Building an energy transition portfolio

The trillions of dollars needed to finance the energy transition will be deployed across a large and varied landscape. We believe the kinds of energy transition investments that make sense for a given investor’s portfolio will largely depend on that investor’s capacity and tolerance for risk.

The risk profiles of the solutions emerging from the energy transition, ranging from “proven technologies” to “early technology bets,” are defined in Exhibit 1. We explore this framework in further detail throughout our series of articles on the energy transition. Generally, we anticipate the risk-return levels of these solutions will conform with our expectations for their corresponding primary asset classes, as shown in Exhibit 2—although some strategies may assume more technology or development risk in order to address key financing gaps in the climate solutions market.

Public Market Strategies Are Climate-Integrated or Pure-Play

The fixed income, liquid real assets, and listed equity asset classes offer a wide variety of energy transition investment opportunities, though most are concentrated in the “proven” and “enabling solutions” categories. As the energy transition progresses, some of these investments are naturally starting to appear in diversified portfolios benchmarked to broad indices, such as the S&P 500, Russell 2000, or MSCI EAFE. But most public market investors access these opportunities through thematic funds dedicated to the energy transition.

For moderate-risk investors interested in the energy transition, we recommend thematic strategies that take an expansive view of the energy transition opportunity set. We often refer to these as “climate-integrated” strategies and they can be found in both fixed income and listed equities. Climate-integrated strategies tend to offer their investors relatively broad market exposure, limit their concentration in high-volatility companies, and invest more heavily in industry incumbents.

As a result of these risk management measures, these strategies seek to limit the extent to which their performance deviates from their asset class benchmarks. But that does not mean they limit their exposure to the theme. Incumbent companies will play a critical role in the energy transition acting as potential customers, developers, and acquirers of new climate technologies, with large balance sheets to deploy towards decarbonizing their operations and business models. Examples of common holdings in climate-integrated portfolios include the world’s largest industrial gas producer, which has a burgeoning hydrogen business; a French energy management and industrial automation company that stands to benefit from the electrification trend; and an Irish manufacturer of building insulation products that improve energy efficiency and reduce utility costs. While each of these companies has a clear connection to the energy transition, their revenues come from products and services with proven use cases and established customer bases.

Investors with a higher risk tolerance may wish to consider thematic strategies that concentrate their capital in “pure-play” investments, which include companies or projects whose business models are tightly bound to the success of the energy transition. Pure-play strategies typically invest in projects or companies with a small number of product or service lines; a narrow industry focus; and, often, limited size or track record. Within fixed income, pure-play “green bond” strategies may purchase corporate, sovereign, and other debt securities issued to finance renewable energy or other climate-related projects. Liquid real asset strategies with pure-play mandates often purchase the equity of power project developers, renewable energy producers, and utilities that are investing heavily in clean energy plants. Finally, pure-play equity strategies tend to combine investments in renewable power producers with investments in companies that provide enabling technologies. Examples of common pure-play equity holdings include a Danish wind turbine blade manufacturer; a U.S. provider of residential solar systems; and the leading manufacturers of solar inverters.

As a result of their narrower focus, pure-play strategies tend not to fit as well as climate-integrated strategies into typical asset allocation buckets. Less diversification means their performance may deviate substantially from asset class benchmarks. We recommend clients treat pure-play strategies as “satellite” allocations and size them within the bounds of their risk tolerance. Manager selection is also a key risk mitigant in our opinion. We look for managers with deep expertise in the industries most relevant to the strategy and the capacity to conduct ongoing thematic research.

Private Markets Provide Targeted Thematic Exposure

The private markets arguably offer a broader selection of investment opportunities than public markets, allowing investors to target their capital in particular sectors, sub-themes, or geographies. Renewable energy assets have attracted the largest volume of private capital, with most deal activity happening in venture capital and growth equity.1 Many of today’s energy transition funds are focused on digital technologies and software. This is in contrast to the “clean tech 1.0” period from 2006 to 2011 when venture investors lost billions on clean energy strategies. During this period, their investments had underappreciated technical risks, required longer development times, and were capital-intensive, while the timing coincided with the Global Financial Crisis, falling natural gas prices, and cheap solar panel manufacturing from China.2

Today, the market has shifted considerably given the advantages noted in The Energy Transition’s Major Investment Themes  while the capital stack for climate technologies has also become more robust. Venture investors have sought to address prior challenges by reducing technology risk and focusing on “enabling technologies” such as electrical grid optimization software, and “niche markets” such as software designed to optimize the management of electric vehicle fleets. Domain and technical expertise have also become key criteria in building investment teams that might invest in hardware-oriented solutions. Due to the critical role that incumbent corporations play in deploying and acquiring climate technologies, we believe investors need strong relationships with corporate strategic players including utilities, industrials and automotive companies.

Funding gaps still exist, however, with market participants noting that first-of-a-kind demonstration projects have limited capital providers. “Patient capital” strategies have formed to address these gaps, featuring extended fund lives and drawing from blended capital, funded by a mixture of concessionary and non-concessionary capital. On the farthest end of the risk spectrum, patient capital providers are investing in some of the most technically challenging and earliest-stage climate solutions. Though patient capital can earn a market-rate of return, many of the opportunities in fields such as fusion energy, long-duration energy storage, electric industrial furnaces, carbon capture technology, and hydrogen are appropriate only for those investors with very long time horizons and, in some cases, a willingness to accept below-market returns.

To the extent investors deploy capital in venture and growth equity, we advise them to balance the risks inherent in those asset classes with private investments that seek lower-risk, lower-returning opportunities. Real asset strategies, which may benefit from the downside protection that tangible assets provide, can often serve in a complementary role. Beyond renewable energy infrastructure funds, we believe investors may generate attractive returns from investments that benefit from the energy transition but are uncorrelated with energy markets. Examples include commercial real estate strategies that use building efficiency technologies to reduce utility costs. Sustainable timberland and farmland strategies that lease property to renewable energy producers may offer similar diversification benefits.

Managing Risk via Portfolio Diversification and Manager Selection

In our opinion, investing in the energy transition means making a bet on the future. Even the most mature climate technologies still need to achieve tremendous scale in order to contribute meaningfully to the world’s ambitions of net-zero greenhouse gas emissions. As a result, energy transition investors may be overweight high growth businesses and require long time horizons.

In 2022, Harvard Business School Professor George Serafeim co-authored a working paper titled “Climate Solutions Investments” highlighting the risks associated with the energy transition theme. The authors identified a portfolio of 632 listed companies that they believed were most representative of the global “pure play” climate solutions market. Though the companies in the portfolio exhibited higher revenue growth than their peers, they typically also had higher expected risk due to worse profitability and lower earnings yield owing to higher capital expenditures; higher research and development costs; and higher salaries, general, and administrative expenses. Furthermore, just under 50% of the market capitalization of the portfolio was in China and other Emerging Markets.3 In our experience, climate strategies also tend to have significant concentrations in the utilities, industrials, and materials sectors, as well as in the small-to-mid capitalization portion of the market.

All these characteristics are sources of risk that can drive substantial volatility. Between 2011 and 2021, Serafeim’s back-tested, value-weighted climate solutions portfolio had an annualized standard deviation of 18.4%; a maximum drawdown of 40.7%; substantial positive factor weightings for size and growth; and a substantial negative factor weighting for profitability. As shown in Exhibit 3, two of the largest clean energy exchange traded funds, the iShares Global Clean Energy ETF and the First Trust NASDAQ Clean Edge Green Energy ETF, have exhibited similar risk characteristics. In all three cases, the climate solutions strategies have exposed investors to substantially more volatility than a standard global benchmark, such as the MSCI All Country World Index.4

In our view, these risks should be balanced against the potential opportunities that climate solutions may bring to an investor’s portfolio. After all, Serafeim notes that his climate solutions portfolio has outperformed broad market benchmarks over various time periods.6 These results highlight the importance of a comprehensive approach to risk management when integrating energy transition investments into a portfolio. We recommend the following strategies:

1. Core Holdings: The energy transition will affect the entire global economy, so, in our opinion, participating in the upside of the transition does not require investment solely in volatile, pure-play strategies. We believe investors should increasingly expect to see transition-oriented names appear in the portfolios of their core managers. For instance, the energy transition is a major component of Fiduciary Trust International’s analysis of utilities stocks.

2. “Climate Solutions” Does Not Always Mean “Low Carbon”: For investors approaching the energy transition purely from an investment-return perspective and not limited by values-based constraints, we see climate solutions opportunities outside of the high growth, “clean tech” sectors. For instance, some energy transition-focused strategies invest in the mining sector, which will need to ramp up the production of industrial metals such as copper, nickel, lithium, and sodium to meet growing demand for batteries, electric vehicles, and other clean technologies. We would expect the integration of these strategies into a portfolio to help balance unintended factor tilts from other climate solutions strategies.

3. Passive is Not Really Passive: We generally recommend investing in the energy transition through active managers in both public- and private-market strategies. Active management does not guarantee outperformance, but we generally believe skilled active managers may offer better returns per unit of volatility than their benchmarks. Passive, public market funds can be useful in providing broad exposure to the theme, but, in our opinion, a substantial amount of subjectivity and judgement is still needed to define the investment parameters, and the indices underlying passive climate solutions funds are rarely updated more than once per year.

4. Manager Selection: We believe the best protection against a permanent loss of capital is to select skilled investment managers. According to McKinsey, assets under the management of private market, sustainable investing funds tripled to more than $270 billion between 2019 and 2022 and more than 330 new funds were launched.7 These figures underscore the importance of maintaining discipline. We prefer working with investment managers that survived the “clean tech 1.0” boom; avoid significant technology risks; are attuned to the risks of commoditization that come with nascent industries; possess domain expertise related to energy markets; and have strong networks with incumbent companies, many of which may be the eventual customers or acquirers of new energy transition technologies.

Risk Management is Necessary for Energy Transition Investing

We view the energy transition as an unprecedented investment opportunity that will touch nearly every sector of the economy. But as investors deploy capital and position themselves to benefit from the growth of the clean energy economy, they must take stock of the associated risks. The dynamics of the energy transition market will change as companies mature, but we believe risk management is key in these early days.

 

This article is part of the Plugging into the Energy Transition series. Click here to download the complete report.

 

 

1 Jody Gunderson, “How Private Assets Can Empower the Energy Transition,” Alliance Bernstein (March 17, 2023), https://www.alliancebernstein.com/americas/en/institutions/insights/investment-insights/how-private-assets-can-empower-the-energy-transition.html

2 Benjamin Gaddy et al., “Venture Capital and Cleantech: The Wrong Model for Clean Energy Innovation,” MIT Energy Initiative, July 2016, https://energy.mit.edu/wp-content/uploads/2016/07/MITEI-WP-2016-06.pdf

3 George Serafeim et al., “Climate Solutions Investments,” Harvard Business School Accounting & Management Unit Working Paper No. 22-054, January 2022, http://dx.doi.org/10.2139/ssrn.4027579

4 FactSet; Fiduciary Trust International analysis

5 Past performance does not guarantee future results and results may differ over future time periods. All investments involve risks, including possible loss of principal. Benchmarks and indices are shown for illustrative purposes only and are provided for the purpose of making general market data available as a point of reference only. Such benchmarks and indices may not be available for direct investment, may be unmanaged, assume reinvestment of income, do not reflect the impact of any trading commissions and costs, man- agement or performance fees and have limitations when used for comparison or other purposes because they, among other reasons, may have different trading strategy, volatility, credit, or other material characteristics (such as limitations on the number and types of securities or instruments). No representation is made that any benchmark or index is an appropriate measure for comparison.

6 George Serafeim et al., “Climate Solutions Investments,” Harvard Business School Accounting & Management Unit Working Paper No. 22-054, January 2022, http://dx.doi.org/10.2139/ssrn.4027579

7 Fredrik Dahlqvist, “Climate Investing: Continuing breakout growth through uncertain times,” McKinsey & Company, March 2023, https://www.mckinsey.com/capabilities/sustainability/our-insights/climate-investing-continuing-breakout-growth-through-uncertain-times