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Running dry: how to profit from a parched world

As demand for water rises and supplies become more erratic, firms with the technology and infrastructure to tackle shortages stand to gain, says Sarah Moore.

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Overuse and poor allocation policies are playing havoc with India's water supplies

This year, Latur, a city in the Marathwada region of the Indian state of Maharashtra, became "the face of India's water crisis", according to local press. Its main source of drinking water, the Manjara dam, dried up in February.

Until last month, the state government had to provide water to Latur's residents using special trains, filled up from a dam in a town 8km away, and gatherings of more than five people were banned, to prevent fights erupting over usage. Thankfully for Latur's residents, the drought has ended, as a better-than-average monsoon season has begun to replenish its dams. But as The Economist notes, Latur's "real problem is not a lack of water".

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On the other side of the story sits the local sugar-cane industry. Sugar-cane production takes up just 4% of Marathwada's cultivated land, but uses 74% of its irrigation water, leaving little left for cultivating other crops.

The imbalance is at least partly due to the political power of the wealthy local sugar barons, just "one element of the bad practice" that has contributed to Maharashtra's water crisis, says Vijay Phandare in the FT. Phandare, a former civil servant who quit after blowing the whistle on an alleged multi-billion-dollar scam, using irrigation projects to appropriate public funds, says "it's been an open secret that 10%-15% of the tender cost has to be given to politicians it is total havoc".

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The problems also stem partly from the 1970s, when major political donors persuaded the government to provide farmers with free electricity for irrigation, removing a significant financial incentive for farmers to be careful about the amount of water they pumped. Latur is far from alone, notes The Economist per person, India has twice as much water as northern China, but efficient allocation is "hampered by mindless overuse and, in many places, a lack of sensible water-allocation policies".

Developed world water disasters

Nor is water mismanagement unique to developing nations. California is in the fifth year of a severe drought. It is America's largest farm state, producing more than a third of America's vegetables and two-thirds of its fruits and nuts. Despite its significance to the sector overall, farming accounts for only 2% of California's economic output, and employs just 3% of its workers.

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Yet agriculture accounts for a staggering 80% of the water used by Californians. This is partly down to California's water rights system it was the last western state in the US to pass laws for managing groundwater use, with relevant legislation not passed until September 2014. The impact of these laws will not be seen right away management plans for underground sources have until 2040 to become environmentally sustainable.

California's Central Valley "is a microcosm of an increasingly parched world that hasn't learned how to manage one of its most precious resources", says Peter Coy in Bloomberg Businessweek. The rights to water use in the Sacramento-San Joaquin Delta have been owned by "senior rights holders" since the gold rush of the mid-1800s, and they are in no hurry to give them up (see below).

Last year a group of farmers who hold senior rights to water usage voluntarily agreed to cut their surface water usage by 25%, after California Governor Jerry Brown called for a 25% cut to urban water use. While this sounds like a step in the right direction, there was a catch in return, the state government had to guarantee that it wouldn't restrict the farmers' water usage in future. It appears that the farmers expect the shortages to get worse, and are keen to lock in their future supply.

Investing in water

In all, water "defines quite well our problems in moving from a world of apparently plentiful resources a world in which, if we screw up, we can still move on to a world of finite resources, where we have to manage carefully to get by", cautions Fred Pearce, former New Scientist news editor and author of When The Rivers Run Dry. Pearce's book, published almost ten years ago, calls water the "defining crisis of the twenty-first century" and it looks as though he might well be proved right.

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Water insecurity can multiply the risk of conflict, argues a recent World Bank report: High and Dry: Climate Change, Water and the Economy. Food-price spikes caused by droughts can "inflame latent conflicts" and "drive migration", which further exacerbates tension. The situation will only get worse.

The combined effects of rising populations, increasing incomes, and expanding cities will see demand for water rise rapidly, while supply becomes more erratic. "If countries do not take action to better manage water resources... some regions with large populations could be living with long periods of negative economic growth," warns World Bank President Jim Yong Kim.

The prospect of ongoing drought is not a cheery one, but there is a potential light at the end of the tunnel. As California and Latur show, when people face a shortage of water they start to value it properly, and act to guarantee its future supply. The worsening problem of scarcity means that governments and businesses will be forced to invest in water infrastructure and other relevant technology. This should provide investors with opportunities to profit.

Solving the water crisis

Desalination is one way to boost supplies of drinkable water. Salt water is forced through a fine membrane, leaving the salt on one side and potable water on the other a process called "reverse osmosis". Saudi Arabia relies heavily on desalination, as do the Canary Islands. But the pressure needed to force water through a membrane fine enough to filter out dissolved salt requires huge amounts of electricity, making it expensive and inefficient.

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For example, there is a desalination plant in London, on the Thames Estuary. When it runs at full power it can produce enough water for 400,000 houses. However, the plant is only allowed to operate during periods of full-blown drought (the last one in the UK was during 2010-2012).

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A more efficient solution is water recycling taking water from sewage works, filtering it, then reusing it for agricultural irrigation, industrial processes and flushing toilets. In North America 75% of wastewater is treated, but less than 4% is reused. While there is some reluctance fully to embrace this approach (the idea of reusing "grey" water has a significant "ick" factor), the scope for growth is huge. Being more careful about the amount of water we use in the first place is another growth area. "Britain has a lot to learn from Western Australians about how to use water effectively," arguesTim Leunig of the London School of Economics.

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In 2014, the city of Perth's dams received 72.4 billion litres of water, much less than the 300 billion needed to supply the city's two million-strong population. A desalination plant, finished in 2006, helps to make up the shortfall, but the local government is also trying to change people's behaviour. Western Australia's Water Corporation now requires all businesses that use more than 20 million litres of water a year to put together a "water efficiency management plan".

The businesses have to break down exactly how much water they use and where; benchmark their water use against other, similar businesses; then set one- and three-year water usage reduction targets. The scheme has reportedly helped more than 330 businesses to save enough water to fill the equivalent of 20,000 Olympic-sized swimming pools.

The policy has also been extended to households the price of water is flat up to an annual level of 150 cubic metres, but above that the price steadily rises, encouraging efficient usage. That contrasts with the UK, where most people still pay a flat rate.

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However, smart water metering is becoming increasingly popular. Smart metering took off in the 2000s, helped by the development of advanced metering infrastructure (AMI) technology, which provides a two-way data link between utilities, meters and consumers enabling the utilities to see consumer usage in real time, and potentially price it according to supply and demand fluctuations.

The European market for smart water metering could be worth $13.4bn by 2020, reckons Seth Cutler of consultancy Frost & Sullivan, and the UK government wants all homes in Britain to be metered by 2030, with Thames Water already pledging to meet this milestone for all of the 3.3 million homes it supplies. We look at some of the best ways to profit from this and other water-efficient investments below.

The Californian drought and US water rights

The rules on water rights in the US vary by location, but there are two main approaches. In the eastern states (all the states east of Texas, with the exception of Mississippi), if you live close to a body of water you usually have reasonable rights to use that water. In the western states, the "prior appropriation doctrine" applies. This is a "first come, first served" system, introduced because many people lived too far away from a river to stake any kind of proximal claim to its supply.

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In California, some rights can be traced as far back as the gold rush of the 1840s/1850s. Those with the longest-standing claims "senior rights holders" have traditionally been able to draw as much water as they like (based on historic usage), with little accountability as to how it is used. As a result, during periods of water shortages, shorter-term rights holders have to reduce their own usage in order to guarantee a supply for senior rights holders. The former can try to get water from reserves or groundwater instead, or can purchase water from the senior rights holders.

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One problem with the current system is that "use it or lose it" clauses incentivise waste if you fail to use all of your water allowance in a given year, it might be taken out of next year's allowance. However, as California enters its fifth year of drought, even those with long-held claims are starting to acknowledge problems with the system.

The five stocks to buy now

FTSE 250 member Halma (LSE: HLMA) specialisesin safety, health and environmental technologyproducts, and operates in more than 20 countries.One of the group's firms, Halma Water Management,designs and makes monitoring and communicationsequipment for water, wastewater and gas networks.It's not a pure play on the water theme, but it's asolid, well-diversified firm with decent exposureto the trend and environmental themes in general.

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It trades on a pricey-looking trailing price/earningsratio (p/e) of 36, but you're paying that price forhealthy growth prospects earnings are expectedto grow at around 10% a year. The forecast dividendyield is just 1.24%, but Halma has proved a reliablepayer historically it has grown its dividend by more than 5% a year every year for the past 37 years.

For something more speculative, see US-listedCadiz Inc (Nasdaq: CDZI). The company owns70 square miles of property with "significant"water resources in Southern California. It plans to take underground water in the Mojave Desert,currently being lost to evaporation and saltcontamination, and use an aquifer system topipe the water to cities in California.

In July,an appeal court in California found in Cadiz'sfavour over six separate legal challengesbrought against its project by environmentalorganisations and a salt mining company.Cadiz is high risk, and the share price hasbeen volatile over the past five years, butclearly the stock has huge potential if its plansgain traction.

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Consolidated Water Company (Nasdaq: CWCO)designs, builds and operates desalination plantsand water distribution systems in several Caribbeancountries, including Belize and the Bahamas. As of2014, its global water production capacity reached26 million gallons per day.

In June, CWCO won thebidding process for the financing, construction andoperation of a seawater desalination plant in BajaCalifornia, Mexico. The company aims to deliver aplant capable of producing 100 million gallons a dayby 2024. It's trading on a p/e of 22 and yields 2.2%.You can also gain exposure to the water theme viaa fund.

First Trust ISE Water Index Fund ETF (NYSE:FIW) is an exchange-traded fund (ETF) that followsthe ISE water index, made up of firms that derivea large part of their revenues from drinkable waterand wastewater industries. First Trust has beaten theS&P 500 by almost 19% over the year to date, partlyhelped by its hefty weighting towards utilities, whichhave been in demand this year as investors hunt for"safe" sources of income. First Trust yields 0.73%and has a total expense ratio (TER) of 0.6%.

Another ETF is the PowerShares Water ResourcesPortfolio (NYSE: PHO). This is based on theNasdaq OMX US Water index, which tracks theperformance of US-listed companies that createproducts to conserve and purify water. Top tenholdings include water and wastewater utilityAmerican Water Works Company, and DanaherCorporation, which makes products to protect watersupplies. Around 60% of the ETF's portfolio is inindustrials, while 23% is in utilities. It trades on a p/eof 23, its current dividend yield is 0.23%, and it has aTER of 0.62%.

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