Statement on corporate governance compliance

Rolls-Royce attaches the highest priority to corporate governance, the system by which the Company is directed, managed and controlled in the interests of all its stakeholders. The strength of the Company's corporate values, its reputation and its ability to achieve its objectives are influenced by the effectiveness of the Company's approach towards corporate governance.

The Board confirms that throughout 2005, the Company complied with the Combined Code on Corporate Governance (the Combined Code). This report and, where appropriate, the Directors' remuneration report, explain how the Company discharges its corporate governance responsibilities.

The Board's composition and directors' independence

Simon Robertson chairs the Board of the Company and Sir John Rose is the Chief Executive. The division of responsibilities between them is set down in writing and agreed by the Board. Peter Byrom is the Company's senior independent director.

There are currently 14 directors on the Board comprising the non-executive Chairman, the Chief Executive, five other executive directors and seven non-executive directors.

The quality and broad experience of the directors, the balance of the Board's composition and the dynamics of the Board as a group ensure the Board's effectiveness and also prevent any individual or small group dominating the Board's decision making.

Each executive director receives a service contract on appointment (see the Directors' remuneration report for further information) and each non-executive director receives a letter setting out the conditions of their appointment. Non-executive directors are appointed for an initial term of three years, which may be extended subsequently with the agreement of the Board. Executive directors are employees who have executive responsibilities in addition to their duties as directors. Non-executive directors are not employees and do not participate in the daily business management of the Group.

The Board applies a rigorous process in order to satisfy itself that its non-executive directors remain independent. On his appointment as Chairman on January 1, 2005, Simon Robertson met the criteria for independence contained in the Combined Code. His other significant commitments are described on the board of directors page. In the case of the non-executive directors, the Board reviews their independence every year, using its own judgement when applying the criteria in the Combined Code. Having undertaken this review in 2005, the Board confirms that all the non-executive directors are considered to be independent in character and judgement.

On January 1, 2006, Peter Byrom completed nine years service on the Board and therefore does not meet one of the criteria for independence contained in the Combined Code. Having conducted a thorough review, the Board has concluded that Peter Byrom remains independent in character and judgement, that there are no relationships or circumstances which are likely to affect his independent judgement and that he is in no way dependent on the remuneration he receives from the Company. The Board believes strongly that in a long-term, complex and technologically advanced business, it is essential that non-executive directors have the opportunity to acquire, over a number of years, the experience and knowledge of the business and the sectors within which the Group operates. With his financial background, City experience and deep knowledge of the Group's business, Peter Byrom is particularly well qualified to serve as the Chairman of the audit committee and as the senior independent director. The Board therefore considers it to be in the interests of shareholders that he should continue to support the Company in both these roles, a judgement which has been endorsed by the independent consultancy, which undertook a review of the Board's effectiveness during 2005. In line with the policy adopted by the Board, Peter Byrom will in future be subject to annual re-election by shareholders.

Role of the Board

The Board is responsible to all its stakeholders for the conduct and performance of the Company.

The day-to-day running of the Company is delegated by the Board to the executive team under the leadership of Sir John Rose, the Chief Executive.

The Board retains responsibility for the approval of certain matters which affect the shape and risk profile of the Company, as well as such items as the annual budget and performance targets, the published accounts, payments to shareholders, major capital investments and any substantial change to balance sheet management policy. This division of responsibilities between the Board and the executive team is set out in detail in a schedule approved annually by the Board, which defines those decisions which can only be taken by the Board itself.

The Board has approved the following statement summarising its core responsibilities:

Primary goal

The primary goal of the Board is to ensure that the Company's strategy creates value for the long-term investor within an acceptable risk profile.

The Board's tasks

In line with its primary goal, the Board's principal tasks are to:

• ensure the development of the Company's strategy and keep it under rigorous review;
• monitor the implementation of the strategy, ensuring that the necessary financial and human resources are in place to deliver it and that effective controls exist to manage risk;
• safeguard the values of the Company, including its brand and corporate reputation and the safety of its products;
• oversee the quality and performance of management and ensure through effective succession planning and remuneration policies that it is maintained at world-class standards; and
• maintain an effective corporate governance framework that delivers long-term value to shareholders.

Directors' induction, training and information

Newly appointed directors participate in a structured induction programme and receive a comprehensive data pack providing detailed information on the Group. An existing executive director acts as a mentor to each newly appointed non-executive director, giving guidance and advice as required. As part of their briefing, non-executive directors visit key sites and meet a cross-section of managers and employees to gain a better understanding of the Group and its operations. On-going training is available for all the directors, including presentations by the executive team on particular aspects of the business.

There is an agreed procedure for directors to take independent professional advice at the Company's expense. This is in addition to the access every director has to the Company Secretary and the General Counsel.

Board effectiveness

The Chairman meets at least once a year with the non-executive directors without the executive directors present, in order to review the operation of the Board.

The Chairman has an annual meeting with each non-executive director to review their contribution to the Board. The senior independent director chairs an annual meeting with the non-executive directors to review the performance of the Chairman, the outcome of which is reported back to him.

Each year, the Chairman reviews the performance of the Chief Executive as part of the annual salary review process overseen by the remuneration committee. The Chief Executive reviews the performance of the other executive directors in the same way.

The Board attaches considerable importance to ensuring that it performs effectively as a team. In 2005, an in-depth review of the effectiveness of the Board and its committees was undertaken by Consilium Associates, an independent consultancy. The review covered Board and committee structure, Board dynamics, the conduct of Board meetings, the information provided to directors and corporate governance. The report prepared by Consilium Associates was discussed by the Board in December 2005 and will be used by the directors in 2006 to implement a number of improvements in the way the Board operates. The audit, remuneration and nominations committees have separately undertaken reviews of their terms of reference and effectiveness during 2005.

Board committees

The Board is assisted by its committees. Details of their membership and principal terms of reference are set out below and in the Corporate Responsibility section. Their full terms of reference are available in the Investors section on the Group's website at www.rolls-royce.com

The following table shows the level of attendance by the directors at Board and principal committee meetings in 2005.

*The number of meetings held during the period a director was in office or a member of a committee

**During 2005, Carl-Peter Forster was unable to attend the Board and committee meetings shown above as a result of the demands placed on him at short notice in his capacity as President of General Motors Europe. In all cases when he was unable to attend a meeting, he communicated his views to the Board or committee Chairman and in the Board's view, he continues to make a very strong contribution to the Company and to the work of the Board and its committees.

Nominations committee

In 2005 the nominations committee was chaired by Simon Robertson. Its other members were the Hon Amy Bondurant, Peter Byrom, Carl-Peter Forster, Sir John Rose, Ian Strachan, Carl Symon and Sir Robin Nicholson (until his retirement as a non-executive director on May 4, 2005). On November 17, 2005 Iain Conn and Sir John Taylor joined the committee, reflecting the Board's view that all the non-executive directors should serve as members of the committee. The committee met five times during the year.

The committee makes recommendations to the Board on the appointment of executive and non-executive directors and on the membership of Board committees. It is assisted in the former task by external recruitment consultants. It reviews succession planning for appointments to the Board and to other senior positions within the Group.

In carrying out these tasks, the committee gives careful consideration to the balance of skills required on the Board, including the need to reflect diversity, international experience and strong managerial and business skills. Before recommending the appointment of a non-executive director to the Board, the committee satisfies itself that the candidate will have sufficient time available to discharge his or her responsibilities effectively.

Remuneration committee

The remuneration committee determines appropriate levels of remuneration for the executive directors and other senior executives. The committee met six times during the year. The committee's membership and principal terms of reference are set out in the directors' remuneration report.

Audit committee

The audit committee consists exclusively of independent, non-executive directors and is chaired by Peter Byrom who has recent and relevant financial experience. In 2005, its other members were Sir Robin Nicholson until May 4, 2005 and Ian Strachan. Iain Conn became a member of the committee with effect from January 20, 2005. The committee met four times during the year.

The committee has responsibility for recommending to the Board the published accounts and for reviewing the Group's financial reporting and accounting policies, including major announcements made to a regulatory information service. It is also responsible for the relationship with the external auditors and for the internal audit function, which in Rolls-Royce is termed Business Assurance. In addition, the committee reviews the Group's procedures for detecting, monitoring and managing the risk of fraud.

The committee has responsibility for recommending to the Board the appointment of the external auditors and for reviewing the scope of the audit, approving the audit fee and, on an annual basis, satisfying itself that the auditors are independent. It keeps under review the Group's internal controls and systems for assessing and mitigating financial and non-financial risk. It also reviews and approves the Business Assurance work programmes and ensures that this function is adequately resourced and co-ordinated with the work of the external auditors.

In order to safeguard auditor independence and objectivity, the following policy is applied in relation to services provided by the auditors:

Audit related services -

these are undertaken by the auditors as it is work that they must, or are best suited to, perform. It includes formalities relating to borrowings, shareholder and other circulars, risk management services, various regulatory reports and work in respect of acquisitions and disposals.

Tax, accounting and mergers and acquisitions -

The auditors are used for this work where they are best suited to undertake it. All other significant consulting work in these areas is put out to tender.

All other advisory services/consulting -

The auditors are generally prohibited from providing these services.

Throughout the year the committee monitors the cost of non-audit work undertaken by the auditors and is, therefore, in a position to take action if at any time it believes that there is a risk of the auditors' independence being undermined through the award of this work.

Risk committee

The Board has a risk committee, chaired by the Chief Executive, with specific accountability for the system of risk management and for reporting key risks and their associated mitigating actions to the Board. In 2005, membership of the committee comprised John Cheffins, Colin Green, James Guyette, Sir John Rose, and Andrew Shilston. Dr Mike Howse was a member of the committee until his retirement on June 30, 2005. Colin Smith became a member with effect from July 1, 2005. Colin Green will cease to be a member of the committee when he retires from the Company on April 4, 2006.

Internal controls and risk management

Directors' responsibilities

The directors are responsible for the Group's system of internal control and for maintaining and reviewing its effectiveness from both a financial and operational perspective. The system of internal control is designed to manage, rather than eliminate, the risk of failure to achieve business objectives and to provide reasonable but not absolute assurance against material misstatement or loss. The Group's approach to internal control is based on the underlying principle of line management's accountability for control and risk management.

In reviewing the effectiveness of the system of internal control, the Board has taken account of the results of the work carried out to audit and review the activities of the Group.

There is an ongoing process to identify, assess and manage risk, including those risks affecting the Group's reputation. This process is subject to continuous improvement and has been in place throughout the financial year to which these statements apply and up to the date of their approval. In 2005 the risk review framework has been enhanced at both programme and sector level and assurance activities more closely co-ordinated with the risk management process.

The Board has reviewed the risk management process and confirms that ongoing processes and systems ensure that Rolls-Royce continues to be compliant with the current Turnbull Committee Guidance on Internal Control and the Revised Guidance for Directors on the Combined Code issued in October 2005, which takes effect for financial years beginning on or after January 1, 2006.

Organisation

The Group has a clearly defined organisation structure within which operational management has detailed responsibilities and levels of authorisation, supported by written job descriptions and operating manuals.

Rolls-Royce also has a code of business ethics which lays down the principles to be followed by employees in the course of conducting business. The code also gives guidance to support achievement of the required standards. Additionally, confidential reporting lines enable UK and US employees to report, outside the normal management chain, any concerns they may have with regard to business conduct.

The risk management system

The risk management system is an integral part of management's approach to delivering business objectives and is a systematic process designed to identify, assess, treat, manage and communicate risks. It also provides a method of escalation and delegation to the appropriate level within the organisation and ensures actions are owned, defined, resourced and effective.

Management is responsible for the ongoing identification and evaluation of significant risks within their areas of responsibility and, using a common process, for the operation of suitable controls or mitigation actions. Risks are recorded in regularly updated risk registers operating at all levels of the organisation and are continuously reviewed and monitored. During the review process, significant emphasis is placed on learning from and sharing prior experience. Risks may arise from a variety of internal and external sources. They may be associated with regulations, customer requirements and competitor actions or could result from the capability of the processes used to execute the business or from external and largely unpredictable events, such as terrorist activity or war.

Risks, irrespective of source, are managed through processes operated by project and functional teams. Management reports regularly to the risk committee on its view of risks and how they are managed so that the Board can then consider and review these risks in terms of their potential impact.

Management has continued to perform comprehensive risk reviews for all key projects, programmes and business change plans. In addition, all the processes operated by the Company are subject to continuous improvement, including the risk management process itself.

Systems of internal control

The general managers of individual businesses are aware of their responsibility to operate systems of internal control which provide reasonable assurance of effective and efficient operations, reliable financial information and compliance with laws and regulations. Financial managers are required to acknowledge in writing that their routine financial reporting is based on reliable data and that their results are properly stated in accordance with Group requirements.

The Group has a comprehensive budgeting system with an annual budget approved by the Board. Revised forecasts for the year are reported at least quarterly. Actual results are reported monthly against budget and variances reviewed.

The activities of the Group are subject to review by the Department of Risk, including Business Assurance and Project Risk Assessment, and the assurance functions of Health, Safety and Environment, Quality and Engineering. These functions operate to work programmes agreed by the appropriate Board member.

The Business Assurance function, which works closely with the external auditors, undertakes a programme of financial and operational audits and reviews agreed by the audit committee and covering all Group activities. The programme includes independent reviews of the systems of internal control and risk management. The findings and the status of corrective actions taken to address these are reported to the audit committee four times a year and to the risk committee twice a year.

Export controls

The Group attaches the highest priority to complying fully with export controls in all the jurisdictions in which it operates. Detailed processes have been put in place to ensure that the Group follows all applicable legal and regulatory requirements.

The Board has established an exports committee, chaired by the Chief Operating Officer, which has responsibility for the application of appropriate controls to the Group's export activity.

In the UK, the Group fully complies with the provisions of the UK Export Control Act on tangible and intangible exports and trade between third parties. Additionally, the Group complies with the relevant EU regulations regarding the export of dual use goods and technology. In other jurisdictions, most notably the USA, the Group vigorously enforces a policy of compliance with both the relevant national legislation and its underlying regulatory intent.

Communication with shareholders

The Company attaches importance to the effectiveness of its communications with shareholders. It publishes an Annual review and summary financial statement as well as a full Annual report. There are also separate reports for the Environment and Community Relations.

The Company maintains a regular dialogue with institutional shareholders and the financial community. This includes presentations of the preliminary and interim results, regular meetings with major shareholders, participation in stockbrokers' seminars and site visits.

In November 2005, the Company hosted a major investors' seminar in Derby, at which a number of Board directors and other senior executives described the Group's progress. All shareholders can gain access to these and other presentations, as well as to the Annual report and other information about the Group, on the Group's website at www.rolls-royce.com

Holders of ordinary shares may attend the Company's AGM at which the Company highlights key business developments during the year and at which shareholders have an opportunity to ask questions. The chairmen of the audit, remuneration and nominations committees are available to answer any questions from shareholders on the work of their committees.

The Company confirms that it sends the AGM notice and relevant documentation to all shareholders at least 20 working days before the date ofthe AGM. For those shareholders who have elected to receive communications electronically, notice is given of the availability of documents on the Group's website.

Responsibility for maintaining regular communications with shareholders rests with the executive management team led by the Chief Executive. However, the Board is informed on a regular basis of key shareholder issues, including share price performance, the composition of the shareholder register and City expectations. Independent research is commissioned annually into institutional shareholder perceptions of the Group. The Chairman, the senior independent director and the non-executive directors make themselves available to meet with shareholders as required.

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