Winning at Climate Change Investing

As strange as it might seem considering the increasingly frightening data and scientific studies being published nearly data (Greenland’s Melting Ice Nears a ‘Tipping Point,’ Scientists Say – NY Times, Oceans warming faster than expected: scientists – Reuters), the effects of climate change are not yet thought of as “Bad” by most Americans.

Despite your humble correspondent’s best attempts, many people simply do not perceive the effects of climate change as exerting a significantly negative impact on the economy or on their daily lives.

This perception will change over the next five to ten years, but one big issue for investors is that it is impossible to know what event or tipping point will cause a change in attitudes sufficient to create an investing catalyst.

This timing issue has already created problems for some very smart capital allocators.

According to an MIT working paper, cleantech investors (mainly VC funds) lost over half the estimated $25 billion in capital deployed in the sector throughout the 2006-2011 period – a figure that included such infamous debacles as Solyndra and KiOR. Japan’s Nihon Keizai Shimbun, quotes the Japan Greenhouse Horticulture Association’s assessment that 60% of all vertical farming ventures in Japan have failed to generate profits, despite high food prices and government subsidies.

Considering these frightening precedents of value destruction, the key to investing in this field is good risk control. Intelligent climate change investors must take steps to limit economic exposure to expensive failures while, at the same time, preserving exposure to the enormous upside potential brought about by the upcoming paradigm shift.

The most important first step in risk control is properly understanding at what stage of development a new adaptation technology stands.

My mental model splits technologies into three categories:

• Evolutionary application of current technology (e.g., improvements to Lithium ion batteries and development of a powerwall)
• Novel adaptation of current technology (e.g., applying sensors and pattern recognition algorithms, IoT, robots, LEDs, and crop sciences to grow food in indoor vertical farms)
• Revolutionary development of new science (e.g., Clean Meat, algal biofuels)

Companies marketing evolutionary applications have the least valuation uncertainty; those marketing revolutionary developments have the most.

As time passes, Evolutionary Applications become commonplace, Novel Adaptations become widely commercialized and begin an Evolutionary Development process, and Revolutionary Developments begin to make their way into the realm of Novel Adaptations. Just think of any recent technical innovations — from VCRs to mobile phones — and you can see this process at work.

From an investment perspective, these technology categories are not created equal.

Evolutionary Applications are usually well-funded and / or overinvested, and there is little chance for a short-term investment edge barring a large market price dislocation. The goal as an investor in these companies is to be patient and vigilant and take advantage of price dislocations when they present themselves.

Companies based on Novel Adaptations succeed or fail on the structural scalability of their operations. Early Novel Adaptations will certainly go down unproductive paths, and some will fail. Competitors and successors learn from others’ failures and develop more productive adaptations.

The goal as an investor in Novel Adaptations is to avoid allocating capital to companies more likely to go down irretrievably unproductive paths and / or to allocate capital to later stage innovators that operate with the benefit of hindsight and which can provide scalable solutions.

Companies based on Revolutionary Developments are closer to being science experiments than to being enterprises. Innovations born from these labs may or may not be able to be commercialized and the time to commercialization is also uncertain.

An investor in Revolutionary Development businesses must be both extremely patient and tolerant of total loss of capital. These are moonshot vehicles with a significant probability of loss, suggesting that if one were to allocate capital to them, it should be sized as a very small part of one’s portfolio.

Evolutionary Application firms are often listed on public exchanges, whereas Novel Adaptation firms are mostly private with perhaps some listed small caps among them (though large cap Tesla TSLA probably fits as a Novel Adaptation firm…); Revolutionary Development firms are either private or are small parts of larger, listed companies.

In my mind, the sweet spot for most investors lies at the boundary between Evolutionary Applications and Novel Adaptations.

From the research I have done to date, I think that vertical farming may be at the Evolutionary Application / Novel Adaptation inflection point right now. Some vertical farms are likely proving structurally incapable of generating a profit (due to too high energy and personnel costs), but others seem to be solving structural problems through observation of the failed attempts.

The firm that I wrote about in an earlier article – Carbon Engineering – looks to be at another boundary line: the boundary between Revolutionary Development and Novel Adaptation. These businesses, too, seem interesting for investors who can afford to hold longer investing timeframes.

Each technology step brings with it increasing degrees of optionality, with little leverage on the Evolutionary Application end of the spectrum to potentially enormous leverage on the Revolutionary Development end of it.

Structuring a portfolio that contains a combination of low- to high-leverage positions in a way that insulates an investor from downside risks while still maintaining that enviable quality of “convexity” (i.e., positions become more profitable the more profitable they are…) is something I have thought a great deal about and which I have, in fact, written an entire book about!

My next step is to apply the theory to these types of investments. Stay tuned.