Water-related Risks in Equities

(Chapter 2 of 6) Pricing in risk.

Donald Graham, CFA

Donald Graham, CFA ESG Specialist, Templeton Global Equity Group

Water risk impacts investors’ equity holdings in two simple, yet key, ways: decreased revenues and increased costs. These risks manifest operationally, potentially impacting or preventing a company’s day-to-day operations, and through the company’s understanding and management of risk via its water and wastewater management plans. Risk in these plans surfaces through supply and demand needs, proper treatment and storage of wastewater, and the company’s interactions with local stakeholders and communities. If not properly managed, these risks can lead to regulatory and reputational issues in addition to a negative impact on water sources required for operations. And, if not properly understood and priced, these risks can negatively impact clients’ assets.

A closer look at mining and minerals

To illustrate these issues, we’d like to focus on the mining and minerals industry, where water risks feature prominently and can significantly impact business valuations. While many mining firms report water-related metrics and various service providers attempt to aggregate and standardize the data, available information remains incomplete and often inconsistent. We believe active investors practicing in-depth fundamental analysis will have a competitive advantage in an environment where such material information is not easily attainable.

Mining and processing raw materials requires large amounts of water and results in a considerable amount of wastewater that must be properly treated and stored to avoid harmful releases of toxic waste into the surrounding environment. Therefore, the two main water-related risks impacting the mining industry are:

  • Equitable water access—What are the community, environmental and capital considerations related to water access and are they being addressed in ways that are both responsible and sustainable?

  • Responsible wastewater management—The bulk of water used for mineral processing is retained in tailings disposal facilities, where the non-valuable parts of ore are stored after separating the valuable fraction. The safety of these facilities for the environment and surrounding communities is of paramount importance and represents a material risk that requires close scrutiny.

We’ll explore both through case studies and how our research process is designed to understand a company’s true water footprint rather than relying on single points of data.

Equitable water access

Water access in the metals and mining industry varies significantly by location. Water access can be a relatively small portion of costs in some areas, but much more significant in areas experiencing water scarcity due to droughts, climate change or resource competition. This can lead to not only higher prices, but also to production disruptions or—in the worst case—a full decommissioning of the mine and material asset write-downs. HSBC estimated that if mining companies had to pay water prices more in line with societal demands and needs in locations with higher population densities and that are exposed to water stress, operating profits would decline by 9% on average, ranging from 2% to 26%, and net debt to operating profits would increase by 40% on average, ranging from 2% to 102%.11

In water-stressed regions, mines viewed as excessive water consumers may face conflict or discontent, and many mining companies find it necessary to go beyond regulatory compliance, particularly when government capacity is limited.12 To avoid competing with other users, mines may invest in infrastructure to source water or increase efficiency. Mines often build desalination and water treatment plants to supply operations and local communities with clean drinking water, which may be a requirement for the approval to operate a mine. Operators are sometimes able to use unconventional and lower quality water—such as seawater, high saline groundwater and wastewater—for various processes.

The water needs of a mining operation can be significant. For example, to produce 1 metric ton of copper concentrate ready to be refined into metal, a typical copper mine would need to mine 154 metric tons of rock and use 65 metric tons of water, resulting in 114 metric tons of slurry tailings (some of which can be recycled).13 To assess a company’s overall water access risk, we want to know how much fresh water is withdrawn and consumed, what portion comes from waterstressed regions and alternative water sources, the percent recycled/reused, corporate efficiency targets, and any record of past breaches of permits, standards, and regulations.

...to produce 1 metric ton of copper concentrate ready to be refined into metal, a typical copper mine would need to mine 154 metric tons of rock and use 65 metric tons of water, resulting in 114 metric tons of slurry tailings.

We also seek information on disruptions due to water shortages, disputes with local communities, increasing water costs, and related capital expenditures, as well as information on asset write-downs or penalties and compliance costs. We hope to see a high level of transparency along with a strong management strategy and effective oversight.

Though disclosures have been improving, gathering relevant information can be a challenging manual task. We attempt to leverage water-related information from external data providers, but we find large gaps and inconsistent data even for the most basic statistics. For example, as of June 2020, MSCI ESG Manager had water consumption data for only 14% of our global equity holdings, and CDP (formerly known as the Carbon Disclosure Project) had it for only 19% of our holdings, reflecting the percentage of holdings that respond to CDP’s annual water questionnaire. For the metals and mining industry, MSCI data feeds did not have consumption data for any companies, while CDP had it for only 25%. However, when reviewing company reports, we found all of our industry holdings reported this data, albeit not always in a consistent and comparable manner.

Challenges in obtaining comparable data for risk assessment underscore the need for more robust reporting standards, such as the Water Accounting Framework (WAF) used by the International Council on Mining and Metals (ICMM). The ICMM requires members to report to at least one of the main disclosures systems, for example: CDP Water, CEO Water Mandate or Global Reporting Initiative. While these are considered good systems, the ICMM has developed more comprehensive guidelines to help investors understand the industry’s material water practices, nuances and risks.14

Water access at Anglo American

London-based miner Anglo American plc has high water access risk, with 75% of sites located in water-stressed areas, according to the World Resources Institute’s Aqueduct tool. In 2019, restricted water availability due to drought conditions decreased copper production by 5%, and the firm’s reputation as an industry leader on ESG issues was impacted by a lawsuit relating to water shortages at a Colombian coal mine in which it owns a minority stake.15 Determined to maintain leadership in resource stewardship, the company’s ambitious water strategy includes a goal to achieve a 50% net reduction in freshwater extraction from 2020 to 2030. It set a target for a 75% recycling rate for 2020, and water withdrawals were down 8% in 2019 compared to 2018.16 Some of its water reduction efforts include technological innovation to significantly reduce the amount of mineral ore having to be processed, dry tailings disposal, dry separation, and waterless processing. A key part of its water strategy is switching to lower quality water to reduce costs and make more water available to communities in which it operates. All of this does not come cheap—costs for water risk mitigation represented over 70% of its capital expenditure in 2018.17

THE NUANCE IS IN THE NUMBERSExhibit 4: Comparing Anglo American and Sumitomo Metal Mining (SMM) water footprints

Source: MSCI, CDP. As of September 2020.

Water access at Sumitomo metal mining

In contrast, Japanese miner and refiner Sumitomo Metal Mining (SMM) has relatively low water access risk and less ambitious management targets. The company uses seawater for 82% of its water withdrawal needs, and 94% of water withdrawals are returned to the environment. However, its smelting business uses a large amount of fresh water and includes facilities in the Philippines, where there are water shortages in the dry season. To address this, the firm recycles water from its tailings storage facility when shortages occur. Given water scarcity in the area, SMM has been providing local residents with high-quality drinking water since the beginning of the plant construction and is working with the local government to evaluate the possibility of installing water facilities that draw drinking water from nearby rivers.

Responsible wastewater management

Water used in extraction and processing usually contains toxic metals and pollutants, which—if not managed properly—can contaminate the environment, potentially resulting in large fines, cleanup costs and loss of water access rights or license to operate. While some of this wastewater can be purified, the process is often prohibitively expensive, and much of the unwanted byproduct ends up in a purpose-built tailings reservoir.18

Tailings are a slurry-like byproduct of extracting minerals and metals from mined ore. There are different ways to store tailings that are suitable for different topographies and climates. The waste in tailings ponds is contained by a dam that must be able to withstand flood risk and seismic activity, with monitoring and regular maintenance to ensure it remains stable. Operations with poor waste treatment practices and storage facilities could experience catastrophic failures, resulting in huge cleanup costs, legal damages and the potential loss of license to operate. Of the 48% of mining companies reporting to CDP, water-related financial losses totaled US$11.8 billion over the last five years, in large part caused by flooding and severe weather events resulting in production disruptions, fines and asset write-downs.19

ANATOMY OF TAILINGS Exhibit 5: Step-by-step process of building a tailing

Source: Franklin Templeton. For Illustrative Purposes Only. *Fines are solid particles with diameters less than 44 microns and are comprised mostly of clay and silt material.

While tailings dam collapses remain rare, the impact of a failure can be catastrophic, as was the case with a tailings storage facility at Vale’s Córrego do Feijão mine in Brumadinho, Brazil, in January 2019. The dam collapsed, releasing 11.7 million cubic meters—roughly a 10-meter high wave—of mining waste on the town and surrounding countryside, resulting in over 10 kilometers of destruction, the contamination of the Paraopeba River, 259 people confirmed dead and 11 missing (as of January 2020).20 Vale’s stock price fell 24% in response to the disaster, a loss of US$19 billion in market capitalization. Its debt was downgraded, there were direct costs of over US$5 billion and the former chief executive officer faces murder charges.21

LOWER-GRADE ORE INCREASES WASTE Exhibit 6: Copper grade, copper metal production and ore production by decade (1928–2017)

Source: World Mine Tailings Failures Organization, as of March 2019.

The risk of dam failures may be increasing. This is partly due to higher water and waste ratios resulting from the increased use of lower-grade ore as high-grade ore is used up, as illustrated in Exhibit 6. Climate change is also increasing the risk of dam collapse through more frequent flooding and extreme weather events. In our view, tailings dam failures can be avoided with strong independent oversight and strict regulatory enforcement. State-owned companies or mines operating in countries plagued by corruption or limited government capacity may be exposed to greater risk, requiring reliable third-party auditors and extreme vigilance on the part of investors.

MANY TAILINGS DAM FAILURES ARE PREVENTABLE Exhibit 7: Causes of tailings dam failures (1915–2016)

Source: UNEP and GRID-Arendal 2017, ICOLD 2001, Chambers 2017.

Following the Brumadinho disaster, a group of institutional investors led by the Church of England and Swedish National Pension Funds (now representing more than US$13 trillion assets under management) have written to 726 extractive companies seeking information on the management of tailings storage facilities (“TSF”), as part of the Investor Mining & Tailings Safety Initiative.22 Most of the largest mining companies responded with disclosures on tailings dams/facilities, details of which have been organized in the Global Tailings Portal, launched in January 2020.23 This free database has information on mine tailings dams around the world, and the next phase of the project will test satellite monitoring and aim to increase the number of dams monitored in its database. The Investor Mining & Tailings Safety Initiative, along with the ICMM, the United Nations Environment Programme (UNEP) and the Principles for Responsible Investment (PRI) also conducted a global tailings review to create a Global Industry Standard on Tailings Management in order to establish robust requirements for the safer management of both existing and new tailings facilities globally.

Comparing Vale and SMM tailings storage facilities

We’ve already begun to use the new Global Tailings Portal to understand tailings dam failures and their potential risks to equity investors. Turning back to SMM for a comparison, we find that the company has relatively low risk of tailings dam failures compared to Vale and other companies in more flood-prone regions with weaker regulatory controls. SMM’s main tailings risk is from earthquakes.

The company has no active tailings facilities in Japan, but given its hundreds of years of history, it has many inactive sites with large volumes of tailings that require responsible oversight and maintenance. All inactive facilities have been closed for at least 45 years. Following the Great East Japan Earthquake in 2011, the government significantly tightened regulations for tailings storage facilities, and SMM identified 11 that needed reinforcement against a largescale earthquake. Improvements were completed in 2018.

By comparison, Vale reports 91% of facilities are categorized as high to extreme risk of failure, and 24 facilities have reported past stability concerns. Many of the facilities are also very high volume, suggesting greater environmental impact from any failure. Brazilian authorities have ordered Vale to close several operations, affecting approximately 10% of production. The cause of the recent dam failure was likely due to deteriorating quality and poor oversight. Given the prior incidents with remaining uncertainty around total costs, investors would be prudent to factor in ongoing environmental damages into their forecasts for Vale. SMM, on the other hand, appears to have relatively low risk of catastrophic failures or damages.

NEW TOOLS TO UNDERSTAND RISKExhibit 8: Global tailings portal data comparing Vale and SMM tailings facilities side by side (As of September 2020)

Source: Global Tailings Portal. *Note: TSFs not categorized based on consequence of failure.

In-depth analysis required

Water issues impacting corporations are first and foremost a matter of community equity and environmental stewardship. The examples explored here are some of the clearest to explain, but every industry has its nuances when it comes to water. Companies and governments that do not recognize them as such, or cut corners or ignore regulations, bear significantly higher risk of value-destructive consequences over a long-term horizon. Companies must prioritize water access and disposal issues when assessing and managing projects in order to conduct accurate cost analyses and manage associated risks. Water disclosures at the corporate level are improving, but are still inadequate, in our assessment, and have not yet been standardized in a widely accepted scoring methodology. We believe in-depth fundamental investors are well-positioned to gauge the true risks stemming from water issues on a case-by-case basis, and to accurately reflect those risks in their company models and investment theses. This ability to uncover and assess difficult-to-interpret information can be a meaningful source of alpha for active managers.




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