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Should Your Investment Strategy Incorporate a Climate Risk Discount?

By Cyrus Lotfipour, Vice President, MSCI and MSCI ESG Research

Consider these three recent developments: California emerged from drought in April 2017, fewer companies reported impacts associated with water scarcity[1], and the average freshwater intensity of companies in the MSCI ACWI Index dropped by 15 percent between 2015 and 2016[2]. While these are positive short term signals for investors concerned with water scarcity, 2017 was also the most costly in U.S. history for natural disasters[3]. This underscored the thinking behind a key trend that MSCI ESG Research identified in the beginning of 2017[4]: institutional investors are shifting their portfolio analysis from the measurement of regulatory risks, such as the U.S. withdrawal from the Paris Agreement, to physical risks, such as exposure to coastal flooding along the U.S. Gulf Coast.

Measuring Water Risk at the Company and Fund Level

MSCI ESG Research assesses risk from water scarcity based on two key variables: how much water a company needs, and how secure is the supply. By way of example, consider two U.S. utilities: Ameren Corporation and Xcel Energy. In 2016, both companies required more than 200,000 cubic meters of freshwater for every USD $1 million in revenue (as of June 30, 2017 based on MSCI ESG Research analysis). While both Ameren and Xcel need large volumes of water to produce power, they face different physical limitations based on the location of their operations. Ameren mostly draws water from states with a relatively high level of water security, such as Missouri and Illinois. Xcel, on the other hand, has most of its operations located in Texas and Colorado, where water resources are already stressed and competition for water is likely to intensify between industrial and agricultural users[5].

A similar level of scrutiny can be applied at the portfolio level. Consider two U.S. funds with similar investment objectives: the PowerShares High Yield Equity Dividend Achievers Portfolio (PEY) and the WisdomTree US Dividend ex-Financials Fund (DTN). On average, holdings in these funds require more than 65,000 cubic meters of water per dollar of sales to operate, ranking in the top 10 percent of all funds in our coverage of over 26,000 mutual funds and ETFs (as of June 30, 2017 based on MSCI analysis). However, based on the geographic distribution of each fund’s underlying holdings, DTN has approximately 60 percent of its asset value invested in high risk regions, while for PEY, the allocation to high risk geographies is 45 percent. Without measuring the potential water risk of an income-focused strategy, investors may run the risk of higher than anticipated exposure to an event such as a severe drought across a portfolio.

FIGURE 1: Measuring Water Dependency and Security in Global Equity Fund Holdings, as of Dec 2017

High Water Dependency_Chart- GreenMoneyJournal.com
Source: MSCI ESG Research, WRI Aqueduct

 

Shifting the Analysis From Scarcity to Flood Risk

While the costs associated with drought in the U.S. declined from USD $4.7 billion to USD $2.5 billion over the last two years, 2017 was one of the most tumultuous years for climate events. According to the National Oceanic and Atmospheric Administration (NOAA), 2017 was the most costly for natural disasters in U.S. history and exceeded the previous record set in 2005 by 42 percent[6]. Approximately 86 percent of the total economic cost was attributed to three hurricanes that exceeded USD $50 billion in costs, all of which made landfall within a one month timespan. The severity of these events served as a wake-up call for investors: not all water-related risk revolves around scarcity. Some investors may question the possible impact of climate change on their portfolios, but the 2017 U.S. hurricane season likely left little doubt about the financial costs that can result from events such as flooding and severe storms.

In one example, Hurricane Harvey resulted in USD $300 million in lost sales and related storm costs for the petrochemical producer, LyondellBasell[7]. The company has four large crackers, four polyethylene plants, and more than 2,000 miles of pipeline concentrated in a region that is prone to tropical storms. The impact of severe weather and flooding has also extended beyond operating assets. In Lake Charles, Louisiana, the South African chemical producer, Sasol, is building a USD $11 billion chemical complex that overlaps with a high risk flood zone. The project, already well over the initial USD $8 billion budget, in part due to weather delays and poorer-than-anticipated subsurface conditions, incurred an additional USD $130 million in costs related to the same storm[8]. As the frequency of severe weather events increases, investors may want to consider whether the projected return on investment adequately considers a discount for future climate risk.

FIGURE 2: Facilities Owned by Companies Held in Two Exchange Traded Funds: PEY and DTN

Water Risk US Map_msci

Facilities shown on map are limited to those owned by companies in the MSCI ACWI IMI as of Sept 2017. Fund holdings are updated as of Dec 2017. Source: MSCI ESG Research, US Federal Emergency Management Agency, US EPA Greenhouse Gas Reporting Program; Gassert, F., P. Reig, T. Luo, and A. Maddocks. 2013. “Aqueduct country and river basin rankings: a weighted aggregation of spatially distinct hydrological indicators.” Working paper. Washington, DC: World Resources Institute, December 2013.  Available here online.

 

To compensate for the fact that not all companies consistently report on the location of their assets, MSCI utilizes facility location and greenhouse emissions data reported to the EPA as a means of filling the disclosure gap. Of the approximately 3,900 facilities that report to the EPA’s Greenhouse Gas Reporting Program and are owned by companies in the MSCI ACWI Investable Market Index (IMI), 35 percent are located in counties that face a high level of water stress, based on the World Resources Institute’s Aqueduct water risk tool[9]. Accordingly, these facilities may face constraints on access to freshwater resources during periods of drought, a higher likelihood of community conflict, or greater operating costs as a result of shifting to alternative water supplies.

Using this same underlying data, we can map company assets to flood hazard zones designated by the US Federal Emergency Management Agency (FEMA). Although the National Flood Hazard Layer has deficiencies – chief among them is the failure to consider land use change in a timely manner[10] – the maps provide a useful overview of the key regions that are at risk. Among facilities located in hurricane-prone states[11], approximately 7.5 percent are located in regions that face a 1 percent annual flood probability.

Following a year of unprecedented costs attributed to hurricanes and flooding, more investors may seek out ways to improve their analysis of physical risks. This not only reflects the growing frequency of catastrophic climate events, but also the emergence of climate-related financial risk disclosure standards[12]. However, investors seeking to measure their portfolio exposure to water risk, let alone mitigate their exposure, face a significant challenge: location is critical, and not all data is created equal. Until companies are required to systematically report on the location of assets, the burden will fall on investors to integrate alternative data sources into their assessment of physical risk.

 

Article by Cyrus Lotfipour, CFA, Vice President and Head of the North American ESG analyst team for MSCI ESG Research. He spearheads MSCI’s water risk mapping initiatives and conducts research on the integration of water risks in the investment process. He also leads the Chemicals and Capital Goods industries at MSCI ESG Research, where he is responsible for the development of ratings methodology and thematic research in these industries. Based in New York City, Cyrus joined MSCI in 2009 and holds a dual degree in economics and biology from Bates College. He is also a CFA charterholder and a member of the CFA Society New York.

 

Article Notes:

[1] MSCI ESG Research analysis of quarterly earnings transcripts from companies in the MSCI US Investable Market Index (IMI) between 2015 and 2017 (-54% reduction in mentions of drought). Source: seekingalpha.com

[2] Calculated based on estimated and disclosed freshwater withdrawals per million USD sales in 2015 and 2016, data updated as of Jan 25 2018

[3] https://www.ncdc.noaa.gov/billions/

[4] “ESG Trends in 2017: A Fundamental Rethink?” Moscardi, Matt and Lee, Linda-Eling, MSCI ESG Research. https://www.msci.com/www/blog-posts/esg-trends-in-2017-a/0556760275 For our 2018 ESG Trends to Watch Report, visit https://www.msci.com/www/blog-posts/2018-esg-trends-to-watch/0828969046

[5] http://www.wri.org/our-work/project/aqueduct

[6] https://www.ncdc.noaa.gov/billions/

[7] USD $200 million was associated with lost sales and storm-related costs in Q3 2017 and an impact of USD $100 million was forecasted for Q4 2017. Source: LyondellBasell Q3 2017 Earnings Transcript. www.seekingalpha.com

[8] https://www.bloomberg.com/news/articles/2017-11-23/south-africa-s-sasol-tightens-purse-strings-for-new-projects

[9] http://www.wri.org/our-work/project/aqueduct

[10 Approximately 22% of community maps are based on data that is more than 10 years old (https://www.bloomberg.com/graphics/2017-fema-faulty-flood-maps/)

[11] Texas, Louisiana, Mississippi, Alabama, Florida, Georgia, South Carolina, and North Carolina accounted for 85% of hurricane landfalls between 1851 and 2015 (NOAA Hurricane Research Division http://www.aoml.noaa.gov/hrd/tcfaq/E19.html)

[12] https://www.fsb-tcfd.org/publications/final-recommendations-report/

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