We talk to Tony Kendall about the challenges of running the treasury department in a major utility company including the need to manage both collections and the working capital cycle.

What are you responsible for in the treasury?

Treasury in Centrica is highly centralised. We manage all the usual treasury functions for our operations in both the UK and North America from our group headquarters in Windsor. We are responsible for funding, liquidity and cash management and the management of foreign exchange and interest rate risk. There is also a small treasury operation in Toronto, which concentrates mainly on cash management. We allow it to run a small cash surplus, although when this runs down, they have to call funds from the UK. Our business in Europe is conducted primarily through a joint venture, so we are not involved in the day-to-day transactions.

We are also responsible for managing our counterparty exposure, although within strict limits set by the risk management department which sits outside treasury.

How does that work?

The risk management department is concerned with all the company’s financial risks with the exception of interest rate and foreign exchange risk. This means they have the responsibility for setting policy on both commodity and counterparty risk management, although with a lot of interaction with treasury.

The risk management department sets a series of counterparty limits, which will then be formally endorsed by the financial risk management committee. These limits, which are purely ratings driven, are then passed down to us and we have to conform to them. Within treasury, we are not allowed to take counterparty risk with any entity rated below A- (or its equivalent). We then have separate limits for all entities rising up to those with a triple A rating. We are aware of the shortcomings of the ratings process and that from time to time errors are inevitably made. However generally we do not feel that we have enough information to gainsay the analysts within the agencies. Our protection against the risk of an error within the agencies is to have fairly conservative counterparty limits and sometimes we are prepared to cut limits when there is some specific bad press about a bank or group of banks. For instance, during the Japanese banking crisis we cut the limits of all Japanese banks relative to their individual credit ratings.

How are you held accountable?

I report into a Director of Tax, Treasury and Risk Management, who reports to the Finance Director. We use the concept of active risk management. For example, in the area of interest rate risk management, we are able to actively manage positions. Our policy is to maintain our long-term debt within a range of 30% to 70% fixed. Within these limits, we can flex the level of fixed rate debt, depending on our overall opinion on interest rates and what is in the interests of the group. On the short-term side, we have the ability to manage interest rate risk quite actively by using forward rate agreements to extend or shorten the duration of the short-term portfolio. Other than this we operate as a pure cost centre, with a mandate to reduce and mitigate financial risk when it arises.

What is your current debt position?

At the last year end, Dec 31^st, we had £53m net debt. From a gross point of view, we had just over £1 billion of debt on the balance sheet. During 2003, we found that acquisition expenditure dried up, so we built up quite a bit of cash. This means that, at the moment, our focus is on managing cash, looking for the best yield taking account of interest rate and counterparty risks, rather than on raising debt.

How do you do that?

We have a spread of investments within the traditional money market products. We are now using money market funds more extensively than previously. We also look at more structured products, although we have a limited appetite in terms of tax structured deposits on the investment side.

How do you manage FX exposure?

In North America, we have a foreign exchange hedging strategy where we hedge both US and Canadian investments. For example, we draw on our $2 billion USCP programme as a hedge against our $300m US assets. We manage our CAD$1.2 billion assets with cross-currency swaps and FX because the Canadian debt market is not as efficient or as accessible as the US market. We try to maintain the balance of debt to assets within a range of 90%-100%, because if we go over 100%, any FX gains and losses hit P&L.

We manage transaction exposure as it is identified, out to about two years.

Was the USCP programme difficult to set up?

Not particularly. It was set up in 1999 in the name of Centrica plc. We made a conscious decision to give some of the dealer business to the banks which had supported us by providing committed facilities. Of our three dealers, Merrill Lynch, JP Morgan and Bank of America, two are relationship banks. In terms of documentation, we found it to be a fairly tried and tested route and it presented no particular difficulties.

What is your position on ratings?

As a company, our rating is very important to us. We target a middle single A long-term rating with both Moody’s and S&P as the cornerstone of our financial policy. We are prepared to adjust our financial ratios to maintain this rating. For example if the rating agencies change their view of the business risk within the energy market then it is highly likely that headroom ratio levels may change. If this was to happen we would in all likelihood amend our Financial Policy ratios. At the moment, there are no particular issues and net debt levels are extremely low. In the long run, we have to maintain a close relationship with the agencies so that they understand what we are doing and we can convey to them any changes in Centrica’s strategy.

How do you manage your collections?

We have two different structures, one in the UK and one in North America. In the UK, our banking is concentrated primarily with HSBC (for collections) and also with Barclays (for making payments). As a utility business, money transmission is very important. We have about 12 million gas customers and 6m electricity customers paying monthly or quarterly. This means we have over one hundred million direct debit transactions every year. The contracts for this business are therefore very large and extremely important to us and we go out to tender on a regular five year cycle. The last time we did, HSBC won the bulk of the business.

We use the two electronic banking systems (HSBC’s Hexagon and Barclays’ BusinessMaster) to organise the daily collections and pooling of the cash. We use these systems to identify the cash requirement or the generated cash surplus on a daily basis.

The North American operation is not quite as substantial as in the UK. Our main money transmission banks are Bank of Montreal and TD in Canada and Wachovia in the US. Just as in the UK, we try to pool everything in North America on a daily basis. Subject to keeping a relatively small amount of cash locally, any other surplus cash will be returned to the UK. Cash requirements in North America will be met from surplus cash or directly from the UK.

How do you manage your working capital?

One of the features of Centrica is that we have a significant working capital swing. We have to pay for the energy our customers consume very quickly, sometimes even in advance. On the other hand, payments coming from the customers tend to lag. We receive cash from the typical customer on quarterly billing about two months after they have used the energy. It is also seasonal. Our cash outflow increases during the winter and then, in the summer as outflows come down, cash starts to come in. So April, May and June are peak cash periods for us and cash continues to build up until about October. Over the course of the year, the cash swing is between £¾ billion and £1 billion. Because of that, we need to make sure that we have sufficient back-up liquidity lines in place.

We have targeted a committed facility level of between £¾ billion and £1 billion as comfortable. This is on a three-year cycle and was last arranged in August 2002. We now have a group of 17 banks who provide us with £915m of committed facilities, split between a 364 day facility and a three and a half year facility. The 364 day facility matured in 2003. It has been rolled once and will be rolled again.

How difficult is it to arrange these facilities?

Quite difficult, because I insisted that all banks had standard documentation. Because of this I had to be extremely careful that I pitched the termsheet (that we prepared with our lawyers) very carefully. At the end of the day it’s a case of meeting the lowest common denominator.

With regards to the rollover of the 364 day tranche, we will have a final deadline somewhere about the middle of August. To make sure we are not caught out by this deadline, we will start the renegotiation process in April or May. This will involve sounding the banks out with respect to the terms they are looking for and also whether their credit committee’s have changed their approach to Centrica. We will then work on the documentation in June and July.

With that number of banks, wouldn’t a syndicated facility be a better option?

No I don’t think so. The syndicated facility was put in place at the time of the demerger in 1997. We put in place a syndicated revolving credit facility of £1 billion because we needed the facility quickly and Centrica at the time had no banking relationships of its own. It was disappointing – we invited about 40 banks to participate but only about 20 banks came in. It was heavily undersubscribed and left the lead arrangers with about £200m each on their books.

When this came up for renewal in 1999, we negotiated bilateral agreements with about 20 banks. Because I wanted all banks to feel they were being treated the same, we also negotiated identical documentation with every bank. This was difficult to get in place, particularly for the first time. We had to make a few concessions, as did many of the banks, but after some negotiation we ended up with standard documentation.

Because of the precedent, we were able to do it again in 2002 although market conditions made it difficult. In particular, we recognised that, because of Enron, there were some credit committees who would not do a deal without some form of covenant. Therefore, we introduced a financial covenant to the bilaterals in 2002 which was not there in 1999.

What do you see as your challenges over the next couple of years?

The main one is IAS 39. Because we are looking at the possibility of issuing comparatives for 2004, we have to have a balance sheet for the end of 2003. At the moment, we are doing a lot of work on the hedges we have in place. We are particularly concerned about the fair value hedges for our bonds. We are not convinced that a straightforward, plain vanilla interest rate swap will, in all circumstances, pass the effectiveness test.

Three examples illustrate the point. Firstly, consider a ten-year bond with a fixed coupon swapped into floating. If the interest rate curve changes once the swap is put in place, there may be a problem. The value of both the bond and the fixed rate receipt of the swap won’t change, but the value of the first floating leg will have moved quite significantly. Secondly, there may be problems with effectiveness if a bond with an annual coupon is swapped into semi-annual LIBOR. Finally, we had a yen bond with a mixture of cross-currency and interest rate swaps. Because the bond isn’t that large, we might find it easier to mark everything to market rather than seek to practise hedge accounting. IAS are causing us some problems and we expect that to continue.

Away from IAS, I have the ongoing challenges of maintaining our relationships with the banks and rating agencies. We have also announced some fairly large potential investments in renewable energy in the form of wind farms. The financing of those projects may well be an area that will prove challenging over the next couple of years.