SolarCity And The Dark Underbelly Of The PPA Model

| About: SolarCity Corp. (SCTY)


SCTY business model on thin ice.

Lower cost, increasing efficiency, and technology alternatives may undermine retained value play.

Accelerating need for GHG-reduction may marginalize solar PV.

Securitizations of solar leases and PPAs will suffer from other market developments.

SolarCity (NASDAQ:SCTY) and other players in solar PPAs -- SunEdison (SUNE), First Solar (NASDAQ:FSLR), Sunpower (NASDAQ:SPWR) -- benefit from some marketing magic: sell a home owner a 20 years Power Purchase Agreement with nominal energy savings over their utility, a "no money down," "self-liquidating" proposition, backed by a lease that is paid down in 10 years, so that SCTY, not the property owner, get to claim the ITC, under a current tax loophole.

The retained value problem

A recent article questioned the retained value assumptions in light of pricing changes. It was part of a series of articles by "Casual Analyst," that is starting to ask compelling questions about this new tulip mania, which is the solar PPA/leasing business. I highly recommend reading those pieces first. The fundamental issue that's easily spotted, retained value, is fairly obvious, i.e. how can you support "retained values" ($$/watt), well above what competitors are assuming? Answer: you can't, really. No surprise there.

However, the problem is far more pernicious than that. The retained value problem appears tricky enough in its own right, simply comparing trends within the solar PV business. However, when you widen the view to "clean energy," or "Greenhouse Gas (GHG) reduction," a very different picture emerges. Few businesses survive for long by banking on uninformed customers, and particularly with the Internet this is becoming an ever trickier assumption. The property owner's job is not to find the most attractive solar PV deal. The job of the property owner is to maximize the value of their property, while minimizing GHG-emissions. And there is no reason solar PV should be such a big winner. It should be the last choice, not the first.

Political Factors

The Baucus energy tax reform proposal is the first indication of some sanity in Washington, though for the moment limited to the supply side, i.e. utility scale projects. It proposes overall incentives for GHG-reductions (not individual technologies) and the more that thinking prevails, the more evident it will become why solar PV is the last choice not the first. In the process, the exemption that allows third parties to assume the ITC should go away, because it is counter productive. It merely helps the industry ram suboptimal solutions down the throats of property owners.

I recently commented on New York State's Draft 2014 Energy Plan. One of my comments was that the presumed "success" of solar PV on Long Island was effectively an example of market failure. If your choice is among geothermal (400% efficient), solar thermal (98% efficient, or better), and solar PV (15-17% efficient today), which would you rather choose? The reason for the success of solar PV is misplaced incentives (read: the 3rd party allocation of ITC), the emotional appeal, combined with the ease of installation and the ease of financing. Solar PV is the easy, though illogical an myopic, quick fix for those desirous of becoming "green."

EXAMPLE: I obtained a quote for a home in CT, and to round the figures, it had $300 in electrical bills, $700 in oil bills (monthly), and sure enough, SCTY could save us 10% (or more!!!) on our electrical bills - i.e. 3% of our energy bills. Reducing our GHG-emissions by ca 25% (the CT portfolio standard has 10% -- going to 20% by 2020 -- renewable content in electricity from the grid). Instead, by using the same roof space (duct work was already in place) with solar thermal could provide whole house HVAC, including hot water, eliminate 80-90% of heating bills, and reduce GHG-emissions by 80% or more. Granted, it's a much bigger job, but clearly it would vastly improve the economics of the home and therefore its long term value. Let's assume we did the solar PPA, and then the neighbors did the solar thermal next year - what would that do to the value of our property?

Overall, NY state wants to see 50% GHG reductions by 2030, and 80% by 2050. Guess how much room that will leave for 25% GHG-reduction projects? Meanwhile CA just adopted new rules that by 2020 all new properties should be net zero.

In short, the political pressures are building away from the subsidization of individual technologies towards the overall GHG-reductions by project/property, and the net zero construction industry has been growing by leaps and bounds already for forty years and is now becoming normative. Which means that it will be a major determinant for real estate values from now on. In general, the states are starting to pull ahead of the federal government in dealing with climate change.

Fraud in the inducement?

How happy will today's home owner be, if he signs that solar PPA, and sells the house 10 years from now? Solar City has already paid off the lease. Assuming our proud homeowner still saves the same 3% on his energy bills with the same 25% GHG reduction, but he's surrounded by the next door neighbor to one side with the solar thermal plant, and about an 75% reduction of their energy bills, and new construction on the other side of the net-zero variety. That solar panel on the roof will depress the value of the home. The home in our example would have gone from $1,000/mo in energy bills to $970/mo. But the neighbors with the solar thermal retrofit went from $1,000/mo to $250/mo, and after 10 years that thermal system would be long since paid off, while the Solar PPA would have another 10 years of run time according to the contract. Within Solar PV itself, 10 years from now new panels may be 25% efficient, and possibly a lot less unsightly, but it's really the alternative technologies which will bypass this idea completely.

If nothing else, this is a class action lawsuit in the making, because SCTY pawned off their 15-17% efficient panels to technologically unsophisticated buyers, thinking they would really keep paying for it for 20 years. Chances that this will hold up over time seem narrow. That bubbly solar PPA peddler may not have to inform the property owner of technological alternatives, but failure to disclose the outlook of today's 15-17% efficient PPA alongside a 25% efficient ones 10 years from now at the time of the lease-signing may indeed constitute fraud in the inducement. It is failure to disclose a technology risk to an unsophisticated buyer. There are potentially two aggrieved classes here, the buyers for failure to disclose the technology risk, and investors for failure the qualify the woolly assumptions in the business plan. The retained value is one questionable number, and the assumptions it rests on in terms of default rates and renewal rates, would likely need revision with every new technology generation that is released. Default rate up, renewal rate down, some of that can and should be part of the forecast of an industry insider.

The securitization problem

I have published elsewhere about the headwinds encountered by the Commonwealth of Pennsylvania and New York's NYSERDA with securitization of Energy Efficiency portfolios. I would argue that securitizations of solar leases will experience some of the same challenges, for reasons outlined here. The prima facie truth that they seem to be self-liquidating propositions at the time of signing, is likely to be falsified well within the term of the PPA contracts, if they depress property values. On top of that the new construction market is moving towards ZNE construction (Zero Net Energy), and the retrofit market to comprehensive building retrofits that achieve 50-90% (and sometimes even 100%) GHG-reductions. From an economic standpoint, clearly anything over 50% constitutes an effective long term energy price hedge. Virtually none of the solar PV retrofits, on leaky old homes, will come anywhere close to even 50% GHG-reductions, and most will be below 25%.

The thermal factor

Generating electricity is a great idea because distribution of the energy is cheap, and the distribution losses are low, which is not the case with thermal energy (HEAT). However, for on-site deployment, where the majority of the demand is thermal -- HVAC and Domestic Hot Water (DHW) -- the extra conversions make no sense, particularly not if PV is 17% efficient and solar thermal up to 98% efficient. To this you can add the fact that solar thermal comes with cheap batteries, aka. hot water, as a way to harvest energy for intraday use, whereas with PV, expensive, and environmentally unfriendly batteries are the only option, unless you combine it with geothermal as an energy harvesting strategy.

All in all, this kind of a simplistic, single technology "solution" sale is a sign of an immature market, and the forces are in place for rapid changes of buyer needs and expectations. We may think we don't have carbon taxation, but the market does. We don't need politicians for that. The financial success of net zero construction, and the well documented experience that these properties hold their value better than ones using fossil fuels, indirectly set up market valuations that will tend to devalue properties that do not have a way to upgrade their infrastructure to near-zero energy (and water!) demand.

The political support for 3rd party conveyance of the solar ITC for rooftop installs is supported only by the famous old battle cry of Henry Cabot Lodge, in the midst of a major crisis: "Gentlemen, is there anything we can appear to be doing?" Already, we see that the political will is emerging to undertake more substantive measures, and largely cosmetic changes like "energy efficiency" and a few solar panels here and there are likely to move to the threatened species list, unless they are part of a more comprehensive solution that scores above 50% GHG-reduction.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

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