Troubled waters

An understated risk

The global pandemic has reinforced the importance of resilience in investment portfolios. This includes sustainability-related risks that investors may have been underappreciating, ranging from vulnerable global supply chains to health and safety issues. We believe increased asset flows into sustainable investing strategies in 2020 are part of a tectonic shift that could last decades.

Physical risks posed by climate events – ranging from hurricanes to wildfires – have captured growing attention in the investment community. We zeroed in on these risks in Getting physical of April 2019, painting a granular picture of the financial implications across municipal bonds, commercial real estate and U.S. utility equities.

In this piece, we extend our work on physical risks to water stress. What do we mean by water risk? One in four people globally live in regions at high risk of scarcity – with water demand exceeding supply – according to the World Resources Institute (WRI). This creates financial risks that investors today may not be pricing in. Examples include rising spending needs (to raise efficiency and meet tough regulations) and the cost of production disruptions (unavailability of water for agriculture or cooling power plants).

Regulators are zeroing on such risks: A recent European Central Bank report included water stress among the physical climate risks it may require financial institutions to manage and disclose.

Water: A scarce resource

In past decades, the global demand for water has been increasing at a pace of 1% annually, according to the United Nations’ 2018 World Water Development Report, as growing urban populations strain resources. At the same time, climate change shifts the distribution of water supply by disrupting precipitation patterns.

Higher water stress levels indicate greater competition among users. This increases the costs of sourcing, and forces conservation measures. Other factors behind this stress include lax environmental rules and pollution, which can reduce water quality and limit its potential use.

Competition for water
Estimated water stress around the world by risk zone, 2030

The geographic variation in climate patterns and human demand for water, together with changes caused by rising global temperatures, result in great variation in the distribution of water stress around the world. The graphic above uses WRI projections that rank geographies’ water stress from “low” to “extremely high” as of 2030. India, the Middle East, northern and southern Africa, Australia, and the U.S. Southwest stand out as likely high risk zones within a decade of today.

Key findings

Water stress has financial implications. Companies with production facilities in stressed regions may face greater operating costs and insurance premiums. They will likely need to spend more on efficiency measures, recycling and conservation – to meet stringent regulations that could tighten even further. In the real estate market, tenant preferences are likely to shift toward green buildings.

We use global real estate investment trusts (REITs) to illustrate how exposure to water stress can vary by location and over time. Our approach combines the geolocation of about 84,000 global REIT properties and mapping them to the 590 publicly listed REITs that own them. We then used the WRI’s “Aqueduct” model to assess REITs exposure to various water stress risks today and in the future. This provides deeper insights on water-related issues faced by companies than traditional assessments, in our view. The risks are not unique to real estate – and we see our approach as applicable across asset classes.

Stress in Southwest
Estimated water stress in the U.S. by risk zone

Source: BlackRock Investment Institute and BlackRock Sustainable Investing, with data from WRI and SNL, May 2020. The chart shows estimated water stress levels across the U.S. Southwest as of 2014 (actual) and 2030 (projected), using WRI data. Grey dots indicate properties held by listed global REITs, as identified by BlackRock using SNL’s database. Water stress is assessed on WRI’s five point scale, ranging from “low” to “extremely high” (1 to 5).

We use the U.S. Southwest to illustrate our methodology. We use 2014 (actual) as our baseline because WRI’s data draw on an extensive modeling and simulation project ran by Utrecht University that spanned 1960-2014. This data represents the most recent and accurate global picture of water stress available, we believe.

Key assumptions: Almost the entire U.S. Southwest, including states such as California, Arizona, New Mexico and Utah, faces extreme water stress issues by 2030. Most of the current REIT properties in the region, indicated by the grey dots, lie in these high risk zones.

Roughly 60% of the global REIT properties we were able to geolocate will experience high water stress by 2030, we find, driven by increased urbanization and the effects of climate change. This is more than double the number today. Water-related issues are not yet a material cash-flow driver for REITs, in our view, and the risks can be mitigated. Yet they may become more material over time due to knock-on effects such as regulatory shifts.

Almost all REIT properties in Malaysia, Philippines, Japan, Hong Kong and Australia will likely be in high risk water zones by 2030, our analysis shows. Roughly two-thirds of today’s U.S. REIT properties will be at high risk of water stress by 2030, double the proportion today, we also conclude.

Investors and tenants are increasingly focused on water stress, as well as other environmental factors such as energy efficiency, green certifications and carbon footprints. REITs that score highly on these metrics can potentially save costs, while screening as more “green.” This may make their equities more attractive to potential investors and their buildings more desirable for occupants.

Water stress has wide-ranging implications across asset classes. We show how the agriculture, electric power and food and beverage industries may be most at risk. The creditworthiness of some countries, states and municipalities facing shortages could also come under threat as they face additional costs to fortify their water infrastructure. This comes on top of other growing physical climate risks such as exposure to flooding and other extreme weather events.

Companies resilient to water stress and other climate-related risks may fetch a premium in the transition to a more sustainable world, we believe. Better understanding and quantifying the risks can help investors mitigate exposures and potentially exploit any mispricing. Related data and insights are valuable tools for investors to engage with companies and issuers on their sustainability-related efforts.

Widening the lens

How might the analysis be extended beyond REITs? Our geolocation-based approach can also be applied to unlisted real estate – and a host of other asset classes and sectors, we believe. The materiality of stress varies greatly across industries, as the Who’s at risk?  graphic below shows. Relatively high water users such as the agricultural, electric power, and food and beverage sectors are among the biggest hot spots, this analysis from the WRI suggests.

Who’s at risk?
Water stress materiality matrix across major equity market sectors, 2020

Source: BlackRock Investment Institute, with data from WRI, 2019. Note: The chart shows the materiality across industries of various physical risks related to the quantity of water supply (too little or too much). The scale ranges from not relevant (white), to low (lightest tone) and very high (darkest tone). WRI’s weights are based on information provided in corporate water disclosure reports and input from industry experts. For details on the methodology see Hofste, R., S. Kuzma, S. Walker, E.H. Sutanudjaja, et.al. 2019. “Aqueduct3.0: Updated Decision-Relevant Global Water Risk Indicators.” Available online at: https://files.wri.org/s3fs-public/aqueduct-30-updated-decision-relevant-global-water-risk-indicators_1.pdf All sectors represent WRI’s assessment, except for REITs, which is based on BlackRock’s analysis replicating the WRI methodology. For illustrative purposes only.

The matrix assesses the materiality of various facets of water risk – ranging from baseline stress to coastal flooding and droughts – across industries. The focus here in on risks related to water quantity – either too much or too little. It does not address the full spectrum of water-related risks. Other components include risks related to declining quality (water that is unfit for use); as well as reputational and regulatory risks (such as conflicts with the public over poor management of wastewater). This illustrates the complexity of assessing risks across sectors – and the need to go beyond headline data. Yet we see it as a valuable starting point for assessing materiality of water stress across sectors.

The impacts could be dire in the agricultural sector, with a direct link between water availability for irrigation and crop yields. Irrigated agriculture is, on average, at least twice as productive per unit of land as rainfed agriculture, according to the World Bank.

Lack of water availability for cooling thermal power plants poses a serious risk to electric utilities. Some 27% of U.S. electric production would be severely impacted by steady increases in water stress by 2030, according to a 2017 study in Nature.

Cities and municipalities in water stressed regions may also face investment costs on wastewater recycling and fortifying their infrastructure. This has implications for the debt of governments and municipalities. Moody’s, for example, said in a report in early 2020 that climate-related risks posed long-term risks to the creditworthiness of the greater-Sydney region in Australia. It identified water stress as the single greatest challenge.

Challenges we plan to tackle include applying our analysis on water stress to companies with global supply chains. This would require a dataset identifying the location of all operating facilities of a firm so that the full exposure of companies – and their securities – can be determined.

Our understanding of the connection between climate risk and financial risk is evolving – and further research is needed to quantify effects with greater confidence. To be sure, rising water stress is not a one-way street. It can possibly be mitigated through breakthroughs such as better irrigation and wastewater treatment, and advances in efficiency and desalination. Yet we have high conviction that water stress is a key component of climate risks that are set to grow increasingly financially material over time. This suggests the time to integrate them into investment processes is now.

The financial implications

Industrial and commercial activity accounts for the bulk of freshwater use around the world. The agricultural, textile, energy, industrials, chemicals, pharmaceutical and mining industries account for around 70% of usage, according to CDP’s 2018 Global water report. Residential and office use are part of the remaining 30%.

The financial implications of reduced water availability are varied. Companies in water-stressed locations can face costs from disrupted production, higher capital expenditures, compliance and enforcement penalties. They may need to spend more to mitigate the effects of water stress, such as investments in efficiency, pollution abatement, re-use, recycling and conservation measures. The takeaway for investors: Companies that manage water resources better than their peers may offer more resilient earnings streams.

The risks cut across sectors. Lack of water for irrigation and animal consumption threatens the food industry. Insufficient cooling water can cause brownouts in electric power plants, hurting electric utilities and their customers. Even the leisure industry may be affected: shortages in India in 2019 forced hotel closures.

Water stress is expected to intensify in the decades ahead, in line with many of the other physical risks posed by climate change that we outlined in Getting physical of April 2019. One in two people will live in water-stressed locations by 2030, the UN Environment Programme (UNEP) expects. Global water infrastructure costs are expected to rise fourfold to $150 billion annually from 2017 levels by 2030, the World Bank estimates.

Who’s vulnerable?
Water stress exposure by REIT market, 2014 vs. 2030

Source: BlackRock Investment Institute, with data from SNL and WRI, June 2020. Notes: The chart shows the percentage of REIT properties in the top-20 global REIT markets that lie in regions with high water stress (zones 4 and 5 according to WRI’s framework), both as of 2014 (baseline) and 2030. Projections are based on WRI data. We used the SNL database to geolocate around 85,000 global REIT properties owned by listed companies. For illustrative purposes only. Forward-looking estimates may not come to pass.

The chart above illustrates how this may play out in the global REITs Industry. Less than 30% of REIT properties today lie in regions with high water stress, according to WRI data. That proportion could more than double by 2030, assuming the footprint of REIT properties remains unchanged.

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