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The Water Cost Index: Blending Finance, Sustainability, and Big Data

Published: 17 Jun 2014

Usman W. Chohan (楚浩云) is an MBA candidate at Desautels with a Concentration in Strategy and Leadership. He is currently on an MBA exchange in Beijing, at a joint program between Tsinghua School of Economics (SEM) and MIT. He previously served as the Special Situations Analyst in the Global Equities Team at Natcan Investment Management, the investment arm of the National Bank of Canada. The following piece is based on his work on financial innovation and sustainability, in collaboration with Professor Hoan Soo Lee of the Tsinghua University School of Economics and Management.

暴殄天物 - "To waste resources is to squander the blessings of Heaven"
- Chinese Proverb

Water sustains all major ecosystems and is at the heart of social development and prosperity. However, it is regrettable that water scarcity is a very real phenomenon affecting broad swathes of the global population: it already afflicts 2.8 billion people around the world, on every continent, for at least one month in the year; while more than 1.2 billion people lack access to clean drinking water all-year round. Furthermore, the United Nations Committee on Economic, Social and Cultural Rights recognizes water security as a basic human right and recognizes the entitlement of all peoples to sufficient, safe, acceptable, physically accessible, and affordable water for personal and domestic use.

It is this last attribute that is particularly interesting: the question of the "affordability" of water; because throughout history, water has not attracted a valuation that matches its ubiquitous use, and so there has not been much significant direct financial return to be reaped from investing in water systems. This is a remarkable point given that humans have in fact had long record of pondering the subject of valuing water. Adam Smith, Copernicus, and John Locke all considered the difficulty that arises from attributing a monetary aspect to the use of water, and in the words of the former: "Nothing is more useful than water: but it will purchase scarce anything; and scarce anything can be had in exchange for it!”

Therefore, it behooves us to consider the paradigm of water valuation, and using our advancements in financial theory and Big Data technology, we may be coming ever closer to finally applying a systematic approach to appraising the rightful importance of water in our societies and economies. Specifically, it is the work of Waterfund LLC, in collaboration with IBM, which is effectively pushing this endeavour forward.

Waterfund is a US-based water financial risk management company that is applying IBM's Big Data technology to develop a Water Cost Index (WCI) which will attempt to quantify the final cost of producing and delivering water for key zones in precise dollar terms. In order to provide specific quantitative data, the index will address four important financial parameters:
1) Energy Cost
2) Interest Rate Risk
3) Capital Spending for New Projects ("Expansionary Capex")
4) Operations and Maintenance Expenditure  ("Maintenance Capex")

The key contribution of IBM's Big Data capabilities to the project is in the ground-breaking application of analytic techniques for studying "unstructured data"; since the quality, format and detail of data sources (primarily water agencies) varies enormously, and previously would have made it prohibitively complex to examine in any systematic fashion. Indeed, one of the staunchest barriers to better analysis of the world's water resources has been that water agencies around the world have not systematized their data and consolidated it for macro-scale study. This is the key challenge surmounted by IBM's computing algorithms for helping construct the WCI.

The Water Cost Index will assess the cost of provision for one unit of "finished water" in that it will encompass the entirety of the value chain underlying end-user consumption. In essence, the index will provide a risk benchmark for quantifying the financial aspects of engaging in water-infrastructure projects, which is why its applications are far-reaching and diverse, including: setting water rates, adjusting water tariffs, calculating risk profiles, devising hedging instruments, underwriting new infrastructure projects, and performing a variety of other financial analyses.

Water utilities could apply the costing information from the WCI to benchmark their efficiency of delivery, and examine their cost structure for significant divergences as part of streamlining their operations. The WCI also provides data analytics for making pro-forma projections, through extrapolation algorithms, of future water costs, thereby bolstering efforts to calculate and discount the future value of cash flows from water projects, which along with scenario analysis of "what-if" variations in the stream of inflows, serves as the underlying bedrock of the art that is financial modelling. By the same measure, credit-rating agencies could apply the WCI towards the risk analysis of both securities emitted by utilities companies as well as specific water projects.These data advancements allow companies in the utilities sector to approach the well-entrenched mathematical modelling practices already prevalent among major companies in the energy sector. The energy sector, of course, benefits from the internationally accepted price of a barrel of oil, which hovers in the $80-$100; and the water cost index will provide similar pricing capabilities to the modelling of water already extant in oil and gas.

 Additionally, the value of the WCI supersedes that of traditional price indices such as the Consumer Price Index (CPI), because the costs of water have been shown not to correlate with broader inflation measures. According to work by Waterfund, between 2008 and 2013, whereas the CPI in the U.S. rose by 10% (cumulatively; non-annualized), the Water Cost Index rose by 30%. This also points to the divergent prices of key commodities consumed by societies, among which water is a noteworthy increase in excess of general inflation.

The sustainable use of water is a logical extension of the benefits provided by the WCI. In recognizing the quantitative worth of water, the conservation and sustainable use of water can be exercised in a methodical fashion. Once the irrefutable, mathematical facts about the cost of water become manifest, targeted measures can be undertaken towards promoting sustainable water use based on rigorous analysis. We can thus begin to ascribe a "fair market value" to a resource that we have so long taken for granted, but which lies at the very core of our economy and society.

It should consequently be noted that the uniqueness of the WCI extends across several factors. First, the valuation of water has been shown to be a historical quandary, whose calculation can now be taken with a mathematically sound underpinning. Second, key players in the water space, such as utilities and the financial agents serving them, can now improve their efficiency and conduct financial analysis for projects with greater assurance. Thirdly, the use of large quantities of unstructured information for studying the global water situation is a highly innovative use of one of the biggest movements in technology today: Big Data. It is evident, therefore, that the Water Cost Index lies at the intersection of three key areas: technology, finance, and sustainability. Measures can be taken in the wake of this breakthrough that can strengthen water conservation efforts, enhance financial accuracy, and divert technology towards helping society flourish through better water management. For the 2.8 billion people afflicted by water scarcity, such progress can further the aim of generating greater investment to provide them with the resource that is their fundamental human right. Ultimately, sustainable solutions such as Waterfund's WCI lie at the heart of our efforts to use that very quintessential element, potable water, whose valuation has long eluded us, in a way that promotes both greater efficiency and global prosperity in years to come.

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