ABOUT INTERNATIONAL POWER WE ARE AN INTERNATIONAL WHOLESALE POWER GENERATOR AND DEVELOPER WITH INTERESTS IN 12 COUNTRIES COVERING FOUR CONTINENTS. FOR REPORTING PURPOSES WE ORGANISE OUR BUSINESS INTO FIVE SEGMENTS: NORTH AMERICA, EUROPE, MIDDLE EAST, AUSTRALIA AND REST OF THE WORLD.

Our business

We generate electricity from gas, oil, coal and renewable energy sources. We also maximise value through complementary activities. These include mining coal and transporting gas by pipeline in Australia, desalinating water in the Middle East and providing steam for district heating systems in Europe. Some of the power we generate is sold to customers through competitive merchant markets. The remainder is sold to single customers under long-term power purchase agreements. Environmental care is an integral part of all our operations. New initiatives range from developing our first wind farm in Australia to increasing our capability to burn more environmentally friendly fuels in our UK coal-fired power station.

The corporate social responsibility section sets out how we manage environmental impacts and our relationship with the communities in which we operate.

Our strategy

We have the people, the resources and the determination to deliver for the benefit of all our shareholders and stakeholders.

Our core skills

Long-term success depends on the quality of the development opportunities we secure. We have been particularly successful in the Middle East, where longterm off-take agreements significantly balance risk in developing and building new capital-intensive plant. Our development, construction management and commercial skills are essential for ensuring satisfied customers and sound financial returns.

Our business requires maximum plant availability, particularly at times of peak demand, and our experienced operations and engineering personnel help us deliver at these times of significant value. There is close integration between operations and trading teams in all our core regions to ensure speed and flexibility of response to market conditions. Our fuel procurement teams are responsible for co-ordinating our gas, coal and oil supply with the demands of our power generation profile.

The regional performance is discussed in more detail below as are corporate costs and exceptional items.

Weak wholesale prices impacted our financial performance in North America during 2003. Gross turnover in North America increased to £414 million from £315 million in 2002, as all plants were operational during 2003. However, 2003 profit before interest and tax decreased to £2 million from £99 million in 2002, due to a combination of low spark spreads and declining compensation payments from Alstom.

In light of recent trading conditions and future price forecasts in the ERCOT (Texas) and NEPOOL (New England) markets, we reviewed the balance sheet book values of the US merchant plants (Hays, Midlothian, Blackstone, Bellingham and Milford). This review resulted in an impairment of these assets by an aggregate amount of £404 million. The revised net book value of these assets totals £600 million.

Given uncertainty in the ability of these merchant assets to meet all future costs including interest payments, our US subsidiary, ANP Funding 1, has proactively approached its US bank group to renegotiate the terms of its non-recourse project finance in order to provide an appropriate long-term financing structure. Discussions with the bank group will examine a wide range of options. As we are also in discussion with the US bank group regarding certain claimed technical events of default, this non-recourse debt is disclosed as current debt in our accounts.

Due to uneconomic prices, we mothballed our modern 1,100 MW combined cycle gas turbine (CCGT) Hays power station in Texas in January 2004, for an indefinite period.

All our European assets delivered a strong operational performance last year. Turnover increased by 8% to £474 million, principally supported by the performance of the contracted assets in this region. Our long-term contracted assets in Portugal and Turkey delivered excellent financial performance, and coupled with a record profit performance from EOP in the Czech Republic, offset the weak market conditions in the UK and helped the region generate profit before interest and tax of £103 million (2002: £100 million).

Overall profitability in the UK was lower than last year due to the termination of the tolling agreement at Rugeley (with TXU Europe) in November 2002 and weak wholesale prices during much of 2003. Following the termination of the tolling contract, the existing £160 million non-recourse debt facility for Rugeley was renegotiated and reduced to £90 million in August 2003. We continue to discuss appropriate compensation with TXU Europe's administrators, but at present we are unable to forecast the timing of a resolution.

In the UK, in order to provide additional support for our contracted capacity during the winter period, we returned the 250 MW mothballed unit at the Deeside plant to service in October 2003.

Although UK wholesale prices showed some improvement in the second half of 2003, significant increases in gas and coal prices quickly eroded this benefit. Despite these tough market conditions, we see potential opportunities to add value by consolidating our position in the UK and we will continue to review market developments carefully.

In January 2004, the UK government announced draft carbon dioxide emission allocations and commenced industry consultation to finalise the position by the end of September this year. The draft allocations for Rugeley and Deeside were broadly in line with our expectations. Carbon dioxide allocations are an important factor in deciding whether the fitting of flue gas desulphurisation (FGD) at Rugeley is economic. This decision will be made in June 2004 when we decide on our plans for Rugele under the Large Combustion Plant Directive (LCPD).

EOP and Pego are well placed to meet their requirements under the LCPD. FGD is already fitted at EOP, and plans are underway to build FGD at Pego during 2006.

The Portuguese government has commenced discussions with incumbent generators to make changes to existing long-term Power Purchase Agreements (PPAs). These discussions are targeted to enable the Portuguese market to integrate with the new liberalised Iberian wholesale power market that is due to commence operation in 2006. These discussions are at an early stage and are likely to continue into the second half of 2004. We believe that the government intends to preserve the value in these contracts and therefore we expect to be kept economically whole through this process.

In February 2004, we disposed of our stake in Elcogas, Spain. This investment had been fully provided against, and the release of a guarantee will result in an exceptional gain in Q1 2004.

To reflect our current management structure we now report the results of our Middle East business as a separate region rather than with the European business results, as reported last year.

Turnover rose to £33 million (2002: £nil) and operating profit increased to £23 million (2002: £9 million) as a result of the acquisition of Umm Al Nar and the commencement of operations at Al Kamil.

In April, together with our partners TEPCO and Mitsui, we acquired a 20% interest in Umm Al Nar, a large power and water desalination plant. The acquisition is backed by a 23-year Power and Water Purchase Agreement (PWPA) with the Abu Dhabi Water and Electricity Company. In July, a US$1.77 billion nonrecourse funding package was secured to fund the acquisition and the associated plant expansion project. Since acquisition, the plant has delivered robust financial and operational performance.

In December, together with our partner Saudi Oger, we signed an agreement with Saudi Aramco to develop, own and operate four cogeneration plants in Saudi Arabia. These facilities will have a total capacity of 1,074 MW and be capable of producing 4.5 million lbs/hr of steam. They are expected to commence operation on a phased basis between March and December 2006. On completion the plants will supply power and steam to Saudi Aramco under 20-year Energy Conversion Agreements. International Power owns 60% of the project company, with Saudi Oger holding the remaining 40%.

In February 2004, the financing for the Saudi Aramco cogeneration projects was completed. The financing comprises a non-recourse US$510 million facility that has a 17-year term. International Power's total equity commitment to the projects amounts to US$78 million.

The construction of the Shuweihat S1 power and water plant in Abu Dhabi is progressing and the plant is expected to commence operation in Q4 2004. The first two of five gas turbines and the first of six multi-stage flash desalination units have been successfully commissioned.

Reflecting the strength of our contracted position in Australia, turnover at £224 million (2002: £226 million), and operating profit at £101 million (2002: £101 million) were both flat when compared to 2002, despite relatively lower market prices in 2003. We continue to retain a strong forward contracted position through 2004.

Work is underway to further develop the open cast coal mine at Hazelwood. This project will extend the life of the mine and will provide coal reserves to support generation at Hazelwood until the end of 2009. The Hazelwood turbine upgrade programme is progressing well and is expected to increase the plant's peak capacity from 1,610 MW to 1,740 MW by 2007.

Construction of the 687km SEA Gas pipeline was completed on 1 January 2004 on schedule and on budget. The pipeline will be used to transport gas from the Minerva gas field in Victoria by Q4 2004.

We are pleased to report that we have secured our first wind power project at Canunda in South Australia. Construction of this 46 MW plant is expected to start in Q2 of this year, with a view to commencing commercial operation in Q2 2005. Power from this plant will be sold under a 10-year long-term contract to AGL, Australia's largest energy retailer. With the addition of Canunda, our Australian portfolio is now well balanced with good fuel diversity, ranging from fossil fired (brown coal and efficient gas-fired) through to wind power.

Our plants in the Rest of the World have delivered steady performance over the past year, with turnover of £128 million (2002: £148 million) and profit before interest and tax at £84 million (2002: £108 million).

Both of our investments in Pakistan (HUBCO and KAPCO) continue to perform well. We have sold a 5% shareholding in HUBCO in line with our policy of selectively monetising investments at the appropriate time generating cash of £21 million. Our equity interest in HUBCO now totals 20.7%. We have booked an exceptional gains of £52 million, reflecting the profit on this sale and the reversal of a previous impairment provision.

Malakoff made two acquisitions in Malaysia in 2003. It acquired 100% of Prai Power, a 350 MW CCGT plant and 90% of the equity interest in Tanjung Bin, a 2,100 MW coal-fired plant. Both acquisitions are backed by long-term PPAs with Tenaga Nasional Berhad, Malaysia's leading utility.

Our 110 MW plant in Thailand sells the majority of its power under a long-term contract to the Electricity Generating Authority of Thailand with the remainder of its output being sold to local industrial customers. In 2003, the plant benefited from increased retail sales to its industrial customers due to the acceleration of economic growth in Thailand, which looks set to continue.

In 2003 we concluded our divestments in China, realising an exceptional gain of £3 million.

Our clear immediate priority is the successful restructuring of the US business and we are focused on finding a solution that provides value for our shareholders. Alongside our drive to deliver value from our existing asset base, we continue to review a range of growth opportunities in our core markets.

Our earnings per share guidance for 2004 remains 7p to 9p.

Corporate costs

In addition, the Group operates regional business support offices in the US, Australia, the Czech Republic, Italy, Japan and the UAE.

These offices vary in size dependent on the scale of operations in the region, and apart from the US and Australia, are primarily focused on business development.

Exceptional items

• impairment of US plant by £404 million;
• reversal of past impairment of our HUBCO investment by £35 million.

The carrying values of our US plant were reviewed following the sharp decline in both current and forward electricity prices in the ERCOT and NEPOOL markets in the US. This resulted in impairment of our US merchant plants (Hays, Midlothian, Blackstone, Bellingham and Milford).

The revised US book values were determined by applying a risk adjusted discount rate of 9.7% to the post-tax cash flows expected from the plants over their remaining useful lives.

Additionally during the year, the Group recorded the following three non-operating exceptional items:

• profit on disposal of a 5% holding in HUBCO of £17 million;
• profit on disposal of a Czech fixed asset investment of £7 million;
• proceeds and a gain relating to China exit of £3 million.

Net interest

Additionally during 2003, the Group recorded an exceptional interest charge of £16 million in relation to the write-off of unamortised facility costs in the US and the UK.

Tax

Additionally during 2003, the Group recorded an exceptional tax credit of £26 million relating to a net write back of deferred tax following the impairment of the US plant.

Liquidity

Operating cash flow for the year ended 31 December 2003 decreased by 27% to £285 million as compared to £391 million for the year ended 31 December 2002. The principal reasons include lower operating profit performance from the US and the UK and a reduction in dividend receipts from joint ventures and associates. Capital expenditure to maintain the operating capacity of our power stations has increased compared with the previous year, reflecting the completion of our new build capacity in Massachusetts and Texas in 2002. Capital expenditure to increase our operating capacity amounted to £57 million as compared to £98 million in the previous year, reflecting spend on the build of our US and Al Kamil plants. During the year ended 31 December 2003, the Group received £56 million from contractors in relation to compensation for plants not achieving the long-term performance levels specified in the original contracts.

Net interest of £79 million (2002: £88 million) was paid in the year reflecting a small reduction in average debt levels over the course of the year, together with a slightly lower average cost of debt. Additionally, debt issue costs totalling £3 million are also included within the interest line. Net tax payments in the year were £14 million (2002: £20 million). Acquisitions and disposals principally comprise of cash receipts from the sale of a 5% holding in HUBCO and from the sale of our investment in VCE (Czech Republic).

Balance sheet

Net assets at 31 December 2003 decreased by £207 million to £1,562 million, as compared with £1,769 million at the end of the previous year. The significant impacts on net assets in the year were a reduction in fixed assets of £404 million following the US impairment, an increase of £35 million in investments following the reversal of the HUBCO impairment and a reduction in tax creditors of £27 million following a net deferred tax write back following the US impairment.

Net debt at 31 December 2003 of £692 million is down from £812 million at 31 December 2002. This reflects the strong operating cash flow of the business and the positive impact of translation of net debt balances denominated in foreign currencies, offset by the write-off of unamortised facility fees in the US. Net debt at 31 December 2003 is shown net of facility fees of £15 million, which have been capitalised and offset against the debt in accordance with accounting standard FRS 4.

In addition, net assets were also impacted by a net gain of £15 million arising on the retranslation of our net investment in foreign entities offset by a reduction of £13 million as a result of the share buyback programme.

Net debt and capital structure

The Group has sufficient credit facilities in place to fund and support adequately its existing operations and to finance the purchase of new assets. These facilities comprise a revolving credit facility for US$450 million (expiry October 2006), the portion of the existing convertible bond for US$103 million not 'put' by bond holders (maturing November 2005), and a new convertible bond for US$252 million (maturing August 2023 but with bondholders having the right to 'put' the bond back to the Group in August 2010, 2013, 2018 and 2023). In addition, the Group has uncommitted bilateral credit lines from various banks at its disposal at the corporate level.

Secured non-recourse finance

The non-recourse debt at Rugeley of £160 million, which was in technical default at the beginning of the year, was successfully renegotiated in August 2003 and the debt maturity reinstated to 2008 for a reduced amount of £90 million. In May 2003 at American National Power (ANP), our US bank group waived all claimed technical defaults on our US non-recourse financing and therefore this debt was redesignated to its original maturity at 30 June 2003. However, in the fourth quarter our US banks claimed further technical defaults on this financing.

Therefore as these issues were not formally resolved at 31 December 2003, the debt at ANP has been reported as current non-recourse debt in our accounts.

In line with all non-recourse finance, any support to the ANP facility would be entirely discretionary, and would not have a material impact on the Group's liquidity or investment capability.

During 2003 both Standard & Poors and Moody's reviewed the credit rating of our wholly owned subsidiary ANP and this resulted in a downgrade to below investment grade. This in itself is not an act of default on the ANP facility, although it does increase the interest margin of the outstanding debt.

Corporate and Group debt

On 31 December 2003, we had aggregated debt financing of £1,435 million denominated principally in US dollars, Australian dollars, sterling, Czech koruna and Thai baht. Of this amount £531 million is due for repayment in 2004, with the majority of the remaining balance due after 2008. This short-term debt includes the ANP facility already discussed in this section.

Treasury policy seeks to ensure that adequate financial resources are available for the development of the Group's business whilst managing its currency, interest rate and counterparty credit risks. The Group's treasury policy is not to engage in speculative transactions. Group treasury acts within clearly defined guidelines that are approved by the Board. The major areas of treasury activity are set out below.

Currency translation exposure

It is our policy not to hedge currency translation through foreign exchange contracts or currency swaps.

Average and year end sterling rates for major currencies which are significant to the Group were:

Currency transaction exposure

Short-term deposits

Interest rate risk

Counterparty credit risk

Critical accounting policies and estimates

On an ongoing basis, we evaluate our estimates using historical experience, consultation with experts and other methods considered reasonable in the particular circumstances to ensure full compliance with UK GAAP and best practice. Actual results may differ significantly from our estimates, the effect of which is recognised in the period in which the facts that give rise to the revision become known.

Our Group accounting policies are detailed on pages 67 and 68. The table below identifies the areas where significant judgements are required, normally due to the uncertainties involved in the application of certain accounting policies.

Of the accounting policies identified in the table a discussion follows on the policies we believe to be the most critical in considering the impact of estimates and judgements on the Group's financial position and results of operations.

Fixed asset valuation

• Interest on borrowings relating to major capital projects with long periods of development is capitalised during construction and written-off as part of the total cost over the useful life of the asset.


• Project development costs (including appropriate direct internal costs) are capitalised from the point that it is virtually certain that the project will proceed to completion.

• Gas turbines and related equipment are depreciated over 30 years to a 10% residual value, unless the circumstances of the project or life of specific components indicate a shorter period or a lower residual value.


• Coal plant is considered on an individual basis.

Tangible fixed assets and fixed asset investments

Consolidation policy - significant influence

Where the Group owns between 20% and 50% of the equity and has significant influence over the entity's operating and financial policies, we generally treat the entity as an associated undertaking or joint venture. Equally, where the Group holds a substantial interest (but less than 20%) in an entity and is able to exert significant influence over its operations, we treat it as an associated undertaking or joint venture. Conversely, although we generally treat a holding of more than 20% of the equity as an associated undertaking or joint venture, where the Group is unable to exert significant influence over the operations of the entity, we treat it as a trade investment.

Associated undertakings and joint ventures are accounted for using the equity method of accounting, which involves including the Group's share of operating profit, interest and tax on the respective lines of the profit and loss account, and the Group's share of net assets within the fixed asset investments caption in the balance sheet. In addition, we provide voluntary disclosure of the amount of net debt held by these entities, although in accordance with UK GAAP, this net debt is not included in the consolidated balance sheet.

The Group generally consolidates entities in which it holds in excess of 50% of the equity and where it exerts control over the strategic direction of the entity. However, if the Group were to hold in excess of 50% of the equity but was unable to exert dominant influence over the strategic direction or operations of the entity, we would account for the entity as an associated undertaking or joint venture.

Liquidated damages

Exceptional items

• profits or losses on the sale or termination of an operation;
• costs of a fundamental re-organisation or restructuring having a material effect on the nature and focus of the Company's operations;
profits or losses on the disposal of fixed assets.

Preparing for the conversion to International Financial Reporting Standards (IFRS)

• presentation of primary financial statements;


• recognition of derivatives and financial instruments;


• accounting for goodwill on acquisitions;


• accounting for employee benefits (pensions and share-based payments);


• accounting for joint ventures, associates and trade investments.