Beyond Carbon: Water Risks and Sustainable Investing

More than 1,900 institutional investors around the world have signed on to the Principles for Responsible Investment (PRI) that encourage investors to integrate sustainable and responsible investment practices into their daily investment decision making.

For many investors, climate and carbon risks are central to their responsible investing activities. Their commitment is reflected in the growth of Ceres Investor Network on Climate and Sustainability as well as such measures as the Task Force on Climate-Related Financial Disclosures (TCFD), Science Based Targets initiative,  and Climate Action 100+ global investor engagement campaign targeting the world’s largest greenhouse gas emitters. Landmark shareholder resolutions at fossil fuel companies and big divestment announcements also demonstrate the momentum this issue has taken on among institutional investors.

These measures are critical to making companies more sustainable and resilient and protecting investment dollars from the huge systemic risks that climate change creates.

But carbon emissions and climate change are not the only sustainability threats. At the recent United Nations Investor Climate Summit in New York City, Norwegian pension fund CEO Yngve Slyngstad described them as just one sustainability risk among many. His fund makes it a point to study the threats that industrial and corporate activities pose to fresh water, oceans, and forests. Likewise, Jeremy Grantham has highlighted how systemic degradation of soils, pollinator communities, freshwater supplies, etc., can cost investors.

Indeed, investors and companies rely on a range of natural resources to create the goods and services they sell. And many of these assets are more vulnerable than people realize. And while climate change is a global issue, natural resources are often rooted in local communities that have just as much claim on them as businesses. This makes local and sectoral environmental exposures, in some ways, even harder to address than global ones. So investors need to be aware of them.

Water risks are a good starting point for understanding broader sustainability issues. Investors need look no further than the water crisis in Cape Town, South Africa, to understand what’s at stake. A clean, abundant, and stable freshwater supply depends on numerous factors, among them healthy land and forests and strong governance of local resources and communities. This means water risk can act as a proxy for many other environmental and social issues.

A recent study of four global investment indices — the S&P 500, Russell 1000, MSCI World, and MSCI Emerging Markets — found that most of their components were exposed to industries with medium to higher water risks. Across indices, the oil, gas, and consumable fuel, semiconductor, and chemicals industries consistently rank high when it comes to water materiality and weight in the index. Electric utilities, food products, beverages, and metals and mining rate highly in these criteria as well. Given how critical these sectors are to global markets, water risks are obviously broad and systemic.

Water concerns already affect investors’ bottom lines as well as future risks to their top lines. Profits at Illovo Sugar and Pioneer Foods in South Africa recently fell by 36.5% and 47%, respectively, due to drought. Earlier this year, drought in Brazil cost aluminum producer Alcoa approximately $50 million in revenue.

Water risks go beyond physical factors and threats to future revenues. When a company comes in competition with local groups for scant water resources, it may be ejected from the market. For example, a Coca-Cola plant in India closed after local farmers accused it of using too much water. In Peru, the mining group Newmont faced severe delays in building a $5-billion gold mine because of protests by local farmers worried about its activities poisoning the local water supply.

It is not just companies that face financial consequences. The ongoing water crisis in Cape Town is a foretaste of what’s to come for many cities around the world. And the dimensions of Cape Town’s dilemma extend far beyond the city’s ability to provide water to its residents and businesses. The larger effect is “credit-negative”: It will cut revenues just as the municipality needs to spend more to address the crisis, according to Moody’s rating agency.

A growing number of investors — NBIM and ACTIAM among them — are growing more vocal about how firms should approach water issues. They have publicized their expectations on corporate water stewardship and embedding water into sustainability planning commitments. These declarations can help others who are considering assessing these risks.

More than 40 institutional investor — from hard-nosed quantitative analysis shops to pioneers in responsible investing — that together manage over $6 trillion in collective assets recently partnered with Ceres to publish the Investor Water Toolkit. The toolkit is a collection of recommended best practices, methods, and data resources for water integration.

The ideas include:

1. How to help pension fund trustees and business leaders better grasp water issues and how to create water goals and policies to guide investment practices.
2. How to understand the materiality of sector and regional water risk issues.
3. How to conduct portfolio-level water footprinting or heat mapping.
4. How to improve buy/sell decision making for public equities and municipal bonds.
5. How to strengthen water risk due diligence for private equity.
6. How to develop and benchmark sustained and results-oriented engagement with companies on water risk.
7. The private equity and municipal bond recommendations in the Toolkit, in particular, can help investors assess water risks related to cities such as Cape Town.

The ideas and methods throughout the Toolkit will make it easier for investors just embarking on the journey to integrate water issues into their investment strategies.

And it is a journey. It cannot be accomplished overnight by buying a particular environmental, social, and governance (ESG) database. As with many ESG issues, water risk requires patience and a step-wise comprehensive approach in building goals, internal awareness, and smart, institutionally relevant risk-mitigation strategies.

But the point is the journey — even the first step — can pay large dividends in avoiding losses and improving awareness.

Water is essential to business, to society, and to life. It is an issue that investors can no longer ignore.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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