Founder of the Journal of Environmental Investing: “It’s all about alpha!”

Most people view environmental change as either a social issue or a marketing opportunity.  With corporations and investors focused on the next quarter, not the long term, it’s often difficult to see the impact of environmental issues on the world of investing.  But as today’s guest contributor Dr. Angelo Calvello argues, society’s response to environmental issues has pushed forward their investing implications to the present day (think: carbon credits, clean-tech investing, and shifting pension mandates for starters).   He writes that, for more and more institutions, environmental investing is all about , not social or policy change.

Special to by: Dr. Angelo Calvello, Editor, Journal of Environmental Investing

“Global warming will be the most important investment issue for the foreseeable future. But how to make money around this issue in the next few years is not yet clear to me. In a fast-moving field rife with treacherous politics, there will be many failures. Marketing a ‘climate’ fund would be much easier than outperforming with it.”

Jeremy Grantham, founder and chief investment strategist of Grantham, Mayo, Van Otterloo & Co. LLC (GMO), can frame a complex investment issue in an elegant and penetrating way. His essay in his July 2010 Quarterly Letter, “Everything You Need to Know About Climate Change in Five Minutes,” is yet another example. However, I find his postscript, used as the epigraph to this essay, especially prescient.

As I argued in the book Environmental Alpha: Institutional Investors and Climate Change, climate change, which really is a broad investment theme that I call environmental investing, is the most important investment theme investors will face for decades. Why? Because climate change is a non-confirming risk: it will affect every aspect of an investor’s portfolio—equities, fixed income, currency, real estate, commodities, and infrastructure. It will hit public and private securities, domestic and international exposures. It is, according to Michael Northrop and David Sassoon

“…unlike any other ‘risk factor’ that our modern financial system has ever confronted. It contains no reciprocal or alternative opportunity. It is a universal threat that will spare no nation, no market, and no industry. This presents a particular challenge for the money managers of the world, whose success relies on their power to manage risk. Climate change renders this power impotent. It’s a risk that can’t be managed around, and the only rational course of action is to minimize its impact.”

I would further argue that while climate change is a risk that we might be able to minimize, we can’t even begin to do this until we develop a robust framework that allows us to identify and quantify these risks. And we are a long way off from achieving this goal. This gap is simply an inherent part of the natural cycle of the investment theme. To develop this risk management and risk mitigation framework, we need to understand that environmental investment risks are fourfold: scientific, economic, policy- and regulation-related, and technological.

Figure 1: Sources of Risk/Drivers of Returns

Source: Environmental Alpha: Institutional Investors and Climate Change, Wiley Finance, 2009.

Moreover, environmental investment risks are, given where our current state of affairs, incredibly dynamic (as Grantham points out), complex, and opaque. readers should be quick to recognize that this situation ultimately gives rise to investment opportunities. Risks, especially dynamic, complex, and opaque risks, give rise to market inefficiencies. And market inefficiencies mean that some skilled managers will be able to gain an edge. Perhaps it’s an informational advantage, a technological advantage, or access to a scarce resource. But this edge means the manager might be able to generate alpha. And because we are talking about environmental investing, I call this alpha “environmental alpha.” It isn’t more equity beta masquerading as alpha. Environmental alpha is return resulting from the application of the manager’s skill in the environmental space – return that is not the result of exposure to a market or risk factor.

Grantham shows some uncharacteristic humility when he admits that he has not yet figured out how to make money in this space, but there are certainly are managers who have figured it out. These managers are typically environmental investing specialists who focus on a specific category or niche because of the heterogeneity of environmental investments and the idiosyncratic nature of the sources of risk and return. A venture capital investment in a start-up company that generates emission credits through a proprietary process that destroys ozone-depleting substances is under the influence of much different scientific, economic, regulatory, and technological factors than a wood-based stationary biomass investment opportunity in Norway.

Let me be quick to address a topic that I would guess is on the minds of readers. When I talk about environmental investing, I am talking about alpha-centric investing, not socially responsible investing. Too often, investors incorrectly and unnecessarily identify environmental investing as a subset of SRI. Let me be clear: environmental investing is not, as one author claims, “similar to Socially Responsible Investing (SRI) in that both are strategies driven by investors’ desire to achieve financial return while maximizing social good.” Maximizing social good is neither a sufficient nor a necessary condition of environmental investing. Environmental investing is about alpha, not absolution. We must measure the value of an environmental investment primarily by a manager’s ability to consistently generate alpha.

Also, let me assure readers that just because there are inefficiencies surrounding environmental investing does not mean that it is easy to generate environmental alpha or that there are huge pools of environmental alpha available from which skilled managers sip. Environmental alpha shares the same attributes as all other types of alpha: it is scarce, transitory, and capacity constrained. But the sheer size of the environmental investment opportunity set is vast; some estimates put it at more than $1 trillion per year for the next twenty years. Environmental investors also have a diversity of opportunities, which I broadly classify as clean tech; sustainable property; land use, land use change and forestry (LULUCF); carbon; and water. Size, diversity, and the dynamic, complex, and private nature of the drivers of returns should mean that environmental alpha writ large should have staying power.

For all these reasons, I urge readers of this website —you seekers of alpha—to begin your exploration of environmental alpha if you have not already done so. You might think it is too early to turn your serious attention to this issue. However, be assured that many of your peers are already enthusiastic participants in the discourse surrounding environmental investing. Investors and thought leaders like Erik Valtonen, the CIO of AP3; CAIA advisory board member Bob Jaeger; Keith Black, a CAIA member and a senior member of Ennis Knupp’s opportunistic strategies investment management research group, and Russell Read, Managing Partner of C Change Investments and former CIO of CalPERS are actively looking for ways to manage investment risks and assess and access investment opportunities associated with climate change.

So I invite you to join the discourse in a structured and rigorous manner by subscribing to a new interdisciplinary scholarly journal, the Journal of Environmental Investing ( Wait. You’re thinking this essay is one long commercial. Well, it isn’t. The Journal of Environmental Investing (JEI) is available free-of-charge, primarily because of the support of our sponsor, BE Bio Energy Group. I mention the JEI because it is the locus for the serious exploration of environmental investment issues.

The JEI’s mission is to facilitate capital flow to fund solutions to our most pressing environmental challenges. Every day, new research on natural resource depletion, pollution, demographics, sustainability, and climate reveals new investment risks and opportunities. To fulfill its mission, the JEI carries high-impact research as well as thought pieces that make environmental solutions more attainable by articulating their challenges and profit potential. The JEI is a platform to bring together disciplines from science to policy to finance, so that experts can pragmatically address topics related to environmental alpha from academic and applied perspectives.

Our first issue, “Beyond COP-15,” demonstrates this confluence of viewpoints. It features twenty-six essays on such topics as the carbon markets; the impact of policy on environmental investing; water; climate risk, fiduciary duty, and disclosure; coal; REDD; and public-private partnerships as catalysts for environmental investing. These essays came from representatives of the Illinois State Board of Investments, Munich RE Asset Management, the National Oceanic and Atmospheric Administration, the World Bank and IFC, Peabody Energy Corporation, Numeric Investors, Cisco Systems, Climate Wedge, the Woods Hole Oceanographic Institution, and Cornell University.

The Journal’s approach to scholarship is collaborative, so I encourage you to suggest new themes, topics, syntheses, guest editors, or reviewers.

I look forward to your contribution.

Angelo Calvello, PhD

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