Moving From Curiousity to Integration: an Investors’ Journey

By Shally Venugopal 7 June, 2010

Shally Venugopal, reviews key lessons learnt whilst working with analysts and investors on research to include environmental risks.

Over the past year the World Resources Institute (WRI) worked with HSBC’s team of equity analysts in Asia and its Climate Change Centre of Excellence to explore the links between emerging environmental trends and key economic sectors in South and Southeast Asia.  The reports—which looked at water scarcity (among other environmental issues) impacts on South and Southeast Asia’s food and beverage, power, and real estate sectors—were released in April 2010, and represent some of the most comprehensive research to date on water risks in this region from an investor perspective.

To disseminate the research findings, WRI worked with the Chartered Financial Analyst Institute and their local societies in the region– organising presentations and meetings in India, Singapore, Hong Kong and Tokyo to engage mainstream analysts and investors in discussions around the impact of water and climate change on shareholder value. For many of the analysts and investors, these conversations were their first exposure to research linking environmental issues to the financial performance of companies.  As a result, there was a strong interest in learning more about these potential risks, but many also acknowledged the challenge of integrating environmental concerns into their analyses.  Below are some of the key lessons we learned, feedback we received on the reports, and thoughts on moving water risk integration in this region forward.

Water risks are not considered in mainstream investment analysis

Nothing new there. Only a few analysts and investors were already considering water scarcity in their investment analyses.  These analysts/investors either had a mandate from their company to do so, or in a few cases, had seen first-hand what impact water risks such as operational disruptions due to conflicts with local communities or water shortages, could have on their investments. The primary reason that more analysts/investors don’t consider water risks is simply a lack of awareness. Other reasons ranged from strong trust (in some cases, blind) in companies’ abilities to overcome and prepare for these risks, to short-termism i.e., water risks were not likely to be material within the investment horizon  e.g. a year.

The lack of robust water data is a key challenge to water risk integration

Several of the analysts and investors who attended the presentations were intrigued by the key findings, but unsure about next steps.  Following the presentations and meetings, some analysts sent updates to their clients informing them that water risks may be an important investment theme going forward for certain sectors.  A few also tried to contrast how well (or not) companies were positioned against their competitors using the regional data WRI provided.  But integrating water risks into financial valuation remains tough for several reasons including:

Lack of robust, reliable and accessible data

Water is local, and so are its risks.  Without robust, reliable and accessible data, it is difficult for the investment community to evaluate what water risks are relevant to companies.  Two types of data are necessary: Physical level data—to determine what risks a company is exposed to– and company level data—to determine a company’s vulnerability to these risks.

Water prices are not an adequate proxy for risk

Since water is highly subsidized in this region, even if prices doubled most company operational costs would not be significantly impacted by price increases.  Furthermore, even if water prices reflected the true cost to society, water access is not a certainty.  In this region, the real risks of water scarcity are not rising water prices, but rather shortages which may lead to operational disruptions and/or the costs of treating and processing water.  So unlike some commodities where projected prices may be used as a proxy to evaluate financial risk, water-related financial risks will vary greatly depending on a company’s use of water as well as local supply and demand factors.

Water risks are complex

Water risks are complex, and are often impacted by indirect factors such as politics as much as direct factors like physical geography. Predicting how these factors will play out going forward is challenging.  Climate change adds another layer of complexity since its impacts are hard to predict but potentially game changing for much of the region’s water resources.  For example, precipitation patterns and water renewals may change, leading to more unpredictability in the availability of freshwater.  The time and resources put into wading through these complex factors may not always result in clear investment recommendations.

Qualitative consideration of water risks is critical in the short run

In the face of uncertainty and complexity, what can be done? Even with imperfect information, there is still a lot of useful analysis of environmental risks that can be conducted  for a financial audience. The most prudent step analysts/investors can take in the short-run is to push companies to hire local water auditors and encourage companies to operate in areas facing zero or low water scarcity.  Additionally, the investment community can differentiate between companies through qualitative evaluation of the adoption of best practices when it comes to water usage and management. It’s also important for investors/analysts to be aware of indirect impacts of water shortages on operations.  For example, companies might be directly dependent on water as part of industrial processes as well as to cool captive power plants.

Investment in data, tools and analysis are important next steps

To more easily integrate water risks into financial valuation the investor community will have to invest in, and support, better water-related data and tool development specific to this region.  In this vein, WRI is developing a Water Index which calculates and maps various water-related risk factors faced by specific industries, relative to basin-wide and national averages. The first pilot of this project is focusing on power generation in the Yellow River basin of China, it is hoped that the index will be expanded to other basins and regions in the future.  Beyond the investment and NGO community, local and national governments also have an important role to play in improving water market transparency and use in the region.  This includes developing better data at the local level, setting appropriate prices for water, developing better water infrastructure, and incentivizing companies to install water savings systems.