Issue Spotlight: Spotlight on Solar Series, Part 2: Market Trends and Structural Evolution

Spotlight on Solar Series, Part 2: Market Trends and Structural Evolution

By: T-REX Group

Look for Part 3 of SFIG's Spotlight on Solar Series in February: Quantifying and Assessing Renegotiation and Rate Risk

Solar Industry Background

The solar industry has experienced significant growth in the past 15 years (a compound annual growth rate of nearly 70%), fueled by multiple factors including business model innovation, declining system costs, and the investment tax credit (“ITC”). At the end of 2015, the solar industry faced a period of great uncertainty, as the ITC was slated to expire in just over a year. That uncertainty was eliminated this past December with the extension of the ITC by Congress, and the solar industry stands to gain tremendously from the extension. In this piece we discuss this extension, the effect it will have on sources of financing in the industry, and how all of these pieces will affect the nascent solar ABS market.

Market Update: ITC Extension and the Impact on Industry Growth

December 2015 was an important month for the solar industry. The ITC, which was previously slated to drop to 10%, was extended through 2021 with the following schedule.

Note: in 2022, the rate drops to 10% for non-residential and third party owned residential systems, and to 0% for host-owned residential systems.

In addition to the rates of the tax credit in the ITC, there are two other very important elements in the recent legislation. The first is the renewal of bonus depreciation, which allows for accelerated depreciation in the early years of a project’s life. Bonus depreciation was extended such that projects that come online before 2018 get 50%, projects in 2018 get 40%, and projects in 2019 get 30% in accelerated depreciation. Finally, a “commence construction” clause was introduced that allows the ITC to be claimed once construction for the project has begun, as opposed to when the project comes online.

The impact of the ITC extension and supplementary clauses on the industry is expected to be substantial. By 2020, GTM Research predicts that annual U.S. solar installations will reach 20 gigawatts (“GW”)—nearly twice what levels would have been without the extension. The two graphs below show forecasted annual U.S. solar installations, with and without the forecasted ITC extension.

Solar Loans

The solar industry’s recent growth has also been fueled by multiple factors aside from the ITC, including financial model innovation through the rise of third-party financing. Through vehicles such as the power purchase agreement (“PPA”) and solar lease, residential and commercial customers have been allowed to bypass the substantial upfront cost of purchasing a solar system by avoiding ownership of the systems. However, as system costs decline and homeowners take advantage of the extended ITC, direct ownership of solar panels is expected to increase through the proliferation of solar loans. The following graph from GTM Research shows the rise of solar loans vs. leases and PPAs (third-party ownership, or “TPO”). In 2020, more systems are forecasted to be owned rather than leased as loans capture 54% of the market, with TPO models comprising the remaining 46%.

These forecasts were made prior to the extension of the ITC. As homeowners are able to take advantage of the ITC, effectively lowering the costs of solar ownership even more, loans could overtake TPO even sooner than 2020.

One example of a solar loan product is SolarCity’s MyPower loan for residential solar customers. MyPower loans are fundamentally different from more traditional loans, such as mortgages, under which level payments are due each month. With the MyPower loan, monthly payments are not fixed, but are tied to the power generated by the system. The loan is structured to amortize in 30 years, although the amortized amount depends on how much power the system produces. Because the payments are tied to power generation, there is the potential for variability in the borrower’s loan payments. The loans can pay off faster if there is over production. Or, if the power produced is not sufficient to make the payment each period, then it is possible that the loan can take longer than the initial term to amortize. In the case that the loan is not repaid in 30 years, the customer will have 2 additional years to pay off the balance. After 2 years, it would be the borrower’s responsibility to pay the remaining balance if there is any balloon payment due.

MyPower customers pay a kWh rate towards their monthly loan payment with an annual escalator of 0-2.9%. In this sense, the loans are very similar to PPAs, with payments tied to power production. Because the payments to ABS investors are ultimately derived from the power production of the assets, it is important that investors have the ability to evaluate and monitor the performance of the loan portfolio through running sensitivity analysis on the power production of the underlying systems. Furthermore, investors must also assess other parameters that affect portfolio cash flows, such as renegotiation and default due to rate risk in the market. This will be the subject of our third installment in the solar series.

Borrowers pay a fixed interest rate – by way of example, the weighted average loan rate was 4.9% in the SolarCity 2015-A transaction. If the borrower’s system does not produce enough power to meet the current interest payment, any unpaid interest is not capitalized but accrued to be paid in future periods. The loan structure allows the borrower to take advantage of the ITC benefit, allowing the borrower to use the resulting tax savings to pay down principal and lower future monthly payments. The borrower is required to pay a balloon payment on June 1st of the year following installation to take advantage of the ITC.

SolarCity 2015-A Securitization

Although the solar ABS market is still developing, the impact of loan proliferation is already evident in the most recent solar securitization: SolarCity 2015-A. This deal is backed by a pool of solar loans, whereas all previous solar ABS deals were backed by leases and PPAs. A summary of the collateral pool, comprised of MyPower loans, is provided in the table below.

The following table compares the key features of all solar ABS transactions, including SolarCity’s recent loan-backed transaction 2015-A which priced on January 13, 2016:

The solar ABS market has had a number of meaningful developments, including the presence of a variety of tax equity structures. In SolarCity’s first two transactions, the systems were owned by SolarCity. This changed with 2014-2, which incorporated the inverted lease tax equity structure into the transaction. In an inverted lease structure, the developer owns the project and enters into a lease with the investor, who then enters into an agreement with an off-taker. Once the lease has completed, the investor exits from the deal, and the developer receives payments directly from the off-taker. SolarCity’s first transaction in 2015, 2015-1, featured the partnership flip tax equity structure in the transaction. In the partnership flip structure, there is the risk that tax equity investors must potentially forego a portion of the tax benefits during the recapture period. This risk was mitigated through an innovative insurance policy in the structure would cover up to 35% of the ITC for the tax equity investor. As solar ABS investors become more comfortable with tax equity, we expect to see more creative structuring solutions to mitigate some of the risks posed by complicated tax equity structures.

Another meaningful development in the solar ABS market is the nature of the underlying collateral. In SolarCity’s most recent transaction, the collateral base is different from that in previous solar securitizations, in that the cash flows are backed not by solar leases or PPAs, but entirely by SolarCity’s MyPower loans. Not only is this a reflection of financing trends in the industry, but it is also significant because it is the first time that the industry has seen solar loans of any form in an ABS structure. It is also noteworthy that two rating agencies rated the A tranche in 2015-A (as opposed to only one in previous deals), which is a sign that solar is gaining awareness in the esoteric ABS space.

The most striking data point on SolarCity’s most recent transaction is the increase in yields from previous deals. On SolarCity’s previous securitization in August of 2015, the yields on the A and B classes were 4.18% and 5.58%, respectively. There are multiple explanations for the increase in yields in 2015-A to 5.00% for Class A and 10.00% for Class B. First, the deal priced during a period of heightened volatility in financial markets. ABS spreads, particularly in credit, are wide across the market. This is magnified by the fact that this transaction is the first of its kind—there has never been a solar loan ABS securitization. Additionally, ratings on Class A for the loan deal are BBB, versus the A rating on the previous lease deal, and the Class B on 2015-A carries a BB rating, versus BBB on 2015-1. Investor concerns with long-dated esoteric assets also adversely impacted this transaction.

As investors become more comfortable with solar loans, we expect to see more deals with loans as the underlying collateral in the structure. As a result, the base of issuing companies will diversify to include regional banks lending to solar developers. With the extension of the ITC, it is also likely that tax equity will play a larger role in the capital structure of solar ABS deals.

New Regulatory Risk: Rate Risk

Another factor which may have impacted spreads on SolarCity’s loan deal is investor discomfort with recent regulatory uncertainty facing SolarCity and the entire industry. Changes to net metering rates in Nevada essentially brought the state’s residential solar industry to a halt. As net metering rates decline, the value proposition to solar customers is diminished, which threatens the business of solar developers. Regardless of the fact that this transaction was not tied directly to Nevada—in fact, 95% of the loans are in California, Colorado, and Arizona—the concern may be that Nevada has potentially set a precedent. However, due to the rapidly growing number of jobs provided by solar companies, it is not likely that such drastic actions will become common in states where solar has a strong presence in the market. This is particularly true in light of the substantial extension of the ITC, which is expected to fuel job growth in the industry.

Conclusion

The extension of the ITC will drive incredible growth and further cost reductions in the solar industry. As solar becomes more affordable for residential consumers, and loans become the primary source of financing in the industry, we expect to see solar ABS backed increasingly by loans. However, as is evident with 2015-A, regulatory risks and rate reform concerns are impacting the ratings and pricing of solar securitizations. In order to become more comfortable with rate risk, investors must know how to quantify it accurately. In our next piece, we will look at rate risk in-depth and provide a comprehensive analysis on how to assess and quantify this risk.

 

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