Directly engaging to understand water risk

Franklin Templeton's Gail Counihan says water resources are at risk from rapid population growth, ecosystem degradation and power generation

Demographic trends, a changing climate and a finite supply of naturally potable water are all converging trends that are placing increasing pressure on the supply and demand of water.

While encouraging progress has been made in the field of desalination, currently this is far from scalable for use at the industrial level and therefore as investors, it is important to understand how companies are dealing with this risk.

Are they incorporating water scarcity into their planning when choosing local sites, what do their drought contingency plans look like, and are they investing to ensure they are more water efficiency in the future?

Many data points relating to how water scarcity is managed are either not widely tracked or are inconsistently reported by companies – it is therefore important for us to engage actively with companies to better understand the risk landscape.

See also: – Opportunities for impact in water investment

Active engagement key to managing company exposure

Water resources, already at risk in a more climate volatile world, are also under growing threat from rapid population growth, ecosystem degradation and power generation. Where water scarcity has been severe enough to have an operational impact, several bond issuers have had their credit ratings downgraded in the past.

Water risk is most severe at the intersection of two variables — lack of investment in resilient infrastructure and occurrence of severe drought. Purposeful engagement, however, provides an opportunity to understand how the companies we invest in are positioned to deal with these risks.

In order to identify companies that are at higher risk of being impacted by water scarcity, key factors such as water intensity relative to peers, the portion of company assets in lines of business that are typically water intensive, and the portion of company assets in geographies that typically experience moderate to high levels of water stress must be taken into consideration. Additional insights are also gathered from existing data – metrics that are universally comparable, or processes and frameworks that exist to manage risk, and are further supplemented by MSCI data for company-specific information.

See also: – Fashion companies lack awareness and transparency on water pollution

Uncovering the operational impact of water risk

Energy utilities and cement manufacturers represent two sectors where water stress is key to valuing and understanding risk in corporate bonds.

With global withdrawals expected to increase 20% by 2040, there is a growing risk energy companies will be denied access to water in times of drought. The findings from our engagement efforts show that EU energy utilities recognise the material risks posed by the growing pressure on global water resources and offer sufficient granularity and oversight of water risk. For example, water KPIs go far beyond the baseline to include metrics such as recycling rate, consumption and discharge by source, water use in megalitres per gigawatt hour (ML/GWh), and water use/overall sales.

When it comes to expectations regarding increases or decreases in water efficiency, an almost unanimous forecast is that the energy utility industry is expected to become up to 25% more water efficient. The key driver of this improvement is an industry-wide movement away from a high-water intensity energy (high thermal capacity) toward less water-intensive renewables, driven by the economic incentive offered by the European Emissions Trading System (EU ETS).

Boosting climate resilience of energy infrastructure

Across Europe, the frequency of extreme weather has been on the rise, ranging from falling river levels to an increased number of droughts or heat waves. Warmer temperatures are fuelling peak demand loads on the continent’s energy grid, and the requirement for cooling water in thermo-electric power plants is an important climate risk that is growing for electricity producers. A mitigating action here is conversion to a mostly renewable generation base, and in this light, we can view decreasing water risk as an unintended consequence of the EU ETS — the scheme provides economic incentive through carbon pricing for utilities to move toward less water-intensive power generation, thus decreasing their water risk.

Cement production also remains a key focus for the EU ETS and has been identified as an industry that needs to achieve deep emission reductions in the coming years. Whilst the cement industry has made strides to measure energy consumption and CO2 emissions, it has lagged on understanding and reporting on its water footprint. Our engagement responses appear to show that accountability for water management and efficiency programmes are strong – perhaps an indicator that these have become standard responses rather than indicators of strong governance.

Active engagement enables asset managers to gather information that improves our understanding of how companies are managing these evolving risks. With varying disclosure requirements globally, it is still challenging to compare companies across regions, and some of our next steps in our cement engagement will include establishing a real-world baseline and sourcing comparable and up-to-date data.

Water risks have become an integral part of investor research and risk management processes. Analysis of results from multiple data sources combined with company responses is becoming more complex. The lack of standardisation not only within sectors, but also across sectors, enhances the complexity. It is therefore important for investors to understand the full range of risks and continue to engage companies to move toward standardisation and a better baseline.

The time to do this is now — complexity will only grow with the growing demand and competition for water.

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Natalie Kenway

Natalie is global head of ESG insight for ESG Clarity and has been an investment journalist for 16 years. She won Editor of the Year at the Aviva Investors Sustainability Media Awards 2021, and was Winner...