ubs research rush for resources

8/8/2019 UBS Research Rush for Resources

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UBS research focus

September 2010

The rush for resourceschallenges emerging markets

Growing resource scarcities need watching

Competition is intensifying

Water scarcity a major risk

Energy efficiency still the best alternative fuel

Cheap labor will get more expensive

Investment opportunities for more sustainable growth


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Contents

Editorial 3

Highlights 4

Chapter 1

Resource scarcities in emerging markets 6

Chapter 2

Competing for scarce resources 10

Chapter 3

Water scarcity a major risk for some emerging markets 14

Chapter 4

Energy efficiency is still the best alternative fuel 19

Chapter 5

Human resource scarcities cheap labor will get more expensive 23

Chapter 6

Resource scarcities create investment opportunities 28

Bibliography 31

Publication details 32

Selection of UBS WMR publications 34

This report has been prepared by UBS AG.Please see important disclaimer at the end of the document.

Past performance is no indication of future performance. The market prices provided are closing prices on the respective

principal exchange. This applies to all performance charts and tables in this publication.


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Editorial

UBS research focus September 2010 3

Andreas Hfert

Jenny Weinkopf

Dear reader,

The global economic crisis and the accompanying fall in commodity prices

could lead people to believe that resource scarcities are not as pressing as theywere in 2008, when prices soared. The reality, however, is very different. Surg-

ing demand from the emerging markets makes this issue timelier than ever. In

the past, many of these countries were too poor to pay for essential resources,

including clean water and energy. But with newly acquired wealth flowing

from their robust economies, they are now competing for resources with

advanced economies.

The 2.5 billion consumers in China and India still spend less than a thirtieth per

person of what their peers in the developed world spend per year. But with

their increasing economic weight, the emerging markets will undoubtedly

account for a larger share of global resource demand in the future. This will

have profound and various consequences. For one thing, the environmental

consequences of much higher consumption of resources have to be addressed.

For another, the risk of conflict both domestic and international over the

distribution of ever scarcer and more expensive resources may become acute in

future. Along with the economic challenge of paying for resources, their

potential to stir up conflicts also needs to be recognized.

Whether robust economic growth can be sustained as resources grow scarcer is

an urgent question. The pessimistic view suggests that resources ultimately

cannot keep up with population and income growth, resulting in widespread

poverty and misery. The optimists are convinced that market incentives will spur

new approaches and solutions.

The fight for energy, water and human skills will lead to higher prices, but also

to innovation and new opportunities. As we show in this UBS research focus,governments are reacting to scarcity with new regulations, protectionism,

higher taxes, new price structures, and infrastructure upgrades. These strate-

gies might improve the situation, but in some instances they may also lead to

misallocations. At the same time, incentives for entrepreneurs to develop new

products in fields such as water and clean energy may open up a more sustain-

able growth path.

Where there are problems, there are also always solutions. This situation may

offer some rewarding opportunities to investors. Highlighting some of theseopportunities comprises an important part of this report. We hope you will find

it a valuable discussion about some of todays most compelling economic

themes.

Editor in chief

Global Head

Wealth Management Research

Dirk FaltinHead Thematic Research


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4 The rush for resources challenges emerging markets

Highlights

Despite the recent economic slowdown, scarcities of

resources are again on the rise. Emerging markets are in

the spotlight for one, they account for increasing shares

of global output, population, and wealth. Their strong

pick-up in resource demand is one of the main drivers of

rising resource prices. Indeed, they are on their way to

becoming the biggest resource consumers. On top of this,

the adverse environmental and social effects of how

resources are used often hit emerging markets harder than

developed economies. How will they be able to sustain

economic growth in face of looming resource scarcities,

while addressing their severe environmental and social

issues? Finding answers to this question will be critical,

with profound implications for economic growth, individ-

ual companies, and for investors.

A stronger state hand in resource competition

The emerging markets increasingly depend on imported

resources to meet surging domestic demand. As competi-

tion for ever scarcer resources mounts, securing affordable

access is high on their agendas. In recent years, govern-

ments have steadily exerted more influence in resource sec-

tors, invoking domestic stakeholders interests and the

strategic importance of resources. A resource-exporting

country can often impose its will on trading partners and

resource companies. Recent examples of government inter-

vention in resource markets include restrictions on agricul-

tural exports, higher taxes on resource profits, and even

the nationalization of resource assets. Importing countries

have responded to uncertainties about their access to

resources with diplomatic efforts, and also with an increas-

ing number of direct investments in resource-producing

countries.

Tackling water scarcity to sustain growth

Water scarcity is particularly pressing in many emerging

markets, as demand growth is often highest where the

water supply is already low. Many emerging markets suffer

infrastructure deficits both for water distribution and

wastewater treatment, with wastage and pollution as fur-

ther consequences. Water shortages can weigh heavily on

an economy. In China, for instance, the direct costs of

water scarcity and water pollution are estimated to be a

hefty 2.3% of GDP. In addition, social and health issues

arise as large parts of the population often lack access to

clean drinking water and sanitation. To tackle these chal-

lenges, large investments and improved pricing mecha-

nisms for water are needed. Some emerging markets have

already applied innovative strategies to meet their water-

related challenges.

Moderating soaring energy demand with efficiency

and renewables

According to US government estimates, global energy

consumption may grow by almost 50% between 2007

and 2035, despite the economic slowdown following the

recent financial crisis. Most strong demand growth is

occurring in the emerging markets, which already account

for a large part of global energy demand in absolute

terms. In 2009, China surpassed the US as the worlds

largest energy consumer. Due to its significant role in con-

sumption and demand growth, we highlight China as the

emerging market set to play a particularly important role

in promoting greater energy efficiency. We see promising

initiatives in China in areas including electricity generation,

buildings, transportation, and industrial processes. In

renewables, China is already the largest exporter of pho-

tovoltaic components. The government is now also taking

more decisive steps to promote the use of wind and solar

power domestically.

The rush for resources challenges emerging

markets

Non-OECD excl. China & India

China & India

OECD

Emerging market energy demand to rise strongly

Note: 20102030 = Forecast (F)Source: US Energy Information Administration, UBS WMR

Primary energy consumption per year 19802030, reference case (in quadrillion btu)

0

100

200

300

400

500

600

700

1980 1990 2000 2010F 2020F 2030F

Brazil China India Africa

0

5

10

15

20

25

30

35

2006

2005

2004

2007

2008

2009

Investments in clean energy rise in emerging markets

Source: UNEP, SEFI, Bloomberg New Energy Finance, UBS WMR

New investments (in billion USD)


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5UBS research focus September 2010

Highlights

Potential human resource scarcities?

One thing that emerging markets are often assumed to

have in abundance is a large labor force, available at low

wages to produce cheap goods. But the recent wage

increases in China seem to indicate a potentially scarcer

labor pool. For now, these developments may merely

reflect cyclical swings in labor demand rather than a struc-

tural shortage. In the longer term, however, in China as

well as in other emerging markets, slower population

growth and fewer rural workers moving to cities may make

cheap labor more expensive. In future, todays emerging

markets will need more skilled labor, while cheap labor

jobs will increasingly move to todays frontier markets.

Vast opportunities for solution providers

Resource scarcities pose formidable economic, social, and

environmental challenges for economies globally and the

emerging markets in particular. Failing to speedily take the

steps needed to tackle these issues will merely worsen their

impact. We think that the risks for economic growth and

for individual companies from rising resource scarcities

should be closely monitored. Along with risks, we also see

vast opportunities for solutions to impending resource

scarcities, including the wider implementation of existing

technologies in emerging markets, innovations in products

and processes to make resource use more efficient, and the

development of affordable substitutes. We think that these

approaches offer interesting opportunities for companies

and investors.


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Chapter 1

With looming scarcities in natural and human resources,

emerging markets face daunting economic, environmental,

political, and social challenges. Finding ways to use

resources more efficiently and to continue growing eco-

nomically in a more sustainable manner are formidable

tasks opening up both risks and opportunities.

Resource scarcities in the aftermath of the financial

crisis

Resources of all kinds are growing scarcer. The impact of

this reality economically, socially and geopolitically will

be a major topic on the international agenda for years to

come. The spikes in prices for energy and agricultural com-

modities in 2008 were driven by several factors: rising

demand for agricultural products used in biofuels, large

financial investments, tight supply capacities for many

commodities, and extreme weather conditions. But sharply

rising resource demand from emerging markets also played

a large role in driving up prices.

Again in 2010, emerging markets strong growth has been

one of the main drivers of rising resource demand, acceler-

ating the growing resource scarcities. As emerging markets

produce more, they grow richer and both sides of that

equation need more resources. Not least, emerging mar-

kets also tend to be more strongly affected by the adverse

environmental and social impacts of the use of resources

than developed economies, for instance in terms of pollu-

tion and food shortages.

In 2008, the social turmoil and political activism in

response to the commodities price boom in some countries

raised concerns that a global resource crisis was imminent.

In the wake of the financial crisis, the situation looked

rather less urgent as commodities prices corrected signifi-

cantly (see Fig. 1.1). While this temporarily eased the

immediate pressure on countries to deal with mounting

resource scarcities, weaker prices in the shorter term have

also discouraged necessary investments on both the

demand and the supply sides. Areas that lag behind in

some countries and regions include investments in produc-

tion capacity, enhanced energy efficiency to moderate

demand increases, and greater use of clean technologies.

Demand pressures continue, especially from the

emerging markets

In the aftermath of the most severe financial crisis in

decades, global demand for commodities experienced a

temporary decline. Developed countries overall economic

growth may remain suppressed for some time, thus easing

overall demand for resources to some extent. In contrast,

the emerging markets have weathered the financial crisis

remarkably well. Especially in Asia, economic growth has

revived sharply, and a stronger focus on domestic markets

has made some of these economies less dependent on

exports to developed economies.

Chapter 1

Resource scarcitiesin emerging markets

0

100

200

300

400

500

600

700

800

2000 2002 2004 2006 2008 2010

Fig. 1.1: Commodities prices are climbing again

Note: Development of respective UBS Bloomberg CMCI price indices.Source: Bloomberg, UBS WMR

Price development of groups of commodities (rebased, 2000=100)

Energy

Agriculture

Commodities (broad index)

Industrial metals

Livestock

Precious metals

0

20

40

60

80

100

1980 1985 1990 1995 2000 2005 2010F 2015F

Developing Asia

C. & E. Europe & Central AsiaAdvanced economies Latin America

Middle East & North Africa

Sub-Saharan Africa

Fig. 1.2: Emerging markets increasing economicweight

Note: 20102015 = Forecast (F)Source: International Monetary Fund, UBS WMR

Share of global economic output, 19802015 (in %)


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Resource scarcities in emerging markets

The shift in economic power to the emerging markets rep-

resents a dramatic development for the global economy, in

our view. Emerging markets account for a growing share

of global economic output (see Fig. 1.2), population, andwealth. While many of developed economies have entered

a period of subdued economic growth, emerging market

demand for a number of resources, including energy and

materials, continues to grow vigorously, exacerbating

resource scarcities in those markets.

Energy demand is a useful example of the overall upward

trend in resource demand. While global energy use fell in

2008 and 2009 due to the global economic slowdown, the

US Energy Information Administration foresees global pri-

mary energy demand growing by almost 50% between

2007 and 2035. Non-OECD countries and especially China

and India, the largest emerging markets, account for most

of this increase (see Figs. 1.3 and 1.4).

while global supply constraints remain

At the same time, supply constraints stubbornly persist. In

our August 2008 UBS research focus, Mind over matter,

we argued that capacity constraints hindered supply

increases (e.g., in the energy and oil sectors) and that

investments in supply infrastructure as well as in technolo-

gies for more efficient energy use would be critical. During

the recent crisis, however, capital expenditure on innova-

tions in technology and development projects were

delayed or cancelled, especially in the developed markets.

Thus, many of the underlying infrastructure and technol-

ogy deficiencies remain in place. In the energy sector,

according to the International Energy Agency, reduced

investment in supply capacity could have far-reaching

effects for economies and the environment. A potential

surge in prices would impose a profound constraint on

global economic growth.

A new emerging market growth paradigm

With some resources already quite scarce, and some even

facing potential depletion, we believe that energy and

resource consumption cannot grow as fast as manyeconomies are growing, at least not for much longer. Eco-

nomic, environmental, and social pressures are rising as

resource scarcity becomes more apparent.

We think that increased competition for resources will

challenge current production and consumption patterns.

The environmental damage from the overuse of resources

and the resulting pollution already threaten the economic

viability of many regions. Meanwhile, greenhouse gas

emissions, which are rising rapidly in the emerging markets

(see Fig. 1.5), will only intensify concerns about climate

change. Social challenges loom, too, as more people in

emerging markets demand higher living standards. Resent-

ment over what is perceived as the unjust distribution of

wealth both from resource profits and from growth

may awaken latent conflicts. The angry public protests and

demonstrations in several emerging markets that accompa-

nied the sharp food price increases in 2008 illustrated how

incendiary these issues can be.

Resource scarcity is more pressing for some countries than

for others. Even acknowledging the gravity of the issue dif-

fers as well. Obviously, emerging markets want to keep up

their high levels of economic growth. From their point of

view, they are just now reaching the stage of development

that todays developed economies enjoyed several decades

ago. At the same time, postponing the necessary bold

steps that would make growth more sustainable threatens

to make economic, social, and environmental challenges

even more severe. The most populous emerging markets,

China and India, which account for the largest increase in

resource demand in emerging markets, have important

roles to play.

Non-OECD excl. China & India

China & India

OECD

Fig. 1.3: Emerging market energy demand to risestrongly

Note: 20102030 = Forecast (F)Source: US Energy Information Administration, UBS WMR

Primary energy consumption per year 19802030, reference case (in quadrillion btu)

0

100

200

300

400

500

600

700

1980 1990 2000 2010F 2020F 2030F0 25 50 75 100 125

Middle East

Latin America

E. Europe & Eurasia

Africa

Asia

OECD

Fig. 1.4: Asias growing resource hunger

Source: US Energy Information Administration, UBS WMR

Incremental primary energy demand 20072030, reference case (in quadrillion btu)

Coal

Gas

Oil

Nuclear

Hydro & renewables


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Chapter 1

The scope of this publication

Despite the global financial crisis, the long-term drivers of

resource scarcity remain in place (see Box 1.1). Emerging

markets in particular face several important challenges thatthey will need to address in the next few years. In this UBS

research focus, we discuss several trends related to the

growing scarcity of resources in emerging markets, includ-

ing the increase in competition for scarce resources and

government interference in response to it (Chapter 2), the

adverse impacts of water scarcity and the notable ways in

which some emerging markets are tackling them

(Chapter 3), the progress in promoting energy efficiency

and renewables that China, the worlds largest energy con-

sumer, is making (Chapter 4), and looming scarcities in

skilled and unskilled labor that several emerging markets

may face (Chapter 5).

We think the increasing scarcity and eventual depletion of

some resources have profound implications for growth and

investments (Chapter 6). We do not discuss the price out-

look for any commodities in this report. The severity and

potential impact of resource scarcities is increasingly recog-

nized by investors. In a June 2010 UBS Investment Bank

survey of central bank reserve managers, respondents

highlighted resource competition as one of the three chief

risks to the global economy over the next 25 years, alongwith demographics and climate change. Resource scarcities

may hamper potential growth in economies that depend

on resource imports and may also affect the value of single

stocks, as companies face impediments in securing suffi-

cient supplies of some resources and a tighter regulatory

environment.

Investments in emerging markets may be particularly

affected, for instance, due to the fact that their economies

often feature resource-intensive industries like mining

and utilities. However, there are not only risks. In our view,

resource scarcities should also create interesting opportuni-

ties for companies that can provide solutions to the eco-

nomic, environmental, and social issues arising from

resource scarcities. These opportunities will likely take

some time to materialize, as will returns for investors.

A long-term view is advised for investors in this area.

100 50 0 50 100 150 200 250 300 350

Middle East

Latin America

E. Europe & Eurasia

Asia

Africa

OECD

Fig. 1.5: More greenhouse gas emissions in Asia

Source: US Energy Information Administration, UBS WMR

Average annual increase in CO2 emissions, reference scenario (in million metric tons)

19902005

20062030


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Resource scarcities in emerging markets

Box 1.1: Understanding resource scarcity

Different resources have different characteristics (seeFig. 1.6). Various factors, often interconnected, influence

their scarcity. In principle, scarcity of a resource arises if

demand for it outgrows supply and no substitute is avail-

able. Most resources do not face absolute scarcity, mean-

ing the total amount of the resource is insufficient to meet

demand. Rather, they face relative scarcity, meaning that

supply may be high, but its distribution does not meet

demand. Several aspects of relative scarcity are worth high-

lighting, and some will be taken up in later chapters.

I A resource may be scarce in one country or region, but

abundant elsewhere. Reserves are often concentrated in

a few countries. In principle, it should be possible to dis-

tribute resources via trade, but trade barriers imposed

by governments can impede distribution. Sometimes

distributing a resource is hindered by inadequate infra-

structure, and some resources are difficult to transport

due to their physical characteristics.

I A resource may be abundant now, but become scarce in

the future (or vice versa). Even if the reserves of a

resource may be limited, the resource may still not be

scarce if there is little demand for it. This situation couldchange in the future if demand increases. For instance,

certain rare metals were little used in the past, but are

now in demand in the production of electronic applica-

tions. By contrast, a currently scarce resource may be

substituted, so that its demand and scarcity decline.

Such changes can be permanent or only temporary. For

instance, the scarcity of a resource may be severe during

economic boom times, but ease during a downturn as

demand fades.

I Prices should, but not always do, reflect the scarcity of a

resource. Usually, as resources become scarcer, they

should become more expensive. High prices in turn

should moderate demand (depending on how respon-

sive demand is to price changes), while at the same time

encouraging investments in increased supply, or in the

development of demand-reducing technologies and sub-

stitutes. The extent to which prices change in response

to increasing scarcities is often distorted. One reason

may be that market prices do not fully reflect all costs

and benefits of a resources use. This in turn may lead to

overuse and waste, and ultimately make scarcities more

severe. This applies to the use of fossil fuels, which has

high environmental costs including air pollution and

greenhouse gas emissions that are not fully reflected in

their price. Another reason for distortions in prices can

be government interventions, for instance, via subsidies

or price controls. While there may be legitimate reasons

for such price interventions, like making a basic resource

affordable for low-income segments of the population,

they may actually make resource scarcities more severe.

Without price increases, demand may continue to rise,

while investments in supply capacities, substitutions, or

more efficient technologies are not made.

Fig. 1.6: Supply and renewability vary for resourcesCharacteristics and examples of resources

Characteristics Examples

Exhaustible, non-renewable Oil, gas, coal

Exhaustible, non-renewable, but recyclable Minerals, metals

Renewable, but use depletes reserves Soil, groundwater

Renewable, use does not deplete reserves Solar energy, wind

Source: Mildner, UBS WMR


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Chapter 2

Chapter 2

Competing for scarce resources

Surging demand in fast-growing emerging markets

increases their dependence on imported resources. Rising

global competition for ever scarcer resources may lead to

increased political interference, with important implications

for economic growth and for companies.

More resource demand, more resource trade

Maintaining high levels of economic growth requires

secure and affordable access to key resources and materials

for economies and companies. As industrialization and

consumption continue to advance in the emerging mar-

kets, the demand for resources keeps on growing, and so

does resources share of international trade. According to

the World Trade Organization, the combined share of

fuels, agricultural and mining products in total world trade

rose from 23% to 31% between 2000 and 2008. Trade in

ores and minerals posted the highest annual growth rates

during that period. The trading growth in resources far

exceeded the growth of total trade during that period (see

Fig. 2.1). China and India, the two biggest emerging mar-

kets, already account for large and growing shares of

global demand for a number of resources (see Fig. 2.2).

This trend is unlikely to disappear anytime soon.

These enlarged trade volumes indicate that many

economies cannot satisfy their resource demands internally

and thus increasingly depend on world markets. Several

countries that previously were self-sufficient in a given

resource, and were even resource exporters, have now

turned into net importers due to their rapidly increasing

resource use. China, for instance, was self-sufficient in

crude oil until 1995, but thereafter became a net importer

(see Fig. 2.3). Indeed, since 2004, it is the worlds third-

largest oil importer. Other countries that once relied on

their own oil reserves are now also net importers, including

Egypt, Indonesia, and the United Kingdom, according to

data from the US Energy Information Administration. Simi-

lar trends can be found for other resources. In sum, the

dependence on external supplies of resources has

increased in recent years.

Political interference

Under normal market conditions, if supply is constrained

and demand rises, prices would simply rise in response. To

some extent, this is what happens, as the price increases in

2007 and 2008 for agricultural commodities confirm.

Today as well, many resource prices are on the rise again.

However, prices are not always simply a function of market

forces. Governments can exert a great deal of influence on

both the supply and the demand of a given resource, on its

price, and on the extent to which substitutes are being

used. For instance, in many countries, subsidies for water,

electricity, or fossil fuels make the consumption of these

resources cheaper than they normally would be. This may

lead to waste and overuse, which in turn can make scarci-

ties even more severe.

Governments have many reasons to intervene in resource

markets, not least among them the interests of domestic

stakeholders. Resource sectors are often considered areas

Fig. 2.1: Total trade doubled, fuels and mining tradequadrupled

Source: World Trade Organization, UBS WMR

Annual value of world exports, 20002008 (in trillion USD)

Manufactures

Fuels and mining products

Agricultural products

0

2

4

6

8

10

12

14

16

2000 2001 2002 2003 2004 2005 2006 2007 2008

Fig. 2.2: Rapid increase in resource demand fromChina and India

Source: UBS Investment Bank, UBS WMR

Share of global demand for selected materials, 2007 and 2009 (in %)

India

China

010203040506070

2007

2009

2007

2009

2007

2009

2007

2009

2007

2009

2007

2009

2007

2009

2007

2009

2007

2009

2007

2009

Alumi-

num

Copper Gold Iron ore

(sea-borne)

Nickel Oil Palladium Platinum Steel Zinc


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of strategic national importance. A government may con-

sider it desirable to restrict exports of resources to prevent

their depletion and ensure their own domestic supply.

In addition, it is often argued that market prices do notfully reflect the environmental costs and the real benefits

of certain resources. Thus, some governments tax the use

of certain fuels more heavily than others, or subsidize

renewable energy, or indirectly make the use of some

resources less attractive by introducing restrictive environ-

mental regulations.

Government policy moves need to be closely

watched

Increasing state intervention reflecting concerns about

growing resource scarcity could well influence resource

competition even more in future. Developments in

resource policy should be prominent on investors radar

screens. Policy moves may drive both market prices and the

allocation of specific resources to different economies and

companies, which has important implications for their

growth and business models, and thus for investors.

We examine three exemplary policy approaches the first

two by resource exporters, the third by importing countries

that have been taken in recent years, particularly in the

aftermath of the financial crisis of 2008. These strategies

typically aim at securing or maintaining affordable access

to valuable resources. As resource scarcity grows more

acute in future, which we expect, we think measures such

as these could be more widely adopted.

1. Export restrictions creeping protectionism?

The surge in food prices in 2007 and 2008 exemplifies

how soaring resource prices can prompt protectionism.

Under the framework of the World Trade Organization,

temporary restrictions on agricultural exports are allowed

to counter food shortages. Several food-exporting coun-

tries, including Argentina and Ukraine, invoked this argu-

ment to impose export quotas or tariffs on various agricul-

tural products when prices reached their peak, in 2008. In

this way, they increased the domestic supply of these agri-

cultural products, thereby soothing discontent among their

populations about the rising food prices. At the same time,

export restrictions by food-producing countries made theprice surges in food-importing countries even more acute.

Similar arguments and measures have been used for other

resources. For example, China produces 97% of the

worlds rare earth metals and for several years has applied

export quotas to these metals to secure its domestic sup-

plies. Many mineral resources are found in only a few

countries, making them candidates for these kinds of

restrictions (see Fig. 2.4). Other resources are not particu-

larly scarce but are nonetheless essential to an industry and

thus fiercely pursued. India, for example, reportedly consid-

ered imposing export restrictions on iron ore recently, and

briefly put constraints on cotton exports in April 2010. Chi-

nese textile producers, among the largest buyers of Indian

cotton, were hurt by Indias restrictions. They had to meet

their needs with more expensive cotton from other coun-

tries. Clearly, such restrictions put upward pressure on

prices, making it more expensive for countries and compa-

nies to obtain the resources they need.

While they may temporarily ease domestic price pressures,

such export restrictions clearly can have profound implica-

tions for world market prices. According to the World

Trade Organization, supply constraints combined with

export restrictions have the potential to drive up prices sig-

nificantly, to the detriment of importing countries or spe-

cific companies that need the restricted resource. There are

other, less direct consequences of export restrictions. For

instance, keeping domestic price increases down can dis-

courage investment in more production capacity, which

may make supply constraints even more severe in future.

According to a study by the International Food and Agri-

cultural Trade Policy Council, export restrictions have clear

negative effects on growth and employment in the coun-

tries that adopt such measures.

While trade restrictions are usually rescinded after some

time, they are troubling to economies that rely on resource

imports. For them, potential export restrictions of producer

countries add to the uncertainty associated with high

reliance on imported resources, and could ultimately weigh

on economic growth. As seen in Fig. 2.4, the supply of

some resources is often concentrated in a small number of

countries, some of which are politically unstable or have

under-developed legal and market frameworks. Some

emerging markets, most prominently China, have therefore

sought to obtain more secure access to resources, for

example, by investing directly in mines in resource-rich

countries. We discuss this phenomenon under approach 3,

below. Such direct investments abroad, however, may also

face opposition and government intervention by the hostgovernments of these investments, as will be discussed in

the following section.

Fig. 2.3: China hasbecome a net crude oil importer

Note: Exports shown as negative numbers.Source: US Energy Information Administration, UBS WMR

Chinas imports, exports, and net imports o f crude oil (in thousand barrels per day)

Exports

Imports Net imports

750

0

750

1,500

2,250

3,000

3,750

1987 1990 1993 1996 1999 2002 2005 2008


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Chapter 2

2. Taxes and nationalization: Skimming off more of

the cream

The motivations for governments to intervene in resource

markets through taxation, regulation, and nationalizationare similar to those for restricting exports. Resource sectors

are seen to have strategic importance, so the allocation of

extraction rights is often controversial. Issues include pri-

vate or state control, national or foreign ownership, and

the split of revenues. If resource extraction is in the hands

of large, often multinational, firms, governments are

increasingly demanding a larger share of the royalties.

The proposed Resource Super Profit Tax in Australia is a

recent example of potential tax increases that were

intended to secure a larger share of mining profits for the

government. While the proposed tax was dismissed after a

change in government leadership, the issue was probably

closely monitored by other large resource-exporting coun-

tries. We think that if one country managed to impose

higher taxes on resource companies, others would likely

follow suit. Further, with increasing commodities prices, we

would expect rising profits from resources to spur domestic

demands to nationalize these profits (if they incur to pri-

vate investors) and to keep them in the country (if foreign

companies extract the resources).

Partial or full nationalization may be imposed through out-

right expropriation, but indirect expropriation through

the imposition of additional costs occurs even more often.

For instance, the renegotiation of contracts putting addi-

tional requirements on companies after the initial invest-

ment phase, or regulatory changes that affect the business

are examples of such additional costs, which could have

made an investment unattractive if they had been known

from the beginning. Past examples include Russia, which

mandated foreign oil and gas companies to partner with

local firms for large-scale development projects, and

Venezuelas increased state control over several sectors,

including oil and gas, steel, and cement. Changes in legal

frameworks may reflect new environmental legislation that

makes a resource sector or business venture less attractive.

The potential changes to rules on offshore oil drilling in theUnited States come to mind in this regard.

Consequently, both higher resource taxes and greater state

ownership can squeeze margins at resource-producing

companies. This in turn could discourage investments in

development projects, which then could constrain

increases in supply, and ultimately lead to higher market

prices for the resource. Both producing companies and

those using the resource as an input would face higher

costs.

3. Securing resources abroad

Securing access to scarce resources has become an impor-

tant foreign policy objective for many governments. This

goal has led to the cultivation of stable diplomatic relations

with important resource providers and the negotiation of

bilateral trade and investment agreements. In addition,

direct investments in foreign resource assets and takeovers

of firms in resource-producing countries aim to overcome

the uncertainties associated with having to rely on imports.

While private companies are active in such foreign invest-

ments, state-owned companies often enjoy the support of

their governments and get favorable access to credit to

finance foreign transactions. The forms of these invest-

ments vary. They may be direct investments negotiated

with governments, joint ventures with local firms, or partial

or complete takeovers of firms active in resource extrac-

tion. We think this last form of direct investment could pro-

duce significant activity in mergers and acquisitions in

resource sectors in the coming years.

China, for instance, has made substantial efforts to secure

its access to resources abroad. The volume of Chinese

often state-owned firms acquisitions of companies in

Fig. 2.4: Resources are often in the hands of a few countriesTop producers and main uses of selected metallic minerals

Top producing countries

Metal 1. 2. 3. Main uses

Chromium South Africa 45% Kazakhstan 17% India 15% Jet engines, gas turbines, magnetic tape

Cobalt Congo 45% Canada 12% Zambia 11% Hard metals, batteries

Copper Chile 36% United States 8% Peru 8% Piping, electrical applications

Gallium China 83% Japan 17% Semiconductors

Molybdenum United States 29% China 28% Chile 21% Missile and aircraft parts

Nickel Russia 17% Canada 16% Indonesia 13% Steel, batteries, alloys

Rare earths China 97% India 2% Brazil 1% Hybrid vehicles, plasma screens, handhelds

Silver Peru 17% Mexico 14% China 12% Jewelry, electrical contacts and conductors

Tantalum Australia 53% Brazil 22% Rwanda 9% Electroniccomponents

Vanadium South Africa 38% China 33% Russia 27% High speed tool steels

Source: Organization for Economic Cooperation and Development, UBS WMR


13/36



resource sectors has surged (see Fig. 2.5). It has also report-

edly made large direct investments, especially throughout

Africa, to obtain usage rights for agricultural land or min-

ing operations, in turn financing the construction of minesand transport infrastructure. South Korea, where land is

relatively scarce and expensive, is also actively acquiring

foreign resource-producing assets. In late 2008, after the

surge in food prices had eased but while concerns about

ensuring an affordable food supply still persisted, one of

the big Korean industrial conglomerates bid for large tracts

of farmland in Madagascar to grow corn and palm oil for

the Korean market. The European Commission has pub-

lished a series of studies on critical raw materials that

economies in the European Union depend on, identifying

the geopolitical arena as the chief risk to its resource sup-

plies. Among other actions, the reports recommended

reaching trade and investment agreements with important

resource suppliers. Several European companies have

reportedly already leased land in Africa to grow crops for

biofuel production.

These are just a few examples of a broader trend. Increas-

ingly, the foreign policies and international investments of

resource-hungry countries aim at securing access to scarce

resources. While host countries may benefit from the

development of those resources, improved infrastructure,

and technology transfers, such investments often face stiff

political resistance. For instance, the Korean conglomer-

ates leases were dismissed by the Madagascan govern-

ment after protests by local farmers contributed to a politi-

cal crisis. Several countries investments abroad have been

greeted with allegations of neo-imperialism and the depri-

vation of poor countries scarce resources. Thus, foreign

investments to secure access to resources may endanger

their license to operate in host countries. Foreign opera-

tors may face restrictions and higher taxes, or even nation-

alization of their assets, as we discussed under approach 2,

above.

Conclusion: Implications for economies, sectors, and

companies

Entire economies and many individual companies are

dependent on importing resources from other countries.The amount of resources that reaches world markets, and

the prices producers can charge, are increasingly influ-

enced by government policies. To reap more benefit from

their resource wealth, governments of resource exporters

are considering policy actions ranging from tax increases to

outright protectionism and nationalization. Such policy

actions have profound implications for world resource mar-

kets, prices, as well as for the competitive environment of

companies. While this trend of greater government inter-

vention in resource markets may hold risks for some, it also

offers opportunities for investors.

Resource-importing economies competing for scarce

resources to fuel their economic growth and foster rising

incomes and living standards may have to find alternative

ways to secure affordable access to the resources they

need. Foreign policy initiatives and investment may prove

successful tools for some, but they also risk potential con-

flicts. Resource-exporting economies, especially those with

strong exports to fast-growing emerging markets, are set

to benefit from rising demand, in our view.

Multinational resource companies may face increasing

challenges as their operations in some countries will come

under greater scrutiny. Their success will likely depend on

how well they can manage the relationships with the gov-

ernment and other stakeholders in host countries to assure

their license to operate at reasonable costs. For instance,

in the past, some emerging markets did not have the

financial and technological capabilities to develop their

resources themselves. This is likely to change in future. We

expect emerging market resource companies to play more

prominent market roles. At the same time, we think there

are still ample opportunities for multinational companies in

the resource sectors, both as co-investors or as suppliers of

the necessary technology and capital goods needed to

exploit those resources.

Companies that depend on an imported resource face

challenges both in terms of access and affordability. Com-

panies with direct access to the necessary resources appear

to be better positioned, but they still face risks in host

countries from tax increases and nationalization. Compa-

nies that are able to adapt their business models to

resource availability and prices by using those resources

more efficiently, or substituting for them, will likely have an

edge over competitors.

Finally, companies with innovative solutions for using

resources more efficiently, and those who find ways to sub-

stitute for scarce resources should see opportunitiesabound. We think these kinds of innovations will be crucial

to ease resource competition and contain the upward pres-

sure on resource demand and prices.

Fig. 2.5: On a buying spree?

Note: Only includes acquisitions outside of China with disclosed deal value. Does not include greenfield foreigndirect investments.Source: Mergermarket, UBS WMR

Chinese companies energy, materials, and mining acquisitions, 20022010 ytd

Australia Middle East

Latin AmericaAsia Western Europe

CEE, CIS & RussiaAfrica North America

Number of transactions (rhs)

InmillionUSDbyregion

0

5,000

10,000

15,000

20,000

25,000

30,000

2002 2003 2004 2005 2006 2007 2008 2009 2010

0

5

10

15

20

25

30


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Chapter 3

Structural problems in the management of water resources

have led to broad under-pricing, which in turn has pro-

moted waste, pollution, and overuse. Water scarcity poses

considerable economic, environmental, and social chal-

lenges especially for the emerging markets.

Growing water scarcity, especially in the emerging

markets

Of all the earths water, the total supply of freshwater avail-

able to support ecosystems and human life amounts to

only 0.01%. While most of the planet is covered by water,

only 2.5% is freshwater, and most of that is frozen (see

Fig. 3.1). These l imited freshwater resources are very

unevenly distributed across countries and regions. More-

over, they are themselves subject to large fluctuations.

Global warming will likely further add to this variability in

freshwater levels, with more land area suffering drought

and flooding.

At the same time, water demand has grown steadily, with

large regional differences (see Fig. 3.2). Emerging markets

are experiencing a surge in their water demand. This is due

to population growth, as well as increasing wealth and

changing diets, combined with ongoing demand concen-

tration through the spread of urbanization. These factors

have led to regional water resource depletion and scarcity

throughout the emerging economies.

Demand growth is often highest where the water supply is

already extremely low. In parts of Asia, Africa, and the Mid-

dle East, many countries have a medium to extreme water

supply risk level, according to Water Security Risk Index

2010. The countries identified as having the highest water

supply risk are Somalia, Mauritania, Sudan, Niger, Iraq,

Uzbekistan, Pakistan, Egypt, Turkmenistan, and Syria. The

OECD estimates that the majority of the population in

emerging markets will live in water-stressed1 areas by

2030. For example, it is expected that China will have to

increase its already stretched supply by 30% by that date

to satisfy its growing demand (see Fig. 3.3). This is

expected to lead to distribution conflicts, tighter environ-

mental standards to protect the water resources, higher

supply and treatment costs, and ultimately higher water

prices in China.

Water scarcity threatens growth

Water scarcity can weigh heavily on a countrys economic

potential. According to World Bank estimates for China,

for instance, the direct impact of water scarcity and water

pollution costs a hefty 2.3 % of GDP, ignoring any addi-

tional environmental costs. In many emerging markets, the

impacts on the three main water user groups agriculture,

industry, and municipal/domestic are immense. We think

Chapter 3

Water scarcity a major risk forsome emerging markets

Freshwater2.50

0.01

0.75

1.74

Fig. 3.1: Estimated global water distribution

Source: Shiklomanov and Rodda (2003), UBS WMR

In %

Groundwater

Glaciers andpermafrost

Lakes and othersurface water

Oceans97.50

120

40

80

0

40

80

Germany

P

oland

Hu

ngary

EU15

Australia

Japan

OECD

M

exico

U

nited

States

G

reece

Korea

Turkey

Czech

Republic

Change in total agriculture water use 199092 to 200204

Change in total water use 199092 to 200204

Fig. 3.2: Changes in water needsdiffer sharplybetween countries

Source: OECD (2008), Environmental Performance of Agriculture in OECD countries since 1990, national sources, UBS WMR

Change in total water use and agricultural water use between 199092 and200204 (in %)

1 UNEP, UNDP and the World Bank label an area water-stressed if theaverage availability is less than 4,700 liters per person per day butmore than 2,700. If the availability is below 2,700 liters per person perday, water is considered scarce. These levels include water for grow-ing food, which consumes the largest share, as well as water for gen-eral sanitation, cooking, bathing, and drinking.


15/36


16/36


Chapter 3

Water industry expected to grow substantially

Globally, the water supply industry is estimated to have an

annual sales volume of between USD 400500 billion, or

an average of about USD 100 per person, according to

Global Water Intelligence. The industry is expected to

grow between 510% annually over the next ten years,

depending on the region and the subsector. Given the

looming scarcity challenges in emerging countries, we

expect growth rates in their water sectors to be well

above average.

Since public funds are unlikely to be sufficient to meet

water investment needs, we think the number of private-

sector cooperation arrangements with government author-

ities (so-called public-private partnerships) will increase

in future. This development should help raise the needed

capital and also improve the management of utilities. After

an initial uptake in public-private partnerships in the early

1990s, mainly in water utilities in Latin America and the

Caribbean (see Fig. 3.5), current trends indicate a shift

towards wastewater treatment projects, especially in East

Asia and Pacific region (see Fig. 3.6). Interestingly, we note

that there seems to be less resistance to private invest-

ments in water treatment than in water provision. In both

cases, however, private investments are still marginal on a

per capita basis, despite some successful examples.

Lessons from successful privatization in the Philippines

The Philippines offers an example of how privatization in

the water sector can contribute to improved provision and

efficiency. By 1997, the water distribution network in

Manila was on the brink of collapse. Reasons abounded:

outdated infrastructure, many unregistered connections,

water availability only during 16 hours per day, leaks result-

ing in loss rates of more than 60%. Then, the water infra-

structure was privatized, with Manila Water and Maynilad

0

5

10

15

20

25

30

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

2008

0

10

20

30

40

50

60

Europe and Central Asia

East Asia and Pacific

Middle East and North Africa

Latin America & Caribbean

Sub-Saharan Africa

South Asia

Fig. 3.5: Less water utility projects with privateparticipation since 2000

Source: World Bank and PPIAF, PPI Database, UBS WMR

Water utility projects with private participation in developing countries,by region, 19912008

Fig. 3.6: More water treatment plants with privateparticipation in Asia

Water treatment plant projects with private participation in developing countries,by region, 19912008

Box 3.1: Water is precious, everyone agrees, but its prices are far too low

In most countries, water infrastructure is operated bynational and local governments. The approaches that

countries take to cost and price structures differ widely. For

example, until 1985, water was free of charge in China.

Currently, most large cities in China charge in the range of

USD 0.190.61 per cubic meter for residential water sup-

plied and treated. This covers only a fraction of the long-

run costs, which the World Bank estimates at about USD

1.07 per cubic meter. Recovery rates would be even lower

if the environmental costs were included. At current prices,

water and sewage services are clearly highly subsidized.

Such subsidies usually aim at ensuring affordability, which

is a critical issue for low-income households in emerging

countries, especially if water has been free of charge his-

torically. This is why moves towards more market-based

water pricing tend to be considered as harming the poor.Experience, however, contradicts this view. In most cases,

private investment and reasonable water pricing can actu-

ally expand the poors access to water. At the same time,

this approach can drive the development and installation

of improved technology to achieve efficiency benefits. Mar-

ket pricing can improve cost recovery for water provision,

and can be accompanied by measures to protect the poor

by providing preferential access. Also, the maximum pro-

portion of household income to be spent on water and

sanitation can be limited to 35%, which is often deemed

acceptable for water pricing. Despite some advances, such

efforts are still in their infancy. We think this is likely to

change as more countries face greater water scarcity and

pollution problems.


17/36


Water scarcity a major risk for some emerging markets

Water becoming agents and contractors of the govern-

ment-owned Metropolitan Waterworks and Sewerage Sys-

tem for Metro Manilas East and West Zones, respectively.

With this new arrangement, water services have improvedremarkably (see Fig. 3.7). While the average price per vol-

ume increased, a progressive tariff structure provides

affordable supply for low income groups (see Fig. 3.8).

We see several factors as key for this successful privatization:

I Clear regulatory framework and robust rate-setting

mechanism that reduced regulatory risk

I Guaranteed real rate of return for investors

I Expertise of international co-investors

I Long concession period (over 20 years)

I Quantifiable objectives on metering, coverage, effi-

ciency, leakage rates, etc.

We emphasize that these are very long-term investments.

Given the significant infrastructure investments, free cash

flows cannot be expected immediately, which limits the

scope for dividends in the years following a privatization.

This means that investors need to be patient. They must

also be watchful: if economic developments turns unfavor-

able or substantial tariff increases are needed, political or

regulatory risks might flare up.

Conclusions and investment implications

Many emerging regions, especially in Asia and Africa, face

major water scarcity challenges that threaten their growth

potential. Just meeting basic needs requires massive

efforts. The growing demands of competing user groups

have to be balanced with protecting the environment.

Especially in water basins where agricultural demand is

likely to grow substantially, competition for scarce water

resources represents a major potential risk.

In some emerging markets, the private sector has proven

that it can play an important role in providing funding and

business expertise in the water infrastructure, which is still

predominantly state-run. Political frameworks and waterpricing need to become more supportive and transparent

to encourage more private-sector involvement, which has

proven successful, for instance, in the Philippines.

Investment strategies focused on water have become

increasingly popular in recent years. While there are certain

political risks for long-term investments, for instance regu-

latory changes such as government interference in water

pricing, we expect the water sector to grow faster than

overall markets in the coming years. In particular, providers

of water infrastructure, technology, and services that offer

sustainable solutions to efficient water use are likely to

experience solid growth.

Fig. 3.8: Progressive tariffscan support low-incomegroups and foster efficient use

Source: Manila Water, UBS WMR

Current pricing schemes at Manila Water (in pesos per month)

0

200

400

600

800

1,000

0 10 20 30 40 50Consumption per connection (cubic meter per month)

Business group

Residential

Fig. 3.7: What privatization can achieve

Track record of Manila Water since privatization

1996 2009 Units

Population served 3.1 6.1 million

Water availability 16 24 hrs/day

Water coverage 58 99 % of population

Water losses 63 15.8 % of supply

Staff 9.8 1.4 per 1,000 connections

Average costs 4.02 811 Peso per m3 (inflation-adjusted)

Source: Manila Water, UBS WMR


18/36


Chapter 3

Chinas water challenge

Interview with Jian Xie, lead

author of the World Bank report,

Addressing Chinas water

scarcity

Interviewer: Christoph Hugi

Mr. Xie, the per capita availability of water in China is

only one-fourth of the world average. How dramatic

is the water situation and what are the three major

water problems in China?

Xie: The situation is very serious, especially in northern

China, for example in the Hai River Basin, where Beijing

and Tianjin are located. The major water problems we

face include little available water per capita to start with,

widespread pollution, which of course make water even

scarcer, ineffective management of water demand, and a

weak institutional framework for integrated water

resource management. Initially addressing the last issue

will be crucial for any sustainable solution.

You identify the institutional framework as a particu-

larly weak area. What are the main issues?

Xie: The Ministry of Water Resources is mainly in charge

of water resource exploitation dams, hydropower as

well as irrigation, and flood control. What is missing, in

my view, is a single authority that addresses acute water

resource problems in an integrated way. This authority

would improve and coordinate all relevant aspects of

water management in a comprehensive and integrated

manner. These areas would include development, restora-

tion, transfer, consumption, treatment, protection, etc.

You recommend water markets and a water pricing

based on marginal opportunity costs, with a two-tier

tariff structure to mitigate the impact on low income

groups. Can you explain what this means?

Xie: There is no doubt that a low water tariff, subsidized

by the government, benefits neither the poor nor the

environment. To address its water scarcity, China has to

use economic instruments such as pricing to improve

water use efficiency and to better manage water demand.

However, higher water tariffs would burden households,

especially those in the low-income brackets. Policy makers

have to take this into account and introduce safeguards to

protect the poor. A well-implemented two-tier system

should serve Chinese households well. The first tier would

provide for the basic water needs of a low-income house-

hold, but not overly subsidize higher income groups. The

second tier would generate enough revenue to cover the

operations and development costs of water companies.

What has happened in the last two years in the

water sector in China? Has there been any noticeable

impact from the global financial crisis?

Xie: To address the nations serious water pollution prob-

lems, the various levels of government have invested

heavily in wastewater treatment facilities in recent years.

The central government has set up a target to increase

the wastewater treatment rate in its Five Year Plan, and

local governments have speeded up their investment in

wastewater treatment facilities in towns, cities, and coun-

ties, depending on their fiscal situations. One concern is

how these facilities can be operated in a financially sus-

tainable way in the longer term, which puts upward pres-

sure on water tariffs and wastewater treatment charges.

Also, the global financial crisis seems to have lowered

pressure on inflation, which some government agencies

have used as an opportunity to raise water tariffs.

Who or what do you think will be the major driver in

the change towards more sustainable water resource

management in China?

Xie: So far, the central governments structure for water

resource management is fragmented, and it is hard to

know when the institutional framework will be changed

in favor of a more integrated water resource manage-

ment approach. However, local governments could be a

driver of reform and set an example. They face acute

water scarcity and pollution problems, and some of them

have taken the lead to introduce a more integrated water

resource management system.

Do you see any opportunities for private businesses

and investors in the water sector in China?

Xie: China will continue to have a huge demand for

investments and technologies in water development,

wastewater treatment, and water saving technologies.

There is much potential for private companies and

investors. But to realize this potential, water governance

has to be improved and the role of governments has to

be better defined to ensure a more open, transparent,

rule-based, and accountable management system.


19/36


Energy efficiency is still the best alternative fuel

The supply of fossil fuels is limited and their use has worri-

some environmental consequences. Recognizing these

problems, some emerging market governments are pro-

moting greater energy efficiency and renewable energy as

alternatives.

Energy demand is growing again

Even though global energy consumption fell in 2009, the

rising trend is still firmly in place. Global energy demand is

set to grow by almost 50% between 2007 and 2035,

according to projections of the US Energy Information

Administration. Fossil fuels will continue to provide nearly

80% of our energy for the next couple of decades at least.

Most demand growth for energy is occurring in the emerg-

ing markets, particularly in China and India. Emerging mar-

kets already account for a big part of global energy

demand in absolute terms. In 2009, China surpassed the

United States as the worlds largest consumer of energy

(see Fig. 4.1). Within a few decades, it went from being a

largely self-sufficient energy consumer to becoming one of

the largest importers and a major participant in global

energy markets. The backbone of Chinas energy system is

coal, supplying roughly two-thirds of its primary energy

demands.

A crucial question today is, how can China at least partially

decouple its energy consumption growth from its eco-

nomic growth? This is essential not only because of the

effects of climate change, which are clearly felt in China.

Local pollution, which is mainly caused by coal-powered

manufacturing and electricity production, adversely

impacts the environment as well as human health. Pollu-

tion also has serious economic implications and burdens

growth. According to World Bank estimates, the annual

costs of air and water pollution in China amount to about

USD 100bn, or 5.8% of GDP.

To tackle these environmental, social, and economic issues,

cleaner energy has become a priority for the Chinese gov-

ernment, and substantial investments in this area will be

made over the next decade. The government has also set

national energy efficiency goals: By 2020, it targets cutting

carbon dioxide emissions per unit of GDP by 4045% from

2005s levels. It intends to achieve this reduction by

improving energy efficiency generally and by replacing out-

dated production capacity. And the share of non-fossil

fuels in Chinas primary energy consumption is targeted to

rise from 8% today to 15% by 2020.

The examples of energy efficiency and renewables that we

discuss mainly refer to China, given its large and rapidly

growing share of global energy use.

Chapter 4

Energy efficiency is still the bestalternative fuel

Fig. 4.1: China overtook US in energy consumptionin 2009

Note: Shaded area represents forecastSource: BP Statistical Review of World Energy June 2010, IEA, UBS WMR

Annual total primary energy consumption (in million tons of oil equivalent)

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

1975 1985 1995 2005 2015 2025US

India

China

Fig. 4.2: Progress in energy intensity slows in China

Source: BP Statistical Review of World Energy June 2010, IMF, UBS WMR

Total energy required per unit of GDP (in kg of oil equivalent per USD, PPP)

Germany

India

China

0.0

0.4

0.8

1.2

1.6

2.0

1980 1985 1990 1995 2000 2005 2010


20/36


Chapter 4

Efficiency: often the cheapest way to reduce energy

demand

In our 2008 UBS research focus, Mind over matter, we

called energy efficiency the best alternative fuel. Thiscontinues to be true. Improving efficiency is a very cost-

efficient way to save energy. Reducing the energy used for

the same level of service in lighting or heating, for exam-

ple brings obvious benefits, and the potential gains from

improved efficiency are truly vast. Government policies

increasingly focus on removing obstacles to improving

energy efficiency. This is evident in many regions of the

world, as more countries introduce efficiency standards

and subsidize the development and use of efficient tech-

nologies.

Chinas energy efficiency still trails that of most developed

and developing countries (see Fig. 4.2). Its rapid economic

growth in recent decades has been matched with soaring

energy demand. While energy intensity the amount of

energy used per unit of GDP fell for several years, it has

flattened since 2001. Despite Chinas efforts to reduce its

energy intensity, energy conservation is not encouraged

through market-based pricing. Fossil fuels above all, coal

and electricity are in fact heavily subsidized, leading to

their overuse.

We see major potential globally, in emerging markets

generally, and in China specifically to improve energy effi-

ciency in areas like power generation and transmission,

buildings, transportation and industrial processes. We dis-

cuss these in more detail, below.

Coal-fired power plants still waste a lot of energy

By 2030, the International Energy Agency projects global

electricity demand to grow by 70%, which is faster than it

expects overall energy demand to grow. Power generation

is often inefficient, with large amounts of energy simply

wasted or lost. Efficiency gains in this area can help to

meet the energy requirements of growing electrification, at

the same time reducing the need to build additional power

capacity.

Coal is expected to remain the predominant fuel for elec-

tricity generation, but it is rarely used efficiently. More effi-

cient coal-burning technology is available but most coal-

fired power plants do not use it. In China, pollution reduc-

tion has been an important reason for closing down older,

inefficient coal-fired power plants and replacing them with

technologically more advanced installations. As a result of

these replacements, the average efficiency of Chinas

plants has climbed to around 35%, slightly ahead of the

United States. As Fig. 4.3 shows, the best technologies

could achieve significantly higher efficiency rates, so there

is ample potential for further improvement in this area.

In addition to its generation, the transmission and distribu-

tion of electricity are often grossly inefficient. Losses are

typically at 68% in developed countries, but are much

higher in developing countries. Modernizing electricity

grids is therefore a priority and this effort received a sub-

stantial part of the recent fiscal stimulus program in China.

Improved transmission efficiency should make electricity

grids more intelligent, which means using technologies

such as smart metering or high-voltage direct current lines.

Buildings much potential but little action

Since buildings have relatively long life spans, todays con-

struction decisions will influence the worlds energy con-

sumption for decades to come. Buildings consume vast

amounts of energy and there are many cost-effective ways

to improve their efficiency. However, in emerging markets,

where there is so much construction activity, potential

energy efficiency gains are not being adequately exploited,

in our view.

0

200

400

600

800

1,000

1,200

1,400

25 30 35 40 45 50 55 60

Efficiency (%)

Average US

Average China

Average EU-25

Status of technology 2007

Advanced 700Csteam powerplant (2020)

Fig. 4.3: Coal power vast potential for efficiencyimprovements

Source: Eurelectric, Alstom, WRI, UBS WMR

Specific CO2

emissions (in grams per kWh)

Fig. 4.4: Demand for bigger homes also grows in China

Note: Shaded area represents forecastSource: OECD, IEA, UBS WMR

Constant increase in residential floor area per capita (in m 2 per capita)

Rural

Urban

0

10

20

30

40

50

1990 1995 2000 2005 2010 2015 2020 2025 2030


21/36


Energy efficiency is still the best alternative fuel

The rapid growth of per-capita living space in Chinas cities

(see Fig. 4.4) makes improved energy efficiency standards

for buildings only more urgent. The International Energy

Agency estimates that urban residential living space inChina increased by 50% from 2000 to 2005, and projec-

tions indicate still greater living space demands ahead. Any

real progress on energy efficiency depends on a strong

commitment to enforcement. As compliance even with

existing building energy codes is low, it is essential to

strengthen the enforcement of efficiency standards as well

as improving incentives.

More sustainable transportation

The rapid increase in the number of cars and buses in

emerging markets (see Fig. 4.5) not only poses a global

threat due to surging CO2 emissions; it also burdens these

countries with crippling urban congestion and damaging

levels of local pollution.

In China, to reduce pollution in the cities, the government is

actively promoting electrification in road traffic. Along with

granting generous subsidies and installing a recharging

infrastructure for electric cars in several cities, China is

building up its own electric car production capacity. Admit-

tedly, electrified transportation is not in itself environmen-

tally friendly, since the power it uses is often generated with

coal. Therefore, we think politicians will have to address therisks of higher pollution caused by this trend. In the long

term, an increasing share of non-fossil power and better

coal combustion technologies should offer solutions to this

issue. Improving the rail infrastructure is also a main feature

of Chinas fiscal stimulus program.

Industrial processes offer much potential

For energy-intensive industries for example, the produc-

tion of steel, cement, pulp and paper, and industrial gases

lower operating costs are driving the pursuit of energy

efficiency. However, energy conservation has not been a

priority; there are still several countries that heavily subsi-

dize fossil fuels, which leads to their overuse, rather than

their conservation.

The potential for more efficient industrial processes is par-

ticularly vast in China. Key Chinese industries cement, for

instance are still using inefficient technologies. Given the

sharp increase in Chinas cement production in recent

Fig. 4.5: Car sales emerging marketsshifting gears

Note: Emerging 16 - Argentina, Brazil, China, Czech Republic, India, Indonesia, Korea, Malaysia, Mexico, Poland,Russia, South Africa, Taiwan, Thailand, Turkey, VenezuelaSource: UBS Investment Bank, UBS WMR

Monthly motor vehicles sold (in million units)

US, EU-15, Japan

Emerging 16

China

0.0

1.0

0.5

2.0

1.5

3.0

2.5

3.54.0

2003 2004 2005 2006 2007 2008 2009

Brazil China India Africa

0

5

10

15

20

25

30

35

2006

2005

2004

2007

2008

2009

Fig. 4.6: Investments in clean energy rise in emergingmarkets

Source: UNEP, SEFI, Bloomberg New Energy Finance, UBS WMR

New investments (in billion USD)

Fig. 4.7: Surging growth of renewables in emerging marketsRenewable power top countries (by rank)

Additional capacity, 2009 1. 2. 3. 4. 5.

New capacity investments Germany China US Italy Spain

Wind power added China US Spain Germany India

Solar PV added (grid connected) Germany Italy Japan US Czech Republic

Solar hot water/heat added China Germany Turkey Brazil India

Existing capacity, end-2009 1. 2. 3. 4. 5.

Renewables power capacity (including all hydro) China US Germany Spain India

Wind power US China Germany Spain IndiaBiomass power US Brazil Germany China Sweden

Solar PV (grid-connected) Germany Spain Japan US Italy

Solar hot water/heat China Turkey Germany Japan Greece

Source: REN21, Renewables 2010, Global Status Report, UBS WMR


22/36


Chapter 4

years, which now accounts for nearly half of the worlds

total cement production, energy efficiency improvements

here can make a big difference. The same is true for the

steel industry in China. Improving and replacing outdatedprocesses offer enormous scope for energy efficiency

gains.

China eyes the renewables market

Renewable energies are not yet cost-competitive and

therefore still depend on public subsidies. Despite high

annual growth rates, they still play only a minor role in

overall energy use. However, technical advances and

economies of scale should soon make renewables more

competitive versus fossil fuels. Several emerging market

governments have expressed a growing commitment to

the production and use of renewable energy sources.

Renewables are appealing because of their low carbon

emissions and also because they improve the security of a

countrys energy supply. As a result, some emerging mar-

kets have become important market participants in renew-

ables, both as suppliers of technologies and as consumers

of renewable energy.

In recent years, China has established a more favorable reg-

ulatory framework to exploit its large solar and wind

resources. In 2009, it was the largest supplier of renewable

power capacity in the world. It is also now the world leader

in clean energy investments, spending almost USD 35bn

and surpassing the United States in this area (see Figs. 4.6

and 4.7). Adding 13.8 GW of wind power capacity in 2009,

China doubled its capacity in a year, taking over second

place in total capacity after the United States. We expect

that wind power will continue to receive strong govern-

ment support due to its economic and environmental

attractiveness and scalability. We look for the Chinese gov-

ernment to soon raise its target for total wind power capac-

ity from 30 GW to 100150 GW by 2020 (see Fig. 4.8).

With significant cost advantages over European peers in

the photovoltaic market, Chinese solar module producers

are increasingly dominating the global market. Driven by

strong demand in Europe, Chinese manufacturers mainlyproduce for export. Chinas own domestic solar capacity,

however, is a paltry 0.3 GW. To support the countrys

renewable energy goals, China is now promoting domestic

growth in solar energy use via new policies and subsidies.

Conclusions: Vast opportunities for energy-efficient

solutions

We expect significant advances in energy efficiency

and renewables over the next couple of years. Concerns

about energy scarcity and security, higher energy prices,

and the environmental impact of fossil fuel use have

prompted many governments in emerging markets to set

more ambitious policy objectives for cleaner energies and

technologies.

With ample investment, energy production should

become more sustainable and energy consumption should

be at least partially decoupled from economic growth.

This should translate into interesting opportunities for

companies developing, producing, and using renewable

and energy-efficient technologies. Investors have become

more aware of the challenges facing renewables, as an

oversupply in wind and solar market lingers. We think

there are more attractive opportunities in the area of

energy efficiency.

Thermal Hydro Wind Nuclear Solar

0

100

200

300

400

500

600

700

800

2020 current target

2010 target

2009

2020 potential revision

Fig. 4.8: Chinas targets for electricity capacity fosterrenewables

Source: NDRC, CEIC, CLSA, UBS WMR

Capacity growth mainly in non-thermal capacity expected (total capacityin Gigawatt)


23/36


Human resource scarcities cheap labor will get more expensive

To be sure, there is still plenty of cheap labor in emerging

markets for now. However, with shifting demographics

and growing wealth, this cheap labor wil l become more

expensive over time. In turn, low-paying jobs will increas-

ingly move to frontier markets.

Labor pool not quite exhausted but getting scarcer

The emerging markets are not quite running out of labor.

Rather, with economic growth taking off, labor, much like

other resources, is becoming scarcer. While cyclical labor

shortages are the result of fluctuations, such as high

demand for agricultural workers during the harvest season,

they are usually resolved in the short term.

Structural labor shortages, on the other hand, occur when

employers are unable to hire at the going rate for an

extended period of time. A number of factors, such as emi-

gration, regulated wages, strong unions, an ageing popu-

lation or one with low growth, as well as delays in the

adjustment of labor supply, can cause structural labor

shortages. Higher wages, unmatched by productivity

increases, are among the consequences of such a labor

shortfall. A structural labor shortage weakens a countrys

competitiveness and can drag on economic growth. While

difficult to measure (see Box 5.1), we think it is worthwhile

to consider which countries could face cyclical or structural

labor shortages in future.

Still plenty of cheap labor for now

Recent labor disputes and wage increases in China raised

concerns that the era of cheap labor which has sup-

ported the export competitiveness of many emerging mar-

kets in labor-intensive goods may be coming to an end.

Several observers view the surge of strikes in China as a

sign of workers newfound bargaining power. The link to

higher costs for exporting companies is quickly made, with

the hasty conclusion that we are seeing the beginning of

the end of Chinas dominance as an exporter of cheaply

produced goods. A cooler assessment of the actual data

suggests these incidents are hardly representative, but

rather anecdotal.

In fact, labor markets for the less educated, in other words,

cheaper, workers are still most liquid in most emerging

markets. This is indicated by their relatively higher unem-

ployment rates (see Fig. 5.1) and is particularly true for typ-

ical cheap-labor countries like China. The main reason, as

shown by Fig. 5.2, is the substantial rural reserves these

emerging markets enjoy. This refers to the rural population

that may, one day in the future, move to urban centers for

employment. Across emerging markets, Asian countries

still have the largest rural reserves.

Chapter 5

Human resource scarcities cheaplabor will get more expensive

40

20

3035

25

151050

Peru

Venezuela

Mexico

C

olombia

Chile

Brazil

A

rgentina

China

V

ietnam*

Ph

ilippines

Malaysia

Indonesia

India

S.

Africa

Russia

Poland

Hungary

Egypt*

Cz

echRep.

Turkey

Fig. 5.1: Skilled labor markets much tighter thanunskilled

* No breakdown of unemployment was available.Source: World Bank, UBS WMR

Unemployment rates for different education levels in 2008 (in %)

Asia Latin America EMEA

Primary Secondary Tertiary Overall1.51.00.50.00.5

R

uralpopulation(%

oftotalpopulation)

75

50

25

100

HungaryPoland

Average inemerging markets

Average inemerging markets

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