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Glenn Yago, Ph.D. Executive Director of Financial Research

Caitlin MacLean Manager, Financial Innovations Labs Alma Gadot-Perez Project Manager, Israel Center

Financing Alternative Fuels: How Israel Can Catalyze Global Oil Independence

Financial Innovations LabTM

Summary

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TABLE OF CONTENTS

INTRODUCTION ...................................................................................................................................... 3 

SOLUTIONS: SEED AND EARLY STAGES .................................................................................................... 5 

SOLUTIONS: MID‐TO‐LATE STAGE ........................................................................................................... 6 

SOLUTIONS: PROJECT FINANCE STAGE .................................................................................................... 8 

NEXT STEPS: A GLOBAL SUMMIT ........................................................................................................... 10 

Acknowledgments We are grateful to those who participated in the Financial Innovations LabTM for their contributions to the ideas and recommendations summarized in this report. We thank Eugene Kandel and Sagi Dagan of the National Economic Council of the Israeli Prime Minister’s Office and Yossie Hollander of the Israeli Institute for Economic Planning for supporting the project. Additionally, many thanks go to Zviya Baron, Vered Doctori Blass of the Milken Institute Fellows Program and Mark Conolly of the Milken Institute for their partnership in this effort. We also wish to express our appreciation to Joel Kurtzman and Martha Amram of the Milken Institute, Rafi Musher of Stax, and Alan Boyce of Adecoagro for their guidance. The Milken Institute is an independent economic think tank whose mission is to improve the lives and economic conditions of diverse populations in the United States and around the world by helping business and public-policy leaders identify and implement innovative ideas for creating broad-based prosperity. We put research to work with the goal of revitalizing regions and finding new ways to generate capital for people with original ideas. We focus on:

human capital: the talent, knowledge, and experience of people, and their value to organizations, economies, and society; financial capital: innovations that allocate financial resources efficiently, especially to those who ordinarily would not have access to them but who can best use them to build companies, create jobs, accelerate life-saving medical research, and solve long-standing social and economic problems; and social capital: the bonds of society that underlie economic advancement, including schools, health care, cultural institutions, and government services. By creating ways to spread the benefits of human, financial, and social capital to as many people as possible—by democratizing capital—we hope to contribute to prosperity and freedom in all corners of the globe.

We are nonprofit, nonpartisan, and publicly supported. © 2010 Milken Institute

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INTRODUCTION

INTRODUCTION

Israel is in a unique position to catalyze a paradigm shift away from global oil dependence. Leveraging its human and financial capital, Israel can align the interests of countries and policymakers who want both economic and environmentally sustainable growth. With strong intellectual property and patenting experience, coupled with the vast expertise of its venture capital community, Israel can deploy a variety of policy and financial instruments to accelerate the development of its alternative fuel industry. This strategic decision could position Israel as a technology, innovation, and financial center for the industry. Toward that end, the Milken Institute held a Financial Innovations LabTM on April 29, 2010, to design economic models to speed the development and usage of fossil fuel substitutes. The session, held in conjunction with the National Economic Council of the Israeli Prime Minister’s Office, explored specific, replicable policies and strategies to channel financial capital into alternatives to oil. The objective was to support Israel’s decision to remove oil as a strategic global commodity by developing affordable, scalable alternatives. The Lab focused on encouraging cross-border collaborations to develop and implement these solutions around the world. Lab participants recommended a systematic approach to expanding the nascent industry and creating viable, competitively priced alternatives to oil. This is accomplished in part by financial incentives and regulatory support that are specific to each stage of development. By building a research consortia focused on new innovations, investing in emerging technologies, and scaling up more mature products, Israel can become a global leader in the sector while creating thousands of jobs and promoting overall economic growth. Currently Israel’s burgeoning clean-tech sector—alternative fuels, storage, wind, and solar technologies—faces a series of challenges in accessing capital. Across the innovation value chain are “valleys of death,” where companies become trapped and unable to move to the next level of development (see figure 1) because the tradeoff of risk and reward is not sufficiently attractive to investors.

Figure 1. The clean-tech value chain

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INTRODUCTION

For example, current investments in Israeli knowledge-based industries are heavily skewed toward seed and early stage financing. After incubation, there is a high level of premature exits as well as expatriation of intellectual and financial capital. However, these early-stage investments can be used to foster new technologies while foreign capital is recruited to appropriately scale the later stages. To bridge these valleys of death, Lab participants discussed how to best leverage public funding with private capital to scale up the overall industry. The focus is on a series of regulatory and financial mechanisms, including government incentives, funds, and public-private partnerships that would promote access to capital along every stage of the value chain (see figure 2).

Figure 2. Public-private market participation

Source: Milken Institute.

When all incentives are aligned and the market players are activated, there can be real change. This requires creating a financial environment that is attractive to investors and providing funding that encourages worldwide adoption of the industry’s practices. These steps were deemed the most critical to implementation:

• Create a tax environment that would give Israel the most favored investment status globally for fuel substitutes

• Early stage: a prize contest and a database to develop partnerships to leverage Israeli capital • Mid-to-late stage: incentives to attract foreign capital, including a venture capital (VC) fund and

government incentives • Project stage: a fuel substitute financing facility that can benefit cross-border partnerships to drive

scale

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SOLUTIONS: SEED AND EARLY STAGES

SOLUTIONS: SEED AND EARLY STAGES One of the biggest challenges when attempting to grow an industry is promoting new technologies that can move past the initial R&D stage. While there is a great deal of expertise and investment available in Israel during the seed stage, more can be done to position newly formed companies for growth and later-stage development. It is also important during the formation of the market to attract bright entrepreneurs. Lab participants offered ideas aimed at improving the viability of new technologies in moving forward. Solution: Map investment opportunities in oil substitutes To expand access to initial seed and early stage capital, a database mapping investment opportunities by stage should be fully developed tracking both Israeli and international research and technology development. The Israeli Institute for Economic Planning has already begun, identifying 34 bio-energy and oil substitute companies, 23 battery and fuel-cell companies, 18 smart engine and combustion system companies, and 20 others in related areas in Israel.1 A comprehensive database would help investors find the best companies that are active in this space, drawing attention from foreign investors. It also would function as a forum for enterprising academics, budding entrepreneurs, potential business partners, and global decision makers to receive guidance, access investment opportunities, and gain direct contact with potential collaborators. Solution: Establish a fossil fuel substitute prize During the seed stage, intense competition for a limited pool of resources can hold back new companies and products. To ensure that innovative ideas make it past this initial hurdle, Israel should establish a competition that could bring capital and prestige to companies and encourage entrepreneurs to enter the industry. The government could provide an initial pool of prize money, with potentially more funds coming from foundations and philanthropists, to reward innovations that reduce oil consumption and overcome potential bottlenecks. The winners could be announced at the President’s Conference or a similar event. Though prizes would start at $1-5 million, the exposure could greatly leverage that sum by attracting new investments to the winning companies. Unlike existing high-tech prize competitions, this effort would focus upon well-defined technology bottlenecks (e.g., battery materials, fuel substitute processes, engine efficiency) and open to researchers and companies internationally.2 The project could also work with existing multinational partnerships for R&D such as BARD3, BIRD4, and BSF,5 which provide grants for research that benefits both the U.S. and Israel. With this infrastructure in place, prize winners could leverage the already established relationships with these organizations and their members to attract more international exposure and capital. This could smooth the transition from seed and early stages to later stages.

1 Berger, A. "Fuel subsitutes companies in Israel." Israeli Institute for Economic Planning. 2010. 2 A model, though on a smaller scale, is the California Cleantech Open, which has been rewarding inventions in clean energy and energy efficiency since 2006. The annual prize of $250,000 has been leveraged significantly: Angel investors and venture capitalists have put $160 million into companies spotlighted by the competition. Eighty percent of the 191 competitors are still economically viable today. This success can be replicated in Israel. See “The Cleantech Open,” http//www.cleantechopen.com/app.egi/content/about/index. 3 Binational Agricultural Research and Development Fund. http://www.bard-isus.com/ (accessed May 25, 2010). 4 Israel-U.S. Binational Industrial Research and Development Foundation. http://www.birdf.com/ (accessed May 25, 2010). 5 United States-Israel Binational Science Foundation. www.bsf.org.il/ (accessed May 25, 2010). 

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SOLUTIONS: MID-TO-LATE STAGE

Solutions: Mid-to-Late Stage

The mid-to-late stage for oil substitute companies involves proving a technology’s viability. To make these products a compelling alternative to oil, companies need to deliver the equivalent of $40 per barrel oil. This requires significant venture capital and private equity to drive scale up and costs down. However, in Israel, the majority of investment activity is in the early stage (see figure 3). But given that Israel ranks second in the world for the amount of funds raised by technology start-ups, great opportunity exists to capitalize on the investment practices and international partnerships already in place to expand to new markets6. Consequently, Lab participants recommended creating a public-private fund to attract both national and foreign investment during the mid-to-late stage.

Figure 3. Investment imbalance

Solution: Create government incentives to attract private capital In this stage, incentives to attract private capital are important. This could include providing capital and guarantees for a public-private fund, various tax incentives, and insurance mechanisms to increase the rate of success for the new technologies and protect the rights of the shareholders. Mid-to-Late Stage Fund The mid-to-late stage fund would be structured with government investment leveraged with private capital at a 1:4 ratio. (For example, if the government pledges $50 million, the match from investors would raise the fund’s value to $200 million.) Like the fund developed by the Chief Scientist’s Office to expand the biomedical sector in Israel, this fund could incorporate multiple limited partners (LPs) to help companies raise later-stage funds; meanwhile, the government could offer a first loss reserve to mitigate large-scale risk. The Israeli government should participate without an expected return and instead effectively cross subsidize the upside returns to the LPs to create a greater profit margin that can be rolled into further oil substitute projects. The fund could also include non-dilutive capital sources such as subordinated or convertible debt to access larger pools of capital before the project finance stage but after much of the technical risk is resolved. Tax Incentives To attract external capital to the fund, regulations can be developed to position Israel as the best tax environment for investment in fossil fuel substitutes throughout all stages of development. The optimal tax treatment for investors and companies in this sector would include a favored investor

6 “VC in Israel- The Beginning,” http://www.iva.co.il/content.asp?pageId=36 (accessed May 26, 2010).

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SOLUTIONS: MID-TO-LATE STAGE

status with incentives to attract partners to Israel. For example, capital gains taxes could be reduced or eliminated, specifically the 20 percent rate that covers both foreign and domestic gains. Dividend taxes could be reduced or forgiven for any effort that qualifies as contributing to the alternative fuels industry. These incentives could also involve incentives to incorporate and register at the TASE (see sidebar).

Establishing an Oil Substitutes Index

As companies move from the early to mid and late stages and into project finance, incentives can be offered for listing on the Tel Aviv Stock Exchange (TASE). To gain exposure to international investors and potentially receive other benefits that would increase liquidity, an alternative energy or clean tech index on TASE could brand the industry in Israel.

TASE already has successful sectoral indices, including one on the growing biomed industry. This could be used for alternative fuels companies and renewable energy firms to further the idea that Israel is the center of the worldwide industry and to attract large pools of investment into the sector. This index could eventually attract listings from companies around the world.

Insurance Mechanisms Price insurance: Israel should make a 10-year commitment to protect alternative fuel companies from oil price drops that reduce demand for oil substitutes. For example, if oil goes below $40 per barrel, the government would cover 70 percent of the burn rate—the amount of capital needed to cover overhead before a company has enough income—of the previous 18 months. This subsidy could be used for as long as 24 months. The cost to the Israeli government of providing this is lower than it might seem. When prices are low, the cost of importing oil also falls. Money from this windfall can go to the insurance program. Technology insurance: Insurance can effectively reduce the risk of failed technology enough to entice investment to the sector. Under these arrangements, insurance could be combined with subsidized loans for projects whereby investors are released from repayment if a technology fails. This would be especially useful to mitigate any productivity risk when a technology is being brought to scale.

• Efficacy insurance: With renewable energy technologies, much of the risk emerges from the supply of inputs and the efficacy of the technology. Governments and multilateral financial institutions often insure renewable energy projects either through direct insurance or a partial risk guarantee fund that addresses the early stage risks and provides guarantees that are supported by subsidies.7 Munich RE has developed probabilistic models to calculate the risk of finding insufficient resources for available geothermal technology, and they have offered an insurance product for the Unterhaching Geothermal Energy Project.8

• Scientific underwriting: The Chief Scientist’s Office or the National Council for Research and Development could monitor and standardize quality assurance for new technologies. They could act as a scientific underwriting body to qualify projects and innovations, providing a government stamp of approval that would raise investor confidence in the product.

7 “Assessment of Financial Risk Management Instruments for RE Projects in Developing Countries,” United Nations Environment Programme, April 2006. 21. 8 Ibid., 51. 

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SOLUTIONS: PROJECT FINANCE STAGE

Solutions: Project Finance Stage

As alternative fuel companies expand, traditional corporate financing sources alone are not sufficient. When building a plant to produce new fuels, alternate sources of funds and different types of contracts are needed, given the large scale of funds and the nature of the risk. Through the creation of public-private partnerships, there is an opportunity to increase the pools of capital needed for this expansion stage, which Lab participants named “project finance.” Solution: Create a fuel substitute financing facility Modeled after a green bank idea introduced by Lab participant Alan Boyce of Adecoagro, the fuel substitute financing facility would specialize in lending to oil substitute developers in this project finance stage. In essence, the purpose of the financial instrument is to establish a highly rated, Israeli-backed oil substitute bond market. In the model, the Israeli government could play multiple roles, from providing guarantees to tax incentives, in coordination with other countries and private investors. The finance facility could be utilized both by Israelis and foreign nations.  Structurally, the Israeli government would issue standardized debt, the value of which comes from an 80 percent government guarantee, a 20 percent equity match, and a capital reserve against a 10 percent first loss guarantee (see figure 4). This could include foreign backing of the bonds, for example, through China’s sovereign wealth fund investing in the loss reserve. Borrowers would receive an interest rate determined by the bond market through transparent pricing, with the loans cancelable by the borrower at the lower of market or par. To facilitate liquidity and lower transaction costs, it is important to have balance within the model and properly aligned incentives. For example, the loans should be funded by bonds with the exact same characteristics (maturity coupon, amortization, etc.).

Figure 4. Fuel substitute financing facility

Source: Milken Institute.

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SOLUTIONS: PROJECT FINANCE STAGE

Additional structural elements can enhance the facility’s creditworthiness while also promoting the effectiveness of its capital for oil substitute businesses. These elements include: Advance market commitments A strategy that has been successful in securing outside investment is to tie in strong purchase agreements and create strategic investment relationships. Predetermined revenue streams are critical. Engaging in a contract with the military, for example, to make a “green military force” would not only generate a sustainable revenue stream for the company through defense contracts, but also demonstrate the worthiness of the product and thus encourage additional investment. Creating multiple government partnerships would represent a very attractive investment option and would establish a foundation for global collaborations to export oil substitutes around the world. Credit enhancements As demonstrated in the finance facility model, credit enhancements can be used to improve overall ratings of an issuance and protect against potential loan loss. For example, the Israeli government could provide loan guarantees or export credit insurance to the companies that are supported by the facility. This could be modeled after the U.S. Export-Import Bank, which provides capital guarantees, export credit insurance, and loan guarantees and direct loans to promote the export of U.S. products. Another example of a credit enhancement would be guarantees offered by the Overseas Private Investment Corporation (OPIC) in the form of loans and loan guarantees for companies investing in the Israeli oil substitute industry. OPIC also offers insurance products that mitigate any potential risk from political violence and expropriation of foreign assets. Defeasance option To minimize the credit risk of the players involved, the facility can set aside financial collateral in the form of a defeasance pool to secure payment obligations. The pool is linked to the timing of the projects, again reinforcing the need for balance, and provides the borrower with a mechanism whereby the project payments are substituted with a sovereign or sovereign agency obligation whose payment schedule matches those of the projects. The borrower gives up the securities and receives the market value of the project finance loan and additional liquidity, thereby defeasing any risk. In one example, the Israeli government needed to maintain its foreign military purchasing commitments but had little funding available. To gain liquidity and lower interest costs, officials decided to refinance the sales through a pool of zero-coupon U.S. Treasury bonds that were set to mature at specified dates; this provided the collateral that eventually led to deeply discounted repayment of debt obligations.

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NEXT STEPS: A GLOBAL SUMMIT

NEXT STEPS: A GLOBAL SUMMIT When building an industry, a toolbox of financial mechanisms and government incentives can increase innovation and investment. The solutions described here can jumpstart growth and create sustainability. From a seed stage prize competition, to a mid-to-late stage fund, to a project finance facility, the entire alternative fuel value chain should be supported by public and private capital. This requires establishing a coordinating management office by the Government of Israel to oversee all program administration and integrate efforts by the government, academic, and private sector. While Israel can become the catalyst to developing a worldwide alternative fuels industry, ending global oil dependence will take multi-national cooperation and worldwide participation in the new fuels market. Consequently, next steps involve not only implementing ideas for increasing investment in Israel but also collaborating with other nations to support the industry. To capture the social energy and imagination needed to accomplish this momentous challenge, the Israeli government should convene an international summit to bring together the developers, corporations, investors, and governments necessary to make decisions within a short time frame. This invitation-only event would target high-level participation from each relevant segment of the industry to create opportunities for collaboration and business partnerships. Participants would focus on financing the future of transportation fuels—not the specific technologies but rather the long-term investment. The 50 to 100 carefully selected participants would discuss options for:

• Developing new technologies • Establishing plants in both developed and developing countries • Creating multi-national investment vehicles (utilizing development banks, governmental

assistance organizations, insurance products, foundations, etc.) • Establishing long-term, international purchasing agreements and price commitments

The summit would produce action-oriented plans to execute investment and development deals to foster significant growth in the industry. This effort, which must be well-coordinated to ensure maximum results, should include creating the above mentioned governing body to oversee the initiative and serve as a one-stop shop for legislative and regulatory policy and program development. Using this comprehensive approach, the Israeli government can change the global paradigm and make a significant impact on decreasing worldwide oil consumption.