Morgan Stanley IM: The Ghost of Climate 1.0

Some very smart investors are focused on finding, funding, and scaling companies that can really move the needle on climate impact. And the good news is that there is an outbreak of innovation in climate solutions—turning fish scales into plastic alternatives, capturing carbon from the air, submerging servers in liquid to cool them, or gene editing bananas to prevent them from browning easily. These are just a few examples of the plethora of solutions capturing our collective imagination and there is something very compelling about their potential to address major climate problems.

And yet, it is worth paying attention to history.

The last big wave of clean tech and renewables investing that began in the late 1990s and lasted about a decade is what is now known as Climate 1.0. It became a boom and then a bust.

Having witnessed the nadir of Climate 1.0 about 15 years ago, the Team saw firsthand how many bold and compelling solutions didn't survive sustained contact with the reality of growth equity investing. At the end of that era, we saw many business models that were not fully fleshed out, that didn't have enough commercial traction, that were overhyped and raised capital at unrealistic valuations, or couldn’t raise follow on rounds of capital and eventually died.

What followed was a long period in the 2010s known as the climate winter. During this time, we stuck to our belief that climate investing was, if anything, even more important when capital was scarce. We were able to invest in some very strong climate businesses that resulted in some exceptional exits. Being right is a small consolation when you're in the minority and it was gratifying to see the return of mainstream investors into the climate space in the early 2020s. We believe the quantum of capital being deployed in climate is nowhere near what is needed to solve the problem. A total of $7.3 trillion of climate finance is required annually by 2050 to achieve Net Zero, and yet funding only passed $1 trillion for the first time in 2022.¹ This trend of investors coming back into climate investing is a very positive one.

However, there appears to be some degree of amnesia that's set in, and the crucial lessons of Climate 1.0 are being ignored or forgotten.

Here are the five important lessons we learned from Climate 1.0 that are worth reminding ourselves of:

1. No science projects: There is no shortage of very compelling technology that looks promising at the pilot stage, but the journey to commercial scale can be fraught with setbacks. It may require going back to the drawing board to refine the technology, substitute materials, change the manufacturing process, or rejig the supply chain. There is value in backing these companies, but they require patient capital ideally from a visionary entity with a very long time horizon like a government department or charitable foundation. These may succeed someday, but not within the time frame of a commercial investor with a closed-end fund. An example from history is solar cells. In 1990, the price of solar panels were ~$8 per watt.² The attempts to commercialize solar photovoltaics were met with little success – the price of generating one watt was simply too high to  be competitive with non-renewable alternatives. However, by 2010, this price had come down ~90% to ~$0.9 per watt and commercial and residential solar started to gain serious traction.³ Along the journey, scores of investors lost their capital in these investments. This doesn't mean solar cells were a bad procurement, it just means at that stage it was a wrong investment for that type of commercial capital.
2. Venture is not infra: Hard climate problems sometimes require solutions that are very capital intensive. While a software company can, quite comfortably, be backed by equity all the way to profitability, most hard-to-abate sectors tend to be capital intensive. Producing regular cement needs long-term sources of funds to cover capital expenditures ranging from 10 million euros for a cement packing plant to several hundred million for a complete production cycle.⁴ Making green cement (i.e., cement created without releasing carbon emissions into the atmosphere) from green hydrogen and using carbon capture solutions roughly doubles the cost of production.⁵ A company will typically seek funding for 3-4 plants to get to commercial scale. This is a high capital expenditure for the newer technology to gain traction to oust the tried and tested but more polluting regular cement technology. Climate 1.0 was littered with investments that failed because successful investors from the dot com era tried to replicate their equity-backed scaling strategies in businesses that required large amounts of non-dilutive funding (i.e. debt) to get anywhere close to profitability. Unfortunately, we also see that fact pattern repeating itself in the current climate cycle where very compelling climate products are struggling to get any funding beyond the pilot phase.
3. Subsidies are not a solid foundation: Economics 101 tells us that subsidies, tariffs, and tax benefits are all forms of distortion of true economic impact. Good underwriting should be focused on whether a business is fundamentally competitive in a zero-subsidy world. This is when the true value of the product or service can be assessed: does it save money, reduce production time, limit the amount of resources consumed, etc. If it wins on one or more of those dimensions, then the company has a claim to long term non-distorted demand. While subsidies can provide a temporary boost to a company, it is worth remembering that they can be fickle. In 2012, the Spanish government controversially cut subsidy payments for renewable energy production without notice. Investing with a focus on the true economic value also reduces the amount of regulatory risk anxiety associated with any investment. Take energy efficiency software as an example— we believe that we shouldn’t invest because we think buyers will need the product to comply with carbon footprint legislation; we invest because the company’s clients can see that saving energy is saving money.
4. Carbon prices are not yet a stable revenue stream: Having a clear CO2 savings calculation is a must. This is how you know the company’s product or service is moving the needle. However, don’t bank on monetizing those carbon savings. A business should have compelling unit economics on a purely standalone basis. Income from carbon credits, when they come, could have the benefit of providing upside to underwriting. However, we continue to wait for that Global Carbon Market, something that has been promised since the Kyoto Protocol. As of today, there are 36 emissions trading systems (and a further 22 under development or construction) with varying levels of size, quality and transparency. If we include carbon taxes and government crediting mechanisms, then that increases the overall carbon pricing instruments to 110.⁶ Prices vary widely from less than $1 per tonne to over $2,500 per tonne for the highest quality credits, but a true commercial carbon market still eludes us.⁷
5. Consumers can be fickle: Green brands can have a lot of momentum, until they don’t. While there is a long-term trend of consuming in a more sustainable way, particularly among the Millennial and Gen Z cohorts, we think that a green promise needs to be combined with other value propositions.⁸ Otherwise, they are subject to fads as many businesses from Climate 1.0 show. Take the recent bankruptcy of Renewcell as an example. Renewcell developed a technology to take cotton textile waste and extract cellulose to make new textile fibres. Environmentalists and leading fashion brands initially supported the venture, hopeful that Renewcell could be an answer to a significant sustainability problem. However, sourcing the feedstock (clothing) proved resource-intensive and led to costly sourcing methods. At the same time, virgin cellulosic fibres faced low cyclical pricing just as Renewcell began to enter the market time and the price for the Circulose was above market realities for virgin products. Eventually, Renewcell succumbed to what many green businesses have found; customers are willing to pay a premium for sustainability, until they aren’t.⁹

Forgetting the lessons of Climate 1.0 is at our own peril. It is vital that climate investing attracts more capital, by an exponential factor, to fund businesses that can help alleviate the climate crisis. But this momentum will be halted and even reversed if practitioners forget any of the above lessons resulting in high profile mistakes. The world cannot afford another climate winter so let’s stay focused on the investing part of climate investing.