Opinions

Elephants in the Room

Elephants in the Room

Water is the elephant in the room no one is talking about. There are many ‘water’ elephants I could go on about, but I am just going to talk about those related to POWER. With almost 96% of China’s electric power requiring water to generate, these elephants should hardly be ignored. I am not going to talk about the water energy nexus or how much water the power sector uses – you can read that here and here, or check out China Water Risk’s interview with the Deputy Director General of the China National Center for Climate Strategy Study and International Cooperation. I am wondering if a shift in fundamentals is required for China’s drive for energy security to succeed given these elephants. And since we cannot wish them away, can we work around them?

ELEPHANT #1: COAL


Of course there is always going to be demand for coal. Despite China’s plan to increase its renewable energy output, it is still almost doubling coal-fired energy by 2020, which is why all coal companies harp on about 12th FYP support for coal demand. Moreover, coal is often seen as a “back up” in case droughts disrupt hydropower production as happened in 2011. Bottlenecks identified by the industry are usually around transportation – i.e. lack of road/railway infrastructure and softer coal prices because of global slowdown …but hang on a second, what about water?

I have been invited to participate in natural resources conferences but so far panel discussions have focused on agri, food and water. The mining companies, which make up the bulk of natural resources, would rather not talk about water. Apparently, no one wants to talk about their Achilles heel.

Water is used in almost every step of coal production – extraction, transport, storage, processing and disposal. In the US, an estimated 800-3,000 gallons of water (3,028-11,355 litres) are used per tonne of coal.

No water = no coal = no energy security.

It’s down to location…

Unfortunately, 47% of China’s ensured coal reserves lie in water scarce regions and almost 57% of China’s ensured coal reserves lie in Inner Mongolia and Shanxi1. Inner Mongolia is water stressed and Shanxi is water scarce.

Hmm… let’s see where some of the coal companies listed on the HKEx operate …

Not a pretty picture. I can see why companies don’t want to talk about this, but does it make sense that investors are also turning a blind eye?

Washing coal and bathtub perspectives

I am going to use Winsway as an example since we looked at where they have adequately disclosed their water risks in their latest bond offering here. I am going to only focus on water used for washing coal, let alone extraction, transport and so on. The amount of water used for washing coal is 80-170 litres per tonne of coal washed. According to the bond offering memorandum, Winsway washes 6.5million tonnes of raw coal which means they use anywhere from 520-1,105 million litres of water per p.a. Here are some bathtub perspectives…

Given these numbers, have they adequately disclosed their water risk in their latest bond offering doc? Is the standard boiler plate risk disclosure good enough?

Although China is the largest producer and consumer of coal in the world, is production at this level realistic with increasing competition for water in the future? Perhaps it’s not just the poor quality coal in China that is driving purchase of coalfields abroad. Maybe this is China’s way of working around this elephant.

With competition for water resources on the rise in water scarce provinces, looks like water will be a bottleneck for coal – it’s only a matter of time.


ELEPHANT #2 : FINANCING THE POWER BUILD OUT


Project/infrastructure finance based on the projected cash flows of the project rather than balance sheet is long considered a “safe” risk by banks. The building of power plants is typically project financed with power purchase agreements (PPAs) offering guaranteed steady revenue streams for loan repayment over a fixed term usually matching the PPA.

The constant revenue stream is premised upon constant generation of electricity. Water is essential to the generation of electricity be it hydro-powered, coal-fired, gas-fired or nuclear. In the US, power generation is the largest user of electricity, not agriculture; the water required to run a 500MW coal-fired power plant will sustain around 250,000 people.

So does this financing model work in China where experts have projected that if business continues as usual, China will be short of water by 199 billion m3 by 2030? The Chinese government echoed this worry, recently stating that water will be a bottleneck for economic development. It has put in place water usage caps to make sure demand does not exceed supply (more here). Oops, we have stumbled upon elephant #2.

This elephant is HUGE!

Not financing is not an option as China plans to double its electricity generation by 2020. Just on the coal-fired power gen front, it will be adding slight under 500,000MW of installed capacity between 2010 and 2020. Growing by 1.7x, 500,000MW is a lot of power – in 2007, the installed capacity of India was around 170,000MW, so China is looking to add coal-fired plants equivalent to almost 3 times the power generation of the whole of India.

Now, that is a lot of coal-fired power plants to be built; lots of water to be used; and lots of money to be raised/ lent.

Assuming that coal supply is secure, is it ‘safe’ to lend to coal-fired power utilities over a payback period of 30 years when they could be facing water shortages by year 18? Should interest rates be higher to reflect this risk?

Ditto for financing of hydropower projects, which are expected to double over the next 10 years.

What about insurance?

With the risk of demand not meeting supply of water in 2030, more droughts and floods potentially causing disruption to both thermal and hydropower generation, should insurance risk premiums also rise? The potential loses/ write-offs incurred could be significant – this is definitely an elephant for insurers.

Assessing the risk and shifting the elephant

A once safe risk may not be so safe anymore. A senior banker said to me – “if you keep going on about this, we may have to re-visit our lending portfolio” – encouraging words indeed. Whilst we may not be able to change what has been lent, we can certainly mitigate against future write-offs.

“Water availability is the most underestimated critical issue for the companies we are financing, but we believe that financial institutions can help make the companies more sustainable in their performance. Our work with WWF looks beyond the risks and shows practical ways how to change them into business opportunities,”

Bruno Wenn, Chairman of DEG.

Perhaps change is not too far away, DEG KfW Bankengruppe spent time and money looking into this with WWF and published Assessing Water Risk: A Practical Approach for Financial Institutions last year.

Participating companies within the DEG lending portfolio were assessed for industry risk exposure to water and the basin risk where they operate.

The methodology used has just been made public in the form of a water risk measurement tool called the Water Risk Filter (WRF). The tool is available online and is free so there is really no excuse not to use it.

According to Stuart Orr, WWF’s freshwater manager involved in the development of the tool, DEG is already factoring these water related risks into the lending policy. “Existing clients of DEG with a higher water risk profile were offered support via the technical assistant fund of DEG, in order to assist the companies to lower the water risks” says Orr and more encouragingly … “the WRF will be applied for new loans”. Read the full interview here.

It’s not about not lending, it’s about lending wisely.

Anyway, there are only so many places along a river we can build a dam / a coal-fired power plant, which brings me on to …


ELEPHANT #3: DAMS


It’s not just the financing of hydro that could be a headache (more on this in Deutsche Bank’s  Hydropower in China: Opportunities and Risks) . Nor the multitude of environmental issues that result from damming (you can read about that here), this elephant results from limited choice.

It’s all clearer in 3D

I got my hands on a 3D map of China last month. A veteran investment banker thought it would help me illustrate water risks better. He was right; the 3D map says it all quite eloquently. Not that it maps anything new/ told me something I didn’t already know about the basic geography of China, but somehow once it’s laid out in 3D, it all becomes clearer!

At a glance, three points popped out (literally!):

  1. A large part of China is mountainous – the orange part denotes mountains >3,000m and the purple >5,000m. Note the sandy colour does not denote desert areas but areas that are >1,000m;
  2. The Himalayan plateau slopes off, replete with rivers from Sichuan into Yunnan and then into Myanmar, Thailand, Laos and Vietnam; and
  3. Limited land is suitable for farming and these are primarily in northern China

Suddenly, it becomes alarmingly clear that the area south of the Himalayan plateau is ripe for the tapping of hydropower. It also doesn’t take a genius to figure out that if China was to double hydropower in the next 10 years, there is no choice but to tap this area.

 

These sites do appear from the map to be easier to access than the Brahmaputra. Perhaps Isabel Hilton is right; all that hoo-ha about damming the Brahmaputra may be much ado about nothing.

No one on the other hand, seems to be talking/ worried about the water security of Thailand, Laos and Vietnam. Frankly it’s not as high up on most people’s radar as they should be.

China may have no choice but to dam the tributaries to the Mekong and the Salween. With no key water treaties between the neighbouring countries, would you be up for investing in a big way in Laos, Vietnam and Cambodia?


Too many elephants to ignore?

Yet again, I have probably raised more questions than provided answers. In the ‘Power Room’ alone, the issues are massive, complex and interlinked; and these elephants are not going away.

Under the current financing and insurance framework, we have made some fundamental underlying assumptions – that water will always be available and that it will be priced at a low cost. Given that this may not the case, we may have to change the way we allocate capital, be it equity, bonds or a straight forward loan to accommodate water risks. Insurance may also have to be re-thought. Risk disclosure could also be improved.

Or maybe we can continue to pretend that these elephants do not exist. But when there is so much money at stake, can we afford to ignore them?

Debra Tan

About Debra Tan

Debra heads the China Water Risk team. She was tasked with taking The Asia Water Project pilot to the next level and was responsible for the direction and build out of China Water Risk portal for ADM Capital Foundation. Debra started her career in finance, spending over a decade as a chartered accountant and investment banker. She has lived and worked in Beijing, HK, KL, London, New York and Singapore. Debra left banking to explore her creative side. She has since pursued her interest in photography and within a year had her first solo exhibition sponsored by a global bank. She also ran and organized hands-on philanthropic and luxury holidays for a small but global private members travel network and applied her auditing, financing and photography skills in the field for various charitable organizations and foundations. Debra believes that we can all make a difference, if only we see the ‘big picture’.

Read more from