While it is only one private company, Thames Water's recent issues have highlighted the wider challenges facing investors seeking to make a positive environmental contribution through equity exposure to UK water utilities.
Popular with income investors, such companies are regulated monopolies often viewed in the equity market as defensive bond proxies due to their regular dividend payments. In an environment where interest rates are near their peak, and eventually begin to fall, they may perform well.
Yet this remains a sector facing major problems. For investors targeting positive environmental impacts, these issues go well beyond controversies over high debt levels, underinvestment and shareholder distributions.
Should You Put Water Companies in an ESG Portfolio?
For equity funds with a dual objective that seek to have a positive environmental impact and generate financial returns, the environmental records of these firms questions their suitability for such a strategy.
In some ways the UK water utility sector is hostage to its Victorian-era infrastructure. Its age, outdated design and struggle to cope with population growth have led to two major problems in particular – leakage and contamination – which have now come to widespread public attention.
Leakage is a considerable problem, as a large amount of water in the UK is simply lost: around 20% is leaked or wasted between abstraction by companies and consumption by households. In a country is which hosepipe bans are now commonplace, and some schools were recently forced to close due to a lack of water supply, this is a major concern.
Contamination through sewage represents an additional, and toxic, issue. The UK's archaic combined sewer system means that, in times of heavy rainfall, sewers flood and overflow into rivers. This is a problem that is only getting worse, as climate change causes more frequent and extreme rainfall events.
The high cost of upgrading the UK's water infrastructure means the utility companies are unable to properly address the problems without hiking customer bills to unacceptable levels. This is somewhat of a catch-22 for UK water utilities, which need to spend more but are constrained, especially given the current cost of living crisis.
Which Stocks Are on The Right Side of The Problem?
Good water treatment, management and provision are all essential aspects of protecting and restoring the natural environment, both now and in the future. Fortunately, companies developing the solutions to meet these objectives are abundant and investible.
Water Ecosystems is one of the four key investment themes comprising our listed equity impact Biodiversity 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 Below Water (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, specialises in water technologies, specifically stormwater drainage, and sources waste plastic from across the country, before recycling it into high specification plastic pipe. Plastic pipe is replacing concrete pipe, which is more expensive (to make and to install) and has inferior performance characteristics. ADS's demand is further supported by a strong infrastructure investment outlook as well as increasing extreme weather events driven by climate change.
Another interesting company in this space is a Japanese business called Kurita Water Industries, an expert in providing ultra-pure water – essential in the manufacture of semiconductors.
Water Treatment and Regulation
Looking ahead, there are a number of forthcoming developments in water treatment which could potentially offer investors interesting opportunities. One in the US relates to PFAS, one of the so-called "forever chemicals", which increasingly can be found in water bodies and sources and are notoriously persistent in the environment and in our bodies.
Earlier this year the US government issued a rule that would require communities to test and treat water for a number of these toxic chemicals. Firms such as Xylem, a leading global water technology company which recently acquired treatment solutions firm Evoqua, could benefit in the future processing and testing of water for PFAS.
More broadly, there are opportunities in the US for investors with companies working to improve water resources. One is Ecolab, which works in various aspects of the treatment, purification, cleaning and hygiene of water, while Valmont, which has origins going back to the 1940s, builds efficient water irrigation equipment for agriculture, used across the globe.
More incidental exposure to water and its environmentally positive impact 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 issue in the low-lying Netherlands.
This expertise is going to become ever more essential as climate change impacts coastlines around the world through rising sea levels, flooding and extreme weather events. The environmental cost of inundation is rising – such as direct species loss and soil salinisation – and therefore we think there should be durable demand for Arcadis's services for years to come.
With climate change having an ever more deleterious impact on the planet, water is going to become an increasingly vulnerable and valuable resource. Equity investors seeking to have a positive contribution on global water supplies have plenty of options but should not be indiscriminate in the water-related companies in which they invest.
Tom Atkinson is an equity portfolio manager at AXA Investment Managers
