Investment diversification is one of the first lessons you learn as an investment professional. In American college parlance it is Course 101, something you learn on day one, and with good reason. In any investment there is a level of risk to accommodate. Diversification is an effective means to manage risk and ensure a level of downside insulation – and there is always a downside at some point. Markets are, after all, cyclical by their very nature.
Those of us who have been active in the investment world over the past 15 years or more will have seen the benefits of this strategy first-hand, as markets have demonstrated a particularly high level of volatility over that time. For those in the UK, we have experienced first-hand no less than four so-called ‘once-in-a-lifetime’ events as the Global Financial Crisis hit, then Brexit, and more recently covid-19 and Russia’s invasion of Ukraine. While very different in genesis, these events have all clearly had a material impact on markets and portfolios. Given their size and scale, it will have been virtually impossible to be totally immune to their impact, but an appropriately diversified portfolio will have afforded some protection, depending on the exact investment strategy.
“Put simply, we are over-reliant on too few sources of power and the war in Ukraine has exposed the full extent of this”
Like any investment market, energy markets are subject to external factors, among which are considerations of supply and demand. Most notably the supply of oil and gas and the demand of governments and consumers. Over recent years, however, other factors have started to weigh in. The impact of fossil fuels on our environment has created a groundswell of support for cleaner, greener sources of energy. People are fed up of being at the mercy of oil and gas producers dictating supply and manipulating global prices, and there is a general recognition that fossil fuels are a finite resource. We have seen just how powerful sentiment can be on markets.
The war in Ukraine has highlighted the stark reality of our current predicament. The energy crunch that we are all experiencing in our homes, at the pumps and in our portfolios, highlights the lack of diversity in our energy supply. Russian gas becomes an issue in Europe and we have chaos. Put simply, we are over-reliant on too few sources of power and the war in Ukraine has exposed the full extent of this.
Diversifying our energy supply is important, not just for investment downside protection or to drive returns but also to achieve our global goals and ambitions with regards to mitigating the impact of climate change. It is encouraging to see the UK take a global leadership position in wind and solar technologies but we are in danger once again of having too many eggs in one basket. On their own, these technologies cannot be the whole solution, given how subject they are to the vagaries of British weather.
For complete energy security, the UK and certain other global governments are viewing nuclear power as the panacea. It is alarming to witness the growing level of support for this technology. Nuclear power cannot and must not be the solution. Parking the considerable cost of building a nuclear power station, we must remember that the construction process is highly pollutive, the sourcing of the raw materials for the power generation is ecologically destructive and the by-product is some of the most toxic material known to man.
Yes, we need diversification, but climate change demands mean that solutions must be considered at all points in their lifecycle from construction through use to decommissioning, not just at the point of energy production. On this basis, nuclear power just doesn’t stack up.
Global issue, global solution
Globally, each market responds to external phenomena differently, and it is clear that we need a diverse range of technology solutions delivered with suitable geographic diversity. Technologies need to complement each other so that energy security is maintained at all times, and we need to recognise that climate change is a global issue that requires a global solution. We are already seeing a lack of diversity in the sustainable technologies that are being deployed. Wind and solar are clearly a part of the solution to climate change but they are intermittent, and investment returns for propositions focused on these areas have been falling over recent years.
Companies involved in these technologies are having to take responsibility for more parts of the development chain, including planning and construction risk, to be able to keep delivering returns to investors, while investors cannot keep relying on subsidies for their returns. They are too subject to the whims of governments and are only ever another unforeseen crisis away from being changed or even withdrawn. Renewable investment has to be able to stand on its own two feet without subsidy.
For us to achieve the triple challenge of providing returns to investors while actually making a positive material contribution to climate change, all with a secure supply, we must embrace greater diversification both geographically and technologically.
“Climate change demands mean that solutions
must be considered at all points in their lifecycle …not just at the point of energy production.
On this basis, nuclear power just doesn’t stack up.”
So where do we go from here? What would be a good outcome from COP27 later this year? Geographically, we need to adopt a far more global approach. Having a net-zero UK is a laudable ambition but it doesn’t fix a global problem. We need to focus global resources where they can have the biggest impact. Solar and wind in the UK can help, though solar in Brazil or Australia or wind farms in the Nordics are clearly going to be far more effective.
Ultimately, however, we must diversify away from wind and solar. We are going to need far more innovation, and investment needs to be put into a wide range of proven new technologies from gas with carbon capture, to tidal, to compressed air solutions, and we need to find far better ways of storing our energy for use on demand. Battery technology is advancing but still has a long way to go before it can provide a long-term solution.
From an investment perspective, incorporating a wider range of technologies will inevitably mean that investors will need to do more homework to
understand their potential (and shortcomings, eg, battery storage only lasting for two hours). Either investors rise to this challenge or they rely more heavily on professional investment firms to do it for them. Inevitably, investors and governments will need to move out of their comfort zones and support far greater innovation.
The bottom line is that without adopting a diversified and innovation-based approach to climate change, we will fail. We will fail investors, we will fail consumers and we will fail our planet. In the run up to COP27, investors and governments need to be mindful that diversification has always been, and continues to be, the only solution that gives appropriate risk-managed returns and energy security, while actually having the potential to address climate change.
Richard Lum is managing partner and co-CIO at Victory Hill Capital Advisors, a London-based firm focused on the energy transition.