The selfish green

Never get emotional about an investment. That is the golden rule for any institution or individual approaching an investment decision. Yet there is an investment area where both logic and emotions have recently come rushing to the fore: climate change initiatives

Climate change has, in the past couple of years, received stronger and stronger attention by policy makers and consumers. Green lobbies aim to create an emotional link to carbon reduction and energy self-sufficiency. Governments encourage rebalancing of energy consumption, too – for example, the UK government has launched an online CO₂ calculator so people can work out their carbon footprint and develop a personalised action plan to cut their carbon emissions.

Solar panels, windmills and rooftop insulation have been promoted as the ultimate household gadgets while corporates are investing in a wide number of green initiatives. And it is not just a matter of image. Being involved in the climate change discussions is increasingly seen as crucial by companies in various sectors because they will all, in some way, be affected by it. Their motto is: if you are not at the table, you are on the menu.

Government support and widespread public awareness have created phenomenally good prospects for companies related to climate change initiatives. So, whether you have signed up to the green movement or are an undefeated sceptic, investing in climate change seems to be a logical idea.

Private bank products

Private banks and their research departments have picked up on this and are offering their wealthy clients products that can both make them feel good about helping the environment and generate a healthy return. It does not get much better than that.

Climate change-related financial products are now in abundant supply. Structured products, funds and indices have been put together by many of the providers, from the big international players to the smaller conservative banks. Talking to the experts, it seems that anything related to climate change is largely outperforming the MSCI World Index. Headline-grabbing returns include Credit Suisse’s Global Warming Index (up 400% on the MSCI since 2002), HSBC’s Global Climate Change Index (70% higher than MSCI since 2004) or even social investment specialist KDL Index, which outperformed the S&P/Citigroup BMI World Index by 40% in 2007. The explanation behind such performances lies not only in the policies supporting climate change, but also in the understanding of how their development affects companies.

“Investment managers and investors recognise that as climate change is better understood as a scientific phenomenon, it is also better understood as an investment issue,” says Thomas Kuh, managing director of KLD Indexes. “Almost every company will face some kind of climate risk depending on what business they are in. Policy makers are now committed to [tackling] climate change by either taxing or developing carbon trading schemes. This will produce winners and losers in the market and it will produce different sets of risks and opportunities.”

New opportunities

Increased commitments to renewable technology both in the EU and US are creating many opportunities for green ventures. The EU has stepped up its commitment to double the share of renewable energy in its energy consumption from 6% in 1997 to 12% by 2010, and is in the second phase of a carbon emissions trading scheme (Emissions Trading Scheme). Ahead of the EU group is Germany, which is set to outperform its neighbours and has put in place tariffs for renewable energy companies, guaranteeing supply to the national grid at a certain price. The system has developed a strong renewable energy sector in the country.

In the US, 21 of the 50 states have established renewable energy standards concerning the share of renewable power used in electricity generation. As a result, there has been explosive growth in the wind sector (installed global wind turbine capacity grew by 27% between 2000 and 2006) and solar power (installed global solar photovoltaic capacity grew by 38% in the 2000-05 period).

Political support and higher consumer demand are important for any venture. Furthermore, public subsidies, in one form or another, allow the development of technology that helps to reduce prices and therefore sustains demand.

“Demand elasticity for solar energy is high,” says Terry Coles, associate director and co-manager of F&C’s climate opportunities fund. “As production prices decrease and technology improves, prices for consumers will also fall, bringing costs closer to grid parity [paying the same price of fossil fuel energy]. As a result, under this scenario consumer demand is likely to increase and this suggests a very positive outlook for the solar industry over the next few years.”

Polluters in play

The outlook is positive and not only for pure play renewable energy companies. Wealthy investors will find that some companies that would traditionally be considered as being in polluting industries are included in climate change-related indices and funds. An interesting example is Toyota, whose research into hybrid engine cars has gained the automotive company a place in a few green portfolios.

In such cases, inclusion is gained by a leadership position in a climate change area on the condition that the company’s polluting activities do not neutralise the impact of the green initiatives. In other words, if a company has a significant role in a green theme but its overall business overshadows the climate change activity, the company might not be selected in the portfolio.

This is why, despite its substantial solar energy business, BP did not make it into F&C’s fund. It is the same story for Japanese company Tokuyama, which produces silicon that is crucial to the solar industry. The company is also heavily involved in cement production, one of the most highly polluting industries.

Banks’ research is proving invaluable to wealthy clients who are interested in specific companies rather than in taking exposure to a pre-selected portfolio. Individual banks’ analysis and structuring capabilities allow private banks’ clients to go beyond investing in a fund or an index.

Philip Watson, head of investment analysis and advice group at Citi Private Bank, EMEA, says that the bank can structure a product around clients’ stock preferences. If a client likes specific companies, the bank can create a structure around share prices and can adapt it to the client’s risk profile.

Riskier stocks

As with any kind of investment, risk plays a role in climate change-related stocks. Depending so heavily on government support is indeed a benefit but it also presents a risk, because very few, if any, of the pure-play green ventures could at the moment survive without some form of subsidy.

With oil prices approaching the $100 a barrel mark and the unresolved issues of oil supply security, policy makers around the world have been forced to seek alternatives and to create incentive mechanisms to support the development of alternative energy sources.

“Right now, oil prices at this level create a subsidy for expensive [renewable energy] technology,” says Mr Watson. “If oil were at much lower prices today there would be a much lower interest in wind turbines or solar panels. Expensive oil prices make attractive technology that used to be considered expensive.”

Mr Kuh agrees: “In many cases you find a correlation between the price of oil and a lot of the pure-play renewable companies. We now see record prices for oil and a lot of pure-play renewables companies trade at very high multiples.”

Vicki Bakhshi, associate director at F&C and adviser to the UK’s Stern Review on climate change, points to the example of biodiesel production in Germany, which has grown rapidly on the back of generous tax breaks. In May 2006, following a review of the incentives, the government decided to tax biodiesel at nine cents per litre – it was worried it was losing out on tax revenues as sales switched from normal diesel to biodiesel. As a consequence, a month later, a major biodiesel company issued a profits warning, saying that the effect of the tax would mean that it would miss its profits forecast.

Bubble fears

Biodiesel and other renewable product companies have grabbed analysts’ attention recently for other reasons. Earlier in the year, a few were trading at exceptionally high price to earnings ratios, which in some cases passed the 100 mark. Thoughts of a green bubble started appearing in investors’ minds.

“There is no question about it, there has been a rush to enter the whole phenomenon of green investment,” says Mr Watson. “Three per cent of energy worldwide is generated through renewable sources but investment in renewable energy in 2006 accounted for about 18% of total investment in energy. For certain companies, valuations imply strong growth. There are lots of competing technologies and there will be diversion between the top and the bottom performing companies. Overall, they are not as cheap as they were just six to nine months ago.”

So it seems that climate change is heating up the stock market, too. Overheated or not, however, this space gives interesting investment opportunities.

“Even when I spoke to investors who remain sceptical, they see that there is an opportunity here because of the widespread acceptance of the climate change issue and because there is an increasing regulatory regime around the world to address the question,” says Edward Kerschner, chief investment strategist at Citi Global Wealth Management.

And the judgement on how good a climate change-related venture is should ultimately be left to the investors, according to Johannes Schmidt, managing director of Siemens Financial Services, whose company is also involved in this area. “Investors are good at deciding if a project is good or bad, if it’s going to work or not, because they are selfish. And if government exploits this selfishness, a lot of things can be done.”

Selfishness to help climate change? This could be the ultimate financial markets’ answer to a social issue.