Principal Risks and Uncertainties
RISKS
In the day-to-day operations of the Group we face many risks and uncertainties. Our job is to mitigate and manage these risks, and the Board has developed a formal risk management process to support this. Set out below are the principal risks and uncertainties which we believe could adversely affect us, potentially impacting our employees, operations, revenue, profits, cash flows or assets. This list is not exhaustive – there are many things that could go wrong in an operation as large and geographically diverse as ours – and the list might change as something that seems immaterial today assumes greater importance tomorrow.
The foundation upon which the Group's risk management process is built is the Group Risk Register. This is compiled based on input from the businesses across the world as well as a top-down review by members of the Executive Committee and Board. This forms the basis of the mitigation strategies put in place for all the key identified risks. In the section below, we have picked from the Risk Register those items we currently consider to be our most important risks. The order in which they are presented is not significant.
ECONOMIC CONDITIONS
There is a link in our business between demand for our services and levels of economic activity; this link is particularly evident in the Local business albeit in the last two years we have also seen signs of lower levels of economic activity impacting our Power Projects business. In the Local business if GDP growth goes negative, demand for rental equipment is likely to shrink even faster and this impact is likely to be multiplied by pricing weakness at times of low demand. We also have some businesses which, by their nature, are exposed to particular sectors – for instance, a material proportion of our North American business comes from upstream and downstream oil & gas, our Australian business is highly dependent on mining activity and our Singapore business has a high proportion of shipping activity.
We are sometimes asked whether the drivers of growth in Power Projects are 'cyclical' or 'structural'. The answer is that one is affected by the other; the immediate force of the structural drivers is affected by the economic environment. In the long-term, the drivers of growth – increasing demand for electricity and inadequate investment in supply – are structural. But the decision to spend hundreds of millions of pounds on sustaining electricity supply using temporary solutions is in most cases a political one. The budgets of utilities in developing countries are generally controlled by government, and money spent on temporary power is money that has to be diverted from elsewhere; the easiest, simplest thing to do is to just put up with power cuts and not spend the money. Only when the pressure becomes intolerable will the coffers be opened. Intolerable pressures include demands from industry and commerce desperate for power; from voters angry about lack of power.
The balance of pressure and availability of money are both affected by economic circumstance and sentiment. If economic growth is strong and tax revenues are growing; if industrial activity is expanding, and deficits under control; if debt is cheap, then customers will be more inclined to spend money on temporary power. This was generally the case in the decade up to 2012. In the last two years, economies in emerging markets have seen lower rates of growth and greater uncertainty, and accordingly the willingness and ability of governments to spend money on temporary power has been tempered.
We mitigate this risk in a number of ways. First, having a global footprint and a fleet that can work almost anywhere is a great advantage because we can move rental fleet between businesses; for example, in 2013, we satisfied the Local business' requirements for large generators out of our Power Projects business, where we currently have some excess capacity. Secondly, we try to ensure that, as they grow, our businesses build a customer-base which is as diverse as possible, to minimise exposure to any single sector or geography. In Brazil we continue to invest in temperature control to reduce our sectoral exposure to offshore oil & gas; while in Russia we are expanding to enable us to develop under-penetrated sectors such as mining. Thirdly, we can quickly reduce capital expenditure which was demonstrated in 2013 by our new fleet investment being £210 million lower than in 2012. Given the large depreciation element in the business' cost base (£273 million in 2013), reducing capital expenditure to a level close to depreciation makes the business very cash generative which, in turn, reduces debt and interest cost.
Another economic factor to consider is the price of fuel, which is usually the single biggest element in the cost of running a generator. Over the last few years, the price of fuel has been fairly stable, with the Brent Blend price1 at around $110. We would not say that the oil price staying persistently high has had a direct impact on people's willingness to rent; people rent generators because they need power, not because it is a cheap way of generating electricity, however, it is most likely a contributing factor when combined with lower levels of economic activity and currency devaluation in certain markets. The overall impact of the oil-price on our business is that, at times when it has been high it has produced huge wealth in oilproducing countries which has been re-cycled into infrastructure investment and this, in turn, stimulated demand for our services. If the oil-price is persistently low – by which we mean under $50 per barrel – we would expect to see an adverse impact on our business in a number of oil-producing countries.
Exchange rate fluctuations can have a dual impact on our performance. The first impact of exchange is a direct one when we translate into our reporting currency, Sterling, as the Group's asset values, earnings and cash flows are influenced by a wide variety of currencies owing to the geographic diversity of the Group's customers and areas of operation. Around two thirds of the Group's revenue and costs are denominated in US Dollars; the next largest currency exposures are the Euro and Australian Dollar, both of which account for around 6% and the Brazilian Real which accounts for around 5% of revenue and costs respectively. The relative value of currencies can fluctuate widely and could have a material impact on the Group's asset values, costs, earnings, debt levels and cash flows, expressed in Sterling. We manage the transactional exchange impact through hedging and denomination of borrowings but we do not try and manage translational exchange impact. In terms of translational exchange, a 5 percentage point movement in the Sterling/Dollar exchange rate would have had an impact in 2013 of around £49 million on revenue and £12 million on trading profit. With respect to our other major currencies a 5 percentage point movement would give rise to a translational impact in the region of £18 million on revenue and £5 million on trading profit. The second impact of exchange rate fluctuations is indirect and mainly impacts our Power Projects business where we tend to transact in US Dollars as the cost base of the Power Projects business is mainly in US Dollars, so we have a natural hedge against exchange rate movements. That said, most of our customers will be collecting their revenues in local currency and in countries where in the last year we have seen significant devaluation against the US Dollar, this will be impacting the affordability of temporary power.
POLITICAL RISK
Power Projects
This section should be read in conjunction with the subsequent section on failure to collect payments. The Group operates in around 100 countries, many in Africa, Asia and Latin America. In some jurisdictions there are significant risks of political instability which can result in civil unrest, equipment seizure, renegotiation or nullification of existing agreements, changes in laws, taxation policies or currency restrictions. Any of these could have a damaging effect on the profitability of our operations in a country.
Prior to undertaking a contract in a new country, we carry out a risk assessment process to consider risks to our people, to assets and to payments. By far the greatest exposure to political risk is in the Power Projects business. In all cases, the safety of our employees is always our first concern, and if the level of risk is considered unacceptable we will decline to participate in any contract; where there are potential risks, we develop detailed security plans to ensure the safety of our employees. In terms of asset risks, the Group uses a wide range of tools and techniques to manage risk, including insurances, bonds, guarantees and cash advances. Power Projects' financial exposures are monitored by the Board on a monthly basis and action plans to address assets, payments or tax exposures are reviewed.
Generally, we find that Governments are keen to behave in a fair way to suppliers of critical infrastructure, such as Aggreko. In the last five years, we have had two incidents, both of which were subsequently resolved, where our equipment was seized by authorities as a result of tax or import duty disputes. Neither of these were material to a Group of our size, but either could have been fatal to a small company. Both are indicative of the fact that we operate in countries where the behaviour of the authorities can be unpredictable, and not always in line with contractual commitments.
The quantum of political risk faced by the business has grown in recent years with the rapid expansion of our Power Projects business, but the benefit of scale is that the risk becomes more diversified.
Scottish Independence
Apart from the political risk which has always been an inherent part of our Power Projects business, we now face a new risk; this is the possibility that Scotland, which is where we are headquartered and have our global manufacturing and product development facility, might separate from the rest of the United Kingdom. Without wanting in any way to enter the political debate on this issue, we have a reporting responsibility to set out in our Annual Report the risks facing the business, and we believe that Scottish Independence could present a number of risks.
At an operational level, it is likely that we would have to deal with significant additional administration cost and complexity in our UK operations, which we currently run as a completely integrated unit, sharing fleet and people without impediment. Following Independence, our UK business operations would have to be split into two separate trading entities, and every time we moved an item of fleet across the border, invoices would have to be raised, and balance-sheets adjusted; we would have to account for tax purposes for our employees' days spent either side of the border. Second, we assume that an independent Scottish Government would wish to have its own distinctive approaches to the taxes and regulations which we currently deal with on a UK level; if Scotland were independent there would potentially be different rates of VAT, personal and corporate tax, different approaches to employment rights, pensions and health and safety. Managing these differences would add complexity and cost to our UK business.
There are also two major macro-economic risks which might affect us. The first is currency, where it seems that the two options for an independent Scotland are either a currency union with the rest of the UK, or a separate Scottish currency. Neither of these options are without risk for our business.
The second macro-economic risk relates to the European Union and the regulation of international trade. Operating as we do in over 100 countries, and with equipment being shipped daily around the world from our factory in Dumbarton, the regulation of international trade is important to us; at present, we are largely governed by agreements negotiated by the EU, which has the heft of being one of the largest trading blocs in the world. We also make extensive use of EU and UK trade promotion. There is a risk that an independent Scotland might not be able to continue in membership of the EU, and that could impact the terms under which we export around the world.
In summary, if Scotland were to leave the United Kingdom and become an independent country, it would likely burden our UK business with added operating complexity and cost. There is also a risk that the outcome of the issues of currency and membership of the EU will not be helpful to our business. At the very least, if Scotland votes for independence we will face some years of uncertainty and hiatus. We will, of course, find ways to manage around this challenge if it arises. The major impact will be in the UK, which accounts for less than 10% of our revenues, and as a global business we will have plenty of options.
FAILURE TO COLLECT PAYMENTS OR TO RECOVER ASSETS
Non-payment is one of the biggest risks the Company faces. The vast majority of the contracts into which the Group enters are small relative to the size of the Group and, if a customer fails to pay a debt, this is dealt with in the normal course. However, the Group has some large contracts in developing countries where payment practices can be unpredictable. The truth is that, with contracts in around 100 countries, there are always two or three large customers who are misbehaving as far as payment is concerned, and we constantly monitor the risk profile and debtor position of such contracts, deploying a variety of techniques to mitigate the risks of delayed or non-payment. This mitigation will vary from customer to customer, but our armoury includes obtaining advance payments, letters of credit, bank guarantees and, in some cases, insurance against losses. As a result of the rigorous approach to risk management, the Group has never had a significant loss although we have had some very near misses. While the scale in our Power Projects business makes it less likely that any bad debt would be material to the Group's balance sheet, the increased number of contracts and countries in which we operate increases the likelihood of a loss and makes it highly likely that, at some stage, a major customer will default or prevent us from repatriating assets.
The risk of non-payment of a receivable presents a particular risk for a public company such as Aggreko, because our customers are rarely attuned to our obligations to update the market regularly on our performance. While we seek to ensure that no single country could cause the Company material medium or long-term damage, failure to collect a major debt could result in an unexpected, and possibly significant, reduction in our profits in any given reporting period. The impact of failure to collect a debt is twofold; first we make a provision or write-off the debt, and secondly, we lose future revenue and profit. We continually make judgements as to whether we need to book a provision against particular debts and, if the debts are material, they could cause us to miss a forecast and lead to a negative share price reaction. Unless a customer actually seizes equipment, deciding whether a receivable will be collected or not is more art than science and there have been several occasions when we have had to make difficult judgements as to when to provide for a debt.
We take a prudent approach to providing for bad debt risk, and in 2013 held provisions of £49 million against this risk in the Power Projects business. Even though we have an ever broader portfolio of contracts, and therefore a more diversified portfolio of risk, we caution investors that the current high returns on capital that we earn, particularly in our Power Projects business, are in effect 'risk-unadjusted', although by carrying large provisions we have partly mitigated this risk by taking a prudent approach to bad debt provisioning. So far, no customer has behaved badly enough to cause us a major problem but, as we repeatedly tell people, it is probably only a matter of time before they do.
EVENTS
The business is, by nature, driven by events. People hire generators because some event or need makes it essential. Aggreko's revenues, cashflows and profits can be influenced significantly by external events as evidenced by the Japanese tsunami or by the contracts to supply power to the military camps in Afghanistan. These events are, by their nature, difficult to predict and, combined with the high operational gearing inherent in our business, can lead to volatility in trading outcomes. By developing the business globally, as well as by increasing and broadening the Group's revenue base, the impact of a single event on the overall Group will reduce. Additionally, the ability to move equipment around the world allows the Group to adjust to changes in utilisation caused by any changes in demand.
FAILURE TO CONDUCT BUSINESS DEALINGS WITH INTEGRITY AND HONESTY
Some of the countries in which the Group operates have a reputation for corruption and, given that many of our contracts involve large sums of money, we are at risk of being accused of bribery and other unethical behaviour. The first and most important way of avoiding this risk is to ensure that people, both inside and outside the Group, know that Aggreko does not engage in, and will not tolerate, bribery, corruption or unethical behaviour. We have a strict Ethics Policy, a copy of which is available on our website www.aggreko.com. Rather than just publishing it, we get every employee to sign it when they join the business; every consultant acting on our behalf agrees in writing to abide by it, and every consultancy or agency agreement has an explicit term stating that the agreement will be terminated immediately if the consultant or agent does not abide by our policy. We have a confidential, multi-lingual hotline, available worldwide, which allows any employee who has any ethical concerns to report them to an independent third party on an anonymous basis.
While the risk of unethical behaviour can take many forms, the most significant risk we run in this area is the behaviour of third party sales agents and consultants in our Power Projects business. Given the ephemeral nature of this business – there might be no business for us in a country for five years and then suddenly a power crisis might present an opportunity to supply 100MW for six months – it is not practical to maintain full-time salespeople in each of the 150 countries where we do, or could conceivably do, business. Instead, we make agreements with organisations which know a country well, can keep our services on the radar of decision makers, and keep us briefed on opportunities. When an opportunity arises, we send in our own salespeople to work with them. These consultants do not get paid a retainer and may receive no compensation other than a 'thank you' and a pat on the back for years; the reason why they are prepared to do this is because when we do win a contract they are well rewarded. And they work hard for the money, often taking responsibility for the supply of critical elements of the project such as finding power-plant sites, providing administration and technical services, labour and security. The fact that they are only paid on results might be seen to raise the risk that they are tempted to indulge in bribery to secure their income. How do we protect against this? In our view, it is all down to the choice of the sales consultant and, to this end, we carry out comprehensive due diligence on all potential candidates. Before we appoint an agent or consultant, we use specialist third-party investigators to conduct comprehensive background checks on them; these checks include obtaining bank references and searches for previous records of inappropriate behaviour or of any family or other links with the customer or government. Once a sales consultant has been appointed, we keep a close eye on them. Payments made to agents and sales consultants are subject to audit by internal auditors to ensure they are in accordance with the agreements, and we have a fulltime Compliance Officer who continuously monitors our dealings with sales consultants and agents. In addition, we carry out regular training of managers and salespeople who deal in at-risk jurisdictions and, from time to time, we conduct independent reviews of contract files. We also structure our sales consultancy agreements to allow us to terminate any agreement immediately and without compensation in the event that we suspect any inappropriate behaviour. Given that these sales consultants have much to gain by working for us, this is a powerful incentive to behave.
We model our compliance regime around the requirements of the UK Bribery Act and the US Foreign Corrupt Practices Act (FCPA). A subcommittee of the main Board was formed in 2011, the Board Ethics Committee, which is composed entirely of Non-executive Directors, who meet to approve our ethics-related policies and procedures, and the compliance thereof. A report from the Committee is set out in the Ethics Committee Report.
SAFETY
The business of the Group involves transporting, installing and operating large amounts of heavy equipment, which produces lethal voltages or very high pressure air and involves the use of millions of litres of fuel which could cause serious damage to the environment. Every day, we manage the risks associated with this business, and we have carefully designed procedures to minimise the risk of an accident. If these procedures are not followed however, accidents can happen and might result in injury to people, claims against the Group, damage to its reputation and its chances of winning and retaining contracts.
The Group has a proactive operational culture that puts health and safety at the top of its agenda in order to reduce the likelihood of an accident. We work very closely with our customers, employees and Health & Safety authorities, to evaluate and assess major risks to ensure that health and safety procedures are rigorously followed. The Group has developed health and safety KPIs which are reviewed by the Board on a regular basis.
COMPETITION
Aggreko operates in a highly competitive business. The barriers to entry are low, particularly in the Local business and, in every major market in which we operate, competitors are constantly entering or leaving the market. We welcome this competition as it keeps us sharp and also helps to grow the overall rental market which, in many countries, is underdeveloped.
We monitor competitor activity carefully but, ultimately, our only protection from suffering material damage to our business by competitors is to work relentlessly to provide our customers with a high quality and differentiated service proposition at a price that they believe provides good value.
PRODUCT TECHNOLOGY AND EMISSIONS REGULATION
The majority of Aggreko's fleet is diesel-powered, and some of our equipment is over ten years old. As part of the increasing focus on environmental issues, countries continue to introduce legislation related to permissible levels of emissions and this has the potential to affect our business. Our engines are sourced from major manufacturers who, in turn, have to develop products which conform to legislation, so we are dependent on them being able to respond to legislation. We also have to be aware that when we buy a generator we want to be able to rent it for its useful life and to be able to move it between countries.
To mitigate these risks, we adopt a number of strategies. First, we retain considerable in-house expertise on engine technology and emissions – so we have a good understanding of these issues. Secondly, we have very close relationships with engine manufacturers so we get good forward visibility of their product development pipeline. When new products appear – particularly those with improved emissions performance – we aim to introduce them into the fleet as quickly as possible to ensure that, over time, our fleet evolves to ever-better levels of emissions performance. An example of this is the significant investment we have made in the development of our gas-fuelled technology in recent years: these engines have significantly reduced emissions compared with other fuel types. Gas powered generation now accounts for 1,485MW of our fleet, made up of 1,210MW in our Power Projects fleet and 275MW in our Local business fleet. Thirdly, if emissions-compliance becomes such an issue that it begins to impact our business in a material way in some territories, our global footprint will be a major advantage as it gives us numerous options for the re-deployment of our fleet. An example of this is in our North American business where, by the end of 2013, around 40% of the fleet is either Tier 3 or Tier 4 compliant, with the previous fleet being re-deployed to other parts of the Group.
PEOPLE
Aggreko knows that it is people who make the difference between great performance and mediocre performance. This is true at all levels within the business. We are keenly aware of the need to attract the right people, establish them in their roles and manage their development. As a framework for people development, we have in place a talent management programme which covers most of the management population. Under this programme, we try to identify the development needs of each individual from the outset, as well as identifying successor candidates for senior roles. We also have an ongoing relationship with one of the world's leading business schools, IMD, to deliver a tailor-made Group-wide management education programme.
Another risk is that competitors seek to recruit our key personnel. For many years, Aggreko has been a target for recruitment and we manage this on a daily basis. We actually regard it as a compliment that so many companies want to recruit our people. The main mitigation for this is to make sure that people enjoy working for Aggreko, that they feel that they are recognised, cared for, and have challenging and interesting jobs. Reward is also an important part of the equation, and there can be little doubt that our policy of rewarding people well for good performance, and of having a successful Long-term Incentive Plan, has acted as a powerful retention tool.