Infrastructure: Water... And not a drop to drink
California’s drought has been making the headlines, but it is part of a wider story that investors should be following. Christopher O’Dea reports
Adam Smith famously observed that water, an essential element for life, can scarcely be used buy anything in the marketplace, while diamonds, although superfluous to survival, command virtually unlimited prices. While the father of free market theory will not be around to witness it, the water-diamond paradox is about to be resolved. Because the dry spell, so to speak, for water’s market value is rapidly coming to an end.
Water has long been a priority in every country, but the water crisis in California has highlighted the implications of neglecting water infrastructure and related public policy. Ongoing recriminations about California’s predicament demonstrate that the state’s water crisis was years – even decades – in the making, which is expected to add urgency to water infrastructure planning and investment around the world.
There is a wide range of infrastructure related to water, encompassing drinking-water supply, wastewater treatment, storm water management, industrial and agricultural water provision and hydro-power generation.
There are investable assets in most sub-sectors, and major infrastructure funds, both listed and unlisted, target some aspect of the water industry in their investment remits. John Laing Environmental Assets, a listed fund that raised £160m (€222m) in an IPO in 2014, invests in waste water processing projects in the UK. Global Infrastructure Partners (GIP) Capital Solutions Fund, the debut infrastructure debt fund from Global Infrastructure Partners, will include water and waste water assets on its target list. The fund is targeting $2.5bn (€2.2bn) in assets and was the largest such fund in the market as of January, according to Preqin.
For investors, the appeal of water assets is clear. In the course of due diligence on one infrastructure fund, James McMillan of consultancy Courtland Partners, reviewed a significant position in UK supply company Thames Water. The company operates in a major city in a developed market, with a clear rate-setting process that sets fees for multiple years, and is rewarded for capital investment under a regulation providing for a guaranteed return on new capital spending.
“You’re not going to get rich, you’re not going to get poor, and you can have faith in the regulatory process,” says McMillan, who joined Courtland after a career in strategic acquisitions and divestitures at BP.
But predictable long-term cash flow is one of the primary reasons pension funds are increasingly looking to infrastructure. “You could get comfortable having an asset like that as part of a portfolio,” he adds.
GIP’s debt fund illustrates the rising demand for debt finance for ever-larger projects, and the interest of institutional investors in providing the capital.
David Cooper joined IFM Investors in 2012 to launch a European debt platform for the £27bn Australian infrastructure consortium. The team seeks to identify and capture premiums for illiquidity and complexity which, in turn, hinge in large part on the sophistication of the underlying regulatory regime. Where infrastructure is more highly regulated, projects tend to tap public debt markets for capital by issuing standardised, agency-rated bonds. In the water sub-sector, that leads IFM’s debt team to prefer debt from water utilities in Spain, where regulation is newer. “It’s a young regulatory regime, particularly in water, so there’s a lot of local content to the debt,” Cooper says.
Water projects also involve most of the sensitive issues that arise in the infrastructure sector when public-private partnerships replace public agencies as the primary or sole provider of basic services to a community. Community concerns centre on whether elected officials are negotiating the best terms, potential conflicts of interest, and typically, a measure of opposition to the higher prices that usually follow in the wake of privatising public services.
“Returns from infrastructure always depend on the end customer who pays the bills,” according to a recent McKinsey paper on how public and private infrastructure leaders can more effectively make the case for projects that often face opposition. “Infrastructure leaders who are considering new investments and looking to win public support can learn from their peers in consumer-focused industries,” says McKinsey.
Customer focus is critical for a sector like water, where the basic price level increases over the long term, and supply constraints are starting to be implemented in some regions of developed countries where ample clean water was long taken for granted. In the US, the average price of water for a family of four using 100 gallons per person per day increased 6.2% in 2014, according to an annual 30-city survey by Circle of Blue, a resource policy and advocacy group that focuses on the linkage between water, energy and food production.
While that was the smallest annual increase in the five-year history of the survey, the average price has risen 33% since 2010, and much more in some cities. Prices in five cities – Austin, Charlotte, Chicago, San Francisco, and Tucson – increased more than 50% since 2010. Chicago’s increase, for instance, is part of a municipal water investment plan initiated in 2011, to double rates over four years, primarily to replace decaying pipes, including century-old wood conduits.
While striking, such cases are increasingly common, according to Bill Stannard, president of Raftelis Financial Consultants, a water rate consultancy, in Circle of Blue’s price report. “What we’re seeing now, for the foreseeable future, is that the annual increase in revenue will exceed the consumer price index by double, on average,” said Stannard.
Raftelis collaborates with the American Water Works Association on a biannual rate survey covering 290 water utilities, which found that rates increased an average of 4.9% annually between 1996 and 2012. The accelerating pace of water price increases is clear. In an article in the journal of the American Water Works Association, Raftelis consultants Sanjay Gaur and Drew Atwater contend that the steadily rising total water bills and a move toward conservation-based rate structures across 14 California counties between 2003 and 2013 “may be a predictor of what’s to come for the rest of the country”.
The United States Environmental Protection Agency has identified nearly $300bn in wastewater and stormwater management needs nationally, and more than $380bn in drinking water infrastructure needs. The EPA says that, “with limited federal funding available, states and communities are beginning to look towards private investment, more innovative financing tools, and new technologies to help bridge this gap”.
In January, the agency formed its own Water Infrastructure and Resiliency Finance Center to assist communities in improving their water infrastructure while becoming more resilient to the impacts of climate change.
In New York State alone, the legislature allocated $200m in its 2015-16 budget for state grants to municipalities to improve existing wastewater and drinking water infrastructure, effectively capping water rates for hard-pressed towns.
But that is just a drop in the bucket – the New York State Department of Environmental Conservation estimates the need for wastewater infrastructure repairs over the next two decades across the state totals $36bn, while the Department of Health says the need for drinking water infrastructure repairs is nearly $39bn.
Private capital is filling the gap, and a recent water pipeline deal in Texas illustrates many of the key issues. While California’s water crisis is garnering most of the headlines, the new frontier for mega-scale water infrastructure is in Texas. The state has been attracting a steady flow of companies and workers from California, such as Toyota, which is relocating its US headquarters to Texas after nearly four decades in Los Angeles. But since a severe drought in 2011, Texans have been hustling to build water infrastructure required to sustain the state’s economic growth.
The City of San Antonio and the San Antonio Water System entered into a 30-year water supply public-private partnership with Abengoa, a Spanish company that designs, builds and operates energy plants and infrastructure using sustainable technologies. Abengoa is also the major investor in the $3.4bn project, which Preqin includes as a notable infrastructure deal in its 2015 Global Infrastructure Report. Abengoa leads the Vista Ridge Consortium, a contracting group that in October last year won city approval to proceed this year with construction of a 142-mile pipeline that by 2019 will deliver 16bn gallons of water annually from aquifers located to the northeast San Antonio. Reports in Texan media said the water would cost as much as seven times the rate San Antonio residents pay for water from the nearby Edwards Aquifer, and lead to a 16% rate hike.
The project demonstrates how water is critical – and that it has been underpriced in arid areas like Texas. With a price tag 1.5 times the size of San Antonio’s annual budget, it is also a topic that draws intense scrutiny from end-users. Although located near one of the most prolific water sources in the US, supply from the Edwards Aquifer is limited by the Edwards Aquifer Protection Program. The programme has become an international model for water-quality protection, having purchased or obtained conservation easements on nearly 150,000 acres of land on which water rights cannot be exploited.
Ultimately, the water-diamond paradox boiled down to a matter of supply and demand. Pension fund investors will face a steady stream of opportunities to invest in solutions that correct that imbalance.