Venture capital and the role of government in clean energy: Lessons from the first cleantech bubble
In its 2022 Special Report, the Intergovernmental Panel on Climate Change announced that to limit global warming to 1.5 degrees Celsius above pre-industrial levels, the world would need to invest $2.3 trillion per year in low-carbon electricity technologies alone. However, Bloomberg’s New Energy Finance estimates that only $755 billion was invested in the global energy transition sector in 2021. This funding gap is particularly acute in the early stages of innovative clean technologies (Polzin and Sanders 2020). These clean technologies, known as cleantech, aim to provide clean energy and sustainable products.
In this context, the recent rise of ‘cleantech’ venture capital (VC), a form of funding for young, high-growth companies, is encouraging. This growth in ‘green’ VC funding has two primary sources. First, the VC sector as a whole has experienced a boom. Second, investors – spurred by the climate crisis and growing public support for innovative solutions – are increasingly interested in investing in new clean technologies. In October 2021, Larry Fink, CEO of the world’s largest wealth manager, argued that the next 1,000 start-ups valued at more than $1 billion would be in clean technology (Clifford 2021).
One might wonder if this optimism is warranted. Indeed, this new wave of investment and interest in cleantech is reminiscent of the boom-and-bust cycle that occurred from 2005 to 2013 (see Figure 1). At the time, rapidly growing interest in clean energy from policymakers led to a similar boom in green investment. From 2005 to 2008, the share of VC funding for clean energy technologies more than tripled. However, clean energy start-ups have proven to be an unprofitable experiment. Less than half of the $25 billion given to cleantech start-ups from 2006 to 2011 was returned to investors (Gaddy et al. 2017). As a result, the cleantech boom collapsed as VC funding dried up.
In our recent paper (van den Heuvel and Popp 2022), we use Crunchbase data on 150,000 US start-ups active between January 2000 and May 2021 to draw novel insights from the early failures of cleantech VCs. A better understanding of exactly why initial venture capital efforts failed can help assess the likelihood of success of this second, less energy-focused, green venture capital investment wave and inform policies aimed at supporting new clean technologies.
Figure 1 Cleantech Boom and Bust
Comment: This figure shows the share of clean energy (LHS) and electric vehicles (RHS) across all VC rounds (Series A to Series J).
Reasons Behind Cleantech’s Venture Capital Failure
Studies addressing the cleantech boom and bust offer multiple explanations for the poor performance of VCs in cleantech and especially clean energy start-ups (Hargadon and Kenney 2012, Nanda et al. 2015). First, the development of new clean energy technologies is capital-intensive and slow to scale, resulting in unattractively long payback periods (Migendt et al. 2017). Second, many clean energy start-ups operate with thin margins in very competitive markets, making it difficult to achieve the revenue VCs seek. Many clean energy start-ups offer a product – renewable energy – that is difficult to distinguish from energy produced by non-renewable sources. Finally, while investing in any start-up is inherently risky, cleantech start-ups expose investors to additional risks – those arising from producing a product that is affected by volatile international markets or related to demand that is dependent on public policy to prove can unstable (Noailly et al. 2022).
Our paper examines whether these interpretations are supported by recent data. Comparing the performance of less capital-intensive digital energy start-ups (such as smart thermostats) to other firms suggests that the high capital intensity and long development time of clean energy start-ups are not the main reasons behind the lack of VC success. In fact, while less capital-intensive digital power start-ups fared better in the early stages of the cleantech bust, these start-ups eventually saw a decline in their profitability and ability to secure VC funding (see Figure 2). At the same time, biotech and electric vehicles have managed to attract investors in recent years despite being capital-intensive.
Figure 2 Venture capital’s willingness to fund energy digital start-ups has also declined
Comment: This figure displays the share of all start-ups that managed to secure Series A funding by industry, based on the year they launched. Values for energy digital start-ups launched before 2005 are not shown due to low data availability (i.e. only three to eight start-ups were funded per year).
Instead, we argue that weak demand for clean energy technologies, as a result of failed efforts at nationwide US climate policy, is the main reason for the failure of VCs in clean energy. After years of growing policy support, VC investment in cleantech peaked just as environmental regulations faced setbacks with the cap-and-trade bill in the US Congress and the failure of the disappointing Copenhagen Climate Change Conference (COP15) in 2019. We use an external Negative shocks to study the impact of changes in expectations of future climate policy support: The unexpected loss of Democrats’ filibuster-proof majority in the Senate in January 2010.
We find that weaker demand expectations significantly affected VCs’ willingness to fund clean energy start-ups, as it made marginal investment less attractive. Declining expectations of policy support led VCs to invest in fewer – but higher quality – cleantech start-ups that performed better than start-ups funded before the shock under more optimistic policy expectations.
We also confirm the second reason for Cleantech VC’s failure. We show that clean energy start-ups are significantly less likely to succeed at home than information and communication technology (ICT) or biotech ventures. Lack of network effects, low reliance on patents and low product differentiation make it difficult to keep competitors at bay and achieve high margins in clean energy. This prevents the ‘winner takes all’ market formation that makes ICT or biotech start-ups attractive.
The future of clean technology innovation and the role of government
The importance of strong demand can help us understand the second boom in cleantech VC and provide insight into which investments are more likely to succeed. First, government policies are becoming more supportive than they were in 2009 (Popp et al. 2020). In the EU, the Fit for 55 plan aims to reduce greenhouse gas emissions by 55% (compared to 1990 levels) by 2030. Although national climate policy remains elusive in the United States, many states have ambitious clean energy goals, such as California’s plan to rely on zero-emission energy sources by 2045. This increasingly supportive policy environment is driving demand for all clean technologies.
However, VC investment in clean energy will likely lag behind other cleantech sectors such as electric vehicles (EVs), as seen in Figure 1. Indeed, VCs have learned to focus on cleantech sectors with existing high demand, where using ‘clean’ technologies requires little sacrifice (The Economist 2021). Some sectors, such as electric vehicles or sustainable food (such as plant-based meat), have few barriers to mass adoption and can differentiate their products, fueling demand and improving profits. The ability of companies like Tesla to manage their brands and drive demand for their specific electric vehicles allows them to create markups unattainable in the more competitive renewable energy industry.
These attractive features have translated into several recent home run successes for Cleantech. Tesla returned 20 times the capital invested during its initial public offering (IPO) in 2010, but its valuation has grown hundreds of times. The appetite for investment in this area has been whet. Nicola Motor Company, a producer of electric trucks, returned 125 times its paid-up capital to its Series A investors in 2020 when it went public. A similar pattern has been observed in sustainable food Impossible Foods, the plant-based meat maker, is now valued at $7 billion and could go public in 2022, returning 82 times its early-stage investors.
These companies have proven that some cleantech sectors can generate outside income fueling this new cleantech boom. As a result, the second boom in VC may have better outcomes than its predecessor. However, clean energy start-ups will likely continue to struggle to attract VC funding. As more innovation in clean energy is needed to tackle climate change, governments should do more.
With this in mind, we also study the effectiveness of public investment in cleantech start-ups (Bai et al. 2021). We find that public investors have performed no worse than their private sector counterparts. However, since VC investments in clean energy perform much worse overall than in other sectors, adjusting for private sector performance in the clean energy sector is not sufficient. Without stronger demand for clean technologies, neither public nor private investors will be consistently successful when financing clean energy start-ups. By implementing continuous demand-side policies (such as a meaningful carbon tax), governments will improve the expected performance of early-stage investors, which will help reduce the financing gap in clean technologies. Only then should the government use targeted public investment to fund cleantech start-ups that will still struggle to attract private sector investment, especially because they have limited outside revenue potential.
Authors’ Note: The views and opinions expressed in this column are strictly those of the authors, and do not necessarily represent the views or opinions of The Brattle Group (“Brattle”) or any of its other employees or clients. Readers of this column should seek independent expert advice regarding any information in this article and any conclusions that may be drawn from this report. The article is in no way intended to act as a substitute for such independent expert advice.
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