The Global Water Shortage: A Transparent Issue

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“When the well is dry, we know the worth of water,” wrote Benjamin Franklin in 1746.[i] Over 250 years later, it seems we are only beginning to know the true worth of water. More than one expert has said that water will be the oil of the 21st century[ii], but that is to understate its value.

Water is so essential that its shortage will impact the world in ways we cannot yet accurately predict. It will affect countries differently, depending on context (geography, demography, etc.) and the actions they take. For politicians, the peak oil crisis will seem quaint in comparison.

This paper will seek to address the economic consequences of the global water shortage. These are already being witnessed and have led to financial innovation in the area of efficient water consumption, some of which is analysed here. The hope is that these innovations are a trickle, which turns into a stream that becomes a mighty river.

Go long on water

The Dow Jones Industrial Average (DJIA) reached a new all-time high at the end of August 2014.[iii] However, its impressive growth is put in context by that of the Dow Jones Water Index, which contains water-related stocks only. In chart 1 below, the DJIA is in red and the Dow Jones Water Index is in blue.

If we agree that stock market performance is based on the accurate expectations of future earnings, chart 1 tells us that we can reasonably expect water prices to rise dramatically in the near future. This prediction even allows for a significant margin of error in the stock price.

In fact, according to data provided by the Bureau of Labour Statistics[iv], water prices have been outpacing the general basket of consumer goods – the consumer price index (CPI) - in the United States for at least 30 years. Figure 1 below shows cumulative inflation of water against the CPI from 1984 to late 2013.

The graphs above only serve to indicate that water has been extremely under-valued until now. However, the justifiable argument that water needs to be priced better needs to be balanced with the equally justifiable “water is a human right” argument: A change of thinking is called for.

An extremely liquid asset

The return on US Treasury bonds has traditionally been used as a measure of the risk free interest rate. “Risk free” is not to be taken too literally here. The American government has defaulted on its debts at least twice[v] but the idea serves to promote confidence in the financial system.  Besides, the risk associated with these bonds is generally negligible.

In the highly unlikely event that the US Treasury disappears along with the risk free rate tomorrow, we can be certain of one thing: everyone will still require water. That is literally a “risk free” assumption. Taking this into account, might risk free water bonds offer a solution?

On August 26th of this year, the city Detroit sold slightly under $2 billion in bonds tied to their water and sewer system[vi]. A city whose debt is classified as junk[vii], has now issued water bonds which currently allow the city to refinance at a 10-year rate of 3.24%[viii] - less than 1% below the yield for so-called risk free government bonds for the same period.[ix]

This is a more sensible solution from a societal standpoint than the profiteering from water that seems inevitable on the stock market. In theory, the demand for a true risk free return could push the yield on these bonds to below that of a treasury bond with the same time to maturity (although given how bad we have been at valuing water until now, it may take a while).

Detroit aims to save $11.4 million a year from the initiative as well as raising $150 million to update the city’s sewerage system.[x] It is hardly going to provide a panacea for Detroit or the water crisis, but the adoption of a new mind set is encouraging.

A new mind set

It is reasonable to suggest that businesses should pay more for water than consumers. One company in Canada was able to bottle 265 million litres of fresh water and pay nothing.[xi].It’s easy in cases like this to point a finger at corporations but an antiquated mind set about the value of water effectively gave the company a green light to do it.

Encouragingly, the same Canadian state where this occurred will put into force a Water Sustainability Act in 2015 to ensure it doesn’t happen again.[xii] No doubt other jurisdictions will follow suit: a mind set is emerging which recognizes that, where water is concerned, people and companies have different consumer surpluses.

Consumer surplus is the amount a buyer is willing to pay for something less the amount the buyer ends up paying for it. For companies, given their incomes next to the typical individual’s income, this surplus has to be much more. On that basis alone, they should be charged more.

Hopefully, the introduction of taxes like these would provide an incentive to big business to innovate new, more efficient ways of consuming water. The precedent of Australia’s water market might provide a blueprint for how water is allocated to corporations.

This system operates much like the carbon trading scheme, where companies trade carbon emissions permits; Australia’s water market provides businesses with water entitlements beyond which, if they wish to consume more water, they need to trade entitlements with other businesses.

The Water Commission of Australia estimated at the end of 2011 that turnover of entitlements amounted to AU$ 2.7 billion annually.[xiii] The system means that the government can limit the quantity of water consumed on the macro level, while a fair price is being paid on a micro level.

Conclusion

The economics surrounding water currently make grim reading (unless you happen to own shares in the Dow Jones Water Index). Economics teaches us that a shortage of anything with a demand causes its price to rise. Clearly, this is the case for water in the midst a global shortage.

Recognizing a problem is the first step to finding a solution, however. The example set by both Detroit and Australia, who are using financial tools to address their individual issues is encouraging and offers a template for others to follow. Hopefully, these represent just the start of the financial innovation that will emerge: water futures markets are an undeveloped area, for example.

Water is above all a human issue rather than a financial or economic one. Unfortunately, as with many global issues, decision makers often only begin to really take notice of the human perspective when they are confronted with the gravity of the economic situation. For all of our sakes, let’s trust that time is now.

 

 

 

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