Table 5.1 provides examples of subsectors included within each functional sector in order to identify the many specific functions within the industry.

Water-Related Applications

One of the more challenging aspects of the water industry from an investor’s perspective is the diversity in the number of markets and/ or applications associated with water. Once you move beyond drinking water and wastewater treatment, many applications fall into the “water-related” designation. And while not as critical as global drinking water, sanitation, and agricultural applications, water-related activities are mission critical to many industrial processes. In fact, this aspect of the business exhibits many of the characteristics of a free market relative to the economic value of water and thereby drives a significant portion of water company profitability.

Table 5.1 Water Industry Sectors and Subsectors

It would be convenient if all of the companies in the water investment universe fell neatly into place. But that is not the case and likely never will be. Having said that, it is important to understand the magnitude of water-related activities in addition to the more pure-play applications. In nature’s economy there is no such thing as “pure” water, and that extends to the human economy as well. A side-by-side view of the water business categorized by application illustrates the importance of these markets to the water industry and to investors. While the coverage of potable water and wastewater applications is relatively straightforward, water-related (or near water) applications are often neglected by investors. In fact, industrial and manufacturing applications are often a key factor in determining the relative investment merits of water companies.

Industrial and Commercial Processes

The industrial market is often slighted in discussions of the water industry in favor of the more visible and recognizable water themes such as potable water and sanitation. The reality, however, is that industrial and manufacturing activities provide a significant amount of the spending on a broad array of water and water-related goods and services and represent the clearest example of market-driven applications in the water industry. Industrial end users have clear economic motives associated with critical process quality control, operational cost efficiencies, the management of compliance costs, minimization of waste, and so on. Accordingly, industrial end users are proactive in adopting innovative methodologies and have been instrumental in facilitating technology transfers and enabling commercialization of disruptive technologies.

Because industrial markets are more directly influenced by cyclical economic conditions, these applications should be viewed in comparison to other markets served. Water companies that are especially dependent on a particular industry (e.g., energy or oil and gas) are likely to exhibit greater volatility than companies that have not only a municipal/ industrial mix but also diversified exposure within the industrial market. Nonetheless, water companies that serve the industrial market often provide critical process-enhancing and -enabling technologies. For example, the need for ultrapure water in many diverse industrial applications is estimated to approach a $6 billion market by 2011. Ultrapure water requires not only ion-exchange resins and membranes to remove contaminants, but also components such as specialized valves, pumps, and piping materials that are able to maintain the integrity of high-purity water in all phases of the process.

Semiconductors. The semiconductor manufacturing process requires ultrapure water at virtually every step, from cleaning to etching. It is estimated that for every dollar of water purchased by a semiconductor producer, it costs $20 to treat it to ultrapure levels and another $10 to pretreat the process wastewater before sending it out into the environment. As such, advanced treatment, recycling, and analytical testing are all water segments utilized by this one industrial process. Ultrapure water is potable municipal water purified on-site to meet the stringent purity requirements of chip manufacturing in reducing the concentration of metals, dissolved solids, and ions. Ultrapure water treatment utilizes membranes with pore sizes down to the hyperfiltration level (reverse osmosis), ozone disinfection, and ion exchange.Analytics require the use of sophisticated mass spectrometry instruments to test for purity levels and controls to constantly monitor the process.

In addition, it takes large amounts of water to fabricate chips. For example, it takes an average of about 2,300 gallons of water to process one six-inch wafer.The larger chip manufacturers can consume as much as 1 billion gallons of water per year at a single location. These quantities not only dictate the need for the efficient use of water and water recycling systems, but also facilitate the need for local and regional water resource management initiatives. Despite the cyclical demand for chips, there is little doubt about the long-term growth of the industry. Much of that growth is centered in China, South Korea, Taiwan, and Japan. The semiconductor business is an application that encompasses both water quality and quantity issues and is one specialized example of the enormous potential associated with industrial applications for water companies that address these specific markets.

Health Care. Water used in health care and hospital settings is another specialized market for filtration, separation, and purification technologies. The quality of tap water used in health care facilities is adversely affected by changes in season, facility renovation and construction activities, and biofilm shedding. Water treatment in this market is not only a microcosm of broader water contaminant issues, but also a unique setting where microbial contamination is an especially problematic situation. Health care-associated infections are a growing and increasingly important industrial application for water treatment technologies. Faucets, showers, ice machines, medical device reprocessing, and wound care are all areas where advanced water treatment is required. Plumbing systems are particularly sensitive breeding environments for contamination (due to temperature and humidity) and result in the formation of biofilms, biological fouling, and microorganism growth.

Cooling Towers. As far as industrial and commercial water markets go, the market for cooling tower water treatment is one of the largest and most competitive of applications. Cooling tower water treatment is akin to the POU markets in its fragmentation, complexity, and confusing array of technological alternatives. In the United States alone, there are an estimated half million water cooling towers used by industry, hotels, hospitals, offices, and commercial buildings. Towers range from small rooftop units to the very large hyperboloid structures that are icons of the industrial landscape.

The basic premise of a cooling tower is the transfer of excess heat from exchangers and air conditioning/refrigeration condensers or waste heat from industrial processes, to the atmosphere. If an industrial plant had only once-through cooling (no tower), it would require a phenomenal amount of water, therefore creating grave ecological consequences from thermal pollution to the receiving water bodies. A typical petroleum refinery processing 300,000 barrels per day circulates about 21 million gallons of water per hour through its cooling tower system. Cooling towers serve to dissipate waste heat more effectively into the atmosphere (remember that anomalous high-latent-heat property of water that enables considerable evaporative cooling). Common industrial applications include cooling the circulating water used in oil refineries, petrochemical plants, natural gas processing, food processing, power plants, and so on. Many water companies supply the water cooling market as an adjunct to other core chemical capabilities or water treatment equipment applications.

Efficiency is critical. Tower tanks and plumbing must be clear of scale and corrosion and free of contaminants such as algae, viruses, and bacteria to operate at optimum efficiency and to protect public health. Cost considerations relate to the significant amount of energy savings that can be achieved through efficiencies in the heat exchange process (scale deposit and corrosion control), while health considerations relate to a microbe-free environment within the systems. For example, Legionnaires’ disease (most notably Legionella pneumophila) is a now well-known example of bacterial disease caused by aerosol exposure from open recirculating evaporative cooling towers.

As result of the evaporative process, solids will concentrate in cooling water over time, thereby inhibiting the heat transfer process and increasing energy costs. Chemical treatment methods have been the predominant method in the prevention of scaling and the growth of algae, but escalating chemical costs and stringent discharge requirements have led to an increased use of nonchemical methods. Microbiologically influenced corrosion and “white rust” have become particular problems due to an EPA ban on the use of highly toxic heavy metal corrosion inhibitors and the reduction of lead content in the galvanizing process, which raises the pH level and facilitates white rust formation, thereby reducing the effectiveness of biocides and scale-inhibiting chemicals. As a result, the use of nonchemical water treatment methodologies is an emerging trend.

The promoters of many alternatives are somewhat dubious in their assertions, thus the analogy to the POU markets. But investors are safe to assume that proven technologies such as ozonation and ionization to combat scale and bacterial formation will increase dramatically in cooling tower applications. Ultraviolet light has also been used to control bacteria, fungi, and bioslimes. As with many emerging technologies, the higher initial cost is not appropriately weighed against the longer-term return on investment, especially in conjunction with the potentially detrimental environmental and health impacts.

Pharmaceuticals and Biotechnology. Water is a critical reagent in life sciences technologies in confronting challenging human health issues. All life science research starts with the use of pure water. Water purification systems are a critical component in biotechnology and pharmaceutical laboratories where requirements can approach 1,000 gallons per day. Flexible purification systems are needed to produce the water quality needed for a variety of laboratory needs and applications, and, as such, encompass both water filtration and separation (membrane) treatment devices. The pharmaceutical industry uses purified water for injection and cleaning processes typically through distillation or reverse osmosis techniques.

Bottled Water. The reader will note a conspicuous absence of discussion related to bottled water as an investment thesis. There are several reasons for this:

• Bottled water has evolved into a consumer-driven beverage category.

• Except for emergency use, bottled water has little to do with sustainably solving global water issues.

• Bottled water does not necessarily ensure quality.

• Bottled water is likely to emerge as part of the aggregate water problem (groundwater depletion and surface water diversion) rather than as a sustainable solution in providing “safe”’ and cost-effective drinking water.

• Centralized water treatment, that is, tap water, provides a safe, cost-effective source of drinking water at a much lower cost to a much greater proportion of the population.

• In a decentralized context, resources for POU treatment must focus on a comprehensive distributed strategy rather than on packaging water.

Bottled water is instead viewed as an application for treatment technologies and comprehensive resource management. For investors who cannot resist the attraction of the admittedly rapid growth in bottled water, particularly in developing countries, there are a number of public companies that could be considered.¹

Heavy Metals. Heavy metals in industrial processes are an especially challenging problem because they generally cannot be degraded or destroyed. Further, while trace amounts of some heavy metals are critical to metabolic function in living things they are very toxic in even low concentrations and accumulate in organisms over time. Unfortunately, the examples of potential contamination from metals are many; antimony (Sb) used in flame retardants, cadmium (Cd) in batteries and coatings, chromium (Cr) in pigments for paints, lead (Pb) leaching from drinking water pipes, mercury (Hg) in lamps, and so on.

In concert with the number of potentially harmful metallic chemical elements, and the diversity of industrial applications in which they are present, there are numerous specialized treatment processes to remove heavy metals. Because of the differing chemical properties of heavy metals, these treatment technologies are often designed for a very specific metals application, for example, the use of ion exchange in the power and electronics industries, distillation to produce pyrogen-free water for pharmaceuticals, coalescing to separate water from oil, and ozonation to bleach papermaking pulp without chlorine.

Drivers of the Water Industry

The term market drivers is investment parlance for the factors that contribute to the growth of a particular market or industry. There are many factors that drive the coalescing water industry: population and demographics, aging infrastructure, global food demand, degradation and contamination of supplies, regulation, technological advancement, economic development, ecological and sustainability considerations, climate change, and institutional reform.The drivers of the global water market encapsulate a complex interaction of economic, strategic, cultural, and political elements. The factors not only represent movement along the supply-and-demand curves, but also positive shifts in the curves themselves, which is indicative of rapidly changing conditions and accelerating growth. But the common thread is that each factor has an explicable link to the growth of some or several aspects of the water business. In totality, these drivers amount to a tsunami of change and create a watershed investment opportunity. Broadly speaking, the drivers can be viewed as exogenous or endogenous (structural).

Exogenous Drivers

The exogenous drivers of the water industry can be viewed in a number of ways. For this purpose, however, exogenous drivers, as those that contribute to the growth of water from outside the industry, are contained within the broad socioeconomic trends of industrialization, urbanization, and globalization. Other, more specific exogenous factors include economic development, water property rights, demographics, culture-based pricing, climate change, and so on. In other words, rather than isolate the discussion of these factors, they are woven throughout the book in the context of a growth driver as it impacts a particular water investment aspect, especially in the context of exogenous institutional factors since they represent potentially significant change in the water industry and reform of water policies. In fact, a World Bank report ² points out the tremendous impact on water industry “performance” (such as in reducing negative health impacts and poverty levels) that can be achieved through reform of water institutions and policies. This is an argument that is reiterated throughout the many discussions of water pricing, technology transfer mechanisms, regulations, and other institutional structures. At this juncture, it is to be emphasized that the broad macro trends shaping the global economy are very much contributing to the growth of the water industry.

Industrialization. Industrialization is a major driver of growth for the water industry by virtue of the simple fact that large portions of the global population are transitioning to large-scale, mechanized economies characterized by extensive resource utilization. As a result, demand for water across a broad range of consumptive uses is outstripping easily accessible supplies while industrial activity impairs quality. In many of these high-growth, highly populated countries, the water stress threshold (1,700 m³ per capita) is rapidly approaching, if not already reached. For example, China has only 8 percent of the world’s freshwater to meet the needs of 22 percent of the global population. In India, urban water demand is expected to double, and industrial water demand to triple, by 2025.

Rising real incomes in industrializing countries increases per-capita water consumption as a result of shifts to higher-water-content consumer products and more water-intensive caloric intakes. Industrialization includes agricultural systems. So-called high-input agriculture uses copious amounts of fossil fuel energy, fertilizers, and water. By definition, industrialization entails a shift to a higher-throughput economy in order to sustain economic growth. The law of conservation of matter, and the first law (conservation of energy) and second law (increasing entropy) of thermodynamics, dictate that the high-waste characteristics of industrialized economies lead to constraints on the carrying capacity of the water environment. It is not that water ceases to exist when humans use it, but that it ceases to exist in the previous concentrations (quantity) and purity (quality). Industrialization is closely connected with urbanization.

Urbanization. Urbanization refers to the process in which an increasing proportion of an entire population lives in cities and suburbs.When more and more inanimate sources of energy were used to enhance human productivity (industrialization), surpluses increased in both agriculture and industry. Urbanization is well under way in many developing countries as a result of the immigration from rural areas. Poverty and conflict are often the push factors out of rural areas, while the pull of urban areas is the amenities associated with economic development. Today, about 9 percent of the world’s urban population resides in megacities (defined as those with more than 10 million inhabitants).Urbanization is positively correlated with economic growth.

Logically, most of the expected growth in urban areas will be concentrated in developing countries.The 2007 Revision of the UN’s World Urbanization Prospects reports that by 2050, 50 percent of the population of Africa will live in urban areas.That translates to a threefold increase in the urban population of the continent. And this scenario is based on an assumption of declining fertility rates. China is expected to be 70 percent urban by 2050.

While the Tokyo metropolis is by far the most populous urban city, with 35.7 million people, other areas of Asia and Africa are projected to have their share of megacities. Cities such as Mumbai, Delhi, Dhaka (Bangladesh), Calcutta, Shanghai, Karachi (Pakistan), Manila, Beijing, and Jakarta in Asia and Lagos (Nigeria), and Kinshasa (Democratic Republic of the Congo) in Africa are included in the largest urban agglomerations by 2020 according to the UN Report. The fastest growing urban areas are similarly distributed with the addition of the Middle East. Beihei, in southern China, is forecast to be the world’s fastest-growing urban area over the period. Cities with average annual growth of more than 4 percent include Ghaziabad (India), Sana’a (Yemen), Surat (India), Kabul (Afghanistan), Bamako (Mali), and Lagos (Nigeria).

There is the argument that economies of scale associated with higher population density enhance the ability to achieve sustainable use of natural resources, including water. That, however, is a very dim light at the end of a very long tunnel. Further, the experience of water utilities strongly refutes the salvation of economies of scale. Dividing a cost over a larger and larger population works only if the cost is relatively fixed. Water scarcity, compliance, and capital spending gaps virtually guarantee that this will not be the case.The infrastructure to accommodate megacities and urbanization is staggering, as previously outlined. And it is important to reiterate that most global water infrastructure spending estimates do not adequately reflect the urbanization in Africa and Latin America.

Globalization. Classical economic theory, despite the principle of comparative advantage, largely underestimated the integration of global economies by focusing on free trade and somewhat dismissing the circulation of capital and movement of labor based on community attachments. It has become glaringly apparent that economic incentives show little nationalistic loyalty, and capital flows know few boundaries. Even labor is globalizing (outsourcing and immigration are manifestations) despite obviously greater barriers than capital. In another example of the chasm between economics and environmentalism, the metaphor “think globally, but act locally” is at a comparative disadvantage to the economic reality of both thinking and acting globally.

Globalization refers to the process of increasing political, economic, and sociocultural integration and interdependence of countries. The benefits of globalization coincide with the principle of comparative advantage; that is, increased economic productivity through the efficient allocation of resources resulting from specialization and greater political stability derived from economic interdependence.

Institutionally, globalization is the development of rules enforced by organizations such as the World Trade Organization (WTO) to increase efficiency in the production and distribution of goods and services. Among other things, ecological degradation is a concern of globalization because of disproportionate incentives among primary (commodity), secondary (processing), and tertiary (facilitating) markets to establish and enforce environmental standards. Globalization has important implications for both water quantity and quality and is a major driver of efficient irrigation techniques, the implementation of advanced treatment technologies, infrastructure design, privatization, and resource management activities. In addition, transboundary water issues require innovative institutional structures to promote sustainable development.

The pivotal role of comparative advantage in the process of globalization helps to illustrate the emergence of virtual water trade. International food trade can be used as a policy mechanism to mitigate water scarcity and reduce environmental impacts. Countries with a relative abundance of water, that is, a water ratio advantage, can grow food and trade it to water-stressed countries.While globalization can certainly have a detrimental impact on water resources, the commensurate spread of “supraterritoriality” can be a powerful driver in transitioning the water industry toward enlightened interregional solutions rather than conflict.

Structural Drivers

Structural drivers may alternatively be referred to as endogenous factors but the intent is the same. These are growth drivers that investors can relate to by drawing upon analogous situations in their investing experience. These factors may be responses to exogenous variables but they emanate from within the industry and can include the rationalization of any structural or operational inefficiencies, consolidation, competition, privatization, convergent or enabling technologies, and so on.

Rationalization. The process of rationalization is both the most productive of business changes and the most nebulous of concepts. Simply stated, the rationalization of an industry, segment, sector, or market is the transformation to a different way of doing business, presumably for the better, and driven by some economic incentive. Perhaps the best way to apply rationalization to the water industry is to look at what is irrational. Is it rational to charge an artificially low price to a critical resource? Is it rational to exclude ecological considerations in the implementation of water resource sustainability? Is it rational to eliminate competition from the provision of water? Is it rational to apply an institutional structure of governance rather than a market-based approach? The water industry is being rationalized from a delivery-based approach to a solution-based system.

Whereas the provision of water has been viewed as the delivery of a product, clean water as a resource will be viewed as an economic good; that is, the economic pressures generated by the internalization of water pollution costs will no longer permit the inefficiencies of bundled services. The “product” will result from specific processes performed on raw water. There are a number of areas within the water industry that are ripe for rationalization. These areas include some of the most promising dynamics for investors and include monitoring and regulatory compliance, decentralized wastewater treatment, water delivery, resource management, distribution channels, commercialization /technology transfer mechanisms, and demand-side management.

The rationalization of the water industry in general, and niche subsectors specifically, will combine a cost containment scenario as seen in health care reform with the teamed technology approach of the bio-and nanotechnology fields that facilitates commercialization. From the rather philosophical construct of rationalization, we will examine two manifestations of the process: consolidation and privatization. Both are structural drivers of the water industry that illustrate the extraordinary investment opportunity that presents itself as water as a public resource is rationalized as water as an economic good.

Consolidation. The global water purification and wastewater treatment business is highly fragmented and consists of a myriad of companies that design, develop, and manufacture equipment, provide products and services, run treatment facilities, and/or engage in a combination of such services and capabilities.The water industry is still coalescing and rationalizing. Industry consolidation will be the trend as customer demands for comprehensive solutions discourage a segmented structure. In short, the industry is ripe for consolidation. The emerging solutions-based approach to water issues seeks to account for the significant differences in the quality of available water supplies and the varying standards of purity required for different applications. Customer demands for comprehensive, cost-effective solutions discourage a segmented industry structure. Scale efficiencies, technology leveraging, cross-selling opportunities, geographic expansion, and enhanced market concentrations are all necessary in maturing markets.

Historically, the water industry has revolved around regulated utilities that functioned rather autonomously as water providers, aided by engineering consultants and supplied by a highly fragmented network of suppliers. Under this traditional structure, costs are bundled together as a system. But the current focus on the delivery of water as a single finished product has proven inadequate in efficiently dealing with the wide variety of water and wastewater problems. While water utilities will retain a pivotal position in the industry, their role will focus on the delivery of a standardized product. The fragmented water and wastewater treatment industry will consolidate to address specific customer needs.

Segments within the water industry that are suitable for consolidation activities include instrumentation, compliance monitoring, membrane manufacturers, pumps, and remediation, to name just a few. And certain commodity-based activities are candidates for horizontal consolidation, such as carbon, bulk treatment chemicals, and ion exchange resins. The water industry is just beginning to fully explore the benefits and opportunities of consolidation.

From an investment point of view, investors should look for companies whose profits are not growing solely from acquisitions but are experiencing earnings growth through successful integration—that is, cutting costs, adding customers, or achieving greater productivity. Consolidation as an economic concept must be distinguished from consolidation as a purely transactional opportunity. While both scenarios have had success in the water industry, the key in the long run is operating integration (strong internal growth) and an above-average return on invested capital, not simply top-line growth in revenue and expanding price-earnings multiples.

Scale economies make it unprofitable for too many firms to coexist in the market. Strategic barriers are more a function of global economics than intentional efforts by incumbents to deter newcomers. For example, the extreme crowding in a number of segments (i.e., chemicals, membranes, carbon, etc.) makes it uneconomic for new competition amid pricing weakness. All this leads to an imperfect oligopoly in that, although there are fewer sellers, they produce similar products.

Privatization. By definition, as promulgated in Executive Order 12803 on Infrastructure Privatization, privatization is defined as the disposition or transfer of an infrastructure asset, such as by sale or by long-term lease, from a state or local government to a private party. Infrastructure assets include water supply and wastewater treatment facilities. Privatization elevates each municipality to the same position of power as a manufacturer who can decide whether to make or buy a product component. Early recognition of this trend focused on the privatization of operation and maintenance services at water and wastewater treatment plants. But the ramifications of water as an economic good go well beyond alternative operating approaches.

An Experiment in Competition. No matter how it is expressed, the cost of providing clean water is staggering, and the financial ability of water suppliers to comply with stringent regulations has created mounting public concerns over water quality. One much-touted solution, privatization, is simply an expression of the stronger underlying economic forces at work in the water industry—the economic transition from public governance to market forces.

That the cost of providing clean water will rapidly increase is not the issue. The challenge to the water industry is to determine how to minimize economic shifts due to increased water prices. As the costs of supplying water increase, municipalities will be induced to look for efficiencies through contracting for the financing and management of certain components of the waterworks system. It is true that private industry is well positioned to unbundle the traditional services involved in the provision of water by applying financial capabilities with inherent economic incentives to concentrate on cost efficiencies. Private companies can design, finance, construct, and operate water and wastewater facilities on a long-term basis, thereby partially privatizing the activity. Potential benefits include reduced pressure on local governmental or municipal debt capacity, shorter design and construction periods, and reduced operational and compliance burdens for governmental units.

While governments are responsible for deciding which services are to be paid for by the public, they do not have to produce and deliver the service. And more and more municipalities are relying on private companies to provide water services in a cost-effective manner. These “contract” providers have an economic incentive to contain the costs associated with the construction and maintenance of water facilities. In this context, the institution of privatization can provide the signals and incentives that correctly reflect the scarcity factor in water resources, allowing users to respond to changing supplies and demands.

The Reality of Privatization. The proliferation of privatizing-type transactions, such as operation and maintenance contracts and turnkey services, is pervasive. Ranging from numerous small contracts with local municipalities to large contracts, these “public-private partnerships” were viewed as a convenient financing option for utilities.Yet, after all of the theory, promise, and hype, privatization has more or less failed to achieve its status as a panacea of the water supply business.The main reason was timing, but its day will come because the economics are just too compelling. There was a confluence of factors that proved to be a drag on the widespread acceptance of privatized activities.

First, although privatization is fondly looked upon as an innovative solution engineered by municipalities to alleviate financial burdens, it was often, in reality, a bailout for water systems unable to cope with stringent compliance requirements. Second, the single greatest opposition to privatizing transactions was the perception of a loss of local control. (Indeed, what is the essence of an investor-owned water utility other than a fully privatized municipal waterworks?) And finally, the utility acquisition rampage by the global mega-utilities and private equity groups proved to be based on a failed notion of economies of scale at a time when privatization clients were very skeptical and ultrademanding.

It is little wonder that concurrent with the privatization phenomenon is the trend toward consolidation in the water supply business. What will remain, however, despite privatization and consolidation, are numerous hopelessly burdened small utilities. These systems will not survive; there is virtually no incentive for the private sector to pursue projects that could be investment risks, especially given the cautious environment. Although not consequential from a supply point of view, the structural implications for the water industry are enormous. This structural alteration provides the opportunity that may finally link the micro alternatives (decentralization) to water treatment with the macro notion of water provision (centralization).

Despite some regulatory and tax hurdles that are not compatible with full privatization, the trend is nonetheless in place. And while the water supply business has focused on the financial and operational benefits of privatization, the industry has largely ignored the fundamental reasons for changing the way in which clean water is provided. That degree of change is not privatization; it is the economic transition at work in the water industry.

The privatization trend continues its evolution in the water industry. Refuse collection and solid waste, formerly municipal functions, have largely been privatized, and municipalities see how this approach might also apply to water and wastewater. But the concept is evolving and taking on new meaning for utilities. With the advent of deregulation in the gas and electric utility industries, consumers see competition developing in a market previously characterized by regulated monopolies. As an outgrowth, water utility customers want to see competition and increased efficiency from water and wastewater utilities. The key question now being asked is how water suppliers can incorporate the private sector into their operations. This fundamental shift in focus presents a substantial investment opportunity for the water industry.

The operational response to this notion of privatization was a rather simplistic duopoly referred to as public-private partnerships. But what started out as public-private arrangements is now evolving into competition, outsourcing, and core competencies—buzzwords unheard of in the water business until now. Facing increasing costs, funding limitations, and government pressure, water utilities are not only seeking ways to finance water system improvements and reduce costs but are rethinking the way they do business.

It is true that private industry is well positioned to unbundle the traditional services involved in the provision of water by applying financial capabilities with inherent economic incentives to concentrate on cost efficiencies. The private sector can take the kind of long-term view that municipal governments once took. Private firms need a return on investment for longer than just 5 or 10 years to gain support of the capital markets.This different dynamic supports a change toward heavier involvement by the private sector but not necessarily ownership, as long as municipalities continue to enjoy special tax advantages in this area.

Competition. Now, rather than privatization, the conflict is couched in terms of competition. Public water utilities see themselves as competing with private contract and outsourcing firms. Utilities are looking at the possibility of forgoing privatization in favor of optimizing or restructuring their internal operations.This highlights the new strategies being implemented to create more cost-effective public utilities, a trend with important investment ramifications. For example, a trend in North America is toward unattended, automated facilities, a practice that the private-sector competition has already employed. And outsourcing is not limited to the water and wastewater treatment function.Automation of the meter reading function is a prime area for outsourcing, and one with enormous potential as information technologies are applied.

While the evolution of privatization in the water industry has tended to polarize the public and private sectors, it is likely that in the long run more municipalities will actively seek privatization but in a manner more consistent with competition and the economic concept of outsourcing. As the process evolves, the incentives of both are likely to converge, based on the premise that the ultimate objective is the cost-effective compliance with water quality regulations while maintaining the public trust. In the interest of investing in water, we therefore begin with the regulatory providers of water—that is, water utilities.