22 November 2023
Water is critical to life on earth and fundamental to many supply chains, manufacturing processes and lived environments. With clear and growing risks around water insecurity, flood risks and pollution, investors should assess their exposure now.
Two-thirds of the planet's surface is water, yet access to clean, fresh water is a pressing concern for governments, investors and the many millions of people living in areas where scarcity is a potentially deadly fact of life.
This challenge will become particularly apparent within the financial services industry sooner than one might imagine: 69% of listed equities state that they are exposed to water risks that could generate a substantive change in their business. Over time, this will directly impact companies and insurance liabilities, but also indirectly impact the assets held by pension schemes, endowments, insurance companies and individuals. So, what should investors consider as they assess the potential impact of water, both on their portfolios and the investments held within them?
Here, we cover some of the key considerations around water today, and why we believe investors should keep close to the issue as they look to mitigate risks to their portfolios, as well as lend powerful help to those in need.
Water - is there a problem?
So many countries and continents have experienced severe water issues in recent years. In one such event last summer floods submerged two-thirds of Pakistan, affecting over 33 million people, displacing tens of millions and killing more than 1,700. As of September 2022, the floods had killed eight million animals and destroyed around 90% of the country’s crops. Recovering from such a catastrophe is difficult as crops and livestock comprise an essential part of Pakistan’s rural economy and livelihoods. Even six months later, more than ten million people did not have access to safe drinking water and more than 20 million still needed humanitarian assistance.
At the same time, according to reports, 2022 saw Europe’s worst drought in 500 years, sections of the Yangtze – China’s longest river – reached their lowest level since at least 1865, and parts of the western United States experienced their most extreme drought conditions in 1,200 years. In 2023, we’ve seen numerous instances of extreme rainfall leading to severe flooding, causing fatalities around the world – for instance, two months of rain falling in two days in Vermont in July, deadly floods in Korea, New York and a massive deadly mudflow (following heavy rainfall) in Georgia.
Meanwhile, one in three people globally (over two billion people) does not have access to clean water. As populations grow and the climate warms, demand for safe and reliable access to water increases, as does the risk of cities experiencing droughts. London, for example, could run out of water by 2050.
Climate change will cause greater water issues since extreme weather events make water scarcer, more unpredictable, more polluted, or all three. However, water can also help fight climate change: sustainable water management is central to building the resilience of society and ecosystems and in reducing carbon emissions. Everyone has a role to play – taking action at the individual, company and financial level is imperative.
Are investors considering their water impact?
Last year, we surveyed around 70 investors who were relatively advanced in terms of their actions on climate change. There were a number of interesting findings:
- Investors are taking action: although relatively few asset managers have launched water funds, most that we surveyed are taking water issues into account when constructing portfolios as part of their climate change modelling, and some asset owners are investing in companies in the water industry.
- However, even for these advanced climate-aware investors, the overwhelming majority are only considering water solutions and the impact of water on (some of) their investments, rather than the impact of their investments on water.
- 92% of the participants in our survey felt that incorporating water-related considerations into their investment process is important. However, what isn’t a current priority for many investors is the wider and more broad-reaching goal of having investment practices aligned with supporting both well-functioning global water systems and Sustainable Development Goal 6 (i.e. clean sanitation and water).
- In terms of understanding water as an ESG and investment issue, while 44% of asset managers said they had a well-developed understanding, 83% of asset owners said their understanding was either only fairly well developed or not well developed.
Water, then, is not central to investors’ decision making, despite its fundamental role in all our lives and civilization at large. In terms of investment considerations, water trails far behind other ESG and wider investment priorities such as climate change, inflation concerns, and carbon and energy issues. This is partly due to the fact that, to date, water has not been adequately priced.
What are the key investment challenges to solve?
The fundamental issue that we unearthed in our research was the lack of transformational vision or goal for water, despite the severity of the risks related to too much, too little or too polluted water, a disruption to freshwater systems or a lack of access to safe and secure water supplies.
When we consider historical approaches to climate change, although some advanced investors were starting to consider its impact on their portfolios several decades ago, the industry as a whole saw little movement, without very clear science-based evidence ways of measuring the risks in portfolios that felt acceptable within the investment world.
Today, a 1.5°C world, net-zero ambitions and other targets remain quite challenging for investors to fully grapple with (partly due to the long-term time horizons involved), but they do provide agreed metrics for companies and investors to focus around, with UK regulation, such as TCFD requirements for pension schemes, evidence of accelerated progress.
Investors need a similar transformational vision or approach for water: an end point or defined outcome to work towards and something that inspires them to continue to improve practices over time.
Unifying the world behind such a vision is complicated by the fact that while carbon emissions are seen as a global risk, water issues are comparatively localized: floods may be occurring in some parts of the world while there are droughts in others. A local focus is crucial (companies - and therefore investors - must take account of the impact they are making on local communities), however until such focuses can be broadened, the challenges around water will not present themselves as global, systemic risks.
The data and governance needed to manage the environmental, social/cultural and economic implications of water risks do not exist in a comprehensive way. To date, it’s generally only been when investors are exposed to water events that impact assets – for example, flood, drought or pollution – that water risks hit their radar (and even then, likely only at the asset manager rather than asset owner level).
Any action from such events tends to be reactive and occurs at the local level, affecting an individual company, asset manager, location or specific supply chain, and therefore doesn’t lead to industry collaboration or a movement of sufficient scale to necessitate widespread change. Better data can transform many small incidents into a single, more influential picture.
Alongside a clearer view of the impacts around water risks, investors also need quantitative measures for this data, so they can gain clarity on the impact of water issues on their investments, and of their investments on water. How can investors measure negative and positive impacts, similar to scope 1, 2, 3 and 4 carbon emissions, for instance? Comprehensive metrics are needed: water volume is most often cited as a measure, but additional metrics are required for investors to align to SDG6, any of which would relate to specific challenges such as flood risk, cleanliness, water security or otherwise.
With organizations (such as CDP) initiating work in this space, better data and appropriate metrics to quantify water risks are hopefully not far off.
What can investors do to get ahead of water risks?
|Valuing Water Principles
|Potential application to investors
|Recognize and embrace water’s multiple values to different groups and interests in all decisions affecting water.
|Know and help protect water resources to preserve the economic, community, environmental and cultural benefits of water as part of investment due diligence.
|Reconcile values and build trust – conduct all processes to reconcile values in ways that are equitable, transparent and inclusive.
|Have a clear investment belief and policy on water along with an engagement program to improve practices where multiple values of water are not currently being recognized.
|Protect water sources, including watersheds, rivers, aquifers, associated ecosystems, and used water flows for current and future generations.
|Avoid products, projects or practices that systemically degrade water sources.
|Educate to empower – promote education and awareness among all stakeholders about the intrinsic value of water and its essential role in all aspects of life.
|Engage with investee companies and investor peers on the importance of valuing water principles, sharing knowledge and practices recognizing shared resources and approaches required.
|Invest and innovate – ensure adequate investment in institutions, infrastructure, information and innovation to realize the many benefits derived from water and reduced risks.
|Allocate funds to invest in innovative companies on water, infrastructure, and new technologies while balancing the need for overall ESG integration.
Asset managers can also set climate policies within their portfolios that reference wider environmental perspectives – on nature, biodiversity and water – to ensure that any climate objectives also prioritize these broader topics. CDP’s recent survey of financial institutions is encouraging – 118 financial institutions indicated they have board-level oversight of water issues. CDP’s work on the Finance Water Action Pathway states its vision as well as the levers of change and key actors.
In terms of engagement, asset owners can ask their asset managers to provide data at the portfolio level and request regular reporting. Almost two-thirds of asset owners in our survey said they were either already doing this or have committed to doing so in the future.
In turn, asset managers should engage with companies to disclose metrics related to water. They can then aggregate this data or determine their own proprietary data and disclose that to investors. Metrics that could be useful include whether water usage is being monitored, whether there have been any detrimental water-related impacts, and what water-related risks are considered. CDP is encouraging voluntary reporting into its database on water security: this is a comprehensive questionnaire, and if all companies completed it, investors would have much better data.
Some asset owners may wish to undertake specific water-related activities as per the Valuing Water Principles (for example, determining clear investment beliefs in relation to water or conducting top-down forward-looking water scenario analysis). However, for most asset owners, this is most likely best achieved within the Taskforce on Nature-related Financial Disclosures (TNFD) framework , i.e. incorporating water holistically as part of other nature-related assessments. This framework, which was released in September 2023, aims to encourage businesses and investors to minimize negative impacts on nature and maximize positive impacts. We expect TNFD to be incorporated into regulation in many countries, and investors may wish to start getting ahead of that in the same way that many did in terms of their climate-related work ahead of the TCFD regulation.
Are there opportunities in addressing challenges around water?
In terms of investment opportunities, investors can explore targeting a specific water strategy fund or investing in individual water-related companies as part of a broader portfolio. Clearly, asset managers are best placed to identify the latter. The majority of investment ideas we see in the market are within the private infrastructure space (and here, there are asset managers running dedicated water strategies), but there are opportunities in broader real assets and public equities.
In the public equity space, the objective of water strategies is to outperform a broad market benchmark over the long term. Asset managers target such an objective because they believe that companies with products and services addressing the environmental challenges associated with water will experience the growth opportunity of the water market over the long term. Asset managers of water strategies look for companies across the entire water value chain and at all stages of the water cycle. Broader overarching themes can be described as water infrastructure, water utilities, water treatment, and water technology. These themes typically show up in highly concentrated sectors.
We advise investors to conduct thorough due diligence on any prospective investments and ensure that they align with the asset owner’s sustainable investment principles and beliefs. For most asset owners, targeting specific, stand-alone water strategies is unlikely to be appropriate right now, but these may be more appropriate for advanced (sustainable) investors and/or those with a specific organizational water mission.
What is Mercer doing in this space?
We recognize that there are an increasing number of ESG-related challenges for investors to consider (for example, climate change, human rights, DEI), not to mention recent yield rises, inflation or asset return challenges. We plan to integrate water perspectives into our work on natural capital and biodiversity, and produce an overall framework to assist asset owners in understanding the impact of water on their investments, and vice versa.
We will continue to undertake selective research on individual asset manager strategies that have a water focus, be they in the private or public markets space.
Unfortunately, as the impacts of climate change become more apparent, water issues – be they floods or droughts, water quality degradation or pollution – are increasingly impacting communities, companies and asset owners’ portfolios.
However, as the data builds, as companies disclose more, as our knowledge builds, the science around this topic develops and we believe that collectively the finance industry – and beyond – can start to make a difference. Financial institutions, be they asset managers, asset owners or banks, can be a central driver towards a more water-secure world – they just need to start.