China Water Risk’s 5 Trends for 2014

By Dawn McGregor, Debra Tan, Feng Hu 11 February, 2014

Horse arriving signals success: 2014 is about setting water goalposts & changing the game

Environmental risk is now often cited as most likely to derail economic growth in China along with the banking crisis and housing bubble. For 2014, the Year of the Green Wood Horse we expect the Chinese government to tackle water & air pollution issues and improving resource efficiency.

“expect to see more “collaborative” policy making across ministries”

China Water Risk

Given limited water resources, comprehensive planning at the water-food-energy is essential and we expect to see more “collaborative” policy making across ministries. Recent Urban Water Tariff reform and the Water-for-Coal Plan are indications of what is to come. More enforcement is also on the cards and we see the recent call by central government to not use ‘state secrecy’ as an excuse to cover up as a positive step for more transparency in environmental data.

Protecting the environment and making sure we use our resources sustainably has long been viewed by the market as a “cost” to the economy. The current belief is that governments/businesses need to choose between economic growth OR environmental protection. We believe there needs to be a mindset shift: Growing the economy AND protecting the environment is possible. The Chinese government’s push to form the RMB4.5 trillion “Environmental Protection & Energy Savings” Industry, which alone will account for almost 7% of the total GDP by 2015, is a clear signal of this shift. It’s clearly time for “un-siloed” thinking and business unusual across sectors.

One way of aligning environment with the economy is to move away from calculating an “Environmental P&L” where the cost of doing business to the environment is calculated in monetary terms. Instead, environmental risk should be embedded into the financial P&L. The true cost of water is not X dollars to the business because no water = no power = no food. Water’s worth runs much deeper (couldn’t resist the pun), it is the foundation on which our economy & society is built. China has signaled that the leadership recognizes this and in 2014, we see more financial analysts factoring water risk into equity valuations and more corporates assessing their water risk exposure as well as embracing corporate water strategies to mitigate risk to their operations.

“It will come down to resource allocation within China & policies formed at this nexus will shape global trade”

China Water Risk

Balancing the economy, environment, food and energy whilst maintaining stability, amidst a backdrop of climate change, is not easy. It will come down to resource allocation within China and policies formed at this nexus will shape global trade. With China upstream of most of the 40 major international transboundary waters it shares with 14 neighbouring countries, we see Beijing playing a bigger central role in regional geopolitics.

China’s water resources have been falling and climate change will only make that worse. Already, Himalayan glaciers, often referred to as the Third Pole, are retreating, groundwater is over-extracted in the North and 9% of China’s wetlands have been lost in the last decade. On the other hand, per capita water use is rising with increasing affluence and urbanization. Can China manage this divergent trend? All eyes on China as it steps up to ensure domestic & regional resource security.

马到成功 “horse arriving signals success”… we hope that the year of the horse will take us along the path of ‘Economy & Environment’

There is a Chinese saying… 马到成功. It translates to “horse arriving signals success”. We hope that the year of the horse will take us along the path of ‘Economy & Environment’ and not ‘Economy vs Environment’. In line with the tradition of gambling in the lunar new year to test luck for the year, our bets are on success. Word of caution though … it might appear like we are not making any progress in 2014 but policies/action this year will set the tone … 2014 is about setting goalposts and changing the game.

Here are our top 5 game-changing trends for 2014:

1.     Race to Clean-up Starts with SEI #1

In 2014, we expect to see more action and policies from the government to ensure the success of its Strategic Emerging Industry #1: Energy Saving & Environmental Protection. This will kill many birds with one stone:

• Satisfy the masses – water and air are climbing to the top of peoples’ worries – 40% of Chinese now think water pollution is a “very big problem” compared to 28% in 2008 (see survey here)
• Shift mindset to “Economy & Environment” – the success of SEI #1 will demonstrate that one can make money from protecting the environment moving away from ‘Economy vs Environment’
• Double savings – focus is not just on ‘using less water’; ‘saving energy’ also saves water (more here)
• Signal “moving out of silos” thinking – linking air / water / energy from a policy standpoint should encourage industry to follow

The clean-up will start with potable water and wastewater. With the deadline to conform to the National Drinking Water Standards looming by 2015, provincial governments should be looking to upgrade provincial standards to the national standard. Also, we expect treatment rates of industrial wastewater & municipal sewage to rise.
We are not the only ones bullish on this: Credit Suisse recently initiated coverage on water-related stocks with their 166 page report “China Environment Sector” which hailed this as the “start of the decade long green cycle” with “strong growth in wastewater and solid waste treatment”. Standard Chartered echoes this sentiment in their report published a few weeks ago stating that “we stay bullish on China’s water and environment sectors. Pollution & water shortage are real issues and policies in place extend market opportunities through 2015”.
To ensure that this RMB4.5 trillion ‘horse’ is not galloping off-track we expect the following in 2014:

• Big stick to match big carrot – better monitoring & enforcement
  • Expect MEP blacklists to continue
  • Changes to the environmental law / litigation reform
  • Harsher punitive measures with increased cooperation between MEP and the police on environmental crimes and higher penalties for pollution violation
  • Better monitoring systems for groundwater pollution and over-extraction
  • Specific industries may face environmental tax – more on imminent coal resource tax reform here
  • Withholding EIA approvals for new projects
  • Cadre performance scorecards to include environmental targets

• Comprehensive tariff reform – rein in water use & make water solutions economically viable
  • NDRC announced a 3 tier urban residential water tariff scheme  to be implemented before the end of 2015 (more here)
  • Expect to see industrial water hikes and wastewater discharge tariffs to be reformed

Once water tariff reforms are in place, expect to see a faster build-out of water recycling & reuse, particularly in water deficit municipalities of Beijing, Tianjin & Shanghai as well as in the water deficit provinces of Ningxia, Jiangsu and Shandong. Desalination and technologies that save energy should also benefit.
With double savings in water & energy, we too bet on this efficiency horse. Looks like we are not alone – despite the current low tariffs, the International Finance Cooperation (IFC) has managed to innovate industrial water & energy efficiency programmes that make clear returns. IFC explains how they do this here.

 2.     Betting on a ‘Business Unusual’ Future

To build a RMB4.5 trillion Energy Saving & Environmental Protection Industry is a tall order. A ‘business unusual’ attitude will need to be adopted by provincial governments, industry and investors alike. The need to drive the economy on limited water also leaves China no choice but to think out of sector-silos.

“central government will move to set policies to push all stakeholders to adopt ‘business unusual’ in 2014”

China Water Risk

To achieve this, we believe that central government will move to set policies to push all stakeholders to adopt ‘business unusual’ in 2014. Policies should be more effective and cohesive, requiring more cooperation across ministries. The Water Tariff Reform & Water-for-Coal Plan are recent examples of cross-ministry collaboration. The streamlining of standards with emphasis on quality over quantity and setting national standards over provincial standards is also expected.

The strategic nature & unique importance of water has been recognized in the 2011 No. 1 Document: Water. Allocation of water across sectors is key. Water will thus be ‘un-siloed’ and interlinked across all sectors (more on moving out of silos here). Due to energy and food security concerns, coal, power & agriculture will be prioritized. Indeed, central government has signaled ‘business unusual’ thinking:

• Water-Energy Nexus (WEN):  Water-for-Coal Plan  (Dec 2013) limits China’s large scale coal base expansion based on regional scarcity and sets guidelines for new coal-fired power plants
• Water-Food Nexus:  2014 No.1 Document (Jan 2014) prioritized food security & resolving environmental constraints including water shortages. China will focus on “basic grain self-sufficiency” whilst increasing the use of overseas markets (see our views on trade in Follow the UK: Import Water).

Although these are more ‘directional’ than instructive, central government is clearly indicating a ‘destination’. How they intend to get there is still not clear.

China Water Risk

Although these are more ‘directional’ than instructive, central government is clearly indicating a ‘destination’. How they intend to get there is still not clear.
Nevertheless, with China striving for 95% grain self-sufficiency amidst a backdrop of rapid urbanization, limited farmlands and water, more crop-per-drop through agritech and better irrigation are likely actions. Upgrading/installing water-in-mining tech and choices in cooling technology in power generation are also key in resolving WEN issues.
What about other industries?

For 2014, we see pressure on water-intensive AND water-polluting industries such as the textile and leather industries. Already, global fashion brands are coming under increasing pressure from local and foreign NGOs for pollution violations. As for leather, check out why we think it’s time for the industry to think business unusual in our in-depth review.
Both these industries rely on cotton and leather is a side product of cattle production. This comes back to raw material exposure. With 50% of global cotton grown in water-stressed China & India, it’s time to look for new materials that are less water & energy intensive.

Imagine “strawberry plants that could yield berries on its stems yet grow sections of organic lace within its roots”

Carole Collet, Founder of Textiles Futures Research Centre

Nike has already started looking into this with the Materials Sustainability Index (MSI), which will hopefully help designers select resource-friendly materials when setting trends. Radical change such as biofacture (combination of biotechnology with tissue from living systems engineering) could emerge in the future.
Carole Collet, founder of Textile Futures Research Centre, asks us to imagine “strawberry plants that could yield berries on its stems yet grow sections of organic lace within its roots”.

A ‘business unusual’ direction is clear.  Incidentally, agritech & new materials are SEI#2 and SEI#3. So how do we invest in a ‘business unusual’ future? As Charles Yonts, Head of Sustainability Research at CLSA Securities says “it’s no secret that water is scarce in China. Chinese water stocks are equally scarce”. Perhaps it’s time to un-silo out of the water sector to invest in alternatives that use & pollute less water.
Ex-banker Martin Haigh did; he bet on Litehide, a company that eliminates the use of salt in hide-making that could transform the industry’s water-intensive & polluting hide-making process – read why he is betting on a business unusual future here.

3.     Companies to Saddle Up with Corporate Water Strategies

Given the direction signaled by the China, we expect corporates to already have saddled up with corporate water strategies to mitigate risks brought on by changing regulatory, economic & scarcity waterscapes. Sadly, this process is slower than expected.
It’s not that companies do not recognize water as a business risk; they do. The 2013 CDP Water Global Report showed that almost 70% of respondents identified water as a substantive risk with financial impacts as high as US$1billion. Moreover, 64% of them expected to be affected by water risks within the immediate future. Despite this, corporates are nowhere near where they should be with regards to management of these risks. We have written on the urgency of closing this ‘disconnect’ here and here .

“water stewardship activities are notably lacking, potentially exposing their company & investors to risks that could be mitigated … companies that continue with such a narrow (reducing water use) focus could be missing potential opportunities and overlooking serious risks”

2013 CDP Global Water Report

Yes, corporates are nowhere near where they should be given the material business risk, but we are getting there, albeit slowly. Regulatory change imminent in the Year of the Horse will accelerate this, meaning past trends may not point to the future. Corporates need to look further out and start thinking ‘business unusual’. A common pool of limited water means that it is not just collaboration within a sector, but collaboration across sectors.

In 2014, leading Chinese State Owned Enterprises (SOEs) may feel the pressure to perform ‘national duty’ and lead the charge to ensure the success of SEI#1. If regulatory & pricing reforms are implemented, we expect to see SOE leaders take the lead by improving their water efficiency and wastewater discharge.

“In 2014, leading Chinese SOEs may feel the pressure to perform ‘national duty’ and lead the charge to ensure the success of SEI#1”

China Water Risk

We expect energy sector SOEs to act first. As we have said here, their “margins will come under pressure and balance sheets will need to be shored up. The slowdown in the economy provides the sector a window of opportunity to hit “reset” in dealing with water.”
Lest we forget, there is also growing reputational risk. In 2103, the MEP has joined both Chinese and foreign NGOs in naming and shaming corporates. Moreover, the public are now more concerned with pollution. It would appear that no one is exempt with the MEP naming & shaming Petrochina and Sinopec. Expect more to come in 2014 with harsher punishments for pollution violations. A corporate water strategy that maps and mitigates physical water risk with clear water usage targets and pollution treatment measures, as well as engagement with communities may help mitigate reputation risk.

That said, setting a corporate water strategy is in an exploratory phase globally. It took H&M over a year to announce its water stewardship programme since leading the charge in 2011 with Nike, Puma & Adidas in committing to Zero-Liquid Discharge by 2020 following a Greenpeace campaign. The other three brands still do not have a corporate water strategy that is communicated to the public or to their investors.
Other leaders such as BASF have not only recognized their water risk but mapped the group’s exposure and set water strategies and targets accordingly. For BASF, it was strategic decision as 22% of global production sites lie in water-stress areas – BASF walks us through the whys & hows of their corporate water strategy here.
Bottom-line: know your China water risk exposure. This may take much effort (see below) and time but the regulatory message is clear … it’s time for industries to stop hanging out by the water trough. Saddle up and prepare to rein in water risks & rope in opportunities in 2014.

4.     Still Horsing Around with Water Risk Yardsticks

Measure & disclose water risks. This is easier said than done. The reality is that there currently are too many measurement yardsticks. Unfortunately, the different tools available to assess water risk were created using different parameters.
The result is inconsistent terminology & results. In short, as WRI’s Paul Reig and Tien Shiao eloquently explain, conflicting reporting methodologies hinder water risk measurement and therefore the ability of companies to set water risk strategies. Read their in-depth review here.

‘Inconsistent’ is not a word financial analysts like to hear. Therefore, although there are tools available to measure water risk, analysts & institutional investors are still complaining that they are not useful. On the other side, companies are saying that they are facing disclosure fatigue. Worse still, the data companies have painstakingly gathered and disclosed are not used by their intended target audience – their shareholders.

An example: MSCI ESG research have tried to map water risks in their report, Water: Upstream & Downstream Impacts from a Well Running Dry. They based their analysis on Hoekstra & Mekonnen’s Global Water Scarcity Blue Water Footprint Maps. On the other hand, in our analysis of water risks for both HSBC and CLSA, we used Aqueduct’s Water Risk Atlas as well as statistics from CEIC and China’s National Bureau of Statistics. There is no right way or wrong way. Methodologies are evolving. Recognising this, the UN Global Compact CEO Water Mandate asked a team of experts to reconcile the differences between various terms and reporting methodologies.
Consistency is key in benchmarking. It doesn’t have to be the perfect method, just a method that works, that is consistent and will be used by financial analysts. The desire for consistent yardsticks is growing; it’s not just SRI Asset Managers that are concerned (see chart below). In 2014, it’s time to stop horsing around: let’s collaborate to come up with common yardsticks that work.

Better & consistent yardsticks will mean at a minimum, improved pricing of water risks in:

• financing of new projects;
• pricing of insurance premiums;
• valuing companies; and
• documenting companies’ water risk exposure for IPO listing on stock exchanges.

Now, wouldn’t that be nice?

5.     Show-jumping Skills Required for Transboundary & Third Pole ‘Obstacles’

As long as China does not sign comprehensive water sharing agreements regarding water ulitisation of transboundary rivers with neighbouring countries, transboundary water management will continue to fuel geopolitical fears in the region. Given China’s search for clean energy in lieu of coal, construction of hydropower plants on transboundary waters appears inevitable. Indeed the NEA Work Plan for 2014 published on 20 January 2014, plans to approve 20GW of hydropower (almost the equivalent to another Three Gorges Dam) this year. As such, we expect to see China continue to demonstrate skills in delicately jumping over/between these obstacles in the regional competition for water.
Deterioration of our water resources is also an issue. In late December, 19 Chinese NGOs published a report saying that China’s 22,000 large dams are causing 60% of the international river basins to fragment. It is believed that these big dams have also changed natural ecosystems, endangering biodiversity and possibly bringing on the droughts.

“… the southern transboundary waters originating in the Himalayan ‘water towers’ need more attention in terms of agreed legal regimes”

Dr. Wouters, Director of the UNESCO Centre for Water Law

Also, Himalayan glaciers, are melting at a faster pace thanks to climate change. Although this Third Pole is not disappearing by 2035 (as alleged in the 2007 IPCC report) the glaciers are nevertheless still melting and this could affect up to 500 million people in South Asia and 250 million people in China (read nomadic perspectives on glacial melt here).

Given the magnitude of hydro expansion in the future and increasing water scarcity exacerbated by climate change, we expect to see increasing regional pressure on China to sign water sharing agreements. China however, has a mixed record of cooperation on water sharing so far as one of the few countries voting against the 1997 UN Watercourses Convention to provide a regulatory framework to resolve transboundary water conflicts (more on China’s water treaty landscape here).
Nevertheless, we see China playing a bigger role in water in the region. There are not only domestic interests to protect but growing international pressure to pursue regional cooperation on water. With Ireland becoming the 33rd party to the 1997 UN Watercourses Convention in December 2013, only two signatories are required before the convention comes into force, with or without China’s consent.

“Ultimately, China needs to move beyond sharing hydrological data with her neighbours to find a win-win solution on water resource utilization in the shared rivers”

China Water Risk

In 2014, we expect to see China continue the soft-path to transboundary water by moving to establish a more comprehensive water law framework so that it can better facilitate the process of solving geopolitical water conflicts. Ultimately, China needs to move beyond sharing hydrological data with her neighbours to find a win-win solution on water resource utilization in the shared rivers. India is also battling with ever-increasing water, food & energy demand, whilst combating climate change impacts on the Third Pole. Side-stepping & jumping around these obstacles may no longer be a beneficial course of action.

Past Trends

• 5 Trends for 2013: The Year of the Snake Not sure what happened in 2012? Read our review and find out what our top 5 water trends are for the Year of the Snake. Will we be bogged down or will we slide ahead?
• 5 Trends for 2012: The Year of the Dragon Find out what’s happened in the water space in the Year of the Rabbit and check out the five trends we see continuing into 2012, the Year of the Water Dragon