Dry powder, favorable policies, and rising consumer demand - who will take advantage of the clean energy tailwinds?
The short answer is climate tech entrepreneurs capturing a niche market with good unit economics, strong pipelines, and low-cost capital stacks.
Climate tech venture capital finished strong in 2022. It delivered $70.1B of investment, 30% of total VC investments (Source).
After equity capital, debt follows for many climate tech startups with capital-intensive hardware to fuel their growth. The largest supply of that debt comes from private lenders (outside of the capital markets and the banking system). The private debt market has grown four times over the last decade (Source). Dry powder (the amount available to invest) in these funds is over $140b. This part of the capital stack is mostly sector-agnostic and yield-focused. It is structured based on the borrower’s specific cash flows and business characteristics, particularly relevant during volatile times (Source).
Society is demanding clean energy and voting in decision-makers to make it happen worldwide. Most consumers (80%) indicated they care about using renewable energy (Source). Government and regulatory policies (e.g., the $555 billion funding package in the USA’s Inflation Reduction Act) are formalizing the move to clean and sustainable energy sources.
These favorable macroeconomic ingredients will only improve as more clean energy assets come online. While market conditions are always changing, there seems to be a recession-proof moment happening within climate-tech businesses.
Who can take advantage of these tailwinds?
Large infrastructure companies with high fixed costs need to go after big projects. They have capital and resources and operate in a highly specialized, localized, competitive market segment with established players. However, they are not nimble and have invested too much in their current business models to take many risks.
Climate-tech startups don’t have the luxury of large balance sheets and income. Instead, they have domain expertise, deep insights, and the ability to take outsized bets on disruptive technologies. They can only survive and grow by efficiently transforming their innovations into new business (and industry) models. Easier said than done. Over the past few years, in engaging hundreds of startups, we have seen three common attributes that enabled successful business models: strong unit economics, scalable pipelines, and low-cost capital stacks.
First thing first: good unit economics. Without them, businesses must be on investors' life support - gone are the days when investors looked for growth at any cost. Especially for hardware companies, scaling deployment with poor economics will only pass muster if investors put a bigger weight on revenues. There are always some exceptions. Investors can be forgiving of high cash burn (and may even encourage it!) as long as it comes with the right (read: exceptionally high, greater than 70%-80%) operating margins at the unit level.
After creating strong unit economics and reaching “product-market fit,” it is essential for startups to focus on deploying their technology at scale. Building a scalable pipeline results from focusing on a niche market. The narrower the beachhead market profile is, the more scalable the business becomes. This might be an antithesis of most VC-backed startups, but after all, “the riches are in the niches.”
Once basic economics have been proven out through field testing and commercial pilots, there is an established pathway for capturing the tailwinds for startups:
- Build a quality pipeline of projects based on attractive commercial terms
- Raise project equity capital
- Close pipeline contracts
- Secure debt to maximize returns to equity
- Scale up for profitability
We will dive deeper into each of these areas in future posts.