by David L. Levy

When most people think about clean energy, solar and wind are the first things that spring to mind. Markets for these renewable energy sources have exhibited rapid growth of about 25-30% annually, and these sectors have attracted the lion’s share of venture capital funding and investor interest. They also tend to dominate the various Exchange Traded Funds (ETFs) that track clean energy. Yet the clean energy economy extends far beyond renewable energy technologies, including everything from power controls and storage, carbon software and trading, and energy efficiency. In transportation, while auto companies chase expensive dreams of electric cars, more economically viable opportunities lie in mass transit, bicycles, and innovative car rental services such as Zipcar. Clean energy is also generating a vast range of engineering, professional, and financial services. The transition to a clean energy economy will therefore change the employment landscape (see Green Jobs Booming and Training the “Green and White” Collar Workforce). At the same time, it’s creating new investment opportunities to rival electronics and biotech. The best investment opportunities are the unsung heroes that lie in the more cloistered parts of the evolving cleantech economy.

There are two core principles involved in understanding which green sectors have the most potential and which are overhyped. The first is that successful investing requires better insights than the average market investor. Share prices for many cleantech companies already reflect the expectation of rapid growth – companies (or sectors) have to outperform these expectations to generate significant returns. Second, the market is not rational – the efficient market thesis does not hold. This means that share prices do not accurately reflect all the information out there. To complicate matters, these two principles are somewhat contradictory: What is the point of better knowledge, if the market is arbitrary?

Well, the market is not completely arbitrary – to some degree, it’s Predictably Irrational, to use the title of Dan Ariely’s book. Investors exhibit herd behavior, leading to macro market distortions – share prices (and P/E ratios) can expand in frothy bubbles or become mired in gloom, with prices detached from underlying profits and cash flows. There are similar distortions at the sector and individual company level. When a new sector is fashionable, investors pile in, the media provides glossy rationalizations, and even policymakers can jump to support the ‘next big thing’. Many investors don’t care about underlying value and try to ride these waves of momentum, but this market-timing strategy requires nerves of steel and considerable luck.

Eventually, reality catches up and capital move on. Interest in fuel cell powered vehicles, for example, has collapsed while biofuels are on the wane. But distinguishing ‘reality’ from conventional wisdom is a considerable challenge, even within the expert community. Ford and GM’s disastrous experiments with electric vehicles in the 1980s and 1990s created a firm belief in the US auto industry there was no future for electric vehicles of any kind, even hybrids. The institutionalization of this view led US car manufacturers to scoff at the prospect of Toyota and Honda introducing hybrids (HEVs) in the late 1990s, and now the hobbled US companies trail far behind (see my 2002 paper on the auto industry and climate change). Similarly, the failure of concentrating solar thermal pioneer Luz in 1991 put the sector in the freezer for over a decade. For HEVs,  the technologies were premature for commercialization, but CST suffered from capricious public policy and the association with low-tech solar hot water (hard to patent the technology) in comparison with high-tech solar PV.   

Tom Konrad, of AltEnergyStocks.com fame, recently presented a model clean energy investment portfolio that tries to identify undervalued sectors with the best prospects. It is notable for the absence of solar, and the dominance of efficiency, transportation, and electric grid.

In fact, the portfolio substantially diverges from the current market cap of various clean tech sectors given in a BofA Merrill Lynch Global Research report. Solar and wind dominate the pie chart, with each having about one-third of the total market cap. Popular clean energy ETFs are similarly overweighted  in solar and wind.

Konrad assesses each sector in terms of several criteria:
1. How big a role will this sector play in our energy future?
2. How large is the market cap of current firms in the sector?
3. Is the industry likely to be disrupted by new entrants and technologies?
4. Are there underlying enabling technologies that will benefit from the sector’s growth, or constraints that will hold it back?

By these criteria, wind and solar PV are poor investments because although they can play major roles in our clean energy future, they already have large market caps – the growth expectations are already “baked in”. Wind at larger scale is constrained by the lack (and cost and planning issues) of long distance transmission. Even worse for solar PV, the sector is at risk from technological disruption and new entrants, particularly from concentrating solar thermal (CST) or new variants of solar PV.

Konrad identifies transmission, smart grid, and storage as the key enabling technologies for the clean energy infrastructure, which have been somewhat overlooked but now seem ready to catch a wave of investor attention. Despite the recent success of lithium ion battery producer A123’s IPO, Konrad is pessimistic about plug-in vehicles due to their cost and inherent limitations of the technology, leaving automotive batteries highly vulnerable to disruptive innovation (also see John Petersen on this).

Konrad’s basic approach is very sound, especially for those who prefer a sectoral approach to the risks of individual stocks. It provides a useful framework for discussing particular technologies. For example, I would favor CST as a sub-sector because of its prospects to scale up at reasonable cost, the lower technological risk compared with PV, and the prospects for integrating thermal storage (also see this on SolarReserve). The offshore wind sector could also benefit from the $125 billion plan to build up to 25 GW of capacity, for which initial contracts were announced in early January.

I’m less sanguine than Konrad about the prospects for mass transit and high-speed rail, at least in the US, as it requires a level of governmental investment and coordination that seems unlikely in the current financial and political context. I fully concur regarding the outlook for efficiency. A McKinsey report points to the economic attractiveness of efficiency investments and a vast market potential of over $500 billion in the US over the next decade. Pike Research recently issued a report supporting a positive outlook, projecting that the Energy Service Company (ESCO) business in the US would increase from $5.6 billion in 2009 to nearly $20 billion by 2020. Utility demand side management programs are a major stimulus for this growth. The Pike Research report also noted opportunities at the intersection of energy efficiency and information/communications technology.

Although this is not the place for a discussion of particular stocks and mutual funds, it’s worth noting that investing in efficiency tends to be tougher than other sectors, because there are few public pure-play companies or dedicated ETFs. On the one hand, there are many small privately held companies, and on the other, some very large industrial companies for whom energy control systems and services are a relatively minor part of their business, such as Honeywell International and Siemens. The situation is similar with clean energy related professional services and software. Pike Research estimates that the market for carbon software management and services was a modest $380 million global market in 2009, but is poised for growth of more than 40% a year. This neglected part of the clean energy market has a few small players, but is increasingly dominated by the large accounting, management consulting, and enterprise software companies.

The urgency of Daniel Goldman’s proposal to create a The Clean Energy Accelerator Corp. (see previous post) is reinforced by an article in the Financial Times today,  Cash Crunch Could Stain Clean Technology. Richard Waters writes that:

The lack of capital, however, is preventing many companies in the alternative energy world from reaching the scale at which they claim they can start to drive down unit costs of production to a level that could eventually make them competitive with traditional sources of energy.

Even companies that have been able to find a market – often due to government subsidies or other mandates that guarantee them a market, in spite of a lack of direct cost competitiveness – are struggling because of the lack of capital.

Though venture capital investments in clean tech have been picking up recently, “traditional project finance markets are still largely closed, and the public equity markets….remain closed to companies that have yet to prove long-term viability.”

Government fiscal stimulus funds have significant sums for environmental goals, but the problem is that current government funding mechanisms are inadequate, temporary, and somewhat arbitrary. The investments required for a transition to a low-carbon economy amount to several hundred billion dollars a year over a more than a decade – far beyond the timescale and scope of current government projects. The proposed energy legislation in the US envisages a revolving clean energy loan fund of just $30 million, and that is being fought bitterly.

The FT article points to one company left on the sidelines:

Quallion, a private maker of cells for advanced batteries, was one of those passed over this month as the US government announced plans for $2.4bn in support for battery makers – one of the first signs that green stimulus money is finally starting to flow.

Quallion had sought $220m to build a factory for truck and car batteries, but must now contend instead with better-financed rivals that have been given a leg-up by the taxpayer.

“When someone comes along and slaps down $300m for a new factory for my competitor, that changes the dynamics of the market,” says Paul Beach, Quallion’s general counsel and head of business development.

The structure of the proposed The Clean Energy Accelerator Corp. would help leverage private capital to generate a larger investment pool and ensure its independence from political pressures, allowing it to focus on more commercial and scientific project criteria.

This guest contribution is by Daniel Goldman, Executive Vice President & Chief Financial Officer of GreatPoint Energy and co-founder of the early stage investment group, Clean Energy Venture Group. He has managed and invested over $4bn in energy technologies and projects and is a vocal advocate of financial solutions for overcoming technology commercialization challenges.

Commercialization of new low/zero carbon energy technologies is essential to addressing job creation, climate change, energy independence, economic competitiveness and long-term energy affordability. Historically, public sector dollars and venture capital investments have funded promising clean energy technologies from laboratory through demonstration scale deployment (i.e., in commercial-like conditions but not at the size necessary for economic commercial operation). Private equity and project finance debt capital markets have historically funded projects and manufacturing facilities once commercially proven.  However, neither government, venture capital firms nor capital markets have tended to bear the risks associated with providing equity capital, which can amount to hundreds of millions of dollars, for initial deployment of capital intensive new clean energy technologies at commercial scale – described here as “first project commercialization”

Courtesy of Paul Maeder, Highland Capital Management

Consequently, many promising clean energy technologies that have been proven at pilot or demonstration size are unable to secure financing for commercial scale deployment.  Examples include utility-scale concentrated solar projects, geothermal technologies, biomass and fossil advanced gasification with carbon capture and sequestration, cellulosic ethanol, other biofuels and clean energy manufacturing facilities (e.g. new wind turbine blade manufacturing).  Proving out such technologies at commercial scale would enable deployment of multiple, large-scale facilities, financed by existing market participants (equity and debt), leading to hundreds of billions of dollars of investment, a material and more rapid impact on climate change, and ability to address other essential policy goals such as energy security, job creation and global economic competitiveness.  Two examples of “shovel ready” technologies on the cusp of commercialization are shown below:

As one solution to this oft-recognized problem, often termed the “commercialization valley of death,” the federal government should establish a new corporation, proposed here as the “Clean Energy Accelerator Corp.”, or “CEAC”, as an agency of the US government on the model of the Overseas Private Investment Corporation (OPIC).  Just as OPIC successfully provides support for the creation of privately-owned and managed investment funds in response to the critical shortfall of private equity capital in developing countries, CEAC would support the creation of domestically-oriented, privately-owned and managed investment funds focused on providing critical equity capital that is otherwise unavailable for first project commercialization. Just as the impact of OPIC’s support of funds that invest in emerging market companies has a multiplier effect (attracting additional investment and financing in companies), so too would the CEAC’s support have a multiplier effect in the following ways:

• Attracting additional private capital to commercialization of clean energy technologies;
• Accelerating the deployment of clean energy technologies and promoting a large market opportunity for follow-on funding; and
• Addressing policy objectives, such as job creation, global economic competitiveness, climate change, economic development, re-tooling of the supply chain infrastructure and energy affordability.

CEAC would provide support for privately-managed funds in a manner similar to the approach of OPIC, which typically provides debt (10-12 year maturities) to funds and also earns a profit participation component; these low-cost loans provided by CEAC, which are backed by the full faith and credit of the US Government, are sold to US eligible institutional investors.  CEAC’s participation in multiple private sector funds, where a minimum of $5 billion could be deployed, would rapidly catalyze private sector investment.  Moreover, like OPIC, the CEAC would establish pre-defined “scoring criteria” for each fund so that Office of Management and Budget could readily ensure that appropriate reserves are maintained based on the risk profile inherent in the portfolio of projects.  Characteristics of the CEAC should include:

• Transparent investment criteria and an independent board that would include appropriate agency secretaries and other senior government officials as well as representatives from the private financial, technology and energy policy communities;
• Management stability, flexibility, agility and experience overcoming traditional federal agency obstacles and enabling effective fund management of complex financial transactions leading to rapid deployment and commercialization;
• Financially self-sustaining as returns on investments revolve to allow for continuing re-investment;
• Ability to accelerate and scale capital formation by mitigating risks facing investors in the deployment of clean energy technologies and increasing the amount and rate of private capital deployed in a time frame that is consequential;
• Use of a proven fund model with funds managed by highly qualified investment managers having a proven track record in equity investing and possessing deep sector expertise, private sector institutional/corporate investors providing equity, and governance over project investments enabling rational exit and liquidation strategies to be implemented; and
• Leverage historical precedent which indicates that the United States has customarily availed its balance sheet for long-term multi-generational national priorities.

A significant number of projects have been identified which would be appropriate for investment by privately managed funds leading to commitments of several billion dollars in a short time frame and providing an immediate springboard for implementation. The CEAC would address a distinct problem within the DOE loan guarantee program (Section 1703), which attempts to ensure pre-commercial projects with innovative technologies have access to private sector debt but leaves the challenge of attracting equity capital unresolved.

With the nation hungry for clean energy solutions and a large number of VC-funded technologies needing help to get through the commercialization bottleneck, the time is now for bold, intelligent and targeted government action to spur the private capital sector to invest in first commercial projects using the existing and successful OPIC model.  While the OPIC model appears to offer the best analogy, other options, such as the Small Business Administration’s SBIC loan structure could also be considered.

The CEAC concept, which has been widely vetted within the investment community and clean energy industry, has received strong support and will naturally attract a broad coalition of interested constituencies including venture capital funds, private equity/project finance market participants, environmental advocates, economic policy makers, industrial, commercial and retail consumers and national security policy makers.  Prominent members of the finance and clean energy technology community are committed to supporting policy makers to make this idea a reality through existing mandates or in new legislation as energy and climate change bills are introduced.