Kristof Bulkai and Hugo Rogers of Thames River Capital on why investment in water is set to rise significantly.
In the middle of the 18th century Benjamin Franklin wrote: “When the well is dry, we know the worth of water.” This statement incorporates a scientific fact, a puzzling piece of human history and two basic economic principles.
It is a scientific fact life cannot exist without water. Given its importance, it is puzzling that in recent history few people have asked how much water is left in the well before hitting the bottom. In terms of economics, Franklin illustrates the law of diminishing returns. Over time, for a finite resource, increasing capital and labour are required to extract the same material.
And the second economic principle? If there is an imbalance between supply and demand then price will solve the equation. We have now reached the point described by Franklin. The well is running dry and the price of water is going up. What can policymakers, companies and communities do about it? Who is going to pay and which technologies will be adopted?
Whatever path is chosen the destination is clear: investment in water will rise significantly. Evidence suggests the floodgates are beginning to open.
Inflation ‘times three’
In the US, Lake Mead has fallen over 30 metres in the past seven years; in Northern India water tables are falling by six metres every year; water resources per capita in Beijing are a quarter of what they were in 1950 and so on. We also described the rising price of water which is a good way to measure the pressure on the system. According to an NUS Consulting Group survey of developed economies, the price of municipal water has risen by 7.6% on average over the last five years. This is three times the average CPI in the same geographies. The pressure on the system is building.
Water investment flows uphill
The OECD calculates that to ensure adequate supplies over the next 20 years real investment in water infrastructure and maintenance will have to grow at 7% per annum. This is a significant hill to climb. Only 11% of the world’s water is supplied by private companies, so to deliver this growth governments have to ramp up spending themselves or shift more of the burden onto the private sector by offering attractive returns. The essential nature of water makes orthodox economic solutions problematic.
Until recently water was free, so rapid price increases are uncomfortable for authorities. Their choice is a difficult one. So far governments have been dragging their feet. In developed economies democracies with four year time horizons, running big budget deficits, are incentivised to neglect long term needs in favour of short term gains. The result is underinvestment that continues until the system is under critical stress. The US is a good example. The American Society of Civil Engineers estimates that over the next five years $450bn should be spent on water infrastructure.
At current rates the actual expenditure will be about half that, even including the incremental boost from the fiscal stimulus package. In fact over the past five years spending on water has been growing at less than 1% above inflation and this spend has gone down as a percentage of total expenditure, from 5.7% in 2003 to 5.1% in 2009. Given water levels in many states, this underinvestment has to end. Although we do not forecast an immediate deluge in the US – the status quo will not change overnight – we do see priorities changing and early signs that investment is coming off the floor.
When the levee breaks
Several other countries have been more proactive. They recognise the problems they face and are reacting to them robustly. As the first movers, they give an indication of the steep change in investment required to resolve these issues. China has 20% of the world’s population but only 7% of the world’s water supply. In the last three years fixed asset investment in water has doubled to $20bn. Surprisingly for a communist state they are using the private sector to help. PPI and similar projects now account for 15% of the total spend and this is growing (see Chart 1).
Necessity has made China a pioneer in private investment in water. Others will follow. Similarly in Australia annual capital expenditure on water has doubled in the last three years and the Construction Forecasting Council expects this to rise by a further 60% in the next decade. This is a big step up.
Solutions
Investments are designed to increase the quality and quantity of supply and to moderate demand growth by reducing waste. They are allocated to rehabilitate existing infrastructure and to extend existing networks and storage. Engineers, construction companies and capital equipment manufactures all benefit; the likes of Aecom, Arcadis and Insituform Technologies.
Metering is another important tool to reduce waste; the UK for example plans to triple the number of water meters by 2025. This helps the outlook for Badger Meter and Itron. New supply infrastructure includes not only traditional dams, reservoirs, pumps and pipes but also two increasingly important technologies: desalination and water recycling.
Desalination capacity is growing at an accelerating rate. According to the International Desalination Association, the growth in installed capacity has been 8.1% in the last decade. In the next decade Global Water Intelligence estimates this growth will be 9.1%. Currently only 4% of water is re-used but recycling technology is of growing importance.
GWI expects installed capacity will more than double in the next five years (see Chart 2). This technology is either used to partially clean waste water for uses other than human consumption, for example in agriculture, or used to clean water thoroughly so it can be drunk.
This already takes place in Singapore; it costs a third less than desalination and it also reduces pollution. Membrane manufacturers, such as Toray Industries, energy saving technology companies and specialist engineers cater to these sectors and are key focus areas for the fund.
Technology also helps suppliers meet quality requirements. For example, to 2013, $110m will be spent annually by US utilities on UV filtration, which will benefit Calgon Carbon with their 40% market share. On top of UV, activated carbon, ceramics, ozone and chlorine are all used to treat water.
Privatisation light
Until recently, governments have not only been reluctant to spend themselves, they have also been reluctant to open the markets to private capital. This is true particularly in developing countries where administrations prefer to create implicit and explicit subsidies to ensure supplies get to the poorest people. Inevitably such a heavily subsidised industry becomes hugely inefficient; there is no incentive to reduce waste if it costs nothing.
According to the World Bank, over a third of water is ‘unbilled’. This is primarily lost through leakage but includes unpaid bills and theft. As the price of water rises, the cost of waste and subsidies rockets. Given the scale of the required investment and the rising costs we expect greater private involvement in the near future. Privatisation can offer significant benefits not only in reducing leaks, but in optimising current operations, maintenance and capital expenditure. Veolia Environnement’s North American chief has suggested there is $7bn of savings available in the US in operations and maintenance alone.
The political implications of ceding control may be controversial but increasing private participation need not involve selling assets outright. We see an increasing number of operations and maintenance contracts outsourced to the benefit of some familiar local and international water companies. As an example, despite the extraordinary tightness of credit at the time, in February 2009 Suez Environnement invested €42m in a 40-year concession in Chonging, China.
The regulatory endgame: the UK
The ‘endgame’ in terms of balancing public requirements with the need to incentivise private investment may look a little like the UK. Uniquely 90% of water in the UK is supplied by private companies. As a result of privatisation leakages have been cut from 30% in the mid 1980 to 22% and they continue to fall. It will take a long time before other markets become as established and as transparent but in due course the obvious benefits of private involvement should become apparent. This increases the range of opportunities for consolidation in the water services industry, again to the benefit of ambitious, well capitalised water companies.
Studying the pressures that we see on governments and infrastructure around the world, allows us to time our exposure to industries and stocks as their profit outlook improves. For example Hyflux, a Singaporean desalination engineer, made an important contribution in 2009 and remains a key investment. Hyflux’s earnings are growing with Asian spending in this space.
We have holdings in other geographies depending on how much investment is likely to materialise (as a result of the US fiscal stimulus for example.) We also monitor the new regulations and the technological breakthroughs that drive the purchases of new equipment and chemicals.
Regulation does not just determine which technology supercedes another it will also drive outsourcing and consolidation, which offer further profitable opportunities. The progress of these factors, appropriate valuations and impending catalysts determine the companies we hold and the construction of our portfolio.
Kristof Bulkai and Hugo Rogers, managers of the Water & Agriculture fund, Thames River Capital
