A blue planet where water is in the red: assessing the investment stress

Analysis of portfolio risks is evolving fast.

As so memorably demonstrated in David Attenborough’s series, Earth is a blue planet, covered by water. However, as little as 2.5 per cent of the water that covers our globe is fresh water needed for drinking and crops. And of that tiny proportion, just 1 per cent is readily available rather than trapped in glaciers and snowfields.
“There is a big imbalance of water availability in the world,” says Lisa Beauvilain, head of sustainability and environmental, social and governance analysis at Impax Asset Management.
At the same time as the Earth’s population is growing and becoming more demanding in its need for water, climate systems are being disrupted so that rainfall patterns are less predictable, aquifers are not being replenished and droughts and floods are making crop yields unreliable. This confluence of factors has not escaped the notice of savvy investors who are increasingly realising that their portfolios are at risk from water shocks. A number of groups are working to develop ways to understand these risks and analyse how they might affect mainstream portfolios. In the past two and a half years, interest in water risk has grown enormously, according to Monika Freyman, director of investor engagement for water at Ceres, the US responsible investor network. In 2015, Ms Freyman asked 35 investor institutions for their views on water risk. The response was clear: “The risks are big and the understanding in the investor community was not where it should be.” She put together a working group of 12 (now swollen to 90) interested parties, known as the Ceres Water Hub. They complained of three barriers to better understanding of investment risk from water.
First, as in almost every area of sustainable investment, there is a lack of data. Water risk is particularly hard to pin down, because it faces all the same issues as other topics (disclosure, transparency in the supply chain and so forth), but it is also dependent on more variables,such as geography and rival demand. The next barrier to improving understanding of water risk was the lack of a mandate from clients. Pension funds and other institutions were not asking their investment managers to take water into account, because they were not conscious of it as a risk. Finally, says Ms Freyman, there was no collective framework or approach – “no how-to guide”.
This was the first self-set task for the Ceres Water Hub, which recently issued an Investor Water Toolkit, to guide investors through the methodologies needed to understand water risk.
Other tools have also been made available recently. The UN-backed Principles for Responsible Investment put out an investor guide to agricultural supply chains earlier this month, titled: “Growing Water Risk Resilience”, while the World Resource Institute maintains a water risk mapping tool called Aqueduct. There has been a creeping awareness generally that water scarcity is likely to be an issue globally, but how relevant is it to investors? Water infrastructure and technology funds (investing in desalination plants, for example) have been on the rise, and impact investors might look at how to ensure access to clean water in least developed countries, but do mainstream equity and fixed income investors need to think about this?
Increasingly, the answer seems to be yes. A prolonged drought in California, followed by news that Cape Town may be facing ‘Day Zero’ when it has to turn off water supplies because there are no reserves left, has woken investors to the reality that water security is increasingly tenuous. Even within the developed world, cities such as London, Tokyo and Miami face water shortages due to failures of infrastructure or changing rainfall patterns. “Cities are becoming thirstier, and there is increasing competition for water,” says Ms Freyman. “A lot of food and beverage companies are experiencing pinch-points
with thirsty crops.” It is well established that mining and resource companies are heavily reliant on water and the analysis is relatively developed for this sector. Bloomberg even offers a tool to value the water risk to mining companies, which need water to process the ore and produce the mineral that is the end-product. The risks to mining companies include a drop in production if there is a water shortage or a need for more water if they are extracting ore of a lower quality which needs more water to produce the pure mineral. They may need to build infrastructure to maintain water supply, or they can run up against social opposition, which can reduce productivity through delays, or even end up with projects having to be redesigned or cancelled in response to the demands of the local community. All of this is often reported by the corporates involved, but even companies that do report water risk are unlikely to include future risks in those reports.
This is where Ms Freyman sees the most interesting work being done: “It’s stress-testing, scenario-testing. There is a catastrophic element to water that requires this kind of analysis.”Ms Beauvilain makes the point that even companies that report on water usage rarely do so at the facility level, making it hard to assess the risk associated with levels of usage. “Water is a localised risk and the missing element is data at the local level.” Impax routinely includes water risk in its investment analysis, even though it does not usually have holdings in the most water intensive sectors, mining and power production. Other water dependent sectors, however, are included in the Impax portfolios, and engagement on this topic is standard.
“We ask about the water shadow price,” says Ms Beauvilain. “In most places, water is too cheap, so we ask if they use an internal shadow price to reflect the true value of it as a resource.”
To illustrate the need for a shadow price, she points out that water in Denmark, the most expensive place, costs 90 times as much as in India, one of the cheapest countries, which fails to reflect the actual water scarcity and therefore operational risk. “It’s not really valued as the incredibly important resource for any development or economic growth that it is,” says Ms Beauvilain.