How I choose green shares to buy

Early morning sunlight filtering through the green foliage of an tranquil forest clearing

With a lot of political attention focussed on the environment lately, many investors have been turning their attention to green shares. The growth in environmental, social, and governance (ESG) investing has accelerated this trend.

But one of the problems is that the phrase ‘green shares’ means different things to different people. A good example of this is the energy sector. Companies like Shell and BP have been trumpeting their move into green energy sources. But personally, I don’t think a windfarm is particularly environmentally friendly. It may (or may not) be less environmentally destructive than burning oil, depending on how one judges such things. But it is less environmentally friendly than reducing energy consumption in the first place. Meanwhile, both companies continue to pump vast quantities of oil. While some investors may see it differently, I don’t regard either Shell or BP as green shares.

Defining green shares

That’s why I think it is helpful first to define what green shares mean. That will vary depending on the investor concerned. Is it about being involved in non-carbon energy projects, such as SSE? Might it be about the industry in which the company operates? Or is it about whether the company offsets environmentally damaging activities? Or is it about all of these things and more?

The answer will be different depending on one’s worldview. What is the same for each investor is the potential value of learning more about what specific companies do. Often it can be tempting to invest in companies based on their financial metrics, with little understanding of what they really do. Starting to look in detail at their operations can be very enlightening. Not only would it help me as an investor understand how green a company is, it would usually also help me understand more about the likely future performance of the company.

For example, one reason I sold Shell last year was that when I looked in detail at their proposed future business footprint, I didn’t foresee the same sort of returns they had been able to generate historically. Similarly, it was only once I started to evaluate recycling companies like Renewi from an environmental perspective that I started to learn more about the economics of the industry.

Environmental and financial returns

Another point I always consider is what a company’s future financial returns are likely to be.

I am a financially oriented investor, so I typically won’t add a company to my holdings if I don’t see a strong financial future for it. But not all investors take that approach. Some are willing to invest in what they see as green shares and accept a lower rate of return from it than they may for other shares.

But the difficulty here is that many environmental shares at the moment are in companies in a fairly early stage of their lifecycle. For example, many commentators expect a shift in future electricity generation and storage needs in the UK. That could be great for companies in that field, such as AFC Energy, Ceres Power, and ITM Power. But what is less clear at this stage is which technologies will be the winners, let alone which companies. As technology evolves and the environmental policy debate shifts gears, what looks like a promising opportunity today could turn out to be less attractive down the line. After decades of use, nuclear energy is still highly divisive in just that way. Such uncertainty can obscure a company’s financial prospects from my vantage point as a potential investor.

Looking to the future

So, if investing in green shares, I would face the risk that a company’s future prospects are hard to assess. In fairness, that is a risk with shares in general. But at least longer established companies in industries with clear economic models ought to have clearer earnings visibility.

That doesn’t mean that I can’t invest in green shares. But it means that I focus on ones where I think there is more clarity about future financial performance. I also prioritise financial prospects. So, while I would be happy for companies to be less environmentally destructive, that isn’t my primary criterion in deciding whether to invest in a company. Instead, the question I ask first is whether £1,000 invested in shares of a company today seems likely to increase or decrease over time. If I can’t assess a company’s prospects adequately, I won’t be in a position to decide that buying its shares could increase the worth of my stake in years to come. So I won’t buy it, even if that ends up meaning that I missed a good opportunity.

Applying common standards

I also consider my general principles when buying green shares.

For example, a key principle of my portfolio management is to invest in different companies across a multitude of sectors. That means that if a company performs less well than I expected, the impact on my portfolio as a whole will be smaller. I would apply that principle when investing in green shares. I would only have them as one part of my portfolio and invest in different companies.

One approach I would consider taking to achieve that would be to invest in a fund or trust which held a basket of green shares. There are lots of these, including Gresham House Energy Storage Fund, Impax Environmental Markets, and Renewables Infrastructure Group. Investing in a fund like this would offer me another advantage compared to buying green shares myself. The fund managers typically set out their investment criteria and do research to establish whether companies match them. So, I could get exposure to a variety of green shares without having to do all of the research legwork myself. But, like all green shares, such funds do also carry risks. For example, early stage technology may be prohibitively costly to commercialise. There is also substantial political risk, so green shares which look promising today could see their profit outlook hurt by regulatory changes.

My green shares to buy

My approach to buying green shares, then, uses the same criteria as any other shares. I look at a company’s financial prospects. I consider its likely future free cash flows: how big are they and how long might they last? I consider the risks, and compare my analysis to the risks and rewards I see in other shares. While I’m happy buying green shares, I buy them because of their possible financial return, not just their ESG credentials.

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Christopher Ruane has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.