Investing for a brighter future

Farley Thomas, global head of wholesale at HSBC Global Asset Management, explains the main sub-sectors for investment in the climate change area.

The issue of climate change has the potential to be the defining investment theme of our time. Potential investments in climate change related industries could rise to an annual average of $1.3tn from now to 2050 (up from $148.5bn in 2007) if carbon emissions are to be halved), according to IEA, Energy Technology Perspectives, 2008.

Just as combating climate change will be crucial to the kind of future that lies ahead of us, so the investment landscape is also experiencing profound change. This does not only apply to those industries that are directly linked to environmental themes, but virtually every industry and sector is likely to be touched by popular and political will to address the challenges that climate change presents.

In understanding the dynamics of climate change as an investment theme, it is important to recognise the timescales. Perhaps more than for any other asset class or investment theme, climate change is undoubtedly for the long term. It is easy to see the potential in areas like solar and wind power, but full-scale commercial viability in many popular climate change areas is a long way off. However, financial market valuations across all industries are based on assumptions surrounding future earnings and there can be little doubt that the potential for the right companies in the right areas could be compelling

Here we look at some of the main sub-sectors within the climate change area, how they have evolved to date and what factors are affecting their future performance.

Solar power

In the case of solar power, the long-term prospects appear strong and from an investor's perspective this theme presents a number of opportunities. Solar-grade silicon producers are experiencing intense demand and the main producers are experiencing significant pricing power as the top five suppliers account for around 85% of the market. Although competition is rising for wafer producers, they are benefiting from high profit margins and the makers of photovoltaic cells are benefiting from high levels of industry growth. Countries like Germany, Spain and the US are leading the way in solar energy, but the ubiquitous influence of China adds an extra dimension to the story as interest and progress in Asia picks up speed.

Solar power is projected to become price competitive with existing power sources in 2012 and, in the interim, the industry benefits from a growing number of governments that are providing subsidies. Interest and demand for solar energy is also likely to be underpinned by expectations for fossil fuel generated electricity costs to increase while the costs of solar energy systems decline. These appear to be favourable long-term factors, but the investment reality should not be ignored. Solar energy stocks have already experienced major volatility and while the long-term outlook appears sound, it is not likely to be a smooth ride. This is where it is crucial for investors to remain dispassionate and objective. Although the concept of climate change may be emotive, it is the job of climate change funds to manage their investments effectively and this should include the basic principles of recognising and avoiding potential bubbles and maintaining a balanced and detached perspective.

Wind power

Wind power is another example of an industry with obvious attractions. The wind turbines that generate electricity can do so in a way that makes this a 'clean' source of energy. Each mega-watt hour of electricity that is generated by wind energy saves the 0.8 to 0.9 tonnes of greenhouse gas emissions produced by coal or diesel fuel to generate the same amount of electricity. Wind power is set to become a mainstream option for electricity and a real solution to climate change.

Government legislation has been a crucial factor in the development of the wind power industry and much of this has been led by Europe. Germany and Spain have been joined by the likes of the UK, Portugal, Italy and France as countries fuelling development and implementation, and once again key emerging market economies in areas like China and India offer significant growth opportunities. Within this context, the supply chain and its capacity to cope with demand are vital. To address these challenges, turbine manufacturers are improving their procurement strategies to ensure long-term technological integration and to improve quality control. The industry is growing fast and has the potential to make a tangible contribution to energy efficiency and this is reflected in the commitment and appetite of companies to keep pace with market influences.

Carbon capture and sequestration

Perhaps a slightly less high profile theme is that of carbon capture and sequestration (CCS), which in its most basic form is capturing and storing carbon dioxide. Carbon emissions are clearly a defining climate change issue and CCS captures, compresses gas into liquid and then transports and stores CO2. It is estimated that CCS could account for around 20pc of global CO2 mitigation by 2050, making it a credible part of the climate change landscape. This is also reflected in the companies involved in this industry, which include Siemens, Total and Air Liquide.

The need for this type of activity is predicated on the fact that coal will continue to play a major and even-increasing role in meeting global energy needs, particularly while oil prices remain at elevated levels. Prospects for coal are currently bright, costing a fraction of oil and natural gas and with huge reserves. With coal generated energy likely to be a factor for many years to come, European authorities are already committed to CCS, stating that their long-term goals for the reduction of CO2 cannot be met without it. The European Union has provided funding for 20 pilot projects and they intend to have between 10 and 12 viable plants by 2015. With plans also in development for a directive on CO2 geological storage, the theme of carbon capture and sequestration is likely to become an increasingly important part of the climate change agenda.

In conclusion...

Industries and sectors that are directly linked to climate change can often be characterised by their immaturity, huge potential and fast-paced technological innovation. These attributes offer exciting investment opportunities but they also demand close understanding, a sound approach and the discipline to only invest where there is viable potential. In this kind of environment, the technology that could save the world today could very quickly be superceded tomorrow by a quicker, cheaper and more effective alternative. Accordingly, investment managers in the climate change arena need to match the dynamism of the industries they follow. To be successful over the long term, they also need to adhere to their basic investment principles, which means crunching the numbers and assessing prospects, just as they would for any other company.

Investment trends come and go, but climate change is here to stay. Lord Stern's report on the challenges we face has helped to highlight the scale of the issues ahead and there is strong evidence that governments across the world have the appetite to take serious action. This is likely to be confirmed in 2009, with the meeting of world leaders in Copenhagen to sign the follow-up treaty to the Kyoto Protocol. Political and public will for sustainable change will hopefully lead to a better environment for us all and investment opportunities abound in those industries charged with the job of putting words into action.