Funding solutions for the climate crisis
A framework for investing in climate tech
By: Sam Smith-Eppsteiner, Carrie von Muench, Josh Rapperport
Building companies that make a dent in the climate crisis is a problem unparalleled in both scope and opportunity. We believe tackling climate change means re-imagining our relationship with the physical world that sustains us and all life: how we feed a growing population, how we power the world with clean energy, how we travel, how we build our homes and machines, how we protect and manage natural resources, and so much more.
Earlier this month, we shared our ‘why now’ for investing in climate tech and a broad framework for thinking about the space. Here, we will examine the framework we shared to highlight some of the areas where we see opportunities for entrepreneurs to build impactful solutions.
We hope sharing our thinking is helpful on your climate journey, and we hope to hear from you soon!
A foreword: Incentives
The first step toward driving emissions reduction at scale is having stakeholders — corporate emitters, shareholders, governments, and consumers — care to reduce emissions.
This may sound trivial, but incentive structures are at the heart of why solving climate change is so hard. Historically, organizations have often been able to pollute for free (or have even been subsidized to do so). Absent meaningful financial incentives to decarbonize, organizations have often perceived climate action as in conflict with obligations to shareholders. As a result, despite 40+ years of warnings from the scientific community, the problem remains far from solved.
Today, incentive structures are shifting in exciting ways that increasingly (if imperfectly!) align commitments to shareholders with commitments to the planet. First, governments across the world are taking action in exciting ways. Most recently, the landmark Inflation Reduction Act in the U.S. allocates $369B over 10 years in ways that could cut US carbon emissions by up to 42% from 2005 levels by 2030 and provide an incredible tailwind for climate startups. Second, the private sector is starting to shift in exciting ways as well. Investors are starting to see dirtier as riskier for myriad reasons. For one thing, consumers, especially younger ones, really care about buying cleaner products, making climate action a key to competitive advantage for many companies. We’ve seen incredibly impactful companies arise by building products that are not just cleaner but also better (cue Tesla as a resounding success).
As a result of all these factors, there’s unprecedented capital available to build new businesses tackling climate change and unprecedented opportunity for those who succeed — which is good because there’s a lot of work to be done!
A framework for climate tech
We see the work that needs to be done in a few ways, as depicted below.
First and foremost, we have to reduce emissions by finding ways to produce the goods and services we all depend on without harmful climate impact. Second, we need to remove carbon dioxide from the atmosphere at scale. Third, we need to invest in climate resilience and adaptation to ensure that a growing population can continue to thrive even on a warming planet. And relatedly, we need to invest in sustainability more broadly to preserve and regenerate our most valuable resources, such as biodiversity and water.
To get this work done, we will need to set ambitious climate targets and establish transparent GHG accounting mechanisms. We’ll also need carbon markets to finance carbon removal and incentivize emissions reduction.
Digging into the work
⛳️ Target Setting and Carbon Accounting
Slowly, these incentive changes are adding up, and today’s incumbent companies are increasingly feeling the heat. Corporate climate commitments have rapidly moved to the mainstream.
Now, companies representing more than one-third of global market capitalization have set emissions reduction targets approved by the Science-Based Targets initiative (SBTi), and many others have made some form of commitment to net zero. In parallel, new regulations are increasingly requiring carbon emissions and climate risk disclosures. As a result, we’re seeing companies widely adopt tools to account for emissions, build strategies for decarbonizing operations, and create offsetting portfolios.
With Watershed reaching unicorn status, lots — and lots and lots — of companies are popping up to meet this need.
Some things we’re excited to see entrepreneurs tackle:
- More accurate accounting solutions for complex value chains: Many of the highest emitting industries have long and complex value chains, making scope 3 emissions (or those in their supply chain) a huge part of their footprint. Tackling this problem effectively requires unprecedented visibility into these long value chains, a problem that technology is well-positioned to solve. We’re particularly interested in companies whose accuracy improves with time and does so scalably (e.g. through a product rather than a service).
- Vertical-specific solutions: Generic approaches often sacrifice accuracy, and we are seeing many companies arise to much more precisely meet needs in specific verticals (eg. food, real estate, etc). We’re particularly interested in companies that find ways to go beyond just accounting and capture more value in their verticals of focus.
🔋 Emissions Reduction
Per the chart below, staying within 2°C is largely driven by finding ways to produce the goods and services we rely on with minimal carbon emissions (also referred to as emissions reduction or decarbonization). Net negative emissions work — or carbon removal — is also an essential piece of the puzzle, but decarbonizing our economy is by far our most important lever for tackling climate change.
Figure S.1 from Negative Emissions Technologies and Reliable Sequestration (2019)
To do this, we’ll need to 1) electrify current systems that are powered by fossil fuels, 2) decarbonize our electricity (e.g. move from burning natural gas to renewable power generation), and 3) adopt more carbon-efficient products and services. To operationalize these goals, we like to think of decarbonization as work on both the ‘supply’ and ‘demand’ side of the global economy. Electrification (1) and greening the grid (2) are on the supply side, whereas adopting more efficient stuff (3) would be demand-side. For example, one way to reduce emissions in transportation is to electrify cars and power the grid with clean energy — that’s the supply. Another way would be to develop and roll out better, faster, more accessible public transit so that fewer people own and drive private vehicles — that’s the demand.
Both sides of the equation need powerful solutions. To contextualize the size of the opportunity, estimates indicate it will cost $50 trillion to decarbonize the US economy; for reference, the US spent $750 billion on enterprise software last year.
To understand how diverse the problem set is and identify the most impactful opportunities here, it’s worth looking at where emissions come from. What we found most striking about the chart below is just how much global emissions (~73%) are driven by energy. Of course, that energy is used across a broad set of application areas. But digging into the data has underscored for us how important the ‘supply’ side of the equation is. Furthermore, the EIA estimates a 50% increase in global energy use by 2050.
Climate Watch, the World Resources Institute (2020)
The good news for decarbonization is that existing technologies provide amazing reduction opportunities & potential — as highlighted in the IPCC Working Group III, Mitigation of Climate Change Report (summary chart below), published in April. We need both to innovate and to accelerate the rollout of the most promising options (i.e., let’s deploy solar & wind asap).
Figure SMP.7 from IPCC Working Group III, Mitigation of Climate Change Report (2022)
Some things we’re excited to see entrepreneurs tackle (given the breadth of decarbonization work, we’ll name only a small portion of ideas we’re excited about):
- Critical mineral supply and battery lifecycles: Electrification will rely on significant increases in supplies of minerals like copper, nickel, lithium, and manganese to produce the batteries, solar cells, wind turbines, and electrolyzers needed to decarbonize our economy. Managing EV battery lifecycles — think assessing state of health, repurposing, and recycling — and mining more sustainably (e.g., our portfolio company Plotlogic) will therefore be critical to meeting our goals.
- Accelerating the rollout of home and building electrification solutions: Decarbonizing buildings, which are roughly half of all end energy use, will require massive deployment of electric systems like heat pumps, electric hot water heaters, induction stoves, and advanced electrical panels.
- Grid optimization and energy management: As vast amounts of new distributed energy resources (DERs) come online, the grid is going from a centralized, one-way flow of electrons and information to a decentralized, intermittent, two-way network with millions of nodes. Technologies that help solve forecasting, asset optimization, peak shaving, and connectivity of consumer data are needed.
- Expanding the scope of foods and materials that can be produced bio-renewably: So much of the world that surrounds us comes from oil or animal feedstocks; to put this in perspective, industrial chemistry accounts for 14% of the world’s GHG emissions. And the production of meat accounts for 60% of GHG emissions in food. While these markets contain tough economics for startups, we are excited to see new tools emerge that make it easier and cheaper to scale bio-based products.
🌡 Emissions Removal
Our atmosphere is incredible. Relatively no thicker than the wax on an apple, it provides conditions for staggering complexity and abundance. But human activity is changing that chemistry. One way to think about the problem is a stock and flow model: there are roughly 1.6 trillion tons of CO2 in the atmosphere (the stock); every year, we add another 40 billion, and natural land and ocean sinking processes leave us with roughly a 4 billion increase every year (the flow).
Therefore reducing the annual 40 billion tons of carbon emitted from human activity to 0 as soon as possible should be our first priority. But, lowering the existing stock is also imperative. We cannot avoid dangerous warming unless we draw down carbon, and a lot of it: 6–10 billion tons per year by 2050. So by carbon removal, we are referring to negative emissions — anything that sucks carbon out of the air.
There are a wide variety of emissions removal methods out there (we highly recommend this primer for those interested). Some are highly permanent but expensive or challenging to scale, like direct air capture. Some are more straightforward to scale but less permanent, like soil carbon. Of course, many things contribute to scalability (e.g. cost, land use, material requirements, etc.), so please consider the below graphic a directional overview only. Regardless, we’re seeing unprecedented amounts of funding and momentum in the space (e.g. Climeworks’ CHF 600M fundraise and advance market commitments) and believe diverse solutions will be essential.
Some things we’re excited to see entrepreneurs tackle:
- Finding creative ways to scale the development of nature-based carbon removal: We imagine that developing carbon projects could meaningfully increase the value of some undeveloped land and create new revenue streams for existing landowners and maybe even new real asset classes for institutional investors. While the processes for sourcing, accrediting, developing, and monitoring projects today are often too burdensome or opaque for would-be developers, we imagine technology could help change that.
- Finding creative new insurance or financing solutions for project development: To date, the main barrier to deploying carbon removal solutions has been the lack of a business case. While this is most fundamentally addressed by carbon markets (below), other forms of financing and insurance can also help, especially for higher-CAPEX solutions.
⚖️ Carbon Markets
Demand for emissions removal is driven by the incentive shifts we discussed at the beginning. Carbon markets are instruments through which that demand gets fulfilled — so, without carbon markets, emissions removal does not get funded. Of course, carbon markets have far-reaching implications beyond just funding emissions removal; for example, studies estimate that the E.U. ETS reduced CO2 emissions by more than 1B tons between 2008 and 2016 alone. Therefore, we believe that flourishing carbon markets are essential for the fight against climate change. At the highest level, carbon markets exist in two categories: voluntary and compliance.
Compliance carbon markets most often take the shape of a cap-and-trade scheme, in which companies obtain permits to emit greenhouse gases from the government and are required to pay if they emit more than their permitted amount. This is an oversimplification, as different compliance markets have different rules and regulations for emitters (e.g. California’s cap and trade program allows for limited offset use) — but you get the idea. Over $800B worth of emissions permits were traded last year alone, with 90% of that value traded in Europe and European prices around $80–100 / Ton.
Voluntary carbon markets are driven by companies choosing to buy carbon offsets. This means paying others to reduce emissions (or remove carbon dioxide from the atmosphere) on their behalf. For example, an airline may offset, or compensate for, emissions from air travel by paying others to plant trees that sequester a similar amount of carbon. Often, these purchases are made in pursuit of a net-zero target. There are a few things to highlight about voluntary carbon markets and offsets in general:
- The market is small, but rapidly growing: Voluntary markets are much smaller than compliance markets, with market size estimates of around $1B. Nevertheless, we are seeing meaningful growth here, with market size estimates for 2030 ranging from $5B to $100B+.
- At their best, offset markets have great potential: Offset markets are instruments for financing permanent carbon removal, a critical tool for combating climate change. Also, offset markets hold the potential to identify and deploy low-cost climate solutions that might have otherwise been overlooked, protect nature, and deliver meaningful co-benefits to local communities.
- However, they have been fraught with controversy: To understand this, we need only look at the types of offsets that companies have been buying. The average price per ton of carbon for offsets purchased last year was $3.13; to put that in perspective, at this price, it would cost $50 per person per year to decarbonize the whole U.S. This cost is clearly too low. Further, many offset projects (e.g. up to 80% of California’s forest offsets) have failed to actually reduce carbon emissions. To understand why, let’s take the example of a timber company that sells carbon offsets in exchange for a promise not to harvest trees on a certain parcel of land for a certain amount of time, e.g. 100 years. If that firm or another one meets demand by logging more on some other parcel, then that program hasn’t actually achieved a real emissions reduction — this is called leakage. Or maybe that timber company wasn’t planning to harvest those trees anyway and is just getting paid to maintain the status quo — meaning the carbon sequestered wasn’t additional. Or maybe those trees burn down in a wildfire — meaning the carbon wasn’t sequestered permanently. There are many ways in which a given offset project can fail to deliver the promised climate benefits.
- As a result, the use of offsets for net-zero targets is controversial: For example, SBTi’s net-zero standard requires that no more than 5–10% of emissions be offset by high-quality removals. And yet, for many, offsets remain an important tool for driving immediate climate impact — and we need all the immediate climate impact we can get.
We are hopeful that governments will continue to expand and improve compliance markets and that improved standards, heightened scrutiny, and accurate monitoring of voluntary offsets will scale capacity to finance high-quality carbon removal.
Some things we’re excited to see entrepreneurs tackle:
- Insetting (where carbon markets meet decarbonization): “Insetting”, also known as financing emissions reductions in one’s own supply chain, is gaining momentum (for those interested, we recommend this helpful overview). For example, food companies might incentivize their farmers to transition to regenerative practices, thereby reducing the carbon emissions associated with their products. We are excited to see more tools and platforms emerge to help diverse industries do this at scale.
🏗 Climate Risk, Resilience, and Adaptation
While climate change mitigation — through both decarbonization and emission removal — is clearly our most important task, we cannot ignore the environmental changes and human suffering of today that will only be accelerated in the next few decades. We have already observed increases in the frequency and intensity of climate and weather extremes, with impacts on human health, ecosystems, infrastructure, livelihoods, and our food system. Experts estimate that the value at stake from climate-induced hazards could rise from about 2% of global GDP today to more than 4% in 2050, and the UN Secretary-General has stated that 50% of all climate finance should be earmarked for adaptation.
As a result, it’s imperative that we better understand the risk climate change poses to our economy and society and invest in resiliency where possible (e.g., drought- and salt-resistant crops, wildfire detection & avoidance). This is why we invested in FutureProof: the team is building insurance products that incorporate the changing physical risk climate change poses to properties. The past is no longer predictive of the future, so new tooling is needed.
Some things we’re excited to see entrepreneurs tackle:
- New to world insurance products: Insurance has traditionally been an engine for risk pricing and transfer; additionally, when done well, insurance can also mitigate risk (e.g. by incentivizing preventative measures) and assist with rapid recovery. Rolling this out at scale will require new products and pricing instruments that new technology can help bring to life.
- Tools to enable better investment decisions: Examples include tools to manage the many risks to real estate portfolios, tools for cities to plan and manage infrastructure projects (shout-out to our portfolio company Replica), and more.
- Investing in remediation: As pressures on our natural resources become ever more intense, it is ever more important that we find ways to remove contaminants and restore ecosystems following extractive activity. Additionally, these remediation efforts also often add to carbon removal (e.g., wetland restoration).
Closing thoughts
We are committed to investing in companies that will enable humans and ecosystems to thrive on a healthy planet. Doing so will require the audacious work of transforming industries rooted in the physical world — but we know it can be done. Over the last decade, we have had the privilege of backing incredible founders building transformative businesses in these spaces. To name a few: Planet enables earth observation, Blue River Technology reduces the chemicals required for agriculture, Afresh minimizes food waste, and Plotlogic makes mining more sustainable.
And yet, we’re barely getting started. The next decade will be defining for climate change. Luckily, as Bill Gates pointed out, we always underestimate what human ingenuity and hustle can achieve in ten years. But there’s no time to waste, so if you’re building a business to help sustain our planet, please reach out. We would love to hear from you!
