Sustainability Matters
Inflation Reduction Act Is Spurring Interest in Clean Energy and Climate-Conscious Investing
Renewable energy funds already awash in inflows. How to position your portfolio.
The impending passage of the most significant climate legislation in U.S. history is spurring greater interest in clean energy investments. Equally important, the legislation makes it more likely that more investors will look at how to position their overall portfolios to account for climate risks and benefit from the inevitable transition to a low-carbon economy.
In fact, since hearing the news that Democrats had hammered out an agreement to address climate change as part of their Inflation Reduction Act, investors have been piling into clean-energy funds. In the two weeks prior to the surprise announcement on July 27, clean-energy funds had estimated net outflows of $223 million. Since the climate deal was announced, investors have rushed into this group of 23 funds. From July 28 through Aug. 10, clean-energy funds attracted estimated net inflows of $433.6 million.
Renewable Energy Funds Pull in Cash, Performance Jumps
IShares Global Clean Energy ETF ICLN went from an estimated outflow of $17.6 million to an estimated inflow of $22.3 million. By contrast, iShares Global Energy ETF IXC, a portfolio of traditional fossil fuel-based energy stocks, went from an estimated $9.6 million inflow to an estimated $75.9 million outflow.
The announcement sparked renewable energy fund performance, as well. In the two weeks prior, clean-energy funds were already up as part of the rallying July stock market, posting an average return of 5.4%. Since the announcement, from July 28 through Aug. 10, the funds posted an average return of 13.7%.
Inflation Reduction Act: A Wide Range of Beneficiaries
Those still considering investing in renewable energy shouldn’t worry about missing out on the news. Morningstar equity analysts see the entire range of renewables benefiting from the legislation, noting the extension of solar and wind tax credits and the addition of incentives for clean hydrogen, stand-alone energy storage, and domestic manufacturing, which will especially benefit solar manufacturers.
Beyond that, my view is that the legislation signals what will become the federal government’s ongoing commitment to supporting the development of clean energy and addressing the climate crisis. While Republicans legislators are currently 100% in lockstep against this bill, it seems unlikely they will have the power or inclination to roll it back anytime soon. They may at some point be able to slow the pace or try to simultaneously take action to prop up fossil fuels (which, by the way, the current legislation also does). But as clean energy’s contribution to the success of the overall economy becomes more clear and as even more clean-energy jobs are created in red states, Republican politicians will be unable if not unwilling to turn back the clock.
Thus, investors should consider clean energy as a long-term investment in the inevitable transition away from the fossil-fuel-based economy, not as a short-term play based on a single piece of legislation.
Three Takeaways for Fund Investors
Fund investors considering an investment in clean energy should keep these points in mind:
1. A clean-energy fund will be more volatile than most diversified funds in your portfolio. While the risk that a clean-energy investment made today will not pan out over the long run seems low to me, renewable energy stocks themselves can be volatile. That’s likely to continue until they have reached a more stable growth trajectory, and there has been a shakeout of early winners and losers.
The best way to assure long-term success and mitigate volatility is to choose a diversified clean-energy fund rather than trying to pick a particular winning stock among the range of clean energy sources and related technologies. Here are several choices to consider:
2. For most investors, a clean-energy fund should be a satellite holding. How much to allocate to a clean-energy fund depends on how much you can invest outside of your core portfolio, which should be allocated to generate the risk-adjusted return you require to meet your financial goals. When using a core-satellite approach, I generally think in a range of 15%-25% for all satellite investments, which tend to be more volatile because of their concentration around particular themes or subasset classes. For clean energy, you may want to start off in the 5%-15% range.
Another approach is to reallocate from those parts of your portfolio that are similar to the clean-energy funds in terms of region, size, and style. For example, ICLN’s regional exposure is about half U.S. and half non-U.S. To build a 10% position, you could take 5% out of your U.S. funds and 5% out of your international funds. Going further, ICLN is about two thirds large cap and one third small/mid-cap and skewed to growth, so if you have exposure in those areas in either the U.S. or international side of your portfolio, you could reallocate from there.
3. Why stop at clean energy? If you are concerned about the risks that climate change poses to your portfolio and also recognize that opportunities exist in areas beyond renewable energy to benefit from the transition to a low-carbon economy, why not consider a total portfolio activation approach (thanks to Trillium Asset Management for naming that concept).
Take a look at your core stock and bond funds. Is there any indication they are being managed with an awareness of climate risk? This should be your minimum standard. After all, you are paying your portfolio managers to take all material risks into account as they work to provide you a competitive risk-adjusted return. Don’t be surprised to find distressingly few funds that have anything to say about how they’re managing climate risk.
Consider instead diversified stock and bond funds that are explicitly climate-aware. There are plenty of them out there. They may have fossil-fuel-free; carbon transition; or broad environmental, social, and governance investment mandates. Across all subasset classes in a typical investor portfolio, you can find climate-aware funds that provide diversified market exposure similar to that of your existing funds.
Addressing Climate Risk Can Create Climate Impact
Mitigating climate risk throughout your portfolio not only helps protect your investments, it also has a broader impact, especially via direct shareholder engagement. As more companies hear investor concerns about climate risk — alongside the concerns of other stakeholders, like employees and customers — it encourages them to take action. According to the Science Based Targets initiative, nearly 3,000 public companies have made net-zero commitments, and climate-conscious investors will help hold them to it in the coming years.
This article originally appeared on Morningstar.com.
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