It’s late in the fourth quarter. The Golden State Warriors, pride of the Bay Area, are down by two. Draymond Green rebounds the ball and passes to three-point savant Steph Curry -- arguably the greatest shooter on the planet. What could go wrong?
The shot hits the front iron, falling to the floor as time expires. The Warriors lose.
It’s a classic example of the “hot-hand fallacy,” which is the tendency to believe that past achievements increase the probability of success in future attempts. I worry that a potential hot-hand fallacy is taking shape among the solar intelligentsia: a misguided belief that the industry’s achievements in recent years point to unabated growth in the future regardless of actions by Donald Trump, Republicans in Congress, or even changing market dynamics.
That’s not to say that solar’s success in recent years was random -- it took a lot of hard work and innovation. Nor does it necessarily mean that solar’s winning streak won’t continue. But assumptions being made today about future growth are based on historical trends that may no longer have predictive value. It is a trap of hubris that is dangerous for the solar industry.
For solar in the U.S., there are poorly understood risks everywhere. Obvious among them is the policy risk to the tax equity market, either through a reduction in the pool of available tax equity via lower corporate tax rates or simply an outright repeal of the solar Investment Tax Credit (ITC). Even staff changes at the Treasury Department have the potential to adversely impact the ITC’s value to asset owners.
There are macro-level issues beyond tax policy that could have even greater impact on solar. Though they may seem unlikely to come to fruition, if 2016 taught us anything, it is that seemingly improbable events can and do occur. For instance, what would be the impact on solar if Trump imposes a 45 percent tariff on Chinese imports, as he has proposed? Probably unlikely, but possible. The ramifications for not only solar, but the entire economy, are difficult to fathom.
The most likely exogenous policy outcome may be the one that could have the biggest impact on solar: continued increases in the federal funds rate by the Federal Open Market Committee. The market is pricing in multiple Fed rate increases for 2017, possibly pushing rates above 1 percent for the first time since October 2008. It is not coincidental that this was the same month that Congress extended the ITC for eight years.
It is easy to overlook the degree to which low interest rates have been a boon for project developers. The ITC gets most of the credit for solar’s incredible growth. But if the ITC has been the primary mechanism by which equity flowed into project finance transactions, zero-bound interest rates facilitated the accompanying debt at cost-effective terms.
Indeed, virtually all of the solar installed in the United States was done so under a 30 percent uncapped ITC and near-zero percent interest rates. The impact of higher rates on solar’s growth trajectory are not exactly clear, but one thing is certain: Project developers will face higher-cost borrowing as lenders look to maintain their margin above the risk-free rate.
Counterintuitively, the best way to respond to higher-priced debt is to find ways to deploy more of it in solar project finance transactions. That is because debt is invariably less expensive than equity, and loans typically only account for roughly 35 percent of solar project capital costs. Applying more debt would squeeze out higher-priced equity, resulting in a lower blended cost of capital.
In fact, our modeling shows that increasing debt in project finance transactions to cover half of capital costs could increase equity yields by 150 basis points.
However, the challenge of convincing banks to increase the size of loans reveals an inherent shortcoming of debt -- it is a fundamentally blunt financial instrument. Lenders have appetite for solar investments, but loans are carefully structured to avoid even the smallest risk of default. Consequently, lenders size deals to the asset’s downside and assign overly conservative terms on loans. This results in ineffective pricing of risk. What financial tools are available to break this conservative lending paradigm and enable banks to extend more debt?
The most obvious answer is external credit enhancements, such as surety bonds or new insurance products. External credit enhancements typically involve transferring risk to a third-party offtaker with a balance sheet capable of absorbing said risk. As a nascent market with a limited track record to assess risk, these enhancements were previously cost-prohibitive or altogether unavailable for solar project financiers.
But the solar market has reached a level of maturity and sophistication that finally unlocks these instruments and can help open the door to new sources of capital. As project performance data continues to become more widely available through new risk management platforms and big-data analytics, the ability to accurately quantify risk engenders confidence in the financial markets that solar is a safe investment.
The global insurance market is a particularly prime venue for solar financiers to increase their creditworthiness. As a means to effectively price risk, insurance is a more preferable source of capital compared with debt. The key differentiator is the willingness of insurance firms to take some losses, which is why insurers are historically best positioned to accurately price low-probability risks. Solar’s variability risk is much more efficiently priced in hedging products than in loans.
To be sure, insurers have significant market challenges of their own. While a zero-bound interest rate environment helped facilitate solar’s growth, it has hindered the ability of insurance firms to meet target yields through investment of their cash balances. This dearth of investment opportunities has led to intense competition for customers in new risk categories, squeezing profits across the board. The insurance industry is hungry for new premium revenues, and solar assets represent a potentially massive market -- the solar asset class today is valued at half a trillion dollars. Insuring the production of these assets would limit the bank’s exposure to repayment risk, thereby allowing lenders to safely increase debt levels in project capital stacks.
Not every industry can be a metaphorical Steph Curry. Solar, like many other sectors of the economy, seems to be underestimating the market risk that our new political reality presents. It would be a mistake to believe and act as if solar is above the fray. Taking action now can prepare solar firms for the market uncertainty ahead.
For solar to truly become unassailable, the industry will need to tap into larger and more cost-effective sources of capital. Exploring new opportunities for credit enhancements is one way to help ensure that project finance transactions receive debt terms consistent with the actual risk presented by solar assets. These new financial tools for de-risking projects are the best way to ensure solar’s “hot hand” continues.
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Richard Matsui is founder and CEO of kWh Analytics, a big-data analytics firm aggregating PV performance data to underwrite new insurance policies for solar asset owners.