Market Analysis

How much do we need to invest in the energy transition?

Solar Panels
Photo Credit: Zbynek Burival, Unsplash

In this post, we frame the financing challenge for climate mitigation and adaptation in the coming decades. In future posts, we will drill into how this translates to opportunities within specific segments - and where, therefore, we think the most exciting white spaces are for new climate finance start-ups.

Key takeaways:

  • We need to increase investing in the energy transition by ~5x—to a total of $4.4T annually—to hit Net Zero by 2050.
  • The sub-sectors requiring the most spending will be energy efficiency, the electricity network, and solar PV—together worth 49% of all spending required.
  • The majority of the capital stack will be private lending and capital markets financing, which are particularly well-suited to maturing technologies in the process of scaling today, such as renewables and EVs.
  • We see huge opportunity for businesses that can connect the right parts of the capital stack with the sub-sectors facing the highest financing need. For example, there is meaningful opportunity for fintech businesses that can reduce frictions for mature technologies trying to access capital markets and corporate lenders.

How much money do we need to hit Net Zero?

The global economy needs to invest $4.4 trillion annually in order to limit climate change to 1.5C, according to the International Energy Agency (IEA). This is a 5x increase from our current yearly spend of $755B. $4.4 trillion in annual investing is large; by comparison, it represents:

  • ~2x the size of the Canadian economy
  • Over 6x the US Defense Budget for 2022
  • ~16x the cost of the 14 Apollo missions, adjusted for inflation

The scale of this is world-historic: As noted climate economist Nicholas Stern has put it, the green transition is “the biggest capital reallocation since the Industrial Revolution.”Note: $5.7T in annual investment is what's needed for our current decade from 2020-2030. For 2030-40 and 2040-50, the yearly investment is $3.7T, leading to a weighted average across three decades of $4.4T.

Where is the money needed?

Almost half of the $4.4T required will need to go to four sub-sectors. The IEA says these are building energy efficiency (22% of the total), electricity network improvements (14%), industrial energy efficiency (8%), and solar PV (5%).

However, some sub-sectors will need to grow much more than others, in relative terms. For example, spending on EV charging infrastructure will need to grow ~65x from its current level. Similarly, biofuels supply will need to grow ~44x, grid flexibility measures by ~33x, and concentrated solar by ~28x. This creates a variety of opportunities across both major markets and smaller markets that will scale meaningfully.

Insight for entrepreneurs: There is significant opportunity in the largest sub-sectors of the transition, but there are also meaningful pockets of huge growth that are exciting, too. Smart plays can take advantage of huge scaling in smaller sub-sectors.

What type of money is needed – and when?

The majority of financing for the transition will come from private lending and capital markets. The International Renewable Energy Agency (IRENA) predicts that 30% of the financing required between now and 2050 will come from commercial lending, and a further 23% from capital markets - primarily in the form of bonds. The remainder will come from private sources of equity (29%), public equity (11%) and development finance lending (7%). In the current decade, the share of private lending and capital markets will be even higher - worth 56%, or $3.2T of the $5.7T in annual financing required.

This creates a significant opportunity for financing technologies that achieve maturity and scale this decade. While IRENA does not break down the type of capital required by specific technologies, we can infer that a meaningful share of the projected private lending and capital markets needs will come from maturing technologies. As Carlotta Perez’s framework of capital needs across the technological development cycle shows, private lending and capital markets are best-suited to technologies approaching and exceeding 25% market share (see Appendix for framework). This leads us to expect that the large pool of private lending and capital markets required this decade will likely be focused on things such as renewable energy generation today and, later this decade, electric vehicles.

Insight for entrepreneurs: Climate finance start-ups should consider the type of capital that is required by different technologies over the coming decades - not just the size of the value pool.

What opportunities does this create?

There is white space for climate finance companies that can bring together the right parts of the capital stack with key segments of the energy transition. Businesses that we believe can succeed will:

  • Improve capital markets’ ability to fund relatively mature technologies, especially in the coming decade. This type of financing is most suited to technologies exceeding 25% market share, such as renewable energy in the United States. Other relevant examples could include heat pumps and other forms of building-related energy efficiency.
  • Facilitate private lending to technologies gaining competitiveness in the coming decade. Technologies gaining competitiveness with market share between 5% and 25% are well-suited to this type of capital. In the United States, electric vehicles have now crossed this threshold — meaning, for example, that businesses providing or facilitating financing for EVs and EV chargers could be well-positioned.

Of course, the prospects for businesses like these will vary by sub-sector. In future Ezra Insights posts, we will go deep on some of these to understand what the capital stack looks like today, what will need to change, and how climate finance businesses might be able to play.

We would love to hear from you, too:

  • Which sub-sectors have you seen the largest capital challenges in? Why do those challenges exist?
  • What financing innovations have you seen in other sectors that could be relevant here?
  • Are there any great climate finance businesses you have seen address some of these challenges? Who are they?

APPENDIX - Perez’s framework of industrial revolutions

  • Gestation phase - Early stage testing and development of technology, with market share of up to 1%. Primarily funded by public R&D funding and speculative private capital via entrepreneurs.
  • Irruption phase - As the technology becomes cost-competitive and grows market share to ~5%, capital is required to scale. This is typically provided by VCs and hedge funds.
  • Frenzy phase - The technology seeks to find a viable business model, approaching 25% market share. Capital comes from private lending in the form of commercial loans, industry equity, and eventually bonds from capital markets.
  • Synergy phase - Slowly the technology becomes dominant, approaching 75% market share with meaningful returns for investors. Private lending and capital markets remain the primary sources of capital.
  • Maturity phase - The technology is dominant, and eventually is challenged by competitors. As this occurs, capital costs increase and demand shifts to newer technologies.

Sources and acknowledgements