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International Power’s principal activities are the development, acquisition and operation of power generation plants together with closely related activities, such as desalination and district heating. These principal activities are supported by a number of local, regional and corporate offices which carry out activities such as trading and treasury operations. All of these activities have inherent risks.
Our general approach to risk management and governance is set out below, followed by a description of the principal risks faced by the business.
Risk management framework
International Power owns, or has equity stakes in, over 40 plants and some closely linked businesses located in 20 countries. Our portfolio contains all major technologies and fuel types with the exception of nuclear power. In terms of age, our plants range from those which entered service in the 1950s through to those still under construction. Overall, the majority of the portfolio entered service less than 15 years ago. Geographically and economically the portfolio is similarly diverse, having a presence in developed and developing countries with a variety of cultural, political and legal systems. Our risk management philosophy is designed to deal with the diverse set of risks faced by our business.
To reflect the profile of our business we have developed a system that contains both bottom-up and top-down elements to identify and manage risks.
| Corporate level |
| Policy, delegations and exposure limits are set at the corporate level, with the Board of Directors taking ultimate responsibility. Acceptable business practices and engineering and operational standards are set centrally. |
| Regional businesses |
| Market and trading risk are managed regionally within the framework set at the corporate level. Political risks are also managed regionally with support from the corporate centre. |
| Business units |
| Risk assessments and action plans are mainly business unit based. Health, safety and environmental compliance activities are also managed locally, albeit within a central policy framework. Business managers are accountable for managing the risks within their areas of responsibility. This principle also applies to the managers of our corporate functions. |
There is a continuous process for identifying, evaluating and managing the key risks faced by the Group. Activities are co-ordinated by the Risk Committee, which is chaired by the CFO and comprises Executive Directors, other regional directors and senior managers.
The Risk Committee has responsibility, on behalf of the Board, for ensuring:
- the adequacy of systems for identifying and assessing significant risks;
- that appropriate control systems and other mitigating processes are in place;
- that residual exposures are consistent with the Group’s strategy and objectives.
During the business planning process, each business unit and functional group identifies and assesses the key risks associated with the achievement of its principal objectives and their potential impact. These assessments are conducted by all material entities. During the year, significant changes in the risk profile are highlighted through the business performance reporting process.
The centrepiece of our risk management activities is an annual, Group-wide, risk review. This is based on the outcome of the business planning exercise, updated as necessary to take account of ‘post business plan’ events. The assessments are synthesised into a Risk Report, that identifies all the principal risks, which is reviewed by the Risk Committee. Where risks are considered to exceed the Group’s risk appetite, the Risk Committee directs which actions are to be taken. The Risk Report is reviewed by the full Board and the Audit Committee. Schematically the annual Risk Report system functions as follows:
In order to compare risks across the Group on a systematic basis, we segment our activities as shown below. In reality, certain exposures interact and other exposures apply to more than one ‘risk area’ (for example, regulatory risk applies to all of our activities). Such cross-segment risks are assessed in each of the areas in which they occur.
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Principal risks and exposures
| Risk | Impact(s) | Mitigating factor(s) |
| Adverse conditions in our electricity sales or fuel purchase markets and/or counterparty default risk |
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| Price volatility or changes in market conditions result in exceptional trading credit support requirements |
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| Spreads outturn below expectation |
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| Challenging engineering, procurement and construction (EPC) market conditions |
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| Changes in environmental regulatory regime limit our ability to operate our fossil fuel plants |
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These risks are discussed in greater detail below, along with other factors that could potentially have a material impact on our business.
Financial risks
Our business can be subject to financial volatility. This can originate from a number of sources, including project company, counterparty related events and general market conditions. One example was the insolvency of TXU Europe in 2002 which resulted in the termination of the Rugeley Tolling Agreement (a long-term agreement to purchase coal and sell power), which caused a shortfall in revenues. Our capital structure is designed to address these risks.
At the corporate level we have a number of loan facilities which provide us with a prudent level of financial headroom (cash plus outstanding credit lines, less known obligations) which can be applied to any aspect of our business should the need arise. These facilities will meet the short to medium-term funding requirements envisaged by the business. Longer-term funding requirements or funding for a particularly large transaction may be sourced from a combination of these facilities and suitable long-term instruments, such as bonds, or by raising additional equity.
The actual choice of funding instrument(s) will depend on market conditions at that time.
In merchant markets we are sometimes required to provide credit support for our trading operations. Fuel and electricity markets periodically experience sharp price movements and when these occur this has an immediate knock-on effect on our trading credit support requirements, which can be volatile as a consequence. The maintenance of financial headroom offers protection against escalating margin calls (which are payments we are required to make when power prices increase above the contract price).
Project development can, on occasions, also require credit support. This support can take the form of parent company guarantees or credit support instruments issued by banks. In the unlikely event that credit support facilities are unavailable to support the growth developments that we are planning, this could require us to reduce our development activities. We consider it highly unlikely that we will have to forgo opportunities as a result of this constraint due to the prudent level of financial headroom that we maintain and the availability of additional bilateral facilities with banks.
At the individual business level we finance our projects with non-recourse debt. We use non-recourse finance as this insulates the Group from adverse events occurring at the project level, limiting our balance sheet exposure on a given project to the loss of the equity in that project. Liquidity in the financial markets has reduced due to the ‘fallout’ from the US subprime market and, although this may increase the cost of non-recourse finance and/or reduce its availability to some extent, we do not believe this will limit our ability to refinance existing projects or develop new opportunities. Other financial exposures and their mitigating factors are set out in this section.
Counterparty risk
We manage our credit exposure to trading and financial counterparties by establishing clearly defined limits, policies and procedures. Energy trading activities are strictly monitored and controlled through delegated authorities and procedures, which include specific criteria for the management of credit exposures in each of our key regions. With respect to our treasury activities, the financial counterparty credit exposure is limited to arrangements with relationship banks and to commercial paper that has an investment grade credit rating.
Counterparty exposures arising from sale and purchase agreements with our customers are monitored and managed locally with assistance from Group treasury. In addition, Group treasury manages the consolidated counterparty credit positions, with the active involvement of the global risk manager. Further information on credit risk is included in note 32 to the financial statements.
Currency and interest rate exposures
Project company borrowings are normally made in the project company’s functional currency. Hence exchange rate fluctuations do not affect the financial stability of our assets. In countries with historically weak currencies we aim to have power purchase agreement (PPA) tariffs denominated in, or indexed to, a major international currency such as the US dollar. This protects future returns against large and rapid devaluations.
Variability in interest payments can introduce further volatility into project returns. We mainly mitigate this risk by fixing borrowing rates, principally by using interest rate swaps. A limited number of our PPAs also have interest rate pass-through mechanisms. Overall, 67% of our borrowings were protected from interest rate fluctuations in these ways at the end of 2007.
In order to hedge the net assets of non-UK operations, borrowings are generally in the same currency as the underlying investment. The Group aims to hedge a reasonable proportion of its nonsterling assets in this way. It is not our policy, however, to hedge currency translation exposures through foreign exchange contracts or currency swaps. This exposes our sterling profits and our balance sheet assets and liabilities to fluctuations that are not related to underlying business performance.
For 2007 and 2006, average and year end rates of exchange to sterling, for major currencies which are significant to the Group, were:
| Average | At 31 December | |||
|---|---|---|---|---|
| 2007 | 2006 | 2007 | 2006 | |
| US dollar | 2.00 | 1.85 | 1.99 | 1.96 |
| Australian dollar | 2.39 | 2.44 | 2.27 | 2.48 |
| Euro | 1.46 | 1.47 | 1.36 | 1.48 |
| Czech koruna | 40.43 | 41.51 | 36.20 | 40.85 |
When one of our projects makes sales and purchases in a currency other than its functional currency this gives rise to a currency transaction exposure. Transaction exposures also arise when dividends or other funds are remitted from our overseas companies. We match transaction exposures in advance where possible, and hedge any unmatched transactions as soon as they are committed. We may use foreign currency contracts and similar instruments for this purpose.
Further information on market risk, interest rate risk and foreign currency risk is included in note 32 to the financial statements.
Investment structures and contingent liabilities
Going forward, the complexity of the Group and its investment structures, together with the rapidly growing body of tax legislation, will make tax planning and forecasting an increasingly complex and uncertain process. We closely monitor actual and potential changes in tax legislation in order to assess the continued effectiveness of our corporate structures and financial planning assumptions. We are supported by external tax experts in making these assessments.
International Power has a number of actual and potential liabilities, arising from certain tax planning assumptions that have not yet been confirmed by the relevant fiscal authorities and from ongoing legal actions, one of which dates back more than a decade. We have appropriately provided for those sums that we believe will ultimately be paid.
Funding of pensions obligations
The Group operates a range of pension plans internationally, with the most significant defined benefit arrangements in the UK and Australia. These schemes guarantee their members that they will receive retirement benefits related to their final salary at retirement, which gives rise to a risk that our pension funds will not be sufficient to meet these obligations.
This type of risk increases from time to time, for example, when share prices fall or in light of the increasingly more onerous assumptions required by actuarial advisers to independent scheme trustees.
The UK defined benefit pension schemes, which have approximately 700 active members, carried out their latest triennial actuarial valuations in 2007, which resulted in valuing the schemes at a combined deficit of £12 million as at 31 March 2007. Deficit repair arrangements have been agreed with the two sets of trustees and as part of this, up-front payments into the funds of approximately £3.8 million were made at the end of 2007. Future service contribution rates have also been increased in line with actuarial advice received.
In 2007, a strategic review of our UK pension arrangements was initiated and we continue to consult with employees and their representatives to ensure the right solution is achieved for the Group and our UK employees. No changes are being considered which affect existing employees. The review has been initiated largely to seek to reduce the Group’s exposure to risk over the longer-term.
Financial processes
We consider that we have an appropriate and robust internal control system. During the past few years we have reviewed our systems of financial control to ensure they were able to meet the requirements of section 404 of the US Sarbanes-Oxley Act for the year ended 31 December 2006. Although, since deregistration from the SEC in 2007, we are no longer subject to the Sarbanes-Oxley Act, we have continued to maintain the same quality of controls, which continue to provide a comprehensive coverage of our business.
In order to measure our performance, the delivery of our strategy and to provide an early warning of variances to our forecasts we monitor a number of performance indicators. The principal financial KPIs are PFO, EPS and free cash flow, details of which are set out on Key performance indicators and financial highlights page.
Insurance risk management
Our risk management processes assist us in the identification of events that can be partly or entirely mitigated through use of insurance, or which we can self-insure. Risks that we insure include, inter alia, business interruption, Directors’ and officers’ liability and property damage. Where we are legally required to effect third party liability insurances these are also in place. Insurance providers recognise the robust nature of our processes and this is reflected in the cost of our policies.
Market and trading risks
A significant number of the projects in which we have an interest operate without PPAs and are, therefore, vulnerable to market forces, which determine the price and amounts of power sold and fuel and CO2 allowances purchased. In particular, the majority of our plants in the UK, North America and Australia operate on a merchant basis. In order to limit our exposure to market movements, we hedge a proportion of our anticipated output by forward selling power and buying forward related commodities including fuel, transmission rights, capacity and emission credits. The key risks facing our market and trading activities and their mitigating factors are set out below.
Hedging activities
Unhedged output is subject to price and volume volatility. To reduce this uncertainty, we operate a ‘rolling hedge’ programme under which we increase the proportion of output that is sold forward as the production date approaches. Whilst we generally aim to hedge a relatively high proportion of our output for the following year, this strategy is dependent on market conditions. Due to market liquidity considerations the majority of our hedging activity is for a maximum period of two years ahead.
It is not always possible to exactly match the expected output of a plant with power sales and fuel and other commodity purchases. Mismatched positions have the potential to result in substantial losses. This potential exposure is addressed in our trading policies, which limit the potential size of mismatched positions.
In addition to asset-backed trading we carry out some proprietary trading (trading not linked to the expected output of our power plants). Our non-asset backed trading activities are limited in scope and any exposures are correspondingly small.
Framework for trading activities
Our trading activities operate within a robust framework of policies and oversight functions. Trading and forward contracting strategies are continually reviewed by regional and corporate trading and risk management professionals, to ensure they are best suited to both local market conditions and corporate risk guidelines. A Group-wide oversight of our trading operations is provided by a Global Commodities Risk Committee (GCRC) which includes the CFO, the head of finance, head of trading and the global trading and risk managers. The GCRC acts under the authority of the Board, and delegates limits and authorities to local risk committees, which have been established in each of our trading operations to oversee the management of market, operational and credit risks arising from our marketing and trading activities. The local risk committees include the trading manager, global and local risk managers, regional directors and senior managers.
Energy market risks and counterparty exposures on our asset and proprietary portfolios are measured and managed using various statistical techniques.
Fuel supply risks
Fuel supply security is fundamental to our business. Most of our markets have robust supply infrastructures, and other factors further enhance our position. These include: mines local to the power plant, fuel storage, dual-fuel capability and sourcing from a number of reputable suppliers. Consequently, we have experienced very few supply interruptions that have had an impact on operations.
We procure fuel under a variety of contractual arrangements ranging from long-term fuel supply agreements (FSAs) to on-the-day merchant gas purchases. The principal determinant of our fuel supply activity is the need to match purchases to power sales, both in terms of volume and price. Hence, we operate long-term FSAs at power plants where we have long-term PPAs and predominantly merchant supply arrangements in our merchant power markets. This strategy helps mitigate against fuel price impacts, particularly in the current climate of high fuel prices, and the spread is locked in on the basis of operational profitability.
It is not always possible to achieve an exact balance between fuel purchases and power production. This is particularly an issue for our projects with PPAs, where the associated FSAs often have minimum fuel purchase obligations. By structuring the purchases flexibly and incorporating appropriate force majeure protection, we are able to mitigate this risk by ensuring, as far as possible, that the price and volume obligations in the PPA and FSA mirror one another and, to date, we have never experienced a significant financial impact due to mismatches between our FSAs and PPAs.
Country and political risks
Most of our projects with PPAs are in countries with a significant degree of country risk. In the past, some PPA tariffs have been reopened by our offtakers and renegotiated. We do not currently foresee the prospect of further renegotiations but this remains a general possibility.
We address country risk exposures in several ways. Country risk assessment is an important element of our due diligence, prior to participating in a project, and we favour projects where international arbitration is available for resolving disputes. Once projects are operational, International Power always strives to be a ‘good neighbour’, supporting the local, regional and national communities wherever possible. We also attempt to maintain good relationships with political institutions and our customers.
The size of our portfolio dilutes the effect of a dispute, at any given project company, on the Group as a whole. Furthermore, non-recourse debt arrangements limit our financial exposure to the loss of our equity investment and future cash flows from the project. Thus, whilst the loss or impairment of assets in a project company might affect the financial performance of the Group, other operating companies would remain unaffected.
Construction and operational risks
Our policy with regard to new-build is, wherever possible, to award major projects on an EPC basis to suitably qualified contractors. EPC contracts transfer the majority of the design and construction risks to the contractor, and provide substantial protection through liquidated damages, in the event of failure on the part of the contractor to meet contractual completion or plant performance targets. Where there is a project specific need to adopt a risk sharing approach within the contract, this is done on the basis of deliverable technical and performance assumptions and with due regard to the ability to manage these risks. We supplement this contractual protection with insurances.
The rapid growth in demand for new power capacity globally and rising raw materials prices have contributed to significant price increases and longer lead times for the delivery of power plant equipment. If this trend continues, there is a risk that greenfield project development timescales will be extended further and, in addition, the ability to secure extensive commercial protection from the original equipment manufacturers will become more difficult. This risk is generally greater for coal fired plant because of longer construction lead times. We continue to work with the main suppliers, such as Alstom, General Electric, Mitsubishi and Siemens, with whom we have long-term relationships, with emphasis on our growth plans and long-term opportunities.
Power plants are characterised by extremely high temperatures, pressures, voltages and rotational velocities. Providing a safe environment for people on our sites and in surrounding areas is a major priority. We achieve a safe environment by using a combination of engineering and operational procedures and standards, provision of training, performance monitoring and by employing experienced staff. In addition, we are currently developing a new engineering risk assessment approach to assist in the identification and management of the key engineering risks across the plant portfolio. This will be rolled out in 2008 to further enhance our approach to risk management.
We are a minority participant in a number of projects and do not set operational standards in such cases. In such circumstances we provide support, where appropriate, and attempt to use our influence to achieve standards that are equivalent to our own. However, our ability to influence partners varies.
During the build period we closely monitor the progress of four major factors: construction programme, cost, quality and safety. Once a plant is in operation we monitor performance by reference to a number of performance indicators including, for example, the technical availability, net maximum capacity, thermal efficiency and forced outage rate.
Health, safety and environmental risks
Excellent HS&E performance is critically important for our business. Risks range from enforced plant closures and substantial fines to damage to the well-being of our staff and to our reputation in the wider community.
HS&E compliance activities
At plant level, HS&E requirements are set by corporate, local and national standards and regulations, and individual plants operate within site specific environmental licensing limits. We have an ongoing HS&E audit programme to provide assurance in this area and we closely monitor the accident frequency rate (AFR) and breaches of environmental permits. AFR and reportable environmental incidents are amongst our KPIs.
Plant operating and monitoring procedures are effective in ensuring that we comply with the conditions of our environmental licences and consents. Whilst we have experienced occasional breaches of our environmental operating limits, there have been no recent incidents that have posed a significant threat to the environment or to our ability to run our plants.
Sites are required to adhere to a set of corporate health and safety standards and to local regulations. Health and safety performance is the responsibility of our plant managers, who are supported by local health and safety specialists. Our global health and safety manager is responsible for ensuring that our corporate standards remain current and are understood by all of our sites.
Environmental regulation
Environmental legislation is one of the key drivers of the long-term development of the electricity industry. Initiatives to reduce greenhouse gas emissions are expected to impose increasing commercial constraints on our ability to emit CO2, and hence our ability to use fossil fuels to generate power without the use of carbon capture and storage. The impact of carbon reduction measures is currently most apparent at our European plants, where we are required to ensure that we have sufficient carbon credits to support our expected levels of generation. Certain of our projects have change of law protection, which enables us to pass on any carbon costs to the offtaker. In such cases the economic impact of carbon risk is removed.
In January 2008 the EU issued proposals for carbon allowances post 2012. If accepted, operators of European power plants will receive zero carbon allowances. The EU further mandated substantial renewables targets. Both of these factors will inevitably impact on our portfolio in the medium to long-term.
At the end of 2007 there was a change of government in Australia and one of the first acts of the new administration was to sign up to the Kyoto Protocol on climate change. Australia is now committed to introducing a cap and trade-based carbon market similar to the European Union Greenhouse Gas Emission Trading Scheme (EUETS) by 2010. Australia is not expected to have difficulty in meeting its Kyoto targets and the impact on our business is not expected to be great in the period up to 2012.
In the US discussions have continued at state level that could lead to CO2 limitations being introduced some time in the future. The absence of single, centrally sponsored, proposals decreases the predictability of final outcomes.
At the global level there is uncertainty over what, if anything, will replace the Kyoto Protocol on climate change when it expires at the end of 2012. Most governments in developed countries have introduced legislation to incentivise renewable generation to the point where growth in renewable generation may have a material impact on our fossil fuelled plants. In response, we made major investments in renewable energy during 2006 and 2007. We have also dedicated resources to reviewing technology trends in order to ensure that we are well positioned to participate in the drive towards a lower carbon environment.
Staffing and HR risks
The power industry has a history of long-term employment at plant and corporate level and staffing is not generally a day-to-day risk issue.
Our industry is highly competitive and we have to balance resources against the need to contain costs. We utilise our extensive experience to make these judgements and have the ability to mobilise people at short notice to mitigate the risk of loss of key staff. To date we have not experienced any disruption of note as a result of unexpected staff unavailability.
We anticipate that terrorism may be a threat to our staff and assets in the foreseeable future. In order to reduce this threat we liaise with local law enforcement organisations on security issues and our corporate security specialist assists vulnerable sites to assess and reduce their exposures. We also utilise the services of a global security consultancy to ensure that our risk assessments and physical security measures fully reflect local conditions. The consultancy additionally has the capacity to provide personal security services if required.
Certain of our sites have high union representation. We have not been affected by industrial action for several years but this remains a risk. We maintain active dialogues with staff unions to ensure that we are aware of any potential issues in good time to mitigate our risks.
Victoria
Indonesia
UK
UK
Georgia
