March 2, 2020
Grants and Green Bonds Are Good, But Need of the Hour Is Risk Capital

India consumes one-third of the global standards when it comes to per capita energy consumption. The level of plastic usage is among the lowest and there is a meagre 4% air conditioning penetration in the country. As India moves up the development ladder and aims to be a $10 trillion economy in the next 10 years, there is going to be a great demand for housing, energy, food and transportation. This scenario will hold true for all emerging economies across the world. A scenario that creates a tremendous opportunity for capital to be deployed in these sectors should be good news.

But the truth is that if India and other emerging countries even increase their consumption by 10% compared to the standards of the global north, there will be a compounded serious effect on the environment. Hence, the hard reality is that our approach to energy, food or transportation cannot use the same framework that the western world once used. This means that the existing and traditional model of power generation, distribution, air conditioning, housing and building infrastructure is not going to work and will rather create havoc, instead.

“Imagine the effect it would have on the environment if India, a country of over 1.4 billion people, would consume similar levels of plastic and oil as a country like the US!”

Interestingly, this constraint also creates a huge opportunity for capital and innovation. We have seen that China has built its massive infrastructure comparable to the west, some would say better, at a relatively cheaper cost by leveraging technological advancements. Likewise, what is needed in these sectors (energy, waste, mobility, etc.) is not a pure investment solution but technology solutions that can help India and the rest of the emerging world attain the same standard of living, without consuming the same amount of resources.

 However, this can only be addressed by putting capital to work in these sectors.

But can only injecting large amounts of capital really solve this? If one analyses the total number of impact investments in the last 3 odd years, we see that more than $500 billion, quite a significant sum, has been deployed as impact capital in climate change areas and for issues related to poverty alleviation. While we see evidence of the impact of VC capital everywhere in our day to day life (Uber, Netflix, Urbanclap, etc.), similar stories don’t exist in the impact investment realm.

 So, what is missing?

The challenge seems to be more about nature and type of capital than the amount of capital. As it generally happens, noble intentions may not always lead to noble outcomes. The biggest change this sector has seen is the inflow of impact capital, which by its very definition, focuses on doing good than generating superior returns. This sounds great, if only the real world was similar to a utopian fantasy of passionate teams working on solving large and complex problems without worrying about generating returns.

Impact capital focuses on societal good and not returns, hence the majority of it is either in the form of grants or green bonds. While grants expect no repayment, bonds do expect the return of principle as well a low level of interest. So, what is the challenge?

There are a few basic challenges with grants and climate bonds. Since grants are non-repatriable capital, they create a limit on available capital, and by nature remain of small size – grants above $10 million are almost unheard of. Compare this with $10 million rounds which happen in the start-up world! Thus, despite best intentions, grants cannot ensure supply of a large amount of capital and as a result by design, keep large problems capital-deficient. Further, there are not enough incentives for teams to build faster, better and cheaper solutions. Therefore, these problems not only remain capital deficient, but also entrepreneur deficient, as entrepreneurs are not drawn to these sectors due to the paucity of funds and lack of alignment of interest.

On the other hand, climate bonds have no such challenge. A huge amount of capital is raised through green bonds and there are many examples of super-sized raises in the past few years, thus helping fund large projects. However, the challenge with bonds is that they are debt instruments. They are risk-averse, dependent on supporting equity, and the strength of the balance sheet. This risk-averse capital can drive away innovation as in a lot of cases; the best outcomes are driven by risk capital and not by debt. Imagine starting Google/Uber/Intel/Paytm by raising debt, where interest needs to be paid quarterly!

The point is that while we do need grants/climate bonds to form the basic layer of capital in order build initial infrastructure as well as support core research, the real need of the hour is risk capital which can fund innovative ideas and help entrepreneurs take bold moonshots in solving large problems.

But the question is why do we need risk capital in the first place and can a capitalistic approach really solve these issues?

Risk capital or venture capital, by its very nature, is geared towards high business failures. Almost 40-60% of the investments by funds are written off and the grand success rate of any fund is not more than 30%. However, the critical point is not the success ratio but rather the failure rate. This business model of the VC world with its high failure rate makes the whole chain of investors, from angels to large funds, mentally aware of the possibility of failure. This, in turn, results in funding of a large number of start-ups, focused on moonshots, as well as simpler pain points. Many a time these do succeed, resulting in paradigm shifts in the industry. Thus, the VC world has been able to create a large impact in every sector that they have dabbled in without necessarily focusing on impact. One the other hand, impact funds, despite their best efforts and focus on impact, have not been able to match up to to the success of VCs.

Therefore, it is quite evident that the path to success stories in the future lies with risk capital which can spur innovation and help us create a driverless car/billion transistors equivalent economy in environment-related sectors. Green bonds and grants only need a significant policy push, but innovations always precede policy, so to truly make a difference in the space, risk capital is the best way forward.