The Business Model in Transition
David Crane, president and CEO of NRG Energy, said provocatively in the spring that people will soon be buying the equipment they need to generate their own electricity at Home Depot. He suggested in view of this that it is not a good long-term business strategy to be putting money into electric distribution companies or into building new central station power plants. Is he right?
Chadbourne hosted a lively debate on the topic in late June. The debaters are Neil Auerbach, CEO and managing partner of private equity fund Hudson Clean Energy Partners, and Ben Cook, vice president of structured finance of SolarCity, taking David Crane’s side, and Larry Kellerman, CEO of Quantum Utility Generation, and Michael Storch, executive vice president and chief commercial officer of Enel North America, arguing that Crane is wrong. (Auerbach and Kellerman were former partners at Goldman Sachs.)
An audience vote before the debate showed 36% of the audience agreed with Crane and 64% disagreed. The moderator is Kenneth Hansen with Chadbourne in Washington.
MR. HANSEN: Neil Auerbach, you have five minutes to speak in favor of the proposition.
MR. AUERBACH: I am sure that for many of you, David Crane’s statement is a bit farfetched. So why is he saying it, and why am I willing to come here with firm conviction to argue that he is correct?
Nearly a decade ago, I made my first solar investment into SunEdison. At the time, SunEdison was selling solar photovoltaic systems to commercial and industrial customers for around $12 a watt. First Solar was selling its innovative thin film modules for more than $4 a watt. Today, First Solar produces modules at a cost of around $0.50 a watt, and SunEdison can install solar systems at a sales price of as low as $1.50 a watt for some of its largest power plants.
For years, we have heard naysayers in this country and elsewhere around the world criticize the solar industry as a massive subsidy sink in a technology that can never compete with fossil fuel-based power generation. If you wanted to heap scorn on the industry, then all you had to do was say one word: Solyndra.
Today, most industry watchers are singing a different tune. By next year, solar PV will be the number one technology choice for new power generation installed around the world. As the industry continues to scale, costs will keep coming down as a highly competitive industry continues to sharpen its collective pencil on every item of cost.
Today the biggest components of cost for residential solar systems are the balance of plant, installation costs, and soft costs such as financing and customer acquisition costs. In the US residential solar markets, the average solar system costs around $4.70 a watt, resulting in a delivered cost to power for retail customers in California of around $0.14 a kilowatt hour and around $0.16 for retail customers in the Northeast. Retail customers pay on average a little more for their power in both places when they buy it from their local power company.
The availability of easy financing from companies such as SolarCity, Sunrun and others has led to an unprecedented boom in the installation of solar PV systems around the country. This year, more than 1,500 megawatts of residential PV systems will be installed in the United States, and that figure is going to increase by 40% to 50% a year over the next several years. And that is all beginning to happen in a market with close to zero demand growth for power.
So where does Home Depot fit in all of this?
The answer is cost. The next frontier in reducing the cost of solar PV for homeowners is outside the module. It is hardware and soft costs such as installation, permitting, financing and customer acquisition. And that is where Home Depot comes in. Home Depot is a metaphor for how the industry is going to cut the cost of finding customers and getting the PV systems on the roof cheaply. In order to get the cost of solar PV to continue coming down, we need to find the cheapest way to identify customers and get their solar PV systems assembled on their roofs, and Home Depot is a master at bringing low-cost solutions for home renovations.
David Crane’s comment is pretty hard to argue with because Home Depot is already partnering with the likes of SolarCity to offer solar PV solutions for residential customers. And that is just the tip of the iceberg.
So the question is, how much can Home Depot and others do to reduce the cost of residential PV?
Five years ago, German homeowners needed to be bribed to install solar systems with a feed-in tariff of over twice the retail power rate. Today in Germany a residential solar system costs a little over $2 a watt, and homeowners can generate their own electricity at a cost one-third below regular retail electricity rates. Now that is incredible. The same system installed on a German rooftop costs less than half of what it costs in the United States. You can bet Home Depot senses an opportunity to make a bucket load of money.
So let’s look into our crystal ball. The costs of residential solar PV will continue to fall 10% or more a year. Utility rates are going to continue to climb 3% to 4% a year. So ponder that. Five years from now, the cost of residential solar PV is going to be at least 30% to 40% less than it is today and utilities will be charging around 15% more.
So it is becoming a little bit clearer as to why David Crane said not to invest in central station power plants and electric distribution companies. Central power stations and local distribution companies are going to have a hard time retaining market share in the face of this enormous competitive threat. Five years from now, solar PV will not be competitive in just 10 states like it is today, it is going to be 30 states. Once residential solar PV costs 10¢ a kilowatt hour, which will happen in many places in the US within the next five years, there will not be many places in the US with a traditional model of electricity generation and distribution that will not be threatened. And if regulators start charging PV customers with access charges to compensate utilities for having to supply grid backup support, the long-term impact will be to convince more utility customers to cut the cord com-pletely to their utilities by going completely off grid and buying a battery. Then those utilities will find themselves in what industry watchers have been calling the utility death spiral.
The changes to the utility business model will not happen overnight. Local distribution companies are not disappearing and central station power plants are not going on display in the American Museum of Natural History. There will still be plenty of local distribution companies 10 years from now, and there will still be plenty of central station power plants, but, in both cases, there will be fewer than today, and that is David Crane’s point.
It is not a lot of fun to be in an industry that is destined to be playing musical chairs for decades. You do not need to agree with the speed at which these events will unfold to agree on the general trend. Recent industry research reports from the likes of Goldman Sachs, Morgan Stanley and Barclays all point to the same phenomenon. Although their estimates of the size of the opportunity for rooftop solar PV in the US range from 40,000 megawatts to over 400,000 megawatts over the next five to eight years, all of them are bearish on the traditional utility sector as a consequence.
This is the same thing that happened to traditional telecom companies 50 years ago when they started losing market share to wireless carriers who were vastly more expensive at the time. Just last year, Verizon Wireless bought out the minority stake of Vodafone in Verizon Wireless for $159 billion. That transaction valued the land-line business of Verizon at less than 10% of the total market capital of Verizon. That’s the possibility to which David Crane is alluding.
I want to end by quoting Mahatma Gandhi. “First they ignore you. Then they laugh at you. Then they fight you, and then you win.” Until five years ago, the utility industry pretty much ignored the solar industry. After the Solyndra debacle, it started to laugh at the solar industry and, more recently, it has started fighting the industry. In the not too distant future, the solar industry is going to win. The lessons of the past and the trends of the present point to the future described by David Crane. [Applause.]
MR. HANSEN: Speaking in opposition to the motion will be Larry Kellerman.
MR. KELLERMAN: In 1882, the central station electric business was born at the corner of Fulton and Pearl Street in downtown New York City with service to 85 different customers and, behind those customers, there were 400 lamps. Ever since that time 132 years ago, there have been the Cassandras of our industry suggesting that the central electric utility business model was going to be defunct and that new emerging technologies would overtake the business model.
Yet the integrated utility model has not only survived, it has thrived this past century and a third and will continue to serve society for many decades to come, not despite the advent of new technologies such as solar photovoltaic, but actually because of them.
As inexpensive as these new forms of self-generation are, with few exceptions, they are not as cost effective as grid-supplied power. The reason is there are three natural advantages that the utilities have and will continue to have. I will describe those in detail. The three advantages are sustainable.
Number one is economies of scale. The utilities are in a better position to reduce capital costs by building new units at scale.
Number two is the cost of money. We are in the most capital-intensive industry on earth, and he or she who has the lowest cost of money wins. Guess who has the lowest cost of money? It is not my friends opposite. It is the electric utilities of North America.
Number three is utilities have an integrated, robust system. It is a network. It is a system. The competitors have at best only part of a system to offer.
There have been naysayers about the utilities for many years. One of the most renowned of those in past history was the CEO of a fortune 50 company who famously called utility executives dinosaurs and predicted their demise. His name is Jeff Skilling, and he currently residing in an all-expense-paid extended-stay facility with iron bars.
Let me drill down into the three reasons the utility business model will thrive for a long time to come. Economies of scale matter a lot, and utilities can dramatically lower capital cost.
Go to Home Depot. See the guy in the yellow smock. Buy your solar equipment from him and have some guy in a pickup truck install it on your roof. That five kilowatts on a per-kilowatt basis is going to cost you 2.5 to 3.0 times the amount that a utility building a 50- to 100-megawatt grid-scale system can either buy or contract from an independent power producer, meaning the utility has a dramatically lower per-kilowatt cost for installation, and the advantage is not simply in the per-kilowatt cost of installation.
Where are you going to have your installation done? It will be done on your roof. Let’s talk about where most solar installations take place: California. If you have a roof in California, that roof is over your head. Where do you live? If you live in California and you live near the coast, the direct normal irradiance or DNI of where you live is 5.0 or less. Where are the utilities and the contractors building their mega-scale projects? They are building them at 3,000 feet in the Mojave Desert where the DNI is 7.3 per unit of solar cell installed, and where the utilities are generating 1.5 times more kilowatt hours over any given year than a residential system where people actually live in California.
Then you have the cost of operations and maintenance where there is an order of magnitude difference in terms of per-unit cost to maintain a residential system versus a central station power plant. It is not that we do not believe in solar. We believe that the rightful owners, the societally most cost-effective owners of solar, are the utilities.
Utilities have a lower cost of money than you. Simple example: the average cost of utility debt is 4.0% for 20-year debt. I pulled SolarCity’s recent 10Q. SolarCity’s cost of longterm debt is 7%. Let’s take that 300-basis-point delta, apply it to 20-year financing on a $20,000 solar system on top of your roof. The total difference in cost of money over that 20-year system is $8,400. Who wins in the long term? The party with the lowest cost of money wins.
Utilities have an integrated, robust system. It is reliable and, unless you want to be Grizzly Adams and live without power for an extended period of your life, in today’s modern world where electricity is not a luxury but a necessity, it is also a necessity to have the grid backing you up. Paying for that necessity at a regulated cost of service is something that will be sustainable for many decades to come. [Applause.]
MR. HANSEN: Larry Kellerman, thank you. Ben Cook from SolarCity will correct misimpressions that took place. [Laughter.]
Consumers Driving the Bus
MR. COOK: More than 500 SolarCity employees working in Home Depots sell rooftop solar systems. SolarCity sells a system every two minutes during the work week. These are not two guys in a truck. These are branded SolarCity employees who do everything from first customer contact to getting up on your roof, to manning call centers 24-7 in case you have any problems. This is an integrated system that enables customers for the first time to pay no money down and save money month one. The average customer from the first time he or she goes into a Home Depot to buy a bag of dirt, a ladder or a hose meets a SolarCity employee and signs up in under 15 days for a $25,000 or $30,000 purchase of electricity over 20 years . That’s one of the biggest purchases that an average customer will ever make.
Why does the customer do it?
Electricity is a commodity that the customer can get less expensively from SolarCity than from the electric utility. This is a trend that is happening not just in energy, but across the market.
I come from Silicon Valley where competitive destruction is a fact of life, and every year we see another Airbnb, Uber or another entrant changing the market. Traditional industries that have not met customer needs as much as much as customers would like are being replaced by better, cheaper alternatives. That is exactly what is happening here.
However, it is more fundamental than that. After 100 years, we are finally moving from a top-down system to a bottom-up system.
We heard that utilities have the advantage in terms of scale economies. Yes, but with rooftop solar, for the first time, you have the ability for homeowners to generate power where it is consumed, and that brings its own savings. There is no need to move electricity long distances from central station power plants. Every year, rooftop solar reaches grid parity in more markets. It is creating a perfect storm.
Bloomberg called it the “phase change” in which the physical system transitions to another state. We are not talking about adding a little bit of solar or a little bit of wind to the system. We are talking about a fundamentally different organizing principle for the system.
How should we think about investing in central station power plants or distribution networks? Germany has gone through a transition already. It spent $166 billion over the last 10 years on renewables and, in the process, E. On and RWE collectively went from a market cap of $170 billion to $70 billion. One of the directors of E. On, Leonhard Birnbaum, said, “Whatever you believe, it will happen more dramatically and more aggressively.”
If you believe we will see some renewables, but not mass adoption, this is what we thought in 2008. If you believe no aggressive dynamic evolution, this is what we believed in 2005. We have already made these mistakes. Be more forward looking.
Larry Kellerman says that utilities have access to cheaper money, but that assumes in the long run that utilities can supply electricity more cheaply. They have no natural advantage. The cost of capital derives from the underlying market position and, right now, Barclays is saying, “We see long-term risk to credit with utilities falling behind the solar-plus-storage adoption curve and long-term risk from comprehensive reimag-ining of the role utilities play in providing electric power.”
So if today you say that utilities have an advantage over decentralized energy sources, remember that these are 30-year bets that are being placed. A case in point about how rapidly a venerable business model can change is the publishing industry. In 1982, the internet was invented by Al Gore. [Laughter.] In 1992, the web came along. In 1997, the smartphone came along. In 2006, Twitter was founded. In 1982, McClatchy’s stock price was $73; it now sits at $5. The advertising revenue that peaked in 2006 is now at 10% of what it was just 10 years ago.
Are you ready to place a 30-year bet on something that is in the middle of a perfect storm? [Applause.]
MR. HANSEN: The last word in the first round goes to Michael Storch.
When Subsidies Disappear?
MR. STORCH: Thank you SolarCity. I am a customer of SolarCity and it has been an absolutely fantastic experience. Acura contacted me through email. SolarCity was offering Acura’s customers an incentive to install solar. I contacted SolarCity. Google Earth was utilized, and a little more than two weeks later, I was signed up. It took a few months to get everything permitted, but it was unbeliev-able. The customer service was fantastic. The system is working beautifully.
So it will come as a surprise that I recommended you sell SolarCity short.
This company is able to do what it does because of tremendous subsidies that hide what rooftop solar really costs. The tax subsidies translate to about a 50% reduction in the effective cost of the systems. Once the tax subsidies expire, instead of roughly 40% of electricity users representing a potential opportunity for the solar rooftop companies, the number will be much smaller.
And that is not the only magic on which the solar rooftop companies rely. The other magic is called net metering, which is a fantastic deal for consumers. As a SolarCity customer, I am getting full credit at roughly 19¢ a kilowatt hour for energy that I generate from my rooftop system. I am burdening the rest of the folks on the grid, since I am no longer bearing a share of the cost. Net metering is a fantastic deal, but it is not going to last.
Net metering is undermining the fundamentals of the utility business. The battle has already been joined and is becoming heated. Arizona Public Service waged an extensive campaign to attack net metering. It was not a great success, but the utility managed to get an incremental charge of about $5 a month from the typical customer with solar on his roof.
It is not a fair or sustainable system to have a dwindling group of customers bear the full cost of the grid.
The utilities will wake up and they will start to work aggres-sively to preserve their market shares. [Applause.]
MR. HANSEN: So we now move into two interactive phases. Initially, the panelists will have a Q&A among themselves, but then we will have Q&A between the panelists and the audience. Neil Auerbach, do you have a question for the other side?
In Your Eye
MR. AUERBACH: Yes. It seems to me that in order to disagree with the resolution, you basically have to believe that customers will stop coming to Home Depot and will instead go to Larry Kellerman’s solar stations in the desert. You are going to have to convince Congress to repeal the 30% tax credit right away, and you are going to have to convince 43 states to get rid of their net metering laws immediately. It sounds like what you guys are saying is David Crane is wrong because all three of these things will happen. Did I get that right?
MR. KELLERMAN: Thank you Neil, but you got it completely wrong. [Laughter.]
I agree that there will continue to be cost reductions in solar generation. I believe that there will be a robust number of choices available to customers, but I also believe that if a customer is logical and acts in his or her own self-interest, he or she will go to the local utility. It is cheaper for Southern California Edison or Arizona Public Service to build a 100-megawatt solar power station, cheaper by far than for a customer of Home Depot to build one, own it and operate it on his own roof.
The utilities recognize that they are the more cost-effective choice. They are starting to use their comparative advantages to fight back. The community solar offerings are an example. Why own a solar system on your roof? You can own an undivided interest in a community solar project that is built at much lower cost per unit, financed at a much lower cost of capital and operated at a much lower O&M cost. That is a superior choice.
I believe customers like solar and will continue to like solar, but I fundamentally believe more strongly that customers like money.
MR. HANSEN: Mike Storch, do you have a question for the other side? I am pretty sure that whatever it is, Neil has a response. [Laughter.]
MR. AUERBACH: Yes. [Laughter.]
MR. STORCH: We are talking about central station generation and a grid in the United States today of more than a million installed megawatts. The total capacity of solar in the US is basically a rounding difference. So even with robust growth in the industry and without the current subsidies continuing for an extraordinarily long period of time, how is it possible for any meaningful penetration given a base of that size?
MR. AUERBACH: The 10% investment tax credit for solar is permanent. A recent Morgan Stanley research report projects penetration for both commercial and industrial and residential solar over the next eight years of as much as 400,000 megawatts. You do not have to support that wild claim, which is made by a pretty eminent researcher, to support the resolution, but the growth will be big.
MR. COOK: Taking SolarCity as an example, we have said that by 2018, we would like to be at a million customers. That pace is less than our current growth rate. The potential market is 41 million rooftops. The opportunity is there. That is why earlier this week we announced that we were going to start manufacturing our own solar panels in a bid to become more vertically integrated. The opportunity for growth is so great that we want to make sure we have all the tools needed to be able to act on the opportunity.
MR. HANSEN: Neil Auerbach, do you have more questions as well as answers for the other side?
MR. AUERBACH: Mike Storch, I do not want to be at all mean spirited because this is a wonderful dialogue, but I found it interesting to hear from Enel Green Power, which is one of the largest owners of wind power in the world, that the subsidies cannot last. The question is: Are you willing to throw the baby out with the bathwater? Are we arguing against subsidies going away for all renewables or is it just the ones that threaten the central station power plants? How does Congress evaluate a claim that subsidies are overdone for one renewable technology and not another?
MR. STORCH: Subsidies are a social choice. Enel is obviously a strong supporter of renewables. My point was not that subsidies have no place, but it would be foolish to assume they will remain indefinitely.
MR. HANSEN: Larry Kellerman, you get the last question if you have one.
MR. KELLERMAN: The great-est investor of our time is Warren Buffet. Our opponents here appear to believe Warren Buffet is stupid because Warren Buffet has spent $15 billion in the utility space over the last decade. His most recent acquisition to close just months ago was Nevada Energy, a utility that serves one of the highest solar insolation regions of the country. So if there is any utility that is going to be right in the path of the bulldozer that David Crane sees coming, it is the one the smartest investor on earth has just bought.
So, Neil, please explain, as a former Goldman Sachs partner, why you believe the world’s greatest investor is stupid? [Laughter.]
MR. AUERBACH: Thank you, Larry. [Laughter.] We were former colleagues at Goldman Sachs, and before I made my first investment in wind energy in a company Horizon Wind, I had go to Larry to get permission because they did not think anything that did not burn could create electricity.
Look, Warren is not stupid. Warren has made a lot of very good bets, but what Warren is also doing is buying a lot of long-dated cash flows. If you look at his investments in solar central station, those have very long power purchase agreements, and he is very happy in this stage in his career to generate those 10%, 11% and 12% returns. But that does not mean that David Crane is wrong.
What will happen over the next 10 to 20 years will be a seismic shift. The SolarCity stock price right now is trading at 16 times current revenue. Smart investors are not all so blinded by Elon Musk’s charm to bid up the stock price on that basis. The reason why they are making that bet is they see the growth rate.
Investment in the solar rooftop sector is a trickle compared to where central station power and utilities are today. Tomorrow it will be a flood.
MR. HANSEN: Moving to the third phase of this debate, do we have any questions from the audience?
MR. JOSHI: Anuvrat Joshi, CFO of Sunperior Solar. Question for Larry Kellerman. Doesn’t the fact that many utilities are considering investing themselves in solar rooftop businesses support David Crane’s view?
MR. KELLERMAN: No. It actually supports our proposition that utilities are durable, sustainable enterprises and that they recognize changing technology. We are all in favor of solar. Solar is a fantastic technology and its cost has been plummeting, and those are great things for society. Utilities are adaptable entities. The reason they have been around for more than a century is that they have been able to adapt. Utilities see the money. They also realize that the future is at least partially a solar future, so utilities want to invest in it. The three advantages that they enjoy over distributed generators will make them formidable competitors.
MR. AUERBACH: It is interesting that you said that utilities are flexible. A report issued by the American Energy Innovation Council in 2011 — that is a group that Bill Gates and Jeffrey Immelt helped launch — said that the utility industry has the lowest investment in innovation of any industry in the world: 0.3% of revenue. So it is a little bit difficult to understand the proposition that utilities are flexible.
The social contract in this country and in many places around the world is really simple. In order to provide reliable power, the states grant monopoly status effectively to utilities, and regulators are there to tame the beast to protect customers from monopolistic behavior.
That is not a business model that encourages innovation, and so when seismic shifts happen, they catch monopolies by surprise. That is what is happening here. Yes, of course the utilities will invest in solar power at utility scale because they have been told to do it and because they are going to earn their regulated return if they are doing it through a rate base, but that does not suggest David Crane is wrong.
What utilities have the hardest time of all doing is adapting. They have to be forced to adapt by regulators. I have no problem with competition, and I stand in favor of competition, but utilities traditionally are not pro-competition. That is not their business model, and it hasn’t been that way for a hundred years.
MR. CHERRY: Bud Cherry, CEO of Eagle Creek Renewable Energy. I think the analogy of distributed generation to cell phones is strained at best. What happens if you live in Brooklyn, Queens, the south side of Chicago, Detroit, Cincinnati? You don’t have an opportunity to put solar panels on your roof. What happens when the sun goes down? California will lose more than 10,000 megawatts of generation at sundown that must be replaced by conventional generation.
MR. KELLERMAN: I look at California. Justin Bieber can put solar panels on his estate in Calabasas. With net metering, he will pay little or nothing for electricity for his estate. Who is bearing the cost? It is the folks in the inner city and the folks who live in apartments, trailer courts and other parts of southern California who cannot afford to or do not have the wherewithal to put solar on their roofs.
Net metering has been a strong stimulant to growth of solar rooftop power, but it creates a perverse societal subsidy. It is the poor members of society who have to pay higher rates that are subsidizing the richer members of society who can afford the larger roofs. That is a social and structural issue that regulators will have to ponder deeply if there is greater penetration of this technology.
MR. AUERBACH: Whether or not the analogy to cell phones is correct, it is close enough to understand how to behave to get ahead of the curve.
The social problem that Larry identifies is not an issue today. It is an issue 10 to 20 years from now. However, one of the big issues that must be figured out is the socialization of cost for those who cannot afford solar. If you have a FICO score of 650 or higher, you are able to have solar on your roof. It does not matter whether you are well off or middle class. The poor is where the problem is.
We are not standing for the proposition that there will not be a grid. Change always bring new problems that have to be addressed. Elon Musk at Tesla will bring even more change with his gigawatt factory to make batteries and then watch out, because the cost of total off-grid solutions in the next five years will come down to the point where people can cut the cord completely and regulators cannot stop it. That is not what regulators are there for. They are not there to prevent consumer choice.
The bottom line in support of the proposition is that consumers are voters who are voting with their feet, and they are going to continue to do so in growing numbers. [Applause.]
MR. HANSEN: With apologies to all the raised hands in the audience, the clock says that we need to move to closing statements. Neil Auerbach, you are first.
MR. AUERBACH: We do not have to like the world that David Crane is painting. We are allowed to be a little bit afraid about whether it will happen just the way he portrays and whether it will cause people economic loss.
Is David Crane right about the future? Look at GDF Suez, one of the largest power companies in the world. Several months ago, it announced €14 billion of write-offs associated with its thermal generation investments. That is not a pretty thing. Joseph Schumpeter described capitalism as a process of creative destruction. People are always figuring out new and better ways to do things.
To support the resolution, you simply need to be convinced that David Crane is onto something real. This is not make believe. The trend is inescapable. It is visible today. Even if the 30% investment tax credit for solar is not extended, it will be only a short-term blip and we are going to see, over the next five to 10 years, explosive growth of distributed generation in this country. It will take decades to reach the full potential because it takes hundreds of billions of dollars. Distributed solar will eventually be cheaper — without subsidies by the way, Mike Storch — than central station power. Once that ha