SolarCity Retained Value Redux: The Utilities Strike Back

| About: SolarCity Corp. (SCTY)


With increased solar penetration, utilities are looking at a dramatic reduction in energy sales and the threat of having to write off the uncompetitive or underutilized assets.

Connection charges and rate tiers are examples of the powerful option that utilities have to slow down solar penetration.

Companies like SCTY and SUNE are likely to see significant compression in retained values as the utilities fight back.

In our earlier articles on the subject of retained values (see here and here), we have discussed why retained values at SolarCity (NASDAQ:SCTY) may be overstated and why investors need to be cautious in estimating retained values and the risks behind them. This applies not just to SCTY but to other companies that are playing the retained value game. These companies include but are not limited to SunEdison (SUNE) and SunPower (NASDAQ:SPWR). In this article, we extend this thesis to include competition from utilities and how that could hurt the growth prospects of these players and their retained value trends.

As the deployment of solar technology increases, utilities are facing several interesting problems. The challenges vary depending on if the utility is regulated and if the utility is investor owned. In general, utilities are not fans of solar energy's distributed nature as it disrupts their business models. The investor owned utilities in unregulated markets have the least shackles and are the best equipped to deal with the expected onslaught of solar technology. Even these utilities do not like the disruptive nature of solar deployment.

The regulated investor-owned utilities, the companies that grieve the solar deployments the most, have been forced into the solar game kicking and screaming and have no interest in making the energy market distributed. And much to the chagrin of these utilities, their hands are cuffed by regulations and they are being asked to facilitate an orderly transition to distributed energy - something that is not in the interest of their shareholders.

Until recently, solar energy was nothing more than a curiosity or an annoyance for the utility players. Most of them did not even believe solar energy would ever reach a cost threshold to make it cost competitive with alternative energy sources. But that has started to change with the dramatic decline of solar LCoEs in the last couple of years. Solar energy has not only breached the retail price points in several markets but recent energy auctions have shown that solar pricing can be cost competitive with natural gas peaker plants even in wholesale environments - especially for the high demand afternoon times.

The utilities are suddenly faced with the prospect that their higher energy need commercial customers may defect rapidly to solar if they take no actions to stem the tide. Their lower value residential customers have been on a similar path for several years now and that trend is accelerating. Some key metrics that utilities are watching in horror include:

- Reduced overall demand per residential customer

- Reduced high margin peak demand per residential customer

- Reductions in energy needs of high volume commercial customers

For utilities, the larger commercial and public sector customers' defection is a worrisome and immediate threat. Residential customer defection is also a threat but that has a much lower economic impact on a per customer basis. At current levels of solar penetration, these dynamics may not pose much of a problem for utilities. However, continuation of the current trends would lead to increasing over capacity and underutilization of the utilities centralized energy generating assets and distribution assets. It does not help that a lot of utilities in recent years have invested in substantial natural gas energy producing assets that now run the risk of being underutilized. These are relatively new assets that have been put in place to exploit low natural gas prices and are only partially depreciated. Underutilization of these assets can have serious negative repercussions for investors. With solar penetration increasing, it is unlikely that some of these assets would ever be put to good use. This assessment, when it comes true, would be followed by major losses when the utilities are forced to write off the uncompetitive or underutilized assets. The utilities cannot let that happen. So, what options do the utilities have?

We believe Utilities are likely to fight back in several ways:

- Where possible, delay approval process and grid connections or refuse to build or delay transmission systems to carry solar energy. These are some tactics that some utilities have already deployed. However, these tactics can get considerable customer and government backlash and are not sustainable. These tactics will also give utilities a bad image and may create yet another reason for customers to defect.

- Regulated utilities may point to the competition in the energy space and successfully lobby for reduced regulation. At a minimum, utilities are likely to get significant leeway from regulators on specific rate schedules. When the rate changes happens, the competitive landscape can change dramatically for solar financiers like SCTY. Some rate related changes that utilities could fight for include:

  • Charge customers for grid access: This is something that is already beginning to happen. This particular approach would make it unattractive for lower usage customers to go solar and increase the breakeven point for solar conversion for other customers. The higher the connection charge, the harder it will become for solar deployments to pencil out.
  • Net metering changes: Currently some solar customers are paid at retail rates for the excess electric generation. Utilities may lobby for and change the net metering rates and rules to the detriment of solar energy customers. To help utilities to push these changes through, in some cases utilities are allowing for existing solar customers to be grandfathered under the older plans. But the news is not so good for newer installations.
  • Make batteries mandatory: Utilities may also try to make it mandatory for solar systems to have a specified amount of battery backup. While there are compelling reasons for a utility to do this, such an action would increase the cost of solar deployment and impede the penetration of solar. (Note 1: This is a complex discussion. Utilities are concerned that once a customer installs a battery they may become less dependent on the grid. Note 2: Even though the solar TAM reduces, SCTY may have a slight competitive edge in this scenario)
  • Change rating tiers: Utilities over the years have used a tiered rate system where customers were charged at higher rates for using more energy or for using energy at peak times. Utilities could charge the higher rate because of the market dynamics and the perceived need to disincentivize energy consumption. Part of these pricing strategies were inherently flawed economically in the sense that higher consumption typically should lead to a lower, and not higher cost.

Utilities could reduce the attractiveness of solar and slow customer defections by reverting energy pricing to a more rational model where customers with higher energy needs pay lower rates. This type of tariff change would make solar technology less attractive to larger customers and more attractive to the smaller customers. However, the larger customer on average is likely to be a better credit risk to the rooftop financiers such as SCTY. In effect, such a rate plan change could decrease the number of credit worthy, high revenue customers and increase the number of less credit worthy, lower revenue customers.

If managed properly, rate tiers are a powerful option that utilities have that could slow down solar penetration. Once on that path, utilities could find other options that help reduce the customer loss. For example, utilities could create new tiers where night time rates are increased to higher non-solar rates.

Utilities can also use rate plans to create ill will toward solar suppliers from customers who have already bought or leased systems. Imagine a scenario where a customer makes a solar system procurement based on average energy cost of "x" only to find that utilities' revised rate schedule changes the average energy cost to "0.5X." The customer may be very happy with the utility for the price drop and very unhappy with the solar company for being stuck with an increasingly unattractive long-term lease. It is easy to imagine what these changes could do to retained values of solar deployments.

- Utilities could build energy farms and sell fractional shares to the customer base. These solar farms can be built at a significantly lower cost structure compared to rooftop systems and can be sold to customers more economically than a rooftop system. And some customers may appreciate the aesthetics of their properties without solar panels. Once again, this dynamic can put significant pressure on long-term solar system prices and thus their retained values.

It may take time for utilities to find the right models that will work for them and it will take them even longer to successfully market them. But it is naïve to expect that utilities will just sit there and let players like SCTY, RGS Energy (NASDAQ:RGSE), SPWR and SUNE take their market share away without any resistance. Expect a hard fought battle from utilities as solar penetration increases. Consumers are the likely winner of these battles. Residential and commercial players like SCTY, RGSE and to a lesser extent SPWR and SUNE are the most likely to face the headwinds.

Make no mistake. We strongly believe that solar energy is the wave of the future and will be deployed abundantly. The article is only intended to sound a caution that competition from utilities should not be discounted and that some of the rosy growth scenarios and retained value projections may not come to a pass.

It is also likely that utility solar demand may see a resurgence as utilities try to combat the customer defections with their own utility farms and try to undercut the rooftop competition. The beneficiaries of the utilities' push back are likely large utility project developers such as First Solar (NASDAQ:FSLR) and, to some extent, SPWR and SUNE.

If you are a customer thinking of signing a long-term solar lease or a PPA, you should stop and think if the utility pricing built into the agreement is realistic.

Disclosure: I am long FSLR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.