Capital Ideas^™ 
Investment insights from Capital Group

Climate change is forcing investors to evaluate two new types of risk: transition risk, the cost of companies transitioning to low-carbon operations; and physical risk, the cost of increased drought, floods, severe weather and a rising sea level. Water stress is one of the most pronounced physical risks from climate change that investors must consider.

Droughts and water scarcity are unpredictable events with a proven ability to stop or reduce production quickly, cause late-stage project cancellations and ultimately alter industry market share. Within water-intensive industries, understanding how companies manage their water supplies can be a key factor in anticipating their longer-term performance.

The semiconductor industry provides a good case study: It is among the most water-intensive industries on a relative basis, and several “hubs” where chips are produced have been exposed to severe, long-term drought in the past. In response, several leading companies have found new approaches to water management, allowing them to recycle upward of 90% of water used and reinforcing long-term sustainability of operations.

In the past year, several large semiconductor companies announced new investments to build capacity in the United States, several of which will be in a growing manufacturing hub in Arizona. At the same time, the drought situation in Arizona is worsening. For the first time ever, in August 2021, the U.S. federal government declared a water shortage on the Colorado River that would trigger cutbacks starting in 2022. Arizona is set to lose 18% of its water allocation, or 63 million cubic meters. This amount represents the equivalent of total annual water consumption for the city of Phoenix, or Intel’s total annual water withdrawal.

Yet despite anticipated water shortages, Intel, the largest producer in the region, is likely able to access the amount of water it needs. In a meeting with Capital Group, the company explained its processes to be able to recycle 80%–90% of water. The company now consumes a very small percentage of fresh water in the region because of its on-site water reclamation facilities, which recycle water back into its own processes or into the municipal water system.

In addition to the reclamation facility, Intel’s water efficiency has significantly improved since it began operations at its Arizona manufacturing site. In the 1990s, Intel needed 2 gallons of municipal water for every gallon of ultrapure fresh water used in its chipmaking process (50% efficiency). Today, Intel uses only 1.1 gallons of municipal water per gallon of ultrapure water (90% efficiency).

Other sectors face tough challenges

The success of semiconductor companies may show a path forward for other water-intensive sectors, but some specific industries, like utilities and food and beverage companies, are likely to struggle. Utilities, which are by a factor of 25 times the largest users of water in Capital Group’s investment universe, cannot currently scale up their water recycling programs to mitigate their risk.

Utilities use water for two major purposes: 1. hydroelectric power, and 2. cooling thermoelectric and nuclear power. It’s intuitive that hydro-powered electricity requires water, but the scale of water needed for cooling thermal and nuclear power plants is also enormous relative to other industries’ water use. Three of the five largest water users in Capital Group’s universe do not have significant hydro-generation operations. And protecting against drought risk could require these companies to move their production sites or, if that’s not possible, switch away from hydro and thermal power altogether.

The risks facing the sector were on display last year in Brazil, where extreme drought caused a spike in electricity prices. Brazil, which derives about 65% of its energy from hydro, had previously diversified into thermal electricity sources (cutting hydro down from 90% of its total power supply) following an extreme drought in 2001 and 2002 that caused electricity blackouts and energy shortages. However, with the severity of the 2021 drought, the country still experienced massive utility price increases. The largest financial impacts are expected to come from higher energy costs for companies that are asset-heavy and energy-intensive but not self-sufficient in producing electricity.

Food and beverage companies face a different challenge. Because they withdraw and consume vast quantities of water — essentially reselling fresh water extracted near manufacturing plants for their products — these companies can face difficult community and regulatory relations in water-stressed regions. And while companies in other sectors have been able to navigate water cuts, shutdowns, regulatory hurdles and community protests by using a freshwater alternative — typically water treatment and recycling or desalination — this is not usually an option for food and beverage companies.

Implications for investors

As climate change continues to alter the planet, investors need additional approaches to understand essential risks and opportunities for resource-intensive sectors and companies. As part of our fundamental investment research process, we analyze how efficiently water-intensive companies manage their water usage.

Our analytical framework includes six different factors, which we use to gauge a company’s exposure to water risk:

How well companies score on these factors helps forecast their ability to operate effectively and deliver results — or not — in the future. Investors may also need to reexamine the near-term attractiveness of certain resource-intensive sectors to factor in the prospect that securing ample freshwater supplies may limit their growth ahead.

By integrating these types of frameworks into our analytical processes, we seek to better identify companies that are successfully adapting to meet the new challenges, as well as those that are likely to struggle to keep delivering value as conditions change. This new type of fundamental analysis can provide a crucial filter to help separate likely winners and losers in the future, potentially leading to better outcomes for investors in the years ahead.

Water risk: a global and local problem

Access to clean, fresh water is likely to be a growing concern in the decades ahead for some parts of the globe. A recent report by the Intergovernmental Panel on Climate Change (IPCC) concluded that continued global warming is likely to increase extremes in the hydrological cycle — meaning longer droughts and more severe flooding. In a 1.5-degree Celsius warming scenario, which is approximately the equivalent of “net-zero emissions by 2050” and aligned with the Paris Agreement, heavy precipitation is forecast to be 1.5 times as likely and droughts 2 times as likely to occur. In the most extreme scenarios considered by the IPCC, heavy precipitation could be 3 times as likely and droughts 4 times as likely. The result of these changes is a likely deficit of fresh water. According to the United Nations, the world is expected to face a global freshwater deficit of up to 40% by 2030.

Even though droughts can have global ramifications, water scarcity risk varies greatly by region and needs to be understood and managed locally. Water only becomes a material risk when companies operate (or attempt to expand into) severely water-stressed areas.

Managing water stress: Innovation is providing long-term resilience

Sectors with the greatest material exposure to water stress include utilities, energy, chemicals, food, beverage, hotels, containers and packaging, semiconductors, and construction materials. Companies in many of these sectors may be able to mitigate — and in some cases eliminate — water stress risk through selecting safer production sites, investing in recycling and establishing local freshwater alternatives.