The story of climate risk capital currently has a major gap

Venture capital investment in climate solutions appears to have weathered the storm and is slowly starting to revive.

That’s encouraging for sustainability entrepreneurs, especially now that I’m hearing from many of them that they’re stressed about the difficult prospects of raising new capital over the next 12 months. Uncertainty surrounding the US election, growing anti-ESG sentiment in the financial world, and unclear macroeconomic indicators (soft landing or recession?) continue to keep many venture capital and growth equity investors sitting back and waiting rather than actively writing checks.

Some good news has come in the form of recent market data. For example, Pitchbook recently released its Q1 Clean Energy Report , which did indeed show a decline in venture capital investment in the sector in 2023 and 1Q24, but it certainly wasn’t a collapse. CTVC’s excellent newsletter showed that early-stage investment (from seed to Series B) increased from 2H23 to 1H24 (although of course down from 1H23). And there’s reason to expect further growth and recovery as the Inflation Reduction Act dollars finally start to make their way to market in the form of actual deployments — Rhodium Group and MIT CEEPR recently showed how much overall clean energy investment (outside of venture capital itself) has been steadily increasing over the past few years.

And while the U.S. election this year adds to the uncertainty in the market, I expect that regardless of the outcome, we will see continued growth in investment capital and rollouts in 2025. After all, such investments have been growing well during the Trump presidency, even before the Inflation Reduction Act. And while there is legitimate concern that major parts of IRAs could be phased out under Trump, there are already signs that there really isn’t much political appetite to repeal major parts of the law. After all, (shocking, I know…) taking away incentive programs is never popular with the political donor class. So, while some IRA rules could be reversed, and the U.S. election results could certainly have a significant impact on rate investment growth, we can still expect investors to respond to ANY election results by getting out their checks again and getting to work. At least at some level.

That’s all encouraging if your goal is for venture and growth dollars to flow more easily into the sector over the next year. But right now, there’s a major gap in the history of climate solutions venture capital: exits.

If venture and growth investors aren’t making a profit, they won’t continue to invest capital in the sector in the long term. It’s that simple. And the two main ways they make a profit are when the companies they’ve invested in go public (rarely) or are bought by larger companies. Sometimes there’s a “secondary sale” of their shares while the company remains private, but that’s not the dominant form of exit.

IPOs have been hard to come by for startups in ALL sectors since the capital market reforms of the mid-2000s. And especially for startups in the sustainability space, which were, frankly, rarely ready (as in: large and growing revenues, with obvious and predictable profitability) for an IPO. There were a few years in the past when the SPAC wave created a window for “early IPOs,” but that window has closed, and the performance of de-SPACed clean energy companies has been largely unimpressive.

“Trade sale” or acquisition by larger firms has always been the dominant exit mode across all startup sectors. But what’s troubling is that the Pitchbook report linked above shows that they haven’t been very accessible to VC and growth investors and their portfolio companies. The “VC Exit Activity in Clean Energy” chart in that report shows that exits have fallen precipitously in 1Q24.

This fits into a general frustrating theme that I’ve seen in the clean energy sector. Many of the startups that are backed by venture capital and growth in this space are technology developers, not project implementers. They are technology innovators, not “putting steel in the ground.” Who is going to buy companies that are technology innovators in these industrial markets? The buyer group for some types of industrial innovations is typically very limited. For example, in the case of efficient lighting, it’s essentially an oligopsony of lighting incumbents. In automotive, the universe of large companies is small and getting smaller. In energy equipment, it’s again a small universe of large incumbents. And what’s worse, unlike in IT, these large incumbents are typically slow and reluctant to spend a lot of money on an acquisition. Over the years, I’ve personally learned how painful it is to invest in really great startups in these sectors, spend years watching great entrepreneurs build products with proven value and growing revenues, and yet not pay a premium for them when it comes time to acquire the company.

To put it bluntly, the natural set of buyers for these innovations quite often sucks. At least from an entrepreneurial perspective.

Yet the vast majority of venture and growth investors in climate solutions still see the sector primarily as a hard-tech innovation sector. Some focus on software innovation more than hardware innovation. But few focus on deployment-style business models, like project developers. Because, of course, what is “proprietary” (i.e., unique) about what such companies bring to the table?

At my firm, which focuses on working with relatively early adopters in sustainability (those that actually put steel in the ground), we’ve seen a few exits over the last few years… but where the buyers were larger infrastructure investors. Not larger, entrenched hardware OEMs, but project finance companies that wanted access to hundreds of millions in project pipelines and proven management teams with proven solutions. These weren’t the “sexy” sectors that are at the top of most clean energy venture and growth investors’ lists, but instead in more “boring” sectors like municipal composting and industrial wastewater treatment. These were companies that had successfully implemented projects and had a long pipeline of signed projects ahead of them. And we’re not alone — if you look back at the limited history of successful exits in the climate space, a disproportionately large number of them were downstream business model innovators, not hard technology innovators. And quite often they were sold to even larger implementers, not industrial OEMs.

The good news is that these large infrastructure investors have a lot of dry powder right now and are desperate to find deals, which means they’ll be motivated to invest more capital in 2025, which hopefully could mean more of this kind of acquisition activity. The bad news is that so many venture and growth capital investors aren’t investing in the types of businesses these infrastructure buyers will be looking for. And while hopefully acquisition activity by more tech-oriented incumbent OEMs will pick up steam after the election, that’s not a given. And who knows when the IPO windows will open and close.

Exit activity has almost always been a big hole in the history of climate and growth investment. I fear that such investors continue to expose themselves to the vagaries of unpredictable and/or unattractive exit paths. I hope not, but at least it is something to be very aware of.