Quantifying the Environmental impact of venture capital

Recently, there has been a growing backlash against environmental, social, and governance (ESG) measurement and reporting as it has become more complex and confusing. The Economist and others have suggested that it is time to separate the E from the S and G as they are masking the necessary focus on greenhouse gas (GHG) abatement (or removal) — the most critical and urgent challenge for humanity. As an example of the difficulties of using combined E, S, & G ratings to guide environmental impact investing, in early 2022, Tesla was removed from the S&P 500 ESG index while Exxon was added.

While we agree with the deep flaws of grouping the E, S, and G goals into a single rating, we further believe we’ve lost our way on environmental impact reporting. Environmental reporting is becoming increasingly complex, expensive, and, unfortunately, more difficult to digest.

In the world of venture capital (VC), the average VC report points to a myriad of UN Sustainability Goals, PRI commitments, European taxonomy (SFDR), or other proprietary metrics vaguely and subjectively, leaving much room for exaggeration or, in some cases, deception. Using current metrics, it is nearly impossible to compare the environmental impact between individual investments or funds.

Conversely, it is straightforward today to compare one asset class to the next and even easier to compare the performance of VC firms on standardized financial metrics like IRR (internal rate of return) or MOIC (multiple on invested capital). The financial industry uses the same metrics to compare individual investments and funds and can do so across asset classes, making them invaluable and critical to investors in their portfolio planning.

Why don’t we have the same for climate impact?

Investors in VC funds and the funds themselves require objective and standardized metrics for measuring climate impact so investors can understand where they are achieving the most significant climate impact for their dollar.

ArcTern believes climate impact metrics should mirror financial metrics in the way they provide historical (period and cumulative), current period, and forecasted period metrics. We believe climate impact should be quantitatively measured in terms of GHG abatement (tons CO2e abated or removed), and ultimately we should be able to calculate a cost per ton of GHGs abated through an investment ($/kt CO2e) in any fund or company.

With this information, investors can compare the GHG abatement impact of individual deals, funds, and asset classes. Additionally, a VC investment could be compared with the cost of a carbon offset to understand where the individual dollar is having the most significant impact in abating GHGs. In this case, the investor would also need to consider that an investment in a carbon offset is a one-time abatement. In contrast, an investment in a company generates ongoing cumulative GHG abatement (akin to planting a tree on your property vs biochar).

With precise financial performance and impact metrics, investors could select investments or managers that optimize their financial and impact goals.

ArcTern’s 6-step approach to quantifying climate impact:

Below are the steps ArcTern employs to quantify GHG Impact and ultimately provide an abatement cost per ton of CO2e for a given period.

1️⃣ Construct the Unit GHG Impact Model

This is one of the most challenging and company-specific steps. The calculations in this step require an extensive understanding of the company’s solution and an in-depth assessment of peer-reviewed science and Life-Cycle Analyses (LCAs). ArcTern recommends that the impact model assumptions be transparent and available for review.

The GHG impact model should start with a clear explanation of the theory of change — how the company’s product or service will directly and/or indirectly abate (or capture) GHGs vs the status quo. The impact model varies considerably from company to company. For example, residential heat pump installations have a GHG impact for years following its initial installation. We dub this model “recurring impact.” As a result, GHG impact is decorrelated from annual revenue. Alternatively, the impact generated by machine-learning software that reduces building energy consumption via an annual SaaS subscription is highly correlated with revenue (presuming no price changes). We dub this “non-recurring impact.”

2️⃣ Calculate Gross GHG Abatement for a Period

With the Unit GHG Impact Model, the Gross GHG for the given period can be easily calculated for either:

• Recurring Impact Models: multiplying the annual GHG abatement per unit by the cumulative installed and operating units
• Non-recurring Impact Models: multiplying the GHG abatement per $ by period revenue; or, if detailed information is available (e.g. GWs of wind plants software is deployed on), a bottoms-up model can be built

3️⃣ Deduct the Company’s Carbon Footprint for the Period

Deduct the company’s carbon footprint (scope 1, 2, and 3 CO2e emissions) for the given period from the gross GHG abatement (which may be negative in the early years). Given the need to calculate scope 3 emissions, this step can be very complex. ArcTern expects many software solutions in the future will offer this at a reasonable price point, and calculating scope 3 will become much easier as more companies in the supply chain track scope 1 and 2 emissions. A simplified estimation approach can begin with a rough estimation of scope 1, 2, and 3 emissions on the product/service and then use general industry metrics for the emissions from general SG&A expenses to arrive at a total carbon footprint estimate for the company’s operations.

NOTE: ArcTern does not currently report on net GHG impact due to the complexity of data collection on scope 3 emissions. We are working with our companies to move to net reporting in the coming years.

4️⃣ Calculate Net GHG Abatement for the Period

The net GHG abatement is simply the gross GHG abatement less the company’s carbon footprint for the given period.

5️⃣ Calculate the Weighted Gross or Net Impact of Investor’s Capital

This is rarely done by investors in the VC community, and ArcTern has not seen it requested by LPs. ArcTern believes investors should only take credit for the GHG abatement their capital has created. Owning 1% of a company and taking credit for the entire emissions abatement is a misleading representation (but common, often without intention). However, we have the data required for this calculation using the capital table, debt holder registry, and enterprise value (EV). Using this information, the investor can calculate its capital investment as a percent of the total EV.

For example, if equity holders represent 80% of EV (EV = equity value + debt — cash) and the specific investor owns 5% of equity[1], then the given investor would take credit for 4% of the GHG abatement for the given period.

Multiplying the total gross or net GHG abatement for the period by the investor share of this impact provides the total Gross or Net Weighted GHG abatement attributable to the given investor.

But shouldn’t investors providing “catalytic capital”[2] get more credit for GHG impact?

We think this approach already accounts for the fact that investors taking more risk on emerging technologies will (usually) own a larger percentage of the company at a lower entry cost. They can therefore have a much greater GHG abatement/$ than later-stage investors on their successful investments accounting for them taking a more significant risk on climate innovations. Note this is no different than the financial world, where successful early-stage investments can deliver enormous financial returns; however, the success rate per investment is much lower. This approach enables us to move the concept of “catalytic capital” from a subjective evaluation to a quantitative one. It also allows investors to compare early-stage VC funds (that claim to be more impactful as they are “catalytic”) with late-stage VC or PE funds on a single metric — GHG abatement per $ invested in the fund.

6️⃣ Calculate the Cost per Ton of CO2 Abatement (CO2e kt/$)

Dividing the total GHG abatement attributable to the given investor by the total capital investment of the investor enables us to arrive at a standard Weighted Gross or Net GHG Abatement per dollar invested. We can now compare any company or fund investment across asset classes (VC, PE, Debt) on an equal basis for a given period … just as we do in finance with its simple summary metrics like IRR, ROI, and MOIC.

In addition to reporting as an Article 9 fund under the EU Sustainable Finance Disclosure Regulation (SFDR), ArcTern provides quantitative GHG reporting on: (1) gross annual GHG abatement for the company, (2) weighted share of this GHG impact based on ArcTern ownership, and (3) the cost per gross ton of gross CO2e abatement (or capture) on an annual basis. ArcTern also includes a running 5-year forecast to provide investors with insight on the dropping cost of the impact that is typical of growth equity investments.

As in the above examples of three ArcTern Fund II portfolio companies, we can see that the cost per ton of CO2e abatement is very high in the early years but drop rapidly over time as the company scales with less equity investment. We can also see that equity investments in climate innovation startups have the potential for outsized returns and impact (we can see a cost per ton of abatement as low as US$5 per kt of CO2e), which makes the venture asset class one of the most cost-effective ways to solve climate change.

[1] A waterfall calculation could be performed at the given Enterprise Value with more complex capital tables and shareholder classes to more specifically measure the ownership of the investor's share class at that point in time.

[2] Some non-profit groups or VC firms claim they provide “catalytic capital” by investing in startups that will be neglected by peers seeking market-based financial returns. It is ArcTern’s opinion that this is a very subjective categorization. How do we know if it was overlooked or simply not seen by other potential investors? How do we know the company would not have raised capital from financial drive investors? Ultimately, the goal of venture capital is to identify investment opportunities before peers, so in a sense, any lead investment without a competing term sheet is an “overlooked” investment opportunity. Still, it does not mean it is “catalytic.”