Four solar industry veterans had a conversation in late August about the top trends in the US utility-scale solar market during a short webinar organized by Infocast.
The group was Ed Feo, president Coronal Energy, Andy Redinger, managing director and group head of utilities, power and alternative energy at KeyBanc Capital Markets, Rhone Resch, the longtime head of the Solar Energy Industries Association and currently a board member of Sunworks Inc., and Jigar Shah, who is co-founder of Generate Capital and a well-known figure in the industry as one of the founders of SunEdison. The moderator is Keith Martin with Norton Rose Fulbright in Washington.
MR. MARTIN; Ed Feo, what do you think are the top trends and challenges currently in the utility-scale solar market?
MR. FEO: Let me name a few and keep it brief. I am sure the others will come up with even more.
One trend is diversification of the customer base. Use of PURPA, a 1978 federal law, to force utilities to sign power contracts is waning. Voluntary arrangements are on the upswing. We are seeing more purchasers who are not investor-owned utilities—for example, electric cooperatives, community choice aggregators and corporate purchasers, and also emergent financial hedge deals. Then there are all the related issues in terms of how contracts change with the different customers.
Another trend is an increase in utility self-procurement. That seems to be growing.
Another trend is continuing reductions in the cost of solar equipment. There were pretty significant decreases in equipment costs from 2016 into 2017. Whether that will continue depends on the outcome of the Suniva tariff case.
Policy uncertainties remain a challenge, such as the looming phaseout of the federal investment tax credit for solar, the post-PURPA world and how that works and, most significantly, the Suniva tariff case that could have significant consequences if it goes in the wrong direction.
Another trend is the incorporation of storage into solar. It is allowing us to come up with a more useful product and putting us in a position to earn more revenue by providing ancillary services.
Turning to financing, there is a lot of money chasing standard, middle-of-the-fairway stuff. The fun starts when you start to see new customers, shorter tenors, different credit profiles and new financial instruments. It will be interesting to see how the financial world deals with these.
MR. MARTIN: Good list. Andy Redinger, what is left?
MR. REDINGER: In no particular order, there is abundant debt and equity, and the costs of both continue to trend lower. Small-scale utility projects continue to dominate the activity. Lenders like us are beginning to look at providing credit past the expiration of the power purchase agreement. There are a couple things going on there in the solar space that are interesting.
The institutional debt market has been lagging the bank market, but seems to be roaring up to speed. Both institutional lenders and the rating agencies have realized there is a lot of potential business in refinancing bank debt with institutional debt. The rating agencies are becoming more aggressive in how they rate projects.
A challenge is we are having to find a way to deal with unrated offtakers. I have several more, but let me leave some, as I would hate to go last in this group.
MR. MARTIN: Rhone Resch, any trends or challenges to add?
MR. RESCH: All of this has the shadow of the Suniva trade case over it and, until we fully flush that out, these other issues may not be as important because the trade case has the potential significantly to increase the cost of solar modules.
Solar panel demand in China is going to be almost twice as big as people assumed at the beginning of the year, closer to a 45- to 50-gigawatt market, which is putting upward pressure on solar panel prices globally. The uncertainty about whether tariffs will be imposed on imported panels into the United States has already led to upward pressure on panel prices as companies buy up the existing inventory ahead of any tariffs that might be imposed.
Looking a little farther into the future, we continue to see new technology coming to market. This will provide new opportunities for companies to lower costs. An example is use of new panel designs with higher-voltage inverters. Optimizers are now being used in utility-scale solar projects. Trackers have a growing percentage of that market. We now have technology to address PID issues with modules.
Finally, a positive development is the number of companies interested in buying operating assets. We are seeing that across the board. A decent resale market has developed for existing solar projects. That bodes well in the long run for utility-scale development. The key is to ensure that the electricity prices that we are agreeing today to deliver under long-term power purchase agreements can be delivered, given where module prices may be headed in the next six months.
MR. MARTIN: Back up. You said there is a new technology to address PID. What is it?
MR. RESCH: It is an issue that we are finding increasingly problematic for some existing projects with lower-quality modules. PID stands for potential induced degradation. It is a process where you see a rapid degradation of modules in the field. When it occurs, there can be a severe decrease in module output.
The good news is we have new technology that can be used to reverse PID where it has set in, but is not yet severe.
MR. MARTIN: Jigar Shah, is there anything left?
MR. SHAH: One thing to add is the utility-scale solar market has a value challenge. Bids have been quite aggressive and, with the upward pressure in module prices, instead of figuring out how to cut costs, companies may do better to find ways to increase value in the asset.
An example is adding battery storage to an existing project.
We have also found companies opting to take advantage of a loophole around section 25D of the US tax code, where they sell individual panels in community solar arrays to homeowners at much higher prices than the infrastructure folks are willing to pay for them. The homeowners claim a 30 percent residential solar tax credit.
These are just two examples. We have been pretty focused on increasing the value of existing solar projects as opposed to cutting costs.
MR. MARTIN: Let’s dig more deeply, starting with the Suniva case. How many of you think tariffs will be imposed?
MR. RESCH: I suspect we will see a combination of tariffs and different import quotas for different countries.
MR. REDINGER: Some tariff will be implemented.
MR. SHAH: I think the industry still has the ability to avoid tariffs by advertising on Fox and Friends and Morning Joe. It is crazy that it has come to that.
MR. MARTIN: Ed Feo, as the lone solar developer on the panel, you are the one person who would actually have to pay tariffs if they are imposed. What do you think?
MR. FEO: The trade case is a big deal, but mainly in the near term from a market-disruption perspective.
If tariffs are imposed at a material level, then there is an incentive to move production to the US, which presumably would be the administration’s aim. The cost of US manufacture would be higher in the longer term, but not a huge number, at least for efficient manufacturers, which the petitioners are not. US manufactured panels will be more expensive because of labor and regulatory costs, and there will be an adder for effectively constrained competition.
That said, there is no reason to think that US-based manufacturing will engage in any more rational decision making than the panel manufacturers as a whole have shown, so I would expect cut-throat competition to return. When we work through all of that and add in the cost improvements in non-panel costs, the conclusion is that the solar industry in the US will still be fine: the cost curve will take a jump up with the tariff and there will be a time lag before US manufacturing can be re-established, after which costs will trend down. There are currently 29 states with viable solar markets. Maybe the list goes down to 20 to 22. Maybe the growth curve stalls and gets pushed out a couple years.
It is “in the meantime” that is of concern: the period between now and the end of 2018 or even into 2019 for all of this to play out. Developers will need a lot of cash to survive.
MR. MARTIN: How is the threat of tariffs playing out currently in the market?
MR. FEO: There has been the near-term effect on the panel market. All crystalline panels that were available, and arguably have a case for not being subject to tariffs, sold out, and the prices went up pretty dramatically as people looked to cover their 2018 projects.
There was a knock-on effect for thin-film modules. This technology is not subject to the tariff case, so developers turned to suppliers such as First Solar, which promptly sold out its production for 2018. So you now have a real constraint on the market in terms of availability of panels for 2018 projects. And First Solar is signaling it has already allocated its 2019 production.
The second impact has been the difficulty in pricing new long-term contracts to deliver electricity. As a developer, you say to customers, “I can deliver a product to you in 2019, 2020 or 2021 at the following cost,” but it is based on assumptions about what the equipment will cost.
The uncertainty has left developers having to strategize about how to mitigate any potential tariffs. How much pain can I take? At what point does the deal basically not make sense? It is hard to find utility and commercial customers who are willing to bear the risk of panel cost increases as a result of the case.
MR. MARTIN: Andy Redinger, how is the risk of tariffs being allocated among market participants?
MR. REDINGER: Banks have a hard time taking any of that risk. In one deal recently where it was an issue, we structured around it by putting all the risk on the developer.
MR. SHAH: For better or for worse, it has been good for our business at Generate. We are willing to take those risks because we have our own module supply, so we have been able to clear deals at 100-basis-point savings from what people thought they were going to have to pay for capital. It has become a way for us to clear the market where we provide construction and tax equity financing, but I get the fact that it is not great for the industry.
MR. MARTIN: Rhone Resch, you said demand for solar panels in China is turning out to be a lot larger than expected. That is leading to upward pressure on prices. The business model for some US solar developers has been to bid a low electricity price to win a power purchase agreement and figure that, by the time the project has to be built, panel prices will have fallen enough to make the power contract economic to perform. Are we now in a period where that business model no longer works and, in fact, developers need to prepare for the reverse?
MR. RESCH: Correct. Since the Suniva petition was filed last April, module prices have increased by 30 percent to 40 percent. The trend for the last three years of rapidly declining module prices has reversed. This is leading to a number of PPA cancellations across the country.
Obviously solar panel demand in China can change from one year to the next. It cannot be sustained at current levels, but this year at least, many Chinese solar panel manufacturers have chosen to keep their modules in China. They are not going to run the risk of import tariffs in the United States. They also get better pricing in China. They find the political uncertainty here frustrating. The sales agents for the Chinese panel manufacturers cannot get modules. They think this will remain true for a while.
Any tariff imposed as a result of the Suniva petition will remain in place for a minimum of four years. Different scenarios could play out. For example, the tariff could be declared illegal by the World Trade Organization. Suniva could ask for another four years beyond the initial four.
Chinese companies could end up setting up new panel manufacturing facilities in countries with little or no tariff. They could set them up in the United States or Canada.
MR. MARTIN: Ed Feo, your number one trend is diversification of the customer base. Is that another way of saying that it is getting harder to find power contracts?
MR. FEO: Not really. Putting aside the potential effects of the trade case, the cost of solar electricity has been falling steadily to a point where solar electricity is a viable alternative for a variety of customers.
We had a huge wave of utility-scale solar PPAs that was driven principally by PURPA or by big renewable portfolio standards. Now you see a lot smaller entities—not the Southern California Edisons of the world, but pretty small utilities—looking to do solar because it is a good economic and environmental decision.
You start to see PPAs for 10 and 20 megawatts instead of the multi-hundred-megawatt projects. Corporate PPAs fall in the same boat, although some of them are much larger.
Then there is the incipient financial hedge market. We have seen merchant wind projects, with hedges to put a floor under the electricity price, for several years now. This has also been a feature of the gas-fired power market. Solar will be next.
However, a lot of this stuff is on hold until the Suniva case is decided and prices settle down.
MR. MARTIN: Has anyone seen solar revenue puts or other forms of hedges already employed in solar?
MR. SHAH: Deals in New Jersey rely on floating SREC prices for a large part of the revenue. We have been able to get 10-year contracts from hedge providers to lock in the price. The electricity price is not as important because it is something like 3.8¢ a kilowatt hour. For us, not being a truly merchant project is important. We need more predictability to the revenue stream.
Tax change risk
MR. MARTIN: Ed Feo mentioned the looming phase out of the investment tax credit in his list of areas where there is uncertainty about government policy. Andy Redinger, what effect is the threat of tax reform having on the market?
MR. REDINGER: In the solar space, not as much as people originally thought, because the principal tax subsidy is an investment tax credit that is taken entirely in year one and has the same value regardless of the corporate tax rate. Changes in tax rates have an effect on the deal model, but they are easily handled through a bit of structuring. Tax change risk has really not affected the market in terms of getting deals done.
MR. MARTIN: The wind tax equity market was down 70 percent in the first half of 2017 compared to the same period in 2016. Solar was flat during the same period. Solar tax equity was a $3.66 billion market in the first half of 2017 compared to $3.7 billion during the same period in 2016.
Does anyone see the potential for corporate tax reform having an effect on the market currently?
MR. RESCH: I don’t. I do not think the investment tax credit will be targeted in tax reform. We already cut a deal so that the ITC phases out gradually after 2019. The ITC reduces to a permanent level of 10 percent at the end of the phase-out period. Any corporate tax reduction and other corporate tax reforms are likely to be phased in over a number of years. I think Congress will decide to leave the current phase-out schedule alone.
You could lose the permanent 10 percent, but I doubt anyone is factoring that into any projects after 2023, which is the deadline for putting projects in service to qualify for a 30 percent investment tax credit or a partially phased-out credit that is still above 10 percent.
The Republican supporters of the solar industry that are on the House Ways and Means and Senate Finance committees will make sure that the ITC is protected. They were the primary architects of the current phase-out schedule a couple years ago.
MR. FEO: I think that’s right. The reality for 2017 deals is no one is worried about loss of the ITC on projects that are put in service this year. The deal papers address what happens if a corporate rate reduction reduces the value of the depreciation. Depreciation is taken over five years. The rate reduction is either being taken into account in the initial pricing or the developer is protecting the investor from the adverse effects of a corporate rate reduction.
MR. MARTIN: Ed Feo, you referred obliquely to community choice aggregators as a new potential customer. Do you see a rush by CCAs in California to sign long-term power contracts? How much of an opportunity are they?
MR. FEO: I would not call it a rush, but they are definitely signing contracts, and the good news is that they are another customer class. Banks will have to address whether they are creditworthy and evaluate how likely they are to be able to hold on to their customers for the entire PPA term.
MR. MARTIN: The California Public Utilities Commission staff estimates that as much as 85 percent of the retail load in California will flee the three investor-owned utilities for CCAs and other suppliers by the mid-2020s. CCAs are the default supplier if a customer does not choose another supplier.
The investor-owned utilities are charging exit fees to departing customers to help pay stranded costs. How will exit fees play into financeability of projects, if at all?
MR. FEO: They are two steps removed. The exit fees are paid by the customers. The CCAs are owed for the electricity they deliver at the contract price times the quantity of electricity delivered. They have not been around for very long, so their credit profiles can be difficult to evaluate.
MR. MARTIN: Andy Redinger, you said there is lots of liquidity: debt, tax equity. The cost of money is coming down. You have also said in the past that there is a wall of money chasing contracted projects. What current discount rates are buyers using to bid for operating projects?
MR. REDINGER: Investors are using discount rates that are below 9 percent for levered equity returns. In some cases, the rates are much lower than that. There is some really aggressive money chasing projects, but the majority of buyers are using levered rates in the 8 percent to 9 percent range.
On CCAs, there is a lot of capital out there. I have no doubt that projects holding power contracts with CCAs will find financing. The issue is at what cost. The cost may be prohibitive once the banks understand that the customers can leave whenever they want.
MR. MARTIN: Ted Brandt of Marathon Capital says that the winning bidders for utility-scale solar projects currently are bidding at discount rates of 6.5 percent to 7 percent unlevered. Do your and his ranges equate or do you just think the rates are higher?
MR. REDINGER: Ted is not wrong. There is some really cheap capital chasing deals.
MR. FEO: Tell me the assumptions, and you will find that two sets of numbers that seem wildly different are not different at all. What has been interesting in the utility-scale solar market to me is how much the valuation is now being driven by an ever-extending life of the asset. A few years ago, people doing deals were assuming a 20-year life. Now the assumed life is usually 35 years or even 40 years
A lot of value is created by the assumptions on power prices in those post-PPA years and the performance levels of the solar project in those years. People are thinking that these assets will be around for a long period of time. The ability to enhance performance of the asset over its life, as Jigar Shah and Rhone Resch mentioned, could have a huge effect on value.
This is not the world of just do your project, finance it, throw it in a drawer and forget about it. You have the opportunity to drive value through four decades.
MR. SHAH: To be clear, I think there is a bubble of sorts. I cannot imagine that the utility-scale assets will be able to command the same PPA price in 40 years. I think we will have an oversupply of power and batteries will be a necessity to help shift the power curve.
MR. MARTIN: Are you taking into account the possible shift to electric vehicles? The Economist magazine reports that some countries in Europe are expected to have banned cars with internal combustion engines by 2040. SSI, an independent research house, predicts that the shift to electric vehicles will lead to a one-third increase in electricity demand in this country.
MR. SHAH: You can have both. If we are adding 15,000 megawatts of solar a year to the grid, that is 150,000 megawatts over 10 years. You are not doing it across all 50 states. You are doing it mostly in 20 states. It is entirely possible to have 50 percent to 70 percent of power coming from solar during the day, which means excess solar power during the day.
MR. MARTIN: Andy Redinger, earlier in the year, lenders were complaining there are not enough deals and there was downward pressure on interest rates. That seems still to be the case, although we have heard lately that some lenders think the deal flow is starting to pick up. What are you seeing in the market?
MR. REDINGER: I would not say the deal flow is starting to pick up. It has been flat all year.
There is so much competition now versus just three or four years ago in this space. Margins continue to be compressed because there is not as much growth in borrowing in the economy at large as the press portrays. A lot of banks are chasing a limited number of solar projects. I don’t think margins have been any tighter than they are now since we started in the business.
MR. MARTIN: Ed Feo, to what do you, as a developer, attribute the dearth of projects seeking financing this year?
MR. FEO: If you look at the numbers, 2016 was a pretty robust year. A lot of projects were pulled forward because of the uncertainty around how long the ITC would be available. That uncertainty lasted until the end of 2015. My guess is that this year we are at half to two-thirds of the 2016 activity.
It does not surprise me that, from the perspective of people looking to invest in or finance projects, it looks like there are not a lot of assets compared to 12 months ago. Valuations have been bid up because of the amount of equity chasing construction-ready or operating assets. There is a supply-and-demand imbalance.
MR. MARTIN: That should bring more developers into the business. When do you see the cycle turning around?
MR. FEO: Assuming away the whole issue of the trade case that, I agree with Rhone, is the wild card, 2018 is going to be a so-so year, and then there will be increasing volumes in 2019 through 2021 to take advantage of the higher investment tax credit before it phases out, and the activity will probably tail off at the end of 2021. Then the question will be what product you have to offer. At some point, the combination of solar and storage should start firing pretty hard, perhaps as early as the 2020 to 2021 time frame. The industry should be able to ride that for the rest of the decade.
MR. MARTIN: Andy Redinger, you suggested that with abundant debt and tax equity on offer, the cost of capital is continuing to trend lower. How much lower? Where do you put interest rates today? Where do you put tax equity?
MR. REDINGER: Margins for tier-one developers are in the area of 162.5 to 175 basis points above LIBOR. There are a few deals involving operating projects with some history getting done at around LIBOR plus 150. I don’t think tax equity yields have changed much in years. They remain around 8 percent. Maybe someone else on the panel can speak to that, but they have not changed from where I sit.
MR. MARTIN: Jigar Shah, you are in the tax equity market. Where do you think yields are?
MR. SHAH: The pricing in the tax equity market has remained rather static. Most of the tier-one developers are being offered between 1.25 to 1.3 times the investment tax credits on their projects. Early in the year, tax equity investors were more likely to say they were at capacity, but now that we are farther along, some are coming up short. I am getting calls from investors who have had deals fall through and are falling short of the numbers they hoped to achieve this year.
MR. MARTIN: Andy Redinger, you said that banks are preparing to lend past the term of the PPA and “a couple interesting things are going on there.” What are they?
MR. REDINGER: It is an indication of how aggressive lenders are becoming as they try to put money to work. They need loan growth. We and others are starting to look at giving credit for a couple years past the end of the PPA term. We would start to sweep cash a couple years before the end of the term so that the loan would still be paid off within the PPA period.
It helps the developer increase the leverage on a project because more cash flow is taken into account in determining the advance rate on the loan.
That is just an interim step. Eventually, I think we are moving toward giving full credit for revenues two or three years past the PPA term with no sweeps before the end of the loan. It is a function of the aggressiveness of the marketplace.
There is a wave of refinancings we see coming, starting late this year into next year and the year after. These are refinancings of deals that were done in 2009, 2010 and 2011. The tax equity is rolling off. We see strong competition from the institutional market as well as the bank market for this business. In the past, it was just banks that went after this business. Now you have a whole new group of lenders vying for those assets as well, which to me screams more competition and lower pricing.
MR. SHAH: The reset of the market creates value. The market has found the new ultimate owners of the assets. A few years ago, yield cos were thought to be the ultimate owners. Now pension funds, insurance companies and others with access to low-cost capital are stepping in as the permanent equity and debt capital for these assets.
MR. REDINGER: I agree, Jigar. The player that still needs to get up to speed is the rating agencies. They have come a long way in the last year, but a lot of projects will need ratings, and the agencies are getting better at analyzing risks, but they still have a way to go in regard to things like the haircuts to which they subject deals. They are moving in the right direction.
MR. MARTIN: Does anyone see rapid consolidation among utility-scale solar developers. Tom Buttgenbach of 8minutenergy Renewables said earlier in the summer that he thinks we will be down to five utility-scale solar sponsors within a reasonably short period of time.
MR. REDINGER: I doubt it.
MR. RESCH: I don’t think five is necessarily the right number, but consolidation is underway and will continue.
MR. SHAH: There is definitely consolidation, but there is an expansion on the other side. For example, look at what the First Wind guys were able to do in terms of raising development capital in New Zealand. They have re-entered the market as a new sponsor. TIAA-CREF has backed four new development platforms. I agree that the traditional players are consolidating into five, but then there are 15 new players that are able to find financial backing.
MR. MARTIN: Ed Feo, you said one of the interesting things about the diversification of the customer base is how power purchase agreements change with different customers. Say more about that.
MR. FEO: The tenor of the contracts is affected. Corporate PPAs have shorter tenors than the 20 to 25 years with which the market was accustomed for utility PPAs. However, the tenors on utility PPAs are also becoming shorter.
The other place we see a difference is the point of interconnection. Sponsors are more likely to have to take basis risk in corporate PPAs. Their power is delivered at a different place than is used for pricing.
MR. MARTIN: We have come to the final minute. Let me sum up what I took away from the conversation. Ed Feo put on his list of new trends diversification of the customer base and a phasing out of PURPA, a 1978 law that requires utilities to buy electricity from independent generators, as a tool to secure utility PPAs. There are more coops, corporate purchasers, community choice aggregators and financial hedges. You just heard him describe how the PPAs change with the change in customer.
Another thing on his list was the uptick in utility self-procurement. Another trend was continued cost reductions in the cost of solar equipment. We have seen a pretty significant decrease in solar panel prices, although the rate of decrease is moderating, if not reversing, due to the threat of import tariffs in the United States and an unexpected doubling of demand this year in China.
He also had on his list two significant policy changes that are potentially in the offing: the Suniva trade case could lead to import tariffs on solar panels and there are potential changes ahead in corporate taxes. We heard that potential tax changes are not having much of an effect this year. However, the potential for tariffs is having a deleterious effect, even ahead of any tariffs actually being imposed. It is nearly impossible to buy panels for 2017 and 2018 projects.
We heard another trend is more developers are looking to incorporate storage into their projects. Storage makes the electricity more valuable because the electricity can be shaped to meet customer need and storage injects more revenue into projects through the ability to provide ancillary services to the grid. We heard there is a lot of money available for down-the-middle-of-the-fairway stuff. There is plenty of money, especially for tier-one developers who can show a successful track record.
The shorter PPA tenors, potential uses of new financial instruments and new types of offtakers with less established credit histories are all posing challenges for lenders and tax equity investors, but the dearth of deals is forcing them to figure out a way to deal with each of them.
Andy Redinger had on his list of trends abundant debt and tax equity, putting continued downward pressure on yields. It is a good time to be a developer in terms of access to capital. Small projects dominate. We heard that solar tax equity deal volume in the first half of 2017 was $3.66 billion compared to $3.7 billion during the same period in 2016. In the competition for deals, lenders are looking at giving credit for revenue up to two years past the PPA term as a way of justifying higher advance rates on loans.
The institutional debt market is gearing up. Deals that were financed in 2009, 2010 or 2011 in the bank market might refinance in the institutional debt market. The rating agencies, Andy Redinger said, are becoming more aggressive in how they rate these projects.
We are also seeing an increase in unrated offtakers. Community choice aggregators in California are an example. Andy said the market will figure out a way to lend to projects with CCA contracts.
Rhone Resch pointed to the Suniva trade case as probably the biggest cloud over the market this year. Solar panels could increase significantly in cost if tariffs are imposed. He thinks there will be a mix of tariffs and import quotas for certain countries. He pointed out that any tariffs would remain in place for four years, although they phase out over that four-year period, unless set aside more quickly by the World Trade Organization.
Solar panel demand in China and India is very hot and is contributing to additional upward pressure on prices. He thinks the demand in those two markets will be much bigger than people thought at the start of the year.
He also pointed out that new technology is coming to market, particularly to deal with sudden degradation in solar panels. He said another positive trend is the intense competition for existing solar assets.
Jigar Shah suggested focusing on how to enhance the value of utility-scale solar projects rather than focusing solely on cutting costs. He looks in deals where operating assets are purchased to try to enhance the value. Adding storage helps, he said. He also pointed out that many people have opted to take advantage of what he called an IRS loophole around section 25D of the US tax code—that’s the residential solar credit—to sell individual panels, presumably in community solar arrays, directly to homeowners.