Nov 9, 2022
Investing in FinTech-Enabled Decarbonization
With companies pledging GHG reductions, businesses that provide integrated services of emissions measurement, insights on reduction, and carbon offsets will play a pivotal role in being agents of change towards a net-zero global economy
Over the last couple of months, I’ve been working with Eric Desai, Managing Director at Vidavo Ventures — a climate-tech VC co-founded by industry leaders and insiders in the most energy- and CO2-intensive sectors, particularly industrials and agribusiness. We invest in technology solutions to help those sectors fight and adapt to climate change. If you’re a start-up on the same mission and raising your Series A, B or C, please reach out to Eric (eric@vidavovc.com) and me (pranav@vidavovc.com)!
Current Market
With Carbon & Emissions Tech startups raising $13.1B and 19 exits worth $3.8B over the course of 2021, there has been strong momentum of capital flow — even with a difficult macro backdrop, $5.6B was raised in H1 2022 — and increased interest. At Vidavo, we think an area within the space that deserves more attention is the software infrastructure for businesses supporting the move towards decarbonization.
However, we have seen some positive momentum with venture-backed software-enabled carbon accounting and offset companies raising $1.5B to date, with roughly two-thirds of that raised in 2022 alone. Most of the money raised to date has been dominated by just 5 companies: Xpansiv, Watershed, Persefoni, Sweep & Patch. Additionally, with the median size of each deal at $34M, we see that these companies are fast approaching the growth phase — to us, the most exciting part! — of their journey.
With that backdrop, let’s dig into our view on carbon accounting, reduction, and offsetting!
Background
Regulatory authorities, investors and customers from across the globe have been pushing businesses to play an active role in combating climate change. This has resulted in a plurality of companies pledging to reduce their greenhouse gas (GHG) emissions, with some committing fully to net-zero.
Most corporate commitments are purely focused on Scope 1 (direct emissions from operations) and Scope 2 (indirect emissions from purchase of energy), which are a major proportion of emissions for companies in the energy and resource intensive industries. However, for a vast majority of companies, these two standards represent only ~20% of their emissions, with ~80% coming from Scope 3 (indirect emissions that occur in the value chain).
Dealing with Scope 1 and Scope 2 emissions is a Herculean task in its own right, but adding Scope 3 to the mix introduces further complexity. For instance, accounting practices alone separate Scope 3 emissions into 15 distinct categories across the value chain, often requiring engagement with numerous business partners, employees and consumers. Before companies get to “solving” their emissions problem, they need to measure and track their emissions in a reliable manner.
Carbon Accounting
A 2021 study by BCG found that though 85% of organizations surveyed were concerned about their GHG emissions, only 9% were able to comprehensively quantify their emissions. On an empirical basis, the study found that companies comprehensively measuring their emissions were ~2x more likely to significantly reduce those emissions.
Beyond businesses being influenced by ESG investors and eco-conscious customers, we believe that the tailwind of regulations around the world will make carbon accounting companies pivotal in this movement. For example, the EU has launched the Corporate Sustainability Reporting Directive (CSRD) that will go beyond addressing just publicly listed companies to even small and medium enterprises by 2026.
Even though concrete regulations around Scope 3 are currently lagging, all signs point to more in-depth and comprehensive disclosure of these emissions in the medium-term.
We think that companies providing carbon accounting services will need to contain six main elements to be competitive, sustainable (longevity), differentiated, and essential to customers. These will likely be enabled by AI, and we have already seen companies bringing many different interesting use cases.
These elements will not only provide completeness of emissions data, but more importantly, actionable insights into ways to reduce emissions and track progress against targets as companies execute on their decarbonization plans. Vidavo believes the arising focus on reduction from carbon accounting is the game-changer awaiting this space.
Carbon Offsetting
Even after companies measure and reduce their GHG emissions, there are still ways to go to reach their net-zero targets. While we believe companies should aim to reduce direct emissions across their supply chains, we acknowledge that offsets can be a useful mechanism to help companies achieve net zero goals in the short-term, if done right.
Compliance credit markets have a significantly large market size at ~$680B (Refinitiv), but governments have already set up infrastructure and standards for these markets, for example through establishing emissions trading systems. Furthermore, these markets are highly susceptible to regulatory changes, and businesses operating in this space open themselves up to a high level of regulatory risk in a constantly evolving landscape.
Voluntary credit markets (VCMs), on the other hand, have a much smaller market size, reaching $1B (Refinitiv) in 2021. However, the growth in the space has been aggressive, with the potential to hit $50B in market size by 2030. With the ever-increasing number of net-zero pledges, we expect the demand for carbon credits in VCM to grow steadily in tandem.
Companies building infrastructure and support for VCMs across the value chain will enable its growth.
High quality carbon credits are a critical bottleneck and unlocking more supply is key to development in the space. As independent registries create verifiable standards around the issuance of accredited carbon credits, we think the supply of offsets through a range of different mechanisms will be pivotal to the success of decarbonization. However, the supply side (carbon capture and removal) has seen a ramp up in investments, with $882M across 11 deals in Q2 2022 — more than 2x the amount invested over the previous four quarters (according to protocol) — and even more being invested in projects that will generate carbon offsets in the future. We think there is potential for significant value accretion by businesses providing investors and corporates the ability to trade efficiently on VCMs, an area that has not seen much venture capital flow.
Investors would need to see several features in order to consider carbon an investable asset class —accessibility, liquidity and standardization being top of mind. We think firms contributing to scaling up VCMs will enable these features through:
- Trading Infrastructure — Platforms that enable listing and transactions of high-volume of vanilla and synthetic products
- Reference Contracts — Liquid and standardized contracts (spot or futures) with daily price signal will enable risk management and supplier financing
- Post-Trade Infrastructure — Clearinghouses would help with the build out of futures markets and registries would provide clear identification of credit issuance from its source project
Looking Forward
We are meeting with startups in the space, and are continuing to evolve our view as our conversations progress. That said, we believe that the current set of fragmented solutions will consolidate over time into a $100B+ industry, and the winners in the run-up to this are likely to have the following:
- Vertical integration across value chain of decarbonization
- Industry specialization
- Innovative or proprietary distribution
We are excited to help companies operating in the space grow further and would love to chat!
