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 lifecycle quality of Wärtsilä’s operations and products, and the continuous, systematic, loss-prevention work at all 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 and operational risks, and lowest with hazard and financial risks.

Risk management process
The Board of Directors and the Board of Management decide and give guidelines on strategic matters. The Businesses are responsible for achieving their set strategic goals and for mitigating and managing 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, co-operates with the businesses in the implementation of risk mitigation work, 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.

Risk reporting
Wärtsilä has strengthened its risk reporting during 2009. The Board of Management in its meetings carries annual Management Reviews on each Business, including their risks and risk mitigation. The risk map of the Group and all Businesses is then presented in the Finance Management Review in the autumn before the budgeting round. The risks are quantified in euros, their probabilities are estimated and risk mitigation actions, including potential investments, are decided in the normal course of business. The Group Risk report is then presented to the Board of Directors.

The Business Management Teams have risk management as a separate item on their agenda. The Businesses are responsible for organising, follow-up actions, and reporting on risk management from underlying Business units. In addition to divisional risk reporting, Wärtsilä has four cross-business risk groups (production, supply chain, quality, and liability risk groups). These forums concentrate on risk identification and mitigation from the corporate view. The groups have approximately four meetings annually.

The Corporate Risk Management function co-ordinates risk management activities and reporting within the Group.

Strategic risks

A specific strategic risk assessment was conducted in 2009. It is a part of the strategic planning process within the Group.

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, plus a stable business mix with a large share of sales deriving from Services, brings Wärtsilä certain stability in a cyclical market. In 2009, the biggest risk for Wärtsilä’s future success was the turmoil experienced in the financial markets and the subsequent slump in the world economy. Important economic matters that will 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 willingness to extend credits, the counter cyclical stimulus programmes adopted by governments - especially in the power and infrastructure sectors, the enhanced activities of multilateral institutions such as IFC, the availability of export credit schemes and guarantees, and other such factors. However, the relatively large order book gives Wärtsilä some time to adapt to the market conditions.

Market and Customer risk
New orders for ships collapsed in 2009. Despite signs of a slow recovery in the world economy, the shipping industry still faces problems with overcapacity and idle anchored ships within the major vessel segments. Once the broader recovery commences, the Asian shipbuilding market will emerge stronger than earlier. Wärtsilä is well prepared for this development by having delivery centres and joint ventures with local players in China, Korea and Japan, and by locating the top management of its Ship Power Business in Shanghai. Wärtsilä is well represented in all the major shipbuilding areas and is active in all major vessel segments. This mitigates both single customer related and geography related risks. However, the financial position of some clients has weakened. Thus, Wärtsilä is constantly following the financial situation of its customer base. The most vulnerable shipping sub-segments are bulkers and containers, where the market is expected to remain very quiet for the next two years or so. Other sub-segments will most likely recover earlier. Ship Power business has had several order cancellations during the year, but the risk of new cancellations decreased during the course of the year. Instead, postponements and rescheduling of orders are being made and expected.

In the Power Plant business, the number of projects under bidding remained at a good level but financial closures of the deals were often postponed due to the difficulties in the financial markets. The bigger projects in particular were difficult to finalise, whereas the market for smaller power plants was less affected. However, existing orders and thus net sales, were not affected. Geographically, Europe, the Middle-East and Africa were the most active. Wärtsilä has four types of customers: Industrial customers, IPPs, utilities, and oil & gas sector customers. The IPP segment is currently challenging, but the market is likely to recover once financing possibilities become more favourable for clients. Power Plants’ strategic objective is to support its customers by offering energy efficient, fuel flexible, and operationally flexible solutions that offer optimal means for managing the varying load profiles of the grids. Wärtsilä’s solutions also enable the introduction of a higher share of renewable energy sources, which need backup generation in order to ensure capacity at all times.

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 copied globally to other relevant Wärtsilä locations. Wärtsilä has over 14,000 customers and an active engine base of nearly 170,000 MW, which means that its dependency on any single customer or customer segment is insignificant. The rapid growth of Services has currently levelled out, but Services’ long-term volumes are still expected to grow faster than new equipment sales. The recession also creates new opportunities for Services as customers want to reduce fixed costs through increased outsourcing. Wärtsilä will develop its service portfolio accordingly.

Competitive situation and price risk
Demand for Ship Power Business was weak during 2009 due to the financial crisis. The overcapacity in the market is expected to create more competition and price pressure in the future. Ship Power’s largest competitors in main engines are MAN Diesel and Caterpillar (MAK). No significant changes took place in the competitive situation during 2009. In the Propulsion Business, competition is more fragmented and varies by product segment. The concept of selling packaged solutions rather than merely components reduces price volatility. The concept of being a system integrator with Ship Design capability will prove to be even more important in the future.

In the power plant market, Wärtsilä’s main competitors are the same engine manufacturers as for Ship Power, plus in some cases also other technologies, notably gas turbines. Wärtsilä managed to maintain its power plant market share in the challenging market conditions of 2009.

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. Consolidation within the customer interface and increased cost consciousness will enhance Wärtsilä’s possibilities for offering a wider scope of service solutions, especially to ship owners.

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 potential business risks related to climate change and Wärtsilä’s products are in the areas of regulatory emission restrictions, and in changes in customer attitudes to using combustion engines.

The International Maritime Organization (IMO) has approved amendments to the MARPOL Annex VI regulations on ship emissions. These regulations set stricter limits on emissions of Nitrogen Oxides (NOx) from the engines, as well as on the sulphur content of the fuel. The new requirements will enter into force in various phases during the years 2010–2020. As regards NOx emissions, Wärtsilä has already introduced solutions that comply with these requirements. Wärtsilä engines are designed for operation on any fuel sulphur content. As a response to the tightening Sulfur Oxides (SOx) emissions, Wärtsilä has developed scrubber technology by which exhaust gases can be cleaned to meet the tight regulations. Additionally, Wärtsilä has a multifaceted gas engine strategy and can provide gas engines to vessels. Being at the forefront of technological developments gives Wärtsilä many opportunities arising from tightening environmental regulations. Shipping can reduce its carbon footprint through ship design, efficient engines, and optimal propulsion solutions.

In 2008, the final version of the "Thermal Power Plants EHS (Environmental Health and Safety) Guidelines" was published by the World Bank/IFC (International Finance Corporation). This publication concluded the review and update work of the World Bank Group’s EHS Guidelines, which consisted in total of 62 Industry Sector EHS Guidelines, and the General EHS Guidelines. The EHS Guidelines are technical reference documents with general and industry-specific examples of Good International Industry Practices (GIIP). Leading international banks have reached agreement with IFC to follow guidelines based on IFC’s environmental and social standards, and have thus adopted the Equator Principles. Many other financial institutions, such as Export Credit Agencies, are also using the World Bank Group Guidelines in addition to national norms in their projects. Consequently, the World Bank/IFC EHS Guidelines are today the minimum environmental standard in global power plant projects. It is estimated that more than 70% of the finance activities for projects in emerging markets, are now carried out in accordance with the Equator Principles.

The EU is currently in the process of preparing its Industrial Emissions Directive. UNECE Gothenburg Protocol revision work is also on-going, and is expected to be finalised during spring 2010. An intensive interaction between the various stakeholders is currently taking place. Wärtsilä is actively engaged in the dialogue between different authorities, associations, industry and customers, in order to ascertain the optimal solution for meeting market needs.

Tightening regulations will create new opportunities for Wärtsilä. In Power Plants, Wärtsilä is a technological forerunner and can offer further improvements, such as more efficient engines, fuel flexibility (such as bio fuels and natural gas) and CHP (combined heat and power) applications with very high total efficiency. Services can offer several retrofit solutions in the after sales market to reduce emissions and increase efficiency. Wärtsilä can also offer environmentally sound solutions for a number of applications, including bilge and ballast water handling.

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. Wärtsilä’s new Delivery Center Ecotech unit began operations in 2009. It will focus on centralising environmental technologies that are related to products other than the engines in order to quickly respond to market and customer needs with fully integrated and validated solutions.

Wärtsilä has also assessed wider sustainability risks, both in strategic and operative risk assessments. However, these were not found to be significant.

Technology risks
As a technology leader Wärtsilä needs to maintain its cost competitiveness and places high emphasis on engine efficiency and emissions control. New products are developed from the viewpoint of lifecycle service and efficiency e.g. through utilising Ship Design, electrical & automation and Ecotech capabilities. Wärtsilä aims to increase the competitiveness of its solutions through solid R&D work.

Operational risks

Operational Risk Management is part of the daily work of the Businesses. Apart from normal risk management work, specific Operational Risk Groups that include members from each Business, have been established and have been operative since the beginning of 2009. Their aim is to establish a continuous process of operational improvements.

Manufacturing risk
In 2009 risk assessments were made with insurers in the biggest delivery centres, Vaasa and Trieste. Other locations inspected included the major propulsion factories in the Netherlands and UK. Significant safety and risk mitigation investments were completed in Trieste. Wärtsilä is using management systems for quality, environmental, occupational health and safety, and other systems to improve productivity and safety. Wärtsilä has begun a process to create comprehensive business continuity plans (BCP) for all its key delivery centres.

With the Ship Power market remaining weak, and as the majority of ship construction has already shifted to Asia, Wärtsilä needs to analyse constantly its manufacturing footprint and capacity costs, including the supply chain. The analysis comprises all manufacturing units with major focus on capacity adjustments in European units with product deliveries to marine markets.

Supplier and subcontractor risk
The centralised Corporate Supply Management (CSM) function manages and controls Wärtsilä’s supplier network to make sure that the suppliers’ performance meet Wärtsilä’s expectations. Supplier performance is, therefore, also continuously measured. An on-going and deeper co-operation with suppliers has been initiated to cover interruption risks, as well as for sharing information on risk management issues and business continuity planning. Several supplier risk audits were completed during 2009 together with the insurer. These audits are now part of the regular work for the CSM and Risk Management functions.

Due to the financial markets crisis, a more comprehensive follow-up of suppliers’ creditworthiness has been set in place. The Corporate Supply Management function has developed its activities by creating close collaboration and relationships with its main suppliers, by emphasising quality, cost, lead-times, and long-term delivery agreements, and by sharing innovative solutions in order to drive down costs. In addition, Wärtsilä has also increased its number of suppliers of certain critical components, and its sourcing in emerging markets. Wärtsilä currently sees opportunities for reducing supply chain costs due to over-capacity and increased pricing pressure within the markets.

Life cycle 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, a risk elimination tool, a single issue list, and in-house validation testing. Furthermore, Wärtsilä seeks to control quality risks by controlling 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 is the full release given to the sales organisations. The 5S (including sort, shine, set, standardise and sustain) philosophy is being implemented in all production sites to increase quality and to support lean operations. Services is responsible for all warranty issues, and offers a feedback loop from the field to production and R&D while taking care of customers’ installations throughout their lifecycle. The company makes warranty provisions to cover any warranty costs that may arise after product delivery. Product liability insurance covers unexpected damages.

Contractual risks
Wärtsilä’s non-service sales consist of project deliveries of various sizes. The biggest deliveries concern turnkey power plants of 100 MW or bigger. However, the risks from individual projects do not reach significant levels considering the total volume of business. Wärtsilä is sometimes also involved in product liability claims. The lifecycle quality of the products and work, initiating from design and including the field service work, plus the use of standard sales contracts, reduce the risk of claims. There is no significant litigation currently under process.

Commodity price risk
Oil
The direct effect of oil price changes on production in Wärtsilä is very limited. 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 smoothed. 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 production costs.

Hazard risks
Occupational health and safety systems, travel safety instructions, and crises management guidelines are aimed at protecting Wärtsilä employees. Wärtsilä has appropriate insurances for its personnel. 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 within Natural Catastrophy areas.

Risks that Wärtsilä is unable to influence through its own efforts are transferred to insurance companies, where possible. 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 centralised Group Treasury with two main objectives: 1) to arrange adequate funding for the Group’s underlying operations on competitive terms, 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 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 losses from foreign exchange rate changes in 2010. The cancellation of orders could lead to ineffective currency hedge. Approximately 65% of sales and 70% of operating costs in 2009 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 69 million.
 
Since Wärtsilä has subsidiaries outside the euro zone, the Group’s shareholders’ equity is sensitive to exchange rate fluctuations. At the end of 2009 the net asset value of Wärtsilä’s foreign subsidiaries outside the euro zone totalled EUR 432 million, of which EUR 339 million was hedged. The ineffective portion of the equity hedges was not significant.
         
IFRS hedge accounting has been applied to EUR 918 million currency forwards. A 10% change in the exhange rates would cause from these currency forwards an approximately EUR 68 million after tax influence on the shareholders’ equity. In 2009 EUR 3 million fair value adjustments related to cash flow hedges were booked in equity. EUR -12 million of the fair value adjustments were transferred from equity to the income statement as net sales or operating expenses during 2009. The result from the ineffective portion of the cash flow hedges, EUR -5 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 2009 totalled EUR 664 (664) million. The average interest rate was 2.3% (4.1) and the average re-fixing time 23 (11) months. At the end of 2009 a one percentage point parallel decrease/increase of the yield curve would have resulted in a EUR 13 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 2009 the floating rate portion of total loans was 39% after adjustment for interest rate derivatives. A one percentage point change in the interest level would cause a EUR 2 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 maintaining sufficient committed and uncommitted credit lines available.
         
The existing funding programmes include:
• Committed Revolving Credit Facilities totalling EUR 555 million.
• Finnish Commercial Paper programmes totalling EUR 700 million.
 
The average maturity of the long-term loans is 71 months and the average maturity of the confirmed credit lines is 31 months. Additional information in Note 25.
         
Wärtsilä Group’s liquidity is strong. Wärtsilä had cash and cash equivalents totalling EUR 244 million at the year end as well as EUR 555 million non-utilised committed credit facilities and substantial Commercial Paper programmes. Wärtsilä minimises 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 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 2009. No losses were recorded on suppliers’ credits. 
         
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) as 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.

Equity price risk
Wärtsilä has investments in publicly quoted shares (Note 15). The market value of these shares at the end of 2009 was EUR 130 million. 10% strengthening or weakening in share price has EUR +/- 10 million impact on Group’s shareholders’ equity after taxes.
 
Wärtsilä also has equity investments totalling EUR 9 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.