With an understanding of what drives environmental investing out of the way, it’s time to look at the potential benefits of putting money into green ventures.

Environmental investments are attractive precisely because of their sources of return and their risks. Breakthroughs in science, changes in policies and regulations, and advances in environmental technologies result in market inefficiencies where some investors know more than others.

Investors with these informational advantages can exploit these inefficiencies to achieve above-market returns, or what we call “alpha.”  For example, an investor could have substantial material knowledge of current and emerging solar-related technologies, the current power industry and transmission grid, and local, national, and international policies. She could use this knowledge to build and manage a long-short equity portfolio comprised of photovoltaic manufacturers, solar, equipment producers, material suppliers, battery manufacturers, installers, and product fabricators. She’d buy those she expects to outperform and short those she expects to lag. The objective could be to generate a return above the risk-free rate or perhaps to beat a benchmark, like the Claymore/MAC Global Solar Energy Index E.T.F. (TAN).

This brings us to a key point: Environmental investing has some rich prospects, but they might not be easily accessible to individual investors. For example, today there are over 200 different solar technologies competing for a leadership position in the U.S. market alone; identifying which—if any—will likely have even transitional (let alone long-term) value is a daunting task, probably best left up to investment specialists.

Still, opportunities for environmental investing are cropping up all the time, if you know where to look. In 2008, two M.I.T. scientists came up with something James Barber, a professor of biochemistry at Imperial College London, described as “probably the most important single discovery of the century.”

Dan Nocera and Matthew Kanan appear to have solved one of the key problems in making solar energy a dominant source of electricity: They developed a catalyst that can generate oxygen from a glass of water by using sunlight to split water molecules. If this breakthrough proves commercially viable at scale, it could render obsolete the current photovoltaic industry, allow solar power to truly compete with fossil fuels as a major energy source, and open the door to new environmentally friendly technologies, like at-home energy systems (thereby improving the lives of billions of people in developing countries) and highly efficient fuel cells to power electric cars. The move from the lab to the marketplace will create dozens if not hundreds of new investment opportunities.

There are and will continue to be great investment opportunities associated with climate change, but remember:

• Go in with a clear mind and a strong stomach. Sure, we all want to save the world, but keep your emotions in check. Environmental investing is about economics, not ethics. And expect some volatility. The uncertainty surrounding just how we’ll move to a low-carbon economy will cause some wild price swings.
• Do your homework. Understand the sources of returns and the nuances of each investment opportunity.  
  Be humble. At this point in the development cycle, investors are more likely to find success through professionally managed environmental strategies like mutual funds, E.T.F.’s, hedge funds, and private-equity funds than through do-it-yourself investment projects.  
• Think globally. Climate change is a global phenomenon; the solutions will be global too.
• Watch those fees. Like any alpha-based strategy, environmental investments typically come with relatively high fees. Investors should always think in terms of net alpha.
• Be prepared to admit you are wrong and to change positions.  Corn-based ethanol wasn’t a complete bust. As long as investors did not view it as the long-term solution, they enjoyed compelling returns on the early projects.   
• Finally, above all else, be patient.

Climate change is a secular theme that will play out over the next 30 years. Early winners could become big winners—or tomorrow’s loser. And the next big thing will probably come from out of nowhere. Two years ago, did you ever think we’d consider algae as the next great fuel source?