Financial Markets and the Natural Environment: An Economic Perspective

What are the different environmental assets in which investors can invest? A new short book, Environmental Markets: A New Asset Class, answers this question and explains the role of markets in reducing pollution and environmental degradation, thereby protecting the natural environment. It also tells the story of how today’s environmental markets have come into being and where they stand today.

At about 160 pages, this short book makes a relatively easy read. It is published by CFA Institute Research Foundation and written by Richard L. Sandor, Nathan J. Clark, Murali Kanakasabai, and Rafael L. Marques. Richard is the CEO of, and his coauthors are managing directors of, the US-based company Environmental Financial Products, which “specializes in inventing, designing, and developing new financial markets with a special emphasis on investment advisory services.”

The book takes an economic perspective and argues for pricing various negative externalities and establishing rights of use. “If property rights in public goods are established and transaction costs are minimized, prices can guide the private and public sectors toward achieving environmental and social objectives at the lowest cost to society.”

Here are some of the insights from the monograph.

What’s the link between environmental degradation and externalities?

“Population growth, industrialization, and urbanization in the past 200 years have resulted in local, national, and global pollution of our environment. Fossil-fuel combustion has resulted in over-accumulation of pollutants that cause smog, acid rain, and climate changes. Entire populations — including China, India, Africa, and large areas elsewhere — face inadequate access to clean air and water. The lack of ownership of these precious commodities is the cause of the problem. The profit maximization model for a firm takes into account only the direct costs incurred by the firm, not the spillover costs, such as the negative repercussions associated with the pollution of air and water. . . . These spillover costs, called ‘negative externalities,’ can be dealt with by mandating limits on emissions or requiring specific modifications in the production of goods and services. Spillover costs or benefits can also be mitigated by taxes and/or subsidies. In addition, externalities can be mitigated when public or private entities create a limited number of emission or use rights — that is, by a cap. These property rights, called “allowances,” can be purchased by companies for the purpose of compliance with environmental laws if they exceed the cap. Similarly, companies that reduce emissions in excess of their targeted reductions can sell their allowances, thereby motivating compliance at the least cost.”

What are environmental assets?

“Examples of environmental assets are rights to emit local and regional pollutants, such as sulfur dioxide and nitrogen oxide; rights to emit global pollutants, such as carbon dioxide; renewable energy credits; water quality and quantity rights; and indices of sustainable corporate equities.”

How to invest in Greenhouse Gases as an environmental asset?

• Commodity Markets. “The most direct way to get exposure to the asset class of carbon-related investments is by taking a position in spot, futures, or options markets for EUA allowances.”
• Equity Vehicles. “Stock picking based on climate risk exposure can have an impact on the overall portfolio return as well as on risks.”
• Exchange-Traded Funds and Notes. “ETFs and exchange-traded notes (ETNs) exist for retail investors interested in EUAs. Most of these instruments provide exposure by holding EUA futures contracts.”
• Clean Technology Companies. “Picking companies that supply clean energy technologies allows investors to gain direct exposure to carbon as an asset class. In recent years, rapid increases in clean energy deployment have occurred in response to climate and renewable energy policies.”
• Climate Funds. “Investors can also consider investments in the climate solutions field. This category includes the subcategories of energy efficiency, clean technologies, and renewable energy supplies.”
• Listed Climate Companies. “Another direct way to get carbon exposure is to take a position in listed initial public offerings (IPOs) of companies active in the carbon allowance space.”
• Listed Carbon Project Development Funds. “The broad class of funds in this category includes originators and developers of carbon allowance–generating projects and traders of carbon credits.”
• Listed Exchanges. “Another environmental investment worthy of mention is the listed exchanges.”
  

How to invest in water as an environmental asset?

• Water Equities. “Opportunities in water stocks exist in filtration, infrastructure, desalination, engineering, treatment, testing, and other aspects of the water value chain. These areas can be broadly categorized into three groups: treatment, management, and infrastructure.”
• Exchange-Traded Funds. “ETFs have become increasingly popular with investors seeking exposure to a commodity or asset class that may otherwise be difficult to access. Water ETFs are no different in this regard.”
• Water Funds and Indices. “A handful of water-focused mutual funds have emerged in the past several years.”

Will these environmental assets matter in the future?

“The past shows that wealth creation is guided by fundamental structural and technological changes in the economy. This lesson from history leads us to believe that the next macro trend will be the commoditization of air and water. Environmental and economic shifts, policy changes,technology improvements, and other innovations will trigger this transformation. Population growth, the rise of China and India combined with their rising incomes and energy demand, resource scarcity, and a warming planet will fundamentally affect the economic fabric of tomorrow’s world.”

“As demonstrated throughout this book, markets in emissions and user rights have solved environmental problems and created enormous investment opportunities. They achieved these ends by commoditizing the externality and then pricing it. The same concept has been applied to weather-driven events and catastrophes. The convergence of the environment and finance is here to stay, and the market mechanisms described in this book are only the beginning. The new asset class of environmental goods is just in its infancy and holds enormous promise.”

You can download Environmental Markets: A New Asset Class as a PDF for free, or opt for the e-book or paperback edition.

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.