What we learned from the collapse of investment in Cleantech 1.0 and how we can ensure the success of Cleantech 2.0.
By Michael Kearney, Senior Associate, The Engine
Numerous accounts have documented the collapse of venture investment in the clean-technology sector during the first fifteen years of the 21st century. Retrospectively known as Cleantech 1.0, investors piled $25 billion into cleantech startups from 2006–2011, funds that resulted in little return on capital. 
The subsequent flight of capital from cleantech increased commercialization challenges for the struggling sector. In the latter part of the 2010s, however, the tide turned once again for cleantech startups. With $4 billion invested in the space since 2017, investors clearly have renewed interest in supporting cleantech companies.
So, what have we learned from Cleantech 1.0? What are investment firms doing differently to account for this newfound knowledge? What problems may still exist, and what can be done to solve them? In short, the investment community has moved to account for the deep technical risk, long development timelines, and capital intensity associated with cleantech investing. However, while energy markets, including electricity, fuels, and transportation infrastructure, seem large, the paths to market are arduous, and value capture in those markets is challenging. For Cleantech 2.0 to be a resounding success for venture investors, a series of structural reforms and government interventions are necessary.
The climate challenges facing the planet are numerous — emissions are tightly tied to global economic growth and, despite progress in reducing emissions in the electricity sector through deployment of carbon-free electricity and efficiency gains in end usage, achieving the Paris Climate Accord goals of limiting global temperature increase to 2°C will require both an extraordinary build-out of existing renewable resources and rapid invention and diffusion of new technologies.
There is an emerging body of evidence that in the energy sector, startups are more likely to fund high-risk, high-impact technical projects  compared to large incumbents with incentives to show growth on a quarterly-returns basis that is not aligned with the longer timelines associated with innovative projects. As a result, these startup projects are vital.
Society must approach the existential challenges of climate change from every angle — every tenth of a degree increase in global temperature that we are able to mitigate has meaningful implications for the future of our planet. That the investment community is stepping up to this challenge is a resoundingly positive step in the right direction.
Lessons from Cleantech 1.0
In a thoughtful review of financial returns during Cleantech 1.0, Gaddy, Sivaram, and O’Sullivan (2016) evaluate the returns to cleantech venture capital investments relative to those in other sectors. Of the $25 billion that investors placed in cleantech firms from 2006–2011, they lost more than $12.5 billion (over 50%). Moreover, whereas successful cleantech investments returned 8.6 times the initial investment to VC firms, similarly successful investments in software companies returned 11.6 times the initial investment, and this likely understates the overall difference as cleantech companies in the sample were more likely to fail.
As we reflect on the Cleantech 1.0 period, it is important to reflect on areas where the investment community has evolved in response to the challenges that hindered returns. Today’s investor community has internalized these lessons, shifted focus, and launched a variety of experiments that offer hope that the returns for Cleantech 2.0 will be different.
Technical Risk: Investors did not fully appreciate the technology risks inherent in clean technologies. Complete understanding of the technological advance at the root of a cleantech innovation requires accessing the frontier of a specific scientific field. Rarely do investment teams retain in-house talent able to adequately evaluate these types of technologies. During the Cleantech 1.0 period, the venture capital industry self-assembled around software-driven business innovations, with VC funds recruiting primarily from MBA programs rather than PhD programs.
In response to this challenge, two divergent pathways have emerged. On the one hand, many firms have eschewed technology risk altogether and found ways to use parallel innovations in software, connectivity, and analytics to build large, impactful businesses in the energy sector. These investors look to high-profile exits like EnerNOC, Nest, and Opower as inspirational endeavors that both provide VC-quality returns and have significant potential impact in the energy sector. On the other hand, cleantech-specific firms have arisen, staffed with the internal technical and sector-specific experts needed to adequately assess industry-specific risks. (Take a moment
to check out the work being done at Clean Energy Ventures and Energy Impact Partners, among others.)
Technology Development Timelines: A different feature than pure technical risk, the timeline to maturity for a given technology can adversely affect investor return. There is a mismatch between a typical 10-year close-ended fund, along with the return requirements thereof, and the plausibly five-to-ten-year time horizons for technology development, scale up, and manufacturing.
New funds and financially engineered structures have arisen to abate some of the more vexing realities related to the long development timelines. Prime Coalition creatively brings philanthropic capital into the capital stack by blending that capital with traditional LP dollars to shift the return profile of the fund as a whole. Breakthrough Energy Ventures and The Engine have extended fund lives to provide game-changing technologies the time to mature.
Capital intensity: In addition to the time it takes to develop technology, cleantech firms require significant capital investment throughout a company’s life cycle.  Importantly, though, it isn’t just that it takes a lot of capital to bring the technology to market but also that even in the early days of a company’s life, the necessary technical experimentation is relatively costly. This is key to the lower returns thresholds described above. Conditional on a comparable exit valuation, a firm that requires more money to get to scale will return less capital.
However, the capital stack is diversifying to include later-stage institutional investors that play a critical role in managing the capital intensity of the cleantech sector as firms scale into commercial readiness. Large institutional investors, such as Softbank, Temasek, Fidelity, and others, are now active players, as are large corporates like ENI.
More change is necessary
These developments are exciting, but they could be largely immaterial if the commercialization path for cleantech companies is not streamlined. There remain significant barriers to the scale-up of clean technologies, barriers that stem not from the inherent technical challenges of innovation, but rather from the market dynamics within which these technologies have to compete.
Across industry verticals, energy technologies face an uphill climb
to commercialization. Consider, for example, the electricity industry. In electricity, end users of innovative products, mostly electric utilities, are highly regulated organizations — their return profile on an investment in an innovative technology looks exactly the same as their return profile on a traditional technology, resulting in a system lacking incentives for change. Similarly, in fuels and any sectors currently dependent on fuels for transportation or high-quality process heat, carbon-free alternatives have to compete with traditional fossil fuels at cost in many cases because economies have not appropriately priced carbon emissions. Moreover, the market price for oil and gas can ebb and flow in response to competitive pressures, which is an existential threat to commodity competitors.
To generalize across end-use applications, cleantech companies face a few specific hurdles getting to market: access capital to scale up production or deploy first-of-a-kind commercial projects, entering highly regulated markets, and working with risk-averse incumbents. These barriers result in reduced market opportunities for energy companies across commercialization stages, in particular at any potential exit point, resulting in reduced valuations and exit multiples. Specifically, companies face four distinct but related barriers:
Funding of early-stage prototypes: Companies have to balance achieving meaningful technical progress at a relevant scale while demonstrating market traction, even though, at this scale, a prototype has little market value.
Funding of first-of-a-kind commercial projects: A critical barrier to commercializing clean technologies is asymmetry between project risk for first-of-a-kind deployments and risk tolerance of capital providers for project finance. In non-commodity fields, a financier would be able to internalize the increased project-level risks by increasing the interest rate on the capital to be provided for a project. However, because cleantech firms often operate in a commodity market, increasing the interest rate on provided capital decreases the economic viability of those projects. In cleantech, this challenge extends beyond the “first of a kind” as well because even after the first deployment, it can take months or years to demonstrate the lifespan and reliability of an infrastructure asset.
Fractured, convoluted regulatory regimes: Regulatory environments remain particularly stubborn to new technologies. This is acute across energy subsectors but perhaps most acute in electricity. For example, 10 years after the first battery storage projects tied into the grid, wholesale electricity markets are still debating how to value energy storage in capacity markets. Regulations within the electricity sector prohibit the primary end users of new technologies, namely electric utilities, from efficiently working with the new technologies on a research or commercial basis.
One game with different rules: The reality is that today, cleantech firms are competing with conventional energy sources in an economy that does not appropriately price greenhouse gas externalities. This limits the market opportunities for cleantech startups, with associated downstream effects on the investment community that reduce incentives for investment across the innovation pipeline. Innovation scholars across fields have articulated the important role of efficient commercial markets for technology as a key element of a functioning innovation system.  Critical to the commercialization of a new idea or product is a startup firm’s engagement in the market with customers, regulators, and larger established firms as strategic partners, exit opportunities, or both.
The fluidity of these engagements is critical to building a cleantech financial system. The path forward here is not complicated — there is no shortage of good ideas about how to solve these challenges. The first and most obvious response is a nationwide price on carbon. However, moving beyond the obvious, focus must reside on pathways to reframe the regulation of energy technology and a national deployment effort.
Considering New Regulatory Frameworks
Unlike drug development, where there is a federally regulated but clear path to commercialization that delineates appropriate value inflection points across the life of technology development, the energy sector in the U.S. is regulated within each state, across collections of multi-state actors, and at the federal level. It is an opaque framework that encourages incumbents to be risk-averse and limits those incumbents’ ability to experiment with new technology.
Consider the regulatory framework for electric power. The challenging role of electric utilities is to deliver power on a sub-second basis across vast distances with high reliability. Downtime is measured in the magnitude of dollars lost in the economy, often on the order of billions of dollars, as we have seen recently in the rolling blackouts in California. As a result, the industry is tightly regulated to preserve reliability and protect consumers — technology innovation and diffusion become casualties of a system that prioritizes reliability.
We must move beyond the false choice of reliability or innovation by creating frameworks that enable both. New rules are needed that empower electricity providers to experiment with new technologies. The federal government could assist with this through the creation of a technology certification office that approves specific technologies for experimentation in risk-averse settings at initially modest investment levels that increase with the technology’s maturity. Moreover, a staged process provides investors with tangible value-inflection points as a company approaches commercialization, value-inflection points that draw more follow-on capital into a company.
A National Deployment Effort
Barriers to cleantech commercialization exist across stages of deployment for clean technologies from pilot projects to broad-scale commercialization. A National Deployment Effort that nurtures technologies from pilot projects to massive impact is necessary. Historically, the U.S. government has played an active role in later-stage commercialization efforts of foundational technologies, and that same effort is required for cleantech going forward.
Consider, for example, the development of the U.S. semiconductor industry in the 1950s and 1960s.  Government procurement efforts were as or more fundamental to the growth of the sector as government R&D efforts. In fact, from 1955 to 1977, government procurement accounted for an average of 38% of all semiconductors produced in the U.S. In 1962, the first year that integrated circuits shipped, the government purchased all of them (100%). At the time, the U.S. government was one of the largest consumers of transistors in the world, just as today, the U.S. government is the largest individual consumer of energy in the world.
A critical barrier to commercializing clean technologies is asymmetry between project risk for first-of-a-kind deployments and the risk tolerance of capital providers for project finance. The government has played a productive role in bridging this gap in the past through tax credits and the DOE Loan Guarantee Program, among other mechanisms. To capitalize on the recent growth in cleantech innovations, however, a codified national deployment effort is necessary that adjusts existing programs and offers new ones that meet the scope of the climate crisis.
The Loan Guarantee Program has supported the deployment of energy projects with significant capital expenses. While it continues to support large-scale efforts, it is an imprecise tool for supporting more modular, distributed, early-stage projects. Potential improvements to the program include expanding the set of technologies that can be supported to a broad umbrella of clean technologies and reducing barriers to entry for all smaller, more distributed, and higher-risk endeavors.
Recently, the Clean Future Act included language for a National Climate Bank. This would be an effective tool for launching new clean technology products and projects into the market. Importantly, the Bank is structured to leverage private sector capital to cover the majority of project costs but only public capital to support the difference between the market value of the project and the ultimate project costs. This is a critical intervention because it is rare for novel clean technologies to be competitive for early projects — often, components/products are not yet being manufactured at scale, and the corresponding projects have to compete in commodity markets.
Finally, as the largest consumer of energy in the world, the U.S. government could serve as a test bed for early-stage commercial energy projects. Procurement and testing mandates for government facilities could do for cleantech what government procurement of early computing technologies did for that hardware market.
The data is clear: the investment community is currently rising to the challenge of supporting the next generation of clean technologies. It is doing so with new approaches and coalitions that address long-standing asymmetries between cleantech innovation and investment structures.
The efforts to align capital to the realities of technology development and the needs of financial markets at all stages will remain undervalued without commensurate attempts to tackle the daunting challenges on the commercialization side for cleantech startups.
Investors, collectively and alongside their portfolio companies, must participate in the national conversation about how best to seed the commercial landscape of our energy future. In response to a depression-like contraction of the economy, the success of the cleantech industry is critical. We must redouble our efforts to ensure that the story of Cleantech 2.0 is one of sustained growth, new industries, and new opportunities for the American people.
2: Nanda R, Younge K, Fleming L. 2015. Innovation and entrepreneurship in renewable energy. In The Changing Frontier: Rethinking Science and Innovation Policy, ed. A Jaffe, B Jones, pp. 199–232. Chicago, IL: Univ. Chic. Press
3: For more information, see here: https://davidmytton.blog/the-data-behind-49bn-of-cleantech-investment/
4: Gans and Stern (2003); Teece (1986); Hellmann and Perotti (2011); Jaffe, Trajtenberg, and Henderson (1993); Saxenian (1994); Porter (1998); Carlino and Kerr (2015).
5: For more information, see here: https://fedtechmagazine.com/article/2018/09/how-government-helped-spur-microchip-industry