Water and Investing: Is Your Portfolio on the Growth Side of Disruption?

Posted by Lydia Miller, Senior Vice President, Dana Investment Advisors

Water is a systemic risk to investors, as in many parts of the United States and other areas of the world this precious resource is in danger. Investors and market players should be deepening their research and investment process to tackle water risks, often hidden in holdings across all asset classes. As investors, how do we first protect our clients from these risks, and how do we position these same clients to benefit from the growth opportunities in companies that are providing innovative systems, products and services to solve water quantity, quality and resilience issues?

Several approaches seek the upside first and target water investments directly, mostly via infrastructure projects. In public equity markets, investments are often made in water utilities and industrial companies with water solutions business lines. Both of these approaches are examples of very worthy endeavors, but they are simply not enough by themselves to protect and grow the assets of most investors. Indeed some of the industrial holdings may be exposed to water risks in other parts of their businesses. Whether you are a universal owner, such as a major pension plan, a smaller institution or an individual, you are probably holding much of your assets in public equities and fixed income products. Particularly on the equity side, we’ve seen a huge move from active to passive approaches, thus the average investor is quite exposed to water risks embedded in various indexes. A recent study using SASB data highlights this exposure for the S&P 500, Russell 3000, MSCI World and EM Indexes. Using water footprinting, this study demonstrated that between 20 and 25 percent of these indexes had “high” water risk exposed industries by weight, and over 50 percent in high and medium risk categories. Divestment is not the answer, nor is targeted solution investing the entire answer in addressing water risk exposure.

We need a systemic approach to solutions and a more holistic approach to risk management and analysis. At Dana Investment Advisors, we are deploying several methodologies within our core ESG (Environmental, Social and Governance) strategies to tackle this widespread challenge on behalf of our clients. This comprehensive approach includes quantitative factor modeling, fundamental analysis including assessment of innovative solutions, advocacy efforts and partnering with other like-minded entities, many of which are non-profits or universities.

Quantitative analysis involves gathering and aggregating a variety of data sources to track water exposure on a company basis and portfolio level. Greater corporate disclosure of such information is still needed, but we applaud the efforts made thus far by forward-looking corporate entities and nonprofits such as CDP that have gathered and disseminated information to investors. We utilize a variety of data providers for “raw” metrics and combine these in a proprietary ESG model. These include Trucost, ISS, MSCI, Bloomberg, Sustainalytics and more. While we have several metrics on water, we also have one that combines water and carbon intensities, as water and energy are inextricably linked. This can mean additional risks for companies setting carbon emission reduction targets that depend upon the continued availability of water. This modeling helps direct attention to those industries and specific companies that require a deeper analytic dive. We are collaborating with Peter Adriaens, Professor of Engineering, Finance and Entrepreneurship at the University of Michigan, and Director of the Center for Smart Infrastructure Finance. The objective of the project, which engages MBA students of the highly ranked Ross School of Business, is to tease out value-at-risk based stock volatility metrics that reflect water exposure risks for companies across food and beverage, semiconductor, energy and consumer products companies.

Fundamental analysis gets to the heart of what is meant by “disruption.” Say the word “disruption” to mainstream investors and one hears about Amazon and its disruptive impact on brick and mortar retailers. To a sustainability or ESG-focused audience, disruption is often focused on renewable, clean energy coupled with storage and the negative impact or “stranding” of fossil fuel assets. Our fundamental work leads us to believe there is disruption across all sectors, as industries and companies embrace or react to technological convergences and resource constraints. Differentiating between the growth sides of disruption and avoiding or mitigating the disrupted sides is and will be a growing source of risk and return for active managers. While we’ve focused on the risk side of water, there is the solutions side that holds much promise, and has critical knowledge of innovative products and services in understanding the playing field.

Water is often said to be a global factor, yet unlike carbon, risks are highly localized. At Dana, we couldn’t agree more with this assessment. Our firm is headquartered in the suburbs of Milwaukee, a city within the Great Lakes Region. According to the EPA, the Great Lakes are the largest surface freshwater system on the Earth (only the polar ice caps contain more fresh water), providing 21 percent of the world’s supply of surface freshwater. We are fortunate to be members of and have access to The Water Council, an organization raising the bar in water technology. We believe The Water Council is fast becoming a center for excellence in freshwater technology, systems and solutions. Such ready access to experts, new technologies and major corporations investing in these water solutions gives us a bird’s eye view or the ability to “plug and play” in this rapidly changing ecosystem of water stakeholders.

Lastly, education and advocacy, both corporate and government, play a huge part in this effort to make our planet and portfolios more resilient. Advocacy involves voting proxies on behalf of client assets in favor of water disclosure, including supply chains, partnering with other like-minded entities, such as Ceres and UNPRI, on policy issues, and directly engaging corporate managements on water issues and sustainable practices. Education and resources are critical to preventing the disruptive effects on water scarcity and quality. Here we would highlight Ceres, a well-known organization dedicated to building a more sustainable economy. The Ceres Investor Network, and specifically its Water Hub, a subgroup of members of which we are a part, recently released an online tool, The Investor Water Toolkit – www.ceres.org/investorwatertoolkit . This not only provides a framework and resources to assess water risks, but is an excellent example of investors – and competitors – recognizing the need to work collaboratively on issues in order to make an impact.

As we write, Cape Town, a city of four million people, is on the verge of running out of water after years of drought. Last year saw horrific impacts of drought and flooding in the U.S. and many other countries. Water is a precious resource, and we can and should rise to meet the challenges ahead. When it comes to investing, there is no avoiding this systemic risk, but there are ways to address it long term and ways to manage the risks and avail ourselves of innovative opportunities as we transition to a more sustainable economy.

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