Investment opportunities in alternative energy

With the signing of a climate deal in Paris, it’s clear that governments, industry and investors are willing to act on the potentially extreme risks associated with climate change.

These include ocean acidification, severe storms, rising sea levels and the mass movement of people seeking to escape these possible scenarios. Notwithstanding debates surrounding enforceability and accountability, this agreement represents a long-term shift towards a new energy economy—one that investors will need to plan for.

Here are three forward-looking assumptions for those pondering energy investments:

• Changing energy regulations in most major markets can put a price on carbon, end the subsidization of fossil fuels and advance the transition to a low-carbon energy system. (A report from the Overseas Development Institute and Oil Change International show the G20 countries currently spend US$452 billion per year on fossil fuel subsidies, which include tax breaks for exploration and royalty breaks.)
• The oil and gas sector is set to experience tough times in the medium term, but will likely remain a significant part of the energy mix until at least 2030. After that, it’s unlikely thermal coal will make a comeback, at least in North America.
• Renewable energy and energy conservation technologies are becoming increasingly attractive for a broader investor base, from venture capital to retail mutual fund investors.

With fossil fuels currently making up about 75% of the world’s energy mix, what can replace it? Recent developments in renewable energy indicate solar and wind energy are poised for rapid growth. Goldman Sachs predicts solar and wind will contribute, in oil terms, about 6.2 million barrels per day between 2015 and 2020.

As a comparison, the U.S. shale boom contributed 5.7 million barrels per day between 2010 and 2015. In other words, solar and wind combined are bigger than the Bakken.

Their development may chart a course similar to what’s expected in the area of artificial lighting. A November 2015 Goldman Sachs study, The Low Carbon Economy, suggests LEDs use 85% less energy than incandescent bulbs, and are poised to have 69% of lamp market share by 2020, up from 1% in 2010.

Opportunities abound in technologies designed to increase energy efficiency and conservation, optimize waste management, and evolve battery power. Once the preserve of risk-prone venture capitalists, investment opportunities in these areas are increasingly viable for retail investors as innovative companies find commercial success, gain scale and go public. The niche is rapidly expanding and becoming part of the mainstream.

The key to investment success in the transition to a more sustainable global economy will be to identify companies that provide resource-efficient or cleaner delivery of key services. This can mean looking for energy efficiency; renewable energy; water; waste and resource recovery; and sustainable food and agriculture-related markets.

These markets address a number of long-term macro-economic themes: growing populations, rising living standards, increasing urbanisation, rising consumption, and depletion of limited natural resources.

The number of sustainable companies has grown tremendously over the last 15 years, as governments continue to provide a more favourable policy environment. Parallel with their commitment to rapid technological innovation is the added benefit to investors of earnings growth that far outpaces traditional resource-based investments.

These markets are complex and difficult to navigate, partly because there’s little sell-side coverage. But that means more instances of mispricing, which specialist managers can use to their advantage.

Some helpful questions to identify mispricing include:

• How much of the company’s invested capital is dedicated to sustainable business lines? How much of its profit and sales are derived from those business lines? Many managers consider a company to be sustainable if the answer to those questions is at least 20%.
• What is the company’s potential profitability? Use standard quantitative metrics, such as balance sheet strength, earnings growth, et cetera.
• What is a company’s commitment to ESG principles? Most will meet the environmental criteria, but how about the social and governance parts?

Keep in mind that as companies in this space evolve from small caps into large caps, they’ll need to improve their corporate governance practices. Constructive engagement with these companies to get them to meet today’s expectations on director independence, board composition and well-structured executive compensation will be of long-term utility in making sure they can sustain their success. Our advice is to hedge your bets. Look for new investment opportunities in emerging technologies, but don’t abandon oil and gas just yet. They will likely bounce back, though we may never again see the booms that have long characterized this industry.

Types of environmental investors

• Resource Traditionalist: This type of investors has significant exposure to traditional extraction-based resource investments and is looking to protect or counterbalance her resource weighting with alternative energy investments, such as renewables.
• Fossil Fuel-Free: This investor believes their investments must totally diversify away from fossil fuels.
• Growth-Oriented: This investor is focused on global solutions that are high-growth and that capitalize on catalysts for future growth (e.g., M&A activity, favorable policy environment, earnings growth momentum, new investment opportunities in untapped markets).
• Infrastructure-Focused: This investor looks to essential services, utilities and facilities to provide a valuable defensive component to her portfolio.

The investor’s allocation to environmental investments depends on risk tolerance, time horizon and investment objectives. These investments may experience more ups and downs as the industry grows and matures. They may also experience growth at a faster rate than traditional investments as these markets mature. Investors can start small and gain comfort.

by Daniel Solomon, chief investment officer at NEI Investments and Robert Walker, vice-president, ESG Services, at NEI Investments.