UPM annual report 2015

IN BRIEF

STRATEGY

BUSINESSES

STAKEHOLDERS

GOVERNANCE

ACCOUNTS

Strategic risks Competition, markets and customers . The energy, pulp, timber, paper, label, plywood and biofuels markets are cyclical and highly competi- tive. In all of these markets the price level is determined as a combina- tion of demand and supply, and shocks to either demand (decrease/ increase in end-use demand, change in customer preferences etc.) or supply (e.g. new production capacity entering the market or old ca- pacity being closed) may impact both the volume and the price level for UPM. Also competitor behaviour influences the market price devel- opment. UPM performance is also impacted by the performance of substi- tute or alternative products. Most notably, the demand in graphical papers in the mature markets is forecasted to continue to decline, due to the shift away from print media to electronic media. Similarly, sev- eral raw materials used by UPM have competing end uses. Consumers’ environmental awareness has also increased, and this may have either a positive or negative impact on the consumption of UPM’s products, depending on the product area. UPM sells a proportion of its products to several major customers. The largest customer in terms of sales represented approximately 3% of UPM’s sales in 2015, and the ten largest customers represented approximately 15% of such sales. M&A and changes in the business portfolio . UPM’s strategic direction is to increase the share of growing businesses with positive long-term fundamentals. This may require acquisitions of new busi- nesses or divestments of existing businesses. Participation in M&A involves risks such as successful implementation of a divestment and the ability to integrate and manage acquired operations and personnel successfully, as well as to achieve the economic targets set for an acquisition/divestment. Regulation . UPM is exposed to a wide range of laws and regula- tions. The performance of UPM businesses, for example the biofuels business, the paper businesses and the energy business, are to a high degree dependent on the current regulatory framework, and changes to regulation, direct and indirect taxation or subsidies would have a direct impact on the performance of UPM. In addition, regulation may structurally restrict or exacerbate UPM’s ability to compete for raw material. UPM’s environment related processes and management are based on full compliance with such laws and regulations, and environmental investments, audits and measurements are carried out on a continuous basis. UPM is currently not involved in any major proceeding concern- ing environmental matters, but the risk of substantial environmental costs and liabilities is inherent in industrial operations. Political and economical risks . UPM has major manufacturing locations in Finland, Germany, the UK, France and the US. In these countries, the slow development of the individual economies and/or of Europe as a whole influences adversely UPM’s performance. Further- more, policies (on European and/or national level) that hamper eco- nomic growth or lower the competitiveness of UPM (for example through adverse regulation or increase in direct or indirect taxation) may have an adverse impact on UPM’s performance. In the developed countries, the unpredictability of regulation may lead to an increasing uncertainty and risk level when investing in or operating in these coun- tries. UPM has manufacturing operations in a number of emerging mar- ket countries, such as China, Uruguay and Russia. In the emerging market countries, the lack of transparency and predictability of the political, economic and legal systems may lead to an increasing uncer- tainty and risk level when investing in, or operating in these countries. These uncertainties may materialize as unfavourable taxation treat- ment, trade restrictions, inflation, currency fluctuations and nationalisa- tion of assets. Operational risks Earnings uncertainty . The main short-term uncertainties in UPM’s earnings relate to sales prices and delivery volumes of the Group’s products, as well as to changes in the main input cost items and ex- change rates. Most of these items are dependent on general economic developments. The main earnings sensitivities and the Group’s cost structure are presented in the Annual Report of 2015, on page 18.

UPM’s available-for-sale investments are recognised at fair value in the balance sheet. Changes in the assumptions used (e.g. electricity price estimate and start-up schedule of the Olkiluoto 3 nuclear power plant) might have a significant impact on UPM’s financial position. Payment defaults . There is a risk of non-payment or non-perfor- mance by the Group’s customers in connection with the sale of prod- ucts. UPM has various programmes in place to monitor and mitigate customer credit risk, and insurance policies cover most of the trade receivables. Additional information about financial risks and the maturity of long term debt is disclosed in the consolidated financial statements (Notes 3 and 31). Hazard risks UPM operates a significant number of manufacturing facilities globally, mostly UPM-owned, and is also the largest private owner of forestland in Finland. UPM is exposed to risks in areas such as occupational health and safety, environment, fire, natural events and site security. These risks are managed through established management procedures and loss prevention programmes. UPM’s insurance programme also provides coverage for insurable hazard risks, subject to terms and conditions. Research and development Innovations are at the forefront in the creation and development of new products that can be used to replace non-renewable materials with renewable, recyclable and low-impact alternatives and provide re- source-efficient alternatives for the future. The aim of UPM’s R&D programmes and business development is to create new technologies and products, provide support to and ensure the competitiveness of its businesses. By cooperating with selected value chain partners UPM aims to increase its speed, agility and effectiveness. In 2015, UPM spent EUR 63 million (112 million) on research and development work equating to 5.3% (9.0%) of UPM’s operating cash flow. The focus was on new technologies and developing businesses. On top of the direct R&D expenditure of approximately EUR 37 million (35 million), the figures include negative operating cash flow and capi- tal expenditure in developing businesses. Versatile use of wood biomass UPM is seeking business development and innovation in various bioec- onomy projects through collaboration. The special focus areas are development of by-product utilisation, resource efficiency and the circular economy. UPM’s Side stream efficiency research is looking for solutions to better utilise the side streams of UPM’s integrated pulp and paper mills; sludge, ash, various rejects and waste heat. The aim is to reduce costs and increase the value of side streams by finding new business oppor- tunities in industrial symbioses. In UPM Kaukas mill, studies have been done to produce biogas from sludge in co-operation with the Lappeenranta city representatives and other external partners. Fertilizer development and nutrient recirculation is also part of UPM’s circular economy targets. Other studies relate to new end-uses for ash in construction applications. Also good saving ideas have been found in mills’ heat efficiency. UPM has a global network of research centres to support the busi- nesses and their development goals. Environmental aspects are system- atically integrated into product design at an early stage. Wide-scale collaboration in new businesses UPM is one of the founding members of the industrial consortium part of the European Joint Undertaking on Bio-based Industries (BBI). This Public Private Partnership (PPP) aims to trigger investments and create a competitive market for bio-based products and materials that are sourced locally. For UPM, the PPP is an important funding element for speeding up the implementation of future investments. UPM is a shareholder in the Finnish CLIC Innovation, which focuses on bioeconomy and cleantech research. The Cluster’s research

programmes focus on bioeconomy as well as energy and environmen- tal research, thus supporting UPM’s internal R&D activities. In 2015, UPM received approximately EUR 1.4 million (2.1 mil- lion) from Tekes (the Finnish Funding Agency for Technology and Inno- vation) for its research projects. These projects were carried out in co- operation with research institutes, universities and other companies. UPM works together with a wide network of universities and research institutes as well as technology suppliers and startups. Partner- ships enable us to develop new solutions and get to the market faster, especially in new businesses. UPM’s intellectual property rights applications remained on a sig- nificant level. The high level of patent registration highlights the prog- ress made in new businesses. UPM actively manages its patent portfo- lio and evaluates the applicability and commercial value of its patents. As such, we are trying to seek new commercialisation partners for pat- ents not suitable for our businesses. Biocomposites combine best properties of natural fibres and high performance polymers UPM Biocomposites develops, manufactures and sells high quality com- posite products for a wide range of consumer and industrial applica- tions. UPM ProFi’s Design Deck range is one of the leading composite decking brands in Europe. Through patented recycling technology, UPM Biocomposites recovers the cellulose fibres and polymers found in label material waste, and gives them a second life. UPM Formi is the engineered range of pure cellulose and virgin polymer compounds suitable for various applications from furniture to consumer electronics. The products have a considerably lower carbon foot print than those made with pure plastics. Biochemicals offer a sustainable alternative to fossil-based solutions UPM Biochemicals offers and develops innovative, sustainable and competitive wood-based biochemicals. The product segments are chemical building blocks, lignin products, biofibrils, and biomedical products. Chemical building blocks are made from lignocellulosic biomass offering a cost competitive replacement for fossil-based monomers and chemicals such as intermediates to bioplastics. Lignin is one of nature’s most abundant materials and an ideal bio-based substitute for various petro-based products e.g. resins and binders. UPM BioPiva™, based on UPM’s proprietary lignin-resin tech- nology, allows resin producers to substitute up to 70% of their fossil- based raw materials with a non-toxic, 100% bio-based, and cost-effec- tive alternative. Biofibrils are cellulose micro- and nanofibril products that can be used for shaping materials and giving them new characteristics. Biofi- brils products can be used as a suspension aid and rheology control agent or reinforcement and barrier element in different uses. GrowDex is a novel wood-based cellulose nanofibril hydrogel for 3D cell culturing and other biomedical applications. It is highly bio- compatible with human cells and tissues. In 2015, UPM’s ValChem project received a EUR 13.1 million funding from the European Union. ValChem stands for Value Added Chemical Building Blocks and Lignin from Wood. The aim is to demon- strate the technical and economic viability of an integrated biochemi- cal process, covering the whole value chain from wood raw materials to a selected platform for chemical and lignin-based performance chemicals. The project is done in cooperation with Sekab, METabolic EXplorer and Technische Universität Darmstadt. Product development at UPM Biochemicals is at the pre-commercial phase, with UPM actively developing and testing industrial applica- tions with its partners in order to create mill-scale industrial concepts.

Availability and price of major inputs . In 2015, third-party suppli- ers accounted for approximately 84% of UPM’s wood requirements. Other production inputs, such as chemicals, fillers and recovered paper, are obtained from third-party suppliers. Disruptions in the sup- ply of key inputs would impact upon manufacturing operations, for example, by interrupting or resulting in the downscaling of production or a change in the product mix. They could also cause price increases for critical inputs or shifts in the availability and price of wood. It is also uncertain how the EU energy policies may impact upon the avail- ability and costs of fibre and energy. Project execution . Investment projects in UPM businesses such as energy, pulp, paper or biofuels are often large and take one or more years to complete. UPM has experience in such projects in various businesses and locations around the world, and applies vigorous plan- ning, project management and follow-up processes. Participation in large projects involves risks such as cost overruns or delays, as well as achievement of the economic targets set for the investment. Partnerships . UPM currently works together with many partners without control over strategic direction and operational output. The highly competitive market situation and, for example, new develop- ments in biofuels or bioenergy are likely to increase the importance of partnerships in the search for higher efficiency or new products and businesses. Partnerships, however, may create risks to the profitability, for example, through changes occurring within the partner entity or changes in how the partnership operates. Ability to recruit and retain skilled employees . To meet the chal- lenges of sustaining growth and improving the effectiveness of opera- tions, a skilled workforce is necessary. UPM is continuously evaluating its recruitment, compensation and career development policies and taking measures to attract and retain skilled personnel, thereby seeking to avoid shortages of appropriately skilled personnel in the future. Availability and security of information systems . UPM business operations depend on the availability of supporting information system and network services. Unplanned interruptions in critical information services can potentially cause a major interruption of UPM business areas. UPM has implemented numerous technical, physical and pro- cess improvements to mitigate the availability and security risks and to reduce the service interruption related recovery time to acceptable level. Risks related to non-compliance . The UPM Code of Conduct sets the standards of responsible behaviour towards UPM stakeholders. They apply to every employee. The code covers topics relating to legal compliance and disclosure, conflicts of interest, gifts and bribes, HR practices, human rights questions and environmental matters. UPM’s environmental performance and social responsibility play a significant role in UPM’s ability to operate and influence the long-term success of its businesses. Negligence or breach of Code of Conduct may lead to legal processes or serious reputational damages impacting the value of the company. UPM ensures that employees are aware of the Code by regular trainings, the company maintains a report misconduct channel and carries out regular audits in its supply chain. Financial risks Changes in exchange and interest rates . Exchange rate exposure primarily affects export operations when sales are denominated in currencies other than those in which manufacturing costs are incurred. Part of UPM’s sales and purchases are denominated in currencies other than the euro (primarily the US dollar and the British pound sterling). To manage exposure to such exchange rate fluctuations, close monitoring of the exposure to currency risks is carried out simultane- ously with the hedging of such risks, using financial instruments includ- ing forward foreign exchange agreements and currency swaps. Fur- thermore, changes in interest rates may have a considerable impact on the values of the company’s assets (e.g. biological assets or available- for-sale investments, such as energy assets), which are valued on a discounted cash flow model. Availability of capital and liquidity . Availability of capital to UPM is dependent on conditions of the financial markets and the Group’s financial health. If either or both of these factors were to change dra- matically for the worse, the cost and availability of capital would be at risk. To mitigate possible materialisation of these risks, the UPM has liquidity reserves in the form of committed multi-year loan facilities.

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UPM Annual Report 2015

UPM Annual Report 2015