Management Board Report on the activity of the JSW S.A. Capital Group for 2012

4. Other information

4.1. Risk factors and threats

The Capital Group in exposed to various risks in every area of its activity. Actions taken in the main area of activity, on account of the highly risky and volatile mining and geological conditions (underground conditions for mining deposits), entail extensive risk. The changing legal regulations concerning the mining of deposits and environmental protection, tax regulations and their interpretation constitute a risk of additional financial requirements being implemented on the Parent Company and the Group.

In 2012, the Parent Company took a number of steps to modify and develop the existing Corporate Risk Management System. As a result of the this work, proposals for comprehensive risk management solutions were developed, based on the practice of COSO, FERMA and ISO systems, while taking into account the high requirements of JSW S.A. and the specific nature of its operations. As a result of this work, the Corporate Risk Management Policy and Procedures were approved by the JSW S.A. Management Board in December 2012 and implemented and adopted for use in January 2013. These documents are a comprehensive description of a formal corporate risk management system that meets the highest risk management standards. The purpose of this system is to:

  • identify the potential events that may have an adverse effect on the Parent Company,
  • keep risk within the specified limits, and
  • ensure the achievement of business objectives in a reasonable manner

Risk management is a continuous process. The Group's quickly changing economic environment forces it to revise and update the list of risks continuously.

In 2012, the Management Board established, within the organizational structures of JSW S.A., the position of a Representative for Risk Management, fully dedicated to the coordination of tasks related to the Corporate Risk Management System. Within the scope of his tasks, acting together with risk owners, the Representative manages risks acting on the basis of the mentioned procedures and policy. Among others, he analyzes the existing risk-mitigating control mechanisms, the rules for measuring exposures to respective risks and develops recommendations for the current risk response plans.

Risks have been presented below where if they ever occur they may exert a material and adverse impact on the Group’s operations, its results and financial position, causing a decline in value and share price. Additional risk factors which are unknown at present or which are currently believed to be immaterial may also exert a material and adverse impact on the Group’s operations, its financial position and operating results.

The following risk factors are among the risk factors to which the Capital Group is exposed and to which special attention is drawn:

4.1.1. Factors related to the Group’s business and market environment

Market risk is managed to mitigate the impact of undesirable effect of changes in market risk factors on cash flows and on financial results. The key market risks and risks related to the business operations include:

Global economic situation

Economic growth determines the situation on the markets for coal, coke and steel. Unequal levels of global GDP and a universal economic slowdown, especially in Europe where financial problems of the Euro zone, mainly in Greece, Span and Portugal were an additional hindrance in the crisis fighting process, reduced the production of steel. In 2012, steel production in European Union states declined 4.7% from the preceding year. As a result of that situation, demand for raw materials used to produce steel and coke, i.e. coke and coking coal, respectively, decreased. The year 2012 was very difficult for coke production because of the lower consumption of coke by the blast furnace steel industry. Out of the 74 blast furnaces installed in Europe, 20 were down and only about 75% of the production capacity was utilized.

Excess supply of coal and coke on the European Union market

In the last decade, the growing global coal market and the increasing demand for coal throughout the work drew new investors to the coal industry. Many new mines were created and the existing ones were expanded, thus increasing the global production capacity. The global production of coal grew very dynamically, from 4.6 billion tons in 2000 to 7.8 billion tons in 2011. Moreover, the coal price growth which has taken place from the outset of 2003 has enticed new and existing international coal producers to expand their production capacities.

The excess coal and coke supply on global markets and the domestic market may lead to a considerable decline in coal and coke prices and may exert a material and adverse impact on the Group’s operations, performance and financial position.

During the current economic slowdown, where new selling markets are sought, product prices reduced or coal or coke inventories placed in storage sites, the Group was quite significantly affected by this risk in 2012. In 2012, coal inventories rose by 684.0 thousand tons compared to the previous year.

Also, coke sales were affected by the declining steel production in European Union states. The declining demand for coke on the European market was noticeable especially in Q4 2012, where steel production was lower and steel manufacturers suspended their orders, waiting for the market to react to China's expected alignment with World Trade Organization's recommendations on abolishing restrictions in raw materials trading. As a result of this situation, the utilization of production capacity of coking plants dropped and coke inventories increased.

Sales to a relatively small number of major customers from the European Union and a considerable downturn in market conditions in the European economy, decline of coal consumption among the Group’s customers in this region or the inability to obtain payment from them

The considerable downturn in market conditions in the European economy, especially in the steel and coke industries may have a material and adverse impact on the Group’s operations, its results and financial position. Furthermore, if one or more of the Group’s major buyers cuts back on the volume of coal or coke purchased or fails to extend supply contracts, this could have a material and adverse impact on the Group’s operations, its results and financial position. Moreover, timely payments hinge upon many factors beyond the Group’s control.

Revenues on sales of the Group's products to five of its Coal and Coke segment customers in 2012 expressed as a percentage of total revenues on sales are described in Item 2.3 of this report.

Decline or volatility of coal and coke prices

The major driver of domestic and international coal and coke prices and its consumption are the overall supply and demand for these products. Demand for the Group's key products may be subject to the influences of global economic cycles, political events, force majeure and hinges on the level of demand for coking coal and coke in the metallurgical and coking industry. Price volatility exerts a direct impact on the Group’s operating and financial results.

In the past the Group has undergone material volatility of coking coal prices and the Company is convinced that there is a probability that such volatility will also occur in the future.

The global economic slowdown was reflected in a drastic decline in benchmark prices for hard coking coal, where the price declined continuously from 330 USD/t in Q2 2011 to 170 USD/t in Q4 2012 (-160 USD/t; -48.5%). The Group, which is the leading producer of hard coal in Europe, was seriously affected by this drop. As a result, its average external coal selling price in 2012 was 14.1% less than in 2011.

The average FCA-based price of coke in 2012 was 19.0% less than in 2011. The market trends and the extent of the drop of prices earned by JSW S.A. were comparable to the quoted prices of coke on the European market (according to the Coke Market Report).

Operational risks that may contribute to lower output or higher costs of coal production

The Group’s coal production volume is subject to operational determinants and events beyond its control, which may disrupt its operations and affect the production volumes in the various mines in different periods. The Group’s mining activity is above all subject to the influence exerted by mining determinants, which include among others:

  • difficult geological conditions such as disruptions to the continuity of deposits characterized by volatility and irregularity that may curtail the effectiveness of mining longwall parcels to a greater extent than anticipated;
  • level of natural hazards higher than forecast which may lessen the ability to mine individual longwalls;
  • mine accidents, fires, explosions and methane combustion, coal dust explosions, methane and rock outbursts and rock falls and collapses;
  • failures of machinery and equipment used in mining and processing.

Even though the Group has taken a multitude of measures to enhance safety these risks may grow in particular in conjunction with mining at deeper levels in the Group’s mines.

Moreover, the events and determinants that may affect production volume and in particular cost growth should include changes to the legal regulations concerning the coal industry.

A new geology and mining law is in force as of 1 January 2012. At present, work is in progress on the executive regulations to this law. The regulations governing coal mining in the face of natural hazards are expected to become more stringent. In truth, the Group undertook advance measures to make it possible to achieve the assumed level of output but it will be difficult to assess their impact on the Group’s mines’ production capacities and mining costs until the final wording of the regulations is published.

The quantity and quality of coal mined by the Group may be lower than customers expect

Estimates concerning coal resources inevitably entail a certain amount of uncertainty and to some extent depend on the geological criteria used, coal prices, cost assumptions and statistical data, which may ultimately prove to be imprecise. As a result, estimates concerning coal resources are regularly checked on the basis of the development of current production or other new information; as a result, one should expect that they will change. If the Group’s actual resources prove to be lower than current estimates, this may adversely affect the Group’s operations, operating results and financial position.

The quantity and quality of coke produced by the Group may be lower than customers expect

Production capacities of the coking batteries may be affected by a number of factors remaining outside of the Group's control. These forecasts inevitably contain some level of uncertainty and to this extent they rely on economic and technical assumptions made, which in the end may prove to be imprecise. As a result, estimates concerning coke production are regularly checked on the basis of new information; as a result, one should expect that they may change. If the actual coke production capacity by the Group is lower than the current estimates then this may adversely affect the Group's outlook and value and its operations, performance and financial standing.

Due to the economic slowdown in 2012, the Group used about 75% of the production capacity of its coking plants.

Ability to operate existing resources, acquire them and utilize economically attractive coal resources at a competitive cost

Resources may not be available when they are needed or if they are available their extraction at a competitive cost in a given period may not be plausible. The Group may not be able to assess the geological structure of deposits precisely in forward-looking regions, which may adversely affect its profitability and financial position if this assessment proves to be erroneous. Moreover, the investment, acquisition and exploration projects planned by the Group may not provide additional material resources or the operation of these resources may not be profitable.

Group’s inability to execute development projects or delays in their execution

Since the coal resources held by the Group are depleted as they are used, the Group’s ability to achieve the planned level of production in the long-term partially depends on its ability to acquire and operate new coal resources fit for extraction from an economic point of view, and its ability to develop new and expand existing extraction activity. The Group’s ability to acquire additional resources in the future may be curtailed by a host of factors over which the Group has no control. The Group’s inability to complete investment projects according to plan may exert a material and adverse impact on the Group’s development, operations, results and financial standing.

Successful integration of newly-acquired companies in the Group

All the acquisitions, joint ventures and investments in minority stakes conducted may involve significant capital investments, a new issue of shares or drawing down considerable obligations. As a consequence, the execution of these projects may lead to an emergence of a number of additional unfavorable circumstances, including problems with effective integration of operations, elevated operating expenses, exposure to unexpected liability and difficulties with attaining the projected levels of efficiency, synergy and cost savings. Each one of the issues discussed above may exert a significant and adverse impact on the Group's results and financial position.

Employee relations may adversely affect Group’s operations

In the hard coal sector, trade unions have an important role in shaping the salary policy, often using protests to renegotiate the salary policy.

The strong position of trade unions gives rise to a situation in which there exists a risk of increasing salaries under the negotiated salary agreements, which consequently may adversely affect the financial performance of the Group. The Group’s failure to maintain proper employee relations may exert a material and adverse impact on the Group’s operational outlook, results and financial position.

As at the date of this report, there were 38 Trade Union Organizations operating in the Parent Company. The total number of trade union members, as employees may belong to several unions, exceeds the number of employees employed with JSW S.A. and as at 31 December 2012 is 27 068, which means that the trade union membership percentage ratio at JSW S.A. is 119.4%.

The Parent Company aims at negotiating with the trade units a Company Collective Bargaining Agreement for JSW S.A. employees and the Labor Rules and Regulations. During the negotiations on the Collective Bargaining Agreement and consultations about the Labor Rules and Regulations, the trade unions did not accept the proposals included in the draft Collective Bargaining Agreement and draft Labor Rules and Regulations presented by the Management Board of JSW S.A. The Parent Company intends to continue the negotiations of the Collective Bargaining Agreement for JSW S.A. employees and the Labor Rules and Regulations.

The Parent Company is considering the implementation of flexible work time to facilitate the achievement of the mines’ production targets by extending the work week to six days depending on the needs of the particular mines. This requires acceptance of the trade unions and the hiring of additional employees. During negotiations the trade unions did not consent to the solution proposed by the Management Board of JSW S.A. whereby mines would operate to pursue their production targets six days a week – while employees would have a five day work week.

Collective disputes with employees may disrupt the Group’s operations

In the hard coal mining sector trade unions occupy a significant position symbolized among others by the ability to engage in protests, including collective disputes. The position held by trade unions is particularly strong on account of the headcount in the sector and its strategic influence over the functioning of the economy. In addition, trade unions’ expectations are based on the terms and conditions obtained by employees of other companies undergoing privatization.

Over the most recent financial year there were two collective disputes in the Parent Company that were described in Item 4.7 of this report.

Despite the agreement signed with the Inter-Union Protest and Strike Committee on a 3.4% basic salary rate increase in 2012 and despite the accepted salary growth plan for Parent Company's employees in 2013-2015, collective disputes may still take place in the future. The possible protests or strikes organized by the trade unions operating in the Parent Company may affect the policies or procedures existing in JSW S.A. which in turn may have a material adverse effect on the Group's prospects, performance and financial standing.

Volatility of PLN and other foreign currencies with respect to the EUR and USD

The Group’s main products are usually priced in PLN, EUR, USD and CZK, while its operating expenses, including employee benefits, the consumption of materials, energy and external services are predominantly incurred in PLN. Other costs and expenditures for investment purchases are incurred in PLN, EUR and USD. Having regard for the structure of the Group’s sales revenues and expenses, the strengthening of the PLN against the EUR or USD may cause the Group’s revenues to fall and as a result may lead to a lower operating result. According to data published by the National Bank of Poland (NBP), the PLN appreciated against the EUR at the end of 2012 compared to the beginning of the year by about 8.4%, and against the USD by 10.0%. As a result, PLN volatility against the EUR or USD may affect the Group’s operations, its financial position and operating results.

The Group is exposed to a significant foreign exchange risk associated with the sales of products to domestic and international markets. To eliminate FX risk, in 2012 the Group entered into FX forwards. The Group also buys materials, services and investment goods in foreign currencies. This curtails the FX volatility risk resulting from selling products in a natural way.

The prospective impact exerted by EUR/PLN exchange rate growth and decline has been depicted in Note 3.1 to the consolidated financial statements of the Jastrzębska Spółka Węglowa S.A. Capital Group for the financial year ended 31 December 2012. Changes in exchange rates of currencies other than EUR do not have a material impact on the Group’s net profit.

Cash flow volatility risk caused by changes in interest rates

The Group is exposed to the risk of changing cash flows caused by changing interest rates. The risk results primarily from the fact that the value of certain assets and liabilities may change as a result of changes in market interest rates.

In 2012, the Group invested its available cash in financial assets bearing interest on the basis of floating interest rates, but also used external financing. In the case of loans, the risk of changing interest rates was associated mainly with the volatility of the WIBOR 1M reference rate, on which most of the applicable interest rates are based. At the same time, the Group held bank deposits earning interest at floating and fixed interest rates.

The risk of changing cash flows is therefore related to the volatility of interest rates on cash held and on external financing.

The Group does not use derivatives to hedge against interest rate risk.

Issues related to local communities

The Group’s business activity may prompt disputes with local communities concerning the areas where the Group conducts or intends to conduct its operations. These issues may in turn lead to protests in these communities or third party claims. The inability to reach a positive solution to issues related to local communities may exert a material and adverse impact in the future on the Group’s operations, financial position and operating results.

4.1.2. Risk factors associated with the legal environment

Difficulty in obtaining or renewing licenses and concluding mining usufruct contracts within the required deadlines

The Group's key business relies on the effective power of its licenses, its compliance with the terms of those licenses and its capacity to obtain new licenses. Granting of a new mining license or extension of a current license requires certain requirements prescribed by the law to be met. The granting or extension of a license may be refused if the intended activity violates environmental requirements, is contrary to purpose of the real property or is a threat to its safety or is a threat to defense and security of the state or its citizens. The Group consults with local government bodies regarding the opening of coal resources in deposits adjacent to the mines. A mining license is granted based on a local zoning plan and if there is no zoning plan – based on the study of zoning conditions and directions. New licenses may be obtained on certain conditions, which include changes to local zoning plans which allow for the possibility of coal mining. Life expectancy of mines may be reduced significantly if new deposits are not opened.

If the Group's licenses are canceled or if new licenses or extensions are not granted to the Group, the Group may be unable to fully utilize its identified mineral deposits, which may have a material adverse effect on the Group's performance and business outlook.

The Group may be subject to a higher excise tax on coal gas and coking gas after 31 October 2013

Pursuant to Directive 2003/96/EC, coal gas and coking gas classified in the combined nomenclature under code CN 2705 are also subject to excise tax. At the same time, this directive gives the power to implement a total or partial exemption or discount on the level of taxation applied to the products under code CN 2705 (including coking gas and coal gas) under the condition that they are used for heating purposes. The excise tax law contemplates an exemption from excise tax for other gaseous fuels for the duration of the natural gas exemption, i.e. until 31 October 2013 or until the time when the percentage of natural gas in energy consumption in Poland reaches 25%. On 30 January 2013, a draft act amending the excise tax act was published. In the coming months, interministerial agreements and consultations will take place in which the final wording of the new regulations governing the taxation of gas with excise tax will be adopted. The proposed wording of the regulations contain numerous exclusions, e.g. use for heating purposes in the electricity generation process and for co-generation of heat and electricity, which applies to the methane drainage gas sold by the Group. In light of the above, the risk of excise tax occurs only if the gas is sold for liquefaction, but the proposed wording shifts this risk to the buyer, raising the prices by the excise tax amount. Nevertheless, until the final wording of the regulations is determined, we cannot rule out that adverse changes are introduced potentially burdening the Group with the excise tax.

The Parent Company may be obligated to remedy mining damages or reclaim mining sites to a greater extent than planned

According to the Geological and Mining Law, the Group is obligated to repair mining damages and it may be obligated to reinstate land to its previous state from before commencing mining activity. Any and all changes to the law that would make these requirements more stringent may lead to higher costs of reclamation and repairing damages.

The Group may be forced to adjust its operations to the EU Climate Policy

One of the priorities of the European Union is to prevent climate change, among others through limiting the consumption of natural energy resources, introducing modern and efficient energy generation technologies, limiting carbon dioxide emissions, reducing energy consumption and increasing the importance of renewable energy generation. In order to achieve these objectives, the European Union has introduced a package under the name of “3x20% by 2020”. As the recent years has shown, the European Commission is very consistent in implementing these goals and it is highly probable that all the future decisions referring to those matters will make the binding standards of consumption, efficiency and quality of energy even more stringent.

Obligations relating to the requirement to increase consumption of energy from renewable sources

SEJ as a power utility producing and trading in electricity and selling electricity to end users is obliged to obtain and present for redemption to the President of the Energy Regulatory Authority (URE) certificates of electricity origin from renewable sources ("green certificates") or pay a substitution fee.

There is also a risk that the cost of obtaining such certificates or the amount of the substitution fee will increase in the years to come. Furthermore, failure to present such certificates for redemption to the President of the Energy Regulatory Authority or pay the substitution fee will result in the imposition of a fine on the company by the President of the Energy Regulatory Authority. This as a result may adversely affect the Group's activity, financial standing and performance.

The Group is a member of the community scheme for greenhouse gas emission allowance trading

Koksownia Przyjaźń, KK Zabrze and SEJ are participants of the community scheme for greenhouse gas emission allowance trading in connection with CO2 emissions.

The necessity to purchase the allowances at an auction, if any, or the necessity to execute projects aiming at reduction of emissions may have negative impact on the Group’s financial standing.

The Group will be forced to adapt its activity to the Industrial Emissions Directive

The Industrial Emissions Directive came into force on 6 January 2011. It defines the rules associated with integrated prevention and control of pollution associated with industrial activity and rules associated with reduction of air, water and soil emissions. The implementation deadline of the Industrial Emissions Directive elapses on 7 January 2013, which means that after elapse of this deadline industrial installations will have to satisfy the emission standards defined in the Industrial Emissions Directive.

The Group may be subject to more stringent environmental protection standards and legal regulations

The legal regulations applicable to the environment and the usage of natural resources are subject to constant change and the trend over the most recent years has been toward making the binding standards more stringent, which may exert an adverse impact on the Group’s operations. Changes to the environmental protection law may force the Company to adapt to new requirements (e.g. adjusting the technologies used by the Group to curtail atmospheric emissions or changes to how waste is managed or water and sewage management), inclusive of obtaining new permits, or changes to the conditions of the current permits which may drive up the Group’s operating expenses.

Introduction of chemical substances into trade by the Group entails the risk of failure to satisfy the legal requirements or change of the regulations pertaining to introduction of such substances in accordance with the REACH Regulation, which may cause financial burden to the Group in the form of additional expenditures, which may then have material negative influence on the Group’s operations, financial standing and results.

The Group strives to limit risk by constantly overseeing environmental protection legal requirements and making the necessary investments to meet all environmental requirements. These actions create great opportunities to lower the level of risk and the costs of adaptation in the Group’s environmental operations and to new conditions.

The Parent Company may be obligated to remit property tax on underground mine workings or equipment (facilities) located in underground mine workings

On 13 September 2011 the Constitutional Tribunal pronounced a judgment unambiguously precluding underground mine workings (tunnel costs) from property tax and making the tax on plant and facilities located in these underground mine workings dependent on their classification as structures within the meaning of Construction Law. In light of the judgment of the Constitutional Tribunal and the decisions made in all the cases pending before the Voivodship Administrative Court in Gliwice (“WSA Gliwice”), which were favorable to the Group, the only doubts are related to the taxation of property, plant and equipment located at the bottom of the mine (in underground workings) and the possibility that the Group may have a duty of paying liabilities for this. Nevertheless, the rationale for those decisions is challenged by the Local Government Appeal Court in Katowice Local Government Board of Appeals in Bielsko-Biała, which filed cassation complaints with the Supreme Court of Administration against all the judgments which were favorable to the Group.

On account of opinions according to which the infrastructure situated at the bottom of the mine in underground workings, just like underground mine workings (tunnel costs) should not be subject to property tax, the Group has not included this infrastructure in tax declarations since 2009.

In assessing the risk linked to the further court proceeding resulting in the possibility subjecting to taxation some of the property, plant and equipment located in these workings, the Group has revalued the liabilities and provisions recognized in the ledgers for prospective disputes with the Townships. Nevertheless, despite the favorable decisions made by WSA Gliwice and the judgment of the Constitutional Tribunal, the Townships continue the proceedings to enforce the funds under the issued tax decisions.

Implementation of a mineral tax

The Group's financial performance may deteriorate if additional new encumbrances (taxes, fees) are imposed on the extraction of coal.

The factor with significant effect on the Group's financial results is the financial risk described in Item 3.10 of this report.