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The Good Thing About Climate Change: Opportunities to Invest in the Climate Change Sector

GMO White Paper – The Good Thing About Climate Change: Opportunities, August 2017

The climate change sector

  • Mitigation
    • Industries involved in the mitigation of climate change and the transition to a clean energy world include solar, wind, nuclear, hydro, geothermal, batteries and storage, smart grid, and clean power generation
    • We also look at the inputs into these efforts, so lithium, copper, and other critical materials fit the bill as well
    • Energy efficiency efforts are also within the scope, including building materials, lighting, and electric vehicles
  • Adaptation
    • We consider companies helping the world adapt to a changing climate as part of the climate change sector as well
    • Companies helping to support agricultural productivity through the production of seeds, fertilizers, farm machinery, etc., would find desperate need for their products
    • Droughts, floods, and changes in precipitation patterns also threaten water supply
    • Believe companies focused on water recycling and treatment, water use minimization, and water system engineering will find their services in high demand as well

Secular growth opportunity

  • IEA estimates that it will cost $9 trillion through 2050 to decarbonize electricity with another $6.4 trillion going into energy efficiency efforts in the buildings, industry, and transportation sectors
  • Fossil fuel consumption continues to rise, and carbon dioxide concentrations in the atmosphere continue to hit record highs year after year
  • Good news is that wind and solar are expected to grow at a substantial rate for the next few decades
    • Projections for renewables growth have continually been revised upwards and believe that current projections are likely to fall well short of the growth that is actually realized as the world continues to mobilize to address climate change
    • Two factors behind the repeated upward revisions to projections for renewables are general forecasting conservatism/anchoring and the falling costs of renewables
    • While there are still challenges surrounding storage and the integration of intermittent, distributed renewables into the electric grid, can now see the light at the end of the tunnel
  • Electric vehicle sales have grown rapidly in the last few years and are expected to do so for many years to come
    • EVs continue to represent a tiny sliver of overall vehicle sales, but falling costs bode well for the future; lithium-ion battery costs have fallen by almost three quarters over the last few years and are expected to fall dramatically from here
    • Battery costs generally make up 20-25% of cost of an EV
    • Various projections indicate that EVs will be cheaper than internal combustion engine vehicles within 5 to 10 years
    • By the way, this does not mean that Tesla is necessarily a good investment

Global public policy and the private market will support the clean energy transition

  • President Trump’s decision to exit the Paris Agreement seems like bad news for climate change mitigation efforts. Unintentionally, though, the decision has had a galvanizing effect on those concerned about climate changes
  • Still a fair amount of uncertainty about US federal policy with regards to climate change – climate change is a multi-decade problem
  • Climate change is a global problem and rather than wavering on their promises, other countries have instead rallied together to reaffirm their commitments in the wake of Trump’s decision
    • China, India, and others are champing at the bit to take a leadership position on climate change and to reap the potential rewards
    • Germany, France, China, India, and others are setting goals to eliminate internal combustion engine vehicle sales within the next two decades or so
  • While public policy support has been critical for clean energy in the past, it’s not obvious that it will be a necessity going forward
    • As cost becomes cheaper than conventional alternatives, public policy will be icing on the cake
  • We are in the very early stages of a massive transition to clean energy, and in a world struggling to find growth, climate change-related industries should truly stand out

Investing in the climate change sector: public vs. private equity

  • Two obvious options for investors interested in accessing the opportunities in the climate change sector: public and private equity
    • There are important differences in the lifecycle stage and risk/return profiles offered by public equities and VC start-ups
    • Public equities provide exposure to more mature, proven technologies, while start-ups offer the chance at a game-changer and the associated windfall, as well as the much more frequent disappointments and bankruptcies
  • There are some advantages to the public equities. More importantly, public equity markets offer a relatively easy avenue for diversification, and we think diversification is important in the climate change sector
    • There will be a fair amount of uncertainty about the precise growth rates of various segments of the climate change sector
    • Would be extremely difficult and expensive to pull together a basket of private investments spanning wind, solar, geothermal, smart grid, storage, seeds, fertilizer, and water
    • Liquidity also obviously favors the public equity markets (it’s particularly important in the climate change sector where there is the potential for a large amount of technological disruption)

The opportunity in the public equity markets

  • Risk and returns:
    • Longest running relevant index was the HSBC Climate Change Index, which was run for around 12 years before being discontinued in March 2016
    • Over the entirety of its existence, HSBC Climate Change Index kept up with the broad equity market, albeit with volatility about 15% higher than the broad market
    • Negative spin on this would be that it delivered the same returns as the broad equity market with significantly higher volatility, not exactly a dream risk/return tradeoff
    • Positive spin would be that it delivered equity-like returns during a period in which the economics weren’t favorable for many of the constituents (e.g., wind, solar, electric vehicles)
    • Believe a pragmatic, disciplined, value-oriented approach to the climate change sector can lead to impressive returns

The valuation of the climate change sector

  • In recent months, the universe has generally traded in line with or at a slight discount to the broad equity market
    • As a sanity check, valuation of the MSCI Global Environment Index paints a similar picture
  • This may seem incongruous as there’s a great growth opportunity but investors don’t have to pay a premium to access that growth
    • This is in stark contrast to the Tech Bubble where investors paid 50, 100, or much higher earnings multiples to get exposure to expected growth
    • While it may be almost certain that companies in the climate change sector will grow their top-line revenues faster than the broad market, much less certain that they’ll be able to convert that top-line growth to bottom-line earnings and profits
  • Market may be worried considering the spotty history of alternative energy investments – two solar ETFs that launched in 2008 are down more than 90% since inception despite strong growth in solar installed capacity
    • It’s clear that solar industry has been more effective at electricity generation than earnings generation

The importance of a value orientation

  • Major wind companies, operating in an industry with much better competitive dynamics than the solar industry, delivered almost 16% per annum from 2000 through June of this year
  • Yet, investors who bought into wind at the energy peak in 2007-2008 had a very different experience – this shouldn’t be too surprising given that wind companies were trading at around 100x normalized earnings and 8x book value at the end of 2007
  • In contrast, those brave enough to invest in the out-of-favor wind industry in 2012, when wind companies traded at 6x normalized earnings and half book value, have been rewarded with returns of more than 50% per annum over the last 5 years
  • It’s critical to have a disciplined value orientation and to understand the evolving fundamentals of the relevant industries and companies – where there is growth and innovation, there will be hype and hysteria

The climate change sector is likely to be particularly inefficient

  • Analyst coverage is low
  • Small to mid-cap universe at this point – biggest solar companies in the world are a few billion dollars in market cap, trivial compared to the behemoths in the oil and gas industry
  • Relatively new, poorly understood sector – understanding the big picture, global policies, details of changing technologies, and companies themselves is a tall order
    • Uncertainty about how things will play out leads to large swings in sentiment and wide dispersions in expectations – all things that breed opportunities

Risks to investing in the climate change sector

  • Policy risks: US pulling out of the Paris Agreement is a good example; China or India or other major countries wavering on their commitments would have an impact as well
  • Technological disruption: this risk can be mitigated through diversification but one can’t completely discount the possibility that cold fusion or some unforeseen technology changes the game in a way that affects large swaths of the climate change sector
    • A lot of people have spent time and money trying to develop clean energy and the advances we see are generally incremental in nature
  • Getting caught up in hype and stories, paying the wrong price, and investing in industries with poor competitive dynamics
    • These are same risks investors face in other sectors of the market and these risks loom larger than policy or disruption risk
Image Source: The Daily Star
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