Expanding the market-shaping toolkit
Using volume guarantees to de-risk demand and accelerate the path to the market of the future
Advanced market commitments (AMCs) have come to climate tech. But as we try to get the green vortex in full gear to decarbonize the global economy and unwind past emissions, we need to be using every market-shaping device known to humanity. What else is lurking out there?
Pioneered in the world of global health, AMCs have been getting more attention in the climate tech world of late – primarily because of Frontier, and more generally as the world tries to organize and accelerate demand for a range of clean technologies. But as I covered in an earlier post, there’s a much broader and deeper set of learnings for climate tech to draw from the world of global health.
The most important insights lie in the market shaping discipline that the global healthy community has built in the service of wider access to high-quality prevention and treatment for HIV/AIDS, TB, malaria, and other diseases. The market shaping toolkit has expanded to include a whole range of approaches beyond AMCs, including R&D prizes, cost-plus negotiations, targeted and time-limited subsidies, securitization of government aid flows, and more.
One tool that has become particularly important—but that hasn’t yet gotten any real attention in climate tech—is the volume guarantee (VG). Taking inspiration from ‘take-or-pay’ contracts used for decades in the commercial world, volume guarantees are a form of demand de-risking that essentially amounts to sales insurance for specific suppliers. Like much of the global health learning I’ve been writing about, VGs are relevant for carbon removal market-shaping efforts, and are also applicable well beyond carbon removal to a range of low- and zero-carbon technologies. We’ll look at examples further below.
A volume guarantee operates basically the way it sounds—and the easiest way to grok it is to take an example. Imagine a company called Hansen Diagnostics, supplier of a new HIV diagnostic technology that’s selling very well in the Global North (US/Europe/etc.). Hansen knows its technology is needed in lower-income countries, but is skittish about investing in building out a sales and service infrastructure in places like Kenya and Cambodia without having security around how demand will materialize in those markets. It’s been two years since Hansen first launched this technology in the US and Europe and it’s still hemming and hawing about expanding globally.
Enter the VG. A third-party organization (typically neither a buyer nor a seller) with a hefty balance sheet and an interest in market shaping—let’s say the Chan Zuckerberg Initiative for our example—approaches Hansen to engage in discussions about a potential VG. CZI offers to contractually guarantee a minimum volume of sales in a set of (e.g.) 30 countries over the next four years in exchange for a handful of commitments from Hansen. Hansen commits to launch its product in all target countries within six months; to honor a price ceiling of $14 per test; and to build up its local service and maintenance capacity to specified levels within two years. If Hansen does all this and makes best-faith sales efforts in the target countries but actual sales only hit 82% of the guaranteed volume level in the first four years, CZI pays Hansen the 18% difference—either the shortfall in revenue, or the shortfall in profit, depending on what the VG terms provided for.
Volume guarantees were first deployed in global health by the Gates Foundation, CHAI and others to shape the market for a range of products from long-acting contraceptives to pentavalent vaccines to HIV drugs. They were effective enough to convince the UK government to launch a new social finance company—MedAccess—dedicated to expanding the use of volume guarantees in global health. Staked with £200 million to begin, MedAccess has signed nearly ten volume guarantees while pushing the world’s learning on how to diligence, negotiate, and reduce the risk level of potential guarantees.
VGs offer a few advantages that, depending on the situation, can make them preferable alternatives to other forms of demand de-risking:
Because VGs are generally not ‘called’—i.e., they set a guaranteed sales floor that typically gets exceeded such that the guarantor makes no payout during the lifetime of the guarantee—they are highly efficient and enable recycling of the capital pool
They enable a third party that doesn’t have any interest in buying a given technology or product to bring its capital to bear on de-risking demand and shaping the market for that technology/product
In exchange for the de-risking they offer, volume guarantors can extract a range of commitments from suppliers—accelerating supply or market launches or capacity investments; pricing; specific forms of transparency; technology transfer or licensing; and so forth—and can elicit these commitments ex ante even before a given stream of sales begins
By standing “outside” buyer/seller transactions, VGs minimize the distortion that can result from market-shaping tools such as AMCs or subsidies that create time-limited sources of demand and therefore sometimes risks like sugar crashes on the back end
One way to understand VGs is to think about the space they occupy in the spectrum of demand de-risking mechanisms. This isn’t a one-dimensional spectrum that’s easy to visualize, because we care about several things: How much does the mechanism de-risk demand for a specific supplier (vs aggregate demand)? How secure is the de-risking? How long does the de-risking last? How efficient is it as a use of capital?
Let’s reflect on a few forms of demand de-risking we already see in the climate tech space. Collective pledges like the First Movers Coalition can send a strong signal about aggregate future demand to the market, but are not binding and don’t solve for secure, lasting demand de-risking to any particular supplier. AMCs like Frontier add significant binding-ness and durability at the aggregate level, but still offer no certainty to any particular suppliers before the moment of purchase. To overcome these limitations, offtake agreements have become our dominant solution for creating the multi-year demand security a supplier or project needs in order to secure project financing and expand supply capacity.(Note that AMCs can—and in Frontier’s case will—enter into offtake agreements with suppliers as they conduct their procurement, but most offtake agreements are undertaken by non-AMC buyers).
While mechanically different from an offtake agreement, VGs offer similar demand security to specific suppliers but—critically—without using up the capital required to buy all of the foreseen supply. Structured in the right way, VGs can unlock project financing while recycling most or all of the capital backstopping the guarantee.
When do VGs make sense? Here are some common features of situations when VGs can be the killer app in the market shaping toolkit:
A new technology—or a key new supplier of an existing technology—is emerging for which strong demand already exists (or at least there is strong reason to believe that demand will ramp up quickly in the coming months and years)
Yet some actor—the supplier, or a project financier / investor etc—is nervous and hesitating to make some important commitment because of non-negligible demand risk. The hesitation could be about providing project financing for a company’s commercial-scale facility; bringing a next-generation product to market quickly when a company’s current product is doing just fine; investing in capacity to launch a product in a new set of markets; or any number of other calculated risks
To get over its hesitation, the supplier or financier needs demand security over a multi-year period
We (the global community) have something we need from the supplier or project in addition to just the core “get over the hump and do the thing” need—i.e., there are other commitments we want to extract in exchange for providing a volume guarantee
Meanwhile, VGs are rarely the right choice at the extremes of the demand-risk spectrum. This is obviously true if demand is highly uncertain and the risk of falling far short of guaranteed volume levels is very significant. But at the other end, if demand risk is negligible, we shouldn’t overuse VGs just because the risk of payout is low—they do tie up the backstopping capital during the life of the guarantee, and if suppliers have easy access to long-term offtake agreements from buyers, then offering volume guarantees (especially if you don’t ask much of the supplier in exchange for the guarantee) can amount to a supplier giveaway.
There are three basic stages of executing a VG:
Diligencing the supply and demand situations to develop forecasts, understand market dynamics, and assess risk
Negotiating the guarantee provisions with the supplier(s)
Ongoing efforts to mitigate payout risk, solve bottlenecks, and monitor the market
At a minimum, to execute a VG a guarantor needs to have sufficient capital to backstop the guarantee and sufficient expertise to conduct diligence and negotiate terms. Depending on the market situation and the level of demand risk, the ‘ongoing efforts’ mentioned above may be relatively light-touch or might require aggressive market shaping efforts. If that kind of quarterbacking and barrier-whacking is needed, the guarantor can either do that market shaping work itself if it has the capacity or—as is more often the case—partner with a market-shaping organization to carry it out. MedAccess has often partnered with CHAI in this way.
Relevance to climate tech
We should be considering VGs as a possibility both within and beyond the permanent carbon removal market. Let’s look at carbon removal first.
For starters, Frontier itself could deploy volume guarantees within its AMC operations as a complement to offtake agreements.Imagine a carbon removal supplier setting out to build its third and biggest commercial-scale facility to date, but needing proof of sufficient customer demand to secure project financing. In some situations, Frontier may have a specific reason for wanting to lock up (ie, actually buy) a significant chunk of this company’s projected supply over a multi-year period, and may therefore opt to enter into a big offtake agreement. In other situations, Frontier may want to help the supplier secure project financing, but may be more agnostic to what fraction (if any) of the projected supply it actually ends up purchasing. In the latter scenario, Frontier could offer a VG rather than an offtake agreement. Doing so—with project financiers at the negotiating table for the first handful of precedent-setting VGs—could unlock project financing while enabling Frontier to recycle most or all of the backstopping capital.
VG guarantors are typically not buyers, but Frontier is a rare bird. Specifically, what is rare about Frontier is its simultaneous pursuit of two goals: 1) purchasing tons for and meeting the needs of its members (Alphabet, Shopify, etc.); 2) optimizing the long-term size and health of the market by dramatically boosting the supply of permanent carbon removal and “maximizing shots on goal.” Adding VGs to its toolkit would enable Frontier to flexibly optimize against these two objectives in a situation-specific way and enhance the supply-expansion impact it can generate with a given amount of capital. And compared to typical guarantors (who want to shape a market but have no interest in buying the product in question), payouts against a guarantee are a much smaller problem for Frontier. As a willing buyer, the only real downside for Frontier would be the moderate unpredictability of payouts.
More generally, any organization with an interest in shaping and expanding the market for permanent carbon removal could begin experimenting with VGs. Philanthropies with substantial balance sheets and a strategic interest in carbon removal are one primary example. The Gates Foundation initially pursued VGs in global health in connection with its strategic exploration of so-called “program related investments” (PRIs). Basically, it was trying to figure out how to create impact through its balance sheet rather than relying solely on its grantmaking.
A foundation exploring a permanent carbon removal VG and with less tolerance for risk than Frontier would likely want to minimize the risk of a big payout. The ideal situation would be a rapidly-maturing carbon removal pathway with falling prices, growing demand, and one or more suppliers with very strong reputations. I haven’t thought this through much, but there might even be ways for a large foundation to partner with Frontier to share payout risk (given Frontier’s openness to buying) while having the foundation bear the bulk of the balance sheet tie-up for a given VG.
How might we use VGs in other areas of climate tech? As a complement to offtake agreements, one can imagine using VGs almost anywhere that a potential guarantor is trying to shape a market and accelerate a green transition. Even in the first few months of writing about market shaping I’ve gotten into conversations with experts about several market situations where VGs could be relevant.
As an illustrative example at the more micro end, some players in the market for U.S.-based kelp production—Alaska being a prime example—have started to sketch out the contours of a VG to accelerate investments in cultivation and processing. Significant demand exists for kelp-derived ingredients and raw materials (e.g. kelp powders, alginate, alternative protein), but the breakeven scale for many of these products starts at ~1,000 mt per year. Launching large-scale Alaskan kelp products in the next 3-5 years requires building a bridge between what farmers can produce today and what buyers require to process seaweed at scale. A philanthropic volume guarantee could set a volume and price floor to induce new cultivation, in tandem with some market-shaping activity to organize the rapidly emerging demand and de-risk the guarantee. With guaranteed offtake at fixed volumes / prices, farmers would be able to borrow to invest in their operations and drive down costs. On the other side, buyers would be guaranteed a steady growth in supply which would allow them to secure the funding needed to build large-scale processing facilities. A guarantee with maximum exposure of just a few million dollars could transform the Alaskan kelp production landscape.
Toward the larger end, one of the biggest climate tech market-shaping needs in the next few decades revolves around clean cooling technologies. Cooling will be one of the greatest sources of GHG emissions over the coming decades as people with more disposable income seek relief from a warming world. Cooling-driven emissions will be heavily concentrated in a subset of countries, notably India, China, Indonesia, the U.S., and a few others. 3 billion new AC units will be installed by 2050, with over a billion in India alone.
Greener AC products are in the works but hitting the market much more slowly than we need. In this piece, Noah Horowitz and Iain Campbell describe their experience with an R&D prize to reduce the climate impact of cooling technology:
In late 2018, a broad-based coalition led by RMI, India’s Department of Science and Technology, and Mission Innovation launched the Global Cooling Prize, a bold challenge to develop an affordable residential cooling solution with five times (referred to as “5X”) lower climate impact than the typical units being sold in the market today … Put simply, to achieve a 5X lower climate impact, a solution delivering comparable cooling would need to use less than a quarter of the energy and utilize an extremely low GWP refrigerant or no refrigerant at all … This competition was a huge success as it pushed manufacturers to think big and pursue dramatically new and innovative designs.
While the Prize’s 5X prototypes were great, one cannot yet purchase either of the [two] winning models. One of the winners has committed to bring a 5X lower climate impact product to the market by 2025, which is very encouraging, but we need to do more.
With tremendous emerging demand and current manufacturer hesitation, this market situation bears many of the hallmarks that lend themselves to a VG intervention—in tandem with quarterbacking efforts to shape the market and organize demand. If there already existed a MedAccess for climate tech, this is a great example of an opportunity that should be on the shortlist for diligence.
The way forward
Eventually, the climate tech world will benefit from large market-shaping financing facilities that can fund aggressive interventions like AMCs, VGs, targeted prizes, and more. Some of these might be focused on a particular climate tech market (e.g. SAFs) but deploy different interventions, where some others might—like MedAccess—specialize in a particular tool like VGs but be more agnostic to the particular type of climate tech. Such financing facilities will be most powerful if they have a growing number of potential quarterback partners who can lead on market shaping activities that need to happen in parallel with the financial intervention.
But just as Frontier has increased the likelihood of other climate tech AMCs by setting a precedent and showing that the water is warm, we need a pioneer to show what a well-designed VG can do. There are plenty of opportunities for a forward-thinking foundation to pick a small or moderate demand de-risking challenge and pull together the right coalition to make a VG happen.
Like many other market shaping instruments, VGs are largely about acceleration. If enough demand exists to make a VG the right choice, the market will generally tiptoe toward the desired future state even in the absence of a VG. But in a global green transition where the ‘time value of carbon’ weighs heavy, we should all be feeling the need for speed.
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A guarantor can also choose to charge the supplier(s) a small percentage fee in exchange for the guarantee, but this isn’t a necessary feature.
In global health, “advanced purchase commitments” (APCs) have emerged as another mechanism that provides similar security to specific suppliers as offtake agreements. APCs are multi-year purchase commitments to one or more specific supplier(s) to buy a certain amount of product, sometimes even before the product in question has been fully developed and launched. APCs differ from AMCs in that they are binding commitments to particular suppliers from the outset.
Thanks to Peter Reinhardt for pointing out that additionality is a critical threshold issue as regards using VGs for carbon removal. Once a VG has been signed for a given amount of tonnage from a specific supplier, would a prospective buyer of some of that tonnage consider those tons to be truly additional? Generally I think the answer should be yes, but it’s worth parsing, and it seems like we should distinguish between what buyers should think about that and what they will in practice think about that.
On the former, I believe the best reason to treat those tons as less than unimpeachably additional is if you have good reason to believe that the guarantor will keep deploying VGs willy nilly no matter what their payout pattern. If they’re likely to — and especially if they have a track record of — just handing out ‘freebie’ VGs even with repeated high payouts, then as a buyer your purchase is not a must-happen part of the flywheel that keeps the marginal tons flowing/happening. Personally, I think this is unlikely for most guarantors, with the possible exception of governments pursuing domestic industrial policy as Robert Hoglund pointed out. Most guarantors will stop the flow of VGs if they frequently have to make significant payouts.
This seems pretty self-evident, and once we accept this system-level view, it follows that VGs don’t undermine additionality.
What might be the counterarguments?
First, you could argue that any VG’d ton is by definition technically not be additional. In a prototypical VG, once a ton it’s VG’d, the supplier has security and is going to produce that ton no matter whether it lines up a buyer or not. But even here there are contractual ways you could change this — too long to be worth going into here, but having to do with whether/how guarantor payouts are connected to deliveries and how production schedules get adjusted during the life of the guarantee dependent on the evolution of sales. If a payout is going to happen for an unsold ton even without that ton being “produced” (ie, removed), then a buyer’s act of purchasing the ton is a must-happen for the ton to be removed.
And second, no matter what buyers should think, some buyers will be persnickety about the most narrow-lens view of additionality (or just misunderstand outright) and refuse to buy a VG’d ton on additionality grounds.
But none of this changes the zoomed-out view of how VGs interact with the additionality criterion at the system/flywheel level. VGs only survive as an ongoing demand de-risking mechanism if buyers show up and buy, leading to the next VG, and the next wave of purchases, and so forth.
The concept of additionality is a social construct rooted in imagined counterfactuals. If we want to tell ourselves the most healthy, accurate big-picture narrative we can’t get trapped in overly narrow thinking. (MRV will be similar — if we’re unwilling to contemplate even modest uncertainty, we’re going to be buying and removing many fewer tons.)
And ultimately, the question of what buyers will perceive about the additionality of tons subject to a VG is an empirical question, not a theoretical one. Personally, I think the chances are high that if and when VGs become a regular feature of the CDR landscape, buyers will basically ignore them and not be concerned with whether a given ton is subject to a VG or not. If Frontier and other influential early buyers and opinion leaders set the precedent that VGs don’t undermine additionality, other (generally less discerning) buyers are likely to follow. But—as with pursuing durable CDR as a whole—the only way the world will know what is doable is if we try. We shouldn’t kill the experiment before we even run it.