Updated: Oct 17, 2020
Jeff Thiel and James Kempf
We are not yet reducing global greenhouse gas emissions fast enough to avert catastrophic levels of global warming. That’s a grim and undisputable fact. It’s also an opportunity for savvy investors. We have the technology now to ensure a livable world for future generations, and investing in that technology will be good for our economy and our health too. The transition to a zero net carbon economy will require a tremendous amount of innovation – new inventions, products, services, and business models. Decarbonization represents the greatest economic transformation since the discovery of oil or the invention of the computer. Businesses that lead this transformation will thrive, while laggards will perform poorly.
It makes sense then that investing in decarbonization should provide patient, disciplined investors with tremendous opportunity to do well by their pocketbooks while doing good for the planet. How can individual investors participate in the wealth creation opportunities afforded by decarbonization? Is there evidence that investing in decarbonization can generate attractive risk-adjusted returns for investors? We set out to answer those questions for ourselves recently by examining the investment vehicles available to individual investors in both public and private markets and tracking the returns from 2011 to the present. What we found gives us confidence that there is significant upside – and limited downside – to using decarbonization as an investment guide.
It’s important to benchmark decarbonization returns against broader market returns. In the decade following the dot-com bubble and including the Great Recession (1/1/2001-12/31/2010) the return to the S&P 500 was only 1.6%. Since the US economy recovered from the Great Recession, the US equity markets have seen the longest bull market in history. From the beginning of 2011, the S&P 500 has realized 12.0% annual total returns. In comparison, an investment since 2011 in an investment-grade bond fund like the Baird Aggregate Bond Fund (BAGIX) generated 4.7% total annual returns. An investment in a popular income-optimized fund like the Vanguard Wellesley Income Fund (VWINX) returned 7.32% from 2011 to the end of September 2020.
During the past decade there have been few liquid investment options that are focused on decarbonization. The simplest approach to getting reasonable diversification with a modest investment is to buy shares in one of the small number of mutual funds that invest primarily in clean energy companies, such as FSLEX, QCLN, PBW, ICLN, TAN, or FAN. These funds overall have beat the S&P 500 during its long bull run, but not by much.
Another approach to investing in decarbonization is to build your own portfolio of publicly traded companies. Using data from various sources, we identified publicly traded companies whose core business is leading the way to a low-carbon economy, such as companies that make wind or solar energy hardware, utilities that are acquiring more renewable energy production than their peers, rooftop solar installers, fuel cell makers, energy efficiency service providers, electric vehicle manufacturers, etc. We identified 14 companies with market capitalization greater than $1BN listed on public exchanges in the United States prior to 2011, and another 8 that have been listed since. We allocated funds evenly to those companies at the beginning of 2011 and rebalanced the portfolio in 2015 to include newly listed companies. We reinvested dividends. This portfolio has generated nearly 27% annual total returns from 2011 to the present.
For investors seeking income and low volatility, Yieldcos are an attractive option. Yieldcos focus on returning cash flows generated from renewable energy assets to shareholders as dividends. These assets largely consist of solar and wind farms with long-term energy delivery contracts, so their cash flows are stable. Yieldcos utilize tax incentives for renewable energy to minimize tax liabilities and distribute more cash to shareholders. There weren’t many listed Yieldcos until after 2013. One of us – James – started investing in Yieldcos in 2015 and continues to actively manage a diversified portfolio which has generated returns exceeding 17% per year from 2015 to the present.
Most companies driving the transition to a low-carbon economy will be new ventures that are not publicly traded. New means risky, and illiquid. To be successful at new venture investing requires time and expertise to conduct rigorous due diligence. A diversified portfolio of at least 15-20 investments is also necessary to absorb inevitable losses as some new companies fail to get off the ground. The conventional wisdom is that 90% of startups fail. But is that really true? And are decarbonization ventures riskier than other ventures?
To address that question one of us – Jeff – created a sample of new “decarbonization” ventures that raised funds during 2011-2017 and compared the outcomes (failed, exited, still going) to date for that sample to the outcomes for all private equity funded ventures. We chose 2017 as the end of the selection period so that the ventures in the analysis would have time to show measurable progress - or lack thereof. Using the Pitchbook dataset, we identified around 23,000 ventures based in North America that raised “Seed” or “Series A” financing rounds of $1-10M during 2011-2017. We isolated a sample of 918 decarbonization ventures from the 23,000 ventures by creating a complex set of filters with keywords, Boolean logic, and manual exclusions. The outcomes of those samples showed the following results:
The failure rate for these ventures was much lower than the conventional wisdom – 17% rather than 90%. Of course, the story of these new firms is not yet told in many cases. There are definitely some “zombies” among the 62% still in business -- companies that are operating but are not on a trajectory to become a going concern. And more will encounter challenges that overwhelm them. One thing we can say with statistical confidence – the rate of failure for “decarbonization” ventures is not significantly different than for all ventures. It’s possible that decarbonization ventures are slightly slower to exit, but that difference is modest.
What are the returns that are possible for patient investors in new decarbonization ventures? We created a simulated portfolio by selecting one investment per quarter from the ~30 companies raising early stage funds in any quarter, and adding that to the portfolio. We selected the company with the innovation that we felt had the greatest potential to reduce carbon emissions, either directly or indirectly. The resulting portfolio of 29 companies was showing strong promise as of June 2020:
Investors have expressed confidence in the prospects for most companies in the portfolio, based on the large amount ($61M per firm) of follow-on financing these firms have received to date. But the most important metric is return on investment. Unfortunately measuring that return requires data not available to us.
One source we can consult for an indication of the returns to a portfolio of decarbonization ventures is the E8 Angel Network based in Seattle, WA (we are both members). E8 pursues “profit with a purpose”, investing in companies with innovations that will make for a sustainable world with healthy, thriving ecosystems. Many of the companies that come through E8’s doors are developing products and services that will accelerate the transition to a low-carbon economy. We selected the companies focused on “decarbonization”, and performed the same analysis that we conducted for the simulated decarbonization portfolio:
Both portfolios are a small sample, but they tell a consistent story. Decarbonization companies are making enough progress to attract significant amounts of follow-on funding. In the case of the E8 companies, we know the post-money valuations of the early funding rounds, and we can look at recent valuations or use multiples of revenue as a means for estimating their current value. Based on those estimates, the 34 companies in this portfolio are growing their value at a rate of 24% per year. That value can’t be easily monetized yet as these companies are not traded on exchanges, but as they mature, they are likely to either be acquired, go public, or start paying dividends out of profits. With patience, investors will realize the implicit value.
We believe that the future is very bright for investments in decarbonization. To date the lack of US federal decarbonization policies and ongoing subsidies to fossil fuels have been a drag on the prosperity and growth of companies with promising decarbonization innovations. But the macro-environment is changing in ways that will generate strong tailwinds for decarbonization ventures. Those voters in the United States who are “alarmed” about the global warming crisis are now the largest and fastest growing segment of the population. More and more large corporations are committing to 100% clean energy consumption, and some are going much farther to eliminate the emissions from their operations and their supply chains. Large institutional investors are making Environmental, Social and Governance (ESG) considerations a key part of their investment analysis because they understand that to prosper in the long run firms must address the challenges of global warming and deteriorating natural ecosystems. Finally, in the US we have an election coming that could usher in a new era of strong public policy support for rapid decarbonization.
Now is a good time for savvy investors to join the decarbonization movement. Our planet needs you!
The authors would like to thank E8 members who helped research results for E8 portfolio companies, and Lillian Thiel who helped with Pitchbook research.