US$1.9tn – The True Cost of Water
By Chaoni Huang 9 May, 2013
Chaoni Huang of Trucost tells us why this unpaid natural capital cost of water matters for primary resources
New research by Trucost for the TEEB for Business Coalition, Natural Capital at Risk – The Top 100 Externalities of Business, estimates the unpaid environmental cost of water consumption by global primary production and processing business sectors at US$1.9 trillion, around 2.5% of GDP.
The report highlights the top 20 region sectors with the greatest natural capital costs of water consumption. Wheat farming and rice farming in Southern Asia were found to have the highest water risk due to high irrigation rates of farming in this water scare region. While many of the natural capital costs are being generated by business sectors in the developing world, the resulting goods and services are being consumed by resource intensive supply chains around the planet—thus it is a global challenge for companies and their investors.
Some of these external water costs are already being internalized by disruptive natural events – severe droughts across China, India and Texas during 2010-11 sparked a number of profit warnings by retailers linked to cotton price volatility. Analysing retailers’ profit margins normalised for revenue growth reveals the impact of cotton price volatility. The chart compares the year-on-year change in quarterly profits of a six apparel firm composite, inverted and lagged, with the year-on-year change in cotton prices. The composite includes profit impact data from GAP, H&M, American Eagle Outfitters, Fast Retail, Adidas and J.C. Penneys.
Inadequate pricing of water driving unsustainable demand in water scarce regions
Water lies at the heart of our global economy. In fact the majority of raw materials that businesses depend on require water in one way or another. However, a gap already exists between supply and demand. If we do nothing to correct this imbalance, by 2030 demand will exceed supply by 40%.
Part of the problem is that water is not correctly valued and this is creating perverse market incentives. For example, the ‘Dry 11’ regions of mainland China provinces create 51% of China’s industrial output and 38% of its agricultural products. As the name suggests, these are the driest provinces with water resources comparable to those of the Middle East – that is a severe water poverty level. Because the price of water in these regions is among the lowest in the world, the market creates an incentive for retailers and manufacturers to outsource services in these areas, despite the high risk of drought or damage to long term water supplies.
Trucost’s water valuation approach takes into account the environmental damages of abstracting water from one specific region. The natural cost of environmental damage is driven by water scarcity. The logic behind this approach is that when a cubic meter of water is abstracted from a region where water is abundant; there is almost no environmental damage. On the opposite, the environmental damage caused by the abstraction of one cubic meter of water in a water scarce region will be significant for the ecosystems of this region.
Companies and their investors face both an opportunity and a significant problem. Consumer demand is set to grow significantly over the next few years with the increase in middle class consumers, especially in emerging markets. However, this is against a backdrop of increasing resource scarcity and the degradation of our natural ecosystems. One of the challenges will be to understand the value of the natural systems we rely on – commonly referred to as natural capital – and how these systems can be managed. The current business model creates significant environmental externalities. Trucost’s research demonstrates that high impact business sectors make an economic loss when the costs of environmental damage such as water consumption are accounted for. However, businesses and investors can take account of natural capital impacts in decision making to manage risk and gain competitive advantage.
Where there is risk lies opportunity…
Trucost estimates that the true cost of water ranges from $0.1/m3 where it is plentiful to $15/m3 in some areas of extreme scarcity. Businesses can take advantage of this wide range and align water use with its availability by using water valuation techniques to evaluate new infrastructure investments, procurement strategies, and product portfolios. Forward thinking companies that take account of their natural capital dependencies will benefit from a more complete picture of the most effective ways to allocate water and other resources that are under steadily growing pressure.
The research also provides a tool for investors to understand the scale and distribution of natural capital risk across their portfolios; how this has, and may continue to become, financial risk; and how this can be mitigated through informed asset selection. Alastair MacGregor, Chief Operating Officer of Trucost, who conducted the study states, “Recent soft commodity price volatility due to drought, and its impacts on company profits, nation’s trade balances and inflation has underscored the dependency of investment returns on natural capital. This trend will accelerate in the future on a number of fronts.”
Valuing water correctly – according to its scarcity – provides insight not just for water corporations seeking to manage precious resources, but also for businesses and investors seeking to build water resilience into operations, supply chains and portfolios. The leading businesses and investors of the future will operate a full cost accounting structure that takes into account both today’s prices and the prices of increasingly scarce natural resources, such as water, adjusted according to their value to the business and society.
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