Dry up: how investors assess water risks

The world is running short of water, but what does that mean for investors? Asset owners in the Netherlands and Norway assess and manage the water-related risks in their portfolios, including the measurement of portfolio companies’ water dependence and water security.

The drought hitting South Africa’s North West Province sounds another warning shot around the dangers of water risk for long-term investors.

It’s affecting the country’s “Platinum Belt”, the source of 75 per cent of global platinum production and home to the world’s three biggest producers: Anglo American Platinum, Lonmin and Impala Platinum.

It’s just the kind of risk flagged in MSCI’s latest ESG research on water risk “A Well Running Dry: Identifying and Assessing Water-related Risk for Investors” which estimates that the total value of sales or reserves at risk from water shortages includes $221 billion for MSCI All Country World Index (ACWI) gold miners, $20.7 billion for MSCI USA Investable Market Index (IMI) electric utilities, and $7.2 billion for MSCI ACWI steel producers. It’s not surprising proactive investors have woken up to water risk.

“We are largely a passive investor so nearly all of our equity investments are invested though an index of about 3,000 companies throwing up constrains as to how deeply we can analyse any one of these companies,” says Piet Klop, senior advisor responsible investment at PGGM Investments tasked with protecting the €40 billion ($53 billion) equity portfolio from water-related risk – a challenge given the lack of data.

“Investors like PGGM need to know how companies compare in their aggregate exposure to water risk and how companies compare in their response to that water risk,” Klop says.

Only with this knowledge can PGGM first engage with companies facing water risk and then, if engagement doesn’t work, exclude those companies from the index, as per their process.

“For meaningful dialogue we need comparable information on those companies; we need metrics that are both meaningful and comparable. This combination is pretty rare still because this is still a young topic for most investors.”

At Norges Bank Investment Management, investment manager for the Norwegian Government Pension Fund Global, water management has been a strategic focus since 2009.

“NBIM is exposed to water-related risk through its investments in about 7,5000 companies many of which rely on water as an input or output factor in their operations and supply chains,” says Jan Thomsen, chief risk officer at NBIM speaking at the launch of the CDP 2013 Global Water Report.

“Within a context of increasing water scarcity and adverse water related events, the fund’s long-term returns may be impacted through company specific risks or increased systematic risks driven by these externalities. Mapping and understanding such risks can be a challenge but is fundamental in supporting investment decisions.”

At MSCI, where research centres on increasing investor understanding of water risk, developing ways to best quantify that risk and highlighting which assets are most in danger, findings have focused on three industries: global gold miners and steel industries and regional electric utilities in the United States.

“All are water intensive companies which have their asset values concentrated in particular regions in a concentration of risk that magnifies the potential impact of water scarcity on the companies’ operations,” says Cyrus Lotfipour, senior analyst at MSCI ESG Research.

MSCI calculated the total value at risk for US electricity companies by taking average state electricity prices, the generating capacity each company has within each basin, and the number of months of water scarcity these basins faced.

“From this it is possible to derive an estimated loss associated with water scarcity,” says Lotfipour. The research estimated losses of $21 billion in electricity sales, roughly 6 per cent of nationwide electricity sales.

However utilities in America’s dry and arid regions like Arizona and New Mexico faced severe scarcity with “30 per cent of their revenue at risk” but utilities in the northeast didn’t face any risk.

Similarly, MSCI found revenue from gold companies was at risk in arid but mineral rich countries like Chile and Australia where the cost of extraction often makes reserves unreachable and found that bigger companies with a diverse footprint are better protected.

MSCI also found that companies are often not implementing strategies to help mitigate water risk. “The most water intensive industries commit to water targets less frequently than the entire MSCI World Index,” says Lotfipour.

Water risk has many different manifestations.

“It’s not just a physical risk around running dry,” warns PGGM’s Klop. “It’s also about regulatory and reputational risk, risks around the disruption of supply chains and new capital expenditure or compliance costs.”

He believes that simple overlays offer valuable insight.

“An overlay can bring home the point that water risk can be material: China may not be able to get hold of its shale gas because the water may not be there. Very few mainstream investors are taking this seriously.”

Klop identifies three key steps in PGGM’s analysis of water risk facing companies. The first is to measure companies’ water dependence and their water security.

“What are the outside risks that can affect the water that they need?” he asks.

The next step is to measure companies “meaningful” response to emerging water risk flagging that companies may become “more efficient” but not necessarily “more water secure.”

Investment strategies could include “constraining the universe” by excluding companies facing water risk and with poor mitigation or tilting portfolios away from water risky companies. He also suggests targeting research towards actively managed portfolios both in private and public equity and is a “firm believer” in corporate engagement.

“Water is climbing up agenda,” he concludes.