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# Swimming in Troubled Waters –

When the well is dry, we know the worth of water.

Benjamin Franklin

## What this research paper is about

Oil is widely considered the most important commodity to mankind, but it isn’t – water is.  Without it, most of us won’t survive for more than 72 hours.  This past summer, my daily morning routine of zipping through the latest news turned into a daily update on the unfolding water crisis.  The stream of horrible news was virtually endless.  California suffered, and continue to suffer, serious drought problems, following months of little precipitation.  So did Germany (mostly along the river Rhine), but the worst weather-related news this past summer probably came from China, where the Yangtze river, which provides drinking water to hundreds of millions of people, completely dried up in places.  Although the temperature in China has dropped somewhat (it was well over 40°C at the peak), the drought continues.

If you, to all of this, add the fact that water consumption, partially as a result of population growth and partially as a result of higher living standards, will rise incessantly in the years to come, there are reasons to be concerned.  It is only a question of time before the first major armed conflict breaks out over a dispute about water rights.  How this is all likely to unfold, and how investors should position themselves, is what this research paper is about.

Two quick points before I begin.  Firstly, you cannot conclude that an extreme heatwave in a single year is the result of global warming.  Such a conclusion would be based on statistically insignificant, meteorological data.  Having said that, the data behind many of the climate change observations of the past few decades is statistically significant, i.e. one should no longer doubt that the climate is changing (although many still do).

Secondly, only a few weeks ago, we published a paper on demographics – on the fact that the urbanisation trend is gathering momentum, and why that will result in declining fertility rates all over the world.  Following up from that, in this paper, I will also look at the link between urbanisation and water quantity and quality.

## Some simple facts

Although over 70% of planet Earth is covered in water, little of it can be used for drinking.  Only 2.5% of all water on our planet is freshwater, and only 1% of all freshwater is easily accessible.  Over the past 40 years, the world’s population has doubled, whereas water consumption  has quadrupled.  Take for example water consumption in the USA.  While it takes about 12 gallons (45 litres) a day to sustain human life, water consumption in the USA averages 158 gallons (600 litres) per capita every day, all included (i.e. including water used for industrial use, agricultural use, etc.).

Worldwide, almost 800 million people (about 10%) have no access to clean drinking water, and about four billion people experience severe water scarcity for at least one month every year.  Agriculture already accounts for about 70% of all freshwater withdrawals worldwide, and the number is rising.  A growing population will cause agriculture’s consumption of freshwater to increase 20% over the next 30 years.  By 2040, there will not be enough water in the world to quench the thirst of the world population and, at the same time, keep the current energy and power solutions going, if we continue to do what we are doing today.

Finally, a brief note on climate change, as that has (as you will see later) a major impact, not only on the quantity of the water available but also on the quality of it.  The global annual temperature has increased at an average rate of 0.08°C per decade since records began in 1880 and over twice that rate (+0.18°C) since 1981, leading to a total rise in the global average temperature since 1880 of 1.28% (source: NOAA).  This has led to an abnormal number of days with above-average temperatures in recent years (Exhibit 1).

The facts in this part of the paper have been sourced from UNICEF, Drop in the Bucket, Seametrics, and National Oceanic and Atmospheric Administration (NOAA).

We publish investment strategies and opportunities in our research papers. This research paper is available to professional investors as part of ARP+ subscription.

## More on the extreme weather events of 2022

A “once-in-a-1,000-year event”.  That is how the recent, severe rainfalls in Death Valley were described by Daniel Berc, a meteorologist at the National Weather Service in Las Vegas.  In only three hours, the Death Valley National Park had 75% of its annual average rainfall with immense damage to follow.  Virtually all roads became impassable, and many cars were simply carried away by the masses of water, with many tourists being trapped.

Now, after the water has receded, there is debris everywhere, which will result in a significant clean-up and repair job.  Was the rainfalls in Death Valley (which is, ironically, one of the driest spots on the planet) caused by the human-inflicted climate change, or was it ‘just’ a(nother) freak event?  Although climate change is the more likely call,  one extreme event is not statistically significant.

Meanwhile, in Germany, after one of the driest summers ever in Europe, the water level in the river Rhine reached record-low levels in mid-August (Exhibit 2), making it difficult to use the river to transport various goods and materials.  Transporting goods by inland waterways is very important to German industry, and an economic crisis was looming.

Water levels have since improved and are no longer critically low, but the episode was a stark reminder of things to come.  If the Rhine becomes impassable, the impact on the German economy will be massive.  One could argue that the episode was ‘just’ a(nother) freak event, but it could also be the result of human-inflicted damage.  Again, we just cannot prove it, as one event is not statistically significant.

The Rocky Mountains in the western USA are famous for their reliable snowfall, making it one of the world’s best ski sports centres.  Well, that is what it used to be like, but the Rockies are changing.  The US West Coast has suffered serious problems this summer, following record-low spring snowpacks in the mountains, which came about as a result of low snowfalls this past winter.  All of this has led to many rivers drying out and to countless wildfires.

And the story gets worse.  The Yangtze river in China, which provides drinking water to 400 million of China’s 1.4 billion inhabitants is drying out.  A brutal heatwave in China this summer with temperatures regularly exceeding 40°C has completely dried out the Yangtze in places (Exhibit 3).  Apart from no longer providing reliable drinking water to hundreds of millions of people, the knock-on effect on the agricultural industry and on industry has been immense.

## Other recent findings

In a research paper earlier this year (which you can find here), I wrote the following:

“Scientists have warned that the Thwaites Glacier in Antarctica (a large glacier the size of Britain) is melting quickly.  A complete collapse of Thwaites will lead to a rise in seawater levels of more than 2 metres, but that is unlikely to happen any time soon. More likely, a part of it – the part that has already partially broken away from the main glacier – will soon collapse into the sea, and that will cause seawater levels around the world to rise by about 65 cm.  This could happen within five years (see the story here).”

Since I wrote those lines, researchers have confirmed that the ice shelf, which holds back the Thwaites Glacier and prevents it from collapsing into the sea, is breaking up much faster than before (source: The International Thwaites Glacier Collaboration).  As you can see in the latest report from the scientists, not only is a significant part of the Thwaites Glacier at risk of collapsing into the sea, but the Pine Island Glacier is also at risk now.  In other words, the 65 cm sea level rise, predicted as a result of the partial collapse of Thwaites Glacier, increasingly looks like the best we can hope for.

Secondly, news coming out of Greenland this summer is equally depressing.  Scientists working up there have found that, even if we stop using fossil fuels tonight, global heating to-date will cause global sea levels to rise at least 27 cm (just under 1 ft).  And, as the use of fossil fuels will not be discontinued tonight, the rise will be much bigger.  It is estimated that if Greenland’s record melt year of 2012 becomes a routine occurrence, the melting ice cap will deliver 78 cm to already rising seawater level.  Furthermore, I should point out that this is in addition to the 65 cm coming from the Thwaites Glacier.  You can read the whole story here: nature.com.

Thirdly, also over the summer, a Norwegian and Finnish research team completed a new study on the temperature rise in the Arctic area, and the conclusion didn’t do much to improve my mood.  In every decade since 1979 (when satellite data first became available), the average temperature in the Arctic has risen four times more than the average temperature in the rest of the world (source: NTB).

Now, some people will probably argue that, should the Arctic melt completely, international trade will prosper, as many shipping routes will be shortened.  Whilst correct, this argument fails to consider the wider implications of a temperature rise.  The only good news in that context, I suppose, is that seawater levels will rise only marginally if the Arctic melts, as most ice around the North Pole is already below sea level.

I could go on and on.  The findings I have just listed form only a very small part of the evidence coming in from every corner of the world that something is astray.  Rivers might dry out after one extraordinarily dry and hot summer, but glaciers don’t melt because of that.  Glaciers collapse because of decade-long above-average temperatures and, when that happens, it is time for all those in denial to sit up and listen.

## How can there be water shortages when sea levels are rising?

Plain logic would suggest that rising sea levels should address the water shortage problem, but things are not as simple as that.  For starters, rising sea levels are mostly caused by melting glaciers and other ice.  Almost all of that melted ice ends up in the sea, meaning that freshwater is turned into saltwater.

A good example is the city of Philadelphia.  Currently, the Delaware River’s salt front lies 40 miles from Philadelphia’s most important drinking water intake.  If sea levels were to rise 3 feet, the salt front would move upstream to within 12 miles of Philadelphia’s city centre (Exhibit 4).  Sea levels in that part of the world are rising 25% faster than the global rate, because the mid-Atlantic coast between New York and Virginia is sinking at the same time as sea levels are rising.

Therefore, even a modest rise in sea levels can cause problems along that coastline.  The latest estimate is that sea levels along the New Jersey coastline will have risen 1.1 foot by 2030, up to 3.5 feet by 2070, and up to 6.3 feet by the end of the century (source: nj.gov).  And those numbers do not include the impact of the collapsing glaciers in West Antarctica (source: The International Thwaites Glacier Collaboration).

Furthermore, if much ice melts now, the rivers will be fed less melted ice going forward, meaning that, in the future, many of the water systems responsible for providing our water supplies today will dry out.  Also, rising sea levels are indicative of other problems, as the rise is at least partially a function of the thermal expansion caused by the excess intake of CO2 by the oceans.

## Is desalination the solution?

Desalinating saltwater is today’s preferred method to address water shortages, but there are some serious issues related to desalination.  For starters, it is exceptionally costly to build a desalination plant.  A large desalination plant, capable of producing 100,000 m3 of freshwater per day, will cost at least $1Bn to construct, and you can then add at least a few hundred million in annual maintenance costs (source: wise-advices.com). If the average American consumes 600 litres of water every day, a$1Bn desalination plant will provide water to about 170,000 Americans.  With a total population of 330 million people, should it (one day) be required to depend solely on desalinated water, almost 2,000 of those plants shall be required at a cost (in 2020 dollars) of \$2Tn – almost 10% of annual US GDP.

Obviously, the US will most likely never have to depend solely on desalinated water, but other countries are less fortunate.  Take for example Egypt, which suffers major water supply problems.  If Egypt were forced to supply all its 100 million inhabitants with only desalinated water, a mammoth investment would be required; in fact so big that it would be well beyond the means of that country.

On top of that, the environmental impact from desalination is not good.  Amongst the many issues to do with desalination is the salt left over from the process, which is called brine.  If poured back into the sea, as almost all countries do, the salinity is increased, and the oxygen content lowered, none of which is good for marine life.  Furthermore, the chemicals used in the desalination process also end up in the sea, and that is harmful as well.

## The impact on water of urbanisation

As I have already pointed out, our water resources are increasingly stressed, but one should not assume that climate change is the only reason why that is.  A growing number of people on planet Earth, a change of land use and increased pollution of existing water resources all play a role in the unfolding water crisis.  Urbanisation happens to be the common denominator underneath all of those issues; i.e. it is fair to say that urbanisation also plays a significant role.

When you convert forest land to urban land, you increase the surface albedo (the reflective power of solar radiation), and that affects the climate.  The temperature rises, and summer storms become more intense.  By removing forest vegetation, you also reduce plant transpiration and canopy interception, both of which have the effect of reducing the amount of precipitation (Exhibit 5).

Urbanisation also affects the quality of water, and there are two reasons for that – increased  pollution and reduced retention capacity (source: G. E. Sun and Peter Caldwell).  Allow me to explain the second factor.  Urbanisation results in a rising number of water-resistant surfaces, and that reduces the retention capacity of the watersheds in the area.  Simply put, as the watersheds suddenly find themselves located in an urban zone, the sediment concentration is dramatically elevated, which affects the quality of the water in question.

As the rate of urbanisation worldwide gathers momentum, the water problems associated with it can only accelerate as well. And, in that context, it is worth reiterating that urbanisation is not at all limited to EM countries.  Even the most developed countries in the world continue to urbanise, and there is a simple reason for that.  It is in urban zones that most of the jobs are.

## Financial market implications

Back in December 2020, a colleague of mine wrote a paper called How to Invest in Water, which you can find here.  The paper you hold in your hands now does not arrive at a materially different conclusion when compared to the 2020 paper; however, given all the problems the events of this past summer have identified, I thought we could all do with an update, and I thought I could provide more detail as to what you should focus on when looking for investment opportunities in water.

Before I do that, I should stress that water is not an exciting, new asset class.  It has actually been an investment object for many, many years and has delivered quite robust risk-adjusted returns more recently (Exhibit 6).  In other words, when I suggest you over-allocate to water in your investment portfolio, I am not exactly bringing an exciting, new asset class to your attention.  What I hope to bring is an investment opportunity, which will most likely turn out to be much bigger than most investors realise today.

What you cannot see in Exhibit 6, though, is the defensive nature of water investments.  The S&P Global Water index has delivered a higher upside capture ratio while benefitting from a lower downside capture ratio when compared to the S&P Global BMI.  Correlation-wise, water is also quite defensive with a correlation ratio hovering around 0.5 when compared to a global equity portfolio

Now to the opportunity set in front of us.  The global water supply is finite, and there is no water on any nearby planet, which can be brought back to Earth.  Instead, the investment opportunity lies in identifying and investing in:

- companies which can deliver water more robustly;

- companies which offer better water treatment solutions; and

- companies which provide a smarter water infrastructure.

Let me make a few comments on each of those opportunities.  Enormous amounts of water is leaked every day.  In the US, according to the water utility industry over there, at least 20% of all water is lost through leaks.  In a few neighbourhoods, that number climbs to nearly 50%.  In the UK, the largest water utility company, Thames Water, admits to losing 24% every day due to leaks.  Therefore,  a more robust pipeline system would go a long way to fix the water problem.

From an investment point-of-view, targeting more robust water deliveries is a major opportunity.  First and foremost, you should invest in companies that manufacture pressure sensors used to detect leaks.  However, you can also invest in those water utility companies that suffer from significant leaks.  Modern technology has made the cost of identifying and repairing existing leaks much more manageable, i.e. the pay-back time of the investments required has been greatly reduced.

The main argument against investing in water utilities is the current direction of bond yields (up).  Water utilities are quite sensitive to interest rates, as their balance sheets are loaded with debt.  If you are of the opinion that interest rates will go much higher, you should probably stay clear of water utilities.

Water treatment involves the treatment of both water and wastewater and involves the removal of harmful contaminants and the prevention of the build-up of harmful deposits.  Many industries use – and the agricultural industry is probably the biggest sinner here – excessive amounts of chemicals in their day-to-day business, hence the need to treat the water.

Investing in water treatment is essentially about identifying the best technological solutions to a problem that refuses to go away.  Every day, farmers are urged to reduce their use of chemicals, and every day more and more chemicals are used.  Therefore, the only viable solution seems to be effective water treatment.  As a result, those companies are not cheap (don’t expect any bargains here!) but the need for water treatment solutions can only grow.

Finally, a few words about how to invest in smart water infrastructure, which is about how consumers of water (whether corporates or households) can comply with regulations whilst, at the same time, reduce costs.  Some of those smart water meters also make recommendations on maintenance and repair.  One example of a smart water infrastructure company is Danaher, a US company, which manufactures a product called Claros – a water software platform that does all of the above.  The Claros system enables customers to collect, access and share data, and to remotely manage treatment processes efficiently in real time, 24/7.

Water funds offer a tempting way to invest in water.  You may benefit from the knowhow of the manager in question, and you obtain instant diversification.  In our opinion, one of the more attractive water funds is the one offered by Robeco; the full name is RobecoSAM Sustainable Water Equities Fund.  The fund fits well into the storyline in this research paper, as it offers exposure to companies which offer great solutions to the water scarcity problem.

In the private domain, investing in water rights seems to be one of the most attractive opportunities but, if investing in private markets is a no-go, you should take a look at Invesco’s Water Resources ETF.  Although far from a pure play on water rights, you do get some exposure to water rights in this ETF.  Should you share my concerns about rising interest rates, the other big advantage of this ETF is its limited exposure (c. 20%) to water utilities.  Other ETFs are typically much more exposed to that industry.

Chirag Jasani is our man on water.  Should any of this be of interest to you, or should you have any follow-up questions, you are more than welcome to email him on cj@arpinvestments.com.  My involvement is limited to the macro side of the story, so you would benefit more from his knowledge than from mine, when it comes to discussing specific investment opportunities in water.  Having said that, you are always welcome to contact me on nj@arpinvestments.com.

## Final few words

According to the UN, only three years from now, an estimated 1.8 billion people will live in areas plagued by water scarcity, with two-thirds of the world’s population living in water-stressed regions.  By 2030, the global middle class will have surged from 1.8 to 4.9 billion people, which will result in a significant increase in freshwater consumption.  Take for example India.  By 2030, water demand in India will reach 1.5 trillion m3.  India’s current water supply is only 740 billion m3.  Furthermore, by 2035, the world’s energy consumption will have increased by 35% when compared to today’s numbers.  That will in turn increase water use by 15%.  Something will have to give!

Water consumption is highly predicable, and water is largely a non-cyclical investment opportunity.  Yes, some of the solutions referred to in this paper may help users to cut back at times of high water prices, but a certain amount of water shall be required, recession or not.  Given the opportunity set identified in this paper, I recommend that at least 10% of your portfolio is invested in water.

Niels C. Jensen.

9 September 2022