A year of transformation

2009 was a year of significant achievement for Centrica with British Gas now transformed and the completion of the Venture and British Energy transactions.

Our existing strategic priorities have now been achieved, and in February 2010 we announced new priorities to build on the robust, vertically integrated business model that we have in place. Centrica is well positioned to pursue growth opportunities and lead the drive to a low carbon world, whilst maintaining the financial discipline to secure strong returns on our investments.

Energy industry overview

Our strong performance over the last year has come against a very challenging backdrop of severe recession and continuing volatility in wholesale energy prices.

Eighteen months ago, high oil, gas and power prices provided a strong signal to producers to continue investment in energy infrastructure. It was a time of high energy usage by retail consumers and gas-fired power generation due to global economic growth.

The impact of the recession led to a fall in demand for gas and electricity in both Europe and North America, an excess supply of gas and a resultant weakening of spot prices, leading to a reduction in upstream investment.

The liberalised UK energy market has proved central to the delivery of secure energy supplies over the past 20 years, while ensuring the UK benefits from the lowest domestic gas prices in Western Europe. The strength of this model was demonstrated when the market coped well with days of record demand through the winter of 2009-10.

However, there is no room for complacency. Since 2004, the UK has been a net importer of gas, and imports accounted for approximately 50% of this past winter’s demand. That figure is likely to reach 75% by 2015 and securing sustainable sources of energy supply for our UK customers is one of our key priorities.

Many in the industry predict an energy gap in the middle of the decade when coal-fired and oil-fired power stations close because of European pollution laws and as ageing nuclear power stations are phased out. We must bridge that gap by moving quickly to build new gas and nuclear power stations and gas storage facilities.

Ofgem, the energy regulator, has acknowledged the £200 billion investment challenge the UK faces, if we are to maintain energy security and start to decarbonise our economy to meet global 2050 carbon targets. That will inevitably have an impact on the cost of energy for consumers, though higher bills can be eased by continuing to invest in improving the energy efficiency of our homes and businesses.

The energy industry is ready to play its part in delivering the investment needed, as long as the Government and regulator can establish the right market frameworks. Centrica, for example, has invested more than £4 billion in the last year alone in new sources of energy for our customers and we expect to spend a further £15 billion by 2020 on new sources of gas, power generation and gas storage facilities that will help underpin the UK’s energy future.

Centrica’s performance

2009 was a year of significant achievement for Centrica. The acquisition of Venture in August and the transaction with EDF to acquire a 20% equity stake in British Energy in November means that we now have a more robust and integrated business model, which enables us to meet a greater proportion of our customers’ energy needs from our own sources. These are long-term acquisitions, concluded in a low commodity price environment, creating an upstream division that is now a growth business in its own right.

Downstream, we have continued to make improvements to the service and propositions we offer to our customers. We are focusing on delivering a range of new propositions and energy efficient solutions to help customers manage their energy bills. We will lead the transformation to a low carbon world through the installation of smart meters and new technological solutions and energy efficiency advice. Our network of highly trained service engineers are well positioned to deliver this growing range of services.

Centrica’s underlying operating performance in 2009 demonstrated resilience in a year of sustained economic downturn and weak commodity prices, with the reduction in upstream earnings being offset by a greater downstream contribution.

The reduction in wholesale gas prices from their peak in 2008 led to a substantial reduction in operating profit for our upstream UK business, Centrica Energy, in 2009. Gas production volumes were 29% lower year-on-year, as we decided to preserve the value of our gas reserves by reducing production from the Morecambe fields. This short-term earnings impact was partially offset by a strong financial performance from our combined cycle gas turbine (CCGT) fleet, which benefited from favorable clean spark spreads. Our new CCGT power station at Langage is now operational and including the investment in British Energy, Centrica’s UK power generation capacity has increased from 4.2 gigawatts (GW) to 7.1GW. Centrica Storage continued to perform well, with Rough achieving the highest level of utilisation since it was acquired in 2002.

Downstream in the UK, British Gas recorded a strong performance, underpinned by higher service levels and improved price competitiveness which led to customer account growth. Our market leading price reductions in the first half of 2009 for residential energy customers, combined with continued strong growth from the services product range, helped us to increase our total product holdings by 550,000. We were also able to grow the number of customers who take both an energy and a services product from us by 164,000, deepening these customers’ relationship with us which should result in higher retention rates. Within business energy our retention rates remain high, as we focus on those customers who value the high level of service we provide.

The North American business experienced difficult operating conditions. The downstream residential energy results were impacted by one-off adjustments totalling £61 million in the year and lower gas and power prices impacted our upstream business. However, the underlying performance of both our downstream residential and business operations was strong, the latter benefiting from the Strategic Energy acquisition in 2008. We continue to see significant growth potential for our North American business and will consider opportunities upstream and downstream to build on our integrated energy model.

In Europe, we completed the sale of our 51% stake in the Belgian business SPE to EDF for £1.2 billion in November, as part of the transaction to acquire our stake in British Energy. As announced at the time of the interim results in July, we plan to exit the small positions we have in The Netherlands and Spain and we are making progress towards this. This will allow us to focus our attention on markets where we already have strong positions and where we see good growth prospects.

Strategic progress

The completion of the Venture and British Energy transactions, together with the improvements made across the organisation, mean that we have delivered against the strategic priorities we laid out three years ago:

1. Transform British Gas
2. Sharpen the organisation and reduce costs
3. Reduce risk through increased integration
4. Build on our growth platforms

In our downstream UK business, British Gas has undergone considerable change. We have dramatically improved our service levels and operational efficiency, and have significantly reduced costs. As a result, our competitive position is much improved, particularly in residential energy, and we have increased profitability in all parts of the business. We have combined our downstream activities into a single business, and with our unique services capability, strong brand and leading position in energy efficiency we are well placed to deliver further growth.

Upstream, the acquisitions of Venture and a 20% equity stake in British Energy fundamentally change the shape of the business, aligning us more closely with our downstream competitors in the UK. These acquisitions provide us with further options in our investment programme building on our leading positions in offshore wind and gas storage.

In North America we have a strong downstream position in key deregulated markets and we have materially grown the scale of our business energy division. We have added gas assets to support the downstream and these, combined with our services presence, give us a strong base to invest for incremental growth and value with the aim of building an integrated energy business over the medium term.

As a result of these achievements we have an integrated, well financed business that is positioned to pursue future growth opportunities. We will consider a range of investment options across our businesses, targeting an appropriate return on investments made.

Our vision remains unchanged – ‘To be the leading integrated energy company in our chosen markets’. We have however introduced new strategic priorities, which will enable the business to move forward and deliver growth.

1. Grow British Gas
   …leading the transition to low carbon homes and businesses
2. Deliver value from our growing upstream business
   …securing sustainable energy for our customers
3. Build an integrated North American business
   …with leading positions in deregulated markets
4. Drive superior financial returns
   …through operating performance and our investment choices

By capitalising on the distinctive capabilities we have built, these strategic priorities will help each of our businesses to realise their full potential, as Centrica strives to become the leading integrated energy company in its chosen markets.

Our business model is highly cash generative, enabling us to support a capital investment programme of around £1.5 billion per annum from internally generated resources. Centrica is therefore well positioned to pursue targeted growth opportunities, with options for potential investment across each business. Strict financial discipline will be maintained to secure strong returns on our investments.

Business outlook

2010 has seen a cold start to the year, leading to record demand for gas in the UK. The country’s infrastructure has coped well following recent investment by the industry, with demand being met by a combination of local production, pipeline gas, liquefied natural gas (LNG) and gas from storage. Our Rough storage facility performed extremely well, supplying around 10% of UK gas demand on each of the three days in January when National Grid ‘Gas Balancing Alerts’ were issued. However, in order to secure the country’s future requirements, we believe that significant further investment and more long-term gas contracts are required as local production declines and an increasing proportion of gas demand is met through imports.

We expect to see continued benefits from bringing our UK residential, services and business divisions together. We will seek to increase further the number of households that hold both an energy and related services product, through the selling of bundled propositions, whilst also expanding our product range as the energy industry moves towards a low carbon future. We announced our intention to build a major smart metering business in July 2009 and in February 2010 we announced the creation of 1,100 new ‘green collar’ roles, through the building of an insulation business. Combined with the new energy technologies we have built up over the past two years and a growing capability of working with local authorities on joint energy saving initiatives, these give us a strong platform for growth. We have also put in place initiatives to deliver cost reductions in excess of our previously announced target of £100 million, allowing us to re-invest in the business as we build on the strength of the British Gas brand. And our price reduction in February 2010 made us the cheapest major domestic supplier of both gas and electricity to UK customers.

The current low commodity price environment in 2010 represents a challenge to our upstream UK business, however our flexible business model remains well placed to capitalise on market opportunities and 2010 will see the first full year of contribution from both Venture and British Energy. Venture has been combined with our existing upstream business to create an organisation that has the technical and operating capability to work across a wide range of geologies and technologies in offshore oil and gas in and around UK, Dutch and Norwegian waters. We are now well placed to become the leading consolidator and operator of mature and orphaned gas assets in the UK continental shelf. The operational performance of the British Energy nuclear fleet has been strong, benefiting from the investment made in the plant in recent years and we are already engaged with EDF on pre-development studies for the next generation of nuclear power stations in the UK.

Having brought 15 LNG cargoes to the UK in 2009 we already have seven contracted for delivery during 2010–11. LNG is likely to provide an increasing amount of gas to the UK over the next decade as local production declines, helping to ensure security of supply for the UK. In this respect our announcement of an agreement to acquire a share of both existing LNG production and substantial undeveloped gas reserves in Trinidad and Tobago is significant. In gas storage, work continues on our three potential projects, totalling 85 billion cubic feet (bcf) which would increase existing UK capacity by around 50%. Final investment decisions are planned for the Caythorpe and Baird projects in 2010 and for Bains early in 2011. Subject to investment approval, Caythorpe is expected to be operational in the storage year 2012–13 with both Baird and Bains operational in the storage year 2013–14.

During 2009 we successfully implemented innovative and efficient financing structures for a number of our wind farm developments. In October we agreed the sale of a 50% equity stake in the Lynn, Inner Dowsing and Glens of Foudland wind farms, together with the provision of non-recourse financing facilities for these assets. In December we announced a transaction to sell 50% of the 270 megawatt (MW) Lincs offshore wind farm to Siemens Project Ventures and Dong Energy and secured enhanced turbines for this development project. Going forward it will continue to be important to ensure that we put in place efficient financing structures for all our investments. We have submitted planning consent applications for our further projects at Docking Shoal and Race Bank in the Greater Wash area which combined would add a total of 1.1GW to our wind portfolio. In January 2010 we also secured a Round 3 wind farm development zone, in the Irish Sea, with a potential capacity of 4.2GW.

On the current forward curve coal remains at the margin, with clean spark spreads remaining above clean dark spreads for much of the year, although spreads have narrowed from the levels seen in 2009.

The macroeconomic environment in North America is improving, with the US economy now out of recession and unemployment beginning to fall, although the wholesale forward prices of gas and power remain substantially below levels seen at their peak in 2008. In our North American business, Direct Energy, a new management team has been appointed and we will focus on improving our returns from the existing business and assessing further opportunities.

Direct Energy is well positioned in key deregulated markets and we see the potential to build the scale and efficiency of the business. We will invest for growth and value and further develop the integrated energy model over time. Our objective is for Direct Energy to achieve a leading position in deregulated markets, to deliver an increasingly material contribution to Group earnings over the medium term and diversify our geographic earnings profile.

Overall the outlook for 2010 is positive and we are trading in line with expectations, with strong downstream performance offsetting the impact of low gas prices on our upstream businesses. Whilst the final outturn will depend on a number of factors, including commodity prices, production volumes and downstream consumption levels, we have confidence in the robustness of our business model and in the forward momentum we have created.

In difficult trading conditions, set against a backdrop of the most serious recession for decades, the commitment and skills of our employees have helped establish a strong foundation on which to build and grow our business. The Executive team and I have asked a great deal from our employees in 2009 and they have responded magnificently – my thanks to them for the part they have played in delivering such a strong performance.

In conclusion, I am delighted with the transformational progress that we have made during 2009, having successfully delivered against our strategic priorities laid out three years ago. Our new priorities take the Group forward, building on the robust, vertically integrated business model that we now have in place. Centrica is well positioned to deliver growth and lead in a low carbon world with new propositions and services for our customers – backed up by new sources of energy. We will deliver value to shareholders by maintaining strict financial discipline to secure strong returns on our investments.

Sam Laidlaw
Chief Executive
25 February 2010