Proposals aiming to boost innovative climate change solutions often include some form of publicly-supported global venture capital (VC) fund. The rationale for such a fund is that government funding is generally available for R&D and private financing is available for the commercialization of mature technologies; but funding is unavailable for entrepreneurial activities—such as proof-of-concept, piloting, firm-building, and marketing—that happen between these two stages. Given this situation, a global climate change VC fund could have a decidedly stimulating effect. Of course, it would also be important for governments not to put all their eggs in this basket, since the VC instrument could quickly reach its limits.
The financing gap is particularly severe for climate change mitigation and adaptation technologies for a number of reasons. Not only is the market for these technologies still at a very early stage of development but it is also driven by regulation. Both of these factors represent significant risks for investors. In addition, low carbon technologies tend to be more capital-intensive and require much more start-up financing than other typical VC investment sectors like information technology. The funding gap is particularly deep in the developing world, which presents a riskier business environment and a more fragmented market for investors.
Several VC-style climate-change funds have recently been launched. The Carbon Trust, established by the British government, already invests in clean-technology firms based in the UK. In partnership with the Qatar Investment Authority, the Carbon Trust plans to set up a £250 million fund called the Qatar-UK Clean Technology Investment Fund, to be supported by both governments. The fund will primarily invest in the UK, but also to some extent in continental Europe and the Gulf Region. This will be the first major publicly-supported climate change VC fund of its size involving more than one country.
Philanthropic organizations are also trying to provide venture capital for developing countries, although most of these fall short of the technology-intensive, high-margin Silicon Valley definition of VC. An example is the Acumen Fund, a non-profit that raises capital from private foundations and provides small amounts of equity and loans for innovative early-stage energy, water, and agriculture projects in developing countries.
This is a good time to scale up such initiatives. With the global recession, the opportunity cost of capital is low, making it easier to invest in innovative projects with long-term returns. Venture capitalists do not typically expect a return for about five to ten years—the time it takes to raise capital and grow companies before selling them. Investing in start-ups adapted to tomorrow’s low-carbon economy would be a more sustainable way of creating jobs than building life-support systems for yesterday’s behemoths.
Now is also a good time for the public sector to step in, since private capital remains scarce. Global VC investments in clean technology were down 44 percent in the second quarter of 2009 compared to the same period in 2008.
But, as I said earlier, focusing excessively on venture capital to boost climate-smart innovation could quickly reach its limits. First of all, in many clean technology sectors, the problem in recent years has not been inadequate venture capital, but the lack of VC-ready firms with proven technologies to invest in. I read in an October 2008 Deutsche Bank white paper that venture capitalists were unable to deploy more than 73 percent of capital available in the clean technology sector in 2006.
A number of middle-income countries with government-funded VC funds have found that there are simply not enough VC-ready investments—too few early-stage firms with promising climate change mitigation and adaptation technologies. Neither the public nor private sectors have traditionally been interested in investing in small-scale seed capital for early-stage firms. Public support for seed-funding, through partnerships with private investors or through matching grants could thus complement venture capital. But in many developing countries, a narrow focus on boosting financing would have limited effects. Often, research institutions, the source of most R&D in developing countries, have a poor track record or little interest in spinning out technologies, and business environment barriers discourage entrepreneurship. These issues would need to be tackled in parallel with financing.
A second challenge a global VC fund would face is finding private sector co-investors (or at least a VC management team) in developing countries. Given the riskiness of investing in startups, private sector venture capitalists generally limit their investments to breakthrough innovations with extremely high potential rates of return. Most breakthrough innovations still occur in rich countries. And private sector co-investors would have few incentives to invest in countries where there is no mature stock market in which to sell their investments. But local private sector partners are essential. Venture capitalists typically bring in-depth knowledge of technology and markets, and a network of possible business partners, clients, suppliers and sources of finance for their investments. They are often themselves serial entrepreneurs who can provide valuable advice.
Finally, while VC might be useful for products that can be bought and sold on the market—say new types of photovoltaic panels or new satellite-based remote sensing systems for water management—it would not be very useful for the types of innovations that need to occur for climate change adaptation in the public sector. Public sectors in all countries will need to find radically new approaches to forest management, urban planning, coastal protection and disaster relief. All of these are very context-specific and will require some level of local innovation. Moreover, they depend on the technological capacity of public agencies, research institutions and individual entrepreneurs, as well as on skills in the workforce, and less on the types of breakthrough innovations that can be spurred by VC.
In sum, a global VC fund could accelerate climate-smart innovation in rich countries and in some rapidly-emerging middle-income economies with an existing critical mass of technology-based firms, such as China and India. A better financing option for most developing country entrepreneurs would be seed capital for incremental innovation, following the Acumen Fund’s model, although we are yet to see if this model is scalable. For adaptation, on the other hand, innovation might be better spurred with funding for capacity building in the public and research sectors.