Solar: Quite Possibly The Next Biggest Bubble & Bust

Solar: Quite Possibly The Next Biggest Bubble & Bust

I'm often asked if solar is a good long-term growth industry. It is and progress is happening quickly to change entrenched policies that reward the $100 million/year lobbying efforts of the fossil fuel industry with subsidies of $70 billion/year (some estimate $400 billion). In comparison, the renewable energy industry has a budget of $1 million/year and receives $12 billion/year in subsidies.

However, when I think of bubble & bust, these days I think of derivatives. In this month's article, just for fun, we'll explore how Power Purchase Agreements and Solar Derivatives could impact our industry.

The Solar Derivatives market is growing to reduce investor risk in residential, commercial and utility solar projects against decreases in kWh production levels over the life of the Power Purchase Agreement (PPA).

Did anyone catch Alan Greenspan's testimony on capital hill after this years market collapse admitting unregulated derivatives trading was a flawed career guiding belief that causes market crashes? There are still no regulations and it may be dangerous to put them in place at this late date.

The solar industry values transparency and is pushing for it in the trading of Renewable Energy Credits (REC), an open market where the green attributes of solar energy can be traded for green bragging rights and to help utility companies meet their state Renewable Portfolio Standard goals (RPS). Before it is too late, the solar industry should also consider promoting transparency and reporting standards for the Solar Derivatives market to help our industry avoid causing the next economic melt-down.

Solar Market Life Cycle – Designing sustainable long-term solar financing standards

I was struck by how rapidly this industry is scaling up. The first Solar Power International started with 75 attendees in 1999 and this year boasted 24,000+ attendees. Within the crowd, I saw only two hemp dressed grey pony tails, most in attendance were wearing suits and polo shirts. It was also interesting to learn that some of the biggest players in the solar market have only been in business from 1.5 – 3 years successfully competing with large multi-national corporations. To use a one of our Huntington Beach surfing analogies, I thought to myself, “you picked the right wave, now paddle like crazy to get on it.”

solarl growth curve

Based on comments from the knowledgeable SEIA/SEPA panelists, the consensus is we have just entered the growth phase of the industry and it should take us at least until 2030 to reach peak maturity.

Eliminating the upfront cost of solar for the buyer is a major hurdle to overcome for rapid market growth. Today, solutions for the upfront cost of solar include loans, leases, property assessed clean energy (PACE) and power purchase agreements (PPA). Innovative solar financing tools are accelerating market growth.

JP Ross, Sungevity, VP, Strategic Relationships, provided an analogy highlighting the need for creative financing solutions as shown in the following illustration:

iphone solar payout

The question JP Ross posed to the audience, “would you pay $36,000 today for an iPhone if I told you it would last 15 – 30 years?” After a few laughs, he concluded essentially the solar industry is asking buyers to make the same decision if the only option offered is to pay cash for a system.

What is a Power Purchase Agreement?

A Power Purchase Agreement (PPA) establishes a $/kWh rate with a fixed escalation rate between 3% - 5.5%. The homeowner, business or utility agrees to purchase the available electricity from the solar system with a buyout option at the end of the PPA term based on a ‘fair market value' determined at the end. Power Purchase Agreements require someone to install & maintain the system, as well as, a financial investor.

The financial investor owns the system and may be a limited liability entity with limited assets. The financial investor uses Solar Derivatives to protect his return on investment in case the electricity produced to sell to the consumer decreases. This protection for the financial investor is available as long as the derivative seller collecting the insurance premium has the ability to pay using underlying capital. With ‘guaranteed' returns, the financial investor to attract more capital and leverage to install more solar systems.

What's a solar derivative?

Derivatives are good because they minimize risk for investors allowing them to attract the capital we need to deploy solar now. What is bad about derivatives is that they are unregulated and therefore have no reporting requirements causing a lack of transparency whereby fraud and excessive leveraging can occur. As in the case of AIG, you can sell derivatives and collect large amounts of premiums within the shadows with no underlying assets to pay claims in the future. In the case of a solar derivative, if a solar system does not produce as many kWh of electricity as the investor agreed to sell the consumer, the investor can use the derivative to stabilize his return on investment. The consumer will seamlessly make up for the system kWh deficiency by purchasing electricity from the grid instead of the roof.

Three risks to solar kWh electricity production.

    1. The solar equipment doesn't produce electrons as projected over the term of the PPA. This could be due to poor manufacturing quality in an effort to cut costs. In such a scenario, the equipment manufacturer could easily go out of business in an effort to mitigate losses from offering a 25-year warranty.

    2. The solar maintenance reserves are inadequate over the life of the PPA. Twenty-five years is a long time and much can happen including unexpected equipment malfunction. Maybe there's even a scenario where solar maintenance reserves are used in a ponzi scheme to supplement short-term investor returns during a period of low kWh production.

    3. A global dimming occurs. Such phenomena is attributed to CFCs in the atmosphere, disturbances like volcanic eruptions or cloud seeding to minimize the impact of draught as China is doing right now.
      Some studies believe the elimination of CFCs has caused a global brightening by increasing the irradiance on the earth's surface as much as 4%. If this global brightening is true, the reduction in the use of fossil fuels from solar deployment could have a similar brightening effect and provide higher returns to solar financial investors and solar derivative sellers.

How big is the derivatives market?

The simple answer, no one knows for sure due to a black box lack of reporting. At its peak, the derivatives market was estimated to have a notional value of $1.1 quadrillion, $1,100,000,000,000,000, or more than 20 times the entire global economy. The term notional is used because no one has to put up capital to sell the derivative; the seller only has to pay when performance deviates from projections. If you've ever received a margin call from your stockbroker, you know the chill of panic that ensues. Right now, derivatives regulation is not politically possible due to the threat to our economy caused by uncovering and deleveraging the existing positions.
The following graph illustrates how derivates work and when we run into problems if they are leveraged. Red represents a solar financial investors desired return on investment. Green represents the premium the solar investor pays to a derivative seller for the insurance that kWh production of the solar system is stable. Blue represents the derivative seller's expected return on invest. If a ‘bad year' occurs, the derivative seller must pay the solar financial investor or the solar financial investor will lose money and access to capital. If the investor looses too much money, he must liquidate his solar investments quickly and usually for less than fair market value.

solar payout

To protect renewable energy consumers from repossession, one solution may be to offer the consumer of the PPA the right of first refusal to purchase and refinance the system after a competitive bidding process. Such a clause would be similar to a mortgage loan modification agreed upon front.

Solar Consumer Conclusion:

In regards to residential solar, if your goal is to one day retire then you must save money for when you no longer work and lower your monthly expenses. Investing in a solar system for your home provides a significant, low-risk, non-volatile long-term return on investment when properly monitored and maintained. Solar systems also reduce your monthly expenses and eliminate your risk of rising utility rates. To reduce your exposure to another financial melt down and losing 40% of your 401K, lock in your monthly utility expense by purchasing a solar system you will eventually own.

Author's Summary:

Power Purchase Agreements are a powerful financial instrument to address the upfront cost of solar systems. However, if the solar industry stands for transparency, solar derivatives trading could set the standard for derivatives reporting using strict leverage guidelines that protect solar investors, maintenance providers and consumers from kWh production variations.
Solar: Quite Possibly The Next Biggest Bubble & Bust


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