Understanding California's Solar Equation

by: Investing Hobo

The photovoltaic (PV) solar industry has gone through extreme ups and downs in recent history offering both protagonists and antagonists ammunition for or against its development. Opponents have often claimed solar costs are too high. Advocates have countered with solar equipment's rapidly declining costs such as PV module average selling price (ASP) declines as high as 80% in the past 3 years.

Rivals have pointed out government subsidies are required to sustain the solar industry. Supporters have noted PV feed-in-tariff (FIT) rates in solar's largest market Germany have dropped below retail grid parity. Adversaries have often questioned the industry's demand growth. Proponents have indicated global PV solar installations have grown at an annual compound growth rate of over 50% in the past 5 years to levels surpassing even the most optimistic projections.

Unlike many other fledging industries in the past several decades, voices against solar have been disproportionately vocal given it competes against a much larger, entrenched, and diverse global energy industry. As a result, information presented about the solar industry have often not been entirely factually accurate and unbiased. As the solar market has grown in almost direct correlation with declining costs, more detailed information regarding the industry has surfaced. At least in California, a potentially large market for the solar industry, newly disclosed information surprised if not shocked both sides in the ongoing solar debate.

Results for California's Renewable Auction Mechanism (RAM) were released late last month and revealed surprising results. Essentially an auction for renewable projects took place in late 2011 for three regional utilities, Southern California Edison (SCE), PG&E (PCG), and San Diego Gas & Electric (SDGE). While SDGE's results have not yet been published, SCE and PCG revealed a combined total of 130MW in winning bids. Among this total, 107MW were for solar PV projects. Although the actual contract pricing for each winning bid was not disclosed, the weighted average of the highest executed contract price was revealed to be just $0.08923/kWh for projects starting in 2013.

How does this RAM feed-in-tariff compare to residential grid averages for each of the three participating utilities? Based on information given by California Public Utilities Commission, average residential electricity rates in 2011 for SCE, PCG, and SDGE were $0.157/kWh, $0.16/kWh, and $0.184/kWh respectively. While the RAM FIT of $0.08923/kWh is only a starting point and subject to adjustments based on overall subscription, it is as low as half average retail grid rates.

What is perhaps most surprising in an era of sub-$2.50/MMBtu natural gas is the RAM vs. Market Price Referent (MPR) FIT pricing. The MPR reflects the long term ownership, operating, and fixed price fuel costs for operating a 500MW combined cycle natural gas turbine. For plants starting in 2013, the same period as the RAM contracts listed above, the MPR FIT is set at $0.09375/kwh. Additionally, the MPR has already been lowered 14% from $0.10898/kWh to reflect recent declines in natural gas costs. In other words, the weighted average of the highest executed contract pricing for renewable projects mostly consisting of solar PV has already reached levels below natural gas rates.

With some actual project bids potentially lower than $0.08923/kWh, the question of whether these bids reflect economic reality rather than publicity by solar companies may arise among skeptics. In order to determine if solar PV has reached economic parity with competing alternatives such as natural gas, LCOE for these projects must be calculated using both known and some assumed metrics. Since one of the contracts involves a US listed solar manufacturer, Trina Solar (TSL), its cost variables will be examined as an example.

Trina Solar submitted two bids for contracts with SCE and was selected for one project 20MW in size. The term for the agreement is 20 years, well within the company's 25 year module warranty. Based on the expected annual energy production, the project has an initial capacity factor of 26% which is at the high end range for most solar plants thanks to California's favorable solar climate. Using Trina Solar's 25 warranty of no greater than 0.7% annual power degradation along with an additional power conversion loss assumption of 10%, about 38,000kWh per 1,000kWp installed should be generated over the 20 year contract term.

In terms of capital costs outside of financing, there are three main components: the cost of the solar modules, balance of system costs, and maintenance costs for the entire term period. For maintenance, an average figure of $20/kW per year is used based on National Renewable Energy Laboratory (NREL) estimates. In terms of module costs, $0.90/watt is used based on Trina Solar's 2012 average module ASP guidance of high $0.80s/watt to $0.90/watt.

The remaining variable which some assumptions are required is balance of system (BOS) costs. While Trina Solar has expanded downstream into the systems segment, no actual cost figures have been disclosed. Thus this figure has to be estimated based on metrics already stated by Trina's direct peers.

First Solar (FSLR) has recently disclosed average BOS costs of $0.98/watt in 2011 and expects costs to decline further to average $0.87/watt in 2012. Because Trina Solar's silicon based solar modules are 20-25% higher in efficiency relative to First Solar's thin film CdTe based modules, BOS costs using Trina Solar's modules should be similar if not meaningfully lower than First Solar using an apples to apples comparison. A relatively higher efficiency module would require lower units per targeted peak capacity and thus should provide cost savings on space, building materials, and labor costs.

Additionally Trina Solar's US listed Chinese peers have also disclosed projected system costs for projects in China. With little doubt BOS costs in China should be meaningfully lower than in the U.S., but nevertheless any disclosed costs offer some baseline estimations. Jinko Solar (JKS) stated in its Q4 2011 earnings conference call prices for solar projects sold in China should average $1.80/watt in 2012.

Assuming module ASP similar to Trina Solar, Jinko Solar expects its BOS costs including markup to range around $0.90/watt. JA Solar (JASO) also referenced a project selling range of $1.60-2.00/watt in its Q4 2011 earnings conference call. However, JA Solar also indicated total system costs were at or below $1.50/watt implying individual BOS costs as low as $0.70/watt. Other large Chinese peers such as Renesola (SOL) and LDK Solar (LDK) have mentioned BOS cost targets in China ranging from $0.50-0.75/watt.

While it is not certain Trina Solar has reached a BOS cost assumption of $0.90/watt used in this LCOE example, it is certainly a target the company could achieve especially by late 2013 when its SCE contract term is expected to start. The company has already started its downstream systems integration over a year ago and since further horizontally expanded in this segment with products such as Trinamount in efforts to reduce overall BOS costs. With peers already quoting costs within this range, it would not be an unreasonable target for Trina Solar to achieve given its history of effective cost reduction in the PV supply chain.

Using the cost parameters described above, the total project cost including maintenance would approximately total $2.20/watt. When coupled with its 20 year electricity output, a simplified LCOE of $0.058/kWh is derived which is considerably lower than the RAM FIT rate of $0.08923/kWh. Outside of module margins embedded in Trina Solar's $0.90/watt module ASP assumption, this project would yield the company an additional IRR close to 5% at this RAM FIT rate.

Using NREL's online LCOE tool also yields similar results with a discount rate of 5.5% to reach a simplified LCOE of $0.089/kWh. This is significantly higher than current interest rates in the US and a percentage below the current People Bank of China rate of 6.56%.

Whether projects using this RAM FIT rate yields adequate IRR is another issue, but it is clear solar PV has already reached cost points well below residential retail grid in California to the point of challenging natural gas generating electricity costs represented in MPR pricing. It is also important to note the LCOE price derived above is based on unsubsidized costs.

Because solar projects in California may be additionally benefited from both state and federal tax subsidies, actual returns may be higher. At least in one potentially large solar market in the world, solar advocates can claim victory as cost parameters have already reached a longer term sustainable level without subsidies.

Disclosure: I am long TSL, JKS, LDK.