As thousands of solar insiders gather in Milan, Italy, for this year's European Photovoltaic Solar Energy Conference and Exhibition, the main topic of conversation continues to be the shortage of solar-grade silicon.

LDK Solar, Hoku Materials, Wacker Chemie and SolarWorld recently announced they will make more solar-grade silicon (also called polysilicon) to help meet the demand. Schott Solar entered two joint ventures with Wacker to make solar wafers using less silicon and Suntech Power signed a $678-million, 10-year agreement with Hoku to secure a steady supply of the precious stuff.

"[Polysilicon] is still the No. 1 issue," said Jesse Pichel, vice president and senior research analyst of technology at investment bank Piper Jaffray. "Supply is tight and prices are high, and - assuming [solar prices reach] grid competitiveness - poly is going to be an issue for a long time."

But, while last year's discussions were focused on easing the shortage, this year's chatter is more about dealing with an increased supply of silicon on the way and, more to the point, the accompanying era of competition it's likely to usher in.

Despite high profits and sold-out demand, the sector that - according to Michael Rogol, managing director at Photon Consulting - has grown at more than 40 percent annually for the last three years is beginning to show signs of tension. And companies are jockeying to find their place in a sector where supply, demand and pricing are on the brink of change.

The result so far has mainly been partnerships and acquisitions. Aside from the joint ventures between Schott and Wacker, concentrating-solar startup Solaria of California signed a deal in August to buy 1.35 gigawatts worth of solar cells from German giant Q-Cells. And SunPower, a solar-panel manufacturer in California, signed a contract to buy two gigawatts worth of solar ingots and wafers from German startup NorSun. SunPower also expanded its place in the market by buying Powerlight, a large solar integrator, in November.

"Everyone sees a lot of poly coming online in 2010 - cheap poly - so they've got to get their costs lower and pre-sell what they make," Pichel said.

Calling Out The Competition

The fact is that competition today is all but nonexistent. With government incentives that can make solar power as cheap as conventional retail electricity, and a polysilicon shortage keeping supply well short of demand, solar companies are selling as much as they can make.

That's good for margins and profits, but it's also limiting the speed at which the solar sector can grow.

If the shortage eases and more solar panels become available, all that will change, and the solar sector will see winners and losers. "A lot of companies not doing anything particularly sophisticated are doing well today, and I don't think that will stay," said Solaria CEO Suvi Sharma. "I think there will be a tightening in the industry."

Of course, not everyone agrees the shortage is ending. While silicon refineries are being built more quickly than expected, demand is still outpacing supply, and that could keep the tight market going for years, Rogol said. Pichel agreed: "There is no end of the shortage."

Still, most analysts agree that prices will fall, although predictions vary as to when.

More polysilicon and lower prices would lead to higher sales volumes and a larger market overall. But the question for the sector is whether it can find a balance between a price low enough to grow demand and a price high enough to be profitable.The trick for each company will be to continue to make money on each sale without losing business to lower-priced competitors.

Pricing the Future

Determining where prices will land is an uncertain task at best. Prices depend on the balance of supply and demand, and both are in question in the solar sector. Demand depends on government incentives, carbon policies that could make solar more competitive, conventional electricity prices and - here's the rub - solar prices.

Research suggests that companies could survive a price cut. According to Photon Consulting report titled "The True Cost of Solar Power," the average price of a solar-power system is approximately $7.75 per watt, while the average cost is roughly $3.60 per watt - or, in some cases, as low as $2.68 per watt.

But solar companies - and their stockholders - would prefer to keep hold of their margins. So the sector is focused on trimming costs, turning to new manufacturing processes and silicon-efficient technologies. By 2010, Renewable Energy Corp. expects to cut its total solar-panel-manufacturing cost in half, ErSol projects a 33-percent cost drop and SunPower expects to lose 30 percent of its cost, according to the Photon Consulting report.

The Fall

Of course, not every company is basking in strong margins.

In August, solar-cell manufacturer China Sunergy (Nasdaq: CSUN) posted a second-quarter loss of $3.8 million, or 14 cents per share, when analysts had expected a profit of $56.5 million, or 2 cents per share. The company blamed the silicon shortage, as well as falling prices.

And Trina Solar (NYSE: TSL) saw shares drop 9.2 percent the day it posted its second-quarter results because its gross margin decreased to 18.9 percent from 22.3 percent in the previous quarter, and from 27.5 percent in the second quarter of 2006. Shareholders sold the stock even though the company beat expectations, reporting that net income grew 51.4 percent from the previous quarter and increased more than fivefold from a year ago.

But Rogol said Trina has the potential to cut costs in the future and raise its margins again. Margins are only getting healthier as companies reach significant cost reductions in the next few years, he said.

In the meantime, incentives are increasing in many markets - Germany's falling tariff notwithstanding - and the U.S. federal tax credit for solar installations alone could pour billions more into the solar sector, he said.

"For margins to contract, you would need to [lower] the price of environmental incentives or the grid price, or see a significant rise in interest rates," Rogol said. "Otherwise, it's highly unlikely."

Watch for more on this debate as the conference continues.