COP26: How investment trusts are preparing for climate change

Businesses pursuing the long road to ‘net zero’ have been some of the top-performing stocks since the start of the Covid-19 pandemic, but some argue markets are still far from grasping the opportunities and existential risks created by the energy transition.

The next UN Climate Change Conference in Glasgow, which kicks off in late October under the better-known moniker of COP26, will probably serve as another wake-up call about how much remains to be done to reduce emissions and blunt the worst effects of man-made climate change.

Fund managers of investment trusts trying to anticipate the social and environmental shifts, say there is still a massive disconnect between bold renewable energy targets and the bolder escalation required in most areas of our lives. That means even in a richly-valued renewables sector, growth prospects are still compelling, as are the potential rewards for those who think laterally about topics from water to software.  

‘Not all investors fully appreciate the breadth of opportunity that the trust has. Both around climate change but also broadly around environmental markets,’ said Jon Forster, co-manager of Impax Environmental Markets (IEM), the flagship closed-end fund at eco-investing pioneer Impax.  

That disconnect is throwing up opportunities in some surprising places too, perhaps even in traditional energy companies, as commodity prices soar. Although, for income-hunters it may still be the case that an expensive transition is more about minimising risks than chasing profits.

As momentum has gathered behind the roll-out of renewables or the potential for hydrogen in the energy system, investors have now cottoned onto the idea that developers of wind farms or makers of fuel cells are primed to grow.  

After an up-and-down decade, the widely-watched iShares Global Clean Energy ETF exploded to a 135% return last year, as the costs of renewable energy reached economic parity with fossil fuels in many areas. While the sector pulled back in the spring and has gone sideways since, some still argue direct opportunities are priced in.  

Forster said valuations were ‘definitely challenging in the sectors that are exposed to net zero’, notably renewables and energy efficiency. The £1.6bn trust has ‘relatively modest’ 10% exposure to the former and around 30% in the latter.

It is an issue the manager and colleague Bruce Jenkyn-Jones have repeatedly flagged, as money floods into the sector particularly via exchange traded and open-ended funds. The trust itself trades at a 7% premium to net asset value (NAV), but even so has set limits on how many new shares it can issue even if investor demand pushes that premium even higher.  

Impax was set up two decades ago on the thesis that environmental markets would have superior growth opportunities as the world wrestles with climate change and other ecological challenges. Forster said that thesis had only become ‘more global, more challenging, more pressing’, but the other thing that has definitely changed is Covid, which has heightened consumers’ desire to shift to a more sustainable future.  

‘Obviously the most obvious opportunities around climate change is renewable energy and energy efficiency, but what we also believe is that consumer preference in particular is driving a desire for more natural ingredients and also less fossil fuel-derived and synthetic ingredients and chemicals going into products,’ Forster said.  

Forster and co-manager Bruce Jenkyn-Jones have been adding to this area. Key holdings include Royal DSM, the Dutch health, nutrition and bioscience group creating more efficient animal feeds with lower resulting emissions; and British chemicals firm Croda (CRDA), enabling the substitution of natural ingredients in personal care and health.

Jupiter Green (JGC) and Premier Miton Global Renewables are two much smaller rivals hunting for direct opportunities, with Menhaden (MNH) fishing in a similar pool.  

Despite its lack of clout with a market value of £57m, Jupiter Green is more in the mould of Impax, as it tilts more towards innovative companies and downplays dividend growth since Jon Wallace became fund manager early this year.  

‘I think we’re in a period now where the market is watching and waiting, partly to COP,’ said Wallace.  

He talked of the ‘disconnect’ between the huge long-term targets which governments have increasingly committed to and the lack of near-term action, but was hopeful COP would help bridge that urgency gap.  

US President Joe Biden has just backed a blueprint for solar power to provide 40% of the country’s energy by 2035, up from less than 4%. But to achieve that, the US must double the amount of solar capacity installed annually by 2025 and double that again by 2030.  

‘The market is actually anticipating that the rate of deployment in some types of renewables in some markets is actually going to decline in the next several years, where clearly the emphasis needs to be on the opposite of that. It needs to be an acceleration again,’ said Wallace.  

That dynamic should play into the hands of leading manufacturers like wind turbine manufacturer Vestas, a holding which is increasingly pivoting from onshore to offshore. In that context, Wallace feels the long-term opportunity still looks very attractive, though like IEM he has also shifted away from more obvious areas. Top holding Norway’s Borregaard produces alternative biochemicals that can replace oil-based products.

Premier Miton Global Renewables (PGIT), a highly-geared £32m ‘split capital’ trust, focuses on companies engaged in the roll-out of renewable energy after it relaunched with an updated mandate in late 2020.

That runs from massive developers and operators like utility SSE (SSE) to ‘yield cos’ like NextEnergy Solar (NESF), an increasingly large sector on the London market, which mostly buys up completed energy infrastructure and passes that income onto investors.  

Formerly running a broad infrastructure fund, Premier Miton manager James Smith had been finding attractive plays in the nascent renewables sector for several years. He then pounced wholesale when valuations hit illogical lows during the coronavirus crash, opening the door for a natural transition into a pure-play green energy vehicle.  

In these segments, he said valuations were ‘still very reasonable’ with big renewable energy developers like Germany’s RWE trading on unexceptional mid-teens price-to-earnings ratios rather than any kind of green premium.

London’s renewables infrastructure trusts also trade at much lower premiums than two years ago. Shares in NESF, for example, stand very close to NAV.  

China is one area which has been driving performance, with Smith saying despite its polluting reputation the country is making ‘huge’ investment in clean power. Top holding renewables developer-operator China Suntien Green Energy is up well over two-and-a-half times from lows earlier in the year, off the back of much higher generation.  

PGIT has delivered an impressive 49% return for shareholders over the last year, while IEM and JGC have delivered 176% and 75% respectively over five years versus 92% for the MSCI World.  

High-yielding RM Infrastructure Income (RMII) has also shifted focus this year towards social and environmental infrastructure, although the fund managers highlighted the sheer amount of capital competing for eco opportunities. Previously known as RM Secured Direct Lending, the £106m trust makes asset-backed loans in the ‘missing middle’ where deals are too small or complex for the likes of UK banks to look at.  

On the environmental side, that might be lending to waste management projects, energy efficiency, rooftop solar, or other services connected to property. However, Thomas Le Grix de La Salle said even within their niche ticket sizes, it was currently hard to lend against environmental infrastructure at attractive yields.  

‘Everyone is chasing the same assets. It's very much a diminishing returns game,’ he said.

That means social infrastructure such as education facilities are the 7% yielder’s main emphasis for the time being, although it has made a small loan to Quimera, an energy efficiency company, where the pipeline could expand.

BlackRock Energy & Resources Income (BERI) is another £104m trust focusing on the disconnect between renewable ambitions and reality. However, when the fund managers looked to refresh the mandate from a pure commodities focus last year, they came to a different conclusion.  

‘The more that we looked at it we [got] the long-term investment case for the sustainable energy strategy but [thought] if we’re right in what we’re looking at there was just so much opportunity left in the traditional energy space as well as the traditional mining space,’ said co-manager Mark Hume.  

The thesis is that as society looks to slash supply of fossil fuels to lower emissions faster, that leads to much lower levels of re-investment by commodity companies. But without the same change in consumer behaviour, prices can only go higher to curtail demand.  

The pandemic seems to have brought the thesis to fruition. Oil crashed last year as demand plunged during lockdown, with some arguing hydrocarbon usage would never recover to previous levels. In fact, in the third quarter of this year oil demand has already returned to 98% of 2019 levels, the International Energy Agency projects. At around $74 per barrel, Brent Crude is higher than pre-pandemic.  

That outlook led Hume and his colleagues to switch the 4.5% yielder to invest in a mix of traditional energy, green energy and mining stocks last summer. That has delivered strong results for shareholders with gains of 52% in the past year including dividends.  

The portfolio currently has about 45% in miners, which are emerging as beneficiaries of the energy transition, while similar supply-demand dynamics pushed copper and iron ore prices to ten-year highs over the summer. Hume picked out the former – holdings BHP (BHP) and Glencore (GLEN) are some of the biggest miners globally – as key, with electric vehicles requiring several times more copper than traditional motors, for example.  

The Blackrock fund manager said the approach let him and colleague Tom Holl be ‘pragmatic’ about the best returns on the uncertain road to net zero. Energy transition stocks, for example, are only about 23% of the trust currently versus the 30% target weight, reflecting the more appealing value they see in traditional areas.

Dunedin Income Growth (DIG) fund manager Ben Ritchie said companies that bite the bullet early and act on emissions will be rewarded as change and pressure accelerates in the next decade.  

‘That will pose some big risks and challenges to certain companies, and it will create opportunities for others. By and large though, I see it probably more as a risk to be managed than an opportunity,’ he said.  

The £486m UK equity income trust, which Ritchie runs with Aberdeen Standard Investments colleague Georgina Cooper, became one of the first closed-end funds to incorporate sustainability into its mandate earlier this year.

For a 3.9%-yielding income trust that still looks very unusual, but Ritchie said there was not a ‘logical link’ between poor sustainability and higher dividends.  

DIG’s switch was driven by moves taken to improve performance since 2015, when the trust had become over-invested in sluggish ‘old economy’ companies to support the dividend before the oil price crash.  Today the trust has more of a balance of growth and income. While now excluding about a quarter of companies in the UK market, Ritchie pointed out the same group had performed poorly and failed to grow their profits for the last decade.

That has led them to jettison UK oil giants, but they remain invested in France’s Total, arguing it has an edge over rivals in natural gas and renewables.  

‘That’s an economic decision to choose Total over Shell (RDSB) or BP (BP) because we think the business is better-placed. And I think to some extent that was justified in that Total didn’t cut their dividend last year along with the rest of the oil companies,’ he said.

With a 73% shareholder return over the last five years, double the FTSE All-Share, DIG has emerged as one of the top-performing trusts in its sector, while its portfolio positioning saw it take less of a hit both on income and capital than most rivals last year.