Measuring Water Risk: The Challenges for Passive Index Investment

Abstract

Water is essential to life and is not typically included in an investment strategy. Water scarcity creates water risk which is environmental, ubiquitous across sectors and geographies, directly impacts future corporate earnings and is completely unaccounted for in equity market benchmarks. The drivers to water risk include climate change and climatic events, failing infrastructures, pollution, inadequate regulations, and poor corporate water stewardship. Energy has alternatives (solar, wind, nuclear, etc.) but there is NO substitute for water. Water stewardship will directly impact future corporate earnings. The “winners” will manage water efficiently while the “losers” will mismanage their water resources, negatively impacting their earnings and consequently their share prices. From an investment perspective, there is a big difference between water-themed indices and water security indices. Water-themed investment strategies consist of highly concentrated (30–40 stocks) portfolios of companies in the water purification and/or water recycling equipment manufacturing industry, as well as some water utilities none of which focus on water security. “Water security is the reliable availability of an acceptable quantity and quality of water for health, livelihoods and production, coupled with an acceptable level of water-related risks” (Grey and Sadoff in Water Policy 9:545–571, 2007). Because water is used by nearly all companies to some degree, water security relates to nearly all companies. Therefore, almost every company possesses some degree of water risk which enables them to be analyzed during portfolio construction to assess and control portfolio exposure to water risk with a tilt toward water security and good water stewardship. The lower the water risk, the greater the water security. There are no standards for reporting water data, therefore we need to apply statistical techniques to ensure comparability across companies and geographies before measuring water risk. Our approach creates a proper distribution from best to worst water risk at the company level. This study relates to the indices developed from Thomas Schumann Capital (TSC). The TSC Water Security Indices have demonstrated superior returns while generating a considerably lower water footprint and carbon footprint. In addition, they have similar volatility, sector exposures, dividend yields, and high correlations to their traditional equity benchmarks.