Risk Management

Strategic risk assessment is part of the strategic planning process within the Group. At Wärtsilä, strategic risks are defined as potentially having a long-term impact on the business.

Business environment risks
The business cycles in the global economy and in our customer's industries influence the demand for our products, as well as our financial position and operating result. The flexible multi-product manufacturing model based on capacity outsourcing, together with a stable business mix with a large share of sales deriving from Services, brings Wärtsilä certain stability in a cyclical market. Important economic matters that indirectly affect Wärtsilä, its clients, and suppliers include inter alia, the liquidity and solvency of the financial institutions - and thus not only their capability but also their willingness to extend credit, the counter cyclical stimulus programmes adopted by governments - especially in the power and infrastructure sectors, the enhanced activities of multilateral institutions such as the IFC, the availability of export credit schemes and guarantees, and other such factors. However, the relatively large order book gives Wärtsilä time to adapt to market conditions.

The implementation of environmental regulations is important for the future growth potential in specific business segments. In 2012 it had still a limited effect on Wärtsilä. However, the acquisition of Hamworthy in early 2012 has expanded Wärtsilä's offering of environmental solutions. This supports Wärtsilä's growth objectives. Wärtsilä actively monitors possible changes in the legislation timeline and scope.

Market and customer risks
In the Power Plants business, there was positive development in large power plant orders, and we received orders for our two largest projects ever during the year. In general, the non-OECD markets remained very active, but in the OECD countries slow growth has delayed investments in power generation. Wärtsilä's installed base is evenly spread geographically with power plants delivered to 169 different countries. This mitigates both the market and customer risk faced by the power plant business.

The business environment for the shipping and shipbuilding industry is challenging, and concerns over the global economy continue to cause uncertainty. The uneven development between various Ship Power customer segments continued throughout the year 2012. The merchant shipping sector in general still suffers from overcapacity, whereas various areas of specialised tonnage, and especially the offshore industry, continue to make investments. The shipbuilding market is dominated by Asian yards in South Korea, China and Japan. Wärtsilä is well represented in all the major shipbuilding areas and is active in all the main vessel segments. This mitigates both single customer related and geography related risks.

The Services business increased by 5% during 2012, and its long-term business is expected to grow in line with the development of the existing installed base, as well as with general economic development. However, the prevailing conditions of the marine merchant market segment impose a challenge for the Service business. Wärtsilä has more than ten thousand individual customers engaging in service and spare part sales annually, and the current active engine base is approximately 181,000 MW. Due to this the dependency on any single customer or customer segment is minor.

During the last few years, Wärtsilä has increased its focus on credit management processes to better manage the increasing risks resulting from higher leverage and decreasing profitability in certain customer segments. Exposure to individual customers is limited, but an industry-wide impact might also affect the profitability of Wärtsilä's Services business.

Competitive situation and price risk
In the liquid fuels based power plant market, Wärtsilä's main competitors are MAN Diesel, Caterpillar (MAK), and Rolls-Royce. In natural gas based power generation, the main competitors are gas turbine manufacturers, such as GE and Siemens. In the first half of 2012, the overall market size for natural gas and liquid fuel based power plants was significantly reduced. In this challenging market environment, Wärtsilä's overall market size is expected to increase. Wärtsilä's success in the market can be attributed to the flexible power generation solution, which can be used in a wide range of different applications and sizes of power plant.

For Ship Power, price competition has continued to be intense. For main engines, the most significant competitors are MAN Diesel, Caterpillar (MAK), and Hyundai Heavy Industries (HiMSEN). The competitive situation and market shares remained largely unchanged during 2012. In propulsion equipment, the competition is more fragmented and varies by product category. One of the main competitors for these products is Rolls-Royce. In environmental solutions, as well as in flow and gas products, the markets are very fragmented. Alfa Laval is one of the competitors in these product areas. The concept of selling packaged solutions rather than only single products reduces price volatility. The strategic move to become a systems integrator with automation and ship design capability has proven to be very important in the competition for new projects with larger and more value-added scopes. However, larger projects may increase variations in business volume depending on the timing of the projects.

In the Services business, Wärtsilä has no direct competitors that would offer a similar portfolio of services from a single source. Excluding the service networks of other engine manufacturers, there are few global players in the service market. Increased pressure on profitability, especially in the marine merchant sector, can lead to a further increase in competition for service in that particular customer segment. There has always been price competition, especially among certain customer groups and application types. The size of this group has, however, not changed to any larger degree.

Political and legislative risks
Wärtsilä is present in nearly 200 locations in nearly 70 countries and has delivered power plants to 169 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 on projects of importance to Wärtsilä's operations. Much of this engagement takes place through interest groups and trade organisations. The company monitors political and legislative changes at both corporate and subsidiary levels.

Climate change and sustainability risks
Wärtsilä has assessed its sustainability risks, including climate change risks, in both strategic and operative risk assessments. However, the risks were not found to be significant. The potential business risks related to sustainability, climate change, and Wärtsilä's products are in the areas of regulatory emission restrictions and changes in customer attitudes to using combustion engines and fossil fuels. The risks in environmental legislation changes are related to the complexity of the overall field of different emissions, the balance between commercially available fuels and resulting emissions, available abatement technologies, the impact on overall energy efficiency, and the resulting financial feasibility of the various alternative ways to meet regulatory demands.

Being at the forefront of technological developments mitigates sustainability risks and gives Wärtsilä many opportunities arising from tightening environmental regulations. Over the years, Wärtsilä has worked continuously to improve the efficiency of its products while at the same time seeking ways to reduce emissions. The fuel flexibility of Wärtsilä's products enables the utilisation of various fuels, including gas and those from renewable sources, while their operational flexibility enables the installation of large capacity based wind and solar energy systems without hampering the reliability of the electricity grid. Wärtsilä's technology also enables energy to be generated with a minimum use of water. The lack of fresh water is expected to be one of the major challenges facing the world in the future. In shipping, Wärtsilä can reduce the carbon footprint of ships through optimised ship design, and optimal propulsion solutions. Environmental Solutions offer alternative technologies to reduce SOx emissions and to treat waste and ballast water. In Power Plants, Wärtsilä's Smart Power Generation concept supports the increase in low carbon power generation, including wind, solar and natural gas fired plants. Wärtsilä offers several retrofit solutions for the after-sales market to reduce emissions and to increase fuel efficiency.

Risk of non-compliance, corruption and fraud
Wärtsilä is in compliance with the law and Wärtsilä's own internal regulations everywhere Wärtsilä does business. Wärtsilä's Code of Conduct is the key guideline for all Wärtsilä employees globally. Wärtsilä is committed to high ethical standards and integrity in its businesses, preventing corruption and violations of the principles set forth in the Code of Conduct, Wärtsilä's Anti-Corruption Policy, and Wärtsilä's Compliance Reporting Policy. Wärtsilä's compliance processes are embedded in all of the businesses, and the responsibility for compliance and awareness of ethics and integrity is that of all Wärtsilä employees.

Wärtsilä is fully committed to compliance with the anti-corruption laws and statutes. Wärtsilä's Anti-Corruption Policy absolutely forbids any kind of corruption and bribery, and the top-management of the company has zero-tolerance regarding corruption and fraud.

In 2012, compliance was strengthened to become a dedicated function in order to support the compliance objectives. The Compliance function promotes group wide compliance and continuously strives to raise awareness of the risk of corruption and bribery. It is also primarily responsible for group level policies and procedures, training, compliance investigations, managing the consequences of non-compliance, and reporting. Further developing Wärtsilä's compliance programme and nurturing Wärtsilä's commendable ethical culture are integral parts of the Compliance function's task. Moreover, Compliance supports and co-operates with other corporate functions in their risk management efforts.

While Wärtsilä is aware of the risk of being subject to fraud by external business parties, and that the risk of corruption and fraud is heightened in many markets where Wärtsilä operates, Wärtsilä maintains its highly ethical practices at all times. Full compliance with its stringent anti-corruption regime, including policies to prevent the corruption and bribery risk of third parties, is demanded by Wärtsilä.

Technology risks
Wärtsilä aims to increase the competitiveness of its solutions, and therefore limit its technological risks, through solid R&D work and innovation. New products are developed based on Wärtsilä's strategic view of offering lifecycle solutions, and with a focus on efficiency through, for example, ship design, electrical & automation, and environmental technologies. As a technology leader, Wärtsilä needs also to maintain the cost competitiveness of its products, and consequently places high emphasis on product efficiency and emissions control.

Operational risk management is part of the daily work of the Businesses. Opportunities and risks are identified, assessed and managed on a daily basis and reported to, and managed by, the appropriate management level. On a periodic basis (weekly or monthly) the status of the opportunities and risks are reviewed and further actions are then taken.

Manufacturing risk
Risk assessments have been made for all the main delivery centres, and significant safety and risk mitigation investments have been completed. Wärtsilä utilises management systems for quality, environmental, occupational health and safety, and other systems to improve productivity and safety. Wärtsilä has implemented business continuity plans for its key delivery centres. Wärtsilä constantly analyses its manufacturing footprint and capacity costs, including the supply chain.

Supplier and subcontractor risk
The centralised Wärtsilä Supply Management (WSM) function is responsible for all strategic sourcing activities. Within that responsibility, WSM manages and controls Wärtsilä's supplier network to make sure that the suppliers' performance meets Wärtsilä's expectations. Supplier performance is, therefore, also continuously measured. A key activity in managing business continuity planning is the continuous assessment of business interruption risks, which is made in co-operation with our suppliers. Several supplier risk audits have been completed jointly with the insurer as one means of mitigating risk. These audits are now part of the regular work for the WSM and Risk Management functions. To further mitigate risks, a comprehensive follow-up of suppliers' credit worthiness has been established.

Wärtsilä Supply Management has developed its activities by creating close collaboration and long-term relationships with its main suppliers. By having these close relationships, WSM secures a common view with its suppliers on values and goals. These shared values and goals support Wärtsilä's management of strategic risks. In addition, WSM continues its supplier structuring programme in order to create and maintain a sustainable supplier base. As part of that programme, WSM is further developing its global sourcing activities. Furthermore, supplier related risks are also addressed by having double sourcing of key components.

Lifecycle quality of products and product liability risk
Launching new products always involves risks. In the R&D process, several risk management techniques are applied, including FMEA (Failure Modes and Effects Analysis), a risk elimination tool, and in-house validation testing. Wärtsilä seeks to control quality risks by monitoring the incoming quality from the supply chain, and by designing and manufacturing products with all due care. Wärtsilä applies a GATE model in order to control the product development process. First, only a limited release of new products is allowed, and via the gate approach, only after testing and further validation has been completed, full release authority is given to the sales organisations. The 5S (meaning sort, shine, set, standardise and sustain) philosophy is implemented in all production sites to increase quality and to support lean operations. The Services business is responsible for all warranty issues, and offers a feedback loop from the field to production and R&D while taking care of customer installations throughout their lifecycle. The company makes warranty provisions to cover any warranty costs that may arise after product delivery. The product liability insurance covers unexpected damages.

Contractual risks
Wärtsilä's non-Service sales consist of project deliveries of various sizes. The most substantial orders concern turnkey power plants. However, in relation to the total volume of business, the risks from individual projects do not reach significant levels. The lifecycle quality of the products and work, from the initial design, throughout all stages of the production process, to the eventual field service work, plus the use of standard sales contracts, including the establishment of a contract review process, together reduce the risk of product liability claims.

Commodity price risk
Oil
The direct effect of oil price changes on Wärtsilä's production is limited, with their impact being mainly demand related. Higher oil prices represent a risk for global economic growth and increase operating costs, especially in the shipping markets. However, they also stimulate investments in exploration and production for oil and gas, both on land and offshore. Furthermore, high oil prices increase investments in gas carriers, gas based power plants and increasingly also in gas fuelled vessels. Low oil prices can delay investment decisions in oil producing countries and regions. Wärtsilä is a global company involved in different shipping and power plant segments where oil price changes can have an opposite impact on demand drivers. This position is further diversified by the increasing importance of natural gas in Wärtsilä's business.

Metals
Metal prices have an indirect effect on the component costs of our products. Furthermore, some key components are sourced with long-term contracts, and thus raw material price volatility is limited.

Electricity
Electricity prices do not have a substantial impact on Wärtsilä's production costs. In the Power Plants business, high electricity prices support investments in new capacity from utility customers. Lower grid electricity prices do not favour industrial investments in their own generating capacity.

Occupational health and safety systems, travel safety instructions, and crises management guidelines are aimed at protecting Wärtsilä employees. Appropriate insurances are in place for the personnel, and to emphasise the importance of employee safety, Wärtsilä's Board of Management has decided on a corporate level target of zero lost time injuries. A specific project has been established for this purpose, and the target is a part of the company's sustainability programme.

Environmental management systems are in place to mitigate environmental hazard risks.

Wärtsilä's Real Estate unit maintains a register of all properties used and gives guidelines for the purchase, sale, rental and security of premises, and uses external advisors for environmental audits.

None of Wärtsilä's major production plants are situated in natural disaster areas. Catastrophic peril related scenarios are identified, and where necessary, exposures are mitigated by, for example, elevating sites above the flood risk level or by constructing flood dikes.

For Wärtsilä's main production sites, business impact analyses have been conducted and continuity plans created to cover both property and business interruption risks.

The risks that Wärtsilä is unable to influence through its own efforts are transferred when 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 captive insurance company, Vulcan Insurance PCC Ltd, as a risk management tool.

General

Wärtsilä has a centralised Group Treasury with two main objectives: 1) to arrange adequate funding for the Group’s underlying operations on competitive terms and 2) to identify and evaluate the financial risks within the Group and implement the hedges for the Group companies.

The objective is to hedge against unfavorable changes in the financial markets and to minimise the impact of foreign exchange, interest rate, credit and liquidity risks on the Group’s cash reserves, profits and 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 position of the statement of financial position, which includes receivables and payables denominated in foreign currencies. The Group does not expect significant losses from foreign exchange rate changes in 2013. The cancellation of orders could lead to ineffective currency hedge. Approximately 59% of sales and 56% of operating costs in 2012 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.

The instruments, their nominal values and currency distribution used to hedge the Group’s foreign exchange exposures are listed in Note 26. Derivative financial instruments.

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 49 million (48).

Since Wärtsilä has subsidiaries and joint ventures outside the euro zone, the Group’s equity, goodwill and purchase price allocations are sensitive to exchange rate fluctuations. At the end of 2012, the net assets of Wärtsilä’s foreign subsidiaries and joint ventures outside the euro zone totalled EUR 769 million (472). In addition, goodwill and purchase price allocations from acquisitions nominated in foreign currencies amounted to EUR 596 million (178). Wärtsilä decided to discontinue hedging the net assets in its foreign subsidiaries and joint ventures in June 2012. Until that, the changes in the fair values of instruments determined as equity hedging were recognised in other comprehensive income, provided that the hedging was effective, and the ineffective portion of the change in the fair value of the hedge and the interest rate difference were immediately recognised in the statement of income in the financial items.

IFRS hedge accounting has been applied to EUR 733 million (1,111) currency forwards. 10% change in the exhange rates would cause from these currency forwards an approximately EUR 55 million (82) net of tax impact on the equity. In 2012, EUR 7 million (-12) fair value adjustments related to cash flow hedges were recognised in equity. EUR -7 million (11) of the fair value adjustments were transferred from equity to the statement of income as net sales or operating expenses during 2012. In 2012, the result from ineffective portion of the cash flow hedges was not significant. In 2011, EUR -2 million was recognised in financial items.


Currency distribution 2012  

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 rollovers). 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 recognised directly in the statement of income. 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 2012 totalled EUR 794 million (652). The average interest rate was 2.0% (2.7) and the average re-fixing time 21 months (16). At the end of 2012, a one percentage point parallel decrease/increase of the yield curve would have resulted in a EUR 14 million (8) 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 2012 the floating rate portion of total loans was 49% (44) after adjustment for interest rate derivatives. A one percentage point change in the interest level would cause a EUR 4 million (3) change in the following year’s interest expenses of the debt portfolio, including derivatives.

Additional information related to loans can be found in Note 17. Financial assets and liabilities by measurement category and Note 24. Financial liabilities.

Liquidity and refinancing risk
Wärtsilä ensures sufficient liquidity by efficient cash management and by maintaining sufficient committed and uncommitted credit lines available.

The existing funding programmes include:
• Committed Revolving Credit Facilities totalling EUR 554 million (494).
• Finnish Commercial Paper programmes totalling EUR 700 million (700).

The average maturity of the long-term debt is 44 months (40) and the average maturity of the confirmed credit lines is 29 months (34). Additional information in Note 24. Financial liabilities.

Wärtsilä Group had cash and cash equivalents totalling EUR 225 million (592) at the year end as well as EUR 554 million (494) non-utilised committed credit facilities. Commercial Paper programme utilisation amounted to EUR 141 million (70). Wärtsilä minimises its refinancing risk by having a balanced and sufficiently long loan portfolio.

Revolving credit facilities

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 minimised by transferring risks to banks, insurance companies and export credit organisations. The company did not have long-term suppliers’ credits at the end of 2012. No losses were recorded on suppliers’ credits.

The credit risks related to the placement of liquid funds and to trading in financial instruments are minimised 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 the maximum amount of their liquid financial assets with the centralised treasury (Wärtsilä Group Treasury) when 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 future defaults from the placements.

Aging of trade receivables

In 2012, EUR 8 million (18) provisions for doubtful receivables have been recognised in the consolidated statement of income.

The Group sells trade receivables in an amount that is currently not significant compared to the total trade receivables. Sold receivables have been de-recognised in the consolidated statement of financial position.

Equity price risk
Wärtsilä has investments in publicly quoted shares, see Note 15. Available-for-sale financial assets. The market value of these shares at the end of 2012 was EUR 2 million (2). A 10% strengthening or weakening in share price does not have any significant impact on the Group’s equity net of taxes.

Wärtsilä has also equity investments totalling EUR 11 million (12) in power plant 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 non-controlling interests and net interest-bearing debt. The target for Wärtsilä is to maintain gearing below 0.50 and to pay a dividend equivalent to 50% of operational earnings per share.