I recently travelled to the IFAT Water Trade show in Munich, gaining a first-hand perspective of the portfolio of products from companies involved in the water industry that we own and the broader investment landscape.
So-called ‘negative water externalities’ form one of the key areas across the sustainable investment landscape that is less well understood by the market. These environmental and social impacts result from poor water quality, underinvestment in testing and disinfection systems, insufficient water recycling and an ageing water infrastructure. In the Sustainable Investment team, we look to invest in companies that are providing solutions to these externalities, that is, not the water companies themselves, but solution providers for municipal, industrial, commercial and residential end uses. The stats are shocking:
- Each year, more than 860 billion gallons of wastewater escapes US sewage systems.
- PFAS – synthetic chemicals found in consumer products – are potentially present in the blood of 97% of the US population[1].
- Closer to home for those in the UK, 14.2 billion litres of sewage were pumped into the river Thames in central London last year[2].
Couple that with improving quality demonstrated in the fundamentals, with multiple players seeing strong improvements in margins and returns over the past few years, the investment landscape for companies looking to address the unmet needs of the water industry is becoming increasingly interesting.
Wastewater is still released untreated in vast quantities across all regions
Source: Berenberg, Jones et al, Earth System Science Data, 2021, share of wastewater untreated=1-(wastewater treated/wastewater production)
The competitive advantage we look for in companies in the water industry is a low tolerance to failure, being a high quality, reliable equipment provider. Water is the only utility with immediately life-threatening consequences if things go wrong, so customers tend to be risk averse. The second competitive advantage we look for in this space comes from companies with a strong distribution channel. Companies that control both the production and supply of their products – known as vertically integrated distribution – have an advantage if they leverage the opportunity to prove the water, energy and cost savings to their customers. We look for companies excelling in this through lifecycle water or energy saving calculators.
A trap some investors fall into is assuming that there are large differences in the technology between some of the large-cap players in water exposed hardware. In reality, a Veralto UV disinfection system is very similar to one from Xylem. However, some equipment shows more variability: under the Hach brand, Veralto’s monitoring equipment tests over 100 parameters (an example of one parameter is a type of bacteria such as e coli, legionella, etc.). The company claims that this is 2-3 times more parameters than the next largest competitor. We initiated a position in Veralto in October 2023, post the spin-off from Danaher and so far, it has been a strong performer for our Global and US funds, up over +40%.
Currents of change – the structural tailwinds driving growth
In developing countries, more than 45 million cubic metres of water are lost through leaks every day [3].
Some of the most compelling companies in the water space are manufacturing integrated solutions through software that gives advanced high-level monitoring of hardware. Software that connects to pipes can give municipalities insight into where exactly leaks are occurring, for example. This leads to faster diagnoses of deteriorating pipes or acute leaks and longer-term cost savings for customers. One company I met with in Munich showed me its version of this software in practice, displaying a graph with two coloured lines: one in blue for ‘non-revenue water’ – water that has been cleaned and purified but not consumed – versus a green line for what’s actually being used. There has been strong uptake for solutions like this in Spain so far and it is being rolled out more broadly. Companies have the opportunity to differentiate in software more than in commoditised pipes or generic pumps, and, as a result, the leaders command particularly high margins.
How industrial trends are driving growth
The structural growth extends far beyond municipality-driven demand. One such example is that water industry names are indirect beneficiaries of secular industrial trends, namely artificial intelligence (AI), semiconductors, data centres and EV batteries, enabling us to spread our investment risk across these cyclical industries.
Take the AI transition for example. Microsoft, Meta and Alphabet have all set targets to become water positive by 2030; in other words, to replenish more water than is consumed. To achieve this, disinfection and testing equipment are needed. The high-water consumption of data centres is driven by their extensive cooling requirements. Each Chat GPT search, for example, uses a gallon of water. This bodes well for our Global and US portfolio holding Ecolab, which sells water equipment to data centres, among other verticals.
Meanwhile, In April, we saw the Biden administration implementing new limits on PFAS in drinking water to four parts per trillion, the most ambitious of the major geographies. This has come down from 70 parts per trillion between 2016-2022. There continues to be an arms race to develop scalable PFAS destruction technology.
Furthermore, capturing and treating stormwater is a +$15 billion market opportunity in the US alone. There are more than 55,000 miles of pipeline in the US system today that are barely maintaining a 200-year replacement cycle, posing leakage issues and sub-optimal storm and wastewater management.[4] To address the renewal of pipes, pumps, tanks and treatment plant systems, $15 billion of Federal infrastructure funding has been approved for state projects[5]. Europe has so far been slower to adopt supportive regulation, with pockets of outliers. In 2023, we saw the UK government lift the £250,000 cap on civil penalties relating to water pollution, making the stakes higher.
I will leave you with one fact. Only 0.25% of the planet's water is usable. The rest is salt water, polluted or locked up in polar ice caps, glaciers and permafrost.[6] We need to improve the recycling of water back into the system, improve the energy efficiency of doing so, upgrade an ageing water infrastructure and prepare for an increasing frequency of severe weather events. This provides a compelling investment opportunity.
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