Background

The Board is committed to maintaining a high standard of financial risk management within the Group. The Group’s policies with regard to financial risk management are clearly defined and consistently applied.

The Group’s principal business is the identification, extraction and processing of mineral resources. The Group does not engage in trading activities and sales contracts are generally negotiated with trading companies or end users. The pricing basis applied in all sales contracts is referenced to prevailing market benchmarks such as the ‘official’ settlement prices quoted by the London Metals Exchange (LME). In general, the policy of the Group is not to hedge the underlying price exposure to its principal commodities, although in periods of high uncertainty or volatility the Group may consider some hedging of revenue and cost items in order to reduce volatility or risk on the Group’s cash flows. The Board may in certain circumstances authorise commodity hedging in order to guarantee the longer-term viability of certain marginal cost operations or to satisfy the specific covenant requirements of independently financed development projects. This was the case in early 2009 when a short-term ‘collar’ hedge programme on copper prices was entered into at a time when the outlook for copper prices was highly uncertain and vulnerable on the downside. The hedge programme extended a maximum of 12 months through to the end of December 2009. Further details of the hedge programme are set out in ‘Revenues and EBITDA’.

Additionally, in limited circumstances where it is not possible to structure intra-group commodity transactions on back-to-back pricing terms, commodity futures may be used to reduce the Group’s economic exposure.

The Group has an investment of 26% in ENRC, a company which is also exposed to similar financial risks as shown below. The impact of these risks on ENRC will impact on its dividend stream and its own market capitalisation.

Responsibility for financial risk management is undertaken primarily by the Group’s centralised Treasury function, operating under oversight of a Treasury Committee which is chaired by the Chief Financial Officer.

The significant risks identified by Kazakhmys that could materially affect the Group’s financial conditions, performance, strategy and prospects are set out in the risk factors page. Details of the Group’s system of internal control is set out in the Governance Framework PDF.

Financial risks

The principal financial risks arising from the Group’s activities are those relating to commodity price risk, foreign exchange risk, interest rate risk, counterparty credit risk, liquidity risks and capital structure. The Group does not engage in any speculative treasury activity.

Commodity price risk

The Group’s mining revenues and earnings are directly impacted by fluctuations in the prices of the commodities it produces. The Group’s principal commodities (copper, zinc, gold and silver) are priced via reference to global metal exchanges, upon which pricing is derived from global demand and supply and influenced by macroeconomic considerations and speculative capital flows. The pricing of the Group’s principal commodities may also include a pre-determined margin or discount depending on the terms of sales contracts. Commodity prices, particularly those derived from global metal exchanges, may fluctuate significantly and may have a material impact on the Group’s financial results.

The Group manages potential downside commodity price risk by focusing on maintaining its low cost producer status and also through the wider strategy of revenue diversification. Management closely monitors the impact of fluctuations in commodity prices on the business and uses conservative pricing assumptions and sensitivity analysis for its forecasting and investment appraisals.

MKM is exposed to fluctuations in the price of the metal content of its products to the extent that metal purchases price at different dates from finished goods sales. MKM uses the natural hedge provided by the back-to-back pricing of purchases and sales on its ongoing operations to manage this pricing exposure. Where there are temporary mismatches in volumes, commodity futures are used on a limited basis to ensure MKM’s economic position is not materially impacted by metal price movements.

The Power business positions the Group as a significant net generator in the Kazakhstan power market. The Kazakh power market has a predominance of large industrial electricity users focused on the natural resource sector, and consequently, electricity demand tends to broadly follow the commodity cycle. Power tariffs are derived through a complex interaction of regional demand and supply imbalances, tempered by specific regulatory interventions to minimise the inflationary pressure on domestic electricity users. The Group sells its power to a mix of wholesale and industrial customers through directly negotiated bilateral contracts.

Foreign currency risk

The presentational currency of the Group is the US dollar, consistent with the pricing currency of the majority of the Group’s revenue. Where possible, the Group, excluding MKM, attempts to conduct its business, maintains its monetary assets and seeks to source corporate debt capital in US dollars so as to minimise its exposure to other currencies. The Group retains surplus cash balances in US dollars for capital expenditure, acquisitions and returns to shareholders. Working capital balances are maintained in a mix of US dollars and local currencies depending on short-term requirements of the business.

Whilst there is a strong correlation between many mining input costs and the US dollar, a significant portion of the mining business’ operating costs are denominated in local currencies, particularly the Kazakhstan tenge. Rates of exchange for these currencies relative to the US dollar could fluctuate significantly and may materially impact the profitability of the underlying operations and the net assets of the Group.

Due to its geographic location, MKM conducts its business in Euros and seeks to price its revenues in that currency, being also the currency in which the majority of its operational costs are denominated. The Group is exposed on its net investment in MKM to the extent that movements in the Euro may make that investment more or less valuable. The Group seeks to mitigate that risk by raising MKM’s debt financing in Euros, thus matching the negative exposure of the debt servicing against the positive exposure of the revenue.

From time to time, acquisitions and capital investments may expose the Group to movements in other currencies and the Group will consider hedging such exposures on a case by case basis.

Interest rate risk

The Group’s interest rate management policy is generally to borrow and invest at floating interest rates. In some circumstances, an element of fixed rate funding may be considered appropriate. Hedging via interest rate swaps or similar instruments may be undertaken during periods where the Group’s exposure to movements in short-term interest rates is more significant, or in periods when interest rates are perceived to be below long-term historical averages.

Counterparty credit risk

The Group is exposed to counterparty credit risk on balances and commitments due from third parties. The Group has adopted policies and procedures to control and monitor the distribution of these exposures to minimise the risk of loss in the event of non-performance by counterparties.

The Group’s mining business protects its exposure to customer credit risk by maintaining strong business relationships with customers and through a combination of documentary credit instruments and requiring payment prior to delivery. Within the Kazakhmys Copper Division, cash is received prior to delivery and transfer of title of the goods for sales to European customers. Sales to Chinese customers are made under letters of credit which are obtained prior to delivery and transfer of title of the goods. MKM manages its customer credit risk with debtor insurance. The Kazakhmys Power Division receives cash up front or has short payment terms depending on the nature of the customer. The Kazakhmys Gold Division has a single long standing customer with short payment terms which is agreed via an annual sales contract.

The Group’s cash management policies emphasise security and liquidity of funds ahead of investment return. The Group’s surplus funds held outside Kazakhstan are predominantly invested in US dollars through deposits or money market securities of investment grade international financial institutions. Maximum exposure and minimum credit rating limits have been set to ensure credit risk is reduced.

The Group must maintain a level of cash and deposits in Kazakhstan with local branches of international financial institutions and well established local Kazakhstan banks. The Group limits its local cash and deposits to working capital requirements and transfers surplus funds to banks mainly in the United Kingdom.

Liquidity and capital management

The Group’s over-riding objectives with regard to managing its liquidity and capital structure are to safeguard the business as a going concern, to maximise returns for shareholders and benefits for other stakeholders and to maintain an optimal capital structure in order to lower the overall cost of capital.

The Group does not have a target debt/equity ratio, but has determined a maximum debt capacity based on a ratio of long-term ‘normalised’ EBITDA which the Board believes establishes a sustainable level of gearing through the commodity cycle. This ratio is reviewed in conjunction with market conditions and prevailing commodity prices in order to ensure an efficient capital structure that is balanced against the risks of carrying excessive leverage.

The Group maintains back-up liquidity for debt maturing within 12 months by way of committed revolving credit facilities totalling $150 million and by maintaining cash on the balance sheet.