Integrating water into our investment decisions

Research analyst at Alliance Trust Investments, Emma Lupton explores how water can be valued and integrated into investment decisions.

This article originally appeared on Alliance Trust Investments’ Sustainable Future Hub.

Access to usable water is one of the most critical aspects of both personal and corporate survival. This most basic need for humanity and the environment has increasingly become a critical input for a range of industrial activities. Yet, for such an important issue it has remained stubbornly difficult to value.

The difficulty in valuing water lies in both its pervasiveness, it impacts the whole supply chain, and its critical importance to people and the environment – industry must drink last.

So while investors are beginning to measure and value factors like carbon emissions or employee injury rates, water is different.

We argue that data on the volume of water withdrawn, or even consumed by a company is of little use to an investor without context. The issues are local. We need to know the degree of water stress in that location, the condition of the water pre and of course post consumption. A litre of harvested rainwater returned unaltered to the natural environment simply cannot be valued in the same way as a litre drawn away from a desperate community and returned in a toxic state.

So, why are we assessing water?
It is becoming clear that this plentiful and infinitely reusable resource is becoming increasingly scarce and constrained. Part of this is natural; 97% of the water on earth is salt water. Of the remaining, 68% is frozen and 30% is locked away underground, leaving less than 1% of our global supply economically accessible with current technologies.

Part of this is demographic. Water use has been growing at more than twice the rate of the population in the last century and as the global average income increases, the demand for protein rich diets increases in turn. This adds to the pressure as protein requires far more water in the production process. And part of this is just poor management; our simple economic systems will not properly price long-term constraints on what is seen as plentiful resources. As a result, we take water for granted.

McKinsey and the Water Resources Group estimate that if this ‘business as usual’ attitude is not altered within the next twenty years, the demand for water resources will be 40% greater than the availability, the World Economic Forum list a water-supply crisis as one of their top global risks within the next ten years. The era of abundance is over and as sustainable investors we want to know who will profit from doing the right thing in our water-constrained future.

From risk…
We do see grounds for hope as companies across a broad range of sectors begin to respond to this critical issue. Significant numbers of companies are now analysing how they use water and are evaluating the risks they face. 68% of respondents to the 2014 CDP Water Program questionnaire reported that water poses a substantive risk to their business. 22% reported that water related issues could limit the growth of their business and, of these, one-third expected that constraint to be felt in the next 12 months.

…To opportunity
This is an important start but we want to identify those companies that are seeing the opportunities in transitioning from being simply better takers of water to water managers. We are particularly interested in those looking to their suppliers or counterparts to exploit the opportunities in becoming water-stewards by working throughout their supply chains and at the basin level.

Being a clean fish in a dirty pond may look good on the company website, but it does little for people, planet or profit.

Identifying the winners
We want to analyse how companies are managing water and integrate this into our understanding of their financial growth prospects. To enable this, water management needs to be integrated into forecast cash flows and valued.

Our report used the apparel sector as a case study. Water use may be more straightforward in the food and beverage sector for example, but this would limit the applicability of conclusions drawn to wider sectors. The apparel supply chain is widely impacted by, and vulnerable to, water related issues at the manufacturing and agricultural levels. Pressure at any of these points can negatively impact upon retailers’ financial returns and conversely, there are financial opportunities for those who manage water issues throughout their supply chains.

Material impacts on financial performance
One of the key factors for the apparel sector is the Cost of Goods Sold (COGS) as a driver of gross margin. Raw material pricing and manufacturing production costs in the supply chain can both be impacted by water, which can therefore have a material impact on the financials of a company.

We assessed the falls in retailer profits and share prices as the drought influenced short-ness of supply and raised cotton prices in 2011. We believe extreme drought was one factor in that cotton price rise and in such a fiercely competitive industry that cost inflation could not be passed on. Share prices fell as the cotton price rose.

Today, with cotton prices relatively low and evidence that water could impact the supply of cotton and the cost of processing it, we assessed the potential impact on retailer profits. We want to avoid complacent companies in this environment and invest in those preparing for water constraints.

Our report assessed the retailers’ ability to diversify their supply chains away from water-constrained basins and select suppliers using water management processes such as new ‘dry’ technologies in production and dying. We have more confidence in the forecast revenues and margins of companies who have strong water management policies extending all the way through their supply chains.

Alliance Trust Investments strategy
At Alliance Trust Investments, we will be furthering our engagement with companies over financially material water issues. We will be demanding a higher level of data disclosure throughout supply chains and are working to incorporate this into our investment process.

We recognise that water is an extremely complex and localised issue but we do believe that companies can deliver solutions to the benefit of all of their stakeholders, not least our clients.
Companies that can manage a resource that is so vital to local communities, the natural environment and gross margins are quite simply better investments.

Emma Lupton worked with the Sustainable Future team for three months highlighting the importance of integrating water further into the investment decision process. She holds an MSc in Environmental Technology, specialising in Water Management, from Imperial College London and has worked for industry experts Global Water Intelligence, managing their Corporate Water Stewardship programmes. Prior to her Masters, Emma worked in the investment management industry and holds the Investment Management Certificate.

Further reading:

Half of world could face extreme water scarcity by 2095