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Michael McCullough
The Water Sector: The water sector is large and growing, currently accounting for roughly $425 billion; it is expected to grow to a $1 trillion industry by 2014 (Yang 2009). The water sector is amorphous. In a 2008 report, Goldman Sachs identified 10 distinct subgroups that comprise the water sector: equipment, valves, water test, filtration/desalinization, drinking water, wastewater, industrial water treatment, infrastructure, automation, consulting/ engineering services (2008: 3). The term water sector is used here broadly to refer to water rights such as the right to tap groundwater and divert river flows, these rights usually convey with land, but in certain markets in the Western United States and in Australia they may be distinct from ownership of real estate. It may also refer to real estate investments with aquatic features like lakes, ponds, and springs. Water-purification and treatment technologies such as desalination, treatment chemicals and equipment also fall under this category. Irrigation and well-drilling technologies as well as sanitation services and utilities come under the umbrella of the water sector, as do water infra*Author Michael McCullough is graduating from the University of Pennsylvania in May 2012. His contact is jmmcculoough@gmail.com **IGEL is a Wharton-led, Penn-wide initiative to facilitate research, events and curriculum on business and the environment. IGEL Research Briefs are written by students on relevant issues in business and the environment and do not represent the views of Penn, Wharton or IGEL. Learn more at http://environment.wharton.upenn.edu 1 This process implies both increasing price for water and added costs for technology. The latter is a better investment than the former, owing to political risks. Expensive water service providers are likely to be labeled as the problem, while providers of efficiency technology could be seen as 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 and power production account for roughly 20 percent of water consumption, roughly equal to domestic consumption (2030 Water Resources Group 2009: 6-8).

ater is an increasingly scarce resource due to booming population growth, increased demand and climate change. Many investors see global water scarcity as an investment opportunity. This ever widening gap between supply and mounting global demand is an obvious selling point for some investment funds eager to acquire an undervalued commodity. Unlike oil, gold or copper commodities, however, the basic supply-demand calculus will not necessarily yield predictable returns on water because of political risks inherent in charging increasing prices for a life-sustaining service. A successful strategy will seek to provide cost-effective technology enabling consumers to receive and enjoy the same level of water service while consuming significantly less water.1 Additionally, water-inefficient production processes, primarily in the agricultural sector account for the vast majority of water consumption, meaning gains 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 for investors, but a strategy must assume provision of a minimum level of domestic and subsistence water services with a hard ceiling on prices for those services. More importantly, a rational investment strategy should consider that agricultural production accounts for the vast majority of water consumption.2 Technology-enabled efficiency gains allowing agricultural producers to grow more with less water should represent a primary short-term focus. The winners in the water sector will be innovators of cost-effective solutions that enable consumers and producers to do more with less water. This paper identifies the opportunities and risks in the growing water sector. The study draws from several leading investment funds with holdings in the water sector, which have misjudged the potential risks and opportunities. It considers recent grass-roots activism and political events surrounding the provision and pricing of water. Finally the paper proposes an investment strategy that limits risky exposure to political backlash over rate hikes for water services by focusing on short-term efficiency gains, primarily in agriculture.
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structure maintenance and construction of projects. Engineering services involved in the design and construction of water-related facilities and the retail water sector involved in the production and sale of bottled water, vending machines, bottled water subscription and delivery services, and water tankers are all included as water sector industries (Yang 2009). Private investors and investment funds can buy rights to water or purchase land with lakes or springs. An individual or a corporation can invest in water-targeted hedge funds, index funds and exchange-traded funds (ETFs), water certificates, shares of water engineering and water technology companies, shares of multinational private water utilities, shares of multinational banks and investment banks that own water utilities or water-related companies. According to Yang (2009), the real story of the global water sector represents a far more complicated interlocking of globalized capital: investment funds, banks, private equity groups, insurance companies, regional public-sector pension funds, sovereign wealth funds and hedge funds partner with one another and with makers and proprietary owners of cutting-edge technology to consolidate water rights and water-treatment technologies. These enterprises also cooperate to privatize public water utilities and infrastructure. Given the tremendous hydrological challenges facing humanity, this aggregation of capital in the water sector comes as a relief to many concerned spectators; however, others have grave misgivings about the capitalization and consolidation of water in the hands of financial interests. Obviously these deep-seated resentments to capital investment in the water sector represent a risk to the investments in the form of political backlash if the price of water services rises above a politically acceptable level. Market Buzz: The market buzz over water sector investments is not new. In fact, it seems to be waning. The water scarcity hypothesis started attracting attention in the early 2000s and was garnering significant attention from the investment community by 2005. By 2007, the water scarcity angle was a major story; however, valuation and liquidity problems in the United State banking system triggered a sharp economic downturn in 2008. In 2009, coinciding with the global financial crisis, sharp losses in newly created water Exchange Traded Funds (ETFs)3 chilled investment and quieted the story.
3 Especially PowerShares Global Water Portfolio (PIO) and PowerShares Water Resources (PIO)

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 40 percent above currently accessible, reliably available supplies (including environmental flows and return flows). One-third of the population, primarily in developing countries, will live in basins where this deficit is larger than 50 percent (2009: 5). The UN estimates 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 worlds fastest growing economies, contains 60 percent of the worlds population but only 36 percent of its water supply. China is experiencing severe water stress, with 21 percent of the worlds population and only 7 percent of the water supply (Goldman Sachs 2008). Demand for water continues to grow at unsustainable rates, driven primarily by population growth and development. At the same time, the worlds fresh water supply is shrinking due to pollution, draining of underground aquifers, and climate change. In the United States, 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 Earths water is fresh water and of that, less than one percent is readily accessible to humans (Scientific American 2008). Pollution is diminishing this supply. The UN estimates that over 80 percent of sewage in developing countries, the countries that have the greatest unmet water demand, flows untreated into bodies of water (Calvert Investments 2012). Given current trends, by 2025, it is estimated that about one-third of the global population will not have access to adequate drinking water (Goldman Sachs 2008). Investment Strategies: Calvert Global Water Fund, a branch of Calvert Investments with roughly $62 million in assets in the global water sector, identifies four key factors driving growth: shrinking supply of a fragile resource, surging global demand driven by population, evolving regulatory landscape and technological innovation (2012). Investment opportunities include buying the rights to actual water, investing in companies that provide water-related services and investing in water-related technology. The first two can create
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exposure to political risks, but the third offers an attractive alternative. However, energy-intensive, high-tech solutions such as desalination may be less attractive than investing in technologies and consulting 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-side management), often through energy-intensive desalination processes. As the report notes, Desalination even with expected efficiency improvements is vastly more expensive than traditional surface water supply infrastructure, which in turn is often much more expensive than efficiency measures, such as irrigation scheduling in agriculture. 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 hightech, high-cost, energy-intensive solutions, investment funds have been keen to invest in this subsector of the water economy, ignoring more straightforward, cost-effective fixes in the agricultural sector. Agricultural Productivity: Ghosh (2009) notes that in emerging market counties like India and China, around 75 to 90 percent of the water demand is consumed by the agricultural sector. The same is true for parts of the Western United States. Here agricultural interests have been the primary causes of scarcity. The public image of water scarcity is inextricably linked with the image of scarce domestic water supply. Popularly imagined solutions are also linked to domestic efficiency

and high-tech solutions to get more domestic water. Investment strategies from sophisticated and waterspecialized investment funds (Goldman Sachs 2008; Calvert 2012) seem drawn to this misconception also. In reality, this approach ignores the real driver of scarcity and the obvious and relatively straightforward solutions. With a large quantum of water being consumed by the agricultural sector, domestic supplies are victims of the reprehensible wastage occurring in the agricultural sector. Thus, shortfalls in both domestic and industrial water supply can often be alleviated by agricultural adjustments. The 2030 Water Resources Group names agricultural productivity as the most important element in preventing a water scarcity crisis by increasing crop per drop through a mix of improved efficiency of water application and through net water gains through crop yield enhancement (2009: 12). These include the familiar technologies of improved water application, such as increased drip and sprinkler irrigation, no-till farming and better drainage, utilization of the best available germplasm, optimizing fertilizer use, and application of crop stress management, including both improved practices (such as integrated pest management) and innovative crop protection technologies (12). Exposure to Political Risk: Investing in water directly results in exposure to political risk. Unpredictability of government regulation can plague markets trading rights to actual water. Changing rules and shifting government disposition towards a major buy-back scheme in Australias Maury-Darling Basin market have combined to drop the value of water certificates there by 90 percent in just two years. Tom Wilkes, a long-time water broker in the Australian market notes that the lack of clarity and changing rules creates uncertain-

Investing in

water directly results in excessive exposure to political risk.

ty, They can change rule[s] with the stroke of a penthings are too uncertain for anyone to invest with any degree of confidence (Business21C: January 2011). Changing regulation is also a key risk for investors in utilities. Water prices are almost always set by governments rather than by supply and demand forces (MoneyWeek: February 2012). Political risk remains one of the main obstacles in private infrastructure projects. Governments often change contracts in order appease angry voters and score political points. Policy makers and voters favor unreasonably low utility fees, precluding returns on expensive infrastructure investment (The Nation: February 2012). The most noteworthy example of political backlash to private water interests was in Bolivia in 2005, when the private company Aguas del Illimani, a holding of multinational water services provider, Suez was shut down. Connection fees designed to cover costs of infrastructure were exceedingly high prompting a general strike and public protests (Barlow 2005). Conclusion: The global water sector increasingly offers opportunities for investment funds. Attempts to consolidate physical water, water rights and water infrastructure to profit from increased fees for water services expose investors to unacceptably high levels of risk in the form of political push-back. Furthermore, such strategies would likely create price incentives for improvements in the agriculture sector, freeing up water, thus offsetting any potential gains. On the other hand, significant opportunities exist in investing in water-related technologies that increase agricultural and industrial efficiencies. Often these employ proven and relatively simple, low-cost technologies. The shortfall in global water supply requires an aggregation of capital to effect agricultural efficiency gains in the short-term and investment in high-tech ventures in the longer-term in order to stave off a global water crisis. Targeted investment in the global water economy provides a valuable social development service and offers the promise of low-risk returns on capital.

2030 Water Resources Group. 2009. Charting Our Water Future: Economic Frameworks to Inform DecisionMaking. <http://www.2030waterresourcesgroup.com/ water_full/Charting_Our_Water_Future_Final.pdf> Barlow, Maude. 2005, Securing the Right to Water in Bolivia. << http://www.blueplanetproject.net/ Movement/Bolivia_05.html>> Barlow, Maude and Vandana Shiva, 2007. Personal communication. Tabbard Inn Hotel. April, Washington, DC. Business21C. 2011, January 11. << http:// www.business21c.com.au/2011/01/australia%E2%80% 99s-water-market>> Calvert Investments. 2012, Quenching the Worlds Thirst for Water. January. Ghosh, Nilanjan. 2009. Economics of Hostile Hydropolitics Over Transboundary Waters: Scarcity Values and Interstate Water Conflicts in India and USA. VDM Verlag Dr. Muller Aktiengesellschaft & Co. KG: Saarbrucken, Germany. Greenwire. 2008, July 28. WATER: Oil Companies See Opportunity in Another Precious Commodity. Goldman Sachs Investment Research. 2008. The Essentials of Investing in the Water Sector; version 2.0. << http://www.excelwater.com/2008-goldman-sachswater-primer.pdf>> Money Week. 2012, February 6. Merryn Webb, How to Invest in Water, the Worlds Most Undervalued Resource. << http://www.moneyweek.com/ investments/commodities/soft-commodities/merrynsomerset-webb-how-to-invest-in-water-20600>> The Nation. 2012, February 8. Wichit Chaitrong, Political Risk Still Obstacle to Private Role in Govt Projects., << http://www.nationmultimedia.com/ business/Political-risk-still-obstacle-to-private-role-ing-30175397.html>> Scientific American. 2008, July 31. Facing the Freshwater Crisis. Yank, Jo-Shing. 2009, October 31. Why Big Banks May be Trying to Buy up Your Public Water System, <www.alternet.org/story/105083/>

References and Works Cited:

The Initiative for Global Environmental Leadership

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