Water Risk and Stock Performance: Can Market Signals Drive Corporate Behavior in Water-Rich Basins?

Water Risk and Stock Performance: Can Market Signals Drive Corporate Behavior in Water-Rich Basins?

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Good corporate environmental practices have marketing value. Such practices and services can captivate and motivate some consumers. However, real data from capital markets – the flow of money and investment within and to corporations for investments and growth – now indicate that environmental performance can also directly and importantly affect overall corporate risk, financial markets performance, and decision making.

The use of Environmental, Social and Governance (ESG) data – or how the firm performs in these areas beyond financial performance – has been on the rise. This is predominantly due to the rapid growth of an investment philosophy referred to as ‘Responsible Investment’.  This type of large-scale institutional investing seeks to integrate the environmental, social and corporate governance insights and behaviors in investment decisions and portfolio allocations. In 2014, the total assets now under management in this realm are estimated at $45 trillion dollars. Not a small sum by any measure.

A shortcoming for Responsible Investing is that information interrelating ESG performance with financial (market) performance tends to be difficult to understand by investors.  In part, the reason is that RI is largely driven by values-based, instead of value-based metrics.  Without a deeper and improved understanding of cause and effect, the economic advantage of companies operating in water rich basins such as the Great Lakes, or the disadvantage of companies operating in water constrained basins, cannot be fully known. Businesses in a water rich area may in fact present investors with an opportunity to diversify their portfolio’s water risk exposures, but to date there have been no market-driven financial tools to understand these phenomena. Secondarily, if water risk can be responsibly and thoughtfully managed within the operations of a business, then does this positively translate to access to lower cost capital, improved credit risk rating, investment desirability, and overall total shareholder return?

Since 2010, the types of data collected to support ESG-based investment decisions have become more fine-scaled. No longer can we see only the overall performance of a broad swath of companies in the aggregate but now have improved insights into specific sectors and firms. We are beginning to understand how corporate culture, ethics and environmental performance for instance interact and drive better decision making within the firm and ultimately firm performance.  In fact, the number and types of ESG metrics that are provided through third party data providers are proliferating, as is the access to these data by asset managers and owners.  A key challenge is how to translate these largely non-financial data to inform risk and return of equities.  Earlier this summer, a series of articles in the Financial Times on corporate water risk made front-page news. The article cited Global Water Intelligence, a market analysis firm, who indicated that firms have now committed $84 billion dollars just in the past three years alone to conserve, manage or obtain water – to manage water risk. Not in a generation has water meant so much to companies.

Credit risk assessor Moody’s pronounced a couple of years ago that water scarcity has negative financial implications in the mining industry, thus further stirring debate on the role that water plays in influencing risk and overall performance in certain sectors of global financial markets. These pronouncements were only the latest in the growing concern over water risk. Indeed, voluntary water risk disclosures by corporations to their investors are growing quickly. Water matters, and matters more than ever.

Typically, physical risk (access to water, supply durability, water quality and temperature) and regulatory water risk (permitting and compliance) assessments use well established risk tools and procedures such as the World Resources Institute’s (WRI) Aqueduct tool, the Water Risk Filter (World Wildlife Fund), and other water footprint tools. Focusing solely on the physical and operational risk presents challenges to fully understand whether and how water impacts risk-adjusted pricing of stocks and, in turn, asset valuation. Without this critical link it is nearly impossible to get corporations to fully focus on water issues, let alone quantify the benefits gained by companies operating in water-rich ares such as the Great Lakes region versus areas with more challenging water access or quality issues.

The price of water still lies well below a point that will automatically trigger corporate investments in water risk mitigation. As a result, the thinking at water risk meetings is moving away from water pricing alone, and moving more broadly towards asset risk and stock volatility impacts. So what does this mean? It means that water, as currently priced, will do little to motivate things like conservation and thoughtful water management. Taking a broader look at just how water influences operational risk, stock price volatility (is it up or down and why), and effects on infrastructure and corporate assets (are water levels down presenting a risk to business performance for instance), add to this rich analysis.

A critical challenge for policy makers, corporate, and capital markets actors is that they all have different objectives, and will try to optimize performance accordingly. For corporations, water quantity and quality affects plant operations, and in turn influences risk management, hedging and capital investment strategies. For equity analysts and investment portfolio managers on the other hand, stock volatility risk (the likelihood of an increase or decrease in stock price and thus the overall value of the firm) in part influences where and how much money is invested between this firm or sector and that one. The link between portfolio allocation decisions and stock risk pricing on the one hand, and water risk management on the other, is that data-driven market signals should be able to influence long-term capital investments. The problem is that until recently there was no way to connect water risk and overall stock performance. Understanding this link is the key to the puzzle.

Equarius Risk Analytics, a Michigan-based financial risk firm is proposing a solution to address this gap by structuring capital market risk metrics for water risk-exposed companies. New water risk metrics are based on corporate financial data and stock performance measures, and informed by operational data.

The rationale works as follows. If the objective is to demonstrate that water risk directly impacts corporate financial performance, and thus sends a market signal to inform companies how better to reallocate resources to manage risk, it is important to understand the market side first. Among many financial metrics, stock and portfolio risk are often represented by a metric that assesses the ups and downs (volatility) of any given stock price. This is a standard type of financial analysis called Value-at-Risk (VaR). However, such volatility analysis only quantifies the overall stock volatility due to all risks and not just risks related to water. The specific impact of water needs to be teased out of the total risk picture.

Equarius Risk Analytics has developed a new multivariate algorithmic approach to quantify how and when water risk contributes to VaR. Called the waterVaR, it is calculated by taking into account the impact of water on corporate revenue in relevant lines of business, and productivity of the company’s physical assets.  Grounded in firm productivity theory and asset risk valuation theory, this approach has shown that water risk accounts for up to twenty percent of total stock volatility (VaR), and can impact future portfolio allocations of water-exposed stocks. Indeed, the company has designed portfolio investment allocation strategies that take into account waterVaR data for electric utilities, steel and mining companies. These ‘smart betas’ for the first time show that by taking into account water risk exposure metrics, the financial performance of the portfolio improves (higher returns and lower volatility risk). These represent important market signals telling companies to better manage water risk or see your participation in portfolios decrease.

For water-rich regions seeking to design economic development policies, the financial benefit of its water resources as related to risk management and corporate performance needs to be understood.  The value proposition needs to be clearly articulated to companies locating in these regions and to investors looking for investments with attractive risk and return characteristics. This important work is underway.

The author:  Peter Adriaens is CEO at Equarius Risk Analytics (www.equariusrisk.com). He can be reached at padriaens@equariusrisk.com