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The Economics of Cleantech Investing

I drafted this memo in early 2003 for a venture capitalist friend of mine, well before the bubble in cleantech.  In light of the back and forth on the recent Solar City IPO, I thought it was worth revisiting.  Some of the points were pretty prescient, calling out many of the challenges cleantech investors and exits have faced,  nearly a decade before they faced them.

 

Risk Economics in Energy Technology Investing


We believe there is substantial economics to be made from venture capital investment in energy technology, especially focused on clean energy and high efficiency or environmentally friendly applications.

However, investors unfamiliar with the sector tend to under-price risk and overestimate stage in technology development and commercialization in energy technology.

Much of this miscalculation can be boiled down to the fact that adoption rates of new technology in the energy sector generally tend to be slower than more traditional venture capital industry sectors.  This tends to be true for a couple of reasons, and has a number of implications for venture capital investment in the sector.  We have tried to lay out a few thoughts for potential investors in the space, which though they by no means constitute an all-encompassing investment model, should be helpful in decision-making.

Integration / Customer Hurdle Issues – This is a sector that tends to be very risk averse in new product and technology acceptance, and does not tend to pay for technology before the product stage, with an attitude of “we as the customer are already taking a huge risk by simply changing our operating procedures or letting you have access to our mission critical, extremely expensive infrastructure, why would we pay you, too?”  This situation is often characterized by very entrenched channels and customers, with multiple levels capable of “saying no”, and a long process to “yes”.  As result the level of product testing is substantially longer than other sectors as well. One implication (also see “Cheap” Technology below) is that technology businesses that have access to customers or are in integration areas tend to be under-priced by investors relative to technology developers.  This under-pricing can be especially true if the business has a vision to acquire technology or IPRs from developers as a price of admission to a customer base.  This set of issues also raises a second set of implications in the engine industry, where the major engine manufacturers, while they are often under pressure for change, are not exactly adept at handling new technology adoption, in part since they sell almost entirely through low-tech dealer networks, and only partially touch the end customer themselves.  Another risk issue here is that investors in technology development have tended to underestimate the power of entrenchment in both customers and channels, and as discussed below, run a risk of being caught in a bind as a one-product wonder without the depth or breadth of solution to protect market share.

R&D vs. Product /Market Development Investments – Because of the slowness of adoption rates, the relative risk of R&D investment bets to product /market development investment bets tends to be substantially higher than in many other sectors.  The implication is that early stage investment (pre- purchase orders) should be done at lower valuations than the same stage in other sectors, while later stage (post purchase order) investment can potentially be done at higher valuations, while achieving the same risk adjusted IRR.  Another implication is that investors often should expect some level of public funding support for technology development as a prerequisite for investment, not as a driver of additional valuation.

“Eternal Pilots” – This industry tends to be under significant environmental and PR pressures and as a result companies in the space tend to make limited investment of resources and capital in numerous pilot programs and “evaluations” that do not have significant likelihood of moving forward in a major way, but may run for years.  This has been especially true of regulated utilities that could often in effect price through some of the cost, or were expecting to bear the cost anyway as part of a PR or ongoing market vision program, as well as major energy companies, who have huge margins, and tend to have massive and far-flung R&D programs.  This tends to obscure the vision of VC investors looking to bet on strategic relationship “traction” as a way to proxy potential product adoption.  In other words, one can easily overestimate “traction”, and investors often tend to overestimate the life cycle stage of a new technology.  The newer the technology, the higher the over-estimation risk would tend to be.

Political Process – This industry tends to be very politically sensitive.  And the entrenched leaders tend to be much better than the startups at managing this process.  One thing this means is that significant public/government backed or public/private capital is available to fund R&D in the area, and that government/military business can often be viewed as core customer base.  It also means that technology development requiring regulatory or legislative drivers can be much riskier than in other sectors.

“Cheap” Technology – Given the above, existing technology tends to be “cheap” on the venture capital scale, and contracted or visible business tends to be the driver of value. Part of this is because the technology is often developed with “cheap” public dollars. The other way to think about it is that if you have the market and access to customers, attractive, proven technology at the product development stage can often be acquired for essentially pure upside.  While this may not call into question a particular technology development investment program, it again does have implications for the value of that technology as opposed to the value of a going concern.

Make One Bet, Not Two – To follow on that point, one implication is that an effective investment strategy may be to accept either technology development risk, or market risk, but not both.  In that, an investment in technology development not be made unless there was a near certainty of obtaining public funding to offset substantial portions of the cost or customer purchase orders once product development is completed, or that investment in customer ramp or market development not be made unless the technology is proven and has extremely limited risk of failure.  Betting on early stage companies that neither have a “locked-in” customer or completed technology may tend to be an extremely risky bet, and should perhaps be done only at quite low valuations relative to other industries.

Gross Margin Ramp – Another area of typical miscalculation is in profitability of new technology.  The sector tends to be a bit more “custom” in its product demands than some industries, and one major bet that has caught investors is cost structure/timing of volume orders.  This is an area where it has proven extremely difficult for many companies to develop enough business to move gross margin positive, let alone operating profit.  A common mistake is to over build manufacturing capacity in an often desperate race to get a marginally cost effective technology to an acceptable cost point to achieve venture like growth projections, when a more effective strategy often might have been to build low volume, higher cost point premium solutions for a smaller market in order to maintain the business during the often long process of technology adoption.  Such a strategy, which tends to be ignored by venture backed startups until too late, can be a key element in reducing the timing risk in this sector.  Part of the issue also stems from technology companies misunderstanding the price point potential and impact on their net price to manufacturer from channel and integration costs, a particularly sore point now to many companies betting on distributed generation technology, as is the point below.

One Product Wonders – Unlike other sectors where large companies are quite adept at acquiring in new products and technology lines, this is a sector where major competitors tend to be more likely to make a build vs. buy decision.  This tends to be more true for high margin components of an overall solution, exactly where technology investors tend to play.  Often investors have found that their supposed channel is in fact their most successful competitor, even despite the fact that the channel may not very good at the solution.  The result is that investors often overestimate how far a single product company can go, and overestimate how badly a potential strategic partner or exit will view that they need a particular technology solution.

While none of these points are meant to invalidate particular investment strategies, they are meant to be points to consider when risk adjusting and developing pricing / valuation strategies for energy technology investments.  At the end of the day, we tend to feel that technology companies in this sector, when compared to many other venture capital investment sectors, should be priced much more closely on visible cashflows than value of technology or market potential, or by “stage”, where the risked economics may not be as easy for an investor to define.

Pike’s Peek at CleanTech

At the foot of the Flatirons along the Front Range of the Colorado Rockies, Boulder is one beautiful town.  With the University of Colorado and the region’s unparalleled outdoor activities, Boulder attracts many intellectual environmentalists.  Of course, like everyone else, this set of people needs to make a buck to pay the bills – there are probably more Ph.D.-holding waiters and waitresses in Boulder than anywhere else on the planet – so over the years Boulder has become a center of energy market and technology analysis.

The list of energy consulting and research firms in Boulder active during the past three decades is too long to include here, and most of them are now defunct and have slipped my memory anyway.  Recently, I came across the newest kid from Boulder-town, Pike Research.

Analyzing the clean technology markets, Pike has organized itself into five segments:  “Smart Energy”, “Smart Grid”, “Smart Transportation”, “Smart Industry”, and “Smart Buildings”.  I guess this terminology is to draw a contrast to all the things potentially considered “dumb” that have been and continue to be pursued to power our economy – including the entire realm of fossil fuels, which is not a topic that Pike covers. 

In each of these segments, Pike’s team either has compiled or is compiling information and perspectives on a number of subsegments, ranging from renewable energy to microgrids to electric vehicles to green buildings.  Individual reports can be purchased, or clients can purchase an advisory service that provides access to all of Pike’s research.

Of course, this research isn’t cheap for Pike to develop, and consequently isn’t cheap to acquire from Pike either.  But, if you’re looking to make a big strategic or investment decision in one of these technology fields, it’s good to have some set of data on which to make judgments.  Pike appears to have one of the more extensive catalogues of research, and so is well-positioned to be one of the first one-stop shops you should visit if you have this kind of need.

Northeast Ohio’s Place in the Advanced Energy Universe

by Richard T. Stuebi

On September 1, the Fund for Our Economic Future – a collaboration of philanthropic organizations in Northeast Ohio – approved a $1.7 million grant to launch a new advanced energy initiative at NorTech, whose mission is technology-based economic development for the region.

This new initiative (stay tuned for a sexy name, to be announced soon!) will become the “center of gravity” or “focal point” for all things advanced energy in the 21 counties of Northeast Ohio. It will also play meaningful roles in coordinating or leading large-scale multi-constituency projects that offer the potential for transformational economic impact in the region.

Representing the Cleveland Foundation, I have worked with NorTech leadership for nearly a year to develop the plan for the initiative, and will be lent to NorTech by the Foundation to serve as a Principal for the initiative.

Although I am pleased with the successes achieved since I joined the Foundation to lead its advanced energy work in March 2006, I am joining this new initiative with enthusiasm, as I am optimistic that the broad reach, resources and support afforded by NorTech will enable an even greater degree of impact.

Given limited resources, we will be unable to pursue an unbounded agenda. Rather, we must remain focused, building on our strengths (which are substantial), and avoiding “me-too” strategies just because other areas are gaining good traction in attractive sectors.

We know we’re joining an already active game: to illustrate, look at the organizations emplaced in Michigan (NextEnergy) and New York (STEP: Saratoga Technology + Energy Park) to pursue similar missions for regional economic development via advanced energy technologies. Indeed, instead of viewing the others as competitors to whom we might “lose”, we must view our colleagues elsewhere as potential collaborators, employing a “win-win” mentality, because we’re all on the same planet together.

I am more confident than ever that Cleveland and Northeast Ohio can be a major player in the advanced energy economy of the future. Even now, we are already a globally-significant factor in fuel cell R&D, wind energy manufacturing, and efficient lighting technologies. Not only can we extend and deepen these clusters, but we have already-extant seeds and shoots in other sectors – such as waste-to-energy, energy storage, alternative fuels, advanced nuclear designs, and power “informatics” (sensors, controls and intelligence) – that can serve as the nuclei for new clusters.

I thank the Fund for Our Economic Future for its significant grant to launch this important new initiative, NorTech for its recognition that advanced energy must become one of the key technological legs for the revitalization of the Northeast Ohio economy, and the Cleveland Foundation for its overall leadership in putting advanced energy on the region’s map of consciousness. All of us in Northeast Ohio – and elsewhere – should give similar thanks.

Northeast Ohio may not, yet, be a world-leader in advanced energy. But at least we’ve got a growing number of oars in the water, paddling with increasing effectiveness in the same direction as the leaders, with whom we eagerly seek to partner.

Richard T. Stuebi is the Fellow for Energy and Environmental Advancement at the Cleveland Foundation, and is also a Managing Director at Early Stage Partners.

Sober Words from DOE

by Richard T. Stuebi

At the recent Western Energy Summit, Dr. Steven Koonin (Undersecretary of Science at the U.S. Department of Energy) made a speech with some eye-opening tid-bits. In this review on GreenTechMedia, Koonin is quoted as saying about the daunting challenges in moving away from fossil fuels:

“We have limited time and limited resources….We cannot let 1,000 flowers bloom indiscriminately.”

“The deployment of inefficient feel-good resources is doubly-bad” because they give the illusion of progress and divert scarce resources.

Coal “is not going to disappear anytime soon,” so much more effort needs to be put into carbon capture and storage technologies.

“If the world wants to seriously address emissions, nuclear will almost certainly have to be part of the future.”

Most interestingly, as reported by the August 3rd issue of the Peak Oil Review, Koonin is said to have opined in his speech that “resource constraints soon will force the Department of Energy to narrow its focus onto the most promising technologies.” If true, this is worrisome because (1) it possibly implies that the DOE isn’t necessarily expecting any major increases in R&D funding — and our national energy R&D budgets are considered by many to be pretty darn low in light of the challenges we face (see, for instance, this report by the Government Accounting Office), and (2) it suggests that DOE will increasingly start picking “winners and losers” — and the public sector is not known for being good at making such judgments.

If anyone can find Koonin’s speech text in full, I’d appreciate getting a copy.

Richard T. Stuebi is the Fellow for Energy and Environmental Advancement at The Cleveland Foundation, and is also the Founder and President of NextWave Energy, Inc. Effective September 1, he will also become Managing Director of Early Stage Partners.

Ah, Chu

by Richard T. Stuebi

As Secretary of the Department of Energy, Steven Chu is a breath of fresh air. As a recent profile in The Economist noted, “Wags used to say that the one essential qualification for being energy secretary was not to know anything about energy.” Well, that definitely doesn’t apply to Dr. Chu.

A winner of the 1997 Nobel Prize for physics, and former Director of the Lawrence Berkeley National Laboratory, Steven Chu is by far the most expert energy secretary the U.S. has had since the founding of the Department of Energy in 1977. (See the list of other predecessors.)

Of course, in Washington, it’s not always the case that knowledge and experience begets success. But any failures that Chu might experience can’t be attributed to lack of resources.

Clearly, Secretary Chu has a lot of money to play with these days: in addition to annual budget of $26 billion (which is certain to increase substantially in coming years), over $38 billion was authorized to DOE as a result of the American Recovery and Reinvestment Act. So far, only about $7 billion of the ARRA monies has been awarded, and a measly $243 million has been actually spent, so Chu has a lot of “dry powder” left.

Let’s hope he puts it to good use, because the public sector is a notoriously poor selector of winners and losers — among technologies and among businesses. Chu is obviously a bright guy; let’s hope he’s smart enough to know what he doesn’t know. (Of course, the last guy to notably discuss the concept of “unknown unknowns” — former Secretary of Defense Donald Rumsfeld — was no dummy, and we all know how well his efforts panned out.)

Richard T. Stuebi is the Fellow for Energy and Environmental Advancement at The Cleveland Foundation, and is also the Founder and President of NextWave Energy, Inc. Later in 2009, he will also become Managing Director of Early Stage Partners.

Abu Dhabi Do

by Richard T. Stuebi

In the middle of the Middle East, built upon riches generated from the region’s vast oil supplies, the city-state of Abu Dhabi is turning to the future.

Abu Dhabi sees that petroleum is a finite game, and that its future success (and the planet’s) depends upon moving onto the next game.

So, in the middle of the desert, Abu Dhabi is building a new city called Masdar. As discussed in an article in the December 6 issue of the Economist, the Masdar Initiative was launched in 2006 to pursue “solutions to some of mankind’s most pressing issues: energy security, climate change and truly sustainable human development.”

The goal of Masdar is to become an innovation center and applied test-bed for environmentally-friendly technologies, with a goal of housing 50,000 people and 1500 businesses at a zero carbon footprint. Abu Dhabi is pulling out all the stops, with a $15 billion commitment to bringing Masdar to fruition.

Clearly, Abu Dhabi is intent on getting good visibility with Masdar. The city is also profiled in an article in the November 24 issue of Forbes (a good issue, incidentally, entitled “Energy + Genius”, focused solely on energy topics), and an article in the September/October Technology Review shows how Masdar is collaborating closely with MIT to create the Masdar Institute of Science and Technology (MIST). Later this month, Abu Dhabi will be hosting the World Future Energy Summit, including a long-list of high-profile speakers.

It seems to me like something of a PR blitz, so one must be at least a little skeptical if Masdar is more hype than reality. However, if Abu Dhabi is able to achieve even a quarter of what they aspire to with Masdar, then it will definitely be a significant step forward for cleantech.

More broadly, if a desert-based city can become close-to-sustainable, then civilization in more temperate climes has a good long-term future.

Richard T. Stuebi is the BP Fellow for Energy and Environmental Advancement at The Cleveland Foundation, and is also the Founder and President of NextWave Energy, Inc. Later in 2009, he will also become a Managing Director of Early Stage Partners.

An Ode to Wacky Ideas

by Richard T. Stuebi

Over the years, I’ve been exposed to many cleantech concepts that are just, well, wacky. I’ve seen articles on tethered airborne windturbines and mile-high thermal generation towers, heard from entrepreneurs touting cold fusion devices and floating solar collectors for thermal electricity generation, and even witnessed what seemed to be a demonstration of a gizmo that purportedly harnesses the ambient magnetic flux in the universe. (Against the accepted laws of physics, mind you.)

Last week, I was sent a link to a story on MSNBC of a Canadian gentleman who is working on man-made tornadoes for electricity generation. This one might take the cake. To quote Bob Uecker from Wild Thing, “Juuuuust a bit outside.” See what you think.

Most mad-scientists are oblivious to the fact that, just because something theoretically is doable, doesn’t mean it should be done or is economic to do.

In the end, though, I gotta give these folks their due. If it weren’t for oddballs pushing the species, humans would probably still be sitting around in caves saying “Ugh”. It’s probably going to be a couple of what are initially considered wacky ideas that produce the necessary breakthroughs to truly solve our energy and environmental dilemmas. So, for that reason, I try to be somewhat open-minded in looking at the crazy stuff that sometimes comes across my transom.

Richard T. Stuebi is the BP Fellow for Energy and Environmental Advancement at The Cleveland Foundation, and is also the Founder and President of NextWave Energy, Inc.

Into the Blue

by Richard T. Stuebi

Last week, the International Energy Agency released a study entitled Energy Technology Perspectives 2008, in which the agency estimated the shifts in the world’s energy system required to reduce CO2 emissions substantially.

In their so-called “BLUE” scenario (I haven’t figured out what “BLUE” refers to), a 50% CO2 reduction from 2005 levels by 2050 — what many scientists believe is about what needs to occur to stabilize the climate — is only achievable by tackling emission reductions that have a marginal cost of over $200/ton CO2. Ouch!

Even more provocatively, IEA estimates that the BLUE scenario would imply a widespread move to near-zero carbon buildings and the deployment a billion electric/hydrogen vehicles plus annual investments between 2010 and 2050 of 55 coal plants with carbon sequestration, 32 nuclear plants, 17,500 utility-scale wind turbines, and 215 million square meters of solar panels. By their accounts, this represents $45 trillion of investment above and beyond business as usual.

In IEA’s words, “BLUE is only possible if the whole world participates fully” in shifting to “a completely different energy system.”

Does anyone doubt the magnitude of the CleanTech challenge/opportunity in the coming decades?

Richard T. Stuebi is the BP Fellow for Energy and Environmental Advancement at The Cleveland Foundation, and is also the Founder and President of NextWave Energy, Inc.

2007 Roundup

by Richard T. Stuebi

As has become my custom, with the year drawing to a close, I now look in the rear-view mirror and try to distill what I see. In no particular order, here are my top ten reflections on 2007:

1. Popping of the ethanol bubble. Not long ago, it seemed like anyone could get an ethanol plant financed. Now, no-one will touch them. Why? Corn prices have roughly doubled, and producers can’t make money selling ethanol into the fuel markets when having to pay so much for feedstock. Along with the increasing realization that public policies so far to build ethanol markets has largely been for the financial benefit of big agri-businesses such as Arthur Daniels Midland (NYSE: ADM), ethanol has now become a dirty word to many. Progress on cellulosic ethanol technologies may not happen fast enough to redeem seriously diminished public perceptions about ethanol generally.

2. Continuing photovoltaics bubble. For illustration of this phenomenon, let’s take a look at First Solar (NASDAQ: FSLR). Nothing whatsoever against the company; indeed, they make a very fine product. It’s just that their share price has increased by a factor of 10 — from $27 to nearly $280 — in one year. At current levels, the company’s market cap is $20 billion, at a P/E ratio of over 200. I know the solar market is hot, but geez, c’mon. A 10x return in one year on a publicly-traded stock is simply not supposed to happen.

3. Increasing costs for wind energy. For many years, wind energy has become more competitive, as the industry matured and production efficiencies were tained. However, with increasing prices for virtually all commodities (e.g., steel, copper, plastics) and a weakening dollar against the Euro (note that most turbines are made in Europe), the economics of wind are unfortunately moving in the wrong direction right now.

4. Gore as rock star. First, an Oscar for An Inconvenient Truth. Then, the Nobel Peace Prize. To top it off, becoming a partner at top-notch venture capital firm Kleiner Perkins. What next for the what-could-have-been 43rd President? Whatever it is, at least the cleantech sector now has its iconic poster-child.

5. Cheers to Google. Google (NASDAQ: GOOG) has gotten into the cleantech game in a big way by creating an initiative with the mission to develop and launch renewable energy technologies that produce electricity more cheaply than coal. Once that aim is achieved, renewable energy will rapidly become ubiquitous, and we really will start getting on a path of serious carbon emission reductions.

6. Death of the incandescent lightbulb. Early in 2007, Australia led the way to ban incandescents, to force a shift to more energy efficient lighting technologies (fluorescents for now, perhaps eventually LEDs). Amazingly quickly, the U.S. followed suit, passing an energy bill by year-end that effectively phases out incandescents by 2014. This should have a major energy efficiency impact, and yield a big cut in greenhouse gas emissions, in a relatively short amount of time.

7. Tightening CAFE — finally! After decades without change, the U.S. Congress finally acted to impose more stringent corporate average fuel economy (CAFE) standards for auto/truck manufacturers. The main milestone is a 35 mpg combined car/light-truck standard by 2020. For the first time, trucks are now part of the CAFE equation, closing the loophole that helped propel SUVs to prominence. Strengthening CAFE is probably the most important thing that American politicians could do to actually make a meaningful dent in reducing dependence on Middle Eastern oil.

8. Uncertain future for coal. On the one hand, MIT released a major study entitled “The Future of Coal” that compels a radical R&D push to commercialize technologies for carbon capture and sequestration (CCS), underscoring the reality that coal-fired electricity generation is going to be a major factor for a long time. On the other hand, I don’t see any such coal R&D push actually happening, nor even that much progress on CCS. A recent statement by the U.S. Department of Energy concerning its oft-touted FutureGen program for piloting CCS technology indicates a possible retrenchment. Meanwhile, Pacificorp — which is owned by Warren Buffett’s legendary holding company Berkshire Hathaway (NYSE: BRKA and BRKB) — recently cancelled a coal CCS project in Wyoming, with a spokesman quoted as saying that “coal projects are no longer viable.” Ouch.

9. Oil at $100/barrel. Starting the year at about $60/barrel and then promptly falling to near $50, oil prices increased steadily from February to November, reaching the high-90’s. I suspect we’ll see $100/barrel sometime in 2008; I don’t suspect we’ll see oil below $40/barrel very much anymore. Even at prices not long ago considered absolutely stratospheric, it appears that there’s been very little customer/political backlash so far: the world doesn’t seem to be ending for most Americans.

10. Serious dollars betting on energy technology. There’s been a lot written about the big surge in venture capital invested in new energy deals. I find even more intriguing the increasing amount of corporate and public sector investment in new energy R&D. As perhaps the most prominent example, in the U.K., the government has pledged up to $1 billion over the next 10 years in matching support to private investments in the Energy Technologies Institute, which includes the participation of such leading corporate lights as BP (NYSE: BP), Shell (NYSE: RDS.A and RDS.B), Caterpillar (NYSE: CAT), Electricite de France (Euronext: EDF), E.ON (Frankfurt: E.ON), and Rolls-Royce (London: RR.L). That’s a lot of money and corporate weight in the mix. I can’t imagine that such an initiative will produce nothing of use.

Best wishes to you and yours for 2008. Let’s hope it’s a good year, even better than the one wrapping up.

Richard T. Stuebi is the BP Fellow for Energy and Environmental Advancement at The Cleveland Foundation, and is also the Founder and President of NextWave Energy, Inc.