There's highly correlated risk in ClimateTech funds, and only one thing to do about it

The world (and LPs) need optimistic VCs, but they’ll have to do their part to make climate-focused funds pay off... and the place to do that work is in DC

ClimateTech funds are popping up like crazy - every time you turn around there’s a new raise. That’s great - it’s been a long time coming and reflects global recognition of the size of the challenge. Still, I’d argue that many VCs and LPs are being way too optimistic, and way too complacent about the biggest correlated risk in their funds, and it’s entirely within their hands to do something about that risk. In short, the products that most climatetech companies are producing do not have much (if any) inherent value. They seem like they ought to have value, and there’s lots of test cases & pilots that show something awesome can be done at price X. But for products that will thrive in a world of carbon scarcity to be worth anything or scale, carbon emissions have to be scarce. Returns are not made out of ought to have value. No company can make emissions scarce. Only government can do that, so investors and founders better get on that, quick.

Let’s start by observing that venture capitalists are not pessimists. Neither are most investors, but VCs and LPs who fund them have a special optimistic gene. VCs forge tight relationships with founders and “go to war” with them. Together they envision the future that those founders will create, and help with more than just providing capital. In many cases they pitch in with setting strategy, introducing partners & potential mergers, hiring, finding additional funders, and supporting the team through the challenges of hyper growth.

They manage to do all this while willfully ignoring that most individual companies will fail to produce much, if any, return. In most portfolios the median investment will be an abject failure. But the winners produce such outsize returns that the median investment doesn’t matter. Even if the value of most companies goes to zero it’ll be a rounding error in comparison with a truly successful company with network economics, economics of scale, or any other ‘winner-take-most’ model. LPs invest with VCs in the hopes of getting in early to the next Google. And new markets & products are thought up every day.

On the other hand, the specter of climate change (not to mention what’s happening here & now) can provoke severe pessimism. The sense that there’s little we can do and warming is already ‘baked in’ has led to the coining of the phrase “climate doomerism” and social scientists and climate activists are hard at work combatting this doomerism1.

But VCs & LPs who invest in Climatetech are optimists, no different than anyone else in early stage investing. Maybe more so. After languishing for many years as an afterthought, VCs now see the potential financial returns to decarbonizing the world’s economy and, in many cases, feel a personal responsibility to do so. As Dave Kenney at VertueLab put it succinctly, “It sounds so dramatic to say it, but we literally have to solve these problems or we die.”2 That’s optimism right there - look for the opportunity amidst the horrible challenges we face.

It’s just not low profile investors who are going to help us not die. Bijan Sabet is stepping back3 from Spark Capital to “invest in seed and Series A rounds with a focus on supporting founders pursuing the challenge of climate change.” Chris Sacca & Clay Dumas of Lowercase Capital fame have raised $800m4 for Lowercarbon Capital to “unfuck the planet”, alongside their “more traditional” VC fund. Breakthrough Energy Ventures is 100% focused, and on and on. Heck, there’s even a substack devoted solely to covering and documenting the VCs which are focused in ClimateTech.

It’s a truism that you shouldn’t invest behind a behavior change that you hope will happen. VCs are willing to see a little further beyond the horizon than many investors. Even so, most VC investments are in the category of “people already want to buy mousetraps, I’ll invest in a company that builds better mousetraps, and these mousetraps are special because with each additional one that they sell the ones that are out there perform a little bit better, so the incentive for the marginal consumer to buy one of Mousetrap Corp’s fancy dancy mousetraps gets better over time, so we will own most of the market.” Even Facebook was an investment that built on the core concept of, yes, the old mimeographed college ‘freshman facebook’. But carbon isn’t scarce today, and emissions regulation is definitely a political hot potato to judge by the CEPP as part of today’s $3.5T reconciliation bill.

Last week Ed Smith covered the Mr. Burns test (put simply: “Don’t invest in anything which requires carbon emissions to be expensive / scarce / regulated because you never know when it’ll come”) and how it’s rapidly becoming the Survivor Test (put simply: “Have a plan for how you will survive between now and when those specific emissions in your sector/market/geography eventually get expensive / scarce / regulated, because when they do you will absolutely clean up.”).

So if the Mr. Burns test is becoming the Survivor test, and capital is rushing into the space… Why are so many VCs investing behind a thesis that decarbonization will happen when it seems like government is doing everything but address the problem? It seems like a gamble that runs counter to generations of investment advice. I’d posit that enough of these investors (a) are personally financially comfortable, (b) don’t want to envision a world in which we fail to reduce emissions, and (c) get the math on just how much money will be made if & when carbon becomes scarce. On (c) I’ll remind you of the rough math from The Bigger Short that if we get to anywhere near the regulatory cost of carbon required to reduce emissions, it could be 5% of global annual product or, I dunno, maybe 50% of global annual profits? So yeah, that’s a lot of money5 to make a bet. There’s a huge unit TAM6 in reducing carbon emissions or building a more resilient world - at this point no one will be surprised by that. Turning it into a $ TAM and SAM will require governments to finally act. If the startups getting funded today pass the Survivor Test, then they’ll make it through the period when it seems obvious that they should make money but they don’t have an obvious way to get paid.

Are the returns far more correlated within ClimateTech pools than they are in most SaaS / D2C / biotech VC funds?

So perhaps the psychology of ClimateTech is actually more like that of most VC funds than it appeared at first blush. The median investment won’t work out, but the few that do will create insane returns. But the question I’d pose is this - are the returns far more correlated within ClimateTech pools than they are in most SaaS / D2C / biotech VC funds? Meaning - is the core risk / reward mechanism just the timing and degree of carbon scarcity / regulation / price? Will any companies in these funds be worth anything if the world doesn’t get its act together and act to directly mandate cutting carbon emissions? Can any of these really be breakouts with enormous valuations without regulation7? Depending on the answer to these questions, the LPs in these funds better have strong stomachs and motivations beyond “VC returns”. As far as I’ve heard, these funds are not being raised with expectations for a different return profile8.

And… I’d argue the single biggest thing they could do for their returns is to begin to exert political pressure to make emissions expensive / scarce / regulated. Sure, working with individual founders is going to be a big important deal, eventually, once carbon is actually scarce. And figuring out how these companies will thrive in a world once carbon is scarce (try for starters to define carbon competitive advantage & carbon network economics & carbon scale economics) is going to be key. But none of that will matter if the world & the US government don’t get around to creating the market9.

It’s never a good look to be a free rider and assume someone else will make your portfolio valuable.

Beyond the biggest, most VCs & LPs don’t spend a lot of time in DC or thinking about changing regulation10. But as ClimateTech has become more mainstream, and as more and more LPs are taking bets on carbon scarcity… they’ll want to and need to do their part to achieve that scarcity11. Early stage investors have rarely banded together to drive changes to benefit all of them - they’re stereotypically looking for private information & private advantage. If VC is looking for companies that solve big problems, then that problem (emissions leading to global warming) can’t be solved within any firm, no matter how visionary the founder. No founder can make carbon emissions scarce or valuable12.

So calling on their congressperson to drive regulation that lifts all ClimateTech investments may not be on yesterday’s to-do-list for most early stage investors. But I’d bet it’ll be on tomorrow’s - and it can’t come soon enough for LPs or for the planet13. It’s never a good look to be a free rider and assume someone else will make your portfolio valuable.

1

Some people like climate super-scientist Michael Mann think doomerism may be as much a threat now as climate denial. He has also said that fossil fuel companies may be changing their tactics from denial to delay via doomerism.

2

https://www.geekwire.com/2021/can-innovate-way-climate-crisis-venture-capitalists-sound-off-saving-earth/

3

The world is full of “I’ve done well, now I’m going to focus on something else” letters. We should all be lucky enough to write one someday. I thought Bijan’s was thoughtful, and the early days of Spark must have been really fun.

4

https://techcrunch.com/2021/08/12/chris-saccas-lowercarbon-capital-has-raised-800-million-to-keep-unfcking-the-planet/

5

Frankly, this period makes me think of the bay area in the mid ‘90s. It brings back thoughts of .com 1.0 where recent college grads (like me) said things at parties like “if I could get a 1% market share of all pet food, that’d be worth billions!”.

6

TAM is Total Addressable Market, and SAM is Strategically Addressable Market. You probably know this if you’re reading along, but I hate it when I’m reading something and I have to look up acronyms, and there’s a number of people who read this from different backgrounds.

7

If you’re sitting there saying “yes, my Climatetech company X will achieve a $1B valuation even if carbon emissions continue unmanaged but for consumer preference changes”, I’d love to hear about that company.

8

There have been some very clever funds which have been raised with different return time horizons, and some which have leveraged philanthropic money to do so as a form of impact investment. The Prime Impact Fund is one great example of a clever alignment of investors and the investment thesis.

9

Every week there’s another headline about how much money governments of various nations could save if they took action X. This week’s was that South Africa could save $6.6B (a meaningful amount in the context of SA GDP) by shuttering it’s coal plants early and speeding the renewable roll-out. The economics of renewables are becoming more and more obvious and compelling. Every week it’s a different plan and a different geography but the story is the same. So why don’t these plans become reality sooner? Because these utilities are not “the country” - they are institutions with people who have jobs, and those utilities and those people have political power. Even if the world would be better off, it’s not clear that those individual companies would be better off financially, so they find ways to delay / avoid closing. It’s going to take organized political will to knock these incumbents out, even if the economics and benefits are compelling. We need rules about emissions and highly emitting things which make the right outcomes obvious & necessary, not studies to say all the great things that would happen if only we made different choices. Seems like most VCs I know would find this obvious.

10

I should point out that the Bill Gates-backed Breakthrough Energy Ventures does a significant amount of lobbying, with good reason. They get this. They’re the exception that proves the rule, and the pattern that I hope gets replicated. Chris Sacca spends a fair bit of time on DC. I’m not trying to say no one does this. But the industry as a whole does not and has not.

11

For new readers, we need rules that reduce and eliminate emissions. A carbon price, a clean electricity payment plan, fuel standards, robust building codes, incentives for home & commercial real estate electrification. If you want to know what the end result might look like, one extremely good example is Saul Griffith’s Electrify. But we need to work backwards to the policies which get us there and get us there on time. It’s not a train for which we can afford to be late. Markets are failing and have failed, because carbon emissions are an externality. There are books written about this. But in short, we need rules which specifically and strictly address carbon emissions and restrict and reduce them, because those are the problem. There is nothing else that is the problem (well there are lots of other problems in the world, but there is no other root cause of climate change).

12

Or, I should say, if you meet this founder & firm who can make carbon emissions scarce nationally or globally, call me. I’ve got a few friends who would put some serious coin into the.

13

And please please don’t imagine I’m saying anyone should not invest in these climate tech funds or that they shouldn’t go “long carbon”. They should. The returns will be insane - assuming we make carbon scarce. I’m doing it. And it’s the single most important project in the world (eg, curing cancer or fixing housing may very well pale in comparison to the destruction wrought in 2100 if we remain on our current trajectory). I am saying that there’s a responsibility to investing in this arena - a responsibility to make sure that you earn those crazy returns by fighting for carbon emissions scarcity. And if it makes you feel better, you can tell yourself it’s a purely selfish motivation based on the returns you’ll make - or not make - depending on the speed of regulation and how strict it is.