Why is it important to have technological innovation? It may seem too trivial a question to ask in the 21st century. After all, most modern people count heavily on smart phones, personal computers, microwave ovens, and internal combustion engines to organize their daily lives. Technologies, if used properly, enhance our well-being; they make previously impossible tasks possible, reduce costs of achieving them, and increase quality of goods and services. Not all technologies make the world a better place by inventing new gadgets that facilitate consumers’ life. A particular subset of them, called clean technologies, which include recycling, renewable energy, electric motors, green chemistry and so on, contributes to society by tackling environmental problems.
Among those problems, climate change is one of the biggest challenges to our planet—it’s of such a large scale that it can potentially affect every nation and many generations down the line. Most of the current methods used to mitigate the impacts of climate change are nonetheless expensive. For instance, generators need to substitute coal with natural gas as their fuels, solar panels or wind turbines need to be installed, and cars need to be electrified or the fuel economy needs to be improved. To limit the probability of catastrophe, or to stabilize the atmospheric concentrations of CO2 at a level of 550 parts per million (approximately double the CO2 level relative to preindustrial times, resulting in a temperature increase of about three degrees), the estimated costs in terms of GDP in the year 2050 could be as high as a 4 percent loss in GDP, according to the 2007 report by the Intergovernmental Panel on Climate Change. Because of this high cost, it is hard to convince everyone in the world to do their parts with the mitigation of climate change. But what if new technologies can reduce these costs? What if they can simultaneously upgrade the user experience? In this ideal case, environmental regulations may even be redundant—the private benefits will be large enough to drive firms and consumers to take actions.
Then the crucial question becomes this: where are clean technologies from? They can be born in the research units of large companies (e.g., LG Science Park in Seoul, South Korea), small enterprises (e.g., LO3, a New York startup that develops microgrids to enable local energy trading based on blockchain technology), or laboratories in universities (e.g., our Lawrence Berkeley National Laboratory). But the development of these technologies is not a self-running business—it requires a variety of lab equipment and supplies, years of labor of scientists, engineers and managers, countless experiments and meetings, and most importantly, a tremendous amount of money, paired with an appetite for risk. In 2008, cleantech investments from venture capital (VC), a type of private equity focusing on financing early-stage firms, exceeded $5 billion, although by 2013 it had dropped to $2 billion. Last year, the Department of Energy made a $6.4 billion budget request to Congress for science and energy research and development (R&D) programs.
If there is no doubt about the necessity of making progress on clean technologies, as well as the difficulty of this task, how can we improve the ways we fund clean tech R&D activities?
Why are clean technologies different?
Incentivizing innovation has been a century-long difficulty. The collaborative nature of knowledge makes it hard to capitalize on the outputs. Fortunately, there have been established approaches to overcome this difficulty, such as the patent system and government grants. Why, then, have they not been enough to support clean technologies?
First, those who sell (e.g., entrepreneurs in Silicon Valley) and pay for (e.g., customers in California) clean technologies may not be the ones who enjoy the benefit (e.g., everyone on the planet, since CO2 is a global pollutant ). The total benefit of additional clean technologies is greater than the private surplus. However, the extra social benefit is not reflected in the actual market transaction—when an electric vehicle is priced, the supplier only considers the cost of making cars, while the consumer only considers whether it’s worthwhile to purchase the vehicle given his or her own mobility needs. Not everyone considers the environment. In economics, this is called externality. Generally, an externality is said to exist when the production or consumption of a good or service has a direct impact, although not through prices, on consumption or production sets of some outside agents whose welfare may be lower or higher due to this impact. One example for negative externality is tailpipe emission: drivers pollute the air breathed in by pedestrians who are not compensated for the health damage. One example for positive externality is home landscape: your neighbors enjoy your beautiful garden view without paying you money for your labor.
Externality (even if it’s positive, as in this case) is bad, because it sends people the wrong price signals. Too little is produced by the car makers who have the viable technology and consumed by customers who are only seeking to purchase new vehicles, as something is missing from the calculation. In this case, the missing part is benefits that the public enjoys from lower climate risks (e.g., money saved from rebuilding houses destroyed by wildfires) resulting from low-carbon fuels.
One justification for environmental regulations is that they enable both parties to consider explicitly the externality associated with the transaction by including the benefits in the balance sheets, therefore making the prices match the underlying value again (including both private surplus and social benefit). Indeed, government incentives play an important role in promoting the deployment of clean technologies in reality, usually in the form of tax credits or direct subsidies. However, the government itself is faced with fiscal constraints, and most incentive programs are only temporary. It’s not quite sustainable in the long run.
Second, the process of developing and scaling up clean technologies itself exhibits different characteristics than that of other technologies. Historically, the VC market has created a successful funding model to support inventors going through the process of commercialization. A VC fund typically invests in dozens of companies in the hope that one of them would earn such a high return that it could cover the losses from the rest. Nonetheless, the model saw great failure for clean technologies during the period from 2006 to 2012. Investors lost large sums of money and eventually left the sector for other opportunities. In a 2016 study launched by Benjamin Gaddy, director of technology development at the Chicago startup accelerator Clean Energy Trust, and Varun Sivaram, the Douglas Dillon fellow at the Council on Foreign Relations, the risk-return profiles of clean technologies are compared with those of software or biomedical technologies. The authors discuss why clean technologies were not as attractive as software or biomedical technologies in VC markets, whose observations are echoed in a recent report by International Energy Agency as well as Goldman Sachs’ 2018 Sustainable Finance Innovation Forum.
The first feature they point to is the tepid demand for differentiation and quality improvement—clean technologies compete with incumbents in energy industries where a dominant product already exists and does a pretty good job. The electricity market is a good example. One does not expect to sell kilowatt hour (kWh) with very high profit margins, no matter how fancy it is. Electricity is just an intermediate input and consumers just want it to do its job—there is not much happiness that can be derived directly from it.
Another barrier is the low valuation premium in the mergers and acquisitions market—a premium for future growth that startups might receive upon exit. In reality, only in very few deals the offers from the clean technology startup buyers were high enough to achieve the targeted rates of return on the VC funds. The underlying reason is that the possible acquirers of these companies are usually utilities and powerful incumbents in energy sectors, which operate in a less dynamic environment where exit and entrance of new business does not happen very often due to historical infrastructure investment or cumulative experiences. Enjoying stable revenue from current operations, they are unlikely to be enthusiastic about increasing competitive advantages by acquiring risky startups and paying a premium for future growth prospects. Yet this situation may be changing given the recent advocates for more action after a series of natural disasters and subsequent financial distress of utilities.
Finally, “bulkiness” is a disadvantage associated with energy-related technologies—they are usually embedded in hardware that is expensive to scale. Demonstrating first-of-a-kind products and building factories to churn out units at scale will require further infusions of money to manufacturing equipment and machinery. Those illiquid, physical capitals are not what VC funds, which emphasize lean and agile business models, end up being willing to hold.
All of these factors have previously come together to make the funding and subsequent development and implementation of clean technologies difficult. However, there are potential solutions to these problems that could result, finally, in the successful implementation of clean technologies. Many of these solutions lie in the same place as the problems: the financial market and the way clean technologies are funded.
The role of finance
One possible way to close the funding gap of clean technologies is to think outside of the box and be open to alternative sources for accessing technologies. Historically about 80 percent of clean technologies were created and owned by multinationals or large national corporations, according to a study by Chatham House, a policy think tank in London, using global patent data between 1976 and 2009. Nevertheless, there are more approaches for established industrial giants to access new technologies: developing them in-house with internal funds (as is the case with the automakers), obtaining them through mergers and acquisitions (e.g., buying a startup from a VC fund), or entering into licensing deals that allow the use of the patented technology. In brief: make it, buy it, or borrow it. Recently, multi-party innovation such as an R&D alliance or ecosystem innovation, a collaboration among organizations to jointly develop and commercialize new concepts, has also become more common. These approaches differ in their requirements for up-front investment and variable cash expenses, as well as ownership of intellectual property, and thus, the lifetime incomes generated from the R&D capital vary as well. Depending on their needs and expectations about future markets, large corporations in fact have many degrees of freedom to choose their preferred ways to get the technology delivered.
There are also multiple ways that entrepreneurs can finance their R&D projects. If VC is not the right one, then they just need to find the right type of investor who can tolerate their particular risk-return profiles. The aforementioned 2016 study, for example, suggests that substitutes for VC funds could be government grants, angel investors (an affluent individual who provides capital for a start-up, usually with philanthropic intents) or institutional investors like pension funds, sovereign wealth funds, and family offices, which are set up to wait for decades to realize returns.
Another way to attract investments is to improve risk management using financial tools. Risk is a long-standing subject in finance, and the market has developed ways to deal with it. For instance, call options are used to protect airline companies against oil price surges. These financial tools exist primarily because different people in the market have different beliefs about the future and they are willing to trade their bets. The usage of these instruments in a research and development context is relatively new, but if uncertainty is the main concern, then traditional instruments that were created for this purpose should be useful. In a 2017 paper, Sharing R&D Risk in Healthcare via FDA Hedges, a group of researchers from the University of Chicago, MIT, and University of Minnesota analyze how new and simple financial instruments, Food and Drug Administration (FDA) hedges, enable medical R&D investors to better share the pipeline risk associated with FDA approval with broader capital markets. They conclude that FDA hedges could effectively spread the risks and ultimately spur medical innovation if they are allowed to be traded in a market. This suggests a similar method could work for financing the research and development of clean technologies, since it works in medical innovation.
Finally, environmental policies could play an important role in boosting investors’ confidence by stabilizing the expected cash flows associated with clean technology projects. In a simplified case, the investor would compare the total amount of money they need to pay to the total future cash flows they can receive (both discounted to present value). If the latter is greater, then it’s profitable to invest in the project. Unlike fiscal incentives, such as tax credits or subsidies, a wide range of environmental policies may not directly provide funds to clean technology innovation or change the costs of doing it. However, they can strengthen investors’ confidence in the prospects of R&D projects and thus make these investors more willing to provide funding. Indeed, the Chatham House’s study finds that the timing of booms in clean technology patent registry coincided with the global wave of renewable energy policies in the 1990s.
While researchers have contemplated ways to incentivize innovation for decades and practitioners have come up with creative ways to facilitate flows of funds, financing clean technology R&D is still an unresolved problem. Clean technologies have distinct characteristics in terms of externality, engineering nature, and organization of the industries they are used in, and therefore require new ways of ensuring sufficient investments, which can be inspired by both long-existed and nascent financial theories and practices.
 CO2 is mixed uniformly in the atmosphere and affects all places.
 They allow the company to purchase a stock or commodity at a specific price within a certain date range. This means that airline companies are able to hedge against rising fuel prices by buying the right to purchase oil in the future at a price that is agreed on today.
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