28 November 2022 | Irena Spazzapan
The 2020s are the critical decade to bend the curve of greenhouse gas emissions. Equally, we are now at a critical moment in history where technology, voters’ needs and monetary factors are converging to form a very powerful trend towards increased investments in real assets, or capex across the Western world. How?
Let’s take technology first. The first thirty years of venture capital fundamentally chased a single trend: Moore’s law of semiconductors enabled the speed and capability of computers to double every two years. The digitalization that followed led the majority of capital investments away from real assets towards software and consumer-facing services. Digitalization is now converging with other technologies – namely ever cheaper electrification of grids, transport electrification, synthetic biology and genomics. Way more complexity but also an increased set of opportunities requiring significantly more capital allocation towards real assets.
Secondly, lets look at voters. In 15 years from 1999 to 2014, US household median real income fell by 13% – in a world where aggregate net wealth was rising at an annual rate of 6%, with a similar trend in Europe. Developing Asia’s capital expenditure rose from 30% of GDP to 40% of GDP, while that in the US and Europe decreased from 22% to just over 20% before recovering around the pandemic. What do voters in the West want today? My guess is cheaper and abundant energy (which is not a given anymore for the first time since the 1970s), climate change mitigation, more defense for the first time since the cold war, reduced inequality, less dependance on Asian manufacturing, affordable housing, cheap (healthy) food. The West has under-invested in capital expenditure for the past 15 years, pushing everything into consumption. Yet, except for reducing inequality and possibly cheaper food, the list above requires lots of capital expenditure.
Finally, monetary factors. Since the 2000s, cheap Chinese manufactured goods poured into western markets, whilst wages remained low in a tight competition with Asian outsourcing – leading to decades of very low interest rates and low inflation. In the “The Price of Time”, Edward Chancellor calculates that the last 20 years have seen the lowest interest rates in 5 millennia going back to Mesopotamia. As it always happens in history, prolonged periods with nominal rates below 2% lead to “pies in the sky”, where free money blurs the concept of investment timelines or science credibility. Crypto or carbon offsets anyone? Yet, this time it is not just the usual monetary tightening with higher rates. We are also likely to shift to structurally higher long-term inflation around 3-5%, leading to long-term low real interest rates – encouraged by politicians to solve the conundrum of capex and oversized national debts. This is very much what happened after WWII, bringing debt to more manageable levels.
I have greatly enjoyed reading Russell Napier's interview, arguing for a return to a massive capex boom in the decades to come, led by governments taking on monetary creation to please voters. If you follow Napier’s thinking, the next 15-20 years will see higher structural (Vs cyclical) inflation and savers’ financial repression which will lead to a historical capital expenditure cycle. Unlike in the 1950s and 1960s, this one will inevitably be more private sector led with a number of state guarantees that do not count as official debt. Take the US Inflation Reduction Act (IRA) as example: the overall package including guarantees is almost 3x the official package of tax credits.
I have been thinking a lot recently about the convergence of this new monetary world with the next 20 years which will be the most critical for the future of humanity. As the rates cycle shifts and inflation goes up, we might have the opportunity to rebalance GDP from consumption to investment. We underinvested in capex for years, so we will need to shift a significant chunk of GDP away from consumption to investment, executing on what voters want. This will require some pretty progressive thinking and tremendous execution capabilities, leveraging the best technology we have to do more with less. A bit like what we saw happening, fast, with the Covid response – now applied to most sectors of the economy. Whilst historically these kinds of shifts happened as a result of over-indebtedness following global wars, it is possible that this time around the radical reset of our economies will instead happen through increased investments leading to a generational financial transfer from savers to borrowers, from the old to the young.
Despite the gloom and doom among some climate activists, we have made progress. Technological innovation is enabling faster progress with less infrastructure investments, and this is a net positive. Ahead of the historical COP21 agreement in Paris, the world was on track to 3.8 degrees in 2016. If you sum existing policies now, we are closer to 2.7 degrees (2.1 with rosier NDCs ie national plans submitted to UNFCCC). This is amazing progress in just 7 years. Equally, the amount of energy required to produce a unit of GDP has fallen by 26% since 2000. Four fifths of German emissions reductions since 1990 reflect lower energy intensity (only one fifth is green energy), in the same period in the US, GDP rose by 29% but emissions by 15%. This all happened in a largely pre-mass electrification world, with voters still largely skeptical about the science of climate change and during the lowest capital expenditure period since WWII. Technology evolution is essentially about doing more with less, and it goes hand in hand with the transition to net zero.
Macroeconomics are often absent from the menu of climate solutions, yet rising rates and structurally higher inflation (ie negative real rates) could lead to a massive spending cycle exactly in the decades that matter the most for our future. Vinod Khosla talks about 12 major areas to focus on spending in the coming decades: electricity, EVs, aviation, shipping, cement, steel, animal husbandry in agriculture, fertilisers, grid storage, high temperature industrial head, water and various carbon removal technologies. I would add regenerative agriculture (in the sense of preserving carbon in land use), semiconductor capital equipment, construction, robotics, sensors and visualization hardware/software, nuclear power generation.
The tables are shifting big time for investments in real assets generating positive cashflow. An unprecedented wall of capital is chasing great investment opportunities in the key transitions around energy, industry and food – helped by supportive policy via tax credits, incentives and demand creation. Venture capitalists are also getting much better at bridging the decades-old mantra that capital intensive businesses inevitably make poor returns. Capex intensive climate unicorns include Solugen, Sunfire, Perfect Day, Form Energy, Upside Foods among others. Hardware or deeptech start-ups at some point become industrial companies, with no shortage of late stage capital focused on such investments.
Yet, rising interest rates mean that the required return on investment for all asset classes is going to increase significantly in the years to come. This is not good news for venture capital that relies on low interest rates when discounting future cash flows. The wall of capital going into climate tech will inevitably dry relatively to 2021 and 2022, and converge to the winners who can get to positive cashflows faster – and to those that can get to higher industrial efficiencies faster. Much like traditional tech titans in Silicon Valley are being pushed by investors to do more with fewer resources, climate tech will have to follow the same route. The great news is that start-ups with the best prospects for generating competitive cost curves and driving efficiencies will greatly benefit from the macro shift to capex, and equally the flow of mission-driven talent coming into climate will further boost the best climate tech companies or create new ones. It is the role of venture capital investors to back start ups with the best prospects for generating positive cash flows within a 10-year timeframe, but is it equally crucial for governments to increase spending in fundamental R&D with a longer time horizon, and to use fiscal levels to make climate solutions economically viable sooner.
At Systemiq Capital, our mission is to improve the odds for humanity by backing the best founders. There has never been a better time to back transformational founders, but equally it is critical to understand the context where investors and founders will operate in the next decade. This is not the time to back “pies in the sky” but solid, game-changing start-ups that can move on the capex train as soon as possible – either as tech enablers (ie helping to do more with less) or direct solution providers. Possibly with a big help from the structural shift in inflation we could still get to below 2 degrees by 2050, avoiding the worst consequences for humanity.
Negative real interest rates could drive a historical capex boom as investors chase returns above the nominal rate of inflation.
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