Pinning the Tail on Inflation
Many real assets besides gold have positive inflation exposures. This article explores four elements for successful investing in real assets.
India relies on the annual monsoon for more than 50% of the water required for agriculture. Consequently, a monsoon "failure" not only reduces food grain production but also subtracts 2-5% percentage points from India's annual GDP.[i] Even more developed countries like Australia and the U.S. with generally dependable water resources are, at times, vulnerable to periods of water scarcity which can reduce growth and harm real asset investments.
Fresh water is a scarce resource! One of the UN's Sustainable Development goals is "Clean Water and Sanitation" which seeks to increase water-use efficiency and ensure fresh water supplies. Besides its use for sanitation and drinking, fresh water is used in agriculture, power generation, metals production, energy refining and other industrial uses.
Since fresh water is in limited supply and has many and important uses, how can it be protected, conserved and allocated most efficiently? According to the Coase Theorem, well-defined property rights and low transaction costs enable stakeholders to achieve efficient outcomes regardless of the initial allocation of property rights. With well-defined water rights and active water markets, water use can be efficiently transferred to where it is most highly valued.
Given the competition for fresh water – with implications for its cost and availability – investors in real assets such as farmland, natural resources and infrastructure must plan and monitor their assets' current and long-term water usage and water sourcing. Benchmarking water and estimating the water footprint is essential to improve water use efficiency.
Water scarcity, and water price variability, affect real asset investments in many ways:
Agriculture: During the peak drought year in 2014, California Central Valley farmers received significantly reduced deliveries of surface water requiring the pumping of additional groundwater and leaving significant acreage fallow. As a result, Central Valley groundwater has been depleted significantly. Over the last five years, counties with water shortages have seen farmland prices decline. For example, prices declined by around 15% in Tulare County.[ii] The observed land value declines may be due to several factors such as crop age, crop yield and water scarcity. Of course, like water scarcity, too much water is also as much a risk. El Niño rains occasionally bring floods and uncultivated land is often susceptible to mudslide and erosion. While farmers usually mitigate such risk by ensuring proper drainage, they may also use such flood waters to recharge depleted aquifers.
Infrastructure: Water is needed for hydroelectric and thermoelectric production. Periods of limited surface water availability affect energy production due to reduced hydropower generation and cooling for power plants. Although these water-related energy production deficits can be offset somewhat by solar and wind, such options are still much costlier than hydro. Periods of limited water supply have financially impacted utility companies and related projects.
Natural Resources: Mines require water for production and processing. Chile, which produces more than a quarter of the world’s copper supply, requires 500 gigaliters (GL) of water per year. Last year, Chile experienced the worst drought in decades leading to reduced copper production as well as increased electricity costs with severe consequences for industry margins.[iii] Mining companies have turned to seawater for a more dependable water supply, but this will require further capital expenditures.
Energy: The energy sector is heavily reliant on fresh water as a production input. To produce transportation fuel requires surprisingly high amounts of water, about 0.65 gallons of water per gallon of gasoline.[iv] Depending on the size and complexity of the refining process, refineries can use large amounts of water making them vulnerable to reduced water availability and related costs.
Existence of water markets for trading water rights can help real asset investors manage their water needs.
For example, in Australia there is significant variability in water prices. While prices historically have averaged about A$100-200 /megaliters (ML), in 2006-07, a severe drought period, the price of water peaked at A$1,000 /ML at its worst! Water prices have even traded near zero in flood years such as 2011 and 2012. To try and help dampen this volatility, Australia has a sophisticated cap-and-trade water market in the Murray Darling Basin (MDB).[v] Water users may trade allocated water rights via water brokers or electronic exchanges for any given year (i.e., allocation trade), allowing water to be reallocated to higher value uses. Holders of water rights may even permanently trade their rights, also known as entitlement trade. Since 2009, more than 1,500 GL of water has traded per year.[vi]
While the agriculture sector is the main participant in the MDB water market, others include utilities, environmental programs and investors.[vii] Both domestic and foreign institutions have invested in permanent water rights. The commercial value of total southern MDB water entitlements is about A$26.3 billion.[viii] The Aither Entitlement Index which, measures performance of water entitlements in the southern MDB, has returned 7% annually since its inception in 2008.[ix] In addition, for some water entitlements, a percentage of unused allocated water can be carried over for later use. Both the ability to trade water and to carry over water to subsequent years have helped participants manage around the region’s drought.
In the U.S., several states such as California, Texas, and Arizona have water markets which allow for short-term, long-term, or permanent sale of water rights. Such markets also allow cities, environmental programs and farmers with higher value crops to secure water, especially during drought conditions. California has had water markets since the 1980s. During the past decade or so (2009-2018) about 1,100 GL of water has traded annually in the form of short-term and long-term (> 1y) leases of water rights.[x] In 2020, after passage of the Sustainable Ground Management Act (SGMA) in 2014, the Fox Canyon Groundwater Management Agency, a special California district which oversees Ventura county’s groundwater resources, started a cap-and-trade styled groundwater market.[xi] If agricultural producers can cut back water usage, they can trade their unused allocation. Since an unused water allocation now has a tradeable value, producers have an incentive to save water. Research shows water markets not only help recharge aquifers but also improve land values.[xii] Groundwater banks also play an active role to mitigate water shortages during dry seasons by “banking” water in wet seasons for the benefit of urban and agriculture needs.
While water trading helps to hedge water availability, perhaps there is a way to hedge water prices? After all, in 2014 surface-water spot market transfer prices reached $2500/ML when generally it averages well below $500/ML.[xiii]
More recently, the Chicago Mercantile Exchange (CME) launched a cash-settled water futures contract market based on the Nasdaq Veles California Water Index. This index tracks, in aggregate, the weekly spot price of water based on observed transaction prices of water rights in California’s most actively traded water markets. The water futures contract may help farmland operators and utilities by allowing them to hedge against potential price increases in anticipation of a drought. Real asset investors may also consider adding water hedges in their portfolios since the price impact of water scarcity is a source of investment performance risk.
While water scarcity creates a need for financial hedging instruments, it also creates opportunities for water infrastructure projects for water conveyance and storage.
To learn more about how climate change is altering the investment landscape, access PGIM's new Megatrends research Weathering Climate Change.
[i] Gadgil, S. and Gadgil, S., 2006. The Indian Monsoon, GDP and Agriculture. Economic & Political Weekly Vol. 41, No. 47
[ii] Source: NCREIF, as of 12/31/2020.
[iii] Lutter, S. and Giljum, S., 2019. Copper production in Chile requires 500 million cubic meters of water. An assessment of the water use by Chile’s copper mining industry. FINEPRINT Brief No. 9. Vienna University of Economics and Business (WU). Austria.
[iv] P. Sun, A. Elgowainy, M. Wang, J. Han and R.J. Henderson, 2018. Estimation of U.S. refinery water consumption and allocation to refinery products. Fuel 221, 542-557.
[v] See T. Goesch, M. Donoghoe and N. Hughes, The Snapshot of Australian Water Markets.
[vi] Allocation data excludes environmental transfers. Source: Australian Bureau of Agricultural and Resource Economics and Sciences
[vii] Reportedly about 8% of MDB is owned by pure water investors. Source: Natural Conservancy Australia. See A. Courtney, Water rights, trading and the new water barons. In the Black. November 2017.
[viii] Source: Aither Water Markets Report, 2019-20.
[ix] The index tracks performance of high security, general security, high reliability and low reliability water entitlements.
[x] K. Schwabe, M. Nemati, C. Landry and G. Zimmerman, 2020. Water Markets in Western United States: Trends and Opportunities, Water, 12, 233.
[xi] In 2014, the State of California adopted legislation to help manage its groundwater, the Sustainable Groundwater Management Act (SGMA). According to the act, local Groundwater Sustainability Agencies (GSAs) must be formed for all high and medium priority basins in the state. These GSAs must develop and implement Groundwater Sustainability Plans (GSPs) for managing and using groundwater without causing undesirable results: significant groundwater-level declines, groundwater-storage reductions, seawater intrusion, water-quality degradation, land subsidence, and surface-water depletions; these are also referred to as sustainability indicators. Source: US Geological Survey.
[xii] A.B. Ayres, K.C. Meng and A.J. Plantinga, 2019. Do Property Rights Alleviate the Problem of the Commons? Evidence from California Groundwater Rights, NBER working paper no. 26268.
[xiii] Source: PGIM IAS, Nasdaq and WestWater Research.