Wednesday, May 09, 2007

Yet another market signal about climate change, but it'll take work to get the answer

Yesterday was about the commodities market and a global warming index, today is about equities. KLD, an investment research firm heavily involved with socially responsible investment, has had a "climate solutions" stock index and last month, it partnered with a financial management firm to allow people to invest in the index.

The GC100 is based on the concept of the climate solutions value chain. Companies in the climate solutions value chain are positioned to benefit from increasing constraints on carbon, high fossil-fuel prices, rising energy demand and a growing acknowledgement of climate risk. The index is constructed to form a basket of companies that provides exposure to companies providing climate solutions.

Their methodology:

The Global Climate 100 Index includes a mix of 100 global companies that will provide near-term solutions to global warming....Constituents are selected from the global universe of companies for their involvement in the following themes: Renewable Energies, Future Fuels, and Clean Technology and Efficiency.....The leading companies in each category are included on the Index....The Index seeks companies representing a range of corporate responses to climate change, including a group of large-, mid-, and small-cap companies representing sectors ranging from energy and utilities to industrials and consumer products. As a result, the Index is more broadly diversified than a traditional energy sector index.

Neither the current price of this index nor its change over time will show a market signal about climate change directly. But there's more - the price-to-earnings ratio, relative to P/E ratios for comparable businesses not investing in climate solutions, should partially reflect whether the market believes climate change will force business changes. Companies can have high stock prices relative to their annual earnings if the market believes the companies will grow rapidly. If the market believes in climate change, the P/E for these companies should exceed the industry average. The companies are here, starting on page 4. All someone has to do is compare the companies to the appropriate sector of the market (which might be a little tricky, but seems doable). Pretty good business school student project, I would think.

Of course there are confounding factors and noise in the signal - people might invest in these companies in anticipation of peak oil or energy security needs; the market will be influenced by government underreaction or overreaction to climate change; and the index depends partly on the skill and P/E preference of the index selectors.

Still, it would be interesting to see what the result is of a P/E comparison. I bet the index managers actually know that, although I don't know if they'd give that information out.

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