Clean energy tech is struggling. Can catalytic capital save the day?

Wednesday, June 19th, 2024 Yici WangJune 19th, 2024 • Bookmarks: 37

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As climate change proliferates, companies are looking to decarbonize, fueling investments in clean technologies. Venture capital investors (VCs) poured over $12 billion into clean energy start-ups in 2022, a six-fold growth from 2019 when the broader VC funding fell 53% year-over-year. But VCs focus only on a small subset of the climate tech industry. They are used to finance software when accelerating climate innovations requires the scaling up of hardware. Solutions such as hydrogen, carbon capture, and battery manufacturing need to build first-of-a-kind (FOAK) facilities to spot any issues or inefficiencies in the manufacturing process before scaling up to a commercial plant. This process requires an investment of $20–100 M for 12 years or more, but VCs typically provide $1–10M over the course of 10 years.

Bill Gates’ $2 billion Breakthrough Energy Ventures fund invests on 20-year cycles with a medium investment size of $25M. MIT’s “tough tech” incubator, The Engine, assumes it will not see a return for 12 to 18 years. But these are minorities. Most Series B+ dollars dry up when the startups need it most to finance large-scale facilities to prove commercial viability. While banks can provide long-term and substantial loans, they require low-risk profiles that startups cannot demonstrate until they have established FOAK facilities to validate their technologies.

Financing needs by development stage (Extantia)

The need for financing now

It’s not uncommon for climate technologies to face this kind of gap. It took decades for solar projects to become mainstream. The policy started with pushing for research and development (R&D). The Investment Tax Credit was then introduced in 2005. The biggest government program in the US for solar owners aimed to deduct 30% of system costs for owners. States and utilities also developed their own local programs that made solar cheaper for manufacturers to make and for customers to buy. Smart policies can effectively drive down the costs of new technology. But the phase of R&D can take less time if it is financed more, through private investments into early-stage clean energy projects.

Prices drop post-R&D (Energy Innovation)

We can’t wait 40 years for that to happen with each and every technology. Unlike 40 years ago, we are seeing storms that left millions out of power, wildfires that razed centuries-old towns, and ecosystem collapse that threatened food commodities.

Investors who figure out how to finance the First-of-a-Kind (FOAK) projects will also have a first-mover advantage and win procurement bids. Large corporations are lined up to use or acquire cleantech solutions to decarbonize. Amazon and Meta are signing power purchase agreements (PPAs), which contract a specified amount of electricity from renewable energy sources. In fact, they are the top buyers of PPAs, with Amazon pledging to power operations with 100% renewable energy by 2025.

Amidst volatile incentives

Policy incentives are massive but not without limitations. The Greenhouse Gas Reduction Fund announced this April was a $20 billion initiative expected to mobilize climate financing at a 7:1 ratio. But its funding targets technologies that have been commercialized as opposed to FOAK technologies not yet used in commercial projects.

These incentives can be volatile, too. A recent capital rule proposed that banks should keep more capital on their balance sheets. It helps banks mitigate financial crisis risks, but as banks reduce their lending, the renewable energy tax equity investments could drop from a projected $25B to $10B.

Catalytic capital as a solution

One way for investors to finance climate tech during the volatility and gap of policy incentives is to leverage catalytic capital. These investments are more patient, risk-tolerant, concessionary, and flexible than conventional capital. They are provided by foundations, high-net-worth individuals (HNIs), governments, and Development Finance Institutions (DFIs), often in the form of debt, equity, or guarantees. They are most suitable for technologies that are not fully commercial and in need of temporary subsidy.

Catalytic capital is patient. In a survey of HNIs, 90% of them are generally willing to accept longer time horizons than those of commercial investors. Patient capital is extremely valuable for a company seeking early investors. It helps them validate innovative business models, technologies, or distribution channels. For example, greenfield projects have uncertain future cash flows and long construction periods. They will benefit from loans with longer tenors, back-ended repayments, or a disproportionate disbursement profile. Catalytic capital will enable loan issuers to do this to take on greater financial risk.

Catalytic capital works well with just about any asset class. It can be blended with debt, equity, and grants. Some projects might need a loan with lower interest rates or longer tenor, while others could benefit from a mix of loans and equity, or even from mezzanine financing—a loan that can convert into ownership if not repaid on time. Its adaptability suits the different needs of investors. Such support is not available from commercial sources and could be the critical lynchpin in the deal.

The patience and flexibility of catalytic capital make it incredibly versatile. It can support projects at any stage, from the initial seed phase to scaling and maintaining the business. This is crucial for developing clean energy projects. Unlike general startups which only need to overcome the hurdle of commercialization, clean energy projects will encounter three valleys of death.

Valley of death(s) for traditional softwares vs clean energy technologies

To maintain positive cash flow between investment rounds, a fintech company will focus on growing its base of paying customers through efficient sales forces. A developer of carbon utilization technology, on the other hand, shall not only design a pilot product that converts CO2 into useful materials. The developer also needs to ensure that as the pilot scales, it can obtain a stable supply of feedstocks and deliver on its long-term agreements with partners. The latter is subject to delay at every step; even the most effective supply chain management and flexible contract terms won’t guarantee everything goes as planned.

The financing need can emerge at multiple points in time for clean energy tech, requiring patient and risk-tolerant capital. For example, Cross Boundary Energy, a provider of renewable energy projects in Africa, grew to a stage where it could access capital from major private equity and pension funds. Even then, it saw short-term financing needs in 2022, and it was able to fill the gap with a bridging loan of $6M from Ceniarth, a single-family office.

Not only can catalytic capital be used to test new ideas. It is also suitable for applying established ideas in new markets. The Southeast Asia Clean Energy Fund II (SEACEF II) provides equity for early-stage and growth-stage investments in energy projects in Southeast Asia. The platform is made possible through $5 million from the Finland-IFC Blended Finance for Climate Program (BFCP) to mitigate country risks. The fund will invest equity in utility-scale solar, wind, and energy storage, in addition to helping businesses go to scale in areas ranging from rooftop solar, energy efficiency, electric mobility, and grid management. It is the first fund to combine public, private, and philanthropic capital with a specialized focus on Southeast Asia.

Why hasn’t it taken off?

If deployed strategically, catalytic capital can mobilize $286 billion in private capital — seven times current levels of mobilization in a typical year by the entire development and climate finance systems. However, this asset type is too misunderstood to have been widely applied.

Catalytic capital can accept disproportionate risk and concessionary returns compared to conventional investments. Many investors shy away from the word “concessionary.” But the cost of concession falls on the providers; it does not compromise the returns for the partnering investors. In fact, it enables partnering investors to make returns off more projects. These are projects that would not have been investable without the concessionary finance de-risking. And not having enough bankable projects to deploy capital at scale has been a key concern for investors.

Assuming the concept is well understood, it still requires a large volume of catalytic capital to demonstrate its viability and attractiveness. Large transactions often lead to higher mobilization. An average transaction of $22M typically mobilizes private dollars 4.1 times the investment, whereas larger transactions of $1 billion will crowd in up to 7.6 times the investment. This is because larger transactions enable larger deal sizes, which give institutional investors enough returns to cover the transaction costs associated with considering multiple smaller deals.

Unlock financing from next-gen investors

Only 3 percent of the 1100+ blended finance deals are larger than $1 billion. To make large transactions, we need to either have large capital providers on board or get people to work together.

Large players began to do more. Besides the Asia Climate Fund mentioned earlier, Allianz Global Investors and other European insurance companies are investing $1 billion to support small businesses, resilient agriculture, and climate solutions in emerging markets. They structured the SDG Loan Fund, one of the five largest blended finance transactions, by partnering with the MacArthur Foundation and FMO, the Dutch DFI. FMO provided downside protection to the senior lenders, agreeing to put up a first-loss reserve of $111 million (10% of the committed private capital). It’s rare for FMO to take such a junior position, and it only happened because MacArthur, with its AAA rating, committed an unfunded guarantee of $25 million to protect FMO against downstream investment losses. The Fund achieved a stunning 9:1 mobilization ratio. The success of large players may encourage more similar investments to be structured.

A fast-growing number of catalytic capital champions have begun over 40 catalytic capital funds and programs over the past few years. Family offices, wealth advisors, corporations, development finance institutions, and foundations have the potential to deploy $17 billion or more in new catalytic capital.

As we saw in the SDG Loan Fund case, foundations hold the key to many of these partnerships with their first-loss position. But their giving has been rather conservative. Most foundations do not give more than 5% of their total assets annually, the legal minimum. Some do this to ensure their perpetual existence by keeping reserves against future crises, while others stick to the minimal requirement because they have always done so.

This begins to change. While family offices manage $6 trillion of global wealth, millennials are further bringing nearly $12 trillion to philanthropies, driven by the greatest generational wealth transfer of $68 trillion and a strong interest in social causes.

The Greatest Wealth Transfer in History Is Here, With Familiar (Rich) Winners,

Graphics by Karl Russell

These new generations of investors can lead the next wave of commitment to effective and innovative use of their assets. They may challenge the priority of having a family office that lives on forever versus creating a more effective, wide-ranging impact. Further, research has shown that philanthropists can do so without sacrificing long-term insolvency.

Building bankable projects

With funding, the next thing on the table is to find projects to capitalize on this funding. The International Energy Agency (IEA) has built a dashboard to track the development stage of hundreds of clean energy technologies. If current projects aren’t enough, experts have advised ways to build more. Climate investors David Yeh and Guy Cohen offer a checklist to design FOAK projects; as climate is highly context-based, there are platforms that develop bankable projects regionally. Africa 50, an infrastructure investment platform, specializes in developing bankable projects in Africa to mobilize private sector funding. Africa 50 has tested that its approach can be replicated across the continent, from developing upstream projects to running market-sounding exercises.

Being additional and impact-aligned

Using catalytic capital does not mean the investors can slack off on diligence. They still need to ask questions like: Is the plant economically viable? Has it secured offtake agreements to guarantee revenue? Has the project obtained regulatory approvals?

Investors also need to make sure catalytic capital is additional and used temporarily. Foundations require their investment to be not appealing to conventional investors. Catalytic capital also needs to be phased down as the project matures and scales. Capital is misallocated otherwise, barring a business from achieving viability that attracts private capital on its own terms.

Catalytic capital also needs to be impact-aligned. Many providers of catalytic capital are impact-driven and require the investment to meet specific impact targets. For example, IFC issued a sustainability-linked loan (SLL) of $300+ million to finance onshore wind and other renewable energy projects. The SLL is structured with two corporate sustainability performance targets, including reducing the borrowing company’s greenhouse gas (GHG) emissions by 60 percent in 8 years, across the company’s operations, customers, and supply chains.

Enabled by a maturing impact landscape

The impact measurement and management industry is mature enough to address additionality and impact measurement. After a decade of efforts, the industry has evolved to offer standard practices that balance the costs and rigor of measurement. In the realm of climate impact, for example, Clean Energy Ventures, a climate VC, developed the Simple Emissions Reduction Calculator (SERC). The tool provides a quick understanding of GHG reduction potential for climate tech startups. The calculator is simple to complete with information already held by most entrepreneurs. Prime Coalition, a climate nonprofit, developed a method to estimate emissions avoided. Its Emissions Reduction Potential (ERP) Analysis projects emissions avoided relative to a counterfactual baseline scenario. These methods help the investor during the due diligence process to select companies that will meet certain climate impact thresholds.

Once the investor decides on an impact measurement framework, it needs to establish a system to collect, manage, and evaluate data. This system should be embedded in the entire investment process. GPs can orient their impact management and measurement (IMM) processes towards the Operating Principles of Impact Management. These are principles built on repeatable best practices for impact screening, due diligence, management and measurement, and exit phases. Within due diligence, GPs can select standard indicators to assess the impact of investments comprehensively across five dimensions (What, Who, How Much, Contribution, and Risk). These developments will also give greater comfort for LPs to evaluate impact strategies.

For smaller-sized funds that find this costly to build, they can look to their partners or third-party advisors for help. DFIs or advisories have rigorous methods of screening projects, demonstrating additionality, and measuring impact. Investors only need to report the client performance periodically, as they already do for the financial metrics. Just add a few questions to the client questionnaires. Advisories like Mission Driven Finance and Align Impact will help design funds, advise philanthropies on investment decisions, and report on impact.

Keep an open mind and start building

Despite a forecast of down rounds ahead in a gloomy economy, existing VCs have capital to deploy. Investors shouldn’t pass on a deal so quickly when it can be de-risked through the use of catalytic capital. Investors can also leverage catalytic capital to support their portfolio companies—many startups will need short-term funding to extend the runway. Potential providers of catalytic capital should initiate more partnerships; foundations particularly would want to note the pressure from the public and the next generation to be more innovative and effective. Together, they can build innovative financing structures and overcome the FOAK valley to scale up cleantech opportunities.