It's Time to Start Talking Water Risk

Despite the paramount importance of water, the risks that scarcity or poor quality pose to economies and individual businesses have received less attention from investors than they deserve when compared with carbon. Inconsistent disclosure practices, and in many cases an outright lack of disclosure, by companies regarding their use of water compound the issue. Poor disclosure poses a distinct set of challenges, but we think there are a handful of useful metrics that astute investors can use to determine a company's reliance on water in its operations.

The Key Determinant: How Reliant is a Company on Water? 

The first and most important question an investor should ask in determining water-related risk is how reliant is a company on water to operate. We posit that water intensity best answers this question. Water intensity measures how many cubic meters of water a company must withdraw from the surface, ground, or sea in order to generate a dollar of revenue.

The idea here is obvious: the more water a company needs to generate a dollar of revenue, the more reliant its business model is on having adequate quantities of water readily available. In turn, the more water-intensive a particular business model is, the greater the risk posed to a company's enterprise value should a water supply be interrupted. The potential for water-supply disruption goes beyond the obvious risk of drought. Poor water resource management by governments, geopolitical factors, and inadequate investment in or maintenance of water infrastructure represent further real risks to the supply of water.

Looking across industries, some clear water-intensity patterns emerge. Based upon estimated industry medians, the electric utilities, paper and pulp, diversified chemicals, diversified metals and mining, diversified chemicals, and agriculture areas rank among the most water intensive. Water is likely to pose a greater risk to shareholder value for companies within these industries.

Less obvious might be that the medical services, automotive retail, or the travel and leisure industries also rank among the thirstiest. We also note that the water intensity of other industries that tend to produce products with high water content--including soft drinks, beer, wine and spirits, and household products--rank close to the middle of the pack on the risk posed by water intensity.

To The Source

A business model's reliance on water is a key driver of water-related operational risk to a company. But this water intensity tells only part of the story.

The location in which a company operates--which dictates where a company's water use actually takes place--is also of supreme importance. The vast variation in climate, geography, geology, population density, and the level of industrial and agricultural development across the globe's surface creates marked differences in water availability. This risk of a lack of water availability is also complicated by localised norms in water governance and regulation. Local stakeholder perceptions of a company's use of water resources only act to further compound the problem.

Physical water risks relate to the potential for a lack of water that is fit for use, or water becoming too scarce or inaccessible. A further source of physical water risk occurs when water becomes too abundant, also known as flooding. Companies are exposed to these differing types of physical water risks depending on their operating locations. Those with operations in the Middle East and North Africa region, including the likes of Palestine, Israel, Jordan, Morocco, Egypt, and the Persian Gulf States, are exposed to the greatest extent of physical water risk, according to the World Wildlife Fund (WWF).

Further variation in localised water risks arises from the marked divergence in the regulation regimes of water resources across the world. They create highly disparate regulatory contexts in which water resources are controlled and made available. Understandably, predictable regulatory environments reduce the risks that regulation poses to the ongoing operations and enterprise values of individual companies. 

Emerging economies top the list for regulatory risk and include the likes of the Democratic Republic of Congo, Afghanistan, Ethiopia, and India. These are countries where access to safe drinking water and sanitation, water policy and management, and water infrastructure financing instruments are well below the global average, according to the WWF. Conversely, European countries rank lowest for regulatory risk.

Reputational risks raise the important issue of stakeholder perceptions. While companies tend to view water more as an economic commodity, water often holds cultural importance to local populations and their land use, human rights, and biodiversity. Media scrutiny and the potential for conflict can further increase risks for businesses. 

A rather different set of countries is highly exposed to the reputational dimension of water risk. Brazil, Australia, China, and the United States feature heightened reputational water risk, according to the WWF. Higher levels of media scrutiny and greater cultural diversity--which tends to result in heightened perceptions of water as a social or cultural good--explain the higher rankings of these geographies.

Furthermore, sustainable, equal, and equitable water sharing is often hindered by competing interests not only within countries but across political jurisdictions. With over 60% of the world's fresh water supply located in 276 transboundary rivers, such as the Nile, Rhine, Danube, Indus, Columbia, Amazon, and Mekong basins, water security often depends on the geopolitical landscape as well. Reputational risk for businesses is often heightened when the water security of other water users is jeopardised.

What Can You Do as an Investor? 

As we've highlighted, water risks faced by individual companies go beyond the business model and include localised physical, regulatory, and reputational issues.

Sustainalytics' ESG Risk Rating is an ideal resource for investors who seek to better understand the risk that water poses to individual stocks. At the core of its ESG Risk Rating is the identification of material ESG issues (MEIs), which present a risk to the enterprise value of each company that Sustainalytics covers. Water-related ESG risks are the major contributor to the Resource Use MEI--one of 20 MEIs that Sustainalytics monitors. Resource use, and therefore water risk, is currently viewed as material for 25% of the 7,786 companies in Sustainalytics' coverage universe.  

Additionally, to broaden one's understanding of the severity and likelihood of these types of localised sources of water risks, we recommend using the WWF Water Risk Filter. This tool can aid in the assessment of localised water risk by providing risk scores across the physical, regulatory, and reputational water-risk dimensions.

Still, investors need to continue to insist on higher-quality, standardized water disclosures from publicly listed companies. In the case of water, even the most basic metrics like water withdrawal and consumption at company level remain patchy at best.

By way of example, just 7% of companies within Sustainalytics' global coverage universe disclosed data on water withdrawal in 2019. Corporate disclosure of water consumption was even less prevalent, with only 3% of companies in the Sustainalytics coverage universe choosing to provide information to investors.

Furthermore, freshwater is not currently abstracted from seawater in these disclosures. A delineation of freshwater and water from other sources in a company's water disclosures would be an important step in the right direction in properly understanding water-risk exposure. With the assistance of carbon emissions data, investors are increasingly allocating capital in a manner that is supporting the transition to a low-carbon economy. The same alertness is needed for the water side of the equation.

Integrating The Information

So, with knowledge of a company's business model and location, one can appreciate the extent of water risk it may face, some real world examples show how to integrate your new-found information into your investment process.

Water-related physical, reputational, and regulatory risks for integrated utility company Entergy (ETR) are low. Nonetheless, it’s a water-intensive business owing to its large fleet of nuclear, coal, and natural gas power plants. Accordingly, Sustainalytics identifies Resource Use (that is, water use) as a material ESG issue and as a major contributor to its ESG Risk Rating of High for Entergy, alongside carbon emissions as well as other emissions of effluents and waste.

Entergy, which has a narrow Morningstar Economic Moat Rating, plans to replace many of its most water-intensive generation facilities with renewable energy during the next decade. And with the stock trading at a 2% discount to our $112 per share fair value estimate, we think the stock currently trades at levels that more than compensate investors for the company's presently meaningful exposure to water and other forms of ESG risk. We assume $12 billion in total capital expenditures for Entergy in 2022-24, supporting nearly 7% annual earnings and dividend growth.

Conversely, wide-moat Intel (INTC) carries heightened location-specific physical and reputational water risks, owing to the chipmaker's significant operations in the US, Israel, and China. While Sustainalytics assigns an ESG Risk Rating of Low to Intel, Resource Use is nonetheless identified as a key contributor to the company's ESG risk exposure. Currently, Intel trades at a 22% discount to our fair value estimate of $65. Therefore, we believe long-term investors should find Intel shares attractive at current levels.

To be sure, even if water risks take their rightful place in the minds of investors, being conscious of risk in all its forms remains key to investment success. A company that has low exposure to water risks--or other forms of ESG risk for that matter--doesn't necessarily make for a good investment. Rather, a stock's price relative to its fair value--which should factor in all the forms of risk that a company faces--remains key to selecting stocks that are likely to outperform the market.

For example, narrow-moat Tesla (TSLA) is not considered to be highly exposed to water-related risk. Its business model isn't highly water intensive. Furthermore, Tesla's largely US-based electric vehicle manufacturing operations face a very low level of location-specific water risk. Accordingly, Sustainalytics does not identify Resource Use as a material ESG issue and gives Tesla an ESG Risk Rating of Medium.

However, with Tesla's stock trading at about a 40% premium to our $680 fair value estimate, uncertainties other than water are important for investors to consider. We see a bright future for Tesla and expect that it will become a top-10 global automaker in the long term, selling about 5.7 million vehicles by 2030. However, with the stock trading near $940 at the time of writing, we think the price factors in far more optimism than it warrants. On this basis, we see significant downside risk to the stock price, with the market's bullish assessment of the long-term growth outlook for Tesla presenting a material risk to investors.

Morningstar senior equity analyst Grant Slade contributed to this report