Investing in blue gold

 

In the developed world we take advantage of water. Access to clean running water is available at the turn of a tap but we continue to waste this dwindling resource.

At a seminar held in July hosted by Carbon International looking at investing in water, Envisager principal David Lloyd Owen effectively summed up the bleak situation regarding the world’s water supply. “Fresh water is a finite resource and we are already running on empty,” he cautioned. “The assumption is water is a human right and we can use it as we wish.”

Unfortunately, we cannot afford to use water as we wish as almost one fifth of the world’s population (about 1.2 billion people) lives in areas where water is physically scarce. Furthermore, one quarter of the global population lives in developing countries that face water shortages due to a lack of adequate infrastructure. 

Even in the developed world – the UK and other parts of Europe, for example – water-related infrastructure is in desperate need of redevelopment. According to FTSE Group manager of the responsible investment unit David Harris, it is estimated that US$4.5trn will be needed to address water infrastructure in the next 20 years. 

It is very easy to get bogged down by the endless list of depressing facts about water scarcity and the environment at large, but for now suffice it to say the amount of fresh water across the globe is coming under increasing pressure from several factors.

A number of the world’s major banks have even turned their attention to water scarcity over the past few years. As Lloyd Owen further observed, since 2007 Merrill Lynch, Citi, JP Morgan and CERES have all issued documents addressing water scarcity.

It is a pressing issue to be addressed and water-related industries need to progress accordingly to cope with this and are throwing up plenty of investment opportunities along the way. In fact, Lloyd Owen even went as far as to say investing in water is one of the “key responses to the global financial crisis”.

 

A scarcity play

Recent years have certainly seen an upswing in the demand for investments that seek to profit from the need for water. If the trend continues, investors can expect to see a swarm of new investment opportunities that provide exposure to firms that develop the technology, processes, equipment and distribution systems to more efficiently manage water. 

Water is now known as “blue gold” among the investment community due to its scarcity, which one of the major drivers creating growth potential for companies and investors. Standard & Poor’s Index Services head of global research and design Srikant Dash said people invest in water predominantly as a scarcity play. 

“Given that much of the developing world has a growing population but limited access to portable water, the development of water infrastructure and purification materials is important,” said Dash. “There is also a need for increased supplies of portable water given the increase in agriculture.”

Other key factors driving the sector include population growth and urbanisation which have boosted the need for improved infrastructure and water purification methods to service every day appliances, for example. Additionally, the increasing effect of pollution has led to a higher demand for water cleansing techniques and technologies to remove impurities from drinking water.

 

Positive activity

A changing global attitude to the environment has led to changing global legislation on water use, which has further driven investment in the water sector. 

The Water Framework Directive (WFD) – which Lloyd Owen described as the “single most ambitious and far reaching piece of legislation” – was introduced in December 2000 and proclaims that member states must aim to reach good chemical and ecological status in inland and coastal waters by 2015. 

“We know it will be costly, perhaps €125bn to 200bn,” said Lloyd Owen. “We will have to do more with less water.”

Also, in December 2008 an alliance of investors, collectively managing US$1.5trn, urged 100 of the world’s biggest companies to join an initiative – the CEO Water Mandate – that will improve their policies and practices around the use of water. 

The mandate is a public-private initiative created by the United Nations Global Compact and designed to assist companies in the development, implementation and disclosure of water sustainability policies and practices. Under the agreement, the endorsing company’s chief executive, or equivalent, must address the global water challenge through six focus areas: direct operations; supply chain and watershed management; collective actions; public policy; community engagement; and transparency.

As of May this year some 50 companies had signed up to the mandate, including Cadbury, GlaxoSmithKline and Coca Cola. 

E.Capital Partners founding partner Paolo Sardi said the CEO Water Mandate was a major thrust behind ECPI’s strategy. When compiling its Global Blue Gold Equity Index, and as part of the ECPI ESG Screening Methodology, ECPI carries out a company ranking based on the level of endorsement of the CEO Water Mandate principles. According to Sardi, this “gives an edge over other indices”. 

Investing in water can of course also boost an investment company’s or pension fund’s green credentials. Four Winds Capital Management head of European Environment Group Valerie Daoud-Henderson said: “Water is something people feel close to so investors are keen to invest in things that are going to participate in helping to solve the water problem.”

However, S&P’s Dash disagreed saying that investing in clean energy indices did not necessarily constitute socially responsible investing. “People don’t invest in them necessarily because their primary incentive is socially responsible investment; it is primarily because they are looking at energy as a scarce resource.”

 

Dipping in

As water is not a tradable commodity, water stocks present one of the few methods of gaining exposure to this diminishing resource. Pension plan sponsors tend to invest in water in two ways. One is direct investment in water-related infrastructure projects through funds. “The negative side to these is that they have lock-in periods and are not very liquid,” said Dash. “But you get less correlated returns over the five or 10-year cycle of your investment.”

On the other hand, pension funds can invest in securities representing companies that are an integral part of the water business. 

According to FTSE Group’s Harris, using an index comes down to the classic passive investing argument. “It is a low cost way to access the sector,” said Harris. “You are evenly distributed by market share across all the different water themes which there are drivers for. So rather than risky bets on certain bits of the water themes you are diversified across all of it.”

There are two basic components to the water industry; one is water utilities and infrastructure and the other is water equipment and materials. 

The methods are complementary, said Harris. “The nearest analogy I can give is investing in buildings in actual real estate and investing in real estate investment trusts (REITs). If you invest directly in these water infrastructure projects you enjoy a low correlation to equities but at the same time you don’t have the liquidity as it is locked out for five or seven years, or more.”

On the securities side (those trading on exchanges) liquidity and transparency comes in pricing so with these funds it is difficult to get transparency in pricing depending on credit market conditions and the viability may be questionable, Harris added.

One increasingly popular strategy is investing in water exchange traded funds and structured products. “The typical investor in ETFs tends to be small institutions and the big players go through separately managed accounts,” said Dash.

According to ETF Securities head of research and investment strategy Nicholas Brooks, one of the benefits of ETFs had is you are buying a basket of stocks so you are immediately diversified and not exposed to one individual company risk.

“Also, they are very cheap relative to buying some of the actively managed funds. In one transaction you are getting a diversified basket of global water companies at a cheap price. They are also highly liquid so you can get in and out of them very quickly.”

 

Performance

“It [water] is a resilient industry whether there is a global financial crisis or not so it is attractive because it is fairly uncorrelated to other assets,” said Four Winds’ Daoud-Henderson. This sentiment was echoed by Impax Asset Management director of investments Bruce Jenkyn-Jones, who said: “Water utilities are resilient because they are long-term investments, the pricing is regulated and there is less uncertainty.” 

Water indices have outperformed across the board as affirmed by FTSE Group’s Harris. “The FTSE Global All Cap performance over the past five years has been 13.5% and for water it is 49.1%; so substantial outperformance,” he said. 

S&P’s Dash added that for the S&P Global Water Index the year to date return (as at July 7) was 7.4%. For five years ending June 30 it was up 54%, the equivalent of about 9%, while the S&P Global Equity Index over the same period was down about 8%.

The West Midlands Pension Fund has exposure to water through its passive equity holdings but also through funds that are actively managed by environmental, social and governance (ESG) specialists, such as those with Sarasin, Impax and Four Winds.

Performance had been varied, but it is worth noting the long-term nature of pension fund investments, as West Midlands Pension Fund chief investment officer Judy Saunders said: “Performance has been mixed as with other asset classes but we have a long-term time horizon as investors. In addition these funds tend to sit in the private equity and infrastructure portfolios which by their nature are not determined by short-term performance.”                             

FTSE Group’s Harris observed a growing competition among different markets in the world between who is going to be the investment ‘home’ for environmental markets. “Competition is not just between governments and countries it is also between stock exchanges,” said Harris. “There is a bit of a battle opening up between the London Stock Exchanges, with the AIM platform, and the Euro NEX.”

The big question, concluded Harris, is “where are the new clean tech companies going to be listing?”