Water, Investors And China—When Will The Investment Case Come Into Focus?
By Melissa Brown 8 February, 2010
Investors have a long tradition of acting like spoiled schoolchildren when the subject of difficult long-term environmental impact is raised. They hurriedly look around to see if anyone else knows the correct one-sentence answer (because they know they should know more), and then they scamper off to follow their popular friends (who are busy talking about the best new video games). This mean, but probably realistic, scenario is facing a severe test. The water crisis in China is real. The long-term trend for water prices is very clear. Hint: the arrow on the chart rises from left to right over time. And, so far, China-focused investors have chosen to buy into a remarkably one-dimensional version of the investment picture by focusing on a small universe of so-called “solutions providers” with little realistic understanding of the broad-based competitive impacts of the water policy challenge.
This scenario is understandably frustrating to the many groups who are working hard to improve our understanding of the China water crisis. There is a lot of grubby spadework to do and, although much of it will reference investors, our precocious schoolchildren will not do much to enlighten the discussion until they can spot the right answer in the study guide. As a result, the key policy makers, information providers, and NGOs will need to develop a model of how investors think to guide their process until markets and the investment debate has matured enough to bring a representative set of investors into the discussion.
My short-list of considerations reflects the fact that investors will veer back and forth between two poles when they think about water in China. The first thesis, highlighted above, is that water will be “blue gold” for growth investors. For enthusiasts, the focus will be on buying medium-tech water services companies, their equipment suppliers and water utilities. A second, contrasting thesis is that water will be a strategic issue for industries and companies that will re-shape competitive outcomes as scarcity sets in. To analyse these two approaches to investing in water, it is necessary to pay a lot attention to the following value drivers that are essential to the China/water investment case:
Price Matters This is obvious right? But far too many people forget that water as a commodity is making a transition from being a no/low cost public good to having a more commercial identity in China. Unfortunately, because it can take decades to make this transition, water is very cheap unless a user is facing scarcity or very high levels of pollution, which make available water unusable. As a result, many users who in the future will face higher prices are currently not receiving clear price signals. This also means that the “cost” of water for heavy users is not priced in. This takes something away from the long-term strategic business case which would see investors steadily migrate toward more efficient users of water or processes that are more water efficient.
Regulation Matters When governments make a decision to take a gradual approach to market pricing of water—and there are many reasons that governments may look for non-price based models—they naturally rely on regulation to control usage patterns. The business case for water frequently rests on the strategies that regulators take, whether it is measures to stop water pollution by shutting down factories or rationing water. Decisions by national and local regulators about the ownership structure of water utilities also matter. In many countries, water providers are highly motivated to invest in new facilities and improve efficiency because they can seek higher tariffs to cover the costs. While in other systems, new capital is channeled only to an investment in the infrastructure, which realise a comparatively low return with no operational upside.
Business Models Matter Water advocates often make the mistake of thinking that anything related to a given sector that is growing in impact must naturally be a money-spinner investors will like. Unfortunately, although water is at the core of a dynamic, long-term investment opportunity, many companies will come and go as the market develops. The conventional wisdom in China at the moment is that you should stay away from water utility assets, which will receive a low return, and stick with the solution providers, especially those who make the “picks and shovels” of the clean water industry, such as purification membranes and industry-specific, water efficiency equipment. While these may be today’s hot picks, investors will have to become adept at looking not just at the “blue gold” opportunity, but the profitability and sustainability of different opportunities as the regulatory landscape matures.
Supply Chains Matter For those who want to invest indirectly around the water theme, it will be critical to analyse supply chains. Here’s one way to think about the issue: If company A buys fabric from only one supplier with old and polluting dyeing equipment and company B buys fabric from a cluster of suppliers in different locations with new equipment, which company will do better as regulation toughens? This supply chain analysis also puts the spotlight on the critical issue for water policymakers and investors—this is a sector where the issues are often location, industry and process specific. It can require a dauntingly large amount of information to make the right judgments.
Scandals Matter It’s not polite to point to scandals, but investors feed off of scandals because that is often when they can gauge regulatory direction and company flexibility in something approaching real time. Scandals in most countries, and China is no exception, often trigger a rigourous period of public policy revision. Needless to say, last year’s melamine scandal redrew the lines around food safety in China, resulting in a new set of winners and losers in China’s dairy sector. It’s not polite, but smart investors are paid to pick winners and losers. Policy advocates should not be surprised that this is when your hard work will attract the most attention from formerly disinterested investors trying to become instant experts. Be ready for them.
Disclosure Matters Disclosure is so worthy that making note of it is like saying that air matters. The painful truth is that investors, especially long-term investors, cannot analyse issues efficiently when they cannot compare and contrast. This has been a huge problem, especially for investors seeking to invest around the industry impacts of water scarcity. Many companies disclose little or nothing about their water usage patterns. It’s buried in their cost of goods sold and hidden in a matrix of strategic decisions they often don’t discuss. This masks the strategic importance of water to many supply chains and business models. It also impairs investors’ ability to analyse the solution providers because investors are left to guess about the actual size of potential markets.
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