Mind the Net Zero Funding Gap

Sebastian Peck, Managing Partner at Kompas, says debt financing can help accelerate governments’ clean energy commitments and support climate tech growth.

Earlier this week, Keir Starmer, the UK Prime Minister, said “painful” choices lie ahead if the country is to fill a £22 billion black hole in its public finances. Implicit in Starmer’s statement was a universal truth for governments facing harsh financial decisions: during periods of economic uncertainty, net zero promises tend to move down the chain of political priorities, with funding for public sector services taking precedence.

The new Labour government has been clear in its commitment to make the UK “a clean energy superpower” and the “‘green finance capital of the world”, but reports have claimed that its ambitious net zero plans will require hundreds of billions of fresh investment. Given the perilous state of the economy, expecting the public sector to provide the investment required is not viable. The only way to hit these green targets is through the mass mobilisation of private capital.

It is a similar story across Europe, where economies are fighting to return to growth following a period of crippling inflation and high interest rates. In such a tough environment, crucial investment into green projects is being delayed or scrapped altogether. Last year, Germany’s Federal Environment Agency said it was unlikely to hit targets to cut greenhouse emissions by 65% by 2030 and would therefore struggle to reach its net zero by a 2045 target. The Scottish government announced earlier this year that it would backtrack on its net zero plans.

These decisions have wide-reaching consequences. In April, Europe’s top human rights court ruled that the Swiss Government violated its citizens’ human rights by failing to protect them from climate change. Legal experts have said this creates a precedent that others can use to seek redress in the courts.

Venture debt’s new role

Clearly some sort of change is required to encourage investment from the private sector. Rachel Reeves, the UK Chancellor, recently announced a £7.3 billion National Wealth Fund, which will provide a mix of debt and equity financing to decarbonise the UK’s heavy industries and, crucially, involve the private sector in the process. It is a positive and ambitious step by the government to overcome the gaping green funding gap we face – but we need so much more.

For much of the past 20 years, funding for early-stage climate technology companies has come via equity investors, mainly venture capitalists (VCs). But the downturn in the equity funding environment since the highs of 2021 has meant another form of financing is emerging – debt.

Traditional lenders in the private sector are typically risk-averse when it comes to providing finance for startups, and generally only lend to companies with a strong financial track record. However, for innovation-focused startups, a good idea can only take you so far. Many young companies, particularly capital-intensive climate tech hardware startups, often lack the evidence they need to convince investors to take a gamble on their ideas.

This has put venture debt financing into sharp focus, as many climate tech companies require investments in fixed assets such as production facilities and machinery. What’s different about the climate tech space, compared to other tech sectors such as software or AI, is that many are building first-of-a-kind (FOAK) facilities, such as new power stations or new cement manufacturing plants.

For this type of project, solely providing equity financing is not an efficient use of funds. Debt financing gives climate tech founders the ability to retain full ownership, access to capital without dilution, and the flexibility to use their funds to grow and scale their technologies.

Complex funding landscape

To prove that climate startups are eligible for the levels of debt financing required to fund these capital projects, founders will have to fundamentally switch their mindset away from a ‘growth at all costs’ mentality to prove to investors that they can identify, quantify and underwrite the risks associated with scaling their capital-intensive company.

Strict criteria around financial, operational, commercial and technological risk exist to prevent lenders from funding companies that will default on their repayments. If a climate startup can demonstrate that it can eliminate, or at least mitigate these risks, it will prove they are a solid bet for more debt providers.

As the number of stakeholders within private sector lending increases – from debt, equity or government funds – so too does the complexity of the funding environment for VCs and founders.

Government as a catalyst

Although we’re seeing the VC industry evolve to meet the unique demands of scaling climate tech startups, certainty around policy from the government is absolutely critical for the private sector to make more informed, confident and considered bets in the climate sector.

The National Wealth Fund and similar programmes in Europe send a signal to the market about future demand as well as underwriting the risk for private investors. The hope is that the use of public funds, as well as private sector mobilisation will result in higher-quality investments for climate tech startups.

To reach climate goals, governments must work in partnership with the private sector and provide a certain policy environment that aligns incentives, reduces risks for private investors and accelerates the green transition.

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