Going with the flow: ESG investing and water scarcity

Water scarcity is a megatrend with widespread macroeconomic implications and adopting ESG principles can highlight companies addressing challenges posed by water shortages

The subject of freshwater shortage continues to dominate headlines across the globe. At the height of the 2018 water crisis in South Africa, experts predicted that the inhabitants of Cape Town would face "day zero" in April – the day that municipal water taps would have to be shut off. A combination of human and natural factors had brought Cape Town to this point, including overuse, mismanagement and drought conditions, which left many of the city's reservoirs below 20% of capacity.

Cape Town's "day zero" was ultimately averted via aggressive water conservation efforts and levels of rainfall not seen for years. However, most experts agree that the catastrophe has in reality only been pushed back to 2019 or 2020.

In fact, Cape Town's water supply issue has been dire since at least 2015, and it is widely acknowledged that only dramatic changes in water management practices can solve the challenge facing the city. These include structural changes to water use patterns, reinforced regulatory oversight and technological advances.

Megatrend unabated: Water supply is critical

Regrettably, it is not only Cape Town that faces fresh water shortage. Globally, only 0.007% of the earth's fresh water resources are fit for consumption, and much of that is in oceans or trapped in glaciers and snowfields. The rest is unfit to drink. Consequently, about two-thirds of the world's population live in regions affected by water scarcity for at least one month per year. Experts estimate that roughly 2.1 billion people live without safe drinking water at home, which impacts their health, education and livelihoods.

These challenges are exacerbated by rapid population growth, with 1 billion people having been added every decade over the past 30 years. A historian, Ernst Gombrich, puts these numbers in perspective by suggesting that if a line were drawn round the earth at the level of the equator, it would measure approximately 40 million meters. Thus, it would then take about 80 million people to form a queue that would circle the globe. 100 years ago, a queue of the world's population would have circled the earth 22 times. Today, with 7.2 billion inhabitants, the queue would ring the earth 90 times! This has staggering implications for the need for natural resources, and water is one of the key elements for human survival.

The dilemma of fresh water shortage contributes to other social concerns as well. For example, Iran and India have seen bouts of social and political unrest over water shortage. In parts of the US, water prices have surged dramatically, and roughly 36% of US households may not be able to afford water within five years. Meanwhile, in China, 20% of the world's population relies on merely 7% of the globe's fresh water supply – with people and policymakers seemingly only recently having woken up to the implications of how pollution and overuse are ravaging the resource.

The expanding threat of water scarcity around the world is the stark, human reality of what researchers and analysts all over the world refer to as a "megatrend" – a sustained global trend that has macroeconomic implications for businesses, economies, societies and individuals.

Much like Cape Town's long-term water challenge has not been solved by shorter showers and a season of good rains, the global megatrend of water shortage is not something that can be easily slowed or reversed. Quite the opposite – annual global water demand is expected to grow by 55% by 2020.

ESG investing and megatrends

While it is difficult to influence supply and demand of fresh water, technology and regulations can offer compelling solutions to help address the ever-growing imbalance. In fact, the United Nations Development Program's sixth Sustainable Development Goal aims to do just this, targeting universal clean water and sanitation supply by 2030.

Alongside the UN, there are currently private companies working to address water challenges in many areas of the world. Investors have the potential to support the most promising of these, with environmental, social and governance (ESG) investing as one lens to guide these investment decisions.

In traditional financial analysis, datasets are analysed across many spectrums to make well-informed investment decisions. While this is undeniably an essential component to identifying how assets could perform under different conditions, in isolation this view in some ways resembles looking in the rear-view mirror while driving a car – moving forward, while looking back.

ESG analysis provides an additional lens that compliments the traditional financial approach by providing tools that allow investors to look forward, similar to looking through the windscreen of the car, to assess some of the upcoming risks. In the case of water scarcity, population growth projections could factor into macro analysis of potential investments. At the same time, review of individual companies' water use policies and patterns could highlight potential operational or reputational risks related to water use, contributing to bottom-up selection of individual securities.

In this sense, ESG assessment can help uncover issues that would rarely appear in a company's financial records. While factoring in these risks could incur short-term financial costs, the approach has the potential to pay off in the long term – in the same way as conducting maintenance and safety checks on an oil rig provides long-term downside protection by helping avoid accidents, but is expensive and could delay projects in the short term.

A perfect fit: The water scarcity megatrend and ESG investing

A megatrend like water scarcity is in many ways a perfect fit when it comes to ESG considerations. Assessing megatrends can help investors evaluate major global shifts in economic, social, political, environmental and technological areas and to identify the potential for structural bull markets, while identifying the salient risks to insulate against portfolio drawdowns. For example, growing population and urbanisation are contributing to the expanding problem of fresh water shortage, while technological advancements are working towards solutions such as desalination and purification techniques.

Adoption of ESG principles can highlight companies that are addressing environmental, social and governance challenges. This could lead the way to investing in those that are active in areas such as: well drilling, waste water treatment – a huge market in China at the moment – leakage detection in water distribution networks, pumping and pipeline infrastructure, water filtration and purification, water testing and measurement or desalination.

Notably, water scarcity is not the only megatrend that presents opportunities to invest from a forward looking perspective. Similar opportunities arise from environmental megatrends such as food scarcity and solid waste management; demographic megatrends such as aging populations, urbanisation and the changing global tourism market; and technology megatrends such as the ongoing digital revolution, the groundswell of innovation coming out of China and the seemingly unstoppable growth of e-commerce.

Juan Aronna is head of investment solutions and products Asia, and Iryna Drobysheva is associate director, ESG and portfolio specialist, RBC Wealth Management.

Date

11 Oct 2018

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