Energy’s Innovation Capital Gap
September 23, 2019
The UN Climate Conference kicks off today in New York which makes this feel like an appropriate time to discuss the current state of capital allocation in the energy sector.
When thinking about the capital landscape for any sector, I think about 4 categories: non-profits, governments (including grants), private capital, and corporates.
Of these four categories, I believe one subset of those 4 is severely underfunded and it may come as no shock to you: venture capital. (Yes, I’m an aspiring venture capitalist)
The Energy Transition
The 17 largest opportunities arising from the energy transition have a potential value of over $4.3T by 2030. The graphic below categorizes those 17 opportunities as defined by The Business Commission whose membership includes Mereck, Alibaba, JP Morgan, and Unilever.
While demand for electricity is currently stagnant or declining, 1.5B people are expected to join the high-energy consumption bracket by 2030 and 1.2B still lack access to reliable electricity - the status quo is changing rapidly.
Regardless of the generation source, grid structure, or consumption habits the majority of the global population is set to either change the way they consume power or do so for the first time ever.
For context, here are the sizes of popular, fast-growing sectors of technology that you might be familiar with:
- eSports = $1B currently, projected $3B by 2025
- Total Cryptocurrency Market Cap = $258B
- FinTech = $305.7B, CAGR 22.7%
Let that sink in, those are all exciting sectors in their own right and the energy transition is more than 11X the largest one listed. Other than healthcare ($10.2T), I can’t think of a larger sector opportunity.
The Funding Landscape
Large private equity firms are already making the shift to sustainable investing due to pressure from their institutional LP base. For example, in 2017 Japan’s Government Pension Investment Fund ($1.5T AUM) required managers to incorporate ESG factors into their investment practice AND announced it would allocate 10% ($150B) to environmentally responsible investments. That number alone is larger than the entire VC industry in 2018.
Public, for-profit firms are investing directly and indirectly in sustainability because they see climate as the number one risk to their businesses according to a survey done by the World Economic Forum that included over 1,000 leaders in business. It should then come as no surprise that for-profit companies are allocating capital against climate and sustainability goals at a record pace.
More specifically, even public companies in the fossil fuel sector are investing in energy innovation, including renewables.
Shell, regarded as one of the most innovative energy companies, is putting over $2B per year into clean technologies because according to its CEO “if we’re not in that business we’ll become marginalized.” One company = half of the current early-stage investment landscape in energy.
As the graph above illustrates, the venture capital industry in energy is almost non-existent, something that is particularly odd given the size of the opportunity.
Early-Stage Energy Venture Capital
Venture capital has historically always punched above its weight. At its core, VC is the capital of innovation. It can change entire sectors in a matter of years (eg. retail, media, and marketing) and disrupt even the most entrenched incumbents.
So why hasn’t it worked in energy, yet? A few reasons, but primarily:
- Incumbents haven’t been forced to change. That’s changing and the Shell example above is one of many.
- The cost of technology is declining rapidly (more on that in a later post)
- Bad-timing by Silicon Valley in the run-up to the fracking revolution left most with a bad taste
- A large number of funds in search of quick exits or markups, both of which are unlikely in a sector like energy where the stakes (and potential rewards) are so high
More on that last bullet point, private fund managers need an awareness of the energy sector, particularly for the hard sciences which are at the core of technologies like biofuels, solar and storage.
The average software startup takes somewhere between 6-8 years to liquidate, while most private funds are 10-year vehicles with 3-5 year investment periods. It doesn’t take long to see that an investment made in year 5 of a fund might run up against the clock at some point.
Additional common myths from the sector include:
Impossible to make money and do good - FALSE
Cleantech companies receiving initial investments in 2010–16 generated a 13.4% gross-of-fee pooled IRR, in more recent calendar year cohorts, performance is looking quite strong, both on an absolute and relative basis compared to the broader PE/VC universe.
Less capital has been chasing deals in the sector, and those firms that remain are much more cautious, phasing in capital based on operating milestones, as the venture capital model is supposed to be applied.
Capital efficiency and unit economics became priorities, and there is generally less reliance on governmental subsidies or policy support to make the companies viable. I actually think this is a tipping point we’ll look back on in the coming years.
Sales-cycles are too long - Yes, BUT...
The sales-cycles in energy can be as long as 18-months, but the contracts are often large and extremely sticky. Due to the nature of integration and high-trust barriers, energy companies don't change software infrastructure often resulting in much higher customer LTV.
Government solutions / regulations are more impactful - WRONG
There are plenty of examples here, but there's no truth that governments can be market makers. Do they help when applied correctly? Absolutely, I think NYSERDA is doing a great job setting the standard with their public/private fund. However, nothing is a substitute for capital that is held to fiduciary standards including maximizing financial returns.
The Most Impactful Way to Allocate Capital
Lastly, venture capital is the best vehicle we have to accelerate innovation. Occasionally, those innovations are trivial, but in most cases they fundamentally change the way we live our everyday lives.
In addition to its huge impact on public markets (Apple, Amazon, Alphabet, Microsoft and Facebook are all venture backed), and employment (5M jobs are tied to firms backed by VC) it’s completely changed the way we live, regardless of how you slice it:
- 2.71B people now use a smartphone almost all of those are iPhones or run on Google’s Android. Both Alphabet and Apple are VC-backed companies.
- Google also made it possible to search a staggering portion of the world’s information in real-time.
- Genetech created synthetic insulin - helping over 100M diabetic Americans.
- Stripe, Square, and Shopify empower small-business owners with financial infrastructure they once dreamed of having.
- Robinhood and Wealthfront have reduced the friction on investing so anyone can now participate in the financial system with almost no added costs.
- Uber is now the first and last touch point for many people in cities they’ve never visited before.
These examples are all profound ways in which venture capital has changed the status quo, or it helped empower an entirely new set of consumers with possibilities they couldn’t access before.
Changing the status quo and an entirely new set of consumers…..where have I heard that before?