To move the needle on climate change, backtrack on early-stage climate tech

Over the years, fortunes were made when innovation had its most dramatic peak: the arrival of the Internet and search engines was one example. The rise of mobile, particularly the advent of the iPhone in 2007, the App Store and the first Android phone in 2008, was another. Today, as much of the world scrambles to move away from fossil fuels and encourage sustainability, climate technology innovation is producing a similar push.

The breadth of opportunity for privately funded startups is almost unfathomable. According to PwC, in the 12 months to June 2021, $87.5 billion was invested in the sector, a 210% increase over the previous 12 months, with the average deal size nearly quadrupling in the first half of 2021. Climate technology, which encompasses a wide range of categories from mobility and energy to the built environment, manufacturing, food and land use, carbon capture and storage, now represents 14 cents of every dollar of risk.

Today, climate tech is a rapidly maturing asset class for private investors, based on scaling ideas and technologies to get us to net zero. But what about public markets, and in particular environmental, social and corporate governance (ESG) funds, of which climate considerations are an essential component? The aggregate value of sustainable mutual funds and ESG-focused exchange-traded funds (ETFs) reached $2.7 billion in 2021. But does investing in such funds actually have an impact on the climate crisis, as many investors presumably intend?

Two key arguments are made by proponents of ESG-aligned investing. One of them is that companies with good ESG scores manage ESG risks more effectively and, therefore, are more resilient as businesses. A high ESG score, for example, reduces the cost of raising capital.

However, whether investing in such funds plays an indirect role in slowing climate change is debatable. This is largely because investments marketed as “ESG packaging” often have little or nothing to do with reinforcing ESG. Last year The Economist revealed that of the 20 largest ESG funds in the world at the time, each held investments in an average of 17 fossil fuel producers.

Now the regulators are going in circles. In June 2022, The the wall street journal reported that the Securities and Exchange Commission (SEC) is investigating Goldman Sachs’ mutual fund activities, with the probe focusing on ESG funds. Separately, a month earlier, German police raided asset management firm DWS Group, majority-owned by Deutsche Bank, over allegations that it misled investors about ESG investing. The raid followed the launch of an investigation by the SEC following claims by DWS’ former chief sustainability officer that the company had overstated its ESG capabilities.

In May of this year, the SEC indicted BNY Mellon Investment Adviser “for inaccuracies and omissions regarding [ESG] considerations in making investment decisions for certain mutual funds it managed. While BNY Mellon’s $1.5 million fine was minimal, it’s part of a clear trend that authorities are finally cracking down on so-called ESG washing.

The second argument advanced in favor of ESG-aligned investing is that these funds generate superior returns compared to conventional stocks and funds. Numerous studies indeed suggest that ESG funds outperform the market. In 2020, for example, the morning star analyzed the performance of 4,900 funds to determine whether sustainable funds can beat their traditional counterparts over the long term. The short answer was that the majority of their sample – around 58% – apparently did.

Yet some skeptics have challenged this premise. A meta-analysis of some 1,140 peer-reviewed articles, published between 2015 and 2020, found that “the financial performance of ESG investing is on average indistinguishable from conventional investing.” This is perhaps something that should not surprise us. One of the reasons ESG funds operate broadly in line with the market is that many are essentially the same companies in new packaging.

To be clear, I’m definitely not against ESG investing. But you have to do it very differently if you want to generate a real impact – particularly in the area of ​​climate – as well as a significant financial gain. Business history teaches us that the “innovator’s dilemma” is real. Legacy companies feel the burden of simply maintaining their status quo, which is why the riskiest and most emphatic ideas often come from startups.

There are more than 3,000 climate tech startups around the world today, including 78 unicorns, with many more on their way to reaching billion-dollar valuations. With most of the value of tech companies tending to be created before IPO, the answer, therefore, for investors wishing to support climate innovation and generate outsized returns, lies in private markets and invests in as many startups as possible, as soon as possible, rather than in large ETFs.

Between 2006 and 2011, venture capital firms in the United States invested more than $25 billion in clean energy technologies, then known as “clean technologies”. Growing awareness of climate change convinced investors that the energy sector was ripe for disruption and, like the semiconductor industry before it, scientific and engineering feats could be turned into profits. “Green technologies – getting green – are more important than the Internet,” Silicon Valley VC John Doerr remarked in 2007. “This could be the greatest economic opportunity of the 21st century.” When reality bit in, more than half of that $25 billion was vaporized. It turned out that the ecosystem was not mature enough and that the technology was too early and too expensive.

Things are very different today. The ecosystem of entrepreneurs, capital and technology is in place. The appetite is there as the net zero race intensifies. Climate technology is indeed one of the greatest economic opportunities of our time. But not like many investors have done so far.

Teresa H. Sadler