Water-related risks are on the rise. Climate change is making weather patterns more erratic, and industrial and agricultural development are causing demand for water to outstrip supply. In a now frequently cited statistic, the World Bank's 2009 Water Resources Group report said that the global water deficit was set to reach 40% by 2030. That report also presented case studies on four regions--China, India, South Africa, and Sao Paulo--that have since experienced water crises.

This report examines the credit implications of water risk and the impact it has on our credit ratings. It looks at the effect of water risk on ratings between July 2015 and August 2017, and how we incorporated water-related factors into recent rating actions. This article is a continuation of a series of publications on how we incorporate environmental, social, and governance (ESG) factors into our ratings. Earlier publications include "How Does S&P Global Ratings Incorporate Environmental, Social, And Governance Risks Into Its Ratings Analysis," published Nov. 21, 2017, "How Environmental And Climate Risks And Opportunities Factor Into Global Corporate Ratings - An Update," published Nov. 9, 2017, and "How Social Risks And Opportunities Factor Into Global Corporate Ratings," published April 11, 2018.

What Is Water Risk?

Water risk is a broad environmental factor, encompassing water stress (the ratio of demand to annual renewable supply), risks associated with water quality that create scarcity, weather events, and other risks. Climate change will have a detrimental impact on both the provision and quality of freshwater resources around the world. Associated impacts from climate change and the depletion of groundwater is leading to coastal flooding, subsidence, and saltwater intrusion (where seawater gets into freshwater acquirers). Other types of water risk include weather events such as excessive precipitation leading to flooding.

Environmental risks are not always negative for credit. For example, China's focus on environmental protection and increasing demand for natural gas instead of coal led us to revise outlooks to positive for China Resources Gas Group Ltd. in June 2017 and China Three Gorges in November 2015. The energy transition to low-carbon technologies has also led to positive outlooks and upgrades in the energy and automotive sectors. As markets and issuers absorb the impacts of droughts, floods, and declining water quality, there are opportunities as well as challenges.

How Water Risk Affects Credit Ratings

The impact of water risk on credit ratings can be both direct and indirect, such as through volatile agriculture commodity prices creating supply chain risk. To examine the broad extent of its impact on credit ratings, we reviewed our research updates--which we publish in the event of rating, outlook, or CreditWatch actions--over a two-year period, from July 2015 to August 2017.

We focused on two main categories of water-related risks: event-driven and continuous factors. Examples of event-driven factors are droughts, heavy rain, and floods, which have one-off impacts. Continuous factors relate to issuers that are dependent on water and weather as a resource or service, which means that water represents an inherent risk or opportunity (see table 1). We excluded weather factors that were unrelated to water (such as heatwaves, or wind). However, we took into account cases in which weather in general could influence creditworthiness, as this could include precipitation.

Table 1

Water was a common environmental factor in rating actions

We published nearly 9,000 corporate research updates from July 2015 to August 2017. Of the research updates published over this period, environmental and climate factors were relevant in 717 cases. Of these, water factors were an important consideration in 197 cases, which is 27% of the total (see table 2). We found 28 rating actions in which water factors were a key reason we raised or lowered ratings, revised outlooks, or placed ratings on CreditWatch. Water factors were mentioned an additional 169 times, meaning they played a part, but not a predominant one, in the rating, outlook, or CreditWatch action. Water factors were as frequently identified as material to issuer credit ratings as social factors.

Table 2

For some cases, water risk was mentioned but may not have been material for the rating change. For example, we cited poor water quality affecting fishing volumes in the upgrade of ASG Parent LLC on June 21, 2017, but the upgrade was driven by improved operating performance and cash flow generation that led to a reduction in leverage. In other cases, water was material to the rating. For example, a severe drought in 2017 affected Brazilian sugarcane processor Jalles Machado, reducing the amount of cane available to process and leaving facilities idle for a period. As a result, we revised the outlook to stable from positive.

Water risk most frequently affected industries that are water-intensive or where weather influences consumers

Water-intensive industries (utilities and power, metals and mining, agriculture) and industries where weather influences consumer behavior (branded nondurables, leisure and sports, business and consumer services, retail and restaurant) were most exposed to water factors. Unsurprisingly, electric and water utilities featured frequently. Notably, the São Paulo drought resulted in negative rating actions for water and waste utility SABESP and electric utility Companhia Energética de São Paulo (CESP), which operates hydropower plants. We took positive rating actions after hydrological conditions became more favorable.

Chart 1

Water factors were mostly negative

Approximately 70% of ratings actions in which water risks were a key factor were negative, with half being downgrades (see chart 2). By comparison, three-quarters of rating actions with social factors and half of environmental and climate-related rating actions were negative.

Issuers that offer water solutions, such as water treatment technologies, have positive influences on credit. For example, our affirmation of the ratings on SPCM S.A. (the parent company of the French chemicals company SNF), cites its exposure to municipal and industrial water treatment end-markets as supportive of its resilience to GDP cyclicality. Its business also benefits from the increasing scarcity of clean water and natural resources.

Chart 2

Table 3

Events had a greater credit impact than continuous risks and opportunities

While continuous factors were present in more credit analyses (61% of cases), event-driven factors were more likely to cause a rating action. There was a rating change in 24% of the cases with event-driven factors, and within that figure only 17% were positive. As climate change continues to fuel volatility in other weather systems and the hydrological cycle, we could see more rating actions caused by water-related events. Where continuous factors were a key driver in a rating change, the result was split evenly between positive and negative actions.

Chart 3

Table 4

Is Water Risk Still In Fashion?

In addition to the above review, we looked at how water risk passes down the supply chain from cotton agriculture to the apparel sector. The example demonstrates how ESG factors are interwoven with broader credit considerations.

In 2011, floods affected cotton production in some key regions, and as a result of this and other factors, cotton prices started to rise--reaching heights not seen since the American Civil War. The effect of this rise rippled through the supply chain to apparel and textile producers. In 2018, a severe drought is affecting cotton production in the U.S., and there are droughts and floods in India. Will history repeat itself?

In the supply chain of apparel retail, water is used to grow cotton, and bleach, dye, print on, and finish the fabrics. The cotton crop needs lots of water to be able to produce high-quality fibers needed for the production of cloth and yarn. It needs more water than other fiber-producing crops like sisal, flax, and jute. Different cotton-growing regions require different amounts of water due to changes in evaporation rates. For example, Egypt and Syria have high evaporation rates and high water requirements, whereas the U.S. and Brazil have lower evaporation rates and so cotton can be grown with less water. Too much water is also a concern for farmers, as floods can wipe out whole fields.

Chart 4

In 2010, severe floods affected China's cotton-growing provinces Henan and Hubei. To compensate, China, the largest global consumer of cotton, began to increase its demand for imports. Supplies had been low over several proceeding years and the ratio of cotton stocks to consumption fell to its lowest level in 15-years. Then in early 2011, floods in Pakistan destroyed 16% of the nation's crops. Prices began to rise as India put a ban on exports, and the price of cotton hit more than $2 per pound for the first time in almost 150 years. Many analysts at the time noted that mills were panicking, which further fueled the price increase.

We cited the record cotton prices in our rationales for a number of rating actions during this period (see chart 5). There were mostly negative actions in the aftermath of the rise in cotton prices, but outlooks shifted to positive in late 2012. Burkina Faso's economy was reliant on cotton exports and the period of high cotton prices strengthened its credit metrics, although it did not lead to a rating change.

Chart 5

In 2018, we have seen drought affecting the south of the U.S. and drought and floods affecting Gujurat in India, both large cotton-producing regions. India is expected to see a 30% reduction in exports, according to Reuters. The impact of these environmental events on prices and credit is complex to assess. Many factors influence prices, including environmental, political, economic, and market factors. Their interaction is what drives the price, and so even if environmental conditions reduce the production of a commodity, prices may rise or fall, depending on other conditions.

The political and economic landscape today is different than in 2011. Although India is exporting less cotton, the government has not put a temporary ban on exports, as they did in 2011. Turkey has reduced its imports of cotton from the U.S. amidst currency depreciation and trade tensions. China has raised tariffs on U.S. cotton imports in response to tariffs the U.S. placed on importing Chinese goods. Further to this, China has been stockpiling cotton in the last few years, and although it has declined from its 2014 high, the U.S. Department of Agriculture projects China's year-end stocks for 2018 to be 2.7x the year-end stocks for 2010 (see chart 4). The state of annual stocks-to-consumption ratios (total annual stock of cotton to total annual consumption) globally and in China in particular typically drive global cotton prices.

Although the water risk has returned, contemporary import and export conditions mean that it is unlikely that we will see a rise in cotton prices like the one in 2011. Nevertheless, we will continue to monitor the impact of ESG factors (alongside all other relevant factors) on an entity's credit profile.

Examples Of Water-Related Rating Actions

Here are some additional concrete examples of how water factors can lead to a rating change.

K+S

• German Potash Producer K+S Downgraded To 'BB+/B' On Expectation Of Prolonged Weak Performance; Outlook Negative, Oct. 21, 2016

We lowered our rating on K+S due to water scarcity.

Low rainfall in June 2016 caused sales volumes to decrease by 400,000 metric tons year-on-year. The company's Werra plant needs to be able to discharge saline wastewater into the Werra river as part of its operations, and years of drought, can cause operating constraints on the facility that impact credit metrics. This operating constraint occurred under weak market conditions, with low potash prices ($30-$40 below our projections) and low sales volumes from a new site in North America.

Thames Water

• Ratings On Thames Water Utilities' Class A And B Debt Lowered To 'BBB+' And 'BBB-' On Weaker Ratios; Outlook Stable, July 24, 2017

Our downgrade of Thames Water was the result of poor water management compared with peers related to leakage from below-ground water assets that resulted in financial penalties.

The company lagged peers' operating performance in terms of customer service and below-ground water assets, resulting in regulatory penalties and fines at a time when the Thames Water financing group had no financial headroom for the rating with respect to its funds from operations FFO to debt ratio. Despite improvements to operating performance in several areas, the company remained affected by the performance of its below-ground water assets, which led to the company failing its leakage target for 2017 and to a number of consumer interruptions.

Hrvatska Elektroprivreda (HEP)

• Croatian Utility Hrvatska Elektroprivreda Upgraded To 'BB' On Improved Liquidity; Outlook Negative, Oct. 28, 2016

The upgrade reflected favorable hydrological conditions and commodity prices over the prior two years.

This allowed HEP, an owner and operator of hydropower facilities, to strengthen its liquidity, building a large cash balance of Croatian kuna (HRK) 2.8 billion. The upgrade followed several years of drought. We anticipate volatility in its cash flow and reflected this in the credit rating.

Related Criteria

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• Key Credit Factors For The Leisure And Sports Industry, March 5, 2014
• Corporate Methodology, Nov. 19, 2013
• Country Risk Assessment Methodology And Assumptions, Nov. 19, 2013
• Key Credit Factors For The Regulated Utilities Industry, Nov. 19, 2013
• Key Credit Factors For The Retail And Restaurants Industry, Nov. 19, 2013
• Management And Governance Credit Factors For Corporate Entities And Insurers, Nov. 13, 2012

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