Equarius Risk Analytics values equity volatility risk of water to global electric utilities at 5-12% of VaR
As the global water community descends on Stockholm for Water Week, equity risk exposure data may serve as a wake up call for corporate risk managers and equity analysts. To date, business water risk analysis focuses largely on operational risks. For example, fixed asset overlays of corporate assets on water risk maps, SEC and voluntary risk disclosures, and independent analysis by leading NGOs and third party data providers to investors all point in the same direction: water as a constrained resource for business operations may become very costly.
Just how costly?
This depends on how you quantify it. One measure of risk is based on expenditures on equipment to offset operational water risks. According to Global Water Intelligence, billions have been spent across sectors as diverse as electric utilities, mining and food and beverage companies, and access is becoming a major cost of doing business. Another measure is opportunity cost. MSCI ESG research has published thematic papers that estimate this cost in the 10s of billions for electric utilities, steel and mining companies. Yet another measure comes from the impact of basin risk analytics conducted by NGOs, which shows that many corporations have assets located in moderate to severely stressed watersheds, spurring discussion of ‘stranded assets’.
Despite these public data, why are financial water risks not integrated in the capital markets?
A major deficiency in the water risk discourse is the issue of financial ‘materiality’ of this risk. In other words, there is no clear market signal on how water impacts asset risk valuation. Equarius Risk Analytics, a financial IT company, seeks to address this missing link by valuing the stock risk exposure from water. Using proprietary waterVaR algorithms and publicly available financial and operational data, the financial risk model integrates: (i) seasonal stock volatility corrected for systemic risk (VaR), (ii) revenue risk exposure (water productivity), (iii) fixed asset (PP&E) risk as a function of watershed indicators, and (iv) stock price elasticity (financial beta).
The waterVaR model is an extension of marginal productivity theory and capital asset pricing model (CAPM) theory, which lie at the basis of resource productivity and capital markets indicators. Hence, the model is capable of extracting and predicting market signals for water risk.
Data for 19 global electric utilities indicate that equity risk volatility from water, as measured by quarterly value-at-risk (VaR) metrics, is valued at $280 M. for EDF, with risk valuation for the runner up Exelon at $122 M. The uncertainty of risk valuations is approximately 20% based on error propagation. Two US electric utilities are in the top five of water risk exposed stocks: Exelon and Pepco. Low water productivity (or high water intensity), and above average asset risk exposure are significant drivers. The lowest water risk exposures (waterVaR) for US utilities are PPL and Northeast utilities.
The water risk sensitivity of the publicly traded electric utilities shows that three US companies are in the top 5 highest waterBeta values: Pepco, Exelon, and Entergy. This risk sensitivity is driven by elevated asset risk exposures (and revenue risk exposures, relative to the sector benchmark). The lowest risk sensitivities to water exposures (lowest waterBeta) are dominated by European companies, in part driven by low revenue risk (high water productivity). These companies exhibit among the highest operational efficiency valuations among their peers (PP&E/EV; fixed asset turnover to operational valuation ratios).
Does stock risk exposure from water amount to a market signal?
Based on extensive market analysis, public equity analysts consider any risks amounting to 3% of VaR ‘material’, and worth watching. For the top 5 companies, the waterVaR ranged from 5-12% of VaR. As disclosures and operational risk data improve and become more granular, waterVaR and waterBeta metrics will become sufficiently robust to inform asset allocations in portfolios. Indeed, the use of waterVaR metrics as a ‘smart beta’ for portfolio allocations (see earlier blog) showed that waterVaR ‘smart beta’ portfolios outperformed allocations based on market capitalization.
Dr. Peter Adriaens is CEO of Equarius Risk Analytics (www.equariusrisk.com).
He can be contacted at firstname.lastname@example.org