Water is not the next big asset class

London, 25 July 2011: Reuters

Trading firms have long dreamed about global markets in water (spot markets, futures, options and swaps) sending the stuff around the world in pipes and tankers from areas of abundant rainfall to make the deserts bloom and run the mega-cities of the future.

It would be the biggest, most fundamental market of them all, far exceeding existing markets in energy, metals and grains.

Enron, the most innovative and pioneering trader of all, bought a water utility in south-west England, Wessex Water, and put it at the heart of entire new division, Azurix, to realise its vision of a worldwide market in water (I was briefly an Enronaut for nine months before the company was engulfed in bankruptcy).

Wessex has survived as a utility, and Azurix continued in a zombie existence, among other things pursuing legal claims against the Argentine Republic, but the dream of creating worldwide markets in water died with Enron.

Marketisation nonetheless remains a tantalising prospect for traders and thought-leaders. Supporters argue putting a price on water would encourage efficient use, avoid overexploitation, and avert the prospect of water wars.

Pricing is a means to avoid a repeat of the "tragedy of the commons" and Malthusian rationing by epidemics, pestilence, war and famine.

PERILOUSLY PEERING INTO THE FUTURE

Citigroup's research department is the latest organisation to contemplate how investors might benefit from the marketisation of water. In a thoughtful essay, Citigroup Chief Economist Willem Buiter concludes "Water as an asset class will, in my view, become eventually the single most important physical commodity-based asset class, dwarfing oil, copper, agricultural commodities and precious metals." (Water as Seen by an Economist, 20 July 2011).

Buiter envisages "a globally integrated market for fresh water within 25 to 30 years. Once the spot markets for water are integrated, futures markets and other derivative water-based financial instruments -- puts, calls, swaps -- both exchange-traded and OTC will follow."

Buiter argues convincingly that water should be seen as a private good. But he has not made a convincing argument that it is a global commodity let alone a tradable and investable asset.

Futurology is inherently dangerous. Forecasters predict continuation of existing trends and miss the disruptive technologies and turning points that remake the world. Disruptive technologies and turning points are impossible to predict precisely because they are so unexpected and revolutionary.

No one can know what the world will look like in 10 years let alone 25-30 years. Go back 25 or 30 years to 1981 or 1986 and the Soviet Union was still a superpower, Ronald Reagan and Margaret Thatcher were still fighting the unions, Paul Volcker was struggling to tame inflation, and the widespread take up of the internet was still 10-15 years into the future.

But it is a fair bet water will never be traded around the world in tankers and on futures exchanges. There will never an integrated global spot market in water let alone complex derivatives. It does not have the right characteristics to be a global commodity let alone asset.

For any plausible water price, the value-to-volume ratio would be too low to support an integrated global supply system. There will not be an integrated global supply system for the same reason there is no global market in bread but there is in oil, copper and gold. It is not worth transporting loaves around the world by boat, plane and truck.

Moreover, most of the value in water lies not in the commodity itself but the value added to it by various processes and services.

The world has so much water it will never be in short supply at a global scale. There are literally oceans of the stuff as well as enormous amounts of brackish water underground. The value-added lies in extracting it, treating it to make it drinkable, extracting salt from sea water, transporting it to the place where it can be used conveniently, and disposing of dirty water to prevent the spread of disease.

There is not much extractable value in the water itself. In contrast, the market for water-related services (treatment, desalination, distribution, waste water collection and disposal) is interesting. But mostly because it is a state regulated utility that can earn guaranteed utility-type returns for investors, allowing them to tap into strong demand growth with minimal investment risk. Utility-type regulation ensures investment risks can be passed straight to customers.

Providing water services is attractive for precisely the same reason as power and gas transmission and distribution companies and private-finance initiative hospitals, roads and other infrastructure. The regulator guarantees a minimum return, and there is the chance to earn even more if the provider can outsmart the regulator.

A GOOD BUT NOT AN ASSET

Buiter explains why water is a private good that can be provided by the market -- rather than a public good that must be provided (or at least paid for) by the state. He makes a convincing case that property rights can be defined and enforced in water. It is a rival product (use by one person precludes use by another) and an excludable one (the owner of the property rights can prevent unauthorised use by another person). He also disposes of the argument that water is some kind of moral right or merit good that should be provided free to all.

Buiter is also on firm ground when he complains about the inefficient use of water supplies in many parts of the world because of poor pricing systems.

It makes no sense to have golf courses and immaculate green lawns in the deserts of the south-western United States or un-metered supplies and water rates across much of the United Kingdom.

But proving water is a private good that is often mispriced is not the same as making the case for treating water as a global commodity and an asset.

TRADING ENERGY NOT WATER

Let's leave aside the obvious objection that consumption goods like oil, gas, copper and grains are not really capital assets like equities and bonds because they do not provide a stream of expected future income, and commodities are therefore not really an asset class in the usual sense of the word.

Water simply does not meet the requirements for a global commodity market to emerge. The key constraint is the prodigious amount of energy needed to desalinate sea water and move water over long distance by pipeline or tanker. Unlike gas, water can't be liquefied or compressed to improve the value-to-volume economics.

At a global scale, water is really an embedded form of energy (an "energy vector") as some commentators on Thursday's FT Alphaville blog explained. The commodity is not the water but the energy.

For a country like Saudi Arabia, with abundant fossil energy and more importantly huge solar resources, the availability of clean drinkable water will never be a constraint since desalination is an option. For China's Xinjiang province, water will always be an issue because it is so far from the sea despite plentiful solar and wind resources.

There will always be local water shortages. The south western United States and Central Asia are prime examples. But it is very unlikely that a global water market will emerge to relieve them.

Investors should stick to boring old water services and infrastructure companies and leave dreams of water markets for pioneers with a lot of money to lose.

Ends --

By John Kemp, Reuters market analyst – for Commodities Now.

The views expressed here are his own.