PDI: Climate Solutions Require Supportive Investment Structures

A recent article by Nathaniel Bullard on Bloomberg.com noted that heady valuations and investor fear of missing out, coupled with the need to fund planetary-scale innovation has provided a tailwind for climate tech. During the first half of 2021, about $16 billion of funding was invested across carbon, consumer, energy, food and water, industrial, and mobility sectors with a climate tech purpose. This amount represented as much as all 2020 funding and is not far behind 2018’s total of $17.9 billion.

As Bullard alluded to at the end of his post, despite the positive headlines, high return expectations typical of venture capital and private equity investors could compromise portfolio companies’ abilities to effectively deliver strong results, both in terms of financial performance and positive impacts. Moreover, so many investors competing for the same investment opportunities with high-return potential can drive up valuations — some companies may end up overvalued, while other well-deserving companies who have slower growth trajectories may see no capital at all.

It is also critical to consider the time horizons of the funds investing into these companies. Investing in climate-related sectors often takes lengthy periods of time. In climate tech, some technologies may take years to develop before the generate any revenue or profits. In infrastructure development — for instance wind, solar, and other investments with significant land take — critical environmental and social risks need to be thoroughly assessed and planned for prior to construction. Stakeholder engagement, biodiversity assessments and management, and other activities are quite nuanced and far from simple check-the-box exercises. They require time and resources that may go well beyond what the project developer originally modelled for, thus having the potential to put a drag on the IRR. Projects can take approximately 7 to 8 years, particularly in frontier markets like Latin America and Sub-Saharan Africa, to reach Commercial Operations Date (COD) due to all the activities needed in the development and construction phases. Asset owners and allocators need to recognize that high return expectations from these projects can put pressure on private equity managers and their developers to cut corners and conduct environmental and social impact assessments as check-the-box exercises. Therefore, investment funds with a short-term scope could suffer an incoherent fate when investing in climate related companies that aim to solve long-term issues.

Fortunately, venture capital and private equity investors are starting to realize this and consider longer-dated funds. An example in venture capital is Breakthrough Energy Ventures. There are numerous examples of infrastructure investors adopting longer dated funds and permanent capital vehicles, as well. But even if funds deploy capital with a long-term lens, high return expectations — perhaps even higher to compensate for the long-term risk investors would be taking — might result in overlooking potentially strong investment opportunities and creating misaligned incentives for companies and project developers when it comes to managing ESG issues.

In order for the private sector to be part of the concerted efforts to make the systemic changes needed to fight the dire consequences of climate change, financing for these companies and projects must be structured in a sustainable way. The immediate need to solve climate issues does not mean rushing investments without a thorough long-term assessment and the proper toolkit to invest sustainably. Speed of action should not be interpreted as speed of analysis or capital deployment; as Napoleon said: “Dress me slowly that I´m in a hurry”.