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Discussions between China and Europe over solar tariff penalties have broken down. This doesn't surprise me. Europe appears to believe that it has considerable negotiating leverage, China has more leverage than Europe will likely acknowledge, and China is considering longer term objectives before any lasting agreements are made. China is fundamentally able to execute long term policies because its government is not saddled with short term election cycles and the poor decisions that result from them. Ridiculously high government debts, for example, are the result of politicians carelessly spending today because they know that other politicians will have to figure out how to pay for it tomorrow, but I digress.

Before I discuss Europe's lack of leverage, China's leverage, and forecast China's longer term actions, let me remind readers about the successful predictions I made back in October. Back then I'd written an article titled Understanding The Future of Solar. In it I predicted that China would make enormous solar announcements after tariff penalty discussions had taken place. In the article I'd mentioned 40 gigawatts, China just announced 35 gigawatts, and you can click here to see that article and what led to those predictions.

Tariff discussions have ended, or broken down if that sounds better or more promising to you, and my belief is that the root cause lies in Europe. Europe's leaders have little leverage in this matter yet must appear effective and powerful to their voters. They must stand strong despite having little to stand on, and China is in no mood to concede. After all, didn't the US and European governments contribute to the overcapacity mess in the first place? Did they not provide wind and solar tax incentives, lure China into spending billions on wind and solar factories, and then yank those incentives away just a few years later? How can a supplier ever produce and deliver to irrational customers that behave like this? When you step back, and truly see it from an unbiased perspective, the bigger picture comes into focus. Should China get slapped with tariff penalties on top of the billions in factory debt they must now pay off over the upcoming years? Fortunately, or unfortunately depending upon your point of view, the answer to this second question hardly matters since tariff penalties can easily be dodged.

Similar to how China avoids tariff penalties in the United States, China's solar manufacturers can likely avoid European penalties by simply performing one or two of the panel manufacturing steps in a convenient country. For example, they can do some steps in Turkey where labor rates are not all that different from those in China. Hitting the US with polysilicon tariffs and Europe with wine tariffs are also options.

China develops and executes 10 and 20 year plans. It has a government structure that is not burdened with short election cycles which too often breed bad decisions, tunnel vision, and wasteful political battles. Related to the energy situation, the government in Beijing sees that there are less than 800 million people in Europe and the US, billions of people live elsewhere, and those that live elsewhere need a source of power that doesn't require pre-existing infrastructure and transmission lines. Solar panels installed directly at the locations of energy consumption are ideal.

Solar is ideal for the developing world and the size of that global energy market, once matured, will be astonishing. Better still, China's path for making solar energy cost-effective is fairly clear now. First, China will run 35 GW of solar projects through their own country so that economies of scale, industry consolidation, and learning curves reduce manufacturing costs by another 15 to 30%. They'll also apply next generation silicon production systems. GT Advanced Technologies (GTAT), for example, offers HiCz where solar cells can produce 30%+ more power for the same manufacturing costs. Add these up, and factor in the bonus cost/kWh savings in having to install fewer panels and acquire less land/space due to that 30%+ boost, and grid parity is achieved just about everywhere. Solar can conceivably overtake all other sources of energy just as the mass populations begin to use an ever-increasing amount of electricity. This outcome is especially likely since the cost/kWh of solar is locked in once installation is complete while the cost of energy from other sources tends to increase over the years.

If you're wondering which companies will prosper from all this, I suggest Trina Solar (NYSE:TSL) and Yingli Green Energy (NYSE:YGE). The large scale system installers are selecting Trina and Yingli panels fairly frequently now because these two companies supply highly cost-effective panels. Yingli has quite a bit of debt, which explains their undercutting of pricing (ensuring cash flow to service that debt) but a secondary benefit is that they are gaining market share. Trina is not as aggressive at the moment but has cash on hand to take advantage of the upcoming industry consolidation. Within the 35 GW of projects announcement the Chinese government stated that they'll provide tax incentives for solar companies who acquire smaller competitors. Trina is well positioned to purchase basic facilities and equipment from bankrupt competitors, and therefore expand business at extremely low costs, with tax benefits to further compound the speed of their growth. Right now I'm liking TSL more than YGE for the yet untapped value of their balance sheet, but both companies should do well given their low panel production costs and the commitment of the Chinese government.

So where do companies like First Solar (NASDAQ:FSLR) and Sunpower (NASDAQ:SPWR) fit into the big picture? Well, I still stand by the statements I made back in October. First Solar's cost/watt (and cost/kWh) are too high and their current profitability is not what it will likely be in the future. First Solar's financials are currently showing profits because they are currently executing old projects awarded with old (higher) profit margins. Sunpower's cost/watt (and cost/kWh) are much like those of First Solar so until things change significantly I won't spend much time talking about it. Canadian Solar (NASDAQ:CSIQ) seems to be fairly well positioned but I'll have to monitor them a bit longer before I publish comments.

Events described above may take some time to develop and a number of external events can impact them. However, my predictions thus far have been fairly accurate despite the storm surrounding these companies. I don't mind storms because without them we wouldn't have such undervalued stocks. With calculated risk comes reward and Trina is already up more than I could have hoped for since I wrote the first Understanding the Future of Solar article.

To summarize and close this article, Trina is my primary pick because they will soon lower costs via improved factory utilization, they can afford HiCz upgrades and thereafter improve the value of their product by 30%+, and with their strong balance sheet they can take advantage of the pending industry consolidation and associated tax benefits. Last but not least, the 35 GW of upcoming Chinese solar installations bodes extremely well for Trina. It's this 35 GW of projects that will fuel Trina's transformation into a highly dominant company just as the solar industry truly begins to take off. Thanks for reading and good luck to all of you in your 2013 and 2014 investments.

Source: Understanding The Future Of Solar - Part 2

Additional disclosure: I am long GTAT.