Investors are not currently pricing in water risk into their analysis, even though it is "a powder keg" and a potential catalyst for sudden change, according to one investment bank.
In a report, Are investors pricing in water risk?, Swiss Bank UBS says there is no accepted framework to do in investment analysis at the moment and puts forward its own top-down approach for how water risk affects investors. The methodology looks at three different aspects of a company's water risk. It starts with the country, then region, before looking at the sector that the company and its supply chain is involved in, and how exposed to water risk it is at each of these levels.
However, by its own admission the report has "just begun to scratch the surface in respect of how to think about water risk in investment portfolios."
UBS argues water is another, just less well recognised, resource of which constraints can add to competition between companies and sectors, putting pressure on margins and balance sheets.
Dependencies on water – such as food and agriculture, direct consumption, industrial production, population health and productivity, and power generation – are potentially political. Therefore rising water risk implies a rising burden of regulation and, generally, regulation is known to affect the costs of running businesses and the price of risk, claims the report.
The report defines water risk as a potential shortage of freshwater supplies relative to need in the context of economic sectors. It suggests numerous considerations investors should apply to their portfolio companies and respective supply chains:
- Are companies in water-intensive sectors operating in drought-stricken areas currently?
- Are companies in water-intensive sectors likely to be affected if current wet climatic conditions swing back to drought?
- To what extent will companies or their operations be affected by climatic volatility and how exposed are they to their local hydrology?
- To what extent might the watersheds companies depend on be weakened by drought?
- To what extent is that risk offset by the structure of the water resources companies or their operations depend on?
In its report, UBS looks at China's water risk as: "Water risk in China is a global issue, which means it is an important issue for investors wherever they are based."
This risk is not expected to decrease despite relatively wet conditions, according to UBS, as it is partly a structural problem. Indeed, the report states China has, over the previous 10 years, moved in the wrong direction in terms of water risk. This is based on analysis of the country's ratio of water sources to uses by province and shows water risk has spread from the west of the country over to the north-east.
Unsurprisingly utilities, including water, electricity and multi-utilities, is the most water intensive sector in China. It was followed by paper and forest products; gas utilities; chemicals; oil, gas and consumable fuels; containers and packaging; building products; and construction materials, according to the report.
Environmental Finance will be hosting a conference next year entitled – Water: Risk, Opportunity and Sustainability 2017, exploring water risk in the market.