The solar industry has come a long way to reach the point where it can compete at grid parity in many markets. Products and services continue to be developed to support the growth each year. In the early years, the market was driven by cash purchases of solar assets. Today, there is a trend toward financial products, and the market is nearing the point where 50 percent of the total solar projects involve lease or power purchase agreement (PPA) financing. However, it remains much easier and much more lucrative for solar developers to work with clients who are paying cash for their system while giving clients the greatest return on their investments. The problem with this model is that it limits access to only the most affluent clients. The prevailing concern has always been the heavy cost burden associated with these transactions. If fees, reserves, guarantees and yields do not reasonably match the risk level, then this sector of the market will remain untouched.
Exploiting this vast market requires a new dialogue between solar developers and investors. Among the considerations that the two parties need to address together is the question of price. At what price can both parties benefit in view of the potential for building a dynamic solar market, the size of which may double in the next two years? There is an enormous, untapped market that could be developed by leveraging the resources of financial institutions.
The plot thickens
The 1603 grant has finally expired, but there is life after the grant in the commercial solar market. The grant both helped and hurt the solar industry over the last three years. While it allowed hundreds of new solar developers to enter the business, it also brought many inexperienced players who set false expectations, leading to confusion and indecision in the markets. It was enacted at a time when banks were not in a position to make tax equity investments in solar due to the events of the 2008 financial crisis. The grant allowed projects to go forward without tax equity. From this point forward, every solar project will go through a tax equity investor and, most likely, that investor will be a bank.
The commercial solar industry has done an admirable job of reducing costs and that has been the biggest story leading to industry growth. The price of an installation has gone from $10 per watt to $3 per watt over the last five years. It may achieve the lofty goal of $1 per watt by 2017. One of the biggest reductions has come in the single largest material cost: modules. Over the same five years, module prices have gone from $5 per watt to $1 per watt. Racking, inverters and the remaining balance of system costs have gone from $5 per watt to $2 per watt. The greatest opportunity for continued cost reduction lies here. There is much work being done and the reductions will happen in the near future. It is the responsibility of solar developers and manufacturers to continue to improve the cost structure. Beyond the cost of installation, the only other cost that determines the price of energy is the cost of capital. To stimulate expansive growth in the industry, the focus now needs to be on the cost of capital.
Enter the banks
Banks hold the power to drive the solar industry forward, creating jobs, energy independence and long-term energy savings that can result in a healthier business and natural environment. Banks have an incredible opportunity to initiate a business cycle which acts to lower the operating costs of successful companies, leading to a healthier, more stable banking environment for themselves. By way of the banks enabling renewable energy projects, we are all aware of the health and environmental benefits to be gained. In addition to the economic and environmental benefits, this opportunity can help banks improve their image at a time when they have been under fire by Congress and the public. The solar industry needs the banks to get active and play a bigger role in the development of the solar industry. There are a number of questions that will be answered this year. Are they up for the challenge? How many will participate? How many will add to their existing programs? Will any begin to drop their yields? When will we see competition for deals?
Get into the act
Fortunately for solar, the long-term extension of the tax credit is in place through 2016, so we do not need a major act like other renewables. The one change that would make the Investment Tax Credit (ITC) more attractive to bank investors is if they could receive Community Reinvestment Act (CRA) credit for making a renewable energy investment. Banks are mandated to invest in tax credits to meet these requirements. Solar, unfortunately, does not count toward meeting this mandate. The Low-Income Housing Tax Credit (LIHTC) and the New Market Tax Credit (NMTC) both help the banks to comply, and both of those industries enjoy more competition for deals and lower yield hurdles. Congress can make this change and it will further align everyone’s interest in advancing renewable energy.
Yields for tax equity have remained in the 8 percent to 11 percent range since 2008. They are justified given the supply/demand mismatch. Banks deserve credit for holding themselves to a high standard and continuing to make investments based on project economics rather than pricing to the market constraint. However, if we saw stable, mature markets as found in LIHTC in the pre-2008 era, yields could drop as low as 6 percent. If we were pricing deals with 6 percent yields, solar would be more competitive in many more states today. One of the reasons other tax credit products enjoy lower-cost capital is they have been around longer and the risks are better understood. As solar markets develop over time, there will be a better understanding of the long-term investment risks. This added insight will lower yields and it should start to happen this year and next. Most of the tax equity investments today come with a range of guarantees. Traditionally, guaranteed yields price as much as 200 basis points lower than unguaranteed yields. A further adjustment should be made today for tax equity investments when compared with other equity investments. There has been an overall adjustment in the market on return expectations. Tax equity investments with full guarantees should not yield a higher return than a much riskier private equity investment.
The cast of characters
Utilities and independent power producers (IPPs) are well suited to own solar generating facilities; they are great asset managers and they are set up for billing and collecting. The challenge with partnering with utilities is they have a higher yield hurdle. The economics of a solar project are always very tight, and 90 percent of the deals cannot afford a yield above 10 percent. Most utilities and IPPs are seeking a higher return. They have had success in the East Coast SREC markets where they can assign a future value to the credits. Their success will be more limited in West Coast markets.
A strong ensemble
Along with a strong tax equity market, it is also necessary to have a deep pool of lenders and sponsor equity investors to round out the capital stack. The biggest challenge here is the term of the debt and the sponsor equity yield requirements. Solar projects come with module warranties of 25 years; however, it is very difficult to find a lender who will go beyond a 7- to 10-year term. A longer term would lower the initial cost of the solar energy and open up a much wider market. As for sponsor equity yields, investors are targeting requirements higher than the risk profile will warrant.
When the curtain closes
Banks have an incredible opportunity to move the market in solar. If given a larger investor field, slightly lower yields, reduced fees and longer terms, the solar industry will see record growth. The solar developers and manufacturers are actively doing their part in cost reduction, and there is room for improvement, but now it is time for the banks to make their mark on the solar industry. Banks will win points with the public, who are their customers and depositors, through job creation, economic development and building a clean air infrastructure, which makes for a healthier environment. Banks will be the difference-maker while gaining handsome rewards in a fast-growing market.
It is a true win-win for both cast and audience, and an opportunity for record industry growth.
With 20 years of experience in both tax equity investing and construction management, Michael Johnson leads the Structured Finance team at SPG Solar.