A good signal for environmental reforms and impacts on companies.
Water. Energy. Food. Three vital components for sustainable development. The interaction of these factors is commonly referred to as the Water‑Energy‑Food Nexus (WEF‑Nexus).
Changes in population, urbanization, diets and economic growth drive demand within each segment—creating complex challenges around the globe. If one WEF‑Nexus component is mismanaged, the other two will ultimately feel the impact.
The linchpin of the WEF‑Nexus is water—as a finite resource, water scarcity has a direct impact on food supply. If a local WEF‑Nexus spirals out of balance, lack of water shifts from being a global, long‑term sustainability concept to a more local and immediate problem. As a result, a country’s water‑energy‑food balance can be a good indicator for the likelihood of greater environmental regulation.
Understanding how the three components interact provides a platform for identifying and analyzing potential effects on companies and industries, most notably through the nature and pace of resulting regulatory reform.
This paper analyzes the rise of WEF‑Nexus pressures across the globe and highlights how insights into the WEF‑Nexus imbalance in China is guiding our investment analysis across a range of industries.
Understanding the WEF‑Nexus
Water, energy and food are three vital components for sustainable development. The interaction of these factors is commonly referred to as the Water‑Energy‑Food Nexus (WEF‑Nexus).
As Figure 1 illustrates, a multitude of factors work to drive demand for food, water and energy—including changes in population, urbanization, diets and economic growth. These dynamics are creating complex challenges around the globe.
As we seek to understand the effect of these complex interactions on companies and industries, a key indicator is the nature and pace of resulting regulatory reform.
China represents a powerful example of how a WEF‑Nexus imbalance works to drive environmental reform. Environmental regulation in China has tightened substantially as the government encourages restructuring of the country’s industrial sector. China’s environmental reform program began nearly a decade ago and, if successful, will drive a structural shift in the economy—with significant investment implications. Key reforms include:
- Scaling down “non‑circular” industries—The imposition of water caps and pollution targets makes it more difficult for businesses that “overdemand” energy and water usage or cause waste management issues. Key industries in these crosshairs are steel, nonferrous metals, petroleum and petrochemicals, chemicals, building materials, paper, and textiles.
- Energy sector reform—The Chinese government is orchestrating a gradual shift in the power generation mix from coal to renewables and natural gas, as well as a shift in transportation infrastructure.
- Agricultural reform—Growing water shortages and soil pollution in China’s main agricultural regions are driving efforts to sustainably improve agricultural yields and reevaluate the range of crops grown.
(Fig. 1) The Water‑Energy‑Food Nexus
The factors driving demand for water, energy, and food
Sources: Water and Energy (UN Water 2014), Food and Agriculture Organization of the United Nations, UNESCO World Energy Outlook (IEA 2017).
The WEF‑Nexus Social Impact
While this paper largely focuses on the effects of the WEF‑Nexus on the environment, it is important to recognize its significant social impact.
Two of the most important social factors affecting environmental reforms are employment and public health. In China, for example, the planned shift to a “circular economy” will stimulate growth in better‑quality jobs. The ability of the government to put pressure on “non‑circular” industries has been made easier as the growing service sector has created new employment opportunities.
Meanwhile, as China’s air, soil, and water pollution problems have prompted public health concerns, the government’s regulatory agenda has evolved to place a greater emphasis on ecological factors. As in the developed world, public health is often a good catalyst for environmental reform—particularly in countries with universal health care.
The Rise of WEF‑Nexus Pressures Globally
Between 2000 and 2016, 1.2 billion people around the world gained access to electricity and many emerging markets experienced rapid industrialization. Between 2000 and 2015, global electricity production increased 57% (3.0% CAGR). The overwhelming majority of this growth came from emerging markets, which grew by 135% over the period. Electricity production in China and India increased 332% and 143%, respectively, while water withdrawals increased 24% and 25%. These rapid changes have had a significant impact on each country’s WEF‑Nexus, which has been further compounded by the fact that neither is water rich.
Water scarcity isn’t only an issue for China and India. Today, nearly a quarter of the world’s population live in water‑scarce regions. In the next two decades, the number of people exposed to water scarcity is expected to double from the current 1.6 billion, largely due to economic growth and urban migration. Regions and countries facing the greatest water and pollution stresses include:
- Asia (Afghanistan, China, India, Pakistan, Philippines, Sri Lanka)
- Middle East (Bahrain, Iran, Israel, Jordan, Lebanon, Oman, Qatar, Saudi Arabia, Turkey, UAE)
- Latin America (Chile, Peru, Mexico)
It is typically easier for politicians to mobilize around locally impactful issues (like water scarcity, rising food prices, or pollution) than a globally focused, long‑term issue like climate change. However, as the impact of climate change intensifies, scientists predict more regions will encounter water scarcity. This means WEF‑Nexus pressures will become a local issue in more and more countries over time. Key indicators of looming environmental reforms include:
- More frequent droughts and rising food prices
- Consistent overdraws on river systems and aquifers
- Agricultural inefficiency—low yields and/or tilts to nonfood crops
- Impact of pollution on public health and quality of life
- Low unemployment—politicians can address ecological issues when there is less economic pressure
As the pull on this finite resource forces more regions into water scarcity, we expect greater intervention by governments as they struggle to manage their water, energy, and food resources. This in turn will likely have a downstream effect, impacting the energy, utility, and transportation sectors as well as other sectors indirectly exposed to the WEF‑Nexus.
WEF‑Nexus Pressures in the Investment Process
From an investment standpoint, water, energy, and food are each important considerations, but the emergence of water issues is often a catalyst for swift regulatory intervention. The mismanagement of water resources is difficult to reverse, and because prices often do not signal a scarcity issue until too late, regulatory responses can be drastic.
Integrating water considerations into an investment process creates unique challenges. Often, the investor cannot register a direct price signal until water resources have become significantly constrained—even then, it might simply be reflected in increased regulation or shortages, rather than a price spike. This is because water markets are relatively underdeveloped compared with energy and agricultural commodities and are far less penetrated by private industry. Also, water is not easily transported, so it doesn’t lend itself well to global trade. However, water trades implicitly on a large scale as it is embedded in many globally traded goods.
As current water data are not always readily available, water often needs to be considered as an intangible factor in the investment process. Figure 2 illustrates how an investment process may be modified to consider the WEF‑Nexus. In this example, the traditional “energy trilemma”—which balances the security of supply, price, and environment—is reconfigured to include water dynamics.
While an imbalance of the WEF‑Nexus can be a catalyst for swift environmental reforms—as has been the case in China—it is important for investors to consider the interplay of environment, price, and security that policymakers must account for.
Policy measures to improve the environment are generally tied to both environmental and social benefits. However, the attainment of any social benefit is typically longer‑term and can come with short‑term trade‑offs. For example, measures to lower pollution by transitioning to cleaner fuels aim to bring long‑term societal health benefits, but energy prices are likely to rise in the short term. This type of trade‑off can make it more difficult for policymakers to implement environmental reforms on a consistent basis. It can drive a start‑stop approach in regulation implementation due to dependency on prevailing economic conditions.
Managing WEF‑Nexus Pressures—China in Focus
In China, WEF‑Nexus problems have been amplified by three decades of exceptional economic growth and rapid industrialization. As the economy expanded, energy demand was largely met by coal‑fired generation. As a domestic resource, coal had the benefit of security of supply at a low price, but its use took a toll on the environment in the form of air pollution and water intensity. Overdependence on coal, coupled with relatively lax environmental standards for the industry, has thrown China’s WEF‑Nexus out of balance. China faces threats to food supplies from soil and water pollution, health hazards for citizens due to poor air quality, and a multitude of risks due to water shortages.
China began a “war on pollution” many years ago and is beginning to see benefits, including regional improvements in air and water quality. T. Rowe Price analysts and portfolio managers have been navigating China’s changing environmental landscape for several years and believe it is still early innings for what will likely be a multi‑decade restructuring of the country’s economy.
Environmental damage in China is felt at both global and local levels. Consequently, the country’s ecological reform program has a twofold approach. At a global level, China’s water supply is predominantly sourced by rivers flowing from the Hindu Kush Himalayan glaciers, referred to as the “water towers of Asia.” These are vulnerable to climate change and are showing signs of retreat. Retreating glaciers not only affect China’s long‑term water supply, but also have the potential to instigate regional conflict.
In 2015, China made a strong commitment to help address climate change by pledging to reduce its carbon intensity by 60%–65% by 2030 relative to 2005 levels. To achieve this, the country intends to double the level of low‑carbon fuels within its energy mix to 20% by 2030. Power generation is expected to drive the bulk of this shift, with coal de‑emphasized while renewables are prioritized as a key industry on the “Made in China 2025” agenda.
China’s efforts to mitigate global climate change should yield domestic dividends in the form a healthier water system and rivers. It should also help reduce water demand from energy generation due to lower dependency on water‑intensive, coal‑fired electricity production.
The country is also aggressively managing its economy at the local level to bring its WEF‑Nexus back into balance. At the heart of its local environmental reforms is a shift toward a circular economy, which is de‑emphasizing any industry that overextends China’s natural resource balance without a commensurate social gain.
In 2009, the Chinese government targeted 10 industries that needed to “close the loop” and go circular: coal, power, steel, nonferrous metals, petroleum and petrochemicals, chemicals, building materials, paper, food, and textiles.
(Fig. 2) The Energy Trilemma Reconsidered
Integrating water dynamics into the investment process
Source: T. Rowe Price.
This material is being furnished for general informational purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, and prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.
The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.
Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date written and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.
The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request. It is not intended for distribution to retail investors in any jurisdiction.
USA—Issued in the USA by T. Rowe Price Associates, Inc., 100 East Pratt Street, Baltimore, MD, 21202, which is regulated by the U.S. Securities and Exchange Commission. For Institutional Investors only.
© 2019 T. Rowe Price. All rights reserved. T. ROWE PRICE, INVEST WITH CONFIDENCE, and the Bighorn Sheep design are, collectively and/or apart, trademarks of T. Rowe Price Group, Inc.