How To Fund High-Impact Climate Innovations

Funding climate solutions requires an enormous amount of capital – now it feels like common knowledge, but we have to say it anyway. According to McKinsey and Bloomberg NEF, we will need over US$200 trillion in cumulative financing to power the green transition, a lot of which will go into hard assets (think physical infrastructure, vehicles, energy systems, etc.), between now and 2050 to hit net zero targets. This is nothing short of the biggest industrial transformation the planet has ever seen.

As more finance comes into the system, we need to get the types of terms of that capital right, and backing climate innovations will require new investment strategies.

First, why is funding climate solutions different?

As Mitch Gainer, partner at Yield Capital Partners says “To reduce emissions, we have to change atoms, not just bits. Although a lot of VC funding goes to software (and it should), most of the impact will come in the form of changing real industrial processes.”

Imagine this. Let’s say we have a company – GreenCementCo, which is developing a zero carbon cement formula – the cement industry accounts for roughly 8% of all global CO2 emissions. After 2 years of developing some promising research in university, they raise US $5 million in government grants for a 2-year intensive R&D exercise. They test the solution in a lab, and go on to raise another US$10 million equity investment from a mixture of specialized early-stage climate venture capital funds and angel investors. At this point, GCC is still more of an experiment than a company. Following promising lab results, GCC raises $30 million in Series A venture capital from strategic investors and corporations to construct a pilot plant, a 4-year process. Following a successful commercial pilot, they raise $150 million in venture funding to build a demonstration facility, requiring another 4 years for construction. Finally, GreenCement secures $500 million in infrastructure investment to construct its first full-scale production plant, with a 3-year timeline for completion. And even after GCC is officially in the market, it could require a decade plus to assess the long-term durability of its product.The below schematic outlines GCC’s journey.

In total, the journey from concept to market took about 15 years and nearly $700 million. To put this number in perspective, most venture capital funds operate with a 10-year timeline, most tech unicorns in the U.S. (predominantly software companies in sectors such as fintech and e-commerce) require somewhere between 5 and 8 years to reach a one billion dollar valuation, and could need 7-10 years to IPO.

Of course, not every climate tech company is trying to disrupt the cement business, and many will follow different pathways into the market. Likewise, not every dollar of climate funding will go to new companies and technologies. However, GCC’s story will be a common one – long timelines for developing and testing greener products coupled with different types of funding with varying risk appetites.

The climate tech capital stack is large, diverse and we need to rapidly build it.

What is a “capital stack”?

A “capital stack” is a way of describing different types of financial instruments that are used to fund companies and projects. In GCC’s case, it had to raise a mixture of funding from a range of different sources throughout its journey. For the past decade or so, to fund startups and new technologies (primarily software-based) we have mainly used venture capital. Yet we are quickly learning that conventional VC approaches and software business models will not be enough to build the climate solutions that we need. Many of the highest impact climate solutions are hardware and R&D intensive, requiring significant testing and piloting before they are even close to market-ready. This different pacing means that the funding instruments and strategies – AKA the capital stack – will need to evolve and expand quickly. Of course, software is and will continue to be critical to the green transition, and venture investors will be equally critical here. However, reinventing our economies will require a lot of hard asset-investing, which needs more than conventional VC funding.

Entrepreneurs, investors, and the larger climate innovation ecosystem need to understand this range of instruments.

So what does the climate tech capital stack look like?

The schematic at the top of the article provides a broad overview of what the “climate tech capital stack” could look like.

There are a couple of things to note. First, dilutive and non-dilutive funding instruments need to operate in concert. Governments, foundations, family offices, corporations, venture capital funds, angel investors, investment banks, private equity, infrastructure and project finance shops, among others, are all needed, often in parallel to one another. Each of these entities has a different vetting process, risk appetite, return expectation and timeline. Some can take on more risk – e.g. bet on an untested idea, but expect their money back in 5-7 years at a significant multiple, while others have lower return expectations but lower willingness to take on risk – e.g. need to see proof of significant revenue – while others never expect to get their money back, but require long, complex processes for accessing their funding – e.g. government funding that needs certifications and lengthy application forms. Point being, none of these groups have an identical investment strategy, yet many are necessary during a climate tech company’s lifetime.

Second, there are a range of milestones used to gauge if and when a company is ready for more funding. Fundamentally, this boils down to timing. Time needed to develop a deep-tech product; time needed for lengthy customer discovery and testing with different segments; time needed to refine and make sure the product is market ready; and time needed to set up a large enough production facility to manufacture it at scale. Each milestone achieved could lead to more funding, but the time, as well as financing, needed to reach each one can be daunting. Whereas software companies can iterate and test quickly, often climate tech companies will require lengthy trial periods that could lead to many, many years of piloting, setbacks and refining before getting even close to being market-ready.

Stefano Gurciullo, a deep-tech investor and partner at Tau Capital explains it well: “Many climate tech companies require significant upfront capital investments in physical infrastructure, testing and manufacturing facilities, and hardware components. The payback periods for these investments can be much longer than typical VC fund cycles, sometimes spanning decades. This extended time horizon necessitates a different investment approach with patient capital and longer holding periods, and often starts well before venture capital comes into the picture.”

How do we build out the climate tech capital stack, and fast?

Success hinges on new policy and funding structures as well as talent development.

While unlocking private funding will ultimately be the difference maker in filling climate finance gaps, we will need governments to incentivize the creation of new, and more diverse funds while also providing patient capital to help derisk new technologies. The public sector has enormous market-making power and can catalyze new funding structures and instruments. We already have some models to follow, at least in the US. For instance, the Department of Energy’s Loan Program Office is providing lower cost debt and grants for early-stage product development, which can help incentivize other investors to participate.

We also need new funding structures, and likely will need new asset classes. In recent years there have been criticisms that rather than creating new financing for climate projects funders have simply re-allocated capital from other areas of their budgets. In other words, we’re seeing a lot of recycling when what we really need is new funding sources. While easier said than done, developing investment vehicles and asset classes for different stages of a company’s lifecycle can help in not simply creating more funding, but incentivize other investors to follow suit. For example, groups such as Prime Coalition’s Trellis Climate are providing first loss capital to crowd in more investment. In parallel, experts such as Ally Yost have written that developing new asset classes such as “Venture Deployment”, specifically for the energy transition could unlock more funding from investors on the sidelines. Additionally, untapped resources such as corporations who specialize in deep-tech industries – e.g. energy, industrials and manufacturing – can be important sources of capital and know-how, offering a quantum of funding and type of expertise that few other investors have.

Lastly, humans themselves have to deploy the funding. Building these new structures and asset classes is in itself a technical skill set, and we will need experts across different domains of the capital stack to vet and execute transactions. We often talk about the needs for more engineers, scientists and manufacturing specialists in the climate tech space, but we also need more finance professionals that understand how to invest in different climate technologies. As Gurciullo says “We do not just need venture capital, we need more and better talent in infrastructure, project finance, venture debt, etc. We need diversity not only in instruments but also in the background of the investment managers themselves.” Just as addressing climate risks is fundamentally about protecting humanity, humans will ultimately be responsible for funding this process.