Advances in digitalisation and environmental technology are enabling a new technological revolution that can contribute significantly to solving many pressing global problems such as climate change. In addition, digitalisation has enabled fundamentally new business models. However, the different types of innovation also have differences in the risk-return profile, to which the financing mix must be adapted. Fin.Connect.NRW can help to find the right financier.
The climate-neutral transformation brings forth many fundamental innovations. Carbon capture and storage, for example, plays an important role in climate neutrality. This refers to the capture of CO2 and the subsequent underground storage of the CO2 in former oil and gas deposits. Through this technology, industries with traditionally high CO2 emissions now also have the technical possibility to produce in a climate-neutral manner in the sense of a net zero.
It is the same with the digital transformation. The data economy is not limited to large US technology companies such as Google, Apple or Amazon. Data-driven business models in particular have great potential for small and medium-sized enterprises in NRW. For example, even smaller bakeries and outdoor restaurants can use sales forecasts based on geo-referenced weather data to precisely adjust their offerings and avoid waste. For many businesses, the analysis of customer data allows them to identify new trends in customer preferences at an early stage. Stationary retail can use sensor technology to collect data on the shopping behaviour of their customers and thus analyse, for example, the effects of changes in product arrangement on purchasing behaviour. This allows retailers to determine how long customers spend looking on a shelf in order to optimise the sorting of products on the shelf based on the generated data. It is also often overlooked that digital platforms, such as Etsy, have made it possible for micro-enterprises in the artistic and craft sectors to offer their products globally rather than just locally. These are just a few examples, but they illustrate that digital technologies offer extensive potential for businesses of all sizes and in all sectors.
Financing mix is based on the innovation model
The current rapid change brings with it high welfare gains, but it also demands that companies participate in the transformation process in order not to lose competitiveness. However, companies can counter this rapid change with different types of innovations. From a financing perspective, the types of innovation differ in their risk-return profile:
- Basic innovations or leap innovations are innovations that are applied in several industries and often break new technical ground. These innovations give rise to further follow-on innovations. Climate-friendly hydrogen in particular can be regarded as a basic innovation for achieving climate neutrality. Basic innovations hold out the prospect of high risks for the first mover, but also high profits. This requires companies that are willing to take these risks and corresponding investors who are willing to participate in these risks. It can also happen that these technologies do not find a private investor due to a lack of initial returns, because widespread use is not yet foreseeable. For the adopters, i.e. those companies that gradually implement these basic innovations in their company and develop business models based on them, the so-called diffusion, the implementation is less risky and can also be financed via the classic bank loan.
- Disruptive or radical innovations are innovations that lead to a change in the existing status quo. While basic innovations are also disruptive, not all disruptive innovations are also basic innovations, because these innovations do not have to affect all industries equally. For example, video-on-demand streaming services were disruptive to the markets for DVDs and Blue Rays, but not to the film industry, from whose point of view they are only a further development of existing products. Electromobility is similarly disruptive for the oil-processing industry and the manufacturers of petrol and diesel engines. Disruptive innovations, new business models and novel forms of cooperation can arise from the shift to more resource-efficient and circular production systems, as it not only requires fundamental changes along the entire value chain, but can also lead to different products and services. Here, not only is the innovation itself a gamble, but it is also risky if companies do not adapt to a changing environment or do so too late.
- Maintaining or incremental innovations are product or process improvements. It will not be optimal for all companies to be a first mover and produce disruptive innovations. Rather, for a large number of companies, the transformations will take place via product and process improvements, e.g. by digitising existing products or processes or adding additional digital components to make data collection and exchange possible or to produce in a climate-neutral way. For the majority of these innovations, existing financing instruments, such as the classic bank loan, can be used. However, due to the potentially high investment volume in the transformation process, thought must be given to how the banks‘ equity can be released as effectively as possible for lending in order to also finance the transformation for the broad mass of companies.
Or the financing of innovations via the house bank, it plays a role whether the innovations are disruptive or incremental in nature. For example, switching a newspaper from print to online is a risk, since some of the existing customers want to continue to receive the printed newspaper and do not want to switch to online. If the acquisition of new customers is offset by the loss of existing customers, future cash flows are difficult to forecast. Thus, despite long-term prospects of success in the short term, a financing bank may find this risk too risky and require a higher equity share in the financing. The additional equity must then be raised by the company in question through suitable investors. However, the inclusion of further equity investors in bank financing is also relevant for companies whose creditworthiness has deteriorated as a result of the Corona pandemic or the energy crisis.
Incremental innovations are a different story. Additional digital control technology and climate-friendly propulsion could, for example, result in a significantly improved machine that would be interesting for existing customers as well as new ones. Demand for this product might even be higher if buyers could reduce their carbon footprint with this machine. This is actually traditional financing with the usual entrepreneurial risks. At the same time, however, funding opportunities that aim to achieve the economic policy goals of digitalisation and climate neutrality can also be used in the transformation. For transformation financing, risk sharing between house banks and development banks thus also plays an important role.
New challenges in financing
As companies expand their business models towards the data economy, new challenges in financing may arise. This is because machinery and equipment or real estate that can be used as loan collateral may not be acquired. Instead, companies will need to invest in human capital, as extensive data protection and cybersecurity skills will be required to ensure secure digital connectivity with suppliers and customers with an exchange of machine data or personal data. In addition, the operational risk increases, e.g. due to cyber attacks. In order to minimise these operational risks, the financing bank might have to demand additional investments in cyber security from the borrower and also be able to assess the quality of the cyber security. Therefore, it is also right that the state of NRW promotes research in the areas of AI and cyber security. However, greater networking with the financial sector should also be sought here, so that it can better assess the operational risks from digitalisation.
Similar considerations apply to the topic of climate neutrality. If a company invests in new climate-neutral production facilities, it may have lower initial returns in the first few years. It is possible that this phase of low profitability is too long for loan financing, so that an additional equity tranche is needed.
Fin.Connect.NRW links the house bank principle with the capital market
For small and medium-sized enterprises, house bank financing also plays a prominent role in transformation financing because they have less experience with capital market financing and also because their smaller size and lower profile make them more difficult for the capital market to find than listed companies. The house bank principle has particular advantages because it reduces information asymmetries between borrowers and lenders and thus allows for more favourable and more tailored financing compared to the rather anonymous capital market financing.
The house banks play an outstanding role in the transformation, as they know their companies better through long business relationships and can assess their potential and risks better than a more short-term-oriented capital market. The latter, however, can take higher risks than banks, especially when financing disruptive innovations, so that networking the various specialised investors and financiers can lead to an improved financing mix for companies in the transformation process.
Fin.Connect.NRW can help to minimise search costs by helping to bring together the various players in the financial centre across the board, especially in transformation financing. For example, workshops are organised on current topics, which are often the starting point for further discussions. Information is regularly placed on the website and in the newsletter. In the future, consideration could be given to further expanding this platform and its information offerings, which could be of interest not least to companies seeking capital and investors offering capital.
