Commodity prices

What is the risk?

Exposures to the physical volume and price risk of certain commodities - including electricity, gas, coal, CO2 emissions permits and oil - arise from two main sources.

Firstly, there is a requirement to match volumes of purchased gas and electricity with customer demand. This exposure is influenced by a number of factors including customer numbers, the weather and changes in energy use.

In addition, exposures arise due to the difference in the cost of fuel and other commodities required for generation, and the electricity revenue derived from SSE's long-life generation asset investments.

A significant proportion of SSE's profitability, including return on investment in power generation assets as well as the ability to price competitively in the retail market, is dependent on the successful management of these exposures. A sub-optimal trading strategy could lead to significant financial loss, loss of customers and increased political scrutiny.

The markets for these commodities are driven by global supply and demand, itself influenced by a number of complexities including geopolitical events, global economic growth, the weather and technology. The global commodity price makes up a significant part of the energy cost to the customer. Increasing commodity prices affect the overall affordability of energy and can have an impact on demand and customers' ability to pay.

How does SSE mitigate it?

·      SSE uses Value at Risk (VaR) measures to monitor and control exposures to commodity price and volume. Trading limits are set by the Board and managed through the Risk and Trading Committee (RTC).

·      Commodity positions are assessed on a daily basis by an independent Risk Management team who also manage breaches of limits according to a defined escalation and governance process.

·      The RTC takes an active role in approving trading/hedging strategies and maintains a framework of individual trader limits, counter-party credit limits and cumulative trading limits.

·      SSE's Capital Allocation Group ensures - and makes recommendations to the Executive Committee on - the efficient use and allocation of capital in the Wholesale business. Decisions to invest in long term generation assets are taken by the Board and consider a number of potential commodity price scenarios which are developed using internal and third party expertise.

·      SSE has an Energy Economics department which provides commodity price forecasts which are used to inform decisions on trading strategy and asset investment.

·      SSE works to develop innovative tariff structures, underpinned by a commodity trading strategy, aimed at providing customers with prices which are both competitive and stable.

Funding shortfall

What is the risk?

SSE's policy is to ensure that it has at all times funds available to meet its liabilities when these fall due under both normal and stressed conditions, without incurring unacceptable costs or risking damage to its reputation.

SSE typically funds refinancing and future borrowing requirements by issuing senior bonds and hybrid capital. In addition, it utilises bank borrowings, index-linked loans and private placements. If these sources of funding were unavailable to meet either increases in overall borrowing requirements or to refinance maturing debt it could impact on SSE's ability to meet its commitments and in turn could force a curtailment of its capital investment programme, adversely impact credit ratings and ultimately affect SSE's ability to trade.

How does SSE mitigate it?

·      SSE's approach to managing liquidity is to ensure that the Group has available committed borrowings and facilities equal to at least 105% of forecast borrowings over a rolling 6 month period.

·      This approach is informed by detailed medium to long term cash forecasting which takes into account anticipated changes in business activity, markets and funding position.

·      The Board, through the Audit Committee, considers the medium term funding plan including a detailed market update report in May each year.

·      SSE maintains a group of relationship banks who support the company's financing activities through their ongoing participation in committed lending facilities which currently total £1.5bn.

·      SSE seeks to maintain a diversified portfolio of debt to avoid over-reliance on any one market. This allows it to build relationships with, and create competition between, debt providers.

·      The Board's policy is to maintain a strong balance sheet and credit rating to support investor, counter-party and market confidence and to underpin the future development of the Group. The current average age of SSE's debt is around 10 years.

Industry and company transformation

What is the risk?

The energy sector is undergoing constant technological improvement and political and regulatory change. It is important that SSE is able to stay at the forefront of the industry by identifying emerging trends, developing strategies to exploit competitive opportunities and question the status quo, striving for continuous improvement in all areas of activity.

In Retail markets, competitive pressure means a failure to keep up with fast-developing customer needs and new technologies could reduce SSE's market share and adversely affect service levels to customers. The advent of smart metering and the changing needs of the customer require a reorganisation of people, processes and supporting systems.

In the Networks business, SSE has proposed significant reductions in overall cost and improvements in the standard of service that customers can expect to receive. To achieve this, it needs to deliver major cost efficiencies and improvements in customer service. Longer term, any large-scale adoption of smaller-scale distributed (local) generation could result in increased pressure on revenues and overheads which may adversely affect return on investment.

In the GB generation market, it will be critical to understand and adopt the latest, most efficient technologies to maximise competitiveness for revenue support payments. An inability to do so could pose a threat to SSE's capital investment plans and threaten its position in the market as a significant electricity generator.

SSE's Enterprise business was created to integrate expertise in contracting, lighting services, utility solutions, telecoms and business relationship management, forming a new standalone business-to business arm of SSE.

The projects to deliver these business transformations are large and complex. It is vital that SSE successfully delivers these in order to give customers the services they require whilst maintaining an efficient cost to serve. Failure to do this could result in falling sales and customer numbers due to a lack of price competitiveness and a poor reputation for service. Poor service standards would in turn impact on revenues through foregone incentive payments as well as damaging SSE's relationship with customers, Regulators and other key stakeholders.

These projects will draw on resources from across SSE and poor management of these resources, poor integration or inadequate scoping of project requirements and benefits could impact on business as usual activities, increase project costs and adversely affect service standards.

How does SSE mitigate it?

·      SSE continues to monitor and engage with both industry and the supply chain on developments in key product areas.

·      SSE's Networks Division has a dedicated Future Networks team who primarily look at incremental technologies aimed at increasing the reliability and efficiency of network assets.

·      SSE has created a Transformation Governance Framework. Building on the success of its Large Capital Projects Framework, this provides a consistent process and tool-set to manage change within the organisation from first principles to benefit realisation.

·      SSE continues to develop the strategy setting process to ensure it considers a wide range of possible directions for the energy sector and the products and services that it provides.

Major projects quality

What is the risk?

SSE continues to deliver its capital investment programme with a number of ongoing construction and IT projects nearing completion and its single biggest construction project, the Caithness-Moray high voltage transmission link, now underway.

It is critical that these projects are delivered on time and on budget, supported by its Large Capital Projects Governance Framework. In addition, SSE needs to ensure that projects are built to a high quality standard as they generally have an economic life of between 15 and 30 years and in many cases longer.

SSE will typically manage the development process and organise the delivery of the project by 3rd party contractors, taking a pro-active oversight role during the construction phase.

Whilst this model ensures that the correct skills are leveraged, SSE has experienced supplier failures in the past most notably in terms of quality control. Whilst contractual warranties will cover the faulty components, there is often a significant unrecoverable cost associated with these events in addition to potential impacts to the service SSE can provide to customers. Added to this, any quality defects may not show up until sometime after the construction of an asset resulting in an expensive and disruptive process of recovery.

How does SSE mitigate it?

·      SSE has a Large Capital Projects Governance framework in place which ensures a consistent approach to project development and delivery and includes a statement of Supplier Quality Requirements.

·      Any main contract suppliers are subject to a number of verification processes which include quality assessments.

·      SSE's standard practice is to ensure it has the contractual right to inspect any manufacturing facility, be present at all tests and inspections and require the supplier to provide verification of various criteria including the origin and history of materials used and the competency of the workforce.

·      In major projects, SSE generally manages the insurance placement by organising owner controlled insurance. This allows it to have greater control and flexibility over the provisions in place. SSE also sees the insurance market as an important source of information on the reliability of technology and uses this to inform the design process.

·      Once new assets are commissioned, SSE's dedicated Engineering Centre of Excellence monitors the operational performance of assets to provide early visibility of any significant issues.

·      Strategic spares, agreed in conjunction with the suppliers, operators and subject matter experts, are in place to mitigate the impact of any quality issues.

Political and regulatory change

What is the risk?

The markets in which SSE operates are subject to a high degree of regulatory and legislative intervention at both domestic and EU level. This legal framework can change explicitly with the introduction of new or revised legislation, or indirectly due to evolving interpretation and legal precedent.

Changes, either explicit or indirect, can lead to additional reporting requirements, the creation of new products or market structures and can have a significant effect on the profitability of SSE's asset base. Any such changes may require amendments to SSE's policies, procedures and operating practices and any failure to act and maintain compliance could result in regulatory action, damage to SSE's reputation and impact upon its operations.

The pace of change in, as well as the complexity of, the energy sector is increasing; following the progressive implementation of electricity market reform, the GB market is the subject of investigation by the Competition and Markets Authority (CMA) which is due to conclude at the end of 2015 and which could result in further significant changes to the structure of the market.

Energy policy and the legislation which may result from manifesto policies was a key focus in the run up to the 2015 UK General Election. Whilst it will take some time to become clear, any ongoing ambiguity with regard to the market and its framework makes sustainable long-term strategy planning more challenging and can have an impact on investor confidence.

In addition to energy specific measures, SSE must also understand and comply with consumer, financial and health and safety legislation and regulation, amongst others.

How do we mitigate it?

·      SSE has dedicated Corporate Affairs, Regulation, Legal and Compliance departments in place that provide advice to the Wholesale, Networks, Retail and Enterprise businesses on the interpretation of political and regulatory changes and take the lead in engagement with regulators, politicians, officials and other stakeholders.

·      There is regular engagement with the Board and Executive Committee on political and regulatory developments which may impact on SSE's operations or strategy.

·      SSE takes a pro-active role in seeking to address sector-wide issues, as evidenced by the publication of its manifesto, "Proposals to deliver affordable, secure and low-carbon energy" which set out SSE's recommendations to ensure a sustainable energy market in the future.

·      SSE has a dedicated CMA project team, to manage the high volume of information gathering and analysis required to engage with the Authority and support its investigations. This team draws on expertise from across SSE and will play a key role in ensuring it is able to quickly and effectively integrate the investigation's outcome into its operations and strategy.

·      SSE actively argues for political action to drive down non-commodity related costs which make up a significant part of the average customer energy bill, including government-sponsored environmental and social policies and its smart meter roll-out costs. To protect customers, particularly the most vulnerable, SSE believes these policies should be funded through general taxation and related to people's ability to pay.