Are renewable and alternative energy ETFs a buy?

With climate change on everyone’s mind these days, renewable energy and alternative energy have become investing megatrends. Renewable- and alternative energy ETFs have become popular ways to trade on concerns over climate change. Behind every ETF lies an index, and a plethora of renewable energy indexes are available, each with its own methodology.

But has the market in renewable energy ETFs matured sufficiently for most investors? Is this a good time to invest in renewable energy ETFs? Do alternative energy ETFs truly represent pure climate plays? Most importantly, should you invest in a renewable energy ETF?

We’ll address those questions in a moment. But first, let’s take a look at why renewable energy matters, and how the global market for alternative energy sources is shaping up in the short term and in the long run.

Why renewable energy matters?

For our purposes here, renewable energy is electricity generated from renewable sources like solar and wind power. It is the cornerstone of our global transition to a more climate-friendly, resilient, and sustainable economy. As we seek to further reduce our emissions of greenhouse gases, demand for green electricity will continue to increase.

The global market for renewable energy and related industries is strong and its outlook is even stronger. The International Renewable Energy Agency (IRENA) reports that global renewable energy capacity rose by nearly 50% from 2019 to 2020. Global installed renewable energy capacity rose 10.3% in 2020 while new fossil fuel installations fell by more than 6%.

These advancements are driven in part by the ambitious targets set by the Paris Agreement. To achieve Paris’s 2050 target of capping global temperature rise at 1.5 degrees Celsius, we must replace fossil fuel consumption. The IRENA Transforming Energy Scenario meets this target by increasing the global share of renewable electricity from 26% to 86%. Under this scenario, many countries will need to achieve complete or nearly complete transitions to renewable sources of electricity.

As regulatory frameworks are established to help support the Paris Agreement’s targets, businesses supporting green energy production stand to benefit. ETFs that draw on carefully constructed indexes of green-energy stocks may reward a buy-and-hold strategy by investors.

Renewable-energy ETFs: an introduction

Alternative-energy ETFs draw on indexes of selected and weighted stocks. Each index reflects a different set of criteria, as do their corresponding ETFs. Some ETFs may represent a more generous definition of clean energy than you do; read each index’s documentation carefully.

Here are some examples of leading renewable-energy ETFs.

Are renewable-energy ETFs a buy?

Past performance is an imperfect guide, especially in a rapidly changing market like renewable energy. Historical prices for alternative energy ETFs can, however, yield some interesting points of comparison. Consider this chart:

ACWI:US is the MSCI All Country World Index, a benchmark representing the global stock market. All ETFs on this chart posted significant gains shortly after Joe Biden’s win in the US presidential election. That peak soon gave way to profit warnings in the wind and solar industries. Pandemic-related supply-chain disruptions and increases in commodity prices have also cooled the market.

Two ETFs, FAN:US and RNRG:US, follow ACWI fairly closely. FAN is a wind-energy ETF, while RNRG represents a wider spectrum of renewable energy producers. FAN trailed the others until mid-2020, when it crossed both RNRG and ACWI. Since early 2021, it has followed ACWI very closely, with RNRG following a similar pattern, but with lower returns.

TAN:US, the Invesco Solar ETF, has benefited greatly from the solar market’s expansion in recent years. It especially profited from a broad belief that solar energy would play a key role in post-COVID economic recovery plans. Another fund, the HANetf Solar Energy ETF, was launched only in June 2021, but has risen by 13.45% since then.

How are these renewable-energy ETFs valued?

A closer look at these ETFs’ financials can help us anticipate their future performance. Let’s start with the most recent P/E ratio reported for each ETF.

• Invesco Solar ETF: 69 (30 June 2021)
• First Trust Global Wind Energy ETF: 24 (31 August 2021)
• Renewable energy producers ETF: 28 (23 September 2021)
• HANetf Solar Energy ETF: N/A
• MSCI ACWI ETF: 26 (23 September 2021)

The Invesco Solar ETF carries a high valuation, which it owes in part to the effects of a global pandemic. Currently, the investment rationale for Invesco Solar predicts that the market for solar-sourced energy will maintain the margins it has established over the last 18 months or so.

I do see massive growth in the solar market, but I anticipate much the same for the wind market as well. With growth will come increased competition, and the companies represented by these ETFs may not flourish to a degree suggested by their valuations. In my personal opinion, the Invesco Solar ETF seems like a good long-term hold. The other ETFs we have studied represent buy-and-hold options at best in my personal opinion.

Do renewable-energy ETFs really help the climate?

It is tempting to think of alternative-energy ETFs as pure climate plays, but that is not the case. Some ETFs include at least a handful of companies that continue to emit large quantities of greenhouse gases.

To help identify pure climate plays, we have developed a methodology for defining and highlighting Pure Climate Stocks. In brief, Pure Climate Stocks represent companies that derive 100% of their revenue from products and services built around technologies that are critical parts of a global solution to the climate crisis. We examine each company’s annual report on a quarterly basis to verify its Pure Climate Stocks status.

This chart lists some of the positions in otherwise climate-friendly ETFs that we find problematic, as they are not Pure Climate Stocks.

First Trust Global Wind Energy ETF and renewable energy producers ETF include the greatest number of problematic positions. But the stars of our earlier analysis also include companies that are not Pure Climate Stocks. Both Invesco Solar and HANetf Solar Energy include Flat Glass Group, a Chinese firm that serves the solar industry that is not a Pure Climate Stock. Flat Glass Group’s portfolio includes other products, serving other industries, that produce significant greenhouse gas emissions.

Summing up

Renewable-energy ETFs are an intriguing way to add more sustainability to your portfolio. They do not, however, limit themselves to Pure Climate Stocks. For a completely pure climate play, you may want to avoid even the least problematic renewable-energy ETFs.

My own climate investment portfolio is limited to individual stocks, with no ETFs. This approach requires some effort, but it keeps me in control and ensures that my investments make the greatest possible maximum difference. I do use ETFs, but only as benchmarks to track my own portfolio’s performance. Renewable-energy ETFs are also good sources of ideas for your own personal investment decisions.

Our experience with Pure Climate Stocks has led us to build our own Pure Climate Stocks index. Still in development, the index will list only pure climate plays. Only companies that make all of their profits by providing solutions for reaching net zero globally by 2050 will be included. As with all our efforts, the index’s methodology will be clear and fully documented. We believe in giving investors all the information they need to make decisions that work best for them. To learn more about the index, and to stay informed of its progress, please subscribe to our newsletter below.

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