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The (re) emergence of energy technology

Over the past year, energy technology has been the subject of escalating interest from the venture community and its institutional investor base. Investment activity in areas such as alternative energy, emissions control, and energy management continues to increase, led largely by a handful of small, pioneering venture firms as well as several large, generalist funds that are making their first forays into the sector, according to Vincenzo La Ruffa of EnerTech Capital.

But while private equity interest in energy has becoming increasingly prominent over recent months, investment is not a new phenomenon. Large buy-out firms have been investing in power plants, transportation lines, and even large energy services companies since the 1980s, and new construction in the energy industry is rarely done without meaningful project finance. Even venture investing in energy technology can trace its earliest roots to the mid-1980s when companies such as Ballard Power and American Superconductor went public.

However, dedicated efforts to identify and invest in energy technology companies didn't take hold until the mid-1990's, when early forerunners such as EnerTech Capital and Nth Power were putting together their first funds.

It is not widely recognized that an energy technology bubble grew alongside the more infamous internet bubble, with companies such as Capstone Turbine, Manhattan Scientifics, and Fuel Cell Energy, reaching massive market caps before crashing with the rest of the market. Rapid growth in the demand for energy, deregulation of the utility industry and a host of embryonic energy technologies sent this market soaring, while the California Energy Crisis, the collapse of Enron, falling oil prices, and a general move back to a more regulated environment saw the sector rapidly tumble. During this bubble, corporate investors, looking both to find opportunities of strategic value to their core businesses and to capture superior returns with balance sheet capital, flooded the energy technology sector with funding. Most of these corporate venture efforts have since been abandoned, but many of the independent venture funds dedicated to the sector remain.

Energy Technology: The Drivers
Why then is energy technology returning to prominence? From a macroscopic standpoint it has never been a better time to invest in energy technology. A host of government, technology, market, and geopolitical drivers suggest radical growth in this sector.

Technology
From a technology standpoint, recent advances in materials science (particularly in nano technology) have enabled the next wave of improvements in fuel cells, solar panels, and various sensing applications. Improvements in information technology have provided new opportunities to improve grid reliability to protect against more blackouts and have lead to significant opportunities in supply and demand electric resource optimisation. Such solutions provide far from incremental value: power disruptions alone cost the US economy more than $120bn per year.⁽¹⁾ As alternative energy and other clean technologies are maturing, economies of scale and scope have, in some cases, lowered costs to make formerly impractical solutions viable alternatives.

This technological momentum is self-reinforcing: as traction develops, talent continues to move into the sector from adjacent industries, promising even more rapid cycles of innovation and greater probability of returns. For example, as the number of fuel cell companies continues to increase, hydrogen production and storage technologies become more meaningful and attract more attention by scientists, entrepreneurs, and investors. In many nanomaterials companies, where research can go in a myriad of directions, energy technology is usually one of the highest-potential opportunities. The role of carbon nanotubes in catalytic converters and hydrogen sensing and storage has been explored by several firms, including Catalytic Solutions, Nanomix, and the soon to be public, Nanosys.

Market Forces
The energy industry faces a complex set of market dynamics due to the partially deregulated nature of the industry, the unique nature of energy as an all-important, yet evanescent, input, and the negative externalities associated with production. This landscape has become even more volatile in the past 18 months. The increasing costs of oil and natural gas have inspired a greater sense of urgency to develop cheaper energy alternatives. New record highs in oil futures were hit in May, and current rates of production only account for 40.6 more years of consumption.⁽²⁾ Recent slashes in reserves by large oil companies have only exacerbated this effect. Shareholders are not alone in these concerns. From the radically higher price drivers pay at the pump to the new fuel surcharges many flyers now face, leisure and work travelers alike bear the cost. Add to this, home heating, and industrial applications, and the deleterious effect of volatile energy input prices is even more dramatic.

With no foreseeable decrease (and more than likely a sharp increase) in our energy demands, it will be difficult for supply to keep up with ever increasing global production. The digital economy can only serve to accelerate this outstripping. Equally as troubling, the resources we do possess are located in often hard-to-reach locations and require massive new infrastructure investments to better match supply with demand. In North America this means particularly high energy costs, and oil and natural gas are coming from further and more remote places, or through more expensive processes, such as extraction from oil sands. In places such as Central Africa, this infrastructure has proved too costly for both local governments and humanitarian efforts, which has made distributed generation alternatives such as solar and micro-turbines particularly attractive. On the positive side, these mounting concerns have inspired substantial new research investment in the private sector, particularly by large energy companies, such as BP and Chevron, who both boast sizeable renewable portfolios.

Geopolitical
Instability around oil and gas reserves is not a new phenomenon but clearly we are in a particular precarious climate. Instability in the Middle East, Russia, South America, and Africa, whose lands and coastlines boast some of the most substantial untapped reserves, all encourage a move to new energy sources. At the other end of the value chain, global concerns over emissions, in particular, tension over mixed participation in the Kyoto treaty promises to leave the political climate around energy in turmoil for some time ahead. In a more open economic environment, massive differences in environmental regulations between the US, Europe, and Japan will lead to increasing tensions. Funding of alternative energy technologies and clean technologies is one of the most politically viable ways for the US to mollify its trading allies, without doing direct harm to large energy companies.

Government
In direct response to the above issues, governments around the world have put together several ambitious programs, virtually all of which benefit the energy technology and clean technology landscape. Besides the well-known Kyoto treaty, the European Union aims to produce over 20 per cent of its energy from renewable sources by 2010. In the US, thirteen states, including Texas and California, have instituted similarly ambitious schedules of renewable energy portfolio standards. Photovoltaics have been an early beneficiary of these regulations, as the relative maturity of the technology has made it a particularly attractive source for grant money. Similarly, companies that offer "negawatt" solutions (reductions in usage, rather than building more capacity), have been an attractive way for utility companies to meet demand without enduring difficult rate-base and build out hearings. Comverge is a venture-backed company, which is the industry leader in this space in the US.

Energy Technology as the new Venture Sector

Mark Heesen, NVCA president was recently quoted as saying that "Energy technology could be the next biotech." It is an apt comparison. Both are very large (energy is $1tn ⁽³⁾ per year in US alone, growing at $20 to $30bn per year ⁽⁴⁾ ), yet relatively specialised fields, that favor an investor that has a base knowledge of the underlying industry, personnel, technology, and buying criteria. Likewise, both sectors have spawned funds dedicated to solely pursuing opportunities that fall within their scope. In the case of biotech, which is several years more mature than energy tech as a venture sector, large funds also found an attractive value proposition and built teams to pursue. Similarly, within the past year, some of the largest venture funds have either hired partners with a very specific energy tech/clean tech mandate and/or have been scouting out conferences and hotbeds of activity to decide exactly how they want to participate.

And with good reason. From a theoretical standpoint, the ratio between market capitalisation generation in energy technology relative to the paucity of private equity dollars targeting the space (roughly $1bn in 2003 ⁽⁵⁾ ) is among the highest, if not the highest, of all venture investment sectors. Consider these indicators of current and future size:

• CalPERS conservatively estimates that water, solar, wind, cleaner coal, hybrid vehicles, and fuel cells, could amount to a nearly $500bn market over the next 15 years.
• The current size of the clean energy market alone is $13 billion per year and it is expected to grow to $92bn by 2013. ⁽⁶⁾
• Many niche markets add to this large investment space, including Automotive/Diesel Catalysts ($5.5bn by 2008); Advanced Batteries ($6.6bn through 2010); Non-chemical water treatment ($19.6bn through 2007); and Central Generation Emissions Control (over $160bn through 2012). ⁽⁷⁾
• Total global investment in the broadly defined energy industry is expected to top $16tn over the next thirty years. ⁽⁸⁾

New LP Interest
Excitement over energy technology and clean technology venture opportunities doesn't exist solely on the GP level. Several prominent institutional investors are now actively pursuing energy technology investments. These efforts are a natural outgrowth of traditional investments in energy buy-out and asset funds, but are new to most. Perhaps most notable are CalPERS and CalSTRS, two of the three largest pension funds in the US, who's board of investors recently approved a program to together invest $500m in energy tech/clean tech alternative investments. CalPERS has already instituted a $200m program to this end that will include investments in venture funds, later stage private equity funds, as well as project finance and special situation vehicles. The large European asset management firm, Robeco, has also reportedly created a E200m fund, which focused principally on clean tech fund of fund investments.

Along with these large forerunners, several smaller institutional players are investing in Cleantech/energy tech focused funds. The Carbon Trust, a private entity funded by energy taxes in the UK is making both direct and fund investments in the sector. Also, several university endowments in the US have been exploring how to invest across the energy value chain.

It would be an overstatement to say that LP interest is pervasive. But as momentum builds and "energy tech" and "clean tech" increase in alternative investment exposure, we can expect LPs to devote more time and resources in understanding these attractive investment sectors.

Where from here?
With fresh flow of capital flowing into this space and a stable of companies not yet at a point of maturity, the fate of energy tech venture investing is still unclear. Certainly, within the next 1-3 years, some well-publicised success stories will need to take place to maintain momentum. In this regard IPO exits would be more attractive so as to prove that these companies are sustainable enterprises, and not solely niche plays.

The link between energy tech and clean tech has been a mixed-blessing. On one hand the sectors are naturally connected via alternative energy and emissions reductions, and the less related cleantech opportunities in water/waste-water and resource optimisation usually have meaningful similarities in their end markets. Moreover, the combination creates a more significant critical mass of deal flow allowing for more institutional interest and viability. However, cleantech also runs the risk of bad association. The sector has long been associated with socially responsible investing, which, while certainly not a bad thing, can detract from the credibility as a standalone venture sector for serious investors. For energy tech and clean tech to mature they will both have to prove their viability independent of grants, favorable legislation, and "double bottom line" accounting.

Private equity investment in energy, while not a recent occurrence, has certainly found new momentum in energy technology venture investing. A strong set of drivers, increasing LP and GP interest all suggest that energy technology, likely alongside clean technology, could be the next great venture investing opportunity.

¹ EPRI, Electricity Sector Framework for the Future, Volume I, p. 40.
Wall Street Journal, May 18, 2004.

² EnerTech Capital is a venture capital firm that provides financing and management support to early stage and emerging growth companies in the energy technology and clean technology markets. EnerTech's industry specialization, domain expertise, and extensive venture experience enable us to identify and invest in companies that offer powerful value propositions in markets that we know well.

³ Energy Industry Administration (www.eia.doe.gov)

⁴ Energy Industry Administration (www.eia.doe.gov)

⁵ CleanTech Venture Network (www.cleantechventure.com)

⁶ Clean Edge, Clean Energy Trends 2004, p. 3.

⁷ EnerTech estimates based on a variety of sources.

⁸ International Energy Agency, World Energy Investment Outlook, Insights 2003, p. 4.