Thematic ETF ideas to play the energy transition

Such ETFs are best deployed tactically as a supporting player in a broader portfolio of investments.

As world leaders descended on Glasgow for COP26 in the final quarter of 2021, the global need to find solutions to the climate crisis has never been greater. The potential rewards for those companies that facilitate the transition to a low-carbon world are also enormous.

I wrote earlier this year about how you can use ETFs to mitigate the carbon risk of your investments by replacing core portfolio building blocks with low-carbon alternatives.

For some this doesn’t go far enough. In this article I will discuss some options for those who want to make more targeted investments using thematic ETFs. Rather than focusing on risk reduction, investment in these often narrow funds offer more upside potential.

But be warned, these funds tend to be pricier than standard trackers and also come with higher expected levels of volatility. They are therefore best deployed tactically as a supporting player in a broader portfolio of investments.

Each of the below investments offers access to highly specific markets and investors should make an effort to understand the dynamics of each exposure before investing.

Decarbonisation solutions

Rather than simply screening out a portion of the global equity universe based on carbon metrics, the iClima Smart Energy ETF (LSE:DGEN) targets companies actively working on decarbonising solutions.

Holdings include British-based FTSE 100 constituent Johnson Matthey (LSE:JMAT). The firm, which specialises in a range of sustainable technologies has set targets for producing net-zero batteries and is currently in the process of commercialising a process to convert renewable feedstocks into a key input used to produce renewable polyester.

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Fund holdings span five distinct sub-groupings: green energy, green transportation, water and waste improvements, decarbonisation enabling solutions and sustainable products.

With around 150 holdings, the fund is broader than most thematic ETFs, and offers mid-cap growth exposure in global developed equities. Its yearly ongoing charges figure (OCF) is 0.69%.

More targeted energy solutions

Hydrogen has long been touted as an alternative fuel source of the future. It is a clean energy source that can be made safely from renewable energy sources. The EU has announced that it sees clean hydrogen as a cornerstone of a climate-neutral energy system.

The L&G Hydrogen Economy ETF (LSE:HTWO) offers exposure to the full hydrogen value chain, from electrolyser manufacturers to fuel-cell manufacturers. To ensure the clean credentials of its holdings, any holdings with revenue exposure of more than 10% to thermal coal will not be added to the index.

Example holdings include ITM Power (LSE:ITM), a British energy storage and clean fuel company. It designs, manufactures, and integrates electrolysers to produce green hydrogen using renewable electricity and tap water.

Its portfolio currently consists of around 50 stocks, the majority of which are growth companies in the industrials segment. Its yearly OCF is 0.49%.

Isolating another specific renewable energy solution is the Invesco Solar Energy ETF (LSE:ISUNLN). This ETF, which costs 0.69% a year, offers targeted exposure to the global solar market. To track the solar industry most efficiently, those companies with highest revenue exposure to solar receive a higher weighting in the portfolio.

Although this approach is designed to offer a more ‘pure play’ exposure to solar, it is worth noting that it also introduces some stock-specific risk. For example, at the time of writing, US solar players Enphase Energy (NASDAQ:ENPH) and SolarEdge Technologies (NASDAQ:SEDG) together represent one-quarter of fund investments.

Investing directly in carbon

One of the greatest things about ETFs is the role they have played in the democratisation of finance, allowing investors access to markets that had once been the preserve of institutional investors.

The SparkChange Physical Carbon EUA ETC (LSE:CO2) launched recently. ETCs are similar to ETFs but in this case track a single commodity rather than a diversified basket of holdings. The ETC is the first of its kind. It promises to cut out the middlemen and allow direct investment in the price of carbon.

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Previous passive vehicles offering exposure to carbon credits bought and sold carbon futures rather than trading in the underlying contracts. The technical dynamics of the futures markets mean that the returns of those products often deviate from the prices of the underlying carbon contracts. Worse news still, for those hoping to make an impact, trading carbon futures does not directly impact the price of the underlying contacts and, therefore, the price of carbon emissions.

When you buy into this ETC, you are not only getting direct price exposure to carbon, but you are physically buying up carbon credit allowances and taking them out of the market, thereby increasing the cost of polluting.

With an annual fee of 0.89%, this isn’t a cheap option, but it represents the purest and most impactful way to access this emerging commodity.

It should also be emphasised that this product offers access to a single commodity and that returns may be highly volatile.

Kenneth Lamont is a senior analyst focused on manager research and passive strategies at Morningstar.