Carbon accounting is complicated
It’s hard to not run into debates over carbon accounting. Almost all of the 6 ‘W’s have a certain degree of contention around them. What environmental metrics do we report? Where and how do we report them? When do we report them – every year, every quarter, in real time? Who reports them and for what primary purpose – to provide a measuring post for our collective progress towards the Paris Accord, to shame the high emitters, or to scope out sustainability-related risks to a company’s financial performance (the most capitalist of aims)?
That’s why standards and frameworks are so important. Standards and frameworks aim to settle the “W”s. But the sheer diversity of reporting guidelines is most indicative of the fact that there is no “one standard.” A few of the most popular include: the GHGRP, SASB, GRI, CDP, CDSB, PRI, DJSI, TCFD…I’ll be the first to admit that keeping track of all of them makes my head spin.
Too many standards
A few efforts have been made over the years to align multiple standards and to clarify the similarities and differences between standards and frameworks. The CDP and GRI signed an MOU in 2013 to increase consistency between them. The CDSB published an Alignment Table in 2018 that sought to clarify which requirements are shared between standards. And most recently, SASB and GRI announced in July that they would be working together to share ways in which the two standards can be used with each other.
Even so, it’s not enough. The sheer complexity of the sustainability reporting universe creates a daunting task for anyone just beginning this journey. For larger companies, this may just be a matter of hiring a consulting firm to wade through the most up-to-date dialogue and painstakingly piece together a generally acceptable sustainability report. For smaller companies though, this could prove to be a prohibitive use of resources.
Just like Turbotax
The ease by which carbon accounting can be done is a determinant of reporting participation. Just look at our individual income taxes for example. In the US, the IRS’s returns received as a percentage of the overall population has increased from 42% to 47% over the last 40 years. For something that is a federal requirement, that is a substantial jump. Moreover, the number of people who have e-filed returns has increased from nearly zero in the 1980s to over 89% in 2019. TurboTax, the most recognizable and widely adopted tax prep software, charted its growth by focusing on ease of use and design. The role of software (and in particular, easy-to-use software) in aiding compliance to our taxation system is clear.
Because of the multiple standards, multiple reporting agencies, multiple formats, multiple goals, and continuous revisions and addendums that currently plague the carbon accounting world, there is an even greater need for a TurboTax-like software to ease the corporate reporting burden, systematically track data inputs and reporting frameworks/standards, and allow the opportunity for more companies to manage their carbon footprint. A company’s challenges in this process are certainly much different and more complex than an individual’s tax returns…which is why we expect that a popular solution will likely require an extraordinary understanding of company data and data management, a grasp of organizational structures, an intuitive onboarding process, comprehension of the nuances of each reporting standard, and patience, patience, patience.
While the COVID crisis has no doubt resulted in tragedy, both in human life and economy, the silver lining of it all is that the environment has benefitted, as evidenced by improvements in air quality, water quality, and possibly wildlife conservation. 3 months into our lockdown, the implications of these improvements on our environmental goals are apparent.
Our Paris Accord goals are achievable, but it will take massive sacrifice to get there
According to an article published by Nature, daily emissions globally are estimated to have fallen by ~17% as of April 2020. To put this into context, researchers estimated that lockdown emissions levels are roughly equal to those back in 2006. This is outstanding progress. Moreover, assuming some form of restricted activity extends through the end of the year, we are looking at ~7.5% decrease in global 2020 emissions, which is coincidentally very close to the number that UNEP recommends we cut emissions annually in order to meet the IPCC 1.5C goal. Said in another way, with the COVID crisis and near global economic meltdown, we are finally on track to reach our climate goals this year.
Though this highlights the ability to reach our goals via reduction in energy consumption alone, it also unavoidably inversely correlates economic impact with environmental impact. The reality is, to bring about the change we need ASAP, COVID has demonstrated that the economy is not likely to be left unscathed. The question for next year is: do we need to shrink the economy another 5%? Seems unconceivable, doesn’t it?
Of course, reduction in demand is not the only means that IPCC points to for overall emissions reduction. Technological development around energy efficiency, carbon neutral power generation, and carbon negative CCUS technologies are huge ingredients that are predicted to offset the need for a disruption in demand. But those are large structural developments that take time and resources. With clean technologies taking multiple decades to come to fruition and most power gen projects clocking in at around 3-4 years of development time, it’s hard to imagine that a truly “green recovery” won’t keep some form of this demand disruption as steady state.
Policy and structural incentives will have to evolve to accommodate progress
Although the environment has generally benefitted from COVID, the same can’t be said for environmental policy. With so much of the demand for carbon reductions gone, prices for environmental offsets have cratered and as a result, cap and trade programs have suffered. This brings to light what will continue to be an issue: once we start getting cleaner, how do we stay cleaner? In times of carbon decrease, caps will need to be artificially increased to accommodate the lower value of carbon. That will mean that though we tout cap and trade as a largely market-based form of regulation, frequent government intervention will be needed when we make progress to ensure that these programs continue to incentivize us in the right direction. And in times like these, when businesses are already suffering, artificially increasing the price of carbon will hurt businesses financially.
Something that could prevent this over-reliance is genuinely increasing the value of carbon. Finding more uses for carbon keeps prices up even in times when we have less of it (and maybe especially in times when we have less of it). What COVID has shown is that focusing our attention on developing technology around carbon use is our most sustainable form of regulation.
So the environmental takeaways from this seemingly surreal time in our life: 1) Decreasing demand to reach our goals is possible and likely necessary. We might have to commit to some level of this disruption in our day to day going forward to reach our climate goals. 2) A large decrease in carbon emissions has unintended consequences on the very mechanisms put forth to achieve them. Increasing the value of carbon should be one of our first priorities to avoid this. 3) Though this crisis is indeed a crisis in every sense of the word, it’s brought forth important learnings that will hopefully guide a smarter green strategy going forward.
It’s actually fairly hard to track down public company GHG emissions data. The GHGRP (Greenhouse Gas Reporting Program) only releases data reported at the facility or regional level, not at the company level. Data at the company level is buried in individual, non-standardized 100-page long climate reports, often in varying flavors of charts, tables, and graphs. Scouring them all manually is a slog. Scraping them automatically is a college thesis-worthy data mining exercise.
Luckily, we do have the CDP, or the Carbon Disclosure Project. CDP’s database aggregates voluntarily disclosed emissions data from a questionnaire sent to thousands of companies. From that questionnaire, the CDP rate companies a score from A – F for their climate change transparency, performance, and leadership.
Of the ~180 companies A-scoring companies that made the list, 28 were financial institutions, 46 were consumer goods or retail trade companies, 37 were industrial services / industrial process / industrial manufacturing companies, and 30 were technology and telecom companies. Only 9 energy companies made the list – all utilities. No oil and gas companies.
The A-minus list does have a group of oil and gas players. Total, ENI, Repsol, Hess all made the CDP A-minus…and a larger handful more – Equinor, Suncor, Petrobras, Shell, ConocoPhillips – made the CDP B-list. Conspicuously absent from the list of “good” scores (defined as a B-minus or higher, which is generous by today’s high school standards) are the rest of the majors, most of the US independents, midstream companies, and oil service names. Out of the ~240 oil and gas companies scored in the database, ~160 have ended up with a big fat F. Most of these companies have ended up in this position due to lack of disclosure or response to CDP. Concho, for example, despite having a climate report, has an F in the system.
Is it fair to penalize companies that might have just accidentally thrown away their questionnaire in the mail? Or simply didn’t know what the CDP is?
As more and more of the energy industry’s future is tied to transition, the answer is increasingly yes. Just like how “good citizen” financial practice for publicly owned companies requires full transparency and adequate disclosure to investors, “good citizen” environmental practice for emitters calls for full transparency and adequate disclosure to the world. To do this in a meaningful way, participation in major disclosure initiatives like CDP is a requirement.
CDP tellingly describes its A-listers as “leaders” earning “leadership” points. As the CDP website states, “Our scoring measures the comprehensiveness of disclosure, awareness and management of environmental risks and best practices associated with environmental leadership, such as setting ambitious and meaningful targets.” CDP claims its high scorers are setting the gold standard for environmental leadership – which means that current environmental leadership is made up of largely non-energy companies.
At the same time, a look at the average Scope 1 + 2 emissions numbers across sectors shows a reverse list (see Figure 1). Energy / utilities companies dominate in their high emissions numbers. An energy company averages emissions many times the emissions for a financial or technology company.
A high emissions number does not mean that the businesses are inherently bad. The energy industry is more prone to high emissions numbers than the technology or financial industries purely due to its proximity in the value chain to higher emitting industrial processes, but it makes up for that in its undeniably important role in human welfare. Reducing emissions while keeping up the responsibility of this role requires thoughtful environmental leadership from the players whose emissions matter the most. And that means full on participation in initiatives like the CDP.
Last time, we explored how the venture capital world came to dislike hardware and prefer software. Modern technology companies with hard assets continuously face difficulty finding funding and often receive heavily discounted valuations because of increased competition for VC capital with similar-stage asset-light businesses. Multiple aspects of an asset-light business align it better with the VC model: the shorter time to return, the more straight-forward (and frequently less technical) value proposition, the perceived lighter capital intensity, and the nimbler business model.
Add to that, the VC world has grown significantly since its inception, which has only increased the compounding effect of the “club mentality” that concentrates venture interest in popular investment areas. The more widely-attractive investment areas receive the majority of the interest because VCs often have to rely on the investment’s ability to attract other investor capital in the same round or subsequent rounds. As a consequence, the less popular and more niche investment areas struggle to attract attention.
Is it unfair for asset-heavy innovation to lack in capital funding because of characteristics inherent to their technology? Or a better question: is it unwise for asset-heavy innovation to lack in capital funding because of characteristics inherent to their technology?
As we are constantly reminded in this time of energy transition, investment in new infrastructure and hard assets is what is needed to bring about the necessary change. When we are putting together our innovation priorities to leave asset-heavy businesses at the bottom of the list, are we being mindful of what is or isn’t productive innovation? One could argue that the current VC model that optimizes for largest economic return with the least amount of capital in the shortest time possible does not equally optimize for largest benefit to society (or at least, to global productivity) with the least amount of capital in the shortest time possible. So, in many ways, the problem of funding asset-heavy businesses mirrors the problem of funding ESG investments. But that’s another article.
The goal of this article is to discuss the current and potential funding models for incentivizing asset-heavy innovation. Certain funds already are structurally more amenable to funding asset-heavy businesses. These include:
Corporate Venture Capital (CVC) Arms of Asset-Heavy Companies – CVCs have the benefit of a sole corporate LP whose strategic priorities are considered alongside economic return, so their “total return” is potentially greater than that received by a strict financial investor. CVCs also have the benefit of having access to larger company resources to evaluate new investments and should theoretically be better positioned to evaluate more engineering-heavy, niche technologies.
Internal Innovation in Asset-Heavy Companies – Sometimes the best innovation in asset-heavy industries is sourced from the incumbents themselves. Developing strong corporate innovation programs by establishing things like an internal pitch competition, innovation fund, incubator, or even a separate innovation / R&D group entirely can incentivize innovation in niche industries and allow whatever technologies come out of that process the wherewithal to scale in being part of a large corporate budget.
Similar to this concept is the idea of “funding” via time investment. The widely publicized 20% Rule at Google and the 15% Rule at 3M are examples of this. In each of those companies, employees are encouraged to devote 15-20% of their time during the workweek to innovation projects that could result in new products for the company.
Family Offices / Sovereign Wealth Funds – Family offices and sovereign wealth funds (SWFs), much like CVCs, have single LPs with often non-financial strategic goals. For family offices, this may be as simple as the family / individuals’ personal interest. For SWFs, this may include a country’s reputational and political impact or job creation. Both of these types of investors tend to look longer-term when evaluating investments, which allows room for certain asset-heavy investments that take longer to scale.
Government Agencies – Government agencies like DARPA have long since funded asset-heavy innovation, especially in the defense industry. With the goal to spur innovation within their home countries, they have similar incentives to SWFs but typically focus even less on financial return. Many of these agencies choose to fund via grants.
Theoretically, the overwhelming interest in asset-light investments and limited interest in asset-heavy investments from institutional VC investors should divert the overlooked asset-heavy investments into the capital above, and these capital providers should naturally increase their exposure to asset-heavy investments because of their lesser competition. Like in any free market scenario, the arb should get priced away. Problem solved, right?
Not so much. Overall funding in venture capital from the above institutions remains just a fraction of all VC capital while asset-heavy investment opportunities continue to grow in breadth and number, especially as heavy industries (like energy) look to focus on innovation. Moreover, corporate R&D budgets continue to decrease, and asset-light businesses like software continue to garner attention from these funds. So where will the new capital that’s needed for asset-heavy businesses come from?
As alluded to in Part 1, I believe there is an entirely new class of institutional VC funds that can emerge to strictly to invest in hard asset technologies. This is and will be necessary to balance out the equation.
What could that look like? Some suggestions:
Large Advisory Boards – Hard asset technologies often require significant engineering and technical expertise. The advantage that CVCs have in accessing a pool of technical resources could be replicated by an institutional fund having access to its own set of SMEs gathered solely for this purpose. The downside is, of course, potential cost of such a construct, and a reliance on third parties for evaluation of a technology.
Builder-led funds – This downside can be eliminated by just having the entire team composed of individuals with technical backgrounds and experience in building / scaling hard asset technologies. Builder-led funds are better able to understand the challenges and opportunities with hard asset technologies, offer meaningful support to their entrepreneurs, and attract like-minded LP capital.
Corporate Partnerships and LPs– Having corporate partners is somewhat like being the CVC for multiple corporates. In addition to having a built-in advisory board, this structure also lends itself to more flexible financial criteria as strategic fit with corporate partners can help drive an earlier exit or accelerate validation of the technology. In some cases, corporate partners pay a fee to the fund to essentially scout out new technologies for them. This offsets some of the required return.
Permanent Capital Funds – Non-traditional VC structures will be necessary to accommodate investments with longer time to maturity. Permanent capital funds are an example of one such structure. In a permanent capital fund, investments are held much like a mutual fund. The fund’s goal is to increase the collective value of all of the holdings. Periodic valuations by third parties establish the worth of each share or unit. Investors in permanent capital funds can buy / sell their stock to each other on a public or private exchange and the fund can periodically sell more stock for liquidity. In removing the requirement of an exit to generate return, permanent capital funds are able to accommodate longer term investments.
The point is: for funds that have the capital structure and mandate to support asset-heavy innovation, there should be an increased preference for asset-heavy investments. For institutional VC funds that may struggle to fit asset-heavy investments in their existing structure, there are plenty of ways to adapt.
To incentivize asset-heavy innovation, we will need to innovate the way we innovate.
I often hear the words “Sorry, I can’t invest in hardware” Or “we’re only interested in capital light businesses” nearly everyday while speaking to others on our energy technology effort. It’s a very common wall to run up against.
Out of the collective $167B raised in the US in 2019 for venture capital deals, $94B or 56% went to software. Within the $73B raised for non-software startups, 82% went to healthcare, services, and consumer goods. Only the remainder - 18% of the non-software pool and 8% of the entire $167B - went to what can be categorized as “hard assets” – startups that specialize in commercial products, IT hardware, energy equipment, and industrial equipment.
For startups that need the most capital to scale, we’ve allocated the least.
It wasn’t always like this
Modern venture capital traces its roots back to the 1940s. As Nicolas Colin details in his essay on the history of venture capital, the emergence of these financial entities came as a result of a technological fervor that began in WWII. The US, fueled by wartime tensions (and those that continued through the Cold War), had a newfound desire to fund scientific and technological breakthroughs. Money poured into R&D efforts at academic institutions to develop technology that would benefit the US military. As a result, we can thank the 1940s - 60s for inventions like radar, the jet engine, rocketry, penicillin, microwave, and the atomic bomb.
But a problem emerged within this innovation renaissance. Commercializing these emerging technologies was a struggle. Underwriters and lenders were used to valuing businesses that were either regular way retail businesses with existing customer bases or businesses with tangible assets that could serve as collateral. Technology businesses fit in neither of these categories. As Colin puts it, “[Tech businesses] couldn’t borrow from banks because their business model was unknown and they still had everything to prove. And they couldn’t raise capital from the public because no financier could value them.” So who would fund these new businesses? This gap in the market quickly became a boon for investment firms started by wealthy families, who saw the opportunity and could afford to take the risk. These first mover investors enjoyed much success in what was a virtually untapped market.
The next boom of venture capital after that continued to fund hard asset technologies. Semiconductors, transistors, microprocessors…and of course, personal computers. Venture capital-funded innovation back then was linked to the production of devices and electronics. But that soon changed when writing software for those devices established itself as a separate industry.
A match made in heaven
Venture capitalists soon found themselves more and more interested in this subspace of ICT, and for good reason. Software was perfect for the venture capital model. Institutional venture capital firms have an investment horizon of 5-8 years, typically make small investments in a large number of firms, and require big returns on a small number of investments in order to make up for the higher startup failure rates. All of this combines to make fast-scaling, low capital cost investments the perfect target for venture capital.
Moreover, the mass proliferation of the venture capital model combined with the lengthening time to exit means that more and more of the future value of a startup becomes concentrated in the ability of that startup to raise subsequent private capital rounds. The modern venture capitalist has to weigh factors that have less to do with the underlying technology and more to do with how this company might be viewed by others. What is the risk that this company might not be able to raise more capital in the future? Would x firm down the street understand and believe in the technology enough to able to invest with me at a later date? Are others in investor space generally looking at this type of technology? How easily sellable is this technology to the investor community?
This line of thinking plays into why venture capitalists invest in “clubs,” like easily understood technology, and like staying within generally accepted areas of interest. This translates well to software. Software often has a straight forward value proposition, its proliferation is embraced by many investors regardless of technical background, and its history of fundraising success provides assurance that there will be a healthy number of investors that look at this type of technology. Software’s popularity in the VC community has in itself cemented its preferential status over other types of technologies.
An evolution waiting to happen?
Unfortunately, this line of thinking also plays into why it’s such an uphill battle to encourage more investment in hard asset technologies. Understanding the superiority of one technology over another in this space often requires scientific or technical knowledge, which presents a hurdle in limiting the number of investors that would have (or care to devote resources to) understanding the landscape. Differentiated hard asset technologies also tend to be nichier areas that aren’t widely marketed as “hot spots” for VCs. The perceived lack of club-worthiness, high capital intensity, and longer time to scale raises the perceived risk for an incoming investor and makes it difficult for him/her to value the business.
Which is precisely what makes them a gold mine. As we saw in the history of venture capital, the lack of ability by incumbent investors to value to certain types of businesses led to the emergence of a whole new class of investors for those businesses. These investors saw the opportunity and invented a new financial entity to handle a different risk profile.
The current venture capital model has evolved to invest in software and asset light businesses. But that’s no reason why investors should shun hard asset technologies. As we see everyday in etech, the number of hard asset technologies increase by the day as the world moves from consumer-led digitalization to industrial-led digitalization. These technologies will increasingly need capital to move innovation forward. And I believe they will find it in the venture capitalists that evolve their fund structures to accommodate them, much as they did once before in history.
Next time we’ll explore what that might look like…
Last time we examined what happens during the ups and downs of the software industry. We found that the average transaction size dropped 50-70% and average valuation dropped 30-90% from peak to trough with some noticeable variability between M&A and VC and time period. This week, we explore a similar analysis, but a bit closer to home in etech.
After the dot com bubble, clean tech followed suit.
The clean tech industry has drawn more than a few parallels to the software industry, as history can speak. Investors viewed clean tech in the early 2000s much the same way as they did software in the 90s: huge markets, large potential for technology-driven transformation, and high growth opportunities. Money poured into funding this new space – a collective $2.3B went into clean tech between 2001 and 2005. By 2007, that number had more than tripled. Federal funding also ramped in earnest, numbering in the double digit billions.
2008 was the first stumbling point. The Great Recession drove down the price of natural gas, which aggressively outcompeted renewable power generation. New capital stalled while old capital began examining their existing investments. China had very quickly ramped up its solar panel manufacturing capabilities and were driving prices down below where most US manufacturers could handle. Private investment in clean tech shrunk in 2009 but then recovered in 2010 on the back of additional government investment (in the order of $100 billion). Unfortunately, that couldn’t and didn’t save existing investments and the clean tech bubble popped in full in 2012. The fiery public implosion of cylindrical solar cell manufacturer Solyndra marked the occasion.
The data shows mostly similar patterns but some key differences
The clean tech rise and fall holds many narrative similarities to that of the dot com era, filled with the classic irrational exuberance that MBA case studies will highlight for years to come. A look at the numbers both illustrates the parallels with more specificity and highlights key nuances that distinguish the clean tech industry.
Figures 1 – 3 show average round size, pre-money valuation, and revenue multiples over time for venture capital in the clean tech industry. Like the software industry, venture capital funding dropped significantly in both average investment size and valuation post-collapse. VC round size in clean tech fell ~80% between 2008 and 2014 while average pre-money valuation fell nearly 50%. Revenue multiples fell almost 80% between 2008 and 2013.
But the shape of these collapses gives us our first clue as to what is different in the world of clean tech. While the software industry rose swiftly and fell swiftly, peaking in 2000 and bottoming in 2002, the clean tech industry experienced an elongated cycle, peaking in 2008 and bottoming in 2013-2015. The more gradual collapse is likely associated with the larger government intervention. Federal subsidies in the 2008-2011 time period served as a prop-up for new funding despite the already deflating growth prospects, keeping companies with unsustainable businesses alive for longer. The software industry, on the other hand, had none of this. What needed cleansing was cleansed, resulting in a steeper cliff but faster recovery afterwards.
The story was even more different on the M&A side. Figures 4 and 5 show deal size and revenue multiples over time for clean tech M&A deals. Though Figure 4 shows a similar reduction in the capital pool happening for clean tech M&A, the scale is modest compared to clean tech and software VC. Deal size drops ~28% between 2008 and 2013 (vs 70 - 80% for software and clean tech VC). It actually also peaked overall in 2005 instead of in 2008 – 2010. Even more anti-climatically, Figure 5’s revenue multiples actually stay flat between 2008 and 2013.
So what is happening here? The M&A and VC transactions look like they’re in different universes because they are. While early stage clean tech opportunities were funded by the VC community, who were in large part converted software investors used to paying high growth multiples, clean tech exits were mostly limited to large energy strategics, like the power and utilities sector for power gen companies, who typically made staid, conservative offers. The differences in approach are starker than those between a software startup and a larger software company. Not having accounted for this change in exit optionality, VC valuations were inflated, contributing to the bubble.
Clean tech won’t make the same mistakes again…hopefully
Clean tech has since recovered from 2012, with annual VC dollars invested reaching its highest ever in 2018 at $14.8 billion. While it’s true that there always will be more cycles to come, the lessons learned from the first bubble have hopefully allowed investors to play smarter and more sustainably in current and subsequent periods of change. Better understanding the need for longer development times for equipment-heavy technology, the value of engineering and manufacturing expertise, and what are realistic returns / exit options will increasingly breed a new type of VC investor, one that is tuned to best capitalize on clean tech. Coupled with the diminishing government subsidies for renewables, we should see a cycle for clean tech that looks more like that of the software industry this time around: unmerciful but quick to bounce back.