The economic (cost and benefit) and financial (risk and return) side of business water risk is proving to be very complex to ascertain. This impacts the uptake or integration of water risk metrics by equity analysts in the risk pricing of assets. To compound the problem, at many forums on the topic, and in the media, the economic and financial risk metrics, and the valuation of risk response strategies, are all mixed together, confusing the issue further. Let’s take this apart:
1. The economic aspect of water resource management (water pricing, water markets, basin transfers and the like), and the costs and benefits of new technology integration, tend to be most advanced. The rationale is that economic theories have guided policy designs for a long time, and new innovations in this area tend to be based on accepted (if imperfect) theoretical basis such as portfolio theory. The mathematical basis, and probability and uncertainty models that underpin these theories and their applications tend to be incongruous with the types of metrics that are collected by sustainability experts, and thus don’t lend themselves easily to integration.
The dichotomy of knowledge displays itself in water risk meetings when water resource economists meet sustainability experts, where arguments are made that the price of water isn’t high enough to warrant extensive investment in water risk management technologies, as has happened in the case of carbon risk mitigation. Therefore, as the argument goes, we need better risk or conservation pricing of water.
2. The business value of capex vs risk transfers to manage water risk is more complex, because it crosses over between cost of water in operations, and the financial risk/return of any given risk management action. For example, in our work with electric utilities such as Duke Energy, the tradeoffs between investing in a cooling tower vs. taking hedge positions on the open market to mitigate revenue risk reside squarely in the CFO office. The decision framework goes well beyond discounted cash flow (DCF)-type valuations, because investing in technology is but one of the options to manage risk.
From a management perspective, flexibility is a premium, and hence short-term flexible options tend to be favored over long-term capital outlay, unless the action is time-critical. This is important not only from an operational perspective, but also from a market risk valuation perspective – how does the market react to the risk management strategies? The latter are often driven by environmental, regulatory, or legal drivers outside the control of the company. Therefore, solutions providers need to argue not only based on price, but based on managerial flexibility needs at the company.
3. Shadow risk pricing has entered the business water risk discourse to provide asset managers and asset owners in the capital markets with an order-of-magnitude financial risk context related to water. Shadow pricing refers to monetary values assigned to currently unknowable or difficult to calculate costs, such as non-marketed goods or externalities. It is subject to various assumptions and tends to be fairly subjective. From a practical perspective, it provides marginal utility on the constrained economics of operations, and thus enables a degree of managerial flexibility for risk-based decision-making.
Shadow pricing is distinctly different from economic cost & benefit, and financial risk & return, in that the financial values are off balance sheet, i.e. they are not explicitly accounted for in the company’s financial statements.
Recent examples include: Environmental profit and loss (EP&L), water risk monetization, and water Value-at-Risk (VaR) metrics. Their intended purposes are not the same, and thus the target audience that consumes the data tends to vary.
EP&L (Puma, PWC, Trucost) allows managers and stakeholders to see the magnitude of positive and negative environmental impacts of business operations, and accounts for ecosystem services in the supply chain. The basis for these estimates are derived from input-output models and data from the literature on natural resource valuation.
Water Risk Monetizer (Ecolab, Trucost) uses scientific algorithms to quantify the potential impact of water scarcity on a facility in monetary terms, a water risk premium. Focused on economic supply & demand principles, the primary financial driver for risk monetization is water pricing in accordance with a facility’s use of water.
waterVaR and waterBeta (Equarius Risk Analytics) metrics bridge operational risk and stock volatility indicators to estimate the contribution of water risk to asset volatility (VaR), and fixed asset productivity. The algorithms are based on firm productivity and asset risk pricing theory. Because they use the same financial risk indicators used by portfolio managers and equity analysts, the metrics allow for computation of the impact of business water risk on stock volatility and portfolio volatility risk budgets.
The question asked in the blog is whether shadow pricing can inform capital markets, or supplement ESG metrics. In our view it is imperative to minimize subjectivity in the analysis. If the financial risk estimates start with verified financial markets data, and are informed by verified operational metrics of the company, the data can be independently verified in current financial risk models to enable wide traction with financial analysts.
Cross-verification of waterVaR estimates for electric utilities with actual expenditures on water risk management strategies (mainly hedging and operations) indicated agreement within 15%.
The author: Peter Adriaens is CEO of Equarius Risk Analytics LLC. He has 25 years of experience in technology development and risk analytics for supply- and buy-side companies in the water risk space.