Why Investors Need to Pay Attention to Water Risk

Water scarcity refers to an insufficient amount of safe, clean water. It can be a problem of supply or resources in areas without adequate sanitation. About 2.7 billion people experience severe water scarcity at least one month a year.

What causes water scarcity?

• Pollution from agriculture and industrial waste.
• Inefficient irrigation and agricultural demand.
• Population growth.
• Climate change.

Water scarcity is a neglected issue that will only intensify as the planet warms. Failure to prepare can come with a hefty price tag—for companies and their shareholders. In 2020, nonprofit CDP estimated that the total potential financial impact of reported water risks was $301 billion [PDF].

Considering water scarcity can help advisors add nuance to the risk/return balance. With more complete risk assessments, advisors can personalize portfolios for their clients' comfort and tolerance levels. And investors who believe there's an opportunity in the growing value of water can target water assets in themed funds.

Water risk falls into four main buckets:

• Physical risk from extreme weather or rising sea levels.
• Operational risk from production or supply chain disruption.
• Compliance risk from government regulations on consumption and pollution.
• Reputational risk from public backlash, media scrutiny, and litigation.

The world's growing population and changing diet have whetted the demand for water. At the same time, reservoirs are shrinking. The United Nations predicts a 40% global shortfall in water supply by 2030.

Across industries, companies rely on water for cooling, heating, transport, and cleaning. Major companies reflected physical water risk in their recent regulatory filings. For example, beverage giant Molson Coors [PDF] listed "inadequate supply or availability of quality water" as a business risk in 2022. Tyson Foods [PDF] also flagged the "decrease in availability of water" as a potential risk.

Morningstar Sustainalytics uses three metrics to measure water dependency:

• Water consumption is the total water taken and used by a firm without returning any to the watershed.
• Water withdrawal is the total amount of water a company needs to consume to create its product or offer its service.
• Water intensity reflects how many cubic meters of water a company withdraws for each dollar of revenue generated.

The more water-intensive a company is, the higher the cost of disruption and the greater the risk to shareholder value.

Global temperature rises have stoked the frequency and intensity of natural disasters. In the first half of 2022, nine U.S. weather disasters caused $1 billion each in damages. Floods can destroy facilities and contaminate freshwater supplies. Droughts can limit production or increase the cost of piping in freshwater.

Understanding how how location affects water scarcity affects water scarcity can help advisors manage risk. Countries face different challenges based on their population density, agricultural development, and access to clean drinking water. ESG risk ratings can help advisors take a comprehensive look at funds and how risk fits into their clients' investment plans.

In the United States, 40 million people and 5 million acres of crops and livestock rely on water from the Colorado River Basin. As the region's population grows, its reservoirs are shrinking from drought and overuse. Water scarcity could dry up the alfalfa farms that feed massive beef and dairy herds. These southwestern U.S. farms supply two thirds of the country's fruits and nuts.

Water risk can also affect operations when it disrupts companies up- or downstream. Extreme weather, pollution, or water scarcity could send shockwaves through the supply chain.

In the Colorado River Basin, a clampdown on water withdrawals by the federal Bureau of Reclamation affects the farms that supply consumer goods leaders like General Mills and Kellogg. And in Germany, a scorching heat wave lowered the water level of the Rhine River, a major shipping route for raw materials. If the river sinks too low, barges must carry less freight or stop running.

Advisors need a clear view into the holdings of investment products to understand and mitigate exposure to water risk. How are investment vehicles built? How do they align with investor risk tolerance and comfort? Will the level of risk help clients meet their goals?

The outlook on water assets isn't all doom and gloom. Many companies are investing in water scarcity solutions scarcity solutions to reduce usage. L'Oréal appears in several thematic funds for its so-called dry factories that recycle 100% of the water used in manufacturing. (Company water fountains and coffee machines get a pass.)

Water risk data gives advisors more information on how sustainable-investing decisions affect the risk, performance, and impact of portfolios. Sustainalytics found that water-intensive companies also often come with high ESG risks.

On the surface, this could be an opportunity to add value for investors. However, risk-adjusted performance showed only a weak correlation between alpha and water intensity. This means that water-intensive companies don't necessarily raise returns to the levels advisors might expect after taking on that amount of risk.

With water data, advisors can see deeper into the risk/reward trade-off of clients' portfolios. Is the amount of risk clients are assuming appropriate for their time horizon and their performance goals? Or would other, less risky investments balance the portfolio?

Water policy often changes at a fragmented, local level. Two United Nations Sustainable Development Goals address the human right to safe drinking water. Under Goal 6, U.N. members pledge to help ensure the availability of clean water and sanitation for all. Under Goal 12, members seek to increase resource efficiency and promote responsible consumption.

The European Union has taken the global lead in regulations to slow climate change. The EU Action Plan is a sweeping 10-point plan to leverage the financial markets to address sustainability and give investors more transparency into the impact of their investments.

As water supplies evaporate, regulations are bound to become stricter to protect what's left—especially if countries have few regulations in place. Austere legislation on water management could raise operating costs or fines for high-intensity companies. Advisors should assess the likelihood of future regulations as part of their risk/return balance of security selections.

Other regions don't have the institutions or formal policies to protect water use, which can also affect risk. Many emerging economies don't have the infrastructure to treat water or efficiently irrigate crops.

The Democratic Republic of Congo is the world's largest producer of cobalt [PDF], a key component of the rechargeable batteries that power electric vehicles and cellphones, according to the U.S. Geological Survey. Despite Congo's rich natural resources, the government's lack of investment in infrastructure and maintenance means that only 29% of people have access to basic sanitation.

Without good governance, communities have no recourse for wasteful or destructive business practices. To help clients parse their environmental impact, advisors can report on the country-level risk ratings of clients' holdings. Country-level data can help clients understand how their investments affect communities that draw water from the same reservoir.

Companies that use water irresponsibly can also face damaging public backlash. According to a Schroders survey, 60% of investors who responded would pull out of a fund after a climate change scandal. Failure to act—or even perceived failure to act--could spark media scrutiny.

Recently, Google got into hot water for its Mesa, Arizona, data center, which will use millions of gallons of water a year to cool its servers. The new facility is one of several now drawing from the strapped Colorado River Basin. As of yet, the bad press hasn't had a material impact, but exceeding the daily allotment could lead to fines or water restrictions in the future.

In some countries, like Brazil, water holds more rarefied cultural value. Its relative social importance raises the stakes for companies seen as unfairly using or polluting water resources.

Water scarcity can also trigger political conflicts over who controls supply. For example, flaring tensions between India and Pakistan could be risky for companies that draw water from the Indus River Basin.

Environmental reputation can be a material risk for shareholder value. Public ESG controversies can halt stock price increases and lead to persistent underperformance.

Morningstar tracks incidents of corporate controversies as part of its sustainability assessments. With ESG reports, clients can see the distribution of their securities by controversy level, from low to severe, as well as the holdings with the most controversy.

The penetrative data can help clients understand their impact on the environment at a more detailed level. It can also help advisors guide decisions about rebalancing by comparing high-performing holdings with risk levels and negative impact.

Greenwashing and lagging company disclosures can muddy the water of risk data. With water reporting metrics, advisors can screen for companies in countries or industries with severe water scarcity.

Advisors build credibility when they initiate client conversations about risk. By understanding how clients will act in volatile markets, advisors can guide them through turbulent markets to think about long-term aspirations.

Risk and ESG surveys help advisors think holistically about personalization. In Advisor Workstation, a proven psychometric assessment captures how clients really feel about risk and feeds answers into a fund screener.

The all-in-one tool helps advisors know more about clients and choose the right funds for their financial goals and sustainability commitments. Advisors can then create compliance-friendly hypotheticals to explain possible scenarios.