Are VCs giving up on RE? Should they?

Cross-posted to Engineering Entrepreneurship.

Statistics released Friday by the Cleantech Group say that “cleantech” VC investments in 2010 hit a record $7.8 billion, up 28% from the $6.1 billion in 2009 for North America, Europe and Chindia. The N.A. data was even more impressive, up 45% to $5.28 billion. Worldwide, solar continued to account for the largest share of the investments, up 52% from 2009 to $1.83 billion.

Although this sounds encouraging, Iris Kuo of VentureBeat had a different take. First, cleantech VC investment has been declining for the past two quarters. Instead, the capital-intensive have been going to government sources, including BrightSource, Solyndra and Tesla.

However, analysts are just beginning to realize that cleantech businesses may be fundamentally unsuitable for VC investment. A series of clues have emerged in the past 6 months.

Exhibit A was the whole debate started by VC Fred Wilson and his “two venture capital industries” thesis:

The first VC industry is investing in software based businesses. The software VC business has been fundamentally altered by the massive decrease in the cost of building and launching a software based business.…

The second VC industry is investing in cleantech, biotech and other capital intensive tech businesses that have economic models that have not been fundamentally altered. This VC industry operates largely the same way it has operated for the past twenty or thirty years.

The statistics were supported by TechCrunch data from the first 8 months of 2010: an average of $5m for web/ecommerce vs. $31m for cleantech.

Exhibit B was the decision of Kleiner Perkins to pull back from cleantech investing and go back to its roots in IT. Of all the major Silicon Valley VCs, KPCB had made the most aggressive bet on cleantech — particularly green energy. This is the firm that in 2007 made a partner out of a former presidential candidate and Nobel Prize winner.

Exhibit C are the observations of one of the most respected IT industry executives, analysts, inventor and entrepreneurs: Bob Metcalfe (MIT ’69), inventor of Ethernet and founder of 3Com. Having finished a decade as a venture general partner, last month Metcalfe said that the VC model (so far) does not fit cleantech:

Q: What did you learn from your investing in clean-tech, or as you call it, enertech?

A: I’m still in the process of learning – this is complicated stuff. But I learned that the innovation environment in the energy space is not there yet. The problems we see are a mismatch between the asset class called venture capital and the innovation opportunities in energy – it takes too much capital and it takes too much time. But I claim that’s only because the innovation environment in energy hasn’t developed, say, the way it has in pharma. Drugs take a lot of money and a long time, but there’s a lot of venture capital activity in drug discovery. That’s because the drug-discovery business has grown into being able to exploit the venture capital model. The partnerships that big pharma has with drug companies in stage one, stage two, stage three [clinical trials] allow venture capitalists to do what they do and get the returns that they need. The energy space has not quite developed, but it will.

This entire debate was anticipated by Prof. Martin Kenney of UC Davis, the editor of Understanding Silicon Valley — perhaps the leading academic expert on Silicon Valley and a longtime expert on hightech VC.

In July 2009, Kenney wrote a book chapter entitled “Venture Capital Investment in the Greentech Industries: A Provocative Essay” that will be published in the Handbook of Research on Energy Entrepreneurship. He notes a number of warning signs:

1. investors have been pouring money into green energy without being able to get it back from IPOs;
2. market growth may be slow, since “clean” technologies are competing with established (and cheaper or better) incumbents;
3. the cleantech bubble investing bubble parallels the Internet bubble;
4. thus far, the most successful cleantech businesses have been self-funded: either bootstrapped (e.g. Danish wind turbines) or internal green ventures from existing multinationals like Siemens and Sanyo.

Kenney tries to offer a positive scenario, suggesting that VCs could learn and adapt like they have in biotech. However, in the past 18 months have been signs that biotech VC may be facing similar problems (if the returns to pharma R&D are becoming less certain).

While the scale of investment in energy is enormous, the VCs have various reasons to actually favor larger deals (and often pension funds throwing money at them to invest). While VC worked great during the 1990s with relatively small investments followed by quick exits via IPO or acquisition, but both are much harder in renewable energy.

The first problem is the time scale. If (as Zider’s 1998 classic HBR article suggests) VCs seek a 10x liquidity event after 5 years (to cover their losers), then doubling the delay to 10 years cuts the IRR by more than half (and the NPV even more than that). For a 10 year exit — and ignoring the increased risk of failure — the same IRR would require a 100x return.

The other problem is that the size of the investment reduces (if not eliminates) the opportunity to exit via acquisition. A 10x return via acquisition was common for $50m dot-com investments, but such exits are going to be much rarer with $500m invested; a 100x return is going to be out of the question.

If VC can’t find a way to make money off cleantech investments, then cleantech entrepreneurs are going to have a hard time bringing their businesses to scale. Without VC, new businesses will have a hard time competing with self-funded multinational incumbents — or government-funded enterprises in large centrally-planned economies.

EVs good on MPG, HPM

A big debate recently on EVs and PHEVs has been how to measure the miles per gallon given that a) sometimes they use no gas at all; and b) electricity is an energy cost, even if it’s not a gallon of gas.

But now I think it’s time to focus on HPM (hype-per-million): misleadingly high press popularity that masks underlying revenue model problems. Electric cars seem to be heavy on the hype — by the vendors, the business press, the general press and even politicians — while sales are barely improved from the first great coming of the EV. (And this time, there’s no one to blame for poor sales but the invisible hand of basic economics.)

An AP report Friday was stark in its assessment:

GM sold 250 to 350 Chevy Volts this month, and Nissan's sales totaled fewer than 10 Leaf sedans in the past two weeks. Production for both is slowly ramping up.

It will be well into 2012 before both the Volt and Leaf are available nationwide. And if you're interested in buying one, you'll need to get behind the 50,000 people already on waiting lists.

It's still unclear just how large the market for electric cars will be once those early adopters are supplied. The base sticker price is $40,280 for the Volt and $32,780 for the Leaf, much higher than most similar-size, gas-powered cars. If those prices rise, it could make them even more of a niche product than predicted. Buyers also are worried that advertised lease deals may not last, and a federal tax rebate of $7,500 could disappear if Congress decides battery-powered cars are no longer a priority.

According to the story, Nissan can build 50,000 Leafs a year while Chevy hopes to sell 10,000 Volts in 2011 and up to 45,000 in 2012.

By comparison, Chevy sells more than 200,000 Malibu sedans a year (for a price that’s half that of the Volt.) Of course, price is everything — now more than ever. And with the new Congress, expansion or even extension of generous Federal subsidies seem less likely than ever.

Edmunds is predicting HEV/PHEV/EV will rise from 2.4% in 2009 to 4.8% in 2013, with EVs only a small fraction. Of the 14-17 million passenger vehicles sold every year in the US, that would be an increase from about 350,000 to 700,000 vehicles a year. Most of those are probably the Prius, which is selling about 400,000 units annually (worldwide).

This is consistent with the November prediction made by Daimler AG CEO:

In 10 years’ time, the overall market share of electric cars is likely to be still in the single-digit percentage range. … In principle it’s similar to President Obama—first, expectations are being raised externally and then people are surprised they don't get fulfilled. From today's perspective it's already clear [that] we won't earn high returns with electric cars in the years to come. And that's the optimistic wording.

Even the 4.8% forecast may be optimistic: selling 70,000 Leafs and Volts would be only 10% of the US market. Given Toyota is driving most of its HEV demand to the Prius, category growth is going to depend on other makers (most likely Honda and Ford) offering their own hit HEV/PHEV/EV models.

Both Honda and Ford have offered credible products, but neither has made much of a dent: even in a good month (October 2010), Honda only sold about 4,000 units in the US. Honda promised to be aggressive in pricing its HEVs and EV models, but the Fit EV (due in 2012) is priced at $30k, only about 10% below the slow-moving Leaf.

So where is the growth going to come from? Yes, $150/barrel oil would increase EV sales (even if it has no direct effect on renewable energy, which instead competes with coal and natural gas.) But that’s not really a business strategy — unless you have the geopolitical connections to arrange a third Arab Oil Embargo.

My own purchase intentions reflect this reality. At one point, I thought my next car would be the $20k Honda Fit Hybrid, until Honda decided not to sell it in the US. Instead, it’s more likely to be $15k for a Ford Fiesta (37mpg), Mazda2 (35mpg) or Honda Fit (33mpg). Ignoring the time value of money, a $15k purchase price differential (vs. a Leaf or Fit EV) buys 5,000 gallons of gas — enough to cover the fuel costs for the entire life of the car. Plus there’s no battery to put in the landfill, or coal-generated electricity to pollute the planet.

The end of the solar house fad

Residential PV is a core segment for the industry, solar hot water in California dates back 100 years, and passive solar design can be traced back to Roman times. So the use of solar energy for houses is both an ongoing market and nothing new under the sun.

However, the idea of college teams competing to build solar houses is a fad that’s just about run out of steam: the business model is fundamentally broken.

The way it’s supposed to work is that students work together to build an energy efficient house that runs off renewable energy. SJSU has its ZEM House. Students learn not only about principles of EE/RE design but also get a chance to put those principles into practice. A side benefit is that the tangible artifact creates visibility both on and off campus for the students, the school and the overall green movement.

The reality, however, is that making a tangible artifact costs money: the numbers I’ve heard are between $800k and $2 million, depending on the competition, team, local costs etc. For example, the 2009 Team California house (produced jointly by Santa Clara University and California College of the Arts) cost $1.3 million to participate in the Solar Decathlon, sponsored by the Department of Energy.

A million bucks is a lot to spend on a house that isn’t really going to be used, and may in fact be torn down or soon forgotten. A lot of that money will go to contractors and PV suppliers and other, but that’s not the most efficient way to use public money.

Meanwhile, $1 million could do a lot of good in many other ways. It could pay for 50 student-years of scholarships at a public university. It’s a good start for endowing a professorship of PV or RE or EE (which can range from $1-5 million, depending on the school). It could install 100 KW of PV capacity on the school roof, or at city hall, or on local residences. (BTW, designing and installing that capacity would be almost as instructive as building a throwaway house).

One local college, Santa Clara University, participated in 2007 and 2009 in the national Solar Decathlon. My understanding is that they won’t be back. The reality is that schools have only so much fundraising capacity (and donor base) and that is better used for either more direct student benefit or a more permanent infrastructure.

So what will replace it? Virtual design competitions? Electric car races? Prototype-scale systems? As with any other business — clean or otherwise — these pedagogical approaches need to be cost-effective and supported by a viable business model

Some observations on global solar adoption

I just spent two days at a workshop for solar equipment producers sponsored by Festo AG. (I was invited to support its efforts to build a Festo-sponsored open innovation community.) Several of the speakers offered great statistics, history and other facts about the development of the industry.

Below are a few “stylized facts” about where PV is being produced and used.

1. Solar Price is Relative

Substitute costs are the key driver of solar adoption. If energy is cheap, no one wants expensive RE. If energy is expensive, RE may not seem all that expensive. European adoption is high due to high fossil fuel prices, while US has historically had cheap energy. However, with our high insolation and high (Tier 4 or Tier 5) utility bills California is almost break-even without subsidies today, Hawaii too. Germany is a long way off, China will be decades away at 5c/kWH.

2. Roadmaps Help

The PC industry grew for 40+ years with a a technology roadmap based on Moore's Law. There is evidence that PV cost cuts also provided a predictable roadmap. According to consultant Ruurd Boomsma, the prices generally fell 5-6% per annum, much more slowly than LCD prices over the past decade. (However, prices fell more dramatically in 2009 and it’s not clear if that’s the new normal or a one-time shock.)

3. US is Inherently Messy

It is clear that the US policy regime is more fragmented, confused and contradictory than either Germany or China. Although Germany has Federalism, the RE policy is mainly at the national level, not the staaten. In most other countries, the states/ provinces are relatively weak and the RE policy is made at the national level. Also, RE policies (eg. for residential solar) are better understood in countries with national policies than in the US (where the major policies are at the state level).

4. Jobs Follow the Entire Value Chain

There's been a lot of discussion (and hand-wringing) on the huge shift of PV production to China and elsewhere in Asia. However, the major shift has been for cells. Modules are more expensive to ship and to inventory, and may continue to be produced near (or closer to) actual use. Installer jobs will also remain in the developed economies and perhaps the balance of system too.

5. California isn’t Serious About Green Jobs

California has spent lots of money on RE subsidies and is proud to lead the nation in such subsidies — just as it led the nation in regulating tailpipe emissions for years. However, the state has been trying for 20 years to destroy the local manufacturing base through regulation and taxation. If not for the dot-com boom, this would have been pretty obvious a decade ago, but the lagging recovery (and 12% unemployment is making them visible now.)

Mayors, legislators and governors claim to want green jobs, but their bureaucracies tie up new manufacturing efforts with red tape through opaque discretionary approval processes. (I heard a few choice examples Tuesday). It’s no coincidence that the silicon has left “Silicon Valley: that Santa Clara-based Intel is building factories in Oregon and Arizona and New Mexico but has closed its last factory in Silicon Valley. SV alumni and VCs start companies here because it’s convenient, but the manufacturing is going elsewhere.

Five years from now, I predict there will be no large-scale solar manufacturing in California. The PV manufacturing growth for California and the Southwest will be in Nevada (no income tax), Arizona and New Mexico.

The Sputnik fallacy redux

In his speech Monday to the National Press Club, Energy Secretary Steven Chu said that clean energy represents a new "Sputnik” for the US. In this remake of the space rate, the Red Chinese are playing the role of the USSR.

To quote from the official press release:

A New Sputnik Moment
Secretary Chu said that China's investments in clean energy technologies represent both a challenge and an opportunity for the United States. While China's experience with rapid, large scale deployment of technologies makes it an important global testing ground and creates opportunities for scientific partnerships between our two countries, it also means that America cannot afford to take our scientific leadership for granted. Secretary Chu stressed that our economic competitiveness depends on jump-starting the next round of American innovation in clean energy.

Dr. Chu’s slides even more explicitly make the Sputnik analogy, quoting Dwight Eisenhower.

As CNET reported his remarks:

Chu said that the U.S. needs to fund research in clean-energy technologies in order to stay apace and take advantage of the economic opportunity that cleaner energy technologies represent globally.

"America still has the opportunity to lead in a world that will need a new industrial revolution to give us energy we want inexpensively and carbon free," he said during his presentation, which was Webcast. (Click for PDF of slides.) "I think time is running out."
…
He said there are risks in the status quo which were detailed in a report called Business Plan for America's Future which was authored by business leaders including Bill Gates, venture capital investor John Doerr, GE CEO Jeff Immelt, and former Lockheed Martin CEO Norman Augustine.

The report said there are many benefits to moving to a cleaner energy system in the U.S., including public health, protection from climate change, and cleaner air, but none of these are recognized by the free market. Also, the scale of investment required in new energy technologies in beyond the scope of commercial companies, which is why the government should fund research and development.

As I noted six weeks ago, there are two problems with this line of reasoning.

First, the cheap Chinese manufactured goods are helping reduce CO2 outputs even if they take market share from US and German firms: Western leaders have to decide which is more important, saving jobs or saving the planet.

Secondly, the idea that renewable energy policy can be approached like a moonshot is a fallacy that was demolished by three leading innovation economists (who all have strong environmental sympathies). (Official Research Policy article here, working paper here).

Dr. Chu’s answer is to throw more money at federally funded technology development. I realize that Dr. Chu is a scientist who spent years spending DOE R&D money, but the answers are going to found in industry, not federal labs.

Yes, the US is and remains the innovation leader of the PV world. But the problem is not technological innovation, but in business models and manufacturing efficiencies. I don’t know what kind of business advice Chu is getting, although both Doerr and Immelt have shown their priority is to get the government to subsidize their EE/RE bets.

Nothing that Chu suggests will change the fact that China has 4x as many young people and will someday have 4x as many science PhDs as the US. Nor will it change the fact that the cost of capital and land and labor (and energy) is so much cheaper for Chinese manufacturing that none of his proposals would bring back US manufacturing in any significant way.

If the US is not going to be exporting manufactured goods to any significant degree, what can it do? It can try to imitate Germany of a decade ago and sell lots of goods to its domestic market before that market is swamped by imports. Or it can try to export technology, services and other innovations that are not so manufacturing- and cost-sensitive.

Finding a good niche

As in any other industry, the success of new cleantech businesses usually depends on finding a good niche. Yes, the big oil companies would like to start with billion (or trillion) dollar market segments, but most other companies need to start with a small, well-defined, highly motivated and easy to target segment.

Today the Merc offered a profile of an intriguing electric vehicle company that seems to be taking a different tack than Tesla, Fiskar and the other big VC-funded firms. Green Vehicles Inc. of Salinas (an hour south of San Jose) is selling the Triac, a tricycle commuter car for $25K, with a top speed of 80mph and a “real” (not best case) range of 100 mph round trip.

The $25K MSRP does not include the $7,500 Federal subsidy and a state subsidy (under AB 118) of up to $5,000. So you pay the 10% sales tax on the full $25k, but still the car is cost-competitive (to buy, before operating costs) with conventional cars selling for around $13,500 — and there aren’t a lot of cars in that range. It would get me the 12 miles to work, or the 4 miles to the LRT to work or the CalTrain to San Francisco.

The car is severely limited in size (two people) and like other pure EVs, in range. But to me, this could be the ideal commuter car to throw into the portfolio as a third car, say for households with a teen driver that has a 2-5 mile one-way trip to high school or the mall job.

More importantly, the low up front cost will allow someone to experiment with this restricted-capability vehicle — inherent in pure EV models — to see if it fits their lifestyle. Even if it only holds two people, I think a $14k vehicle (after incentives) has a much bigger audience than the $57k ($35k after incentives) Tesla Model S sedan.

An honest (ex) politician

Corn-based ethanol makes no sense from the stand point of economics, food policy, energy policy or land use policy. Monday, former senator and presidential hopeful Al Gore admitted this reality: even as a former politician, it puts him in a select group who will admit this Emperor Has No Clothes. (It also confirms the speculation at the time of his divorce that he never plans to run for president again).

As Reuters reported:

"It is not a good policy to have these massive subsidies for first generation ethanol," said Gore, speaking at a green energy business conference in Athens, Greece. First generation ethanol refers to the most basic, but also most energy intensive, process of converting corn to ethanol for use in vehicle engines.

"First generation ethanol I think was a mistake. The energy conversion ratios are at best very small," he said, referring to how much energy is produced in the process.

The U.S. ethanol industry will consume about 41 percent of the U.S. corn crop this year, or 15 percent of the global corn crop, according to Goldman Sachs analysts.

Alas, half of the GOP senate thinks they’ll be a presidential nominee in 2012 — about the same number of Democrat senators assume it’s possible for 2016; pandering to foolish farm state subsidies is a bipartisan effort. (Perhaps the GOP House members will live up to their budget-cutting claims.)

So while it would be nice to end the ethanol craziness, it seems like things are going to get worse before they get better.