The investment case for water can be hard to understand – or can even arouse ill feeling, writes Fiona Rintoul.
Water falls from the sky; it is free and essential for life. How can you buy and sell it?
The answer is you can’t – or not to any meaningful degree.
“Water itself is not a commodity in the way that oil or gas are,” says Nick Wood, chief executive of Resonance Asset Management, which runs an industrial water infrastructure fund alongside two funds focused on wind energy.
Wood doesn’t see a future in the “financialisaton” of water, believing the likes of water futures and water rights are best left to the people on the ground in the regions affected. Where professional investors do have a role is in areas such as water treatment and water utilities.
The Resonance fund invests in what are effectively mini water treatment plants for industrial companies, working alongside engineering companies. Contracts typically run for ten to 15 years. The fund closed in 2016 and currently has 11 investments. It will be fully invested when it reaches 15.
Water treatment is an area of enormous growth, says Wood. The three drivers of this are water scarcity in certain parts of the world, which puts pressure on companies to use water more efficiently, water stress and regulation.
“In most parts of the developed world, there is stringent and tightening regulation on what can be discharged into the environment,” he says. “That trend is also very strong in emerging parts of the world, China in particular.”
The Resonance fund has a specific focus and the institutional investors who invest in it generally pull the funds from their “specialist infrastructure” buckets. For equity funds focused on water, the issue of defining a universe is more complex.
“There is no such thing as a water sector,” says Catherine Cahill, senior portfolio manager on the natural resources equity strategies team at KBI Global Investors. “The water sector is a collection of companies focused on very niche-end markets all over the world.”
Some water plays are less obvious than others. Justin Winter, co-portfolio manager of Impax’s water strategy, highlights companies that produce much less water-intensive products than competitors.
“That could be a company in the pharmaceutical sector that has a product that allows biologics to be made in a way that is much less water-intensive than the alternative technology,” he says. “It might be in building materials where a company has a chemical solution that allows concrete to be made in a much less water-intensive way.”
Even the fashion industry is part of the universe. Impax invests in a company that produces fibres that have a number of applications, including clothing made from sustainable forests.
This diverse range of potential investments means that specialist managers can be better placed to unearth the opportunities, believes Cahill. It also means that an investment in a water fund provides investors with a take on the markets that they simply cannot find elsewhere.
“We’re niche in terms of how we look at the world but we’re certainly not narrow,” says Cahill. “You’re getting a unique kind of exposure, yet very well diversified all over the world, with exposure to different end markets and different business models.”
Apart from financials, there isn’t a sector in the global economy that water doesn’t touch. Furthermore, many of the companies are small to mid-cap and as such, are off the radar of big generalist equity funds. So, given this richness, how do managers of water funds select their investments?
For Cahill, it depends on how purely and honestly you want to play the theme. KBIGI’s approach is that the companies in its water strategy must be companies providing solutions to water-critical issues, which include supply issues, providing solutions to regulatory demands and the need for infrastructure repair, and new technologies.
“We then overlay purity criteria,” says Cahill. “Companies have to have a least 50% of their revenues coming from water.”
There is an obvious ESG angle to this, and many of the companies that run water funds are also sustainability specialists. But it isn’t all about sustainability. It’s also about stability and above-average returns. Impax launched its water strategy partly in response to demand from mainly institutional investors seeking – as anyone would – these characteristics.
“It’s hard to see there being any disruption,” says Winter. “Water is used for agriculture and it’s used extensively in different industries.”
Resonance Asset Management has never positioned its water infrastructure fund as an ESG product. When it closed the fund in 2016, the company didn’t have any investors whose primary driver was an ESG mandate, but that is changing.
“Our investors are investing with us out of their infrastructure/private equity pool where they are looking for long-dated, long-duration predictable income that’s non-correlated to the broad market or real estate,” says Wood. “However, based on enquiries to date, particularly from the US, I suspect that when we follow up, there will be interest from investors that have an ESG mandate.”
If they are pension funds, these investors may have a fiduciary mandate too. But they are looking to get exposure to the kinds of investments that Resonance Asset Management offers and to put it within an ESG wrapper as well.
Not watering down returns
As well as offering stability, investments in water offer the prospect of above-average returns. The structural drivers underpinning this are multiple and strong, and unlikely to evaporate any time soon. Regulation, costs and plain good sense compel companies to use water more efficiently and to pollute less. This has knock-on effects for resource efficiency more generally.
“A number of our plants take water that is deeply contaminated with organic waste and treat it with biological treatment methods and in the process generate biogas, which we capture and use for power generation on site,” says Wood. “The by-product from that process is usually an organic rich cake that can be used as fertiliser.”
Growing affluence is also fostering increasing demand for water, notes Winter. Places that weren’t sewered now are, creating new markets for dishwashers and washing machines. At the same time, there is tightening on the supply side due to climate change and over abstraction of water because of human activity.
These are issues that affect everyone and all companies. Alongside increasing investment in water-specific strategies, there is therefore a growing focus on water risks and water management across businesses.
“Businesses globally need to identify the extent to which their operations are at risk of water shortages, as these may cause disruption to operations,” says Kristina Church, senior investment strategist for sustainability at Lombard Odier. “In particular, the food production industry is prone to such crises.”
A local issue
The Carbon Disclosure Project (CPD) is one organisation that can help investors to monitor how well companies are managing their water usage.
“We look at water from a climate perspective,” says Carole Ferguson, head of investor research at CPD, who also points out that water is a very local issue.
“You can’t talk about water in a global sense,” she says. “It depends on which country you’re sitting in and which local place within that country.”
She highlights the World Resources Institute’s Aqueduct tools, which map out water stress. Perhaps this element of localisation helps to explain why water stress doesn’t grab the headlines in the way that, say, temperature rises do.
“We need people like us to keep talking about it,” says Ferguson.
In the end, of course, water stress is intimately connected with other climate change themes. Smart investors need to stay ahead of the curve.
“We believe it is vital to accelerate the transition from our ‘take-make-waste’ economy to one that harnesses nature through the circular bioeconomy and preserves natural capital through a leaner form of industry,” says Church. “Water sits at the heart of natural capital and ecosystem services and transcends multiple different industries in terms of its impact on risks and returns.”
Water is a diverse and innovative sector – and one that the Covid-19 pandemic may help to bolster. Cahill notes that tolerance for water contamination is likely to fall as the public focuses on health risks, while infrastructure spending through recovery packages could provide a tailwind, as water infrastructure is renewed in developed markets and extended in emerging markets.
Ultimately, though, water issues are a matter not just for specialist funds, but for all investors.
“We can see the responsibility for water pollutions is shifting from the water distributors to the actual polluters,” says Church. “Identifying these risks and evaluating companies’ practices along their water use is a crucial component of assessing business resilience.”
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