Image Credit: Sol Systems
We discuss our thoughts on guarantee and the development of the industry each year. The past 12 months included the introduction of import tariffs from a president who reiterated his doubts about manmade climate change while championing coal. Even the industry expanded and developed, as it will in 2019.
As solar technologies becomes more efficient, prices continue to fall, which is quickly making solar the most cost-competitive source of energy in the nation. Despite a lack off national policy action on climate change and renewable energy, Americans have created and strengthened networks and opportunities to advance renewable energy. State policies have quickly shifted further in favor of renewable energy, and corporate demand continues to drive procurement.
The industry remains a developing multibillion-dollar marketplace for investors, clients, and entrepreneurs. But it is a complex one. New investors and developers have to be tactical with how they approach the market. Here’s one perspective.
America still has our back…
America overwhelmingly supports energy. As of January 2019, 73 percent of Americans support the further development of renewable energy, based on The Pew Research Center, which is one of the largest pluralities in history. The United States has the greatest electricity load on earth, and these same Americans are power customers who support both policy initiatives for renewable energy and who will create the need for renewables in the next decade. In 2018, we noted that Americans overwhelmingly support our industry, but we did not expect how quickly this could translate into renewable support at the country level.
In 2018, New Jersey passed a renewable portfolio standard (RPS) with a goal of 50 percent renewables by 2030, and the governor has said his goal for reaching 100 percent renewable energy by 2050. The District of Columbia and a 50 percent renewable energy target passed . In September 2018, the California state legislature passed SB 100, which requires the state to generate 100% percent of power from carbon-free sources, with a 60 percent renewable portfolio standard built in.
New Mexico Gov. Michelle Lujan Grisham signed an executive order in January 2019 that commits the country to reduce carbon emissions by at least 45 percent below 2005 levels by 2030. Governors in Maine, New York, Colorado and Illinois have all set 100 percent targets.
These policies have broad and significant impacts on solar regionally, since RPS legislation generally enables both in-state and out-of-state development. Climate change has become one of the most important problems for younger generations, as it should be. The prioritization of coverage is changing . Given the recent Democratic takeovers of six state houses, as well as six governorships, expect additional legislative support for renewables in 2019.
…as do corporate customers
Corporate clients continue to move into direct energy procurement based on cost savings and corporate sustainability targets as we anticipated. In 2018, there were 75 new corporate renewable deals, supporting almost 7 gigawatts of new jobs. This is twice as much as 2015. Expect this trend to continue in 2019, particularly in the PJM Interconnection land where there is tremendous demand from clients, a huge and dynamic market to encourage solar, impending RPS change, and a federal Investment Tax Credit (ITC) that compels urgency.
How corporate clients acquire solar energy will be the biggest change over the coming year. The corporate customer has developed from purchasing voluntary renewable energy certificates (RECs), to purchasing compliance RECs, to actually contracting for the output of power from a particular renewable energy project. This development has largely been driven by the concept of additionality. Corporates would like to know that there is a causal relationship between their efforts to procure renewable energy and new builds.
The primary instrument for clients who wanted to procure electricity from offsite projects in the past three to four years has been the contract for difference (CFD). A customer purchases energy from a project at a set price at a set node. The CFD is an elegant solution but it can be baffling for clients. Increasingly, these clients will look to utilities and retail electricity providers to sleeve electricity for them and also to integrate renewable energy purchases in their bills.
NRG and Engie are leading this effort now. Anticipate this trend in 2019 to expand. The providers can shape and firm electricity to offer 24/7 power. Some corporates, like Google, are doing so by themselves.
Costs continue to drop and efficiency continues to rise
Prices are currently driving this change in the industry. All-in prices for solar projects have fallen around 80 percent since we started our business in 2008. They continue to fall today. One year ago, we suggested that the industry would have a low-30-cent module by year-end 2019. At the moment, module manufacturers visiting our offices said we were crazy. That was understandable when modules were 50 cents.
Modules are now priced at 30 cents (normalized cost for power class) and below since the source of solar modules remains vast, module manufacturing is becoming cheaper, and China has slowed its procurement. We expect this trend to continue.
Additionally, and just as importantly, module efficiency is increasing. Greater adoption of PERC, N-type cells, split cell, and bifacial will drive module functionality increasingly upward. A standard 350-watt module in 2018 will become a 380-watt module over the next year, raising energy density, reducing installation costs, and increasing overall output.
To further this trend, balance-of-system costs and architectures are improving. Tracker performance at a sub-array degree is increasing (as an example, see the TrueCapture technology our friends at Nextracker launched lately ), creating a projected 2 percent more energy. DC optimizers will create 3-5 percent more energy longer-term, whilst mono-PERC and bifacial modules may add up to five percent more efficiency. These are small changes independently, but create together uplift.
We also see the continued adoption of 1,500-volt architectures, which enable lower installed costs and greater efficiency at the system level. Furthermore, series inverters, previously most common for small commercial applications, will become the predominant solution for small utility jobs. String inverters can lower prices, but they also allow a system to partly operate with no “truck roll” and an O&M visit. Bringing down long-term O&M prices is one of the single best ways to create value across an operational portfolio.
Expect large solar project portfolios owners like Global Infrastructure Partners, Helios and Brookfield to focus on these prices to increase yields and financial yields over time. At some point portfolio owners will retrofit systems to add string inverters.
All this implies that we’ll build vastly less expensive yet more efficient solar. Utility-scale jobs are being assembled at 90-95 cents per watt right now. That was unthinkable two decades back. We’ll build at or below 85 cents per watt. This pricing has resulted in sub-3 cent PPA prices. There is not any technology that may compete. Lazard, as they have for decades, does a great job of illustrating this in their annual Levelized Cost of Energy (LCOE) Report.
Energy storage is the area in which our industry most needs to adapt, as we noted last year. The question isn’t when, although if storage will become an integral component of all utility projects that are solar. Most discussions around storage have been around lithium-ion batteries, which are the exact batteries in your phone. For those who have a Tesla, you’re driving with 7,000-10,000 telephone batteries. This technology holds tremendous promise, but as our friend Colin Murchie explained lately , we’ll likely need to integrate pumped water storage and other technology for true load-shifting.
Use of hydro in France, where 71 percent of the electricity is produced by nuclear power plants, is a fantastic template. Companies like Google and asset owners like Brookfield and Avangrid are already incorporating hydro to firm solar and wind. It’s a huge differentiator, and will continue to be.
The asset class grows
Significant customer demand and falling prices continue to drive the expansion of the solar asset category. In 2018, there were approximately 109,000 megawatts of solar installed worldwide, with 14,000 megawatts of that capability installed in the United States. Looking forward, we see a huge pipeline and significant investor demand. Globally, solar will become one of the dominant sources of new electricity generation, and solar and wind are expected to provide 50 percent of all power in the world by 2050: a roughly $10 trillion market.
Solar assets within the United States are particularly attractive for investors since they’re dollar-denominated, real assets, non-correlated to the stock market, and are also relatively inflation-insulated. Europe and Asia have specific requirements for banks to invest in renewable energy, as it reduces their capital set-aside requirements. Many sovereign wealth funds and multilateral banks have a mandate to invest in renewables. Therefore, there is still a number of new investors in the marketplace from Japan, Europe, the Middle East and China.
All these basic factors have created a highly competitive and sometimes volatile sector. Over the last decade we have seen that while the market itself is expanding and solar has turned into a growing share of our power, strategic business success is volatile. Generally, expanding markets are complex.
In sophistication is opportunity for the investor
New investor entrants in the U.S. market mean more competition, which drives down the cost of funds for projects. A lower cost of capital generally means that investors are willing to accept lower yields in their investments in solar assets since the investments are seen as less risky than the alternatives. Because capital costs are relatively high for solar, and ongoing expenses extremely low, a lower cost of funding dramatically drives down the LCOE for solar and PPA prices for the customer.
This causes growth for the business but raises some challenges for specific investors. To contend, these investors must either accept lower yields, take on more structural or operational project risk to keep their returns, or move earlier in the development cycle to secure pipeline and ensure their targeted yields (which can be a sort of risk).
New and more aggressive investors
This lively poses a tremendous chance for investors who have a lower cost of funds than the private equity that is now supporting much of the solar development activity in the United States. These private equity or hedge fund investors find it increasingly tough to compete in owning solar project assets and thus are adapting or looking for new or less mature assets. This trend has occurred several times.
A number of these private equity investors are being displaced by insurance companies, sovereign wealth funds, and pension funds that buy new or operational assets, or buy down the equity from programmers in operational assets or portfolios, in what some refer to as a recycling of funding. In a recent case, AES and its affiliate S-Power transacted with Ullico to market down equity in their 1,300-megawatt portfolio of renewable assets. John Hancock has been actively purchasing down equity in portfolios, and lots of developers are actively selling their equity down.
We expect our Helios infrastructure platform to stay competitive and to be a partner for programmers in this environment. Also expect NextEra, Avangrid and EDF to be active participants in this market. Newcomers like Ørsted and Equinor and large Japanese gamers will also actively participate if they can both adapt to the more complex financial market of the United States and partner with regional firms that know the investment landscape.
Regional or localized partners with development expertise are critical, as they enable these investors to better evaluate projects and risks, navigate a very close-knit community, and aggregate large portfolios.
Investors and independent power producers focus on development to boost yields
This change in market participation is driving a number of funds and investors that traditionally purchased solar resources when they were beginning or complete construction, to move earlier in the development cycles. The aim is to secure a pipeline sooner so that investors don’t need to compete for more mature assets. Another way is that these investors are currently trying to maintain yield.
While this strategy makes sense in some instances, investors pursuing this strategy need to take care to evaluate the pipelines they buy. Not all projects are created equal.
This growing investor landscape has similarly affected independent power producers. Many IPPs that traditionally held on to the solar resources they developed are adapting their version from a develop-and-hold model into a develop-and-sell model. This has been driven by the chance to sell their assets at very competitive rates, and also because most developers/IPPs have a rather high weighted average cost of capital (WACC) that accounts for the risk imbedded in their development enterprise. This high WACC can’t compete with current institutional funds.
This process is accelerated by the fact that many of these very same IPPs are also trying hard to support early-stage pipeline that is taking longer than anticipated to harvest and are being forced to refinance their funds lines with investors.
Creating differentiated financial products
Other investors seek to gain an advantage through differentiated financial products in the business. In 2019, a number of investors, such as Helios, will fund partially merchant solar projects. Solar jobs can either have a merchant tail (and most utility jobs do) or a merchant cap, where only some of the overall output of the energy is contracted. To allow these jobs, certain banks are starting to offer debt products around primarily or fully merchant solar projects. Already, some banks offer debt products that amortize beyond the PPA term.
We also expect that several IPPs and funds will start to safe-harbor solar projects for the 30 percent ITC by buying equipment equivalent to at least 5% of the eventual cost of the project. This will allow them to use the 30 percent ITC for jobs that are operational in 2020 or 2021. We expect NextEra, Avangrid and other developers to invest heavily in this strategy as they have previously. While it may not look like much, the difference between a 30 percent ITC and a 26 percent ITC will have a marked effect on investor returns and the competitiveness of investors.
Development or contracted resources? Not all assets are created equal
In 2018, we warned that resources were overvalued, value conflated and non-differentiated. Stocks, bonds and real estate were not trading on market fundamentals. That holds true today, which is why volatility in the stock market has increased rapidly. Investors are seeking to reallocate their funds but are challenged to know where to place their money.
As the wider capital markets deleverage, and investors reallocate, they are looking to park their money into stable assets to guard returns. This has been a tailwind for the solar market for the past 3 years as institutional funds poured into solar resources based on their stability.
In 2019, the prices of funding for solid solar projects with long-term PPAs and contracted revenues will continue to fall. These are tremendous infrastructure resources. The cost of capital for jobs now ranges from 6.5 to 7.75 percent unlevered after-tax, although 100-300 basis points of that return depends upon assumptions and structuring.
However, expect the asset differentiation occurring in the wider market to impact what has been a comparatively frothy market for solar development assets previously. Programmers with portfolios of projects with no PPA or with no offtake in sight may struggle. This will be a significant issue for the business over the coming year.
Don’t pack peanuts
There’s a huge difference between a project that has contracted one and earnings that does not. It’s just one more reason that the customer (and customer demand) will drive our business.
The United States now has approximately 150 gigawatts (which is insane) of solar in interconnection queues. A number of these projects have some combination of site control and early-stage permits, but don’t have a customer offtake, and sometimes they don’t even have a strategy for securing a customer. We often refer to these portfolios as a cardboard box with packing peanuts.
We urge developers that are considering embarking on this approach. It’s a strategy in a market. We urge investors to value interconnection queues. A number of these jobs will fail or be warehoused for the long run.
1 additional hard lesson for the business (ourselves included) is that several of the new markets are more complex and slower to mature than anticipated. New York, Illinois, Virginia and much of PJM stay appealing, but project development timelines are being stretched, which means developers must hold these jobs either on balance sheets or in comparatively expensive development facilities for more.
Pending RPS legislation may make these markets more attractive in another 3 decades, but the first timing of several development funds and the high cost of capital in these funds makes it hard to nourish and create multi-state portfolios with long lead times. These challenges have put significant pressure on both the developers and the financial partners that provide the funds for many programmers to invest in early-stage assets.
As the wider market is deleveraging in 2019, many of the development funds that supported solar development assets from 2015 to 2018 will mature and look to shield returns to investors. These funds will look to capitalize on their investments and will force developers to either partly or fully monetize their resources, and possibly monetize their platforms. As a result, many developers have sold off or will sell off their preexisting pipelines and development assets to source capital and repay these facilities.
Focus on core experience
We recommend that developers pull back out of a buckshot approach to markets and focus on a smaller number of states/geographies where they could create differentiated value and a competitive advantage. There’s a huge chasm between being a successful regional programmer and being a successful national developer.
That’s a journey in which programmers can quickly shed capital, focus and success if they’re not careful. Those solar developers that were disciplined in their approach and concentrated on the fundamentals in their niches (locational marginal pricing, congestion and coverage ) have succeeded and will continue to do so.
Opportunity amid change
The long-term fundamentals are there for our business to be successful, and we expect solar to keep growing to the single largest source of power in the United States. There are two calibrations that are occurring in the market right now that are important to recognize.
First, are a large number of investors looking to enter the market or gain market share. These investors are out-competing traditional investors, who are in turn looking to secure yield by creating differentiated value through more innovative financial structuring or by purchasing earlier stage assets.
Second, many programmers have cast a wide net on the marketplace and will be challenged to financially support these huge pipelines. The programmers will either sell or refinance their portfolios, or sometimes will sell their development stage. Others are going to refocus their attention on a geographic approach that is more regionalized.
In some ways, these tendencies merge Needless to say, and the developers and investors that could navigate the chance will create value. We urge investors to dig deeply with partners to understand project risks that are imbedded. We urge developers to stay focused on core markets and to work to understand the fundamentals of the increasingly larger and more intricate electricity market that will drive real-time locational pricing and customer demand for the coming decades.
The Sol Systems team is eager to play our part in helping this industry expand and succeed to face the generational challenges of climate change and energy infrastructure transformation. We wouldn’t want to be doing anything with anyone else. Great luck to all you who commit your lives to this industry. It isn’t easy; it is crucial.
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Yuri Horwitz is the co-founder and CEO of Sol Systems. This is an edited version of his 2019 CEO outlook.
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