Despite gaining greater attention at COP26, water risks in portfolios are not always well understood by investors.
Michael Lewis, Head of ESG Thematic Research at asset managers DWS, was disappointed by the decision by the IFRS Foundation to take a ‘climate-first’ approach to its strategic expansion into setting standards for sustainability reporting.
That might sound strange from an ESG-focused investor, but Lewis was aggrieved that other critical environmental factors such as biodiversity loss, deforestation and water scarcity were not included.
“It is a policy that falls short because it is not recognising the importance of the ‘nexus’ between natural capital and addressing the climate challenge,” he said. “Of equal importance from an environmental perspective is the role of our oceans, land and forest play as natural carbon sinks.”
According to Lewis, over four billion people lack safely managed sanitation services, while 2.2 billion people are drinking contaminated water. Around 80% of the world’s wastewater is returned to the environment untreated with detrimental impacts on nature, and a third of all rivers in Asia, Africa and South America are severely polluted.
There’s more – of the 1,000 most severe natural disasters that have occurred since 1990 when measured by number of people affected, water-related disasters account for 90%, including floods, storms, and droughts. In addition, it is estimated that by 2050, 51% of the world’s population – as many as 4.9 billion people – will inhabit areas facing higher water risk. This would expose 46% of global GDP and put over 40% of global grain production in jeopardy.
“We are concerned that freshwater is not getting the attention it deserves,” he says.
Low profile, high impact
Echoing these concerns is Cate Lamb, Global Director of Water Security at CDP, the sustainability reporting platform. “The single-minded pursuit of carbon emission reduction at all costs over the last decade has come at its own cost of a lack of awareness with regards to water,” she says.
“We cannot achieve the goals of the Paris Agreement if we forsake nature and the freshwater resources that the world is so dependent on. It has been observed that water represents less than 1% on the balance sheet but 99% of the global economy relies on a stable supply of it. We need to begin tapping into this – pun intended – as it has been the poor relation.”
Lamb is encouraged by a perceived shift in the lead up to COP26 and praises the recent Intergovernmental Panel on Climate Change (IPCC) report, which stated that climate change is having a marked impact on water cycle, bringing more intense rainfall and associated flooding, as well as more intense drought in many regions.
The report added that water security and the climate resilience of water and sanitation systems are critical to the stability of global society and to sustainable development efforts.
Martin Conroy, who manages the KBI Global Investors Water Strategy fund, is also feeling more confident that water will be high on the agenda at COP26. “There is an increasing realisation that there is no point tackling the carbon problem if you are not also going to tackle impacts such as flooding and drought,” he says. “COP26 will see more focus on water than ever before. Governments are ramping up their spending on water such as the US infrastructure bill. It is very much front and centre.”
As well as attention from policymakers, addressing the issues around water usage and availability also requires an increase in investor and corporate understanding and transparency, adds Lamb.
“Many financial institutions are still struggling to understand where within their portfolios water-related risks and impacts may exist,” she says. “It can be a somewhat complex issue. But the need for urgent action at scale is becoming increasingly obvious. Better action needs to happen more swiftly.”
From April next year, the CDP will be issuing its first ever water-related disclosure request to financial institutions asking them to disclose relevant risks and impact across their portfolios. This is part of a broader strategy by CDP to increase the range of environmental impacts covered by its disclosure platform.
“It will help investors see which companies are exposed to potential quality or quantity related risks and impact both directly and in their supply chain,” she explains. “It will add another layer of granularity which leads to more intelligent engagement.”
In preparation, CDP has recently made its Water Watch tool public. This ranks over 200 industrial activities, according to their potential impact on water resources, including apparel, biotech, pharmaceuticals, food and beverage, agriculture, infrastructure, materials, power generation, retail, manufacturing, hospitality, transportation, and services.
For each activity, the tool ranks for the three key stages of the value chain: direct operations, supply chain and product use, assessing both the dependence of the activity on high volumes of freshwater withdrawal or consumption and the water pollution or degradation potential of the activity.
Widespread water risks
Use and abuse of water resources can be found in a wide variety of sectors. CDP has found that the clothing industry, primarily through dyeing and related treatments, has a critical impact, as do pharmaceuticals and farming. Investors and intermediaries have an influential role, says Lamb.
“The financial sector also has potentially very high exposure, down to their investment practices. It is a sector responsible for the construction of dams at the heads of free-flowing rivers and investing in agricultural companies which are polluting freshwater resources at an unprecedented rate,” she says. “They could be a force for good if they can turn it around.”
The energy sector also relies on on stable supplies of good quality water, explains Lamb. “If we are facing a future where water is no longer guaranteed in the volume, quality and temperature the company needs, then they will be facing quite severe risks.”
DWS’s Lewis places materials as well as the food and beverages sectors on the water watch list. “Within materials, the need for key inputs such as water and energy in the mining sector is likely to physically and financially constrain the establishment of new operations in water stress regions,” he says.
Lewis stresses the importance of investor engagement, citing work in this area conducted by non-profit Ceres’ Valuing Water Initiative (VWI).
“The VWI aims to generate experience on how to sustainably, efficiently, and inclusively allocate and manage water resources and deliver and price water services accordingly,” he explains. “Efforts are underway to improve water metrics and disclosure which is in line with wider efforts to enhance sustainability reporting more broadly.”
According to Lewis, DWS consumes a significant amount of data to inform its proprietary water risk rating methodology for listed securities. Its metrics include freshwater withdrawal/consumption; water intense operations; water management / strategy / performance / policy; and business disruption risk from water related incidents.
“Aside from identifying high levels of water risk, we have also been able to identify the sectors, sub-sectors and individual securities where exposure to water has the potential to provide the most opportunities. These tend to be most concentrated in industrial gases, home-improvement retail, building products, specialty chemicals and renewables,” he explains.
Conroy has been on the lookout for water champions since his fund was launched in 2000. It invests in 30-60 global companies providing solutions to water scarcity across all parts of the water cycle including water and wastewater utilities, water infrastructure and water technology.
“In the developed world, it is all about the rehabilitation of ageing water infrastructure and the long-term target of improving water quality,” he says. “We are investing in solutions providers, including consulting engineering companies building water infrastructure and climate resiliency projects such as flood protection. We also invest in equipment suppliers, which covers pipes, pumps and valves, but also the tech companies who do everything from water meters to leak detection.”
Conroy says he looks at the positive, negative, and neutral aspects of what each target portfolio company is doing around water.
“It is not an exact science. Companies are improving their reporting with Europe, helped by the EU Taxonomy, ahead of the US,” he says. “We predict that more than 70% of the activities of our companies are having a positive impact as related to the UN Sustainable Development Goals. The remainder is neutral rather than negative. There is a small element of negative such as a company that pumps water which has a small exposure to oil and gas.”
As with other aspects of ESG-based analysis, Conroy is finding himself diving ever deeper into how investee firms conduct their business. This ‘enhanced engagement’ goes beyond disclosed market data, he says, cites a Chinese water utility in his portfolio, focused on building infrastructure, treating water, and servicing Chinese households.
“The obvious question is: how sustainable is it? Are they extracting water from reservoirs which because of climate change will run dry? We are seeing favourable results around the level of extraction they are doing and reducing leakage.”
Conroy suggests the challenge is seeing both the minutiae and the big picture.
“It is about measuring the real-world impact of their activities,” he says. “Ultimately we believe the long-term winners will be the companies adhering to best practice. They can have a very big positive impact on both water and energy efficiency. The link between carbon and water has never been stronger.”