Beyond the bottom line

Positive environmental and social outcomes for the future water industry and its long term investors

Over the past decade the investment industry has been evolving.

It stands at a turning point: as society becomes more aware of, and concerned about, the environmental and social challenges, so are investors increasingly looking to put their capital to use for the benefit of the environment and society.

Clearly, there is still a big audience that questions the financial attractiveness of such investments.

However, there is also a growing pool of investors that believe the opposite – there is an incremental value to be created.

The water industry – and individual water utilities – can tap into these investors. They can enhance the attractiveness of the investment by focusing on positive environmental and social outcomes.

But long term investors require some things in return. And they put water utilities on the spot.

First, some context.

Water utilities need to balance a range of interests

Water utilities are organisations that need to balance the subtle relationship between:

- Customers, that require the social commodity – water
- Environment, that supplies the natural resource
- Investors, who provide capital and require financial returns

Water regulator and utilities ensure that the ultimate goal of delivering safe and affordable water to society is met without jeopardizing the needs of the other two ‘stakeholders’:

-          The environment must be protected to enable the future generations to have equal access to water as the current one does
-          Investors’ rights must be protected, and the reward promised, as they are asked to provide the capital that enables to build and operate these water networks.

Investors’ gain from environmental and social focus

So why and how should an effective focus of the water utility on positive environmental and social outcomes attract investors?

And what is in it for people?

Investors look to optimise the balance of risk and return of their investments. Where the risks are higher, they will expect a higher return – and vice versa.

As investors trade off the stability for incremental return in deciding where they allocate their capital, they consequently reduce the cost of this capital for the opposite party.

A lower cost of capital then enables businesses to invest at lower cost, which for utilities means reducing the financial burden of their investments on the customers they serve.

Because a utility’s core goal is to deliver affordable water to its customers, it needs to ensure the cost of financing the water network is kept low.

Increasingly many investors are taking a wider view of risk – including environmental, social and governance practices.

This is known as ‘ESG’ investing.

ESG in long term investing

The Environmental, Social and Governance practices of businesses are key factors determining the risk level.

Today, a growing number of investors are integrating E, S and G risks analysis in the investment assessment.

It has been proven over and over that negative financial outcomes have followed from:
- Weak business adaptation to environmental risks
- Mistreatment of the employees or societies impacted by operations
- Poor governance practices

The ESG focus is therefore crucial in assessing how sustainable the business model of a given water utility is.

In order to maintain the license to operate, and reduce the perceived risk for investors, water utilities have to clearly establish a way of operating that minimises any negative footprint on the environment, society, and investors.

Examples of E, S or G factors evaluated for water utilities

MSCI is a global provider of data for the financial industry, including multi-asset portfolio analysis tools.

They highlight ‘Water Stress’ as the key Environmental risk factor for UK water utilities, as the long-term availability of water resources defines companies’ ability to meet the customer demands. Assessment of items such as leakage rate helps to evaluate the magnitude of risk for a given utility.

From the Social perspective, MSCI evaluates among other Labour Management practices by looking at health and safely working conditions, or retirement plan options.

But what about returns?

However, minimising the ESG risk ignores the incremental opportunity, or the return side of investment.

Water utilities are not isolated in their microcosm, but suffer from the effect of external factors that affect the costs, revenue, profitability and returns they offer.

-          Climate change is continuously challenging the infrastructure resilience – as early as in 2018 the major weather externalities caused water pipe breaks across the systems, costing people hours of access to water, and utilities thousands of pounds in fixing these damages.

-          Industrial and human activity endanger the safety of water resources, as a number of new contaminants emerge: from micro-plastic pollution to dissolved drugs in the water sources. These are expected to have large implications on human health, and will cost large amounts of money to be removed from the water supplied into homes.

-          Farming is increasingly more reliant on irrigation, often abstracting the water from common water sources, but also polluting it with fertilizers dissolved in the run-off water.

Effectively focusing on positive environmental and social outcomes is one step beyond business protection. It is about active contribution toward better future.

Long term investors are therefore not only concerned with how effective a company is in managing its exposure to current environmental and social risks, but seek companies that foresee the future challenges and work on their mitigation before they create major harm.

Long-term investors:
Seeking positive outcomes

1. Addressing inequalities and affordability

Water utilities provide a social commodity, and therefore need to ensure they address inequalities in the population they serve.

A utility that effectively addresses the low affordability among its customers is protecting the social coherence and its long term business model.

-          This can be achieved through a combination of actions, from special schemes aimed to support the struggling customers, through innovation in cost management for customers like smart meters, all the way through to more efficient financing costs that reduce the pressure on bills for entire community served.

-          Consolidation of the network into large operations with continued drive for operational efficiency also helps to distribute and reduce the per-customer cost of running the water network, supporting the affordability of the water access to population served.

2. Use resources more efficiently

Climate change, urbanisation and population growth are increasingly working against the water utility’s traditional water sourcing practices. The utility needs to evaluate its role in mitigating this pressure over the long run. Looking for proactive solutions will not only alleviate environmental challenges. It will also imply more sustainable long term returns for investors, who should be willing to reduce the cost of provided capital as a result.

- Introducing water leakage detection across the water network helps to offset some of the population growth implications, reducing the pressure on the water abstraction

- Investment in innovative solutions around water sourcing is another key active solution with large environmental returns: implementing water capture or water reuse technology can avoid abstraction in the first place

- A water utility investing in water reuse will help to minimise the water abstraction, protecting the natural resource. It will have a more resilient business structure than that which increases its abstraction volume in response to securing larger water supplies for the future demand. The benefit is thus not just enhanced sustainability of the water resources, but a more attractive investment opportunity that attracts capital and reduces its cost.

3. Sharing the benefits fairly…and the costs

The bill for water resource management is too big for population to carry, and the risk to the business model in trying to keep it can be the escalation up to re-nationalisation or falling affordability of the water bills. As benefits should be shared fairly, so should the costs. Thus part of the burden needs to be moved onto other economic players.

A utility is best positioned to create a positive environmental impact by cooperating with external parties. These strategies can help to minimise the harm made to the environment, for example through pollution or over-abstraction controls. Working jointly with all stakeholders of water resource will help create positive outcomes for environment. This cooperation will also help utilities to reduce the amount of future investments needed to solve the issues, thus protecting against the water bill inflation – a positive outcome for society.

The sector can attract
long-term investors

Attracting the investors that acknowledge the environmental and social positive outcomes as the key investment drivers will bring the industry’s long term cost of capital down, simultaneously enhancing the utilities’ focus on environmental and social challenges.

So what practical steps can the water industry to attract long term investors?

There are many ways for water utilities to be individually sustainable – and for impact-focused investors to build their cases. What is most needed is a unified approach to assessing the business and incentivising it for this positive contribution.

Improved transparency would be the most effective way of:

- Reducing the perceived risk of investment
- Reducing the cost of capital
- Attracting the right amount and type of investors

A framework that formalises the key ingredients of sustainable and positive business model for water utilities will also play a key role in meeting the needs of customers and the environment – and building the reputation of the entire industry and its individual players .

Alina Donets is a Portfolio Manager on Allianz Global Water fund, and a Vice President Equity Research Analyst at Allianz Global Investors GmbH

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