Under Stress: What does water risk mean for company valuations?

Failure to address water risk can have a devastating impact on corporate value

Water scarcity is one of the most prevalent threats in the world today, posing a risk to both human health and economic activity. By 2025, it is estimated that two-thirds of the world’s population could be living in ‘stress conditions’.* And yet, for many companies the real price of water is undervalued and they still have a long way to go if they are to successfully tackle their ‘water footprint’.

Failure to address water risk can have a devastating impact on cash flow, balance sheets, reputation and thus, ultimately, corporate value. For us, assessing and successfully managing water risk is a sign of good corporate governance and is an important part of our engagement with management teams. We believe three key factors are vital to assess both the risks for a business’ long-term sustainability, and where the potential investment opportunities lie:

Awareness: knowing and understanding the risks
The worst-case scenario for a company is operating in a water-intensive industry, such as semiconductor manufacturing (where large volumes of ‘ultra-pure’ water are needed), in an area that becomes acutely water-stressed. It can mean increased costs as the company attempts to mitigate the restricted water supply, reputation-damaging conflicts with local communities dependent on the water source, or new regulations or licensing from government. In recent years, droughts in areas like Texas and California have shown this is not exclusively a developing world problem.

A number of tools have been created to help companies assess the potential risks at a more granular level, such as the WWF Water Risk Filter, but many businesses continue to underestimate how widespread their specific exposure could be.

Disclosure: transparency over water risks
Ultimately, how a business evaluates its exposure to water risk – and crucially how it manages it – is an indicator of its overall approach to corporate governance and stewardship. Transparency is vital if investors are to fully understand a company’s exposure to water risk. As investor awareness has grown on the subject, there has been an increase in water-risk disclosure initiatives; these have included the CDP’s water disclosure programme, which we are signatories to.

Mitigation: the potential solutions and opportunities
Good sustainability practices, either through better management of resources, or innovation to cut water use, can ultimately generate greater investor returns. Companies which are actively encouraging suppliers to improve their water conservation, quality monitoring and treatment and recycling of waste water are recognising the potential impact and demonstrating that they take the issue seriously.Measuring the impact for investors
A company’s policies on water management will only ever be part of the equation when considering an investment decision, but a failure to take the issue seriously can be a ‘red flag’ for poor corporate governance. The emphasis for us is on engagement with management and making a judgment on how they are addressing any issues. Where we believe there is a higher chance of water risk (either directly or through the supply chain), a company’s awareness, disclosure and mitigation of the issue is built into the governance and sustainability industry frameworks we use in our analysis.
These frameworks consider the potential impacts of water scarcity and the key metrics with which they can be assessed. In semiconductor manufacturing for example, there are clear impacts on operations from water scarcity: disruption to manufacturing, costs of water recycling, restriction on capacity expansion, and fines for improper recycling. We can assess this by measuring the intensity of production, alongside evidence of policies on water usage and proactive community engagement. While company engagement can often be a subjective process, failure of a company to disclose its action on water risk can be a sign it is not taking the issue seriously enough – which could lead to a substantial impact on future valuations.

Wider collaboration
We have taken this process a step further and are participating in two PRI (Principles for Responsible Investment) collaborative engagements: on water use in the agricultural supply chain; and on hydraulic fracturing (fracking), as many oil and gas wells are located in water basins with high, or extremely high, water stress. In recent months we have engaged with several food companies and a large sportswear firm. In both these engagements we hope to improve disclosure and encourage the adoption of best practice among companies.

Looking to the future
It is clear to us that those businesses which consider their ‘natural capital’ alongside the more obvious ‘financial capital’ are more aware of the potential impact which external influences could have on their operating costs and business models. By rigorous analysis, through our governance and sustainability framework, we can identify those firms which are more susceptible to water risk, as well as those which are adapting to the long-term challenges, adopting more innovative processes and better placed to deliver more sustainable returns.

*Source: Food and Agriculture Organisation of the UN (FAO), 2015.

David Sheasby is Head of Governance and Sustainability at Martin Currie.