Risks and risk management

Achieving Vattenfall’s strategic ambitions requires economic value creation and profitable growth. This is to take place within the framework of safe energy generation in all respects. These ambitions are important guiding points in Vattenfall’s continued work on being competitive, creating value, being a positive force in the industry and contributing to sustainable development in society. Vattenfall creates economic value when it exceeds the required rate of return on net assets with a set level of balanced risk.

Risk organisation

Vattenfall’s operations are exposed to a number of risks that affect earnings and the balance sheet. To address these risks, Vattenfall has established a risk management organisation and process. Governance takes place through a set strategy and established body of rules. To be able to effectively manage risks, methods and models are being continuously being developed to measure and evaluate risks.

The Board of Directors has overarching responsibility for internal control and risk management at Vattenfall. The Board, in turn, has given Vattenfall’s management a risk mandate. Management delegates this mandate to Vattenfall’s business units. Each unit manages its own risks and has some room to manoeuvre within its respective mandate, and is responsible for ensuring compliance with reliable methods for measuring risks. The results achieved by the units are followed up on a continuous basis and reported to the executive management in accordance with set reporting routines. Risk reporting and the utilisation of mandates are conducted by an independent risk control function.

The Group’s risk management is co-ordinated by a Risk Committee (VRC) under the direction of the CFO. This committee is tasked with reviewing principles and mandates, and approving risk instructions. The committee is also responsible for ensuring that uniform definitions of risks are used within the Group. In addition to the VRC, Vattenfall has several local risk committees and risk-specific committees; for example, environmental risks are co-ordinated and evaluated by the Group’s Environmental Committee.

To further improve risk management and governance within the company, Vattenfall has adopted the use of Enterprise Risk Management (ERM). Implementation was carried out in 2008 and will continue in 2009. ERM gives management an effective means of taking uncertainties, risks and opportunities in the company into account and comparing them with each other. Through this, management gains better guidance in business decisions and business planning as well as support in achieving its strategic objectives. Once the process is fully implemented, continuous identification, valuation, management and reporting of all types of risk will be conducted.

Risks at Vattenfall

Political risks, operational risks and environmental risks are general in nature and exist in all units throughout the Group. The more specific risks in each part of the value chain are discussed on Definition of risks. Insurable risks are managed centrally by Försäkrings AB Vattenfall Insurance. The Group’s funding is conducted primarily through Vattenfall Treasury AB, the Group’s internal bank. The treasury operation aims to provide cost-effective management of the Group’s financial risks. The Group’s loans, investments and currency trading are handled for the most part by Vattenfall Treasury AB and, to a lesser extent, by Vattenfall Europe AG. The Group’s liquidity is centralised in Group cash pool systems. The main risks that arise in connection with the Group’s financing are liquidity risk, interest rate risk, currency risk and credit risk. For a quantification of financial risks, see Note 35 to the consolidated accounts.

Political risk 1

Political risk is defined as the business risk that can arise as a result of political decisions. Examples of this are price regulations in electricity distribution and transmission, uncertainty regarding a new political majority, or changes in finance policies. In connection with acquisitions and other investments, this type of risk is managed by adjusting the cost of capital.

Another type of political risk stems from changes in the rules governing the energy industry. These can concern such factors as changed taxes, environmental surcharges, changes in environmental legislation and permit requirements, changes in how natural monopolies are regulated, and political objectives regarding the composition of the energy system. This type of risk is more difficult to predict and protect against. To mitigate this risk, Vattenfall conducts active business intelligence activities and maintains contacts with decision-makers in relevant markets. Vattenfall also belongs to various national and international trade organisations.

Operational risk 2

Operational risk refers to the risk of incurring financial loss, or a loss of trust, due to errors or defects in the company’s routines.

• Administrative risks - the risk of loss due to shortcomings in the company’s division of responsibility, competence, reporting routines, risk measurement and evaluation models, and in control and follow-up routines
• Legal risks - the risk of loss arising from the non-fulfilment of contracts due to shortcomings in documentation, counterparties lacking the right to enter into contracts or uncertainties regarding contract validity
• IT and information security risks - the risk of loss due to defects or other disruptions in IT systems and the handling of Vattenfall’s information assets
• Nuclear safety - the risk of outages due to deficient safety work and a deficient safety culture (read more on Nuclear power)

To limit operational risks at Vattenfall, each business unit is responsible for ensuring that well-documented routines, reliable IT systems and satisfactory internal controls are in place. For more information, see Corporate Governance Report.

Environmental risk 3

Vattenfall works systematically to maintain control over the environmental risks that the company’s operations can be believed to give rise to. Environmental risk work is also conducted as part of the company’s ambition to be Number One for the Environment.

The general concept of “environmental risk” can be broken down into two categories: environmental risks and environmental liabilities.

Environmental risks

A combination of, and the probability of, an activity that results in environmental damage. Environmental damage is defined in this context in accordance with Article 2 in the Environmental Liability Directive (2004/35/CE).

Environmental liabilities

Cases where emissions, use of substances, or the use of technology in accordance with currently applicable environmental legislation requires remedial measures and/or where demands are made on financial reporting of provisions. The consequences of an environmental risk can entail the following, for example:

• Contamination/clean-up costs
• Impact on the Vattenfall brand
• Opinions and policies that lead to more cumbersome permit application processes and production limitations

The business units’ reporting on environmental liabilities covers the following areas, among others:

• Air, water and ground pollution
• Oil-filled cables with lead encapsulation
• Mercury in electrical equipment and fumes
• Insulation in electrical equipment
• Asbestos in thermal power plants and CHP plants
• Magnetic fields from transformers and power lines

Risk management

At the end of each year a compilation is prepared of the company’s environmental risks and environmental liabilities, and of the provisions and actions that are needed. This compilation is based on joint-Group reporting according to definitions that are decided on internally. This analysis includes a general evaluation of the risk situation and the trend in recent years.

Much of the work on continuously preventing and controlling environmental risks is conducted locally and is based on the knowledge and experience that exists in the Group’s units. In addition to this, the business units are responsible for identifying and expressing risks and liabilities in accordance with the joint definitions in order to create an overall picture for the Group.

Preventive action in this area is one way of enhancing the Group’s competitive strength in the long term. To give an example, in the German companies, provisions have been made to clean up contaminated land and restore land after coal mining. This also applies for areas in which action plans have been drawn up in consultation with the pertinent authorities.

Liquidity risk 4

Liquidity risk pertains to the risk of not being able to pursue the trading strategy due to insufficient liquidity in the market. Liquidity risk is minimised by maintaining an even maturity structure and a long average remaining term in the company’s debt portfolio. The maturity profile of Vattenfall’s debt portfolio is shown in the diagram in Note 35 to the consolidated accounts.

To safeguard the availability of funds and maintain flexibility, the Group has several types of debt issuance programmes. The Group’s target for short-term liquidity is always to have no less than 10% of the Group’s sales and at least the equivalent of the next 90 days’ maturities in the form of liquid assets or committed credit facilities. Vattenfall’s credit rating for long-term and short-term borrowing respectively is A-/A-2 from Standard & Poor’s and A2/P-1 from Moody’s. Vattenfall’s goal with regard to credit rating is to maintain a rating in the single A category.

Interest rate risk 5

Interest rate risk in the Group’s debt portfolio is measured in terms of duration, which is permitted to vary from a norm of 2.5 years by up to 12 months either way. The duration of the Group’s debt portfolio at year-end was 2.4 years. Including Capital Securities the duration was 2.9 years. To adjust the duration of borrowing, the company uses interest rate swaps, interest rate forwards and options, among other things. The Group’s interest rate sensitivity during a 12-month period is shown in the diagram in Note 35 to the consolidated accounts.

Currency risk 6

Currency risk pertains to the risk of a negative impact on the consolidated income statement and balance sheet caused by changes in exchange rates. Vattenfall is exposed to currency risk through exchange rate movements attributable to future cash flows - transaction exposure - and in the revaluation of net assets in foreign subsidiaries - translation exposure (or balance sheet exposure). The Group’s goal in managing currency risk is to minimise exchange rate effects while taking into account hedging costs and tax aspects. Currency exposure in borrowing is eliminated using currency interest rate swaps for the purpose of avoiding the effect of exchange rate differences on earnings.

The Group has limited transaction exposure, as most generation, distribution and sales of energy take place in the respective companies’ local markets. In the Nordic operations, most transaction exposure arises in conjunction with the hedging of electricity prices, primarily on Nord Pool, while in the German and Danish subsidiaries, transaction exposure arises primarily in conjunction with purchases of fuel. In both cases, currency risk is managed through the use of forward exchange contracts.

The Group’s units shall hedge contracted transaction exposure when it exceeds the equivalent of SEK 10 million. Hedges are made through Vattenfall’s Treasury unit, where currency risks are managed within established risk limits for interest rates and currencies. The Group’s translation exposure is reported in Note 35 to the consolidated accounts.

Credit risk 7

Vattenfall uses external rating information, where available, to manage and limit its credit risk. In other cases, internal models are used to establish the creditworthiness of its counterparties. Individual limits are established for each counterparty, and each counterparty is assessed on a regular basis. Exposures are followed up in relation to the credit limits on a daily basis. If necessary, additional credit assurances are demanded in the form of a guarantee from the Parent Company or a bank, for example. In cases were master agreements are entered into, net calculation of debts and receivables for an individual counterparty are permitted. In cases where Vattenfall has more than one master agreement with the same counterparty, a master netting agreement is desirable in order to calculate the net debt and receivable amount, even when trading in different commodities, such as electricity, coal and gas. In many cases agreements are used which limit credit risk through an arrangement by which the parties pledge assets to each other if the exposure exceeds certain, set amounts (such as CSA agreements). When contracts are made in marketplaces, such as the Nordic electricity exchange (Nord Pool) or the European Energy Exchange (EEX) in Germany, which offer central counterparty clearing, the risk is towards the market place instead.

Electricity price risk 8

Electricity price risk is the risk that has the single greatest bearing on Vattenfall’s earnings and is thus the most important factor for value creation. A sensitivity analysis of changes in the wholesale price of electricity is provided in the table below.

Vattenfall’s hedging positions in various markets as per 31 December 2007

Electricity prices are determined by fundamental factors such as water levels, available generation capacity, fuel prices, prices of CO₂ emission allowances and electricity consumption. Continuous analysis of these factors is crucial for the successful management of electricity price risk. (Read more about electricity prices on Europe's energy markets.)

Vattenfall hedges its generation and sales using physical and financial electricity forward contracts available in the market. Such hedging is done while taking into account liquidity in the market at different periods in time. As the sharp fluctuations in electricity prices have shown in recent years, forward trading is an important way of smoothing out and balancing the major price risks in operations. The amount that is hedged varies, and the Group hedges in accordance with established mandates and generally for three years ahead in time (see chart above). Vattenfall enters into long-term contracts with major industrial customers. These contracts pertain to time horizons in which there is no possibility to hedge prices in the market and which stretch as far as 2019. Total volume for the period 2012-2019 amounts to 125 TWh. The business units conduct their hedging in Vattenfall’s various markets through Vattenfall Trading Services, which hedges its own positions in external markets, such as Nord Pool and the EEX.

The mandates allocated to the various business units regulate how large of an electricity price risk is acceptable. Exposure is followed up in relation to the mandate on a daily basis. To measure electricity price risk, Vattenfall uses methods such as Value at Risk (VaR) and Profit at Risk (PaR) along with various stress tests.

Sensitivity analysis

Market-quoted price risks	Change	Impact on profit before tax, SEK million for the three-year period 2009-2011
Electricity	+/-10%	+/-15,800
Coal	+/-10%	+/-2,800
Gas	+/-10%	+/-1,300
CO2	+/-10%	+/-1,500
Uranium	+/-10%	0

The sensitivity analyses of Vattenfall’s profit based on variations in various market- quoted risks are performed independent of each other. Each parameter is calculated separately without any connection to the other risks. Most of the parameters affect Vattenfall’s earnings with respect to both income and expenses. The reason for this is the pricing connection that exists between the price of coal/gas/oil/CO₂ emission allowances and wholesale electricity prices. The connection between these is described in more detail on Europe's energy markets. The analyses take into account Vattenfall’s level of hedging as per 31 December 2008.

Plant risk 9

Vattenfall’s largest insurable risks are associated with the operation of power generation and heat production plants. Vattenfall’s plants can be damaged as a result of incidents and breakdowns of components and equipment which, as a rule, give rise to substantial costs due to outages. Plant risk also includes damage to Vattenfall’s transmission grid and distribution network.

Plant risk can be reduced through loss-prevention measures, good maintenance, training, advanced planning in the renewal of Vattenfall’s plants and good administrative routines. An example of a maintenance investment is Vattenfall’s investment programme in nuclear power, which is aimed at achieving long-term high operating safety and extended useful life.

Plant insurance

The Group protects itself against major economic loss to the greatest extent possible through insurance. Vattenfall’s nuclear power plants in Sweden have insurance cover for property damage through EMANI, a European mutual insurance association. The Nordic nuclear insurance pool participates in this insurance programme in Sweden and also writes nuclear liability insurance. Nuclear liability risk in Germany is insured by the German Mutual Atomic Energy Reinsurance Pool and by the mutual undertaking between German power plant operators.

Försäkrings AB Vattenfall Insurance, a captive company, provides various levels of contracting, property and business interruption insurance for other plants in the Group.

Electricity transmission and distribution networks are uninsured, with the exception of transformer stations and switchgear. The reasoning is that these risks are not generally covered by most insurance companies. Vattenfall continually works to reduce electricity network vulnerability.

In Sweden, companies have strict and unlimited liability for damage to third parties as a result of dam accidents. Vattenfall and other hydro power generators have therefore taken out dam liability insurance together that utilises all available capacity in the insurance market.

Vattenfall Reinsurance S.A. in Luxembourg reinsures part of the insurance obligations of Vattenfall Insurance. Economies of scale and direct access to the international reinsurance market help keep total insurance costs low.

Fuel price risk 10

Measurement and management of fuel price risk is conducted within the individual generation units. Fuel prices are affected by macroeconomic factors, among other things. Vattenfall manages fuel price risk by forecasting and analysing price trends. For example, financial and physical instruments for coal and oil are used to smoothen earnings over time. However, most of Vattenfall’s coal-fired plants in Germany use lignite from Vattenfall’s own mines. For coal-fired electricity generation, hedges on electricity and coal prices are co-ordinated to safeguard margins. Uranium is used as fuel in Vattenfall’s nuclear power plants. This price risk is limited, however, since the uranium fuel constitutes a relatively small portion of the generation cost.

Investment risk 11

Vattenfall is a highly capital-intensive company and has an extensive investment programme (see Condensed cash flow statement).

Prior to every investment decision, a risk analysis is performed. By simulating various outcomes of price, cost, delays and cost of capital, the risks associated with each individual investment are assessed.

Counterparties, number and exposure, SEK million, per rating class

The chart above shows Vattenfall’s counterparties in which the exposure is greater than EUR 5 million per counterparty. The breakdown is based on rating classes and the amount of the credit exposure per rating class. The rating classes are from Standard & Poor’s. “Other” consists of exceptions for contracts that have existed for a long time and which Vattenfall has taken over in connection with acquisitions.

Vattenfall’s Capacity Management Group function ensures that capital is invested in a way that will maximise long-term economic value. In addition to a strategic investment “roadmap”, a list of priority investment projects is continuously updated to guide the Executive Group Management in its investment decision-making process. Projects are ranked according to a number of main criteria: support of Vattenfall’s overarching strategic orientation, consequences for the existing generation portfolio, risk profile and profitability.

Volume risk 12

In the generation activities, Vattenfall manages its volume risk through analysis and forecasting activities concerning precipitation and snowmelt. Analysis models are based on extensive weather history, among other things.

Volume risk arises also in the sales activities as deviations in anticipated and actual delivered volumes to customers. Volume risks are managed by improving and developing forecasts of electricity consumption. Another way is to transfer this risk to customers when drawing up the terms of contracts with customers or by including this risk in customers’ rates.

Price area risk 13

Price area risk arises when the price of electricity differs between various geographic areas. Vattenfall’s price area risk is centralised and is managed by Vattenfall Trading Services through hedging in the respective areas in which delivery is to take place. In the Nordic countries, the Nord Pool electricity exchange provides financial instruments - area swaps - which can be used to manage price area risk. Vattenfall Trading Services is also a market maker on Nord Pool. Through this undertaking, liquidity is ensured in these financial instruments, and Vattenfall also helps spread risks for other operators.