Is water investing a missed opportunity?

It's raining, it's pouring - but not necessarily when it comes to water investing.

Australia is facing a return of La Nina. There are few water restrictions in place across the country. It’s easy to forget that water has a price (until you get your water bill…).

Water is easily one of the most precious and scarce resources in the world. After all, our very survival depends on it. Strangely though, it’s not a front of mind investment for most. In fact, outside of the rural community, many Australians wouldn’t be aware of water rights and trading. Or the fact that water can be a financial investment.

Australia is quite unique in its approach to water so I spoke to three experts to understand the ins and outs. Euan Friday, CIO of Kilter Rural manages two water funds with one in partnership with the Nature Partnership and the Murray-Darling Wetlands Working Group. Angela Ashton and Dominic Beange from Evergreen Consultants assess a range of funds as part of their ongoing research for clients, with water funds among this.

Giving your portfolio a drink

Water investing can be direct or indirect.

The direct path involves water rights.

In Australia, this works a bit like you buying land, according to Euan Friday.

“You purchase a permanent water entitlement that is recorded in land title offices. This entitlement gives you the right to participate in the dam system associated with your title. Much like a property, you can choose to use it yourself, or rent it out to someone else.”

So what does your water right give you aside from a title over a particular patch where water flows? A water allocation which is announced on a monthly basis. You receive a water bank account. Your allocation is credited to the account and debited as you use it, based on flows. You can use the water allocation or trade it.

To add some (more) complexity to the situation, water rights can be general or high security rights. Different states may also have a few extra categories of rights.

“General rights can be cut back in a drought whereas you have certainty over your allocations with high security rights,” says Dominic Beange.

The type of people who might own or rent a water right range from farmers to institutional investors. Retail investors who go down the direct path might consider direct purchase, use fund managers like Kilter Rural or invest in a company like Duxton Water (ASX: D2O) which makes its revenues from its water rights holdings.

The indirect path of investment involves companies with a water association. As a side note - this is more along the lines of what you might be looking at if you look for international water investments.

There’s a big range in this. 

On one hand, you could be looking at plumbing companies. On the other, water technology and water management. Some examples include irrigation technology company Rubicon Water (ASX: RWL), purification company De.Mem (ASX:DEM) or even plumbing and bathroom supplier Reece Ltd (ASX: REH).

The size of the Australian market

Australia’s largest water trading area is in the southern Murray-Darling Basin. It is dominated by high value horticulture, such as fruit and nut trees, or wine grapes. The value of issued water entitlements Australia-wide is estimated at $26.3 billion (Source: ACCC Murray-Darling Water Markets Inquiry Final Report). 

The chart below shows the key areas where surface water is traded. 

The estimated value of the water turnover was $6bn in 2020-21 (source: The Australian Water Markets Report). This excludes any environmental transfers – water ‘donated’ to wetlands for example. 

Traded volumes were at a record high – but rainfall meant prices were lower. The bulk of the allocations are used for agriculture.

Water entitlements are typically split between private ownership and environmental ownership.

“Around 25% of ownership is government for environmental purposes. About 7% is institutional and the remainder is farmers,” says Dominic Beange.

Some interesting additions to note:

• 11% of Australian water rights are under foreign ownership. Canada has the largest holding.
• The Federal Government is committed to a 450gl water buyback target for environmental purposes.

There are pros and cons of Australia's water management system. 

Critics are concerned that the involvement of investors has made it more difficult for farmers to access water and pushed up prices. 

Advocates say that investors have introduced capital, liquidity and alternative access options to the water market. 

The ACCC Water Rights Inquiry Final Report views the system as efficient on the whole, but needing further oversight. Either way, it's a complicated situation and the system is unlikely to disappear.

Why invest in water?

From an intuitive perspective, investing in water sounds like a good idea – it’s a scarce and valuable resource and Australia has a highly regulated market. But what does this actually look like in terms of the economics.

Can water generate a return?

Short answer – yes.

Long answer. Water can have both growth and income properties so can generate a return in different ways.

The water rights title has growth potential - in fact, titles have increased in value despite heavy rainfall in the last year.

There are different ways water can generate an income. Leasing out the entitlement works like any other property so you would receive a regular rental income from the contract. Alternatively, you can generate returns from trading entitlements using forward and spot sales.

“You can only make yield if you lease the rights or trade allocations to farmers,” says Euan Friday.

The performance of water investments, including entitlement values, leases and water prices, is typically uncorrelated to other asset classes. Surprisingly, it’s not correlated with rainfall either.

That’s not to say rainfall won’t affect prices for trades. In a wet year, allocations are higher and prices in turn lower due to higher supply. In a dry year, allocations are lower so in turn, prices will be higher due to the demand for a scarcer resource.

Water also tends to be a fairly stable investment according to Dominic Beange.

Investors concerned about sustainability might be interested to know water investing in aligned with sustainable development.

Agriculture businesses which use water in the most efficient ways are more likely to survive and be successful using the Australian model. The system also considers environmental flows and needs. Kilter Rural makes regular water donations as part of one of their funds.

What sort of returns are we talking about here?

There's not a lot of players in the market but I've listed a couple below. Figures are as at end July 2022.

• Kilter Rural's Kilter Water Fund has delivered 1 year returns of 23.69% and 15.30% annualised since inception in June 2014.
• Kilter Rural's Murray-Darling Basin Balanced Water Fund has delivered 1 year returns of 18.35% and 14.14% annualised since inception in October 2015. 
• Argyle Capital Partner's Argyle Water Fund has delivered 1 year returns of 16.45% and 16.33% annualised since inception in August 2012.
• Riparian Capital Partners’ Riparian Water Fund has delivered 1 year returns of 8.17% and 7.59% annualised since inception in August 2020.
• Duxton Water has delivered 1 year returns of 21.56% and 14.06% annualised since inception in September 2016.

A tall glass of risk?

Wouldn't it be nice if there was a risk-free investment? But alas, there isn't. 

Climate change is an obvious risk for water investments and a highly concerning one.

“There’s a definite trend of lower inflows. It’s a competitive market and over the longer term, we’re always closer to the next drought,” says Euan Friday.

He also notes the risks to owning water titles can be similar to owning an investment property. Owning a right in an area where there aren’t many irrigators for example is likely to mean a lower return. There’s also a matter of diversification which can be challenging for individual investors compared to institutional investors.

It may sound odd to talk about liquidity - we are talking about water! Unfortunately, that's also a very real challenge for this market.

Water rights titles are not necessarily highly liquid whether you invest directly yourself or via a fund manager. It's not something you can just trade in the next hour if you need to free up cash. Generating returns also requires a long term approach.

Titles and allocations are capped too which can favour demand, but on the flip side, this requires other investors to be cashed up and looking. In a tough market, it might be harder to sell a title. Titles in high irrigation areas will be more expensive and more in demand than other titles.

How to invest in water

Is water a missed opportunity for Australian investors? After all, even foreign investors see the value in our water system.

Dominic Beange fears that the opportunity may have passed for many to get into water investing given caps on titles and the likely decrease in available allocations pending Government policy on buybacks. However, Australian investors can look at investing in a few ways.

1. Direct purchase of a water right title
2. Invest in funds offered by managers like Kilter Rural, Argyle Capital Partners or Riparian Capital Partners.
3. Invest in companies that actively participate in the water market like Duxton Water or that access water rights such as agriculture businesses and managers like Rural Funds Group.

Will water be your next investment - or is there another hidden opportunity that you are focusing on?