California Net Metering Successor Tariff Is Yet Another Nail In Lease/PPA Business Model Coffin

| About: SolarCity Corp. (SCTY)

Summary

There is a widespread belief that California Net Metering decision was favorable to the solar industry which we believe is valid but in a more limited way than many realize.

What investors may not realize is that this decision was very negative to the lease/PPA industry and threatens the survival of lease/PPA companies such as SCTY and RUN.

Our analysis suggests leases and PPAs will become unfinanceable and the business will peak in 2016/2017 and decline there afterwards.

Last week, when California Public Utilities Commission voted on a Net Energy Metering successor tariff, or NEM2, it appeared that the decision was essentially the same as the preliminary PUC ruling from December. However, as with any political process, PUC commissioners have slid in some subtle but important changes in the final decision. Compared to the preliminary ruling, the final decision has the following three significant changes:

  1. Transmission charges, estimated to be about $0.02 per KWH have been eliminated from the charges that solar system users will have to pay. This is a very significant win to the solar industry compared to the preliminary decision.
  2. Time of Use, or TOU, rates are mandatory for all NEM successor tariff customers as opposed to starting from January 1, 2018, per the preliminary ruling. While the change from preliminary ruling may not have much of an impact, directionally this is adverse to the solar industry which has been fighting against TOU rates and the decision incrementally favors the utilities.
  3. Systems with customer-sited storage are mandated to be treated in the same manner as those systems interconnecting without storage. This is a big nod to storage interests. While storage is largely uneconomical without steep subsidies, the arrival of TOU rates will incrementally boost California storage market. Given potential synergies between solar and storage, this change can also be seen as an incremental positive for the solar industry.

All things considered, we can say that this decision was more favorable to the solar industry than the preliminary decision which by itself was considered quite a victory in the industry's fight with the utilities. But perception of victory is subjective.

Let's consider the major elements of the ruling and evaluate the short- and long-term impacts on the key stakeholders:

  1. Grandfathering: This is by far the biggest win for solar interests in utility rate case proceedings. While no duration of grandfathering will assure long-term economics of a residential rooftop system, it will certainly create a base level regulatory protection for the system owners. On the flip side, grandfathering is a long-term albatross to utilities and non-solar ratepayers. The downside here is that utilities and non-solar ratepayers are handcuffed into honoring bad public policy over an extended period of time in a rapidly changing industry. While a 5 year grandfathering can fall within the realms of acceptable public policy, a 20-year grandfathering is decidedly poor public policy and mainly serves the interest of lease/PPA financiers who are underwriting 20/30 year financial instruments. However, even in the most favorable scenario to lease/PPA interests, investors can safely disregard cash flows after 20 years (ex: renewal terms of leases/PPAs, last ten years of MyPower loans, etc.)
  2. Favorable battery connection regime: This is a significant positive to the battery and solar industries as it makes possible a hassle-free deployment of storage systems behind the meter. The key negative for utilities here is that they need to be cognizant of battery/solar arbitrage against existing infrastructure.
  3. No cap on NEM2: A cap of 5% on the original Net Metering was one of the uncertainties of the business models of the lease/PPA companies. That cap has now been eliminated under NEM2. Investors should, however, note that a new net metering regime is mandated in 2019 and the new regime will certainly be more restrictive and will certainly reduce the available TAM for lease/PPA companies.
  4. Nonbypassable charges: The purpose of nonbypassable charges is to allocate at least some part of grid cost structure to solar users. This is a per KWH charge that is tied to the energy drawn from the grid without netting the PV output. This is almost like a fixed charge to PV systems in the sense that the generation capacity of the solar array has no bearing on these charges. This convoluted method, which only a regulator can love, was one of the bigger concessions that the utility industry was able to get in the current rate case. To be sure, solar lobby was successful in cutting the nonbypassable costs by about half between the preliminary decision and the final decision with the removal of transmission fee from the charge calculations. Nevertheless, these charges create up to $0.02 per watt headwind to new installations. On a $0.15/KWH lease, a $0.02 adder is a meaningful setback in the economics of the system. From a customer perspective what this could mean is that a perceived savings of, say, $0.06 a KWH under the previous regime could now become a perceived savings of $0.04 - i.e. a 33% reduction in perceived benefit. This would considerably shrink the TAM of the residential lease/PPA market compared to the past Net Metering regime.
  5. One time Connection charges: Utilities have succeeded in tagging on a connection charge for solar systems which is an appropriate economic cost. This cost, which is expected to range from about $75 to $150, will not materially change the economics of a typical solar system. A 5 KW solar system costs customers approximately $15,000 (at $3 per watt). A $100 charge, for example, would increase the overall cost of the installation by a fraction of 1%. Nevertheless, this is one cut in a death by thousand cuts.
  6. Move to Time Of Use rate schedules: This is probably the least well understood part of the ruling by investors. Under the previous net metering regimes, the solar power generated by a rooftop system was being compensated at the highest rate tiers applicable to the customer. Under TOU rates, most of the solar systems' production is likely to be compensated at lower "off-peak" rates. The TOU rates are also very sensitive to usage scenarios and a system that may appear economical in a specific usage scenario at the time of installation may cease to be economical within a few years due to lifestyle changes or change in property ownership. The TOU rates will also ensure that the compensation will decrease over time making lease/PPAs uneconomical in as little as 5 years into the 20/30 year term. While the market may not have realized this yet, we believe lease/PPA model is dead under the TOU rate structure.
  7. Reasonable minimum bill: The ruling also allows for a reasonable minimum bill which also can reduce solar rooftop economics in some situations. However, the impact of this will not be known until the utilities develop and implement the new rate schedules.
  8. Virtual net metering: The ruling also requires utilities to provide a path to residents of multi-tenant buildings to go solar. In effect, this ruling was also an overt boost to community solar. While community solar deployment models vary widely, the cost economics of community solar are superior and this model could see a significant growth spurt in the foreseeable future.

What should be evident from these changes is that the perception that residential lease/PPA interests have won this war is patently flawed. We suggest the lease/PPA companies are more of a Black Knight than Arthur in this fight.

If solar/lease PPA interests are like the Black Knight, why are the utilities not celebrating this decision? That answer is that even this decision falls far short of what makes for a sustainable solar policy at the DG level. The solar and battery installations driven by this decision will considerably alter the long-term energy economics in California. Virtual net metering also increases the potential for residents of multi-tenant buildings to go solar. This once again will work to increase solar penetration and accelerate the cost shift. By the time the current net metering is revised in 2019, there will be massive amount of rooftop and other distributed solar that, when considering the impact of 20-year grandfathering, will wreak havoc with the business models of the top three California Investor Owned Utilities. The substantial cost shifts enabled by this ruling will bring back the memories of death-spirals. We view this decision as credit negative for all the three IOUs. Further deterioration down the road could also come back to haunt Yieldcos with California utility assets.

Unfortunately, there are few winners out of such bad rate-making decisions. The main winners in the decision will be: DG solar installers (not including lease/PPA financiers) and customers who purchase their own solar systems.

The challenge for investors is that it is difficult to see the long-term implication of these changes due to the byzantine nature of PUC decision making. When faced with an unknown beast in solar and when challenged to come up with a new rate design, the PUC design process led to an Elephant by committee scenario.

One of the simplest and most easily implementable solutions to fix the cost shift problem of solar would have been adoption of a baseline fixed charge consistent with the cost structure of the grind. For example, this is the approach that was taken by Sacramento Municipal Utility District, SMUD, arguably the most well-run utility in California. Unfortunately for ratepayers in the PUC territory, the difference between SMUD management and CPUC is that delivering cost effective service to customers does not even make in to the guiding principles of the PUC.

Nevertheless, to give where credit is due, TOU rates are certainly a very compelling path to communicating proper price signals to customers over the long term and the PUC should be commended for leading the charge on this new path.

Coming to the subject of precedents, California has now set a new precedent in dealing with solar and it is not a positive one for the lease/PPA companies. California has now shown other utilities and PUCs yet another option to fight the solar cost shift - TOU rates. More than anything else, we expect that TOU rates would be the biggest game changer in the future rate-making cases. We expect TOU option to spread widely and, when combines with other policy options, effectively decimate the lease/PPA TAM in the US within 2 to 3 years.

For solar lease/PPA investors, predicting the imaginary savings of 20/30 year long leases/PPAs has become considerably more difficult. It will take some time for investors buying these revenue streams realize that the lease/PPA streams are laced with increasing uncertainty and risk. The risks and uncertainties of the underlying rate structures and economics when coupled with large price and technology obsolescence risk mean that the discount on this class of assets should be in the low teens as opposed to the 6% estimates used by managements of the lease/PPA companies.

In our view, it is absurd to argue that this decision is a positive to lease/PPA companies like SolarCity (NASDAQ:SCTY) and SunRun (NASDAQ:RUN) when in actuality it considerably reduces the already shrinking TAM, makes it more difficult to articulate the benefits of a lease/PPA system, and creates uncertainty in the long-term cash flows. We continue to assert that this is going to be a constantly losing war for lease/PPA interests punctuated by an occasional win in a skirmish. Any victories proclaimed on the way will be pyrrhic. Other companies impacted, but to a lesser extent, include SunEdison (SUNE), due to its Vivint Solar (NYSE:VSLR) purchase, SunPower (NASDAQ:SPWR) and RGS Energy (NASDAQ:RGSE). A second order effect will also be felt by suppliers such as SolarEdge (NASDAQ:SEDG), EnPhase (NASDAQ:ENPH) and several module manufacturers with high exposure to the California lease/PPA market.

As NEM2 kicks in and as utility actions increase, we predict that 2016 is likely the peak year for installations under the current lease/PPA regime. We expect the US residential lease/PPA market growth to moderate substantially starting Q3 2016 and to start its decline in 2017.

While it may take some time for the market to realize the impacts of changing landscape, there should not be any doubt that the equity in residential lease/PPA financiers like SolarCity and SunRun is worthless.

Our View On SCTY & RUN: Sell Short

Disclosure: I am/we are long SUNE, SEDG.

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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