Water Risk Could Sink Investors

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Financial analysts need tools to make better decisions about investments that depend on water.

As the world observes Water Day this year, a new and rather unlikely group is starting to pay more attention to issues of water risk and water quality: financial analysts. They must take into account a myriad number of factors when making decisions, adding up tiny details to look for hints of future performance. But something as basic as water can also have a huge impact on companies’ performance, and even today, water risk is missing from many investors’ calculations.

Though climate change and other environmental trends can have a major impact on companies and industrial sectors (and recently, the SEC advised publicly-held companies to inform investors of any potential risks of climate change) nearly half of global money managers are still ignoring climate change risk completely when they make their investment decisions, according to a recent survey. The same can be said for water risk. Right now, many companies are inadvertently betting on water that, in the coming decades, might no longer be available.

Investment and Environmental Risk

Environmental data, even when available, does not fit neatly into the financial models that investors commonly use. Environmental trends are complex and have a long time horizon, making them difficult to accurately quantify and predict. As one analyst put it, “If it’s going to be a problem in 2025, tell me about it in 2024.”

The World Resources Institute, with Goldman Sachs’ Center for Environmental Markets and General Electric are currently developing a Water Index to help investors and financial analysts understand various water-related risks affecting different sectors and companies. The Water Index will help financial analysts model the local nature of water -related risks and externalities, thereby allowing water risk to be included in cost of capital calculations. A better grasp of water risk can help to shift investment in water intensive industries toward areas where the impact on water ecosystems and people are more benign. At the same time the water index can inform corporations where investments in water efficiency or treatment can achieve the greatest impacts.

What is “water risk”?

From a financial perspective, Water risks are disruptions, costs, revenue losses, or growth constraints due to a lack of water. Water scarcity, water pollution, and water competition can all limit the growth of a company, and can start to hurt asset performance and investments.

There can also be a reputational cost. Companies with a brand to defend are starting to notice the intensifying competition around water. It can hurt a company’s reputation to be viewed as taking water from more deserving causes such as local people or farmers, even if a company may be completely within their legal rights for access. Take Coca-Cola, for example. They were accused of using up local water resources in India, and took a reputational hit for that.

These risks can force a cost upon a company that they may not have included in their calculations beforehand. Right now there are few financial analysts that incorporate those long term costs into their valuations. But investors are becoming savvier and are starting to demand to know about these risks in order to make better investment decisions.

Vulnerable Sectors

The food and beverage industry, the power industry, mining, and some kinds of manufacturing, like semi-conductor manufacturing, are particularly exposed to water risk because they depend on large quantities of water for production, and some of that water needs to be very high quality. Power plants, for example, depend on large quantities of water for cooling. If this water isn’t available, they have to reduce output or, in extreme cases, shut down.

Water risk can hurt these companies in different ways. It can disrupt operations, it can drive up costs, and it can reduce revenues. It can impact their assets, their performance, and their decisions about the design and location of a facility. If water supplies run low, or if the temperature rises too high for power plants to discharge cooling water, dams or power plants can be forced to reduce output.

Making a Water Index Work

Water is local, and any index has to appreciate and account for that. Risk will be different depending on the region and the sector. The Water Index will be a standard methodology that is flexible enough to be replicated in different regions and sectors, and transparent enough so that people can make sense of it. To work, it must be easy to apply to as many parts of the world as possible.

Though developing a usable Water Index will be challenging, there is a huge demand. Earlier attempts have focused mostly on quantifying water footprints and companies’ impact on the environment. A new Index would instead look at the environment’s impact on companies. This is a key paradigm shift, and could revolutionize the way investors can make decisions about the environment, and the future.