Chapter 4 Chasing Capital
Through the first half of 2015, SunEdison looked unstoppable. A developer of massive, utility-scale solar projects, the company was surfing a wave of expansion in renewable energy markets around the world. Over the past decade, the global installed capacity of solar had risen from just 4 gigawatts (GW) to nearly 200 GW. And yet solar had just breached the 1 percent threshold as a share of the world’s electricity, implying decades worth of growth to come.1
Recognizing the market’s inexorable growth, SunEdison signed contracts around the world, from Asia to Africa to Latin America, to build massive solar farms. It also went on a buying binge between 2014 and 2015, spending nearly $5 billion on acquiring a global wind energy developer and a major U.S. installer of rooftop solar. Financial analysts parroted SunEdison’s executives, who called the company the next energy “supermajor.”2 That characterization was speculative, but not wildly so: in July of that year, the company’s market value would peak at over $9 billion.3 CEO Ahmad Chatila had Exxon, the world’s biggest oil company, in his sights, remarking: “Their market cap is around $400 billion. That’s what we’re going after.”4
That spring, I invited Chatila to share his grand vision for the future at a lunch roundtable at the Council on Foreign Relations. He gave an optimistic and inspiring talk. Afterward, as we debriefed, I asked why he had moved the company away from developing solar technology to instead financing and building projects with off-the-shelf solar panels. Chatila’s response surprised me, given that he was an engineer by training, with decades of experience in Silicon Valley’s research-intensive microchip industry. Exiting the solar manufacturing business was the best decision he had ever made, he assured me, because the engineering behind solar panels wasn’t where the value lay.
The future of the industry, he contended, was the development of ingenious ways to raise the necessary up-front capital to construct new solar projects. In fact, in the early 2000s, SunEdison had invented the “solar-as-a-service” business model, in which the company would take out loans to construct large solar installations for its commercial clients, who would then pay for the generated power for decades to come. Now SunEdison would pin its strategy for the future on a new financial innovation: the YieldCo.
The YieldCo was a seductive idea. Simply put, it is a collection of renewable energy projects packaged into a company that is publicly listed. By selling shares on the stock market, this company then can raise capital to purchase new renewable energy projects. A liquid investment that any retail or institutional investor can trade, YieldCos offered the tantalizing prospect of deepening the capital pool available to fund solar power.
What’s more, SunEdison realized that by creating a YieldCo, it would create a customer that would purchase the solar projects SunEdison developed and supply the funds to build even more projects. Enamored by the model, SunEdison actually created two YieldCos—one focused on projects in the United States and another that would buy up projects across the developing world—and it aggressively advertised shares in these new companies to stock market investors. Investors gobbled up the shares, wooed by SunEdison’s promises of soaring stock prices and fat dividends. A few market analysts wondered aloud if the YieldCo model was too good to be true, but most ignored the naysayers; SunEdison assumed that its YieldCos would supply the cash it needed to continue its breakneck growth.5
As it turned out, the model was indeed too good to be true. Just a year after I hosted its triumphant CEO, SunEdison completed an astonishingly fast fall from grace, declaring bankruptcy under the crushing weight of its $16 billion debt load (figure 4.1). Spooked by a perfect storm of unfortunate events—including a crash in the price of oil and rumblings from the U.S. Federal Reserve about an interest rate hike—investors had dumped their YieldCo holdings. The share prices of SunEdison’s two YieldCos tumbled, undercutting the YieldCos’ ability to purchase projects from their parent. SunEdison would later face lawsuits for plundering the remaining cash of the ostensibly independent YieldCos to make its debt payments.6 Once the cash flows from the YieldCos dried up, SunEdison was left with no option but to fold.
SunEdison’s market value crushed by mounting debt. The left y-axis measures SunEdison’s market value (filled circles), which peaked at nearly $10 billion in 2015 before the company declared bankruptcy in April 2016. The right y-axis measures the company debt burden (filled squares), which soared to more than $16 billion as SunEdison acquired companies and expanded its project pipeline around the world.
Source: Bloomberg.
In the wake of SunEdison’s collapse, analysts scrambled to determine what went wrong. Was this the end of financial engineering in solar? Was it simply unrealistic to expect that a solar energy supermajor might rise up to challenge conventional fossil fuel supermajors? The right answer to both questions is no. SunEdison flopped because of its overly aggressive growth strategy, questionable governance of its YieldCos, and rash accumulation of debt.
But Chatila was not wrong in his conviction that financial innovation could enable the solar industry to rapidly scale up the deployment of existing solar panel technology. SunEdison’s mistakes were its own, but they do not contradict the broader wisdom of finding ways to enable new investors to fund solar projects that line up well with their investment criteria. And although its failure is a setback for the industry, SunEdison will not be the last ascendant solar company with the potential to rival the oil majors.
In fact, although a rapidly growing solar sector needs more funding than its current investors can provide, there is reason to be optimistic that financial and business model innovation will deliver trillions of dollars of new investment in the coming decades. Fundamentally, projects based on existing solar technology are remarkably safe investments. Today’s solar photovoltaic (PV) installations are simple infrastructure projects that, once built, produce power for decades. And solar’s costs are falling predictably, making the business case increasingly compelling. Given these characteristics, solar power lines up well with the needs of deep-pocketed institutional investors around the world. All of this suggests that it is only a matter of time before new approaches dramatically expand the pool of capital available to fund solar power.
The financial innovation needed to expand this pool of capital does not require reinventing the wheel. Under Schumpeter’s paradigm (see box 3.1 in chapter 3), an innovation is an invention that has been brought to market. So adapting novel financial instruments from other sectors and popularizing them for the first time in the solar sector exemplifies financial innovation. According to New York’s energy czar, Richard Kauffman, there is plenty of inspiration to be drawn from other sectors of the economy to augment funding sources for solar projects:
Projects in the [United States] rely upon an old-fashioned and anachronistic form of financing that is different than how other parts of the U.S. economy are financed. Rather than use bond or stock markets, projects depend on non-capital market sources of so-called tax equity, bank debt, and private equity where rates of return can approach typical private equity rates of return of 12–15 percent. [New strategies] … don’t require going to the lab; they involve applying financing techniques that have already been invented and are used widely in other parts of the economy, but have not yet been applied to this sector.7
Kauffman is suggesting that by tapping public capital markets, the solar industry can finance projects at a lower cost of capital—the rate of return demanded by the investors who provide the capital—than it can using funds from its existing, private sources.
To deploy solar projects, the industry needs to recruit two types of capital: equity capital and debt capital. Investors provide equity capital to a company in return for an ownership stake, and they provide debt capital in return for a promise to be paid back at a later date with interest. The cheapest equity capital can be raised on public stock markets, through which investors purchase stakes in listed companies and earn returns through increases in share prices or dividend payouts. And even more than equity, the industry needs debt capital, which tends to be cheaper than equity capital and therefore represents the majority of infrastructure funding. The cheapest debt capital can be raised on public bond markets, through which investors can make loans for a predetermined period and receive interest payments in the meantime. Accessing these two public capital markets would connect the solar industry to a broad range of investors, including deep-pocketed institutional investors hungry to fund infrastructure.
To tap public stock markets, the industry can emulate a strategy applied by the oil and gas industry to raise public equity capital for infrastructure projects, such as transcontinental pipelines. Indeed, the YieldCo was originally modeled after a common financial vehicle from the oil and gas industry. Clearly, this imitation was not entirely successful, but the industry is already working on tweaks to attract capital for solar projects without running the risk of another SunEdison-esque implosion. To access public bond markets, especially to fund small, distributed solar projects through debt capital, the industry can employ the strategy that the real estate and automobile industries use to make owning a home or driving a car affordable to millions of Americans: bundle a diverse portfolio of consumer loans into a tradable security attractive to investors. Ironically, that strategy, known as “securitization,” was the culprit behind the Great Recession of 2009. But by meticulously collecting and analyzing data from solar projects to ensure that investors can accurately assess the risk they won’t be paid back, the industry can safely and profitably take advantage of securitization.
But it will take more than deep-pocketed investors to speed the deployment of solar PV projects. The oil and gas industry benefits from supermajors who use their substantial balance sheets to identify and develop new projects. Similarly, large corporations will need to undertake the initial risk of developing solar installations and serving as a conduit to direct capital from wealthy investors to worthy projects. The power sector has such behemoths, but only some of them are in a position to embrace solar. In the United States, regulated electric utilities—which own and operate the grid and are subject to strict government scrutiny—are often fixated on the potential threat from distributed solar power. By contrast, unregulated power companies in the United States and abroad are aggressively seeking investment opportunities in solar, most in utility-scale projects. And even corporations outside the energy sector, including technology giants such as Google and Microsoft, are beginning to invest in solar power in a big way.
The private sector must be front and center in financing solar power. But the public sector has an important role to play as well. If governments intelligently deploy their resources—which are scarce compared to solar’s capital needs—they can mobilize much more funding from the private sector. State and local governments have already unveiled a variety of innovative approaches to encourage private investment flows, for example by marshalling public borrowing power to direct capital toward solar. National governments around the world are also rolling out initiatives to attract capital, such as by helping foreign investors hedge against the risk of local currency depreciation. And multinational institutions, including the World Bank, are deploying credit enhancement mechanisms, which make the terms of investing in solar power more attractive. Importantly, governments should avoid indiscriminate incentives that make solar power dependent on public funds. Only if solar projects have the potential to be profitable will financial engineering and public incentives succeed in unlocking large flows of private capital.
The proliferation of innovative approaches for directing capital toward solar power is a promising start. Perhaps from the ashes of SunEdison’s flameout will emerge a genuine solar supermajor.
Toward YieldCo 2.0
The example from the oil and gas industry that inspired renewable energy YieldCos was a decades-old financial vehicle known as the “Master Limited Partnership (MLP).” An MLP pools together a diversified portfolio of oil and gas infrastructure assets, such as pipelines and processing facilities. Investors then can buy shares of MLPs on the stock market. MLPs get special treatment under the U.S. tax code: they pay no corporate tax and can distribute the revenue generated by their oil and gas assets directly to shareholders as dividends. MLPs are hugely popular because they are liquid (i.e., investors can readily trade their shares on the stock market), they diversify risk through pooling many assets, and shareholders can expect reliable dividends. In 2016, publicly listed MLPs were worth roughly a half-trillion dollars.8
If solar power projects could be bundled together into MLPs and listed on public stock markets, the industry would be able to tap into nearly limitless pools of equity capital, just as the oil and gas industry has. That’s because the world’s largest investors are hungry for new opportunities to invest in infrastructure—so much so that from 2013 to 2017, the number of institutional investors holding infrastructure assets more than doubled.9 Investors that are even more active, such as private equity funds, are also looking for stable infrastructure investments (witness a $40 billion partnership in 2017 between the Public Investment Fund, a Saudi Arabian sovereign wealth fund, and Blackstone, a private equity investor, that is structured for long-term infrastructure holdings.10)
Infrastructure investors seek opportunities to park their capital and harvest reliable income for several years or even decades without having to worry about reinvesting their money in new assets. Solar PV projects fit the bill. Yet they can’t be bundled into MLPs because of U.S. tax code restrictions enacted thirty years ago, well before it became clear that investors would have much appetite for including solar power projects in their portfolios. After oil and gas companies formed the first MLPs in the 1980s, the practice caught on in unrelated sectors—the Boston Celtics even became an MLP—because of the resulting tax benefits. Seeking to block tax evasion but also encourage some forms of investment, in 1987, Congress restricted the scope of MLP income to activities such as the production and transportation of depletable natural resources. More recently, as renewable energy has grown in importance, lawmakers have tried in vain to amend the U.S. tax code. In 2012, Senators Chris Coons (D-DE) and Jerry Moran (R-KS) introduced a bipartisan bill, the MLP Parity Act, to allow MLPs to include renewable energy assets, but the legislation never passed.11
Undeterred, some energy companies devised the YieldCo structure as a way to approximate an MLP. In 2013, the American power company NRG listed the first public YieldCo, NRG Yield, setting off a wave of fifteen U.S. and European YieldCo offerings over the next two years.12 They all followed the basic MLP model by bundling together a diverse portfolio of renewable energy projects, listing on the stock market, and paying quarterly dividends to shareholders. Most YieldCos held a portfolio of large, utility-scale solar and wind energy projects, although some ventured into owning smaller, rooftop solar installations as well.
Soon the European and American YieldCos began to diverge in their approaches. European YieldCos were basically holding companies, offering investors little more than a convenient way to invest in a bundle of renewable energy projects. But American companies had ambitious plans for the YieldCos that they created. Some of those firms, such as NRG and Nextera, owned conventional power plants and saw solar and wind projects as an attractive way to diversify their assets. Others were pure-play solar developers, such as SunEdison, SunPower, and First Solar, who wanted to stake out their share of a growing solar market. Both kinds of firms saw their YieldCos not only as a way to bring more capital into the solar industry, but also as a way to goose their own growth.
This motivation led to a clever partnership between parent sponsors (such as NRG or SunEdison) and their YieldCo children. Here’s how it worked. The sponsor would create a publicly listed YieldCo—advertised as an independent company—but retain some degree of control over its operations, such as through a majority ownership stake or board seats. Then the sponsor and the YieldCo would split up the low- and high-risk aspects of developing a renewable energy project. The sponsor would take on high-risk activities, like obtaining land and government permits, building a solar farm, and finding a long-term buyer for the power. The YieldCo, by contrast, would undertake the lower-risk activities of owning and operating a diverse portfolio of projects.
This separation of high- and low-risk activities, then, would allow both sponsor and YieldCo to make money when the YieldCo purchased a project from its parent. The sponsor would sell newly constructed projects at a high-enough price tag to return its investors a healthy premium for the risk that they had assumed. But the YieldCo would view the same price tag as affordable because its shareholders would not demand hefty returns on a low-risk investment. In fact, shareholders saw the reliable dividends—payouts from the sale of solar power produced by the projects that YieldCos owned—as a terrific alternative to the near-zero returns from U.S. government bonds and other safe investments.13
So far, so good. But sponsors oversold the potential of their YieldCos to investors—a tactic that ultimately doomed the model. No sponsor went as far as SunEdison in spinning the fantasy that YieldCos would mint money for their investors. Not only could shareholders in its first YieldCo expect reliable dividends, SunEdison promised, but they could also look forward to surging growth in those dividends—north of 30 percent a year.14
How could such gains be achieved, given that the dividends should have merely reflected the stable revenue streams of the underlying solar projects? Well, SunEdison insisted, it was possible because its YieldCos would continue to buy new projects, which would generate new revenues. SunEdison assured investors that those new projects would be “accretive”—that is, they would increase the YieldCos’ value, boosting share prices and enabling the YieldCos to raise even more cheap money on public markets to buy more projects. The model was a frenetic upward spiral—a virtuous cycle that guaranteed that everyone would make money.15
Investors lapped it all up. Most of them were major investors in oil and gas MLPs and salivated at the prospect of a familiar investment vehicle with jaw-dropping growth prospects. By the summer of 2015, they had bid up YieldCo market values to a collective $28 billion, over double their market debut.16 But the euphoria didn’t last long: Just as YieldCo values spiraled upward, so too were they vulnerable to a vicious downward cycle. If their share prices dropped, the dividend yields would necessarily rise, and the YieldCo no longer could afford to buy expensive solar projects from the parent developer and still pay their shareholders the expected dividends. This stagnation would depress share prices further and continue the downward spiral.
That the transition from upward to downward spiral happened in July 2015 was a matter of happenstance—a confluence of random events that by themselves should not have had much of an effect on the solar industry. Nevertheless, it was the perfect storm. Oil prices crashed by 20 percent, spooking the MLP investors who had piled into YieldCos; panicked, they sold off both the MLPs and YieldCos. This sell-off may not have been totally rational—after all, solar projects produce electricity, and oil fuels vehicles. The two do not often compete, and they basically never do in the United States (although some countries, such as Saudi Arabia, do use oil to generate power).
Investors were also spooked by statements from U.S. Federal Reserve policymakers who all but guaranteed an imminent hike in interest rates. A rate hike would mean that YieldCos would face competition from government bonds and other safe investments, whose returns suddenly would be more attractive. On top of all this, four YieldCos issued shares worth $2 billion in June and July, pumping a new supply of YieldCo stock into the market just as skittish investors did not want it anymore. As a result, YieldCo share prices plunged (figure 4.2). Both of SunEdison’s YieldCos would lose over 80 percent of their market value over the next six months. SunEdison’s demise followed shortly thereafter, when it could no longer service the mountain of debt that it had taken on to build solar projects that its YieldCos no longer could afford to buy.17
Crash in 2015 oil prices and U.S. YieldCo market values. The left y-axis measures a weighted average of YieldCo share prices on the stock market, which increased by 15 percent in the first half of 2015 before shedding half their value later that year. The right y-axis measures the price of oil in the United States, which increased above $60 per barrel in April 2015 before crashing to less than $40 per barrel.
Source: Sivaram (2016).
Ironically, throughout this period of upheaval, solar power projects remained fundamentally attractive investments because falling costs made them even more economically competitive. But, by pursuing rapid growth, U.S. YieldCos managed to nullify this basic advantage of a portfolio of solar projects as being a safe haven from the volatile stock market. By relying on the growth-driven upward spiral, YieldCo sponsors baked rising share prices into the YieldCo business model. In doing so, they made the success of a YieldCo more dependent on whether the rest of the market was rising or falling. By one estimate, this additional risk added a hefty 2 percentage points to the cost of YieldCo equity, making it harder for them to raise low-cost capital.18
Sponsors also managed to convert another potential YieldCo strength into a weakness by exerting their control over YieldCo business decisions. In theory, YieldCos should be low-risk vehicles that own and operate existing projects, isolated from the higher risk that project developers assume. But some sponsors, such as SunEdison, forced their YieldCos to guarantee that they would purchase projects before they were complete, thus transferring the associated construction risk. Moreover, when times got tough for SunEdison, it tried to raid the cash holdings of its global YieldCo. When the YieldCo’s management protested, SunEdison overhauled the YieldCo’s board of directors. Magically, the new board immediately agreed to transfer $150 million to SunEdison.19 But by tying its YieldCos to its own volatile fortunes, SunEdison further swelled the risk of what should have been a boring, independent holding company.
Since the bubble burst, the share prices of surviving American YieldCos have become much more comparable to their European cousins, which have steadily maintained modest valuations. In particular, YieldCos in the United Kingdom have followed a much less ambitious model that could serve as a more stable vehicle for use around the world. U.K. YieldCos tend not to be affiliated with a particular sponsor, insulating them from external meddling. And they are designed to grow very modestly, in line with inflation, rather than to gobble up new projects to fuel share price and dividend growth. Finally, they rely less heavily on debt than their U.S. counterparts did, further reducing risk.
Not everything is perfect about these vehicles. In particular, U.K. YieldCos tend to have limited diversity in the projects that they own. Still, the general contours of the U.K. YieldCo—a modest holding company that offers a liquid investment opportunity in safe renewable energy assets—are promising. And the model is not confined just to the developed world. For example, in India, firms are looking to publicly list infrastructure investment trusts that could house solar projects, among other assets. Having learned from the U.S. YieldCo crash, Indian regulators are imposing rules that would prevent a single sponsor from exerting too much control over these vehicles.20
Some analysts have proposed taking a step further to create a YieldCo 2.0 that would solve all the problems of the initial U.S. version. The Climate Policy Initiative calls such a financial vehicle a “Clean Energy Investment Trust.” It would largely resemble a European YieldCo, but it would bundle together a much broader pool of renewable energy projects (probably across international borders and from multiple different developers) to build a diversified portfolio without reliance on a single sponsor. Deep-pocketed institutional investors would be involved from the earliest stages of forming this vehicle to ensure that it would have low management fees, would distribute all the revenues from the underlying projects back to investors, and would be forbidden from adding new projects and chasing growth.21
In the future, publicly traded vehicles (the moniker “YieldCo” may go out of fashion, but the underlying concept should endure) might raise cheap equity capital for a diverse range of solar assets, not just utility-scale solar farms. Although the first generation of such vehicles largely focused on raising equity capital for large-scale projects, the strategy of bundling assets into a holding company in which stock market investors can buy ownership stakes works just as well for smaller, distributed assets, such as rooftop solar. And if they proliferate, YieldCos may also specialize, each one catering to a different market niche.22
The bright side of the YieldCo 1.0 fiasco is that the solar industry has learned its lesson and is moving toward financial vehicles that could attract new investors without adding undesirable risks to the sector. And back in the United States, in addition to redesigning the YieldCo model, solar firms are redoubling their efforts to convince Congress to alter the tax code to make it legal for renewable energy projects to be housed within MLPs. They are also lobbying lawmakers to make it legal to include renewable energy projects in real estate investment trusts (REITs). Both of these moves would enable tried-and-true financial vehicles to be used to direct capital toward solar power.23
The solar industry is maturing after a tumultuous boom-and-bust cycle. As it contemplates revising its strategy to tap public markets for equity capital, it now appears to be on track to balance financial innovation with a lower risk appetite, which is promising. But what about debt capital? SunEdison found itself crushed under its mounting debt load. Can the broader solar industry avoid the perils of too much leverage while still using financial engineering to expand the available pool of capital?
Securitization Blanket
At first blush, it might be unsettling that the financial trick that some solar companies are using to attract cheaper debt capital is the same maneuver that helped cause the Great Recession. Investment banks used that trick, securitization, to bundle, slice, and dice subprime mortgage loans from around the country. They managed to hoodwink the ratings agencies into certifying that the resulting high-risk derivatives were low-risk, but no amount of financial engineering could take garbage in and spit anything but garbage out. When this reality became clear, the global economy collapsed.
But there is good reason to be optimistic that securitization won’t end in disaster when it comes to financing distributed solar installations on the roofs of homes and businesses. There’s nothing intrinsically wrong with securitization, which is a general term that just refers to pooling many assets together to create securities that investors can then buy and trade. In fact, the process of bundling together a diverse portfolio of loans is a tried-and-true way to reduce risk. By carefully vetting each of the underlying loans, one can be confident that they won’t all go bad at once.
Beginning in the 1970s, banks began to securitize mortgage loans, bundling them together to create mortgage-backed securities, which investors then could purchase. In subsequent decades, these securities gave rise to the more general category of asset-backed securities, which offer investors an opportunity to invest in everything from auto and student loans to Domino’s Pizza franchise royalties.
In the run-up to the financial crisis, Wall Street abused securitization by packaging subprime mortgage-backed securities together into an arcane entity known as a “collateralized debt obligation.” But since the crash, federal regulators have reined in these abuses, and asset-backed security markets are thriving again. Today, the U.S. mortgage-backed security market is worth about $9 trillion, and the asset-backed security market is worth $1.4 trillion. Attracting these enormous sums of capital has made it possible for Americans to engage in activities with an up-front cost they wouldn’t normally be able to afford. For example, only 14 percent of consumers bought cars outright in 2015. Instead, 55 percent took out an auto loan, and a further 31 percent drove off the lot without actually owning the car, thanks to an auto lease.24 Car companies finance loans and leases for consumers and then sell asset-backed securities on bond markets, freeing up capital to provide even more loans and leases. (Some analysts have warned, however, that rising subprime auto lending has inflated a dangerous auto asset-backed security bubble, waiting to pop.25)
The auto industry’s success in promoting car leases and loans could be a model for the solar industry—provided that it scrupulously avoids risky lending practices. Indeed, the two asset categories are comparably valued—in 2015, the average U.S. car sold for a little more than $30,000, and the average residential solar installation in California cost around $20,000.26,27 And as is true in the auto industry, both leases and loans play important roles in financing distributed solar installations. In 2016, roughly half of all residential solar in the United States was leased by companies that, like SolarCity (now part of Tesla), retained ownership over the installations; the other half was owned by customers, who typically took out loans to finance the up-front cost. As the cost of solar falls, customers are increasingly choosing to own, rather than lease, their solar systems; by 2019, two-thirds of new customers are projected to own their solar systems.28 But the capacity of solar providers to offer loans to customers is limited by their modest balance sheets.
That’s where securitization comes in. The stable cash flow from customers making monthly payments over multiple decades makes distributed solar investments a natural fit for institutional investors.29 If solar providers can sell securitized loans and leases to investors, they can expand rapidly to serve enormous untapped distributed solar markets. One meticulous 2015 study of buildings across the United States found that rooftop solar has the technical potential to power 40 percent of national electricity demand.30 That figure is an extreme upper bound, but it gives a sense of how much room rooftop solar has to grow from its present role supplying just a fraction of a percent of U.S. power. And as the cost of rooftop solar has fallen, the number of U.S. homes and businesses installing solar has risen, driving annual market growth of more than 40 percent from 2008 to 2014.31 Today, there is twice as much solar capacity on residential rooftops than on larger buildings.32 And substantial untapped potential remains, although growth has been limited by the availability of financing.
Outside of the United States, there is also tremendous potential to expand rooftop solar, both in the developed and developing world. In particular, India has set an aggressive target of 40 GW of rooftop solar by 2022. But there, too, limited access to finance remains the biggest barrier to rooftop solar growth.33
In the United States, securitization to raise debt capital to deploy distributed solar is gaining momentum. From 2013 to 2016, distributed solar providers, led by SolarCity, raised more than $1 billion by selling securities backed by residential solar assets on bond markets.34 In a securitization, a solar provider bundles a diverse portfolio of loans for rooftop solar installations into a special-purpose vehicle, which is a way to protect the loans even if the solar provider were to go bankrupt (figure 4.3). Then the provider issues securities to fixed-income investors, who receive interest payments funded by the cash flow from the underlying loans. And with the loans off the solar provider’s books, the provider is free to finance new solar installations.
How solar securitization works. (Note that the ratings of the securities on the right side are aspirational—through 2016, no solar securitization has resulted in the issuance of AA- or higher-rated bonds.)
As securitization grows in popularity, some companies, such as Mosaic Solar, are focusing exclusively on securitizing loans for solar installed by other providers.35 A good sign that investors are getting comfortable with securitization is the steady increase in the advance rate (the percentage of the value of the underlying loans that investors are willing to buy in the form of securities). Between 2013 and 2016, the advance rate for new solar securitizations climbed from 62 percent to 75 percent. At those levels, it is starting to approach the advance rates of over 90 percent for auto and mortgage securitizations, with which investors are intimately familiar.36
Moreover, an innovative approach, called “warehousing,” has emerged to fill the capital gap to get solar installations up and running in the first place so that securitization can then proceed. This strategy entails raising capital from investors and donors to fund several developers to construct a portfolio, or warehouse, of rooftop solar projects and sign contracts with customers to make monthly loan or lease payments. Once the warehouse is assembled, it can issue securities and pay back the warehouse investors. In 2014, Connecticut’s Green Bank helped finance such a warehouse, demonstrating the role that the public sector can play in mobilizing private finance. Now international development banks are looking to deploy the warehousing strategy in the developing world to raise the capital needed to build rooftop projects and make it possible to securitize them.37
Nevertheless, there are still obstacles to more widespread use of securitization as a way of financing distributed solar installations. As interest rates creep up in the United States, the yields on newly issued solar securities also have risen—from 4.8 percent to 6.25 percent between 2013 and 2016. This uptick makes it more expensive to raise capital, which might dampen the growth of distributed solar. Moreover, few companies have a large and diverse enough portfolio of solar assets to do their own securitization. Until smaller solar providers begin to pool their assets together and jointly securitize them, then, the market for these securities may remain small and illiquid, which is undesirable for prospective investors.
Regulatory changes could also slow the momentum behind securitization. In most U.S. states, owners of distributed solar power can send excess power that they don’t consume on site to the grid, canceling out some of the power that they consume from the grid at other times, like at night. The rule that allows this is called “net metering,” and utilities hate it. Because owners of solar power get to reduce their bills by the amount of energy, in kilowatt-hours, that they send to the grid, the utilities argue—correctly—that those consumers avoid paying for the construction and operation of the grid. Yet they still depend on that grid when their solar panels produce less power than they need.
In several states, utilities have lobbied furiously to amend net metering to reduce the rate at which excess solar power is compensated for or add charges to solar owners’ bills to cover the costs of the grid. In some places, such as Arizona, they have succeeded, dampening the growth of residential solar. If more states roll back net metering, consumers in those states would save less money on their monthly utility bills by installing solar power. That reduction might make it harder for them to make their monthly loan or lease payments, lowering the income that an asset-backed security might generate for investors. In this way, regulatory changes might reduce the appeal of new securitizations.
A final risk facing securitization is counterintuitive: the price of solar installations actually might be falling too fast. The price of a U.S. residential solar installation halved between 2009 and 2015, from $8 to $4 per watt.38 If this trend continues, customers may be unwilling to continue paying loan payments on an asset whose market value has plunged only a few years after it was installed.
Fortunately, the rise of big data may both enable securitization and prevent it from turning into a bubble that abruptly bursts. To drive down the risk of investing in portfolios of distributed solar projects, investors will need as much evidence as possible that the solar installations perform as expected over their full lifetimes and that customers reliably make their monthly loan or lease payments. Some firms are beginning to provide exactly this data. For example, kWh Analytics has built a database of several hundred thousand operating solar projects around the United States.39 It has then taken that database to major insurance firms, which have agreed to offer insurance against the solar systems producing less energy than expected.
The insurance firms are happy to participate, having seen reams of data confirming that solar projects do indeed produce as much electricity over a year as the models predict. Assured that the solar projects will work as intended, investors in securitized solar loans need only worry about solar owners defaulting on their loans—a risk that is straightforwardly quantified for home or auto loans and should not unnerve bond markets or ratings agencies.
As more data become available, investors will gain access to a wealth of evidence that enables them to correctly price the risk of solar securities without exaggerating that risk. Evidence is the best way to ensure that solar securitization grows through responsible investing rather than speculation. With more data, solar PV panels could transform from a niche product in need of specialty financing to a totally normal household accessory. One firm, Sunlight Financial, thinks that one day, it could be as easy to finance rooftop solar panels through a home equity line of credit as it is to buy furniture or renovate your bathroom.
I have been focusing on financing for rooftop solar PV projects, but such projects are not the most cost-effective way to deploy solar power or reduce greenhouse gas emissions. In the United States, the average cost of a utility-scale solar plant in 2016 was $1.06 per watt, whereas that of a residential solar project was $2.89 per watt (solar PV projects on commercial and industrial rooftops achieve some economies of scale and are therefore cheaper than residential rooftop projects).40 Some argue that rooftop solar power brings additional benefits to the grid, for example by reducing power losses over transmission lines when solar produces power near where it is used, or by avoiding the need to invest in expensive new grid infrastructure by lightening the load on the grid. These benefits are possible in theory, but in reality, rooftop solar is often more likely to increase rather than relieve strain on the grid. For example, one study of California determined that only if rooftop solar were located on a specific 10 percent of the grid could it help avoid costly grid infrastructure upgrades.41 More commonly, solar can overload equipment designed to deliver power from the grid to the consumer when a rooftop solar system feeds power back to the grid.42 This does not mean that distributed solar systems are necessarily uneconomical. Larger distributed systems—for example those mounted at ground-level in urban areas at the scale of a few megawatts—can enjoy economies of scale and feed their power directly to electrical substations that can handle the influx of power instead of overloading neighborhood circuitry.
Rooftop solar, however, often enjoys strong political support, partly because it tends to create more local jobs than larger solar project sizes. Taking consumer preferences and political realities into account, it is likely that rooftop solar will inevitably feature prominently in the total mix of solar capacity as the industry grows, regardless of the theoretically optimal mix. And that optimal mix could shift thanks to technology; future rooftop solar projects connected to the grid through smart inverters could, for example, provide greater benefits to the grid than rooftop solar currently provides.
Although utility-scale solar is already much cheaper than rooftop solar, the economics of utility-scale installations could improve even further with more debt financing. And just as for rooftop solar, the rise of data could unlock cheap debt capital for utility-scale solar as well. Utility-scale projects are large enough that companies are able to raise project financing without bundling many projects together. Still, the winning strategy should look similar for utility-scale solar plants as for distributed solar projects: convince investors that the risk of a solar project is low in order to obtain low-cost loans. If insurance companies are willing to insure the power production from a large solar installation that is contracted to sell its power to a credible offtaker (a customer for the electricity unlikely to renege on the contract, such as a utility that will transmit solar power to homes and businesses), then potential investors can have high confidence that the project’s cash flows will cover interest payments on the debt.
This scenario is analogous to how the electric power industry derisks natural gas power plants to raise cheap debt finance. Firms will purchase financial hedges to lock in the long-term cost of input fuel and the price of output electricity, which is basically taking out an insurance policy that the plant will make as much profit as expected.43 That insurance allows the firm building the plant to raise cheap debt capital from investors who are satisfied that the project has a low risk.
Beyond enabling such derisking insurance, data could reduce the cost of debt capital for a diverse set of projects, from rooftop to utility-scale solar.44 With good enough data on how much revenue a project in a certain region will earn, a firm might even be able to raise debt capital based on a promise to build a solar farm on a parcel of land, similar to how the oil and gas industry can raise capital to drill wells by convincing investors of the value of their reserves.45 Down the road, the next step is to expand high-quality data collection to developing countries, where skittish investors need hard data to get comfortable with plowing their capital into markets having both high growth potential and high perceived risks.
Searching for a Supermajor
On the table in front of me lay nearly four sumptuous dumplings—nearly four because I’d managed to steal a bite of only one. Between my clumsy grasp on the chopsticks and the torrent of questions that I was trying to answer, I didn’t have much chance to dig into the meal. I was ensconced in a luxuriously wood-paneled dining room of the historic Hong Kong Gentlemen’s Club, where the executive team of China Light and Power (CLP) was grilling me about the current state of solar power markets around the world in 2016 and their prospects for the future. My answers could influence the company’s solar expansion plans. The mouthwatering dumplings were going to have to wait.
CLP, one of the biggest electric power businesses in Asia, with operations in several countries, traditionally has owned power plants that run on fossil fuels, mostly coal. But as the CEO, Richard Lancaster, was fervently arguing from across the table, times were changing thanks to the falling cost of renewable energy and policy breakthroughs like the Paris Agreement on climate change. In 2007, CLP made a pioneering pledge to cut its carbon intensity (i.e., the carbon emissions per unit of generated power) by 75 percent by 2050. That’s probably the most ambitious target of any major power company in the world. To meet it, CLP is aggressively deploying renewable energy in China, India, and other markets, while divesting some of its fossil plants.46 Although most of its renewable investments have been in wind power, the plummeting cost of solar had caught CLP’s attention. Hence its interest in understanding burgeoning solar markets across Asia, and my growling stomach.
Companies with CLP’s size and reach could be as crucial to the future of solar power as the deep-pocketed investors that solar will need to attract. CLP owns more than $25 billion worth of power plants, but only 16 percent of them are renewable generators.47 Such companies have an enormous balance sheet and appetite to transform their holdings in the coming years. Crucially, they are willing to take risks to develop projects that, once constructed, turn into ripe investment opportunities where institutional investors can park their money.
This process happens all the time in the oil and gas industry. In that sector, supermajors with big balance sheets are able to make big bets on large infrastructure projects. Because their balance sheets comprise debt and equity from the world’s biggest investors, the supermajors are in effect acting as conduits for that capital, directing it to fuel the industry’s growth.48
SunEdison grew so fast, and took on so much debt, because it was trying to replicate this strategy. Ultimately, its demise was a reminder that the company was a long way off from achieving the necessary scale to really act as a supermajor. Perhaps another pure-play solar company will adopt a more measured growth strategy and gradually fill that role a decade or more in the future. But right now, large electric power companies looking to diversify from fossil fuels are the best-positioned entities to transform their business models and don the mantle of solar supermajors.
Actually, this view applies only to some firms in the electric power sector. Electric power companies come in two major flavors, a result of a push for deregulation around the world. For much of the twentieth century, there was largely only one type: the vertically integrated utility. These utilities owned both power plants and the transmission lines and distribution infrastructure to deliver power to their customers, and they enjoyed a monopoly over a limited service territory to sell their power. Then, around the turn of the century, markets across North America and Europe started to deregulate—that is, they no longer awarded a monopoly to a single utility over all power-related activities. This deregulation led to a restructuring of the industry. State-regulated utilities still retained monopolies to own and operate the power grid in their service territory. But competitive markets sprang up, in which private companies that owned power plants would sell their power, and regulated utilities would buy it. These two types of firms—regulated utilities that have a monopoly over the power grid in a limited area and unregulated companies that own power plants, often in multiple countries—are responding to the rise of solar in very different ways.
The regulated utilities are unlikely to become solar supermajors. Their opinion of utility-scale solar tends to be blandly positive because they can buy cheap electricity from solar farms (although state mandates might require them to buy more than they know what to do with). They reserve their strongest opinions for distributed solar, which they tend to view with suspicion and sometimes fear.
Regulated utilities in the United States are the ones that are lobbying to roll back net metering. One of their fears is the so-called death spiral, in which customers install rooftop solar, reduce their bills, and cause nonsolar customer bills to rise to cover the costs of the grid. This rise, in turn, makes solar a more attractive proposition than buying electricity from the grid, leading to even more customers reducing their bills and raising the bills of the remaining, dwindling pool. The prospect of fewer and fewer customers buying electricity that flows through the grid makes utilities that own the grid view solar as a competitive threat.
In addition to distributed solar, a new trend called “community solar” appears threatening to utilities. In community solar, consumers can band together to collectively own or lease a larger-scale solar installation. In many U.S. states, consumers then can use net metering to offset their power purchases from the grid with power generated by the community solar project. But the economics of a large-scale solar project are often much better than those of a small rooftop installation. So net metering provides extremely generous compensation for community solar consumers, slashing their electricity bills and accelerating the death spiral. Indeed, community solar has shot up, accounting for nearly 5 percent of annual U.S. solar installations in 2017 from next to nothing in 2015.49
With their attention focused on stopping distributed solar from eating into their customer base, regulated utilities are making only limited inroads into becoming players in the growing solar industry. And, utilities that might be interested in making the leap will have a hard time doing so. In deregulated states with competitive wholesale power markets, regulated utilities are not allowed to develop and own large solar power projects that sell power into the wholesale market. Instead, regulated utilities have tended to sign power purchase agreements with developers of large solar projects, often to meet obligations under state renewable energy mandates. Moreover, it is tricky for regulated utilities to market and install distributed solar because they might run afoul of antitrust laws owing to their monopoly status within their service territory.50
Still, there are some models for regulated utilities to pursue business model innovation and capture some of the value in the growing solar market. For example, utilities have reams of data on the customers in their service territory, whereas acquiring customers is an increasing component of the costs that distributed solar providers face.51 By partnering with solar providers and taking a cut of their sales, utilities can make money even as more customers install distributed solar.52 They can even make it easier for customers to pay for clean energy upgrades, such as solar panels or energy-efficient home retrofits, in installments as part of their monthly electric bill.53
In contrast to their regulated cousins, unregulated power companies are eagerly expanding into solar. In the United States, regulated utilities are often subsidiaries of holding companies who own other, unregulated subsidiaries that are free to build power plants and sell power into competitive markets. Many of these unregulated counterparts of regulated utilities—such as Duke Energy Renewables, Southern Power, Berkshire Hathaway Energy Renewables, and NextEra Energy Resources—are investing heavily in solar power. In fact, through 2016, half of all utility-scale solar projects in the United States were owned by unregulated subsidiaries of utility holding companies, and analysts forecast that they will further increase their share of the U.S. solar market.54 Many of these companies have historically owned fossil fuel generators, but they are now piling into the cheapest power-generation source in the United States—solar power.
Similar trends are occurring abroad. Companies that have historically owned conventional power plants are driving a boom in solar investment. Enel, formerly Italy’s national utility, which has expanded into a global powerhouse since Italy deregulated its power sector, bid aggressively to develop solar projects across Latin America at record low prices.55 But it is Chinese firms—for instance, CLP in Hong Kong and China Three Gorges Corporation on the mainland—that dominate investments in solar around the world.56 All these power companies have enormous balance sheets, which they are starting to use as a conduit to channel investment toward solar power.
Although electric power companies looking to diversify from fossil fuels are the most likely candidates for solar supermajors, they are not the only corporate players tempted by solar power. A recent entrant to the industry, the Japanese technology giant Softbank, has made an enormous bet on solar power. Led by Japan’s richest man, Masayoshi Son, Softbank leaped into solar after Japan’s Fukushima disaster, developing 500 MW of solar in the country and then pledging $20 billion to invest in India. In late 2015, I sat down in New Delhi with the CEO of Softbank’s energy subsidiary, Raman Nanda, a tall, charismatic, Oxford-educated McKinsey veteran. I remember wondering to myself whether his blue-chip pedigree might hinder him from succeeding in the rough-and-tumble atmosphere of India’s business world. He soon dispelled my doubts. The next day, when I arrived for a meeting in the energy ministry, I ran into Raman, who was making the rounds before bidding in a major government auction. A few days later, Softbank won a major contract to build a utility-scale PV project in the Indian state of Andhra Pradesh. Within a year, Raman triumphantly sent me a Google Earth satellite photo of three adjacent project sites. Two were barren—waiting to be built on by slow-moving local firms—but Softbank’s site already brimmed with 350 MW of installed solar panels.
Aside from Softbank, other global technology companies have entered the renewable energy business. As of 2016, Apple, Google, and Amazon had all created energy subsidiaries and were aggressively investing in powering their data centers with wind and solar power to reduce exposure to volatile and rising electricity costs.57 Outside the tech world, MGM Resorts, which owns much of the Las Vegas strip, defected from NV Energy, the regulated utility owned by Warren Buffett. MGM plans to double its consumption of renewable energy now that it can go out and arrange its own power contracts for fifteen casinos that are no longer captive utility customers.58 That trend could accelerate—three-quarters of the Fortune 100 companies have set renewable energy or sustainability targets. And corporations accounted for over one-fifth of renewable energy added to the U.S. grid in 2015, up from virtually none in 2012.59
Rising corporate interest could add another headache for regulated utilities, which are already distraught over losing residential customers to distributed solar and could now face an exodus of corporate consumers to utility-scale solar. Indeed, it is ironic that regulated utilities are a lonely category of firms that are not cashing in on the solar boom. Aside from them, a remarkably diverse assortment of corporations is investing in solar. Comprising unregulated power companies, tech titans, retailers like Walmart, and industrial giants like Dow Chemical, this myriad of firms may actually represent a new model to power the growth of solar, making the supermajor model that worked so well for oil and gas obsolete. That a wave of corporations is willing to alter their business models to invest in solar is a promising sign for the industry’s future.
Public-Sector Training Wheels
To date, governments and international institutions have played important roles in directing capital toward solar power. Many argue that the public sector will continue to be integral, as the solar industry seeks new sources of capital from new investors and firms to fuel its continued growth. Indeed, public entities at a range of levels, from municipal governments to international development banks, have already unveiled innovative financial tools to mobilize private funding. Although public dollars are scarce, they can unlock much more private capital if deployed intelligently. So in the near term, the public sector could play a substantial role in attracting new private capital. But in the longer term, beyond five to ten years, the public sector will have been successful if it makes itself obsolete. A truly successful solar industry will continue to grow entirely through private capital flows and efficient markets.
The public sector has its work cut out for it on this score. It has provided roughly 15 percent of all funding to date for renewable energy. Given the vast amounts of capital needed to finance the growth of solar into a mainstream energy source, the proportion of public funding will certainly not increase. More likely, in fact, it will have to decrease under the constraints of public budgets. So, somehow, the public sector will need to do more with less, mobilizing more private capital with proportionally less public funding.
That is a tall order. McKinsey estimates that globally, there is a $1.5 trillion annual gap between current spending and the spending required to build the power-sector infrastructure needed to rapidly reduce greenhouse gas emissions. Most of that gap is in emerging economies.60 But at the same time, because institutional investors are hungry for stable, long-term cash-flow, the Organisation for Economic Co-operation and Development (OECD) estimates that pension funds and insurance companies could invest $2.8 trillion per year in clean energy (see figure 4.4).61 And a growing share of the investment community is motivated by sustainability mandates. In other words, investors are just waiting to be matched with the right projects and to get comfortable with investing in solar. The public sector’s role is just to provide the training wheels for the private sector to ultimately drive solar’s growth all by itself in the future.
Required investment levels in solar power to limit climate change. The top chart plots levels of investment in solar energy under a business-as-usual (BAU) scenario and compares those levels with higher ones needed through 2040 to keep the world on track to limit global warming to 2°C. The bottom chart provides a viable breakdown of these required investment levels by source. Currently, private bank loans and direct equity investments by, for example, private equity funds are the most common sources of capital. But in the future, new sources of debt and equity capital will be needed. Raising corporate balance sheet debt and asset-backed securitization are ways to direct debt capital from public debt markets toward utility-scale and distributed solar projects. Equity capital can come from vehicles like YieldCos that enable investors to buy shares of a portfolio of renewable energy projects on public stock markets. Finally, although deep-pocketed institutional investors invest most of their capital in public markets, they also have substantial capacity to provide both debt and equity capital directly, through direct loans and ownership stakes in projects.
Source: Bloomberg New Energy Finance (2016).
Multilateral development banks (MDBs) have led the way to date, and they still have some tricks up their sleeves. MDBs like the World Bank are most effective when they reduce the risk that investors face when investing in solar projects. One tool that they can use is to provide loan guarantees, which reduce the concern that a private investor might have about being paid back for supplying a loan to build a solar project. Guarantees can take various forms. One type protects against political risks such as government expropriation of assets. Another guards against offtaker risk, making a lender whole if a solar project goes insolvent because its customer (for example, a utility) reneges on a contract to purchase solar power. Although MDB guarantees are common, only 4 percent of them are used to help finance renewable energy. Of that, the majority goes to hydropower projects, and just 7 percent goes to solar, so there is plenty of room for MDBs to expand their use of guarantees to encourage more solar investment.62
An MDB can also crowd in private investment through a strategy known as “loan syndication,” in which the bank leads a coalition of investors to finance a solar project. These investors might have been too wary of investing by themselves, but they are happy to do so with the security that many other investors, led by an MDB that conducts most of the due diligence, are jointly undertaking the risk with them. For example, in Jordan, the International Finance Corporation (IFC), an arm of the World Bank Group, brought together a consortium of banks in 2014 to provide more than $200 million in loans to seven solar projects.63 Going forward, both loan syndication and guarantees are promising and inexpensive approaches for MDBs to ease new institutional investors into financing solar, especially in emerging markets.
In addition to MDBs, governments around the world are rolling out innovative ways to crowd in private funding for clean energy. For example, the New York Green Bank offers loans at market rates to solar projects that make economic sense but aren’t yet considered mainstream enough for private banks to fund.
One strategy that MDBs devised but that governments soon adopted is to issue “green bonds.”64 In essence, these are just like normal bonds that investors can buy and trade, but their proceeds must be used for sustainable projects. Governments at every level—national, state/provincial, and municipal—now regularly issue these bonds to raise funding at low cost that can be used for clean energy projects. Green bonds are a good example of how the public sector can catalyze private activity that soon becomes self-sustaining. Now utilities, corporations, and banks are all issuing green bonds. In 2016, green bonds worth over $100 billion were issued and certified to meet a set of principles created by large banks that allow the bonds to be labeled “green.” In addition, unlabeled bonds worth nearly $600 billion that mostly financed sustainability projects were issued.65
In the developing world in particular, the public sector will need to provide incentives or guarantees to embolden private investors who are often unfamiliar with emerging markets and wary of the heightened risks. But developing countries’ governments may be strapped for cash. The incentives that they do choose must be extremely efficient at mobilizing many private dollars for every dollar of public finance.
India provides a good example of this imperative, requiring massive infusions of capital to meet its solar goals. To encourage domestic investors to provide loans at decent terms, the Indian government can scale up its use of partial credit guarantees, which reduce a local bank’s exposure to default.66 To attract foreign investors, the government has announced plans to roll out a currency-hedging facility. Currency risk spooks foreign investors who do not want the solar projects they have financed to become less valuable in, for example, U.S. dollars. This risk can add up to seven percentage points to the minimum rate of return that investors will tolerate, preventing them from investing in otherwise attractive solar projects.67 But by offering to share some of the currency risk with foreign investors, the government could increase the number of projects that make business sense for those investors to fund.
Other risks that chill the investment climate relate to India’s dysfunctional energy sector. Its electricity utilities are in bad financial shape, raising fears that they might renege on contracts to purchase power from solar projects. They also have failed to invest in upgrading the grid, which might not be able to handle an influx of solar power. If the Indian government could successfully reform the energy sector, possibly deregulating its utilities as much of the developed world has, it would substantially reduce the risks facing investors in solar projects.
Those sorts of structural economic reforms, which can enable solar power projects to be profitable even without incentives, should be the first priority of governments across the developing world. Indeed, the appropriate role for the public sector is to provide training wheels for private investors in solar, not to create dependence on a public crutch.
The decade ahead is a crucial one for the solar industry. To fund its rise as a mainstream energy contender, the industry will need to tap into the largest capital pools in the world. It will take financial engineering to coax institutional investors to trust solar with their capital, and the public sector may have to provide training wheels for a limited period. But already the capital has started flowing, and major corporations have begun to act as conduits to direct that capital toward solar projects around the world. So, despite the massive scale of the need for investment in solar power over the coming decades—on the order of trillions of dollars—there is good reason to be optimistic that financial and business model innovation will rise to the challenge.