04 Jun 2018
Over the past 20 years Australian governments have implemented globally significant water reforms, including the unbundling of water rights from land, creation of markets and an approach to water planning and entitlements embedded in the National Water Initiative.
The formation of water markets has enabled users to reveal the value of water, respond to different drivers over time and for water to be allocated to those who value it most.
"Australia’s [water] system is not perfect but provides a clear competitive advantage.”
The blueprint called for governments to commit to progressive removal of barriers to trade in water and meeting other requirements to facilitate the broadening and deepening of the water market, with an open trading market to be in place.
When we look at water management frameworks in other countries Australia’s system is not perfect but provides a clear competitive advantage.
The level of new investment - particularly in the southern Murray-Darling Basin (MDB - has been astonishing. All the main irrigation industries are doing well and the response in water asset prices has been remarkable.
However this is creating some uncertainty and many agribusinesses are now looking for ways to appropriately value water as a component of their investments or operations.
Water entitlements are the ongoing rights to receive an annual share of available water resources in a consumptive pool as established in a specific river system or aquifer.
Water entitlements are like buying the right to own an empty bucket and every year the government resource manager will come along and fill up that bucket with a certain amount of water given climatic conditions and specific reliability characteristics of that bucket.
Water entitlements are generally secure, tradeable, divisible and mortgageable in the same way as land. Entitlements are now unbundled from land in active water markets (see figure above).
Water allocations are the volumes of actual water allocated to water entitlement holders during the water year. Water allocations are analogous to a commodity and are extracted from water systems and applied as inputs to production.
There is trade in both water entitlements and allocations and they are related but separate markets. There is also leasing and options of entitlements and forward trades in allocations.
With water ownership restrictions lifted progressively it is now possible for basically any individual or firm to hold water entitlements and trade allocations to them on a daily basis.
Unbundling & trade
About 90 per cent of Australia’s water trading occurs in the southern MDB. The outcomes of reforms are positive for investment in Australian irrigated agriculture with potential application and benefit globally in dealing with one of the world’s biggest challenges – water scarcity.
Water planning, entitlement and market reforms which have been undertaken in Australia have enabled the irrigated agriculture sector to withstand the stress test of a one-in-1000 year drought sequence and proven to be resilient. Whilst the millennium drought no doubt caused significant pain major government intervention was not required.
Essentiality the industries with flexible water use requirement such as annual crops (rice) and dairy were able to reduce water use and thus production and the water they owned was able to be traded to wine grapes, nuts and other permanent plantings with fixed water requirements. Through trade both parties were better off.
Importantly during the millennium drought it wasn’t a case of would I be able to get access to water - it was an economic question of ‘how much are am I willing to pay?’
Plugging holes in Sunraysia
For many farmers in the Sunraysia region in Victoria’s North West the availability, security and ongoing supply of water is top of mind. The latest summer featured a series of days over 35 degrees which placed huge demand on the river system.
The Barmah Choke is a bottleneck in the system which restricts water flow from the upper Murray to the Sunraysia region.
As planned and immature tree plantings below the Choke reach full production in the next five years, including an additional 15 thousand hectares of almonds, there will be even more demand placed on the system.
Some farmers in the region hold permanent water entitlements but remain heavily dependent on the temporary water market and are concerned about cost.
Sunraysia avocado and mango producer Ryan Marr currently irrigates using temporary supply as well as small amounts of permanent supply and carryover and is particularly concerned about the amount of water available during extreme dry conditions.
“There are a lot of permanent plantings going in the ground at the moment which is going to make temporary water in low supply during dry years,” Marr says.
“Low supply means higher pricing, which will make it all the more important to ensure your business is healthy enough to withstand short term high prices if relying on temporary water.”
He’d also like to see more investment in water storage.
“We have seen huge areas of new greenfield sites approved for irrigation, making additional investments in water storage infrastructure absolutely critical at this point,” Marr says.
During the millennial drought from 2001 to 2009 temporary water prices reached $A1,000 per ML (currently sitting at ~$A240 per ML) which had an enormous impact on Sunraysia’s wine, dried grape and citrus industries.
Despite this there are some farmers that are almost completely dependent on the temporary water market.
Sunraysia mixed horticulture farmer Hardeep Singh is reliant on the temporary market and water accounted for around 15 per cent of his operating costs in the last financial year.
“I'm not concerned about the actual security of supply but I am more concerned about the market manipulation that exists in the water market and government regulations which will put pressure on the price,” he says.
“As the price of water increases, low-value commodity growers become water sellers and free up availability for more of the permanent planting growers. So I think water will be available at hard times but you will have to pay.”
There are others that err on the side of caution and hold enough permanent water entitlements (at 100 per cent allocation) to irrigate their entire operation.
Many large corporates investing into permanent tree crops in Sunraysia are also opting not to tie up capital in permanent water but mitigate risk by adopting a long term water strategy.
This generally includes a mix of buying from the spot market, leasing permanent entitlements from investors and negotiating forward allocation agreements for up to five years.
When it comes to water supply, our farmers are faced with many options and must decide whether to direct capital towards permanent water at an extremely high price or use it to increase the amount of land available for production, among other things.
Whatever the decision, every farmer in the region should be seeking to mitigate the risks of another millennial drought and decide on the best strategy for them now and into the future.
Jason Marr, Regional Executive, North West Victoria, ANZ
Real risks & opportunities
The latest investment boom has brought with it both risks and opportunities. Even if you own water entitlements there is no guarantee water will be delivered to your pump on the river when you need it.
There are real physical constraints, particularly in the Murray system, around how much water can get below the Barmah Choke to the Sunraysia and Lower Murray region and this will be pushed when newly planted almond trees reach maturity.
The second risk is around price. With significantly increased demand the price of water entitlements has gone up to the point where many are starting to question the value in owning entitlements. In addition those which want to purchase entitlements are finding them very hard to come by.
There’s lots of capital at risk, expensive trees at risk and reputations at risk. There’s risk associated with upfront asset purchases and then through the investment life cycle.
The best way to deal with these types of risk and uncertainty is through a rigorous, well-governed and well-informed approach to water risk management. Small improvements can make a big different to overall returns, risk exposure and the comfort of managers, investors and banks.
This must be tackled from several angles including risks which sit around a water portfolio strategy including market risk, deliverability risk and regulatory risk.
Returns in unbundled world
There are a couple of possible explanations for high water entitlement prices which are open to debate but one factor is very important and that is the expected rate of return for the asset class based on its characteristics. This obviously makes a very big difference to your valuation.
With water, land and operations increasingly separated it’s important to come to a view on the risk weighted desired return for each of them and decide what you want to be.
With water entitlements, buyers are increasingly seeing them as a relatively low risk asset class akin to land. Many buyers are either satisfied with lower returns or banking on further capital growth.
So, water is likely to progressively move to this type of investor - and this movement has been occurring in the process of entitlement assets appreciating.
Chris Olszak is a Director at Aither, an economics, policy and strategic advisory firm with primary expertise in water policy and reform, water infrastructure, floods, natural resource management and the environment.
The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.
04 Jun 2018
12 Jul 2018