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Increasingly, investors and their financial advisors are taking notice of green investing and are asking whether and how environmental criteria should be considered in their portfolios. I believe a global consensus is emerging that the challenge of our time is to achieve energy security and economic growth while minimising pollution and preventing irreversible damage to our ecosystem. The 'green economy' is a retooling of our existing energy infrastructure, manufacturing processes and consumption patterns so that we can have continued prosperity and growth without depleting our natural and non-renewable resources. This challenge presents a tremendous opportunity for all stakeholders, not the least of whom are investors, who stand to benefit from its success.

But when selecting investments, what environmental criteria need to be considered and why? The answer lies in what moves the needle with regard to risk and return. Broadly, green investments can be divided into two categories: 'pure plays' and 'environmental leaders'. Think of the first group as companies that are in business for the specific purpose of providing green goods and services and the second group as companies that are environmental leaders within their respective industries. Pure plays can be further broken down into the following subsets: renewable energy, energy efficiency, and environmentally friendly products and services. Pure plays usually tend to be more risky, small-cap companies offering higher growth, while environmental leaders tend to be more diversified, less risky and multi-cap. Therefore, the risk/return profile of a green portfolio is a function of the weighting between pure plays and environmental leaders.

The next step is to identify which criteria to use within each category to select appropriate investments. Starting with pure plays, the key word is energy. On the supply side, there is renewable energy and on the demand side, there is energy efficiency. The advantages of substituting renewable energy generation for fossil fuel-based energy are achieving energy security, preventing environmental degradation and long-run cost savings. The major advantages of energy efficiency, on the other hand, are short-term cost savings and reduced energy demand. Think of the output of energy efficiency as 'NegaWatts' or energy consumption dollars avoided. In many ways, efficiency provides the low-hanging fruit because the payoff goes right to the bottom line and is measured in reduced energy bills. Personally, I believe that as the developed world enters a period of fiscal constraints, which might even lead to fiscal restraint, energy efficiency may have an advantage over alternative energy since it is the cheaper options. To invest in energy efficiency, one can look at companies involved in Smart Grid applications, efficient transportation and green building. The latter sector is particularly attractive, if you consider that buildings consume 30% of the electricity in the United States and produce almost half of the greenhouse gas emissions.

Let us take a closer look at alternative energy companies. This sector is comprised of companies engaged in the following forms of energy generation: geothermal, solar, wind, future fuels and fuel cells. Some may include nuclear energy in the list, though I do not personally subscribe to that. Nuclear energy's waste problem, which makes it non-renewable in my mind and the fact that unimaginable things do happen are the main reasons for my lack of enthusiasm. Then there is natural gas and clean coal. I view the former as a viable 'transition fuel' as we ramp up the renewables. Clean coal may eventually make sense, although at the moment, there is no such thing as 'clean coal'.

So which alternative energy industries should an investor be interested in today? I favour those sources that are close to the cost of coal, natural gas and nuclear. Today, geothermal and wind energy can compete with fossil fuels. Solar is still expensive, though the cost per kilowatt-hour (kWh) is decreasing rapidly.

According to a 2009 Credit Suisse research report, at an average $6/watt system price, the levelised cost of electricity (LCOE) for solar photovoltaic panels (PV) is approximately $0.15 per kWh for crystalline systems and $0.14/kWh for thin film, including the investment tax credit incentive. According to the Solar Energy Industries Association, (SEIA) as recently as 2007, the average system price was $7.50/watt and the declining cost trend continues. It is also important to note that in several states, including California, Hawaii, Florida, and Massachusetts, grid parity is already being reached by certain systems, according to a recent study by the National Renewable Energy Laboratory. If the LCOE drops to $5/watt, grid parity in Southern California and Hawaii is even reached without incentives.

Solar will arrive, in my opinion, though I would not overweight it relative to geothermal and wind energy – in the near term, there could be some shakeout, with supply growing possibly faster than demand and the uncertainty surrounding government incentives. Solar still needs some level of support, whereas wind is farther along the grid-parity path. One of the challenges in wind energy is the amount of capital needed for most projects, which tend to be fairly large scale. But I am excited about the prospects for the industry. The United States is the leader in total installed capacity, with 35 GW, followed by China, which has an installed base of 26 GW. China had a 39% share of new installed capacity in 2009 versus 26% for the US, according to the World Wind Energy Association (WWEA). To put wind versus solar into perspective, the wind capacity that was added in 2009 alone is almost twice as much as the entire cumulative capacity of global solar electricity in place today.

My approach to investing in wind has been to focus on the areas of the vertical supply chain where there are few competitors and supply constraints. For example, the rotor bearings are highly specialised and only a few companies in the world make them. We have also looked at big wind project developers that have utility scale expertise. They can do well as long as the macro picture for wind looks good, whether or not that is an excess supply of turbines.

In the renewable energy space, in addition to wind and geothermal, I am starting to pay attention to waste-to-energy and biofuel. When the latter was mainly comprised of companies involved in corn ethanol, it did not seem appealing, but with new advances in cellulosic ethanol and algae fuels it is becoming more interesting.

But one of its biggest challenges for the green economy is the uncertainty in the level of government support. The American Recovery and Reinvestment Act of 2009 and similar government stimulus in Europe and especially China were very supportive of alternative energy and energy efficiency. At the federal level, the Waxman-Markey bill (also known as the American Clean Energy and Security Act) would establish a cap-and-trade system for greenhouse gases. The bill was approved by the House of Representatives in June 2009 but has not made much progress in the Senate. The Kerry, Lieberman, Graham climate change bill is now just the Kerry-Lieberman bill, and few in Washington give it much of a chance of passing. The BP disaster is boosting the case for limits on offshore drilling but has not translated to a broader appetite for more comprehensive legislation. However, with the alternative energy companies gaining clout and the prospect of green jobs, there is probably some appetite for the carrot (supporting alternative energy and cleantech), if not for the stick (punishing traditional fossil fuel energy generation and imposing carbon caps).

One also needs to look at regulation. The US Environmental Protection Agency (EPA) recently announced it will expand permitting requirements starting July 2011 under the Clean Air Act to cover all new facilities with greenhouse gas (GHG) emissions of at least 100,000 ton per year and modifications that increase GHG emissions by at least 75,000 ton per year. The EPA estimates that approximately 900 additional permits covering new generating capacity and 550 permits covering existing capacity will need to be obtained as a result of the ruling.

It is clear that there are both positives and negatives on the legislative and regulatory front regarding green sectors. On balance, however, it is perhaps the uncertainty that creates the biggest headwind for green stocks.

Although short-term uncertainties face the green economy, it will represent one of the biggest opportunities for investors going forward. Ultimately, investment performance is the difference between price entry point and price exit point. Investors in green companies should be in the 'buy phase' and therefore focused on finding attractive entry points. If we consider that the greening of the economy does not end until we have retooled the global economy to enable it to continue to grow within the constraints imposed by limits to non-renewable resources, we can all feel confident that we have only just begun.

Jan Schalkwijk, CFA, portfolio manager, has 13 years of experience in the investment industry and is the founder and chief investment manager of JPS Global Investments. From 1997 to 2005, he worked at Franklin Templeton Investments, where he was vice president of investment platforms.

This article first appeared in FA Green (July 2010 issue). For more related articles, please go to