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Utility Regulation and the Nobel Prize

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Last month French economist Jean Tirole won the 2014 Nobel Prize in economic sciences. According to the Royal Swedish Academy of Sciences, he deserved the award because he has “clarified how to understand and regulate industries with a few powerful firms.”

With the increasing penetration of renewable energy driving conversations about appropriate utility rate and regulatory structures for the 21st century, in this post we explore three takeaways from Tirole’s work as they apply to electric utility regulation.

Jean Tirole: Three Key Takeaways for Regulation of Electric Utilities

1. Offer regulatory choices that provide incentives while avoiding the ratchet effect

Suppose regulators do not know the true potential of firms they regulate to reduce cost. If they offer cost-based, rate-of-return structures firms will have little incentive to reduce cost even when it is possible. On the other hand, if they offer fixed-price structures firms will have a strong incentives to reduce costs, yet depending on the price level allowed it may be the firms—not ratepayers—that capture the benefits.

Tirole showed that regulators can resolve this dilemma by offering firms a carefully designed menu of regulatory schemes and letting the firms choose between the options. Offered the two polar choices above, firms without good cost reduction opportunities would take the rate-of-return option, while firms with them would take the fixed-price option. A regulator can use a more sophisticated menu to ensure some of the benefits of cost reduction are shared with ratepayers.

Tirole also showed that regulators must be able to offer long-term contracts for high-powered incentives (such as fixed prices) to be optimal. If regulators can ratchet prices down after firms have made investments, firms will avoid making investments that require longer payback periods. To avoid this ratchet effect, such regulators should offer only modest incentives in the short run.

2. Incentives for firms offering network access should depend on competitors’ output

Regulated firms often control access to an intermediate good that other companies can use to compete in end markets. If the regulated firm’s profit is dependent only on its own level of output (or assets) it has an incentive to overstate the cost of providing access to such companies to foreclose that competition. Therefore, Tirole says “the regulated firm’s incentive scheme should depend not only on the firm’s cost and outputs but also on the output produced by its competitors”!

3. platform markets require network externalities and are sensitive to price allocation

Tirole has been a leader in the study of platform markets, such as those for video game systems, operating systems, payment systems, and newspapers. He defines such markets as those in which:

(a) the amount users benefit from the platform depends on the number of other users of the platform (i.e., video game developers prefer platforms with many gamer customers), and

(b) the volume of transactions depends not only on the total price level, but on the distribution of prices between parties that use the platform (i.e., advertisers and subscribers to a newspaper are charged different prices).

As we will see below, New York would like to set up a platform market for distributed energy resources.

Implications

Several states, including Arizona, California, Hawaii, Massachusetts, Minnesota, and New York are considering changes to their regulatory frameworks for electric utilities to manage or encourage the use of distributed energy resources, fairly allocate costs, and improve efficiency.

Let’s look at how some of the takeaways from Tirole’s work could be applied in two of these states: New York and Hawaii.

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SolarCity Customer Acquisition Cost and What Really Matters

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We are regularly asked to comment on customer acquisition cost (“CAC”) in the solar industry because we’ve calculated it for so many firms.

In 2012 we published a report on CAC called Solar Marketing Effectiveness.  We concluded the average CAC was $5373 / customer, or $0.89 per Watt.  We have since helped several firms with CAC on a proprietary basis and the numbers we’ve seen in those projects aren’t too different.

It’s not uncommon for us to get objections that go something like this: “SolarCity says their customer acquisition cost is only $2500.” or “Other sources say it is only $0.50 or $0.60 / Watt.  Why are your numbers different?”

In both cases it comes down to how expansive the definition of CAC is.  Our approach is not unlike that of a sculptor.  We start with a solid block of material—all costs, as captured in a company’s books—and we cut away everything that is not CAC.  Thus, we are unlikely to overlook certain acquisition costs just because we forgot or did not know to ask for them.

How straightforward this is depends on the financial detail we have.  If we have access to a company’s general ledger, we can review each transaction to determine if it is related to customer acquisition.  It can be more difficult if we only have access to the P&L.  Some lines on the P&L may contain certain expenses that are CAC and others that are not.  For example, a company might have one line for “marketing & advertising” and another for “salaries & wages”, but that doesn’t give us enough information because we should realize that some—but not all—of the salaries and wages line is for the marketing and sales teams.

Nonetheless, it is often possible to make an CAC estimate from financial statements and other reasonable assumptions.  For example, we estimate that SolarCity’s residential customer acquisition cost in for the quarter ended March 31, 2014 is about $1 / Watt installed or $0.70 / Watt booked.

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What is the Solar Cost of Capital?

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In a previous post, I said Woodlawn Associates believes solar project sponsors (i.e., equity investors other than tax equity) expect to earn an 8-11% after-tax internal rate of return on their investments.  As I said in that post:

Whether 8-11% is a good deal for the financier depends on its cost of capital.  If a financier’s cost of capital is 10%, the net present value of its investment is essentially zero.  On the other hand, if its cost of capital is 5-7%, the NPV of each solar system is several thousand dollars.

So how does one determine cost of capital for a project sponsor?  First, we have to understand what we mean by “sponsor”.  I use the term to mean the company that invests regular equity in project companies, which is usually a holding company subsidiary of a parent solar financing company:

Figure 1: Simplified Subsidiary Structure of Solar Finance Company,
and Sources of Capital

Solar Cost of Capital Figure 1

In this post I will first examine the cost of capital for project companies and then for sponsors/holding companies (the green boxes in Figure 1).

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Financing Returns in Residential Solar

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Happy 2014 everyone.  The deep freeze here in the Midwest is making me wish I was in California this week.  By the way, how much better do solar panels perform when it is 15 degrees below zero?  (Assuming they aren’t covered with snow?)

We’ve had several organizations ask us over the last few months about the returns for financing residential solar.  Before we get there, however, let’s make sure we understand what’s included in the returns.

Essentially, there are only two places to earn returns in residential solar: from installation or financing.  Installation (or “dealer”) businesses earn profits much like any contractor does, by finding customers and getting them to pay for an installation of equipment.  Financing businesses earn money by investing money in solar systems up front and collecting fees over a long period of time.

Some companies, like SolarCity and Vivint, are vertically integrated in these business. Others, such as Sungevity, acquire customers and provide financing but rely on others to do installations.  However, these variations don’t create new profit pools, they are just different ways of splitting up the profit pie.

We’ve discussed the profits in the dealer part of the business before.  But how much profit is there in the financing part of the business?  This depends on a few key factors:

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Preparing for a Successful IPO

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Twitter will soon go public, but more than 100 companies have completed IPOs in the past six months or so. Many of those newly-public companies have struggled as stocks. They are up an average only 2%, while NASDAQ is up 13% over the same period. Nearly half of those IPO companies are actually trading below their offering price.

We have directly participated in 17 IPOs and supported many more.  In our opinion there are three main stumbling blocks for companies going public in today’s market:

Stumbling Block 1:  Public and private investors have very different expectations

Most companies that IPO started with venture capital backing. These and other private investors in high-growth companies tolerate of a lot of uncertainty. They value a company’s “story” and have long time horizons. By contrast, public market investors have quarterly, monthly, or even daily time horizons. They hate surprises and value consistency. This is not to say that venture investors have infinite patience, nor that public investors are short-sighted, but that there is a very real difference in the pressures on each of them.

Stumbling Block 2:  The IPO process does not help management bridge this gap

The IPO process itself can become all-consuming for management. Preparing forecasts and offering documents and going on roadshows can consume a major portion of management’s time. And, there is tremendous pressure to get the deal done. There may only be a limited time in which the IPO window is open. The board, which typically represents the company’s venture investors, wants a liquidity event. The bankers’ incentives are largely aligned with completing a listing. In this environment there is little time for management to learn about the needs of its new investors. In fact, at the very time the company is shifting from investors who value the long-term outlook to those who value quarterly consistency, management is pulled far away from actually operating the business.

Stumbling Block 3:  The IPO is only a first impression

Public investors have grown skeptical of IPOs to a degree and are looking to see whether management can meet expectations for several quarters after being public before really committing to a stock.

We advise our clients considering IPOs about five major solutions to these stumbling blocks:

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