With a new president taking office who says he’s committed to tackling climate change, environmental financial opportunities—investing in assets whose value is affected by the risks and opportunities associated with climate change—might be the antidote for toxic portfolios.  

But before moving too quickly, remember America’s love affair with ethanol. By 2004, ethanol was a favorite environmental investment, with numerous I.P.O.’s on ethanol companies, and it was embraced by politicians and investors alike.

It all ended badly. I can’t decide if the turning point was last April, when a United Nations expert called biofuels a “crime against humanity,” or if it was in November, when Goldman Sachs announced that its analysts would no longer cover listed ethanol companies because of their “dim future.” Advances in scientific understanding, changes in policy and sentiment, and new technological developments all played a part in this change in affection.

So what’s an investor to do now? How can people find success in environmental investments while avoiding the next ethanol? Investors need to understand the following:

Unique opportunities: Environmental investments break down into five major categories: carbon and other commodities (typically emissions-related); water; clean technology; property; and timber. Someone might make a “pure play” call, such as investing in carbon-only funds, or he might opt for diversified environmental funds. But it goes further still. There might be broad overlap because technologies have applications in more than one area (environmental property investments, for example, would also include clean technology investments), and the categories cut across asset classes and trading styles.

Sources of returns: Science is only one of the factors that effects environmental investing. Greenhouse gas levels (GHG) are rising, and so is the average global temperature. Current thought is that we need to reduce the level of GHG emissions within the next 20 or so years if we are to avoid catastrophic and potentially irreversible environmental damage, as well as equally dangerous consequences for the global economy and society.

Another driver is economics. Climate change imposes two sets of costs on society: the cost of adapting to expected consequences, like extreme weather events, rising sea levels, lower crop yield, and increased diseases; and the cost of mitigating greenhouse gas to reach the emission target by improving energy efficiency, such as switching to technologies that produce fewer emissions.  

This understanding of costs allows governments to create policies and regulations, like the Kyoto Accord, that set a clear price for carbon and provide incentives and structures to persuade businesses and individuals to reduce GHG emissions (mitigation) and prepare for changes in climate that are likely to occur regardless of our future actions (adaptation).

Finally, there’s technology. GHGs come from too many different activities across numerous sectors for there to be a single technological silver bullet. Our response to climate change will require a portfolio of technologies that mitigate greenhouse gas emissions (think of efficient lighting; improved insulation; more fuel-efficient vehicles; technologies that use solar, wind, geothermal, and tidal and wave energy) and help us adapt to the consequences of climate change (such as desalination; digital controls; seawalls and storm-surge barriers). These various technologies give rise to a broad array of environmental investment opportunities.  

Risk assessment: Environmental investments not only carry the same challenges as more traditional investments, they come with some unique risks.

Take, for example, what happened to EcoSecurities, one of the largest developers and suppliers of emissions credits. The Irish company puts together environmental projects that generate carbon credits and sells to needy buyers. Each project must be independently certified to the United Nations as environmentally legitimate.  However, in late 2007, the U.N. rejected several of Ecosecurities’ projects on the grounds that they would have been financially viable without the revenue from credits. This caused EcoSecurities to write off a portion of the credits it promised to deliver.  The company's shares, traded on the London Stock Exchange's AIM index, dropped by more than 80 percent in the following year.  

Here’s another case. Last July, the U.S. Court of Appeals in Washington vacated the Clean Air Interstate Rule. This unexpected decision shocked the emissions markets, sending prices into a tailspin, and introduced a level of complexity and uncertainty for other similarly planned cap-and-trade schemes. The price of sulfur dioxide allowances on the Chicago Climate Futures Exchange dropped from more than $300 per ton to about $100 per ton in two days.  Prices have rebounded to about $215 per ton.