Risk management in Wärtsilä is a continuous process of analysing and managing all the opportunities, threats and risks faced by the company to achieve its goals and to ensure the company remains a going concern. The basis for risk management is the life cycle quality of Wärtsilä’s operations and products, and the continuous, systematic loss-prevention work at all the levels of the Group on the principle that “everybody is responsible”. In the long term this is the only way to reduce the total risk costs. The relevant risks for Wärtsilä have been classified in four sections; strategic, operational, hazard and financial risks. Risk is defined as the outcome of the probability and the loss exposure of the occurrence. The outcome or potential loss expectancy is highest with strategic risks, operational risks and lowest with hazard and financial risks.

The Board of Directors and the Board of Management decide and give guidelines on strategic matters. The Businesses are responsible for achieving their strategic goals set and for mitigating and covering all their risks. The risk management function is part of Group Treasury, which reports to the CFO. It reviews the business risk profile, prepares the risk management policy, cooperates in the implementation of risk mitigation work with businesses and develops global and local insurance schemes with insurance companies and brokers. The Audit Committee reviews and assesses the adequacy of risk management. The risk management policy is endorsed by the Board of Directors.

Strategic risks

The strategic risks and especially the risks involved in the daily implementation and management of achieving these strategic goals are overlapping with operational risks and thus it is very difficult to try to differentiate them from each other. Many of the strategic risks were handled in the Operational Risk Assessment in 2008.

Business Environment risks
Business cycles in the global economy and in our customer industries influence the demand for our products as well as our financial conditions and operating result. Our flexible manufacturing model based on capacity outsourcing as well as a stable business mix with a large share of sales deriving from Services brings Wärtsilä stability in a cyclical market. In 2008 the biggest risk for Wärtsilä’s future success is the turmoil experienced in the financial markets during 2008. It will inevitably slow down the global economy and might even lead into a severe global recession. How deep and long it will become depends on several matters beyond Wärtsilä’s control. Important economic matters that will indirectly affect Wärtsilä and its clients and suppliers include inter alia the liquidity and solvency of the financial institutions and thus not only their capability but also willingness to extend credits, the counter cyclical programs adopted by governments especially on power and infrastructure sectors, the enhanced activities of multilateral institutions like IFC etc, the availability of export credit schemes and guarantees etc. However, the record order book gives Wärtsilä some security and a good basis for 2009 activities.

Market and Customer risk
Over three-quarters of global shipbuilding now takes place in Asia. Wärtsilä has responded to this development by setting up new delivery centres in China and India and by locating the top management of Ship Power Business in Shanghai. A new joint venture company producing medium speed engines in Korea started operations during 2008 and a further new joint venture producing low-speed engines will be inaugurated in China in 2009. Wärtsilä sells the products to shipyards but also markets them with the total life cycle concept to ship owners. The closer cooperation with the end customers, ship owners, has been enhanced by the acquisitions of ship design companies Vik-Sandvik, Schiffko and Conan Wu. Wärtsilä is well represented in all the major shipbuilding areas and active in all major vessel segments. That mitigates both single customer related and geography related risks.  In today’s economic downturn the new order intake will slow down and the weaker capitalised shipyards and ship owners might face financial difficulties and cancellations of orders might not be avoided. The most vulnerable shipping sub-segment is bulkers which accounts for 10% of the total order backlog at the end 2008. Further ahead this might lead to consolidation of market participants which in turn might open up new opportunities for strategic solution based cooperation with bigger counterparties.

Power plant sales continue to be distributed evenly around the world, which has consequently reduced risks associated with specific customer groups or countries. Wärtsilä has four types of customers: Industrial customers, IPP’s, Utilities and oil & gas sector customers. The economic slowdown and availability of financing might have a more serious effect on new order intake and even on postponement of some existing orders in particular in the industrial segment but also in some IPP projects whereas projects with utilities and in the oil&gas sector are likely to be affected to a lesser extent.

Wärtsilä’s Services Business has expanded both through acquisitions and organically. During recent years Wärtsilä has acquired new capabilities within propulsion, automation and boiler services, which are being cloned globally to other relevant Wärtsilä locations. The strong business volumes of Wärtsilä’s customers have further boosted service sales. Wärtsilä has over 10,000 customers and an active engine base of about 160,000 MW, which means that dependency of one customer or customer segment is very insignificant. The earlier downturns or recessions in economic cycle have not caused a dip in the Services net sales.

Competitive situation and price risk
In 2008 demand was strong in Ship Power Business until 3^rd quarter 2008 and the order book rose to a record level. Thereafter the new order intake has decreased. However, the order backlog of the shipyards and Wärtsilä cover the next couple years. The potential overcapacity in case of a more prolonged recession might create more competition and price pressure in the market. Ship Power’s largest competitors in main engines are MAN Diesel and Caterpillar (MAK). No significant changes took place in the competitive situation in 2008. In the Propulsion Business the competition is more fragmented and varies by product segment. The concept of selling packaged solutions rather than merely components reduces the price volatility.

In the power plant market, Wärtsilä’s main competitors are the same engine manufacturers as in Ship Power and in some cases other technologies, notably gas turbines. Wärtsilä’s market position improved, especially in the heavy fuel oil power plant sector. During the review period competitiveness was still affected by component availability and pressure on component prices. The impact of currency fluctuations has so far been limited.

In the Services Business Wärtsilä has no direct competitors that offer a similar portfolio of services from a single source. Each service has therefore its own identified set of competitors. Excluding the service networks of other engine manufacturers, there are few global players in the service market.

Political and legislative risks
Wärtsilä is present in 160 locations in more than 70 countries and has delivered power plants to 160 countries. Political developments and changes in legislation can have a significant impact on Wärtsilä’s business. Wärtsilä actively monitors political and legal developments in its markets, and engages in dialogue with various official bodies in projects of importance to Wärtsilä’s operations. Much of this engagement takes place through interest groups and trade organisations. The company monitors legislative changes at both corporate and subsidiary levels.

Climate change and Sustainability risks
The climate change and other sustainability related risks were systematically evaluated in the operational Risk Assessment conducted in 2008. The potential business risks related to climate change and Wärtsilä’s products are in the areas of regulatory emission restrictions and change in customer attitudes in using combustion engines. The International Maritime Organization (IMO) approved amendments to the MARPOL Annex VI regulations on ship emissions. These regulations set stricter limits on Nitrogen Oxides (NOX) emissions of the engines as well as sulphur content of the fuel. The new requirements will be in force in various phases during years 2010–2020. Concerning NOX emissions Wärtsilä has already introduced the solutions to comply with these requirements. Wärtsilä engines are designed for operation on any fuel sulphur content.

The WB (World Bank)/IFC (International Finance Corporation) Thermal Power Plants EHS (Environment, Health, Safety) Guidelines is at the moment undergoing a major revision and it is expected to become in force during 2009. Leading international investment banks have made an agreement with IFC to follow guidelines based on IFC´s environmental and social standards and thus adopted the Equator Principles. Many other financial institutions are also using the World Bank Group Guidelines in addition to national norms in their projects. Consequently World Bank/IFC EHS Guidelines are today the minimum environmental standard in global power plant projects. EU is also currently in the process of updating the IPPC (Integrated Pollution Prevention and Control) Directive. UNECE Gothenburgh Protocol revision work is also going on and is expected to be finalised during year 2009. An intensive interaction between various stakeholders is currently taking place. Wärtsilä is actively engaged in the dialogue between different authorities, associations, industry and our customers in order to find the optimal solution for the market needs.

The risks in environmental legislation changes are related to the complexity of the overall field of different emissions, the balance between commercial available fuels and resulting emissions, available abatement technologies, impact on overall energy efficiency and resulting financial feasibility. Wärtsilä recently launched a new unit, Delivery Center Ecotech, for centralising Environmental technologies that are related to products outside the engines in order to quickly respond to market and customer needs by fully integrated and validated solutions. Please find more information on sustainability risks under the Hazard risk section.

Operational risks

General
An operational Risk Assessment covering all Wärtsilä’s Businesses was completed in 2008. The operative risk management was considered to be at an acceptable level. Risk teams including members from each Business have been established for mitigating these operational risks. In the context of this work Business Continuation Plans (BCP) and from bottom-up-risk reporting from separate Business Units all the way up to the Board of Directors will be developed.

Manufacturing risk
In 2008 a risk assessment was made with insurers in the two biggest delivery centres, Vaasa and Trieste. Other locations inspected included major propulsion factories in the Netherlands and Norway. Improvements in the premises security and employee safety have been implemented. Wärtsilä is using management systems for quality, environmental and occupational health and safety and other systems to improve productivity and safety. Based on the order backlog and on the plans and investments the total production in 2009 will be increased. Continued monitoring of the new order intake, delays and potential cancellations is required with the selling Businesses in order to ensure fast response time in the supply chain.

Supplier and subcontractor risk
The centralised Corporate Supply Management (CSM) function has been operative since 2006. Its purpose is to manage and control Wärtsilä’s supplier network making sure the suppliers meet the expectations in terms of the performance. Hence the supplier performance is also continuously measured. A continuous deeper co-operation with suppliers has been initiated covering accident risks as well as sharing information on risk management issues and business continuity planning. First such supplier audits were completed during 2008 together with the insurer. These audits will be a part of the regular work for CSM and for Risk Management function. Due to the financial markets crisis a more comprehensive follow-up of suppliers’ creditworthiness is also required. Even though the major suppliers have increased their capacity in 2008, there is still a challenge concerning the capacity ramp up and related costs in 2009 and the delivery times of suppliers and subcontractors. To meet these challenges the Corporate Supply Management function has developed its activities by creating closer collaboration and relationships with its main suppliers, by emphasising quality, cost, lead time and long-term delivery agreements and by sharing innovative solutions in order to drive down costs. In addition Wärtsilä has also increased the number of suppliers of certain critical components and its sourcing in emerging markets.

Life cycle quality of products and product liability risk
Launching new products always involves risk. Wärtsilä seeks to control this risk by designing and manufacturing products with all due care and by simulating its products through testing their reliability using design methods such as FMEA. The Risk elimination tool was implemented in 2007 and is systematically applied in R&D projects to assess and eliminate potential risks during the development of a new product. The tool supports any risk management process and contributes with clear prioritisation through a Single Issue List, assigned responsibilities, follow-up and a standardised reporting structure. In-house validation testing is the final step to confirm first-time-right performance of a new product before it is released to the market. Tight delivery schedules create further challenges to ensure the quality of the company’s component deliveries. The company makes warranty provisions to cover any warranty costs that may arise after product delivery. Product liability insurance covers unexpected damage.

Contractual risks
Wärtsilä’s non-Service sales consist of project deliveries of various sizes. The biggest deliveries concern turnkey power plants of 50 MW or bigger. However, the risks of individual projects do not reach significant level considering the total volume of business. Wärtsilä is sometimes also involved in product liability claims. The life cycle quality of products and work starting from design to the service work on the field and the usage of standard sales contracts reduce the risk for claims. There is no significant litigation under process.

Commodity price risk

Oil
The direct effect of oil price changes on production in Wärtsilä is very limited and the small oil volume consumed in R&D is hedged. The indirect effects of oil price volatility on customers are outweighed in importance by the long economic life of the investments, fuel efficient technologies and the availability of alternative fuels.

Metals
Metal prices have an indirect effect on engine component costs. This exposure is not hedged but annual agreements are in place to balance the short-term fluctuations. Furthermore some key components are sourced with long-term contracts and thus raw material price volatility is generally smoothened. The raw material prices increased until 2nd quarter 2008 but as they have subsequently come down it is likely that there will be a positive, although limited, effect on Wärtsilä’s production costs in 2009. The Propulsion Business hedges its exposures to different metal prices including copper, nickel and aluminium. These risks are small from the Group’s perspective.

Electricity
Electricity prices have no substantial impact on Wärtsilä’s productions costs.

Hazard risks
Occupational health and safety systems, travel safety instructions and crises management guidelines aim to protect Wärtsilä employees. Wärtsilä has appropriate insurances for its personnel. Wärtsilä Real Estate unit maintains a register on all properties used and gives guidelines for purchase, sale, rental and security of premises and uses external advisors for environmental audits. All Wärtsilä’s major production plants are situated outside of Natural Catastrophy areas. Risks that Wärtsilä is unable to influence through its own efforts are transferred where possible to insurance companies. Wärtsilä uses appropriate insurance policies to cover indemnity risks related to its personnel, assets, business interruption, and third-party and product liability. Wärtsilä has established its own reinsurance company, Vulcan Insurance PCC Ltd, as a risk management tool for this purpose.

Financial risks

General
Wärtsilä has a centralized Group Treasury with two main objectives:

• it arranges adequate funding for the Group’s underlying operations on competitive terms,
• it identifies and evaluates the financial risks within the Group and implements the hedges for the Group companies. The objective is to hedge against unfavourable changes in the financial markets and to minimize the impact of foreign exchange, interest rate, credit and liquidity risks on the Group’s cash reserves, profits and shareholders’equity.

The Financial Risk Policy is approved by the Board of Directors. The Treasury employs only such instruments whose market value and risk profile can be reliably monitored.

Foreign exchange risk
Foreign exchange exposures are monitored at the Business level and then netted and hedged at Group level. All fixed sales and purchase contracts are hedged. The estimated future commercial exposures are evaluated by the Businesses and the level of hedging is decided by the Board of Management. Hedge accounting in accordance with IFRS is applied to most of the hedges of these exposures. The hedges cover such time periods that both the prices and costs can be adjusted to new exchange rates. These periods vary among Group companies from one month to two years. The Group also hedges its balance sheet position, which includes receivables and payables denominated in foreign currencies. The Group does not expect significant exchange rate losses from any changes in foreign exchange rates in 2009. The cancellation of orders might lead to ineffective currency hedge. Some 72% of sales and 70% of operating costs in 2008 were denominated in euros. The Group’s profits and competitiveness are also indirectly affected by the home currencies of its main competitors: USD, GBP, JPY and KRW.

Some Group companies in countries whose currencies are not fully convertible like Brazil and China have unhedged intercompany loans nominated either in EUR or USD. Total amount of the loans is EUR 37 million (31.12.2008).

Since Wärtsilä has subsidiaries outside the euro zone, the Group’s shareholders’ equity is sensitive to exchange rate fluctuations. At the end of 2008 the net asset value of Wärtsilä’s foreign subsidiaries outside the euro zone totalled EUR 419 million, of which EUR 335 million was hedged. The ineffective portion of the equity hedges was not significant. IFRS hedge accounting has been applied to EUR 1,037 million currency forwards. 10% change in the exchange rates would cause from these currency forwards an approximately EUR 77 million after tax influence on the shareholders’ equity. In 2008 EUR -18 million fair value adjustments related to cash flow hedges were booked in equity. EUR 22 million of the fair value adjustments were transferred from equity to the income statement as net sales or operating expenses during 2008. The result from ineffective portion of the cash flow hedges, EUR -2 million, has been booked in financial items.

Interest rate risk
Wärtsilä is exposed to interest rate risk primarily through market value changes to the net debt portfolio (price risk) and also through changes in interest rates (re-fixing on roll-overs). Wärtsilä hedges interest rate exposure by using derivative instruments such as interest rate swaps, futures and options. Changes in the market value of these derivatives are booked directly to the income statement. Interest rate risk is managed by constantly monitoring the market value of the financial instruments and by using sensitivity analysis. Interest-bearing loan capital at the end of 2008 totalled EUR 664 (283) million. The average interest rate was 4.1% (4.9) and the average re-fixing time 11 (7) months.  At the end of 2008 a one percentage point parallel decrease/increase of the yield curve would have resulted in a EUR 7 million increase/decrease in the value of the net debt portfolio including derivatives. Wärtsilä spreads its interest rate risk exposure by taking both fixed and floating rate loans. The share of floating rate loans as a proportion of the total debt can vary between 30–70%. At the end of 2008 the floating rate portion of total loans was 61% after adjustment for interest rate derivatives. A one percentage point change in the interest level would cause a EUR 4 million change in the following year’s interest expenses of the debt portfolio, including derivatives.

Liquidity and refinancing risk
Wärtsilä ensures sufficient liquidity at all times by efficient cash management and by keeping large enough committed and uncommitted credit lines available.

The existing funding programmes include:

• Committed Revolving Credit Facilities totalling EUR 410 million.
• Finnish Commercial Paper programmes totalling EUR 600 million.

In addition Wärtsilä has signed a EUR 30 million long-term loan agreement. This loan was disbursed in January 2009. The average maturity of the long-term loans is 60 months and the average maturity of the confirmed credit lines is 35 months.

Wärtsilä Group’s liquidity is good. Wärtsilä had cash and cash equivalents totalling EUR 197 million at the year end as well as EUR 360 million non-utilized committed credit facilities and substantial Commercial Paper programmes. Wärtsilä minimizes its refinancing risk by having a balanced and sufficiently long loan portfolio.

Credit risk
The responsibility for managing the credit risks associated with ordinary commercial activities lies with the Businesses and the Group companies. Major trade and project finance credit risks are minimized by transferring risks to banks, insurance companies and export credit organizations. The company did not have long-term suppliers’ credits at the end of 2008. No losses were recorded on suppliers’ credits. Wärtsilä has a Vendor Note receivable and some other minor receivables totalling EUR 9 million, maturing within 4 years, from the new owners of the sold Oy Ovako Ab shareholding. Credit risks related to the placement of liquid funds and to trading in financial instruments are minimized by setting explicit limits for the counterparties and by making agreements only with the most reputable domestic and international banks and financial institutions.

The Group companies deposit all their liquid financial assets with the centralized treasury (Wärtsilä Group Treasury) if local laws and central bank regulations allow it. The Group’s funds are placed in instruments with sufficient liquidity (short-term bank deposits or Finnish Commercial Papers) and rating (at least single-A rated instruments or other instruments approved by the Group’s CFO). These placements are constantly monitored by Wärtsilä Group Treasury and Wärtsilä does not expect any defaults from the placements.

Equity price risk
Wärtsilä has investments in publicly quoted shares. The market value of these shares at the end of 2008 was EUR 84 million. 10% strengthening or weakening in share price has EUR +/- 6 million impact on Group’s shareholders’ equity after taxes. Wärtsilä also has equity investments totalling EUR 12 million in power plants companies, most of which are located in developing countries and performing well according to expectations.

Capital risk management
Wärtsilä’s policy is to secure a strong capital base to keep the confidence of investors and creditors and for the future development of the business. The capital is defined as total equity including minority interest and net interest-bearing debt. The target for Wärtsilä is to have a solvency ratio of 35–40% and to pay a dividend equivalent to 50% of operational earnings per share.