Risks and risk management

Essity is an international group with sales in approximately 150 countries and manufacturing at about 90 production facilities in some 30 countries. The geographic structure means that operations are conducted in countries and in markets with different cultures and varying degrees of maturity. Essity is exposed to a number of strategic, operational and financial risks, which could exert a negative impact on the Group’s operations. Accordingly, it is of major importance to have a systematic and effective process to identify, manage and mitigate the effects of these risks in a controlled manner.

Processes for risk management

The responsibility for the management of risks follows the company’s delegation scheme, from the Board of Directors to the President, and from the President to the Business Unit Presidents. The delegation scheme entails that risks are primarily managed by Essity’s business units at local level, but with central coordination and follow-up. The latter is mainly achieved through the business units’ continuous reporting and in the annual strategy process. Risk identification and risk management are a key part of the latter. Identified risks are classified in this process according to the likelihood of the risk becoming a reality and the potential impact it could have on the group. The model also includes how risks shall be mitigate and followed up.

Essity’s financial risk management is centralized. The Group’s internal bank handles the Group’s financial transactions and energy risks. The financial risks are managed in accordance with the Group’s finance policy, which is decided by Essity’s Board of Directors. Together with Essity’s energy risk policy, the finance policy comprises a framework for financial risk management. The risks are compiled and followed up continuously.

Essity has a corporate internal audit unit, which follow up that Essity’s organization complies with the set policies.

Based on current knowledge, the following are deemed to be the main factors that risk having a materially negative impact on the operations:

Risks that impact Essity’s ability to achieve established targets

GDP trend and economic conditions

Risk

Demand for Essity’s products is affected by general macroeconomic trends and the resulting fluctuations in its customers’ purchasing power and consumption patterns. Professional Hygiene is the area of Essity’s operations that is most sensitive to economic movements. The healthcare sector for Incontinence Products and Medical Solutions also risks being negatively impacted by the public sector’s budget situation. Sales to the retail sector, which accounts for the bulk of sales of hygiene products, may also be adversely affected by reduced purchasing power among the company’s consumers.

Action

In all operations, it is important that Essity implements a number of measures to try to manage the effects of economic movements that take place. Examples of this include measures to reduce costs, reviewing the capacity and production structure, and creating higher customer value through product innovations. Essity also works on differentiation to move toward product areas that are less sensitive to economic fluctuations. An example of solutions that can create value for Essity and its customers is Tork PeakServe in Professional Hygiene, a high-capacity dispenser for towels that is labor-saving for the customer. Sensors in public toilets, which facilitate in optimizing the work to empty waste baskets and to refill paper and soap, are another example of solutions that can create value.

Environmental impact and climate change

Risk

Essity’s operations and the products used in the manufacturing process have an impact on air, water and land. Essity is subject to extensive environmental regulations in all of the countries where the company conducts operations. More stringent environmental requirements, remediation of the environment in connection with plant closures or breaches of permits could incur higher costs for the Group.

Risks related to climate change and the financial implications of this have attracted increased attention. Not least as a result of the 2015 Paris Agreement and new guidelines from the TCFD (Task Force on Climate-related Financial Disclosure).

Action

Essity’s strategic framework and sustainability policy stipulate guidelines for the Group’s measures within the environmental area. Environmental impact and the impact of climate change are part of the annual strategy process, which includes the identification, assessment and actions for managing these types of risks. Risks are managed, for example, through preventive work in the form of certified environmental management systems, environmental risk inspections in conjunction with acquisitions, and remediation projects in connection with plant closures. The use of energy, water, transport, production waste and raw materials is controlled using the company’s Resource Management System (RMS). The data is used for internal control and follow-up of established targets. Essity also works to reduce the volume of production waste.

Essity has adopted the SBTi¹⁾-approved Science-Based Targets to reduce the company’s climate impact and to support the 2015 Paris Agreement. Essity works to reduce carbon emissions by, for example, making investments in renewable energy and energy-saving programs.

¹⁾ SBTi: Science Based Targets initiative

Political decisions and regulatory measures

Risk

Essity conducts operations in a large number of different countries. In some countries, the institutional structures are more established and developed, while the political, financial, legal and regulatory systems in others are less predictable. In both cases, political changes and decisions, as well as amended legislation and regulations could have a negative impact on Essity’s operations in the form of higher costs or some other obstruction. In general, the regulatory requirements imposed on Essity’s operations and products are intensifying.

One example of risks associated with political decisions is if the UK were to leave the EU without an agreement.

Action

Essity works continuously to monitor, evaluate and anticipate changes in its business environment in the form of political decisions and amended regulations in the areas that are of particular importance for our operations.

Essity participates in various national and international industry organizations, as well as in other types of partnerships. The aim is to gain early knowledge of and contribute actively to the development of areas that are significant to our operations. Environmental and energy issues are of particular importance to Essity.

The circular economy, use of resources and more specifically, issues relating to waste, plastics, chemicals, and emissions to water and air are examples of other key areas.

The public sector is both a significant customer and an important stakeholder group for Essity. The company is therefore working actively on matters relating to health and medical care, as well as care for the elderly. By complying with and contributing to the development of relevant regulations, Essity shares its experience garnered from existing systems to decision-makers in countries where new structures are being built or existing systems reformed. An example of this is the development of systems for subsidized prescription of incontinence aids in countries where such benefits were not offered in the past. Similarly, Essity monitors developments in regulations covering medical solutions.

Measures adopted by the company to limit the effects if the UK leaving the EU without an agreement include an increase in inventory levels and transport capacity in the UK.

Competition

Risk

Essity is subject to considerable competition from other producers of similar products. Essity is also exposed to the risk that alternative products and solutions with the same or similar function (substitutes) could replace the products included in Essity’s range. Substitutes exist for virtually all Essity products. This may involve such products as cloth diapers or cloth rags for household or industrial cleaning, or completely different solutions to meet the needs of consumers, such as menstrual cups or electric hand dryers. Competition and the occurrence of substitutes presents the risk of a negative effect on sales and pricing of Essity’s products and jeopardizes the company’s market position.

Action

Essity’s focus on customer and consumer insight guides its innovation activities, ensuring that new products and services are competitive. Essity develops the company’s offering to meet the needs of customers and consumers in terms of the products themselves, but also in providing these in the relevant sales channels. New solutions are developed through the company’s own research and development activities in cooperation with customers, consumers, suppliers or partners. Through its processes for monitoring the business environment, Essity follows up on new players and substitutes in the market and their impact on the company. Read more about innovation in the chapter Innovate bigger brands.

Dependence on major customers and sales channels

Risk

Essity’s success is attributable to its ability to offer attractive products, services and brands and to make these available to customers and consumers. Essity’s products are sold through retailers, pharmacies, online sales, distributors and resellers, with retail representing the single largest customer category. If these players are not successful in selling Essity’s products, this could have a negative impact on Essity’s earnings. In general, there is a consolidation trend in several of Essity’s sales channels and markets – particularly in the retail trade – through mergers and purchasing alliances, which could increase dependence on individual, large customers. Digitalization is also changing customer and consumer behavior, preferences and demand.

Action

Essity’s customer structure is relatively dispersed, with customers in many different areas of business. In 2018, Essity’s ten largest customers, most of them retail companies and distributors, accounted for 24% of net sales. The company works to maintain strong and long-term customer relationships in strategic customer segments, as well as building relationships with new customers. Essity is participating in the increasing digitalization trend and its impact on customers, consumers and channels, for example, through online sales. Essity also places great importance on developing processes, products and information to ensure customer satisfaction.

Production facilities

Risk

Essity has around 90 production facilities in some 30 countries. Fires, machinery breakdowns and other types of harmful incidents in plants could lead to considerable value destruction, loss of production and income, which ultimately, could have a negative impact on Essity’s market position.

Action

From this perspective, the aim of Essity’s risk management is to effectively and cost efficiently protect its employees, the environment, the company’s assets and the business. Essity strives to create and retain a balance between loss-prevention activities and insurance coverage.

The loss-prevention work is conducted in accordance with established guidelines that include repeated inspections by external risk engineers. Other important elements of loss-prevention activities are maintenance of production plants and machinery, staff training, and good orderliness. Essity invests continuously in loss-prevention activities to reduce its risk of damage in various ways. For example, the sites are usually protected by sprinkler systems. All wholly owned facilities are insured to replacement cost and for the loss of income. Within the EU, insurance is primarily conducted within the company’s own insurance company, with external reinsurance for major damages. Outside the EU, Essity cooperates with market-leading insurance companies.

Unethical business practices

Risk

Essity works in a large number of countries and in environments where unethical business practices and violations of human rights may occur. The risk of such business methods is deemed to be very serious. The financial consequences of violations may be very severe in the form of various sanctions and fines. Violations also risk having a negative impact on the company’s reputation in the market.

Action

Essity has a program for regulatory compliance, which aims to minimize the risk that Essity participates in or is associated with unlawful or unethical business practices or commits violations of human rights. The program is based on a Code of Conduct adopted by the Board of Directors. The Code contains policies for how the company and its employees are to behave in the workplace, in the community and in the market. Training of Essity’s employees regarding the Code of Conduct takes place continuously. Within certain areas, corruption and competition regulations, Essity has an in-depth program for risk evaluation and various training courses for employees. The implementation of the regulatory compliance program is reported continuously to a committee, which includes the internal audit function and parts of the Essity management.

Employees

Risk

To meet its targets, Essity is dependent on being able to recruit, retain and develop qualified and motivated employees.

Action

Essity ensures access to employees with relevant competence through strategic staffing and succession planning. Essity is focusing on making the company known as an attractive employer in the markets in which it operates. Internal recruitment and rotation is facilitated through a “Job Portal”, where vacant positions are advertised internally and externally. The company’s ambition is that all employees should have a personal development plan focusing on both training and new challenges. Essity strives to ensure that salaries and other benefits are adapted to the market and competitive in the labor market in which the employee works. Essity is working actively to build good relationships with union organizations.

Legal risks

Risk

Legal risks comprise a number of risks in, to some extent, diverse areas. Amended legislation, violations of laws in the operations or errors in any agreements signed by Essity, are some examples of legal risks that could have negative financial implications for Essity. In certain instances, they may also result in protracted and costly legal processes.

Action

Essity constantly monitors developments in a number of areas and addresses any legal risks that arise in cooperation with external advisers. By their nature, legal issues are often national, which means that local experts are also often engaged by Essity in various issues.

Suppliers

Risk

Essity is dependent on a large number of suppliers. The unplanned or sudden loss of key suppliers could result in costs and disruptions to the company’s production. Suppliers could also cause problems for Essity through non-compliance with applicable legislation and guidelines or by otherwise acting in an unethical manner.

Action

Essity enters into supply contracts of various durations with a large number of different suppliers. The agreements ensure the supply of key input goods. The Group has several suppliers for essentially all important input goods. In-depth collaboration also occurs with particularly selected suppliers in the development of materials and processes. Essity continuously evaluates suppliers to ensure compliance with agreements entered into. Particular importance is placed on suppliers with operations in countries and industries deemed to be exposed to risks. The assessment of key suppliers may take the form of a questionnaire, an on-site visit or independent audit.

Information and IT

Risk

Essity relies on IT systems for its operations. Disruptions or faults in critical systems risk having a direct impact on production and other important business processes. Errors in financial systems risk affecting the company’s reporting of results.

Action

Essity has a management model for IT that contains governance, standardized IT processes and an organization for information security. The latter works with continuous risk assessment, preventive measures and the use of security technologies. Standardized processes are in place for the implementation and change of systems and IT services and for daily operations.

Cost of input goods

Risk

Input goods account for a considerable part of Essity’s total operating expenses. The market price of input goods fluctuates over time and could influence Essity’s earnings positively or negatively over time. The price trend for a number of input goods over the past ten years is presented in the diagram below.

Action

Fiber (pulp and recovered paper) is a significant cost item, mainly in Consumer Tissue and Professional Hygiene. Price fluctuations for fiber are mainly managed through long-term relationships with suppliers and by optimizing purchasing from different regions and of varying qualities. The cost of oil-based materials is driven by the oil price trend and represents a major cost item in Personal Care and for diverse packaging materials. The oil price trend also impacts transport costs. The impact of price movements on input goods can be delayed through purchasing agreements with fixed durations. Efficiency improvements in the company’s operations, changed product specifications and price increases are examples of measures to dampen the effect of rising costs for input goods.

Essity’s costs for input goods are described in the chapters Description of costs and Raw materials.

Energy price

Risk

Energy price risk is the risk that increased energy prices could adversely impact Essity’s operating profit. Essity is exposed to price movements of electricity and natural gas, but the price of other energy commodities also directly and indirectly impacts Essity’s operating profit.

Action

Essity centrally manages the energy price risk related to electricity and natural gas. According to Essity’s energy risk policy, these price risks can be hedged for a period of up to 36 months. Energy price hedging is effected through financial instruments and fixed pricing in existing supply agreements.

Essity safeguards the supply of electricity and natural gas through centrally negotiated supply agreements. The portfolio of supply agreements and financial hedges shall be effectively spread to minimize Essity’s counterparty risk.

In 2018, Essity purchased about 5 TWh (5; 5) of electricity and about 8 TWh (8; 8) of natural gas.

The graph displays Essity’s price hedges in relation to forecast consumption of electricity and natural gas for the next three years. The graph includes financial hedges and hedging effected via supply agreements. For further information concerning financial price hedges, see Note E6 Derivatives and hedge accounting.

Currency

Risk

Transaction exposure

Transaction exposure is the risk that exchange rate movements in export revenues and import expenses could negatively impact the Group’s operating profit and the cost of non-current assets.

Translation exposure

Translation exposure is the risk to which Essity is exposed when translating foreign subsidiaries’ balance sheets and income statements to SEK.

Long-term currency sensitivity

The table below presents a breakdown of the Group’s net sales and operating expenses by currency, which provides an overview of the Group’s long-term currency sensitivity. The largest exposures are denominated in EUR, USD, CNY and GBP.

Action

Transaction exposure

Transaction exposure, resulting from exports and imports, can be hedged for a period of up to 18 months. The currencies with the greatest net volume were hedged as follows: USD 1 month, CNY 0 months and GBP 1 month. Contracted future payments for non-current assets in foreign currencies can be hedged up to the full cost.

Most of Essity’s business is conducted outside Sweden and therefore, transaction exposure primarily arises in currencies other than SEK. The largest exposure comprises a purchase requirement for USD and a selling requirement for CNY and GBP. The significant USD exposure is a consequence of the Group’s purchase of pulp that is invoiced in USD.

During the year, there was continuous hedging of, primarily, trade receivables and payables, as well as future payments of non-current assets. The majority of hedges mature during the first quarter of 2019. For further information relating to hedging of transaction exposure, see Note E6 Derivatives and hedge accounting.

Forecasted net flows 2019

Translation exposure

Essity manages translation exposure by distributing the liability across various currencies where the Group owns assets so that key figures that are material for the company’s credit rating are protected in the long term against exchange rate effects. Translation exposure in the income statements of foreign subsidiaries is not currency-hedged. As at December 31, 2018, net debt amounted to SEK 54,404m (52,467; 35,173). Distribution by currency is shown in the table below.

For further information relating to hedging of translation exposure, see Note E6 Derivatives and hedge accounting.

Credit

Risk

Credit risk refers to the risk of losses due to a failure to meet payment obligations by Essity’s counterparties in financial agreements or by customers.

Action

Credit risk in trade receivables

Credit risk in trade receivables is managed through credit checks of customers using credit rating companies. The credit limit is set and regularly monitored. Trade receivables are recognized at the amount that is expected to be paid based on an assessment of the anticipated credit losses for the remaining lifetime of all trade receivables at the balance sheet date. For further information concerning trade receivables and recognition of anticipated credit losses, see Note E3 Trade receivables.

Financial credit risk

The objective is that counterparties must have a minimum credit rating of A–/A3 from at least two of the rating institutes Standard & Poor’s, Fitch and Moody’s.

Essity strives to enter into agreements that allow net calculation of receivables and liabilities. In certain cases, there are also supplementary terms to these agreements regarding the exchange of collateral.

Credit exposure in derivative instruments is calculated as the market value of the instrument on the balance sheet date. Credit exposure in derivative instruments amounted to SEK 1,255m (1,555; 1,259), gross. Taking net calculation agreements per counterparty into consideration, credit exposure of derivatives amounted to SEK 810m (1,084; 971). At year-end, the total credit exposure was SEK 4,028m (4,964; 5,214). This exposure includes credit risk of SEK 3,081m (4,107; 4,244) for financial investments. Refer to the table below for the distribution of credit risk by category.

Liquidity and refinancing

Risk

Liquidity and refinancing risk is the risk that Essity is unable to meet its payment obligations as a result of insufficient liquidity or difficulty in raising new loans.

Action

To ensure good access to loan financing, regardless of the economy and at attractive terms, Essity strives to maintain a solid investment grade rating.

Essity is to maintain financial flexibility in the form of a liquidity reserve consisting of cash and cash equivalents and unutilized credit facilities totaling at least 10% of the Group’s forecast annual sales. Essity limits its refinancing risk by having a good distribution in the maturity profile of its gross debt. The gross debt must have an average maturity in excess of three years, considering unutilized credit facilities that are not liquidity reserves. Surplus liquidity should primarily be used to amortize external liabilities. Essity’s policy is to not agree to terms that entitle the lender to withdraw loans or adjust interest rates as a direct consequence of movements in Essity’s financial key figures or credit rating.

The Group’s financing is mainly secured by bank loans, bond issues and through issuance of commercial papers. The refinancing risk in short-term borrowing is limited through long-term credit facilities from bank syndicates and individual banks with favorable creditworthiness.

Essity’s net debt increased SEK 1,937m in 2018. At year-end, the average maturity of gross debt was 3.5 years (4.3; 4.0). If short-term loans were replaced with drawings under long-term unutilized credit facilities, the maturity would amount to 4.2 years. Unutilized credit facilities amounted to SEK 20,554m at year-end. In addition, cash and cash equivalents totaled SEK 3,008m. For further information, see Note E2 Financial assets, cash and cash equivalents, and Note E4 Financial liabilities.

Interest rate

Risk

Interest rate risk relates to the risk that movements in the interest rates could have a negative impact on Essity. Essity is affected by interest rate movements through its net financial income and expenses.

Action

Essity strives to achieve a good distribution of its interest maturity dates to avoid large debt volumes of renewals occurring at the same time. Essity’s policy is to raise loans with floating rates, since it is Essity’s understanding that this leads to lower interest expense over time. The interest rate risk and interest period are measured by currency and the average interest term shall be within the interval 3 to 36 months.

Essity’s financial items decreased in 2018. The decrease is primarily due to lower interest rates. Higher average net debt had a negative impact on financial items during the period. Essity’s largest funding currencies are EUR, GBP and USD, refer to the graph. To achieve the desired fixed interest period and currency balance, Essity uses financial derivatives. The average interest period for the gross debt, including derivatives, was 26.7 months (30.1; 8.5) at year-end.

The average interest rate for the total outstanding net debt including derivatives, amounted to 2.55% (1.83; 2.26) at year-end.

Gross debt distributed by currency