This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.
Image credit:Federico Rostagno/Shutterstock.com
I periodically get the following question, especially from millennials: Have you considered adding a renewable energy ETF to MoneyGeeks portfolios?
I understand where they are coming from. After all, Im a millennial myself. Climate change is one of the most pressing issues of our generation, so its only natural that we should do our part.
However, while I sympathize with their intentions, I have decided not to include any renewable or clean technology ETFs in any of MoneyGeeks portfolios. In this article, I will explain my reasoning, using the example of clean technology/renewable energy ETFs such as the PowerShares Cleantech Portfolio (Ticker: PZD). (If you dont know what an ETF is, please read my free book).
Are Clean Tech Companies Really Clean?
Let me first talk about what clean technology means. As youll see, that definition matters in our decision whether or not to invest in a particular ETF.
Lets take the example of PZD to show you what I mean. If you go to the ETFs official website, it states that PZD invests at least 90% of its total assets in stocks of clean technology companies that comprise the (Cleantech) Index. I presume the rest of its assets (i.e. the less than 10%) consists of cash and stocks that used to belong in the Cleantech Index that the ETF hasnt sold yet.
This sounds great, but how exactly does a stock qualify for the Cleantech Index? Unfortunately, thats a bit of a mystery. Ive tried for days, but Im still not able to access the official document regarding the indexing methodology. However, we can make some guesses by looking at the individual constituents of the ETF.
As of the time of this writing, the most heavily weighted stock in the ETF is a company called SGS. SGS provides inspection, testing, certification and verification services to its clients, so that the clients can operate safely and cleanly from an environmental perspective.
While SGS undoubtedly provides services that the world needs, theres one thing that an environmentally conscious investor should keep in mind: some of the major clients of SGS include oil, gas, and even coal companies.
Now, SGS doesnt help with the extraction of oil, gas and coal directly - rather, they provide inspection and verification services. So on the one hand, you could say that what SGS does is good for the environment - through inspection, they may prevent low quality chemicals from getting used, which could release harmful chemicals into our environment.
But on the other hand, you could argue that they help oil, gas and coal companies extract more resources by lowering their costs associated with inspection and verification. This point particularly hits home when you read on SGSs official site that that their services help with coal exploration. Therefore, whether SGS belongs to a Cleantech index is up for debate.
SGS is not the only stock that belongs to the clean technology gray area. Xylem, which is the second most heavily weighted stock inside PZD, also deserves scrutiny.
Xylem builds and provides services related to water infrastructure. While you can again argue that they make the world cleaner in some sense, like SGS, they also retain oil and gas companies as clients. Specifically, Xylem provides pumps, mixers and lots of other equipment directly related to the extraction of oil and gas. In fact, many of their products are even used in oil sands extraction, which some consider to be the dirtiest method of extracting oil in the world.
I could go on, but I think you get the point. While SGS and Xylem may fit within some peoples definition of clean technology, they may not jive with other peoples definitions.
This problem of defining what clean technology is extends beyond PZD to other ETFs as well. For example, those looking to combat climate change may feel tempted to invest in a renewable energy ETF like the Guggenheim Solar ETF (Ticker: TAN). However, an ETF like that introduces a whole new set of problems.
Some of the largest solar companies in the world are based in China, so they unsurprisingly make up a significant portion of TANs holdings. Unfortunately, Chinese solar companies have spotty environmental records, to put it mildly.
The majority of todays solar panels are made up of polysilicon, the production of which yields a lot of silicon tetrachloride as a byproduct. Silicon tetrachloride is toxic but expensive to properly recycle, so Chinese solar companies have been dumping them illegally in order to keep their costs low. Tragically, the remarkable fall of solar panel costs in recent years is owing a lot to this cheap method of producing polysilicon in China.
In light of this information, one has to question whether TAN (i.e. the Guggenheim Solar ETF) qualifies as an attractive candidate for the environmentally conscious investor. I think that for the majority of such investors, the answer will be no.
Investment Merits of Renewable Energy Stocks
Still, such investors may yet see a way around the problem. What if they were to invest in individual renewable stocks that were based only in the developed world? While thats possible, I would have to question whether thats a good idea from an investment perspective.
The list of investible renewable energy stocks is not that large. At present, there are about a hundred renewable energy stocks that trade around the world. Of the hundred, about half of them trade on foreign exchanges that most Canadian investors dont have access to.
Of the stocks that trade in North America, many of them are related to biofuels, which I doubt most environmentally conscious investors have much interest in. As with fossil fuels, biofuels consumption releases carbon dioxide into the atmosphere. Furthermore, many of the problematic Chinese solar companies trade in North America as well, so youll have to exclude those too.
Of the maybe 30 stocks that are left, about a dozen of them are penny stocks. Most of these stocks became penny stocks through business failure, and are therefore not worth investing in. For example, GT Advanced Technologies used to be a $15 stock at one point. Today, it trades at around 2 cents.
In the end, youd be left with perhaps a few more than a dozen stocks to choose from. Its extremely hard to create a diversified investment portfolio from such a small pool of stocks, and without adequate diversification, the portfolio would be too risky for most investors. This is compounded by the fact that the renewable energy industry itself carries an inherent risk.
While some claim that renewables are now as cheap as fossil fuels, in reality, only a tiny fraction of renewable energy fits that description. For example, solar energy is cheaper than coal generated energy at noon on a sunny day in Nevada, but is more expensive in other places and at other times.
Because renewable energy generally costs much more than traditional sources of energy, it needs government subsidies in order to make it appealing to its customers. Unfortunately, government policies have a habit of changing, and when they change for the worse, they can have devastating effects on the solar industry. For example, solar stocks fell by over 40% during the year after Germany announced solar subsidy cuts in February 2012. Britain is currently following Germanys steps with their own subsidy cuts.
Furthermore, new technology can quickly render existing renewable companies obsolete. I seem to come across a new article every year where some brilliant young scientist creates a vastly more efficient solar cell. Most of the time, such articles are more hype than substance, but one of them could become more than just hype. It would be a shame to invest in the renewable energy equivalent of Altavista, only for Google to come along later.
As if thats not enough, renewable energy investors have to contend with the fact that certain countries see renewable energy as a strategic imperative, and will do everything in their power to see their own companies succeed.
For example, China has helped its own solar companies by turning a blind eye to their environmental practices, enabling those companies to sell solar panels at dramatically lower prices compared to their competitors. Chinese companies have since been slapped with tariffs by Western governments to even the playing field, but that hasnt repaired the damage wrought in years prior.
Because of these factors, renewable energy stocks have done very poorly historically. The PowerShares WilderHill Clean Energy ETF (Ticker: PBW), which casts a wide net to include renewable energy related stocks, has gone down by over 80% in the past 10 years. The U.S. stock market average, in contrast, has gone up by over 60% during that time. I personally expect renewable energy stocks to continue to underperform in the years ahead.
How Buying Stocks Helps Companies
Now, some people may have the desire to invest in renewable stocks despite the risks, because they feel that doing so will help those companies. Unfortunately, owning renewable stocks will do very little to help those companies succeed.
There are two ways in which buying stocks could help its company - by encouraging new stock issuances, and by increasing executive compensation. Lets talk about each of these in turn.
Generally, when you buy a stock, your money doesnt go to the company. Instead, your money goes to whomever sold you the stock. However, there are exceptional situations when the money you use to purchase a stock does go directly to the company. This happens when the company itself sells you the stock, and such situations are called stock issuances.
Companies may choose to issue stock when they cant fund a project themselves. For example, if a company only has the capacity to spend $50 million using cash in the bank and from new loans, and if a new project would cost $80 million, the company may raise $30 million through stock issuances.
Issuing stocks is easier for companies when their stock prices are high, because that means the company as a whole is valued highly. For example, lets say a company has 10 million shares outstanding. If each share trades at $50/share, the company would be valued at $500 million, and raising $30 million would not a big deal as $30 million represents just 6% of the companys value. However, if each share trades at $10/share, the company would be valued at $100 million, and raising $30 million will be much tougher as it represents 30% of the companys value.
If you choose to buy a companys stock, you add to the demand for the stock, which leads to increases in share prices and therefore the companys value. This makes it easier for the company to raise new money through stock issuances, and therefore to fund new projects.
While this may sound like a meaningful way to help the company, the problem is that youll need to buy an awful lot of stock in order to meaningfully move a companys stock price. For most big renewable energy companies, millions of dollars worth of stocks trade every day. Pouring $10,000 of your savings will hardly make a dent in the companys stock price.
Furthermore, if you push up the price of a stock unreasonably high, theres a big chance that some of the existing owners of the stock will choose to sell their holdings. Such selling will push the price of the stock back down, partially neutralizing the effect of your stock purchase.
Another way that a high stock price might help the company is through executive compensation. The upper level managers of a company, such as its CEO and CFO, usually receive large portions of their compensation through stock options. Since the value of such options depend on the value of its stock price, high stock prices increase the compensation received by such managers.
In theory, a company that pays well will attract better managers, and better managers may help renewable companies thrive. Unfortunately, studies have shown that the link between executive compensation and the companys performance is tenuous at best. It appears that higher compensation breeds overconfidence, which can actually hinder the executives performance.
Unfortunately, buying stocks of renewable companies will do very little to advance the adoption of renewable energy around the world. If you want to take up that cause, I believe there are better ways.
Therefore, I believe that investing in renewable energy stocks is like chasing two rabbits at once. It would be nice to do something good for the environment, and to make money at the same time. Unfortunately, investing in renewable energy stocks will achieve neither of these goals very well.
If I spot an interesting renewable energy company, Im open to including it in MoneyGeeks premium portfolios. However, I will make such a decision on investment merits alone. With regards to ETFs, I dont see myself including any of them in any of MoneyGeeks portfolios for many years to come.
This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.
