As the world is grappling to face the threat of climate change, investment in the climate tech and sustainability space has become more urgent. Despite its slow and steady pace, especially when compared to investments in other popular spaces such as fintech and Web3, the Southeast Asian region has begun to see more money flowing into the space.
But how does an investor in the climate tech and sustainability space assess a potential investment? What does their decision-making process look like? More importantly, considering the significance of impact for startups in the space, is there any difference in the way investors are assessing them?
For investors in the space, profitability is not the only factor that they consider when investing in a climate tech and sustainability startup. They look into how these startups are creating an impact; more precisely, how their solutions can make a change in the society by helping it face the threat of climate change. Beyond that, these investors also consider how significant the impact of the solutions is.
In March, Third Derivative, the venture capital and accelerator programme that aims to accelerate climate innovations, published an article that explains how the organisation assesses the impact of a potential investment in the climate tech and sustainability space. The article details the thought process behind the key criteria that they use; it gives us an insider look into their decision-making process.
To help us get a deeper understanding of their method, e27 speaks to Chetan Krishna, Transportation Investments and Research at Third Derivative and the lead author of the article.
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Behind the method
Krishna begins by explaining the thought process behind the development of this method, which Third Derivative uses to assess a potential investment’s impact on mitigating the risks of climate change. Every year, the organisation receives hundreds of applications for its programme from startups across different sectors and geographies. This is why they need a standardised process to help compare the potential climate impact of these different startups.
“When we were looking for a way to do this, we realised that there are not too many methodologies out there, but we are not the first entity to try and create such a methodology. What we did was that we leveraged a lot of great prior work by our peers in the ecosystem … when we surveyed their works, we decided to take a first-principles approach to categorise climate impact, identify the parameters of interest and outcomes that we wanted to achieve from an assessment. Then, we took what was already there, added our own thinking to it, and modified it to get a method that helps us quantify and do the apple-to-apple comparison across geographies and sectors,” he elaborates.
First and foremost, as an investor, Third Derivative will certainly look at the commercial strengths of the startup’s solution. According to Krishna, it needs to be compelling for customers and able to capture market share.
But this leads to another question: does having a high impact always equal having high profitability? The short answer will be yes, says Krishna, as it typically means a large revenue opportunity.
“We try to prioritise climate impact. So, every company needs to meet a minimum impact threshold. After a company has met that threshold, we still do an independent assessment of its commercial strength. We try to find companies that are scalable, profitable, and sustainable; that is where our resources will go to.”
The three steps
We finally get to the part where we are going to take a look at the method that Third Derivative uses to assess the impact of a climate tech startup. It consists of three steps:
Step 1: Defining the type of climate impact
There are two types of startups that the firm is looking for: Direct Mitigation Measures and Enablers.
Direct Mitigation Measures (DMMs) are solutions that help replace legacy, GHG-intensive anthropogenic forcers with more benign alternatives, the firm explains. They give the example of electric vehicles that replace internal combustion engine vehicles, or solutions that aim to “heal” some of the damage done by removing carbon from the atmosphere. An example of this solution will be direct air capture technologies.
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On the other hand, Enablers are startups that create indirect impact through key complementary technologies and solutions, such as charging infrastructure for EVs or project financing platform technology that speeds the adoption of rooftop solar.
For Third Derivative, companies in both categories play a critical role in achieving decarbonisation “at the speed and scale the world needs.”
Step 2: Setting thresholds for climate impact potential
According to the firm, given the scale of the annual global GHG emissions today, what the community needs are a “gigaton-scale drawdown effects from new innovations that are typically global in origin and scope.” These innovations also need to span sectors such as industry, transportation, power, the built environment, and agriculture and land use.
In determining climate impact threshold values for DMMs and Enabler companies, Third Derivative tested and calibrated against its current portfolio, which was selected after reviewing more than 1,000 startup applications to the programme.
“We also took a top-down approach assuming a portfolio of 100 startups, with the knowledge that some will fail but others may be wildly successful. Altogether, we wanted the potential impact of our portfolio to be commensurate (at least the same order of magnitude) with the climate problem. For example, 25 successful startups, each with the potential to mitigate 0.25–1 Gt CO2e/year, would yield a total reduction of 6–25 Gt CO2e/year. We can then add the GHG reduction potential of startups focused on carbon removal through our First Gigaton Captured initiative launching in summer 2022,” the firm elaborates.
Step 3: Conduct a quantitative assessment of climate impact potential
Once Third Derivative identified the type of impact and set thresholds for high-potential solutions, it can quantitatively assess a startup’s impact against those thresholds.
“We deliberately avoid making assumptions about a solution’s scaling trajectory or the possible impacts of changing policy incentives or barriers on scaling (i.e. fulfilled potential in the future). The emergence of future CSEs and DEEs can help speed that adoption as well. We also avoid choosing winners between multiple low-carbon technologies attacking the same problem (e.g. between direct air capture and nature-based solutions that both remove carbon dioxide from the atmosphere),” the firm writes.
“This approach is analogous to comparing the total addressable market (TAM) between startups as opposed to projecting their revenues and cash flows. It means that our method does not project the yearly carbon abatement attributable to a solution as it scales.”
What lies in the future for Third Derivative
In developing this method, Third Derivative is not ashamed to admit that there are certain limitations –and they are looking forward to continuously improving this method to its finest form.
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What kind of improvements do they have in mind, and how can this method be better?
“Even when we were developing this methodology, we wanted to be inclusive of startups who are operating in countries where the countries themselves have lower responsibility towards global emissions than, say, a region such as the US or the EU, who have historically produced large polluters … This could include companies in countries such as Singapore or Southeast Asia in general, where the overall emissions are low. But these countries will develop and their emissions will increase. Solutions in these places also need to create a climate-resilient future for these geographies,” Krishna explains.
“In order to be inclusive of such companies, we modified our climate impact criteria, and we did this even while it was being developed. So it was active learning on our part, as we were developing.”
The firm already has some ideas on how they want to further develop the method in the future. For example, they would like to be able to accommodate companies that can provide spillover effects. One example of such companies will be Tesla. In addition to helping decarbonisation attempt, it has helped to increase consumer acceptability for electric vehicles.
They would also like to develop their method beyond screenings.
“In the future, we also want to track the climate impact that our companies are creating over the course of the programme and beyond,” Krishna closes.
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