Profiting from power

When Binder Hamlyn and Price Waterhouse came to prepare the British nuclear industry for privatisation, the issues they faced were of a complexity unmatched by any other business. How do you account for fuel reprocessing costs? Or put a price on the eventual decommissioning of nuclear power stations? And how do you calculate the cost of storing waste into the 22nd century?

The Government announced its intention to privatise the more modern power stations of Nuclear Electric and Scottish Nuclear under a new holding company, British Energy plc, in May 1995 (the older Magnox stations would be retained in a separate publicly-owned company). The run-up to flotation in June 1996 was short and demanding in terms of resolving numerous operational, financial and accounting issues.

A successful merger

Distinct parts of two former public sector organisations, with different accounting policies, had to be married together for the flotation. The capital structure created had both to enable the Government to achieve its sale objectives and allow the ongoing management to be left with a commercially viable business. The merger also had to be achieved in such a way as to produce a combined track record that met Stock Exchange requirements and the expectations of private investors, enabled distributable reserves to be created and yet did not fall foul of the Companies Acts or UK, GAAP and European state aid restrictions.

The whole process started in 1988 with the Government White Paper, Privatising Electricity, which originally proposed the sale of the nuclear operations in England, Scotland and Wales. It then formed part of the privatisation of the whole of the electricity supply industry. In 1989, however, the Government took all nuclear activities out of the equation because of doubts about the cost and efficiency of this method of power generation: some of the advanced gas cooled reactors stations were not performing well and there was uncertainty about the costs of financing proposed new pressurised water reactor stations of which Sizewell B was the first.

So, in 1990, two new public sector companies for nuclear generation were created – Nuclear Electric in England and Wales, and Scottish Nuclear in Scotland. Over the ensuing five years, both made significant advances in reducing operating costs and increasing output. The result was a marked improvement in British Energy’s trading record and profit potential. The prospect for privatisation became both a viable option and the subject of political debate once again.

How were the problems of waste management, fuel reprocessing and decommissioning costs overcome? In the case of British Energy and its constituent companies, accounting for these costs was stabilised to a large extent as a result of the fixing of contracts and improved processes to estimate costs.

If we consider the nuclear fuel cycle – comprising various stages of preparation at the front end and the handling, storage, reprocessing and ultimate disposal of waste fuel and associated products at the back – we can see the type of arrangements now in place.

British Nuclear Fuels (BNFL) is the sole provider of most back and some front- end fuel cycle services for British Energy which has been negotiating through Nuclear Electric and Scottish Nuclear over a number of years to establish greater cost certainty. On 31 March 1995, contracts were entered into with BNFL covering a significant part of the fuel cycle costs. These agreements were essentially fixed price (subject to inflation indexation) and retrospective to 1989. Because the deal eventually negotiated was more favourable than had been assumed in the past, exceptional credits were included in British Energy’s accounts.

Cutting fuel costs

The nature of the contracts with BNFL is such that reprocessing costs will decline through the life of the contract cutting the fuel cost to British Energy. The stepped reduction in price is recognised as it occurs rather than being held over until the end of contract since there is no absolute certainty that fuel will be sent to BNFL for reprocessing. British Energy’s total future payments for fuel reprocessing and storage costs are estimated, based on projected outputs, at around #4.9bn in discounted terms. It has already written off some #3bn of this. The balance, relating to fuel yet to be burnt, will be expensed over the remaining operating lives.

Likewise, steps have been taken to establish and plan for future costs of decommissioning – the closing and dismantling of a nuclear station’s operations at the end of its life (usually 30 years) – estimated on the basis of technical assessments of the methods likely to be used under the current regulatory regime. Following the publication of the Accounting Standards Board’s discussion papers on provision, the estimated decommissioning costs are now provided for in British Energy’s balance sheet when stations begin operating commercially. They are capitalised as part of the cost of construction and depreciated over the lives of the facility, in accordance with FRS5. The costs are discounted since decommissioning work will take place up to 135 years after closure.

While all costs are estimated and although no large nuclear power station has yet been closed, there is a growing volume of experience of the early stages of decommissioning. In the 1995 Nuclear Review, the Government concluded that a segregated fund was the best way to reassure the public that the generator would meet its obligations. So a fund company has been set up, independent of British Energy and its subsidiaries. It has received an initial endowment and will continue to receive an annual contribution from British Energy, subject to inflation indexation. The contributions are estimated to be sufficient to meet projected liabilities to the proposed timetable of decommissioning. But British Energy is not liable if costs overrun the estimates. The funds must meet the additional liability up to the limit of the fund. British Energy’s investment in the fund will be shown as a receivable and the decommissioning liability as a provision.

Financial high gear

As a result of its high fixed cost base and the combination of its large long-term nuclear liabilities and its debt under the new capital structure, British Energy is both operationally and financially highly geared, sensitive to changes in revenue principally influenced by electricity prices and station output. It will be incumbent on British Energy as a private sector business to try to maintain a progressive dividend policy, supported by improving profits. Both because of the high operational gearing, the large degree of estimation of nuclear liabilities and the impact of inflation, against which it is difficult to hedge, British Energy’s reported earnings can swing by tens of millions quite easily. However, because of the non-cash nature of these estimates the group’s strong cashflow should be more stable.

The accounting issues, let alone operational ones, facing British Energy are complex and have evolved over a period of time. Its policy has been to recognise the full value of liabilities in its balance sheet and to match these costs against fuel burnt or station lives. By entering into long-term contracts where appropriate, the company has gone a long way to fix its cost base, removing much of the uncertainty and enabling it to develop a long-term strategy which will underpin future success. Accounting for nuclear power generation worldwide will continue to evolve in the future, but it is to be hoped that the UK experience will be shared universally.

Alastair Scrimgeour is a partner with Binder Hamlyn and was lead partner on the British Energy privatisation assignment for which the firm was joint reporting accountants with Price Waterhouse

FACTORS WHICH WILL AFFECT BRITISH ENERGY’S PROFITABILITY

Electricity prices: British Energy is a ‘price taker’ under the pooling system and is unable to influence its prices other than through contracts for differences and supply contracts.

Output: Revenue is determined by price and output. All generation is sold and consequently British Energy seeks to maximise output from its stations, although there is a trade-off with station lifetimes.

Station lifetimes: Any extension in station lives beyond those currently assured will lead in the longer term to a significant increase in earnings and cashflow from additional output achieved during the period of extended life.

Operating costs: In line with other major corporations, British Energy will continue to seek efficiency improvements in all spheres.

Inflation: In addition to its normal operating revenues and costs, inflation has a significant impact on the revalorisation charge British Energy makes each year. Accruals and provisions for back-end fuel costs and decommissioning are stated in the balance sheet at current price levels, discounted to take account of the timing of payments. Each year, a financing charge is included in the profit and loss account to release one year’s discount from provisions made in prior years and restate these provisions to current price levels. Given the provision for nuclear liabilities at 1 April 1995 was #3.9bn, a 1% swing in inflation on revalorisation impacts results before taxation by approximately #40m.

Returns from new investment: Because the stations have a finite operating life, it will be essential for British Energy to invest in new revenue streams in the medium to long term to sustain its earnings potential and, therefore, support its dividend policy.

Fixed assets: British Energy’s fixed assets are stated in the balance sheet at the lower of cost less accumulated depreciation and economic value. Economic value is based on the discounted estimated future cashflows of the power stations. These are determined by performance of the stations. Because of a reassessment of future selling prices and the loss of the nuclear premium, the value of the stations was written down by #1.2bn in the year ended 31 March 1996.

Taxes: Because of the long-term nature of British Energy’s decommissioning costs, many costs will be incurred after the stations have ceased operating. Consequently, there may be insufficient taxable profits in the existing business against which to offset these costs and hence they will be disallowable.