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Pension fund portfolios and water risk

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Why is water important?

South African cities, such as Cape Town, Port Elizabeth, Durban and Johannesburg, have in the last five years each experienced drought and severe water stress. Most recently, and perhaps most severely, the City of Cape Town experienced the worst drought in over 100 years, resulting in strict water restrictions and significant concern being expressed by city residents, local and national government and the business community.

Incidents of drought and water shortages have affected millions of South Africans. This has brought the true value of this natural resource to the forefront of people’s minds, as water scarcity increasingly becomes an issue that can no longer be ignored. Our dependence on water extends beyond our biological or sanitation needs, as it has an economic value across all its competing uses. Water poses both an economic and social purpose, requiring both business and civil society to become better water stewards by becoming water wise and protecting our shared water resources.

Water therefore plays a crucial role in South Africa’s economic growth and development, serving as a primary input to production and the basis for sustaining life and the environment. This resource should therefore be recognised as an economic and social good.

What is water risk?

Approximately 70% of our planet is made up of water. However, only an estimated 2.5% of this is freshwater. From our freshwater sources, less than 1% is easily accessible to support the planet’s 7.7bn people.

Water is a finite resource and a basic need in South Africa. According to a 2017 WWF SA report, titled Together investigating the future of South Africa’s water supply, the demand for water is expected to increase by 32% in 2030 relative to 2016 due to increased population growth, industrial development and urbanisation. It also forecasts that South Africa will reach a water deficit of 17% by 2030.

According to an online article published by the World Economic Forum in April 2019, water risk is ranked as the fourth-highest risk from a likely negative impact perspective to doing business. The uncertainty of the future supply and availability of water places significant risk on water-intensive industries such as agriculture, mining and manufacturing. The scale and nature of water risk will vary from one industry sector to another. These risks fall into three categories – physical, regulatory and reputational risks – with each posing a financial risk to a business and its investors.

I. Physical Risk

The relative freshwater scarcity, extreme weather events and projected impacts of climate change on water accessibility create uncertainty about reliable water availability in the future. According to the WWF SA report, the projected climate change impacts on freshwater availability in South Africa are rated as one of the highest risks for businesses because rainfall patterns in South Africa will increasingly vary. The western part of South Africa is expected to become drier, while wetter conditions are projected for the eastern part of the country. Changing rainfall patterns will also impact the type of crops that can be grown across the country, as well as the overall food security in South Africa.

The other component to physical risks resulting from water scarcity is the state of South Africa’s ageing water infrastructure systems. Second to the recent droughts and water crisis, South Africa’s water infrastructure has increasingly been put under the spotlight. According to the department of water and sanitation there is a maintenance backlog of approximately R10bn, which could increase water prices in the future. Physical risk will be at an even higher level if sufficient and necessary water infrastructure maintenance does not prevent any further ageing and erosion of South Africa’s bulk water infrastructure system.

II. Regulation

The South African water sector is governed by legislation and regulations that enable the creation and management of institutions and policies for water management at both national and provincial level. However, most of the legal regulations are not fully enforced. Poor enforcement of water-related legal frameworks, such as water-use licences for metals and mining companies, can put further strain on an already constrained water supply in such regions. The risks for people and business are not only supply related, but also include the potential financial losses for those businesses who do not comply with water rules and regulations and will be subject to forced shutdowns and/or significant fines and penalties.

III. Reputational risks

Reputational risk becomes more apparent as people become fully aware of their basic human right of access to clean water. Growth in water demand due to population growth and increased urbanisation will require water to be redirected from rural water catchments to urban water catchments. As a result, there will be increased competition between business and communities on a number of water-influenced socioeconomic factors, such as prioritising clean and healthy water for human consumption to meet human basic needs.

Reputational risk also comes into play when perception around water use, pollution and corporate behaviour on water usage may have negative impacts on a company’s brand, influencing  the purchasing decisions of its consumers. When the actions of a company are poorly executed, understood or communicated with local stakeholders, the consequence is that the brand, and perceptions of it, may suffer, resulting in unnecessary financial losses to the company and its shareholders.

 

Water stewardship

Water stewardship is a new way of thinking about water management, which encourages water use efficiency and improving management of water-related activities. Increasingly, business dependency on freshwater is being recognised and understood. There is also an appreciation of the positive role business can play in overcoming the water challenges we face.

To improve sustainable management practices of water-related activities, it is imperative to form effective partnerships with the private sector, public sector, NGOs and local and national government to mobilise resources and map out roles that different stakeholders can play in, for example, critical river catchments. The private sector is increasingly showing interest in forming partnerships to formulate mitigation initiatives to reduce shared water risks.

 

How should investors respond?

It is most important that the business sector understands and evaluates its exposure to water risk, as it can have a serious impact on business operations. For example, according to a Cape Chamber of Commerce survey, the estimated impact of Day Zero on Cape Town business was the following:

More than 6.7% of businesses were expected to shut down on Day Zero due to not being able to function without municipal water supply;

11% would have had to send their staff home;

79.4% believed the situation was a significant threat to their business operations.

Businesses should strategically evaluate their supply chain, including customer vulnerability, to determine what can be affected by water risk. This will help business understand where in the water value chain water risk points are so that the relevant mitigation and adaption actions can be taken.

A key first step in reducing water scarcity risks is to have a better understanding of the freshwater ecosystems in which companies operate, and to seek to optimise the range of goods and services these ecosystems provide to a broad range of stakeholders.

The second step would be to assess water risk across investment portfolios and proactively engage investee companies to manage water-related risks. Tools such as the WWF Water Risk Filter (available at https://waterriskfilter.panda.org/) and the Carbon Disclosure Project can be used to assess water risk for specific industries in specific locations in relation to various risk drivers. More information on water-related environmental, social and governance (ESG) issues and improved water risk management may be achieved through increased company engagement through water stewardship activities on the part of retirement and pension funds.

Why is this important for trustees?

According to ASISA, South Africa’s retirement fund industry is worth approximately R3.6tr, representing approximately 40% of the South African savings industry. This number includes the Government Employees Pension Fund assets (approximately R1.9tr). As investors and shareholders of these assets, the ultimate beneficiaries of these funds have significant power to engage asset managers and corporates on any issues that may impact the long-term performance of their investments. The UN Principles for Responsible Investment (PRI) refer to such engagement as active ownership, which is a core component of being a responsible investor. In this context, active ownership refers to being an active shareholder through:

Exercising the right to vote proxies at investee company AGMs for example; and

Engaging with companies to address any material issues of an environmental, social or governance (ESG) nature that may impact the long-term value and return of an asset. 

Active and engaged shareholders can be very effective in influencing companies’ behaviour in addressing water risks so as to ensure value creation over the long term. Further to this, Regulation 28 of the Pension Funds Act makes responsible investment a regulatory requirement by stipulating that pension fund trustees must “give appropriate consideration to any factor which may materially affect the sustainable long-term performance of a fund’s assets, including factors of an environmental, social and governance (ESG) character.” The Guidance Note on Sustainability of Investments and Assets issued in June 2019 by the Financial Sector Conduct Authority (FSCA) builds on this regulation and seeks to encourage better disclosure and transparency by retirement and pension funds in this regard.

It is evident that ESG issues, such as water risk, should be considered in pension funds’ investment and active ownership processes. Trustees, being elected guardians of these assets, have a crucial role to play in ensuring that, as per their fiduciary duty, they are engaged and active investors across their portfolio of investments.

What can trustees do?

There are a number of ways trustees can ensure that water risk is appropriately addressed in their funds. These include the following: 

1. Ensure that ESG factors are incorporated within the fund’s investment policy, philosophy and investment management process.

The fund’s investment policy, philosophy and process should specifically address how ESG issues, such as water risk, are considered in the investment process where such issues may have long-term financial implications on underlying investee companies. Such considerations should also be included in the investment mandate provided to the underlying asset manager/s contracted to manage the pension fund’s assets. Regular monitoring and reporting by investment managers to the pension fund should give the board of trustees confidence that such issues are being appropriately addressed by their service providers.

2. Ensure that your fund has an active ownership policy and process in place.

  • An active ownership policy should be developed to encompass both proxy voting and engagement responsibilities with investee companies. A proxy voting policy acts as a guideline for how a fund’s shares should be voted by their investment manager/s. These guidelines should address pertinent issues of an ESG nature that may come up for shareholder approval at a company’s annual general meeting (AGM)
  • The fund should also understand the nature of the engagements on ESG issues between investment managers and the companies in which they invest and the outcomes from such engagements.
  • Some possible questions that relate to water scarcity and water risk that a trustee may want to address with investment managers / investee companies could include:
  • Does the company adequately disclose its water consumption in its annual or integrated report? If its operations use a significant amount of water or its suppliers do, are water consumption volumes sufficiently disclosed?
  • How has the company’s water consumption changed year-on-year and what measures are in place to reduce water consumption and/or to conserve or recycle water?
  • Does the company make disclosures to CDP and CDP water?

3. Assess your fund’s water footprint

Understand your fund’s exposure to and reliance on water at overall portfolio level. This analysis should identify companies within your investment portfolio that are most exposed to water scarcity and water risk; understand which investee companies are leaders and/or laggards in managing their water risk; and which are compliant/non-compliant with environmental laws etc. This holistic analysis can help in understanding how the fund is impacted by water scarcity and water risk across its investment portfolio and also provide powerful information to engage asset managers and investee companies on the management of such ESG risks.

4. Consider allocating assets to investments that have a specific mandate in place that addresses water stewardship / water resilience as a key outcome.

As per Regulation 28, a fund may invest a portion of its portfolio in unlisted assets. In some instances, these alternative assets may have specific environmental or social impacts over and above risk and return objectives. A number of impact funds that have such a dual mandate are available in South Africa. Trustees could consider consulting their investment consultants and investment managers to learn more about these types of investments.

 

REFERENCES:

WWF-SA. 2017. Scenarios for the Future of Water in South Africa. Available: http://awsassets.wwf.org.za/downloads/wwf_scenarios_for_the_future_of_water_in_south_africa_v7_6_pf_1.pdf

WEF. 2018. Available: https://www.weforum.org/agenda/2019/04/these-are-the-biggest-risks-facing-middle-east-and-north-africa/

Cape Chamber of Commerce. 2018. Available: http://capechamber.co.za

ASISA. 2019. Available: https://www.asisa.org.za/ [This number includes the Government Employees Pension Fund assets (approximately R1.9 tr).]

Financial Services Board Pension Funds Act 1956 Regulation 28 (2) (c) (ix). 2019. Available:  https://www.fsca.co.za

Sustainalytics and AP7 Water Management and Stewardship: benchmarking Corporate Practices, June 2019. Available: https://www.sustainalytics.com/esg-research/stewardship/water-management-stewardship-benchmark-2019

 

THe CARBON DISCLOSURE PROJECT (CDP)

The Carbon Disclosure Project (CDP), runs a global disclosure system that enables companies to measure and manage their environmental impacts. Areas of focus include climate and water. There are a number of South African companies that participate in this project and therefore publicly disclose water and carbon data on an annual basis. If a company uses a significant amount of water in its operations, it is global best practice to participate in the CDP or similar initiatives and to seek to improve its outcomes year-on-year, and to learn from peer reviews and sector leaders in an effort to improve performance.

For more info on the CDP, visit: https://www.cdp.net/en/info/about-us

 

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