How to invest in water
Our water supply is like a giant milkshake, and each diversion is a straw in the glass. People have a sense of our water supply as infinite, but in reality, it’s finite and exhaustible.
Robert Glennon (water-law expert, University of Arizona)
Why is fresh water inexpensive when it is critical for life and human survival, while diamonds, which mainly serve an ornamental purpose, have a steep price attached to them? Economists, starting with Adam Smith, have long pondered this puzzle- the so-called diamond-water paradox.
An explanation of the paradox is the seeming abundance of water. However, as Niels Jensen highlighted in a recent ARP+ paper, ‘Investing in Natural Resources in a Changing World, Part III’ (appropriately sub-titled ‘Why it is impossible to overstate the severity of the pending water crisis’), water scarcity is a material concern in the world today. Niels cites a number of worrying United Nations statistics, including:
- over 2 billion people live in countries experiencing high water stress;
- a third of the world's biggest groundwater systems are already in distress;
- assuming the climate continues to change at the current pace, by 2030, water scarcity will displace up to 700 million people;
- nearly half of the global population is already living in potential water-scarce areas at least one month per year and this could increase to some 5 billion by 2050.
With the combination of population growth, urbanisation and rising living standards in developing countries, the expectation is that the demand for water will continue to rise rapidly. On the other hand, according to the United Nations, higher temperatures and more extreme weather conditions are projected to affect the availability and distribution of water. Rainfall, snowmelt, river flows and groundwater will all become less predictable. Meanwhile, the quality of all that water will most likely deteriorate.
If you were to apply Adam Smith’s thinking on supply and demand to water, it would seem like a very attractive investment opportunity indeed. At ARP, constantly with our megatrend thinking cap on, ‘Running Out of Freshwater’ is one of the key associated investment themes identified within our wider ‘Climate Change’ megatrend, which we believe will create attractive investment opportunities over time.
Further, investing in water, in some instances, provides investors with the opportunity to be part of the solution to the water scarcity issues facing the world. According to the Food and Agriculture Organisation (FAO), water scarcity is the biggest challenge of the 21st century and, of the 17 United Nations Sustainable Development Goals (SDGs), three are related to water scarcity.
So how can you invest in the ‘Running Out of Freshwater’ investment theme? This paper explores the array of options available to you.
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Options for Investing in Water
There are a number of investment strategies you can adopt when making an allocation to water. In order to establish which methods are most suitable (and available to you), the items summarised in Exhibit 2 will need to be considered. As with most investment strategies, if you are a large institutional investor with a long investment horizon, there will be more options available to you than if you are a smaller individual investor.
The main strategies you can employ when investing in water are shown in Exhibit 3. The characteristics displayed are for exposures via a fund. Direct exposures in each category will require a higher level of investor sophistication but grant you greater flexibility in focusing on water and to be part of the water scarcity solution.
Over the next few paragraphs, we discuss each of these strategies in more detail.
Water Exchange-Traded Funds (ETFs)
If you would like to “dip your toes in the water” and simply gain a passive exposure to a broadly diversified number of companies related to water businesses, and you are comfortable having equity beta in your portfolio, then investing in a water ETF may be the simplest and most efficient solution.
There are a number of ETFs available in the market and you will need to decide which one is the most appropriate. The larger water ETFs are iShares Global Water (S&P Global Water Index) and Invesco Water Resources (NASDAQ OMX US Water Index), at over $1.6bn and $1.2bn respectively (as of end of November 2020). Other water ETF providers include First Trust and Lyxor.
We include the iShares Global Water ETF industry breakdown in Exhibit 4 to provide you with some insight as to the kind of exposure you would have in a water ETF. Typically, you are mostly exposed to industrials followed by utilities.
When selecting an ETF, you will need to consider which geographical exposure you would like. For instance, Invesco offers 3 ETFs- Invesco Water Resources is mainly allocated to the US, while Invesco Global S&P Water (S&P Global Water Index) and Invesco Global Water (NASDAQ OMX Global Water Index) are both global- albeit still with around 50% in the US. The level of diversification of most ETFs is similar, within the 30-50 range of underlying companies.
While investing in ETFs is often one of the least costly routes for gaining exposure to many equity strategies, it is good to be aware that expense ratios in water ETFs are higher than many other equity ETFs. The Total Expense Ratio (TER) for iShares Global Water and Invesco Water Resources are 0.65% and 0.60% respectively. Note also that these ETFs can trade either at a premium or a discount to NAV- an inherent risk in ETF investing.
Actively Managed Public Equity Water Portfolios
Rather than investing passively in water via an ETF, allocating to an actively managed portfolio of listed companies related to water via a fund or an investment trust may be more suitable if you would like to exploit some of the underlying return drivers in the water space. Some of the key themes often expressed by active equity managers, in addition to the demand and supply imbalance discussed earlier, include ageing infrastructure and innovative technologies and solutions, i.e. they actively select companies that provide solutions to the global water challenge.
Most developed countries are struggling to maintain their aging water infrastructure at a sustainable rate while many developing countries still need to complete the basic framework for water and wastewater systems. According to the World Bank, in developing countries, more than 45m cubic metres of water are lost through leaks every day. According to the Global Infrastructure Hub, the world faces a $15 trillion gap between projected investment and the amount needed to provide adequate global infrastructure by 2040.
Companies which produce next-generation sensors and monitoring equipment that help avoid wastage through leaks and/or increase the efficiency of water usage are types of active equity allocations held.
Innovative technologies and solutions
Technologies to solve some of the issues, other than aging infrastructure, are being developed in a number of fields including:
- Agriculture water technology- according to the United Nations, 70% of the world’s available freshwater is used in agricultural production. Companies which address wasteful use of water in agriculture, such as drip irrigation (only intermittently wets the soil that is closest to the crop providing higher moisture levels while using less water), are examples of agriculture water technology stocks held in active portfolios.
- Water treatment and reusage- around 75% of the world’s available freshwater supply is unsafe for consumption due to contamination or pollution [United Nations Educational Scientific and Cultural Organization]. In China, nearly 60% of the country’s underground water and a third of its surface water is classed as “unfit for human purpose” [China’s Ministry of Land and Resources]. Companies specialising in filtration systems such as permeable membranes or UV filtration are examples of these types of companies.
- Desalination- 97.5% of the world’s water is seawater and 2.5% is freshwater. Desalination is therefore one of the solutions in the battle to increase the amount of freshwater globally. Desalination is not embraced by all, though, as the process is less sustainable and very costly, requiring large amounts of energy and producing brine as a by-product, taking a toll on marine life. Some technological improvements have mitigated some of the concerns. Companies manufacturing membranes used in the process of desalting seawater are examples of stocks held in portfolios (for our discussion on desalination see ARP+ paper, ‘Investing in Natural Resources in a Changing World, Part III’).
Note that fund managers will often allocate to some of the more defensive style stocks in the universe. Pictet Water Fund, at over £5bn in assets under management, claim to “combine defensive stocks with more adventurous growth stocks”. Water utilities, which are widely held in water ETFs, are almost always less cyclical and generate highly predictable cash flows. Note that while most specialised long-only equity water manager have a global exposure, around half or more of their holdings are typically allocated to US water companies.
Individual Water Related Public Equity
If you already invest in stocks directly, have the required skillset and are comfortable with the higher risk embedded in owning individual stocks, investing directly in water related public equities is an option. If you would like to focus on a few select names meeting the water solution criteria, this may be one of the most suitable methods.
Danaher Corporation (NYSE: DHR) is a US listed company frequently found in actively managed water equity funds. Danaher describe themselves as:
…a global science and technology innovator committed to helping customers solve complex challenges and improving quality of life around the world…. Our Water Quality businesses deliver precision instrumentation and advanced purification technology to help analyze, treat and manage the world’s water, from municipal and wastewater treatment facilities to lakes, streams and oceans.
Thermo Fisher Scientific (NYSE: TMO) is another US listed company commonly found in active water portfolios. Amongst other, according to their website, Thermo Fisher Scientific:
… manufactures a wide range of water quality products from Barnstead™ water purification systems, to Orion™ pH and electrochemistry analyzers, meters and accessories to Thermo Scientific™ AquaSensors.
In terms of valuations, as of mid-December 2020, Danaher Corporation is just over 44x, while Thermo Fisher Scientific stands at around 38x earnings.
A more unusual way to gain exposure to water is through water rights. Water rights give the owner the right to use water from a water source, such as a river or groundwater.
Water right laws are very complicated and vary by region (even state by state within the US), so water rights would not typically be an area the average investor would invest in directly. Opting for a fund specialised in water rights would be a more sensible route, and there are indeed funds that specialise in water rights in western United States and in Australia.
Australia is often considered the most sophisticated water rights market with a model that is based on river systems. The water trading in the Murray Darling Basin is estimated to be worth about $2bn annually [MDBA, ABARES]. The Australian market is unique in that there are two separate products as shown in Exhibit 6:
- water entitlements- the right to a share of water from a particular water resource, such as a river or underground aquifer; and
- water allocations- the right to access a volume of water, made available under a water entitlement, in a given year. The amount of water allocated will vary each year and is dependent on factors such as storage levels of specific reservoirs, climatic conditions and aquifer recharge status.
Water entitlements can be bought and sold, as can the actual water allocations (or in some instances leased out).
The right to water is highly political and litigious, often posing ethical questions. Water right markets are frequently criticised for creating wrong incentives. A 2016 Wall Street Journal (WSJ) article, ‘The US wants to adopt a cap-and-trade plan for water that isn’t working’ argued, amongst other, that the increased amount of trading by dedicated water funds in Australia (estimated around 14% of water licenses at the time of the article) was a contributor to the significant increase in water prices, exposing farmers. If you are an institutional investor, we recommend that, before you make an investment in water rights, you make sure you and your stakeholders are comfortable with any potential headline risk investing in water rights may create.
The buying and selling of water rights in the US has historically only happened in the spot market; however, as of the 7th December 2020, one can now trade water futures, tied to the Nasdaq Veles California Water Index which measures the volume-weighted average price of water. While the market is expected to be used primarily for hedging purposes by farmers, municipalities and the likes, if you are a hedge fund or other sophisticated investor, you may be able to speculate in this market. Although it is still early days, the January 2021 water contract that went live on the 7th December only had two trades, according to Bloomberg. A space to watch in the future?
As mentioned earlier, c. 70% of all freshwater is used for farming. It would follow that another route you can take for gaining exposure to the ‘Running out of Freshwater’ investment theme is to invest in farmland. The farmland can be orchards, cropland or other, but the key aspect is that it has natural access to water.
Dr Michael Burry, made famous in Michael Lewis’ book “The Big Short”, argued in an interview with New York Magazine in 2015:
Transporting water is impractical for both political and physical reasons, so buying up water rights did not make a lot of sense to me… What became clear to me is that food is the way to invest in water. That is, grow food in water-rich areas and transport it for sale in water-poor areas. This is the method for redistributing water that is least contentious, and ultimately it can be profitable, which will ensure that this redistribution is sustainable. A bottle of wine takes over 400 bottles of water to produce — the water embedded in food is what I found interesting.
As growing almonds takes large amounts of water to produce (around 1 gallon per almond), Dr Michael Burry is reported to have been actively buying up almond farms in California with natural access to water. Following in similar footsteps, Harvard University’s endowment, valued at just over $40bn in 2019, is reported to have bought up an estimated $305m worth of vineyards in California with prime access to groundwater [Business Insider, 2018]. That said, this investment has been mired with controversy due to ethical considerations.
A variation to the above is buying land and improving the way the land is managed in order to protect, restore or conserve the natural water resources of the land. Some types of lands that can be purchased are timberland, grassland and ranchland. Clearcutting timberland practices and overgrazing on ranchland have resulted in widespread damage of natural water infrastructure and contamination of water sources. Sustainable land management practices restore and preserve the natural state of the land for long-term use.
Investing in farmland can be via a fund or direct land ownership. Funds may not have a dedicated focus on the water aspect of the investment, but water will typically be one of the various areas a fund manager will want to take advantage of.
Infrastructure, Private Equity and Venture Capital
The water crisis in Flint, Michigan in 2014, where lead from the city’s aging pipe system leached into the water supply drew nationwide attention. Yet, today, residents of Chicago and many other US cities still suffer from an ageing infrastructure. According to The Economist, $8.5bn is needed to rectify Chicago’s infrastructure- an amount which the city government does not have. Joe Biden’s plan to build a ‘modern, sustainable infrastructure” (www.joebiden.com), makes references to water across the board. We include one relating specifically to water infrastructure:
Ensuring clean, safe drinking water is a right in all communities – rural to urban, rich and poor – investing in the repair of water pipelines and sewer systems, replacement of lead service pipes, upgrade of treatment plants, and integration of efficiency and water quality monitoring technologies. This includes protecting our watersheds and clean water infrastructure from man-made and natural disasters by conserving and restoring wetlands and developing green infrastructure and natural solutions.
The renewed attention to these issues by Biden’s administration, and the reality that local governments, often short of cash, may have to turn to the private sector to achieve greater efficiency, augers well for investments in infrastructure and private equity. Also, consolidation in the industry provides opportunities for infrastructure and private equity firms to provide the capital required and to assist in the consolidation and the turnaround. Meanwhile, in developing countries, capital and expertise is required for new and improved treatment plants and better water networks, amongst other.
Away from infrastructure, the water scarcity play can be achieved via private equity or venture capital-like investments in innovative technology solutions. In addition, investors have a number of niche areas to pick from – areas such as vertical farming, ocean conservation, alternative meat and aquaculture, which may be particularly interesting if you are seeking a sustainable angle to your exposure. Take for example aquaculture. It is a controlled process of cultivating aquatic organisms especially for human consumption and is directly linked to UN SDG 13 (Life Below Water- protection of oceans and their ecosystems and non-depletion of wild fish supplies). Private equity impact funds are another route which can be explored.
If you are a large institutional investor with appropriate in-house resources, direct investments in these areas are also possible; however, most institutional investor may find these types of opportunities more accessible through funds and/or co-investments. Note that, when you invest in a fund, not all the holdings may necessarily be linked to water. Another issue is that some of these sorts of funds, particularly the larger and more successful funds, will have quite high minimum asset thresholds, resulting in these types of opportunities being only accessible to investors with significant assets behind them.
Green bonds, like traditional bonds, offer investors the opportunity to earn interest by lending money to an entity over many years. Companies, states or cities that issue green bonds must invest the funds raised in projects that benefit the environment.
There has been a rapid rise in green bonds since the first one was launched by the European Investment Bank in 2007. Green bonds raised $271bn in 2019 (see Exhibit 7), about 4% of total bond issuance globally. The size of the green bond market might increase sharply if the European Commission decides to use them to fund just under a third of its €750bn stimulus package.
A number of these green bonds fund projects which involve addressing water and wastewater shortfalls. Environmental Finance has estimated that just over $3bn sustainable water management green bonds were issued in the United States up to October 2019. Although the green bond market still has a long way to go, it may be an area of interest should you be attracted to the sustainable aspect and are willing to accept a lower return profile.
The other side of the coin
So far, we have discussed how you could make an allocation to water in your portfolio to benefit from the ‘Running out of Freshwater’ investment theme. An equally important consideration which has received a lot of attention in the context of climate change but less so in the context of water scarcity (although the two are intricately intertwined), is the assessment of the systemic water risks already embedded in your portfolio. Ceres, a non-profit organisation which encourage investors to address sustainability issues, have created a useful ‘water toolkit’ to help assess water risks. They highlight three key risks:
- Physical risk which includes potential disasters such as droughts and flooding as well as other ’physical’ risk factors such as poor infrastructures and declining supplies.
- Regulatory risk which, in the current uncertain political environment, is significant. Policy changes by incoming governments and/or unexpected increases in tariffs pose a threat that investors should bear in mind.
- Social/reputational risk which revolves around potential sanitation violations, blocking of current/planned operations in the local community and various customer/workforce perceptions.
With the various options presented in this paper for gaining exposure to the ‘Running out of Freshwater’ investment theme, you should feel better equipped to make the plunge to invest in water (if you haven’t already). You may recall that, quite recently, Niels Jensen recommended you allocate no less than 25% of your overall allocation to natural resources to water. Such a high allocation is testament to the critical nature we have assigned to water. You can read his arguments if you go to ‘Investing in Natural Resources in a Changing World, Part V of V’.
Nevertheless, to stay ahead of the curve as a megatrend investor, it is equally as important to assess your portfolio now and determine which systemic water risks you may already be exposed to. Given the pending water crisis (which is already unfolding), we would strongly encourage you to address these risks sooner rather than later
Alison Major Lépine
18 December 2020