Green Energy Investing For Beginners, Parts II and III:

November 21, 2009

How Much to Invest, Where, and the Risks

This is a second guest contribution by Tom Konrad Ph.D., CFA, an investment analyst and policy wonk specializing in clean energy.  This is an edited version of two articles that first appeared on AltEnergyStocks.com, where he blogs about investing.  He also writes about energy policy and economics on Clean Energy Wonk. It’s worth burrowing down into some of the links to find out more about prospects for specific sectors and companies.

A reader of my article on asset allocation for green energy investors brought up an important point: we may have green opportunities in our own lives, such as improving the energy efficiency of our homes, which will return much safer and higher returns than green stocks, especially when the market as a whole is as overvalued as I currently believe it is.

Homeowners typically have a large number of high-return energy efficiency investments they can make.  Since energy efficiency reduces energy use, it both produces returns and is very green, since pollution from fossil fuels is reduced.  Even reducing the use of renewable energy is green, because all energy production has some impact on the environment and uses resources.  Furthermore, energy efficiency reduces financial risk, because you are less subject to fluctuating energy prices if you use less energy.

Assess Your Opportunities

An energy audit is a good way to discover your opportunities.  Many utilities have programs to give customers free or subsidized energy audits.

Check with your utility (gas and electric) first to see if they have such a program.  If not, and you are a do-it-yourselfer, visit a website dedicated to helping you improve your home’s efficiency, such as the EnergyStar site. If you’re not a do-it your selfer, look for a RESNET certified energy auditor and pay for an energy audit.  Prices for audits vary a lot, but I’ve heard that $200 – $300 is a good ballpark figure.

You will be amazed, or even shocked, at how many opportunities for savings you find, even in a brand-new home. The improvements you make usually qualify for federal tax credits, as well as (possibly) rebates from your utility or state tax credits.

Any energy efficiency or renewable energy measure with a payback of less than 10 years is likely to be a better investment than green stocks or funds, especially in today’s overvalued markets.  Here are ten that almost always have great financial returns, many of which are good enough to perform even if you rent and plan to stay in one place for a year or two. 

  1. Keep your car tires inflated to the proper pressure.
  2. Change and clean your air furnace filter regularly. Take a hose and get the dirt off the coils in the outside heat exchanger as well.
  3. Caulk air leaks.
  4. Use Compact Fluorescent Lights.
  5. Install a Water Heater Blanket.
  6. If you have an old fridge in the garage or basement, unplug it.
  7. Install low-flow showerheads.
  8. Use an intelligent Power Strip to turn off standby mode.
  9. Get a power meter to hunt for energy hogs around the home.
  10. When replacing electronics, computers, cars, and appliances, get energy efficient ones, especially anything that’s often on or in standby when plugged in. (cordless phones, TVs and set-top boxes, clocks, etc.)

Lists like this abound on the internet. Consult several for ideas.

How Much to Invest

An informed decision of how much to invest in green energy is at least as important as how you make the investment.  The choice between green Exhange Traded Funds (ETFs) and green Mutual funds rests on a difference of about one percent per year, caused by differences in fees.  Yet in the first three quarters of 2009, the S&P 500 (general stocks) returned 17%, ICLN, a green ETF returned 21%, and my ten green stocks for 2009 returned 41%.  With differences between performance as large as 20-30% a year (green stocks did much worse than the market as a whole in 2008,) the decision between investing 10% of your portfolio or 60% of your portfolio in green stocks will make a large difference (8% to 12%) in your total returns for the year, far more of a difference than how you invest.  The other important factor will be sector selection within green energy.  I believe that the main reason my Ten Green Stocks for 2009 have done so much better than the benchmarks is because I emphasized sectors I believed would benefit from the stimulus package.  At that time, the stimulus was  only something that I (and other green commentators) were predicting as part of Obama’s response to the financial crisis (He had not yet been sworn in.)

Your Allocation Decision

How much of your savings you put into green energy will depend on two things:

  1. Your risk tolerance and market expectations.
  2. Why you are investing in green energy in the first place.

All further discussion in this article assumes that either:

  1. You have chosen not to time the market.
  2. You have faith in your own predictive ability, and believe the market will continue to rise, OR
  3. Your portfolio will be hedged against major market moves.

Risk Tolerance

Many green energy investments are more volatile than other sectors.  This is because the majority of green energy stocks are not yet profitable, and do not have the internal cash to see them through hard times.  This can force companies to raise money from the financial markets when those markets have fallen, and will cause the stock prices to fall further in market declines.  Such stocks are especially concentrated in the domestic and specialty green ETFs, such as PBW, TAN, and KWT.  Most of the green energy mutual funds, and the international green energy ETFs such as ICLN and PBD are less volatile due to a higher concentration of established companies.

Investors can deal with the greater volatility of green energy in several ways:

  1. Stick to the less volatile green energy investments.
    1. Stock investors can emphasize profitable green companies over unprofitable ones.  Almost all of my 10 for 2009 picks referenced earlier are profitable companies, and those that are not currently profitable had a history of profitability prior to the financial crisis.
    2. Stick to the less volatile ETFs that contain a broad base of profitable global companies, instead of the more volatile domestic ETFs.
  2. When hedging your portfolio, use a larger market hedge than you would otherwise.  The method I outline in my hedging strategies article automatically incorporates this adjustment.
  3. If replacing an allocation of normal stocks with an allocation of green stocks in a larger portfolio,
    1. Replace an equally volatile sector allocation with your green energy allocation, or
    2. If replacing an allocation to ordinary stocks, replace part of that allocation with less volatile bonds, and part with green energy stocks.

Investment Motivation

It makes sense that the more confident you are that green energy will outperform other sectors, the more money you should allocate to it.  Keep in mind, however, that almost everyone has a strong overconfidence bias. That is, we believe we are going to turn out to be right a lot more often than we actually do.  This bias persists even when we are aware of overconfidence bias.

Hence, we should only let our confidence in green energy have a small influence in our overall allocation decision.  Like market timing, this is another rule that I honor in the breach: my entire stock portfolio is in some way related to green energy.  In ten or twenty years, we’ll find out if I actually know what I’m doing, or am just overconfident like most everyone else.

Motivation: Doing the Right Thing

If your main motivation for investing in green energy is to be more environmentally responsible, you are faced with a trade-off: the more you invest in green energy, the more volatile your portfolio will become.  However, feeling better about your investments may make you more comfortable with the added volatility.  This may allow you to hold more green energy because of your increased risk tolerance.

However, if you don’t believe that green energy will outperform, there are less risky ways to do the right thing.  You could instead replace your stock holdings with companies that are more green than most companies in their sector.  In a recent paper by Meir Statman and Denys Gluskov entitled “The Wages of Social Responsibility”, the authors found that socially responsible investment managers were able to achieve higher returns by favoring “best of class” companies in each sector, a process they described as socially responsible “tilt.”  In contrast, they found that completely shunning sectors such as alcohol and firearms led to lower returns over time.  Based on theses results, there is a win-win available for environmentally responsible investors who want to do the right thing: they can rebuild their entire stock portfolio by keeping the same sector allocations they had made before the change, but replacing the stocks in each sector with the greenest stocks from lists such as Newsweek’s rankings of the 500 largest US Corporations that I wrote about in September.

Motivation: Fighting Climate Change

If your motivation for investing in green energy is to fight climate change, you must balance the trade-off of increased risk from concentration in one industry, with your expectation that that industry will produce higher long-term returns because of increasing regulation of greenhouse gasses, and support for alternative energy.  In general, I find it very difficult to predict which companies are going to benefit from climate change regulation.  Will politicians choose to subsidize solar, wind, biofuels, or energy efficiency?  Will carbon credit giveaways create a windfall for utilities and other large emitters of greenhouse gases.

Not being able to predict politicians, I instead choose to focus my investing based on the (clearly false) assumption that politicians will do (roughly) the right thing. How do we know what the ideal actions are?  We look at reports from relatively unbiased sources that recommend particular actions.  I recently wrote two articles based on an article from two economists that looked at what Modern Portfolio theory has to say about the best technologies for climate mitigation (here and here.)

In terms of how much of your portfolio you should devote to fighting climate change, it should depend on how quickly you expect the effects of climate change to occur.  The biggest gains from a climate change focused portfolio will occur as more and more political leaders stop being able to ignore the urgency of responding to climate change.  I personally feel that this will be triggered by the increasing frequency of climate-related disasters, caused by the increasing severity and frequency of unusual and dangerous weather events such as hurricanes, droughts, floods, and blizzards.  This is something that I already see happening, but I don’t expect it to be obvious to the many people who want to ignore the effects of climate change for another 5-15 years.

Based on your own belief of when you expect this political transition to occur, you should only allocate money to climate change mitigating investments if you do not need to withdraw that money before the expected political change is likely to occur.  In some ways, this political change has already begun, and money is being awarded to deserving green energy firms.  However, investors should not ask what has already happened, but what unexpected changes are likely to occur.  The unexpected (by most other investors) change that I expect is the realization that Climate Change will not only be a serious problem, but that it will be a serious problem in our lifetime, and that it’s worth risking damage to the economy by devoting massive resources to the project of combating it.

In my case, my investment horizon is about 20-30 years, which is longer than the 5-20 I expect for the political change, so I consider fighting climate change as a good motivation to increase my portfolio’s allocation to green energy.

Motivation: Peak Oil

The connection between fossil fuel prices and the performance of green energy stocks is tenuous at best.  Investors should not expect their solar stocks to go up or down with the oil price.  After all, we do not yet have a fleet of plug-in vehicles which might let us substitute electricity from solar for gasoline from oil.  Hence, investors motivated by peak oil should stick to green energy sectors which reduce the need for liquid transportation fuels.  These sectors include biofuels, hydrogen fuel cells, technologies which make transportation more efficient, and technologies such as batteries which enable the electrification of transport.

Like climate change, how soon you expect to see the effects of peak oil should affect how much money you invest.  I feel that the effects of peak oil in terms of the reduced affordability of gas and diesel are already upon us.  This does not just mean high oil prices (which we have), but decreasing ability to purchase oil due to the economic disruption and contraction caused by those prices.  Low oil prices make our economies vibrant, which provide the money needed to buy oil.  High oil prices cripple the economy, which in turn means that we’re less able to buy oil at any price.  This is what I mean be “reduced affordability.”

In a recent report, “The Peak Oil Market,” Deutsche Bank predicts that post peak, both oil prices and oil demand will fall due to the introduction of disruptive technology: plug-in vehicles (If they’re right, investing in oil or oil companies is not the best way to profit from peak oil, but rather the potential disruptive sectors.  Of the sectors I mention above, efficient transportation, hydrogen, and electrification are the only ones that can possibly scale to replace a significant portion of our fossil fuel demand.  Biofuels are limited by the available supply of biomass.  Biomass can more efficiently power a vehicle when burnt to produce electricity to charge an electric vehicle’s battery than when converted into liquid fuels for an internal combustion engine.  A similar efficiency argument applies to hydrogen, although breakthroughs in electrolysis and fuel cell technology could change this.  However, I don’t consider betting on possible technological breakthroughs a sound investment strategy.  After all, even if a breakthrough occurs, it’s at least as likely to come from a new player than an industry incumbent.

Batteries will need some technological breakthroughs in order to make plug-in vehicles economical enough to displace gasoline. However, the needed improvements to the electric grid needed to accommodate electrified transportation (as suggested in the Deutsche Bank report) can be accomplished with existing technology.  Hence, investors motivated by peak oil should be looking to investments in transport efficiency, transmission and smart grid stocks.

In terms of how much to invest in these strategies, it probably should be a lot (at least if you believe as I do that the peak in oil production has either already happened, or will happen soon), and it should probably be accompanied by a hedge using shorts in oil intensive industries such as airlines.  The hedge is necessary because a peak in oil supply will hurt the world economy, and is likely to make stock prices as a whole fall, quite possibly even the stock prices of the companies which are working to displace oil with disruptive technology.  However, it is a good bet that these companies are likely to fare better than companies whose economics depends on the large scale consumption of cheap oil.

Conclusion

Your goals, expectations, and risk tolerance will affect both how you invest in green energy, and how much you invest.  Before you make any decisions, answer these questions for yourself:

  1. Do I believe investing in green energy is the right thing to do? Will this help me bear the pain of declines in my portfolio?
  2. How soon will Climate Change reach the top of the political agenda?  Do I have the time to wait for the expected investment returns?
  3. How soon will oil production peak?  Do I have time to wait for the expected returns?
  4. How confident am I about my answers?  Do I have reason to be confident, or is my confidence based on self-delusion?

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