The watershed year for H2O

16 Jan 2022 | Climate litigation. ESG flows. Sovereign debt woes. Plus, green investing goes blue.

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👨‍⚖️ Last year was one of the top-five warmest on record, setting the stage for a 2023 characterised by climate litigation (which had, already, doubled between 2015 and 2022). The Guardian spotlights a case of unprecedented magnitude, filed against the state of Montana by citizens claiming violation of their constitutional rights including to “a healthy and clean environment.” Financial rights haven’t fared much better in some states. According to a new study, the boycott of ESG-friendly financial groups by Republican state officials has cost taxpayers $708M in higher-interest payments.

⛵ Did Vanguard quit NZAM because US retail customers in passive funds are less motivated by and/or able to act on climate? So Reuters argues. Of the $8T overseen by Vanguard, 80% sits in (mostly retail) vanilla index funds, which can’t be tailored to specific social or environmental objectives. By contrast, the other ‘Big Three’ firms — BlackRock and State Street — are NZAM loyalists. Perhaps it’s easier to ignore the GOP backlash when you cater to a higher relative proportion of institutional (and, indeed, European) clients, who are more likely to demand sustainable products.

💰 The energy crisis (coupled with a tech sell off) made it a challenging year for their relative performance, but 2022 flow data underscores the enduring appeal of sustainable investments. ESG ETFs accounted for 65% of all flows into European ETFs in 2022, up from 53% in 2021. The €51B in new capital brought total assets from €235.3B to €248.8B, or nearly 20% of the total European ETF market. Potentially a bigger threat to 2023 data, the rising benchmark for sustainable products is putting pressure on providers to justify or downgrade their strategies.

💳 2022 was a “brutally” expensive year for natural disasters, reports the FT. Munich Re recorded global losses of $270B, of which $150B were uninsured. Developing nations suffer more and yet are less likely to have coverage, warns Simon Mundy. Pakistan is an alarming case in point. Munich Re assessed its $15B in flood damage (the highest disaster bill of any event, bar Hurricane Ian) as “minor,” i.e. too low for a meaningful insurance estimate. Not even middle-income nations are insulated: In China, flooding losses came to $5B, of which only $300M were covered.

🗺️ Pakistan’s national debt is $274B (c.90% of its GDP), of which $100B is owed to external lenders. Reeling from interest rate rises, many low-income countries are one economic or environmental shock away from bankruptcy. Unfortunately, the global sovereign debt crisis comes as natural disasters are escalating in economies already in dire need of adaptation and mitigation funds. Defaults would jeopardise private investment from risk-averse institutions. Facing calls for a dramatic international financial response, the IMF and multilateral banks have a busy year ahead.

The watershed year for H2O

Just before the credits roll in the Big Short, a caption tells viewers that Michael Burry/Christian Bale — famous for having called time on the subprime mortgage crisis — is “focusing all his trading on one commodity: water.”

Of all the stuff covering the world’s surface, 3% is freshwater or suitable for crop irrigation. Of that, just 1% is safe for human consumption. UN data show that one quarter of the world’s population lacks access to drinking water; up to a half will live in water-stressed areas by 2025. By 2030, finds Morgan Stanley, demand will exceed supply by 40%. The dislocation presents enormous risks. It also creates opportunities.

For now, the former is dangerously underpriced by investors, warns CDP. Despite having caused 75% of recent disasters, water-related events were identified as a portfolio risk by just 18% of institutions in 2022. Sure, it’s easier to turn a blind eye to events happening in regions of the world that you can’t see — or, from an investment perspective, to which your capital isn’t exposed. But ravaging water crises risks permeate most regions and sectors.

Take the US. Having cost California $34B so far, recent floods are still not enough to mitigate the effects of record-setting droughts in 2022. The Colorado Basin, which supplies water to 40M people in seven states, remains endangered. Jackson, Mississippi faces more shortages, after 150K citizens lost access in August.

It isn’t a crisis with ‘only’ humanitarian casualties (were that the case, it’s safe to assume Burry wouldn’t be interested). Water is a vital resource and component in the production of almost everything, particularly in the agriculture, textiles, mining, and energy industries.

Some US$15.5B has been or is at risk of being been stranded. It makes access to or more efficient use of water a valuable advantage for the winnowing number of companies able to feed, clothe, or connect a growing population without interruption. Insulation from the operational and supply-chain damage wrought by droughts or floods will only grow more critical.

Financial risk is investment opportunity

Among January outlooks, there was one notable consensus view: 2023 will unleash a torrent of nature-based investments.

Though the nature and climate crises are inextricably linked, nature-related risk has long been in the shadow of its cousin. That began to change at COP 15, where the finalised Global Biodiversity Framework unlocked commitments to and capital for nature. Coming up in March is the first dedicated UN water conference in recent memory, which is expected to fan awareness — and investment appetite.

RBC Capital Markets predicts forestry, agriculture, and especially water will outperform other sustainability themes in the year ahead. Beyond creating a fertile ground for companies with access to water, shortages (coupled with a growing population and industry reshoring) are a tailwind for water infrastructure, innovation, and efficiency. There, argues RBC, investors will find high-quality defensive exposure. It certainly has upside potential: Today, 80% of wastewater is released untreated.

But the early stage of adoption yields obstacles as well as opportunities. Compared to climate or emissions, investors are dealing with a data deficiency when it comes to water-related risks and impacts. Neither reporting frameworks nor regulations are fully evolved, resulting in a relative dearth of first-party company information.

In the mining sector, controversy over water use has added to the incentives to invest in mineral production in the US, reports the FT. Reshoring could lead to better regulated localised processes and lower transport-related emissions. But it’s not only the archetypal negative-impact industries that require greater scrutiny.

The S&P Global Water Index (featured below) is comprised of companies of the type recommended by RBC, justifying its positive impact on SDG 6 (Clean Water and Sanitation). Utilities and infrastructure tends also, however, to have a broadly negative impact on the environmental SDGs 13 (Climate Action), 14 (Life Below Water), and 15 (Life on Land). If not armed with holistic sustainability data, investors seeking to capitalise on the opportunities created by the water crisis may, inadvertently, contribute to the same issues that catalysed it in the first instance.