Chief Executive's Review

It has been a year of extraordinary turbulence in the commodity markets. During the first half of the year we experienced volatile and rapidly rising global oil and gas prices driven primarily by growing demand in Asia. In the second half the sharp contraction of credit markets caused a collapse of worldwide oil demand and the oil price. By the end of the year this started to feed through into a softening of the wholesale gas price. Although Centrica has navigated well through this market upheaval our profitability has been impacted with the upstream benefiting at the expense of downstream margins.

Only five years ago the energy environment in which we operate was very different to the one that we are in today. Then, wholesale gas markets were reasonably stable, security of supply was a distant concern with the UK self-sufficient in gas and exporting its excess to the continent and new nuclear power was not universally welcome.

A great deal has changed.

Even though energy prices have softened as a result of the recession, the long-term trend remains upwards driven by the industrialisation of Asia, the increased costs of oil and gas extraction, political uncertainties surrounding sources of supply and the need to decarbonise our economies to meet the challenge of climate change. In the UK, domestic oil and gas production continues to decline and our import dependency is growing sharply. The power generation fleet is ageing and needs replacing with low-carbon technologies. In the US the new Obama administration has placed a high priority on meeting the challenge of climate change which, as in Europe, will place an additional but necessary cost on the consumer.

Taken together the triple challenges of ensuring security of supply, minimising climate change and providing affordable energy pose profound questions for the whole of the energy industry. There are no easy or cheap answers, although energy efficiency has a vital role to play. What is clear is that unprecedented levels of investment will be required over the next two decades to meet these challenges.

Gas

The UK is increasingly reliant on imports. Some 35% of UK gas was imported in 2008, and it is estimated that 70% will be imported by 2015. Demand for gas remains at high levels globally, despite the economic recession and that the UK has to compete in the global marketplace. So Centrica is investing in new gas assets in the British and Norwegian sectors of the North Sea.

We are also investing in contracts and UK infrastructure to enable us to import increasing amounts of liquefied natural gas (LNG). In January 2009, we received the largest shipment of LNG ever delivered to the UK. But LNG is also a global product and the UK and Europe are competing with Asia and North America for LNG supplies.

Going forward, as additional LNG production comes on-stream and an increasing number of players enter the market, we will be pursuing a range of sourcing strategies.

Price volatility and supply constraints can be eased through storing gas bought during periods of low demand. The UK has relatively limited storage we have around 16 days of gas storage compared to about 77 in Germany and 88 in France and so this is another area in which Centrica is investing.

Power

The European Union and national governments are imposing strict limits on CO2 emissions and stretching targets for the use of renewable energy. The European Renewables Directive, for example, will bind the UK to a 15% renewables target by 2020. The UK Government has suggested that this is likely to mean up to 3035% of electricity could come from renewable sources compared with less than 5% today. According to the Government, this will require around 100 billion of investment.

However, renewables alone will not be able to fill the medium-term supply gap. The alternatives are gas, coal or nuclear power stations.

We are close to completing the first gas-fired power station to be built in the UK for almost five years, at a cost of 400 million and expect this to begin commercial operation later in 2009. We also firmly believe that a vital longer-term contributor to energy security in a low-carbon world is new nuclear capacity. Much of the existing nuclear generation fleet will be retired over the next 15 years, and the replacement process has a very long lead time so decisions need to be made today. Our Rights Issue in December has provided the resources to enable us to be actively involved in this market.

Centrica’s strategy needs to be able to address the complex issues that the industry faces, and to do so in ways that can deliver sustainable value for our shareholders. This requires us to manage all of the risks and opportunities we are facing with a clear vision and an understanding of where our corporate responsibilities lie. Our strategy must be able to respond appropriately to the needs of our vulnerable customers, to ensure the health and safety of our customers and employees, as well as meeting the challenges of security of supply and climate change.

I believe that it can, and that in seeking to create an integrated energy company, operating upstream by developing new sources of gas and power, and downstream with strong brands and innovative propositions, we have a robust approach to meeting the challenges ahead.

We have continued to operate the business in line with the strategic priorities we set at the end of 2006, and report on those over the next pages. In short the increasing extent of vertical integration in Centrica, the emphasis on operational excellence, the reduction of our cost base and the improvement in our customer service meant that we ended 2008 with a stronger business and momentum for the future.

UK gas supply/demand 1998–2018

Graph showing UK gas supply/demand 1998–2018

Source: Office of National Statistics, DECC, National Grid

Energy hedge ratio %

Graph showing the Energy hedge ratio (%)

  • Key: Morecambe Morecambe
  • Key: North Sea North Sea
  • Key: Acquisitions (20062008) Acquisitions (20062008)
  • Key: Wind Wind
  • Key: Drax Drax

PRIORITY 1 TRANSFORM BRITISH GAS

British Gas Residential is the core of our business, and it needs to deliver consistently high levels of service and profitability if we are to succeed.

The transformation, therefore, aims to:

  • improve our price competitiveness, service levels and product offer
  • reduce our costs through best-in-class productivity while remaining a great place to work
  • achieve long-term margins of 67%

Open to read more

The progress we’ve made

During 2008 our customer service improved significantly. Average time to answer and to handle calls reduced further and our proportion of industry complaint levels fell by nearly a third over the year. Compared to 2007 we also increased the percentage of customer enquiries which were resolved on the first call and substantially reduced the transactional exceptions associated with the new billing system. These service improvements enabled further progress to be made on our cost reduction initiatives. Our operating cost base in 2008 was over 200 million lower than in 2006.

In October Ofgem published the initial findings of its probe into the energy supply industry in Britain. The report concluded that effective competition exists between the major suppliers. However, it did make recommendations to reduce certain retail price differentials, particularly relating to former incumbent electricity suppliers who charge different prices for in-area and out-of-area customers. It also suggested a reduction in tariffs for those customers with a prepayment meter, to more accurately reflect the additional cost involved in supplying those customers. British Gas complied with this recommendation in a matter of a few weeks.

What’s next

We have created a strong foundation here over the last two years and now is the time to take British Gas to the next stage of its evolution. Building on our already strong brand in the UK we are seeking to deepen the customer relationship by combining the energy and services propositions. This will offset the gradual decline over time in the use of gas by consumers in the UK as we move to a lower carbon economy, and take full advantage of the increasing demand for energy efficient products and services. To best achieve this we will combine British Gas Residential, British Gas Business and British Gas Services into a single customer-focused organisation. This will enable us to launch new bundled products under the British Gas brand, products that customers want, to increase customer loyalty, to further reduce costs and to target even more efficiently the substantial support we already provide for our vulnerable customers. Phil Bentley, the current Managing Director of British Gas Energy, will run this new organisation. Chris Weston, current Managing Director of British Gas Services, will take over leadership of the Direct Energy business from Deryk King in July 2009.

PRIORITY 2 SHARPEN THE ORGANISATION AND REDUCE COSTS

We operate in a highly competitive market for customers at national level and for global sources of energy.

In order to compete in the long term, our organisation has to be as lean and efficient as possible, with the people and structures that enable us to make the best use of the skills and resources we have.

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The progress we’ve made

In July Mark Hanafin joined Centrica as Managing Director Centrica Energy and Europe. This further strengthened the executive team. Various initiatives in the year across the Group meant that we finished 2008 as a leaner organisation without affecting our ability to grow. This helped to reduce our Group like-for-like operating costs by 40 million, despite the inflationary pressures, particularly in the offshore services environment.

What’s next

We have a strong leadership team in place and improved capital allocation, risk management and cost control processes, which will enable us to drive superior financial and operational performance. Going forward, we consider operating cost advantage to be a key competitive differentiator for Centrica and we will be relentless in the pursuit of further cost reductions, while enabling growth across the business.

PRIORITY 3 REDUCE RISK THROUGH INTEGRATION

We need to produce more of the energy that we sell. In the UK, we are only able to supply 29% of our gas requirements from our own gas fields and 58% of our peak electricity demand from our own generation facilities. The remainder has to be bought in highly volatile world markets.

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The progress we’ve made

During the year, we made good progress. We acquired additional gas assets in the British and Norwegian sectors of the North Sea. In March we increased our equity stake in the assets originally acquired from Newfield in 2007 and in October we completed our acquisition of assets in the Heimdal area of the North Sea. At the end of the year we announced an agreement to acquire an additional interest in the Peik gas field in the UK and in January 2009 we agreed to take additional equity in the York gas field. These deals provided us with both producing gas assets and valuable exploration and development prospects.

During the year Centrica Storage announced two important potential gas storage projects. In March we began engineering studies to explore the potential to convert the Bains gas field in the Morecambe Bay area into a storage field with a capacity of up to 20 billion cubic feet (bcf). In September we acquired the Caythorpe onshore gas field and began the process of converting it into a storage field capable of holding up to 7.5bcf of stored gas. In February 2009 we announced our intention to create an additional 60bcf gas storage field in the UK North Sea following the acquisition of a 70% share in the Baird gas field.

In power generation we completed the Lynn and Inner Dowsing wind farm development off the Lincolnshire coast, the largest operational offshore wind farm development in the world. In Devon, the construction of the Langage gas-fired power station continued, although the contractor has experienced some delays and we now expect the station to become operational towards the end of 2009.

In September we announced the signing of a Memorandum of Understanding with EDF to acquire a 25% share in the British Energy business. This would add significantly to our upstream position and provide us with a long-term hedge against volatile wholesale power prices, with access to power where the price is not impacted by the cost of oil and gas, and an opportunity to grow through new build nuclear construction in the UK.

The proceeds from the successful 2.16 billion Rights Issue towards the end of the year provide us with the capital required to complete the British Energy transaction and make further material progress in increasing the upstream asset base and reducing risk.

What’s next

We will continue to expand our power generation fleet as part of the overall upstream hedge to reduce the exposure to the increasing volatility in power prices and spreads. Here we will seek to cover an increasing amount of our UK electricity demand load and to grow and better align our generation mix with that of our competitors and the wider market. As part of this, our discussions with EDF, regarding us potentially acquiring 25% of British Energy are continuing. We will also pursue external financing to allow us to develop and build on our wind farm portfolio, and additional options to grow the size of our conventional gas-fired fleet of power stations.

In gas we are continuing to push ahead on reducing our exposure to the short-term volatility in wholesale gas prices by acquiring additional gas assets and striking gas contracts. In pursuing this we will focus most of our asset acquisition activity on the UK and Norwegian sectors of the North Sea while also continuing to evaluate LNG opportunities. Building closer relationships with National Oil Companies, to secure competitive long-term sources of gas for our customers, remains firmly on the agenda.

PRIORITY 4 BUILD ON OUR GROWTH PLATFORMS

Centrica’s growth businesses in the UK, Europe and North America have great potential for increasing the Groups profitability.

We are focusing on new opportunities, such as providing low-carbon products and services, and increasingly on integration in the North American business. This will see us concentrate on the geographies and service areas in which we are already strong, and support the retail businesses through the construction and acquisition of new power assets.

Open to read more

The progress we’ve made

The financial results in the year show real progress with this priority. In British Gas Business and British Gas Services we grew revenue, operating profit and customer numbers, while delivering ongoing cost efficiencies. In North America we faced a difficult economic environment. However here too we increased customer numbers and delivered a strong financial result, partially due to favourable exchange rate movements. Our acquisition in June of Strategic Energy doubled the size of our commercial and industrial (C&I) energy supply business and made us the third largest commercial supplier of energy in North America. In Europe, in January 2009 we completed the acquisition of an additional 25.5% of SPE, giving us a valuable controlling stake of 51%. Unfortunately Oxxio, our business in The Netherlands, recorded a disappointing loss*. We have taken action to stem losses here, including replacing management.

What’s next

The reorganisation in British Gas provides us with an opportunity to increase the overall value of our customer base by expanding the overlap between our energy and services businesses through bundled offerings under a single brand. In North America we will also integrate further by building on the platform we have already established and tightening the focus on key geographies. In doing this we will establish a centralised service platform which enables us to compete more efficiently. With better focus will come a greater degree of integration, primarily through the selective acquisition and construction of gas and power assets, to provide growth opportunities and support for the retail businesses.

* including joint ventures and associates, stated net of interest and taxation, and before exceptional items and certain re-measurements

In summary

Following a record 2007, the financial performance in 2008 was good despite a much harsher environment. We made strong progress against the strategic priorities we set out at the end of 2006. The outlook for the global economy remains very challenging and in the UK 2009 could be particularly difficult for many of our customers, both residential and commercial. We will continue to place our customers needs at the forefront of our agenda, alongside our determination to deliver increasing long-term value for our shareholders.

Sam Laidlaw
Chief Executive
26 February 2009

Our strategic priorities:

Transform British Gas

  • New billing system complete
  • Service levels dramatically improved
  • Removed over 200m of costs since 2006
  • Popular fixed-price and online propositions
  • Essentials tariff for vulnerable customers

Sharpen the organisation and reduce costs

  • New senior management structure
  • Like-for-like Group operating costs reduced by 40 million
  • Becoming increasingly efficient

Reduce risk through integration

  • First major UK power station for almost five years
  • Completed worlds largest offshore wind farm development
  • Acquired more gas assets and received first LNG shipment
  • Announced two major new storage projects in 2008

Build on our growth platforms

  • Strong customer growth in BGB
  • Increase in sale of BGS secondary products
  • Upstream and downstream acquisitions in North America
A ship carrying LNG

In January 2009, we received the largest shipment of LNG ever delivered to the UK.

Direct Energy vehicle

Our Direct Energy business in North America.

British Gas Residential operating expenditure m

Graph showing British Gas Residential operating expenditure (m) for 2006, 2007, 2008

Generation mix %

Graph showing Generation mix (%) for the UK and Centrica

  • Key: Gas Gas
  • Key: Coal Coal
  • Key: Oil Oil
  • Key: Wind Wind
  • Key: Nuclear Nuclear
  • Key: Other Other

Growth business EBIT m
(earnings before interest and taxes)

Graph showing Growth business Earnings Before Interest and Taxes (m)

  • Key: BGS BGS
  • Key: BGB BGB
  • Key: DE DE
Centricas UK headquarters

Centrica's UK headquarters in Berkshire.