Banking in the Age of Water Risk

By Debra Tan 19 September, 2016

Banks with long investment horizons are exposed. Tan says prudence dictates we must start to waterproof portfolios

Environmental risks are becoming more material. In a vicious cycle, it is not just businesses which impact the environment but the environment is also now affecting the ability of businesses to operate.

In China, there are also regulatory risks to consider. These pertain to the allocation of water to ensure national water, energy, food and economic security. They also cover tighter standards with higher penalties to protect drinking water sources from industrial contamination. Complying with these risks will likely mean companies will have to incur increasing CAPEX and OPEX.

Investors view regulatory risk to be tangible, material and immediate …
…73% of those surveyed view cost of compliance to tighter regulations as material

We found in our recent investor engagement regarding the various water risk valuation methodologies that 70+ investment professionals/asset owners surveyed saw this risk to be tangible, material and immediate. Our report also shows that 73% of those surveyed view cost of compliance to tighter regulations as potentially material to cash flows and valuations.

Yet, despite this, a common complaint among experts (see here and here) is that bankers, investors, corporates and even water resource managers and specialists have not come up with a cohesive & comprehensive strategy to tackle or value these risks.

Floods risk which can run into billions is the water risk that investors were least worried about

These issues are not going away. If anything they are going to get worse. Whether they be melting glaciers in the Tanggula Mountains that feed the Yangtze or depleted aquifers deep in our earth, they will have implications for businesses and for our future. The stats are alarming. By the end of the century, research led by Peking University projects that 67% of China’s ice may be gone and NASA satellites show that 21 of the 37 of the largest aquifer systems globally are being depleted.

Already we know that the costs of floods are rising and can be highly disruptive to supply chains and cost billions. Yet interestingly, investors we surveyed recently regarding various approaches to water risk valuation rank flood risk as their lowest concern vis-à-vis six other types of water risk. The top being competition for water in the future; the costs related to this can be unimaginable, in both monetary and social terms.

Water risks know no borders. Thanks to trade and intricately linked supply chains, physical risks, say a flood or a drought in China could disrupt production. Similarly, a policy shift in China also has global implications. Supply chains should also be mapped and assessed for water risks as a step toward “waterproofing  exposure”.

Bank loan books could be exposed to these water-related risks, which are likely material

Banks with long term loan portfolios/project finance do not have the luxury of short term investment horizons of hedge funds. Their loan books could be exposed to these water-related risks, which are likely material. Indeed, from our own experience, 48% of investment professionals/asset owners who provided feedback said they were doing the survey because they were worried about water risk, yet 0-4% use the tools available to assess water risk regularly. A quarter of those surveyed was working with debt and/or fixed income.

Are these risks and their potential impacts factored in by banks? Or are banks just considering their ‘water exposure’ as the water used in their office buildings & branches?

Some banks are more enlightened than others. A recent review of global practices of environmental risk analysis by financial institutions was made by the Cambridge Centre for Sustainable Finance. Their report showcased a range of illustrative case studies across geographies, financial sectors and risks. As can be seen from the table below taken from the report, the range of actions varies across banks.

This review was commissioned by the G20’s new Green Finance Study Group (GFSG) which was established by China with the aim to integrate environmental risk into mainstream financial decision-making.

Although we are a long way from this, there are reasons to remain optimistic. Risks can be tackled if they are recognized and China “gets it” on both fronts:

• Near term credit risk: ICBC, one of China’s big banks has stress tested the impact of environmental factors on credit risk. Why did they do this? Because new and stricter environmental policies in China could impact their clients’ operations and increase credit risk. The bank’s reputation could also be hurt as a result of poor environmental risk management practices.

• Longer term risks brought on by climate risk: China and the US formally agreed to ratify the Paris Agreement at the G20 summit. China’s NPC has voted to review and ratify the deal bringing us one step closer to an enforceable Paris Agreement.

Interestingly, HSBC, one of the earliest banks to recognize the impacts of climate change, is not amongst the banks highlighted in the table above. The bank has however committed to spend USD100 million towards a corporate water programme, in recognition of water as one of the top rising global risks. Surely CSR and risk management should be aligned?

Multiple stakeholders with polar viewpoints must work together

The way forward is littered with issues that need to be resolved. Multiple stakeholders with contradictory viewpoints need to work together. These viewpoints could be polar opposites. Here are examples from conferences attended in the past few months:

• Tackling shorter term or longer term issues: at the Water Leaders Summit in Singapore when leaders in the water industry were asked about the long term biggest challenge facing their industry in the future, they cited the lack of financing over climate change and the fragmented nature of the water industry. The water industry was more concerned over how they were going to finance the next project than managing/adapting / building resilience for increased variability in water resources brought on by climate change.

• Varied approaches & different focus: at World Water Week in Stockholm, where there is more of a policy focus, the disconnect between the water and climate spaces was explained by their different viewpoints: water resource managers manage the supply of water at extremes while climate scientists speak in averages of temperature changes. There was also opposite views as to whether there was too much or too little financing available to build resilience in water infrastructure. More on views from Stockholm here.

Clearly the various segments of the water industry are not aligned, let alone moving out out of the water silo into “water plus” like water + food/agriculture, water + energy, water + climate, water + economics. I won’t go into why we need to work together because you can read our views on that in “Back to Basics: G20 Water-nomics, Trade-offs & Trade” on the G20 portal.

In an increasingly resource constrained world, we need to tackle these now. Accelerating financial flows to fund sustainable development is one way. Here, check out the short report just released by UNEP Inquiry directed at policymakers to address major gaps in SDG funding.

Directing capital responsibly can be one way forward… new frameworks & guides released this month can help

Directing capital responsibly is another way forward. The GFSG and PRI can help us ensuring that we “lend/invest right”. Frameworks like the one published this month by Trucost and Golden Credit Rating, one of China’s key credit rating agencies together with support from China’s Green Finance Committee are a good start. There is also PRI’s “A Practical Guide to ESG Integration for Equity investing” and of course CWR’s own report “Toward Water Risk Valuation”, also released this month – in both Chinese and English”

The feedback, interest and reaction to our own work in water risk valuation have been heartening. What surprised us was that 45% of investors wanted to engage with us because they want to embed water risks in their valuation model, yet only 23% of them were SRI investors.

Water risks have come of age & banks with longer investment horizons are more exposed

The bottom line is that water risks have come of age. They have seeped into the mainstream. Regulations have made them more immediate and tangible. We need to factor them into valuation models be they equity or debt. Among the various capital providers, banks with longer investment horizons are more exposed. Scientists still say the current tools are not perfect but this is not an excuse not to start, because any banker will tell you that credit risk evaluation and equity valuation is an art rather than a science.

Prudence dictates we must start