Exploring the math behind a typical village water purification system through the lens of an investor
In our first article on drinking water, we spoke about the gravity of the problem in India- 67% of households do not treat their drinking water and 638 million people (almost half the population) still defecate in the open. In the next post, we discussed how there is no dearth of technologies in India to treat drinking water but that the problem lies in execution. Most public-private partnerships projects in water have failed to deliver clean water to the masses. Our third article talks about some of the key private operators and revenue models in the drinking water sector and discusses some innovative approaches by companies. While private sector companies have been experimenting with various business models, they are yet to crack the code.
Key questions we are seeking to answer
This article focuses on understanding the economics behind a typical village water purification system. The aim is to find out why investors have shied away from investing in drinking water companies despite water being a basic necessity with potential for widespread demand and social impact. We are seeking to answer two basic questions: What are people at the bottom of the economic pyramid willing to pay for clean water? And, can water companies create a profitable and sustainable business model by selling water at these price points?
The fine balance between profitability and affordability
A study conducted by Hystra throws some light on our first question– How much are the masses willing to pay for clean water? Hystra’s report focuses on business models providing safe water solutions across the globe, including Naandi, Sarvajal, E Health Points and Unilever Pureit in India. According to the report, BoP (base of the economic pyramid) households are able and willing to pay on an average INR. 3 for a 20 liter jerry can of pure water to be picked up from a central community system. Interestingly, if water was delivered to their doorstep, households were willing to pay up to INR. 5. This research was conducted three years ago and taking inflation into account, today most community water systems sell water for INR. 4 – 6 for 20 liters (without delivery). At this selling price can a private water company sustain and be profitable? Perhaps not- our math on a typical village water purification system suggests that water companies struggle to cover costs at these price points. The biggest challenge faced by water companies catering to rural communities is to recover capital and operating costs while maintaining affordability for the masses.
To answer our second question on profitability and sustainability of water businesses, we put together a spreadsheet model that lays out the math behind a typical community water purification system in rural India. Our model is based on a set of assumptions listed below:
- System is owned and operated by a private water company
- System is based on Reverse Osmosis (RO) technology and costs INR. 10 lakhs (~$17k)
- Water is sold at INR. 5 (for 20 liters)
- Model assumes that the water company bears the cost of electricity, however land is provided by the local government, free of cost
- 70% of the capital expenditure is funded by debt @15% for 6 years
- Project has no terminal value as it is handed over to the local government or village committee after 10 years.
The aim of this exercise is to get a bird’s eye view of the potential returns from a village water system. We understand that, in reality, numbers may vary depending on the location, technology, quality of water source, cost of labor etc.
Our initial math, based on the above assumptions, indicates that a water kiosk has the potential to earn a return of 20-25% p.a. over a period of ten years, insufficient to attract a financial investor. Seed funds and venture capital funds undertake huge risks when they invest in startups and require to be compensated accordingly. They look for projects with potential to earn upwards of 30% returns annually and have stayed away from investing in potable water companies because of the limited potential for returns after taking into account the risks.
Our analysis and conversations with experts in the water industry suggest that there are a few key drivers of the business model.
- Selling price. Price is undoubtedly the biggest driver of profitability. Our model currently assumes a constant selling price through the ten year period as it is challenging to raise prices when catering to the masses. Companies need to ensure that water is affordable else people will shift back to the next available alternative- traditional purification methods like boiling or no purification at all. Our math suggests that a mere 50 paise increase in selling price has the potential to improve project returns by approximately 7% p.a., so if a company can raise prices after 3-5 years, project returns can be boosted significantly.
- Electricity cost. We understand that very often electricity is subsidized or provided free of cost by the local government. However, our model is built to be self-sustaining and assumes that the water company bears the cost of electricity. Every INR. 1 increase in electricity costs, impacts potential returns by 1% p.a.
- Capital expenditure. The initial capex cost is another important variable. A reduction in the average capex cost of an RO system of INR. 10 lakhs by 50% can increase returns by a whooping 20% p.a.
What we’d like to see in a water company
Unitus Seed Fund is looking to invest in a water purification business model with potential to be profitable and scalable. Our next article on this series talks about the kind of water companies we’d like to invest in. We are in process of scouting the private drinking water business landscape to find one or more of such startups.
More on safe drinking water in India:
Quenching the thirst of India’s masses
So many water treatment techniques, so few that truly work
Creative business solutions to India’s drinking water problems