By Monika Freyman, CFA My previous article, ” Liquidity Risks of the H2O Variety ,” explored growing investor awareness about water risks within their portfolios and how that awareness plays into their investment decision making. Here, I will examine some of the increasingly sophisticated approaches that investors can take to integrate water risks into portfolio management. My recent survey of 35 institutional investors’ water integration practices found that while many investors think their methods, tools, and databases need to improve and evolve, they also found it worthwhile to integrate water into their research processes. And no wonder. As population pressures create competition for water, global groundwater supplies are declining and climate variability is increasing – leading to longer droughts and more intense flood events. All these factors pose risks that are hard to ignore. Water risk analysis happens at different stages of investment decision making, from the initial asset allocation strategies, to portfolio level analysis, through to the buy/sell decision. For example, one pension fund brought together portfolio managers from different asset classes to study how different markets, investment instruments, and geographic regions are exposed to the global water crisis. A few investors were also consistently analyzing their portfolio’s water risk exposure or its water footprint. Although far from a perfect approach – often missing location specific data or wastewater production metrics – portfolio water footprinting can be helpful in flagging companies and sectors with high water risk exposure relative to a benchmark and highlighting where further analysis is warranted. Various forms of portfolio analysis and attribution software allow managers to run water use metrics versus an index. For an example of water footprinting, see this South African study . At the individual security level, investors identified three critical research steps to obtain a comprehensive picture of water risk exposure: Understand Corporate Water Dependency: This varies by sector and, of course, company, with some industries relying heavily on access to abundant freshwater suppliers directly or in their supply chain. Corporate water dependency is not always easy to assess, but some companies are making the task easier by reporting their water use and wastewater trend data more consistently on their websites, in their annual reports, SEC filings or to data aggregating organizations, such as CDP Worldwide’s Water Program . Combine Water Dependency Data with an Assessment of Water Security: This gives a more comprehensive picture of corporate water risk exposure. A company may have high water needs but have their operations located in relatively water abundant regions. Another company, however, may be operating in regions of high water competition and drought. Such assessments are not simple to perform, but evolving tools, such as World Resources Institute (WRI)’s Aqueduct corporate water risks map , the World Wildlife Fund (WWF)’s Water Risk Filter , and other efforts are seeking to make the task easier. Get a Sense of Corporate Water Risk Awareness and Response: This step is essential because a company may have high water needs and poor water security, but mitigate the risks very effectively by elevating water issues to strategic decision making and putting water management and reporting systems in place. Tools such as The Ceres Aqua Gauge can be used to assess how well companies are managing their water and their exposure to water risks. For a more comprehensive list of third-party water tools and analytics, An Investor Handbook for Water Risk Integration is a helpful resource. Once water risk analysis is conducted on a corporation or security, our research found that fund managers use this information in a variety of ways, from avoiding high water risk industries or companies, to influencing internally created company environment, social, and governance (ESG) scores, to clarifying corporate engagement priorities. Several managers use their corporate water risk assessments to influence or modify financial projections or their weighted average cost of capital assumptions. For example, one fund manager studying companies in Brazil conducted scenario analysis modeling regarding how much the market cap of companies would be impacted if they had to absorb more of the costs of treating their wastewater discharges, especially as drought intensified and communities and regulators were becoming less tolerant of water use and pollution. Once impacts to market cap were assessed and shared with the management of those companies, engagement on those issues was far more pointed and productive. Other managers were trying to get a deeper understanding of the probability of large financial losses due to strategic risks related to water, such as not being able to grow revenue, access new markets, or develop new facilities. No matter what methodology one chooses to deepen water risk analysis practices, the most critical things to keep in mind are that water risks can lead to unlimited financial impact and loss. If a company loses access to water, a community kicks them out of a region due to water concerns, or permission to discharge wastewater is denied, the financial and strategic implications can be immense. For example, Newmont Mining (NYSE: NEM ) has postponed a $5 billion project in Peru due to community concerns over its water practices. In addition, it is important to look at sector specific issues, as water risks related to mining are obviously very different to those in semi-conductor manufacturing and so on. An Investor Handbook for Water Risk Integration includes a sector-specific cheat sheet on these issues. And most important of all: No matter how incomplete your water risk analysis starts off, it will likely provide a better understanding of sector or company risks (and opportunities) – which ultimately should add predictive power to your existing research processes. The goal is not to be perfect in your methods from the outset, but to begin including water risk analysis into your portfolio management practices. Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.