Pouring Sugar on the Floor: The Financial System and Water Resilience
The team at Stockholm World Water Week were kind enough to invite Tom to deliver the final TED-style talk of the week, discussing the relationship between the financial system and water resilience. The video is below (rewind to the start after the ads), with the transcript beneath. Our thanks to Mr. C. Munger for the title, and sorry about Tom’s hilarious freeze face. Enjoy.
Thank you, it’s a huge pleasure to be here at Stockholm International Water Week. I’m sorry you have been deprived of the opportunity to hear Marisa Drew of Credit Suisse speak and instead are faced with the prospect of ten minutes with a funny-looking British man of questionable credentials, but hey, we can’t have everything.
My name is Tom Ferguson, Managing Partner of Burnt Island Ventures - a specialist early-stage venture capital fund for the water sector. The subject of this session, the relationship between the financial system and water resilience is as foundational as it comes.
It’s interesting how this session is phrased - transitioning the financial system to enable water resilience. It seems to me that the financial system is so large and complex it would be unwise (but very European) to think that it is something that can effectively be corralled and controlled. I advise all of us to think in terms of macro and micro incentive structures and to differentiate between what we can control in terms of the financial system, and what we can’t.
Charlie Munger, Warren Buffett’s partner at Berkshire Hathaway has a great quote we should keep in mind about incentives: “The iron rule of nature is: you get what you reward for. If you want ants to come, you put sugar on the floor.”
So let’s set a couple of waypoints. First, what do we mean by the financial system? So at least three of my business school professors will kill me, but I think it’s worth simplifying and cutting it into four areas:
Private markets for both equity and credit
Public markets for both equity and credit
Government (through spending, taxation, interest rates, and regulation)
Other - e.g. Insurance companies, INGOs, philanthropy, stock exchanges etc
Second, what do we mean by water resilience? As the theme of World Water Week I’m sure you’ve heard 14 different definitions, but the One True Definition (it’s not but I like it and it derives from a Steve Kloos observation) is “the new or continuing provision of water and sanitation services at the right quantity, quality, price, place and time in the face of increasing challenges to the achievement of any of those factors”.
Let’s be clear, complete resilience is impossible. Climate change isn’t going to let us get away with anything easily - you’re not going to comprehensively deal with the floods that inundated Zhengzhou two weeks ago, or flattened the US corn belt in 2019. The Global Drought Monitor currently shows alarming disparity between extreme wetness and extreme drought across the world. We’ve painted ourselves into a tight corner - or at least the generation or two above us did.
We have to remember that water resilience is in essence physical. These are pipes and concrete, filters and tanks. Yes, we need sensors and software to maximize efficiency and minimize risk, but water resilience is a physical endeavor. And physical endeavors are risky, complicated, and expensive.
So before you get to the financing piece - how do you enable resilience, because it’s really difficult.
It means water recycling systems, it means infrastructure to manage more extreme rainfall, it means inventing and commercializing affordable clean toilets, it means effective ways of treating more saline water as sea levels rise. It is investment in treatment, conveyance, recycling, desalination, renewal, storage, generation, cloud seeding - essentially a bunch of projects. And to receive financing, projects have to be either profitable - or be unprofitable but made possible through external intervention.
The ants need to see sugar on the floor.
So let’s take the profitable projects first. These aren’t really the problem. As of Wednesday evening, Global Water Intelligence lists 272 desalination projects worldwide. San Francisco’s $939m upgrade of their biodigester facilities in one of their treatment plants is one that is close to home for me. These things get funded through a mix of state, federal, and private funding, through an impenetrable process that leaves knowledgeable people much richer (at least on the private side).
And what of the unprofitable projects? These can be broken down into:
Borderline - not quite hitting a desired or required rate of return.
Returning at cost or just above, but basically out of the scope of the market.
Unprofitable and a really hard sell, but makes sense for, y’know, humanity.
It seems to me the immediate work is to get as many of the projects in group 1) Borderline into the Profitable section as soon as possible, and then work on group 2).
A few observations here:
First, Reference Pricing. We are starting to see a shift in the baseline of what is deemed “unprofitable” - in Oakley, Utah, the town has been forced to put a moratorium on building until new water sources are secured. What is the cost to the town of the growth foregone? THAT is the reference for the pricing of water infrastructure investment. The recent European floods will cost insurers about $2-3bn. Municipalities, companies, governments are all being given an object lesson in what the actual cost of water is, and all of them will have more healthy (and scary) frames of reference when computing the value of a given water project. Mercifully, the main thing we need - that water projects be appropriately costed not only in terms of the value they create but also the value destruction they help avoid - is happening.
Second, Public Support. Unprofitable is often a function of political risk appetite. Solar and wind projects were unprofitable as all hell until governments decided to drive them down the cost curve through price support after 2008 - the result was a 90% reduction in price, and energy costs to the consumer of as little as 1c/kWh. The renewables explosion is as much a function of government intervention in the financial system as it is a result of innovation.
Third, ESG. Unprofitable is also a function of your own cost of capital - and your own required rate of return. There is a mass migration of private and public equity (and debt) towards ESG (Environmental Social and Governance) investments - hitting 2.3trn in assets at the end of Q2, up $139bn from Q1. This has real ramifications for resilience projects. Bond issuances, for example, for infrastructure upgrades in vulnerable parts of the world, or for new treatment infrastructure, is attractive to both public and private investors (partially because it could work out fine financially, especially with government support from revolving funds for example, and partially because it looks great in their new client prospectuses) - and so you as the project developer have to pay less in interest to get access to that capital. Given that you are paying less to secure access to that financing, the overall rate of return of the project can be commensurately less for you to still make your cut on the project. So now, less financially attractive projects can get built. Because they’re sexy.
But what of group 3)? The ones that are highly unlikely to stand on their own two feet financially, but may make all the sense in the world from a human perspective. There are plenty of options for entities, from philanthropists to INGOs to governments, to backstop a project into existence if they so wish. It’s really a question of resources, and will. And with water becoming a more insistent priority in the era of climate change, my bet is that there will be a whole lot more will, and water projects are going to see a whole lot more resources.
With each disaster, with each demonstration of the financial ramifications of the costs of a lack of water resilience, the willingness to pay for water resilience projects goes up, and the decision on the part of the financial system as to whether to finance those projects gets easier.
A note on our electeds. Governments have the advantage of intrinsic scale. They have the largest balance sheets, the largest access to debt, and the ability to make a rule that applies to all actors in a country (or in the EU’s case a continent). They seemed to get it with the energy transition. Why is this support not provided to water? Why can we not subsidize water projects on the equivalent basis of a subsidy per/kWh? I bring this up to water people and they always say how it doesn’t apply (water’s too complicated, it’s special, it’s heavy, it’s locally contingent, the analogy doesn’t hold), but I’ve never seen a group of smart influential people get into a room to say - we’re subsidizing water systemically, let’s just work out how.
And what of the boardrooms? Encouragingly, corporate attitudes are changing. Companies including Microsoft, Dow, AB InBev, Gap have all committed to becoming Net Water Positive. One of the tech majors is looking at a major project to reclaim directly all the water they use in their operations from contaminated sources. Each of these commitments will (they’d better) translate into meaningful investments in process upgrades, recycling, watershed management - improving water resilience, and driving technology down the cost curve.
Technology. My home field. We started Burnt Island Ventures on the back of three core observations.
There are more and better entrepreneurs starting water companies, and better entrepreneurs build better companies
The market they’re operating in is becoming increasingly dynamic (don’t get me wrong, still stodgy, but just less so)
There is going to be increasing competition to buy the best emerging companies between current incumbents, emerging competitors, and infrastructure private equity - and that’s even before you have the potential for IPOs.
Despite these healthy tailwinds, venture capital in water is spectacularly underfunded. The data is sketchy at best but there was probably about $200m of venture investment in water globally last year, for a $900bn market. For scale, fintech received $34bn in VC funding in Q2 of this year alone.
A lot of very wise people will tell you that the technology we need to secure our water future exists - it’s just a question of deploying it.
Well, if it was the right technology, then it would already have been deployed. The right performance at the wrong price or cost structure is the wrong technology. I can assure you that we are nowhere near done on the technological front. At Burnt Island Ventures, we see a ton of great ideas, but we need more. We need to run more and more imaginative experiments, we need to increase our gross number of failures, because with thanks to Thomas Edison, the more failures we have, the closer we’re getting to what works - Zero Liquid Discharge, large-scale recycling, atmospheric water generation, PFAS removal, stormwater management systems - all these will be a no-brainer for cities, companies and consumers alike, once we get them right. But there has to be a commercial case for them - we can’t blame the bankers or investors for not funding technology that doesn’t make commercial sense.
Thanks so much for your time, and I hope you enjoy the panel - Steve and George thanks so much for your friendship and support as we’ve got BIV off the ground. Marcella and Lawrence your reputations precede you. I’m sure it’ll be a cracking conversation. Many thanks, and enjoy the session.
