How Water Risks Will Impact Credit Ratings

By Justin Sloggett 26 May, 2021

Fitch Ratings' Sloggett shares how to incorporate water risks in credit rating decisions amid mounting difficulties

Water risks, both freshwater and saltwater, can cause severe disruptions or even downgrades of creditworthiness to corporates and financial institutions. However, it is difficult to value and price water risks given the unpredictability of various manifestations of water risks. To get an inside look of how a rating agency handles this problem, we sat down with Justin Sloggett, Director of Sustainable Finance Group at Fitch Ratings to learn more about how Fitch Ratings values water risks and how these risks affect credit ratings.

CWR: Over the last few years Fitch has started to publish more reports on various water risks – what prompted the accelerated pace of reports on this front?

Justin Sloggett (JS): Fitch Rating has for many years assessed water risks in certain sectors such as beverage, protein, regulated networks and utilities as a fundamental part of our credit analysis. Our analysts have also taken account of water risks in analysing bond issuances by local, regional and national governments.

We have assessed water risks for years but recently the way we look at them has changed

What has changed recently is that we now systematically review and clearly display how these water credit issues have affected our credit rating decisions across all of our analytical groups: Financial Institutions, Non-financial Corporates, Public Finance and Infrastructure, Sovereigns, and Structured Finance and Covered Bonds. The motivation behind such a move was a clear market signal from investors that asked for more transparency on how ESG risk factors were impacting rating decisions of credit rating agencies.

Fitch responded by rolling out its ESG Relevance Scores at the beginning of 2019. By the end of that year, we had managed to allocate ESG Relevance Scores to over 10,500 rated entities and transactions. Our dedicated ESG Research team was also formed in the same year and has since produced numerous ESG thematic reports alongside the special ESG research reports written by our ratings analysts within the analytical groups.

CWR: Can you walk us through the main risks you are concerned about due to potential credit issues? 

JS: The main risks vary across sectors and asset classes. As such, Fitch applies a sector-by-sector approach to analysing water issues. This is also the case for all environmental and social issues that we assess, score and disclose in our reports.

That said, water-related credit issues are relevant for a wide variety of sectors and asset classes, which is illustrated by the heat maps in our report entitled “Relevance and Materiality of Water Issues for Economies and Entities”.

In the past two years, we added another layer to the integration of ESG issues in our credit rating process. The above mentioned ESG Research team is responsible for helping our credit analysts to assess medium to long-term ESG risks and monitoring when they turn from being a long-term risk to a medium-term or even a short-term risk, which could potentially affect credit profiles. The team members work closely with our analytical groups and write dedicated thematic reports on these ESG risks, which can ultimately help to inform analysts’ views when formulating criteria and methodology for our credit ratings.

Longer-term climate risks (e.g. flood risks) to key real-estate markets are rarely priced in bonds or insurance costs

One such research report entitled “Growing Protection Gap for Physical Climate Risks” notes that we believe that the longer-term climate risks to key real-estate markets are rarely priced in bonds or their underlying property insurance costs. Flood risk is a key example of a pervasive, long-term environmental risk that can be difficult to measure and price with a high degree of precision. Insuring against the existing hazard of flood events is challenging because of the difficulty in predicting damages from flood waters in urban areas.

In addition, there remains a high degree of uncertainty as to the magnitude and frequency of future flood events arising from climate change. Highly detailed, often costly, data is required to price this risk accurately and low affordability represents a major barrier to wider coverage, particularly for small businesses or emerging markets.

CWR: How does Fitch take these risks into account when considering credit ratings? 

JS: We focus on six main water issues:

1. Floods – One-off large volume of water causing agricultural, property and infrastructure damage
2. Droughts – Prolonged dry weather causing water shortages that reduce agricultural, commercial and industrial production and economic output
3. Competition – Agricultural, commercial, industrial, power and domestic consumers accessing the same water source causing unsustainable exploitation of groundwater and surface water that leads to water shortages, rationing, business disruption, loss of operating licences and conflicts
4. Quality and pollution – Inability to source or disruption to supply of high-quality water, and requirements and legislation to prevent water pollution
5. Infrastructure – Insufficient and failing infrastructure that disrupts freshwater supply
6. Supply chain – Disruption to reliable sourcing of ingredients and products produced in high-stress areas.

Fitch analysts will only consider water issues to be credit-relevant, and therefore a water-related credit issue, when water usage forms a key input to the economy, management strategy, product, manufacturing process, operation or project. If one or more of the six water issues are relevant to a sector, then Fitch analysts will assess whether they are relevant and material to an entity, transaction or programme by looking at the potential credit impact of water usage and supply:

1. Water usage in the manufacturing process;
2. Water usage of product;
3. Water usage of operations;
4. Water supply in economic development.

If they are relevant and material to an entity, transaction or programme, water issues can materialise as one of several key credit risks such as: macroeconomic, operational and cash flow, profitability, refinancing, regulatory and litigation, and reputational.

Water issues can materialise as one of several key credit risks

These credit risks can have a rating impact in combination with other factors, or even be a key rating driver that has a significant impact on a rating on an individual basis.

CWR: Are there some water risks that you are more worried about? 

JS: While we do assess whether water risks are material across all issuers, we have observed that some water risks are more material than others within sectors and asset classes.

For instance, our Sovereigns team have constructed two composite indicators for country exposure to water stress and droughts on one hand and flood risks on the other. We have captured water stress and droughts, and flood risks separately given the apparent negative correlation between the two categories of risks.

For many sovereigns, water risk may depend more on a ‘weakest link’ than an average ranking of several factors

Intuitively, a country facing risks of water shortages would be less exposed to risks of extreme downpours although floods could also lead to deterioration in water supply from infrastructure destruction and pollution. This approach is in line with our view that, for many sovereigns, water risk may depend more on a ‘weakest link’ than an average ranking of several factors.

Currently Egypt and Laos are two examples of sovereigns where the credit risk issue “Water supply in economic development” is minimally relevant to the rating; having either a very low impact or being actively managed resulting in no rating impact. For Egypt, the risk is that water scarcity could impact the agriculture sector and the economy more broadly but this is being well managed. For Laos, its high medium-term growth potential is dependent on the continued effective management of its hydropower sector.

CWR: Are you mainly considering the physical water risks, or do you also look into government action or inaction which could increase or alleviate the risks? 

JS: We look at both. As highlighted earlier, physical climate risks are relevant to the property and real estate sector and related structured finance products. Network utilities and infrastructure also tend to have direct exposure to disruption from physical climate risks.

How issuers anticipate and respond to government action though is equally important. Governments can be highly reactive to short-term unrest and negative media coverage. This can lead to operational disruption if issuers fail to anticipate future government action – such as reallocation of water rights or increased rates. In Australia, some gold miners have had high-security water rights rescinded by regulators in response to drought conditions and pressure to safeguard domestic supplies.

We look at both physical risks & govt action…

…regulatory fines can have an impact on the creditworthiness of water utilities

Regulatory fines can have an impact on the creditworthiness of water utilities. For example, due to inadequate service and poor water-leak management, Thames Water Utilities Limited received GBP230 million of regulatory performance fines between 2016 and 2020, which will reduce free cash flow by GBP188 million during the next price control period (in nominal terms). This contributed to a downgrade of its parent company Kemble Water Finance Limited on 31 October 2018.

CWR: Is all of this research and analysis carried out internally or do you use external research as well? 

JS: All our research is conducted internally. Fitch analysts assign credit ratings and their corresponding ESG Relevance Scores, and are therefore responsible for conducting ESG research for their designated issuers. Analysts within the Sustainable Finance Group provide assistance with thematic issues and trends as well as reviewing all ESG Relevance Scores on a regular basis to ensure accuracy and consistency across sectors and asset classes.

CWR: What are some of the difficulties in incorporating water risks into credit rating decisions? 

JS: This differs by water issue. Floods, droughts, competition, water quality and pollution all require supply-side water data that is specialised and can be costly to source and assess. These water-based events are also difficult to predict and assess given that their risk outcome depends on how entities exposed to the risk react not only to the event but also to how their competitors are reacting.

Most dire economic effects will probably occur beyond the timeline of credit rating horizons, which may lead to a discounting of real risks present today

The issue of time horizons is a familiar one with regard to pricing floods and droughts, as the most dire economic effects will probably occur in future decades beyond the timeline of many investment strategies or credit rating horizons. This may lead to a discounting of real risks that are present today.

Despite these limitations and many others, Fitch analysts do monitor issuer’s exposure to water supply disruption and their response to changes in the regulatory landscape. They will also make a qualitative assessment on the issuer’s procedures, controls and strategy for water and wastewater management.

CWR: Unfortunately, a lot of these long-term risks need to be understood so that actions change today or there will be a credit issues in the long term – can credit rating agencies help with this by providing some kind of signal? 

JS: Yes. It’s about being transparent on which ESG issues are affecting credit ratings, and in particular the transmission mechanisms that can cause the risk to materially impact the credit rating decision. This requires a systematic approach to understanding the relevance and materiality of ESG issues to each issuer, sector and asset class across all regions and markets.

Fitch’s ESG Relevance Scores methodologies and accompanying ESG in Credit reports do exactly that. Four ESG in Credit reports, in addition to the already-available “Relevance and Materiality of Water Issues for Economies and Entities” report, will be release later this month on:

• greenhouse gas emissions and air quality;
• energy management;
• waste and biodiversity; and
• exposure to environmental impacts.

ESG Relevance Scores are transparency scores. ESG Relevance Scores describe how ESG factors have affected credit ratings. Rating analysts allocate ESG Relevance Scores for 14 to 15 environmental, social and governance risk factors and provide an overall ESG score, ranging from 1 to 5. An ESG Relevance Score of 1 is allocated when an environmental, social or governance risk has no credit relevance to the sector or its constituent entities. An ESG Relevance Score of 5 is allocated when an individual environmental, social or governance risk is unambiguously causing a change to the current rating level of an individual issuer or transaction.

Further Reading

• Getting Old & Feeling Unloved: Water Needs A Multi-Billion Dollar Makeover – Ageing water infrastructure presents a new set of problems that will eventually lead to a breakdown in our water systems. It’s time for a multi-billion dollar makeover says CWR’s Tan
• Wipeout – 8 Reasons Why Stress Testing For Chronic Risks Will Strand Assets – Systemic shocks from water risks are inevitable unless action is taken to reduce emissions. CWR’s Dharisha Mirando & Debra Tan share 8 things you need to know about stress testing your portfolio
• It Happened – Central Banks And Water Risks – Half a dozen new reports by the NGFS means that CWR has achieved a key milestone in embedding water risks in finance. Debra Tan and Dharisha Mirando expand on these game-changing moves by the central banks. The credit evolution has started
• Climate Fight: Finance As Asia’s Most Effective Weapon – Green finance is set to take off as regulations promote carbon pricing and better disclosure but Dr Ma and Huang also see gaps that need closing like integrating ESG factors in risk management
• Looking for water in China’s 14FYP – The new China is not the old China. CWR’s Xu & Tan went searching for water in the 14FYP and are left feeling optimistic, see why in our review

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