How to Play in China’s Water Sector
By Josephine Wu 21 July, 2010
Despite the urgent need for water infrastructure, investment in water continues to lag – is China’s blue water turning gold?
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China’s water sector is weighed down by the huge need for water and wastewater infrastructure. While the Chinese government recognises the urgency of the water crisis, investment in water facilities continues to lag behind other sectors: Of China’s US 130bn stimulus package in 2009, water was allocated only 9% of the pie. But with the increasing prioritisation of water– also seen in the proposed 12th Five-Year Plan that promises RMB 75bn to build sewage treatment plants–private investors see opportunity. China Water Risk asks Josephine Wu, a veteran investor in the region’s water, if China’s blue water is turning gold.
CWR: Many in the investment community are hesitant to go into the China’s water sector citing issues such as corruption, protectionism, lack of guarantee on returns, and low tariffs. Are any of these issues a deal-breaker for you?
Josephine: China is still an emerging market, so there certainly are inefficiencies in the market. The water sector, specifically, has been a very fragmented and policy-driven sector. A real concern for me is the lack of transparency and disclosure in terms of the water pricing mechanism. The local governments dictate pricing sometimes without being able to present a valid (and believable) argument. There is also the lack of decent size companies to invest in, companies that have the right governance structures and business models. The majority of the listed companies tend to be small to mid-cap.
But as an investment manager, you understand that there are no guarantees, and therefore you need to strike that balance between risks and rewards. I believe in taking calculated risks– backed by extensive due diligence and constant dialogue with industry experts of countries I invest in. China’s water sector still provides a lot of opportunities, if you know where to look and what to expect.
CWR: Focusing on allegations of China’s “protectionist” tendencies in the water sector, do you think that the current model of public–private partnerships is good for China?
Josephine: Because water is a very important resource and a scarce commodity without any substitute, China will continue to focus on protectionism. The current model of public-private partnership has been running for many years and most foreign companies have accepted the fact that they will have to play by the rules and partner up with Chinese firms to get into the market. Veolia spent more than 10 years in China before they finally started making money.
In the short term, foreign players with solid experience in wastewater and water supply should have access to juicy management contracts with smaller Chinese firms. In the longer-term, companies with advanced water technologies will flourish in China, and in the region.
CWR: How do you understand the issues around tariff setting?
Josephine: Tariffs in China are among the lowest in the world. However due to sensitive issues around CPI inflation, harmonious society policy by the central government, and farmers being the biggest user of water in China, it is difficult to have one-time tariff adjustment across the board. But provinces and cities, specifically the wealthier ones, are now allowed to adjust their tariffs. This tells us that China’s water price will go up eventually, along with the economic development of different provinces.
CWR: What are the common misconceptions that investors have about China’s water sector?
Josephine: I find it very interesting that investors believe that the sewage business is the most profitable or holds the most potential. When in fact, one only has to look at the annual returns of these companies to see that this is far from the truth. Collecting money from government is always difficult and delayed. In addition, any tariffs hike won’t benefit sewage operators as most of these projects are BOT projects, which means the internal rate of return has been determined at the time when contracts are signed. Also, investors should be focusing on utilization rates on the capacity rather than the pure increment of the capacity, because in the long run, companies are paid on utilisation rates not on capacity installed.
CWR: How should investors set out to play in China’s water sector?
Josephine: Investors need to adjust their expectations when looking at the China water market. And they have to look very carefully at how the water sector value chain works in the different provinces rather than looking at the sector as a whole, because the water sector is still driven by local provincial policies or approvals rather than by central government decisions.
Fundamentally, investors need to understand that water is a long-term commitment and not a quick turn-around money-making sector. I tend to invest in companies that are vertically integrated, asset acquisitions based and least account receivables, as they will benefit from the continued growth of the water sector on a long term basis.