Case study: Reducing portfolio water risk

1. ESG anlysis

The apparel sector is identified as vulnerable to waterrelated issues, as they can impact the supply chain in raw material production and manufacturing processes. Effective water management can directly (positively or negatively) impact the financial returns of a company, particularly as water resources become increasingly stressed; for the seventh consecutive year, the World Economic Forum’s Global Risks Report has ranked water crises within the top five risks in terms of impact. We believe, therefore, that there are opportunities for companies that manage these issues properly.

Around 33% of global textile production is based on cotton as a raw material. Cotton is one of the top five crops causing ground water depletion, with 1kg taking around 20,000 litres to produce – the equivalent to a pair of jeans and a t-shirt.

China supplies 30% of the global cotton market, making regulation there important. China’s environmental regulation is most strict on heavily polluting sectors, including textiles and apparel, which do not contribute highly to national GDP74. This could have a material impact on retailers relying on suppliers from China. Given that China’s 13th Five-Year Plan for Ecological & Environmental Protection (2016-2020) and the Water Pollution Prevention and Control Law were approved (effective from 1 January 2018), monitoring and penalties will increase.

2. Integration technique

At BMO Global Asset Management, the F&C Responsible Global Equity Fund searches for companies with a proactive approach to water management. We believe this predominantly offers Cost of Goods Sold (COGS) benefits, from raw material sourcing to manufacturing costs. Given that water can impact both aspects, companies which are less financially exposed to potential negative shocks, due to proactive management of the issue, should be identified.

When conducting fundamental research, the BMO Global Asset Management Responsible Global Equities team incorporates ESG risks and opportunities and runs scenario analysis that stress-tests different outcomes. For water management, we expect a proactive approach to contribute to an enhanced margin profile relative to peers over the long term. The last major spike in the price of cotton was in 2011, where the price per pound exceeded $1.90, up 150% from early 2010. The shortage of supply was in part linked to widespread drought conditions, including in the largest cotton producing regions, China and the US. At the time, high street retailers referenced the increased price of cotton to explain falls in company profits and share prices. Since then, the price of cotton has fallen and the benign cost environment could trigger complacency among companies. To prepare for similar shocks in the future, we therefore investigate how well companies are protected against supply-side shocks.

3. Impact of ESG integration

When the cotton price is high, companies decide whether to pass on this higher cost of raw materials to price-sensitive consumers or internalise the impact to COGS. During the supply shortage in 2011, VF Corporation (VF) passed on around half the cost to consumers and absorbed the rest into its margins.

With VF-owned within BMO Global Asset Management’s F&C Responsible Global Equity Fund, we analyse its water management practices closely. VF purchases around 1% of the world’s cotton annually for its denim brands and water-related issues can have a material financial impact on the company. When cotton prices were high, the company’s detailed knowledge of customers facilitated its decision on what costs could be passed onto customers, and what costs should be internalised. A progressive water management strategy contributes to our positive view of VF, meaning greater confidence in VF’s long-term profit margin profile relative to peers.

Through the CDP water programme in 2017, VF – which scored a B - disclosed that it is undertaking company-wide risk assessments – at a river basin level, across existing and new facilities, and within its own operations and supply chain. Working with Deloitte, VF assesses the potential financial value of water risk. Water impacts related to the success of its growth strategy are also evaluated. For new facilities, water availability and flow rates are assessed on current and future operating conditions. Where water-intensive manufacturing facilities are located in high water-stressed regions, reverse osmosis water treatment plants reduce risk, as almost 100% of water is recycled at these sites.

Our analysis positively views the company’s acknowledgement of water risks and mitigation through strong management of the issue. VF is developing a comprehensive water strategy with WWF, including a review of strategic opportunities, water implications on key raw materials, scenario analysis of water quality and quantity, and tariff/regulatory changes. We are therefore engaging with the company and monitoring progress.