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What’s Wrong With Energy Investments?

As I indicated before, I have become a big fan of the reporting and writing on Xconomy.com. Bill Aulet has posted several articles on xconomy and two recent ones are just simply must read. He titled them “What’s Wrong with Energy Investing” Parts I&II.

In What’s Wrong with Energy Investing? Part I Bill articulates well the need to not lose sight of finding efficiencies in a largely hydrocarbon-based economy as we work on renewable energy sources:

While there clearly used to be a shortage of private equity capital for energy ventures (and rightly so because of their highly cyclic nature), that problem has gone away. Money is now gushing in. By my simple calculations, the amount of money available to energy ventures from dedicated private-equity funds quadrupled from 2005 to 2006, soaring from approximately $5B to $20B. I believe this is even understated. The point is that the money is flowing in at an amazing rate. But where is it going? Energy as a sector is almost as non-specific as technology or transportation. We have to peel back the label and take a closer look.

The lion’s share of the money that is dedicated to energy is earmarked for renewable or alternative energy. Renewable or alternative energy is a fantastic thing and it is necessary, but wholly insufficient, to deal with the energy problem. The biggest part of the energy riddle that needs to be solved resides—and will continue to reside for the next 50 years—with the hydrocarbon side. How do we find more to meet the booming demand? And, how do we find ways, through technology, process, and/or business-model innovation, to reduce the environmental impact of hydrocarbon usage? Renewables is a rounding error when compared to the 80 to 90 percent of the demand that hydrocarbons (i.e., oil, gas, coal—ah!, there it is the four-letter word of energy) fill and will continue to fill for the foreseeable future.

We should and must invest in renewables and alternative energy for the future and there will be some big wins there relative to investing. But with all the new money and attention rushing into this small part of the sector, we are majoring in minors. The major focus should be how do we deal with the continued need for hydrocarbons and how do we make this cleaner energy. Just to put this in perspective, the world would be dramatically better off from an energy-supply standpoint if we could find a way to improve recovery rates at oil and gas wells by 1 percent than if we built a million new wind turbines. If we could find a way to reduce CO2 emissions from automobiles by 1 percent it would be, from a quantitative and practical point of view, thousands of times more positively impactful than increasing solar energy production by a hundred times.

Here is a comment I left on his website:

I did a quick back of the envelope calculation based on your point that without tackling the hydrocarbon economy’s efficiency problems, we would be “majoring with the minors”. In the near term, you are quite right!

US population traveled roughly 3 trillion miles last year that emitted 984 million tons of CO2. If we went the direction of Europe and used ‘clean diesels – for even just 50% of our transportation usage – a conservative estimate would show us gaining 12-13% reduction in CO2 emissions. If we also chose to follow EU that is recommending 120g/km of CO2 emissions in 2012, then we will observe a conservative estimate of 20-22% reduction in CO2. That is more than 200 tons of CO2 from just the transportation sector alone. And this technology is available now! Not tomorrow, and not dependent on improvements in battery technologies or massive changes in our infrastructure.

His What’s Wrong with Energy Investing? Part II is also very interesting. He describes some of the characteristics of a typical energy entrepreneur and the challenges that he/she would face. Once again, at least from my limited experience I think he is dead on with the point. While there is always a role for a smart businessman or a generalist in a growing business, one cannot just plant a consultant, banker or an IT expert in an energy startup and expect them to somehow make the magic happen. Instead of paraphrasing, I quote below:

When new industries arise (e.g., computer hardware, software, telecom, internet, wireless, medical, biotech), they have their own unique characteristics. Obviously, the technical talent required differs greatly in these industries, but so do the entrepreneurial skills required. Entrepreneurs are the change agents who commercialize the disruptive invention, and the inventor (a technologist or some sort of visionary) needs them to create a meaningful new venture. The entrepreneur is the great integrator and the propeller of the new venture.

An entrepreneur who is successful in software usually is particularly skilled at identifying market opportunities and then executing a market-pull, customer-intimate, product strategy in a rapid fashion—getting innovations to market quickly and then iterating to improve the products. These skills are clearly transferable to Web 2.0 venture creation but are not as relevant, and, in fact, may be counterproductive, in a biotech entrepreneurial venture. Biotech entrepreneurs need to have a much more methodical approach over a longer period of time than Web entrepreneurs, and they must possess a distinct ability to manage a company and a project through significant regulatory obstacles. Similarly, as I will explain further, Energy Entrepreneurship is much different than any brand of entrepreneurship we have seen to date. In fact, I would argue that being an entrepreneur in the energy arena is unquestionably the hardest form of entrepreneurship by at least one order of magnitude.

Let’s look at all the attributes or dimensions of expertise that an Energy Entrepreneur needs:

1. Multi-dimensional knowledge of science and engineering disciplines. While the entrepreneur is most often not the technologist or inventor, he (note: I use “he” and “his” in the gender neutral sense) does need to understand the core scientific drivers of the market as well as the technology or science drivers behind his various product offerings. For many new Energy Ventures that could well mean possessing an understanding of aspects of chemistry, biology, engineering, biotechnology, environmental science, computer science, and production systems, to name just a few. Does that make energy entrepreneurship unique amongst technology sectors? To the magnitude that such expertise is required, yes.

2. Longer time frame. While there are exciting exceptions like EnerNOC (NASDAQ: ENOC), the time frame required for an energy company to get traction is much longer than with companies in most other sectors. Biotech companies are similar in this regard, but in general, energy is far outside the bounds of other sectors.

3. Bigger scope and scale from a financial standpoint. Just from a financial standpoint, a typical energy new venture requires large amounts of capital. Investors have to make significant initial bets and then be ready to follow them up with even bigger bets.

4. Ability to deal with public perception and often-intense emotion. Energy is inextricably tied to controversial natural resources, public safety, and environmental issues—not to mention questions about economic impact. Part and parcel with this come public politics and emotion.

5. Adroitness in governmental affairs. Energy is not just emotional—it is politically charged with a significant policy dimension. If one chases down the full value chain of energy-related products, he or she will almost always find that they are directly affected by governmental actions.

In addition to these traits, there is another important and challenging market condition that exists in energy that is fundamentally different from other high tech industries today. It is the imperative to effectively deal with (e.g., by partnering, collaborating, or at least neutralizing) the very people you are trying to disrupt. To a much greater degree than in other sectors the existing hierarchy in energy cannot be ignored.

Energy entrepreneurs, especially those in energy production, don’t enjoy the luxury of having numerous possible routes to market—because it is almost always the case (even though they try to avoid it if they can and a few succeed) that they must deal with the existing hierarchy, which controls the infrastructure.

This is a difficult challenge in general because existing successful hierarchies are very content in homeostasis and resist significant changes (as Clayton Christensen details in The Innovator’s Dilemma). In energy, it is even significantly more challenging because those controlling the infrastructure are notoriously (and appropriately) conservative beyond what would be seen in other industries.

And here’s the summary:

I recently heard a very smart venture capitalist say that he plans to “take successful entrepreneurs from other industries who want to give back now and put them in energy.” In general, I find this approach sorely lacking. For a sports analogy (which is a bit of a stretch I know, but it makes my point), transferring Michael Jordan’s extremely prodigious mental and physical athletic talents from basketball to baseball didn’t really work—nor will it generally work in energy entrepreneurship.