
£m
Total
£m
2015
1 year
or less
£m
Borrowings measured at amortised cost
Floating rate instruments1,637.41,637.41,609.81,609.8
Total borrowings1,637.41,637.41,609.81,609.8

Electricity price risk

The group is allowed a fixed amount of revenue by the regulator, in real terms, to cover electricity costs for each five-year regulatory pricing period. To the extent that electricity prices remain floating over this period, this exposes the group to volatility in its operating cash flows. The group's policy, therefore, is to manage this risk by fixing a proportion of electricity commodity prices in a cost-effective manner.

The group has fixed the price on a substantial proportion of its anticipated net electricity usage out to the end of the AMP in 2020, partially through entering into electricity swap contracts.

Sensitivity analysis

The following table details the sensitivity of the group's profit before tax and equity to changes in electricity prices. The sensitivity analysis has been based on the amounts of electricity swaps in place at the reporting date and, as such, is not indicative of the years then ended.

Increase/(decrease) in profit before tax and equity2016
£m
2015
£m
20 per cent increase in electricity commodity prices7.79.5
20 per cent decrease in electricity commodity prices(7.7)(9.5)

The company has no exposure to electricity price risk.

Currency risk

Currency exposure principally arises in respect of funding raised in foreign currencies.

To manage exposure to currency rates, foreign currency debt is hedged into sterling through the use of cross currency swaps and these are often designated within a fair value accounting hedge.

The group seeks to manage its risk by maintaining currency exposure within board approved limits. Currency risk in relation to foreign currency denominated financial instruments is reported monthly to the treasury committee through the operational compliance report.

The group and company have no material net exposure to movements in currency rates.

Capital risk management

The group's objective when managing capital is to maintain efficient access to debt capital markets throughout the economic cycle. The board therefore believes that it is appropriate to maintain gearing, measured as group consolidated net debt (including derivatives) to regulatory capital value (RCV) of United Utilities Water Limited (UUW), within a target range of 55 per cent to 65 per cent. As at 31 March 2016, group consolidated gearing was 61 per cent (2015: 59 per cent), which is comfortably within this range.

Assuming no significant changes to existing rating agencies' methodologies or sector risk assessments, the group aims to maintain, as a minimum, its existing credit ratings of A3 with Moody's Investors Service (Moody's) and BBB+ with Standard & Poor's Ratings Services (Standard & Poor's) for UUW and debt issued by its financing subsidiary, United Utilities Water Finance PLC.

In order to maintain existing credit ratings, the group needs to manage its capital structure with reference to the ratings methodology and measures used by Moody's and Standard & Poor's. The ratings methodology is normally based on a number of key ratios (such as RCV gearing, adjusted interest cover and Funds from Operations (FFO) to debt) and threshold levels as updated and published from time to time by Moody's and Standard & Poor's. The group looks to manage its risk by maintaining the relevant key financial ratios used by the credit rating agencies to determine a corporate's credit rating, within the thresholds approved by the board. Capital risk is reported monthly to the treasury committee through the operational compliance report.

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 table below sets out the valuation basis of financial instruments held at fair value and financial instruments where fair value has been separately disclosed in the notes as the carrying value is not a reasonable approximation of fair value.

Group
2016
Level 1
£m
Level 2
£m
Level 3
£m
Total
£m
Available for sale financial assets
Investments8.78.7
Financial assets at fair value through profit or loss
Derivative financial assets – fair value hedge583.8583.8
Derivative financial assets – held for trading(1)181.8181.8
Financial liabilities at fair value through profit or loss
Derivative financial liabilities – held for trading(1)(261.7)(261.7)
Financial liabilities designated as fair value through profit or loss(338.0)(338.0)
Financial instruments for which fair value has been disclosed
Financial liabilities in fair value hedge relationships(2,149.5)(143.5)(2,293.0)
Other financial liabilities at amortised cost(1,309.9)(3,520.2)(4,830.1)
(3,459.4)(3,489.1)(6,948.5)
2015Level 1
£m
Level 2
£m
Level 3
£m
Total
£m
Available for sale financial assets
Investments8.68.6
Financial assets at fair value through profit or loss
Derivative financial assets – fair value hedge521.6521.6
Derivative financial assets – held for trading(1)161.0161.0
Financial liabilities at fair value through profit or loss
Derivative financial liabilities – held for trading(1) (205.2)(205.2)
Financial liabilities designated as fair value through profit or loss(333.7)(333.7)
Financial instruments for which fair value has been disclosed
Financial liabilities in fair value hedge relationships(2,142.6)(75.4)(2,218.0)
Other financial liabilities at amortised cost(2,530.3)(2,268.2)(4,798.5)
(4,672.9)(2,191.3)(6,864.2)

Note:

  1. These derivatives form economic hedges and, as such, management intend to hold these through to maturity. Derivatives forming an economic hedge of the currency exposure on borrowings included in these balances were £177.2 million (2015: £152.2 million).
  • 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 on observable market data (unobservable).

The group has calculated fair values using quoted prices where an active market exists, which has resulted in £3,459.4 million(2015: £4,672.9 million) of 'level 1' fair value measurements. In the absence of an appropriate quoted price, the group has applied discounted cash flow valuation models utilising market available data in line with prior years. The £1,213.5 million reduction(2015: £1,493.9 million increase) in 'level 1' fair value measurements is largely due to the maturity of a £425.0 million bond during the year and a decrease in the number of observable quoted bond prices at 31 March 2016.

In respect of the total change during the year in the fair value of financial liabilities designated at fair value through profit or loss, of a £4.3 million loss (2015: £65.0 million), a £15.1 million gain (2015: £4.6 million loss) is attributable to changes in own credit risk. The cumulative amount recognised in the income statement due to changes in credit spread was £74.1 million profit (2015: £59.0 million). The carrying amount is £135.9 million (2015: £131.6 million) higher than the amount contracted to settle on maturity.

Company

The company does not hold any financial instruments that are measured subsequent to initial recognition at fair value or where fair value has been separately disclosed in the notes as the carrying value is not a reasonable approximation of fair value.