by Stephen Lacey
December 01, 2016

We're now offering Squares transcripts to our two podcasts, The Interchange and the Energy Gang. Below is an edited version of our latest episode of The Interchange.

Stephen Lacey: This is The Interchange, a weekly conversation on the changing business of energy and cleantech from GTM Squared. I'm Stephen Lacey joined by Shayle Kann in his corner office here in the Boston office. How are you, sir?

Shayle Kann: I'm great. How are you?

Stephen Lacey: Good. We're sitting around the table with Nicole Litvak who is a senior analyst for solar markets here at GTM Research. Hey, Nicole.

Nicole Litvak: Hey, Stephen.

Stephen Lacey: Today, we're talking about one of Nicole's specialties: residential solar finance. America's residential solar market is in the middle of a pretty monumental shift for a couple of reasons. The first is that solar growth is slowing down, partly because of policy uncertainty in some states, and partly because of issues at top national installers -- and we'll talk about those. That, in turn, is leading to local installers taking up a greater market share. Consequently, solar loans and cash purchases are growing while third-party leases and PPAs are falling. Solar is getting cheaper, and loans and cash purchases are more accessible for consumers. Also, local installers are more likely to offer a loan, and in order to compete to meet this demand, all the major third-party financiers are now offering a loan product of some sort.

There's a lot of complexity behind this switch: complexity dealing with customer preferences, customer acquisition techniques, capital availability, growth rates and the general order of the residential solar industry. I want to start with one stat, Shayle, that can maybe help us explain the state of the market, and then I want Nicole to riff on this. 16 percent. This year, the residential solar market will likely only grow 16 percent. Last year, residential solar saw 71 percent growth, and then the year before that it was 59 percent. What does that stat tell us about the state of the market? I think that will help us lay the foundation for this shift in solar financing in the sector.

Shayle Kann: Yeah. I think that is maybe the most important statistic for residential solar in the U.S. right now. The trend we had been seeing, what we had become somewhat accustomed to over the previous four or five years, was the residential solar market growing at 50+ percent every year. In fact, I think the lowest growth year for residential solar since 2012 had been 59 percent annually, and like you said, over 70 percent last year. This market is just booming every single year. Then this year, it doesn't just sort of turn a little bit. It drops down to something in the mid-teens. We'll see how it works out at the end of the year. Again, it's a market that's still growing, just to be clear. A lot of markets can't show 16 percent growth in the first place, but it's growing a lot slower than it has in the past. And what's difficult for us, as we're trying to understand what's driving this, is to parse out a number of different things which are happening simultaneously and obviously impacting this growth rate.

You've got a few specific markets where there was a lot of residential solar installed in the past year that have basically disappeared this year thanks to changes to rate design and net metering -- Nevada being the biggest one there. Nevada was a top-three market last year, and it has fallen off the map this year. That's a state-specific issue that causes the overall market to grow a little bit less than it had. There isn't another Nevada, quite, out there this year. There might be one next year. Utah's a good case for that.

You've got this state-specific thing. You've also got this company-specific thing, which we'll talk about more. But if you're looking at what drove a lot of that growth the past few years, it was a small number of large companies. At least a couple of those large companies this year, most notably SolarCity and Vivint, have some company-specific issues that have caused them to slow down both strategically and by necessity.

And then you've got this question: have we started to fatigue the lowest-hanging fruit in terms of residential solar customers? Have we gotten to all the customers that are going to adopt early, and then now it's going to be a bit more of a slog to get the next phase? Or are the economics just not there in enough places anymore? We're trying to separate out each of these issues individually and understand what it means about the future of residential solar when some of the shorter-term company- and state-specific things will disappear.

Stephen Lacey: I bring this up because, Nicole, in your latest report on residential solar finance, you talk about these factors. Are there any that we can pinpoint as more important than others for slowing down growth this year?

Nicole Litvak: I think, as Shayle mentioned, it's really a combination of the company-specific factors and then state-specific factors, and those aren't mutually exclusive things. When you look at the market in terms of more established state markets like California, New York, Massachusetts, those are starting to slow down just because of that consumer fatigue, because that happens to also be where those big companies like SolarCity are most active, so when they slow down, the market as a whole slows down. They're two pretty interrelated issues.

Shayle Kann: Just look at California alone. California's still like close to half of the residential solar market nationally. It's emblematic of what happens in a market that gets higher penetration, so you can ask these questions about customer fatigue. Within California, the growth is slowing down faster for the larger companies than for the smaller ones, but it's a lower growth year for the local installers too. It's not just specific to those top few.

Nicole Litvak: Right, but at the same time, a lot of those small installers are still growing, just perhaps a little bit slower than in the past. There are definitely opportunities for those companies. Again, that goes back to financing and the new opportunities for them to reach customers with new loan products.

Shayle Kann: Right. The other thing that I think is interesting is net metering. Nevada basically killed the solar market by imposing, at that time, retroactive changes. But even just the forward-looking changes made solar completely uneconomic. California largely retained net metering, except it implemented some small changes, and then most importantly, implemented what are going to be mandatory time-of-use rates -- generally cheered by the solar industry. The economics of time-of-use rates can be good for solar in the short term. Certainly solar advocates generally consider time-of-use rates highly preferable to changes to net metering, things like that. But, anecdotally, the pending, looming change to mandatory time-of-use rates has made it a little bit more difficult for solar installers to sell solar to customers now.

In a sale, you can imagine how complicated this is. You're going to a homeowner who doesn't know anything about solar, and you're saying, "Well, here's how the economics work for you now, but let me just tell you, they're going to change probably in two years. They could still be good, but it's going to be dependent on when you use energy and how you change when you use energy." It just makes it a little bit more complex. The ways the rates and solar compensation are changing can be good for solar in a purely theoretical sense, but in a realistic sense, when you're actually at the kitchen table, selling solar to a customer can be harder.

Stephen Lacey: One of the things that you point out in the report is that customer acquisition costs are rising across the residential solar sector, and that's changing how companies reach out to find new customers. That's opening up new opportunities for channel partners. Is it a consequence of installers not being able to communicate these potential new rate designs, or is it just that we've tapped the first echelon of consumers and it's now getting harder to find that that second tier?

Nicole Litvak: Yeah. I think it's a combination of those two things, as well as just increasing competition. You have more companies in the market, especially in existing major state markets, and new markets like South Carolina where everyone's trying to flood the market to take advantage of a rebate. You end up with customers getting so many bids from different companies, and then that means all of those companies have lower closing rates and therefore higher customer acquisition costs.

However, I wouldn't necessarily say costs are going up for everyone. It's definitely a lot more so on the national companies, which, especially at the beginning of this year, their bookings were slightly down, but they were still spending a lot of money and investing a lot in new marketing and advertising and sales efforts, which resulted in their costs being as high as $1 a watt. Whereas we still hear from a lot of local installers that they have costs well below the 50¢ per watt average that we see.

Shayle Kann: Which is interesting, right? I think the benefit of being a smaller local installer is just the benefit of not requiring the kind of growth rates that SolarCity and all the other public companies do. You can rely a little bit more on the lower-cost customer acquisition strategies like referrals. Everybody knows referrals are your best way to get solar customers, but you can't grow 50 percent a year just on referrals alone, especially when you get to a slightly larger scale.

It's an interesting question in the long term. If you want to build a big, national residential solar brand, are you going to have to just keep throwing a ton of money at it to get the next customer? Or is there going to be a point where something tips and you develop a national brand name, customers start coming to you and you get the benefits of this national scale on customer acquisition -- as opposed to today when it sort of seems like being a big, national player is a hindrance in terms of customer acquisition, albeit a benefit in some other ways?

Stephen Lacey: Yeah, which goes to the tipping point that I mentioned at the beginning. We don't really know yet. I mean, we're still seeing the evolution of these business models, and therefore the changes in the financing offerings that these companies are offering consumers, and the way they go out to channel partners to acquire new customers. This is all in flux, and we can't really even answer that question.

Nicole Litvak: Right, yeah. I think over the past few years, we thought the trend was moving toward vertical integration, because SolarCity and Vivint Solar, the two big vertically integrated companies, were growing so much faster than everyone else. Now it's turned, and people are starting to question whether that business model is actually the right way to scale profitably. We're starting to see not only the financing part break away, but also the customer acquisition piece, like the channel partnerships that you mentioned. That's becoming a lot more relevant to those national companies that are now looking to get their customers, not just leads from outside sources.

Shayle Kann: But it'll be interesting to see now, with SolarCity in particular being a part of Tesla, which has built its entire strategy on vertical integration. The big vertically integrated company is still going to be there. It's going to be called Tesla Solar maybe, but whatever it's called, it's out there -- so we'll still be able to measure the success of that type of business model versus the disaggregated.

Nicole Litvak: Right. SolarCity now has their channel partner built into the company, whereas others likes Sunrun and Vivint are going to other companies, particularly those that specialize in a certain kind of customer acquisition, like door-to-door or phone sales. There are a lot of companies that do one particular thing really well, and that's where they're finding the lowest-cost customers.

Stephen Lacey: OK. Next year, for the first time since 2010, I believe, loans and cash purchases are going to make up the majority of residential solar sales.

Nicole Litvak: Yeah, since 2011.

Stephen Lacey: Right. What is the significance of that? I mean, what's driving loans and cash purchases? I mentioned in the intro that solar's getting cheaper, those offerings are more accessible to people, but the biggest installers are finding that to keep up with many of the local folks that are more likely to offer loans, they need to make those offerings as well.

Nicole Litvak: Sure. First of all, when you look at local installers, they have always preferred to just sell a system to a customer, whether that's just for cash or with a loan, because those installers in many cases can make better margins on a loan versus a lease. They're typically going after a different type of customer than a SolarCity or a Vivint is, and those customers are more likely to want to own their own systems.

Stephen Lacey: What type of customer is that exactly? I mean, what's the difference between a customer that SolarCity might approach and a customer that a local solar installer might approach?

Nicole Litvak: Yeah. This is generalizing a little bit, obviously not true of everyone, but the typical SolarCity customer might be someone who has never considered going solar until someone comes to their door with this proposition. They will probably only go with that one company that they talked to. They are looking to just save money, because that's what's gonna work from the sales perspective. You go to someone's door and tell them they're going to save money on their electricity bills from year one. That's that customer, whereas the customer going with the local installer is someone who has maybe thought about solar a little bit more, gotten a few bids from different companies, and is not necessarily looking to save money right away, but has done the math and realized that in certain circumstances, you know, if they're staying in their home for a long time, it might be a better option for them to buy the system.

Stephen Lacey: Okay. Dig deeper into why that's happening, that next year we will see more loans and cash purchases than leases and PPAs which have dominated since 2011.

Nicole Litvak: Sure. For the local installers, they now have access to so many more loan products that didn't exist a few years ago. As we've already talked about, those companies are now growing faster than the big, national installers, and so that's helping to tip the scale in favor of customer-owned solar. Then on top of that, the national companies, SolarCity, Vivint and Sunrun especially who make up about half the market, they're all starting to shift away from third-party ownership towards customer ownership. Those companies have such a big portion of the market that if they even get to 50/50, that's gonna make a huge difference.

Shayle Kann: Let's just talk about SolarCity. I think this applies in a slightly different way to Vivint and Sunrun as well, but SolarCity I think got itself into a bit of a trap. Here's the quick story of SolarCity as a public company, I think. SolarCity goes public, and basically the story that they're telling the market at that point is that, we're a finance company more than anything else. What we do is we put these assets on customers' roofs and we have a contracted, safe, 20-year cash flow that's gonna come from that. The value you should ascribe to us, SolarCity, has relatively little to do with our cash flow. We're going to be cash-flow negative, we're not going to be GAAP profitable, but what we have is this long-term cash flow that's going to make us incredibly profitable eventually, and so you should value us based on this metric, retained value, which has been much discussed about SolarCity.

The public markets bought it, and so SolarCity's market cap kept growing, they kept doing more things, they made a bunch of acquisitions, they kept installing more and more. They were losing more and more money, but that was the plan from day one. They get up to ultimately, like a $5 billion market cap, and then the market turns on them for a few reasons, some of which of their own doing. They were missing guidance a couple of times, some of which were just market sentiment turning against both them and against solar in general.

As their stock starts going down, they have to sort of figure out, well, if it's going to get more expensive for us to borrow money, which we're going to have to do under this plan we've always had, then we need to have a different story about where our value comes from -- but the whole story has been retained value. We need to have these long-term, contracted cash flows. They try to introduce their own loan product because they realize that loans are attractive. It's called the MyPower loan, and they pitch it really heavily, but it looks like a PPA or a lease, in part because it still gives them these long-term, 20-year cash flows, but customers don't really like it that much. It's just not that popular.

Stephen Lacey: Shouldn't we say "liked"? Didn't they abandon the MyPower loan?

Shayle Kann: Yes. So then SolarCity launches a loan to a lot of fanfare, it does sell a bunch of these loans, but it's not taking off like they want it to, so they abandon MyPower and eventually have to go back -- now they can't be telling investors anymore that the whole story is about these long-term cash flows. They actually need to become cash-flow positive. They were saying that at the end of 2015, that they were going to be cash-flow positive by the end of this year. In order to be cash-flow positive, they want to be selling systems, so they do these cash equity deals in order to generate a bunch of cash, but really, a loan is fine. In a world where they need to be generating cash, they need to be cash-flow positive.

Now they're sort of forced into loans, and they appear to be pretty good at selling loans too, but it's a totally different story. By this point, investors are a little bit fatigued from the changing story, which in some ways investors themselves forced upon SolarCity. It was just this weird dynamic that led SolarCity down from a $5 billion market cap to a sub-$2 billion market cap before it was eventually bought by Tesla for a little over $2 billion. It's a weird story of the relationship between a company's strategy and the public markets that it depends on.

Nicole Litvak: Right, and that's why none of those companies have their own loans now. They're all working with partners so that they don't have to hold the loans on their own balance sheets, because they've realized that they do need to get closer to profitability sooner.

Shayle Kann: This is something I've never fully understood. It does make sense that they don't want to hold the projects on their own balance sheet, but the loan providers also aren't holding projects on their balance sheet either. I mean, they're small startups, a bunch of these companies. They can't afford to do that either. I know Mosaic raised a ton of money, and that's probably because they're going to hold a bunch projects on their balance sheet and securitize them, but most of the loan providers don't have that kind of capital. Why couldn't SolarCity or Vivint or whoever just do what those standalone loan providers are doing and use a bank as the source of capital, and just make their margin on the installation?

Nicole Litvak: I think in theory they could.

Shayle Kann: Yeah. I just don't understand. [...] This is a general question, right? SolarCity is using Mosaic for loans and dividend, and Sungage?

Nicole Litvak: Sunlight.

Shayle Kann: Sunlight. Right. Anyway, point being, SolarCity has always done it all itself, and all of a sudden it's working with a couple of partners. If I'm one of those partners, I guess I'm definitely nervous that at some point SolarCity is going to say, "Well, I'd rather be doing this myself."

Nicole Litvak: Yeah. It's definitely a risk on the loan partner side.

Shayle Kann: Yeah, and we'll see what happens, but maybe there is some reason. Maybe it is that they just want to generate cash. You wonder whether that changes under Tesla also. I mean, one of the things that I wonder in general about SolarCity under Tesla is SolarCity is a now a small part of a large Tesla empire. I don't how much attention SolarCity is going to get in the long term. Can SolarCity hide under the radar and do what it wants for a while? I don't know.

Nicole Litvak: Yeah. I was also originally wondering whether the acquisition would affect SolarCity's mix of financing, because I thought, well, maybe they'll go back to leasing, to try to bundle the car and the roof and the solar and everything. But then they most recently announced that as high as 305 of new bookings a couple months ago were purchases, and they expect that to increase.

Shayle Kann: Speaking of purchases -- we mostly talk about it as the transition from leases to loans, but cash purchases are actually a bigger share of the market. And the further costs come down for solar, one has to assume more people just going to buy these systems straight out, right?

Nicole Litvak: Yeah, definitely. Out of customer-owned solar at this point, more than half is still cash, although some of that is people getting their own loan from from their bank, but yeah, you're right. Residential solar is gonna be $2 a watt by 2020. That's $12,000 for a 6-kilowatt system minus the ITC. You're under $10,000, which is really not very much to be spending. That's like a used car.

Stephen Lacey: The description of SolarCity's transition was apt, but why is a company like Sunrun not following SolarCity's shift to loans and cash purchases? I think you point out that only 16 percent of the systems that they're financing are financed through loans. What's up with Sunrun?

Nicole Litvak: Yeah. That's something I've been a little curious about. They've been the one that's really stuck to their original plan with third-party ownership. They seem to have been pretty successful still in raising additional tax equity financing, so if you're still able to do that and there are still customers out there, it does make sense if they want to scale the way that SolarCity was scaling before. Plus, like you said, 16 percent was about as high as as they got with purchases -- but that's actually pretty high without even trying. That's basically as high as as SolarCity was, which I think says a lot about customers.

Shayle Kann: Right, and I think Sunrun isn't facing the same kind of public market troubles that SolarCity has been. Sunrun has been hitting its guidance, which has given it a little bit more leeway. It didn't have the same kind of inflated valuation in the first place, so it never had this big boom and bust in the same way, and so Sunrun I think has a little bit more leash to continue to do what it wants to do. That said, I think you have to anticipate that Sunrun's share of purchases or loans is going to go up. I think it'll follow the market to some extent.

Stephen Lacey: At this stage in the discussion, I think it'd probably be helpful to talk about the different types of loan products that are out there, because we see things stretching from anywhere from five to 20 years. What different types of products are we seeing offered by installers?

Nicole Litvak: Yeah. That's actually a major difference between the current loan market and the original leasing market -- you know, where there was basically just one 20-, maybe 25-year product. With loans, there are so many different options both for the customer and for the installer, because you can have different combinations of a lower interest rate with a higher dealer fee, or vice versa.

Shayle Kann: Could you explain just for people who don't know what the dealer fee is? I think this is something outside of this little universe of residential solar financing. People sometimes don't understand the interplay between the interest rate on a loan and the dealer fee.

Nicole Litvak: Sure. The dealer fee is the fee that the installer pays to the loan provider, like say that's Mosaic. They would pay a percentage of every deal that they close. That's part of how Mosaic and those companies make money. The way that they've structured it is, for instance, if an installer wants to be able to offer a really low interest rate to a customer, they can do that, but they have to pay a much higher a dealer fee -- which could be close to 20 percent to the loan provider, or vice versa. They can pay a lower fee and charge a higher interest rate. The thing is it all kind of evens out in the end because they are going to end up tacking on that fee to what they're charging the customer. They can't say that it's specifically for that reason, but they do tend to raise prices across the board for customers if they know they're going to be paying these fees.

Stephen Lacey: There are also loans that look kind of like cash purchases where you have 0 percent interest, but you have super onerous fees and penalties if you miss payments. Is that how it works?

Nicole Litvak: Yeah. Usually you might have a one-year loan with 0 percent interest rate, and that is just for the ITC portion. It's assumed that you'll pay back that 30 percent as soon as you get it. Then you have, say a 12-year loan for the other 70 percent, but if you don't pay back that 30 percent that you had 0 percent interest rate on, that will skyrocket.

Stephen Lacey: Okay, so that's usually a hybrid product, then.

Nicole Litvak: Yeah. Well, a lot of them are hybrid products.

Stephen Lacey: How common is that?

Nicole Litvak: I think it's pretty common either to have two separate loans like that or to have some sort of a structure where you're expected to pay back that 30 percent balloon payment after you get the ITC. To go back to your original question of what's becoming more common among all the different types, I think there's two different loan products for two different types of customers.

There's the longer-term 20-year loans, which are pretty common. That gives people the same benefit, like you said, of a PPA or a lease where you're saving money from day one. A lot of them come with all the maintenance and O&M included, so they don't really have to think about that, and they're saving money. That works for a lot of customers. Then there are shorter terms. Actually, they go as low as one year, but I'd say 10 or 12 years is probably the most common on the shorter end of loans. With that, in certain states like in Massachusetts with SRECs you can actually have a 10- or 12-year loan and be saving money from year one. In some other states, maybe not the first year, but it's still a better long-term deal than a 20-year.

Stephen Lacey: That's an important distinction to make here because what products are offered depends on policy constraints and how market is set up. As you point out in your report, in some early markets, it might just be easier to offer PPAs and leases to scale very quickly, and in some more mature markets, loans are taking off. What is the interplay between offerings and how a state market is actually set up from a policy perspective?

Nicole Litvak: Yeah. The other thing is that a lot of these newer states don't have legal third-party ownership, and that again goes back to the reason why we're seeing a shift, is that in new markets like Florida and Texas, loans and cash are the only option. That's helping to drive that.

Stephen Lacey: But in a state like Nevada for example, it was third-party offerings that caused that surge there.

Nicole Litvak: Yeah. That's true, but I don't necessarily think that would happen again, like if another state opened up like that next year, because SolarCity and those companies have already started to shift to loans. I don't know that they would make that same decision to go into a different market.

Stephen Lacey: You had mentioned that there are tax equity constraints due to the limited number of players and folks that had decided to get out of the solar market because of the uncertainty around the ITC, but there's also capital constraints around loans. Mosaic has been very successful in raising capital for loans, I think $0.5 billion this year. Their latest fund was $250 million, and as you pointed out to me when I chatted with you for a quick story I was working on, that only represents like 20 percent of the demand for loan products here in the U.S. There are capital constraints everywhere in residential solar right now.

Nicole Litvak: Yeah, because a lot of these loan companies, they're just startups, so they're all still struggling and and figuring out how to raise capital. For that reason, over the last few years, as they have all scaled up, installers have to have multiple loan providers. They can't just have one partner because they don't know who's going to have money when. Yeah, like you said, Mosaic has raised about half a billion this year, but over the next five years, customers are going to spend almost $25 billion on solar that they purchase, whether that's cash or through a loan, but even if you assume that $10 billion out of that $25 billion is loans, we're still nowhere near how much capital we need.

Shayle Kann: But you have to imagine that in theory, the total pool of capital that could relatively easily be deployed toward solar loans is going to be way bigger than the pool of capital that could easily be deployed and tax equity, right?

Nicole Litvak: Yeah, the investors themselves. There are a lot more types of investors that could in theory get involved.

Shayle Kann: Yeah, exactly. The boom in residential solar that we've seen over the past five years -- the big companies created out of that, the $1 billion companies, were essentially finance companies.

I wonder whether that's going to be true in the next wave of residential solar, whether your biggest venture-capital successes, for example, are going to be in the finance space or doing something else. CRM software, customer acquisition, installation, whatever it is -- is finance going to be the thing that generates the next $1 billion residential solar company? That's certainly the bet that Mosaic and all these other companies are making, but I wonder whether financing will at some point in the future get commoditized and we'll end up with another part of the value chain where there's something more interesting to do.

Stephen Lacey: Speaking of the future, let's wrap up with a look even further down the line, because your report goes through 2021. What does the financing landscape look like in residential solar by 2020 or 2021?

Nicole Litvak: Yeah. We're going to continue to see this shift toward customer ownership for all the reasons that we've discussed, particularly as costs come down, as the national companies move toward customer ownership, toward loans and cash sales, and as new markets that don't have third-party ownership open up. When you combine all those factors, we're going to get down to about 27 percent third-party owned by 2021.

I think there will always be a market for third-party ownership, at least over the next decade or so, because there are a lot of customers who still want that, a lot of people who cannot monetize the ITC right now. On the installer side, there are still going to be those companies that are trying to reach certain customers very quickly, and are using that model to scale in certain places or certain situations, but overall, we do expect the vast majority of the market to be customer-owned.

Stephen Lacey: The ground continues to shift. Nicole Litvak is a senior analyst for solar markets at GTM Research. Thanks, Nicole.

Nicole Litvak: Thank you.

Stephen Lacey: I'm Stephen Lacey with Shayle Kann, and this is The Interchange, a podcast from GTM Squared.