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Banking on Scarcity: Risks and Opportunities for Investment Funds in the Water Sector

Banking on Scarcity: Risks and Opportunities for Investment Funds in the Water Sector

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IGEL Student Research Brief by Michael McCullough
IGEL Student Research Brief by Michael McCullough

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 Michael McCullough
ater is an increasingly scarce resource dueto booming population growth, increaseddemand and climate change. Many inves-tors see global water scarcity as an investment oppor-tunity. This ever widening gap between supply andmounting global demand is an obvious selling pointfor some investment funds eager to acquire an under- valued commodity. Unlike oil, gold or copper com-modities, however, the basic supply-demand calculus will not necessarily yield predictable returns on water because of political risks inherent in charging increas-ing prices for a life-sustaining service. A successfulstrategy will seek to provide cost-effective technology enabling consumers to receive and enjoy the samelevel of water service while consuming significantly less water.
Additionally, water-inefficient productionprocesses, primarily in the agricultural sector accountfor the vast majority of water consumption, meaninggains in efficiency can do much to close the supply shortfall if increasing prices incentivize efficiency (Ghosh 2009; 2030 Water Resources Group 2009).The water sector has tremendous growth potential forinvestors, but a strategy must assume provision of aminimum level of domestic and subsistence water ser- vices with a hard ceiling on prices for those services.More importantly, a rational investment strategy should consider that agricultural production accountsfor the vast majority of water consumption.
Technol-ogy-enabled efficiency gains allowing agricultural pro-ducers to grow more with less water should representa primary short-term focus. The winners in the watersector will be innovators of cost-effective solutionsthat enable consumers and producers to do more withless water.This paper identifies the opportunities and risks inthe growing water sector. The study draws from sev-eral leading investment funds with holdings in the water sector, which have misjudged the potential risksand opportunities. It considers recent grass-roots ac-tivism and political events surrounding the provisionand pricing of water. Finally the paper proposes aninvestment strategy that limits risky exposure to polit-ical backlash over rate hikes for water services by fo-cusing on short-term efficiency gains, primarily inagriculture.
The Water Sector:
The water sector is large and growing, currently accounting for roughly $425 billion; it is expectedto grow to a $1 trillion industry by 2014 (Yang2009). The water sector is amorphous. In a 2008report, Goldman Sachs identified 10 distinct sub-groups that comprise the water sector: equipment, valves, water test, filtration/desalinization, drink-ing water, wastewater, industrial water treatment,infrastructure, automation, consulting/engineering services (2008: 3). The term watersector is used here broadly to refer to water rightssuch as the right to tap groundwater and divertriver flows, these rights usually convey with land, but in certain markets in the Western UnitedStates and in Australia they may be distinct fromownership of real estate. It may also refer to realestate investments with aquatic features like lakes,ponds, and springs. Water-purification and treat-ment technologies such as desalination, treatmentchemicals and equipment also fall under this cate-gory. Irrigation and well-drilling technologies as well as sanitation services and utilities come underthe umbrella of the water sector, as do water infra-
*Author Michael McCullough is graduating from the Uni-versity of Pennsylvania in May 2012. His contact is jmmc-culoough@gmail.com**IGEL is a Wharton-led, Penn-wide initiative to facilitateresearch, events and curriculum on business and the envi-ronment. IGEL Research Briefs are written by students onrelevant issues in business and the environment and donot represent the views of Penn, Wharton or IGEL. Learnmore at http://environment.wharton.upenn.edu
1 This process implies both increasing price for water andadded costs for technology. The latter is a better invest-ment than the former, owing to political risks. Expensive
 water service providers are likely to be labeled as “the prob-lem,” while providers of efficiency technology could be seenas “problem solvers.”
2 In 2009, agriculture accounted for approximately 3,100 billion cubic meters, roughly 71 percent of global water withdrawals. Industrial processes, primarily energy andpower production account for roughly 20 percent of waterconsumption, roughly equal to domestic consumption(2030 Water Resources Group 2009: 6-8).
structure maintenance and construction of projects.Engineering services involved in the design and con-struction of water-related facilities and the retail wa-ter sector involved in the production and sale of bot-tled water, vending machines, bottled water sub-scription and delivery services, and water tankersare all included as water sector industries (Yang2009).Private investors and investment funds can buy rights to water or purchase land with lakes orsprings. An individual or a corporation can invest in water-targeted hedge funds, index funds and ex-change-traded funds (ETFs), water certificates,shares of water engineering and water technology companies, shares of multinational private waterutilities, shares of multinational banks and invest-ment banks that own water utilities or water-related
companies. According to Yang (2009), the “real sto-ry of the global water sector” represents a far more
complicated interlocking of globalized capital: in- vestment funds, banks, private equity groups, insur-ance companies, regional public-sector pensionfunds, sovereign wealth funds and hedge funds part-ner with one another and with makers and proprie-tary owners of cutting-edge technology to consoli-date water rights and water-treatment technologies.These enterprises also cooperate to privatize public water utilities and infrastructure. Given the tremen-dous hydrological challenges facing humanity, thisaggregation of capital in the water sector comes as arelief to many concerned spectators; however, othershave grave misgivings about the capitalization andconsolidation of water in the hands of financial in-terests. Obviously these deep-seated resentments tocapital investment in the water sector represent arisk to the investments in the form of political back-lash if the price of water services rises above a politi-cally acceptable level.
Market Buzz:
The market buzz over water sector invest-ments is not new. In fact, it seems to be waning.The water scarcity hypothesis started attracting at-tention in the early 2000s and was garnering signifi-cant attention from the investment community by 2005. By 2007, the water scarcity angle was a majorstory; however, valuation and liquidity problems inthe United State banking system triggered a sharpeconomic downturn in 2008. In 2009, coinciding with the global financial crisis, sharp losses in newly created water Exchange Traded Funds (ETFs)
 chilled investment and quieted the story.
Supply and Demand Paradigm:
For some investors, buying into the water scarcity thesis is as straightforward as supply and demand.The 2030 Water Resources Group publication,
“Charting Our Water Future” estimated that by 
2030, consumer demand for water will rise a full 40percent above currently accessible, reliably availablesupplies (including environmental flows and returnflows). One-third of the population, primarily indeveloping countries, will live in basins where thisdeficit is larger than 50 percent (2009: 5). The UNestimates that by 2050 two-thirds of the world will
 be “water stressed,” with almost two billion people
living in countries facing water scarcity (Greenwire
2008). Asia, home to the world’s fastest growingeconomies, contains 60 percent of the world’s popu-
lation but only 36 percent of its water supply. Chinais experiencing severe water stress, with 21 percent
of the world’s population and only 7 percent of the
 water supply (Goldman Sachs 2008). Demand for water continues to grow at unsustainable rates, driv-en primarily by population growth and develop-
ment. At the same time, the world’s fresh water sup-
ply is shrinking due to pollution, draining of under-ground aquifers, and climate change. In the UnitedStates, water demand has tripled in the past 30 years, while the population has grown by only half.Globally, water consumption is doubling every 20 years, outpacing population growth by two-to-one. Water is a finite resource. Only three percent of the
Earth’s water is fresh water and of that, less than
one percent is readily accessible to humans(Scientific American 2008). Pollution is diminish-ing this supply. The UN estimates that over 80 per-cent of sewage in developing countries, the countriesthat have the greatest unmet water demand, flowsuntreated into bodies of water (Calvert Investments2012). Given current trends, by 2025, it is estimatedthat about one-third of the global population will nothave access to adequate drinking water (GoldmanSachs 2008).
Investment Strategies:
Calvert Global Water Fund, a branch of Calvert In- vestments with roughly $62 million in assets in theglobal water sector, identifies four key factors driv-ing growth: shrinking supply of a fragile resource,surging global demand driven by population, evolv-ing regulatory landscape and technological innova-tion (2012). Investment opportunities include buy-ing the rights to actual water, investing in companiesthat provide water-related services and investing in water-related technology. The first two can create
3 Especially PowerShares Global Water Portfolio (PIO) andPowerShares Water Resources (PIO)
exposure to political risks, but the third offers anattractive alternative. However, energy-intensive,high-tech solutions such as desalination may be lessattractive than investing in technologies and con-sulting services that increase agricultural efficiency.The 2030 Water Resources Group report points out
that countries’ responses to water shortfalls have
focused on creating additional supply (supply-sidemanagement), often through energy-intensive desal-ination processes. As the report notes,
“Desalination –
even with expected efficiency im- provements
is vastly more expensive than tradi-tional surface water supply infrastructure, which inturn is often much more expensive than efficiencymeasures, such as irrigation scheduling in agricul-ture. These efficiency measures can result in a net increase in water availability, and even net cost saving when operating savings of the measures
outweigh annualized capital costs (2009: 8).” 
Perhaps because of governmental focus on high-tech, high-cost, energy-intensive solutions, invest-ment funds have been keen to invest in this sub-sector of the water economy, ignoring more straight-forward, cost-effective fixes in the agricultural sec-tor.
 Agricultural Productivity:
Ghosh (2009) notes that in emerging market coun-ties like India and China, around 75 to 90 percent of the water demand is consumed by the agriculturalsector. The same is true for parts of the WesternUnited States. Here agricultural interests have beenthe primary causes of scarcity. The public image of  water scarcity is inextricably linked with the imageof scarce domestic water supply. Popularly imag-ined solutions are also linked to domestic efficiency and high-tech solutions to get more domestic water.Investment strategies from sophisticated and water-specialized investment funds (Goldman Sachs 2008;Calvert 2012) seem drawn to this misconception al-so. In reality, this approach ignores the real driverof scarcity and the obvious and relatively straightfor- ward solutions. With a large quantum of water be-ing consumed by the agricultural sector, domesticsupplies are victims of the reprehensible wastageoccurring in the agricultural sector. Thus, shortfallsin both domestic and industrial water supply canoften be alleviated by agricultural adjustments. The2030 Water Resources Group names agriculturalproductivity as the most important element in pre-
 venting a water scarcity crisis by increasing “cropper drop” through a mix of improved efficiency of 
 water application and through net water gainsthrough crop yield enhancement (2009: 12). Theseinclude the familiar technologies of improved waterapplication, such as increased drip and sprinkler ir-rigation, no-till farming and better drainage, utiliza-tion of the best available germplasm, optimizing fer-tilizer use, and application of crop stress manage-ment, including both improved practices (such asintegrated pest management) and innovative cropprotection technologies (12).
Exposure to Political Risk:
Investing in water directly results in exposure to po-litical risk. Unpredictability of government regula-
tion can plague markets’ trading rights to actual wa-
ter. Changing rules and shifting government dispo-sition towards a major buy-back scheme in Austral-
ia’s Maury 
-Darling Basin market have combined todrop the value of water certificates there by 90 per-cent in just two years. Tom Wilkes, a long-time wa-ter broker in the Australian market notes that thelack of clarity and changing rules creates uncertain-
 Investing inwater directlyresults in exces-sive exposure to
 political risk.” 

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