Water and credit investment opportunities in climate change era

Converting water-related challenges into credit opportunities can be a complex task. Here we discuss how our strategy of active engagement navigates this evolving investment landscape – by Saida Eggerstedt

Water, an underappreciated natural resource, is essential to every production plant and every community. Its socio-economic and environmental importance cannot be overstated. However, responsible and conscious use of water, with specific usage targets, reduced wastewater, and clean return of unused water to nature, are yet to become a global norm.

According to the World Economic Forum, US$175 billion per year will be needed to achieve the targets for UN Sustainable Development Goal (SDG) 14 (Life Below Water) by 2030. In parallel, an estimated annual US$114 billion, according to UNESCO, is needed to accomplish UN SDG 6 (Clean Water and Sanitation) within the same time frame. These staggering mandates should align the national agendas of countries globally towards addressing water scarcity, which currently impacts at least 50% of the world’s population under high water stress conditions for at least one month a year.

So, why might the water sector represent a valuable investment opportunity for credit investors? Well, there are several compelling reasons.

Firstly, water companies are consistently involved in ongoing capital expenditure projects, including new initiatives and maintenance. This expenditure is primarily financed through the bond market, making them a strong candidate for credit investment.

Secondly, given the importance of credit investors in financing water projects, we often play a key role in shaping the governance and sustainability parameters.

Lastly, the use of sustainable bonds by water companies is increasing. These instruments not only provide an investment vehicle but also allow investors to contribute indirectly to environmental conservation and responsible usage schemes.

Unearthing opportunities in the midst of global water challenges

To tackle issues relating to water sustainability, covering both scarcity and management, companies will need to adapt to the changing environment, as well as new regulation from governments battling to mitigate the effects of rising temperatures. These changes present both threats and opportunities within the credit market.

Driven by climate change, technological breakthroughs and policy shifts, the landscape of water-related investments requires an active engagement strategy to discern good investment cases from the less promising. More specifically, the ones with a long-term plan to tackle climate change risks from those running day-to-day operations with eye only on short-term profits.

We aim to highlight the importance of active ownership by credit investors through examining some real-world examples of water management companies.

Surging forward: strategic assessments and impactful collaboration

Our collaboration with companies encompasses examining various key factors linked to water utilisation. For instance, we assess the efficiency of their water use and the extent of water wastage. Some sectors with unexpectedly high-water usage include the technology sector, where semiconductor manufacturers are among the largest industrial consumers of processed water. In these cases, we evaluate how potential investee companies are innovating with water reuse and recycling strategies to reduce their environmental impact. A prime example of our analysis and engagement efforts can be found in our work with the South Korean semiconductor company SK Hynix, the world’s second-largest memory chip manufacturer and a leading semiconductor supplier.

Since our decision to invest with a particular focus on social and environmental impact, notable advancements have been made by the company. It has enhanced its monitoring and water reuse rates, while also increasing the volume of treated and bypassed wastewater, particularly through a significant investment made in 2023 aimed at further diminishing water usage and wastewater generation. Moreover, the company has optimised its total energy consumption, recognising the economic impact. To further contribute to environmental sustainability and biodiversity conservation, an ecological park has been constructed by the company — a testament to its commitment to positive environmental practices.

The benefits of active engagement

Working with companies as a credit investor, active engagement is more than a mere investment strategy. It becomes a dynamic window through which we can probe into the integral workings of a potential investment – gaining insights about everything, from a company’s operations and future plans to the potential risks and opportunities nestled within. This granular level of understanding can be a game-changer, separating sustainable investments from those bearing substantial risks.

Active engagement encourages a two-way exchange of information, which enables investors to voice their expectations clearly and achieve good understanding. Through such engagement, credit investors can conveniently track the sustainability efforts, environmental social and governance (ESG) performance, and the creditworthiness of their investments.

Case study 1: the win-win scenario with American Water Works

Let’s turn our attention to American Water Works (AWW), the largest public water and wastewater utility in the US. According to the company’s website it services more than 1,700 communities with safe and reliable water, serving 3.5 million customers across 14 states.

Its commitment encompasses an affordable pricing strategy designed to cater primarily to residential customers, maintaining water costs significantly below the Environmental Protection Agency’s (EPA) suggested guidance of 2% of household income. This initiative directly aligns with SDG 6, which underscores the need for safe and affordable drinking water for all.

The company’s forward-thinking approach is also visible in its wide array of initiatives towards water conservation, which include leak detection programs and consumer education campaigns. Simultaneously, the company prioritises investments in infrastructure upgrades and the adoption of renewable energy sources, significantly aiding in water management efforts.

It is clear that American Water Works is committed to sustainability, as we found out through our analysis and engagement with the company.

Our most recent engagement involved exploring several environmental, social and governance topics. These included the topic of water quality and resource management, initiatives in renewable energy, and proposals for rate adjustments. We also discussed the company’s operations across numerous states, a significant expenditure of US$1 billion for Perfluoroalkyl and Polyfluoroalkyl Substances (PFAS -a type of pollutant) issues, and an aim to entirely replace lead materials by the year 2030. The company gave some insight into its growth strategies as well, which include plans for adding customers and a renewed dedication to renewable energy, solar energy in particular.

Through active engagement, we as investors have a timely awareness of the strategies and measures employed by companies like American Water Works, affording us the ability to assess future performance and creditworthiness actively.

Case study 2: navigating the turbulence with a UK water company

Active engagement doesn’t merely highlight the positives. In the case of one of the largest water companies in the UK, our active engagement brought to light issues related to pollution and regulatory fines. These red flags led to a decision to exit this credit investment in 2023, underscoring active engagement’s role in identifying and mitigating investment risks.

Since our divestment, news reports of regulatory action against several UK water companies have further highlighted how active engagement can uncover regulatory risks, providing crucial insights for credit investors. In this context, the role of active engagement in maintaining alignment with environmental sustainability, as outlined in SDG 14, becomes even more critical.

Active engagement played a crucial role in not only identifying these risks but also providing an avenue for investor dialogue with the investee water company, underlining the need to improve governance and operational issues.

Advancing with active engagement

These case studies illustrate how active engagement sharpens our perspective as credit investors, enabling us to navigate the intricate landscape of water sustainability. There are many challenges ahead, not only in the shape of outdated infrastructure and inadequate wastewater management practises, but also in the form of accessing clean water. And as we’ve now seen in the case of the UK, the regulators are not sitting idle anymore. The Water Services Regulation Authority (Ofwat), the body responsible for economic regulation of the privatised water and sewerage industry in England and Wales, shook the industry in August this year by outlining fines totalling GBP 158 million and launching robust investigations into premature sewage spills. Similarly, the Environment Agency’s plan to reimpose unlimited fines for polluters is indicative of a tougher regulatory future.

These regulatory repercussions signal the rising importance of financial risks and compliance in the water sector. They also highlight the potential for credit investors to incentivise better compliance and improved water management strategies.

While active engagement helps identify a company’s dedication towards sustainable water practices, it equally helps unmask ESG and regulatory risks. We are looking to deepen our engagement with companies especially around emissions of water. More specifically, we wish to focus on the metric of how many tonnes of emissions are discharged into water by investee companies for each million EUR invested. At present, data in this area remains inadequate, and we believe it’s paramount to clearly define this metric to better understand the emissions represented within our portfolios so that one can also engage on mitigation steps.

At Schroders, active engagement extends beyond aiding in investment choices. It aims to influence companies towards sustainable operations and practices. Even after exiting a credit investment our engagement continues, allowing future cooperation possibilities and possible future investment opportunities.

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_{For illustrative purposes only and does not constitute a recommendation to invest in the above-mentioned security / sector / country.}

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_{On 17 September 2018 our remaining dual priced funds converted to single pricing and a list of the funds affected can be found in our Changes to Funds. To view historic dual prices from the launch date to 14 September 2018 click on Historic prices.}