Earnings Transcript for UU.L - Q2 Fiscal Year 2014

Executives: Darren Jameson - Head of Investor Relations Steve Mogford - CEO Russ Houlden - CFO

Analysts: James Brand - Deutsche Bank Ashley Thomas - SocGen Dominic Nash - Macquarie Verity Mitchell - HSBC Bank Fraser McLaren - Bank of America Merrill Lynch Iain Turner - Exane BNP Paribas

Darren Jameson: Good morning everybody and many thanks for attending and good to see many familiar faces here today. For those who don't know me, I'm Darren Jameson and I look after investor relations at United Utilities, and as usual I just need to run through a few housekeeping issues this morning. First of all, as always, please could we switch off mobile phones and BlackBerrys? And I understand that a test of the fire alarm is not planned, so if you just hear a sound, it's for real and we need to leave the auditorium through the doors in the corner of the room please. And of course today, as usual, the presentation should be considered in the context of the cautionary statement towards the back of your presentation packs. So, I'd now like to hand over to our Chief Executive.

Steve Mogford: Thanks so much, Darren, and I apologize again for my voice. I hope it sort of lasts through the period. I think somebody suggested as I came in this morning that it was an allergy to analysts, because I had this last time, but no, it's just another case of man flu. So most of you fellows will know how hard it is to struggle in that situation, but I think apparently you'll know it's just a minor cold and get on with it. So good morning, ladies and gentlemen, and welcome to our half year results presentation. We are four months away from the end of AMP5 and we are very pleased with the progress we've made over this regulatory period. We set out to enter AMP6 underpinned by a strong platform of sustainable performance, and this has been achieved. We began this regulatory period as a lower quartile performer on most operational measures but we'll start AMP6 as a leading operational performer in our sector, having delivered or exceeded our AMP5 outperformance targets. Our strong performance has also given us the capacity to reinvest around £280 million for the benefit of all our stakeholders. I'm extremely grateful to our people for the role they have played in transforming the performance of the business, and particularly for putting the customer first, making us one of the most improved companies in the sector for customer satisfaction. AMP6 will place more emphasis on companies' operational performance, and whilst there is no room for complacency, I'm confident that the foundations we have built over the last four years give us a solid launch point for the next regulatory period. This is the agenda for this morning's presentation. I'll provide an overview of our operational progress and Russ will then cover our financial performance. I'll then remind you of the key features of our October draft determination response, before summarising. So here are the highlights. You know that we have delivered significant improvements in customer satisfaction this AMP, as measured by Ofwat's Service Incentive Mechanism or SIM. We were delighted to see this recognised in our draft determination where Ofwat confirmed that our performance took us out of the penalty zone, which is a great achievement considering that we started the AMP as an outlier in the sector. We are a leading operational performer and achieved upper quartile environmental status for the second consecutive year. Our capital delivery performance continues to be good and we expect to deliver around £850 million of investment in our asset base this year. We are confident of delivering or exceeding our AMP5 outperformance targets. We've continued to grow our water retail business in Scotland and we are the most successful new entrant in this market. And we are delivering on our AMP5 dividend policy, with an increase of 4.6%. So, starting now with our customer service performance, you'll know that the sector uses the SIM score as its principal measure of customer satisfaction. Ofwat published in the summer the combined SIM scores for 2013/14, which is the last of the three years of performance measurement to determine whether companies receive a reward or penalty. This chart shows our significant improvements over the last three years. We are one of the most improved companies over the period. Our combined SIM score for 2013/14 was 83 points, which represents an above average score, and places us 9th in the sector and 5th amongst the water and wastewater companies. Having begun AMP5 as an outlier, it was extremely difficult for us to be in reward territory, but our three-year score moved us outside of the SIM penalty zone. This was reflected in the draft determination we received from Ofwat at the end of August, and we are obviously delighted with this outcome, but we know there are things that we can still do better. Our plans for AMP6 will see us focusing on driving customer satisfaction still further. I have mentioned previously that Ofwat intends to change the SIM methodology for AMP6. The emphasis will change, with qualitative SIM representing 75% of the total score, up from 50%, and individual parameters making up the score will also change. So this will lead to variations in companies' relative positions as we begin AMP6. Ofwat and the companies are currently piloting the new process in preparation for implementation of the new scheme in the first year of AMP6. Moving on to Business Retail, we've been building our capability over the last two years to help ensure that we are in a strong position as competition evolves. The Scottish business retail market for water has been open for several years and the English business retail market for water and wastewater is due to open fully in 2017. Whilst there has been limited switching by businesses in England so far, we can expect more activity from April 2015 when a higher retail margin will be available to competitors. We are very active in the Scottish market and have continued to grow our retail business. We have now gained over 200 customers, covering over 2,600 sites and representing future annual revenue of around £14 million. This positions us as the second largest water retailer in Scotland and the most successful new entrant. We have an experienced retail team, and this combined with our proactive approach and competitive pricing, has helped us to make rapid progress. We also continue to pursue a significant and growing pipeline of further opportunities. Price isn't the only important factor for customers and we continue to offer and develop a range of value-added services and flexible service offerings, tailored to the needs of each customer, such as waste to energy consultancy and advice on rainwater harvesting and grey water recycling, and this is all invaluable experience ahead of the market opening in England. Now, looking at our wholesale business, this table shows Ofwat's latest KPIs assessment for the ten water and sewerage companies, covering a broad range of operational metrics. Once again, we've delivered a leading performance and the best amongst the listed companies, with predominantly green assessments. The EA's environmental performance report, published in the summer, also confirmed an upper quartile performance for UU. We were delighted that our good asset serviceability performance over AMP5 was recognised by Ofwat in our draft determination, with UU being one of only four water and sewerage companies not to receive a penalty relating to this area. I mentioned previously that we've developed a new operating model for our wholesale business. It takes us beyond the traditional approach to delivering water and wastewater services and introduces new levels of performance monitoring and response in delivering reliable services more efficiently. We are currently piloting the new model around our region and early results underpin our response to our draft determination in accepting Ofwat's upper quartile efficiency challenge. I'll provide further detail in future presentations. Now turning to our capital delivery performance, I'll cover capital delivery and Russ will discuss our OpEx performance later in the presentation. Delivery of our capital program continues to go well, benefiting from our sustained focus on delivering commitments on time and within budget, and the improvements we've made in our project and risk management capability. We invested £419 million in the first six months of this year, which is a £12 million increase on the first half of last year. And importantly, our internal measure of how effectively we deliver our capital program, our TCQi score, remains high. We continue to achieve a score of over 95%, and as a reminder, this compares with a score of around 50% four years ago. Our challenge now is to sustain this performance through this year and into AMP6. Our cumulative investment in our assets across AMP5 now stands at £3.3 billion. Having delivered our largest annual capital program in a decade last year, we are on track to invest a similar amount this year and expect CapEx to be around £850 million. This includes transitional investment of around £40 million, which will aid a smoother and more effective start to AMP6. This transitional investment will be recovered within the forthcoming price determination. I'd now like to cover our environmental, social and governance credentials, or ESG for short. Operating in a responsible manner is fundamental to the way in which we run our business. We've always placed significant emphasis on governance and we're pleased to see that our strong ESG performance continues to receive external recognition. We have retained our 'World Class' rating in the Dow Jones Sustainability Index, an award we've now held for seven consecutive years. This year we also achieved industry leading performance status in the multi-utility/water sector. UU has the highest ranking, 'Platinum Big Tick', in the Business in the Community's Corporate Responsibility Index, and holds membership of the FTSE 350 Carbon Disclosure Leadership Index. And we are one of only four FTSE 100 companies, and the only water company, to hold all three accolades. In addition, we were pleased that PwC recently awarded UU 'Highly commended' status for 'Excellence in Reporting in the FTSE 100' at the 2014 Building Public Trust Awards. Over AMP5, we have committed to reinvest around £280 million of our outperformance, providing benefits for customers and the environment, and as we look to the future, we have continued to expand our apprentice and graduate programs to attract and develop high calibre people. In total, we have over 150 apprentices and graduates in the business at any one time. Overall, our customers are set to benefit from below inflation growth in average household bills for the decade to 2020, and we believe that our responsible approach to business is delivering for all our stakeholders. Now, over to Russ.

Russ Houlden: Thank you, Steve, and good morning everybody. This is another good set of results in a tough North West economic climate. A 2% increase in revenue, tight cost control and a lower tax rate combined to increase operating profit by 1%, underlying profit before tax by 3% and underlying EPS by 4%. This is after the impact of the previously announced special one-off customer discount, which is part of our responsible approach to business and our sharing of outperformance with customers. We have declared an interim dividend of £0.1256 per share, up 4.6%. This increase comprises RPI inflation of 2.6% for the year to November 2013, which is the rate included within our price limit for 2014/15, plus 2% in line with our stated dividend policy. We also have responsible financing policies, with RCV gearing down to 57%, which is within Ofwat's AMP5 range, and our dividend policy for AMP5 targeting growth of RPI plus 2% each year keeps dividends growing in line with RCV. As usual, we have made some adjustments to reported profit to get to underlying profit, which we believe gives a more representative view of underlying performance. We had a £20 million fair value loss in the half year, largely due to losses on the swap portfolio which fixes rates for the regulatory periods. This resulted from a decrease in medium-term sterling interest rates during the period, partly offset by a gain from the unwinding of our derivatives hedging interest rates to 2015. This £20 million fair value loss compares with a fair value gain of £100 million in the first half of last year. We had no large one-off tax adjustments in the first half of this year, whereas last year we had two large one-off tax credits, £159 million relating to reductions in the corporation tax rate and £125 million relating largely to an agreement with HMRC. These factors resulted in reported profit being significantly lower this year. However, the more meaningful underlying measure was up £8 million to £176 million. So this is a summary of the underlying income statement after making the adjustments shown on the earlier slide. Revenue for the half year of £859 million was up £14 million, or 1.6%, after adjusting for the special customer discount, of which £13 million was applied in the first half. Underlying operating profit of £343 million was up £3 million as a result of the increase in revenue and tight cost control. Underlying profit before tax of £221 million was £7 million higher than the first half of last year. This was due to the increase in underlying operating profit of just over £3 million, alongside a decrease in underlying net finance expense of just over £3 million which mainly reflects the impact of lower RPI inflation on our index-linked debt. The underlying tax charge of £45 million was marginally lower than last year, as the tax impact from higher profit was more than offset by a fall in the total tax rate. We have continued to manage our cost base tightly. Overall, our operating expenses, including IRE and depreciation, increased by £10 million or just 2%. As you can see from the slide, there were a number of cost movements between the two periods. I won't focus on each item individually, but I would like to discuss in more detail bad debt. We highlighted in May 2014 that debt collection was likely to become more challenging for UU, particularly as our region suffers from high levels of income deprivation. Even as the North West economy recovers, it is unlikely to have much impact on deprivation, which is the principal driver of our higher than average cost to serve. In the draft determination, Ofwat recognised the impact of deprivation on our retail costs by making an adjustment. In the first half of this year, bad debt expense has increased by £5 million, from 2.2% to 2.7% of regulated revenue, as a result of three main factors, of which one is economic and the other two are more technical. First, the cumulative impact of economic factors on customers' ability to pay, including the tightening of real disposable incomes in the North West; second, an increase in the number of customers re-commencing payment through our help-to-pay initiatives has resulted in additional revenue recognition and associated bad debt under IFRS accounting; and third, a recent review of bad debt provisions for business customers in preparation for systems upgrades ahead of full market opening. Looking ahead, bad debts will continue to be challenging for us, with the tightening of real disposable incomes, the impact of recent welfare reforms likely to intensify, and the possibility of further provision reviews as we enhance our systems. Whilst our debt management processes have been externally benchmarked as efficient and effective, we will continue to refine and enhance them. Turning now to the statement of financial position; property, plant and equipment was up £191 million in the first half of the year to £9.5 billion, as we continue to make good progress on our CapEx program. Cash and short term deposits of £111 million were similar to the position at March year-end, with the impact of capital expenditure broadly offset by drawings from our EIB loan. Total derivative assets have increased by £48 million, to £561 million, mainly due to a decrease in market interest rates during the period. Derivative liabilities remained broadly unchanged at £107million. As at September 2014, the group had an IAS 19 pension deficit of £115 million, compared with a deficit of £177 million at March 2014. This £62 million favourable movement mainly reflects a decrease in inflation expectations, partly offset by a reduction in corporate credit spreads. Retained earnings have increased by £44 million, mainly as a result of actuarial gains on our DB pension schemes. Net debt was £168 million higher than the position at March 2014, mainly reflecting expenditure on our substantial capital investment program. Now this chart shows our RCV and gearing level. The blue bars, representing RCV, have been adjusted to reflect actual capital expenditure to date. The September 2014 RCV has also been adjusted to reflect information contained within Ofwat's recent draft determination. These bars show the growth of our RCV. The green line shows the movement in RCV gearing since we completed our non-regulated disposal program. Our gearing has reduced by around 1% since March 2014, and is now 57%, due to a modest increase in net debt compared with the growth in the RCV. Our gearing remains within Ofwat's assumed AMP5 range of 55% to 65%, supporting a solid A3 credit rating. Moving on to cash flow, net cash generated from operating activities was £369 million, a reduction of £10 million compared with the first half of last year. This small decrease mainly reflects an increase in tax paid between the two periods. Cash used in investing activities was similar, as our capital investment program continued at high levels. And net cash used in financing activities was just £13 million, compared with £179 million in the first half of last year. This difference is mainly due to the fact that we drew down £150 million of cash from our EIB loan facility in the first half of this year. And finally, an update on our hedging and financing. Looking first at our hedging policy, as a reminder, we leave the equity portion of the RCV exposed to RPI inflation by hedging the debt portion of the RCV for inflation through index-linked debt and the effect of our pension scheme liabilities. With regard to nominal debt, we've now fixed around three quarters of our floating rate exposure across the 2015-2020 period. We intend to substantially fix the remainder through to 2020, over the next six months. In preparation for AMP7, we intend to continue with our 10-year reducing balance policy for the post 2020 period, to help manage our exposure to the cost of debt to be allowed at PR19. Now, on to financing. In the second half of last year, we bolstered our robust financing position with a £500 million loan from the EIB. We chose not to take this loan in index-linked form as we were already appropriately hedged for inflation, in line with our policy. We have so far drawn down £250 million with an average term to maturity of around 10 years. We intend to draw down the remainder of the loan in tranches within the next year. In addition, we renewed £50 million of committed bank facilities in the first half of this year. So, overall, we have continued to maintain a robust financing position, with headroom into 2016. Now, back to Steve.

Steve Mogford: Thanks, Russ. I'll provide a brief reminder as to how our AMP6 business plan is progressing, before summarising our performance. As you know, we submitted our representations in response to our draft determination in early October, and in doing so made a number of revisions to our business plan. Our submission represented a comprehensive response to the points raised by Ofwat in our draft determination and in discussions thereafter. The release we issued to the market at that time provides more detail about our representations, and although nothing has changed since then, I thought it would be useful today to give you a little more insight into the key drivers behind our plan revisions. The wholesale totex component of our draft determination was a significant element of our representation. We made a number of revisions which reduced our claim by approximately £370 million, and for simplicity, these fell into three principal areas. First, we made a number of scope adjustments reflecting developments since our earlier submissions. Second, Ofwat had stated that its models made an implicit allowance for aspects of our business plan and for which we had made a claim for additional funding. And following third party analysis, we reduced our claim to account for these implicit allowances. And third, in issuing draft determinations, Ofwat required companies to achieve its estimate of upper quartile efficiency for totex in AMP6, and we revised our submission to deliver this, supported by third party assurance of our costings. This leaves our remaining claim for totex adjustments at £628 million, which we believe are not accounted for in Ofwat's models. Ofwat asked for a significant amount of additional evidence backed by third party assurance in support of our claim and we provided a comprehensive submission. The pay-as-you-go ratio Ofwat used in the draft determination didn't reflect the impact of reduced totex on our OpEx/CapEx split, and as financeability of our plan is particularly sensitive to FFO-to-debt, we have provided Ofwat with a revised set of pay-as-you-go ratios to be considered in setting our final determination. In our view, maintaining the existing credit ratings helps keep the cost of borrowing down and is in the best long-term interests of customers. On retail, we were pleased that the draft determination reflected our proposal for a £19 million per annum adjustment, relating to the extreme levels of income deprivation in our region and the associated impact on our retail costs. Our representation also addressed a number of detailed points relating to calculation of retail cost allowances. In formulating our response, we held detailed discussions with our regulators, our Customer Challenge Group and other stakeholders, and we also had the opportunity to present our business plan revisions to Ofwat last month. We now await the final determination, which Ofwat is scheduled to publish in a couple of weeks' time, on 12 December, and we'll then have two months to consider our response. So, in summary, we have delivered another good financial performance. Our improvement in customer satisfaction during AMP5 has taken us out of the SIM penalty zone. We've again delivered strong operational, environmental and capital delivery performance. We're delivering or exceeding our AMP5 outperformance targets. And we're continuing to take a responsible approach in sharing the benefits of our outperformance with customers and shareholders. Overall, we have made significant and sustained performance improvements in AMP5, and combined with our new wholesale operating model, this provides a solid foundation for the next regulatory period and beyond. So that concludes our results presentation and thanks very much for listening. We'll be pleased to take questions.

A - Steve Mogford: Okay, we've got a floating mike. James?

James Brand: James Brand from Deutsche Bank. Three questions. Firstly, in terms of the nominal debt that you have hedged for the next regulatory period, I think you said in the past that when you had hedged less than you hedged now, that it had been around 4%. I was wondering now that the interest rates have been pretty low, whether there was any update on that guidance, whether that was still appropriate? Second question on the £50 million of efficiencies you were targeting for this period, you said you expect to hit or exceed your targets. I was wondering whether there was any more granularity you could give on that £50 million, whether there's scope to do better than that? And then thirdly, post the review I was wondering, given that Severn Trent announced yesterday they were going to have a Capital Markets Day, whether that was something you were considering or ruled out or any thoughts on that?

Steve Mogford: You want to pick up the debt issue and I'll pick up the other two?

Russ Houlden: Sure. On the debt, as I said in the presentation, we've now hedged about three quarters and the previous guidance we've given of about 4% is still I'd like to say that's the right thing for your modeling there. We'll be hedging the remaining 25% over the next sort of three to six months. And on the efficiencies point, we do expect to exceed it, we haven't quantified by how much and we'll give you more detail at year-end. As to the Capital Markets Day, Steve, we've talked about it a few times but…

Steve Mogford: Yes, we've talked about it a lot in terms of what level of interest it would be. We'd be very happy to do that and I think certainly after the final determination as we start talking in detail about the plans for AMP6, that's something that we've considered doing. We haven't set a date for it. I think we will canvas the level of interest and largely how many people really are going to attend something like that, particularly if it's in the North West.

James Brand: Thank you.

Steve Mogford: Any others?

Ashley Thomas: It's Ashley Thomas from SocGen. Just on the bad debt increase, the £5 million in the three buckets, the last bucket, I guess the review of the provisions is potentially one-off. Could you perhaps sort of give us sort of broad split of how those three buckets pan out?

Russ Houlden: Yes, certainly. The three buckets are all roughly similar size, which is why we described those three factors of equal weight. So they are all roughly a third, a third, a third. In terms of the provisioning for business customers, it was a one-off as we went through systems upgrade, but there are more systems upgrades to come, and so I'm flagging that there may be further one-offs over the next year or two as we do that.

Dominic Nash: This is Dominic Nash with Macquarie, a couple of questions please. Firstly, so the progress of Severn Trent was out yesterday and announced quite a major efficiency program. This is I think on their benchmark I think it was 14 employees per manager. Have you done a benchmarking sizing and would you be looking at a scheme sort of in similar sort of scale, I think it was 10% of entire workforce? And secondly on bad debts and deprivation, I don't think you've got social tariff in place yet as a company. Is this something that you're looking at, obviously in labor talking about as being mandatory, and what sort of impact would that have on your numbers if at all?

Steve Mogford: I think if you look organizationally, we mentioned over a year ago that we will reorganize the business essentially to sort of facing to the kind of structure that businesses will need to address and fix with separate price caps and focusing really on two aspects of wholesale, water and wastewater, and then the two retail, non-household and household. So we are originally the early mover in that. What we've also been doing progressively over the last few years is restructuring our business, very much making a lot of the changes that we need but on a progressive basis. So we don't have any current plans for a massive change because it's something we've been doing for a number of years, and working that through. But I think the key issue now for us is about, as you go into a new operating model, a new way of working, a lot of the discussions now are about how you retrain these skilled people to actually work in a different way, but we certainly don't see ourselves in a similar situation of needing to make a big one-off hit to the organization because we've been working progressively for a number of years. I think as far as the deprivation issue…

Russ Houlden: I think the point was mainly about social tariffs, but I think it's worth sort of setting a theme here, because we have such a deprived community in the North West, we've been on this point for many, many years and we have many, many schemes, and if you add up the results of those many, many schemes, they are larger than any other company by far. And so for example in the UU Trust Fund we have 5,400 customers at the moment, in the Arrears Allowance Scheme we have 17,000 customers, the WaterSure tariff 8,000 customers, Social Housing tariff 41,000 customers, and we have a Support Tariff Scheme which was, it was a bit like a social tariff but it was a predecessor to that with about 5,000 customers. In terms of the specifics of the social tariff as currently named, we have consulted with customers, which is what we were required to do, we have got customer support for our social tariff that relates to particularly disadvantaged vulnerable pensioners and there's quite a big pool of those that we could help and we'll be announcing something probably around about the April timeframe.

Steve Mogford: Yes, so to take you under the social tariff arrangements, you were required to consult with customers because it actually requires customer support. We've done that. We've had to go through several rounds, because you can imagine, in a deprived community the capacity to effectively cross-subsidize is limited. So having done that, we now have a scheme which we feel has the support of our customer base and that we'll put in place from April. I think the broader issue that you raised about labor policy, I mean clearly we've heard labor talking about social tariff and the extent to which they may mandate a scheme, what you'll find is that what U.K. and the rest of the sector are actually engaged with labor at the moment talking about that and actually providing a lot of background to what goes on in the sector. So there's a lot of information exchange being done at the moment about what already goes on, and the extent to which individual areas of the country are very clearly in support or otherwise of those kinds of schemes. I think you'll find a large part of the large community in the sector will be moving into a social tariff environment next year.

Verity Mitchell: Verity Mitchell, HSBC. I've got two questions, one is about Scotland. If you could tell us, is there a particular group of customers that you're seeing success with in terms of the largest group that you've won, and you've mentioned some initiatives, so it would be interesting to see where you have real competitive edge? And secondly, you mentioned about systems upgrades and that it's part of responding to AMP6, if you could just perhaps give us a bit more color about what you're planning in what areas on system upgrades? Clearly there might be some extra costs associated and also some extra bad debt, so that would be useful color. Thank you.

Steve Mogford: Scotland, I think the issue with Scotland is that we've entered the market with an intention of actually rather than chasing revenue, chasing margin. So we've gone for good quality customers. We've not competed where we felt the margin is being eroded too much through competition. And what you'll find is that we are actually winning both large multi-sites as well as single-site customers, and it's really about quality of the business margin available and looking for profitable business rather than just simply going for volume for revenues. And what you're finding is, as you start to build your reputation in this sector, then the opportunity opens up. So we put a lot of emphasis into very good customer service and the way that we transition that customer across as being important. I think what is also becoming apparent in the business retail market is clearly it starts to take you inside the customer's value chain. So from simply looking at a customer as somebody where a pipe comes in and the pipe comes out, we start to look at that customer in the context of what's their business, what are they trying to achieve with their own business objectives and how can you support that, and that starts to bring into play a number of value-added services. So we have a thing called UU Total Solutions which is a group of individuals looking at all sorts of things and it ranges from simply leak advice, so are you on top of leakage, are you giving them the data and actually flagging to your customer that they may have a leak before they know, and then getting in and providing advice through to such bizarre things as we've been working with Safari Park on actually modifying their penguin pool, because basically all they had got was a pretty standard swimming pool system and it wasn't appropriate for the penguins. And it's amazing, we have that sort of knowledge and competence in the organization. But that gets you into a whole range of different areas and that's actually been the experience in the Scottish market. I think Business Stream would tell you the same. And so we're starting to move into an area where those opportunities start to come with a retail relationship. I think when you look at systems upgrades, one of the things that we did very early in this process, I think once we saw business retail coming down the pipe, if you excuse the pun, what we did was we said, a lot of the competencies within the companies are as wholesalers, they are about treatment, they are about distribution, and we went out and said, what we need is a competent retail team. So we went out and found people who had experience of retail gas and electricity markets, the retail sectors. Scottish experience has been invaluable. And those people are the team that have been driving our retail activity. One of the key drivers on success in the retail market is cost to serve. If you think of new entrants, both the incumbents but the other new entrants that we might see, cost to serve is important and therefore having systems which minimize the cost to serve is important. So actually this morning, we've gone live with a new business retail system which effectively is a customer relationship management system, which we are standing up and takes us off our conventional systems into a standalone business retail customer relationship system, gives us a lot of efficiency in terms of the way that we then can transact on accounts. As we go forward into AMP6, you know that we've had a lot of dialog with Ofwat around average cost to serve in the household retail market, and what we envisaged and is part of our plan is the cost of doing a major overhaul again of our domestic retail systems and processes to further drive both customer satisfaction but also to further drive the cost to serve for our domestic customers. So kind of work in context of that retail interface and actually attacking cost to serve and getting to the targets that we set ourselves for AMP6.

Fraser McLaren: This is McLaren from Merrill. Just wondering, in relation to the £370 million revision, if you could just speak a little bit about how that breaks down into the three components which you mentioned please?

Steve Mogford: Essentially it breaks into two areas really. One is about £90 million of scope reduction, and the £280 million is a combination of either efficiency or as an adjustment subjected with implicit allowance, and I can't recall the split between the two. We always tend to think in £90 million and £280 million of the £370 million, but essentially that's where we are. We had some scope adjustments also when we resubmitted our plan in June, where what we had done was we got an activity scope adjustment again coming out from discussions with regulators, but we had also included acceleration of the scheme. So the net impact was negligible. But for this time around, it was £90 million adjustment on scope, and those are the things that as we've gone through development, we feel that identified with our regulators we don't need to do or we've been able to say, there's another way of actually skinning that cat.

Fraser McLaren: And then just perhaps one more please on the net debt-to-RCV, are you expecting much movement between now and the end of the year, and during the next period how important do you think it is to move to Ofwat's new target range, if you see that being a one-off move or something that you would look to do gradually over the period?

Russ Houlden: In terms of debt-to-RCV for the rest of this period, I expect it to remain fairly stable. It's been fairly stable as you see in this period. In terms of next period, we have to think about our credit ratings and our financing policy, which I've made quite clear I think a number of times, which is that our overarching policy is to retain access to the debt capital markets in good times and bad, because you don't know when next credit crisis is going to hit. Our capital demands are quite large and therefore we can't afford to be out of the market. And it's for that reason that we target an A3 rating and we've been very clear about that, but also of course we like to retain an S&P BBB+ rating, and we shouldn't forget about that because if the two were to become too far drifted from each other, that would become problematic. And so, I think this sort of links into – because you're talking about Ofwat targeting a level of gearing, I don't think that's quite right. What Ofwat does do is it uses a gearing level for the purpose of setting a WACC and that gearing level is 62.5% for the next term. We've had discussions about that, and I think I've talked about this before several times, that that is not to be seen as a target. It is not encouraging ask the listed companies to increase our gearing nor is it encouraging securitized companies to reduce their gearing. It is simply a number that they use in order to set the WACC. So from our point of view, debt-to-RCV at the levels that we have and the levels that we envisage for AMP6 are perfectly fine to retain the A3 rating, but what I've said a number of times before is, the key thing in AMP6 is actually the S&P rating of BBB+, and so debt-to-RCV is not the key constraint, the key constraint is FFO-to-debt. And it's for that reason that we have set the pay-as-you-go the way that we have with – used pay-as-you-go in order to solve for the financeability problem and it's therefore critical that our pay-as-you-go request that we put into Ofwat is actually allowed in final determination, because that will support financeability, support the BBB+ and therefore support our access to debt capital markets through the cycle. It's also important for customers, because if that BBB+ were to slip, then in the end it would add to customer bills. So that's a long answer to your question, but that's the reason why it's not just debt-to-RCV, that's the message, it's the FFO-to-debt.

Iain Turner: It's Iain Turner from Exane. Just a couple of questions. The remaining 6 million to 8 million gap between Ofwat and you, is it possible to analyze that into scope and sort of efficiency? And then on your headroom on financing, is that the right level of headroom or should you have a bit more? I mean what you've got there is you've got some medium-term stuff and you've got cash but it's less than one year's CapEx, so would that be something you're looking to put more borrowing in place in the sort of near future or in the next 12 months?

Steve Mogford: I'll pick up the 6 million to 8 million. Essentially in going back with our response to draft determination, we addressed the sort of modelling issues, so things like implicit allowances, we addressed the efficiency issue of upper quartile with a reduction to our plan. So we now have 6 million to 8 million as scope supported by detailed analysis, third-party support, both of need and also of costing. So when you look at the 6 million to 8 million, 6 million to 8 million does reflect content in our plan which we are proposing to undertake during that period. And so, we are positive about the work we've done to underpin that, but I think we've addressed the efficiency challenge through the other measures that we've taken in the plan. So it's now more about agreement on scope than it is agreement on efficiency.

Russ Houlden: On the headroom point, we have – our basic policy is to keep headroom between about 15 and 24 months of liquidity, and we do that partly through the cash and the undrawn borrowings. So at the moment we've got another £252 million drawn on EIB loan. We would do it partly through the committed facilities which we have with 10 or 12 banks. So I think it is at a perfect level and we are quite relaxed about our position on headroom, but it does need you to retain continuous access to that capital markets that I discussed in an earlier point.

Unidentified Analyst: [Indiscernible]. Just following up on the debt question on FFO-to-debt, have you had any further discussions since we last spoke with S&P about how they're going to do the calculation given IRE effectively disappears now, and related to that, have you had any discussions with your auditors regarding how they will be accounting IRE going forward given that KPMG certainly or in the past on one occasion an older company they audited under IFRS and allowed zero IRE in the account?

Russ Houlden: I think on the FFO-to-debt point and S&P, I think there is no further development from what they've already published on the topic. There has been a published statement from them and one from Moody's on how they intend to treat things going forward, and everything we've discussed within is consistent with the written statement. On IRE accounting, I think there is a difference between regulatory accounting and statutory accounting. I think statutory accounting doesn't change.

Ashley Thomas: It's Ashley Thomas from SocGen. Just a follow-up for Russ on the FFO, sort of how do you view hybrid generally? If Ofwat didn't come back and accept your proposed pay-as-you-go, could that potentially be a tool to help meet the 9% to 11%?

Russ Houlden: This is a favorite topic for discussion. I think I can see very little [indiscernible] as we said in the answer before, but I'll sort of reiterate my position on hybrid. We have no accounting intention to issue a hybrid, but hybrids do have a place in any treasurer's toolkit. The hybrid as you know is a funding instrument that combines the credit supported features of equity with the scheduled interest and principal repayments of debt, and it will normally have a 50% equity credit attached. Now, hybrids can be useful in a situation where the credit metrics are temporarily stressed, and in such situations you'd look at the cost and benefits of equity versus hybrid. However, if you look at our draft response, our response to the draft determination, we have not created temporarily stressed credit metrics. So if that DD response is supported, then there is no situation in which hybrid would be required. Now obviously when the turf is assembled, we'll see what does actually comes out in the final determination, and if there were a temporary credit stress, then it's a tool that might be used, but if it was a permanent credit stress, it wouldn't work.

Steve Mogford: So that's positive situation for this. I mean, we always get one, don't we? Any other questions?

Steve Mogford: No? That's great. Thanks very much. Thanks for coming on everybody, appreciate it. Thank you.