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China’s drought underscores water crisis risks to investors

With one of the worst droughts in China since records began 60 years ago, asset owners and managers are weighing more seriously the material risks of the water crisis.
China’s drought underscores water crisis risks to investors

Regional asset owners – including AustralianSuper, Taiwan’s Cathay Life Insurance and Japan’s Sumitomo Mitsui Trust Asset Management – have joined forces as signatories to the Ceres’ Valuing Water Finance Initiative (VWFI) which aims to highlight the financial and investor risk posed by dwindling water resources.

The initiative, launched this August with a group of 64 signatories representing $9.8 trillion in assets under management, aims to engage 72 companies in establishing better water management systems.

Among the target companies are large-scale food companies with a high water footprint such as Nestle, Kraft and Danone. Asian beverage giants such as Asahi Group Holdings, Suntory Beverage and Food and Kirin Company have also joined corporates recognising the material risks of the water crisis.

The initiative prioritises a set of six guidelines that align with the United Nation’s 2030 Sustainable Development Goal for Water (SDG6) and supports the aims of the Ceres Roadmap 2030.

These include encouraging corporate action on: water quantity; water quality; ecosystem protection; access to water and sanitation; board oversight; public policy engagement.

"The water crisis is playing out around the world in many ways, from severe drought and pollution to inadequate access to safe drinking water, all of which disproportionately impact our most vulnerable communities,” said Mindy Lubber, CEO and president of Ceres.

“The private sector must recognise water’s importance for their institutions and investments lest they further expose themselves and society to increased material water risk.”

CHINA’S BIG DRY

The initiative underscores the importance of water to financial systems and comes as China is facing its most devastating drought in six decades leading to severe power shortages across the south-western province of Sichuan.

Hydro-electric dams make up about 80% of Sichuan’s power generation and nearly 15% nationwide but the big dry has halved energy output in Sichuan compared with last year.

As a result, Sichuan local authorities told up to 16,000 industrial consumers to shut down between August 15-25. Sichuan produces about 6% of China’s industrial output.

The power cuts have shut down operations in the region at firms such as Toyota and Foxconn, one of Apple’s main suppliers.

The drought is also set to affect supply chains globally. In Wuhan, about 900km east of Chongqing, low water levels on the Yangtse river have meant that ocean-bound cargo ships have been unable to carry full loads.

Analysts say that while this is hurting China’s manufacturers in the short-term, the ripples are set to fan out globally over the long-term.

STARK PICTURE

Max Pacella of Innova Asset Management sees at least four factors that could present serious investment risks in China: a property sector crisis; a metals sector slowdown caused by drought; a food crisis and the ongoing zero Covid policy.

“This is a stark picture for the near-term, with the government facing a battle on multiple fronts and with issues which intrinsically bleed into each other,” Pacella said in a note.

“The drought leads into agriculture, power and production, which coupled with a lack of confidence generated by zero Covid impacts further on consumer willingness to take on debt and invest in property.”

He said food security in particular would likely be the first problem in China’s investment landscape, with late summer rains failing to provide adequate water for the Autumn rice harvest.

“With food prices already on the rise, this represents a major problem, not only for the loss of potential export value, but for the cost to replace domestic consumption which would normally be provided by these regions,” Pacella said.

“We recently invested in the BetaShares Global Agriculture ETF, seeing food security as a significant thematic to play out over the long-term.”

HEAVY METALS

Hydroelectric power make up around 8% of China’s total power supply, which means the cost of energy input will drastically increase for those manufacturers and processors that can still operate.

“The area has to make a quick shift towards other accessible forms of energy such as coal – this is during a time where the price of coal futures has increased 65% since April 2022,” he says. “If industrial complexes cannot access power easily, or have to absorb dramatically higher costs of input, then production will stagnate or halt all together.

“This puts several key industries such as lithium, copper, and aluminium, at risk.”

He said lithium was the most apparent of these problems, with China being the third largest exporter of lithium in the world (13% of global supply), and Sichuan itself representing around 20% of total domestic production.

He said that although these short-term risks contributed to Innova’s decision to exit out of Asia ex-Japan exposure earlier this year, he did not believe the picture spelled complete doom for investment in China.

“Quite the opposite, our own long-term forecasts see the region as one of the highest returning equity markets globally,” he says.

“Both in the context of a portfolio and individual investment, we think there need to be compelling signs of recovery and policy shifts in China before the short-term return compensates risk adequately.”

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