Centrica Preliminary Results 2008
26 February 2009
Chief Executive’s Review
Sam Laidlaw – Chief Executive
Thank you very much, Nick. Good morning everyone. As Nick showed, 2008 really was an extraordinary year and one that I never envisaged when I took over at Centrica in 2006. The crisis in the global financial markets and the recession that followed, rapidly reversed the direction we have seen recently in commodity prices.
Brent Crude which at the beginning of the year was 90 dollars a barrel went right up to 147 dollars a barrel and by the end of the year was down below 40 dollars a barrel. And it is this volatility that is really the very reason that we have been working hard in transforming the business over the last two years. And I think that the changes that we have made have really underpinned the strong financial results we had in 2008. So while much has been achieved, we have got a lot further to go and we need to keep moving the agenda on.
So let me share with you this morning, both progress to date and how we are adjusting our emphasis to stay ahead of market developments. The priorities I set out exactly two years ago are to transform British Gas, to sharpen the organisation and reduce costs, to reduce risk through increased integration and to build on our growth platforms. Now let’s look at each of these in turn.
Firstly the transformation of British Gas. We fundamentally changed the performance and internal structure for British Gas over the last two years. We have redesigned the organisation around our customers. We split the business into three segments, focusing on our customers needs to better understand where the value is created and to drive accountability. Our operational changes have made us much more efficient. We’ve continued to increase our service levels and two of the key processes, call handling and billing have improved materially.
Innovation in our processes means that they are now much clearer, better targeted and quicker to market. Our fixed price products help us to retain customers after the price rises of 2008 and we now have over a million customers who service their own accounts online. We are also helping 1.4 million vulnerable customers through our Essentials tariff, our CERT commitment and our social programmes such as ‘Here to Help’, And as you know all this has produced real results. We are now answering the phones much more quickly and consistently. Our inbound call traffic is down over 40% and our share of industry complaints at 25% is now well below our energy market share. And in a year when gas prices rose by around 50%, we held our customer base relatively stable. These service improvements have not come at the expense of cost control. In fact the opposite is true. Better service means lower cost. Since 2006, we lowered headcount by 2,800 positions and we have reduced operating costs by over £200 million.
So now we move on to Phase 2. It was important to separate the energy and services businesses back in 2005 to allow us to really concentrate on fixing the basics. Although we continue to work very closely together and the two businesses share a common database, the intention was always to bring the two back together when the time was right. And that is what we have announced today. We are reuniting British Gas to maximise the opportunities that a single brand and business present. As Roger said earlier, Phil Bentley will now assume full responsibility for the retail operations in the UK.
Today we know that British Gas has around 12 million households that we service who hold 24 million products. But of the 12 million, only 1.9 million hold both an energy and a services product. This is a huge opportunity for us and the structure we are putting in place will make sure that we grab it. Our goal will be to expand this overlap significantly as well as to attract new customers to both energy and services. Our customer data tells us very clearly that the value of a customer increases when they take both the services product and an energy product. This will be no surprise.
But the level of the difference might be. Our analysis suggests that energy churn alone is over 20% lower when they take both products. And we experience a similar drop in churn when we add an energy product to a services relationship. As customers add products, their lifetime value increases due to increasing revenues, lower churn and of course decreasing marginal costs. When you combine the benefits of reduced churn with the increased customer spend with British Gas, the potential value creation is significant. Specifically the lifetime value of a British Gas customer who holds both energy and services can be more than double that of the customer holding a single product only.
And of course this will also help us to remove duplication and cost from the single organisation. We have made strong progress in reducing our costs to date and we expect to carry on the momentum we have achieved recently. Although our plans here are still developing, we believe the opportunity here over time is to reduce the cost base by a further £100 million. In summary, this single unified structure will enable us to increase customer loyalty, better target our sales and marketing to drive value, further improve customer service and remove cost. British Gas is now well positioned for growth.
Now on our second priority, to sharpen the organisation and reduce costs, we have talked about the progress here we’ve made before. The upper management has been rationalised, a more transparent structure to our business now better enables us to really drive performance. The processes around capital allocation, individual performance management, planning and cost control have all been overhauled. And we continue to be relentless on cost control. In 2008 we actually reduced our Group like-for-like costs, in addition to the £70 million we took out of British Gas by some £40 million. And it is important to understand that cost control has gone well beyond the residential energy business and is embedding right across the Group. Even in the original growth businesses, we have always considered it vital that we keep the lid on costs by improving efficiency while we encourage growth.
As you see here, on the important measure of operating costs as a percentage of gross margin, we have made great progress across all of our businesses. Efficiency and cost control will never leave the agenda.
On our third priority to reduce risk through increased integration, we have moved things on considerably in upstream gas. Over the last two years, we have successfully acquired additional gas and oil properties with potential reserves of around 800 bcf equivalent. That is almost three times our 2008 gas production levels. And we have invested around £1 billion of cash in these acquisitions and in accelerating the development programme from other North Sea assets. Our North Sea properties now make up 40% of our total gas production.
We also now have a focused set of exploration opportunities in the North Sea and Morecambe bay to assist with the replenishment of reserves over the longer term. The drop in Asian and North American demand for gas imports and the decline in the UK domestic production, have made the UK a much more attractive market for worldwide LNG imports. At the end of last year we commissioned our capacity at the Isle of Grain and we have already landed three LNG cargoes at this facility. So taking all these steps together you can see the net result is that we have actually increased our overall energy hedge, which is our measure of gas price exposure, from 21% in 2006 to 34% in 2008.
Now in power we have also made excellent progress. We will soon have a gas and renewables fleet in the UK of 5.3 Gigawatts. And we currently cover 58% of our peak electricity requirements from our own stations. As the lowest carbon fleet, this positions us well as we move towards an increasingly carbon constrained economy.
Two major projects have been underway in 2008. At Langage our gas fired power station in Devon, the project is around 90% complete, but on this fixed price EPC contract, the contractor has suffered some delays and we now expect this to be fully commissioned towards the end of this year. Our second project has been managed in-house, Lynn and Inner Dowsing. This is the world’s largest offshore wind farm project. And it began exporting power to the grid in the fourth quarter of 2008 and has already started to make an important contribution to the earnings in the segment. Wind could be an increasing part of the future fuel mix if the economics of offshore wind stack up. Now recent cost increases and construction services are challenging the returns, but we have a pipeline of 1.4 Gigawatts which we expect to progress if we can reduce costs and enhance the returns.
Looking forward in the upstream, we will stay focused on building our hedge in the UK. In a world where there are now fewer credit-worthy counterparties and the cost of credit to provide margin requirements has increased, the physical hedge provided by integration has become increasingly important. With gas we will continue to focus on acquisition and development opportunities in the UK and Norway, where we currently have a £1 billion development plan over the next three years. The Norwegian continental shelf is less mature than the UK and we have a sizeable presence there now with a highly skilled team and a full operators’ license.
And as I mentioned earlier, LNG is coming to the UK and over the next twelve months we expect over 40 BCM of additional annual LNG to come onstream worldwide. This will become an increasingly important facet of our business providing vital diversity of our sources of gas supply. On this front our discussions with National Oil Companies are continuing. And the growth in LNG supply over the short term, potentially outstripping the growth in demand, the importance to producers of securing demand has increased.
And we are pushing ahead on the power side as well. We need to raise our asset cover to capture the value as it moves between the upstream and the downstream, and to enable us to absorb the extraordinarily high intraday volatility that we see in the power sector. This will strengthen our earnings, but also benefit our electricity customers. Adding to our generation fleet is important in absolute terms, but it is also important that we diversify the input fuel type. As the electricity price correlates closely with the price of gas, adding non gas fuel generation and moving towards a more market neutral fleet, provides a hedge for our gas customers and again reduces the volatility of our earnings.
During 2008, the power price was extremely volatile, but the forward price has been more stable. Although short term prices have softened significantly, the medium term outlook remains less bearish as the pressure on reserve margins will build as optedout coal and oil plants have to shut down in the middle of the next decade. And the British Energy deal could move us a long way in terms of both power cover and overall energy hedge.
As Roger said, the compelling strategic case here still exists. But we will need to ensure that as we progress negotiations with EDF that the deal in its entirety adds value for Centrica shareholders. For the medium term the transaction could give us access to at least 25% of the current nuclear output and for the longer term, the right to participate in 25% of EDF’s new nuclear fleet in the UK, raising our power cover to over 90% and taking our overall energy hedge up by over 10 percentage points to around 50%. We will however not be content to stop here if we can find value to further close the structural hedge through gas acquisitions and we do see more opportunities coming to market and as they come we will pursue them if we can pursue them for value.
We also consider gas storage to be an effective hedge against the impact of seasonally volatile gas prices. And this is an area where we have real competitive advantage. Rough has been an excellent asset for Centrica for many years and is providing the UK with essential security of supply. However, the next step is to pursue a storage strategy which involves multiple assets in different storage locations. The portfolio effect that this will bring enables us to deliver extrinsic value well beyond the value of the individual stand alone assets.
To this end, with this morning’s announcement about the Baird Field, we now have three major new storage assets, totaling around 85 BCF, over half the UK’s current storage capacity. This would entail an investment of around £1½ billion over the next four years and would produce a large long-term business opportunity.
We have also been performing strongly on our growth platforms. We had record years of profits in British Gas Business, British Gas Services and Direct Energy. All of these businesses also grew both revenue and customers, and as I mentioned earlier, drove down their costs as a percentage of gross margin. The result is that overall we have raised profit by 50% over two years in these businesses and they now make up 30% of Group operating profit. Going forward BGB and BGS will roll into the single British Gas organisation and I believe that this will only enhance the growth possibilities from here.
In Europe we now have a controlling 51% interest in SPE in Belgium and following the approval of the first significant tranche of Pax Electrica 2 which provides us with lower cost nuclear electricity, this business is now fundamentally more competitive. This is a very valuable position in Europe. Nick explained the detail behind the Oxxio results. This was undoubtedly disappointing. We acted decisively and took appropriate short term measures to ensure that the mistakes are not repeated and the management team has been replaced.
In North America, Direct Energy will soon be under new leadership. Deryk has developed a great business over eight years. He has built this from nothing to a business serving over 5 million customers with almost £6 billion of revenue and delivering an operating profit of over £200 million. Across Canada and the US we now have a substantial presence in mass markets energy retail, home services and upstream gas and power. And the Strategic Energy acquisition in 2008 makes us the third largest commercial energy supplier in North America. And I believe that Chris Weston can build on this platform and really take it forward from here.
We have two clear goals as we go forward. Although we will never ignore opportunities as they arise, we will focus the business on the key geographic areas of Canada, the US North East and Texas. In doing this we will concentrate on states where we have a strong presence through the Direct Energy brand, backed up by a centralised low cost support model. In conjunction with this, we will further integrate the Direct Energy business in these key energy supply areas through the development and acquisition of upstream assets, both in power and growing the output from our North American gas production business. We will also concentrate our services business on our key retail energy geographies to support the marketing positions we built up and again provide us with valuable growth opportunities. North America will continue to be an important part of the Group growth story.
So in summary, we delivered good results in the most difficult commodity environment we have seen in Centrica’s history. The next phase of the British Gas transformation is now underway and I believe that this will really differentiate British Gas from the competition. Developing the energy hedge in the UK remains important and as always, we will only acquire assets where we see value. North America is an important growth avenue for Centrica and now that we better understand where the rewards are here, we will focus the business and further strengthen it through appropriate levels of asset cover. I believe the progress we have made to date and the future direction I have outlined, position Centrica very well for the next phase of our development.