Risk factors and uncertainty

The volatility in the macroeconomic context, financial market instability, management processes complexity and continuous legislative and regulatory evolution entail a renewed capacity to protect and maximise tangible and intangible sources of value that characterise the corporate business model. Pirelli adopts a pro-active risk management system which, by systematically identifying, analysing and assessing risk-prone areas, provides the Board of Directors and management with decision-making tools so that they can anticipate and manage the effects of these risks, guided by the awareness that the assumption of risk is a fundamental part of business management.

The Pirelli Risk Model systematically assesses three categories of risks: external risks, strategic risks and operating risks.

1.External risks

Risks whose occurrence is outside the sphere of influence of the company. This category includes risks related to macroeconomic trends, changes in demand, competitor strategy, technological innovation, the introduction of new regulations, and country-specific risks (economic, security, political and environmental risks).

2.Strategic Risks

Risks that are typical for a specific business sector. Proper management of these risks is a source of competitive advantage or, on the contrary, a cause for failure to achieve plan targets (three-yearly and yearly). This category includes market risk, product innovation and process risk, human resources, raw material price risk, production process risk, financial risk and M&A risk.

3.Operational Risks

Risks generated by the organization and corporate processes, which do not bring any competitive advantage. This type of risks includes Information Technology, Business Interruption, Legal & Compliance, Health, Safety & Environment and Security risks.

Transversal to the risks mentioned above are social, environmental and business ethics responsibility risks and reputational risks.

Risks associated with social-environmental responsibility and business ethics are risks associated with non-compliance with local and international regulations and corporate policies regarding respect for human and labour rights, the environment, business ethics and can be generated both by the organization and as part of its value chain, as well as within the supply chain. These risks in turn can lead to reputational risks.

Reputational risks are related to actions or events that could engender a negative perception of the company by its main stakeholders. The main areas of risk in this category are, in addition to the aforementioned risks related to social-environmental responsibility and business ethics, also the inherent risks of leadership, quality and the level of product innovation.

System of risk management and internal control in relation to the financial reporting process. 

The company has implemented a specific and detailed system of risk management and internal control, supported by a dedicated IT application, in relation to the process of preparing financial half-year and annual separate and consolidated statements.

In general, the internal control system implemented by the company aims to ensure the safeguarding of equity, compliance with laws and regulations, the efficiency and effectiveness of corporate operations as well as the reliability, accuracy and timeliness of financial reporting.

In particular, the process of preparing financial information is through appropriate administrative and accounting procedures, drawn up in accordance with criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of Tradeway Commission.

The administrative / accounting procedures for the preparation of Financial Statements and all other financial reports are prepared under the responsibility of the Executive in charge of preparing the corporate accounting and financial reporting documents who, together with the Chairman of the Board of Directors, shall certify the adequacy and effective application in the Financial Statement / consolidated and the Interim financial report.

To enable certification by the Responsible Officer, the companies and relevant processes that feed and generate economic, equity or financial information have been mapped. The identification of companies belonging to the Group and key processes is done annually on the basis of quantitative and qualitative criteria. The quantitative criteria involve the identification of the Group companies that, in relation to the selected processes, represent an aggregate value exceeding a certain threshold of materiality.

Qualitative criteria involve the examination of processes and of companies that, in the opinion of the Chief Executive Officer and Chief Financial Officer of the business sectors, may present potential areas of risk, though not included in the quantitative parameters described above.

For each selected process, the risk / control objectives have been identified related to the preparation of Financial Statements and related disclosures as well as the effectiveness / efficiency of the internal control system in general.

For each control objective verification activities have been implemented and specific responsibilities have been assigned.

A supervisory system was implemented on the controls performed by a mechanism of chain certifications; any problems that emerge in the evaluation process are the subject of action plans whose implementation is verified in subsequent closings.

Lastly, a quarterly release was finally scheduled by the Chief Executive Officer and Chief Financial Officer of the subsidiaries of a declaration of reliability and accuracy of the data sent for the purpose of preparing the consolidated Group Financial Statement.

Around the dates of the Board of Directors approving the consolidated data at June 30 and December 31st, the results of the verification activities are discussed by the Chief Financial Officer of the Sectors with the Responsible Officer.

In summary, a system has been adopted for continuous and systematic controls that provide reasonable assurance regarding the reliability of the information and of the economic and financial reporting.

The Internal Audit Department performs regular audits aimed at verifying the adequacy of the design and operation of random controls on companies and processes, selected on the basis of materiality. 

On the basis of regular reports, the Responsible Officer reported to the Board of Directors on the effectiveness of the System, through the Audit, Risks, Sustainability and Corporate Governance Committee. The same Responsible Officer, together with the Chairman of the Board of Directors, also provided the declaration pursuant to paragraph 5 of article 154-bis of the CFA.  

External risks

RISKS ASSOCIATED WITH GENERAL ECONOMIC CONDITIONS AND CHANGING DEMAND IN THE MEDIUM TERM

As described under the sections "Macroeconomic and market scenario 2014" and "Outlook 2015", after a 2014 still marked by a high level of uncertainty, Pirelli expects a gradual, though not particularly significant, acceleration of the world economy during 2015, driven largely by the recovery in the advanced economies (mostly the USA). The performance of emerging markets (especially oil exporters) will on the other hand continue to be affected by the current weakness in commodity prices. Elements of uncertainty will remain and might derive, inter alia, from the normalization of the monetary policies in the United States, possible political tensions in the more economically fragile emerging countries and, last but not least, geopolitical tensions in the Middle East and Ukraine.

COUNTRY RISK

Pirelli adopts a "local for local" strategy creating productive presences in rapidly developing countries to respond to local demand with competitive industrial and logistic costs. This strategy increases the competitiveness of the Group also allowing overcoming the phenomenon of strengthening "trading blocs" and the increase of protectionist measures (customs barriers or other measures such as technical prerequisites, product certification, administrative costs related to import procedures, etc.).

Under the strategy, Pirelli operates in countries (Argentina, Brazil, Mexico, Russia, China, Egypt, Turkey, Venezuela and Indonesia) where the general economic and political context and tax regime may prove unstable in the future.

In fact, structural elements of risk persist in Latam area, identifiable especially in the political-economic scenario of Venezuela and Argentina, and in Egypt, where, to date, the political and social instability is still dominant and has led over the past three years to an alteration of the normal market dynamics and, more generally, the operating conditions of business. To these scenarios of uncertainty, during the latter part of 2014, the current economic and political crises in the region Ukraine was then added, whose implication in the medium to long term remains to this day still very uncertain.

The Group constantly monitors the evolution of risks (political, economic / financial and security) related to the countries in which it operates in order to continue to adopt timely (and if possible in advance) measures to mitigate the potential impacts of changes in the local context. Moreover, in situations of under utilization of the capacity of some factories, shifts in production between Group plants are possible.

RISKS RELATED TO CHANGES IN DEMAND IN THE LONG TERM

Over the last few decades, some social and technological trends have emerged that might have a material impact over the medium-long term on the automotive sector and indirectly on the tyre market. On the one hand, these are represented by growing urbanisation (according to United Nations estimates, about 70% of the global population will live in urban areas in 2050) and, on the other hand, by changes in the values and behaviour of younger generations (increase in the average age when a driver’s license is obtained, loss of importance of owning a car, increased recourse to various types of car sharing).

These factors will be complemented by the spread of information technologies, with a concurrent expansion of e-commerce and/or telecommuting, and frequent regulatory changes in both mature and emerging economies to limit the presence of polluting vehicles within and near metropolitan areas. These dynamics might be followed by an evolution in automotive sector demand (from changes to vehicle dimensions or type of propulsion system to possible resizing of cars to satisfy the transportation preferences of citizens), with contingent impact on tyre sector dynamics.

Pirelli constantly monitors the evolutionary changes in automotive sector demand by actively participating in international working groups, such as the one engaged in the Sustainable Mobility 2.0 (SMP 2.0) project sponsored by the World Business Council for Sustainable Development (WBCSD). The principal aim of SMP 2.0 is to study the possible long-term evolution in urban mobility and promote solutions that might improve the social, environmental and economic well-being of the urban population.

Strategic Risks

RISKS RELATED TO THE TREND IN PRICES AND AVAILABILITY OF RAW MATERIALS

Natural rubber, synthetic rubber and raw materials related to oil (in particular chemicals and carbon black) will continue to be a factor of uncertainty in the cost structure of the Group, given the strong volatility in recent years and their impact on the cost of the finished product (approximately 35% of sales in 2014).

For the main raw materials purchased by the Group possible price scenarios are constantly simulated in relation to the historical volatility and/or the best information available on the market (ex. forward prices). Based on different scenarios, increases in selling prices and/or the different internal actions for recovery of cost efficiency (use of alternative raw materials, reduction of product weight, improvement of process quality and reduction in waste levels) are identified and which are necessary to ensure the levels of profitability expected. 

FINANCIAL RISKS

The Group is exposed to financial risks, mainly related to the exchange rate, obtaining financial resources on the market, fluctuations in interest rates, the ability of customers to meet their obligations to the Group and the price of financial assets held in the portfolio. Financial risk management is an integral part of Group business management and is handled directly by the headquarters in accordance with guidelines issued by the Finance Department on the basis of general risk management strategies identified by the Managerial Risk Committee.

Exchange rate risk

The geographical distribution of Pirelli production and commercial activities entails exposure to “transaction” and “translation” exchange rate risk.

The currency translation risk is generated by commercial and financial transactions made in individual companies in currencies other than the functional one, due to fluctuations in exchange rates between the time when the commercial/financial relationship originates and when the transaction is completed (collection/payment).

The Group policy is to minimize the impact of transaction exchange rate risk related to volatility; consequently, Group procedures make the Operating Units responsible for collecting complete information about all positions that are subject to transaction exchange rate risk (mainly represented by receivables and payables in foreign currency). This risk is hedged with forward contracts made, where possible, with the Group Treasury.

The managed positions subject to exchange rate risk are mainly represented by receivables and payables denominated in foreign currency.

The Group Treasury is responsible for hedging the net position for each currency and, in accordance with established guidelines and restrictions, it closes all risk positions by trading derivative hedging contracts on the market, which typically take the form of forward contracts.

Furthermore, as part of the annual and three-year planning process, the Group makes exchange rate forecasts by using the best information available on the market. The fluctuation in the exchange rate between the time of planning and the time when a commercial or financial transaction originates results in a currency translation risk on future transactions with respect to the objectives communicated to the market. Each time, the Group assesses the need to engage in hedging transactions on future transactions for which it typically uses both forward and optional purchase or sale transactions such as risk reversal (i.e., zero cost collar).

Pirelli owns controlling interests in companies that prepare their Financial Statements in currencies other than the euro, which is used to prepare the consolidated Financial Statement. This exposes the Group to currency translation risk, due to the conversion into euro of the assets and liabilities of subsidiaries operating in other currencies. The principal exposures to currency translation risk are constantly monitored and it is not currently deemed necessary to adopt specific policies to hedge this exposure.

The year 2014 saw a significant depreciation of the main currencies of emerging of interest to Pirelli against the US dollar (USD), above all the Venezuelan Bolivar, Argentine Peso, Turkish Lira and, to a lesser extent, the Brazilian Real and Egyptian Pound. This general trend of depreciation of emerging currencies, partly due to exogenous factors - such as the monetary policies of the US Central Bank - and specific internal macroeconomic conditions, combined with a euro value against the US dollar stronger than expectations in the first part of the year resulted in an overall negative effect for the Group.

As for 2015, Pirelli expects - in line with the main market operators - a continuation of the current trend of depreciation of the main currencies of emerging countries attributable, once again, to the effect of the change in monetary policies by the Federal Reserve and specific elements of country risk (with particular reference to the Venezuelan Bolivar and the Argentine Peso).

Finally, as regards the euro/US dollar exchange, Pirelli expects a weaker euro compared to the levels at the end of 2014. Also in this case, significant elements of uncertainty remain, such as, among other things, the monetary policy decisions to be taken by the Central banks on both sides of the Atlantic.

Liquidity risk

The principal instruments used by the Group to manage the risk of insufficient financial resources available to meet the financial and commercial obligations in the terms and deadlines established, are comprised by its annual and three-year financial and cash-pooling plans. These allow complete and fair detection and measurement of incoming and outgoing cash flows. The differences between plans and actual data are constantly analysed.

The Group has implemented a centralised cash pooling system for the management of collection and payment flows in compliance with various local currency and tax regulations. Banking relationships are negotiated and managed centrally, in order to ensure coverage of short and medium-term financial needs at the lowest possible cost. The procurement of medium and long-term resources on the capital market is also streamlined through centralised management.

Prudent management of the risk described above requires the maintaining of an adequate level of cash or cash equivalents and/or highly liquid short-term financial instruments, and the availability of funds through an adequate amount of committed credit facilities and/or recourse to the capital market.

In addition to the available portion of the revolving credit facility of euro 1.2 billion maturing November 30, 2015, which in December 2014 is used for euro 75 million, the Pirelli Group resorts to the capital market by diversifying products and deadlines to seize the best opportunities available each time. For example, in November 2014, a bond issue of euro 600 million with 5-year duration was placed with qualified investors as part of EMTN (Euro Medium Term Note) program - document platform for the issuance of bonds on the Euromarket - whose maximum amount was set at euro 2 billion.

Interest rate risk

Fluctuations in interest rates affect the market value of financial assets and liabilities of the Group and net financial expenses.

Group policy tends to maintain the following ratio between fixed rate and variable rate exposures: 70% fixed and 30% variable.

In order to maintain this trend ratio, the Group enters into derivative contracts, typically interest rate swaps.

Price risk associated with financial assets

The Group is exposed to price risk only regarding the volatility of financial assets such as listed and unlisted stocks and bonds, representing 3.2% of total assets of the Group. Derivatives hedges are not normally set up to limit the volatility of these assets.

Credit risk

Credit risk represents Group exposure to contingent losses resulting from default by commercial and financial counterparties.

Regarding commercial counterparties, in order to limit this risk, Pirelli has implemented procedures to evaluate its customers’ potential and financial solidity, monitor expected incoming cash flows and take credit recovery action if necessary. The aim of these procedures is to define customer credit limits. Further sales are suspended when those limits are exceeded. In certain cases customers are asked to provide guarantees. These mainly consist of bank guarantees issued by parties with the highest credit standing, or personal guarantees.

Less frequently, mortgage guarantees may be requested.

Another tool used for risk management of commercial receivables are insurance policies: as of January 2012 the company signed a two-year master agreement with a leading insurance company for worldwide coverage (Egypt, Venezuela and China are excluded from the policy) of the credit risk mainly related to sales of the spare parts segment (with about 77% of acceptance rate in December 2014).

The master agreement above has also been renewed for 2014.

In the course of 2014 the general situation of trade receivables remained essentially in line with the closing of the previous year.   

The Group operates only with highly rated financial counterparties for the management of its temporary cash surpluses or trading in derivative instruments.

Pirelli does not hold public debt instruments from any European country, and constantly monitors its net credit exposure to the banking system and does not have significant concentrations of credit risk.

Operational Risk

ENVIRONMENTAL RISKS

Activities and products of the Pirelli Group are subject to numerous environmental regulations related to the specificity of the different countries in which the Group operates. These regulations have in common their tendency to evolve in an ever more restrictive manner, also because of the growing concern of the international community over the issue of environmental sustainability. Pirelli expects a gradual introduction of ever stricter laws in relation to the various environmental aspects on which companies may impact (atmospheric emissions, waste generation, impacts on soil, water use, etc.), by virtue of which the Group expects to have to continue to make investments and/or incur costs that could be significant.

In regard to the impacts from climate change, no significant risks have been found in relation to production processes or markets in which the Company operates. Instead, in terms of opportunities, Pirelli Green Performance tyres exhibit growth potential, given the relevant lower environmental impact and the possible regulatory evolution in many countries as it was in Europe with European labelling standards.

Employee health and safety risks

The Pirelli Group, in the exercise of its activities, incurs expenses and costs for the actions necessary to ensure full compliance with the obligations under the regulations regarding health and safety in the workplace. In Italy in particular the law relating to health and safety in the workplace (Legislative Decree 81/08) and subsequent updates (Legislative Decree 106/09) have introduced new obligations that have impacted on the management of activities at Pirelli sites and the models for allocating responsibilities. Failure to comply with current legislation involves criminal and/or civil penalties against those responsible and, in some cases of violation of the legislation on health and safety against the Companies themselves, according to a European model of objective liability of companies incorporated in Italy (Legislative Decree 231/01).

Product defect risk

Like all manufacturers of goods for sale to the public, Pirelli could suffer liability claims related to the alleged defects of the materials sold or may be required to launch recall campaigns of products. Although in recent years there have been no significant cases and such events are however covered from an insurance point of view, their occurrence could have a negative impact on the reputation of the Pirelli brand. For this reason, the tyres manufactured by Pirelli are subjected to careful quality analyses before being placed on the market, and the entire production process is subject to specific "quality assurance" procedures with safety and performance objectives constantly raised.

Litigation risks

In carrying out its activities, Pirelli may become involved in legal, fiscal, trade or labour law disputes. The Group adopts the necessary measures to prevent and mitigate any penalties that may result from such proceedings.

Risks associated with human resources

The Group is exposed to the risk of loss of resources in key positions or with "critical know how". To address this risk, the Group adopts remuneration policies periodically updated also based on changes in the general macroeconomic scenario as well as on the basis of salary benchmarks. There are also long-term incentive plans and specific non-competition agreements (also with retention effect). Finally, specific "management" policies are adopted to motivate and retain talent.

Risks related to information systems and network infrastructure

The Group's operating activities are increasingly dependent on the proper and uninterrupted operation of information systems and network infrastructure in support of business processes. Accidental human errors, access by unauthorized third parties, vulnerabilities in security systems and/or "simple" failure or malfunction of systems and network infrastructure could have negative impacts on operating activities, cause loss of critical business information, have negative repercussions on corporate image and/or determine the risk of non-compliance with laws and regulations.

Based on the main risks identified in the analyses performed in previous years, in 2014 the Group focused on the preparation of a new technical and organizational solution of Disaster Recovery to strengthen the ability to ensure continuity of the support systems of business activities.

Particular attention was paid to the implementation of policies to increase controls to ensure further strengthening of the monitoring of IT security for offices and factories, infrastructural and application, also by introducing new technologies of logical protection to mitigate the new risk scenarios detected: Mobile, Cloud, Internet Of Things. With this same focus technologies were also introduced aimed at the protection and traceability of the most critical know-how through the adoption of file classification and encryption tools.

In order to raise staff awareness on cyber risks related to Internet navigation and the use of social networks, an awareness campaign has been initiated for all staff regarding the proper use of IT tools.

Also, to limit the risk of blackouts of IT services at the branch offices and factories, a type of network was designed with the increased widespread presence of redundant connectivity for each premise and the use of different providers and technologies.

Business interruption risks

The territorial fragmentation of the operating activities of the Group and their interconnection expose it to risk scenarios that could cause the interruption of business operations for more or less prolonged periods, with the consequent affect on the "operational" capabilities and results of the Group itself. Risk scenarios related to natural events or accidents (fires, floods, earthquakes, etc.), wilful misconduct (vandalism, sabotage, etc.), the failure of the auxiliary plants or interruption of the supply of utilities can, in fact, cause significant property damage, reduction and/or interruption of production, particularly if the event concerns production sites with high volumes or specific products (high-end). Pirelli monitors vulnerability to catastrophic natural events (in particular flood, hurricane and earthquake) with estimates of potential damage (given the probability of occurrence) of all the Group's production sites. The analyses confirm adequate monitoring of the Business interruption risks, thanks to a comprehensive series of security measures, prevention systems of harmful events and mitigation of potential impacts on the business, also in light of the current business continuity plans as well as insurance policies in place to cover property damage and business interruption. With reference to the earthquake risk, and specifically to the facility in Turkey, particularly significant seismic events could result in losses exceeding the limits insured resulting in negative impact on operating results. 

Even the Pirelli supply chain, with particular attention to the Tier-1 suppliers is subject to assessment in relation to the potential business interruption risks. The Group has therefore implemented a series of mitigation measures to reduce the vulnerability of the supply chain; in particular extension of the portfolio of approved plants for each supplier, approval of materials/alternative suppliers, increased levels of safety stock of critical materials, etc.

Reputational and social-environmental responsibility risks

Reputational risks

Since 2013 Pirelli has decided to develop an ad hoc method to identify and measure reputational risks, construed as the present or prospective risk of lost profits or lower share price resulting from negative perception of the Company by one or more stakeholders. While on the one hand reputational risk has to be construed as the contingent occurrence of a negative event tied to one of the three macro-families of risks mentioned above, on the other hand it must be managed as an independent event precisely because its scope depends on the expectations of stakeholders and the impact of the negative event.

In 2014, the chosen methodology resulted in the identification of 24 reputational risks specific to Pirelli. This mapping derives from the analysis of a series of internal and external drivers including: negative events with an impact on reputation which occurred in the sector worldwide over the last ten years; interviews with external Key Opinion Leaders on sector trends, particularly mobility and sustainability; interviews with internal Key Opinion Leaders. The identified risk events were then measured by the stakeholders general public in the five key countries for the Group and led to definition of the governance and management structures, as well as the preparation of any mitigation and/or crisis management plans.

Risks in social, environmental, business ethics responsibility and third-party Audit

Risk management at Pirelli is enterprise-wide and includes the identification, analysis and monitoring of environmental, social, financial and business ethics risks that are directly or indirectly associated with the company, at Pirelli affiliates or in relations with them, such as sustainability of the supply chain.

Ad hoc assessments are also carried out before entering a specific market, in order to assess any political, financial, environmental and social risks, including those connected with human and labour rights. Together with constant co-ordination and monitoring at the corporate level, compliance with Pirelli rules on economic, social (especially human rights and labour rights), environmental and business ethics sustainability is assessed through periodic audits commissioned by Pirelli from specialised external firms, in addition to the extensive activities of the Internal Audit Department. Particular attention is devoted to the sustainability of Pirelli sites and those of company suppliers operating in emerging countries.

Again during 2014 Pirelli commissioned third-party Audits of its suppliers, in addition to continuing internal monitoring through the activities of the Internal Audit Department.