Water stress—the hidden risk in Latin America

Nick: Welcome to ‘The Angle’ from T. Rowe Price ─ sharper insights on the forces shaping financial markets begin here. In this inaugural season of ‘the angle’ we're diving into the world of the blue economy. I'm Nick Truman and I'm your host as we learn more about this intriguing and rapidly evolving area of the economy and financial markets.

In the series so far, we've learned about the importance of the blue economy for countries, communities, and global economic activity. There is enormous potential for sustainable development of the blue economy, but it’s under threat from a range of challenges confronting ocean and clean water resources.

Today, we're going to explore one of those challenges in more depth ‘Water Stress in Latin America’. Latin America accounts for around 30% of the world's freshwater resources. But mismanagement, exploitation, pollution, and climate change related impacts are increasing the region's water insecurity. So, the two guests I have joining me today are analysts Mariel Abreu and Duncan Scott. They've worked on this very research topic, so it's great they're able to join us and share their insights today.

Welcome Mariel and Duncan.

Mariel: Thank you Nick for having me here. Very excited to talk about this topic today.

Duncan: Yeah. Thanks for hosting Nick, really important topic and happy to be part of the discussion.

Nick: Water is vital, yet the risks of not having enough are often overlooked. A good starting point to our discussion today is to take a step back and explain to our listeners why today's topic of water stress is so important. Mariel, why don't you start with a discussion on the supply and demand dynamics?

Mariel: Yes, Nick, thank you. That's a very good way to start the discussion. So, let's start with the problem of supply. Water is one of the most valuable natural resources and necessary for human life. 60% of human body is formed of water, and we cannot go without it for more than three days. It's also very important input for major industries that play a relevant role in the everyday life, from food to energy.

So, to put this in context for the audience, 75% of our planet is covered by water, but only 3% of this water is fresh water, and only 1% of that is water that we can actually use for human and industry consumption.

Nick: Gosh, only 1%. That’s is, that’s quite a shockingly low number.

Mariel: Another relevant factor is that there is a high distribution imbalance in freshwater supplies in our planet.

Only 10 countries in the world account for two thirds of the total freshwater resources we have. So, that is the first issue, we have a shortage in water supply in our planet, and not only the quantity, but also the quality has been declining over time.

Climate change is also another cause of water stress. When we look at the water stress levels, which basically measures water withdrawals to available water supply in our planet, the metric has been worsening over time all around the world.

And this is in part due to the high temperatures that we are experiencing. And this will continue to deteriorate over time as we have higher temperatures and the droughts become more frequent. I'll give you interesting data points. For every one degree increase in average temperature, there's a 20% decline in water resources.

Nick: Wow, that is a very interesting data point on rising temperatures and water supply. What about the demand side dynamics for water?

Mariel: Yeah, sure. So, on the demand side, water use has been increasing at more than double the rate of population growth, according to United Nations. The growing global population is expected to reach around 10 billion by 2050, which implies greater food and energy demand, which are two industries that are heavy users of water.

So, water stress will be one of the top challenges for humanity in the next decade and one important risks to global GDP growth. The World Resources Institute, for instance, is estimating that around 30% of the world's GDP will be exposed to high water stress by 2050, and around half of the world population is projected to live in water stressed regions.

Nick: Goodness me, those statistics are pretty stark. So perhaps I can bring in Duncan here. So how does water stress link to the sustainable development goals?

Duncan: Yeah, thanks, Nick. I mean, there's also this material funding gap when it comes to water. So, if you look at the United Nations Sustainable Development Goals or SDGs. And for those not familiar with those. So, there are 17 goals to end poverty, protect the planet, and ensure prosperity. And each of these goals has specific targets to be reached between 2015 and 2030.

And the two goals linked to water, so SDG number six and SDG 14, are among the most underfunded sustainable development goals. And I think the finance industry can potentially play a key role here in helping to move the dial to catalyze investment into supporting these SDGs. And, you know, despite how crucial water is to human life and business, the risks that come with not having enough of it are often being overlooked by investors.

Nick: As you've both outlined, water is critically important. It's a strategic asset in scarcity. Mariel, why so much focus on Latin America? Are there already signs of water scarcity in Latin America?

Mariel: Yes, you're right Nick. And similar to other parts of the world, Latin America is also experiencing the effects of water scarcity. The region has around 30% of the world's renewable water resources, but it is also one of the regions facing one of the greatest water stress in the world. So as part of our recent research on water, we look at data from the World Resources Institute and Chile and Mexico, for example, came up among the highest water stressed countries in the world today. And this is the result of climate change, exploitation, and high polluting activities in the region.

Nick: So, Mariel, can you drill down and give us some more specific examples?

Mariel: Yes. So, we have started to see the effects of this issue in the form of higher social unrest and greater government pressure. Also increasing restrictive regulation to protect and secure water for human consumption in Latin America. In fact, water related events have become more violent and frequent in the region in the last decade.

Let me give you two examples. In Chile, water has become a national security issue. If you look at hydrology has been sequentially declining in the last decade. And in 2022, the Chilean government announced a plan to ration water for the capital of Santiago for the first time in history.

Another example is Mexico, where we've seen a lot of protest a few years ago over the federal government decision to relocate water flows to comply with international obligations of water transfers. And these caused people to block roads for more than a month that resulted in huge losses for companies in that location.

Nick: These are clear signs that water stress is already having an impact in certain countries given that water availability is expected to continue declining in the coming years, there's a risk these events become more frequent and potentially even more severe. Duncan, what are the potential knock‐on implications?

Duncan: As we look forward, there is definitely concern that these events could become more frequent. I mean, as we've kind of discussed, water availability is declining, populations are growing, water stress is increasing. So, this declining water security could worsen conflicts between social groups or between industries. I mean, essentially, we have these growing populations, plus economies that are industrializing.

Plus, industries are growing and consuming more water. And all these people, industries competing for access to supplies of water that are decreasing. So, I mean, if you have an industrial user, so, you know, a pulp mill or a power station, that's consuming huge quantities of water at the same time that the population is having its water use rationed, it creates a potentially very challenging dynamic between population, industry, and political parties who are the ones who have to enact and enforce water use regulations.

So, yes, it's challenging dynamic and it potentially also raises the risk of political instability as well in certain countries where this is a particularly acute risk. Yeah, and I think this definitely has knock on implications for companies and issuers and regulation.

Nick: Mariel, Duncan referenced possible or probable rise in regulatory risk. Can you put a bit more color around that, please?

Mariel: Yes, that's right. Companies will be more exposed to water related operational challenges going forward. And one of the reasons will be restrictive regulations, as Duncan mentioned, because there's increasing social pressure to improve water security for human consumption. So, when we look at Latin America, for example, all countries have a maximum volume of water extraction to which industry players must comply by regulation.

Nick: So, Mariel what types of industries and companies are we talking about here that are going to be most impacted?

Mariel: Agriculture is the most exposed to this risk since it represents almost 70% share of water usage in Latin America. The energy sector is also a heavy user of water. In Latin America, for instance, the matrix, generation matrix is almost 50% hydro, which is directly correlated to hydrology conditions, and even thermal plants are very water intensive since they use water for cooling to be able to operate.

Nick: So, for companies operating in these sectors, Mariel, are there any potential financial implications? So, are they going to need to change production methods or invest in new equipment to become more water efficient?

Mariel: Yes, Nick, you are right. There are potential knock on financial implications. Companies will need to become more water efficient. So that is likely to mean investing in new equipment and changing production methods. Let's take the Chile example.

In the last five years, hydro generation in Chile has been around 30 to 45% lower than projections, which means these companies have been producing more with thermal facilities, which in turn results in a very material pressure to margins. So, one of the things that we're seeing in the Chilean segment is that these companies are investing more in renewable energies and basically diversifying their matrix away from hydro plants.

Nick: Duncan, that's some really fascinating insights from Mariel. What approach can be taken to assess if a company is vulnerable to water risk?

Duncan: Yes. So, I think the first thing I'd highlight again here, Nick, is that water stresses is not evenly distributed globally. So, it's very much a localized issue. So even though several parts of LatAm face high levels of water stress. So, you know, we mentioned Mexico and Chile. There's other countries in the region that have much better water security.

So, in these countries, water related risks maybe are not such a material concern. Maybe those that are more tropical climate or a long‐wet season, so somewhere like Panama, for example.

So there’s big variations in water stress across the different countries in LatAm, But, then even within a country, water stress can vary widely. So, again, taking Mexico as an example, averaged across the whole country, Mexico looks pretty water stressed. But actually, in the south of the country, you again have quite a tropical climate and there's actually relatively low water stress in the South. So, some areas in the north, much more arid, much more desert like, I mean, these areas can be very water stressed and that's where water scarcity is a real issue.

So, what this means is that looking at country level averages for water stress and for water availability is probably not the best approach, especially for these large Latin American countries with very varied terrains and climates, so, Mexico, for example. Using geo location data can potentially be a better approach in the analysis of water risks for a company. Essentially this means analyzing water availability and water stress at the individual asset level across an issuer’s entire asset base.

So, looking at the level of water stress at the precise location of an issuer's production facility or factory or mill or whatever it is, rather than looking at this country level average data for water availability.

Nick: Duncan, I understand you've spoken with companies that are potentially vulnerable to water stress. Mariel, you've been on the ground visiting these companies. What are your high‐ level takeaways from these meetings and visits?

Duncan: Yeah Nick, so we've spoken with, with companies across many of these sectors in Latin America to understand how they're attempting to mitigate water related risk, essentially. This includes, you know, how they're changing their practices and operations to reduce water use, whether they're able to switch water sources for a particular asset. And in particular, things that can lower freshwater use, so whether that's, desalination equipment or upgrading cooling systems. And a big part of our discussions with issuers focused on oversights of these issues. So, so who's responsible for assessing and managing these water related risks at a company. We spoke to a number of major issuers across these industries, across numerous countries in Latin America, some of whom are facing serious challenges from water stress to date, others of whom were less materially exposed.

Our takeaways from meetings is that these management teams are highly aware of water related risks. Broadly, they're taking steps to mitigate this risk and to minimize their water footprint. I think there's been so many issues related to water scarcity in Lat Am that we've touched on today in the last few years, that this issue is very much front and center for many of the management teams.

Nick: Mariel, I understand that you were recently in Brazil, and you've got some insights that you can share.

Mariel: Yes, I just came back from a week in Brazil visiting water utilities and Brazil is a good example of a country that has been under‐investing in this sector in the last few decades. Just to give you some reference, around 12% of Brazilians don’t have access to water and around 45% doesn't have sewage collection and treatment.

Brazil has to reach universal sanitation coverage to 99% in the next ten years. That has an estimated investment amount of around $180 billion, and the private sector, which only serves around 25% of the total population, will play an important role to help reach this target, especially in the sewage segment.

Nick: That brings an end to today's discussion. Mariel, on behalf of our listeners thank you so much for providing your insights.

Mariel: Thank you, Nick. It's been a pleasure to be here.

Nick: And, Duncan, thanks so much for sharing your insights as well on this really important topic.

Duncan: Yeah, thanks for having us today Nick, really enjoyed the discussion.

Nick: Looking ahead to the rest of the season we’ll deepen the discussion around the blue economy. We’ll explore how sustainable objectives can be measured. The key points I learned from the discussion today are the rising risks of water stress in Latin America and that certain industries and companies are going to need to find new processes become more efficient with their water use.

Thank you for listening to the angle. We look forward to your company on future episodes in this season.

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