The trend towards water as an investment asset is likely to grow. Aled Jones and Michael Green explain how the actuarial profession could play a vital role in long-term risk modelling and enterprise risk management for the water sector
There are few resources globally that are more complex than water. There are as many ways of setting up and managing water supplies and markets as there are risks to supply. However, one thing is clear - water management is becoming more critical to the success of economies in all regions of the world.
Too much water (flooding) leads to significant economic damage. For example, the total clean-up cost of the recent UK floods could be as much as £1bn, £500m of which is likely to be incurred by the insurance industry. Too little water can be equally damaging, as shown by the recent droughts in the USA which has driven up food prices and cost the insurance industry over $10bn in each of 2011 and 2012 - although this is heavily subsidised by the US government.
In many countries water utilities are in public ownership, and in almost all countries heavily regulated. However, as the need for capital investment increases, it is likely that public-private partnerships - whether formal market structures or regulatory frameworks allowing in private capital - will be needed and private investment into the water sector is increasing globally.
Water as a key economic development indicator
Rapid rural-urban migration and growth in global population, industry and agriculture are causing a significant increase in the water footprint of human society. In some locations of the world there is already water stress either due to low water availability or overdevelopment. The south east of England is one of the most water-stressed regions of Europe due to intensive development not matched by available water supply.
Water is believed to be the primary medium through which people, ecosystems and economies will experience the effects of climate change. There are significant implications for sustainable development, economic growth and poverty reduction efforts, as well as wider implications for agriculture, energy, insurance, house building, environment and public health.
Water scarcity has consequences on health, biodiversity, economic development, and the prospects of conflict between different groups of water users both locally and internationally. Although most of the planet is covered in water, there are many specific regions where it is in short supply. Perhaps the biggest geopolitical implication of this is the suggestion that water shortages in the highly-populated north-eastern part of China may halt the currently rapid growth of China's economy.
Investment in the water sector will need to account for potential climate change impacts, as well as a growing demand from population and industrial output increases. Understanding the future supply-demand balance of water at a regional level requires significant modelling effort in the near term if local economies and industry are to avoid challenges. In addition, extreme weather events are likely to provide significant shocks if systems are not resilient.
Modelling these long-term trends and short-term events is needed to better understand the impacts on finance and economic activities. For example, recent work by Standard & Poor's has explored the potential impact on the credit ratings of water and energy utilities in water-stressed regions. And the reinsurance industry has invested significantly in catastrophe modelling for extreme weather events associated with droughts and flooding.
Given the overwhelming uncertainty in the future climate, two categories of risk have been suggested. The first category encompasses direct and indirect risks posed by climate change. The second is associated with the concept of maladaptation.
An individual or organisation could be seen as wasting a large amount of money on measures designed to mitigate potential impacts that may be less severe or never occur. The very notion of maladaptation and its negative connotations means many stakeholders are hesitant about investing in costly assets or schemes, such as building a new sea wall or installing a new irrigation delivery system, as these assets may take decades for their full benefits to be felt. Therefore, a much clearer approach to long-term risk modelling is required and enterprise risk management techniques could be usefully deployed. The actuarial profession could play a vital role in this modelling effort.
Water as a commodity
The global water sector requires annual investment of over $400bn. The largest fraction of this will be in the water utilities, which are mainly publicly owned. However, with increasing water stress private sector investment and opportunities are increasing.
Over the past decade there has been an emergence of water markets and water indices such as the S&P Global Water index. Over the next decade companies across the water sector and supply chain will see huge opportunities to benefit from the need to invest in order to adapt to changing weather patterns, improve water treatment and manage water between times of too much and too little.
Innovation in water efficiency technologies, treatment, reuse and desalination are all seen as potential solutions to water stress and are seeing increasing investment globally. The trend towards water as an investment asset is likely to develop.
Water is not easily transportable and is vital for human life. Globally the price of water varies significantly and depends on existing infrastructure and available water supply. However, the use of price to regulate demand is not straightforward. Overseas companies operating in a poor country can afford more, so they get priority over local business and people. Those who can afford it get the water, those who can't just to have to somehow do without. This can only be mitigated through a policy package that includes social welfare components to counter pure market pricing.
The market distortion that this potentially creates translates into market uncertainty but the issue of increasing incentives for investment while protecting people's access to water is one that is not going to go away.
Therefore, the regulatory environment associated with water exploitation is likely to create market distortions (it will never be a 'pure' market derived price on water) that may be difficult to manage or predict.
These complex regulatory issues alongside infrastructure requirements need careful modelling to better understand water as an investment asset.
This article was contributed by the Global Sustainability Institute (GSI) at Anglia Ruskin University. The GSI is part of the [email protected] European platform on water efficiency