Although it is just one private company, Thames Water’s recent troubles have highlighted the wider challenges facing investors seeking to make a positive contribution to the environment through capital exposure to UK water companies.
Popular with income investors, such companies are regulated monopolies, often viewed in the stock market as defensive bond proxies because of their regular dividend payments. In an environment where interest rates are near their peak and eventually start to fall, they may perform well.
Yet it remains a sector facing major challenges. For investors focused on positive environmental impacts, these issues go beyond controversies about high levels of debt, underinvestment and distribution to shareholders.
Should you put water companies in an ESG portfolio?
For dual-purpose equity funds that seek to have a positive environmental impact and generate financial returns, the environmental records of these firms call into question their suitability for such a strategy.
In a sense, the UK water sector is hostage to its Victorian-era infrastructure. Its age, antiquated design and struggle to cope with population growth have led to two major problems in particular – leakage and pollution – that have now attracted widespread public attention.
Leakage is a significant problem as a large amount of water in the UK is simply wasted: around 20% is leaked or lost between abstraction by companies and consumption by households. In a country where hose bans are now commonplace and some schools have recently been forced to close due to a lack of water supply, this is a serious problem.
Sewage pollution is an additional and toxic problem. The UK’s archaic combined sewer system means that during heavy rainfall, sewage floods and overflows into rivers. This is a problem that is only getting worse as climate change causes more frequent and extreme rainfall.
The high cost of upgrading the UK’s water infrastructure means that utility companies are unable to deal with the problems properly without raising customers’ bills to unacceptable levels. It’s somewhat of a catch 22 for UK water companies who need to spend more but are strapped, especially given the current cost of living crisis.
Which stocks are on the right side of the issue?
Good water treatment, management and provision are essential aspects of protecting and restoring the natural environment, both now and in the future. Fortunately, companies developing solutions to achieve these goals are abundant and investable.
Aquatic ecosystems are one of the four key investment themes that make up our listed equity biodiversity impact strategy. We seek to invest in sustainable companies that support the SDGs with a focus on clean water and sanitation (SDG six), Responsible consumption (SDG 12) and Life underwater (SDG 14).
Halma, for example, is a high-quality company with a portfolio of water and other environmental businesses. It is a lesser-known business to global investors, but well-known domestically for its capital discipline and impressive track record in growing small businesses with promising products and services in the water and environmental sectors.
Water testing is a major theme with a number of other companies we hold, including Agilent and Thermo Fisher – both US companies making high quality environmental testing equipment.
Advanced Drainage Systems (ADS), another US company, specializes in water technology, specifically stormwater drainage, and collects plastic waste from around the country before recycling it into high specification plastic pipes. The plastic pipe replaces the concrete pipe, which is more expensive (for production and installation) and has lower operational characteristics. Demand for ADS is further supported by a strong outlook for infrastructure investment as well as increasing extreme weather events driven by climate change.
Another interesting company in this space is a Japanese company called Kurita Water Industries, an expert in providing ultra-pure water – essential for semiconductor manufacturing.
Water purification and regulation
Looking ahead, there are a number of upcoming developments in water treatment that could potentially offer investors interesting opportunities. One in the US is related to PFAS, one of the so-called “permanent chemicals” that can increasingly be found in water bodies and sources and are known to persist in the environment and in our bodies.
Earlier this year, the US government issued a rule requiring communities to test and treat water for a number of these toxic chemicals. Companies like Xylem, a leading global water technology company that recently acquired purification solutions firm Evoqua, could benefit from future water treatment and testing for PFAS.
More generally, there are opportunities for investors in the US with companies working to improve water resources. One is Ecolab, which works in various aspects of water treatment, purification, cleaning and hygiene, while Valmont, which dates back to the 1940s, builds efficient agricultural irrigation equipment used throughout world.
More incidental exposure to water and its positive impact on the environment is also possible through firms such as Dutch engineering and design consultancy Arcadis. This company is a leader in land reclamation, which is a particular problem in the low-lying Netherlands.
This expertise will become increasingly important as climate change impacts the world’s coasts through sea level rise, flooding and extreme weather events. The environmental costs of flooding are increasing – such as direct species loss and soil salinization – and so we believe there should be sustained demand for Arcadis’ services for years to come.
As climate change has an increasingly damaging impact on the planet, water will become an increasingly vulnerable and precious resource. Equity investors seeking to make a positive contribution to global water supplies have many options, but they should not be picky about the water-related companies in which they invest.
Tom Atkinson is an equities portfolio manager at AXA Investment Managers
