This report aims to illustrate the potential rising credit risks on chipmakers that could result from more frequent and more intense water stress. We analyze how and why such credit risks may become more material for credit through the specific case study of the sector leader, Taiwan Semiconductor Manufacturing Co. Ltd. (TSMC).

Why it matters:  Water is a critical input to the chipmaking industry. Yet continued access to the resource may increasingly become challenging if droughts and water shortages are more frequent.

What we think and why:  Water security will be an increasingly important factor to semiconductor firms' credit profiles. Mishandling of water resources could disrupt a firm's operations, hurt financial performance, and potentially hit customer relationships. By extension, any potential disruption in production may impact their end-markets given the generally integrated semiconductor supply chain.

Climate change is testing chipmakers. Semiconductor firms' water consumption is rising, both absolutely and on a per-unit basis, as processing technology advances. Meanwhile, climate change is raising the rate of extreme weather, the frequency of drought, and the volatility of precipitation, limiting chipmakers' ability to manage production stability.

S&P Global Ratings believes that water security will be an increasingly important factor to semiconductor firms' credit profiles. While most firms have been adept at managing the problem till now, the growing severity and frequency of water shortages may overwhelm entities' contingency planning.

Chart 1

The semiconductor sector is on track to increase water consumption by a mid to high-single-digit percent each year, driven by capacity expansion and the demands of advancing process technology. Globally, chipmakers already consume as much water as Hong Kong, a city of 7.5 million [1].

Chart 2

TSMC's consumption per unit grew over 35% after it advanced to 16 nanometer (nm) process nodes in 2015. We believe this was mainly due to the migration to advanced nodes, which require more fabrication processes.

Chart 3

There is a direct line between water use and chip sophistication, as fabs use ultrapure water (fresh water processed to extremely high purity) to rinse wafers between each process. The more advanced the semiconductor, the more process steps, the more water consumed.

We explore firms' rising sensitivity to water stress using TSMC as a case study. The report looks at water supply in Taiwan, the company's water-use efficiency and access to water sources, and its readiness to manage water shortages. We envisage drought scenarios to gauge the effects on the company.

Chart 4

In our view, TSMC's water security issues are meaningful, but modest relative to its peers. We don't believe water shortages will hit the foundry's operations or hurt the credit profile within the next three years.

However, beyond this timeframe, capacity expansion and technology development could leave TSMC with less leeway to weather a severe drought. Our stress test estimates that TSMC's demand for feedwater could double from the 2022 level by 2030. Poor water-supply management could cause its output to undershoot our forecast for 2030, by up to 10%.

Chart 5

Chipmakers in other regions also face the challenge of increasingly scarce water resources, making drought-related operational disruptions possible.

About 80% of the industry's water consumption is concentrated in a handful of companies. Many of these entities focus operations in water-scarce areas such as Shanghai and Xi'an of China, in Korea, and in the U.S. state of Arizona. The TSMC case study serves as a starting point to look at the impact of climate change on the chip sector, and other water-intensive industries.

Rainfall Is Increasingly Volatile At TSMC's Base Of Taiwan

Eighteen percent of global semiconductor manufacturing capacity, and 90% of advanced chipmaking capacity, is based in Taiwan. Its centrality to global chip supply means that water supply instability on the island hit semiconductor supply chains worldwide.

Chart 6

About half of the water supply in Taiwan is typhoon-related rain that usually falls in the summer and autumn. Southern Taiwan, where a significant portion of TSMC's production capacity sits, is more dependent on typhoon-induced precipitation than the north. Fewer typhoons have reached Taiwan over the past decade, contributing to four droughts (including one confined to central and southern Taiwan) in the period (see chart 7).

Chart 7

The National Science and Technology Center for Disaster Reduction in Taiwan estimates rainfall could decline 10% during the dry season by 2050, from current levels, according to domestic press reports. The center also projects that the consecutive number of days without rain will increase, and that the number of typhoons that reach Taiwan will drop 15% in the same period.

Chart 8

TSMC Will Be Exposed To Water-Supply Risk

With the inexorable migration to more advanced semiconductor process technologies, water-purity requirements should rise. This means that TSMC may have to filter out more water that falls short of its increasingly robust purity standard. That may constrain TSMC's ability to further improve its rate of water recycling, in our view.

Chart 9

Most of TSMC's production capacity resides in three science parks. The firm is using a rising share of water supplied to the parks. The ratio is particularly high in Hsinchu (about 12%) and southern Taiwan (about 14%). The regions contain TSMC's most advanced fabs--for example, a 3nm fab in southern Taiwan, and a 2nm facility planned for Hsinchu.

Chart 10

Six reservoirs are feeding water to the three science parks. Their water levels are volatile and were highly affected by the 2021 drought. For example, Zengwen Reservoir is a key water source for the Southern Taiwan Science Park and it is the largest reservoir in Taiwan--it has around 1.4 times the combined capacity of the other five reservoirs supplying to TSMC. Zengwen has stayed below half capacity for more than 60% of the past four years, largely due to reduced typhoon rain.

Chart 11

We conducted a sensitivity analysis that projects TSMC's likely feedwater consumption in 2030, and how this may result in shortages (see table 2). Feedwater demand will be 1.4x-2.0x that of the 2022 level, in our view, depending on capacity expansion and the firm's progress in developing advanced nodes. Such water demand needs would test TSMC's ability to manage this resource, potentially disrupting foundry operations. For reference, Samsung Electronics Co. Ltd. expects its water intake will more than double by 2030.

We estimate TSMC's water cost at between new Taiwan dollar (NT$) 1.0 and NT$2.0 billion in 2022, based on its municipal-water consumption and water tariffs in Taiwan. This accounted for less than 1% of the company's NT$2.26 trillion in revenue that year.

The company should be able to pass on extra costs to its customers of potentially higher water tariffs and the expense of using tanker trucks when facing a severe drought. This assumes the company can maintain its technology leadership.

Chart 12

What Are The Rating Implications For TSMC?

Water supply risk is unlikely to hit our rating on TSMC in the next three years, which reflects TSMC's strength in semiconductor process technology, high profitability, its robust net cash position, and positive operating cash flow.

Table 1

The rating also accounts for the company's resilience to drought-induced water shortages over the past few years. TSMC should be able to tackle similar threats without a meaningful hit to its operations, provided that water shortages end within a few months.

However, TSMC's challenges are growing quickly, as its increasingly sophisticated production expands and as climate-change effects kick in. TSMC's demand for feedwater could rise 40%-100% by 2030, from the 2022 level. The higher base of water use, in tandem with a likelihood of longer and more frequent droughts and more volatile rainfall, will likely leave the company with less leeway to manage dry spells.

Table 2

Should the company be able to maintain its technology leadership, the impact on TSMC's business profile and profitability from any output volatility is likely manageable. Customers' dependence on its supply allows TSMC to lock in end demand and compensate for lower unit sales with price rises. TSMC may also focus limited water supplies on producing advanced chips, while cutting output of its mature chips, which are lower-margin. Such shifts in product mix should buoy its EBITDA margin, even as absolute profit dips.

If the technology gap between TSMC and its competitors meaningfully narrows, production hiccups caused by water scarcity could weaken TSMC's market position. Customers may move orders to TSMC's competitors to manage supply-chain risk. Such an outcome might result in diminished creditworthiness for TSMC.

We conducted a stress test to estimate the impact of a repeat of the 2021 drought on TSMC's operations in 2030. In such a scenario, we expect the company's output to fall 1%-10% short of our forecasted production in 2030.

The wide range in our projection reflects the wide-ranging variables influencing this outcome. They include the company's ability (or not) to diversify away from municipal water supply, its production capacity by 2030, and the firm's level of technology advancement and product mix by that year.

Many factors are outside of TSMC's control. These include the government's efforts on rainfall harvesting, and its policy of restricting water supply to industrial entities during droughts could drastically change the picture. Some of our key assumptions for this stress test are:

• The test only focuses on TSMC's capacity in Taiwan. We believe most new capacity of TSMC, particularly that for cutting-edge process nodes, will be built in Taiwan;
• Any drought lasts no longer than three months, only affecting the operation for one quarter; and
• TSMC can temporarily reduce water consumption by 10% during a drought without affecting its production and output. This could be achieved by slashing water supplies to noncore businesses, expanding its use of recycled water, etc.
• Reclaimed water supply to TSMC would also drop during a drought, although at a smaller degree than the decline in municipal water supply. This is because a drought would also reduce volume of wastewater generated by industrial enterprises and residents, a source of reclaimed water.

Table 3

Water Shortages Will Be A Rating Consideration For Many

Water supply risk is not confined to TSMC. It is a global issue that is important to all chipmakers, or any water-intensive industries.

As indicated at the start of the report (chart 1), many of TSMC's competitors base operations in water-stressed regions. Examples include Semiconductor Manufacturing International Corp. (unrated), which is building fabs in Shanghai and Beijing. Samsung Electronics Co. Ltd. (AA-/Stable/A-1+) is expanding its facility in Korea's Gyeonggi-do province, while maintaining large capacity in Shaanxi province, China. Intel Corp. (A/Negative/A-1) and TSMC are investing tens of billions on new fabs in Arizona.

Chart 13

Just as significantly, the global tech hardware supply chains are dependent on only a handful of key chipmakers. A reduction in operations for one of them could hit production for the very wide range of downstream players. The worldwide chip supply shortage during the pandemic has well illustrated the intricate entanglements of the tech supply chain and its susceptibility to event risks.

Any potential output instability of TSMC due to water supply shortage would likely amplify such a risk, given its dominant position in the supply of advanced semiconductors. Firms such as Apple Inc., NVIDIA Corp., Advanced Micro Devices Inc., Microsoft Corp., Qualcomm Inc., and MediaTek Inc. rely heavily on TSMC, just to name a few.

Climate-change effects are unpredictable and abstract for many. For chipmakers, and the billions of people that use semiconductors in everyday devices, the impact may become much more concrete.

End Note

[1] Water Supply Challenges For The Semiconductor Industry' by Semiconductor Digest on Oct. 24, 2022.

Writer: Jasper Moiseiwitsch

Digital Designer: Evy Cheung

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