How To Do Climate Tech Venture Investing Right: Pitfalls and Opportunities
With the recent boom in ESG and climate tech investment appetite, venture capitalists cannot lose sight of the importance of finding venture-style returns, not just to satisfy LPs but to expedite the transition to a zero carbon economy. The energy industry is unforgiving, and investors will still experience 2008-style busts if they do not recognize the industry’s unique constraints.
When I started my first role in corporate strategy and innovation at a large utility, I was full of strong convictions about which energy technologies held the most promise for quickly driving decarbonization. Like many recent engineering grads, I was a techno-optimist who believed that fundamental economics should generally win out. However, I also started studying nuclear engineering the year Fukushima killed the nuclear renaissance, so I had a unique appreciation for regulations, socio-political appetite, and the challenges of financing and constructing big physical infrastructure. What I learned in my 6 years in the role was that there exist systematic constraints that throttle the pace of innovation for certain components of our society’s energy infrastructure. These constraints have less to do with preserving incumbents (though they can have that effect) and more to do with keeping our energy systems universally affordable and reliable for all stakeholders in society. The “move fast and break things” approach is fundamentally incompatible with most of our energy system, and driving towards decarbonization intrinsically places tension on affordability and social equity issues in our communities. That being said, it is absolutely crucial for our entrepreneurs and venture capitalists to find ways to expedite the transition to a zero carbon economy for all. Many have criticized the short time horizons that traditional venture capitalists often seek with 10 year fund, but I would argue such urgency is critical to building the best companies and meeting our carbon reduction targets. The best service venture capital can provide is finding the best ideas that work today and scaling them quickly. In the interest of advancing that goal, I present this list:
Pitfall: Relying on regulated utilities for initial product sales
Regulated utilities have extremely slow procurement lead times (12–24 months) for most budgets and extreme risk aversion to new products and vendors. This is by design and it is generally a byproduct of the way they are regulated. Utilities are legally structured to provide affordable and reliable service to their designated customer base. They do not have a means of getting a higher return for taking a higher risk; their revenue and profit margin is essentially locked-in. Therefore, utilities make for terrible initial customers to conduct market discovery or achieve product-market fit. Some utilities have designated innovation budgets or incentive carve-outs but startups are still prone to getting stuck in pilot project purgatory. Conversely, utilities can make for excellent late-stage customers because they are such sticky and durable customers once a new product or market has been fully proven-out. This pitfall can be very insidious for many startups because many new product ideas must ultimately get the blessing of a regulated utility even if it is not obvious up-front. Many startups get pulled into a utility sales process simply because the function they are addressing is a mandated utility function in most parts of the country. The best way to help mitigate the utility sales bottleneck is to target your sales team directly at the utility regulator. This strategy worked for OPower and it has worked for many other startups since.
Pitfall: Forgetting that Americans don’t pay much attention to their energy or carbon
Several years ago an EPRI survey suggested that Americans think about their utility bills approximately 30 minutes per month (unless it is on auto-pay and then it is probably close to zero minutes per month). It is important for startups to not underestimate the difficulty of getting residential customers to engage on energy products. In most states, electricity makes up only 1–2% of household income. Startups must focus on adjacent value-adding services and make the engagement process as seamless and frictionless as possible. Commercial and industrial customers are far more price conscious and increasingly more carbon conscious. Commercial and industrial customers can make for more attractive beachhead customers but they are also much better served than residential customers are today.
Pitfall: Assuming the energy industry’s large market size is your market size and forgetting how much debt is embedded
$450 billion in annual electricity sales may seem like a big number until it is understood that most of that revenue goes towards servicing various types of low-interest debt used to finance long-lived infrastructure that keep energy prices low. There is very little appetite to pay a premium or accept greater risk for an unproven technology in the main supply chain of energy. Many energy entrepreneurs and investors make their fortunes wielding much larger funds targeting much lower IRRs than VCs. Understanding the deal execution, incentives, and dynamics of these larger infrastructure funds and debt investors is key to scaling a new hardware product. Creative financing and risk reducing strategies will be crucial to success.
Pitfall: Forgetting energy is a commodity
No matter how many elective carbon offsets are purchased by Google, energy will remain a commoditized industry for the majority of the economy. Much more so than other industries, energy startups must be very conscious of their competitive threats and potential substitutes. Energy storage is a great example. Many venture investors are very excited about the potential for lower cost and higher performance energy storage technologies, but they often fail to acknowledge that a battery having many applications also gives it many substitutes. Grid-scale storage can be replaced by transmission & distribution investment, demand response, hydrogen electrolysis (which could be seen as another form of demand response or energy storage), dispatching a generator, or simply over-building renewables.
Pitfall: Missing that your customers have split-incentives
Many energy customers face split incentives, where the value of a potential product is split-up between two or more stakeholders and no one stakeholder’s value is larger than the product cost. A great example of this is commercial rooftop solar: commercial tenants pay the electric bill and would benefit form rooftop solar net-metering reducing said bill, but the tenant may only have 2 years left in their lease and the rooftop solar payback period may be 3 or more years. A clever startup called Energetic Insurance solved this problem by introducing a financial product to mitigate the lender’s risk. Split incentive problems appear all-over the energy landscape, especially at the grid edge, because product benefits are generally just above costs for such a commoditized market and electricity has historically been heavily cross-subsidized between customer segments. To carry the example further, some of the commercial rooftop solar’s value may actually be realized by the surrounding utility customers because the generation profile of the rooftop solar happens to alleviate a distribution system constraint. No one has solved that problem yet.
Opportunity: FinTech solutions that improve capital efficiency and solve split-incentives
So much of the energy industry is about putting large amounts of capital to work over long periods of time. As the wave of ESG investing continues to swell, there will be numerous opportunities for startups to engage investors, qualify ESG status, identify mis-priced risk, or best-of-all, create markets for capital deployment that were previously missed. This could include ESG ratings tools for bonds, equity, and rate cases; new insurance products for behind-the-meter assets at the grid edge (upstream or downstream); crowd-funding platforms for distributed energy resources, non-wires alternatives, or energy efficiency. Any FinTech product or service that can put more capital to work or improve returns by a few bips will be a multi-billion dollar company.
Opportunity: Digital “picks and shovels” that increase transaction liquidity
Even in the absence of a decarbonization and electrification transition, there is a huge need for digitizing the project development and transaction process for energy infrastructure at all power levels and voltages. Rooftop solar installers need to reduce customer acquisition costs, renewables developers and EV installers need better insight into interconnection costs, energy efficiency retrofitters need better insight into load and customer data. Project development is the bread and butter of transitioning our infrastructure quickly and cost-efficiently, we need the “Stripe” and “Twilio” equivalents for energy industry transactions.
Opportunity: Tools that fill and clean gaps in critical data sets
Across the grid there are huge gaps in critical infrastructure datasets: AMI and SCADA records are missing or inaccurate; power plants sensors fail or lose connectivity; records simply don’t exist for a lot of underground and last mile infrastructure. Many of the AI and “digital twin” applications silicon valley has been selling are hamstrung by the lack of high quality and complete data sets for energy systems. Utility IT teams are deaf to all of the exciting algorithms because they are struggling with the first step of fixing their in-house data. Data privacy and sharing regulations can also lead to missing data where it is most needed. Finding creative solutions to preserving privacy and securing data while it is shared is crucial to unlocking new value.
Opportunity: Very hard tech that can actually establish a lower long-run commodity cost-structure
There are a lot of hardware startups emerging in the climate tech space. Many offer only incremental improvements in existing cost structures for commercial products or run the risk of being undercut by the downward trending cost curves for wind, solar, and lithium ion batteries. In fact, many hardware solutions for addressing climate change already exist and are just waiting for demand to materialize. However, there are still a subset of hardware opportunities that offer structurally lower cost potential (or higher performance) potential. Some examples of these include advanced battery chemistries, solid-state electrolytes, thermal storage, nuclear energy (fission and fusion), new transportation modes, advanced heat pumps, advanced sensors, and the list goes on. The hard part as an investor is doing the technical diligence to be sure the hardware you are looking at has disruptive cost reduction potential as opposed to just incremental.
Opportunity: Repurposing existing physical infrastructure
The grid is old. Our modern energy system has been built up over nearly two centuries and we don’t get a blank slate as we try to make the transition to zero carbon. The most efficient solutions for society must take the existing infrastructure into context: existing transmission lines and substations, power station interconnections, pipelines, geological storage, airports, and seaports. Establishing new rights-of-way is very costly in developed countries. Electrifying more of our economy and relying more heavily on renewables will mean finding creative ways to slot new technologies into or alongside of existing sites. EV chargers will need to integrate into the built environment; industry will need to find ways of receiving larger and cheaper sources of power; decommissioned coal and natural gas plants will need to find new lives as data centers or batteries. There will be an ecosystem of technologies and creative business models that make the most of incumbent infrastructure. For instance, the industrial real estate market could place a much larger emphasis on electrical interconnection and power price availability that intersects with transportation options.
Conclusion:
The most sustainable and effective agent of change is a well designed, for-profit company with a durable business model. Talented investors seek not just a good story or a compelling technology, but a business that works in the current market environment. Finding such opportunities in a market with woefully lagging carbon policies is a very challenging task. This list of opportunities is only a sample of the constraints climate tech investors need to be aware of as they deploy their newly raised funds. As we enter this second and likely prolonged phase of clean energy investing, the pace of our zero carbon transition hinges on investors’ ability to discover, navigate, and learn these lessons.
