The Business Water Risk Elephant: Metrics, Investment Decisions and Policy Design

The Business Water Risk Elephant: Metrics, Investment Decisions and Policy Design

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Water risk elephantThe fable of the blind men touching and correctly describing different parts of the elephant, but not seeing the whole, has been applied to illustrate many truths and fallacies.  It is particularly apt in fields where there is a deficit or inaccessibility of information and need for communication to integrate the impact of partial viewpoints on policy, business operations and investment decision-making.  The incomplete understanding of business water risk, particularly where financial aspects are considered, provides a poignant case.

The different parts of the elephant are represented by the viewpoints of the analysts’ lens on business water risk.  Thanks to the excellent work of many, particularly non-profit, organizations, the physical, reputational, and regulatory risk pillars have now become engrained in the thought process of those engaged in this debate.  This has led to a proliferation of metrics that attempt to describe and quantify the three risk categories.   These metrics and weighted risk indices are sold to asset managers and asset owners by companies such as MSCI, Bloomberg, Thomson-Reuters, as well as by niche players such as Trucost, Quantis International, or LimnoTech.  Management consultants such as Deloitte and PwC are capitalizing on the strategic positioning opportunities for corporations, and NGOs such as Ceres, CDP, WRI and WWF make data from corporate disclosures or bespoke analysis available at marginal cost or for free.  There is no shortage of information describing business water risk, so why is there no broader adoption of the learnings by the financial markets (and by corporates)?

There is no consensus on which metrics are key to understanding the economic (cost/benefit) and financial (risk/return) risk impact of water on market valuation of traded assets.

From our research, it comes down to how this information is captured by equity analysts or CFOs, and integrated in their investment decisions, or how it is translated in water resource management policies.   How are those that live in the physical realm of business water risk communicating with, and translating data and information to, those in the financial realm?  Sustainability specialists in large corporations, third party data providers, and investment management groups or banks tend to still operate largely separately from the financial analysts and investment side decision-makers.  The asymmetry of information, educational and experiential backgrounds impacts whether the tail, the trunk or the ears of the business water risk elephant are emphasized.

Whereas the early stage of the water risk debate has been driven by values-based (largely non-financial risk and governance) considerations, the holy grail of the debate centers around the economic, financial or equity risk quantification to drive change.  Surely, if we get a good handle on this, market signals, costs of business, credit warnings, and environmental profit and loss (EP&L) will shift the debate towards more effective policy tools and investment decisions by CFOs and asset managers?  Let’s look at four perspectives:

1.  The Corporate CFO’s Perspective.  In our engagements with the CFO suite of a number of public companies, the objective to ‘make better (short and long term) investment decisions’ is key.  Their role is to run an effective and efficient finance operation by minimizing risk and costs, and grow revenue and profits.  Response to regulation and finding operational efficiencies are part and parcel of this role, so there is inherently a strategic and catalytic activity to drive innovation across the enterprise.  Hence, the water risk analysts who are focused on business operations have started to emphasize the potential economic losses (cost and benefit) from improvements on inefficiency or constrained access to water.  These have translated to largely ‘off balance sheet’ pronouncements.  At the same time, long-term capex investments (in water technologies), and short-term flexible business interruption insurance and hedge positions are on the books.  The CFO, in his/her primary role, needs to keep an eye on the capital markets as well.  How are the business water risks perceived by analysts, and how will water risk management decisions impact both financial operational efficiency and stock performance?

2.  The Asset Owner and Asset Manager’s Perspective.  An interesting shift has taken place here.  Our initial interactions with investment banks and asset owners focused on the environmental impact of projects.  More recently, the consideration how constrained resources will impact the project’s profitability is taking more of a front seat.   The narrative on project investing goes: “We’re interested in investing in this shale gas project. What are the environmental risks that may impact our investment?  The water risk expert alerts to water constraints, contamination and cost of water transport and disposal.  The investor inquires with the O&G company about its risk management strategies, and the investment goes forward with some contingencies, if warranted“.  Asset managers such as pension funds have strategic plans, that often include sustainability mandates, informed by complex financial risk models.  Decisions on whether to allocate water risk exposed companies in portfolios need to fit within expected risk & return parameters, and need to consider volatility risk budgets of portfolio managers.  Will water risk (management) impact financial performance of the fund or portfolio, returns to investors, and the cost of portfolio risk underwriting?  

3.  The Policy Maker or Water Resource Allocation Manager’s Perspective.  Theirs is a mandate of designing and implementing policies that drive fair allocation to basin stakeholders while preserving public access, a universal right.  Traditionally the domain of water resource economists, both supply- (pricing) and demand- (basin transfers, markets) side tools have been developed to address scarcity issues and design policies for effective water resource management.  Unfortunately, because of inefficient knowledge transfer between those collecting water risk metrics, and those designing complex mathematical pricing and market approaches, the adoption of risk metrics in resource allocation strategies is limited. Additionally, it is becoming apparent that pricing strategies – even ‘conservation pricing’ – have their limitations to induce significant behavior changes because corporations have many flexible risk management responses to their avail.  Sustainable water management at the river or basin level is more of a reputation- (and values-) driven risk management proposition for corporations.  Hence, the risk and asset value to investors tends to be more tenuous and complex.  That is, unless a tangible financial risk or benefit can be realized using regulatory sticks and carrots, and internal corporate innovation.  Does good corporate water stewardship of local water resources confer material benefit that can be captured by the companies and its investors, shareholders and stakeholders?

4.  The Technology Provider’s Perspective.  Innovations in technology for process efficiency improvement, supply extension, or recycling and reuse are central to corporate water risk management.  Investor organizations (e.g. CleanTech Group), economic developers (e.g. Global CleanTech Cluster Association), and technology management organizations have been focusing on identifying the opportunities for inventors and innovators to link up with corporates.  It is the technology stakeholder that arguably makes the greatest use of the water risk metrics to design their offerings and structure new business models based on sales and service.   Indeed, over the past three years $84 bn. was spent by corporates on technologies for water risk management, adding to capex outlay, increased cost of business, thus impacting profits.  Our research from working with innovators and equity investors has indicated that technology value propositions based on cost and benefit alone often don’t scale or result in broad adoption, even if their impact on the efficient use of water is significant.  Value-based financial analysis to the corporation in terms relevant to the CFO office is often missing, and comparison of technology to other (non-technology) management solutions for water risk management (relevant not only to the CFO, but also to equity analysts) are absent from the discourse.  How can technology innovators effectively address both cost issues and contribute to the strategic value of flexibility for the corporation to respond to business water risk?

With the different parts of the business water risk elephant receiving a lot of attention, how can the debate evolve to the complete whole, and what is the role of understanding the economic, financial and stock volatility aspects in this process?  Research at Equarius Risk Analytics (www.equariusrisk.com), a financial IT firm in Michigan and New York, indicates that it is imperative to go back to the fundamentals of  firm productivity and asset risk valuation.  The company markets waterVaR (value-at-risk) and waterBeta leading market indicators that are predicated on revenue and asset productivity risk as a function of stock price elasticity and residual VaR signals during water risk events.

Advances in economic and financial risk theory have underpinned corporate finance, investing approaches, pricing mechanisms and market strategies.  There is a lot of hype and data out there, rendering difficult the opportunity to make information actionable for investment decisions and policy design.  By basing water risk materiality to businesses and capital markets on incipient market signals and operational corporate risk management valuation, standardization of the business water risk assessment process is plausible, and the opportunity from corporates to policies and markets scalable.

About the author:  Peter Adriaens is CEO of Equarius Risk Analytics.  As a Professor of Entrepreneurship & Strategy, as well as of Environmental & Water Resource Engineering at the University of Michigan, he is focused on investment strategies and risk analytics for industrial renewal.  He can be reached at padriaens@equariusrisk.com.

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