Institutional Research

Venture investing in Germany

Posted on by S Klamp

Deutsche Bank recently commented on the new venture grants available in Germany. No doubt, Germany is way behind the s-curve when it comes to venture investing. But what do you expect from an economy and society that is known for its conservative approach to…everything?

To be clear, we are in favour of venture investing as a means of creating new companies that have the potential to be big, one day. We agree with the authors of the Deutsche Bank report that it is not necessarily a question of How Many but rather a question of Quality. Having said that we advocate that there also needs to be a critical mass of start-ups in general before the How Many questions makes a difference. An market equilibrium overall needs to be established that can also absorb failures without stigmatising failing teams.

The US venture market has dealt with that under a ‘contingent contract’ basis. That is, teams get together to work on an idea and only if they manage to attract investment they will fully form. If not the team members move on. It is not unusual to see different teams iterating on a number of ideas, de facto having failed with a prior idea, to see a new company and team emerging.

The US model allows for energetic entrepreneurs to test the market without being held absolutely accountable for ideas that failed to attract funding at that time in history. It often does not mean that the idea was not valid (agreed, sometimes that is the case!), but it may be that the idea was too early for the market and other variables had to come into focus first before an idea has enough substance and a network that enables a faster adaption rate (Think of creating Apps before the iPhone even existed).

It is that clustering of capabilities on the one hand and the network effect (+ structure/regulation) of the local market on the other that allows for ideas and people to come together. Regrettably the latter too often walk away too early and do not give it enough time and chances to see the fruition of their own ideas. But who can truly afford waiting? It is that ‘idle’ time that appears to bug investors. It appears that the question that is forming in investors/society’s mind is “What, you still have not secured funding?” therefore you must be a failure. Regrettably that is utter nonsense. In fact, Germany would do good to overcome that attitude to venture investing as the venture market is required to create exactly that, the next big thing. The benefits of only company making it and the impact it has on people in that region or country is difficult to price in terms of future market capitalization. But surely we can agree that the position momentum may inspire other aspiring entrepreneurs to try too?

We suggest that Venture Investing is the only way to capture the potential upside when good ideas take off. Not every company can be the next Google or Youtube. Even smaller start-ups value as part of the value chain may make a difference later on when other things may fall into their place.

Clean.Invest – RSS Feed for our Cleantech & PE/VC Fund and Company Blog

Posted on by S Klamp

We have reached 50,000 readers on our blog – we are surprised about the level of interest and like to thank our readers for the continued support. If you haven’t subscribed to our RSS feed yet, you may want to consider to add https://cleaninvest.wordpress.com/feed/ to your RSS feed either in MS Outlook, netvibes.com or any other news/content aggregator. Alternatively, you can click on the link on the left navigation pane to subscribe.

We have also enabled the tweets, email, facebook and print functionality for all our content. Use it if you think others may be interested in the same stories and research.

Again, many thanks for your support. If you have any suggestions for topics, insights or critique, please feel free to get in touch. We welcome your thoughts.

Water Purification IPO landscape

Posted on by S Klamp

HaloSource‘s $80m IPO on London’s AIM market marks another interesting listing. Origo Partners and Masdar Clean Tech Fund are among some VC funds that were able to orchestrate a nice (partial) exit in this difficult economic period. Net proceed raised are some £28.9m. Other selling shareholder include Unilever Swiss Holdings AG, Britannia Holdings Ltd, and Washington Research Foundation.

We like to look back on the thesis for the water industry in general and with regards to Water Treatment and Purification in particular. Arthur D Little published a report back in 2008 title ‘The Water margin: How strategic management of water can grow business value‘.

ADL’s report cites Foster’s brewery in Australia. Foster’s embarked on a programme to minimize water consumption per unit of output without compromising quality. ‘Foster’s Yatala Brewery, the most water efficient brewery in the world, uses just over 2 litres of water for every litre of beer which is less than half the international standard of 5 litres.’ Moreover, the brewery doubled its capacity but water consumption only increased by 10-15%. The key observation that is drawn is that ‘water management needs to be embedded throughout the organization. This may require behavioural change, process innovation, systems innovation, skills development and more.’

We agree and would add that any change is difficult and the cultural backdrop important. Australian’s have learned to adopt to their natural water supply levels whereas many Western Europeans and Americans are still ignorant and lavishly use water. As this example shows, corporates do worry about water efficiency and addressing it itself leads to a competitive advantage. Whilst the West is concerned with efficiency, the company HaloSource is concerned about getting clean water to people in the first place.

Thus HaloSource addresses different markets. Markets that notoriously are challenged to get access to safe and clean drinking water. We note that the firm’s revenue mix is somewhat concentrated and water clarification is currently the firms core product accounting for some 87% (YE2008) of group revenues. Core clients are Eureka Forbes and Pool Corp, which represent 28% of group revenues.

The latter firm mainly operates in the seasonal swimming pool business whereas Eureka enhances the life of many poorer communities especially in India. We consider Eureka be a risk factor as product substitutes are ample. The question is whether there will be any margin pressure on HaloSource going forward. Euraka is owned by Shapoorji Pallonji Group. Pool Corp. business is very seasonal and we could not make out whether HaloSource is hedging this business with derivatives to reduce the likely volatility in revenues.

To date, HaloSource has accumulated operating losses of $46m whilst revenue are growing at a reasonable rate. With 2009 gross profit of around $5.8m there is likely to be a significant J-curve before HaloSource will ever be profitable. The business risk is still significant as the order books is still relatively dependent on a few core buyers. Should anyone switch product this could materially affect the performance of HaloSource.

To conclude, HaloSource is a company worth watching. We have seen big corporates buying up assets in this space and HaloSource may become a target for one larger player if it can proof to be profitable in medium term. Previously we reported on Zenon which was snapped up by GE for a reported $650m. Other players that are active in this market are Dow Chemical and 3M.

Chinese 12th 5-year plan – New Energy, New Energy Cars

Posted on by S Klamp

Are the days counted for China’s top-down macro economic decisions and for its state-owned monopolies? The next 5-year plan proposed by the Chinese Government focuses its attention on new energy and clean-energy cars. According to China Daily the government intents to ‘speed up new energy development and promote clean and efficient use of traditional energy, develop hydroelectric and nuclear power, and increase strategic oil reserves’.

Alongside new materials, high-end manufacturing, next generation information technology, and biotech,  these industries form part of the “new magic 7” emerging strategic industries. (The old magic 7 consisted of national defence, telecom, electricity, oil, coal, airlines, and marine shipping.) It appears that the new magic 7 are more focused on bottom-up drivers and allow companies to use their ‘innovation’ process to drive capital allocations.

Ahead of the Chinese party conference, HSBC published a report titled ‘China’s next 5 year plan – what it means for equity markets‘ which investigates the new proposal in some detail. Specifically, the overall objective of the 12th five year plan (2011-2015) lies in the pro-rate increase in domestic demand to total demand and secondly, and as importantly, the overall reduction of the carbon footprint (CO2) by 40%-45% by 2020.

Source: HSBC, China's 12th 5-year plan, New Magic 7

Further, the proposal projects that urbanisation will march on. HSBC estimates that a further 200-300m people could be urbanized over the next 20 years. If the hukou or registration simplification process moves in line with this shift, the projection suggests that consumption should increase significantly. The caveat here is that the property market development should ensure that the property bubble itself can be contained and price movements are more gradual going forward.

More importantly, there appears to be a continued drive to allow private capital to compete in what once were state monopolies or controlled industries. This should be great news for China focused private equity funds. From our view, there are still many low hanging fruits to be harvested by the largest funds in the region, including John Zhao’s Hony Capital for example. The investment pace has slowed a little since 2007 but funds are still putting capital to work. We need to wait and see whether some assets were overpriced and IRRs for Investors will be meaningful. Our views is that funds that put money to work throughout business/ macro cycles will do well for the time being.

We also note the drive to reduce high pollution and high energy consuming industries. For one, any energy price subsidies should be reviewed to allow a ‘fairer’ market price. Regrettably we feel that this process will take longer than currently proposed. We see a risk that some local producers/ polluters input cost competitiveness may be at risk on the global stage. In particular, pharmaceutical, the glass and other high water/power consuming sectors could lose some of their appeal. Can the government afford this – yet?

Source: HSBC, China's 12th 5-year plan, Roadmap

Certainly, the governments objective to double or indeed triple per capita income can only be a welcomed target. With that, domestic consumption levels should raise dramatically allowing for more propensity to consume (let’s hope little will be used for gambling!). Overall, the plan is intriguing and we look forward to seeing particulars.

To sum up, the China Council for International Cooperation on Environment and Development (CCICED) suggests four scenarios for a low carbon economy until 2050. Although not that specific yet, it demonstrates the authorities focus on renewable energy and commitment to cleantech. The four scenarios proposed split into four categories: (i) BaU (business-as-usual) under high growth rate (BaU), (ii) Low Carbon Scenario under high growth rate (HCL), (iii) Enhanced Low Carbon Scenario under high growth rate (HELC), (iv) Low Carbon under high growth rate (LLC). See the link above for more details.

China’s Pathway Towards a Low Carbon Economy

China’s Pathway Towards a Low Carbon Economy

Climate Equity Selection and Climate Opportunity

Posted on by S Klamp

HSBC released a recent report on their Climate Equity Opportunity list (pdf), or short ‘CEO’-list. The list comprises 88 companies that derive 20% plus from their low carbon energy, energy efficiency and storage, or water and waste.

HSBC sees the fastest growth for Renewable Energy in Emerging Markets and proposes that Energy Efficiency makes up the largest opportunity, about 53%. Overall, HSBC estimates that the total market size could be around $2.2trn. Sizing the Climate Opportunity accompanies HSBC’s Climate Equity Opportunity research piece.

HSBC’s report ‘includes five key segments: transport efficiency (USD677bn, CAGR 18%), building efficiency (USD245bn, CAGR 10%), industrial efficiency (USD183bn, CAGR 6%), energy storage (including fuel cells) (USD66bn, CAGR 15%) and smart grid (USD23bn, CAGR 8%)’.

However one sector stands out. HSBC suggests that the electric vehicle market will grow more than 20x by 2020 to reach USD473bn. This based on the assumption that the grow will be back-loaded, i.e. the growth will be faster in the second half of the decade as input prices fall and the industry starts to see scale. Importantly, the report estimates that battery costs will come down from about USD1000/kWh to about USD350/kWh. Underlying the assumptions are global electric vehicles (EV) sales of 8.65m units and sales of 9.23m plug-in and hybrid electric vehicles (PHEV). The average prices for PHEV gasoline and diesel vehicles in 2020 will be 5-10% lower than average EV prices (USD27,500).

Source: HSBC, September 2010

Saft Groupe makes an interesting appearance in the HSBC report. According to the analysis, 75% of Saft’s sales comes from markets where it ranks sector leader. More importantly, sales are diversified across other industries including the military. We mentioned Saft Groupe back in February 2010 when we advocated that the automotive industry will change forever. But not without an improvement in the Energy Storage sector. We connected our argument to the Lithium-Ion market. Overall, we continue to rank Saft Groupe as a very interesting play on the interconnection between EVs and Energy Storage. However, HSBC prefers Energy Efficiency over Energy Storage. We cannot agree more, in the near-term anyway.

Batteries, Lithium Ion and the Automotive Industry

Posted on by S Klamp

MEET (Muenster Electrochemical Energy Technology), Germany is getting ready to launch a new 2000sqm research hub focusing on battery technology, most likely a significant effort will go into lithium-ion.

Prof Winter, MEET (University of Muenster, Germany)Professor Winter (recently at Graz, Austria) will chair the workgroup at MEET (homepage). Research-in-Germany.Org gives a summary of the plans and objective proposed by MEET. We note that the commitment by the regional government, the University and the private sector (including Volkswagen, Evonik and Chemetall) is impressive, on a regional scale: “The Ministry of Innovation, Science, Research and Technology of the state of North Rhine-Westphalia is funding the project to the amount of €5.5 million for the coming three years. Münster University is contributing €7.5 million. Further funding is coming from the North Rhine-Westphalian Ministry of Economic Affairs and Energy as well as the German Federal Ministry of Economics and Technology.” The private sector is financing the chair at the University with some €2.25m which is certainly impressive given the economic climate we are in.

We wrote about Evonik previously and consider it a very interesting company that may be in the position to shape the future of lithium-ion batteries. Naturally, since Volkswagen is one of the key sponsors of the centre we must assume that they have a commercial interest to link themselves with Professor Winter and his battery research team. The automotive industry is bound to change forever, no doubt. My colleagues focused on the supply side of the lithium-ion market and whether, subject to a successful scale of electric vehicles, the supply chain is secure. In his piece “The Great, Fake Lithium Supply Scare” Brett draws the conclusion that we should not worry. Although the market is too young to make credible predictions the debate is certainly worth watching. Arguably we need to better understand whether lower grade lithium-ion can be used as an input into a high-end technology process.

Autocluster, NRW (http://autocluster.nrw.de/)

Autocluster, NRW (http://autocluster.nrw.de/)

We wrote about the need to direct further money into research for energy storage and continue to see this as one of the most important research and investment themes for any serious cleantech venture investor. It is interesting that governments can play a significant role in kick-starting a debate as well as put money into the area with a targeted approach. Autocluster.NRW gives a strong, systematic approach how to create a new hub/ cluster that can concentrate core capabilities in a region. We would like to draw readers of the report to page 58ff (‘Screening of R&D project in NRW’). It highlights the efforts of various academic institutions and how their co-ordinate their efforts to maximize their combined research capabilities. The report highlighs efforts currently made by industry to drive battery technology forward. ‘According to the German government, the number of electric vehicles on the road will be 1 million by 2020’ and ‘[a]ccordingly, the resultant higher electricity needs for 1 million vehicles in 2020 must be addressed’. The authors deduct that this would require some 5 power plant blocks of 600 megawatts each (~total need about 3TWh).

To contrast the recent UK initiative of a Green Investment Bank, Autocluster’s core competence building based on a regional level sounds proactive, constructive and combines both a coordinated effort made by governments and the private sector. Can the UK mirror the effort and come up with a strategy that is as visible? Bob Wigley, good luck!

Green Investment Bank – Bob Wigley, Lord Stern to lead Commission

Posted on by S Klamp

We keenly await further details coming out of the UK’s pre-Budget report on plans of creating a £2bn Green Investment Bank in the UK. The plan is to use £1bn of taxpayers money and marry it with private funding. No doubt, the question is whether this is only a starting point or ‘Is that all’?

A mere £2bn would not make much of a difference; a number of philantrophic investors are putting similiar amounts into the space – single-handedly.

Surely, two things must be addressed for a successful Green Bank (a) a path for the masses to access investments and saving schemes to participate in this growing, and long-ranging industry that is at the brink of becoming *the* growth driver for many economies and (b) the institutional client business unit must encompass an asset management division that sets out significant strategic investment mandates on how to (i) increase the UK’s participation in Alternative Energy (AE) segment and (ii) increase the UK’s position in the world in attracting foreign capital for (UK based) venture firms which are in desperate need for funding. The industry is emerging ‘bottom-up’: full-stop. No doubt, it is risky to invest into a young industry and whereas Europe is talking a lot about what a Renewable Energy and Cleantech (CT) world could be like, the San Francisco bay-area venture community is busy funding businesses that promise the ‘holy grail’ of renewable energy, or near enough.

Contrasting the efforts to China, Germany and the US, the UK must seek to identify this initiative as a root cause event for change with regards to transition a fossil fuel economy into an AE one. The objectives are not simply altruistic: both the Conservatives and Labour must identify an industry that can make good on loosing key industries over the past decade and create a new domestic industry that can absorb and subsume available labour and their respective skills and capabilities. AE is a high-tech industry and missing out on a promising cross-sector industry may be one of the largest strategic mistake any developed nation may make.

A global view on clean growth can be found on the United Nations Trade and Environment website. It published a report comprising of 20 essays how to address the Renewable Energy issues. Under the title “Promoting poles of clean growth to foster  the transition to a more sustainable economy” it brings together thoughts on active ways to engage, both from a private and public sector perspective.

Bob Wigley, Chairman Green Investment Bank Commission (Source: bobwigley.co.uk/)

In the UK, Bob Wigley has been announced as a key banker to steer the Green Investment Bank Commission (pdf). His pedigree should put the plans on strong footing and we are keen to see a swift execution of the proposal. In our view, he can only do good. The business case is simple: “New green technologies represent an important new source of jobs, investment and enterprise in the UK. Over the past decade, the UK has been reliant on housing, the public sector and the financial industries for over 70% of our economic growth. This has to change”. Furthermore Lord Stern, instrumental in assessing the Renewable Energy position and the economics of Climate Change of the UK, agreed to advise the Working group. His comments on the plans can be found on the LSE website but we found that his views are right: “But it will need substantial investment, some of it risky in the early stages as learning takes place and policies become more settled”. The Financial Times reported of delays in the execution of the plans and the final proposition may take some time to crystallize; most certainly nothing is likely to happen prior to the General Elections.

To sum up, we are in full support of the idea of a Green Investment Bank and will keep an eye on the development. Our thoughts are simple and pragmatic: whatever the final idea, if the Government makes a start, private money will follow. We disagree that the ‘cost of learning’ can be described as ‘sunk-costs’. It is an investment into the future of an aging industrial economy and re-inventing and re-education of a nation comes at a price. That price most certainly is higher than £2bn.

Water scarcity – an investment opportunity

Posted on by S Klamp

The Water Investment Market
Investing in water is not an easy task. The stock universe is limited and liquidity is an issue also. The public equity funds we looked at by and large invest in the same stocks. The bigger the fund, the more likely the fund is to deviate from a ‘pure play’. Some funds invest in GE as a water play which may be dubious.

Source: Goldman Sachs

Source: Goldman Sachs, 'Americas: Multi Industry' (2008)

To defend the funds that do, Goldman Sachs’ primer on water identified that although GE only generates a small % of revenues from water (<2%), in absolute terms ($2.3bn, 2007E) GE does generate significantly more sales than many of its pure play counterparts. We wrote about this previously and also elaborated in this water piece by Matthew.

Challenges of Water Scarcity
“By 2025 over 40% of the world population could be living in water-scarce regions” (UNEP, ‘Challenges of Water Scarcity’). It becomes more and more apparent that as investors, a significant part of due diligence needs to be devoted to the aspect of water. It plays a critical role in the manufacturing process. Historically economies that had access to water have prospered and that is unlikely to change. It is imperative therefore that an assessment of firms sustainability planning takes water and water rights into consideration. Anecdotally, a glass manufacturer in China once mentioned to us that they had to drill 12m down to get access to groundwater. That is up from 4m the previous year. The information was not disclosed in any corporate material but came to light during a visit of the manufacturing facilities. The implications are enormous.

Water infrastructure Issues
The water sector has been chronically underinvested for decades. Simply put the incentive structure simply was not there (see ‘The economics of water‘). According to Brennan Investment Partners “[t]he US has an estimated backlog of between $300 billion – $1 trillion in water infrastructure replacement and upgrade requirements that should drive an annual rate of 6% – 8% spending growth”. The challenge for investors is to identify the right play: via public market equities, debt, venture capital and technology investments? The alternative: to pass and simply let public (or quasi) deal with the infrastructure element or engage via Public Private Partnerships. Until the subsidies for water are reduced, it makes for a difficult investment thesis. Fact is, water is an input factor to many industries. Reducing the subsidy on the price of water will make the cost curve for some firms relatively less attractive. Kinetics launched a fund that focuses on Water Infrastructure Investing (see below ‘The Funds’).

CO2 and GHG – again
The link between CO2/MH4 and water is important. It comes to no-one’s surprise that agriculture contributes significantly to the increase in CO2 and GHG. Methane is 21x as potent as CO2 and with the demand for more protein comes higher methane output – a dangerous and vicious circle. If earth temperature rises as predicted so will the demand for water to achieve the same yield. We wrote a separate piece on Water and the Food Chain – Crop per drop.

The Funds
We looked at a number of water ETFs and funds.

Dickerson’s Summit is certainly one that has been around for some time. John Dickerson is a little apocalyptic. However we recommend his water investing primer. His most recent paper makes a case for water investing in 2010.

Source: UNEP, Vital Water Graphics

Source: UNEP, Vital Water Graphics

A newer firm, Brennan Investment Partners LLC, has launched a Water Infrastructure Fund in 2007 and as of Dec 31, 2009 has about $23m assets under management (AuM). Brennan wrote an investment primer that should make for a good read. His February 2010 conference call note can be found here. The fund size is relatively small still. As per December 31, 2009 Top 10 holdings include URS Corp, Ameron International, Geberit, Lindsay Corp, Armtec Infrastructure, Veolia Environment, Northwest Pipe, Guangdong Invest, Tetra Tech, Itron. Brennan Investment Partners is closely linked to Kinectics (Mr Brennan runs both funds). Kinetics, aside from the Mutual fund, runs the Water Infrastructure Fund. The presentation uses a UNEP chart that is informative albeit a little out of date (see on the left).

Credit Agricole Funds Aqua Global has about $31m AuM. The press release stated that the fund would make investments in companies that derive at least 25% from water relative activities. In a narrow sense, we are not sure whether this is true for the current top 10 holdings. The holdings include Nalco, Cia Saneam Minas Gerais-Copasa, Pentair, Sabesp, Suez Environment, American Water Works, Torishima Pump, Geberit, Calgon Carbon, and ITT.

The Aqua Resources Fund, managed by FourWinds Capital Management, appears more diversified with respect to regional merit. Have a look at their Q4/2009 Newsletter. It is a closed-end fund.

CLSA launched a Water and Waste Management fund out of Singapore. A strong proposition. A more holistic piece on investing in Asia’s water sector was published by the Association for Sustainable & Responsible Investment in Asia.

UPDATE1: KBC offers a Water Fund that currently has about €240m AuM (retail). Top 10 Holdings as per Jan 31, 2010 include Agilent Technologies, American Water Works, Pentair, Danaher, Flowserve, Kurita Water, Suez Environment, Toray Industries, Nitto Denko, and Millipore Corporation. The institutional KBCAM Eco Water fund has about €720m AuM. As per 31/12/2009 the portfolio owns about 50 stocks and has a PE of 17.2x with a P/B 2.2x. Average market cap of portfolio holdings is about $3bn.

UPDATE2:  Calvert’s Global Water Fund is managed by KBC’s team.

In contrast, Pictets Water Fund has some $3.1bn in assets. Per January 2010, Top 10 holdings include Veolia Environment (5.4%), Suez Environment, American Water Works, Geberit, Kurita Water Industries, Sabesp, Severn Trent, United Utilities Group, Pennon Group and CEMIG (3%). Therefore, Pictet has about $170m invested in Veolia.

There are other funds but across the universe, the funds appear to invest in the same stable of stocks. Given the concentration around the relatively small universe, it is somewhat difficult to decide which horse to back. Pictet, although with a broader mandate, certainly will have a marginal impact on the daily trading activity. If one is invested in one of the smaller funds, this may impact the NAV of the funds – both up and down.

Water and the Food Chain – Crop per drop

Posted on by S Klamp

The food chain
Food prices are bound to explode. Not only do we face a rise in population but we also are confronted by the need to improve our biofuel and ethanol feedstock (Unecsco – Institute for Water Education, ‘Water footprint of bio-energy and other primary energy carriers‘, 2008). No doubt the correlation between soft commodity indices, equity markets and major currencies has increased. The drivers are somewhat clear: increased speculation in the various futures markets. It is commonly known that agriculture consumes the most water across the globe. Technology and irrigation management have played vital roles for decades aiming to maximize yield. Horticultural projects such as maximizing yield of strawberry output in the UK are common practice for example.

In a nutshell it is possible to enhance agricultural output by enhancing yields, increase the acreage used, or by fastening the velocity of the harvesting cycle. Both Standard Chartered and Deutsche Bank have published investment reports that center on the implications of the food chain. “If the world population reaches 9.1bn by 2050, this will require a 70% increase in food production from 2005-2007 levels, including a 900m tonne (43%) increase in cereal production and a 200m (74%) increase in meat production” (Standard Chartered, ‘Special Report – Food’). The population growth implies that we add a country the size of the UK to the global population every year. The challenges continue along the food chain: “1 tonne of grain typically requires about 1’000 tonnes of water” (Standard Chartered, ‘Special Report – Food).

Source: 2030 Water Resources Group, 'Charting our Water Future', 2009

Source: 2030 Water Resources Group, 'Charting our Water Future', 2009

We observe that the need for water will rise dramatically with wealth. China and India are likely to demand higher levels of protein away from rice to chicken, pork and other meat products. To ramp up production, water will be a crucial element to satisfy the hunger of the emerging new middle class. McKinsey warns “[b]y 2030, under an average economic growth scenario and if no efficiency gains are assumed, global water requirements would grow from 4,500 billion m3 today (or 4.5 thousand cubic kilometers) to 6,900 billion m3.” The consultants continue saying that the shortfall is dramatic (see graphic).

The modern Silk Route
The Ukraine is perceived to be able to support the agricultural supply chain. It harbors significant amount of black soil, some 40% of the worlds total. However, the countries infrastructure is in desperate need for upgrading. Nonetheless, as an investment play participating in the Ukrainian agriculture may yield significant returns. Accessing the market will be difficult as will be the due diligence. We would expect that land title is difficult to secure and the rule of law needs to be assessed carefully.

While the weather appears to become an ever larger factor we can safely assume that parts of Africa, Asia and the Middle-East will be significantly affected should earth temperature rise as predicted by a number of scientists. What are the implications for these regions then? To maintain a constant agricultural yield, higher capex is likely to be an issue. To increase areable land significant upfront investment in sophisticated agriculture systems will be required.

The Food and Agricultural Organization (FAO) has recently published a new model to forecast yield and crop production. The Washington Post claimed that India is investing $4.2bn to lease land in Ethiopia supports Standard Chartered’s special report on Food which highlights (investment) opportunities for Africa. Land utilization across Africa is relatively low thus any increase in yield will be significant on a percentage and per capita basis since we are starting from a low base. Deutsche Bank takes a more holistic approach as it investigates both the demand and supply side in more detail. An interesting observation is that the “current available commodity inventories for corn is just 47 days” (adopted from USDA-NASS 2009). The report further notes that “[c]hanging precipation patterns and the shifts of regional weather to be hotter and drier in some regions while other regions become more moist will cause severe challenges to existing agricultural systems.”

Investment Opportunity
We believe that investments in water and the food chain are closely related. Agriculture projects or funds that participate in the food value chain are intrinsically linked. Further, as the soft commodity future markets are well developed we expect to see a rising correlation between water markets and the food sector.

Source: IDA, GWI, Desal Data, 'Desalination in 2008 - Global Market Snapshot'

Source: IDA, GWI, Desal Data, 'Desalination in 2008 - Global Market Snapshot'

So how to play it? Fundamentally, Venture Capital investments in bio-fuels can give an indication where the opportunity is going. Since bio-fuel does compete for arable land this space should be watched carefully. Consequently, as the competition for alternative energy increases, we expect demand for biomass and ethanol to increase which will impact water and food related investments. We recently saw a few specialist funds that aim to capture the very niche opportunity that may exist in exploiting the food (and water) value chain, in particular with respect to Africa. A further opportunity that is worth highlighting here, is the potential for desalination projects (desal). Investments in the space have moved significantly and we expect further investment dollars being deployed in this area. The Global Water Intelligence group has published an overview on the state of Desal projects that is worth having a look at. A number of funds (mutual, hedge and vc) invest in ‘Blue Gold’ or water.

Ernst & Young conducted a few interviews with people who have a vested interested in the water space including water and technology company executives, venture capitalists and investors. Worth a read to get an idea what current thought leaders are up to.

The economics of Water

Posted on by S Klamp

Why do we worry about water so much? Even in the UK we talk about droughts a lot – just to get news on historic floods a day or month later. Isn’t water really a regional issue or should we trade water cross border thus water rich countries helping water scarce economies? We are positive that many people have never really thought about whether water is tradable like any other commodity. And, is it?

Who owns the right to water: the government, companies, or land owners? Generally speaking, governments own the rights to water. But water is tradable and the market distinguishes three levels of water permits. Below we will investigate what it means with respect to the pricing of water and how we can benefit as financial investors.

Source: ADB, 'Water rights and Water Allocation', 2009

Source: ADB, 'Water rights and Water Allocation', 2009

The three levels are tradable water abstraction rights, tradable rights to water-based resources and tradable water pollution rights. We kick off the article by assessing both how water is priced and which factors need to be considered. Before we start, we hope that our readers can generally agree that “water should have a price in order to achieve two objectives, namely recovering the cost of providing the particular water service and giving a clear signal to the users that water is indeed a scarce good that should be used wisely” (Van der Zaag, P. and Savenije, H.H.G. (2006) ‘Water as an economic good: The value of pricing and the failure of markets’).

Water Pricing in the EU
The European Environmental Bureau published a report on the pricing structure of water back in 2001. The EEB report opens by saying that “60% of European cities over exploit their groundwater resources. Along the coastlines in Southern Europe and on many islands, seawater is already intruding into the depleted underground aquifers, making them unusable as drinking water.” The issue of pricing water focuses on what to include in the total cost of water. The concept of Full Cost Recovery (FCR) includes various factors but ensures that (i) Operation and Maintenance Costs, (ii) Capital Costs, (iii) Opportunity Costs, (iv) Resource Costs, (v) Social Costs, (vi) Environmental Damage cost as well as (vii) Long-Run Marginal Costs (LRMCs) are included, at least in theory. Further, the ‘Polluter Pays Principle’ (PPP) ensures that it is the one who pollutes pays instead of the society as a whole. That way it is possible to create incentive structures for polluters to reconsider whether to pollute or to enhance the discharge to minimize pollution. So far the theory.

Fact is water is non-substitutable and irreplaceable which makes the calculation, in practice, challenging. For example, calculating marginal costs could be solved, or at least addressed, by smart metering although it would be near impossible to achieve a 100% service ratio.

How does the EU assess water pricing then? Essentially three levels persist: tariff structures and levels, charges and subsidies. Those are then applied across three sectors (a) households, (b) industry and (c) agriculture. Tariff structures enable utilities to collect a relatively stable revenue base and thus minimize their business risk. It probably does not inspire ‘market’ forces and the need for innovation is somewhat arbitraged away as revenues are surely coming in. Further, the issue of regional monopolies may impact the pricing behaviour of municipalities and utilities. We can distinguish between two charge systems: abstraction charge and pollution charge. The former collects payment at point of abstraction and aims to demonstrate that by minimizing leakage money can effectively be saved and the ecological benefit is obvious. Some countries trade in water abstraction rights (FAO, 2006). The latter does what is says on the tin: it charges a price for polluted waters. Germany is leading the initiative but many other European countries have adopted a similar concept. It is the closest to the Polluter Pays Principle. Subsidies prevail on many levels but the most obvious is tax reductions for new water treatment plants et al. Although the cost-benefit analysis is difficult, the water sector generally charges below its FCR principle.

Tradable Water Pollution Rights
In an report (2004) published by the Inter-American Development Bank the authors Andreas Kraemer, Eleftheria Kampa and Eduard Interwies conclude that “[e]xperience with tradable permits for water pollution control is accumulating primarily in Australia and the US, which are both advanced economies with long regulatory history in water management and pollution control. The introduction of trade for water pollution control has benefited in these cases from solid scientific understanding of the pollution problems in question, existing monitoring infrastructure and enforcement capacities”.

However, the market is still relatively young and the authors admit that it is too early to know whether the economic benefits can be explained systematically.

Conflict Potential
We are not in the position to comment on the various conflicts associated surrounding water rights. However we point out that whenever cross-country/cross regional water flows tangent on various jurisdictions, conflict is pre-programmed especially in water scarce regions. We suggest this paper by the Munk Center for International Business in Canada on issues surrounding the US-Canadian relationship on water. Other prominent research has been conducted around the River Nile and the water abstraction issues from countries further upstream. A very good report was published by the Asia Development Bank.

Further reading:
http://www.ucowr.siu.edu/updates/pdf/V109_A2.pdf
http://ageconsearch.umn.edu/bitstream/19790/1/sp02ha02.pdf
http://www.uwsp.edu/cnr/uwexlakes/economicsOfWater/documents/34_waterRights_weber_paper.pdf