Portfolio theory can lend insights into which carbon abatement strategies
policymakers should pursue. If policymakers listen, what will it mean for
Good Info, Not Enough Analysis
I've now read most of my review copy of Investment Opportunities for a Low Carbon World.
The quality of the information is generally excellent, as Charles has described
in his reviews of the Wind
and Solar and Efficiency
and Geothermal chapters. As a resource on the state of Cleantech
industries, it's generally excellent. As an investing resource, however,
it leaves something to be desired. Each chapter is written by a different
expert in a particular field, which means that the information is up to date,
and comprehensive, but this approach means that there is little attempt to
compare the potential of the different investment opportunities presented.
What is the point of in-depth research into carbon abatement technologies if we
do not then take the next logical step and emphasize the technologies with the
greatest potential for carbon abatement and investment returns?
A Portfolio Approach
The most useful attempt at investment decision-making is buried in the
otherwise uninspiring last part of the book. A summary of a 2007 report from the
London Accord, A
Portfolio Approach to Climate Change Investment and Policy is buried
among self-promoting chapters from companies such as Nissan
promoting their (real) investments in clean technology, The
report uses a Monte Carlo implementation of Modern Portfolio Theory to determine
low-risk mixes (portfolios) of carbon-mitigation strategies, and was written by
Professor Michael Mainelli of Z/Yen Group, and James Palmer.
While intended primarily for policy decision-makers, A Portfolio Approach attempts
to determine which portfolio of carbon reduction technologies is likely to
produce a desired level of climate change at the lowest cost (or highest
investment returns) at the lowest risk of failing to achieve the reduction
goal. Phrased this way, it is easy to see why portfolio theory is an
appropriate tool, since it is designed to minimize systematic (overall) risk
even when all individual strategies in the portfolio have significant risks of achieving
the expected returns and carbon reductions.
The data on various carbon reduction strategies came mainly from the 2007
IPCC Working Group report, "Mitigation of Climate Change."
This report is not complete, omitting some technologies with significant CO2
reduction potential, in particular solar
thermal collectors such as solar hot water heaters and larger
installations for process heat in industrial processes. "Solar,"
as referred to in the report, refers solely to solar Photovoltaic and
Concentrating Solar Power (CSP.)
One decision I found questionable was to ignore the carbon reduction
potential of investments with "negative abatement costs on the basis that
these investments should be undertaken under any business-as-usual scenario, and
are not strictly investment measures as a response to climate change."
(p5/22) This is circular logic. For an investment
with negative cot to exist, there must be a market failure. Almost by
definition, in a well functioning market, all investments with negative cost
will have already been made. Simply saying that these investments
"should" be made assumes that these market failures will correct
themselves without any effort on the part of policymakers. Why should
market failures correct themselves in the future if they have not
In the authors' defense, they run one scenario (#3) in which investments with
negative abatement costs are allowed, and they state "Further examination
of negative abatement proposals seems in order, as it should be important to understand
why these investments fail to be made under current financial conditions.
Neglected negative abatement may justify regulatory intervention by
policymakers, e.g. imposing minimum building or transportation efficiency
requirements." (pp.17/22 and 18/22)
From the hedging in this statement, and the fact that they spend less time
discussing scenario 3 than either of their other two, I conclude that something
prevents the authors from giving market failures the attention they are
due. I find this an extremely common failing among financial
practitioners, and believe it is an unfortunate and common consequence of
in-depth training in financial modeling. Most financial models contain an
assumption of market efficiency, and do not produce meaningful results in cases
of large and persistent market inefficiencies. Without tools to model
market inefficiencies, practitioners are prone to ignore them, convincing
themselves that the inefficiencies are unimportant or will cure themselves.
Most of the critiques
of "Green Jobs" programs are based on this fallacy.
Put another way, if you have a hammer (a modeling technique which assumes
market efficiency, such as modern portfolio theory), you tend to see all
problems as if they are nails (efficient markets.)
Since the authors only look at scenarios 1 and 2 (those which ignore negative
cost investments) in depth, these are the scenarios I will focus on. I
believe the results of these scenarios are still relevant answers to the
question, "After negative cost investments in energy efficiency have been
made, which positive cost investments should we pursue?" Even if all
the necessary carbon reductions could be achieved with negative cost
investments, it would most likely be unwise to pursue such an approach to
mitigate climate change: like all investments, there is no
assurance that the expected reductions/returns will be achieved. Pursuing a wide
variety of carbon-reduction strategies provides the greatest chance that some
such strategies will achieve the expected reductions, and others will
exceed expectations, thus making up for any investments in the mitigation portfolio
which do not achieve the expected reductions.
The chart below shows a series of "frontier portfolios": That is,
portfolios of carbon abatement investments which achieve specified levels of
carbon abatement at minimal cost. The vertical axis is gigatons (Gt) of
emissions (CO2e) reduced annually, and the horizontal axis is the annual investment
needed to achieve this level of reduction.
There are diminishing returns for carbon abatement, with the cost of
incremental abatement increasing significantly above 15 Gt CO2e per
year, and no practical increase in abatement beyond 20 15 Gt CO2e and
$400B expenditure per year.
For comparison, to stabilize the atmospheric concentration of CO2
ppm, a goal which, according to Joe Romm, will require 8 Gt CO2e
(approximately portfolio 2) of reduction by 2030, and another 10 Gt CO2e
(for a total of 18 Gt CO2e, or portfolio 4) by 2060. Since
the model does not include negative cost investments in energy efficiency or
solar thermal collectors, it is likely that these levels of abatement could be achieved
at considerably lower cost by incorporating these opportunities.
The pie charts in the first column show the fraction of carbon abatement
expected from each investment in the selected frontier portfolios, while the
second column shows the cost of each investment. The two columns differ
because different investments produce different levels of abatement per dollar
of investment. For instance, the cost wedge for Biofuels in portfolios 3
and 4 are much larger than the corresponding abatement wedges. This
indicates that abatement with biofuels is more expensive on a per-ton basis than
for the other investments in those portfolios.
I will focus on portfolios 2, 3, and 4, since those are the portfolios which
deliver the necessary levels of abatement, which we will need to ramp up to over
the coming years and decades.
The most striking thing about these portfolios is that Forestry dominates CO2
abatement, as well as cost in portfolios 2 and 3. The more aggressive
portfolio 4 has three relatively large cost wedges: Building Efficiency,
Forestry, and Biofuels.
Unfortunately, according to the report's authors, the carbon abatement from
Forestry is very uncertain. To make matters worse, the methodology used in
the report is extremely sensitive to the expected returns (or abatement, in this
case) of particular investment classes. Small errors in the expected
returns can lead to frontier portfolios which are dominated by a single
investment class, in this case Forestry. The report notes that
"forestry abatement potential is highly uncertain." (p.8/22)
While we can conclude that forestry is likely to be a significant part of our
carbon abatement strategy, there is a good chance that forestry will not
dominate the mix as it does in the model.
For stock market investors who want to allocate part of their portfolio to
forestry, I recently wrote about investing in forestry
stocks and forestry exchange traded funds (ETFs). While I was focusing on
the potential for forestry to benefit from biofuels and bio-electricity in the
article, any marginal demand for forestry services (including carbon
sequestration) should benefit this sector.
Hydropower is also a significant investment in these portfolios. Much
of this investment will probably take place in the developing world, but there
are also significant opportunities for upgrades to facilities at existing dams
in the developed world. I looked at the potential for hydropower
stock market investments last year.
Biofuels also contribute significantly to all the portfolios, especially in
the higher abatement scenarios, although the costs are high relative to other
investments. I don't believe that this is very realistic if we are also
going to have large contributions to carbon abatement from forestry. My
guess here is that the authors did not take into account the negative
interactions between forestry and biofuels, where an increase in one will drive
up the costs of the other because of competing land and water use. Land
used for forestry cannot also be used for biofuels, and vice versa.
We see significant contributions from wind in portfolios 3 and 4, and the
costs and potential for wind are much better understood than for many of the
other scenarios. Better yet for stock market investors, investments in
wind are simple, with two
wind energy ETFs allowing a simple investment in the sector. Of the
have a slight preference for FAN
(you can see my
Efficiency, in all its Forms
Finally, port folio 4 shows considerable investment in Building
Efficiency and Industrial Efficiency (which we usually refer to as just Energy
Efficiency), while portfolio 2 has a good slice of Transport
efficiency (what we usually call Clean
Transportation.) Keep in mind that these slices are only investments
that do not have "negative cost," that is they do not cost less than
new investments in conventional generation. Since efficiency dominates
investments with negative cost, the total investments in all forms of efficiency
are likely to be many times what we see in these graphs. While there is
not yet an energy efficiency ETF available, there is one focused on clean
transportation, the Global
Progressive Transport ETF (PTRP). I also have a few stock
picks in clean transport.
For industrial and building efficiency, there is no ETF, but here are five
of my favorite efficiency stocks, and you can find a much larger list of energy
efficiency stocks here. It's also important to note that smart
grid stocks will fall into this category as well, at least for the purposes
of the report. Here are five
of my favorite smart grid stocks.
Geothermal also has a small slice of portfolios 2 and 4. This is
significant given the small current size of the industry: even these small
slices imply rapid growth for an underappreciated sector. I mentioned three
geothermal stocks to consider here, but I have since sold
my stake in Raser
Technologies (RZ), and will probably not repurchase it. Our Twitter
followers saw that first. Charles did a good run-down of the public
geothermal stocks in June.
It's also worth looking at what is not in the efficient portfolios,
but since this entry is already quite a thesis, I'll save that for later.
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indication of future performance. Please take the time to read the full