08/10/2007
Investment Adviser – 8th October
Water – the strategic commodity
While we cannot invest in water on the commodity exchanges, the markets for water-related investment are substantial and growing. Global annual revenues are in excess of $400bn and overall growth rates are in the order of 5% in developed markets and 10-15% in developing countries. Market segments have widely differing profiles, from the defensive established utility and water management businesses to high growth clean technology. There are opportunities for both equity and bond investors in water.
Water covers 80% of the earth’s surface but, 97% of this is salt water and two thirds of the remaining 3% is frozen in the form of ice caps or is otherwise inaccessible. The supply of fresh water is relatively static but the quality is threatened by factors such as pollution and local difficulties caused by excessive development draining underground aquifers, water withdrawal in arid regions and changing weather patterns including droughts and floods. Demand, on the other hand, is rising at double the rate of population growth, on the back of industrialisation and increasing affluence. Humans currently use over half of the available fresh water supply and by 2025 this figure could rise to 90%. The balance of demand and supply is not neat. Some countries and regions enjoy an abundance of water while others struggle for every drop. Supply is very much a local issue and transporting water on a large scale is not feasible, on either financial or ecological grounds, so the imbalances will remain and water stress will increase, affecting up to 58 countries by 2025. At the same time, restricted transport and delivery options means that it is not traded on commodity markets.
Although water is the most important resource in the world, determining the locus of people, agriculture and industry and the shape of development, its status as a non-traded commodity underpins decades of mispricing. If water is free or subject to a flat charge, there is little incentive to use it efficiently. Attempts to tackle water shortages fall into two main categories: restrictions on use and market solutions such as price adjustments and metering. Exhortations to be more frugal in the use of water are directed at domestic users but need to be followed through with the installation of meters, which is happening in the UK, albeit slowly. Domestic use accounts for 22% in the UK but only 10% globally. In contrast, 71% of fresh water is used for agriculture but traditionally agricultural users are rarely charged according to use. This has resulted in underinvestment in irrigation and water reclamation, which is now being addressed because of increased stress and pollution of river systems and groundwater. For example, the Australian government initiated renegotiation of the state-controlled Murray Darling water rights after several years of drought compounded by excessive water withdrawal, which depleted and degraded the water supply for 14% of Australia.
Water-related infrastructure spending is a priority in both developed and developing economies. Projects range from reservoir and dam building to repairing pipelines and stemming leaks. The capital expenditure requirement for water infrastructure represents real growth of around 7% per annum. The scale of the problem is illustrated by this summer’s flooding in the UK, where drainage and existing flood defences were clearly inadequate and the parlous state of Chinese reservoirs, where 44% are considered ‘sick or hazardous’ – China plans to spend 51 billion yuan ($6.8bn) over the next three years on reservoir repairs.
The clean tech market – for environmental technology devoted to sustainable water recovery, distribution and disposal - is growing at 12% per annum. Desalination is evenly split between thermal and reserve osmosis approaches and adoption is spreading from the Middle East to North Africa, Australia and other countries, driven by necessity and helped by efficiency and cost improvements in reverse osmosis. As it remains an expensive option, desalination is reserved for domestic and industrial use. At the less high tech front, the market for waste water treatment is projected to grow at an annual rate of more than 10%. Recycled or reclaimed water makes up circa 4% of global supply but this will inevitably rise in areas of acute shortage such as Israel, Australia and Tunisia.
The chart illustrates the gains enjoyed by equity investors in water and related industries. For corporate bond investors, there are two sources of interest: water utilities and project finance. Water utilities form an important part of the investment grade corporate bond market. Heavy investment programmes over long time frames and known pricing levels add up to predictable flows. There is also implicit protection against downgrades – the presence of an active regulator means water utility bonds will almost certainly remain investment grade. On the project side some of the same criteria apply. Projects such as constructing dams, desalination plants or flood defences are large scale and long-term financing, up to 25 years is needed.
Frances Hudson, Global Thematic Strategist at Standard Life Investments.
Standard Life Investments Limited, tel. +44 131 225 2345, a company registered in Scotland (SC 123321) Registered Office 1 George Street Edinburgh EH2 2LL.
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