Potential Valuation Problems For SolarCity Commercial Paper

| About: Tesla, Inc. (TSLA)
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This week, SolarCity (SCTY) came on the market with an issue of its Solar PV asset backed paper. It will be interesting to see how this ends up being valued. Recently NYSERDA, the New York agency that finances energy retrofits, and "energy efficiency" projects, ran into some challenges with placements in the secondary markets, as did the Commonwealth of Pennsylvania. I would hold that these problems are entirely due to the fact that there is no good way to value this paper, except on the basis of the marginal energy savings, but that's a sales argument at best, not a rational basis for valuation. There is no sound financial approach to this class of paper. The only, albeit somewhat weak, comfort factor is that the customer should have sufficient free cash flow as long as it's cheaper than the historical alternative, but that is potentially a fallacious argument. The real question is what alternatives are being looked at.

It will be interesting to watch how these placements fare, and how they hold up in future. If the valuations do not hold up, that would become a serious question mark behind solar PPA/lease business models in their current form. And there is every reason why these valuations are dubious, and eventually that should be reflected in the market, as we return to basics in terms of the economics and finance of energy retrofits.

The Supplier's Perspective

From the supplier's perspective it seems easy enough, for if they are offering the property owner a cheaper alternative to what they are paying for electricity today, that appears to be a win/win proposition. Driven by both the various incentives, and by a simplistic approach based on marginal energy savings--the SolarCity website touts Control Your Energy Bill, and the company offers a variety of energy efficiency products and services--the case seems clear enough. This is the general industry approach which has evolved from the insight from the seventies that within the context of the grid overall, it was cheaper to reduce demand than to increase supply, and as a result, renewable energy technologies get slotted in to this energy savings approach, which really makes sense for the equipment suppliers and for the utilities. Not necessarily for building owners.

The Customer's (Property Owner's) Perspective

From the viewpoint of the property owner, it may not be as clear, although the overwhelming majority today may not be aware of their alternatives and their choices.

The property owner makes two decisions when he commits to a solar PPA, and neither is addressed in the usual sales proposition, for the providers by and large are just pushing widgets out the door, with an easy rationale to sell them by--energy savings--and glossy brochures, with sunny, shiny people and their proud new panels. They offer to reduce the energy bills which the property owners certainly do have, so what should hold stop the owner from going ahead? The fact that sales were slow to get off the ground at least initially, points to a certain amount of cognitive dissonance about these decisions. The issues may not be what they seem.

The two decisions a property owner makes in this case are:

  1. Space allocation (usually roof-real estate), alternative uses of the same space are pre-empted by a long term commitment.
  2. Capital allocation: he commits his resources one way, which precludes alternatives.

Starting from the space problem there are several competing options. Depending on the nature of the roof, and the location, these may include: green roofs, solar thermal, building mounted wind turbines, and more. Other solutions may not compete for space, but for budget dollars, and those include geothermal heat pumps. This latter option, geothermal heat pumps, may actually combine very well with Solar PV, under the right plan. However, you would then specify a different size panels.

Since the building owner normally does not have a plan, he usually makes a suboptimal choice if he signs on the dotted line for the shiny new panels. At the extreme this could be fraud in the inducement and material for class-action law suits. Simply put, the same space that is used for PV panels, could in most cases be better used for solar thermal and provide heating and cooling for the whole house, instead of just saving pennies on utility bills. Geothermal, though it does not compete for the same space, also often offers an economically superior outcome in private residences. And if you wanted to go with geothermal, your choice of Solar PV would be different at least in size.

Lastly, there is a technology risk, solar PV today is 15-20% efficient, solar thermal is up to 98% efficient, and geothermal is 400% efficient. Solar Thermal are mature, and are not going to get a lot better, but solar PV is? How is that PPA going to look on my house if the neighbors are buying solar PV 10 years from now, and it's 50% efficient?

The Valuation Problem

If the property owner was paying a certain size utility bill, and now his monthly bill is reduced, arguably they are a good risk. At first blush that seems true enough, but it does not hold up to scrutiny.

For the property owner, reasoning from marginal energy savings to justify an equipment purchase, ignores the important objective of maximizing appreciation of his asset, his building. Therefore the property owner should be concerned primarily with evaluating all the alternatives, before he signs on the dotted line. Once he commits to one major expenditure based on marginal energy savings alone, he is fairly well committing himself to an energy savings model, which suffers from diminishing returns for obvious reasons.

The Potential for Class-action Lawsuits

In short, the property owner is in potentially being swindled out of asset appreciation if there were alternatives for his building. That might seem academic to some, but it won't be if the neighbors make different decisions and their property values go up faster than the reference building.

By way of a thought experiment let's look 10 years later. Our property owner, A, gets himself a Solar PPA, and some energy efficiency upgrades on 1/1/14, and saves 25% over his 2013 electrical bills, but he still has his gas bill for heat and hot water. On his same street are comparable properties, one of whom went with Solar thermal, which handles his entire heating and cooling, with his old furnace as a backup, and yes he had to finance it himself, but he had the benefit of PACE bonds, etc. and the result is, he reduced his household energy bills 70% compared to 2013. And owner C went even one step further, with the benefit of an inheritance, and PACE bonds, and implemented geothermal, and an integrated thermal/PV solar solution, resulting in an 85% reduction of his total energy bills. They all sell in 2024, and A has 15% appreciation compared to end 2013, B has 25% appreciation and C has 35% appreciation. Meanwhile, the price leaders in the area are now a development of net-zero condos nearby. What are the chances someone might claim they were had, and then their lawyer realizes there are another 500,000 like him?

The Fix

The fix is simple, but it means work. Every property should be treated as a potential energy producer as well as consumer, and a 30 year capital budget with a thorough appreciation of the engineering integration of different solutions is a must. The government from its end should stop incentivizing specific technologies, for it leads to bubbles and sub-optimal projects. The incentives should be directed towards overall project results, by property, regardless of what technologies are used, and the targets should be to reduce Green House Gas Emissions. Modestly, I have proposed such changes in an open letter to President Obama, and subsequently to New York's Governor Cuomo, about underwriting standards for the Green Bank.

Counterpoint and other Considerations

The only defense of the sales proposition, is simply that today everyone in this market place is using marginal energy savings as the way to sell their technology. That is obviously not a good enough reason. It should be noted that up to a point the problem gets bigger, as buildings get bigger, as there tend to be more opportunities for integration.

The history of the situation is that the dialog was originally shaped by the utilities, and the need to incentivize property owners to do what was good for the utility. Given that we are a capitalist society it is now time to let the invisible hand do it's work, for the switch to on-site production of renewable energy means moving energy from liabilities to assets, and if it is done right, this will result in significant property appreciation. Thus property appreciation needs to move center stage.

Implications for Solar PV Retrofits

The implications for the whole sector of solar PV retrofits are that there is a fair amount of froth in the current wave of enthusiasm, because the sales proposition rests on the ignorance of the buyers, and that is liable to come to grief in some way shape or form. Eventually, property owners are bound to realize that energy is their biggest expense after the mortgage, and that all decisions are interdependent, so that a proper capital budget will need to come first. This will slow down the buying process. If proper planning becomes the norm, the choices will become more diversified across renewable technologies.

Perhaps even more importantly, if the structure of incentives changes, that could have a big impact. Incentives now are on technologies, products, there is a strong argument that the incentives should be on properties/projects.

What this information means in the market remains unclear, but the economic facts will not go away. Evidently, if these issues are exposed on 60 minutes, or Consumer Reports starts coverage of this issue, or someone organizes a class action suit on the basis of deceptive business practices, that could start shifting the tide in consumer acceptance. Similarly if one or more companies figure out a way to make the alternative palatable, i.e. contracting with property owners on the basis of long term property appreciation, things will change. If significant financial institutions begin offering energy retrofit financing on the basis of long term asset appreciation not marginal energy savings, this "energy efficiency" paper will be downgraded in secondary markets, and that could drive change. Until one of those events begins to take shape, this issue is a question mark that will hover over the industry for some time to come, but it could turn the outlook for this sector decidedly more cloudy.

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.