THE BEST BETS ARE ON THINGS THAT BEAT CLIMATE CHANGE

Investing in Climate Change 2010; A Strategic Asset Allocation Perspective
Mark Fulton, Bruce M. Kahn, Nills Mellquist, Emily Soong, Jake Baker and Lucy Cotter) January 2010 (DB Climate Change Advisors/Deutsche Bank Group)

SUMMARY
There is a newly reborn determination to aggressively build New Energy and Energy Efficiency until global climate change is turned back by choking off the Old Energy-generated spew causing it. Momentum started gathering in the darkness of shock and disappointment at the outcome of last month’s Copenhagen climate summit. The political turn of events in Massachusetts has sparked the drive to brightness.

Many of the heroes of the European Union at the forefront of the effort to introduce EU-wide and international policies to cut greenhouse gas emissions (GhGs) have turned to the building of New Energy (NE) and Energy Efficiency (EE) with a renewed fervor.

Deutsche Bank (DB), which has been at the heart of the EU effort to build an effective cap&trade system to reduce GhGs since its inception, sees the fervor and, in Investing in Climate Change 2010; A Strategic Asset Allocation Perspective, has put out a simple message to its investors: Climate change fighting investments belong in your portfolios because they will make you money.

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Why is one of the world’s most important investment banks and financial institutions so certain bets on climate change fighting companies will pay off? Because:
(1) Governments around the world have mandates and policies in place to drive NE and EE growth and more and better such policies are emerging;
(2) Climate and environment concerns, national security concerns and the push for economic recovery are driving technological innovation like never before;
(3) Climate change investment covers NE, EE and much more (such as effective water management and increased agribusiness productivity), sectors that outperformed markets in 2009 and are set for unprecedented growth;
(4) Climate change investment means investing in the new infrastructure that economic recovery funds are already supporting and will continue to support around the world;
(5) Climate change investment is growing as a percent of total market size and by that measure alone warrants expansion in portfolios; and
(6) The DB analysis demonstrates that inclusion of climate change sectors in a portfolio improves returns.

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Footnote: This puts yet greater emphasis on effectively designing incentives that will drive the growing momentum to build NE and EE, as described in LOOKING FOR THE BIGGEST NEW ENERGY BANG FOR THE BUCK, which outlines what Deutesche Bank has learned about incentives from watching the growth of the New Energy industries in the EU.

Deutsche Bank’s long engagement suggests there are 3 requirements for effective incentives, transparency, longevity and certainty (TLC). Experiments with incentives in the U.S., Japan and the EU have taught much about what imparts TLC to New Energy growth and it is being incorporated into emerging nations’ ambitious programs. This will greatly add to the industries’ momentum and the value of investments in them.

Bottom line: Bets on the things that will turn back climate change will pay off in many ways.

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COMMENTARY
The value of the tentative agreement on climate change reached in Copenhagen is like beauty – it is in the eye of the beholder. But smart investors look past beauty to the numbers.

The numbers show that investments in companies engaged in the fight to reverse global climate change – in the aggregate – do better than the overall market.

International emissions trading markets are not yet a risk-controlled way to engage financially with the climate change fight. Uncertainties such as (1) the international community’s failure to commit to cuts in Copenhagen, (2) the resistance to cap&trade in the U.S. Senate and (3) China’s failure to guarantee a transparent audit of its emissions reductions tend to make emissions markets allowance prices low and volatile. Offset and Allowance trading is still part of the Wild West of investing.

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But the Copenhagen Accord emphasizes national and regional GhG-controlling programs and requires signatory governments to publicly record their commitments by January 31, 2010. Such declared plans will drive the growth of a New Energy economy.

International turmoil and the peaking of fossil fuel resources will add energy security concerns to the drivers of a gathering momentum.

Effective incentive programs responsibly administered and injected into ambitious infrastructure-building programs in the emerging economies (China, India, Brazil, Indonesia, etc.) will also be a major factor driving growth.

Looking back: DB’s description of its 2009 predictions for investments in climate change fighting efforts were optimistic, anticipating long-term growth. Performance matched prediction, as those parts of the DB portfolio grew 0.7% faster than investments as a whole.

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A summary of 2009:
(1) Accepted diversification strategies were compromised by the extreme 2008-09 financial downturn. Credit dissipated, markets failed and everything lost value.
(2) Risk aversion was the strategy until a rebound started in March 2009.
Worldwide stimulus programs infused economies in general and the New Energy economy in particular. $500 billion will be invested and deployed in 2010.
(3) Global markets had recovered “sharply” and were in “a solid uptrend” by 2Q09, led especially by investing in low capital aspects of the New Energy economy like Energy Efficiency.
(4) Private markets were slow in the first half of the year, picked up after that but were down overall.
(5) Low natural gas prices, now detached from oil markets, was and remains the most threatening factor to investing in the New Energy economy.
(6) Unsettled policy adds to ambiguity going forward.

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Expectations of 2010:
(1) Climate change fighting investment is a fast-growing part of the broader market.
(2) It adds “alpha” to investment portfolios, having already outperformed world benchmarks.
(3) A variety of factors will support its continued “strong long-term growth.”
(4) There is not a complete absence of uncertainty.

Long-term global thesis and opportunity: Climate change is a severe threat and GhG-cutting technologies and their supporting activities are the solution. NE and EE also offer solutions to other pressing challenges, including the need for new jobs and energy security. The cost for business and industry of not acting will be greater than the cost of building a New Energy economy. There is a high upfront cost but the long-term payoff (in the ownership of new technologies and productive assets) will justify the investment, making such a use of capital a wise investment strategy. Vehicles exist (public equities, private equity, venture capital, infrastructure funds) through which to channel such investing.

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Governments:

Only government-scale incentives will drive big enough growth to meet the global need for emissions-free energy fast enough. The longer building is delayed, the more it will cost to meet the challenge.

GhG emissions are a classic economic externality, carrying a cost that is not part of the market price of fossil fuels.

Only governments can put a cost on the now invisisble and atrocious harms done by the GhGs spewed because of the world’s present dependency on fossil fuels. Through direct pricing, taxes, cap&trade systems, incentives, mandates, standards and other policies governments are doing so, in pursuit of revenues and jobs.

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Governments are also looking for incentives with TLC (Transparency, Longevity and Certainty) to leverage private investment buy-in.

The outcome at Copenhagen will drive all these processes, especially in the area of well-designed Feed-in-Tariffs (FiTs).

Market size: The size of climate change fighting markets will be proportional to long-term energy, food and water demand. That demand will follow population trends and resources availability. It will be huge.

Given government plans and population trends, power generation and energy storage for power and transport ($97 billion in 2008, $92 billion in 2009) cannot help but see increased demand and growth. Demand for Energy Efficiency in buildings and power generation will grow for the same reasons. $10 trillion ($500 billion per year) will be needed through 2030.

Long-term, through 2050, agricultural production must double. This will put a pressure on water supplies for which any answer is likely to attract enormous financial attention.

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Investors:

The New Energy economy will be created with public capital. But it will require private sector buy-in to be sustainable. The first buy-in must come from the investment capital held by pension funds, insurance companies, endowments and foundations, high net worth individuals (HNWI) and families and corporations. They have a diverse set of needs, interests, risk tolerances, return expectations and investment time horizons.

But climate change fighting investments are considered by DB to be alpha opportunities and unlikely to compromise anybody’s investment goals (the liability-avoidance of pension funds, wealth accumulation by families, the missions of endowments and foundations).

Institutional portfolios with Socially Responsible Investment (SRI) and environmental, social and governance (ESG) mandates are already early adopters and will remain important.

The strength of the economic case for climate change investment will attract pension funds, endowments and HNWIs.

Investors will come mostly from the developed world, plus some large sovereign wealth funds from China and the Middle East. Investments in New Energy deployment and improved agricultural production and water infrastructure will grow in both the developed and developing world.

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Markets:

Climate change fighting investment sectors are expected to be “a distinct investment theme” in 2010. They will involve several asset classes and engage public equity, private equity, venture capital and project finance of infrastructure.

Climate change fighting investment sectors (NE, EE, water and agribusiness) outperformed the overall market, after the bottoming out, in 2009. This shows markets are responding to the demand of adapting to and mitigating climate change. EE and agribusiness have led, but all primary sectors of climate change fighting investment have been strong for 3 years running.

DB expects a similar performance in 2010. Building EE may lead. Climate change fighting investments and associated sub-indices (agriculture, NE, EE and water) all outperformed the MSCI Global Index in the last 3 years and DB believes such investments will again outperform the broader market indices.

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Private equity investors and venture capitalists evaluate investments differently than public equity markets. Several studies of PE/VC returns show significant positive performance by climate change fighting investments from 2003-to-2007 and 2006-to-2008.

DB sees reason to proceed cautiously in watching or investing with private equity and venture capital. A longer time (at least 5 years or 10 years) is recommended. Awareness of the investment stage ( and distinguishing between the capital allocated, committed, drawndown, invested, and distributed stages) will indicate the time necessary for a return.

Knowing the valuation methodology (not market priced, less frequent) will indicate the potential for return. Knowing the method by which the predicted return was calculated (internal rate of return, vintage year returns, time-weighted annual returns) will add to the transparency of the investment.

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Project finance/infrastructure investments were severely compromised in 2008-09 by the shift away from tax equity investing. Project finance slowed in the U.S. but policies in the EU allowed continued capital deployment in NE projects.

Capital in 2010 will still not be what it was in 2007-08, but DB expects it to rebound worldwide because demand will be driven by all the factors described above.

At least $10 trillion dollars of climate change fighting infrastructure investment is expected over the next 5-10 years, 50% going to water, 22% going to power and 19% going to critical infrastructure for agriculture (roads and rails).

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Asset Allocation:

Investments vary by asset class, with differing risks and returns. DB sees opportunities in many climate change fighting asset classes and in infrastructure financing, private equity, venture capital and public equity strategies.

DB developed a Strategic Asset Allocation (SAA) to help bring climate change fighting investment into its investors’ portfolios. It (1) apportions the investment according to market proportions, (2) formulates predicted returns and volatilities, and (3) correlates the predictions with its wealth of historical data. Details are crucial here and there is no way to succinctly do the SAA method justice. Consult the paper before investing.

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The bottom line on Strategic Asset Allocation (SAA):
(1) Allocating to climate change fighting investments offers investors more chance of getting their targeted return.
(2) DB uses an aggressive overweight of 6% allocated to climate change sectors, against a 2% global market capitalization benchmark. With this weighting, historical returns from climate change fighting investments are greater than benchmark returns, giving the overall portfolio a 0.7% bigger yield.
(3) A more conservative 5% weighting for climate change fighting investments adds 0.4% to the portfolio’s yield.
(4) DB picked the 6% weighting only because historical data suggests it is achievable.

It is with no disrespect to the heroic activists who protested at Copenhagen and are regularly fighting coal and nuclear industry ambitions that NewEnergyNews suggests this rigorous assessment of investing in NE, EE and associated sectors is perhaps the happiest news yet from the real frontlines of the fight against climate change.

Beating climate change will take money. Big money. Asking the people who make it, invest it and advise about investing it to put their money to work "merely" for noble purposes is like asking vacationers to visit Port-au-Prince this week. Some, nobly and generously might, but not enough to create a tourism industry there.

The fact: Those who have money will only put it where it will make money. The good news: They can do no better for themselves than by investing their money in the fight against climate change. And it just so happens it's not a bad thing to do for this good earth either.

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QUOTES
From the report: “The Copenhagen Accord leaves us with a choice – we can decide the glass is half full or the glass is half empty. The majority of the analysis seems to suggest the latter because not only was there no legally binding agreement but also not even an agreed global emission reductions target. We, however, believe the “Glass is half full” largely because the coalition of those who want to take action expanded to the key emerging markets (China, India, Brazil, and South Africa) and the Copenhagen Accord was drafted by senior leaders of these four countries plus the President of the United States – an unprecedented outcome in international negotiations and one that provides an important foundation toward a more ambitious international agreement based on this political understanding.”

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- Deutsche Bank’s 2009 perspective on climate change fighting investments, as quoted in the current report: "In our view, as the financial markets stabilize, many climate change sectors should recover early in both public and private markets, as they have regulatory support and strong long-term growth prospects…"
- From the current report: “…carbon markets are only going to affect investment decisions in the long-run as it will be many years before a robust, stable and hedgeable carbon price emerges…”