Cleantech Future Threatened By Weak Venture Funding

01/19/2011 12:14 am ET | Updated May 25, 2011

NEW YORK -- The push to develop cleaner energy technologies--a widely embraced strategy for nurturing innovative new industries--is increasingly threatened by a shortage of investment, according to venture capitalists, entrepreneurs and renewable energy experts.

New technologies that can enable broader use of wind, solar, and other renewable forms of energy require billions of dollars in research and development. But potential investors are balking at the sums involved, cognizant that early-stage technologies are an especially risky bet, with the majority of start-up companies almost certainly doomed to fail.

At the same time potential American ventures are stalling, China's leaders are directing enormous political and financial support toward forging a Chinese-made clean energy future. And they are moving fast. Chinese factories churn out enormous quantities of solar cells and wind turbines. More importantly, China is investing aggressively in innovation, with spending for clean energy exceeding $51 billion last year--a 31 percent increase from 2009, and ten times the level of American governmental support.

This lopsided disparity has occasioned talk that the United States is on the cusp of a modern-day Sputnik moment. American industry has built itself on a legacy of innovation, from the advent of the automobile through the expansion of aviation and into satellite communications and the Internet. In each of these spheres, American companies and know-how have played dominant roles in pioneering technologies and developing lucrative products. But as cleantech now emerges as the next potentially enormous area of global innovation, the United States risks falling behind.

"America still has the opportunity to lead in a world that will need a new industrial revolution to give us the energy we want, inexpensively and carbon-free," said Secretary of Energy Steven Chu in a recent speech. "It's a way to secure our future prosperity. But I think time is running out."

More than bruised national pride hangs in the balance. Whoever manages to develop the technologies that will govern the energy infrastructure of the future--one likely to feature less oil and coal and more cleaner sources--stands to reap hundreds of billions of dollars in royalties.

Innovation often is advanced through costly failures. For every idea that succeeds, spawning a Google or a blockbuster biotech drug, legions of botched efforts are discarded along the way, with their outcomes furthering understanding. That process requires investors willing to tolerate huge losses--a trait so far missing among would-be backers of early stage American cleantech ventures.

Venture capitalists, the swashbucklers of finance, have tended to play a crucial role in the formation of new industries, taking on the major risks of developing unproven technologies in exchange for a slice of the potential spoils. Venture funds piggy-backed on the government's investments into the research that produced biotechnology and the Internet to create the companies that developed the products.

But in cleantech--short-hand for everything from solar power to electric vehicles to software that efficiently manages power consumption--venture capital money has not been reaching many promising areas, especially the riskiest technologies with the heaviest financial demands. A growing body of evidence suggests the traditional venture capital model may be ill-suited for many sectors of cleantech.

"These are things that overtax what the venture community is oriented to do," said Mark Muro, an expert on energy at the Brookings Institution. "There's a built-up model through Internet and IT and that leads to the expectation of significant, large, highly profitable exits fairly rapidly, but that's really a very different proposition with cleantech, where you have somewhat unproven technologies, and this high burden of infrastructure."

If private investors continue to shy away, research and development will depend upon a major contribution from the government. But despite promises of aggressive support from the Obama administration, the dollars have yet to arrive.

Some believe that the pullback in venture funding is the result of earlier over-indulgence by firms that did not understand the nature of the clean tech industry.

"Tons of money rushed in without looking at the fundamentals of the industry," said William Aulet, managing director of the Entrepreneurship Center at the Massachusetts Institute of Technology, which is keen on developing the next class of clean energy ventures. "There was an overabundance of capital that went into clean energy."

FUTURE INDUSTRIES

Clean technology innovation amounts to more than the starry-eyed ravings of laboratory eggheads. The drive to develop new technologies has been propelled by a trio of overlapping potential benefits--limiting carbon emissions, diminishing the nation's dependence on imported oil, and generating American jobs by designing and constructing a modern energy infrastructure.

Spending about a billion dollars a day, the United States consumes nearly a quarter of the world's petroleum. Imports make up about half that supply, often from states ruled by hostile governments that sometimes use the revenues to sponsor attacks on American interests.

As last summer's disastrous oil spill in the Gulf of Mexico made clear, even depending upon sources in friendlier locales poses substantial environmental risks. Burning fossil fuel is the single largest source of greenhouse gas emissions, which scientists finger for exacerbating climate change that increases the likelihood of wide-scale natural disasters.

Clean energy technologies have the potential to bring money back into America from abroad, while potentially creating millions of jobs--particularly in hard-hit areas of the Rust Belt.

But progress in clean energy may be severely constrained without substantial infusions of venture money. This is a problem that goes beyond dollars: Venture capitalists bring the forward-looking mindsets required to develop emerging industries. They are among the only people who can look at a proposal describing the way algae dredged off pond scum could someday power an office building and see opportunity rather than science fiction.

Venture capitalists are gamblers--a reality that owes to the long odds that attract them, offering massive rewards in exchange for often-lethal risks. Generally speaking, venture capitalists accept that as little as eight percent of their total investments will account for over 70 percent of their ultimate profits.

Given the odds against any one investment producing gains, venture capitalists are inclined to spread their chips across the board, investing in a great variety of projects. They can't afford to sink all or most of their capital in a few companies. As a result, venture firms have been drawn to less capital-intensive sectors, such the ever-proliferating Internet startup industry.

Venture firms are also reluctant to invest dollars without a clear sense of how they can get their money out--typically, by selling their shares at an initial public offering, or to another company. Many cleantech ventures come with great ambiguity about the exit, owing to lengthy time-frames and considerable construction costs.

Venture capital found its perfect match with the Internet. AOL, Google and Facebook could all be constructed with relatively little finance, because they required little in the way of physical infrastructure. But cleantech businesses tend to require far heavier levels of investment, both in time and in money. That has tended to frighten off venture firms, who are loath to sink too much in one place.

To be sure, serious money has been flowing into cleantech ventures. Investments reached $5.28 billion last year, up 45 percent from 2009. But these dollars have been funneled in to only certain segments of cleantech, the areas that require less capital, such as energy efficiency software, or the development of fuel cells.

Meanwhile, high-risk, capital-intensive ventures like offshore wind farms, biofuel refineries and unproven solar cell technologies have been generally starved of venture funds, say experts. Venture funds are extremely reluctant to put their dollars in these sorts of projects before companies can demonstrate the viability of their technology, not only in the laboratory, but also at commercial scale. They fear the so-called Valley of Death, that interregnum between successful prototype development and established commercial viability into which most start-ups perish.

"Stuff that comes out of the lab may be great but it's certainly not a business, it's certainly not a product," said Lawrence Murphy, of the National Renewable Energy Laboratory, a government run lab for energy research. "Getting that first plant is really a big problem."

Last year year, only eight percent of venture capital investments reached biofuels--a particularly capital intensive slice of cleantech--and four percent landed in wind, according to a report by the Cleantech Group, a research and advisory firm for clean energy investment.

"Capital intensity in energy has always been a problem with venture capital," said Dennis Costello of Braemar Energy Ventures, a venture firm with a focus in energy technology.

For a typical venture firm with perhaps $300 million to invest, some $40 million to $50 million available for each chosen start-up, and the goal of exiting successfully within a decade, cleantech investments often seem unpalatable. One solar cell manufacturer, Solyndra, has already required $970 million in venture capital in addition to $535 million in loan guarantees from the Department of Energy--this, before it has even sold its shares publicly.

Ze-Gen, another cleantech company, practices something akin to modern alchemy, turning shredded tires and metal harvested from construction waste into synthetic gas fuel. This is precisely the sort of high-reward venture that now threatens to be denied funding, given the incompatibility of the traditional venture model, argues the company's vice president of corporate development, Gideon Gradman.

"Something like Ze-Gen, where you have a true technological innovation in materials conversion, requires plants," he said. "You need power plant evolution or other energy assets that are large."

The only cleantech companies that are gaining finance relatively easily are those with limited technological difficulty and a clear path toward their projected revenues, say experts.

About half of the $500 billion in new investments in cleantech worldwide between 2007 and 2009 came from project finance--funding for long-term projects to build infrastructure, typically for proven technologies like wind turbines and solar panels. These types of financing are rarely prepared to make a billion dollar gamble for riskier technologies.

"The system as it is today is broken," says Aulet, of the MIT Entrepreneurship Center. "It needs to mutate and it will mutate. It's fundamentally flawed because it looks for capital efficient investments."

AMBIVALENT GOVERNMENT

Given the incompatibilities of the private sector, government support may be crucial for cleantech to fully develop.

Biotech and the Internet, industries that also entailed high risks and costly failure, almost certainly would not have reached fruition without considerable governmental support. Yet compared to other countries--especially China, whose breakneck growth has absorbed ever-increasing amounts of energy, putting a premium on efficiency--the United States has been half-hearted in supporting clean energy.

Lack of research of money may be the most conspicuous hindrance, but a lack of encouraging policies may be of the greatest immediate impact. Experts bemoan an unstable regulatory environment that makes it difficult for risk-averse investors to calculate the costs and anticipated revenues of cleantech ventures, making them reluctant to bet their dollars. The government has proffered incentives in the form of federal grants and loan guarantees, but many expire and must be renewed on one to two year terms, making every business subject to the changing whims of Washington--a tough proposition for investments that can take over a decade to come to fruition.

In December, anxiety spread through the clean energy community over the potential expiration of a Treasury grant program that covers up to 30 percent of the cost of alternative-energy projects. Despite partisan squabbles, the program was renewed. But don't expect nerves to settle for long or investments to make confidently as a result: The extension lasts only a year.

"The most important thing we can do is quit dilly-dallying around about whatever we're going to do in terms of legislation and make it long term," said Murphy, of the National Renewable Energy Laboratory. "Investors say, look, if the tax credit isn't sound and long-lived, don't even talk to me."

Among the biggest factors dogging clean energy ventures is the continued lack of rules mandating that American industry ratchet down its carbon emissions, say experts, adding that the adoption of such a regimen would immediately create a market for cleaner sources of energy. Last summer, Congress considered a so-called cap-and-trade system that would have limited emissions while rewarding cleaner companies with the the right to sell emission permits. But that proposal died amid tepid Democratic support, Republican opposition and the furious warning from industry that the measure would be a job-killer.

"The regulatory regime over many years has become so cumbersome," said Gradman. "The government is not willing to promote the development of new technologies at the expense of a small but vocal opposition, whereas in other countries they're willing to say, listen, this is something the nation needs to develop and we're going to do it."

But the most conspicuous lack of government support is found in the area of dollars for research and development. President Obama, who campaigned on promises to direct $150 billion toward clean energy, has yet to deliver anywhere near that.

Last year, the federal government spent about $5 billion on research and development in clean energy. By comparison, the government spent $30 billion on biomedical research. The American Energy Innovation Council-- a group of business leaders including Bill Gates that urges the government to invest in new energy technology-- calls for R&D to reach $15 billion. The Brookings Institute asks for even more--$30 billion.

"Too little public money has gone in," said William Janeway, a managing director at private equity firm Warburg Pincus. "Compared to the world of the 1960s and 1970s when the federal government accounted for more than half of all [R&D] spending."

The lack of support is particularly pressing for renewable energies because they must compete with the behemoth fossil fuel industry. Almost 86 percent of all energy used in the US in 2010 came from fossil fuels.

China's investments are striking, and they have been deployed in pursuit of notably ambitious goals.

In 2010, China overtook the United States as the largest wind power installer, and now controls almost half of the world's solar panel production. China is on track to meet nearly all its energy demands through wind power by 2030, according to researchers at Harvard and Tsinghua Universities.

"We spend just a drop in the bucket of what we could effectively use to compete quite aggressively in the world market," said Murphy. "If we don't move quickly we're going to lose out to the Chinese."

China's focus on cleantech innovation has already yielded substantial dividends. China accounts for more than two-thirds of all cleantech IPOs, according to research by the Cleantech Group, while eight of the ten of the biggest cleantech IPOs last year came out of China. In 2009, China went from fifteenth place to fifth in international patents.

Experts say it is hard to imagine the United States mobilizing to match that sort of investment, even as time slips away.

Americans are still coping with the hardships of a slow-recovering economy, making long-term energy goals seem secondary. Immediate concerns, such as avoiding layoffs in police departments and school districts facing budget cuts, can obscure the future benefits of pursuing clean energy, as well as the future dangers in failing to do so.

Indeed, some are skeptical that the United States will be able to institute the policies needed to compensate for the ambivalent support of the private sector, making the cleantech future tenuous.

"I see no prospect of that for the foreseeable future," said Janeway. "It usually takes some kind of external forcing of a crisis. It's not clear anything short of the Greenland ice cap melting will change people's minds."