Directly Engaging To Understand Water Risk

(Chapter 3 of 6) What we’re learning from European utilities and cement manufacturers.

Gail Counihan

Gail CounihanESG Analyst, Franklin Templeton Fixed Income

We’ll now focus on risk and use fixed income investing as our lens. Firms with water intensive business operations and those operating in areas of water stress—where water withdrawals are high relative to supply—face the risk of having to pay higher water prices or losing access to water supply. These risks are likely to rise in the future: water scarcity is rising due to population growth, over-use, and ecosystem degradation, plus more frequent and severe droughts. Where water scarcity has been severe enough to have an operational impact, several bond issuers have had their credit ratings downgraded in the past, as illustrated in Exhibit 9.

Water risk is most severe at the intersection of two variables—lack of investment in resilient infrastructure and occurrence of severe drought. Since droughts are outside our control, we engage with companies to collect information that will allow us to understand how the companies we invest in are positioned to deal with these risks. In practice, this means that we try to understand any mitigation attempts by companies, investment into preparing for these risks, best practice within the sector and the realities faced by certain geographies or sectors.

Our first port of call is existing data—disclosures that have been made that will assist us, metrics that are universally comparable, or processes and frameworks that exist to manage risk. We then use MSCI data for further company specific information, and our final port of call in gathering data is a short questionnaire that is sent to each company we engage with. Our first objective is to learn more about how these risks are managed, and once we have established a good benchmark, we will continue engagement in cases where we think this risk management can be improved.

WATER SCARCITY’S OPERATIONAL IMPACTSExhibit 9: Examples of recent water-related impacts on company bond ratings (As of October 2020)

Source: Franklin Templeton based on our research of water-related downgrades. *S&P Global Ratings, COP24 Special Edition: Shining A Light on Climate Finance. December 2018.

Our engagement process

We follow an internal process to identify companies that are at higher risk of being impacted by water scarcity, as measured by MSCI. Using water risk as an example, some of the factors that we consider in identifying these companies include:

  • Water intensity relative to peers
  • The portion of company assets in lines of business that are typically water intensive
  • The portion of company assets in geographies that typically experience moderate to high levels of water stress
  • Presence and nature of water-related controversies

We then review these companies in more detail, and where we require more information, we will engage the company to provide us with some extra detail around the following areas:

  • Further information around the firm’s approach to estimating water scarcity
  • Water efficiency targets over the next five to 10 years
  • Any initiatives to work with the company’s supply chain on water scarcity strategy
  • Investment into water efficiency
  • Targets and investment around recycling levels and returning wastewater to the environment safely
  • Accountability for management and delivery of water management strategy and KPIs

To better illustrate our process, we’ll focus on some key findings from recent engagements in Europe with energy utilities and cement manufactures—two sectors we believe highlight how water stress is key to valuing and understanding risk in corporate bonds.

Energy utilities

A typical power company is a large user of water—most are cooled by river water—but a negligible consumer, as much of the water is returned to the source after it is used and treated. Most of the loss, or consumption, occurs through steam. Water is critical to thermal and nuclear power generators—which currently account for around 60% of power generated in Europe and over 40% of freshwater withdrawal.24 Global withdrawals are expected to increase 20% by 2040.25 Given the high withdrawal rates, if the source is a static body or a river, there is a risk that the company will be denied access in times of drought.

Water is critical to thermal and nuclear power generators—which currently account for around 60% of power generated in Europe and over 40% of freshwater withdrawal.

We recently engaged seven energy utilities operating in the EU. Here are some of our key findings based on our survey:

  • When it comes to expectations regarding increases or decreases in water efficiency, an almost unanimous forecast is that the organization is expected to become up to 25% more water efficient. The key driver of this improvement is an industry-wide movement away from a high-water intensity energy (high thermal capacity) toward less water-intensive renewables. The spending to achieve improved efficiency is cited as being a defined percentage budgeted in annual or forecasted research and development (R&D) budgets—almost half of companies chose this—or “ad hoc” spending.

  • With respect to accountability and organization governance, there was consistency among responses. All the companies have an executive committee member responsible for management and delivery of water management strategy and oversight of water KPIs. In terms of the KPIs that are tracked, there was divergence in responses—ranging from baseline KPIs such as those that are obtained from a water supplier, to more granular metrics such as recycling rate, consumption and discharge by source, water use in megaliters per gigawatt hour (ML/GWh), and water use/overall sales— the latter providing investors with the most easily comparable metrics from one company to the next. We will continue engagement where required in order to source these comparable metrics.

  • Water recycling is not cited consistently as a target, and where it is pursued, we observed only marginal savings in thermal processes. For example, the installation of a system for the recovery and use of rainwater at a thermal power plant may be expected to save 2% in annual withdrawals or treating wastewater from power plants and might result in a 1% saving. It is useful to compare these marginal improvements to the fundamentally lower water intensity that is associated with renewable power generation.

    Overall, we were encouraged by the granularity and oversight of water risk in our respondents. We will continue engagement with some issuers where we think disclosure and internal processes can be improved.

    EU ETS—boosting climate resilience of energy infrastructure

    Across Europe, the frequency of extreme weather has been on the rise—ranging from falling river levels to an increased number of droughts or heat waves. Warmer temperatures are fueling peak demand loads on the continent’s energy grid, and the requirement for cooling water in thermo-electric power plants is an important climate risk that is growing for electricity producers. A mitigating action here is conversion to a mostly renewable generation base, and in this light we can view decreasing water risk as an unintended consequence of the European Emissions Trading System (EU ETS)—the scheme provides economic incentive for utilities to move toward less water-intensive power generation, thus decreasing their water risk.

    Cement

    Next we’ll focus on cement production—also an activity covered by the EU ETS. Not only because it is the most used construction material in the world—you’ll find it on every continent and in every market from frontier to developed—but also with global growth, concrete production is increasing substantially and is projected to grow more. The industry has made strides to measure energy consumption and CO2 emissions but has lagged on understanding and reporting on its water footprint. As seen in Exhibit 10, a 2018 report from the International Energy Agency (IEA) and the World Business Council for Sustainable Development (WBCSD) Cement Sustainability Initiative (CSI) projects cement production to increase 12%–23% globally. Of that growth, 75% is projected to occur in water-stressed regions.26

    PROJECTING CEMENT THROUGH 2050Exhibit 10: Cement production by region projected through 2050, with world high- and low-variable projections (in megatons/year) As of 2018

    Source: IEA, WBCSD, CSI, 2018. Base year cement production data 2014 Minerals Yearbook: Cement, United States Geological Survey data release, 2016. There is no assurance that any estimate, forecast or projection will be realized.

    As we did with energy utilities, we created a direct engagement process and survey with three of the larger European cement manufacturers. The feedback received has helped us to start building a picture of what good forecasting and operational management looks like.

    • When it came to understanding water sources, responses that were common included leveraging more than one source of water availability assessment tools—such as the GEMI Local Water Tool, Aqueduct or the Water Risk Atlas. Having a clearly articulated water management strategy in place, having a view of the extent to which operations will become more efficient over the short to medium term, and working directly with suppliers to understand their water strategy together form the baseline of good operational management.

    • Regarding investment, there is no clear trend with regard to spending to achieve greater efficiency. Approaches ranged from ad hoc spending to the investment being a defined percentage of the R&D budget—the latter would ordinarily be associated with a dedicated strategy to target water efficiency and would represent the best practice among responses.

    • With respect to KPIs for recycling and returned wastewater, we couldn’t obtain a clear picture of best practice. Metrics were either reported as absolute numbers or percentages—rendering both as non-comparable. This will be an area that we continue to engage on. An internal price for water is something that is being used by most of our respondents—an indicator of good water governance.

    • There was consistency across the board with respect to accountability for water management and efficiency programs—this is something that has become standard practice rather than indicative of strong governance. While we think the level of risk management and oversight in our respondents varied widely, we also think the baseline level of oversight was stronger than global peers, due to regulation in the European region.

    Active engagement helps us gather information that improves our understanding of how companies are managing these evolving risks. With varying disclosure requirements globally, it is still challenging to compare companies across regions, and some of our next steps in our cement engagement will include establishing a real-world baseline and sourcing comparable and up-to-date data.

    Having a clearly articulated water management strategy in place, having a view of the extent to which operations will become more efficient over the short to medium term, and working directly with suppliers to understand their water strategy together form the baseline of good operational management.

    Complexity necessitates engagement

    These engagement examples are just scratching the surface, and we immediately saw the need for further engagement. Additionally, analysis of results from multiple data sources combined with company responses is quite complex. The lack of standardization not only within sectors, but also across sectors, enhances the complexity. It is important for us to understand these complexities and continue to engage companies to move toward standardization and a better baseline. The time to do this is now—complexity will only grow with the growing demand and competition for water.

     


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