Beyond Water Pricing: Does Business Water Risk Reverberate in the Financial Markets?

Beyond Water Pricing: Does Business Water Risk Reverberate in the Financial Markets?

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A couple of weeks ago, a series of articles in the FT on corporate water risk made front page business news, in part because of the statements from corporate chiefs that water risk may be a more urgent risk issue than climate change.  The article cited Global Water Intelligence, a market analysis firm, to indicate that firms committed $84 bn to conserve, manage or obtain water over the last three years.  Further, Moody’s indicates that water scarcity has credit-negative implications in the mining industry.

These pronouncements were only the latest in the broadening of water risk integration in ESG investor risk data.  Voluntary water risk disclosures are on the rise across all industry sectors, based on data from CDP, a non-profit focused on providing corporate environmental risk metrics for investors.  The Ceres group, a US-based nonprofit, is increasing its scope of business water risk intelligence for institutional investors, with focus on electric utilities, food and beverage and hydraulic fracturing industries.  Increasingly, methodologies are being developed to capture operational cost or policy risk to understand the magnitude of corporate water exposure.  Engagements with ESG risk analysts at institutional investment firms are helping to scope the types of data needed to understand investment risk.

Typically, physical and regulatory water risk assessments employ basin and/or corporate risk tools, such as the World Resources Institute’s (WRI) Aqueduct tool, the Water Risk Filter co-developed by WWF and DEG, and water footprint tools based on life cycle assessment principles.  Even though it is unclear how these data are  – or indeed should be – used by investors, the focus on the operations side presents challenges to understand whether and how water impacts risk pricing of stocks.

 Water-Risk-Sensitivity-mining-700x374-2

The imperfect information flow between physical and financial (market) risk resulting from the lack of a liberalized and transparent water market is well known.  Thus, ‘conservation rate’-based water pricing at the utility level attempts to induce corporate behavior with respect to water use.

However, these rates are well below the trigger point to incentivize major corporate investments in water risk mitigation.  As a result, the discourse at water risk meetings is slowly shifting beyond water pricing, and towards asset risk and stock volatility.  The case for stranded assets due to water is increasingly part of the conversation.  Indeed, the impact of opportunity cost is orders of magnitude higher than that of water price alone.

I am not a water resource economist, but from where I sit in business strategy, pricing has its limitations to influence corporate behavior, or to provide a market signal for risk.  The water argument is different from carbon:  Emissions pricing and resource pricing elicit different responses, in part because water opportunity cost is a derivative of resource constraints and water pricing.  Consider the following.  In the summers of 2007-2008, the revenue losses incurred at once-through coal plants in the Southeastern US were on the order of $300K-$5M per plant, and per month.  At the same time, the price of water was $1/1000 gal.  If we want to use the carbon market analogy, the point where water pricing exceeds the opportunity cost is well over $3/1000 gal, a non-starter in the policy discourse on water privatization and human rights to access.

As we have noted in our research, in the case of public companies, the CFO needs flexibility and will tend to resort to flexible short-term market-based risk management tools before investing in long term capital asset allocations to mitigate supply risk.  As we reported on earlier, the CFO toolbox differs between industry sectors, depending on whether the impact is direct or indirect, and the extent of the firm’s dependency on commodity markets.

Water-risk-mitigation-spectrum-700x414-1

Hence, the magnitude of business water risk is somewhere between the actual business opportunity cost and the cost of risk management alternatives.

Asset valuation shifts and financial risk management strategies reverberate in the market and impact stock volatility (VaR).  This has been the case for decades – it just wasn’t clear that some of these risks were imparted by water.  Water pricing appears to be a bit of a red herring in the business water risk discourse.

The question then is: how can asset valuation shifts and financial risk management cost be quantified?  Is financial risk from water already implicitly priced in the market?  Can volatility risk pricing be interpreted given voluntary and SEC disclosure information or Moody’s credit ratings?

One approach, advocated by Equarius Risk Analytics, a financial risk data firm, centers around structuring waterVaR and waterBeta metrics for water risk exposed companies.  The company takes a ‘big data’ approach to statistically tease out relationships between policy enactments, commodity shocks, operational crises or management events on the one hand, and idiosyncratic (temporal or company/industry-specific) financial risks captured using Value-at-Risk (VaR) analytics, on the other.  The result is a statistical VaR residual that has financial relevance to a weather, drought, flood or water-based regulatory event, if you will…

This residual is the maximum potential value of the idiosyncratic risk during the water risk-exposed time horizon, and is the basis for the waterVaR  metric, which represents the valuation of stock volatility due to water risk exposures.  The valuation is corrected for stock risk sensitivity and asset-level risk exposure information.  To arrive at the sensitivity risk measure, Equarius Risk Analytics has defined a waterBeta based on: revenue risk exposure to water (relative to a benchmark), financial risk volatility (beta) and the fixed asset risk impact on operational value of the firm.  Hence, different industries and companies within an industry (e.g. electric utilities, mining, food and beverage) exhibit variable sensitivities to how risk reverberates in the market.  The inserts in the figure are an exploded view of the least exposed stocks.

MSCI-electric-utilities-700x408-1waterBeta-MSCI-700x414-1

In short, waterVaR and waterBeta estimates are as much about operational water risk, as about the valuation of opportunity cost risk management strategies by the market.  For the companies shown, the waterVaR is up to 18% of VaR.

Market signals from business water risk exposure will need to consider both operations-level risk information and stock volatility resulting from idiosyncratic risk events.  Back-testing of waterVaRs with corporate risk management data and other disclosures on asset-specific risks will serve to continually improve on these leading indicators.

Peter Adriaens is CEO of Equarius Risk Analytics (www.equariusrisk.com), a financial risk data and services firm with operations in Ann Arbor, Michigan and New York.  He can be reached at padriaens@equariusrisk.com or pa@keystonecompact.com.

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