In order to transform the state of North Rhine-Westphalia, high investment volumes must be financed not only in existing but also in future technologies. The technologies necessary for a successful transformation are only partially mature. The question therefore arises as to which financing matches which level of maturity of the required technologies and how Fin.Connect.NRW can support the financing of these technologies.
In order to take advantage of the opportunities of transformation in changing markets, investment and financing decisions often have to be made with a higher degree of uncertainty about the actual prospects of success. For example, in a portfolio of financing commitments, it is impossible to say with certainty ex ante what the “pearls” will be at the end of the day and where defaults may occur. Therefore, diversification and risk management are crucial in practice. This also affects the question of the extent to which financing should be done with equity and/or loans (possibly with liability relief) or to what extent other financing instruments can be helpful (subsidies, securitizations, etc.). It is also important that investors and financiers have “stamina” and do not expect a return on investment in the relatively short term.
The technologies required for transformation have different levels of maturity. Solar systems and wind turbines are largely mature technologies that have immediate application in the market and must be expanded for transformation. This is primarily about financing high investment volumes. The situation is different for electricity storage, carbon capture and storage and hydrogen technology. Some of these are still in the research and development stage or are almost ready for the market. The financing of these technologies therefore involves a level of risk that is often too high for bank loan financing.
Measuring the maturity of technologies for transformation
Two systems have been established for measuring the maturity of technologies. One is the Technological Readiness Level (TRL) developed by the US space agency NASA and the other is the Commercial Readiness Index (CRI). NASA measures the maturity level of technologies from TRL 1 to TRL 9, although the latter is not yet commercially ready for the market, but merely represents the successful completion of research and development. TRL 9 then means, for example, that a prototype has passed the test in a wind tunnel or a similar test infrastructure. So this indicator ends before the marketing of the product begins or a sales structure is established. CRI 1, on the other hand, covers TRL 1 to the beginning of TRL 8. CRI 2 begins in the second half of TRL 8 and ends at the beginning of TRL 9. CRI 4, CRI 5 and CRI 6 extend beyond TRL 9. At CRI 3, research and development has been successfully completed. CRI 4 and CRI 5 already have a marketable product, but the manufacturer is a first mover that has yet to experience the commercial success of the technology on the market. It is only at CRI 6 that an established technology is available, which a later adopter then gradually implements in their company and for their products. Wind turbines and solar systems, for example, comply with CRI 6. Anyone who produces their products with green electricity therefore also has incremental innovation. On the other hand, the capture and storage of carbon is classified as CRI 4. However, high-performance electricity storage systems are currently between TRL1 and TRL6.
Funding of research and development
The level of maturity plays a role in financing. Because not every financing instrument is suitable for every level of maturity. TRL 1 to TRL 3 involves basic research that can be financed through research grants. This often involves research from universities or research institutions that cooperate with companies. For example, funds can be obtained from Horizon Europe. Development grants can be used for TRL 4 to TRL 6, industrial research. The EIC Accelerator is an EU funding instrument for innovative startups and SMEs working on innovations that have high potential for technological progress, but are also associated with corresponding risks. In addition, national funding programs such as the Central Innovation Program for SMEs or SME-innovative support up to TRL 5 or 6. The SME instrument from Horizon 2020 even supports up to TRL 9.
Seed capital is hesitant to start financing technologies at TRL 7, so that there is a financing bottleneck for technologies that is referred to in the literature as the “Valley of Death”. The problem at this point is that the cash flow is often still negative. There is therefore no market adjustment between good and bad ideas, but rather a market imperfection, because even good ideas at this level of maturity do not necessarily find financing due to a lack of initial returns, a lack of personnel or a lack of infrastructure. To mitigate the Valley of Death, the EU is using the SME instrument. This is a funding program for innovative SMEs that is specifically intended to address and mitigate the Valley of Death. The focus here is on innovations that are in the area of further development, e.g. demonstrators, clinical studies and work to obtain approval. The budget is 10 billion euros over a period of seven years.
Financing growth
Venture capital financing begins at TRL 8 or CRI 2. However, there can be a valley of stagnation at CRI 4 and CRI 5 if business models cannot be scaled sufficiently due to a lack of financing. Here, too, it can happen that companies with good ideas have to leave the market because they cannot scale their product. Challenges for companies in financing round B are often the establishment of suitable personnel as well as the development of sales and marketing. In financing round C, the focus is on expansion into new markets and also on a possible takeover of competitors. It is often too early to take out loan financing or this only takes place at very high interest rates. However, due to the high capital requirement, it is also more difficult to find venture capital investors. To mitigate this valley of stagnation, the European Investment Bank launched the European Tech Champions Initiative. This is a fund-of-funds that aims to enable later-stage venture capital funds in the EU to grow so much that they can better provide companies with scale-up capital.
Financing the transformation
At CRI 6, the technologies are fully ready for the market and can then also be financed via bank loans, as there are robust cash flows at this point. Innovations are no longer disruptive, but rather incremental, i.e. they are product and process improvements to existing, established products or business models. This is the bulk of innovation in companies. At this point, however, there can be a “lack of technology diffusion” if banks only grant restrictive loans, for example because their equity capital is not sufficient. In view of the immense investment volumes for the transformation, the banks' equity capital can definitely represent a bottleneck factor, so that a lack of technology diffusion can arise. At this point, securitization can help to release the banks' required capital for the transformation. The European Investment Bank also offers hedging instruments such as guarantees to secure loan portfolios from SME loans. What is important about securitization is that banks do not grant loans that they would not have granted without securitization. This originate-to-distribute model contributed to the global financial market crisis in 2008 and 2009 because excessive risks were taken because there were incentives to pass them on. Therefore, only high-quality loans should be included in a securitization. Therefore, securitization should not be used to solve financing bottlenecks that should actually be financed with venture capital. There is a securitization platform expert group at the Deutsche Bundesbank to promote securitization to support the transformation.
Even if the financing of incremental innovations is no longer high-risk financing, the transformation creates higher risks. Companies have to finance high investment volumes, so that their level of debt increases, which is also associated with a loss of creditworthiness. At the same time, companies can also have their credit rating downgraded if they invest too late in transforming their business model. If demand shifts towards more sustainable products, this will be to the detriment of the cash flows of companies that do not yet offer sustainable products. This can then represent a credit risk from the banks’ perspective. In addition, companies must expect that banks want to reduce their so-called portfolio emissions, i.e. the CO2 content of the loans they grant, so that companies that transform too late must expect financing bottlenecks.
How can Fin.Connect.NRW improve the financing of the transformation?
Innovations are necessary to successfully manage the transformation - some have already reached market maturity, others are still waiting for a breakthrough. However, at all levels of maturity, there are financing bottlenecks that need to be overcome. Information about applying for grants as well as funding instruments or financial market players that suit the company in question is often helpful. The task of Fin.Connect.NRW is to close information and knowledge gaps and to bring companies and financial market players together. This includes information campaigns for companies from North Rhine-Westphalia and supra-regional information campaigns to network investors with companies in North Rhine-Westphalia.
It is also important to provide scientific support for the topic of transformation financing and to cooperate with financial supervisory authorities. Because the transformation is associated with risks that must also be distributed appropriately - i.e. must be borne by those who are able to bear higher risks without getting into difficulties. Depending on the phase of a company's life, other forms of financing are appropriate, for example venture capital for innovative, technology-oriented startups. But even when it comes to bank financing, the risk distribution between banks and development banks must be correct.
On June 14, 2023, the state parliament of North Rhine-Westphalia decided to strengthen Fin.Connect.NRW. The aim is to further strengthen the networking of stakeholders and develop an information campaign to increase the level of awareness of Fin.Connect.NRW. The climate protection package approved by the cabinet on June 13, 2023 also includes the strengthening of Fin.Connect.NRW as an important component for financing the transformation in NRW.
