David Sheasby considers why water risk is such a pertinent issue for investors.

The amount of water-stressed areas across the globe is on the rise as a result of large populations, increased urbanisation, industrialisation and climate change. 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.

Water scarcity is one of the most prevalent threats in the world, posing a risk to both human health and economic activity. In 2015, the Food and Agriculture Organization (FAO) of the United Nations (UN) estimated that two-thirds of the world’s population could be living in stress conditions (where water is restricted by either drought or lack of access). While a number of organisations have taken steps to improve their water stewardship, it is also clear from company engagement that long-term impacts – and potential costs – often remain underappreciated or ignored completely.

Failure to address water risk can have a devastating impact on cash flow, balance sheets, reputation and thus, ultimately, corporate value. In its Global Water Report, CDP (formerly the Carbon Disclosure Project) stated that on average, business respondents identified exposure to eight water risks that could generate a substantive change in business revenues or operations. Companies reported detrimental impacts to their businesses totalling more than US$2.5bn. These losses underline the pressing need to take action. However, in many cases, according to the report, meaningful action to address the problem remained “elusive”.

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 long-term sustainability, and where the potential investment opportunities lie: awareness, disclosure to shareholders and mitigation strategy.

Awareness

The worst-case scenario for a company is operating in a water-intensive industry, such as semi-conductor manufacturing (where large volumes of ultra-pure water are needed), in an area that becomes acutely water-stressed. Here, water comes at a premium. It can mean increased costs as the company attempts to mitigate the restricted supply, reputationdamaging 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. There are three areas in particular, with potential for severe impacts.

Agriculture

Approximately two-thirds of water withdrawal comes from agriculture, compared with 19 per cent from industries and 12 per cent from municipalities, according to UN FAO research. Naturally, as water scarcity increases, it is this sector where the impact is most immediately obvious. For example, in 2013, New Zealand (the world’s largest exporter of milk-based products) suffered its worst drought in nearly 70 years. Listed dairy co-operative Fonterra, which processes a significant percentage of the country’s milk, had to raise the advance rate it paid to its farmers and reported a drop in operating cashflows of 28 per cent compared with the previous year in its 2013 annual report.

Supply chains

The impact on agriculture does not stop at the farm gate, as a significant water risk for many companies comes from exposure to the agricultural supply chain. In fact, most firms will be impacted to some degree. Beverage companies, for example, use large amounts of water in the production process, but are also impacted indirectly further up the supply chain, such as in the production of high-fructose corn syrup (which is often used as a sweetener). Apparel retailers are particularly at risk, given the intensity of water use in their supply chains. As an example, more than 20 million tonnes of cotton are produced per year, according to the International Cotton Advisory Committee, and in some estimations it can take several thousand litres of water to produce just one kilogram. Higher cotton prices in 2011, in part caused by drought in areas including China and the US, impacted the profits of several apparel companies. For example, fashion retailer H&M reported in its 2011 annual report that higher prices had led to increased purchasing costs and contributed to a 15 per cent fall in profits.

Mining and other extractive industries

Water is a critical input to extractive industries. Recently, we analysed Chilean mining company Antofogasta, which needed access to already scarce water resources used by local communities. Faced with the possibility of losing its licence if it did not act, the company proposed investing in a desalination plant to reduce the strain on water resources for the local community. However, this method incurs substantial costs and we incorporated this into our financial modelling of the company.

Disclosure

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. As investor awareness has grown on the subject, there has been an increase in water-risk disclosure initiatives, including CDP’s water disclosure programme. Larger firms are beginning to encourage this disclosure in their own supply chains. Ford Motor Company, for example, has asked 250 suppliers to report their water-management data, while fast-food company McDonalds has included the issue of water risk in its annual environmental scorecard, asking 353 of its top suppliers for an assessment of their individual water risk.

Mitigation

Without awareness and disclosure, it is impossible for a company to take the necessary action to insulate itself from these risks. But from an investment point of view, mitigation is probably the most important. It is here where 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. And some big names are showing leadership here. Coca-Cola, for instance, has targeted a 25 per cent cut in water use by 2020 (based on a 2010 baseline), while mining firm Rio Tinto has developed a water strategy which manages this resource not just for environmental reasons, but as a significant business asset with an economic value.

Another key area of mitigation is how companies address water management. Taiwan Semiconductor has recognised its water resources are limited and has committed to saving water in its daily operations and supply chain. Its core water resource-management activities are focused on collaborating with the central government, evaluating the climate-change risk of Taiwan’s science parks; putting wastewater recycling and reuse projects in place; and promoting internal and supply-chain inventories. The company is also sharing its experience with the broader industry to encourage water conservation on a wider basis.

Elsewhere, companies are turning to innovation to help mitigate water risks. In 2012, the global agribusiness Syngenta launched its first integrated water solution for US corn farmers, who were facing their worst drought in more than 50 years. It combined high-quality genetics, crop-protection and crop-enhancement protocols, coupled with advanced irrigation technologies, sensing equipment and agronomic advice. The model was offered to growers managing more than 3,000 acres in various parts of the US corn-belt. The company claimed the new model led to yield increases, compared with plots using traditional growing protocols.

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. Water is often heavily subsidised, particularly for industry and agriculture, so the financial impact can be hard to gauge. Water is a local or regional concern, which is difficult to transport over long distances and there is no generally accepted pricing mechanism. For this reason, attempting to incorporate a uniform ghost price for water into financial calculations would not be meaningful. That said, as the risks associated with water scarcity are often not reflected in asset prices, greater scrutiny is needed.

Engaging with companies

The emphasis then, has to be on our engagement with management and making a judgement on how they are addressing any issues. 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 and have a substantial impact on future valuations.

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 used in analysis. These frameworks consider the potential impacts of water scarcity and the key metrics with which they can be assessed. To take the example of semi-conductor manufacturing once again, 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. This can be assessed by measuring the intensity of production, alongside evidence of policies on water usage and proactive community engagement.

Collaboration

We have taken this process further and are participating in two PRI (Principles for Responsible Investment) collaborative engagements: on water use in the agricultural supply chain; and on fracking, as many oil and gas wells are located in water basins with high water stress. Recently we have engaged with several food companies and a sportswear firm. We are assessing companies’ levels of disclosure, with the aim of establishing potential requirements which may be necessary and setting objectives to change business practices in the future.

Looking to the future

Businesses which consider natural capital alongside financial capital are more aware of the potential impact which external influences could have on their operating costs and business models. By rigorous analysis 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.

David Sheasby is head of governance and sustainability at Martin Currie

Civil Society Media wishes to thank Martin Currie for its support with this article