The American Energy Innovation Council (AEIC) released a new report last week, Catalyzing American Ingenuity: The Role of Government in Energy Innovation, which makes the case that the US government should dramatically increase its investment in energy innovation in order to enhance US competitiveness, energy independence, and create affordable clean-energy alternatives. The AEIC doesn’t represent the clean energy industry; rather, it’s a small but highly influential group of CEOs (and a couple of former CEOs) from Lockheed Martin, Xerox, Kleiner Perkins, Microsoft, Dupont, GE, and Cummins. The AEIC report makes the historical observation that “From gas turbines to smart phones, medical imaging technologies to space flight, GPS to the internet, government funded innovation research has improved lives, created jobs, and supported more than a century of U.S. preeminence.”

The report documents the various market failures that impede private sector investments, such as the risky, long term nature of R&D, a lack of competition, and the difficulty in monetizing all the benefits of clean energy. The report highlights the inadequacy of US investment in relation to global competitors, such as China and Germany, and recommends support for “innovation hubs” that encourage “concentrated talent, the exchange of ideas, and the creation of new technologies and ventures” in regional business clusters.

The report was released the same week that California-based solar firm Solyndra filed for bankruptcy after receiving hundreds of millions of dollars in government assistance and loan guarantees, fueling a fierce debate about the wisdom of government investment in clean energy. This is not the place to discuss the details of the Solyndra case (see here, here and here), but it’s clear that much of the criticism stems from a larger, ideologically-motivated campaign against government support for clean energy, with strong links to the political forces against carbon regulation. While it’s true that Solyndra and Massachusetts-based Evergreen have filed for bankruptcy and many manufacturers have seen their profit margins eroded by intense competition, the industry as a whole is booming. The solar industry is the fastest growing sector in the country, with sales rising 67% in 2010, and the cost of panels has fallen by 80% since 2008.     

Despite efforts by Fox News and the Competitive Enterprise Institute to disparage renewables and even claim that solar “doesn’t work”, the recent bankruptcies are actually a sign of the industry’s success, bringing the typical transition to maturity, commoditization, and a shakeout of higher-cost producers. Commoditization and cost pressures are severe in the power sector where price is the primary driver, while branding and differentiation are relatively unimportant. Unsurprisingly, manufacturing is therefore shifting rapidly to lower cost locations, notably China. Yet employment in the US solar sector has still grown by 6.8% since August 2010 (net, after taking into account the recent failures) and the US enjoyed a $1.9 billion trade surplus in solar products in 2010.

The AEIC report is only the most recent attempt to raise the alarm regarding US prospects in clean energy. Countries are frequently framed as being in a “race” for a dominant position. The Breakthrough Institute, for example, attracted substantial publicity for a 2009 report titled: Rising Tigers, Sleeping Giant: Asian nations set to dominate the clean energy race by out-investing the United States. The Pew Trust followed in 2010 with a report titled Who’s winning the clean energy race?, and the headline conclusion that the US has fallen to “a distant third in the race for clean energy investment” was picked up by a multitude of news sites.

The notion of a clean energy “race” does have valid conceptual grounding in the idea of regional business clusters. Clusters are geographically concentrated networks of businesses and related institutions such as industry associations, universities, training institutes, and research centers. Clusters usually comprise a range of connected value chain activities, including specialized suppliers and engineering firms, venture capital, professional services, as well as sophisticated customers demanding the latest and best features. As a result, clusters are characterized by a concentration of sector-specific skills and a rich network of connections among people and organizations.

Clusters are attractive as foundations for a dynamic regional economy because they tend to generate high levels of innovation, investment, and incomes. All the firms in the cluster benefit from lower costs, better access to specialized inputs, and the latest information on market trends, production techniques, and technological developments. Importantly, clusters are resilient and enduring, as once they reach a critical mass, their competitive advantages encourage self-sustaining growth. Moreover, business activities are geographically “sticky” and so can resist pressures to outsource to lower cost locations. Clusters therefore enjoy first-mover advantages, as early successes, such as Denmark’s wind industry, become established and enjoy enduring advantages.

A cluster promotion strategy is gaining attention in policy circles. The recent Brookings Institute report on the US clean energy sector found a strong assocation between concentration of business activity in metropolitan areas and rates of growth. The report noted that “Not only are other nations bidding to secure global production and the jobs that come with it but the United States currently risks failing to exploit growing world demand.”. A key recommendation is that the “federal government should increase its investment in new regional innovation and industry cluster programs.”

It’s important to note, however, that the success of the solar industry and its transition to maturity is a result of global investment in R&D and manufacturing, including substantial government support in China and Europe. Rapidly falling solar energy costs create widespread benefits for buyers of solar panels, for energy consumers, and for those employed in the fast-growing industry (not to mention the environmental benefits!). Moreover, national and regional clean energy clusters are not separate racing teams, but are elements of a larger complex global industry with intertwined value chains. Recent academic work has demonstrated how successful business innovators are connected through “global pipelines” to international business networks. In clean energy, many firms operate right from the outset with global customers, suppliers, capital, and technology.

In this dynamic and high-risk environment, the failure of a Solyndra or the shift of some commodity manufacturing to China does not necessarily signal the loss of US competitiveness. As the global clean energy industry grows and matures, firms will reconfigure their global value chains, shifting activities across countries. The US is likely to specialize more in services, finance, and design than manufacturing. It’s still important to invest in creating vibrant clean energy clusters, but the benefits should not be measured in short-term events or narrow national terms. Indeed, it’s critical to understand the competitive basis of high value-added regional clusters in the context of global industries, and to develop collaborative strategies among business, universities, and governments to support their growth.

If the triple catastrophe in Japan has any silver lining, it’s the boost to non-nuclear renewables such as wind and solar energy. Japan faces immediate power shortages in the wake of the earthquake, tsunami, and nuclear meltdown, and as Geoffrey Styles observes:

As of the end of 2009 Japan already had the world’s third-largest installed solar power capacity at 2,600 MW, to which another 1,000 MW or so was apparently added last year. For Japanese businesses suffering from rolling brownouts, solar power is one of their few options other than diesel generators for becoming more self-sufficient fairly quickly.

The Japanese nuclear disaster is already having global repercussions, as other countries review their nuclear energy strategies. “The industry could enter another two-decade global freeze like the one that followed the Chernobyl disaster in 1986”, according to the Financial Times. In the US, concerns about safety could rekindle the anti-nuclear movement and slow down development of new projects. The Swiss reacted first, suspending approvals for three new reactors. The German government announced a nuclear moratorium and that it is indefinitely shutting the oldest seven of the country’s seventeen plants. China announced that it was suspending new approvals for nuclear reactors, though Russia and France have declared their continued commitment to nuclear technology.

It’s possible that memories will fade and the world will get back to business as normal, putting the nuclear revival back on track. But the severity of this crisis in an industrialized country with an advanced nuclear industry and strong safety culture suggests that there could be a long term impact. Charles Perrow, Professor Emeritus of Sociology at Yale University, and author of the classic book Normal Accidents about Three Mile Island (and guest blogger on Climate Inc.), has argued that even with the best safeguards, occasional accidents are inevitable, or “normal”, given the extreme complexity of some technological systems combined with human fallibility, pressures for profits, lax governmental oversight, bureaucratic inertia and organizational hierarchy. For nuclear reactors, the outcome can be catastrophic. The prospect of even one Fukushima-style meltdown every few decades, or the cost of even more elaborate safety features, is likely to severely curtail new nuclear investment.

In the short term, closing nuclear capacity will raise CO2 emissions as utilities restart gas, coal, and even oil and diesel fired generation capacity. These old mothballed plants tend to be inefficient and expensive, however, and capacity is limited. The need for a short-term fix will also increase demand for fossil fuels, raising prices and further spurring interest in renewables and efficiency. Not everyone is sanguine about the impact on renewable energy, however. John Peterson, writing for AltEnergyStocks.com, notes that:

The nuclear reactors that have recently gone off-line in Japan and Germany accounted for roughly 125 TWh of electricity production last year. In comparison, global electricity production from wind and solar power in 2009 was 269 TWh and 21 TWh, respectively. In other words, we just lost base-load power that represents 43% of the world’s renewable electricity output. The gap cannot possibly be filled by new wind and solar power facilities.

While it’s true that wind and solar are still in their infancy and cannot completely fill the gap, they can be deployed far more quickly than conventional power plants due to their flexible scale. Of course, there are constraints on total production capacity, and large scale installations can be delayed by siting and permitting issues, but the prospects for renewables are suddenly a lot brighter, after a year in which the momentum toward carbon regulation and pricing appeared to have stalled and the clean energy train was in danger of being derailed.

The reaction in the markets to events last week supports this view. While nuclear stocks and ETFs plummeted, clean energy investments reacted positively even as the overall market declined. The chart below shows the jump in price (blue line) of PBD, a global clean energy ETF from PowerShares since the disaster hit Japan March 11.

It’s interesting to note that PBW, an ETF with greater focus on US-based firms and less exposure to a broader array of cleantech technologies such as energy storage and controls, has not performed nearly as well. This is perhaps unsurprising in light of the challenges faced by the US clean energy sector, particularly solar energy. In January, Evergreen Solar, Inc. announced that it would be shutting its doors on its Devens, Massachusetts plant despite receiving $58 million in grants and tax incentives to open the facility, according to the Boston Globe. Now, the company is shifting production to a facility in China by the end of the first quarter of 2011. If the disaster in Japan has a silver lining for the clean energy sector, it’s important that the US not let the opportunity slip away.

by David L. Levy

When most people think about clean energy, solar and wind are the first things that spring to mind. Markets for these renewable energy sources have exhibited rapid growth of about 25-30% annually, and these sectors have attracted the lion’s share of venture capital funding and investor interest. They also tend to dominate the various Exchange Traded Funds (ETFs) that track clean energy. Yet the clean energy economy extends far beyond renewable energy technologies, including everything from power controls and storage, carbon software and trading, and energy efficiency. In transportation, while auto companies chase expensive dreams of electric cars, more economically viable opportunities lie in mass transit, bicycles, and innovative car rental services such as Zipcar. Clean energy is also generating a vast range of engineering, professional, and financial services. The transition to a clean energy economy will therefore change the employment landscape (see Green Jobs Booming and Training the “Green and White” Collar Workforce). At the same time, it’s creating new investment opportunities to rival electronics and biotech. The best investment opportunities are the unsung heroes that lie in the more cloistered parts of the evolving cleantech economy.

There are two core principles involved in understanding which green sectors have the most potential and which are overhyped. The first is that successful investing requires better insights than the average market investor. Share prices for many cleantech companies already reflect the expectation of rapid growth – companies (or sectors) have to outperform these expectations to generate significant returns. Second, the market is not rational – the efficient market thesis does not hold. This means that share prices do not accurately reflect all the information out there. To complicate matters, these two principles are somewhat contradictory: What is the point of better knowledge, if the market is arbitrary?

Well, the market is not completely arbitrary – to some degree, it’s Predictably Irrational, to use the title of Dan Ariely’s book. Investors exhibit herd behavior, leading to macro market distortions – share prices (and P/E ratios) can expand in frothy bubbles or become mired in gloom, with prices detached from underlying profits and cash flows. There are similar distortions at the sector and individual company level. When a new sector is fashionable, investors pile in, the media provides glossy rationalizations, and even policymakers can jump to support the ‘next big thing’. Many investors don’t care about underlying value and try to ride these waves of momentum, but this market-timing strategy requires nerves of steel and considerable luck.

Eventually, reality catches up and capital move on. Interest in fuel cell powered vehicles, for example, has collapsed while biofuels are on the wane. But distinguishing ‘reality’ from conventional wisdom is a considerable challenge, even within the expert community. Ford and GM’s disastrous experiments with electric vehicles in the 1980s and 1990s created a firm belief in the US auto industry there was no future for electric vehicles of any kind, even hybrids. The institutionalization of this view led US car manufacturers to scoff at the prospect of Toyota and Honda introducing hybrids (HEVs) in the late 1990s, and now the hobbled US companies trail far behind (see my 2002 paper on the auto industry and climate change). Similarly, the failure of concentrating solar thermal pioneer Luz in 1991 put the sector in the freezer for over a decade. For HEVs,  the technologies were premature for commercialization, but CST suffered from capricious public policy and the association with low-tech solar hot water (hard to patent the technology) in comparison with high-tech solar PV.   

Tom Konrad, of AltEnergyStocks.com fame, recently presented a model clean energy investment portfolio that tries to identify undervalued sectors with the best prospects. It is notable for the absence of solar, and the dominance of efficiency, transportation, and electric grid.

In fact, the portfolio substantially diverges from the current market cap of various clean tech sectors given in a BofA Merrill Lynch Global Research report. Solar and wind dominate the pie chart, with each having about one-third of the total market cap. Popular clean energy ETFs are similarly overweighted  in solar and wind.

Konrad assesses each sector in terms of several criteria:
1. How big a role will this sector play in our energy future?
2. How large is the market cap of current firms in the sector?
3. Is the industry likely to be disrupted by new entrants and technologies?
4. Are there underlying enabling technologies that will benefit from the sector’s growth, or constraints that will hold it back?

By these criteria, wind and solar PV are poor investments because although they can play major roles in our clean energy future, they already have large market caps – the growth expectations are already “baked in”. Wind at larger scale is constrained by the lack (and cost and planning issues) of long distance transmission. Even worse for solar PV, the sector is at risk from technological disruption and new entrants, particularly from concentrating solar thermal (CST) or new variants of solar PV.

Konrad identifies transmission, smart grid, and storage as the key enabling technologies for the clean energy infrastructure, which have been somewhat overlooked but now seem ready to catch a wave of investor attention. Despite the recent success of lithium ion battery producer A123’s IPO, Konrad is pessimistic about plug-in vehicles due to their cost and inherent limitations of the technology, leaving automotive batteries highly vulnerable to disruptive innovation (also see John Petersen on this).

Konrad’s basic approach is very sound, especially for those who prefer a sectoral approach to the risks of individual stocks. It provides a useful framework for discussing particular technologies. For example, I would favor CST as a sub-sector because of its prospects to scale up at reasonable cost, the lower technological risk compared with PV, and the prospects for integrating thermal storage (also see this on SolarReserve). The offshore wind sector could also benefit from the $125 billion plan to build up to 25 GW of capacity, for which initial contracts were announced in early January.

I’m less sanguine than Konrad about the prospects for mass transit and high-speed rail, at least in the US, as it requires a level of governmental investment and coordination that seems unlikely in the current financial and political context. I fully concur regarding the outlook for efficiency. A McKinsey report points to the economic attractiveness of efficiency investments and a vast market potential of over $500 billion in the US over the next decade. Pike Research recently issued a report supporting a positive outlook, projecting that the Energy Service Company (ESCO) business in the US would increase from $5.6 billion in 2009 to nearly $20 billion by 2020. Utility demand side management programs are a major stimulus for this growth. The Pike Research report also noted opportunities at the intersection of energy efficiency and information/communications technology.

Although this is not the place for a discussion of particular stocks and mutual funds, it’s worth noting that investing in efficiency tends to be tougher than other sectors, because there are few public pure-play companies or dedicated ETFs. On the one hand, there are many small privately held companies, and on the other, some very large industrial companies for whom energy control systems and services are a relatively minor part of their business, such as Honeywell International and Siemens. The situation is similar with clean energy related professional services and software. Pike Research estimates that the market for carbon software management and services was a modest $380 million global market in 2009, but is poised for growth of more than 40% a year. This neglected part of the clean energy market has a few small players, but is increasingly dominated by the large accounting, management consulting, and enterprise software companies.

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?

This is a guest contribution by Tom Konrad Ph.D., CFA, an investment analyst and policy wonk specializing in clean energy.  This article first appeared on AltEnergyStocks.com, where he blogs about investing.  He also writes about energy policy and economics on Clean Energy Wonk. I’ve found AltEnergyStocks.com to have some of the most insightful economic and financial analysis of clean energy sectors and specific companies.

Investing in green energy can be good for both the climate and your wallet.  How good depends on choosing the right investment vehicles (mutual funds, ETFs, or stocks) and sectors to invest in. This will get you started.

More and more investors are investing in green energy.  According to the Cleantech Group, the Cleantech sector is now the largest sector for venture capital investment.   Green Energy is not just for venture capitalists.  Small investors have done well in 2009.  Since the market bottomed at the start of March, the average green energy mutual fund topped the S&P 500 by 13%, while the average clean energy ETF beat the S&P 500 by 18%.

Knowledgeable investors will scoff at that last statistic because, of course, most green energy companies are riskier than the tried-and-true companies of the S&P500, and what out-performs in an up market will under-perform in a down market.  That is true, but only to a point.  When I investigated it this Spring, I found that green energy stocks had outperformed the rest of the market even on a risk-adjusted basis.

Nor are all green energy companies risky.  While the sector has more than its share of profitless startups, there are also established companies which have been making the planet a greener and safer place for a long time, but now have the opportunity to benefit from rising public awareness of the need to do something about climate change. By knowing what to look for, an investor can be green without taking on excessive risk.

Stocks, Exchange Traded Funds, or Mutual Funds

The small investor has three basic options:

1. Green Energy Mutual Funds,
2. Green Energy Exchange Traded Funds (ETFs), or
3. Individual Green Energy Stocks.  

Green Energy Mutual Funds

Mutual funds will be the most familiar option to the small investor.  The available green energy mutual funds are all actively managed, which means they try to choose the best green companies.  Mutual funds charge high fees for this service, but I have been unable to find evidence of skill among green mutual fund managers which would justify the cost.  Numerous studies of the mutual fund industry also find that manager skill is very rare and difficult to distinguish from (much more common) manager luck.  Green mutual funds are not the best way to gain exposure to the sector: even compared to most actively managed mutual funds, the green energy mutual funds are quite expensive, and so they make sense only for investors who have no other option.

I took an in-depth look at the available green energy mutual funds here.

Green Energy ETFs

The second option is green energy Exchange Traded Funds, or ETFs.  ETFs are like mutual funds in that they allow an investor to own small stakes in a large number of companies with a single investment, but, unlike mutual funds, they do not have managers who try to pick the best investments.  Instead, their goal is to gain exposure to a wide range of green energy companies by buying the companies in an industry index.  Investors buy ETFs from other investors on a stock exchange, much like they would by individual stocks; the ETF manager seldom deals directly with individual investors.  This hand-off approach means that they can charge investors much smaller fees for their services.  Furthermore, since there is little evidence that active mutual fund managers add value, the ETF investor benefits from cost savings, but probably does not lose any benefit from active management.

ETFs are an appropriate investing strategy for a hands-off investor with a few thousand dollars or more to invest.  I published an in-depth look at the available green energy ETFs here, which includes recommendations of the best ETFs for different types of investors.

Green Energy Stocks

The final option is investing in green energy stocks.  This can deliver significant cost savings relative to investing in green ETFs (and almost certainly will deliver cost savings relative to mutual funds), but typically requires considerably more investment of time than does using the green ETFs.  This must be weighed against the additional work required to select individual stocks instead of ETFs, but carries the advantage of access to green energy sectors which the mutual funds and ETFs neglect, better control of both sector and stock selection..

In order to give readers a relatively simple option to invest in green energy stocks without a lot of work, I have published a list of 10 stocks on January 1st for the last two years.  My ten green stocks for 2008 lost 55% that year, but this was still better than all the ETFs and all but one of the mutual funds in 2008.  Most of these lost between 60% and 70% of their value in 2008.  In the first three quarters of 2009, my ten picks returned 41.5%, handily beating the green ETF I chose as a benchmark (by 20%).  (I have not looked into the performance of all the ETFs over the same period.)  As with mutual fund managers, it’s impossible to say if my 1 3/4 year track record is skill or luck, but at least the costs are low.

I’ll publish a new list of ten on AltEnergyStocks.com at the start of 2010.

Four Articles on Sector and Stock Selection

No matter which investment vehicle you use, understanding a little about the clean energy sectors can lead to a stronger, safer, and more profitable portfolio.  It can also lead to a greener portfolio, in the environmental sense of the word.

I’ve published a series of articles to help investors make the right decisions.  Two are based on research into which technologies would be most effective against climate change.  The first looked into those technologies which would have a significant impact on climate change, and the second looked into those technologies which were not going to make significant contributions.  I  believe it makes sense to structure your portfolio to reflect the technologies which are actually going to make a difference.  People who want to do the right thing will know that the companies they own are doing the right thing about climate change.  People who want to make money will know that rational investments to fight climate change will also benefit the companies they have invested in.

The third article looked at the types of questions investors should ask when selecting stocks or sectors, as part of a basic framework for investment decision-making.  We are currently inundated with information about companies, but most of it is useless when trying to predict stock returns, because it is already reflected in market prices.  Knowing the difference between useful information and useless information can dramatically reduce research time and lead to better decision-making.

The final article in this series looked at psychological factors which can lead incautious investors to invest unwisely, and how investors who are aware of this tendency can do better. The article also includes a list of twenty green energy stocks and sector ETFs that I think have the best prospects in their sectors.

Stock Selection Shortcuts

Individual stock selection is also more complex than selecting a few companies from stock lists, even my lists.  Selecting stocks requires a level of due diligence when looking into each company.  However, for investors who would like a shortcut and don’t want to use my lists, another trick would be to choose stocks from the portfolios of the green mutual funds to match your intended sector allocation.  Even if we can’t be sure that the mutual fund managers are good at stock picking, we can be fairly confident that they have looked into the companies in their portfolios and avoided the obvious scams.

I tried such an approach by using stocks from the mutual funds’ portfolios when I constructed my Quick Clean Energy Tracking Portfolio earlier this year.  The purpose then was not to outperform the mutual funds by better sector selection, but instead to match their performance at lower cost.  It didn’t work out that way.  The portfolio vastly out-performed, which turned out to be due in large part to an unexpected bias towards riskier stocks than those in the funds, in combination with a strong upward trend for the overall market over the period in question.

Even though that particular experiment did not work, the portfolios of the green energy mutual funds and ETFs are good places to start when selecting green stocks, and I will continue to do so myself.

For investors following the mutual fund or ETF routes to green portfolios, I give breakdowns by sector of each fund’s portfolio in the linked articles on Green Energy Mutual Funds and Green Energy ETFs.

Part II of this series will attempt to help you decide how much to invest in green energy. (Link will be broken until publication.)

AltEnergyStocks DISCLOSURE: None.
AltEnergyStocks DISCLAIMER: The information and trades provided here and in the comments are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.