SolarCity (NASDAQ:SCTY), we believe, has a problem with how it is valuing its leases and PPAs. We have written several articles about this topic (see here, here, here, and here). This problem is not unique to SCTY and affects other companies in the industry including SunEdison (SUNE) and SunPower (NASDAQ:SPWR). In this article we look at the fundamentals of how an asset is leased and what is wrong with the current lease/PPA models. We also discuss some mechanisms companies can use to fix the problem so that investors can have a realistic assessment of a company's assets.
In typical leases, payments are calculated primarily based on asset characteristics (initial value, terminal value, etc.), customer specific risk (credit worthiness), and market risk (macro economy, default rates, discount rates, etc.). These instruments also give customers a reasonable exit path (prepayment options) should the customers' financial needs change. This works well for homes, autos, and other products where the asset, market characteristics, and consumer behavior are well understood.
The problem with the solar industry today is that the lease/PPA instruments are being priced to fail. The root causes of this are the assumptions that are being made about the long term economic value of the asset and the long term customer behavior. The solar industry, we believe, has problems on all of the following fronts:
In a typical leasing situation, if the assumed terminal value of the asset is too high compared to the market value, then the customer is likely to walk away from the asset creating renewal/default problems. On the other hand, if the assumed terminal value of the asset is too low, then the lease/PPA company would be leaving money on the table.
A lease/PPA is bound to fail if the value of the instrument does not approximate the marketplace reality. As such the initial prices of the solar asset being built into the models of solar companies are high due to the tax equity shenanigans - a solar lease provider is likely to record an asset at a higher cost than actual market cost. Valuing the output of the system at unrealistic rates only makes this problem worse.
To fix this problem, companies like SCTY should develop internal models to forecast the price of assets and forecast the price of energy twenty to thirty years out. The risk with this approach is that such models may not be rooted in reality and could be biased. There could be considerable divergence between models of different companies even when it comes to evaluating the same asset. There are couple of possible solutions to this modeling problem. SCTY, SUNE, SPWR, First Solar (NASDAQ:FSLR) and other companies in the industry could work together to develop asset value models for the whole industry. Or, industry consultants could use the current information void as an opportunity to forecast long term asset prices for various markets (residential, commercial, industrial, utility, rooftop, ground mount, etc.).
There are two key vectors where the behavior of solar customer is not well understood:
The first is the behavior of the customer when their solar asset prices are not compatible with the instrument that they own. Will a client likely walk away from an energy producing asset if competing solar assets are producing power at a lower cost? The only real solution to this problem is to model the financial instruments so that the asset values in the instruments closely reflect the reality. This offtaker risk is unlikely to be significant if the value of the energy asset closely mirrors the actual value of the energy being produced by the asset for the duration of the agreement.
The second aspect is aesthetics. When it comes to their home, consumers care about its curb appeal. Commercial property owners may not be as particular but even they care about the look and feel of the property. Leasing/PPA companies and investors need to be cognizant that solar technology is changing rapidly. Concepts such as Building Integrated Photovoltaic technology (BIPV) may be a lot more realistic and price competitive within the next 20 years. Regardless of whether BIPV is successful, it is very likely that the curb appeal of future solar solutions will likely be far superior to what we have today. Research is needed in this area to quantify consumer behavior towards the lease/PPA vendor and the asset itself if the existing/old solar assets meaningfully take away from curb appeal.
Another significant risk that is not being modeled is the energy needs of a typical customer 20 to 30 years down the road. The energy needs of customers in 20 years will likely far exceed their energy needs today. Electric cars and increased dependence on automation are two examples of factors that are likely to drive the increased energy usage (offset to some extent by higher efficiency lighting and appliances). A solar energy system designed today may not be sufficient for the needs of customers 20 or 30 years from today. When a lease/PPA agreement reach their terminal stage, customers may not have space available on their roofs to augment their systems and may opt for a newer higher efficiency system based on energy needs, aesthetics and other factors.
Companies like SCTY need to be cognizant of the obsolescence risk and have an appropriate model to discount for the expected customer loss.
Meaningful pre-payment options
Customers do not like being trapped. To be viable long term mechanisms, leases and PPAs need to have provisions for pre-payment at meaningful terms. One should note that meaningful would imply that the solar asset's price and energy rate is reasonable at the time of prepayment. Once again, for this to be possible, the industry needs to have reasonably accurate long term price projections of solar assets.
As solar penetration increases, competition from existing Utilities and alternate energy suppliers will be intense and the energy markets are likely to be in an upheaval. The solar output, without storage, is entirely a daytime endeavor. Customers would still need energy from the grid (or from storage) at nights. The night time requirement is likely to increase as electrical vehicles like Tesla become pervasive in the market. From an energy solution perspective, the customer demographic that is likely to move to solar early may be the same demographic that is likely to move to electric cars early. The net result could be an energy profile with accentuated daytime generation and night time consumption pattern. This would require increased storage capacity at home or increased need to tap the grid at night.
In the new distributed energy paradigm, the trick for the asset heavy Utilities will be to manage the transition in such a way as to gradually reduce their dependence on day time energy generating assets. They need to increase the focus on night time capacity and the distribution infrastructure to make money. In such an environment, the needs of a Utility protecting its interests will be divergent from the interests of a company like SCTY. A common ground could develop where both sides can co-exist without much friction. It is impossible to predict winners and losers on a global scale as it is more than likely that each regional market will have its own risk profile and find its own equilibrium. In each market, the economic output of a solar system, and the economic value of the leases and PPAs, can vary vastly depending on the competitive mechanisms used by the incumbent utility.
In summary, what the solar lease/PPA companies need today is quantification of market risk and a rapid generation of viable long term data predictions. A disciplined actuarial approach is needed so that future financial instruments can be priced properly.
When SCTY and others start to adopt these mechanisms, what they will realize is that leases and PPAs need to be structured with decreasing energy prices over time. And, that would mean a considerable drop in the retained value of the assets they currently hold. This would mean an earnings hit and a reset of investor expectations in the short term but would lead to a more sustainable financial model in the long term.
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.