UPM annual report 2014

Fair value estimation The different levels of fair value hierarchy used in fair value estimation have been defined as follows: Level 1: quoted prices (unadjusted) in active markets for identical assets or liabilities. Level 2: inputs other than quoted prices included within level 1 that are observable for the asset or liability, either directly (that is, as prices) or indirectly (that is, derived from prices). Level 3: inputs for the asset or liability that are not based on observ- able market data (that is, unobservable inputs). The fair values of commodity derivatives traded in active markets are based on quoted market rates and included in Level 1 Fair values of Level 2 financial instruments (e.g. over-the counter derivatives) have been estimated as follows: Interest forward rate agree- ments and futures contracts are fair valued based on quoted market rates on the balance sheet date; forward foreign exchange contracts are fair valued based on the contract forward rates in effect on the balance sheet date; foreign currency options are fair valued based on quoted market rates on the balance sheet date; interest and currency swap agree- ments are fair valued based on discounted cash flows; and commodity derivatives are fair valued based on quoted market rates on the balance sheet date. The fair values of non-traded derivatives such as embedded derivatives are assessed by using valuation methods and assumptions that are based on market quotations existing at each balance sheet date. Embedded derivatives that are identified are monitored by the Group and the fair value changes are reported in other operating income in the income statement. The Group's fair valuation procedures and processes are set by the Group management. Fair valuations are performed quarterly by respec- tive business areas or functions. Fair valuations are reviewed by the Group’s Finance & Control management and overseen by the Audit Committee. Available-for-sale investments categorised in Level 3 are disclosed in Note 22 and biological assets categorised in Level 3 in Note 20. The following table analyses financial instruments carried at fair value, by valuation method.

Operational credit risk With regard to operating activities, the Group has a credit policy in place and the exposure to credit risk is monitored on an ongoing basis. Open trade receivables, days of sales outstanding (DSO) and overdue trade receivables are followed on monthly basis. Potential concentrations of credit risk with respect to trade and other receivables are limited due to the large number and geographic dispersion of companies that comprise the Group’s customer base. Cus- tomer credit limits are established and monitored, and ongoing evalua- tions of customers’ financial condition are performed. Most of the receivables are covered by credit risk insurances. In certain market areas, measures to reduce credit risks include letters of credit, prepayments and bank guarantees. The ageing analysis of trade receivables is disclosed in Note 26. The Group considers that no significant concentration of cus- tomer credit risk exists. The ten largest customers accounted for approxi- mately 17% (17%) of the Group’s trade receivables as at 31 December 2014 – i.e., approximately EUR 240 million (240 million). The credit risk relating to the commitments is disclosed in Note 39. Electricity price risk UPM is hedging both power production and consumption in the mar- kets. UPM’s sensitivity to electricity market price is dependent on the electricity production and consumption levels and the hedging levels. In the Nordic and Central European market areas the operative risk management is done by entering into electricity derivatives contracts. In addition to hedging UPM is also trading electricity forwards and futures. As well as hedging, proprietary trading risks are monitored on a daily basis. Value-At-Risk levels are set to limit the maximum risk at any given time. Cumulative maximum loss is limited by stop-loss limits. Electricity derivatives price sensitivity Sensitivity analysis for financial electricity derivatives is based on posi- tion on 31 December 2014. Sensitivities change over time as the overall hedging and trading positions change. Underlying physical positions are not included in the sensitivity analysis. Sensitivity analysis is calculated separately for the hedge accounted and non-hedge accounted volumes. In the analysis it is assumed that forward quotation in NASDAQ OMX Commodities and EEX would change EUR 1/MWh throughout the period UPM has derivatives.

The effect in equity would have been EUR 13 million (14 million) lower/ higher, arising mainly from foreign currency forwards used to hedge forecasted foreign currency flows. The following assumptions were made when calculating the sensitiv-

the hedging instruments attributable to the interest rate move- ments balance out almost completely in the income statement in the same period. However, the possible ineffectiveness has an effect on the profit of the year. • Fixed rate interest-bearing liabilities that are measured at amor- tised cost and which are not designated to fair value hedge relation- ship are not subject to interest rate risk sensitivity. • In case of variable to fixed interest rate swaps which are included in cashflow hedge accounting, fair value changes of hedging swaps are booked to equity. • Variable rate interest-bearing liabilities that are measured at amortised cost and which are not designated as hedged items are included in interest rate sensitivity analysis. • Changes in the market interest rate of interest rate derivatives (interest rate futures, swaps and cross currency swaps) that are not designated as hedging instruments in hedge accounting affect the financial income or expenses (net gains or losses from remea- surement of the financial assets and liabilities to fair value) and are therefore included in the income-related sensitivity analysis. Liquidity and refinancing risk The Group seeks to maintain adequate liquidity under all circumstances by means of efficient cash management and restricting investments to those that can be readily converted into cash. The Group utilises com- mercial paper programmes for short term financing purposes. Commit- ted credit facilities are used to secure financing under all circumstances and as a backup for commercial paper programmes. Refinancing risks are minimised by ensuring balanced loan portfolio maturing schedule and sufficient long maturities. The average loan matu- rity at 31 December 2014 was 4.9 years (5.1 years). UPM has some financial agreements which have Gearing as finan- cial covenant. According to this covenant gearing should not exceed 110% (31.12.2014 gearing was 32%).

ity to changes in the foreign exchange risk: • The variation in exchange rates is 10%.

• Major part of non-derivative financial instruments (such as cash and cash equivalents, trade receivables, interest bearing-liabilities and trade payables) are either directly denominated in the func- tional currency or are transferred to the functional currency through the use of derivatives i.e. the balance sheet position is close to zero. Exchange rate fluctuations have therefore minor or no effects on profit or loss. • The position includes foreign currency forward contracts that are part of the effective cash flow hedge having an effect on equity. • The position includes also foreign currency forward contracts that are not part of the effective cash flow hedge having an effect on profit. • The position excludes foreign currency denominated future cash flows and effects of translation exposure and related hedges. Interest rate risk The interest-bearing debt exposes the Group to interest rate risk, namely repricing and fair value interest rate risk caused by interest rate move- ments. The objective of interest rate risk management is to reduce the fluctuation of the interest expenses caused by the interest rate move- ments. The management of interest rate risk is based on the 0.5 years aver- age duration of the net debt portfolio as defined in the Group Treasury Policy. This relatively short duration is based on the assumption that on average yield curves will be positive. Thus this approach reduces interest cost in the long term. At 31 December 2014 the average duration was 2.2 years (0.5 years). In 2014 UPM made a decision to execute certain inter- est fixing transactions, which prolonged the duration to 2.2 years. Dura- tion effect of these transactions are long-term but gradually decrease over time. The Group uses interest rate derivatives to change the dura- tion of the net debt. The Group’s net debt per currency corresponds to the parent company’s and subsidiaries’ loan portfolios in their functional curren- cies. The nominal values of the Group’s interest-bearing net debts including derivatives by currency at 31 December 2014 and 2013 were as follows:

Liquidity EURm

2014 2013

Financial assets and liabilities measured at fair value

Cash at bank Cash equivalents Committed facilities

535 165

462 325

Fair values as at 31 December 2014

Effect

2014 2013

EURm

925 1,025

Total balance

of which used

–

– –

Level 1 Level 2 Level 3

EURm

+/- EUR 1/MWh in electricity forward quotations Effect on profit before taxes

Loan commitments

–25 –76

+ / - + / -

8.6

9.6

Assets Trading derivatives

Used uncommitted credit lines Long-term loan repayment cash flow

–49

Effect on equity

5.0 5.8

1 61 52 328

–

62

–291 –506 1,233 1,257

Liquidity

2014 EUR bn

2013 EUR bn

Derivatives used for hedging Available-for-sale investments

– 380

Capital risk management The Group’s objective in managing its capital is to ensure maintenance of flexible capital structure to enable the Group to operate in capital markets. To measure a satisfactory capital balance between equity investors and financial institutions the Group has set a target for the ratio of net interest-bearing liabilities and total equity (gearing). To ensure sufficient flexibility, the aim is to keep the gearing ratio well below 90%. The following capitalisation table sets out the Group’s total equity and interest-bearing liabilities and gearing ratios:

Currency

–

– 2,510 2,510

At 31 Dec.

53 389 2,510 2,952

EUR USD GBP CAD

3.1 0.4

4.0 0.1

The most important financial programmes in use are: Uncommitted: • Domestic commercial paper programme, EUR 1,000 million Committed: • Revolving Credit Facility, EUR 500 million (matures 2016) The contractual maturity analysis for financial liabilities is presented in Note 31. Credit risk Financial counterparty risk The financial instruments the Group has agreed with banks and financial institutions contain an element of risk of the counterparties being un- able to meet their obligations. According to the Group Treasury Policy derivative instruments and investments of cash funds may be made only with counterparties meeting certain creditworthiness criteria. The Group minimises counterparty risk also by using a number of major banks and financial institutions. Creditworthiness of counterparties is constantly monitored by TRM.

Liabilities Trading derivatives

–0.2 –0.2 –0.7 –0.7 –0.2 –0.2

22 111 81 156 103 267

– 133 – 237 – 370

Others

Derivatives used for hedging

Total

2.4

3.0

At 31 Dec.

Most of the long-term loans and the interest rate derivatives related to them meet hedge accounting requirements.

Fair values as at 31 December 2013

Total balance

Level 1 Level 2 Level 3

EURm

Interest rate risk sensitivity At 31 December 2014, if the interest rate of net debt had been 100 basis points higher/lower with all other variables held constant, pre-tax profit for the year would have been EUR 4 million (4 million) lower/ higher, mainly as a result of higher/lower interest expense on floating rate inter- est-bearing liabilities. Effect to equity would be lower/higher 45 million (0 million) as a result of an decrease/increase in the fair value of deriva- tives designated as cash flow hedges of floating rate borrowing. The following assumptions were made when calculating the sensitiv- ity to changes in interest rates: • The variation of interest rate is assumed to be 100 basis points parallel shift in applicable interest rate curves. • In the case of fair value hedges designated for hedging interest rate risk, the changes in the fair values of the hedged items and

Assets Trading derivatives

As at 31 December 2014 2013

1 56

–

57

EURm

Derivatives used for hedging Available-for-sale investments

101 307

– 408

Equity attributable to owners of the parent company

–

– 2,661 2,661

7,478 7,449

At 31 Dec.

102 363 2,661 3,126

Non-controlling interests

2

6

Total equity

7,480 7,455 3,058 3,485

Liabilities Trading derivatives

Non-current interest-bearing liabilities Current interest-bearing liabilities

20 166 104 43 124 209

– 186 – 147 – 333

406

643

Derivatives used for hedging

At 31 Dec.

Interest-bearing liabilities, total

3,464 4,128 10,944 11,583 3,464 4,128 –1,063 –1,088 2,401 3,040

Total capitalisation

Interest-bearing liabilities, total

Less: Interest-bearing financial assets, total

Net interest-bearing liabilities

Gearing ratio, %

32

41

CONTENTS

ACCOUNTS

93

94

UPM Annual Report 2014

UPM Annual Report 2014