Switching on to alternative energy

Until relatively recently, alternative energy was a bit part player in the investment industry. The companies involved were mostly small and unprofitable. Investors needed a very long time horizon or high principles to consider it.

But regulatory drivers have conspired with increased consumer awareness and a soaring oil price to push alternative energy into the forefront of investing. Is it a good investment? Or simply the latest green fad?

The sector has attracted several new launches over the past six months. Guinness Asset Management launched Alternative Energy and Global Energy funds in March. At the same time, specialist investment group Impax launched its first OEIC – the Environmental Leaders fund. Virgin and HSBC launched climate change funds in January and November respectively. On the investment trust side, new funds like the Ecofin Water & Power Opportunities have emerged, while ETFs and structured note providers have also seen launches in this area - such as Lyxor Asset Management's recent New Energy and World Water products.

Also, many of the new agricultural commodities funds, like the Sarasin AgriSar fund, have an allocation to alternative energy, usually through bio-fuels. The demand for bio-fuels has been a major driver in high agricultural prices with recent research by Goldman Sachs suggesting that biofuels add 0.5-1% each year to global demand for grains.

Climate change is also having an impact, with concerns over rising temperatures decreasing agricultural yields and therefore pushing up prices.

Of all these factors regulation is currently seen as the key one.

Ian Simm, chief executive of Impax Group, which specialises in environmental investments, says: “The EU Renewables Directive laid out the percentage of power that should come from renewable sources by 2010. This required huge investment in wind farms and solar power. The US has had different types of regulation based on tax credits since 2004.”

In consequence there has been a strong upturn in demand for wind turbines and solar panels, with many of the companies involved seeing growth of 20%-30% per year. Mainstream utilities companies have been forced to sharpen their acts, which has led to increased M&A activity. Simm has seen 21 of his holdings taken over, often at a substantial premium.

Simm says that the high oil price has also made many of these investments more economically viable. Many sources of alternative energy looked expensive when the oil price was $60 per barrel, but look cheap in comparison to $105-dollar oil.

At the same time the universe of potential stocks has grown from an estimated 250 companies five years ago to around 1,000 companies now. The Virgin fund, in common with many green/ethical funds, adopts a positive screening criteria using specialist alternative investment group GLG.

Simm says that many companies are now profitable, have strong pricing power and that share prices have outperformed.

The drivers look set to remain in place. The pressures on the oil price are likely to continue with no sign of any significant slow-down in demand. New supply is coming on board, but it is a slow process. Regulatory pressures are likely to intensify rather than diminish as climate change maintains its place on the political agenda. It also tends to ensure that alternative energy stocks are less sensitive to the prevailing economic climate.

Christopher Lindsey, manager on the Sarasin AgriSar fund, says that the only real risk to this general outlook is that global warming does not turn out to be as bad as currently forecast.

Investors would get less concentrated exposure to alternative energy through a green or ethical fund, which have also performed well in recent years. However, alternative energy is no longer the niche investment it once was and has firm drivers for future growth.

1 April 2008