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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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Utilities and Distributed Solar

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Large utilities seem to be increasingly interested in distributed solar as a business.  Consider the news from the past 60 days:

These aren’t the only such companies looking into the business.

Here’s an overview of significant, publicly announced activities in distributed solar by the 20 most valuable utilities and power companies:

Figure 1: Top Utilities’ Investments in Distributed Solar

Top 20 Utilities and Distributed Solar

Why are they making these investments?

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Electrical Potential: Reducing Customer Acquisition Cost and Increasing Lifetime Value in Solar and Competitive Electricity

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Two of the most compelling stories in energy over the past few years have been the rapid growth of competitive electricity supply (“CES”) and rooftop solar. Although the two industries directly compete in some states, we have worked with executives in each industry who know relatively little about the other. However, we believe CES and solar businesses could help one another reduce customer acquisition costs and solar companies could help CES businesses stabilize cash flows over a longer period and increase customer lifetime value.

Both industries have enjoyed rapid growth in recent years. Eleven million consumers in 13 states plus the District of Columbia buy power generation services from competitive suppliers. (For the most part these consumers continue to buy electricity delivery services from a local monopoly utility.) The number of residential CES customers has grown at 16% annually since 2008 and more than half the consumers in some markets buy from a competitive supplier.

Meanwhile, the amount of residential solar capacity installed each year has grown at an annual rate of 56%. One of the key drivers of this growth has been the emergence of third-party-owner financing models, in which consumers spend little or no money up front but agree to host systems at their homes and buy the power produced for 15 to 20 years. Another has been a precipitous fall in the cost of solar equipment.

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The Economics of Residential Solar Installation

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Residential solar dealer profit margins look at lot like those for conventional electrical, plumbing, and HVAC contractors.  What should dealers do?

Over the past year, Woodlawn Associates has worked with nearly 20 residential solar dealer-installers on projects to optimize the costs of customer acquisition and installation. These projects were quite tactical, but it is worth considering some of the more strategic findings and their implications.

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