Venture Capital's Clean Dreams for China
This summer, the government of the eastern city of Wuxi had to turn the taps off, cutting off water supplies to millions. The reason was that chemical factories had dumped too much untreated effluent into the city's main water source, Lake Tai, feeding a massive algae bloom that choked the water body.
Just half an hour's drive from the lake's shore, however, were three factories where workers in face masks and green jumpsuits were assembling paper-thin, black or dark-blue silicon crystals into panels. The factories, operated by a company called Suntech Power, can make enough panels in a year to generate 325 megawatts of clean solar energy.
The situation in Wuxi - unchecked pollution on one hand, and green industry on the other - embodied the contradictions in China's latest investment opportunity: Cleantech.
Much like information technology, cleantech can be difficult to define. Just as "IT" can mean anything from spreadsheet software to virtual MP3 players, "cleantech" is an umbrella term that covers areas as diverse as energy-generation (solar, wind, biofuels), water treatment and energy efficiency (buildings and monitoring systems).
"Cleantech is not a single industry, it's a very huge universe," said Don Ye, founder of Tsing Capital, one of the country's first venture capitalists to focus on cleantech. "It is not a sector, it's more like a concept."
With the IT-cleantech parallel in mind, maybe it's no surprise then, that venture capitalists (VCs), for so long the kingmakers of the tech world, have been upping their stakes in cleantech investments. China represents perhaps the most lucrative of these opportunities, serving as both a potential manufacturing hub for cleantech exports and as a vast future market.
According to research by the Cleantech Network, cleantech-focused investment in China in 2006 rose 147% year-on-year with US$420 million invested in 26 deals. In the first quarter of 2007, US$154 million was invested. This makes cleantech the third-largest destination for venture capital in China after the IT and telecoms industries.
THE SILICON CONNECTIONCleantech and IT are linked by more than money. The two are connected by a raw material that most of the world can no longer live without: Silicon.
Semiconductor manufacturing, which turns silicon into the chips that run electronics everywhere, has turned out to be a business model for Chinese solar companies. These companies turn silicon into photovoltaic cells that absorb sunlight and transform it into electricity. Silicon was the perfect bridge between venture capitalists and cleantech entrepreneurs.
Suntech Power's US$396 million share offering on the New York Stock Exchange at the end of 2005 heralded the start of a Chinese solar boom. The company's shares, which first opened at US$15, now stand at about US$40 and its founder, Shi Zhengrong, is one of the richest men in China.
Since Suntech's listing, more than half a dozen Chinese companies involved in the production of solar energy have gone public. The most recent market debutant was LDK, which listed in June.
Ye backed two of those solar plays: China Sunergy, which listed on the NASDAQ on May 17, and LDK.
"We made 5-10x on those companies," he said. "In other words, the [returns] were over 1,000%, so it looks good."
China's cleantech space is clearly profitable, and the smart money is beginning to give chase. But what sparked this Sino solar bull-run? To answer that question, a look at the solar supply chain is needed.
Most of the Chinese solar companies are manufacturers of photovoltaic cells (PVs) or modules, which are sets of mounted cells. These modules are the building blocks of systems that convert sunlight into electricity. These cell-makers must buy their supplies from companies that sell raw polysilicon or microns-thin silicon wafers. The raw materials are assembled in the firms' factories in China and then exported to markets like Germany, Spain and Japan, where government subsidies make solar energy viable.
Many of the world's biggest cell-makers, however, are part of conglomerates.
The Japanese manufacturing giant Sharp, for instance, is the world's largest manufacturer of PV modules, according to research firm Clean Edge. The size of these companies means the proportion of their business exposed to solar energy is relatively small.
However, a number of global factors, including the rising price of oil, has driven demand for renewable energy - which includes solar - stocks.
"There's a desire for people to play the solar trend, but there [were] limited opportunities to do so in the public markets," said Michael Holman of Lux Research, which follows the cleantech industry. "That's what's driving up a lot of these valuations."
UNFAMILIAR TERRAINCleantech is alluring, but it's not easy for VCs to get into it in China. While many of them have a thorough grounding in computer science and engineering, they are less surefooted when it comes to navigating cleantech's intellectual terrain.
"Cleantech is very different from IT. In IT you do a lot of meetings and it's related to software bits and bytes," said Andrew Chung, a senior associate at Lightspeed Venture Partners, a Silicon Valley firm. "But with cleantech, you're dealing with material science, you're dealing with physics, optics, fluid dynamics, synthetic biology - a totally different set of sciences."
According to Chung, who says he has reviewed more than 400 cleantech companies in the past 18 months, many VCs in China are hunting for later-stage deals in companies with simple business models that depend on execution more than technology. Many Chinese firms are far from the cutting-edge of clean technologies; instead they operate copycat business models, deploying technology that's widely in use but promising better and cheaper execution.
"In China you accept the fact that the technology will be relatively commoditized, but [VCs] need to look for guys and teams who have a solid model and can execute the heck out of it."
There is also the greed factor. Both public investors and VCs alike are prone to plumping for the next big thing in order to make a quick and lucrative exit.
This kind of bandwagon-hopping is one reason why some believe the Chinese solar stock prices are unsustainable.
END OF AN ERAWhile PV makers can control their labor and assembly costs in China, their demand for polysilicon is driving the price of the raw material up. The Chinese firms' sole advantage - their cost - is therefore being threatened.
"For the guys in the middle, the Suntechs of the world, all the margin will be squeezed out," Lightspeed's Chung said.
Indeed, at the time of writing, prices of these stocks were tumbling because of investor suspicion that LDK misstated its polysilicon inventory. The firm has denied the allegations so far.
The next wave of Chinese cleantech companies will have to abandon the PV industry's cheap exports model if they are to find growth. A number of factors must coalesce for this to happen, notably policy and enforcement.
For one thing, Beijing has to make it worthwhile for cleantech companies to target China as a market instead of relying on policy pushes in Japan, the US and Europe.
While the central government has signaled its support for clean energy by creating a renewable energy law and mandating, under the 11th Five-Year Plan, that 15% of China's energy to come from renewable sources by 2020, industry participants say these broad policies have not translated into action.
"[The Renewable Energy Law] is too general. It's hard to follow," said Jerry Li, head Cleantech Network's China subsidiary. "You see sentences in regulations and laws, but there are no practical procedures to follow."
If structures are put in place that enable cleantech firms to break free of the factory-based manufacturing model, they could start to act as aggregators, packaging different technologies in order to offer installation, monitoring and consulting services to clients.
Tsing Capital's Ye is a believer in the next-gen services model for Chinese cleantech. In the water treatment business, he says, firms are usually locked to a fixed tariff.
In order to make money, they must deploy the most efficient technology and management techniques to reduce costs. The difference between the fixed rate and the cost would be theirs to keep.
"It's like a janitor service. The client doesn't have to care what detergent I'm using or what kind of broom I'm using," he said. "It's a fixed rate. [Water treatment firms] can introduce anybody's technology, but the cornerstone is service."
Ye also believes that the next cluster of IPOs could come from energy efficiency companies. These energy service companies (ESCOs) profit by helping customers save energy. Typically, ESCOs don't charge customers anything for installing energy-saving equipment. Instead, they take a fixed amount - usually 50% - of a customer's energy savings.
Energy-saving will be big, Ye argues, because of the government's goal to reduce the country's energy intensity by 20% by 2020. Others tip clean-coal technology and wind power, citing policies targeting those sectors.
SHORT OF IDEASBut government action is not the only foundation for cleantech success - gains from indigenous technology are important too. Most Chinese cleantech companies rate low on innovation, according to Holman of Lux Research. The solar companies, for example, tend to buy their technology either as turnkey systems from firms like Applied Materials in the US, or by forming joint ventures that base manufacturing operations in China while drawing technology from abroad.
No breakthrough technology from a Chinese company is on the horizon. What's more likely to happen, Holman says, is local companies will start to modify existing technologies to reap incremental gains. He cites Shenzhen Nanotech Port, which was one of the first to start manufacturing carbon nanotubes, a type of advanced material, on a mass scale. They worked from research by Chinese Academy of Science, which in turn built on advances made by Japanese labs.
"That's the type of pattern you'll also see in solar energy technology," he said. "In the next 10 to 20 years you'll start to see the more novel innovations."
China's innovation deficit is structural. In countries like the US, funding for basic research comes from the government. As the science gets closer to commercialization, it goes through research universities and eventually industry picks up the tab. But in China, most universities are still developing their research capacity, and government funding tends to go to the national Academies of Science.
This centralized model for funding research is inefficient and doesn't lend itself well to commercializing technologies.
Governments still play significant roles in cleantech funding globally. In 2006, a total of US$48 billion was spent on emerging cleantech research and development around the world, according to Lux Research. Half of that came from governments, while about 46% came from large corporations. The remainder, about US$2 billion, was bankrolled by VCs and private equity funds.
"In China, funding is biased more strongly towards government funding and significant investment from corporations. Relatively little is coming from venture capital," Holman said.
THE ROAD AHEADChina's relentless growth is now giving way to a gentler "harmonious society" as Beijing accepts more must be done to prevent the country's environment from being consumed by its economic engine.
"The first 10 five-year plans were only concerned with the supply side. The government always wanted to produce more," said C.S. Kiang, dean of Peking University's environmental science college. "The 11th Five-Year Plan is the first time they said 'we need to improve energy efficiency and reduce pollution.' They are now talking about demand."
This is happening against a backdrop of rocketing oil prices and a growing consensus about climate change. If the right doses of capital and technical creativity can be added to government policy, could China eventually lead the world in the cleantech stakes?
Lightspeed's Chung answers with an emphatic yes.
"In China, [the environment] is a survival issue [and] the government has the ability to put their muscle behind it. It can say 'tomorrow all the coal-firing facilities in this province must adopt this technology - and they'll do it. Add all those things up, including the capital going in right now and the entrepreneurial interest that's been energized and you're going to get a lot of activity that will be amazing to see. China will become a cleantech powerhouse in the next 20 to 30 years."