Repost: Putting a price on H₂O
Carbon markets are just the start of a revolution putting a price on natural capital
The UN water summit, the first for more than four decades, begins today in New York. It comes as the IPCC revealed this week that half of the global population experience severe water stress for at least part of the year. The deficit could get worse over the next decade. Demand for freshwater is expected to outstrip supply by 40% by 2030 if current practices continue, according to the World Economic Foundation (WEF).
At the height of last summer, in what was then the middle of a severe drought in Europe and a heatwave in North America, I published this article highlighting the supply chain risks posed by water scarcity. The most important part of the article though for me was what to do about it. As the subtitle of the article alludes to, I believe that carbon markets are just the start of a revolution in putting a price on natural capital. Putting a price on water could be next, but it won’t be easy.
The original article was published behind the paywall, but considering the timeliness of the issues raised in this article I’ve decided to remove it on this occasion for the benefit of all Carbon Risk subscribers. I hope you find it useful and do leave a comment.
”When a well is dry, we know the worth of water” - Benjamin Franklin
Energy is life. We price it. We trade it.
Carbon emissions are an externality of life. One that we increasingly price and trade.
Water is also essential to life. Yet we fail to put a price on it or trade. Instead it is close to free, or heavily subsidised, even to consumers who could pay more.
Putting a price on the first two in the ‘energy-carbon-water’ nexus enables scarce resources to be allocated more efficiently. Putting a price on them provides the incentive to ensure supply and demand move towards a stable balance. Not to do so would result in persistent surpluses and deficits - harming those in need of affordable energy and polluting our atmosphere with carbon dioxide. Yet despite the benefits we have yet to really begin to recognise the benefits of putting a price on water - the scarcest, most precious of the three.
According to the UN, agriculture accounts for 70% of global water use compared with 22% for industry and just 8% for domestic users. These proportions vary by region with agriculture even more important in Asia, Latin America, and Africa. Meanwhile, in Europe and North America, industry dominates demand for water.
Everything we eat, whether it is your eggs and toast you had for breakfast, the salad you had for lunch and the steak you had for dinner indirectly consumes massive quantities of water in its production. For example it takes 547 litres of water to produce a kg of potatoes, 1534 litres per kg of corn and 2,191 litres to produce a kg of soybeans. But those numbers pale into insignificance once you consider the amount of water needed to produce meat. To produce just one kg of beef requires 109,671 litres of water.
Energy runs on water. In fact, among industries, the global energy sector is the world’s largest water user. Almost all forms of energy production and power generation (whether it be nuclear, oil, coal, gas and of course hydroelectric) depend upon water for their operations, including the transportation of fuels, cooling generators and used to extract oil from beneath the ground. It takes 38 litres of water to power one house for one month from gas (~1000 kWh), up to 2,100 litres of water from coal and up to 31,000 litres of water to power one house for one month from oil (see The forgotten giant of clean energy and High and dry: Drought threatens Germany's plan to burn more coal).
Metal supply runs on water. At a basic level drinking quality water is required to support towns that have developed in remote areas, home to mining staff. Water is also favoured in mineral processing because it is a low cost and energy efficient way of transporting materials between processes – including disposing of, or storing, waste materials. Water is also a very efficient medium for supplying chemicals and mixing materials and it is an essential ingredient for some chemical processes. It is also the most convenient medium for gravitational and centrifugal separation of minerals from host rocks.
Other essential industrial processes are also big consumers of water. For example, in Taiwan water reserves were so low in the summer of 2021 that water restrictions were placed on the semiconductor chip industry. The world’s largest chip manufacturer, Taiwan Semiconductor Manufacturing Co Ltd uses more than 150,000 tonnes of water per day, equivalent to approximately 80 standard swimming pools. Other areas where chipmakers are setting up, such as the US state of Arizona are also suffering from acute water shortages that threaten the production of chips.
This reliance is often most acute in areas already afflicted by water shortages, often making the problem even more acute. This is especially problematic for agriculture where water consumption is especially high and water is permanently withdrawn from its source. This can occur either because the water has been evaporated, transpired by plants, incorporated into products or crops, or consumed by people or by livestock. The majority of the water used in agriculture involves water consumption and so is otherwise removed from the immediate water environment.
Nearly 93% of the Middle East’s onshore oil reserves are exposed to medium to extremely high overall water quantity risk according to the World Resources Institute (WRI). For energy companies operating in the Middle East, inadequate desalination or other water infrastructure can disrupt ongoing projects, delaying oil drilling, production, and processing extraction and production.
Mines can also have a negative impact on the quality and availability of local water supplies. Mines that go beneath the water table are dewatered by pumping, which draws-down the water table in the surrounding landscape. This can reduce the water available to other users and reduce the discharge to streams and other groundwater-dependent ecosystems. Finally, the water from dewatering must be discharged safely to rivers, lakes, or storages and may need to be treated to remove acidity or high metal concentrations.
Energy generation and to a lesser extent, industrial processes tend to take the form of water withdrawals. Water withdrawals are defined as water that is diverted or withdrawn from surface or groundwater, but where some of this water can return back to the water system as return flows. Unfortunately the water that returns to the local environment is not always to the same quality as that first consumed.
The water demand-supply deficit is projected to reach 40% by 2030 if current practices continue, according to the WEF. Population growth, economic development including increased urbanisation, and volatile weather patterns is likely to mean that water stress escalates over the next decade. The competition between agriculture, industry and people for the scarce water supplies is going to become more intense.
Unfortunately, there is a spatial mismatch between the demand for water and the ability of the Earth’s geography to supply it. Water covers approximately 71% of the earth’s surface; however, 97% of it is too salty for productive use. Of the 2.5% that is usable freshwater, 70% is in icecaps, and much of the rest is in the ground. This leaves just 0.007% of the earth’s water supply in the form of readily accessible freshwater.
Much like arable land, that freshwater is not evenly distributed with some regions experiencing surpluses relative to demands from their population, while others experience extreme scarcity. For example, ~5% of the global population live in North America and it is blessed with 29% of freshwater. Asia also has around one-third of the world’s supply of freshwater, but it has to support 60% of the world’s human population.
The supply of water is governed by the flow, rather than the stock. This means there is also a temporal mismatch between demand and supply. There are exceptions like reservoirs which can store water for extended periods of time. In the main though, consumers of water are concerned whether the rains will return and that the river will continue to flow. For the majority of water consumed, the weather and seasonal factors are especially important.
The ‘commodification’ of water challenge
A number of factors typically complicate ascribing value to water as a commodity. For instance, the implicit value of water itself is arguably delinked from its price in that the value of water in sustaining life may be so much greater than a market price can truly capture.
Governments often deem that access to water is a basic human right for which they attempt to ensure access is equitable, no matter how rich or poor you are. In economic terminology it is known as a ‘merit good’. The historical position that water should be free at the point of consumption is very difficult to row back from.
Water assets generally do not have clear and transferable ownership title – rarely can one individual claim rights to a specific reservoir or lake – thus making it difficult to trade water assets, as opposed to more conventional commodities. To be traded on the global commodities exchanges, a resource has to be transferable (even if you are selling future rights to it) and transparently priced.
Water is often seen as a special type of good, a “commons” in the same way that the atmosphere, the oceans and the Arctic are perceived. Regulating access to the these “common” goods is fraught with difficult questions. Who pays to clean it up and in what proportion? How should access be restricted to avoid one party taking more than their fair share? The misuse of water is a classic case of the tragedy of the commons, an economic theory in which every individual tries to reap the greatest benefit from a given resource.
While the ‘merit good’ argument makes sense for the supply of water to the citizens of a country, it does not makes sense in the case of supplying water to agricultural, industrial and energy users. Here, water is an essential input into their production and so they should be made to pay at minimum the marginal cost to supply (including the externalities associated such as sewage).
Putting a price on water should mean that efficient users conserve water, and sell it onto those less efficient yet highly demanding users. This physical settlement isn’t possible with water because of complex rights issues. Trading the rights to water is not the same as trading the underlying natural capital asset. The price could go to stratospheric levels, but if there is no water available then farmers and other industries dependent on water cannot do anything about it other than try to be more efficient in their use.
As with other commodities, price can theoretically help manage demand while providing an incentive to increase supply where it is needed the most. However, the cost of transporting water over long distances means that the supply response, if there is any, is likely to be prohibitively high, at least currently.
The revolution in putting a price on natural capital has barely begun. Carbon markets have flourished over the past decade or more. Investors and governments are increasingly looking at ways that biodiversity can also be priced. Water could become the next important natural capital market to grow. Indeed, trading of water rights has become more common in water-scarce regions, including Australia, Israel and China, as well as parts of Europe and the US.
The trading of water rights in Australia, an area normally associated with acute water stress but also high demand from agriculture, has existed for some time and is now a $1.4 billion market. The price of water rights in the Murray-Darling Basin (an area of very high water stress located in South East Australia) increased from less than A$100 per million litres (ML) in 2017 to almost A$800 per ML in 2019/20 as water storage levels fell sharply. However, in recent months water levels have increased and are now close to 100% capacity. As a result the water price has plummeted back to below A$100 per ML, or equivalent to ~US$70 per ML.
Israel has sold water to neighbouring Jordan since the mid-1990’s. Jordan is one of the world’s most water deficient countries. In 2021 the two governments agreed on a deal that would see annual water exports from Israel almost double to 50 million cubic metres.
In China, droughts and inefficient water management has meant that many areas, particularly in northern provinces of the country have experienced a water-shortage crisis. Since 2014 China has piloted several water rights markets and in 2016 set up the China Water Exchange.
However, the lack of a clear legal definition of the right to use water has stymied its development resulting in very little in the way of traded volume. In China all water is owned by the state which sets annual water-use quotas for each province. The provincial governments then distribute them among local governments under their jurisdiction.
Meanwhile, in California the right to access water has been priced. Between 2017 and 2019 the Nasdaq Veles California Water Index, a weekly spot rate price of water rights in California, averaged around US$250 per one-acre foot. February 2020 was the driest February in California for over 100 years and the state suffered from acute water scarcity. Over the next three months the price more than tripled to US$700 per one-acre foot in June 2020, before gradually dropping back to US$500 per one-acre foot in October.
In late 2020 exchange operators CME Group and Nasdaq launched a cash settled futures contract based on the price of water in California. Since then water scarcity in California has become even more acute with the state enduring its driest start to the year since the late 19th Century. In July this year prices increased to US$700 per one-acre foot, a record level (equivalent to US$863 per ML).
An issue with natural capital markets such as water futures is that there is likely to be little or no information flow prior to the front month of the contract. This is a problem according to Craig Pirrong, Professor of Finance and Director, Global Energy Management Institute, Bauer College of Business University of Houston, one that’s likely to stymie the contracts development and means that it is very unlikely to turn into a means for speculation or hedging:
“There is little information that arrives today that would motivate people to trade today contracts with payoffs contingent on future weather, even for a future only months away.”
A shadow price of water
In the same way that many companies are adopting an internal carbon price in the absence of a formal compliance carbon obligation, some are adopting an internal price for the water they use. By doing so they hope to incentivise changes in business practices to better reflect the risk that water scarcity could have (see In the shadows: Everything you need to know about internal carbon pricing).
Companies around the globe are increasingly talking about water related risks during earnings calls. According to Barclay’s, mentions of “clean water and sanitation” in corporate transcripts doubled over the last 15 years.
A 2021 report from Barclay’s suggests that equalizing water costs across emerging and developing areas while factoring in the cost of droughts, floods or other extreme water events, reputational damage and impacts of water shortages means the true cost of water is three to five times more than that typically reported by companies.
While adopting an internal price of water may help to encourage water users to become more efficient in their use of water, potentially resulting in lower demand, it does not on its own provide a means for the physical trade in water to take place, arbitraging the price disparities between areas of water surplus and deficit.
Water as a natural capital asset class?
Water has many of the features we think of in an asset. It is scarce, durable and valuable.
However, the market for carbon allowances and offset credits, there are no visible markets in the physical trade in water beyond very narrow water-scarce geographic boundaries.
This fragmentation results from the political issues involved (e.g. merit good and lobbying by major commercial users), the designation of water rights (e.g. who owns what and pays whom?), and the physical barriers in the way of more interconnected markets (e.g. the transportation of water over long distances, through pipelines or tankers).
Over time disparate water markets are likely to become more connected, extending the right to access over a broader geography while also ensuring that markets can be physically settled. You only have to look at the development of the oil and gas market - previously high regionalised markets - into a global market as an example.
The main thing stopping this from occurring is a recognition that water is currently being under priced. As its value goes up, the incentive to invest in the infrastructure required to develop a more regional, and then global market will increase.
It is still very early for investors to get involved in actively buying or trading water as an asset class. It’s time will come though. As water scarcity issues become more frequent and acute then the pressure for governments to put a market determined price on H₂O will intensify.
Water is critical for low production, high value commodities such as gold where water is needed to transport and process very low grade ore – over 250 ML of water is required to produce a tonne of gold.