Working Together to Bridge Capital Gaps for Early Infrastructure in Climate Tech
To fight climate change, we need to accelerate climate technologies at all stages of development. But infrastructure projects built after a technology leaves the lab face a variety of capital gaps before they reach commercial acceptance. And few investors are filling them today. How do entrepreneurs experience these and other early deployment gaps, and why aren’t investors filling them? And what unique roles can catalytic capital play in “de-risking” projects to make them more attractive to a wider pool of investors?
On June 14th, Prime was honored to feature Hernan Cortes, Department Of Energy Loan Programs Office (LPO); Jennifer Holmgren, LanzaTech; Sarah Kearney, Prime Coalition; Karine Khatcherian, Closed Loop Partners; Ananth Pharshy, Prime Coalition; and Lou Schick, Clean Energy Ventures in a conversation exploring these questions. (Learn more about the event here.) Below, find a recording, takeaways, and paraphrased recap of the event.
Recording
Takeaways
Skipping steps is risky: For example, some companies may try to move from pilot projects to first of a kind commercial projects to save money or manage pressures to accelerate from venture investors. But “there are no shortcuts in science,” noted Karine in quoting earlier interviews with Jennifer. Skipping steps can significantly derail projects later down the road.
All capital is not the same ‘color’: We’ve been mismatching the color of money that goes with which development phase. For example, venture money is essentially based on the promise of 50% annual returns, noted Lou, and “if you have a 40% IRR, it’s almost inconceivable” to prioritize patience. The question is: what should venture do, and what should the others do?
On the other hand, project financing — which tends to expect lower returns at higher investment amounts — requires deeper due diligence: Due diligence includes detailed financial models, contracts, independent engineer reports, market studies, and more. Young companies aren’t always set up to meet these standards. “We have a lot of applications that come to us in the LPO that have terrific technology and have great prospects for the future but they don’t have the commercial side and financial side ready,” says Hernan. Entrepreneurs benefit from engaging a strong team of P&L/finance, marketing, and engineers early.
Catalytic capital enables, accelerates, and/or deepens impact that wouldn’t be possible without it. It absorbs “risks that finance-first investors are unable or unwilling to take on,” notes Sarah. In what ways might catalytic capital enable early deployments that might otherwise struggle or accelerate their path towards project financing? Strategic investors, government, and catalytic financing all play a role in bringing a technology to commercialization.
Investors benefit from deeply understanding the challenges entrepreneurs face in accelerating towards project financing. For example, “will entrepreneurs go through these teething pains early in anticipation of greater gains in the future?” Ananth asked. And how can we collectively help them?
Deep Dive (Discussion Summary)
See below for a shortened/paraphrased version of the transcript. Please listen to the recording for details!
Welcome
Sarah Kearney: Prime is a nonprofit that mobilizes catalytic capital to support climate solutions that could significantly reduce GHG emissions and that might struggle to raise sufficient support without us — like when the time horizon to retire technology risk is too long for finance-first investors or there’s a binary deployment risk no other investor is structurally able to take on.
Since 2014, we’ve supported companies at their earliest formation stages, but we’ve always been concerned about what happens when those same types of innovators are ready to deploy at scale. After years of hard work, we’re now seeing enough momentum in the philanthropy community to imagine addressing that later stage capital gap with catalytic capital at a meaningful scale.
In 2021, together with our philanthropic partners at Blue Haven Initiative and Schmidt Futures, Prime launched a research inquiry to more deeply characterize the capital gaps. That research is informing our work and we hope it's helpful to all of you.
Panel: The Gap, from Multiple Points of View
Karine: Jennifer, you once shared with me that we can accelerate a lot of things, but scientific process is not one of them. Your quote was “there are no shortcuts in science.” Can you walk us through the process a young company goes through, or should go through, from an idea in a lab to a solution ready deployed in hundreds of installations?
Jennifer: How do we scale a new idea? First, it needs to be optimized in the lab. Then it gets piloted. After that, it gets demonstrated in the field, with real feedstock. Then, you build the first commercial (FOAK) project. If you're doing a plant, just buying a compressor is a 12-month lead time!
At each stage, you learn more and get more data. But many people try to skip a step, like trying to go from a pilot to the first commercial project without doing a demo. In that process, you may find that there was a contaminant in your gas that you hadn't considered. So skipping that interim step may come back and bite you. The important thing to remember is that the smaller the plant, the cheaper it is. If you're going to optimize something, you don't want to do it on $100 million FOAK plant; you want to do it on a $10 million pilot.
There are many brilliant people that can accelerate financing or government support in getting a new idea into the field. But skipping steps in the deployment process isn’t one of them, and it gives disruptive process technology a bad name.
Karine: Where is it easy or hard for companies to find funding at each stage?
Jennifer: Raising cash is hard, period—no matter what stage—especially if you're doing something disruptive to articulate an idea that nobody's ever heard of. It’s hard at the early stages, and it gets harder as you get bigger. LanzaTech was founded in 2005. Although we've built a couple of commercial plants, we still haven't crossed over to where we're profitable. We raised over $500 million to get to this point. And that doesn't include the amazing government support we've gotten. That $500 million is the tip of the iceberg.
The bigger a unit gets, the more expensive it gets. Since it doesn't pay back at the demo stage, it's harder to get cash. There's two elements to crossing the valley of death for a process company, which is going to take 15-20 years to get to the first FOAK project.
Patience: Most venture capitalists 10 years ago had 10-year funds. They wanted to push you to exit at the end of 10 years. Fortunately, some of the new funds now are 20 years.
Strategic support: Many of our strategic investors—over 50%—want our technology to succeed. They know it'll take forever. They're willing to be partners to get scale.
If you can mix venture capital funding, strategic funding, and government funding, you start to get three different perspectives that will guide you. Don't think of money as money! Think of money as knowledge that's coming into your pool to guide and help you grow.
Karine: Lou, you're representing the VC investor community, but you've also coached entrepreneurs and have perspective as a growth and project finance investor. You're also my tech guru. What was the most surprising thing you learned across your journey?
Lou: As Jennifer was talking, I remembered my time at the GE Research Center at the turn of the century—(I love saying that!). GE wanted to build an identical replica of a polycarbonate plant in Cartagena that worked well in the US. It didn't get commissioned until two or three years later. At least a billion dollars was pissed away. And they invented polycarbonate! I share this because the cost of skipping steps is hard to predict. Even experts get it wrong.
One surprising thing I've learned is that terms don't have common definitions. Nobody agrees on the meaning of terms like pilot, demo, and first commercial. We don't yet agree on the fundamental language of what we’re proving at what stage or what success looks like at each stage. Even in discussing this report, we had to sit down and define what we were talking about. This is a problem in the ecosystem. I hope all of you will be learning how to talk to each other about what risks are being mitigated by what actions, how long it will take, and what you mean by that.
Karine: Lou, why are steps skipped in the first place?
Lou: We've been mismatching the color of money that goes with the development phase. You can apple polish this however you want, but venture capital is based on the promise of 40% annual returns. If an entrepreneur says: “I won't understand how that demo project impacts my first commercial plant until I've run it for two years,” the venture investor hears: “I've lost 50% of my return.”
So it becomes vital to figure out what venture should do—and what others should do. I'm delighted with how Jennifer referenced strategic partners. Can you define a scope that is venture investable? Can you define partners to help along stages of development? You may need to come up with clever ways to get liquidity for early stage investors. But at the end of the day, you need to match the money, and its risk tolerance & timescales, with the problem that you're trying to address.
Karine: While doing the research, one company said: “Our investors want us to do a demo within 12 months. I am doing a demo right now, and they want me to do a demo in 12 months that shows progress. What do they mean?” Are incentives misaligned?
Lou: Venture investors tend to talk in terms proof points: “I'll give you $1.98, and then you'll prove something. Then I can raise more money at a higher valuation, and I'd retire my first exposed risk.” It's good practice— even the longest journey begins with the first step. If we can define observable proof points, everybody can agree we’ve mitigated some risk and supported a step up in valuation. But when people are speaking different languages, you get pressure to say, “these are the three things I need to prove to raise my Series B, and I need them by next Thursday or I'm not going to satisfy my pro forma.” Satisfying your pro forma is not the same as learning technology to scale it properly. There is a mismatch with the incentives that increase a company’s valuation.
In the olden days, it was simply, “That's too risky. I'm never building anything.” I think we're past that now. But we still don't know how to build things and collaborate across stages. That this why convening different stakeholders is vital. The incentives are not vague for venture investors; they are not well matched to the risk retirement necessary for scaling large industrial facilities. That's why strategic investors are important.
Karine: While strategic investors are getting more involved, they're not necessarily investing huge amounts and it can take them 2-3 years to get a decision on a project.
Lou: It is true that strategics have long decision-making processes. We've been working on trying to get the strategics and their related stakeholders to engage drastically earlier in the process. Instead of sending your sustainability person to sit at Greentown Labs, send a P&L person. It's less about the money that they put in early than it is about the insight. We try to get strategics to the table as part of our due diligence before we fund a company. Sometimes they put in money, but mostly we want critical, insightful responses about what needs to be proven before they’re willing to move real resources. That requires the people who run the operating businesses to be involved, rather than theoreticians or R&D, because things fail when you get to regulations, labor, and safety.
Karine: Government is the third leg of the stool. Hernan, you’re the 800-pound gorilla in the conversation. How much does the government have in this space?
Hernan: I think if Build Back Better moves along, we would be an 800-pound gorilla. Right now, we're maybe a lean 400-pound gorilla! The Department of Energy traditionally has supported research and development funding through grants, and the Loan Programs Office (LPO) provides loans for commercial demonstration. The LPO has $40 billion that remains to be deployed in renewable energy, advanced fossil, nuclear, and automotive for FOAK projects. Applicants must prove that it's one of the first three US deployments of this technology.
The Office of Clean Energy Development (OCED), which is being stood up right now, has ~$20 billion to help support demonstrations. Overall, $60 billion is a drop in the bucket.
LPO
LPO can lend up to 80% of the cost of the project. The loans that we make are meant to look like a commercial loan and must have a reasonable prospect of prepayment. A demonstration project must already have been completed, and our engineers and experts must believe that it is a deployable technology with a market. We have internal resources to analyze that market and make loans even if there aren’t long-term offtake agreements. We’re trying to help demonstrate the first installation, so that the private sector will come in and do the second, third and fourth. It's important that it look like a commercial loan, so that when it's gone through its shakeout period, it's starting to repay and the risk is now behind it.
If there isn’t a reasonable prospect of repayment, we do not fund it. In many cases, the projects we fund could be supported by a bank if it was the third or tenth FOAK. But banks don't necessarily have the technology expertise or risk tolerance to be that first lender into projects. We can demonstrate it so they can come in afterwards.
I appreciate that Lou mentioned bringing in P&L folks. Applications come to us that have terrific technology, but they don't have the commercial and financial side ready (engineers or staff in marketing & finance). If we don't have a model and market proposal, it's hard to come to the conclusion that we can achieve reasonable prospect of repayment.
OCED
OCED also has a commercial outlook. It supports up to 50% of the cost of late-stage demos. They don’t have to repay. Private equity investors, philanthropists, or the sponsors have to fund the other 50%. OCED reviews, from a technical and financial perspective, the viability. But if the project is successful, it has proven itself at a late stage level so that it would be viable for, say, the LPO to do the next one as a commercial loan that expects repayment or for a private investor to make that investment. But $20 billion, is, again, a drop in the bucket.
Karine: What would be your final call to action?
Hernan: To let you know that LPO and OCED are here. This program has been quiet for years. We have incredible support behind us from the administration to carry the ball forward from what DOE has been able to do successfully for decades on the R&D side. We take that through to commercial demonstration and full commercialization. So I’m looking forward to working with many of you on new projects and technologies to solve our greenhouse gas issues.
Filling the Gaps: Potential Roles for Catalytic Capital
Ananth: For those in the audience coming at this from a for-profit, finance-first or other worldview, what unique perspective does Prime bring to this problem?
Sarah: Prime Coalition is a mission-driven nonprofit; we focus foremost on social and environmental impacts, even if we’re doing so using the mechanisms of venture capital as we have over the past ten years or today contemplating project finance.
We also work hard to foster an atmosphere that is collaborative rather than competitive. In service to our mission, we listen, support, lead, and follow, leveraging our financial and non-financial resources without pride of place. We cannot do this work without active participation from mainstream investors, and the project finance perspective that you bring, Ananth, is critically important to this work.
Ananth: Prime also brings unique experience in designing catalytic capital strategies. At a high level, what is catalytic capital?
Sarah: In our work, catalytic capital comes from impact-first asset owners like foundations, donor advised funds, corporate giving programs, family offices, high net worth individuals, or trusts that want to prioritize impact and focus on companies or projects that would struggle to raise sufficient financial support without us. Catalytic capital enables, accelerates, and/or deepens impact that wouldn’t be possible without it, by absorbing risks that finance-first investors are unable or unwilling to take on.
Ananth: What role do you see Prime playing as a bridge builder in filling these capital gaps that the report identified?
Sarah: Prime designs catalytic capital for projects that have a very high potential to reduce greenhouse gas emissions and meet our definition of additionality. In our venture practice, we ask: “does this company require support from Prime or another catalytic investor in order to achieve its climate impact potential?” If the answer is yes, then the climate solution fits our criteria of additionality for venture capital.
Today, as Prime is thinking about how we might apply catalytic capital to fill the gap facing early deployments, we’re evolving our definition of additionality to be less binary - beyond “will it or won't it be funded.” For example, I can imagine cases where early deployments might be able to receive financing, but the terms of financing would fail to protect the impact of the underlying technology. A more sophisticated definition of additionality is critical for ECI (Early Climate Infrastructure).
Ananth: So, we’re having to ask questions like ‘are entrepreneurs, even the funded ones, receiving the most accelerative capital for this particular project at this particular time’?
Sarah: Exactly! We’re asking these complicated questions about the highest and best use of this precious resource - catalytic capital-that answers only to charitable purpose rather than fund life cycles or election cycles.
Sarah: This is where you come in, Ananth! Recognizing that you’re at the very beginning of our design process, how do you foresee catalytic capital being applied?
Ananth: Given the unique value of philanthropic capital, that’s an important question. Rather than choosing one approach at the outset, we’re approaching this as an opportunity to learn by doing. Prime looks to invest catalytic capital into 2-3 demonstration or first-1-to-n of a kind projects by Q4 2023 to help Prime contemplate a more permanent program. We hope to experiment with partnerships, market segments, catalytic tools, check sizes and our own internal processes around impact assessment and additionality.
Can you elaborate on the partnerships part, given some of them may be in the audience today?
Ananth: First off, it’s gratifying to see an ecosystem forming around this problem. Whether it’s the DOE’s OCED program that Hernan referred to, NYSERDA, or private institutions. As an impact driven organization, we’re seeking partners who are aligned with us from an impact standpoint. We’re also looking for others who may be more ‘finance first”, where we can use catalytic capital to de-risk specific aspects of a project that they’re not able to handle.
Also, following up on the ‘seal of approval’ recommendation in the report, we’re building out an Investment Advisory Committee that’ll help us identify impactful projects where Prime can bring maximum additionality.
Sarah: So, the objective would be to address risks that our partners aren’t able to assume.
Ananth: Broadly speaking, we’re hoping to move technologies away from growth equity earlier in the technology life cycle, in the process crowding in cheaper project equity and longer term project finance debt into emerging climate solutions. How can we help demonstrably derisk projects faster, so entrepreneurs don’t stay reliant on venture money later than they should be?
Also, project financing tends to be very ‘hands on’. So, the big question is, will entrepreneurs go through these teething pains early in anticipation of greater gains in the future?
Ananth: In this context, Sarah, I'm also struck by the non financing challenges mentioned in the report. How are you thinking about non-investment interventions?
Sarah: Unsurprisingly, Karine found that entrepreneurs are experts in their field but understandably have a high-level understanding of project finance. This non-financial gap opens up a variety of interventions that a nonprofit like Prime could support through traditional grant programming, alongside catalytic investment programming.
But we need to be convinced about why companies or projects need nonprofit support from us. It might be that the expertise is difficult for innovators to find or access or the expense is viewed as unreasonable or low priority. Wouldn’t it be great to live in a world where early-stage project innovators could work with a nonprofit that would provide support for grant fundraising from government or private sources, do emissions or other impact assessments, or help them think through community engagement during deployment planning?
Sarah: As we wrap up, Ananth, what are your big insights in this work so far?
Ananth: First, many promising technologies are neither talked about nor receiving funding, because of unaddressed risks or because they’re generally neglected. Our job will be to ensure everyone that’s deserving from an impact standpoint gets the attention they deserve, which is core to Prime’s mission.
Second, In some ways, my job is to simply sit back and listen with an open mind to people telling me what they’re struggling with, and to bring catalytic capital to bear on a subset of those problems that meet our high conviction threshold. It’s a great place to be.