The concept of investing in water is well established in Australia, where water rights have been unbundled from land and considered to be separate property rights. Water rights are freely traded in an open market that has been progressively established with the dual objectives of economic efficiency of water use and environmental sustainability.
The framework of Australian water markets provides two tradeable property rights:
Water entitlements: are perpetual rights to a share of water from a particular water resource, such as a river, storage, or underground aquifer. They’re like owning airspace in a dam: Higher-security water entitlements represent the airspace closer to the bottom, which more reliably contains water; and lower-security entitlements represent the airspace closer to the top, which may or may not contain water, depending on seasonal conditions.
Water allocations: are the rights to access a volume of water, made available under a water entitlement, in a given water year. These rights are traded independently from water entitlements. The amount of water allocated varies from year to year in response to such factors as storage levels, climatic conditions and security type. Water allocations are the physical water that irrigators can pump and use on an annual basis.
Investing in water centres around acquiring the perpetual water entitlements and selling or leasing the annual water allocations to end users of water (irrigators) in order to generate income.
Water entitlements on issue in Australia are capped, meaning entitlements are limited to the current volume. These entitlements are insufficient to irrigate all available land. Irrigators with a higher capacity to pay for water via crop gross margin per unit of water applied can outbid other irrigators for entitlements and allocations in the market, which is expected to drive water toward its highest and best economic use.
Water entitlements are distinct to their geographic regions and are spread across Australia. Historically, 90 per cent of trade has been encapsulated in the Murray–Darling Basin, which is responsible for approximately 65 per cent of Australia’s irrigated farmland and 40 per cent of Australia’s gross value of agricultural production.
Ownership of entitlements is heavily concentrated between the Commonwealth, as a holder for environmental purposes, and private farmland owners. Our data shows non-landholding water investors are estimated to hold only a small portion of the total entitlements on issue.
Water investors play an important role in the market, providing irrigators an alternative capital source and providing much-needed liquidity to the market, as investors cannot generate returns without selling their allocations to irrigators.
Water entitlements as an alternative asset class
Australia’s water markets are now a central part of the Australian agriculture sector and form an intriguing investment case study. Investments in certain water rights have delivered strong returns over the past five years, with no evidence of correlation to traditional asset classes. Riparian’s internal research shows low negative correlation to the S&P500, ASX200, MSCI World Price Index and US and Australian 10-year bonds rates over the past 10 years.
This raises the important question: can the market continue to deliver uncorrelated positive returns?
Water prices are driven by numerous factors, unsurprisingly many of which are not commonly associated with traditional markets. There is a strong relationship between climatic conditions, storage levels, irrigated agricultural commodity prices and short-term water market returns. Agricultural productivity growth and the transition of farming businesses from low value to high-value production affect longer-term shifts in water demand, capacity to pay and long-term market return prospects.
As the key drivers of water market returns are inherently different to the primary drivers of other traditional asset classes, water entitlements have shown no evidence of correlation to those markets, making water entitlements one of few investments providing a genuine source of alternative beta.
Water entitlements form a nuanced and intriguing asset class. At Riparian, we believe their lack of correlation with other asset classes will continue to be sustained as irrigators increase their capacity to pay for water. The Australian water market and regulatory framework have evolved to manage challenges and externalities, and they will have to continue to evolve. There’s a lot riding on their success.
Brent Loeskow, associate partner, Riparian Capital Partners