1. Introduction
Water resources are one of the 17 UN Sustainable Development Goals. Global demand for clean water is expected to exceed 40% of the available supply by 2030, but the quality and quantity of freshwater have declined significantly over the last few decades due to global population growth and climate change [
1]. The global water crisis has become the world’s third-biggest threat and one of the main risks that the business sector needs to address [
2]. Some water intensive global giants have taken note of the problem and have begun to address the impact of water vulnerability on corporate sustainability. For example, BHP Billiton incorporates water management into its core concerns in exchange for the smooth implementation of its local mining business [
3]. Nestle has taken the initiative to help farmers improve agricultural irrigation, so as to ensure the supply of agricultural materials and demonstrate its social responsibility to acquire social licenses to locally operate [
4]. Studies have shown that water systems are now increasingly vulnerable and thus companies face serious physical, reputational, and regulatory water risks [
5,
6]. When companies internalize these risks, they already have significant implications for their business development [
7,
8,
9]. However, most companies are still unaware of the risk and opportunities presented by water issues [
10].
Despite corporations facing serious physical, reputational, and regulatory water risks simultaneously [
5,
6], business studies have mainly focused on reputational and regulatory risks by exploring the impact of social factors such as institutions and stakeholders under socio-centric theories and ignoring the possible direct impact of natural resources and the environment itself on business development [
11,
12,
13,
14], i.e., most scholars only treat natural resources and the environment as a scenario for research rather than incorporating them directly into their research frameworks. Although research concerning climate change issues has recently begun to focus on physical risk by exploring the direct impact of the natural environment on business financial outcomes (i.e., research from [
15,
16]), such research is still in its infancy and water issues are absent. The results from research considering the impact of climate change issues on firms may only have limited reference to water issues because environmental issues vary considerably [
17] in terms of issue scale and stakeholder pressures [
13,
14,
18,
19,
20,
21].
To avoid the tragedy of the commons, government water governance is regarded as an important method to solve water issues. Apart from regulation instruments which bring pressure to urge social agents to save water resources and protect water environments, governments simultaneously invest huge funds into water infrastructure to secure water supply and retore water environments that could relieve regional physical water risk. However, current research mainly focuses on the regulation and ignores other tools [
22,
23,
24]. Studies only from the perspective of environmental regulation do not fully capture the impact of government environmental governance, ignore the possible crowding out or multiplier effects between different instruments, and tend to lead governments to adopt more stringent regulatory tools. Overly stringent environmental regulation, while beneficial to the achievement of regulatory objectives, may negatively affect firms’ production and operations due to excessive pressure [
25]. At the micro-level, this can result in companies not being able to effectively adapt to the external institutional environment in the context of sustainable development, thus hindering the achievement of corporate goals; and at the macro level, it can lead to a lack of effective micro-level pathways to the sustainability of water resources.
Thus, this paper uses pooled cross-sectional regressions with year and industry fixed effects to examine the effects of water vulnerability on corporate financial performance and analyze the moderating effect of government water governance (which can be divided into water regulation and water investment). This study finds that water vulnerability could negatively impact corporate financial performance, and water regulation can intensify but water investment couldn’t significantly relieve the negative impact in general. However, the relationships above differ between SOEs and non-SOEs and water-intensive and non-water-intensive industries. For SOEs, they seem more vulnerable to water risk and water regulation could exert its positive moderating effect on the negative relationship between water vulnerability and corporate financial performance when compared with non-SOEs. For non-water intensive industries, they suffer more losses brought by physical water risk, and water regulation could make them worse. Water investment, though having insignificant moderating effect in the full-sample regression, could worsen the effect of water vulnerability on corporate financial performance in water intensive industries.
The contribution of this paper is threefold: firstly, different environmental issues have different impacts on firms, but previous studies have mostly focused on the impact of climate change and air quality. This paper focuses on water resources, further enriching the research on the impact of natural resources and the environment on firms. Secondly, previous research on water vulnerability has focused on its measurement and its relationship with economic development, but few studies have examined the micro-level impacts of water vulnerability. This paper focuses on the impact of water vulnerability on corporate financial performance, enriching the research on water management. Thirdly, previous studies have focused on regulation, neglecting government investment in environmental issues. This paper further divides environmental governance applied by the government into two types of tools, regulation and investment, verifying that different government environmental governance tools have differential impacts, and enriching the research on environmental governance.
3. Hypothesis
Firstly, water vulnerability is expressed as an imbalance between the supply and demand of water resources within a region over a certain time. Companies can only obtain water from external sources, such as permits for abstraction or from water supply companies. Both government administrative permits and water company supplies correspond to the availability of local water resources [
51]. The lower the availability of water, the more likely it is that the local area is at risk of water scarcity even in cases of extreme scarcity. Under such circumstances, water will be prioritized for basic social needs [
56,
57], while the production needs of businesses will be a lower priority, meaning that businesses may face water outages or that the water supplied will not be sufficient for daily operations. Even if water resources are relatively abundant where a company operates, the risk of water scarcity can spread downstream through the supply chain [
58,
59]. On the other hand, the less water available, the higher the cost of water for businesses, in terms of water prices, water rights fees, water taxes, etc., thus increasing the cost of doing business [
60,
61]. Furthermore, deteriorating water quality further contributes to water scarcity. Businesses also need to treat water resources etc. when using water, which increases the cost of water use and faces higher water costs when using water from the public network [
61]. Deteriorating water quality also represents a deterioration in the regional environment, which can have a serious and long-term negative impact on business operations by affecting the ability of companies to raise capital and access resources such as high-quality human resources.
Secondly, water vulnerability is also manifested by changes in precipitation patterns due to climate change and an increase in the number of extreme meteorological events, resulting in changes in the amount of water available in the region in time and space scales [
62,
63]. The unpredictability of physical risks such as droughts and floods and major disasters can pose a serious threat to business operations [
64,
65]. For example, droughts can exacerbate water scarcity problems faced by firms, while floods can cause production disruptions and equipment losses [
66].
Therefore, we assume that water vulnerability deteriorates the business performance of a firm and increases the business risk of the firm.
Hypothesis 1. The higher the water vulnerability, the lower the corporate financial performance.
Water vulnerability is a measure of the state of water resource systems that are subject to shocks from human activities and natural changes, and the degree to which they are difficult to restore to their original state after a shock [
67]. According to Xia Jun et al. [
68], adaptive management of water resources is needed to cope with the impacts of climate change and human activities on the spatial and temporal distribution of water resources. As a public resource, government intervention is seen as an important method to ensure that public goods are allocated appropriately for social welfare to prevent the tragedy of the commons caused by the ‘free-riding’ behavior of various users [
69,
70]. Governments intervene mainly through regulatory instruments such as legislation and enforcement, as well as an investment such as engineering and ecological restoration [
71]. There are differences in the mechanisms and effects of different policy instruments on water governance, but there is currently a focus on regulatory instruments, with little research focusing on the impact of government investment [
22,
23,
24].
Environmental regulations are common tools applied by the government that are coercive to businesses. The stronger the pressure for environmental regulation, the greater the pressure felt by companies to maintain environmental legitimacy. Corporate environmental legitimacy means that companies demonstrate good environmental performance in the way that stakeholders expect. In the case of water resources specifically, this is expressed in terms of the expectation that companies conserve and sustainably use water resources [
5,
72,
73]. Businesses facing regulation on water issues can feel pressure for transformation. On the one hand, companies need to accelerate the obsolescence of existing equipment and technologies and make adjustments to existing inventories that do not meet new environmental requirements, which affects business performance in the short term. On the other hand, process transformation and technological innovations are needed to improve water efficiency and reduce effluent emissions. However, innovation is inherently risky and unknown, in that technological innovation does not necessarily reduce the risks faced by firms in the short term [
49]. Water regulation also means that firms face the possibility of paying high water taxes and higher water contamination penalties. Thus, water regulation can intensify the negative effect of water vulnerability on firms.
In addition to environmental regulation, governments will further enhance water infrastructure and restore water ecosystems to change the spatial and temporal distribution of water resources in terms of quantity and quality [
74]. For example, the construction of the South–North Water Transfer Project by the Chinese government has changed the regional distribution of water resources and improved the adaptive capacity of water-scarce areas [
75]. The improvement of the water environment and water ecology has improved the regional natural environment. As mentioned above, environmental degradation affects labor costs and operational efficiency. Thus, environmental improvements reduce labor costs and help improve business efficiency. Reservoirs and dikes can improve the region’s resilience to floods and droughts, reducing the risk of production losses. Investments such as reservoirs and water diversion projects increase the amount of water available to the region. Although these storage and supply projects can lift the price of water services, water price is relatively low and does not fully reflect its scarcity value in general [
60,
72]. The benefits of water investment may outweigh the cost that firms have to pay.
Thus, we hypothesize that:
Hypothesis 2a. Government water regulation positively moderates the relationship between water vulnerability and the corporate financial performance.
Hypothesis 2b. Government water investment negatively moderates the impact of water resource vulnerability on corporate financial performance.
6. Conclusions and Implications
Our analysis highlights a previously under-appreciated economic cost of water vulnerability. Our results suggest that companies in places with great exposure to water vulnerability exhibit higher financial losses, and water governance applied by the government can partly significantly influence the impact of water vulnerability. Specifically, water vulnerability negatively impacts corporate financial performance, and water regulation intensifies the negative impact while water investment insignificantly reduces the negative impact. Our main results are consistent with Northey et al. [
51] and Ortas et al. [
53] that water conditions matter to firms. However, Northey et al. [
51] and Ortas et al. [
53] did not investigate the impact on corporate financial outcomes. Our results are also consistent with the research made by Huang et al. [
15], and Kling et al. [
16] on the impact of climate risk on corporate financial results, and provide evidence related to Tashman [
13] in that firms are indeed dependent on natural resources. However, Huang et al. [
15], and Kling et al. [
16] did not consider the impact of governance and Tashman and Rivera [
14] mainly considered regulation tools. Li Zihao and Yuan Bingbing [
22] considered different governance tools, but they failed to examine the different impacts on corporate financial outcomes and did not consider the effect of natural vulnerability.
Furthermore, we re-examined the relationship above in different sub-samples and found some interesting results. Water-intensive enterprises seem immune to water vulnerability, for they may have implemented water adaptative management. The effect of water regulatory pressure on them seems to diminish, while water investment may generate short-term harm because of the increase in price of water supply services. Non-water intensive enterprises are vulnerable to water vulnerability and are sensitive to regulation. This may be due to their carelessness in water adaptive management. Although the increase of water price does not bring in obvious financial losses to non-water intensive companies, their water use is anticipated to be monitored by the government. Compared with non-SOEs, SOEs suffer relatively more short-term economic loss when faced with water vulnerability due to their attributes of having more responsibilities in social welfare.
Our results have some implications. For firms, water vulnerability matters to their financial performance. Enterprises should work together to build water security; non-water intensive enterprises should especially establish the awareness of water risk and conduct water adaptive management and non-SOEs should share the responsibility for water issues. Secondly, firms should conduct water adaptive management to establish competitive advantages. Considering that the water consumption standards for several industries are under-enacted after the National Water Action Plan was issued in 2021, water institutional pressure, which is relatively low, may be intensified, especially on non-SOE businesses. For the government, water institutional pressure is needed and should be intensified because most firms do not realize the threats of water risk and the importance of water adaptive management at the firm level. However, the focus should shift to non-SOEs and non-water intensive firms by strengthening their water consumption and contaminants discharge auditing or so on. Secondly, the negative impact of water regulation on businesses also needs to be considered when increasing the pressure on water regulation in the future. Regulation tools should be used in conjunction with other governance tools. Thirdly, despite water investments not generating immediate benefits for most enterprises, they are generally beneficial in mitigating regional water vulnerability in the long run. Governments should attach more importance to this and invest in water infrastructures.
However, this study is subject to some limitations. First, although we attempted to employ as full a dataset as possible of all listed firms in the Chinese main board market, there may still be a selection bias because listed firms are a relatively small subset of all companies in China. Therefore, one should be cautious when interpreting our results for general Chinese firms. Second, although we took as many commonly used indicators to measure water vulnerability as possible, the indicators of water vulnerability are far from agreed upon. Hydrologists are still striving to explore more accurate indicators and methods to measure water vulnerability. More measurements of water vulnerability could be used to re-examine the relationship between physical water risk and firm financial outcomes. Thirdly, we mentioned that different governance tools may have multiple or cross-out effects, but we did not further test whether the multiple or cross-out effects exist in our study. Finally, we only tested the cotemporal effect. However, water vulnerability and water governance tools may have an intertemporal effect on corporate financial outcomes that deserve investigation.