The Group is exposed to a number of risks and has an established, structured approach to risk management. The risk committee has accountability for the system of risk management and regularly reports to the Board the key risks facing the business and the mitigating actions the Group has put in place to deal with them.
Risks are analysed under four broad headings:
Business environment risks
Corporate responsibility
The Group recognises the benefit that is derived from conducting business in an ethically and socially responsible manner. This approach extends to the supply of raw materials and components, the provision of a safe and healthy place of work and investment in technologies to reduce the environmental impact of the Group's products and operations. A failure in any of these areas could damage the Group's reputation and disrupt its business.
The Group is committed to high ethical standards and a new Global Code of Business Ethics will be launched in 2007. An employee engagement programme will be undertaken in 2007 to strengthen employee awareness of the Group's values. The Group communicates its standards to its first tier supply base through a supplier code of conduct.
External events which might affect demand for air travel
Civil aerospace is an important contributor to Group revenues and profits. The willingness of passengers to travel by air is influenced by a range of factors, including economic, health and security issues. For example, following the tragic events of September 11, 2001, the Group's civil aerospace profits more than halved as a result of a short-term reduction in the demand for aero engines.
The impact of this risk is mitigated by the Group's business strategy, which has enabled it to develop a broader business base, with the defence, marine and energy businesses being less susceptible to this type of risk. In addition, the developing civil aerospace business model, with its emphasis on increasing aftermarket services revenues, has proved to be resilient, providing a high degree of protection against any shortfall in demand. The Group has also demonstrated its ability to respond rapidly to changes in demand through the adjustment of its cost base.
Strategic risks
Aftermarket
Aftermarket revenues contribute over half of the Group's annual sales and are an essential element of the returns the Group expects to make from its investments. Any threat to the security of aftermarket revenues through, for example, a failure to provide an operational service which meets customers' expectations, would threaten the Group's level of profitability.
The Group is focused on providing a high standard of service to all its customers, investing in capabilities such as its recently established Operations Centres, which monitor engine operations in real time, co-ordinating and integrating data to enable Rolls-Royce to provide better predictive information and operational advice to its customers. Increasingly, customers are selecting a broader range of services through long-term service agreements, under which the Group assumes a higher level of responsibility for the maintenance and availability of its engines (over periods which average 12 years) in return for a usage-based fee. The Group deploys customer satisfaction surveys to monitor its service level.
Competitive forces
The markets in which Rolls-Royce operates are highly competitive. The majority of its programmes are long term in nature and access to the key platforms is critical to the success of the business. This requires sustained investment in technology, capability and infrastructure, which presents a high barrier to entry. However, these factors alone do not protect the Group from competition, such that price competition and technical advances made by competitors could adversely affect the Group's results.
The Group has developed a balanced business portfolio and maintained a steady improvement in operational performance, which together with the establishment of long-term customer relationships and sustained investment in technology acquisition, allows the Group to respond to competitive pressure.
Financial risks
These are risks that arise as a result of movements in financial markets. Principal risks are: movements in foreign currency exchange rates, interest rates, commodity prices and counterparty credit risk. A description of these risks and details of the Group's risk mitigation actions in this area are provided in the Finance Director's review page.
Operational risks
Performance of supply chain
The Group manufactures approximately 30 per cent by value of its gas turbine products and some 70 per cent is provided through supply chains external to the Group. Any failure of the supply chain would present a risk to the Group's ability to meet customer requirements and to achieve its financial goals.
The Group's strategy is to simplify the external supply chain, forging deeper, strategic relationships with fewer but stronger suppliers, including the allocation of a significant portion of new civil programmes to risk and revenue sharing partners.
The Group is also investing in its manufacturing facilities, replacing old factories with modern facilities, which will enable it to improve productivity and reduce costs by developing world-class manufacturing facilities and processes. In addition, the Group has a business continuity programme, to manage the risk of a loss of a major capability or facility.
IT security
Increased globalisation of the business and advances in technology have resulted in more data being transmitted across global communication links, posing an increased security risk.
Security systems have been upgraded with the latest technology and Rolls-Royce maintains effective communications with other industrial companies and the appropriate government agencies to share information on potential threats.
Programme risk
The Group manages complex product programmes with demanding technical requirements against stringent customer schedules. This requires the co-ordination of the external supply chain, manufacturing operations, partners and engineering functions. Failure to achieve programme goals would have significant financial implications for the Group.
The Group employs project management controls on a routine basis. All major programmes are subject to Board approval and are regularly reviewed by the Board with a particular focus on any emerging risks.