Just add water

The biggest water crisis in the world could well be in the US. Do investors have an opportunity to rehydrate the nation and invigorate their portfolios at the same time? Christopher O’Dea reports

Just add water. That simple phrase created a fortune for travelling salesman Duncan Hines who pioneered the practice of restaurant ratings for travellers in the 1930s. But it was the mass-market boxed cake mixes bearing his name that made it possible for every 1950s US housewife to become a pastry chef – by just adding water.

In Hines’ day, the US municipal water system was a source of national pride. But times have changed and the biggest water crisis in the world may well be in the US.Much of the infrastructure needed to store and deliver water is crumbling, and water supplies are dwindling in many areas, including some of the fastest-growing regions in the south-east and intermountain west. California’s drought garners much of the news headlines, but water supply and infrastructure problems are happening across the US.

Flint, Michigan, highlights the problem of crumbling water infrastructure in the US. Flint suffers from a median income 46% below the US average and operates in a virtually continuous state of financial emergency. Flint’s crisis with drinking water contamination by lead started in April 2014, when the city changed its water source, which was being supplied by the Detroit Water and Sewerage Department. Officials failed to apply corrosion inhibitors to water coming from the new source – the Flint River. The corrosive river water caused lead from ageing pipes to leach into the water supply, resulting in extremely elevated levels of the heavy metal – a major public health threat. Between 6,000 and 12,000 children in Flint have been exposed to drinking water with high levels of lead.

While the effects of the lead contamination may not be known for years, those affected may experience a range of serious health problems. The crisis has devolved into partisan finger-pointing, magnified by often technical scuffles between the overlapping local, state and federal regulatory agencies charged with overseeing water supplies and environmental matters.

Flint is the tip of the iceberg. The condition of nearly half of the water infrastructure in the US is poor, very poor, or beyond its useful life, according to the American Society of Civil Engineers (ASCE). 

In its Report Card for America’s Infrastructure for 2013 – the most recent available data– the ASCE paints a bleak picture of the country’s water works. Some of the nation’s one million miles of water mains date to the Civil War era, and are not examined unless there is a break. Those are becoming more common, with an estimated 240,000 now occurring each year, according to the ASCE. 

Now the laws of engineering are taking over. The useful life of component parts in a public water systems range from 15 to 95 years, ASCE says, and the annual replacement rate is set to increase dramatically from approximately 4,000 to 5,000 miles of drinking water mains today to a peak of approximately 16,000 to 20,000 miles annually around 2035. 

“Pipes installed during the middle of the 20th century are likely to begin to fail in large numbers,” ASCE says.

Because these assets last so long, water systems that were built in the latter part of the 19th century and throughout much of the 20th century have, for the most part, never experienced the need for pipe replacement on a large scale. But this is changing fast, according to the American Water Works Association (AWWA).

In a 2012 report on the cost of refurbishing the water system, the AWWA pegged the aggregate replacement value of US water pipes at $2.14trn (in 2010 dollars). Since not all pipes need to be replaced immediately, the AWWA estimated the most urgent investments could be spread over 25 years at a cost of approximately $1trn. “The need will double from roughly $13bn a year today to almost $30bn, in 2010 dollars, annually by the 2040s,” the AWWA concluded.

Delaying the investment “can result in degrading water service, increasing water service disruptions, and increasing expenditures for emergency repairs”, the report said. “Ultimately we will have to face the need to ‘catch up’ with past deferred investments, and the more we delay the harder the job will be when the day of reckoning comes.” By 2050, the AWWA reckons, aggregate investment needs for drinking-water pipe replacement would total more than $1.7trn.

While the AWWA confirms that “the cost will be met primarily through higher water bills and local fees”, major capital financing will be required. Although the water infrastructure problem is national in scope, water supply is a local affair in the US. The current federal budget allocates more than $260m in funding for ‘water innovations’.

Filling the allocation bucket

The bleak financial picture is a clarion call to institutional investors as they increase their allocations to infrastructure. Private capital will be needed to close the gap, as well as innovative financing structures that can be adapted to local circumstances across the country.

A team of researchers at Stanford University has devised a framework to fund water projects based on lessons learned from the energy sector. Newsha Ajami, the director of urban water policy at Stanford’s Water in the West programme and co-author of the team’s report, says the risk facing US water systems “calls for new thinking and innovative, multipurpose infrastructure solutions”.

The Stanford team contends that financing tools and techniques from the electricity sector have the potential to bridge the financing gap to next-generation water systems.

The report notes essential similarities between the two industries. “Utilities in both sectors provide commodities to customers that are required for modern life,” it says. “In turn, both sectors currently rely on extensive infrastructure networks and are highly regulated by many levels of government. Fiscally, the two sectors rely on revenue streams for most of their funding, and the financial health of their institutions plays a key role in accessing capital.”

While investors in infrastructure funds can currently acquire water utilities, either in whole through large private equity funds or in part through listed infrastructure funds, the Stanford project argues that the course of water-sector investing should be re-routed in the same way that rivers are re-directed. 

In the electricity sector, they note, “distributed clean energy projects – such as customer, community or utility-scale solar and wind energy systems – often rely on a diverse set of public and private funding sources.” Similarly, Stanford argues, “the water sector should take advantage of funding sources such as bonds, end-user fees and venture capital”.

Stanford’s water research team concludes that “due to uncertainty in project cost recovery, private funds for distributed infrastructure and technologies can be difficult to acquire.” Investors “can be reluctant to invest in water-related projects because the water sector is extremely capital-intensive, risk averse, fragmented, and heavily regulated.” Those impediments mean it “can be difficult for financiers to receive high or short-term returns on water infrastructure investment”.

Part of the problem is the quantity of small systems in the US – the ASCE counts nearly 170,000 public drinking water systems across the US. Many have limited access to federal and state public funding because government grants are decreasing in number, and often do not account for operations and maintenance costs, while funders, such as the Water Infrastructure Finance and Innovation Act, have project size requirements that local water authorities are unable to meet.

To investors looking for secure sources of income, “inefficient water pricing policies that link revenue to customer consumption result in unstable revenue streams that directly and indirectly contribute to a lack of funding for new projects,” Stanford says. Water services are the most expensive utilities to operate in terms of capital required per dollar of revenue, yet water is typically the least expensive utility bills “because many water utilities in the US are public entities with locally elected boards, board members can be unwilling to raise rates due to fear of public backlash”.

With the directness of engineers, the AWWA minces no words about where that leaves US communities. “The United States is reaching a crossroads and faces a difficult choice,” they say. “We can incur the haphazard and growing costs of living with ageing and failing drinking water infrastructure. Or, we can carefully prioritise and undertake drinking water infrastructure renewal investments.”