Photo Credit: thelightningman.com
On March 31, 2016, GTM ran an article by David Burton titled "Navigant Consulting’s Report on Residential Solar Misconstrues Value of Tax Attributes." The Navigant report critiqued by Mr. Burton was submitted as testimony in the UNS Electric rate case by my company, Arizona Public Service (APS).
Mr. Burton’s criticisms warrant a response, since his comments appear to be intended to undermine the validity of the Navigant report. However, first it is helpful to go over the key findings of the report -- particularly since Mr. Burton only mentioned them in passing.
Navigant’s report provides an analysis of project returns for solar third-party-owned (TPO) providers -- solar leasing companies such as SolarCity, Sunrun, and Vivint Solar -- and their project investors in utility service territories across Arizona and California. Navigant “calculated total project return independent of the breakdown of possible recipients of the project return (i.e., whether an equity investor, a tax equity investor, or the third-party provider itself is the recipient of the project return on invested capital).”
Navigant’s analysis concluded that TPO solar providers and their project investors can adjust to some proposed changes in utility rate structures, while maintaining acceptable project returns.
Navigant’s report lists the following key findings:
- Solar TPO providers elect to operate where they can maximize their return by undercutting utility rates.
- Solar TPO providers track utility rates and price accordingly, as evidenced by higher observed lease/PPA prices in jurisdictions with higher utility rates. These higher lease/PPA prices cannot be fully accounted for by variations in system cost, solar production, and tax rates.
- Project returns for solar TPO providers and their project investors vary by utility service territory, with higher project returns calculated in service territories having higher utility rates.
- Federal incentives such as the Investment Tax Credit (ITC), accelerated depreciation, and bonus depreciation have a significant impact on project return. Returns are also amplified considerably by the solar TPO provider’s ability to use a system fair market value (FMV) rather than system cost when claiming the federal incentives.
- Despite continuing declines in solar system costs and favorable policy decisions, such as the reintroduction of bonus depreciation and an extension of the ITC, lease/PPA rates have recently increased in certain locations, consistent with public disclosures from leading solar players and indicating higher project returns for solar TPO providers and their project investors.
As noted in Navigant’s report, these key findings are largely consistent with statements and disclosures made by major solar TPO providers to investors and should be noncontroversial. Instead of addressing the report’s key findings or final conclusions, Mr. Burton elects to criticize three inputs and assumptions used by Navigant in its analysis. Below, I comment on each of his assertions, showing that Mr. Burton has fallen short in his intent to undermine the soundness of Navigant’s analysis or the validity of their report’s key findings and conclusions.
Use of “fair market value” to pad returns of solar companies
Mr. Burton questions Navigant’s assumed markup of the fair market value (FMV) reported by solar TPO providers for federal tax purposes when modeling project returns for solar TPO providers and their project investment partners. He goes on to write that a “tax dynamic that Navigant’s report appears to have misunderstood is the degree to which ‘fair market value' is used to determine the purchase price to the tax equity investment vehicle and accordingly that the tax attributes may exceed the cost to build the system.” This is a curious criticism coming from a solar finance and tax expert. Let’s discuss why.
First of all, it’s important to remember that the major solar TPO providers (SolarCity, Sunrun, and Vivint Solar) all state in their SEC filings that they report the FMV rather than the actual capital expenditures of the solar system when claiming the federal tax incentives -- both the 30 percent ITC and depreciation. The FMV reported for tax purpose is considerably higher than the actual capital expenditure, allowing solar TPO providers and their project investors to increase the value of the federal tax incentives.
Knowing that the FMV markup is a crucial cog in the solar TPO business model and would have a large impact on the project return analysis, Navigant simply assumed a conservative 35 percent markup over the all-in system cost. This meant that a solar TPO provider would incur costs of $2.76 to $2.77 per watt-DC to market and install a residential system in Arizona, but report an FMV of $3.73 to $3.74 per watt-DC for federal tax purposes. Navigant cited several sources as evidence why the FMV markup assumption could have been much higher, referencing an FMV range of $4.20 to $4.75 per watt-DC.
Even so, Mr. Burton appears to suggest that Navigant’s 35 percent markup is unreasonably high, given that the U.S. Department of Treasury issued guidance saying that only markups of 10 to 20 percent are appropriate. If Mr. Burton thinks the renewable energy analysts cited by Navigant have overstated the FMV reported by solar TPO providers, let’s look at what SolarCity has recently disclosed itself. In July 2015, the Kroll Bond Ratings Agency stated in the presale report for SolarCity’s fourth securitization that SolarCity disclosed an FMV of $5.03/W for projects being securitized. The residential projects underlying the securitization were largely built in the second half of 2014, a time when SolarCity reported an all-in installation cost of $2.86/W to investors on earnings calls. This computes to a 75.87 percent markup over the all-in cost to install -- well above the 10 to 20 percent markup deemed appropriate by Treasury.
Mr. Burton goes on to ask a couple of important questions -- “Is the (Navigant) report suggesting that solar companies are doubling the markup provided for in the Treasury’s memo? If so, how are tax equity investors and the solar companies’ accountants accepting that?” As illustrated above, the answer to the first question appears to be yes.
As for the second question, the Navigant report does not address why tax equity investors and solar companies’ accountants would accept the risks associated with FMV markups multiples above those allowed by Treasury. One hypothesis as to why tax equity investors are accepting the practice is through the use of tax indemnity agreements that are prevalent throughout the residential TPO solar industry. These agreements have rated insurers insure a significant part of any tax indemnity liability resulting from an IRS audit, in some reported cases up to 35 percent of any liability. The following risk factor disclosure included in the SEC filings of the largest TPO solar providers, SolarCity and Sunrun, reinforces this point.
The Inspector General and the Civil Division of the U.S. Department of Justice are investigating the administration and implementation of the U.S Treasury grant program, including possible misrepresentations concerning the fair market value of the solar energy systems submitted by the Company in U.S. Treasury grant applications. If the Inspector General concludes that misrepresentations were made, the U.S. Department of Justice could decide to bring a civil action to recover amounts it believes were improperly paid to the Company. If the U.S. Department of Justice is successful in asserting this action, the Company could then be required to pay material damages and penalties for any funds received based on such misrepresentations, which, in turn, could require the Company to make indemnity payments to certain fund investors. The Company is unable to estimate the possible loss, if any, associated with this ongoing investigation.
Omission of meaningful details regarding the report’s assumed overhead and marketing costs incurred by solar companies
Mr. Burton questions whether Navigant properly accounted for overhead and marketing costs incurred by solar TPO companies when determining the total costs for solar systems. He intimates that the system installation costs used were too low. Again, this is a curious angle of criticism given the high level of expertise that Navigant brings to the table on solar markets and cost analysis.
Navigant estimated all-in costs for a residential solar system installed in Arizona in 2016 at $2.76-$2.77 per watt-DC. In a response to a data request from The Alliance for Solar Choice (TASC), Navigant stated the following:
Navigant used a wide variety of reputable industry sources to build and benchmark its bottom-up PV system cost estimates. While various sources may allocate costs to different categories, the total installed system cost estimates used in Navigant’s analysis are consistent with reported costs by company public disclosures, third-party estimates, and government agencies. Such sources included estimates from leading industry players, third-parties, industry associations, and government agencies as well as dialogues and interviews with solar industry collaborators.
Mr. Burton questions whether Navigant fully accounted for the overhead and marketing costs incurred by TPO solar companies because they did not have a cost component labeled “marketing” or “sales” or “door-to-door sales guy." As indicated above, Navigant did account for those costs, but they were accounted for under different cost categories.
Whichever way the cost components are sliced, what matters in the end is that the all-in installation costs used in Navigant’s analysis accurately reflects 2016 costs for a TPO solar provider. SolarCity told investors on its Q4 2015 earnings call that its costs were $2.71 per watt, inclusive of marketing and G&A, matching well with Navigant’s assumption of $2.76 per watt. Navigant’s cost assumptions also match well with residential solar installation costs reported by IHS Energy and Bloomberg New Energy Finance.
The real-world economic value of bonus depreciation
Mr. Burton also contends that Navigant “misconstrued the real-world economic value of bonus depreciation.” He goes on to state that “tax equity investors are in fact quite reluctant to monetize bonus depreciation.”
Recent statements from SolarCity, the largest solar TPO provider, seem to undermine Mr. Burton’s assertion that Navigant misconstrued the value of bonus depreciation. On a panel discussion in March 2016, Albert Luu of SolarCity told Keith Martin of Chadbourne and Parke that SolarCity and its project investors have taken the value of bonus depreciation in the past and are expecting to do so in the future. Here is the exchange:
Mr. Martin: Albert Luu, has SolarCity managed to get anybody to use the depreciation bonus?
Mr. Luu: We have had a few tax equity investors take bonus depreciation. We continue to have those discussions. Our focus is on reaching the flip so that the assets return to SolarCity as early as possible. We have some tax capacity ourselves, so we would like to take bonus depreciation even if the tax equity investor will not do so.
We don’t disagree that certain deal structures can make the use of bonus depreciation by a tax equity investor difficult. However, the actual claiming of bonus depreciation is a mixed bag -- dependent upon the tax appetite of both the tax equity investor and the project sponsor. In the end, as SolarCity’s Mr. Luu indicated, it is highly unlikely that both solar TPO providers and their project investors will elect to leave the additional value derived from bonus depreciation on the table.
Navigant’s key findings and conclusions remain valid
As illustrated above, Mr. Burton’s criticisms of Navigant’s report fall flat and Navigant’s key findings remain valid. The extension of key federal tax provisions, continued decline in installation costs, and increases in lease/PPA prices are expected to continue to boost project returns for the large solar TPO providers moving forward. This is consistent with recent statements by solar TPO providers such as Sunrun, whose CEO told Bloomberg Business in March 2016 that the solar TPO industry was seeing margins increasing because installation costs were coming down and that companies would be able to raise prices to follow utility rate increases. Such statements bolster Navigant’s conclusion that solar TPO providers and their project investors can reduce lease/PPA rates and adjust to some changes in utility rate structures, while maintaining project returns they have been previously willing to accept.