An Unlikely Foot Soldier in the Climate Change Battle
Combating climate change, in many ways, is compelling humanity to develop environmentally friendly and sustainable ways to meet our needs. We have made slow but steady progress in lowering greenhouse gas emissions, but a lot more needs to be done. In the future, existing and yet unknown technologies could work in tandem to wean humanity from environmentally hazardous substances and processes.
When considering investments in sustainable technology businesses, we evaluate cost of ownership relative to existing “dirty” technologies, potential for mass adoption and how economic benefits are shared between consumers and shareholders. In some cases, economic and environmental benefits accrue in large measure to customers and society with scant value creation for shareholders. In other cases, most of the economic value gets allocated away from equipment makers to other areas within the value chain.
One equipment maker that checks all the right boxes
from our perspective is Energy Recovery, a manufacturer
of pressure exchanger (PX) devices used to increase
energy efficiency in industrial processes involving high-pressure
pumping of fluids or gases. Today, the company’s
PX devices hold a 90%+ market share in large scale
desalination projects, and the device is more efficient and
lasts longer than its competition, which results in a lower
total cost of ownership in our view. These devices operate
at near physical limits of efficiency (98%), are cost effective
(typically under 2% of overall project budgets), exhibit
almost no wear and tear after more than a decade of
use, are mission critical and have a long-established solid
reputation in the industry, so there is little or no incentive for
customers to purchase a competitor’s product. Today, the
company’s gross margin is almost 70% and partly reflects
some pricing power created by its attractive product
In addition, the company’s pressure devices are on
the cusp of playing an important, if not dominant, role
in substituting hydrofluorocarbons (HFCs) with carbon
dioxide (CO2) as refrigerants, which could reduce the
global warming potential (GWP) of heating, ventilation, air
conditioning and refrigeration (HVACR) equipment by 2,000
to 4,000 times. We believe that even if the company faces
stronger competition in the future, especially in the HVACR
market, the end markets are large enough to comfortably
accommodate multiple participants.
To understand Energy Recovery’s earnings potential over the
long run, it’s essential to understand desalination, HVACR
and industrial wastewater end-markets.
According to the United Nations, nearly half the global
population (around 4 billion people) live in areas that
face water scarcity at least one month per year, a number
that could increase to 4.8–5.7 billion people by 2050.
Moreover, about 96% of liquid freshwater globally consists
of groundwater, but withdrawals for drinking water,
agriculture and increased aridity due to climate change
have significantly distressed 13 of the 37 largest aquifers
globally.1 NASA further estimates that it takes 10,000–20,000
years to fully recharge groundwater, so we believe it should
be considered a non-renewable resource for practical purposes. Regions don’t need to face perennial water
shortages to deploy desalination-based solutions, in our
view, and we might be approaching an inflection point in
Seawater desalination using reverse osmosis (SWRO) is the
most cost-effective way to produce freshwater, a process
where Energy Recovery occupies a dominant position.
About 50% of the global population lives within 60 miles
of saltwater, and SWRO could play an important role in
addressing freshwater shortages long term.
Today, we believe the desalination market is still subscale,
and yet costs are competitive with alternative solutions
such as rainwater harvesting and river linking projects.
As desalination increases, fresh water’s wallet share
should remain manageable over the long term in our
estimate. We believe conservation alone will not be nearly
sufficient to sustain the world’s freshwater reserves, so
we anticipate robust revenue growth rates for Energy
Recovery’s desalination products for the foreseeable future,
albeit punctuated by inherent variability in desalination
Refrigeration and HVAC
Refrigeration and HVAC equipment mainly use HFCs as
refrigerants and have a GWP of 2,000–4,000 depending
upon the type of refrigerant used and its application.
CO2 has a GWP of 1 but requires much higher operating
pressures to be effective in cooling applications which
requires greater energy consumption, especially when
ambient temperature is high. As such, use of CO2 has been
restricted to regions that have low ambient temperatures
and where regulations are more stringent i.e., Northern
Europe. About 125 countries have accepted an agreement
to phase out use of HFCs over the coming years, and the
Environmental Protection Agency in the US has developed
rules to phase out the production and import of HFCs.
Replacing HFCs with low GWP refrigerants is imperative
for the environment and is backed by regulation, but
broad adoption of CO2 as a refrigerant has proven to be
uneconomic thus far, especially in warmer climates.
Energy Recovery’s PX device — both in theory and lab tests
— significantly lowers energy consumption when using CO2
as a refrigerant and produces even greater efficiency under
higher ambient temperatures. An independent scientific
research paper sponsored by the US Department of Energy
examining Energy Recovery’s PX technology suggests that
the company might have the highest efficiency solution
on the market. We believe the company has a significant
opportunity to gain a meaningful market share and possibly
dominate the CO2 based refrigeration and HVACR markets
over the long term.
From a revenue perspective, HVACR end-markets are a
positive for Energy Recovery — they carry several billion
dollars of annual revenue potential for PX devices, and
the market is mature, with 70%–80% of demand coming
from replacement needs, which could improve the mix of
Wastewater treatment and drinkable water are inherently
linked. It’s essential that we do not pollute our shrinking
freshwater supplies, and to that end, we expect a concerted
effort by governments and corporations to enforce treatment
of industrial wastewater discharges. For example, batteries
used in electric vehicles are very water intensive and could
be a growth area for Energy Recovery in treating water
discharge. The company’s PX devices significantly lower
energy costs when contaminated water is treated through
reverse osmosis membranes, meaning industrial wastewater
treatment could be a significant growth market for Energy
There can often be a conflict between what is good for
investors and what is good for the planet. We believe that
Energy Recovery will excel in both areas, and we were
pleased to be able to add the stock to our portfolios at an
As of 30 June 2022, Diamond Hill owned shares of Energy Recovery, Inc.
The views expressed are those of the author as of July 2022 and are subject to change without notice. These opinions are not intended to be a forecast of future events, a guarantee of future results or investment advice. Investing involves risk, including the possible loss of principal. Past performance is
not a guarantee of future results.