In the recent past, we have written several articles about unrealistic assumptions behind solar project metrics. In particular, we believe that the phrase "retained value" as it is currently used in the industry is a disgrace to basic principles of valuation. In this article we discuss the securities that back these new genre of solar assets.
To evaluate the quality of the financial instruments tied to the solar assets, it is imperative that investors understand the characteristics of the underlying assets and the assumptions used to compute the revenue streams from the assets.
Virtually all lease and PPA agreement backed instruments that we see today make the following assumptions:
- Flat or increasing energy prices over the term of the lease
- A high residual value for the solar asset at the end of solar lease/PPA agreement
- A high energy rate for the solar asset after the end of the initial solar lease/PPA agreement
- A low default rate during the term of the agreement
- A high renewal rate at the end of the agreement
- No change to the operating cost of the asset
- Estimated life of the solar system is 30 years or more
In contrast to these assumptions, here are the underlying truths of solar energy market:
- System cost per watt continues to be on a rapid decline. For instance, First Solar (NASDAQ:FSLR) (our thesis here) had a system cost per watt below $1.50 per watt for utility scale systems at the end of 2013 and expects this number to drop to less than $1.00 per watt by 2017. With the efficiency improvements and market dynamics in place, we believe there is a clear line of sight to a system cost per watt of $0.50 or less with a decade. Esoteric, higher efficiency technologies could drop this cost even further. For the purpose of this article, we assume that system cost per watt plateaus at a $0.50 level during the next decade and increase at the rate of inflation in the subsequent years. Note that these numbers are for utility scale systems and the corresponding numbers for commercial and residential applications will be proportionally higher. We believe that over the long term, utility and market energy prices will track the reductions in solar energy. Utilities are likely to make up for the loss of revenues by changing tariff structures, divesting energy producing assets, increasing connections fees, and using other creative revenue generation options.
- The above solar cost dynamic when combined with the static or increasing energy costs of the solar system indicate an ever increasing delta between market price of energy and the energy price a customer is paying under a solar lease/PPA contract. The wider this delta becomes, the bigger the customer dissatisfaction and the higher the default rate.
- Companies argue that default terms of the PPAs/leases will be superior to auto loans, prime mortgages, and that the risk is comparable to defaults of utility bills. The lack of critical thinking displayed in this assumption is astounding. The simple truth is that a customer not paying the solar financier is not at all similar to a customer not paying your local utility energy bill. Not paying a solar PPA will not result in the customer losing power in the house. The most likely recourse for the system provider in this situation is to renegotiate a lower lease with the defaulting customer or to uninstall the system at a considerable cost. The owner then needs to look for ways to deploy what is likely a somewhat obsolete and undesirable system.
- Solar panels degrade over time and the energy output capability of the system reduces with passage of time. While the exact amount of energy loss in time is variable between different products, a 20% reduction over a 20 year period is considered typical. This loss of efficiency occurs in a regime where newer panels are increasingly more efficient. This dynamic once again widens the delta between desirability of an existing system versus the desirability of a new system.
- And finally investors needs to be aware of the operating costs of an energy plant. Currently, companies are procuring attractive long term ground leases for a 20 year term for utility applications. However, for Residential/Commercial rooftop/ground mount applications, the real estate is essentially free. In operating terms one way to look at these leases/PPAs is that the current project owners have negotiated a zero cost ground lease for 20 years. While that is a great deal for the initial term, the negotiating power at the end of the lease term shifts to the land owner. In other words, it is unwise to expect the current favorable ground lease terms to extend into the future when the current lease terms end. This dynamic will decisively increase the effective cost of operating a solar asset beyond its lease term.
- The above factors taken together also mean that economic life of the solar system is more likely to be the same as initial lease term which typically is 20 years.
The above analysis makes it clear that almost every key assumption behind the current solar asset model is flawed. And if the asset model is flawed, the return on the asset is flawed too. As the default rates increase, the derivative financial instruments based on these asset models are likely to significantly underperform the market. Given this reality, we can conclusively say that any solar financial instrument with assumptions similar to the ones stated in this article are subprime with the following exceptions:
- The return on the financial instrument need to be backed with minimum return guarantees
- The financial instrument needs to backed by an asset or guarantee other than the solar asset itself
It is time for the industry to wake up and start assessing the solar assets and the associated derivative instruments with an appropriate risk model.
Stocks affected: SolarCity (NASDAQ:SCTY) (see thesis here and here), SunEdison (NYSE:SUNE) (thesis here), SunPower (NASDAQ:SPWR) (thesis here), FSLR (thesis here), RGS Energy (NASDAQ:RGSE) (thesis here)
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.