Water Disruption: Investment Risk From Multiple Angles

(Chapter 1 of 6) Before the well runs dry: The time for investors to understand water risk is now.

Julie Moret

Julie Moret Global Head of ESG, Franklin Templeton

Donald Graham, CFA

Donald Graham, CFA ESG Specialist, Templeton Global Equity Group

Gail Counihan

Gail Counihan ESG Analyst, Franklin Templeton Fixed Income

Author name

Greg Danielian Research Analyst, Franklin Templeton Fixed Income

Greg Wilkinson, CFA

Greg Wilkinson, CFA Institutional Portfolio Manager, Franklin Real Asset Advisors

Jonathan Malawer, CFA

Jonathan Malawer, CFA Head of insurance linked securities, commodities and environmental strategies, K2 Advisors

“When the well is dry, we know the worth of water.”

Benjamin Franklin, 1746

There is a lot of talk about how regulatory reforms connected to climate change will impact financial markets. However, we firmly believe the leading issue, at the end of the day, is that we have been entrusted to look after our clients’ assets and are responsible for returning those assets in better condition than when we received them. Therefore, we have a duty to understand the full spectrum of business relevant risks that can reshape a company’s or sector’s competitive positioning in the marketplace and impact its operational resiliency.

Riffng on Benjamin Franklin’s observation in the context of the current landscape of understanding the importance of water to financial markets: if we don’t know how much water there is in the well, we won’t know until the well goes dry. Meaning: unknown and undisclosed risks are likely to be mispriced and put assets at risk. Therefore, companies and sectors lacking understanding of their water sources and footprints, lagging in disclosure of water risk, and/or postponing adjustments to the regulatory reforms touched upon later in this piece all present long-term risks to investors.

With all the charts, examples and best practices we outline in this piece, ultimately, we are trying to help end investors understand that water itself isn’t just an economic policy issue and risk arising from population growth and climate change. Water is impacting the day-to-day operations of investee companies and how they are thinking through their own business models and business risk.

The macro view: our water future

By 2030, the global population will reach nine billion and the world will require 40% more water than it does today.1 However, the global supply of accessible fresh water accounts for less than 1% of water supplies and will not grow with population. This limited supply is threatened by overuse, contamination, and over-demand. The World Economic Forum (WEF) has identified “Water Crisis” as one of the top five global risks in terms of impact in nine out of its last 10 Global Risks Reports, including 2020.2 The WEF classifies water crisis as a “Societal” risk; it’s easily argued that a water crisis would envelop the totality of the WEF’s risk categories: economic, environmental, geopolitical and technological. Critical investments in purification, reuse, efficiency and delivery infrastructure are required on a global scale—including in first world countries such as the United States.

WATER SCARCITY WILL IMPACT GDPExhibit 1: Economic impacts of climate change-induced water scarcity by world region, 2050 (As of 2016)

Source: World Bank. “High and Dry: Climate Change, Water, and the Economy,” World Bank, Washington, DC. 2016. Note: The range of impacts, as determined by the type of policies implemented to cope with water scarcity, is from a business-as-usual policy (–14%) to a policy seeking to reallocate water to the most productive uses (–6%). There is no assurance that any estimate, forecast or projection will be realized.

Then, there’s climate change. Projections of 2°C increases in global temperature from climate change, expected by 2050, will accelerate water scarcity in many regions of the world. As seen in Exhibit 1, the World Bank estimated that water scarcity exacerbated by climate change will cost some regions 6% in gross domestic product (GDP)— without policy change, declines may reach 14%.3 These declines are not limited to frontier and emerging markets; they impact every continent and economy, as seen in Exhibit 2. The San Francisco Bay Area—home of Franklin Templeton’s headquarters—is in one of these water stressed regions.

This may seem counterintuitive to some. California is perceived to be a land of abundance; home to two of the world’s most fertile and water intensive valleys—the “Central” and “Silicon”—one growing almonds and the other cooling data servers. In reality, it’s in one of the most droughtprone and high water risk regions in the world. And, without early 20th century water wars (have you seen the movie Chinatown?), multi-billion-dollar infrastructure investments, and a system of the most complex and litigated intrastate and binational water agreements on the planet, the world’s fifth largest economy would have run out of water decades ago. Think about that in the context of risk to an investor.

Finally, California is often cited as a microcosm for an impending global water crisis driven by population growth and climate change.4 Referring to the highly complex nature of water in California combined with climate change, Dr. Peter Gleick—a MacArthur Genius Fellow who many refer to as the foremost expert on world water—points to California as a “laboratory for all of peak water’s concerns.”5 Peak water is an idea he coined akin to peak oil. Meaning, all the water (or oil) on the planet is already here. As we use it, and pollute it in the case of water, it will never be replaced. Again, take a minute to think about that in the context of risk to an investor. Yet very few asset managers are talking about water risk as an investment concern. Why is that?

WATER STRESS IMPACTS ALL MARKETSExhibit 2: Country-level water stress in 2040 under business-as-usual scenario

Source: World Resources Institute, August 2015. Note: Projections are based on a business-as-usual scenario where global socioeconomic and emission trends continue on their current trajectories.

Why we’re thinking about water…

The projected declines in water availability, and corresponding dips in GDP, present across-the-board risk for investors. And these risks extend to all asset classes and encompass a broad range of sectors—from those with logical connections, like agriculture and utilities, to those that may not be so apparent, like packaging and semiconductors. In already water-stressed emerging and growth markets, like China and India, climate change models project that stress to grow.

This significantly impacts sectors where many investors are now seeing growth opportunities, such as: apparel, textiles, metals, mining and materials. These sectors are essentially “building blocks” for other sectors. Therefore, the water risk in these sectors does not stop once they are grown or extracted; they carry forward to the complex web of sectors that transform the building blocks into products—think of everything from lithium-ion batteries in your smartphone, to the shirt you’re wearing.

As stewards of our clients’ assets, we believe water risk must be accounted for in portfolios today, not in 2030 or 2050. But how can this be done? Water is not only a misunderstood commodity but also a basic human right recognized by the United Nations (UN) in 2010. As sustainability-informed investors using environmental, social and governance (ESG) metrics as key performance indicators (KPIs), how do we address the dual-bottom line of adding value to clients’ portfolios while also contributing to positive outcomes? How do we translate macro-scale risks into a focused investment lens? And, finally, what is our role as investors and what more can we do to move the dial?

These are all important questions. And we admit we don’t have all the answers. But we are thinking about these questions on a daily basis and aspire to grow our knowledge base and capabilities. It is our duty as active managers and stewards of our clients’ assets to and solutions that address information gaps and benefit clients’ portfolios. It is within these information gaps that mispricing happens. Where mispricing happens, an active manager can find an opportunity.

In the case of water, we see three main areas contributing to information gaps: pricing, risk and markets. The subsequent chapters of this piece explore each of these ideas through the lens of equity, fixed income and alternative investments.

The signals

Before we dive in, it is important to quickly discuss the underpinnings of our strategy related to water. First, we believe ESG factors can have a material impact on the longterm performance of the investments we make. And, as ESG-informed investors, we analyze ESG factors alongside traditional financial and economic measures, to promote a more comprehensive view of the value, risk and return potential of an investment. The analysis includes looking at current and upcoming “signals” that are going to shift the landscape for all investors. We don’t want to go into great detail about these regulatory issues but feel it is important to touch on them briefiy.

Current signals include the UN Sustainable Development Goals (SDGs) and the corresponding targets set for 2030. These will drive companies’ bottom lines, consumer and investor behavior, and the long-term viability of some industries. Looking forward, we are confident major regulatory reforms focused on directing investor capital toward carbon neutrality, such as the implementation of the 2019 Sustainable Finance Disclosure Regulation (SFDR) and the 2021 European Union (EU) framework for a common classification for sustainable activities (aka, the “Taxonomy Regulation”), are going to drive assets toward companies implementing best practices for sustainability and disclosure. As we highlight throughout this piece, disclosure is key to understanding risk and is lacking in many industries. In our view, companies and sectors currently leading on disclosure of water risk and its impacts on operating costs will have a leg up on competitors who are trailing or resistant.

Bottom line: water risk imperils clients’ assets

Our fundamental position is guided by three main principles. First and foremost, our stewardship and fiduciary responsibility to our clients. We must make better-informed decisions because we have a duty to our clients.

Second, the time to identify water risk is now, not the future. Water risk is a material risk. We must recognize that broader environmental risks are beginning to pose business-relevant vulnerabilities today. These vulnerabilities translate into asset value destruction through asset impairment via valuation. We are always trying to connect the dots on how these broad issues translate into asset impairment by identifying the channels of financial impact that macro-factors could have on a company and how our analysts price in this impact—whether pricing through a readjustment to a financial model or through an adjustment to a company’s financial forecast. For example, if a company operating in a waterstressed region does not have good governance and/or broad oversight of its water supply, these problems will trickle down to the bottom line through higher operating costs or a lack of supply chain optimization.

Third, as active managers, ultimately, our goals are to be better informed managers generating sustainable risk-adjusted returns for our clients. We must be able to identify companies and sectors, through their management of these issues, that differentiate themselves as better run businesses. We must identify companies where latent risks become much more business relevant, and in quicker time frames than anticipated. We are also seeking to identify companies providing solutions to deal with water scarcity, water sanitation and water efficiency.

We anticipate these issues are going to take on much more prominence in the asset management industry and the client landscape. Issues related to climate change—water scarcity, sea level rise, more severe storms and wildfires—can no longer be ignored or be considered latent risks just because many believe they are priced too far out or they will not impact portfolios until a point in the distant future. As a fiduciary for our clients’ assets, we must be positioning our portfolios for climate change today, not in 2030 or 2050.

 


 


WHAT ARE THE RISKS?

All investments involve risks, including possible loss of principal. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Investments in lower-rated bonds include higher risk of default and loss of principal. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value. Municipal bonds are debt securities issued by state and local governments and are generally exempt from federal income tax and also from state and local taxes for residents in the state where the bond was issued. They typically offer income, rather than capital appreciation potential. Corporate bonds are issued by corporations. Bonds with lower ratings and higher credit risk (risk of default) typically offer higher interest rates to compensate investors for the higher risk associated with the investment. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Treasuries, if held to maturity, offer a fixed rate of return and fixed principal value; their interest payments and principal are guaranteed. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in emerging market countries involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Such investments could experience significant price volatility in any given year. Investing in the natural resources sector involves special risks, including increased susceptibility to adverse economic and regulatory developments affecting the sector—prices of such securities can be volatile, particularly over the short term. Some strategies, such as hedge fund and private equity strategies, are available only to pre-qualified investors, may be speculative and involve a high degree of risk. An investor could lose all or a substantial amount of his or her investment in such strategies. Real estate securities involve special risks, such as declines in the value of real estate and increased susceptibility to adverse economic or regulatory developments affecting the sector. The companies and case studies shown herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton Investments. The opinions are intended solely to provide insight into how securities are analyzed. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio. This is not a complete analysis of every material fact regarding any industry, security or investment and should not be viewed as an investment recommendation. This is intended to provide insight into the portfolio selection and research process. Factual statements are taken from sources considered reliable but have not been independently verified for completeness or accuracy. These opinions may not be relied upon as investment advice or as an offer for any particular security. Past performance does not guarantee future results.