Issue Spotlight: Spotlight on Solar Series, Part 1: Solar Industry Trends & Financing via Solar ABS

By: T-REX Group

Introduction

The solar industry has experienced a period of unprecedented growth over the past 15 years. Annual installations of photovoltaic (“PV”) systems in the U.S. have grown from 4 megawatts ("MW") in 2000, to over 6,000 MW today, resulting in a compound annual growth rate of nearly 70 percent, and a total growth rate of nearly 155,000 percent. This growth has been driven by three main factors in the solar industry:

  1. Rapidly declining costs: Since 2005, the blended average cost ($/Watt) of a PV system fell from approximately $8.00/watt to less than $3.00/watt.  
  2. Business model innovations: The introductions of the Power Purchase Agreement (“PPA”) and the solar lease to the industry have allowed solar developers to reach customers who previously were unable to afford solar panels. Because these agreements do not require upfront investments from customers—only contracted payments over time—developers have been able to quickly expand their customer base. Costs have fallen by over 73 percent as manufacturers, faced with increased certainty in product demand, continue to make long-term investments in panel production.
  3. The Investment Tax Credit (“ITC”): The ITC allows consumers and commercial users to reduce taxable income through a 30 percent tax credit. Since the ITC’s inception in 2006, annual solar installations have grown by over 5,000 percent.

The ITC is set to expire in 2016. However, Congress voted on December 15th to extend the 30 percent tax credit through 2019, with annual decreases from 2019 through 2022, at which time the tax credit will reach a 10 percent floor.  Prior to this action, there was considerable uncertainty as to what source of financing will fill the void left by the absence of the ITC. If it were to expire in 2016 as expected, installed solar capacity had been forecasted to drop by 57 percent, leaving total installed capacity only slightly above 2013 levels. As the market looks ahead to replace the ITC as a funding source in the coming years, there are two other financing mechanisms currently in place, yieldcos and securitization, which could fill this void in the capital stack. As discussed in more detail below, we expect that securitization is best poised to fill the gap as a source of low cost funding for sustainable growth of the solar industry. 

Yieldcos

The first funding mechanism is the yieldco, a publicly traded company that owns and operates solar projects purchased from a parent company. Yieldcos distribute up to 90 percent of cash available for distribution in the form of a dividend to shareholders. Yieldcos are similar in structure to Master Limited Partnerships (“MLPs”), which are used in the oil and gas industry to pass on income to investors. However, income for MLPs must come from certain “natural resource activities,” including crude oil and natural gas, but excluding solar assets.

Yieldcos, introduced by industry leaders such as NRG, SunEdison, and SunPower, quickly gained popularity due to two key factors. First, the low interest rate environment left many investors hungry for yield. Because yieldcos return nearly all of the cash flow from the assets to investors in the form of a dividend, they have been touted as viable alternatives to debt instruments offering historically low yields. Additionally, the yieldco allows investors to obtain exposure to renewable energy through direct ownership in the underlying asset, as opposed to owning a piece of an entire (more risky) solar company. Solar assets are typically backed by 20-30 year contracts, and thus offer stable, predictable cash flows.

However, recent volatility in the yieldco market has raised significant concerns as to the value proposition and financial sustainability of these instruments. The first concern is the effect that inevitable increases in interest rates will have on yieldcos. As interest rates rise, the impact on yieldcos will be two-fold. First, yield-hungry investors who flocked to the vehicles will likely transition gradually to more familiar fixed income investments. Additionally, it will become more expensive for the parent companies to borrow the funds to acquire the projects necessary to fuel growth.

The second issue for yieldcos is a structural one related to growth. Yieldcos attract investors by providing both income from dividends and growth in the dividend per share. Achieving the necessary growth will be challenging for yieldcos in the long-term. Given a portfolio of assets that remains the same in size, cash flows will not increase substantially over time: power produced by solar assets decreases as panels gradually degrade, and PPA rates are capped at low escalators. Additionally, the majority of the cash generated by the assets must be paid out to investors, and thus cannot be reinvested in the business to drive growth. Yieldcos must thus rely on issuance of new shares to fund the acquisitions of new projects. For these reasons, many investors have become skeptical of the long-term sustainability of the growth that yieldcos promise.

Finally, recent volatility in oil prices has adversely impacted yieldco share prices. There is no substantial economic justification for falling solar prices as oil prices decline, as oil and solar are used for different applications: oil for transportation, and solar for electrical production. Regardless, financial markets tend to link the two, with volatility in the oil markets driving down the value of publicly-traded solar assets, including yieldcos. Yieldco performance is thus tied to volatility in the oil markets, and as discussed previously in this article, this may hurt yieldcos looking to issue new shares.

Securitization

The second source of financing poised to replace the void left by tax equity is securitization. Like yieldcos, securitization has recently gained popularity in the solar industry. In a solar asset backed securitization, securities are backed by pools of cash-flow generating assets, such as PPAs, leases, or loans. While the cost of capital on tax equity is upwards of 7 percent, the cost of funds for Class A tranches of solar securitizations has ranged from 4.02 - 4.8 percent. It is important to recognize that costs of capital for solar securitization should continue to fall as investors and rating agencies become more comfortable with the solar ABS asset class. Issuers can use the funds obtained through securitization to pay off more expensive sources of capital on the balance sheet and to fund future development at more attractive rates. The ability to access capital at lower costs to drive growth has been a major force behind the adoption of securitization in the solar space.

Furthermore, the structural nature of securitization has benefits that make it a more attractive financing option than yieldcos. While yieldcos are subject to certain aforementioned concerns which the parent company cannot control, such as rising interest rates and oil price volatility, funding available via securitization is based primarily on the characteristics and operating performance of the assets themselves. As solar assets continue to develop strong operating performance history, and as access to standardized data on asset performance increases, yields on solar ABS deals will trend downward.

The State of the Solar Securitization Market

There have been five priced securitization deals in the solar space to date. These asset backed securities, backed by PPAs and solar leases, have all been offered under Rule 144A, and as such are private placement deals available to Qualified Institutional Buyers. A sixth deal from AES Distributed Energy was announced in September, but has yet to price. The AES deal will be the first solar ABS deal sponsored by a utility company. 

Additionally, SolarCity recently structured its fifth securitization backed entirely by solar loans, a first for the industry. The transaction consists of two classes of notes (rated BBB and BB for the A and B tranche, respectively, by Kroll Bond Rating Agency), and is backed by a pool of 11,583 solar loans. As system costs decline and solar loans gradually replace third-party financing, we expect this to be the first of many solar securitizations backed by pools of loans.

A comparison of all transactions priced to date is provided in the table below. 


Note: ADSAB is the aggregate discounted solar asset balance.

As solar installations increase and portfolios grow, the size of transactions will continue to increase, making entrance into the public registered ABS market more economical for issuers.  Likewise, as institutional investors become more comfortable with solar as an asset class, one can expect to see more demand for these securities in both the private and public markets.

Risks of Investing in Solar

Solar ABS investors must take into consideration two types of risk. The first is contract risk. When off-takers (the entities that ultimately consume and/or purchase the solar energy) default, those that eventually renegotiate do so at a lower rate, which decreases cash flows to the solar company, and, by extension, to ABS investors. To date, solar companies have experienced nearly negligible default rates: in its 2014 annual report, SolarCity reported an annual default rate of only 0.6 percent.

However, due to regulatory changes to existing rate structures, solar companies can expect this renegotiation risk to increase as off-takers are faced with lower rates from utilities. An example of regulatory change driving increased renegotiation risk is the utility rate reform in California. In July of 2015, the California Public Utilities Commission modified its existing rate structure by reducing electricity rates for households that make up the majority of solar customers in the state. This rate reduction decreases the economic value proposition of solar, which is based on providing electricity at rates below utility rates. Solar ABS investors will have an interest in accurately and rigorously analyzing the risk that default and contract renegotiation pose.

The second risk that solar ABS investors must thoroughly understand is performance risk. There are two primary ways in which asset performance affects cash flows. The first is the panel efficacy, which directly impacts available cash flows: the more powerful the panels, the more energy they are able to produce, and thus the more cash flow is available to investors. This is measured in the industry by degradation, the rate at which the capacity of the panels declines over time. Although the industry standard for degradation is 0.5 percent per year, investors will likely want to stress this number in a more sophisticated fashion across a portfolio of solar assets.

The second factor associated with performance risk is weather. Seasonality and unexpected weather events can substantially impact project cash flows, and investors may want to assess this risk by stressing exceedance probabilities. Weather impacts portfolios differently based on geography and seasonality, and we expect investors will not find it sufficient to simply apply static “base case” (P50) or “conservative” (P90) assumptions across geographically diverse assets. Power generation scenarios in solar are typically measured in terms of exceedance probabilities, which define the probability of a given event being "exceeded." For example, a "P90" scenario describes a case in which the anticipated amount of power generation is expected to be exceeded with a probability of 90 percent.

Conclusion

The tremendous growth in the solar industry in recent years faces a potential setback as the ITC, which has played a critical role in the industry’s growth, begins to decrease in 2019. Capital sources which depended on a 30 percent ITC will have to be replaced with alternative funding sources in order for the solar sector to continue its growth trajectory. While yieldcos and securitization have both recently become common financing alternatives to tax equity, we expect that the challenges facing the yieldcos will likely result in securitization’s emergence as the most viable financing mechanism to fuel continued growth in the solar industry. 

Look for Part 2 of SFIG's Spotlight on Solar Series, to be published in January: A Comparative Analysis of Solar ABS Deal Structures.

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