PracticeAuditIFRS – Sector focus: utilities

IFRS - Sector focus: utilities

How has the power industry fared with the transition?

Attention was tightly focused last month when National Grid Transco reported its results under the new regime of international financial reporting standards. Many had predicted volatility and confusion in the markets as the figures were presented with enhanced profits.

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However, no such excitement ensued. The most significant areas impacted by the adoption of IFRS were the accounting treatments of replacement expenditure and regulatory assets. Other key areas affected included the treatment of pensions and other post-retirement benefits, profits on disposal of properties, deferred taxation and goodwill.

But as Paul Rew, PricewaterhouseCooper’s energy and utilities leader in the UK, says: ‘National Grid Transco as a network operator is different from some other UK gas and electricity companies in that it does not buy or sell energy. This means that it may be less affected by IAS39, which deals with financial instruments and derivatives, including those that may be included within energy sale or purchase contracts.

‘Water companies will also no longer have the special arrangements for renewals accounting they have previously enjoyed under UK accounting. Many utilities, because of their large work forces, have large pension fund deficits, which will now have an effect on their balance sheets. It’s too early to say how the market is going to react to these new figures, there has to be an educational process.’

But as National Grid was keen to stress, the adoption of IFRS only represented an accounting change and did not affect the operations, cashflows or distributable reserves of the group. Similarly, there will be no impact on the regulated asset values or regulatory agreements of any of the group’s businesses.

Commenting on Transco’s results at the time, Steve Lucas, group finance director, said: ‘We regard these changes as positive in that they will enhance comparability with other European companies in our sector, not least in relation to the biggest change, which concerns the treatment of replacement expenditure.’

When asked if IFRS gave Severn Trent any worries or problems, spokeswoman Jane Rhead said: ‘Severn Trent is working thoroughly through the implications of IFRS and will communicate in detail on this to the City in September 2005.’

That is three months after it presents its prelims in the old format and makes Severn Trent one of the majority of companies yet to talk to the market about IFRS.

As one of the City’s leading utility analysts says: ‘We principally look at utilities in terms of cashflow and IFRS has not fundamentally changed this fact, so I don’t see any real change in how utilities are going to be viewed.’

While Transco may benefit from the treatment of stranded assets, which will lead to an elevation of earnings per share and a change in the way replacement expenditure is dealt with, others who spend less on replacement costs are unlikely to benefit in the same way.

Most utilities have a far more neutral position on their replacement costs. Every utility has its peculiarities and the water companies may do well out of deferred taxation. Fair value is also something which may well affect how these companies are viewed, though it may be too early to say whether it will have a positive or negative effect.

Investment bank, Dresdner Kleinwort Wasserstein and credit analysts Joshua Galuan and Stephane Buemi point out that utilities in general could be more affected than other corporate sectors by fair value and provisions.

This is because of large commodity derivative portfolios and sizeable nuclear and decommissioning provisions. The change in fair value of some kinds of contracts will now appear on P&L statements and may result in volatility in profit numbers.

But overall the DrKW analysts underline the central point that the new presentation of figures will not disturb the underlying cash generation which is the main feature of utility businesses. They also point out that the markets already make adjustments to utility figures ‘and some of these adjustments may mirror requirements under IFRS.’

Rew points out that the utilities are major components of the market and as such have a large investment following, which has every incentive to understand the meaning of the new figures. But, he says, ‘understanding may not come overnight – we might be talking at least a few months. Although there are several dedicated analysts who have a deep understanding, others may not be so well informed.’

Scott Fulton of Fallon Stewart, an independent research company specialising in the sell side of equity markets, says: ‘The effects of IFRS are now becoming clearer as more companies are reporting under the new regime. Although there are still issues – not least with companies not explaining enough to analysts about the changes – there is less volatility in companies reporting under IFRS than there was earlier in the year.

‘Analysts still need more guidance about what the new figures mean. Without it they are more likely to be confused, which could lead to accounts being misread which in turn could affect share prices. The problems are being solved, and in the long term I don’t see a real issue, but there will be some misunderstandings in the short term.’

Scottish Power’s story: how will IFRS affect the electricity provider
In terms of getting ready for IFRS this year, David Nish, finance director of Scottish Power, was ahead of the game – he started two years ago. He found that the vast majority of new standards involved in IFRS had little impact on the company’s financial position.

However, while some standards, such as accounting for share options, involved minor changes, there were four or five which involved considerable amounts of effort, not least IAS39, financial instruments: recognition and measurement.

This controversial standard requires the use of current market values for financial instruments such as derivatives. Energy companies are particularly affected by this as they make a wide use of derivatives to hedge against future fluctuations in energy prices. Nish and his team had to identify each one of the embedded derivatives which potentially could be involved in Scottish Power’s thousands of contracts.

The company has reached such a position – not least because of its early planning – that it now has the right computer processes in place to maximise the hedge effectiveness of its contracts so as to remove any unnecessary volatility.

As Nish says: ‘The important thing to remember is that cashflows are no different. All we are doing is presenting the information in a different way. The economic decisions don’t change. And as for market confusion, we have been gratified that while National Grid’s profits rose under the new system, the market did not mark up the share price.

‘This shows that the market realises that although what is reported may be different, the business is the same. In the end, our cash flow is unaffected by IFRS and that is the most important factor.’

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