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.