From brown to green energy: How investors can adapt their portfolios in the transition to a low-carbon economy

The world is getting hotter. The potential consequences of a two-degree Celsius temperature rise has not only driven diplomats to sign a historic climate change agreement, but also spurred regulators in countries around the globe into action. This rapidly evolving regulatory landscape is creating numerous opportunities for investors who are interested in capitalising on the transition to a green, low-carbon economy—without materially impacting performance.

Key trends in the carbon landscape

With the Paris Agreement entered into force on November 4, 2016 and 122 countries who have ratified their participation to date, the transition to a low-carbon economy is well underway. This landmark agreement aims to keep the overall increase in global temperatures to below two degrees Celsius. This will mean a major shift in how we produce and consume energy going forward. We expect to see greater emphasis on energy efficiency, pressure on the coal industry, and increased investment in renewable technologies like solar power, wind power, hydropower, and biofuels.

Some of the world’s largest carbon emitters—including the United States, Australia, and China—have already begun making headway on the de-carbonisation front.

In the United States, President Obama’s Climate Action Plan saw a roll-out of specific regulatory initiatives to reduce greenhouse gas emissions and increase energy efficiency. The Australian government has set a Renewable Energy Target of 23% of expected energy generation coming from renewable sources by 2020. In addition to the over $100bn China is already investing in domestic renewable energy (more than double the US figure), China has expanded their overseas investments in green technology to more than $32bn in 2016 – a 60 percent increase on the previous year.

Although an incoming Trump presidency could undermine US commitment to enforcing the commitments made under his predecessor, some experts believe Chinese capital has become a more important driving force behind the expansion in renewable energy capacity around the world than US policy. Five of the world’s top six solar panel manufacturers are Chinese, as are five of the top 10 wind turbine manufacturers.

Within the financial sector, the Taskforce on Climate-related Financial Disclosure (TCFD), chaired by Michael Bloomberg, is expected to publish its final report and recommendations in early 2017 to push for greater transparency of climate-related disclosures in corporate reporting, allowing investors to better assess the impact of climate risk on their portfolios. All these regulatory responses to climate change mean that the global energy mix will continue to gravitate away from traditional fossil fuels, or “brown” energy, and towards renewable, green energy. This shift brings some risks that investors should factor into their approach to the energy sector, but also presents significant opportunities.

Some of the pitfalls include the risk that carbon-intensive securities will lag behind the broader market in the long term or that fossil fuel assets become ‘stranded’, no longer contributing to the economic viability of energy and coal mining companies, and traditional risks like illiquidity and market volatility.

On the flip side, investment opportunities in this space are plentiful and will only continue to grow as the world shifts to a greener economy. Investors can already access carbon-themed investments via public and private markets, including equity, fixed income, and alternative markets. Green real estate, green bonds, climate-friendly companies focused on renewable energy sources, and companies with high ESG scores are all opportunities investors can capitalise on to align their portfolios with this long-term trend and reduce exposure to carbon-intensive holdings.

We at Russell Investments are excited to look for ways to incorporate these opportunities into our investment strategies:

• We have been managing portfolios for Australian and European clients for over a year that not only reduce carbon footprint by over half, but also increases investment in those companies expected to contribute positively to the energy transition – all achieved with a very low tracking error.
• For a large distribution partner and client in Japan, we crafted an Environmental Technology strategy that is focused on investing in companies with environmentally friendly technologies.
• We have also launched actively managed decarbonised ESG equity and fixed income strategies for a Belgian insurance company.

The zeal for low-carbon is not expected to cool off anytime soon. We anticipate investors will look for ways to adapt their portfolios, so as to benefit from the opportunities and reduce the risks associated with this ‘hot’ 2017 investment trend.