Climate: Changing the narrative on “hard to abate” sectors

Leveraging venture capital for complex problems

By: Sam Smith-Eppsteiner and Carrie von Muench

There’s no way around it: If we want to make a dent in the climate crisis we absolutely must tackle our hard-to-abate sectors. Sometimes described as “horsemen of the climate apocalypse,” the worlds of road freight, cement, steel, chemicals and aviation are collectively responsible for roughly 30% of the world’s emissions — and the scope 3 emissions of many of our most essential industries. We rely on these sectors to deliver affordable cars and homes, well-stocked grocery stores, and affordable travel to see the ones we love. They’ve been termed hard to abate because there aren’t NPV-positive decarbonization solutions available at scale today. In other words, the market failures that have prevented us from solving climate change long ago are particularly pronounced in these sectors.

Transparently, as financial investors, we’ve wrestled with what we can back here. To win, companies need to compete in commodity markets in which incumbents pollute for free, often overseas. They often need to build out massive facilities, requiring large amounts of capital and time before getting to market. Finally, it has often been unclear to us if a single process innovation can sustain a competitive advantage over time as others innovate. Competition is abundant. It can look like someone leveraging the same tech at a lower cost structure (e.g., China going from producing 0%- nearly 60% of the world’s PV cells in 10 years driven by subsidies). Or, given the commodity nature of end-products here, it can look like totally orthogonal approaches (e.g., different battery chemistries competing to achieve the same 8 metrics).

But we have many reasons to be hopeful. First, demand signals have never been stronger: as customers demand cleaner products and talent increasingly wants to work for mission-aligned employers, companies are increasingly determined to tackle their carbon footprints, including scope 3 emissions, and in doing so, are creating undeniable demand signals for cleaner commodities. For example, First Movers Coalition members have committed to more than buy more than $12 billion worth of net-zero products, and initiatives like SteelZero reflect a growing appetite for even bolder commitments. Second, regulatory incentives have changed the cost floor for cleaner alternatives dramatically. For example, the IRA’s $3/kg hydrogen tax credit is a game-changer for accelerating the rollout of clean hydrogen, the “swiss army knife” of industrial decarbonization. Third, many incumbents are seeing the writing on the wall and investing in new solutions — for example, ArcelorMittal, the world’s largest steelmaker, recently led a $120m funding round into green steel startup Boston Metal. Fourth, venture capitalists are investing as well, with north of $20 billion in dry powder. And, perhaps most importantly, we’re seeing the best batch yet of brilliant, determined entrepreneurs tackling these challenges. Earlier this year, we had the chance to spend the evening with ~20 such entrepreneurs and came away inspired and hopeful. While we don’t have all the answers, we wanted to at least share some of our takeaways from the event and some of the questions that we are wrestling with as we think about investing in these spaces.

Some takeaways:

You can absolutely build a valuable hardware-driven company, but hardware alone often isn’t enough. Four of the 10 most valuable public companies are hardware-centric (Apple, Tesla, TSMC, and Nvidia). At the same time, primarily hardware — and materials-driven companies lost $0.8-$0.95 on the dollar in cleantech 1.0 (we like this work by MIT, this post by Equal Ventures, and this work by Bessemer). While investing in physical assets was not as lucrative as software, there were still some winners — but on a longer investment time horizon. Tesla’s market cap topped $1 trillion almost 12 years after it became a public company, and other hard tech companies (e.g., QuantumScape, LanzaTech) took more than a decade to become unicorns (more in this post by B Capital). The conclusion? Unless you’re operating in a large and epically supply-constrained market, finding ways to either 1) enable brand-new capabilities (e.g., Nvidia in 1993 bringing 3D graphics to the multimedia market), 2) provide a vastly superior customer experience and brand affinity (e.g., Tesla and Apple), or 3) bring a new business model that transforms the market in which you operate (e.g., TSMC) and/or lets you build an information advantage over time will be critical.

The demand signal today is undeniable, but don’t bet on a sustained green premium. We’re certainly seeing green premiums for many commodities today — for example, in the past decade, high quality recycled plastics reached a premium of 60% over virgin plastics — but this dynamic is only sustainable in markets where demand is expected to outpace supply for the foreseeable future, a risky thing to bet on in the long term given the markets’ tendency to find balance. To bet on a company in this space, we’d need to see a path to 1) cost parity or advantage versus conventional alternatives (while still leaving room for a healthy margin and with reasonable assumptions!), or, even better, 2) outsized value beyond climate impact (via one of the mechanisms described above).

As a result, if in doubt, the approach with the lowest cost floor wins. Leveraging synthetic biology for fuels and materials is a great example of where this critical point has often been missed. While we certainly could make 60% of the physical inputs to our economy biologically, it’s not clear to us that we should, particularly where clean & performant synthetic alternatives exist. Why? For many synthetic approaches, the price of electricity sets the cost floor, and for most biological approaches leveraging microbes, the cost of sugar sets the cost floor; the former will usually drive better economics than the latter. We’re intrigued by Savor’s synthetic approach to fats for this reason. With that said, it’s important to caveat that we’re big believers in synthetic biology’s potential to solve major climate challenges — more of our thesis in our bio-centric newsletter, Bio Endeavors. Hydrogen is another great example: assuming hydrogen is generated by electrolysis, it will only make economic sense in areas where electrification is impractical (e.g., not for most road transport, as well-described in this dated-but-still-relevant post by Jigar Shah and a more recent study).

Carefully considering your role vs. that of incumbents is mission-critical in the early days. Ian at Cantos wrote a great piece on full-stack deep tech last year where he rightly pointed out that selling equipment or services to a slow-moving, thin-margin incumbent is a really tough spot to be in as a startup. At the same time, building a new full-stack company doesn’t always make sense, particularly in an environment where the cost of capital is high. For example, we find Universal Hydrogen’s approach in aviation incredibly thoughtful: they are building conversion kits for regional aircraft that both de-risk their technology and get them to market by 2025, but the long game is to position themselves as an essential enabling element for hydrogen-powered aircraft that will ultimately be produced by incumbents starting in the mid-2030s (replacements for the Boeing 737 and Airbus A320). In this way, they can drive impact at scale while still avoiding the fusion-scale investment required to build a massive aircraft program.

Figuring out the financing path early — and creatively — is essential → While the available capital stack looks well-resourced, there’s a huge gap between early-stage venture capital checks and the $200m+ DOE loan program scale checks, particularly given the relative slowdown of growth rounds in the current market. We like CTVC’s post on the bridge to bankability, which dives into this gap in more detail. Certainly, there are lots of creative ways to bridge this gap, for example:

1. Grants: There’s a wealth of grants available, and also a wealth of experienced folks available to help startups access those dollars (e.g., we’ve heard great feedback about Joel and Ross at Climate Finance Solutions and know that others like Boundarystone do similar work as well).
2. Debt and equipment finance: Certainly, venture debt continues to be an option, but other forms of credit are also available. For example, we’ve heard from folks who had great experiences with Third Sphere’s credit group and CSC leasing for equipment financing.
3. Forward purchase agreements: We’ve seen PPAs be game-changing in renewables and, more recently, in carbon removal via the work done by the Frontier Fund.

However, even amidst all these options, there continue to be major barriers, especially for first-of-a-kind facilities. For example, to access credit, early startups are often expected to have offtake agreements signed, which simply aren’t standard in many industries with more fragmented supply chains (e.g., ready-mix concrete). We’ll readily admit that we don’t have a crystal-clear perspective on what the right financing path should look like, but we’re convinced that figuring this out in the early stages for each company will be critical.

Finally, we believe in a ‘yes and’ approach, not a one-size-fits-all solution → We enjoyed a spirited debate about the value of SAFs vs. hydrogen for long-haul flights, but given that we’re nowhere near where we need to be, we need it all — and almost certainly will for the next half-century to come.

A few themes we’re excited to invest in:

Decarbonizing hard-to-abate sectors is mission-critical work for our planet, and we’d love to put dollars to work solving some of these problems. Two themes we’re thinking about these days (although far from an exhaustive list):

Companies using new technology to tackle the “developer’s plight” → For us to succeed in these hard-to-abate areas, we’re going to need to develop a lot of projects. We believe that new technologies built on foundation models can make the development process much easier, faster, and more likely to succeed, particularly when it comes to siting; navigating complex local and national permitting and regulatory landscapes; and traversing government incentives. We’ve enjoyed meeting some great teams in the space such as Othersphere and Blumen, and are excited to share more of our thinking in a future post to come.

Companies driving 10x more volume in supply-constrained markets (i.e., may have technical risk, but effectively no market risk) → For example, every single person we’ve spoken to in aviation-land can’t get enough SAF — literally cannot buy enough of it — despite the fact that SAF costs 2x the price of conventional jet fuel today. While technical defensibility is certainly on our minds, for large and supply-constrained markets, there is room for multiple players to build significant companies provided you can deliver supply in a cost-competitive way and get creative about the business model in a way that builds a sustainable advantage.

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Thanks for reading. If you’re building a company to tackle hard-to-abate sectors, whether in the above categories or not, please reach out — we’d love to hear from you.

Special thanks to: Paul at Universal Hydrogen, Joe at Lydian, Akshai at Brimstone, Kevin and Caleb at Molten, Henrik at Savor, and many more for conversations that have inspired us — and most importantly for the kickass work you’re doing to tackle these critical challenges. We are grateful to be part of your journey.