Betting on Water

photo credit: flickr/foxxyz

A new project will help identify and measure the water-related risks facing companies and their investors, and lead to better environmental decisions.

Water scarcity, water pollution and water competition are various risks that could significantly harm a company’s operations. Even so, they are often overlooked by investors, financial analysts and businesses. Piet Klop, Senior Fellow in WRI’s Markets and Enterprise program, answers questions about why water matters to companies.

What do you mean by “water risk”?

Water risks, in short, are disruptions, costs, revenue losses, or growth constraints due to water shortages and declining water quality – all can affect asset performance and the profitability of a company.

There can also be a reputational cost. Sustainable growth requires companies to be constructive when sharing any kind of resources with the communities where they operate.

Investors are also becoming savvier. They want to know about these risks in order to make better investment decisions.

How can investors, financial analysts and companies measure water-related risks?

WRI is working, in partnership with Goldman Sachs and General Electric, on developing a Water Index. It will use publicly available data on indicators for water quality and water scarcity, and create map overlays combining and comparing the various risks.

The index also has to account for the fact that water is inherently local. Risks will be different depending on the region and the sector. We’re building a standard methodology that is flexible enough to be replicated in different regions and sectors, and is transparent enough so that people can make sense of it.

There’s a huge demand for this. No one has really cracked it yet. Earlier attempts have focused mostly on quantifying water footprints as companies’ impact on the environment. This index flips it, and looks at the environment’s impact on companies. This is a key paradigm shift, as it allows investors and others to assess how water-risk affects a company’s operations and bottom line.

If this is going to serve the needs of the target audience, which is financial analysts, risk underwriters, and investors, it has to be timely and adaptable to different regions of the globe.

What sectors are most exposed to water risk?

The food and beverage industry, the power industry, mining, and manufacturing are particularly exposed to water risk. They depend on large quantities of water for production, and in the case of semi-conductor manufacturing that water needs to be of very high quality. Power plants, for example, depend on large quantities of water for cooling. If the water isn’t available, or if they can’t discharge cooling water into rivers or lakes because they are already too hot, they have to shut down.

Where will you first develop and test the Index?

We are starting in China, but we really could have started anywhere, since many river basins around the world are water-stressed. We chose the Yellow River Basin in China because it is water scarce and power demands are growing at 10 percent a year or so. Coal is the fuel of choice for power generation there. Coal which brings with it a huge water demand, not just in the power plant itself but in its supply chain, because it also requires huge amounts of water to process.

How do companies’ decisions change when they take water risk into account?

It depends on the sector. Our prototype is initially focusing on thermal power generation and its water risks. There are options to make the sector less vulnerable. Plants can be built on better sites where more water is available. Authorities and investors can choose a different power source overall – coal, for example, is very water-intensive compared to natural gas. And wind power doesn’t require any water at all. There is technology available to make power plants more water efficient, but these come with a tradeoff in overall efficiency and cost. With “dry cooling,” plants can cool with air rather than water, but this reduces overall efficiency by 20-30% or more. That’s a lot, and it means there’s sometimes a tradeoff between carbon emissions and water use. You can try to engineer your way out of water scarcity, but there’s no free lunch. It comes at a cost.

Why is it so challenging to calculate water risk?

Right now it’s hard to quantify these risks as well as we would like to. When, or what chance is there, that you’ll be hit by a drought? There’s really no way to know for sure, but investors need to know about timing to be able to include this kind of thing in their cash flow analysis. They need to know the probability and magnitude of an impact before they can put a real cost on it. It’s hard to do, as it is for many other environmental issues. But that’s why we’re here. If it were easy, it would happen all by itself.

But right now, without any sense of water risk, companies are inadvertently betting that water will be available in the long term, without really thinking about it deeply. They are making long-term bets on water that, in the next 40 years, might no longer be available.