Increasing finance for eco-innovation
London Principles Workshop
Introduction – Alice Chapple
A warm welcome to Gresham College. We are going to be talking about the landscape for investment in clean technologies and the barriers to investment in clean technology; whether access to finance is a barrier; what the financial institutions in the City of London in particular are doing to finance innovation.
There are two contexts in which this discussion is taking place. The first is the City of London. What are the opportunities for the City in investing in clean technology, who are the players at the moment, what are they financing, what is the Government support for the sector, and so on. The second is a wider context about what the role of the development of clean technology can play in addressing global challenges: climate change, water shortages, resource depletion and so on.
Reading the newspaper yesterday, I saw a report by the Royal Institute of Chartered Surveyors, which said that if we are to meet carbon emission targets of 60% reduction by 2050, then for London alone we will need to have, with current technology, 17,037 wind turbines or 53 million solar roofs or 25 nuclear power stations, one every 7 miles around the M25. So if you are an optimist, then obviously you would see this as a business opportunity; if you are a pessimist, you would realise how much this means a challenge in terms of what we need to mobilise. That is existing technology. What we are looking for is the next branch of new technology to meet that growing challenge.
So either way, whether you are a pessimist or an optimist, then clean tech is clearly an area that we want to get to grips with. We hope to explore the opportunities for finance and how they will meet those challenges.
The Forum’s work on access to finance for clean technology has been supported by Gresham College, and many thanks for this wonderful hall they have lent to us for this morning; by DEFRA; by the Department of Trade and Industry, and by the City of London. We are preparing a report capturing as many thoughts and ideas as we can, so your contributions are most welcome and we look forward to interactive sessions in the question and answer part of the day.
I now look forward to hearing the speakers, so first of all we will hand over to Stuart Fraser, who is Deputy Chairman of Policy and Resources at the City of London.
The importance of the City in supporting innovation and driving change
Stuart Fraser, Deputy Chairman, Policy and Resources, City of London
On behalf of the City of London Corporation, welcome to today’s seminar. I would say once again that I am delighted that the City of London, the DTI, DEFRA, Gresham College, and the Forum for the Future are all working closely in partnership to address this issue.
I was struck by a thought: 10 years ago, this meeting would probably have been inconceivable. To have managed to fill a room with financial services representatives to discuss the issues of eco-innovation, let alone run two complete seminars, I think would have been virtually impossible. This was always a sort of subject for niche manufacturers and well meaning ‘greens’, definitely not for mainstream consideration, and to talk about renewable energy, back then, was likely to crack a few jokes about solar-powered tepees and joss sticks, but of course no one is laughing any more. Environmental problems are mounting, public concern continues to grow, and resources are becoming scarcer. We are now burning four barrels for every new one we discover. Global public policy, from Brussels and Beijing, is likely to begin to reflect this fact, and so clean tech is now recognised as the technologies of the future. There are no longer niche markets, but they are definitely mainstream. It is therefore clear that the demand for environmental technologies, for solutions which make us a greener and leaner market, is a growth market, and to mix my colours, I think we are now in a green gold rush!
If we are to meet this demand and if the City is to profit from the investment in a new generation of industries, it is essential that we seize the opportunities that present themselves now. We are standing on the threshold of a new era and one which mirrors the rapid growth and development of information technology in the late ’eighties. In another ten years, I believe that clean tech will be taken for granted in mainstream business models, the way that information technologies are now. Again to mix my metaphors, the train is leaving the platform; we have to make sure we are on it, otherwise we will have a lot of running to catch up.
Japan is already ahead of us in the design of hybrid cars and that has already had a very damaging impact on the American auto industry. Brazil leads the way in the bio fuels market. American industrial giants such as General Electric have put development of clean tech at the heart of their business plans, and I quote from the words of GE’s Chairman: “We are investing in environmentally cleaner technology because it will increase our revenue, our value and our profits, not because it is trendy, or moral, but because it will accelerate our growth and make us more competitive.” I think you can say that the big beasts of the corporate world have certainly scented blood.
However, the parallels with the early days of the IT industry are remarkable, because the core developments in world changing technology are not being driven by global multinationals with multi-million pound budgets, but by entrepreneurs, by Small and Medium Enterprises, working out of university technology parks or enlightened industrial units. I am sure I do not need to emphasise the point to this audience of the importance of the SME sector. I think this is the area where the innovation is at its highest, and they have the skills to respond very quickly and sensibly to changes in the market.
As I stated in the last seminar, huge efforts are being made across a very broad front of various arms of Government, at national, region and even local level, in conjunction with a whole range of private sector organisations to promote the growth of the SME sector. But the question we posed last time was: are eco-innovation or clean tech SMEs a special case? Do they have unique needs that set them aside from other SMEs when it comes to financing? We received some very interesting answers, and certainly put to rest one of the most persistent myths about financing the eco-innovation sector, namely that there is a lack of finance out there. In fact, quite the opposite is true. Venture capital firms are actively supporting clean tech, and funds are available for businesses which demonstrate commercial viability and a clear strategy for growth. This is the same with any sector – clean tech should not be treated as a special case. In fact, the success of specialist funds in generating attention in the UK, and in the US, show clean tech is already the fifth largest sector for investment.
Just in the last few days – my paid job is being a fund manager – I received three interesting investments. I have one here called (they are not recommendations, by the way) Low Carbon Accelerator, a new fund being launched. I have been invited to a seminar on carbon emissions trading by Henderson’s, who are very big in the investment field. And there are other environmental funds, all of them concentrating in this area. Okay, at the present moment they are not raising billions, they are raising tens of millions, but you can see that it is a very big and accelerating trend.
That is obviously not to say that everything in the garden is rosy. There is still much that can be done by Government, investors and SMEs themselves to enhance investment, which of course brings me to the reason that we are here today. I hope you will, over the course of this morning’s seminar, hear from a number of extremely well-informed individuals who will discuss various aspects of financing for clean tech. However, it is only part of the picture. I think it is true to say that the audience here represents a unique concentration of knowledge and experience, and I hope that the answers that will be given and the questions asked will move this agenda forward. How can we increase cooperation across public and private sector organisations to enhance activity in the area? Can we ensure that standards and certification regimes can best facilitate clean tech rather than acting as a barrier? And what could be done to build bridges between those who need capital to bring products to the market and those who are seeking to invest in the next generation of companies?
Finally, I would like to stress that the City of London Corporation believes that the City has a vital role in supporting this new and burgeoning sector, and we will continue to work with our partners in business and Government and in NGOs fully to realise its potential. I do hope you will find this discussion interesting and stimulating, and I cannot emphasise enough how much your contribution to the debate will be valid.
Early-stage companies – is access to finance a key constraint?
Alice Chapple, Director, Sustainable Financial Markets, Forum for the Future
The first session, which I will talk briefly about, is, in the early stage of companies, is access to finance a key constraint?
The Forum held a workshop, which some of you attended, in May 2006, bringing together venture capitalists, entrepreneurs and Government to discuss the barriers to clean tech development, with a particular focus on access to finance. The workshop built on work done by the Environmental Industries Unit at DTI, and Jonathan Lonsdale, who is here today, has done a lot of work in this area. It brought together the venture capitalists and the entrepreneurs, and explored the Government’s role. We had some excellent input at the workshop. This brief summary of the key issues is based on the discussions there, on research carried out by the Forum over the summer, and follow-up discussions with key players.
As little as a year and a half ago, a report by the Clean Energy Group suggested that an important funding gap existed in very early stage venture financing for clean tech companies, but as Stuart Fraser mentioned, the results from research and from our workshop – and obviously evidence from the number of funds coming into the market – indicate that this is no longer the case in absolute terms, although there are areas where it is more strong than others. We will hear from Jens Lapinski later, but figures suggested in May 2006, of the £500 million publicly disclosed funding of private, clean tech companies, 10% came from grants and awards, 20% from non-institutional investors such as the business angels, but the vast majority, 70%, came from institutional investors such as venture capital funds. In the US, predictions by Red Herring are that the number one trend in VC investing in 2006 will be investment in green start-ups, and the UK is showing a similar trend.
So why the change? It certainly seems to be the case that the mobilisation of public sector money in the form of VC funds, in the form of Carbon Trust and various grants, have helped. The DTI has made efforts to streamline funding support, through organisations such as Carbon Trust, and the fundamentals are changing. There is a growing recognition of the need for clean tech products to meet growing challenges and an expectation that this will be translated into demand. So there is evidence that finance is available and not the key barrier, and our workshop explored other underlying barriers.
Work done by the DTI in assessing responses of 73 clean tech investors in the UK to a survey carried out by the DTI’s Environmental Industries Unit shows that access to finance does feature in responses, but other factors – proof of product, certification, standards and regulatory uncertainty - are also key. Finance will obviously depend on the technology coming to market quickly enough to meet the funders’ return targets. If certification is expected to take a long time or it is difficult to obtain proof of product, then finance will obviously not be forthcoming. Clearly, finance will also depend on the market being in place in the reasonably short term, and one of the key constraints perhaps to greater development of clean tech is that consumers may not demand cleaner alternatives to traditional products in the short term. They may be unwilling to pay higher prices for new clean tech products because they do not themselves pay the carbon cost or pollution cost of the old product. So public intervention, at least in the short term, may be required, and I will touch on the interventions that the public sector is making later on.
The Institute for Manufacturing at Cambridge has produced an interesting paper outlining the barriers in different sectors, breaking down the data. So for example, funding for R&D is a key constraint in development of renewable and low carbon energy, but not necessarily for cleaner technology and processes. Proof of product, on the other hand, is a particular barrier for the waste and water sectors.
I will now look at the barriers from the perspective of the entrepreneurs. From our workshop, many of the same issues were raised as barriers by the venture capitalists, but a strong theme coming through from the VC perspective was also the lack of management expertise and therefore poor ability to see a technology through to market.
Business incubation services are therefore critical to closing the early stage finance gap. Management teams were seen to lack experience, roots to market were not well defined, and start-up ventures found it time-consuming and difficult to chase the next round of financing. It is not that the finance was not necessarily there, just that accessing it was sometimes very difficult.
New Energy Finance has prepared an incubation white paper looking at the role of incubation, ranging in services from basic facilitation, provision of office space and so on, to a much more hands-on service, including business consultancy, mentoring, access to potential financial sources, and even early stage financing.
The major kick-start to clean energy incubation in the UK came in 2004, when the Carbon Trust began investing in start-ups, through grants to existing incubators. There are now 14 incubators in the UK supporting clean technology, with 48 companies receiving support. The Carbon Trust will be building on their incubation programme by launching further incubation investments at the end of this year.
While public finance has had a major role in the development of the incubation market, university and research institute-led technology transfer has proved to be one of the most efficient mechanisms for graduating business start-ups from incubation to follow-on finance and development.
What are the other critical factors that have made investment in early stage VC more attractive, and what is the public sector doing to support the growth of the sector? The process of obtaining certification for products is obviously a barrier which is in place to protect the consumer but can be unnecessarily slow. In particular, the lack of harmonisation between countries in Europe creates frustration, and work is going on to try and improve those standards and the process of certification. The British Standards Institute and the DTI have been working together to create standards that support innovation, looking to develop fast-track specifications where possible.
There is sometimes resistance to change, particularly from private sector players, in the sector, and existing players in the sectors.
Fiscal incentives are also critical. The Environmental Industries Commission undertakes practical research and lobbying on how regulation and other public sector intervention affects the landscape for development of clean tech.
Tax incentives, such as the enhanced capital allowances and the Enterprise Investment Scheme, could be better targeted to support clean technologies. Some delegates in our workshop advocated a green fund, as in Holland.
Intellectual property rights is another important area. The regimes for transfer of intellectual property from universities to the private sector need to be improved in order to encourage more research and take-up.
And the role of public procurement in creating markets is critical. The DTI is currently working on development of its forward commitment project. Through this, it will hope to put in place a commitment to purchase, at a point in the future, a product which does not yet exist commercially against a specification that current products do not meet, and at sufficient scale that makes it worthwhile for suppliers to invest in tooling up and manufacture. Clearly, if this takes off, it will be a key element for financiers to see the cash flow coming in from these new technologies. The DTI-sponsored Environmental Innovation Advisory Group is currently trying to iron out the legal issues of this project.
Knowledge sharing between research institutions and business is clearly also a very important component in the system, which enables public sector and private sector research organisations to apply their research knowledge to important business problems. The DTI has initiated a knowledge transfer partnership scheme which enables UK businesses to benefit from the wide range of expertise available in public and private sector research organisations and higher and further education institutions.
I felt a little bit like Gordon Brown, providing you with all this list of things which the Government is doing, but I think they do illustrate very clearly that support by the Government for clean tech is going on, and show also that there is a meaningful dialogue between the entrepreneurs and Government on the issues that the entrepreneurs are raising, and the venture capitalists are raising, about what needs to be done to encourage further investment in these areas.
But the marginal increase in the attractiveness of clean tech proposals, arguably, may not be enough to promote sufficient large scale Research and Development and commercialisation, unless perhaps the costs associated with climate change and resource depletion brought on by old tech can somehow be internalised into the valuations of clean tech companies.
In conclusion, we found that: funding is available; that incubation support is critical and forward procurement will help; new fiscal incentives are being reviewed and may emerge. In order to assess properly the risks and opportunities in climate change and resource shortages, financial markets may just need to consider whether their current valuation techniques are adequate, and support from the public and private sectors working together will address those barriers.
The next speakers will outline how the financial sector provides access to finance for clean tech, as it moves from demonstration and proof of product to the next stage in its development. I would like to welcome Jens Lapinski from Library House to tell us more about the way that that takes place in the market.
The current landscape for clean tech financing – opportunities and threats
Jens Lapinski, Vice President, Analysis and Consulting, Library House
I woul like to give you a little disclaimer that basically says: don’t take anything I say too seriously for investment purposes! Library House is an information services company, and we sell information on companies that have the potential to be very successful going forward to investors, large corporations, governments, and the companies themselves, and I manage all of our bespoke work.
What I am going to tell you about today is centred around not the public market investments that are taking place in clean technology, but I am going to talk about private markets, venture capital investors investing in these companies, and the drivers behind those. The key driver behind everything I am going to talk about is about chicken and egg, and it is about that chicken! I think it is very, very important. I am going to start at a very basic level. I am not going to talk in too much detail about individual investment trends in sub-sectors and so forth.
I am going to talk about the big theme, and the big theme that is driving everything right now is China. The emerging economies, with enormous numbers of people in them that are increasing their personal level of wealth, are driving everything that is happening in the world right now. What that means is that the demand for commodities, and in particular oil, and everything else, is going through the roof. China is consuming an extraordinary amount of oil. Right now, they are consuming about 8% of the world’s oil. This is going to increase very, very rapidly. What that means is that the prices for commodities are going through the roof because supply cannot keep up with demand, and that is the key driver for everything clean tech. This is going to last for many, many years. There is a bull market under way in commodities that is going to last for another 10 years, if you believe what certain people are saying, and in addition, what that does to the environment, as we all know, is this: it causes global warming, which is causing problems at the other end, and clean technology companies are fundamentally about addressing those things – it is reducing the amount of energy required, it is reducing the amount of waste, it is making the entire supply chain, the energy supply chain and the value chains that all businesses are based upon or deliver against, more efficient.
What that means for venture capital is the following. You have had a number of very substantial exits, meaning realisations of profits. This has caused everybody in the sector to say, ‘Oh my god! Have a look at how much money can be made there!’ and everybody is rushing in. So every single VC fund in the UK right now, apart from may be the bio tech funds, is looking at clean technologies, which means that clean technology over the last five years has been the fastest growing investment segment in the venture capital space, and this has also then continued further downstream, has impacted quite significantly on the Alternative Investment Market, on the London Stock Exchange, and you have seen a significant number of IPOs there. And then the real question is: how will clean technology grow in line with this commodities bull market that is currently under way?
There are a number of European companies that operate in the clean technologies space. One is a company called Conergy that is sort of a one-stop shop for everything solar technology, set up in Germany in 1998. Right now, I believe they have got about €750 million revenue. For a company founded eight years ago, that is an extraordinary amount of revenue. They are highly profitable. The investors who gave them money, who were from the Stuttgart region, made at least 20 times, but more likely 30 to 35 times, their money, although this sum is undisclosed. That was extraordinary exit.
Q-Cells, which is a very famous solar technology company also based in Germany, there was a press release by Apex saying that they made I think 27.7 times their money back within 18 months. That is the biggest return on venture capital in the last five years worldwide. There is nothing bigger than that – apart from Google, only Google is bigger – and it is definitely the biggest thing that has happened in Europe. It is bigger than Skype, it is bigger than everything else.
ITM Powers, a UK company, were the early investors, who put far less money in than Apex and Q-Cells, and they also made about 20 times, maybe more, their money, and were also very, very happy.
It is very important to understand that these are the top of the game. It does not get much better in venture capital land! So, when something like that happens, and it happens again and again and again and again and again – I could give you another four or five examples – a lot of people take notice, and a lot of people say, ‘Wow! This is actually really interesting. We should look at this.’ When you talk to venture capital companies, what they will tell you is that they are all starting to look at clean technologies.
The interesting thing is that most of them are already there, most of them have been investing in clean technologies for many years, and actually a realisation has I think arrived in the sector about investing in energy-efficient technologies. They have been investing in low power consuming devices and so forth, and they have never viewed them as clean technology, although arguably they fit into that value chain. When I tried to quantify how much of that is actually happening, and I apply a looser definition of what is clean technology and I really look at the entire energy value chain from upstream generation, infrastructure, consumption, and I classify clean technology venture capital investments in the UK over the last six years or so, and the overall percentage of clean tech investment has actually grown quite considerably and is now at around 20%.
Arguably, the investment growth of clean tech by now is limited far more by the total VC money that is available in the UK rather than by desire of venture capital investors to invest into the sector, because they are all doing it already, and I am very pleased to hear that I am not the only person running around telling people that there is no equity gap and there is a huge amount of capital out there, and have people knocking on my door saying, ‘I want to see the great companies that are doing green technology.’
For example, in January 2005, Vinod Khosla who used to be a partner at a very famous venture capital firm based in Silicon Valley called Kleiner Perkins Caufield & Byers came to Cambridge. He has been one of the most successful investors who has invested traditionally in network technology storage, internet infrastructure, all in information technology. We had prepared IT companies in Cambridge and so forth, and he said, ‘Well, I want to see clean tech. It’s the future. It’s all clean tech.’ He has since then left, set up Khosla Ventures, which focuses exclusively on this sector pretty much.
So a lot of people have already taken note. Everybody knows it is going on. Every VC that I know who has got a technology background will look at this space.
What this is doing on the public markets is that you have quite an interesting number of clean companies. I think over the last two years, about 25 companies have listed on AIM, with a total market capital of £2.5 billion. It is not that one big IPO has got a market cap of £2.5 billion, but there are a lot of smaller start-up companies that are raising funding and that are going public on AIM, and I think AIM is going to be quite crucial in providing the entire investment ecosystem with sort of later stage cash and is also a very good exit route for a lot of early stage investors.
Jim Rogers is a co-founder of the Quantum Fund, which he founded with George Soros I believe in the late 1960s, early 1970s. Those guys returned about 4,000% returns to their investors, which is quite a lot! He has published a book that I liked quite a lot called ‘Hot Commodities’ in which he says that he believes that because of the overall trends that are happening in China and the huge demand for commodities, and oil in particular, before all the new production capabilities would come on line, it will take at least 10 or 15 years before supply will have caught up with demand. As a consequence, he is looking at a bull market in terms of commodities for at least the next ten years (he published the book in 20040. So if you believe in that, then that means that there is going to be fantastic market conditions for clean technology companies for the next eight years at least, according to him. That is obviously quite a significant opportunity for the entrepreneurs who will run these companies and for investors, because that is more or less the time frame which they are looking at. I think throughout we can re-evaluate how the commodity markets are doing, how the demand for clean technology is stacking up and so forth, to assess what the more medium term growth potential of the sector is.
My final thought on all of this is that, right now, when I look at most of the technologies that I see, they are largely addressing business markets, so many of those solutions are sold to other big companies, which is good business. When consumers make buying decisions because of clean technology inside the product or because a product delivers value to them that ties back to clean tech, then the market is going to make an enormous jump, because obviously, at the end of the day, consumers are the purchasers of pretty much everything that is out there. If they start buying mobile ’phones because they are produced or manufactured in a clear way, if they buy mobile phones because they have got a solar panel built in, if they start to buy cars – and this is already happening – because they are cleaner and better for the environment, I think all of that, when this is happening in a very conscious way.
When actually having clean tech built into products will be one of the key value delivering features of products throughout everything that we buy, I think when that happens, clean tech will have really maximised its potential. When you think about how many products are out there for which this applies, then you realise how big this entire sector could really become. I think it could be absolutely extraordinary. That is my personal opinion. Yesterday I found a little device called Solio. I thought it was quite cute, so I went on to the internet and nicked the photo. This is basically a little device that you can take with you, you flap it open and it produces power, and this is selling extremely well. So the more of these kinds of things that are out there, the better I think the entire sector will develop.
We at Library House believe that it is going to be very interesting to see what is going to happen in the next three to four years. There are a lot of interesting companies out there, and a lot of interesting investments taking place.
Financing the commercialisation of clean tech – picking the winners
Mark Thompson, Director of Research, Canaccord Capital
I need to give you the caveat at the beginning, that this is not investment advice. I will talk about a number of stocks, but please do not rely on it. This is really just for background information – caveat emptor applies! I can give you the full disclaimers, but we will be here all morning doing that!
My role is to research companies in the sustainability space, as we call it, and what I am there to do is make money for investors. That is not necessarily picking good companies or bad companies, it is picking good stocks, stocks that will either go up when you expect them to go up or go down, because you can make money on either side, so just put that subtlety in place. My background is I was an engineer by first degree, went to London Business School and, about nine years ago, got involved in this space, financing renewables in Europe and the US. I have been both on the corporate finance side and the investment management side and the research side, so I have a very wide spread of experience. You could say I was one of the relatively early movers. There are a few others amongst the audience here. We saw this market develop very slowly and have seen it really accelerate over the last few years.
There was a very good question at the beginning asking what is sustainability, how do you define it, and I thought I would just throw in my definition and how I apply it to the companies we follow. What we look for are companies that have a positive environmental Net Present Value, and that means they are having a positive impact on the environment. Yes, there might be some down-sides, but net net you are coming out in advance. They have also got to be exposed to the macro trend, and this is one of our investment themes, that there is a huge macro trend in environmental regulation, environmental awareness, and the approach to the environment. If they are taking advantage of those changes and are going to be able to make money from that, that fits into our universe, and also, the bulk of the business has to be exposed to environmental technology, sustainability. So I would not look at BP, which does some marvellous advertising campaigns and owns I think at least four wind turbines, but you know, I add no value – it is an oil company. Where I add value, hopefully, is where the bulk of the value comes from environment technology. And the last way we look at stocks is sustainability stocks, environmental technology. It is a bit like pornography, in that you actually recognise it when you see it. That is not particularly scientific, but it is quite an effective way of taking a universe and making sure at least I can follow some very interesting stocks and sectors as a result.
When Alice approached me several months ago to talk here, she posed some questions, and I thought I would just lay them, to run through what is happening in the UK market, the US perspective, what has happened over the last couple of years, what are the opportunities, who is investing, is there a bubble and, fundamentally underlying this, can the current financial system deliver the necessary change? Hopefully I will answer at least most of those.
Just to give you some idea on who we are, Canaccord Adams is the investment banking part of Canaccord Capital. We are a Canadian-based house, £400 million market cap, fairly international focused. We have a great focus on small and mid-cap companies, quite unusually, and we focus across North America and Europe. Somewhat unusually in the market, we are purely institutional. In London we only follow five sectors, and I am actually one of three analysts who follow sustainability companies. There is myself in London, I have a colleague in Boston, and a colleague in Canada. So it is something that Canaccord has committed to quite heavily for a number of years. All three of us following this space have been active for at least six years in looking at these stocks, so we have seen the market go up and down a couple of times.
One of the things I produce as part of my research and for the benefit of investors is something called the Sustainability Quarterly, so each quarter we put out a review of what has been going on. As part of that I build what we call the ROS Index, Resource Optimisation and Sustainability – that is the title it gets internally – and that is an index of all UK small-cap stocks that fit in to the sustainability space, and that covers everything from water, renewable energy, fuel cells, composting, recycling, anything that I see fitting in that universe that is listed in London.
That universe has grown from four companies at the beginning of 2004, when I first started calculating it, to 61 companies at the end of last quarter. That has been an enormous growth, and I think it is a very good indication of the interest that is in the capital markets for this space. It has very nicely outperformed AIM. I will give you a caveat though: I would not read too much into it, because when you grow from four companies to 61 companies, there is some bias in the data and it is very hard to adjust it reliably, so just a word of caution. I would not come away from this saying resource optimisation, sustainability companies have outperformed AIM by 80%, 90%. I think that would be a false conclusion. I think the numbers are slightly less than that. As I said, the index, 61 companies, £4 billion-worth of combined market cap. The largest company is just over 12% of the index, so it is still quite a skewed index. The top 10 represent 62%, so even worse than the FTSE 100. That will change and that is changing as we grow and more companies appear. I re-run and re-calculate the index quarterly, and you also get a significant degree of volatility hidden within that index. And my final point is it is not investable; that is is a slightly technical term – yes, you could hold those stocks, but it would be very hard to replicate the index’s performance because of liquidity issues, and there are a lot of small stocks there.
I’ have pulled out the top performers and the worst performers from the end of last quarter to date and on a 12-month trailing basis. That is there for interest. Really what I want to point out there is those are not investment recommendations. Clipper Wind Power, for instance, might be a really good stock, it might be a really good company, but I am not sure it is necessarily a good investment. Having run up 80% over the quarter, it might be over-valued – it does not necessarily mean that is something you should be putting into your portfolio today. Equally, you might argue that Solar Integrated Technologies, just to pick on them at random, is that a bad company? It might be. I do not know. I don’t research it. But it might actually be quite a good investment because it is going to bounce and come back having fallen so far. Most of the drivers for each of these companies are very individual. It is very company-specific. You cannot read, I think, too much on the sector.
Looking at what is happening at the market, I think the fuel cell cycle is probably, if not over, certainly constrained. We have had a lot of fuel cell companies come to market. I think the market is a lot better informed, and a lot more cautious there. So I do not think you are going to get quite the same valuations and hype as we have had over the previous year. I think Bio Fuels have stalled, for a couple of company-specific problems, though the fundamental trends are very positive. The carbon funds, CO2 investing, is unproven and there is a lack of data out there to make sensible analysis possible. There is a gap for water technologies. We have lost a lot of good water technology companies, and that is one area where I think you will see more development and there is a big appetite in the market for water-related technologies. The recycling, resource efficiency-type stocks have not really taken off. There are a few of them appearing, but the market has not really cottoned on to that trend yet.
Looking at the US, it is quite interesting, because the US took off as a listed play for clean tech several years ahead of Europe. They benefited a lot from the fuel cell hype and the energy efficiency markets back in the late ’nineties. My colleague from the US happens to be over in London this week and we were chatting about it this morning. It is all small cap, but to them, small cap is over a billion dollars in market cap. So it is actually quite sizeable, but not as many stocks as we have in Europe. It has become mainstream. I do not know if anyone has travelled to the US in the last 9, 12 months? Climate change, environment, is all very topical – possibly not in the mid-West! – but on the West Coast and certainly New England it is very topical.
People are talking about it; they are well informed. As my colleague was saying, all of a sudden, it’s cool; people like talking to him at dinner parties! It is an interesting area, it is very topical, and the mainstream investors have recognised that this is an investment opportunity, and that just because it is ‘green’ does not mean it is unprofitable. There are some solar companies, particularly in the US, that have incredible margins. At the EBITDA level, they are incredibly profitable. Whether the valuation makes them a sensible investment, that is a different discussion, but a lot of these companies have turned into mainstream opportunities.
The US though is still very much focused on energy. It is still very much focused on ‘how do we keep driving our 10 mile per gallon SUVs?’ ‘How do we keep burning the highest level of energy per capita in the world?’ ‘How do we keep coal going?’ ‘How do we not change our lifestyle?’ But the shift has started. The politicians are talking about climate change and the environment. There is better information, and people are becoming more aware. I think 248 US cities, as of a month ago, had signed up to Kyoto. Now, it means absolutely nothing in economic terms, these cities signing up, but it is an indication of interest and changing attitude – the US is becoming far more aware.
Now, fortunately, from my business perspective, Sarbanes-Oxley and some other issues going on in the US has made London the preferred market of choice for a lot of these companies, because of the criteria that AIM brings.
How do you access this market? There is a whole host of ways. You can invest directly in unlisted companies. There is a demand for angel capital. We get a lot of requests for people coming at a very early stage looking for early money to help them on, and there is a number of C-funds that are not specifically green but will support this space. As I mentioned earlier, I was in Switzerland at the beginning of last week – 52 venture capital funds with €3 billion worth of money to deploy into this space. Okay, it’s small compared to some of the MBO-type funds out there, but it is a significant amount of money given that five years ago there was €500 million worth of money sitting at the same conference. It has changed significantly.
There are far more funds looking at the space, and part of their success is the fact that they can point to these exits, to Q-Cells, to ITM and the others, and say, ‘Hey look, they made 20 times their money – we can do the same.’ Not sure if that is true, but it helps them attract money into the space. You have obviously got different ways of playing it. You can invest in global equities, pure play companies, the type I follow in London or my colleagues follow in America, in Canada. There are commodities. You can play into carbon, weather derivatives. There are a lot of ways of getting access to this market. There are a lot of focused funds specialising in environmental technologies, in water, in new energy, and can give you specific exposures to these. There are a number of exchange traded funds equally coming out. I am slightly cautious about those, because I am not sure they give you exactly what they say on the tin, because they hold some fairly large companies that are not necessarily pure play clean tech. There are at least three specialist funds I am aware of that have more than a billion dollars each to invest in this space. That is an enormous change over the last three years. There are wider green funds, funds like Jupiter, like Henderson, that are investing in the broader environmental sustainability space, and then you have got the carbon funds, which have grown enormously over the last 12, 16 months. I am slightly cautious about them because it is very hard to analyse what is going on underneath and understand what the underlying investment value proposition is, but if you are wanting exposure to carbon, that is probably the only way you can, as an individual, or as a non-specialist fund, get exposure.
There is some debt. Alice asked is there much debt, are there many opportunities – not much at this stage, because we are still looking at a relatively nascent industry, and you tend to get debt and tradable debt only appearing later in the process.
Who invests in clean tech? Well, just about anyone who wants to make some money. The specialist funds are growing very rapidly. The area we have seen the biggest change is the hedge funds, and by talking about hedge funds, I am not talking about necessarily the macro arbitrage, the long/short; it is funds that do not have a benchmark, that are not held to an index, that can actually look at an investment and say, ‘Yes, I’m going to put money into this because it is going to make me money.’ They do not have to hold a stock because it is in an index. They are not worried about tracking. They are not worried about competing with their peers, which is possibly why some of the pension funds have been relatively slow to get into this space, because they are so constrained by benchmarking against their peers rather than absolute return.
The other interesting driver of this has been people looking to hedge their energy exposure, so oil and polluting sources of energy, saying, ‘Well, okay, you’ve got this, how do we hedge this risk? We’ve got 95% of our portfolio in oil or power. Let’s offset that with some clean tech.’ The traditional SRI funds have been remarkably slow to play in this space. I do not know whether that is a market cap limitation, whether it is an indexing limitation, but having had the fort leadership position five years ago on sustainability, they seem to have lost it, at least as an outsider, and getting very focused on corporate governance and issues that are important but are not necessarily an active approach to the environment.
I am also talking to far more generalist funds out there, who are reading about this in the Financial Times every week. I think since the beginning of January last year, when Kyoto started to kick in, there has been an article in the FT on environmental matters every week, almost every day, and that is a great way of getting fund managers to think, ‘Hang on! Is there some money? Let’s follow the flow. How do we play?’ and making them more aware that this is a serious sector. There is some retail following but on a stock by stock basis, it tends to be relatively uninformed – ‘the barmy army’ as one of my colleagues calls them!
What makes a great investment? Well, a simple business – there iss nothing surprising about it. If you cannot explain it in a couple of sentences, it is probably not worth investing in. You need growth, you need consistency, you need predictability, and you need a good management team to deliver it, and really, you could also put with management, good communication skills, the ability to explain their business, to talk to investors, to push information out there, to put benchmarks so you can see that they are progressing.
Great short term performance (and maybe I’m looking at a couple of the fuel cell stocks) is lots of sizzle. There are a couple of these fuel cells stock in particular where the Chief Exec is fantastic, bangs the table, really gets excited about global warming, and he has done a fantastic job of raising money to get into his company; whether it is a good or bad investment, I am not sure, but he has done a great job, lots of sizzle. The steak is sufficiently far off, if you will excuse the American metaphor, sufficiently far off that you cannot apply any normal metrics.
A lot of companies actually suffer when they transfer from generating some revenue to start getting profitability at the gross margin, operating margin lines, because all of a sudden you can apply normal metrics, and you think, ‘Well, hang on, 100 times earnings? Is this sensible?’ and you often get that dip. That is the problem with any growth stock, and it is not peculiar to clean tech, but we seem to have a disproportionate number of companies that are still at a relatively early stage.
A lot of these also have a reality disconnect, and I can run you through a couple of valuations. When you have time lines that are so long, particularly on fuel cells (and I’ll pick on Ballard Power, which is still probably the 500 pound gorilla in the space) but if, you know, I would apply a 25% discount rate to Ballard Power each year. If I am out by one year on its timing, my valuation is out by 25%, just by definition, and when you have got a 10 year time frame before it has got any real revenues, you have got a lot of inaccuracy there, so you have really got to play the sentiment and it is quite difficult to do that.
How do you pick winners? Management is key. That is what we look for when we want to float a company. Is this a management team I trust? Will they look after my money? Do I actually want to work with them for the next few years, and do they have the skills to make this company real? They need a good competitive advantage that is sustainable. They have got to be able to scale up their products and actually get a route to market. At the risk of picking on the fuel cell stocks again, a lot of these have technologies, possibly better mousetraps, but I am not sure how much money they will need to invest to get this so that you and I can buy it, and there are a couple of stocks that are aimed at the combined heat and power for domestic use. My concern is how long has it taken us to get condensing boilers into the market? How slow has that been? I have just written far too large a cheque for a new boiler, Category A, 91% efficient; but you need to support that. It is quite hard to get that roll-out, and you need to look at that when you are assessing some of these investments, and sometimes I think ramp-up rates are optimistic. And also the lessons of history. That is one of the things my colleagues and I bring, that we have seen a lot of these stocks ramp in the 1999-2002 period and then come down and then pick up again. So yes, we have missed some trends, but hopefully we are avoiding some of the crashes.
Is there a bubble? By definition, 50% of stocks are over-valued, 50% are under-valued, and that is how you end up with an equilibrium in the market. There is a very well known thing called the hype cycle. It was designed by the Gartner Group and an analyst called Jackie Fenn, and that really talks about, if you look at the red line, that is the hype cycle. That is what the market is doing. If you look at the green line, that is actually what the company is doing. It is chugging away quite happily, and the market sees the technology, gets vastly over-excited, then it does not quite deliver as fast or as quickly as you would like, comes crashing all the way down into the trough of disillusionment, and then gradually the market catches up and a few years later, when they have started delivering, reality and hopefully the plateau of productivity meet.
It is an interesting statistic that in the US there are 15 analysts following solar companies. Only two of them, one of them being my colleague, have actually done it for more than 18 months. So is there a bubble? In solar, yes; bio-fuels, I think it is marginal because there has been a big correction over the last couple of months in the US – fuel cells, quite a few of those are very over-valued – recycling, probably not; renewable energy, probably not.
The real question is does it matter if there is a bubble? Yes and no. Yes, because I would hate there to be a big crash and for the institutions to back away from this market and for us not to be able to get cash into clean tech companies as a result of people getting scared. No, it does not matter, because that is the nature of markets – they do over-correct and under-correct, and it will work its way through, and you are seeing now far better informed investors, people who have followed some of these bubbles and are understanding the stocks far more clearly.
Now a bit of prediction for the future. I have a variety of predictions. I was enjoying myself making these! I think AIM will continue to grow, for a number of reasons: first, because it is a very well designed market for early stage companies; its regulatory environment, its support, is great for any early stage company, and that is positive. Talking with a lot of US companies, they like raising money over here, particularly at the early stage, because most European investors get the environment story. It is changing in the US, but most get it, you do not have to explain the environment, the macro driver; you explain the business. All too often in the US, you end up explaining what is happening with global warming and why it is important and what the regulations are, rather than concentrating on the business case. And also, it has been a great boost to AIM, is Sarbanes-Oxley, which has made it prohibitively expensive for a lot of small companies to access NASDAQ, which was the previously credible market for early stage funding, and that has taken a lot of them over here. I think roughly 2% of all companies on AIM are American, and there are 1,800-odd companies on AIM at the moment, roughly, and that is growing, and the Stock Exchange team has done a huge effort in marketing AIM into North America, so there are more and more companies coming over as a result.
I think the market will get more discerning. At least half the fuel cell stocks listed on the market will be half their current value inside two years, because reality will have caught up with a lot of them and just their ability to deliver will cause problems.
I think at least one carbon fund will blow up in commercial terms, because you cannot, or I cannot, get below them and assess the investments. I do not know if they are investing sensibly in HFC plants in Indonesia or buying carbon at the right price. It is a very difficult area to assess, and just human nature suggests one of those will have a problem.
I think, and I hope, we will get another wave or tidal company coming to the market. Some of you will be aware of the wave power company that came to the market around three years ago, and has had problems because it never quite delivered. That has soured the whole market, which I think gives a good example of why it is important to get early successes. I am hoping clean water technology companies will start to reappear because there is definitely a demand for that as an investment opportunity.
We are also starting to see the lessons of history being applied to solar, distributed power, and taking a view on time to commercialisation.
I am looking forward to seeing the first renewable energy real estate investment trust. Hopefully the legislation can be shaped because putting operating assets, effectively like an income trust in Canada, into that type of structure I think will be a great way of playing this space and providing an income-based product. A lot of people I am sure are looking to the property market come January when real estate investment trusts become available to the general public to stick in your ISA or your pension. Being able to have a similar thing for a dividend-producing renewable energy base I think would be great.
Specialist funds will expand, both in number and size. I don’t think that is really a very difficult prediction. A lot of them have been raising money very successfully and I am seeing more and more appear from different fund managers.
The big investment themes I am looking at, which I see happening over the next couple of years: I think the US will sign up to Kyoto, possibly not formally, but certainly it will tie in so that post-2012 it will get involved, and my prediction is it will happen roughly 10 minutes after the next President arrives in the White House!
I think nanotechnology will play a big role. This is not the nanotechnology, the hype, that happened in the US five years ago; this is the real product starting to come through, and that will be better catalysts, better batteries, improvements in new materials, material science coming through. That will deliver some really exciting companies.
‘Clean coal’ will be a big theme in the US. I do not think coal can ever be clean, but that is my environmentalist credentials coming out. But with the US sitting on 25% of the world’s coal, that is going to be a big theme over there.
Bio-fuels I think will recover because it fits in very neatly with existing infrastructure. It is a very easy one to fit in, and we will see money going into second generation bio-fuels, which is the ethanol lignocellulosic materials. You will also see a consolidation coming through, because there is a vast number of small bio-fuel plays all around and I think those need to consolidate.
And finally, filtration technologies, both for air pollution and water pollution, will play a very big role.
Will the current model deliver? I suppose I am almost bound to say yes, working in the markets. I think the Stock Market is probably the least inefficient way of delivering capital for where it is required. It is not perfect, but it is rather like democracy: democracy is the worst way of running a government until you try and find an alternative, or until you look at the alternatives. The market I think is good; it does go through cycles, but it will direct capital as needed.
There are a few things I personally would like to see, which I think could help the whole space. I would love to see clean tech created as a sub-sector of the AIM market or the FTSE index, because all of a sudden fund managers who are generalists will have to pay attention to it. They will have to decide am I over or under-weighted in clean tech stocks, and that will just push far more interest in that space.
I would like to see improved reporting quality. Maybe that is an analysts’ type of thing, but a lot of the data coming from these companies is of a very variable standard and it is not very consistent and it makes it hard for me to provide a good service to investors as a result. It is also the willingness of the markets to pay for research. Yes, that is a self-serving comment, but if you are not willing to pay to look at these small companies and to provide research, someone has got to pay my mortgage, and much as I like the space, I cannot pay it just on goodwill, and a lot of the big institutional investors have cut back on what they pay. They have pushed the trading margins down for shares significantly, down to a few basis points. It is very hard to get the original depth of research required to support this type of sector. I think the work that the Enhanced Analytics activity is doing is great, but it needs to move away from the broad SRI criteria and actually look at some of the proactive stocks rather than the more passive approach to SRI.
For the people from Government here, consistency, predictability, reliability in Government regulations – I don’t think there’s anything new there. The markets are very happy to deal with it, but they do not want to factor in political risk, because that normally is very heavily penalised because it is very hard to focus on. But if you can get some predictability, the markets will then react around it, and I think the comment earlier on taxes driving climate or driving behaviour was very astute, because that is changing the dynamics and the economics of a lot of this space.
Finally, again a pet hate, avoidance of grand projects where Government puts money into carbon sequestration in the North Sea or something like that – I am not sure that is a good use of capital. Great political game, but whether it actually delivers anything for the environment, I’m not sure.
Institutional investment in clean tech – perspectives on risk
Emma Hunt, Senior Associate, Mercer Investment Consulting
I work at Mercer Investment Consulting. Not everyone is going to know who we are. But first, as with Mark, this is not investment advice, but just some ideas.
Who are we and what do we do and who are our clients? We are a big investment consulting firm. Our clients are mainly pension funds from around the world. We have about 30 years’ experience advising institutional investors, and by that predominantly pension funds, but also charities, large foundations, and a number of other big collective groups. We have got investment consulting offices throughout the world. They cover offices throughout the UK and Europe, the US, Canada, Asia, Australia, New Zealand, etc. and we have got a very good sharing network, so a lot of the advice which we might give in one country – and this is particularly relevant to clean tech – will also be shared with other countries as well. We have got about 40 full-time researchers, about 100 consultants involved in manager research.
This relates back to what do we actually do. We research into investment themes. That might be alternative themes – global equity, UK equity, etc – but it also might cover alternative investment opportunities, and this is where we cover areas such as commodities, clean tech, international property, etc., and it is within this context that we are looking at clean tech.
Bear in mind our clients are pension funds – they have got money, they have got lots of opportunities for investing this money. We have focused a lot today on clean tech, and I just want to remind ourselves that this is not the only investment opportunity that pension funds are looking at. They are looking at equities, property, commodities, a very wide range of groups. This creates a huge amount of choice for pension funds. There are literally thousands of investment managers out there from which to choose. Of those investment managers, there are tens of thousands of products. Within Mercer Investment Consulting I think we cover something like 4,000 managers throughout the world, and, within our database, we have between 15,000 and 18,000 investment products. We are just skimming the market, but it gives you the idea of how much choice is out there, how much competition is out there for the money of institutional investors.
We talked a little bit earlier about what is clean tech investing. I am not going to dwell upon this. I have divided it into two particular areas – low carbon emitting sources, clean energy – solar, voltaic, solar voltaic, solar thermal, wind, biomass, small hydro – and there are a number of other sub-sets of that. But I also want to stress that if we are widening this clean energy out into clean technology, we are including other water and waste management solutions, energy efficiency technologies, etc. We have focused a lot today on renewable energy, clean energy. I want to widen that. That is not what clean tech is purely about, not from the way we see it within investment opportunities. We are drawing on opportunities in technology, in infrastructure, ad hoc projects, products, a whole range of areas.
Having said that, we are widening it out to clean tech. I am actually going to focus a little bit on clean energy, looking at the investment drivers. Again, we have covered this a little bit already, so I am not going to dwell too much on this, but this is the sort of thing that determines how pension funds begin to make their choices about how they are going to direct their funds, their assets.
They will look at macro environment and micro environment options. Within the macro environment, if we look at the investment drivers for cleaned energy, there is high and stable demand for energy. We heard again and again that in China there is huge demand – it is happening now and it will continue for the next ten years and more. In India, they are following closely behind. Rising fossil fuel prices – again, nothing new here. We have had a step change. There is talk that there will another major step change and the price of oil could go up to over $200 a barrel by 2012. That is phenomenal. There is concern over continuation and security of supply. There is a global threat of climate change, with resulting multilateral commitments from governments. This is all stuff we know. These are not things that are coming in; they are actual realities, they are happening now.
The falling technology costs and increasing competitiveness of renewable energy is interesting. When we are looking at funds which are operating in this space, we look at the knowledge of investment managers when they are looking and assessing companies in this particular area. Falling technology costs – this has been considered one of the barriers, so why is renewable energy not coming in, why is it not being successful, why has it not actually taken off yet? One of the barriers was that it was just more expensive to produce than our existing fossil fuel methodologies. This is beginning to change, partly through subsidies from different governments, as we are beginning to see, in Japan for example: they were one of the early subsidisers in this area, they have got the infrastructure in place, and they have withdrawn their subsidies. Particularly in the solar side, solar energy is on a par with the fossil fuel electricity prices. This is a major achievement, and this is what is going to drive quite a lot of the competitiveness for renewal energy going forward.
A couple of speakers have mentioned the micro environment. This is very important for investors. We now actually have a good pool of high quality companies emerging. Good investments are not just good ideas, they are how you put that into practice. It is about management, it is about revenue generation, it is about profitability, and it also is obviously about valuation. We believe now, probably for the first time ever, we actually have enough of a pool of high quality companies from which investment managers can choose. We think now we have probably got enough experienced investment managers with specialist knowledge in this area for them to be able to make discerning decisions. Would I have said that five years ago? Probably not, but I think we are just feeling it now.
This is where I could get into dodgy ground: looking at the micro environment, they are estimating double digit profit and growth forecasts for their underlying investments. I am not going to say any more about that.
So, when pension funds come to us and say, ‘Right, okay, we feel as though we want to find out more about this whole area of clean tech investing – what sort of products are there for us to look at?’ Blimey! Where do you start and where do you stop? Mark covered a bit of the macro, with an overview of the products. They can get opportunities in the carbon market, indices, da-di-da-di-da… The way we are beginning to present this information, and it is not the only way you can present it, is by looking at the types of underlying investments you can have. There is a very good publication called ‘The New Energy Finance’. They did a report, at the end of June 2006 I think, and they said that there are 165 private and publicly quoted institutional funds to choose from, and those are largely in the US and Europe. We are going to use that as our starting point. It is not the only point, but when we are explaining this to pension funds, this is our starting point.
Within those types of funds, there is a huge variety. They can be structured according to mix of underlying investments; equity (we have heard a lot about that earlier) both on the public equity side through AIM, through FTSE, the main exchanges, but also in private equity; through project finance and infrastructure projects. This information – these investment opportunities are coming up now. They are providing incredibly strong internal rates of return, and that is very appealing for investors that are looking for dividends over different time periods. Infrastructure can provide that. Likewise with debt. There is a small amount of debt out there. It is not particularly popular, but we should not discount it as part of the mix within some of the products. What we are finding is that most investment products are a combination of these. A lot put their money into both public and private equity, a little less in infrastructure, a small amount in debt. Having said that, there are a number of very, very strong Australian funds that are focusing purely on infrastructure, with a small amount in debt. So there’s a huge number of products to choose from is the point of this.
The breadth of investments can be broken down into lots of different ways. I am going to emphasis the point. They can be clean energy-specific, so that can be sector-specific investment vehicles. So there is a fund called Chrysalix that invests solely in fuel cells. Sun Edison’s Sunny Solar Fund invests purely in solar. Sustainable Asset Management has developed its own sustainable water fund. So you can have these sector-specific types of investments. These can be broadened to include other clean technologies, so you get a wider diversity of methods within your portfolio. From a pension fund point of view, that is very appealing. Within pension funds’ fiduciary duty, they want to try and maximise returns within an acceptable risk framework. That means they will take on a certain amount of risk in order to achieve high returns, but that does not mean to say that they are going to take on phenomenal risk. Spreading their investments by looking at different technologies and different sub-sectors is very appealing for them.
So how are we beginning to advise clients on this? We have spoken to about six clients just in the last six weeks or so. They tend to be very large clients, over $10 billion in each fund. We are suggesting that they are suitable as satellite investments. We call satellite investments a relatively small allocation within a diversified portfolio. To give you an idea, a big fund, over $10 billion, may have say 3 to 5% maximum in private equity. Well, we are suggesting a very small, less than 0.5%, allocation to clean tech funds, so it is a small satellite investment. We are stressing its medium to long term investment horizon, low correlation to other assets.
That second point is very important. When a fund is looking at their overall portfolio strategy, they will be able to take on a certain amount of risk. One of the appealing aspects of something like clean tech is it has got very little correlation with the other investments in the portfolio. For example, a classic UK corporate pension fund, mid-size, about 2 billion or something like that, might have about 30 to 40% in UK equity. That is a large amount in one area. We can strongly say that clean tech investing has a fairly low correlation with that, and that is something very appealing when you think in portfolio management terms.
We always get asked about risk, because again, a second part of fiduciary duties is to look at maximising investment returns within acceptable risk boundaries. We are finding this very difficult to assess when we are looking at these types of funds. We are not too hung up about it at the moment, but it is certainly something that we will be looking at over the next few years, as clean tech takes a stronger place within pension funds’ portfolio strategies. At the moment, we believe that risk is being driven by the underlying investments, via the companies in which those funds are invested. That is pretty obvious really. But each of those companies has very high idiosyncratic risk, therefore it is up to us to look very closely at the managers which are looking at those products to look to see how far they are assessing the risk of those companies. So that is one thing we are looking at the investment managers when they are making their investment choices.
We believe thereare going to be a lot of failures in this area. We have been talking about bubbles, but we have also been talking about a lot of the positive elements there surely are, but we do want to stress there are going to be failures. Is it going to be 50% of the companies which are publicly quoted? Possibly a lot more than that, but there are going to be a lot of successes too, and this is why we do need to stress that careful manager selection is even more crucial. There are a lot of managers doing this at the moment. There will be more managers coming in. These returns, as we have heard, are very appealing – we want to take advantage of this market. But it is going to be the managers which have the depth of experience, the detailed knowledge of those companies, the relationships with those companies, that we believe are going to succeed.
So what sort of investors might be interested? Well, since I prepared this, about two weeks ago, things have changed. They have moved on already. I have put as the first point ‘Any long term investor seeking high absolute return and the ability to take on risk as part of a wider investment strategy.’ I am just going to leave it there. One would think that the ‘mission-based’ organisations such as foundations and charities would be interested. We are not finding that is the case. Traditionally, socially responsible investors – again, we are not particularly finding that is the case. The early movers – we have seen them in the big state-sponsored funds. In the UK, some of the local authorities have taken an early move on this area; and overseas, particularly some of the big Norwegian funds, are putting a lot of money in this area; a lot of the US state-sponsored funds; in Australia, New Zealand, we have had lots of discussions with clients, just in the last two weeks, wanting to look at different investment vehicle choices within this area. We do think the state-sponsored funds are going to be the early movers and they are going to drive a lot of the investment in this space.
Having said that, if you actually look at who is investing in these types of funds, and in this whole area, it is the companies themselves. GE, Siemens, BP, BA: they have all invested some of their money in this particular space, so that is an area which we cannot ignore. We are about to undertake an initiative where we are going to contact something like 300 investors throughout Europe, a whole bunch of investors in the US, Australia and New Zealand, and many of those are going to be the big corporate pension funds. After we have undertaken this particular initiative, I will have a much better sense of who is going to take the next step, over the next 12 to 18 months.
In summary, exceptionally strong investment drivers have come together to create a satellite-style investment opportunity now. There is a big enough pool of good quality revenue-generating, high growth potential, investment opportunities that exist for money managers now – a good sign. There is a diverse range of carefully structured investment products managed by knowledgeable professionals that now exist for pension funds. This is good. We have got products for them. Risks exist, but we believe that they could be reduced through careful manager selection. Anyone can be a clean tech investor.
Institutional investment in clean tech – perspectives on risk – Nick Robins, Head of SRI Funds, Henderson Global Investors
We have had a lot of very good presentations so far on the ‘what’ of clean tech. I would just like to give you a little presentation of the ‘how’ we do it. We are one of the several tens of funds operating in the public space, so this is just how we do it. The emphasis, the message I would like to give to you is, in a sense, how our approach, how many of the factors, have to be the traditional fund management skills. We do have some particular added elements to our investment process, but that has to be mixed with the traditional fund management skills.
We call our approach ‘Industries of the Future’, the companies and sectors and themes that are going to benefit from the wide drive for sustainable development. We do not just look at environment themes. We believe sustainability is a fundamentally disruptive phenomenon in the global economy, generating investment themes. These themes are very useful ways of structuring portfolios and driving performance, and to actually harvest the benefits of that, you need to have top-down analysis and a bottom-up stock selection.
There are two aspects of our investment process which would be fundamentally different from a normal investment process, and three which are fundamentally the same. The top-down theme selection is fundamentally different. Idea generation is not particularly different. We have a corporate responsibility evaluation, which most investment managers do not. Financial analysis is fairly traditional.
In the area of top-down theme selection, there are ten themes, five of which are fundamentally looking at environmental drivers. I think the area I personally am most interested in is the efficiency theme, actually looking and seeing how we can use less energy and materials in terms of delivering goods and services. It is deliberately diversified and this is a global approach. We have about 4,700 companies listed around the world which fit one or more of these themes.
Supporting some of the analysis that Mark and others have said, there are some very fundamental drivers of this. We have carried out some back testing of this 4,700 universe, looking at the different themes. Many issues we all know, we have with back testing, but in each of the years, the weighted median of this universe has outperformed the benchmark, which is the MSCI World. For us, that suggests there is something of interest here which we believe most mainstream fund managements are not capturing.
From that large pool, the 4,700 stocks, we have a monitoring universe, and we have a whole series of ways in which we generate ideas. We do use some quantitative techniques. We use brokers and strategists such as Mark. We use our own internal economics team, our mainstream colleagues on the European, Asian, UK and American desks, and our own internal ‘Industries of the Future’ analysts. So there, in terms of idea generation, is fundamental traditional fund management techniques.
We also carry out a corporate responsibility evaluation, partly because the fund, in a sense, requires it – it is a socially responsible investment fund – but partly because we think it is a very good way of identifying risk, particularly as many of these areas are operating in highly regulated and sensitive sectors.
Then the fund managers will look at the fundamental analysis of the companies, in terms of market, in terms of the valuation, timing, and corporate strategy – nothing particularly new here.
And finally portfolio construction. The two areas to highlight around here is that while we are looking at the ‘Industries of the Future’, this is not necessarily a small and micro-cap fund. Half of the stocks will be in the MSCI World Index. It is not necessarily a particularly high risk fund. The tracking error is about 5 to 8%.
Just to give you a sense of how this approach works in practice, how we get through a pool of about 250 stocks in the clean energy large universe down to about 100 in the monitoring universe, to a portfolio of about 15 – this is from March – a global fund, there are only two UK listed stocks in that list. They happen to be the smallest and they happen also to be US stocks, PolyFuel and Ocean Power Technology.
The theme of this presentation and this workshop today is how is the City is helping to drive fundamental change. As I said, I think sustainability is fundamentally disruptive, but it is by no means a one-way bet. If you look at the longer-term, 10 year performance of clean tech, many of the sub-themes, particularly fuel cells, are nowhere near the peaks of 1999/2000. We feel it is best understood as a multi-dimensional investment theme, to diversify risk and gain opportunities. There is a need for understanding of new factors. There is a need for specialist understanding, plus the traditional investment skills.
I think we also need to reflect on the issues of the investment life cycle, the time horizons, when we consider that the average holding period for a stock on the London Stock Exchange is now 11 months, and at the end of the 1980s, it was 8 years, and one of the biggest areas of investors in this space, in the first part of this year, has been very short term hedge funds. We need to think about what time horizons we are really playing with in terms of investing in this area. And also in terms of issues of scale: we see particularly in the water sector that we are developing essentially oligopolies already, that many of the smaller companies have been bought out by the larger players, and I think we need to consider the implications of that.
We have only just begun. I think one of the concerns we have, again about potentially the UK and London as a market, is that we actually, as in a wider market, have a very, very carbon-intensive market. Our estimates suggest that about 15% of global greenhouse gas emissions are listed on the UK stock market, if you think about the emissions from the goods and services of the fossil fuel companies, and we are becoming, with listings such as Rosneft and so on, potentially, in the large cap area, more carbon-intensive. So while it is great to see all the work in AIM, great to see Biocare Solutions listing yesterday, which we took a stake in, we do need to think about the overall balance of the London market and, at the moment, it is very carbon-intensive.
Can existing financing models deliver the necessary change?
Michael Mainelli, Professor of Commerce, Gresham College
I think what we started with today was a very interesting question: ‘Are you an optimist or are you a pessimist?’ ‘Is the glass half-full or is the class half-empty?’ It is a great question, because if you believe in the strong markets hypothesis, it is totally the wrong question. The right question should be ‘Why are we using a glass that is twice as large as we need?’! So I sit here and think to myself, why are we debating this? If the numbers add up, the numbers add up, the investment will flow, and conferences like this are, strictly speaking, unnecessary!
You are probably curious about who I am and what I do. Don’t worry about that! I run a firm, a think tank in the City. We are very a commercial think tank and we are behind a lot of things that go on, but we do have a bit of a manifesto – we believe that the world would be a better place if people made better decisions every day, and we believe that those better decisions are likely to be based on better information and knowledge, which I think will play to some of the research people here, and also based on the use of market techniques. I also happen to hold a Chair here, the Mercers’ School Memorial Chair, and give lectures on anything that comes into my mind that touches on the subject of commerce.
What are the real problems in the financial markets? Well, arguably, there are not any, but that would be a very complacent view to take, and in fact one that I would argue is wrong. We do have some deep and fundamental problems with something like climate change and addressing it. We do have problems with things like clean technology. The reason is, fundamentally, if you look out at a period of about 50 years, we wish to change the world’s entire infrastructure. That is what we’re trying to do. We also wish to change the way in which the entire world order works. Every breath that we take in the future is a breath that ought to be costed. So we are privatising air. This was a big joke during the Thatcher era, but that is effectively what we would like to achieve. If we cannot achieve that, and we cannot do that through a tremendous number of interlinking factors, really a lot of this is not going to go far, and so the problem we face is clearly one of time horizons. Now, there are a lot of technical issues to do with financial evaluation, quality adjusted life year calculations, discount rates, and I could really bore you to tears and I think we could all have a lot of fun judging those! But let’s talk about some of the real problems, and really they are political.
The first thing is a lot of us like to sit in rooms and debate about the long term issues, whether or not R&D ought to be there, but voters drive the politicians, and the politicians have a tendency to jump up. One of the speakers earlier made a very good point about the desire for consistency of government response. Governments love tax. Tax is brilliant, because you can stand up there and hammer the Chelsea vehicles, you can hammer mobile phones – you can pick anything you like and it plays very well. In the City, of course, this is terrifying. This is called inconsistency. It is capricious. And so when a government economist talks to me about a 2% cost advantage over 50 years, and obviously the macroeconomics work out, all I know is that my clients take any particular tax thing, give it 12 months if they think the Government is going to stay in power, 18 months if they think there are some sort of political things there, and anything beyond two years is really thrown out the window. I actually would wish that many of the speakers perhaps had not emphasised tax so much. I think what is important, on the other hand, is ownership, so I am somebody who believes very much in cap and trade and not at all in carbon tax. Taxation-based policies tend not to solve long term issues, and I think this is a point we might wish to address perhaps in a future discussion.
The second thing that I felt today was very good was the notion of bubbles. Every major asset investment theme over history – canals, railways, telegraph, telephone, electricity companies, internet companies – every last one of these things has resulted in a gargantuan asset bubble, and I seriously doubt that clean tech will be different. That does not mean you cannot make money out of it. It does not mean this might not be a 50-year bubble, but there is a bubble coming and it will arrive. That does not make it wrong. This is what Schumpeter talks about in terms of creative destruction. We have to innovate. These are the ways that the market actually performs. I see nothing wrong with it. I think as people who are advising other people on investment we can take perhaps a very long term view and say, yes, there is a bubble here, and when it pops, around 2050, some people will get hurt, but you can make a lot of money on the way up.
The other thing that we have been talking about a lot today is an implicit belief that the markets will work. I am a fervent believer in market forces, but I cannot look around me and say that everything is working brilliantly – far from it. I think one of the problems we really have to face up to here is the huge differentials globally between the scale of the public sector and the scale of the private sector in making these changes. I think one of the most worrying aspects of Europe as a whole is the extraordinarily large percentage of monies dispersed through Government as a percentage of GDP. This means highly differential reactions, and you know, personally, if I was sticking my money into a tech firm that was neutral in every other way, I seriously doubt I would be sticking it into a European tech firm, and there are some very good reasons for that.
As I frequently point out to people within the Government who go on and on about tax, which they are clearly using as an instrument of policy, I say every time I have looked at investment appraisals, normally the junior managers come forward and they present these appraisals, and they say, ‘Of course this is all before tax.’ The reason they say that is because the investment appraisal before tax is easy. The after tax bit is very complicated. Every board I have ever sat on has always said, ‘Well, that’s nice. Now we’re going to do the after tax calculations.’ When you are looking at hurdle rates and ask, am I looking at a 12% rate of return, a 15% rate of return, what is my average cost of capital, blah-blah-blah-blah, the tax rate differentials can make far more than all the difference. It can make many multiples of the difference of all the other marginal investment decisions you look at, and this is really quite a telling argument for people who say, ‘Well, you know, where’s it going to happen.’
I wonder if any of this is really going to happen in Europe? I am a supporter of the London markets, and I think that is a different thing. If you look over the historical perspective, the capital markets based around London have delivered over the years. I think it is going to be messy – markets always are, that is what they are about, so I think historically we can deliver in this area.
A number of the speakers alluded to the current short term horizon. We have got to look at the fact that there is a tremendous amount of churn on the markets; ask is AIM really a market for raising capital or a place where investors put an option down? That they have cleared at least some of the hurdles; are they getting some advertising and some other things? Especially when one looks at the rate of turnover, real turnover, in the AIM market, you have got to say there is not a lot of liquidity there, and that is not what people are coming to the AIM market for, in my opinion, in general, to raise money; they are there to actually complete a transaction, but I know that is not orthodoxy.
We are seeing some principles emerging. I alluded earlier to the clarity of ownership. There is at least a movement now that markets over taxation are the right way to go.
The third area is the one that we are going to have the most problems with. This is really going to be driven by the private sector, or we are going to tie this up in a lot of fuzzy, muddled, Third Way, PFI, PPPs, and a number of other things that leave everybody absolutely unable to untangle unless they read Private Eye and see where they scams are going on! So there are some real challenges there in terms of clarity over this. These are investment decisions. They should be clear investment decisions and they should be made.
What are we doing? Well, I do think that there is one fundamental disjoint in this, and it really does relate to the long term versus the short term. We at Gresham College, my firm, and many other people in the audience have been supporting initiatives we have done, and I would like to point out too that one is the Farsight Award – I have a judge from the Farsight Award beside me, Alice here. The Farsight Award is an attempt by USS, Gresham College and others to promote the concept of a Man Booker Prize for the best long-term research. It is going to be awarded at Cabot Hall in the Docklands, and there are some leaflets outside in the hallway explaining a little bit about the Farsight Award itself. I shall not give away the winner, but what we are trying to do is to get the City to wake up to the fact that there is a hunger out there for long term research on initiatives to do with climate change, nanotech, mobility, clean technology, etc. Clean technology is one of those areas to which we would like to see the City paying more attention. Mark, you said one of the things you wanted was more investment research, and I agree with that. I think what we need here is more agreeable research – is wave, arguably, on balance, better than wind, or vice versa?
The second initiative we are tackling is something called the London Accord. The London Accord is a much grander vision, and the idea here really is to re-do something very akin to what was done in Denmark a couple of years ago, the Copenhagen Consensus, but with a number of major changes. One is to focus solely on climate change itself, basically how much carbon do you get out for the cash you put in. The second thing that we would like to focus on in the London Accord is actually getting City research firms to do the research rather than farming this out to academic economists, and we have pledges of support from the likes of Morgan Stanley, Deutsche Bank, HSBC, Saracen, and I would like to talk to a couple of people today about getting their research teams involved.
The idea is to pick off, in a consensus style, some of the areas of long term investment research into climate change and see if we can generate some reasonable accord about the broad ranges so that we reduce the research costs for everybody in the market; everybody is capable of making those decisions and relating it back. If we can get the London Accord off the ground, BP have been talking about funding and providing a lot of manpower. The City of London Corporation, as in so many cases, has been very supportive, and is looking at providing things like publishing the research. The idea would really be two major conferences with publications by each of the investment research houses and some co-ordinating publications.
The real benefit I feel of something like the Farsight Award and the London Accord is two-fold: one, it is pushing out to the general public the fact that the City actually cares and has an interest in it, and strangely I think, when I look and talk to my friends, they have a lot more confidence in commercial motivation, solving problems, if it is well directed, than they do in whether or not some politician is likely to win or lose a marginal seat. So this is one big benefit.
The other thing is I do not think the City has been strong enough in standing up to people and pointing out where these cases really do not hold water. There are a lot of SRI initiatives out there, they are great for the press, etc., but very few people get up and ask some of the blunt questions. I think some of the questions there about, oh, wasn’t this CHP, what’s going on here with solar panels, when are these things going to pay off, what policies are needed to really make these things work? These are lessons we need to be more coherent about instead of, for example, going for the next Welsh wind farm tax subsidy. We need to really start thinking about some of the deeper issues. And so I am hoping that the London Accord will in fact push back some standardised City views that can be chewed upon by NGOs and Government economists; that they can see that the City does not really take tax over a very long period into account when it is making decisions; that it can see that discount rates matter – whether you like them or not, that is the way we make these evaluations – I would like to see some of that resolved.
In conclusion, financial models are really the only thing that will deliver a real response to climate change, and a real response to the implementation of clean technology that we would all like. The question is how can we let them, and that is the question I would leave to you.
I am so pleased to see people like you turn up here at one of my homes, Gresham College. I think you are all working on how we sell the financial reality of clean technology but sell it responsibly.
I wil just give a brief summary of where I think we have got to. I think most people here feel that the capital markets will deliver in some form. There is clearly support that is required by Government in all sorts of ways, from the ways that we identified in the early stage through to fiscal incentives, if they are clear and if they are consistent and then they get out of the way, and issues along long term and short term investing. We heard about the length of time people hold their stocks. Is there something that the Government can do to create momentum around longer holding of stocks, for example, or is that something that also should be left to the markets to work out?
What we have done today is explore the landscape; we have explored a number of the issues. We have recognised that the public sector has a role, but the private sector, the capital markets, are doing well allocating capital to this area. What our report will try to do will be to bring together all of those inputs and produce not only an understanding of what is going on in the clean tech market at the moment, but also some recommendations for taking forward for the public sector, and for private sector. Michael has mentioned a couple of the initiatives which people in the private sector are taking in the form of the London Accord and the Farsight Award. The Enhanced Analytics Initiative is something which was mentioned as well.
Please get in touch with myself or anybody else in the Forum if you have any other observations that you were not able to air today that you feel are important to bring to our attention, in our analysis.
© London Principles Workshop, Gresham College, 19 September 2006