Water Markets Are Key to Properly Valuing Water

(Chapter 5 of 6) Australia may be the model of the future.

Greg Wilkinson, CFA

Greg Wilkinson, CFAInstitutional Portfolio Manager, Franklin Real Asset Advisors

The things which have the greatest value in use have frequently little or no value in exchange; and, on the contrary, those which have the greatest value in exchange have frequently little or no value in use. Nothing is more useful than water; but it will purchase scarce anything; scarce anything can be had in exchange for it. A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it.

Adam Smith, Wealth of Nations

Obviously, Adam Smith didn’t know about climate change when he wrote about water’s value in exchange—if only he could see us now! What he did get right was that the value of any good is very much based on the value of exchange. When Smith was writing his magnum opus that formed the basis of free market capitalism, water was an abundant resource in many places. Over the last 250 years, this has obviously shifted—the value of water has risen in that time as it has become a more finite resource over much of the globe. And, as we’ve discussed throughout, growing demand and shrinking supply will only increase the value of water further in the future.

We believe formal markets, like those in Australia and the western United States, are going to be established in more countries in the coming decades as we experience increasing competition for water. As pointed out by water economists Sarah Ann Wheeler and Dustin Garrick, of the University of Adelaide and University of Oxford respectively, how those markets form will be critical. In a recent piece in the Oxford Review of Economic Policy, the pair wrote, “As competition for water intensifies, economic policy must not only address where and how to develop more formal markets, but also how to facilitate gains from trade where the institutional preconditions already exist.”39 These institutional preconditions often refer to water rights and the government policies that regulate their exchange.

From a pure economic theory perspective (i.e., textbook stuff and Adam Smith), increased regulation is counter-productive to optimal market performance. However, in our experience, the concept of regulation as it pertains to formal water markets is different. Government regulation, especially in the case of the world’s most established and robust water market—Australia’s Murray-Darling Basin (MDB)—has been key to the formation of the market and will remain key into the future to ensure the market functions properly. For example, to lay the groundwork for market formation, it took the Council of Australian Governments (CoAG) landmark Water Reform Framework of 1994 to take the massive first step in market formation. This step was the separation, or “unbundling,” of water and land rights, quickly followed by CoAG’s National Competition Policy that allowed water to be moved to its highest valued use.40 On the flip side, both these factors continue to be barriers for efficient market transactions in the western United States—the best-developed market after Australia.

As a result of these policies, the Australian market has grown considerably in the last 30 years, as seen in Exhibit 15, which focuses on the southern MDB (sMDB), where the bulk of trade occurs. Take note of the spike in trading that occurred once the Water Reform Framework and National Competition Policy were enacted. To put this into context, if you have read other sections of this paper, and to provide scale of the amount of water moving on the market: in 2015–16, the trade in the sMBD alone was roughly equivalent to Arizona’s 2.2 MAF Colorado River allocation.42 Trade in the entire MDB market exceeded 5500 gigaliters (GL) that same year.

That said, water’s value hasn’t risen as quickly as one might expect due in large part to the complexities of pricing and valuing it—we won’t go into detail here, as it is well-covered in water economics papers. Take our word, it is best summed up in a simple statement by three water economists in Australia: “The price of water almost never equals its value and rarely covers its costs.”37 Some of this pricing/valuation discrepancy is due to the absence of formal water markets over most of those 250 years. This is not to say markets don’t exist—water has been traded for thousands of years. However, in the case of water, informal markets are often inefficient. And, in many cases, as seen in India’s proliferation of tubewell drilling and selling groundwater pumped from those wells on non-regulated exchanges, for example, they compound water stress and do not address valuation discrepancies.38

BUILD IT AND THEY WILL TRADEExhibit 15: Annual volume of water allocation and entitlement trade in the sMDB, 1983–2017 (in GL)

41 Source: ABARES. 1983–84 to 2009–10 taken from NWC (2011). 2010–11 to 2016–17 allocation data provided by the Murray–Darling Basin Authority, entitlement data produced internally by ABARES. Allocation data excludes environmental transfers. Entitlement data includes entitlements transferred to the Australian Government as part of the Murray-Darling Basin Plan.

Over just the last eight years, the value of entitlement trades adjusted for inflation is estimated at A$10.1 billion (US$7.2 billion) and has grown in volume over that period.43 More important than trade volume, is the fact the market has seen price fluctuation based on supply and demand. As seen in Exhibit 16, water prices have spiked in water scarce drought years and dropped in years with high water availability. Allocation prices peaked during the worst of the Millennium drought before declining to near zero during the 2011 and 2012 floods. In essence, the market is doing what it needs to do—more adequately valuing water. This is extremely important as Australia moves forward and the impacts of climate change increase.

SUPPLY AND DEMAND = WATER PRICE Exhibit 16: Monthly allocation prices and storage volume in the sMDB, July 2000 to January 2019 (AUD millions/GL)

Source: ABARES. Volume weighted average price from BOM. Storages from Water NSW, SA Water and Goulburn-Murray Water. SMDB storages include Hume Dam, Dartmouth Dam, Yarrawonga Weir, Lake Victoria, Menindee Lakes, Blowering Dam, Burrinjuck Dam, Lake Elidon, Lake Eppalock, Cairn Curran Reservoir and Laanecoorie Reservoir.

To ensure the market functions properly into the future, the Australian Competition and Consumer Commission (ACCC) conducted a major inquiry into the MDB water market. The main takeaway of the ACCC’s interim report (released in June 2020) focused on “…the need to reconsider governance frameworks focused on the proactive development and regulation of markets, to promote open and fair trade across the Basin. The ACCC will be considering governance and other options for improving water trading markets.”44 We agree with this conclusion and believe it is an important step in the maturity of the market. On the flip side, The Hamilton Project of the Brookings Institution, has openly called for expanded federal leadership and regulation in the western United States in order to develop a better market for water trading.45 And market formation has been largely stalled or inefficient in other countries—China, Chile, Spain, Canada and South Africa, to name a few—due to the lack of regulation and government oversight.

Who’s dipping a toe and why?

In the sMBD in 2018–2019, the majority of trades, making up 61% of transferees/buyers and 65% of the transferors/sellers in the market, are between irrigators and other water users. That said, they accounted for just over 20% of the volume of water both transferred and received.46 Essentially, traditional users of water (read: agriculture) are doing a high number of trades but are buying/selling smaller volumes of water. On the flip side, the majority of high-volume transfers—making up 42% of water transferred and 32% received—is happening in an infrequent number (>1%) of large trades involving Environmental Water Holders (EWH).47

These EWHs are government-owned rights that were created under the 2005 Water Act, which created the legal foundation for water to be set aside to maintain environmental values of rivers and streams, and the 2012 Basin Plan that essentially created a cap-and-trade system to cap allocation in order to ensure long-term sustainability of the MDB’s water resources and the market. It is important to note that the majority of their trades are zero price trades between EWH entities. Meaning that their trade volume does not impact the market cap or pricing in a significant manner.

Over the last four years, institutional investors’ participation and share of the market substantially increased in the sMDB. In 2015–2016, they made up 1% of both buy and sale trades, and 4% of water volume purchased and 7% of volume sold. In 2018–2019, this increased to 16% of all buys and 5% of all sales, and 14% of volume purchased and 20% of volume sold.48 Participants in the market are pension funds and institutional investors from both inside and outside Australia. This includes the largest holder in volume of water rights: the Canadian Public Sector Pension Investment Board, holding around 2% of all available rights on the market purchased.49 The market is also attracting interest and participation from US, UK, Chinese and Japanese institutional investors, among others. In time, we expect these exposures to increase among institutional investors—who typically will not move meaningfully into an asset class unless they can build a large exposure—as the market matures and expands to parts of Australia outside the MDB.

Investors are attracted to water markets as a diversifier, but also to the income stream water rights provide that you might see in fixed income or other real asset investments.

Investors are attracted to water markets as a diversifier, but also to the income stream water rights provide that you might see in fixed income or other real asset investments. However, these real assets have been more reliable in a low global interest-rate environment, as Australia’s growing demand for water has fueled price increases. This is not to say there is no market volatility; in years with above-normal rainfall or flooding prices can plummet, as seen in 2011 and 2012 in Exhibit 16.

The similarity to fixed income extends beyond income streams as water rights in the Australian system, where they are unbundled from the land, may have more value than the land itself and the rights are effectively allocated in tranches—similar to mortgage-backed securities (MBS) or commercial mortgage-backed securities (CMBS)—based on whether the right is a high or general security right.50 High security rights receive their full water allocation first—as long as water is available—and are similar to the most senior tranche of CMBS. High security rights also have the highest value in temporary leasing markets and can provide stable income flows. A general security right has lower priority and is only filled when all the systems’ allocation commitments are met. They are more similar to high-yield investments, as they are higher risk and are more subject to year-to-year variability. There may be years with high water demand when they do not  receive their allocation. Due to the higher risk profile and variability, general security rights are much more subject to trading and speculation.

Finally, this brings us to the significance of water investing from an ESG angle. The Australian water market is playing a critical role in water conservation through environmental allocations; by allocating water to the highest valued use; and through water pricing based on available supply. There is also a social element to this story. Water markets have created social benefits to the rural agricultural communities historically challenged by variance in rainfall and commodity prices. With climate change, these communities are going to suffer significantly unless mechanisms are created to smooth variability in revenue and income. We believe water markets are supportive of this goal.

We believe the Australian market could be the model of our global water future. And we are not talking hypotheticals or distant time horizons for this model to develop in other regions. We’ve already seen elements of the Australian market form building blocks to solve major water challenges in other markets. For example, large scale environmental allocations dedicated to the restoration of the Colorado River Delta are a key element in a recent binational agreement between the United States and México, which prevented major allocation cuts to agricultural users and municipalities in Arizona, California and Nevada. In order to sustain longterm supply, you cannot destroy the source.

Staving off further water starvation

There is no way around it—Australia is water-starved and has historically experienced high variability in rainfall. This has increased—and will continue to increase—with climate change. Focusing on just the MBD, stream flow has been on a decline since the 1970s and Commonwealth Scientific and Industrial Research Organisation (CSIRO) projections, based on a 1990 baseline averaged over the entire MDB and a middle of the road climate change scenario, projects reductions in average annual runoff of 9% by 2030, 15% by 2050 and 23% by 2070. Extreme drought scenarios, like those seen during the Millennium Drought of 2000–2010, project declines in the MBD of close to 40% by 2020, over 60% in 2050, and exceeding 80% by 2070.51 It’s important to note that these projections occurred before the 2012 Basin Plan. And, in fact, these projections were the catalyst for establishing the cap-and-trade system and formalizing EWHs’ critical role in the market.

IN THE FUTURE A DIAMOND IS WATER Exhibit 17: sMBD weighted water allocation price by scenario*

Source: ABARES. February 2020.
*Note: For each scenario, a range of water supply conditions are simulated (based on the historical climate sequence 2005–2006 to 2018–2019) to provide a picture of potential water market and irrigation outcomes across representative ‘dry’, ‘average’ and ‘wet’ years. There are two key caveats to these scenarios. First, the climate sequence used (2006 to 2019) is particularly dry in the context of the longer historical record and may differ from average future climate conditions. Second, these scenarios are based on current farms using current capital and technology, and do not allow for long-term adaptation (innovation / technological change) or structural adjustment (changes in capital investment). Current market scenario based on current irrigation development (horticultural plantings), current water recovery under the Basin Plan, current trade rules and commodity prices. Future market scenario based on full maturity of recently established almond plantings, and future water recovery to meet Basin Plan requirements (3,200 GL target) via on-farm infrastructure upgrades. Future market (dry) scenario is as above, but with an 11% reduction in water supply and a 3% reduction in rainfall. There is no assurance that any estimate, forecast or projection will be realized.

Water markets will be essential to properly valuing water as the impacts of climate change increase in the MDB. Just looking at a recent model that the Australian Bureau of Agricultural and Resource Economics and Sciences (ABARES) developed for the sMBD that recreates the climate conditions in 2006–2019 and projects them into the future, there is likely to be a significant increase in water market prices. Taking those conditions and introducing an 11% reduction in water supply and a 3% reduction in rainfall, they predict future market prices 50% higher than the current market.52 The model doesn’t even take a crack at the extreme drought scenarios, but it is easy to imagine the impact it would have on the price of water. And that is entirely the point. In order to properly allocate water to the best use, it must be properly valued. This valuation is critical not just to market pricing but also to decrease the likelihood that we treat future water like a lump of coal when it is truly a diamond.



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