Water Risk Valuation – What Investors Say

By Hubert Thieriot 19 September, 2016

We surveyed 70+ investors about water risk valuation. Here are 8 key messages from our discussions

In our report, “Toward Water Risk Valuation” (English & Chinese), we adopted three approaches to quantify water risks for 10 energy listed companies and asked over 70 investment professionals/asset owners from over 50 financial institutions / funds (“Investors”) what their thoughts are on the results.

These three main approaches have been used:

• Shadow pricing’s impact on P&L
• Balance sheet exposure to water stress
• Regulatory risks & compliance costs

And here are 8 key points drawn from our discussions with Investors on these approaches …

1. Investors are worried about water risks – more by some than others

The investment professionals/asset owners (hereafter called “Investors”) we talked to are clearly concerned about water risks: 48% said they did the survey because they are worried about these risks.

Investors also say that some risks matter more than others. Although concerned about droughts and floods, they appear to be even more worried about risks related to the availability of water. “Competition for water” ranked as the #1 concern; followed by “scarcity exposure”; then “groundwater depletion” and “droughts”. Reputational risks and floods, although important, are less of a concern.

2. But there is gap between alleged concern and concrete action

So far, this concern has not translated into much action. Despite the Investors expressing concern over various water risks, only 37% of them said they actually conducted water risk assessments recently.

Also, Investors appear to be unaware of existing initiatives to gauge water risks. All the tools we identified were unknown to most of investors, with 61%-90% of Investors having never heard of them before.

Perhaps this is due to a lack of communication around these tools, or perhaps it is best explained by one Investor: “We don’t want lots of words. Nobody reads tool instruction manuals. We want something practical we can use… Collaborate with brokers maybe”

3. Investors are divided over a shadow pricing approach to valuation

The first approach we used to quantify water risk is the shadow pricing methodology. Results show wide-ranging impact on margins within & between sectors, ranging from -1% to -13% for the 5 coal companies (Coal-5) and from -3% to -24% for the 5 power companies (Power-5).

Although a majority of Investors acknowledge the impact margins to be “material” or “very material”, they have serious concerns over the concept of shadow pricing & the underlying assumptions. There was enthusiastic debate over whether shadow prices fairly represent the water risk exposure for either sector.

In the end, Investors did however appreciate the ability to estimate a range of impact by sector and 82% agree shadow pricing was a good first step, but a first step only.

Shadow pricing needs complementary analysis of the exposure to physical water stress and regulatory risks.

4. Water stress maps are useful, but watch out for granularity issues

The report also shows the results of a more conventional approach which consists of measuring companies’ assets’ exposure to water stress.

We mapped the 79 mines of the Coal-5 and 135 thermal power plants of the Power-5 to find that 3 of the 5 coal companies’ source >85% of their coal output from extremely high water stress areas, whereas Power-5 generate 34%-81% of their thermal electricity from the same areas. Over 90% of Investors express concern after seeing these results. The map below shows coal output & power generation but the report also sets out exposure of coal reserves and power generation capacity. (click on image to enlarge)

However, given Greenpeace’s report, we took a closer look at the Kuye River catchment, which holds 49% of Shenhua & 70% of Yitai’s coal output. Local studies show extremely high water stress, contrary to WRI’s Aqueduct BWS map indications. Granularity issues explain such discrepancy. Remapping all the assets on the new high resolution China BWS map reveals significantly higher exposure across for the Coal-5.

5. Regulatory risk = #1 Investor concern

A last approach to gauge water risks was to look closer at regulatory risks and potentially increasing compliance costs. China has indeed issued a considerable amount of regulations to enhance water management, especially in the energy sector as managing China’s tight water-energy nexus in the parched North is high on China’s agenda – just think about tighter norms for water use and water discharge, constrained allocation of water use permits, mine water mandatory recycling rates, use of reclaimed water for power plants etc.

Most Investors see regulatory risks as more tangible & immediate than physical water risks

Most Investors we talked to see regulatory risks as more tangible and immediate than physical water risks. At the end of the survey, 59% of Investors indicated they may commission/conduct more research on regulatory risks over 41% for physical water risks. And this is not only about costs: for most of them, investing in non-compliant companies is a breach of fiduciary duty.

6. Investors want more decision-relevant disclosure with a bias toward mandatory disclosure

While conducting our analysis, we quickly came across data consistency & completeness issues. For instance, water related disclosure at the company level is of little use for water risks assessments. Not surprisingly, over 90% of Investors want facility level disclosure of water use for instance. Yet none of the 10 analysed ListCo’s disclose such numbers. Another utility (CLP) is faring much better in that regard – more on this here .

Investors feel stock exchanges can do more … companies can use official targets as yardsticks in disclosure

Investors also feel that stock exchanges can do more, and most of them (86%) would like to see water use levels as part of “mandatory disclosure required by exchanges”.
So as to ensure ‘apples with apples’ comparison, we also recommend companies use official regulations, targets, standards & quota norms as yardstick in their disclosure.

7. Challenges remain – tools still omit pollution & are time consuming to use

Investors also pointed out that the current shadow pricing and mapping tools ignore pollution challenges. This is a “must-fill” gap given that:

• water pollution issues are potentially the most material contingent financial liability in the mining sector; and
• regulatory risks are becoming more material as China shows growing determination to tackle water pollution.

We are happy to learn that some tool developers are working on incorporating such issues, so stay tuned to China Water Risk to hear about latest developments.

Other challenges remain, such as the high labor intensity of accurate water risk analyses. Indeed, water risks are very much location-dependent, both physical (e.g. water stress) and regulatory (e.g. allocation of water use permits). One therefore needs to know where are companies’ operations, what are the local conditions of water resources and demands, what are the policies regionally in place etc.

Another challenge is the ability to compare with other (environmental) risks. Is the fight against air pollution more likely to affect companies’ returns than water pollution? Is overcapacity a much more acute and immediate risk?  The answer varies across sectors and water may not even be a material risk for all industries.

8.  The water risk valuation journey has only just begun

Water risk valuation is still a nascent art; currently, full of approximations and blind spots. We are glad to see that Investors care about these issues and that initiatives are sprouting up to help them. We hope this report will offer Investors a quick glance at what exists on this front today and help the investment community find consensus/ standard framework regarding water risk valuation.

Investors are hungry for more. When asked about which sectors would they like to see more analyses of, three names jumped out: #1 Textile, #2 Agriculture and #3 Food & Beverage. We’ve only just begun. Water risks are not going to go away, if anything they may rise. This is a journey we must embark on.

Further Reading
 1 September 2016 – China Water Risk releases a new report titled “Toward Water Risk Valuation – Investor Feedback on Various Methodologies Applied to 10 Energy ListCo’s”.
The report details investors’ feedback on various water risk valuation approaches: shadow pricing’s impact on P&L, balance sheet exposure to water stress and regulatory risks & compliance costs
10 listed energy majors operating in China have been analysed: five in coal mining and five in power generation. 70+ investment professionals/asset owners across various asset types (“Investors”) from more than 50 financial institutions/funds provided feedback on the results.
This report is available in English and Chinese

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• Corporate Leadership For Depleting Aquifers – Earth Security Group’s CEO brief warns that depletion of aquifers is creating systemic business risks and geopolitical challenges. See why authors Litovsky & Hill Clarvis think these are risks so great that countries & MNCs must come together to collaborate on solutions

• Quantifying Water Risk: What’s My Number? – Industries are exposed to water risks but financial valuation of such risks remain elusive. China Water Risk’s Thieriot reviews existing quantification tools & methods and highlights gaps that need to be filled to put a number on water risks
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• BWS-China: WRI’s New Water Stress Map – With more granular data from the Chinese government, WRI China upgraded its Aqueduct Baseline Water Stress (BWS) maps for China. BWS China developers Wang, Zhong & Long explain key differences