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From the Archives: The 2007 Outlook for Climate Change Investment

Launched in 1992, Worth turns 25 this year

While the topic of climate change is on top of mind now perhaps more than ever, exactly 10 years ago in August 2007, Worth published a discussion in the magazine about the climate change investment among five experts. Contributing writer Eileen P. Gunn said: “Affluent investors face a once-in-a-lifetime opportunity to claim prime positions in this inevitable global trend.”

Investors who scoff at movie stars arriving at awards shows in hybrid SUVs might easily dismiss global warming as the topic du jour. After all, many Americans have responded to both celebrity pretension and sky-is-falling environmental rhetoric with a collective yawn.

A survey in January 2007 by the Pew Research Center for the People & the Press asked Americans to rank priorities for the president and Congress—global warming placed 20th of 23 issues. Yet beyond the public’s indifference, fundamental economic and political change is underway. Fifteen states, representing 38 percent of the U.S. gross state product, will have regulations in place by 2012 to limit greenhouse gas emissions, according to a report by Citigroup. The leading presidential candidates from both parties have made statements about climate change, suggesting that more federal regulation of carbon emissions and gas mileage are likely to be part of our collective future. As Edward Kerschner, chief investment strategist at Citi Global Wealth Management, says, “Whether or not you believe in climate change, regulation is here, and it is going to create winners and losers.”

To gain better insight into how this ill-defined future might impact the economy, the markets and individual investors, Worth spoke to five experts—three backed by the resources of global investment banks, one who has been investing in environmental plays since 1990, and one who brings a distinctly tech-oriented view to his analysis of the markets.

“Whether or not you believe in climate change, regulation is here, and it is going to create winners and losers.”

  • DAVID DARST chief investment strategist, Morgan Stanley’s Global Wealth Management Group in New York.
  • EDWARD KERSCHNER chief investment strategist, Citi Global Wealth Management in New York.
  • ROBERT WEISSENSTEIN chief investment officer, Credit Suisse Private Banking Americas in New York.
  • JEFFREY LEONARD CEO, Global Environment Fund in Washington, D.C.

Is it too soon to think of climate change in purely financial terms?

Edward Kerschner: Regulation is here, and it is going to create winners and losers. Just because you don’t believe in climate change doesn’t mean you don’t want to invest in companies being affected by the perception of it.

Robert Weissenstein: A whole business and economic framework is developing around this issue. The question used to be: What will we do when we run out of oil? That’s not green so much as it is a question of how we will keep our economy going. Where will we go when that finite resource ends? Well, we will identify replacement energies that work. A lot of those—ethanol, solar, wind—used to sound like crazy sources of energy, but we now know that they are viable alternatives to oil and gas. The next step is building the infrastructure to deliver these alternatives in a cost-efficient, practical way. I don’t know how green a train is, but you need to transport ethanol, so maybe trains are good investments.

Do these opportunities stem from fundamental shifts in our economy, or are they part of something more short term and mutable?

David Darst: I think that it depends on what you’re talking about. Solar has a Holy Grail aspect to it, and it is considered more long term. There has been this feeling that if we could figure out a way to collect it and transmit it, that’s the key. Biofuels, such as ethanol, on the other hand, could be cyclical. Weather can play a big role in the economics of biofuel, and then you have government policy coming into play with farm-belt politics and trade agreements with places like Brazil. Then you have the question of sugar ethanol versus corn ethanol. Also, a lot of people say the economics of biofuel don’t make sense. There is some disagreement.

What role will government play in the transition from a carbon-based economy?

Kerschner: Regulation by the government drives these developments. For example, the volume of carbon futures traded on the European Climate Exchange [in Amsterdam] more than doubled between March 2006 and March 2007. Why? Because in Europe, new regulations take effect in 2008 limiting carbon emissions.

In terms of governmental regulation, Europe is ahead of the United States, and most countries have set targets for renewable energy. However, there are a number of things the U.S. government can do, like creating research-and-development subsidies and tax subsidies. It can also fund research and regulate the number of miles per gallon required in automobiles.

Jeffrey Leonard: I’m not a big believer in subsidies, but you need a critical mass of infrastructure. You need subsidies to make some of these things work. We haven’t been consistent with government support. In 1979, 2 percent of government spending was on R&D in environmental innovations. Today it’s two-tenths of 1 percent.

I’m also concerned with the way we throw money into pork barrel and white elephant projects today. These are 50-year challenges. I’d like to see long-term government commitment, but instead, six months ago you had politicians standing in cornfields and people throwing money at ethanol. Now there’s a backlash against it.

How is the current green gold rush similar to and different from the dot-com era?

Kerschner: This is a fundamental shift in the economy. It’s not frothy or bubbly. With the dot-coms, most of it was conceptual, easy to create. Most solutions to climate change involve real, physical assets. When you need hard assets, it’s harder to get a speculative bubble than when things are driven by concept.

Seth Scholar: This is mainstreaming like crazy right now. And there are real risks that come with that—some of the same risks with the tech bubble, like too much money chasing too few opportunities. There is an innovation pace that is fast and furious that’s going on right now, and a lot of money is chasing it. You have to worry about valuations. During the tech boom, while there was a bubble, there were also real, valuable things coming out of it. I don’t think this is any different. After the bust, we saw lasting changes, and the same thing will happen here.

Should an investor think of climate change as a portfolio sector, or is it a theme that can affect an entire portfolio in different ways?

Leonard: Clearly, there is a sector allocation opportunity similar to biotech or medical services. But we think of it less as a sector and more as a theme. For us, it’s more about efficiency than climate change. We need to move toward efficiency in energy and petroleum.

Weissenstein: I don’t think there is an allocation. There is an acknowledgement that it’s an important investing theme. You have to make sure you understand the implicit and explicit exposure you’re getting out of this. You might not buy Wal-Mart because it’s green, but its plan to sell low-impact bulbs will be big, so there’s implicit exposure there.

Are there more opportunities in the United States than in other parts of the world?

Kerschner: You have to think of it as a global story. There’s the impact of drought in Australia and opportunities in biodiesel in Malaysia. We have 85 or 86 stocks that we believe are positioned to benefit. Of those, only 20-odd stocks are U.S. companies.

“We have to wean ourselves off of old ways of manufacturing, and we have to be in a cleaner place.”

Weissenstein: We have to wean ourselves off of old ways of manufacturing, and we have to be in a cleaner place. But look at what’s going on in developing economies. They don’t have infrastructure to retrofit. Most cars in Brazil run on ethanol. They don’t have gas stations to transition over to ethanol. They don’t have factories that need retrofitting. So they have a running start in a perverse way. It’s the leapfrog effect that we saw with mobile phones. That speaks to what goes on in those economies from a practical and investment standpoint.

There are also issues like clean water. We’ve been talking to venture capital firms that invest in whatever it takes to deliver clean water to remote villages. Why does it matter to an investor? If you improve infrastructure, economic growth ticks up, and that has a cumulative effect on the global landscape. You can spend your time more effectively because you’re not cleaning water and you’re not dealing with as many health issues. You have new business—and activity and markets rise from that.

What trends or developments really pique your interest?

Darst: When it comes to wind versus solar versus water, people look for breakthroughs in all those areas. But our view is that you want to get exposure to water. Water is the oil of the next 40 years. So we’re looking at all aspects of getting potable water to people—infrastructure, utilities, bottled water. There are innovations like a straw that makes the most polluted water potable when you suck through it. I was recently in Perth, Australia, and there’s a desalination project that is driven by wave energy there.

Leonard: I look for business strategies that are sustainable and steady and long term. I like the analogy of selling picks and shovels to miners in the gold rush. If the solar and wind industries are going to grow by double digits, they’ll need companies that sell components to them. So I like companies that sell ancillary products to the solar or wind industries as they roll out.

Weissenstein: I’m most interested in infrastructure impact. We’re learning to move away from inefficient polluting energy sources, but haven’t found a way to get new things out there in a meaningful way, and that’s pretty exciting stuff. It’s not enough to discover new sources; you have to think about how people will access them. For example, solar is interesting, but expensive to deliver. So companies look at how to do it in a far less expensive manner. You need technologies to capture it and turn it into something useful, and that’s about infrastructure.

How can an investor apply this environment theme to more traditional investments such as large-cap public companies?

Darst: I think investors need to be on the offensive thinking about climate change. They can add things to their portfolios based on the assumption that things will get worse locally, and incrementally that certain companies can help. And they can take advantage of the stock prices for those companies going up. I see venture capitalists doing green investing. Investors will want to put money into partnerships that create companies that will be public.

Leonard: With bigger companies, you have to look at how much of their revenue comes from innovation. I think there will be a lot of spin-offs. Dow Chemical did two spin-offs in the 1990s that we participated in. They were pure plays that wouldn’t make a dent in Dow’s earnings, but the company can enjoy the spin-offs’ stock growth. We’ll see more of that. GE might say, “Let’s publicly list our water division or Ecoimagination division because that’s the high growth area.”

Scholar: Even in more conservative asset classes you have short-term ups and downs. You have ethanol plays like ADM that have moved up and then back and then up again. In addition, you have a company that has one great division, but has a lot of baggage from other parts of the company, like GE. So the question is, how do you tap into that green value

“Investors need to be on the offensive thinking about climate change… [and] add things to their portfolios based on the assumption that things will get worse.”

What are the risky outliers in this genre, and what can an investor expect from them?

Scholar: A lot of the new developments are about technology. But if you’re interested in these individual technologies, then it’s like investing in other kinds of tech—you have to know what you’re getting into. These companies are nascent and in areas where things are hard to understand and fast-moving. I don’t think people always understand how complex the issues are. For example, government subsidies prop up a lot of these markets, so it’s not just a matter of investing in this company with a time period for it to pay off being x. The subsidies are a factor, and you have to ask what happens to the business if those disappear.

And because it’s so early, there are going to be bumps. You can have volatility related to energy prices or geopolitical risk. If there is a Democratic administration in 2009, it could be good for these companies—but that remains to be seen.

With so many green opportunities, where does an investor start?

Kerschner: There’s no proverbial silver bullet, so you don’t want to wait around for the one winner. This is a total behavioral shift for business. It affects energy, transportation, new cars, power generation, electric lighting and insulation. There will be a lot of little winners. Solar technology works in places where there is sun, and wind technology in places where there is wind. You want to diversify.

Leonard: A lot of these industries are small. You have 40 percent per annum growth in the solar industry, but that’s from a very small base. Because of the size of these markets, there is a lack of depth of opportunity, and broad swings in valuation.

I look at how regulations are changing things now. Companies in certain industries cannot deploy old solutions and they need new ones. That’s bringing new technologies into the field. I like companies that address a solution for an existing customer base. They’re not doing something new; they’re displacing. They’re migrating existing revenues from someone else’s old way of doing things to their new way. For example, the pulp and paper industry is notoriously wasteful and inefficient. So I’m looking for tiny companies that can improve that. I don’t invest a lot in fuel cells or other things that are 20 years off. I look for companies with accelerating revenues that can scale without huge amounts of capital or technology.

Weissenstein: There’s always an issue that’s a starting point. For example, companies want to move into clean, renewable sources of energy, like wind. GE manages wind turbines, so it’s part of its income. There are companies in Europe that rely on wind entirely. So where are they getting the wind turbines? Then there’s the interest in making buildings more energy efficient. Who will make conversion kits for that? Maybe air-conditioning companies. You go through the process, discover the source they will use, the impact it will have, and you keep going down this road, asking what it means after this and after that.

Reprinted from the August 2007 issue of Worth.

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