Published: September 01, 2013
As a global engineering firm operating in many of the world’s most dynamic but also some of the most volatile regions of the world, NEM Energy B.V., part of the Siemens Group, has to apply its combination of innovation and precision that characterises its product suite and approach to project delivery to its treasury management activities. Managing risk is a particular challenge, which has to be assessed and managed at an individual project level. In this article, Bert van der Donk, Treasury & Risk Manager discusses how NEM uses trade instruments in combination with other approaches to help manage collections risk that derives from both individual customer credit risk and wider political risks.
NEM is a global business, and although the number of customers with which we work is limited due the specialist nature of our activities, these are located in all parts of the world. Similarly, we work with suppliers and subcontractors globally. Like most engineering companies, the majority of our treasury activities relate to individual projects. We manage each one independently, which includes financing, risk management and cash management. Each project has its own cash flow profile, with different timings of cash inflows and outflows according to the project, but each project should be cash-neutral when considered on an aggregate basis. In general, projects do not need to be financed externally, as projects that have a negative cash position can typically be financed through surpluses in other projects. In addition, as part of the Siemens group, liquidity is centralised on a group basis, which enables further access to internal financing if required. As a result, cash management is relatively straightforward.
We have three core banks with which we have a close relationship. A major aspect of this relationship is the bank’s ability to provide guarantee facilities, and support in a correct and precise drafting of the wording of the trade instruments applied next to efficient execution. For example, it is a common requirement that we provide performance and warranty bonds to customers. In addition, we work with an insurance partner to provide guarantees. With a project-based approach to treasury, however, managing credit risk is a major activity. Not only do we focus on managing our risk to each individual counterparty, but political risk is becoming a more significant issue than in the past. Emerging markets and the Middle East are particularly challenging where credit reference information may not be readily available and where the political situation may be opaque and fast-changing. The use of trade finance instruments is therefore an essential aspect of our risk management approach.
We rely on our banks heavily for the issue of letters of credit (LCs), standby LCs and dealing with incoming guarantees and standby LCs. We work with banks that can confirm (standby) LCs in particular. With the growing importance of political risk, and the cost of insuring this risk increasing, we need our banking partners to share some of this risk. This enables us to adhere to our internally set credit risk management policy.[[[PAGE]]]
We prefer standby LCs over bank guarantees for three key reasons:
Firstly, if we need to issue a guarantee to a customer, the use of standby LCs is transparent as it is always conducted according to recognised universal practices.
Secondly, a LC always has an end date. As such you are not dependent on any release-action of the beneficiary. In case the latter abstains from such action, the facilities remain blocked while the underlying contract is already duly performed. Therefore the fixed end date is particularly important to us.
Thirdly, a standby LC offers better security on incoming payments, as if a customer pays late, we can make a demand for payment under the standby LC by simply sending the overdue invoice and statement to the bank. This assists with cash flow forecasting by improving the predictability of collections.
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Partnership with ING “ING and NEM have enjoyed a relationship that extends for more than a decade with a particular emphasis on trade finance instruments encompassing LCs and Bank guarantees. In addition, the bank has a comprehensive banking relationship with the wider Siemens Group, particularly focused on servicing the Group’s European operations. As a complex, global engineering business solution provider, NEM requires trade finance solutions that are specifically designed to meet NEM’s credit , political risks and - to a lesser extent – cash management guidelines associated with each project including standby LCs. The latter instruments are commonly used in the United States and Latin America, and at a global level in the oil and gas sectors in particular. In Europe and Middle East, bank guarantees are typically used. However, NEM has taken a less conventional approach and preferred to select trade instruments according to each individual scenario. It is an important part of our service offering at ING to be able to offer solutions that meet the individual cash and risk management needs of each of our customers, and the projects in which they are engaged, fulfilling the role of a true partner bank.” Jean Bonnet, Senior Consultant Trade Finance Services at ING |
We review the commercial and risk conditions of each project regularly and evaluate the instruments that are in place to protect our risk. This includes both guarantees that we issue, and those that we receive from our suppliers, including suspension of force majeure clauses and clear delivery statuses. If we determine that our political risk is high, we liaise with sales teams to manage processes such as warehousing carefully to minimise trapped cash that may be vulnerable. We also clearly specify payment conditions in the customer contract, e.g. what would happen to the contract in the event of the country becoming subject to an embargo. These same terms are included in the LC which should mirror the contract. To ensure that this is the case, we draft the LC at the same time as contract negotiations.
We typically work on a relatively small number of high-value projects, so we do not need to deal with a large volume of transactions. As every project is unique, so too is each LC. This makes the use of templates and automated processes more difficult than in a more standardised environment, so each LC is managed individually. Not all customers are willing to issue a LC, in which case we transact business under open account, but this applies in only a few cases where we already have a trusted, proven business relationship for which internal credit limits are put in place. Even in these cases, we still need to mitigate political risk through credit insurance or a combination of insurance and export credit agency financing. In some cases, such as in the case of a recent project in Iran, it was not possible either to insure our risk or obtain an LC. In this instance, we constructed the payment schedule carefully so that we always received more cash from the customer than the costs we had incurred, including future supplier commitments.
Based on our experience of managing risk in emerging and/ or politically volatile markets, it is important to consider the full range of instruments that are available, and leverage the right instrument in each situation. This is not limited to bank or insurance solutions: as an exporter of capital goods, we have worked with the Dutch ECA very successfully. The basis of a trade instrument should always be the customer contract which sets the conditions for delivery, payment etc. The greatest difficulty in this respect is the final payment which may be assumed to be due after a certain period as opposed to being linked to a specific project deliverable. LCs have proved particularly valuable for our business, not least as that a customer’s ability to an LC demonstrates its financial viability and good banking relationship. In instances where using an LC or standby LC is not feasible, political or credit risk insurance should be considered.
Risk is not limited to customer payment performance: supplier risk is also a major consideration, both individually and from a wider political risk perspective. To manage this, we visit our suppliers and subcontractors regularly and assess their financial and operating conditions. There are insurance products available, such as subcontractor’s default insurance, and construction wrap-up insurance in the US, but these allow the pass through of risk, as opposed to mitigating risk, and currently we do not use these products, although we may consider doing so in the future.
Maintaining effective communication between NEM and our banks is essential in order to ensure that trade instruments meet our needs exactly and are drafted correctly. These banks also add value by sharing their expertise derived from working with a variety of companies with comparable risk management needs. Similarly, we work closely with internal sales, procurement and logistics teams to understand and mitigate our risk. This internal and external dialogue, based on common objectives is essential to manage risk and transform credit and political risk to performance risk. Project delivery is more closely in our control and an area in which NEM excels, so we are leveraging our strengths, whilst minimising potential areas of weakness in which we have less control.
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