Sustainability Investing Is Back Again. Here’s How to Do It Right This Time.

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Talk to any cleantech investor who was active in the mid to late 2000’s, and you’ll hear tales of financial carnage and woe. From 2006 to 2011, venture capital firms spent over $25B on cleantech startups and lost over half of their money. Of the cleantech companies funded after 2007, more than 90% ultimately failed to return the capital invested. The aftermath was an overall cooling down of sustainability investing for the next decade. As one Bloomberg article put it in 2014, venture capitalists had come to view “cleantech” as a “dirty word.”

But fast forward just a few years and cleantech investing is quietly coming back in vogue. Nobody really uses the word “cleantech” anymore, perhaps out of fears of inducing some sort of traumatic flashback to the failures of the prior decade, but words like “sustainability,” “impact”, and even “clean-energy” are now the accepted catchphrases. In this second wave of cleantech investing, a new tide of Limited Partners is seeking to prioritize profit and impact equally, funnelling $10.5B in new capital into environmental and social impact funds in the U.S. in Q1 2020, a major step up from the $7B recorded for Q1 2019, just the year prior. The tech elite have also entered the scene. Backed by names like Bill Gates and Jeff Bezos, Breakthrough Energy Ventures has committed $1B to investing in startups that fight climate change. Tech giant Amazon too has announced a $2B Climate Pledge Fund to invest in sustainable technologies and services that will help it reach its net-zero carbon goal in its operations.

Is sustainability investing here to stay? The verdict’s out right now whether the trend will stick or fall to the waysides of delusionary hype once again. But by Jove, for the good of the environment, let’s hope it sticks. Our future generations depend on it. Accordingly, just as you guessed it, this blog post is about sustainability investing: why it failed the first time; what is different the second time; and how to optimize investments in this arena. In writing this, I hope that sustainability becomes an attractive area for investment. In doing so, perhaps we can make the world just a little bit better.

Why Sustainability Investing Failed The First Time

So that we do not repeat the errors of the past, we must first understand what made the first wave of cleantech investing fail back in the 2000’s. After reading several analyses why cleantech failed, I’ve compiled a summary of what many industry folk think are the main reasons behind the past cleantech investing failure. Here it is below:

  • Wrong Risk/Return Profile: The most common aspersion on sustainability investing that I’ve heard is that sustainability investments do not fit the risk, return/time profiles of institutional venture capitalists. That is, such investments are highly risky but generally provide low returns and have a longer time frame before an exit (much longer than the 10-year time horizon that venture capitalists seek to realize their gains).
  • Few Exits: The exit — whether through an IPO or acquisition — is the desired pinnacle of every investment. However, in cleantech, exits are far fewer than in other industries. The most likely acquirers for startups are manufacturing behemoths in the automotive, energy, and industrial sectors, which generally do not pay significant sums for acquisition targets. In addition, IPO windows for cleantech startups are few and often ephemeral in nature.
Series A-round startups from 2006–2011. Source
  • Unsophisticated Investors Investing in Science Projects: In the heyday of cleantech investing, you saw quite a few generalist funds investing large amounts of capital into cleantech startups. Many of these investments were in exploratory science projects, rather than in scalable products that can drive company growth, as these generalist investors lacked the expert knowledge of specialists, thereby making poor investment decisions.

Given the above, it may be easy to write off the industry entirely. However, as I explore in the next section, let’s not act too quickly. Things are looking different this time around…

Why Things Are Different: Making the Case for Sustainability Investing This Time Around

Let’s not fool ourselves. Sustainability investing will only stick if there are financial returns at the end of the road. Without that, sustainability investing becomes closer akin to project financing or even nonprofit grantmaking. Accordingly, in evaluating whether this second wave of sustainability investing will truly stick, we must ask ourselves the key question: do the conditions today make it so that sustainability investing is at last a money-making enterprise?

From the last wave of cleantech investing, a number of structural factors exist today that suggest that sustainability investing is better primed for profitability and, perhaps this time, here to stay. These are as follows:

  • The Decline in Renewable Energy Costs: Likely the most important factor that has changed since the first wave of cleantech investing is that the cost of renewable energy has declined to the point where the unit economics of many of the industrial processes that utilize clean energy have become economically viable. From 2010–2018, the cost of electricity from renewable sources decreased by ~45%. Today the average cost of renewable energy is ~$0.08/kWh and expected to decrease to <$0.01/kWh, enabling the clean manufacturing of products to be produced sustainably and cost competitively with existing dirty alternatives.
  • The Rise of Catalytic Capital: The growth in catalytic capital has provided startups with the necessary funding to bring exploratory science projects to a point of near-commercial viability, at which point venture capitalists are willing to underwrite the risk. In the first wave of cleantech investing, venture capitalists were the ones throwing money at these science projects, as opposed to the now more typical sources of capital that include government grants, philanthropic organizations, and climate-concerned wealthy individuals. Today venture capitalists are investing much later in the life cycles of tech innovations, thereby reducing the risk of commercial failure.
Catalytic capital is the bridge enabling science projects to reach a state of commercial viability until venture capital steps in. Source.
  • Sustainability Has Become Mainstream: Consumers have become insistent in their demands for better sustainability products, forcing large corporations to adapt. From 2013 to 2018, 50% of Consumer Packaged Goods growth came from sustainability-marketed products. Products marketed as sustainable also grew 5.6x then competing products that were not. The result is that many large corporations have jumped on the sustainability bandwagon — not necessarily out of the goodness of their steely corporate hearts but because they see the revenue opportunities in not only sustainability-marketed products but in cultivating a brand image as a sustainability leader.
  • Sustainability Innovation Leaders Forcing Competition to Adapt: Across multiple sustainability categories, the rise of certain innovation leaders are pushing market incumbents to react and pivot towards new sustainability innovations. As an example, in the food industry, Beyond Meat is forcing food industry incumbents to consider meat alternatives or, at the least, improve their treatment of animals. These types of “influencer” sustainability leaders were not around in the first wave of cleantech investing.
  • Greater Number of Potential Acquirers: Faced with pressures from sustainability-concerned consumers, innovative competitors, and, in certain instances, new government regulations, legacy corporations that were not in the habit of making acquisitions in the past have begun acquiring new sustainability companies to survive in the long run. Facing the inevitable decline of oil, many of the “super-major” oil companies — including BP, Shell, Total — have already poured billions of dollars into clean energy projects and have begun making select acquisitions in renewable energy companies. You can expect acquisitions to accelerate for certain sustainability sectors, given the changing market dynamics I’ve mentioned above.

Compared to the 2000’s, the appetite for all things sustainability-related right now is certainly high. The growth of consumer eco-consciousness and the rise of influential tech disrupters to legacy incumbents have forced corporations to innovate in the direction of sustainability or face inevitable decline. While some corporations will adapt through the sheer might of their R&D forces, many will have to seek external help — whether through partnership, becoming a customer, or making an acquisition of a sustainability company. In any case, these market forces create the optimal conditions for enabling emerging sustainability startups to thrive.

The First Principle of Sustainability Investing

It’s important to note that sustainability is actually quite a diverse field, and there’s several ways to attack this beast. Sustainability investing includes everything across your deep-tech verticals like renewable energy, power storage and distribution, electric vehicles, advanced materials, and so forth. Broadly defined, it can also include new energy services, alternative forms of mobility like scooter-sharing, and various business model innovations and/or software offerings that all support the mission of going green.

This brings us to our first principle of sustainability investing: not all verticals within sustainability investing are equal. Breaking down sustainability across its various verticals, we get to appreciate the complexity and diversity of sustainability investing — particularly how not all verticals result in the subpar performance that came to be associated with this industry during the first wave in the 2000s. From a Cambridge Associates study of cleantech companies, we indeed see that there are certain categories like smart grid and energy storage that were able to hit a 32.5% and 29.6% IRR respectively. Software companies or those companies with value propositions centered on business model innovations — rather than deep tech plays with big patent portfolios — tended to perform the best.

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In looking at the historical performance of the various sustainability verticals, you can draw certain conclusions about where you should put your money: if you want to truly downsize your risks and optimize your chances for returns as a sustainability investor, you may just want to stick to investing in the verticals where the odds are slightly more in your favor, which likely means less deep tech and more software, services, and business-model-innovation-type companies.

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That said, a history of negative returns in certain sustainability sectors does not necessarily mean a future of negative returns (though it should certainly put you on guard). The structural changes that have happened since the first wave of cleantech investing — the decrease in renewable energy costs, the rise in catalytic capital, and the overall mainstreaming of sustainability — all suggest that this second wave, even for the more deep-tech sustainability startups, is not doomed to repeat the failures of the past. Of course it goes without saying: if you’re willing to defy the risk of investing in historically underperforming verticals like advanced materials and clean energy, don’t you dare skimp out on the diligence. Talk to the experts in the field. Read the scientific literature. Consume the startup’s technical papers. Make sure that the technology innovation of your pursuits is closer to point of commercial viability than the point of high-risk science project.

A Sustainability Investing Playbook

Now that you’ve hopefully signed on to the world of sustainability investing, it’s time for the fun stuff: understanding whether a particular sustainability company would make a good investment. At the sustainability team at BMW i Ventures, we’ve come up with a playbook of how to evaluate a new sustainability investment. This playbook is most apt for the hardtech-type investments but can also be applied more generally across the field. It’s also important to note that if you’re investing in a SaaS sustainability company, you better employ your traditional SaaS techniques (though that’s a discussion for another post).

Below is our playbook for how to invest sustainably in sustainability:

  • Drop in: The product should be able to “drop in” to an existing customer’s workflow or product. If adoption of the product requires deep integration, is the technology so game-changingly superior that customers will be forced to adopt it? Remember: if deep integration is required, you may turn off customers entirely or, in the alternative, you will have to wait longer timelines for securing new customers, thereby facing slower paths to growth.
  • Sourceability: The product should not require the inputs of materials that are hard to get or prohibitively expensive. For manufacturing-heavy startups, you want to make sure to vet their supply chain to ensure no hiccups to production in the future.
  • Cost Competitive: The product should be cost competitive with existing alternatives. If it is more expensive than existing alternatives, you need to make sure that the product is so superior over all other competitors that the customer is willing to pay a premium. There are certainly exceptions. Some CPG players, for example, are willing to pay a small premium for the recycled plastics that go into their various food packaging and shampoo bottles because they can market themselves as sustainability leaders. However, more times than not, the customer will revert to its existing alternatives rather than pay a premium.
  • Equal or Superior Performance: The sustainability product must demonstrate equal or superior performance to existing alternatives in the market. Ordinarily venture capitalists want to see value propositions where the disrupting technology is something like 10x order of magnitude of improvement to existing alternatives. However, if you have a sustainability product that is a replacement to some unsustainable legacy alternative (e.g. a new recycled material that replaces a traditional fossil-fuel based material), “equal” performance in this realm is what you need to strive.
  • Productizable and Scalable: The product must not be a science project, and the team must demonstrate a clear path to commercialization for the product within the traditional venture-capital time horizons.

Based on the failures of the first wave of sustainability investing, venture capitalists have understandable reasons to proceed with reluctance in making investments that impact the environment in a positive way. However, as I’ve explored here, there’s many reasons to be more optimistic this time around. The decline in renewable energy costs, the growing consumer demand for sustainable products, and the growing consensus that corporations must act with a conscious or fall behind to their competitors are just some of the reasons to believe why this time sustainability investing is here to stay. Also, with our sustainability playbook, hopefully now you feel a little bit better equipped to tackle climate change as investors, as consumers, as people.

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For the last couple weeks that I spent thinking about, researching, and writing this piece, I’ve been holed up in my apartment in San Francisco, with the windows closed and the air purifier running with a constant hum. I remember waking up to skies of armageddon orange. I remember the smell of smoke and fires. I remember that I had two days of constant on and off headaches due to the air pollution. Since the beginning of the year, nearly 7,900 wildfires have burned down 3.4 million acres in California. Since August 15, the wildfires have caused the destruction of 5,400 structures and 25 fatalities.

As a Bay Area native, I’ve lived in California my whole life. I’ve never experienced something like what we’ve gone through the last few weeks. Climate change is a reality. We cannot deny it. It’s time to act now or face the irreversible damage to the environment from our human actions. The future of humanity rests on effective climate change mitigation. Investing sustainably — growing the next generation of technologies to fight climate change — brings us one step closer in this mission.

Special thanks and shout-out to my sustainability colleagues Cedric Char and Greg Smithies. They provided the much-needed sounding board and insights to bring this piece together.

Feel free to add me and message me via LinkedIn. Always happy to exchange thoughts: https://www.linkedin.com/in/samantha-huang-10375b106/

Disclaimer: This blog represents solely the opinions of myself, not my employer.

Principal at BMW i Ventures. VC trends. AI themes. Social commentaries. A personal blog bridging tech, business, and human issues by a curious mind.

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