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04/22/2010

Calculating the Risks of Impending Water Shortages


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World Water UsageWater is taking center stage alongside the emission of carbon as the preeminent environmental risk facing the planet in the twenty-first century. And, in a manner similar to its early response to carbon risk, the private sector has begun to prepare for an era of stricter regulation and rationing of what is perhaps the earth’s most precious finite resource.

The media has recently focused on water scarcity primarily from a climate-change perspective. Glacial melting—which Achim Steiner, executive director of the UNEP (United Nations Environment Programme), has called “the canary in the coal mine”—is reportedly depleting the freshwater supply of vast regions of Asia and South America. 

Most of the world’s freshwater is stored in glaciers, and as glacial melting accelerates, more melts away into riverbeds and ends up as seawater before it can be extracted for agriculture, drinking, or other uses. Deepening droughts are also creating critical food and national-security crises in many regions of southern Africa. Journalists chronicling the clashes between Kenyan and Ugandan fishermen eking out livelihoods in the fish-depleted waters of Lake Victoria, in East Africa, have linked the lake’s fragile state to climate change.

According to the UN IPCC (United Nations Intergovernmental Panel on Climate Change), by 2050 greenhouse gas impacts will cause twice as many areas of the globe to enter into a state of water stress as those that will be rescued from it. By 2025 it is estimated that 1.8 billion people will be living in conditions of absolute water scarcity (defined as annual per capita freshwater availability below 1,000 cubic meters a year), and two-thirds of the world’s population could be living under water-stressed conditions (with annual freshwater availability below 1,700 cubic meters per capita).

The impacts of climate change on freshwater resources will indeed be dramatic. However, the accelerating rate at which humanity is consuming water, especially in the faster-growing, developing regions of the world, also plays a principal, and often underreported, role in the water-scarcity crisis. While freshwater is theoretically a renewable resource, it is currently consumed and degraded without regard for the wide and unpredictable fluctuations in its seasonal and geographic availability. More importantly, global water consumption is increasing at twice the rate of the world’s population. Due to population density patterns and rising per capita consumption, water is being withdrawn most unsustainably from locations where it is least plentiful to begin with—for example, in the southwestern US. Unfortunately the price signals that ordinarily balance supply and demand in the marketplace are largely weak or absent for water. In many of the world’s water “hot spots,” no regulation of any kind stands in the way of the exploitation of freshwater resources.

The Private Sector Awakens to Water Risk

As they wait for governments and supranational organizations to step into the regulatory breach, institutional investors are increasingly demanding that companies do a better job of reporting their water usage. In August, for example, the Norwegian government’s €276 billion pension fund announced that it would begin requiring the 1,100 companies in its portfolio of holdings, representing €33 billion in value, to meet certain defined minimum standards of water risk reporting and management. The fund is focusing on seven sectors: food, agriculture, pulp and paper, pharmaceuticals, mining, manufacturing and power, and water supply.

Companies have been slower to react. “When prioritizing investments, companies often overlook local sensitivities like water scarcity, policies, and conflict,” says Melissa Barrett, a manager at Arthur D. Little, in London. But as water scarcity increases, it is imperative that companies recognize the business consequences that may result, she maintains. For example, a 2008 report published by the World Resource Institute and JPMorgan Chase estimates that a shutdown of a Texas Instruments or Intel Corporation semiconductor chip plant due to temporary water unavailability could translate into a revenue loss of as much as $200 million in a given quarter (Klop and Wellington 2008). Intel operates plants in water-scarce locales like Chandler, Arizona, and Haifa, Israel.

Acknowledging the materiality of water risk, some companies are beginning to devote significant internal resources to managing it. Arjen Hoekstra, professor in multidisciplinary water management at the University of Twente, in the Netherlands, and a leading authority on the emerging science of “water footprinting,” notes that companies appear to be defining their water risk along three broad categories. First is the actual physical risk of water shortage to direct operations or that of the supply chain. The second can be defined as a general CSR (corporate social responsibility) risk. “There may not be an immediate physical risk for the company’s product, the business itself may have access to water, but other entities or members of the community where the business operates may not have equal access,” says Hoekstra. “Or the environment may suffer because of overuse of water in a particular catchment area where the company operates, and it may consequently be interested in taking action to reduce its water footprint there.”

Companies often turn the third risk category, which could perhaps be described as “guilt by association,” into a marketing opportunity by attempting to brand themselves or their products with an exemplary “water image” for competitive purposes. Hoekstra notes this is particularly true of companies in the beverage or personal care industries, which manufacture products that are closely linked with water use. “A company’s image in these cases may be harmed simply because people feel it has a negative water footprint associated with it,” even though direct operations may have minimal impacts, according to Hoekstra. On the flip side a company that has invested in creating a water-friendly brand may attract environmentally conscious consumers away from its competitors.

Defining the Water Footprint

Water footprinting is in its infancy, and so far no clear global standards have emerged. The Water Footprinting Network, a multistakeholder alliance of NGOs, corporations, researchers, and supranational organizations, is spearheading efforts to establish a uniform set of water footprinting standards and to encourage enactment of regulations that will promote the sustainable and equitable use of water. Members include the International Finance Corporation of the World Bank Group and corporations in water-intense industries, including Unilever, Nestlé, PepsiCo, and the Coca-Cola Company.

The network has generally defined a water footprint as a way to measure both an entity’s direct and indirect water use. The footprint includes “blue” water (surface or groundwater), “green” water (rainwater stored in the soil), and “grey” or polluted water. A footprint should delineate not just the total water consumed or polluted but also where it is consumed or altered and when (e.g., during dry or rainy seasons).

Hoekstra, who serves as the scientific director of the Water Footprint Network, states that the group is determined not to repeat the mistakes made during the development of carbon footprinting standards. “We realized that with the carbon footprint we lacked clear standards, and consequently there ended up being a lack of uniformity in carbon footprint accounting. As a result reduction targets for carbon can’t be set coherently. So in the early stage of water footprint research we are trying to engage all stakeholders to ensure all sectors are involved in the process.”

But even if a group of key stakeholders like the Water Footprint Network agrees to a set of standards, if they are not enforced they are unlikely to be universally adopted. “Some supranational body needs to create the equivalent of a Kyoto Protocol for water,” argues Michael Diaz, CEO of the Zürich-based sustainability rating agency INrate. “Just as we have seen in the case of the Global Reporting Initiative’s sustainability reporting framework, when standards are just voluntary we see some leading companies conforming, but the majority of the large-cap companies do not.”

Uncovering Hidden Risks

Given the current absence of uniform footprinting standards, reliable price signals, and compulsory disclosure requirements, analysts must engage in aggressive detective work to arrive at a meaningful assessment of a company’s exposure to water risk. INrate’s Diaz notes that while it is possible to identify broad industry sectors that are the most at risk, identifying water risk on a company level and benchmarking it across a sector is another matter entirely.

That said, a number of companies are beginning to disclose some water-usage data, often on an aggregate basis. However, notes Richard Mattison, managing director of Trucost, in London, most report what they have been licensed to use rather than what they actually use. In underregulated markets, he says, this can create serious anomalies.

What is more, data on global water usage, even when it approaches accuracy, provides little insight into a company’s underlying water risk unless that usage is linked to water withdrawal in a specific geographic location. “Water usage is a far more complex analytical issue than greenhouse gas emissions, because, unlike carbon, it has a very local impact,” remarks Mattison. “What we would like to see is companies report on water use relative to available water locally. In other words, not just their own direct abstraction but their exposure due to the fact that they may be abstracting that water where it is less renewable than in other locations.”

Some companies do provide data on water usage by product, but it is usually not presented in a way that can be utilized by securities analysts. “A company may give you a water-usage number of so many cubic liters per units of production, and that is helpful,” says Heather Langsner, director of sustainability research at RiskMetrics Group, in New York. “But rarely have companies rolled up all their facilities into that number and there is little context for that number within the GAAP [Generally Accepted Accounting Principles] framework.”

One approach to analyzing water risk that can be relevant for investors, notes Langsner, is to track the incremental changes to the company’s operating costs and to compare those changes with competitors in the industry that use the same industrial processes. “This approach may reveal some opportunities for cost efficiencies but is not likely to reveal something material. Reported targets and usage-reduction strategies are helpful, but the most traction is likely to be derived by focusing on the macroindustry level and by investigations at the company level.” This requires analyzing the water footprint starting with inputs into the manufacturing process and ending with how much water is used when the product is consumed.

Assessing the water risk of the total product life cycle is particularly challenging. Most companies provide little information about the water risk along their supply chain, and few have devoted any resources to analyzing it. That can mean substantial hidden risks for businesses that do not manufacture their own products or rely on inputs from water-intensive sectors like agriculture.

Langsner notes, however, that as companies become more adept at scrutinizing their supply chains for hidden water risks more company and sector exposures will be uncovered. She reports that certain companies in the fertilizer and chemicals sector are currently “shooting themselves in the foot” because the products they manufacture make water use a bigger issue for other sectors like industrial agriculture. The latter sector, incidentally, has so far provided virtually no disclosure to investors related to this hugely material risk. On the other hand, Langsner notes, companies in the semiconductor industry, which have typically been negatively targeted for their water usage, have recently implemented many water-saving technologies.

Water Risk Management— Gauging the Corporate Commitment

While many corporations are creatively engaged in greenwashing their commitment to addressing water scarcity, sustainability analysts have become more adept at distinguishing the substance from the hype in CSR reports. Diaz explains that INrate analysts look to see if the company has taken concrete measures to reduce its overall water use and if it has set qualitative and quantitative reduction targets. “You have to look at the entire product life cycle where water use is relevant,” he says. The reductions can be made during the production process or by technologies that reduce water use when the consumer uses the product. INrate likes to see that the company has provided a clear and precise description of how water use has been reduced.

When companies get serious about water risk management they often find their corporate cultures and approaches to business are fundamentally transformed in ways that make the investment community take notice. Arthur D. Little, which consults with companies on water risk management, advises its clients to focus on both ends of the value chain, where water impacts are likely to be most pronounced. “Leading companies are having to work much more closely both with the agricultural sector and end users,” says Barrett. “These stakeholders are often widely dispersed, requiring new business models and ways of working.”

Sharon Squillace, manager of the thematic research program at KLD Research & Analytics, in Boston, notes that it is especially critical to see that companies operating in emerging markets have begun to engage with local communities and municipal authorities on the issue of water use. “If there is a community controversy surrounding a company’s water sourcing and withdrawals—especially as it impacts indigenous people who depend on a particular water source for food, livelihood, and water rights—that raises a particular red flag.” Sooner or later those companies will be required to acknowledge a shared partnership in the sustainable use of this scarce resource, even if they are not subject to any current regulation.

How Company Reporting Stacks Up

Although there was unanimous agreement among the analysts polled for this story that current water footprint reporting falls far short of best practices, examples of companies that are committed to improving that reporting are beginning to emerge. For example, notes Squillace, Nike has one of the best programs in place to address the water management of its supply chain. Its program addresses the toxicity of manufacturing emissions to water, not simply water withdrawal. Nike has made progress in assessing and reducing wastewater from operations into the upper reaches of its supply chain. It requires both its contracted factories and the vendors who supply textiles to those factories to adhere to local regulations or Nike’s compliance standards for wastewater management—whichever are stricter. All Nike footwear factories must either operate an on-site wastewater treatment plant or be connected to a centralized one. “In 2006, 282 suppliers participated in its water program, compared to 40 suppliers in 2001, when the program began,” says Squillace. “Very few other companies in the apparel and footwear industry have really taken on initiatives to address this issue in their supply chains.”

The food and personal care manufacturer Unilever, wine and spirits company Diageo, and beer manufacturer SABMiller were recently cited by the Ecumenical Council for Corporate Responsibility (ECCR) for showing “evidence of addressing the need to use water sustainably, of seriously examining how they use water and of considering how water stress might affect their business” (ECCR 2008). While the council’s report highlighted the progress being made by these companies in its survey of 15 leading food and beverages companies, it recommended that the sector as a whole needed to do a better job of “identifying water stress and the impact of water use; taking more responsibility for water use in the supply chain; consulting with local communities; making environmental performance a factor in senior executive remuneration; [and] enhancing accountability through reporting and disclosure, especially in terms of water consumption, water abstraction and site-level reporting” (ECCR 2008).

In its sustainability reporting, Unilever openly acknowledges its significant exposure to water risk; its brands are heavily dependent on water at all stages of the product cycle, and a majority of Unilever’s operations depend on irrigated water systems. The company has taken numerous steps to measure and reduce its water footprint. These include programs to reduce water use in its manufacturing processes; the implementation of close partnerships with suppliers, especially in the agricultural sector, to reduce water use; and the reengineering of products to reduce water footprints at the consumer level.

Unilever has piloted a set of “vitality metrics” in its home and personal care product lines, which allows consumers to measure, for example, the quantity of water used per product per shower. In its 2008 report on water usage, the company reports that it has reduced the amount of water it used per ton of production by 63% since 1995. Unilever factories routinely collect reusable water—for example, water evaporated when vegetables and fruit are dried. The company also harvests rainwater at its soap factory in Khamgaon, India, to replenish the local water tables in this rain-parched region. It treats all wastewater on location for secondary use.

Squillace notes that SABMiller is one of the few companies that provide data on water use by type, including water consumption of its agricultural inputs, as part of its water footprint reporting. “It is a self-protective measure to be ahead of the curve in strategically managing these risks, especially since water is a critical ingredient for its product and it has significant operations in water-scarce regions,” says Squillace.

In August SABMiller published its first detailed product footprint for the value chain of its breweries in South Africa and the Czech Republic. In the report’s preface the company notes that the study was designed not as a mere reporting exercise but “to make better operational decisions concerning how it manages its plants, how it works with suppliers and how it engages with government, to reduce business risk and improve environmental sustainability” (SABMiller 2009). The report closely relates water use to water scarcity, linking specific water-catchment areas to operations. Like Nike and Unilever, SABMiller is also stepping up efforts to recapture and purify wastewater. For example, the company recently built a new water-recovery plant at its Tanzanian brewery that will recycle 65% of the plant’s wastewater.

Coca-Cola: A Classic Case of Water Risk

Perhaps no other global corporation better represents the risks that a large and visible water footprint present to brand identity and the bottom line than Coca-Cola. In June 2007 Coca-Cola embarked on a highly publicized multimillion-dollar partnership with the World Wildlife Fund to conserve water in seven key watersheds and to reduce the company’s own direct water use and that of its agricultural supply chain, beginning with sugarcane.

Coca-Cola has announced a goal to reduce worldwide water use by 20% against a 2004 baseline by 2012. It has also pledged in its latest sustainability report to return “to communities and to nature an amount of water equivalent to what we use in all of our beverages and their production.” To accomplish this the company has set goals to: “reduce the amount of water used to produce our beverages; recycle water used in our manufacturing processes so it can be returned safely to the environment; [and] replenish water in communities and nature through a global network of local partnerships and projects” (Coca-Cola 2009).

While analysts applaud these efforts, they report that Coca-Cola’s water reporting continues to be inadequate given the size and scope of its water risk. While Squillace notes that Coca-Cola has done a lot of good work with the World Wildlife Fund around water stewardship, she maintains that the company’s water reporting has not been systematic. “While they do a lot of reporting on total water use and efficiency at the global level for bottling worldwide, they do not provide local or regional water-use data at the facility level, which is essential for accurately measuring the impact of water use and the effects from their operations.”

Nonetheless, the big risks the company continues to face are easy to spot. Langsner noted that she got “some interesting results” when she juxtaposed Coca-Cola bottling facilities in Africa with a CIA (Central Intelligence Agency) map of water-constrained regions of the world. The company has been the object of campaigns by local environmental groups for its use of groundwater in water-stressed regions of the Indian subcontinent.

In 2004 Coca-Cola lost its license to use water at its Kerala, India, plant. Although the company has made earnest attempts to engage in water conservation in India and has installed more than 300 rainwater-harvesting structures in 17 states, the closure of the Kerala plant and pressure by local activist calling for the closure of other plants puts the company’s operations at risk in other water-parched regions of the world. “The effect on the Coke franchise would likely manifest initially as limits on the company’s license to expand to new regions,” observes Langsner. “And secondarily it would show up as an effect on the brand and sales, if NGOs decided to more aggressively push the matter.”

Aside from the water it uses for bottling, Coca-Cola must manage the risk associated with the water-intensive production of sugarcane and oranges. Possible solutions for companies that rely on water-intense inputs like Coca-Cola are threefold: they can develop less water-intense methods of agricultural production, shift their product sourcing and operations into more water-abundant regions, or substitute less water-intense inputs. In Coca-Cola’s case, this may mean substituting alternative sweeteners with lower water-usage requirements.

Coca-Cola’s claim that it is close to achieving “water neutrality” and intends to be water neutral in India by the end of 2009 has been greeted with some skepticism. At one point the Water Footprinting Network defined water neutrality as the reduction of an entity’s water usage through every possible “reasonable” action and by offsetting the residual footprint by making “reasonable” investments in water-sustainability projects. The network now prefers, however, to downplay the concept of water neutrality because it has tended to encourage companies to direct their efforts too quickly toward compensating or offsetting their water use rather than water footprint reduction.

In the final analysis, water offsetting, unlike carbon offsetting, must be implemented in the specific locality in which the corresponding degradation arises to be effective. “I don’t think you can achieve water neutrality in the way that you can be carbon neutral,” says Judith Reutimann, a water analyst at INrate. “Greenhouse gases mix in the atmosphere and become a problem for the whole earth. Water scarcity is very local. Of course you can be water neutral for the whole company, but if in the end the result of your actions is that there is a region that suffers from water scarcity and another that has enough water, the problem is not solved.”

Langsner believes that the socially responsible investment community has unfairly singled out Coca-Cola for censure when in fact many of its competitors are also operating in water-stressed regions of the world. “The entire beverage sector faces fundamental water risk, and the analysis has to be informed by the results of serious and forthright attempts by the management of these companies to grasp their business risk.”

Water Scarcity Opportunities

In the absence of regulation, determining what are reasonable investments in water-use reduction or water-offset projects is ultimately an internal decision. “How far should a company go to reduce its water footprint when it has social, environmental, and economic risks to weigh?” asks Richard Skidmore, a consultant with Arthur D. Little. “It is somewhat easier to quantify the economic risks but much more difficult to weigh the social and environmental ones.” Arthur D. Little advises companies to review immediate cost savings associated with the investment, projected cost savings based on forecasted prices for water, and intangible benefits, such as enhanced stakeholder perceptions and “first mover” advantages.

As part of its offerings, INrate has selected a group of companies, some of which are first movers in water footprint management in water-intense sectors, and others of which provide water-efficiency solutions to those sectors. Among INrate’s current picks are: the Italian water utility Acea, which has undertaken process optimization with systematic loss detection for all its water-distribution systems; Jain Irrigation Systems, an Indian company that has developed drip irrigation systems using cutting-edge water-saving technologies; and Geberit, a Switzerland-based manufacturer of low-water-use toilets and other water-efficient sanitary technologies. INrate also highlights United Natural Foods, the largest US-based, publicly traded wholesaler of natural and organic foods. Organically produced crops are reported to be far less water intense than their conventionally produced equivalents. For example, a 2005 Cornell University study reports that organically farmed corn and soybeans used significantly less water, caused less soil erosion, and create significantly less nonpoint source pollution than those that were conventionally farmed.

The Future of Water Risk Analysis

UNESCO-IHE (United Nations Educational, Scientific, and Cultural Organization International Institute for Hydraulic and Environmental Engineering), Arthur D. Little, Fidelity, Goldman Sachs, and JPMorgan Chase are among the organizations that have produced insightful reports on the big picture and the broad sectors that will be affected by water risk. “Now it is time for everyone to roll up their sleeves and evaluate companies individually,” says Langsner. She reports that RiskMetrics will be narrowing the analysis down to the company level, working to develop a water-risk-analysis service that will use specific data on companies’ operating assets matched to region-specific information related to water scarcity and regulation. The analysis will include pertinent environmental regulations that impact company operations: “It may not be a rule or law locally with water in the name but it might be a ban on certain types of operations or emissions that are water relevant.”

RiskMetrics sustainability coverage includes 300 companies that operate in emerging markets in which water regulation does not currently exist but where water risk may impact the viability of operations in the not too distant future. “You may be able to operate a plant in these areas now but in five years you will not,” predicts Langsner.

Will corporations have the wherewithal to meet the often-daunting water management and reporting requirements increasingly demanded by the investment community? The answer is that they will have little choice. “Five years ago many people were asking the same questions about greenhouse gas reporting,” says Diaz. “Will it be possible for corporations to report on CO2 for the entire life cycle of their products? Today we see companies moving exactly in that direction. When we go back 10 or 15 years, socially conscious investors wanted textile manufacturers to monitor working conditions for 1,000 suppliers. Today we know it is possible. Gap had the problem, and they had to move forward to address it.”

Diaz expects that within five years the most innovative companies in the most water-intense sectors will be providing the kind of water footprinting information that the investment community requires to assess water risk. “The problem with water is huge just as it is with CO2. We expect that national and supranational regulation will come, and companies need to be ready.”

References

The Coca-Cola Company. 2009. 2007/2008 Sustainability Review.

The Ecumenical Council for Corporate Responsibility. May 2008. Water Sustainability: Meeting the Challenge.

Klop, Piet and Fred Wellington. March 31, 2008. Watching Water: A Guide to Evaluating Corporate Risks in a Thirsty World. JPMorgan and World Resources Institute.

SABMiller and World Wildlife Fund. 2009. Water Footprinting: Identifying and Addressing Water Risks in the Value Chain.

–Susan Arterian Chang writes on sustainable investing and the new economy and recently launched a new website, the Impact Investor.

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