Beyond petroleum

Television viewers in the US recently have been treated to the spectacle of commercials sponsored by nicotine empire Philip Morris earnestly warning children against the evils of underage smoking. This phenomenon is the direct result of Altria ? nee Philip Morris – sensing which way the politically correct winds are blowing, diversifying its holdings away from a reliance on tobacco.

Energy companies, under similar pressure to meet evertighter political and social environmental standards, are undertaking similar initiatives, both cosmetic and practical.

Shell, for example, has been quietly but actively doing what one venture capital professional calls ?kicking the tyres? in the emerging energy technology market ? looking to get in on the ground floor as renewable energy sources emerge that will perhaps some day supersede reliance on fossil fuels. The hydrogen fuel cell technology market is widely considered the most promising emerging energy sector in the renewable energy market, a category which includes hydro, geothermal, solar, and wind power.

In business since July 2001, Vancouver-based Chrysalix Energy, an early-stage venture capital firm focusing on fuel cell and related fueling technology companies, is a private equity joint venture between Shell, Ballard Power Systems, BASF Venture Capital, The BOC Group, Boeing, Duke Energy, and Mitsubishi.

Launched two years ago, London-based Conduit Ventures, the first European based venture capital firm which focuses purely on fuel cells and related hydrogen technologies, also has Shell as a cornerstone investor. The other partners in the venture are Mitsubishi and Johnson Matthey.

Another relevant European provider of venture capital is SAM Private Equity, which is part of Zurich-based SAM Sustainable Asset Management. As part of its strategy to invest in technologies that advance a more sustainable use of resources, SAM Private Equity has backed a number of innovate fuel cell developers.

Other major backers of hydrogen fuel cell investing are energy conglomerates and automotive manufacturers.

Of course, hydrogen cars won't swallow what Shell sells. Fuelcell engines are powered by electricity generated through a chemical reaction between hydrogen and oxygen. Because they emit water vapor instead of harmful exhaust gases, they discharge no carbon dioxide, a major cause of global warming. The hydrogen alternative is also attractive to policy makers in the developed world who see it as a means to wean themselves off dependency on oil supplies from the volatile Middle East.

Government backing
The hydrogen fuel market received its most high-level endorsement to date in January last year when, in his State of the Union address, President Bush announced $1.2 billion in federal funding to promote the acceleration of the hydrogen economy and fuel cells, so ?America can lead the world in developing clean, hydrogen-powered automobiles.?

In April, Congress upped the ante when a Senate committee endorsed a five-year, nearly $3 billion research program to develop hydrogen fuel cells and a hydrogen supply system with the goal of making hydrogen-powered cars competitive in showrooms by 2020.

In fact, most governments of the developed world are pushing hydrogen power. Allan Rock, Canada's Minister of Industry, has released a Canadian Fuel Cell Commercialisation Roadmap. In Japan, the government aims to have approximately 5 million fuel-cell vehicles on Japanese roads by 2020. Since fiscal 2000, Tokyo has allocated ¥20 billion (€150 million; $190 million) to ¥30 billion every year for fuel-cell vehicle development.

The European Union has also set aggressive goals, including a plan to replace 20 percent of the fuel now used to run vehicles with alternative energy sources by 2020. The EU plans to invest €2.2 billion ($2.4 billion) over five years in hydrogen projects.

Such positive indicators of serious government commitment are the best signal emerging technologies can display to the public and private investment markets, investment professionals believe. The blessing of government, ?provides a critical sign to the industry, because it is going to take government support to develop and implement the infrastructure required for hydrogen to take hold,? says Ron Pernick, co-founder of San Francisco-based market research and consultancy firm Clean Edge.

But has the private sector been moved by the political endorsements?

?The government's endorsement is important because it signals the reduction of policy barriers,? says David Haberman, the founder of Canyon County, California-based consultancy IfLLC, who previously worked as a member of the hydrogen technical advisory panel for US Energy Secretary Bill Richardson during the Clinton administration.

Still, hydrogen remains a very small segment of the renewable energy sector, itself only a fraction of the overall energy market.

Just under $1.1 billion was invested in 179 emerging ?clean? technology ventures, from solar power to water purification, in 2002, according to the Cleantech Venture Network, representing 5.1 percent of overall venture deals in that year.

According to Investing in Clean Private Equity, a report published by the Stanford Graduate School of Business in March last year, clean energy accounted for $488 million worth of venture capital investments in the US during 2002. While this number has shrunk from a high of $1.2 billion in 2000, it has increased as a share of total venture capital dollars invested from 0.9 percent in 1998 to 2.3 percent in 2002.

Dream cars
Where are the VC hydrogen dollars going? Not into cars.

?When we talk about new energy applications, particularly when we talk about hydrogen fuel cells, people automatically connect that with automobiles,? Wal van Lierop, president and chief executive officer of Chrysalix Energy, says. ?Although there are significant opportunities for VCs to play a roll in that long road from beta-testing to a hydrogen vehicle mass market, they have to remember the arrival of a full fleet of hydrogen cars is still a long way away.?

Beyond the technological limitations are economic realities. ?The demand for hydrogen technology in cars is primarily driven by environmental concerns,? van Lierop notes. ?That is not enough to induce most customers to pay up for these products.?

Most VCs operating in the fuel cell sector ?heavily discount fuel cells for transportation applications,? says Tim Woodward, managing director of San Francisco-based energy sector specialist venture capital firm Nth Power. ?The businesses that are successful in raising money are the ones that can demonstrate there is some near-term market they can pursue.?

Woodward believes breakthroughs in fuel cell technology for transportation applications will come largely from development within the corporations already involved in the sector, either the automotive companies themselves or the vendors who are already familiar with providing products to that industry.

Competition from these corporations, in fact, is welcome. ?When you see a General Motors or a United Technologies starting to invest in hydrogen, their hydrogen activities are inconsequential to their bottom line and inconsequential to their stock performance and yet they're beginning to talk of this new vision, and that lends a whole new layer of validation,? Haberman says.

Chris Behrens, managing partner at New York-based diversified private equity firm JP Morgan Partners, says emerging power technology deals have tended to work when the public market is open and able to provide follow-on capital. ?Often they have good core technology but lack near term commercialisation ? that's why corporate investors like Caterpillar and GE are sometimes the best investors,? Behrens says. ?They can help jump-start sales and profits.?

Signs of growth
The big corporations are not only investing directly in promising startups within the hydrogen power space but are emerging as major backers of sponsored or independent venture capital firms. Shell's initiatives are just the tip of the iceberg, according to Woodward. Woodward says limited partners in hydrogen power boutique investors typically include ?corporate entities that are either directly or tangentially involved in the energy sector,? particularly utilities and energy companies, but also electronics companies and materials and industrial companies.

?The strategic investors understand you have to be a little more patient,? van Lierop says. However, he emphasises investment in hydrogen power opportunities is a business, not a science experiment: ?Chrysalix is a VC, so while our strategic backers may have a lot of strategic goals in mind, for Chrysalix itself the goal is to create top-tier returns for our limited partners by building great companies.?

Another promising sign for the commercial prospects of hydrogen technology is that large venture capital firms in North America are warming up to the sector, hiring specialists and in some cases setting up separate divisions. ?We now see mainstream, generic investors such as Vantage Point, Atlas, and Mayfield moving into this area because the deep-pocket investors recognise this is a significant space to be in,? van Lierop says.

Consumers first
Consumer demand is currently focused on convergence technologies in personal devices ? cell phones, digital cameras and laptop computers. ?There is a real demand for more energy in that area. Customers are willing to pay; the Japanese OEMs [original equipment manufacturers] are pushing for more power; and the VCs in the Valley see this as the last missing link required to support a truly wireless economy,? van Lierop says. ?This is one area where demand for fuel cell technology is heating up tremendously and the most interesting companies operating in this space are being snapped up as we speak.?

Haberman sees hydrogen technology taking off in three core markets: Generators, batteries and ?embedded power.? Examples include direct methanol batteries and advanced storage for lap tops and cell phones. According to Woodward, ?The venture community thinks those markets are easier to penetrate and will ripen much, much sooner ? not next year, but within a three-to-five year horizon.?

There are significant hurdles to overcome before hydrogen fuel cell technology emerges as a mainstream source of energy ? and accordingly as a viable investment sector.

Haberman notes the absence of benchmarks and a lack of clear due diligence criteria in assessing value criteria. ?If someone is going to invest in this area they can't just invest in the technology; they have to invest in the technology in the context of the applications package that it's aimed at.?

There is also a fundamental lack of understanding in business and investment circles about the nature of fuel cell technology. Many unfamiliar with the technology assume it to be the scientific equivalent of the philosopher's stone ? energy from nothing, the ultimate free lunch.

Dan Reicher, a partner at Wellesley Hills, Mass.-based New Energy Capital, who was assistant secretary of energy for energy efficiency and renewable energy at the US Department of Energy from 1997 to 2001, is quick to debunk this popular misconception: ?A fuel cell requires a fuel source; and that source is hydrogen. Hydrogen in and off itself is not an energy source; we have to make hydrogen from other substances.?

Overall, however, the combination of government prodding, technological development, and increasing consumer demand makes hydrogen a growth sector and definitely one to watch. ?I think one of the big things this sector is gong to focus on in the coming year is expectation management, making sure the market and investors, both private and public, understand the time to impact,? Haberman says. ?There will be a lot of transition from research to hardware.?

If trends meet expectations, television viewers in 2020 may be treated to the spectacle of Shell, taking its cue from Philip Morris, running commercials against the evils of fossil fuels.