Cities like Beijing and farming heartlands are at risk of water shortages from China's surging demand for power, says HSBC.

China builds an average of three new power stations a week; by 2030 it plans to add more power capacity than exists in the US, the UK and Australia today. This will require huge amounts of water for cooling and driving steam turbine generators. The country’s water resources are already stretched and climate change is making conditions even tougher.

So what does this mean for investors and companies?

We believe that water and power risks must be a top priority when planning capital expenditure. It is vital that the availability of water and the potential effect on supply chains is taken into account for the life of the investment.

Forty percent of China’s total agricultural output is produced in water-scarce regions. We believe five provinces – Hebei, Shanxi, Shandong, Henan and Jiangsu – and three municipalities, Beijing, Shanghai and Tianjin, are most at risk of water shortages. The industrial sector is doubly exposed because it consumes well over 80% of all electricity.

Given the investment implications, it’s important to look at how China is attempting to deal with the twin challenges of generating sufficient power to drive its giant economy and protecting its precious water supplies.

In 2010, thermal power represented 74% of China’s total installed capacity and hydropower 22%. This means that almost all power generation relies on water. The nation’s industrialisation, urbanisation and rising affluence will increase demand for electric power and with that comes the further depletion of limited water resources.

China’s annual renewable-water resource per capita averaged slightly over 2,000 cubic metres in 2003-2010, just above the water stress level of 1,700 cubic metres. On closer examination, this water is not evenly distributed throughout the country’s 31 provinces and municipalities. Eleven provinces are already water scarce (meaning they have less than 1,000 cubic metres per capita per year) and climate change, caused mostly by carbon-dioxide emissions from burning fossil fuels, exacerbates existing water stresses. The Chinese government recognises this and has responded by setting tough new water quotas as well as pollution reduction targets.

Coal and hydro expansion

We estimate China’s power sector uses approximately 10% of the nation’s water, relatively low compared to the UK’s 34% and 49% in the US. However, China plans to add 1,212 gigawatts of water-reliant power capacity by 2030, equivalent to almost six times India’s current installed generation capacity. Coal-fired power will continue to dominate: in the decade to 2020, China plans to add 453 gigawatts of coal-fired power capacity, equivalent to double Russia’s entire 2009 power generation capacity.

China’s coal-fired power capacity expansion will also involve an increase in coal mining, which consumes an abundance of water for extraction and processing. We estimate that 47% of coal reserves are located in water-scarce regions. Water scarcity could also lead to a greater reliance on coal imports; for example, 30% of China’s ensured coal reserves are in Shanxi, a province suffering from extreme water scarcity.

Changes in water availability also threaten hydropower. Although hydro-capacity is usually built in water-rich areas, the effects of shortages can be felt more quickly in the event of drought. Some hydropower stations have operated at below capacity in recent summers due to droughts in southern China.

The government plans to expand hydropower from 216 gigawatts in 2010 to 568 gigawatts by 2030. Unfortunately, the damming of rivers upstream has the potential to generate tensions with countries further downstream, so hydropower in China comes with geopolitical risk.

We believe the expansion of China’s installed thermal and hydro capacity will further stress water resources. Even with a change in fuel mix, we expect that 87% of power capacity will still require water. That means efficiency needs to be greatly improved.

Capping water use

Energy efficiency is as important as water efficiency. Using less energy would reduce demand for power, alleviating some of the water stress. China has improved both water and energy efficiency in recent years, although much more must be done to achieve national targets.

Stricter energy-efficiency targets have already been imposed on the industrial sector after they missed 2011 targets. We think industrial water targets could follow suit, though more efficient expansion may also require more upfront capital expenditure.

Water scarcity puts the metals and mining, utilities production and supply, and manufacturing segments at risk. No water means no electricity, and no raw materials such as iron and steel. As mentioned earlier, some 40% of agricultural output is produced in water-scarce regions, mainly in the country’s north. Climate change will also affect agricultural productivity through increased temperatures and altered water availability. Moreover, since agriculture is of prime importance to China in terms of food security, competition for water could become fiercer.

The central government set national water quotas in 2011. In response, provincial administrations have set and released 2015 water caps. Since the total of the 31 provincial caps actually exceeds the national total for 2015, some inter-provincial planning or collaboration will have to take place. We believe this further highlights the problem of enforcement in China. Moreover, some of the most water-scarce provinces have been given the toughest water pollution-reduction targets, making it extra hard to balance growth with water quantity and quality.

Since 45% of China’s GDP originates in water-scarce provinces, we think provincial water caps could force a change in the economic mix. Facilities may have to relocate, and water quotas and pollution-reduction targets could be enforced more strictly than in the past. In addition to the five provinces and three municipalities that are most at risk of water shortages, three borderline stressed provinces – Guangdong, Zhejiang and Inner Mongolia – are also vulnerable as they fluctuate in and out of water stress.

China’s planned economy is taking water and other resource stresses into account, however, the growth profiles of power and water in certain provinces seem to reveal a planning mismatch. Although water tariff hikes are also a concern, we believe the greater risk lies with water shortages. Improving both the water and energy efficiency of operations is crucial.

Water and power risks need to be considered as a core feature of capital expenditure plans. Project financiers should consider these resource shortages before funding assets, ensuring that water availability has been taken into account, and somewhat assured, for the life of the asset. Investors should examine the effects of potential water shortages on facilities located in water-scarce provinces and whether direct operations or supply chains could be affected. Companies should be more conscious of water quotas and pollution targets as they strive to make operations more efficient, as water targets may be more strictly enforced than in the past.

Finally, we believe that water constraints will provide an additional driver for industrial energy efficiency, already a priority of the 12th Five-Year Plan. Without upfront action now, we believe the risk remains and future assets could be left stranded high and dry.

Wai-Shin Chan is climate change strategist at HSBC. This article is drawn from HSBC’s report “No water, no power: is there enough water to fuel China’s power expansion?”