The move to a decarbonised world offers one of the most exciting moments for investors I have encountered in all the years I’ve managed money. However, such is the scale of the transformation that it’s easy to feel overwhelmed by the choices available to engage with this megatrend.
The first thing to bear in mind is that investing in the energy transition is as much about growth as it is about long-term capital preservation. Here are four ideas to ensure you’re capturing both when building a multi-asset portfolio around the theme.
1. Remember: diversification helps build resilience
The transition is a myriad of overlapping sub-themes. For example, the next decade will require widespread upgrades to the grid to support our increasing reliance on electricity.
For investors that could involve targeting utility companies, the miners producing the copper for wiring, or even the businesses that are manufacturing the cables or involved in the design and development of sub-stations.
The availability of these sub-themes should be positive for any strategy because they help achieve diversification through a broad set of thematic characteristics and build resilience into a portfolio.
Allocating to big energy transition themes like climate solutions, transition materials, and water and waste is a good start. But broadening your scope to take in more specific sub-themes of the transition can protect a portfolio from an over-concentration in stocks that may be charging a green premium, which might be sensitive to interest rate movements.
Exploring new industries that fit into a transition strategy is important, but it isn’t always straightforward. Take the potential sub-theme of technology firms which support decarbonisation initiatives. This could include companies developing artificial intelligence (AI)-driven systems to optimise grid infrastructure maintenance, power-generation sites, or simulate climate and weather conditions. AI is particularly tricky for the transition though: how do these businesses remain sustainable when their energy demand is so high – and growing?
2. Keep an open mind on products and places
Be agnostic about geographical diversification. Instead, find the best companies that offer performance around a theme. It may be there are certain companies benefitting from transition developments or regulation in a particular country or region, but be cautious of overweighting to just a handful.
Be flexible too when it comes to asset classes – building a transition portfolio with a mixture of fixed income, equities, and alternative credit such as infrastructure debt all adds resilience and a natural yield diversification. The maturation of the green and blue bond markets means there are increasingly attractive options in fixed income directly linked to the energy transition, while equity holdings can allow for a greater level of engagement with issuers.
However, the primary focus should be to find the right issuers that support the theme, and then select the options that best fit the strategy. The energy transition is not a short-term project and many of the options have decades-long investment horizons. Various pieces of global legislation – including the Inflation Reduction Act (IRA) in the US and other tax credit schemes – are supporting a very long-term approach, encouraging investments in companies now that will have an impact all along the trajectory to net zero.
For those looking for more immediate returns, we’re already seeing benefits in certain sectors. The world is undertaking a massive buildout of renewable energy infrastructure and a shoring up of electricity grids. Further down the line we expect green technologies that are nascent today – those focused on hydrogen, cathode materials, and battery storage more generally, for example – to provide ongoing support to the trend.
3. Be rigorous when exploring ETFs
Alongside traditional investment options, exchange traded funds (ETFs) can offer investors a cost-effective way to focus on a specific theme, while maintaining the liquidity of their holdings by being able to trade intraday. These tracking indices follow a set of rules, so investors must be comfortable with the intellectual property that goes into the creation of an index and the principles it follows. While most traditional ETFs return beta of the underlying strategy they are tracking, portfolios focused on specific themes will want rules that maximise the alpha they’re after.
There are a lot of options. Be thorough in selection. One ETF can be materially different to the next, contradictory even. Those constructed around a hydrogen theme can have holdings that contrast significantly to those built for climate or clean energy. There are many more ETFs that target specific sectors such as solar power, wind energy, and other sub-sectors. Combining them can be effective, but due diligence ensures the correct exposure. Even so, in a passive ETF you’re likely to get a tail of names that you’re less interested in. Active ETFs might be preferable and provide another option that gives investors more control and allows managers to leverage their own sectoral and regional analysis – but again, thorough research is vital.
4. Never take your eye off the risks
With the transition come the physical and financial risks posed by climate change. No matter the strategy it’s important that the companies which investors chose exposure to are managing those risks. Businesses that are transitioning now are in theory reducing their future costs. Those that aren’t potentially are storing up issues for the years to come.
Regulatory risks are also significant. While many policies – such as the IRA in the US and green financing initiatives in Europe – are enshrined in law, there can always be shifts in the way they’re implemented. There could also be a change in the frequency at which new initiatives are brought in, although given the energy transition is increasingly core to both economic growth and energy security this seems unlikely, particularly in Europe since Russia’s invasion of Ukraine.
Indeed, the transition has become one of the central themes of the investment landscape, and – while acknowledging the risks – its strong, long-term structural growth is particularly appealing. The momentum around decarbonisation is solid; the number of investment strategies available to explore the theme is vast. It’s time to consider taking advantage of them.
