The rooftop solar business model in transition
Where is the rooftop solar business model headed with business possibly shifting to direct sales, analysts pressing for positive cash flow and at least 10 states expected this year to revisit their net metering rules? A group of panelists addressed these and other questions at the Chadbourne 27th annual global energy and finance conference in early June. The following is an edited transcript.
The panelists are David Field, CEO of OneRoof Energy, Mina Kim, general counsel of Sunrun, Nicholas Mack, general counsel of Spruce Finance, Robert Scheuermann, president of SoCore Energy, and Jorge Vargas, head of the Americas for the AMP Solar Group. The moderator is Todd Alexander with our New York office.
MR. ALEXANDER: Mina Kim, is the solar rooftop market moving in the direction of direct sales where customers buy rooftop systems rather than sign long-term power purchase agreements for electricity or long-term leases to rent the rooftop equipment?
MS. KIM: No. We are not seeing any change, frankly, away from third-party ownership of rooftop systems. About 15% of our business is direct sales. That percentage may move up a bit, but not a ton. Any shift toward direct sales is driven more by our distribution channels at any particular moment in time than by consumer demand. We do not see a long-term trend toward direct sales.
The recent extension in the investment tax credit should mean there will remain an incentive for third-party ownership over the longer term. Residential tax credits for direct sale transactions will go to zero after 2021, but third-party-owned systems will continue to benefit from a 10% tax credit.
MR. ALEXANDER: Nick Mack, do you agree?
MR. MACK: I have a slightly different view than Mina. We are seeing more of a balancing. For example, in the California market, which is the largest residential solar market in the country, third-party-owned systems were about 70% of the market over the last few years, and I think we will see for the end of 2015, 2016 and probably 2017 a move toward more of an even split between third-party-owned and direct sales with financing or straight cash.
I think that third-party ownership still offers a lot of value to a large segment of consumers, especially those who do not want the up-front cash outlay or who are somewhat intimidated by the concept of ownership and want someone else to monitor and care for the equipment.
At the same time, as homeowners become better educated about solar and as the price of an installed solar system comes down — it has basically dropped from around $40,000 to $20,000 for the average-sized system over the past several years — a lot more homeowners will be interested in ownership.
This will be particularly true during the next few years when direct purchasers of systems will still qualify for a 30% tax credit. We are seeing this trend in our deal pipeline.
MR. ALEXANDER: David Field, one selling point that bigger rooftop companies offer is the ability to put the whole package together. A solar PPA or lease is a form of long-term financing. As the cost of a rooftop system drops to $20,000, are homeowners more likely to take on the financing themselves?
MR. FIELD: I am more in Mina’s camp. Homeowners buy what homeowners are offered, so it is a function of who is knocking on their door, calling on the phone or sitting down with them in their kitchens.
We continue to see the same consistent split of about 80% third-party ownership and 20% direct sales, notwithstanding the proliferation of companies eager to make loans to finance direct purchases.
Direct sales are driven by the thousands of solar installers that sell and install solar in the United States. They can make a lot more money if they sell for cash. There are a lot of these installers who say, “I am not going to sell Sunrun’s PPA or our PPA or anything else, because the rooftop solar companies do not pay me as much as a cash transaction pays.” Therefore, they sell only a Mosaic loan product or cash or other financial products.
At the end of the day, it is a function of who is in front of the homeowner. What we are seeing is that as more non-traditional solar distribution platforms come to the market, like retail energy providers, they find it easier to sell a PPA, basically sell an electricity rate, because that is what they do. They sell competitive electricity in the northeast and elsewhere as a rate.
I think that consumers want a choice. You will always have consumers who say, “I want to own something and want it simple, and I am fine taking care of the maintenance and everything else. It is part of my house.” And then there are many others, I think the vast majority, that say, “This is a service. I am just buying electricity, so sell it to me like you would electricity.”
MR. ALEXANDER: Jorge Vargas, on which side are you?
MR. VARGAS: I agree with David that consumers want a choice. I was doing research on solar back in 2009 when I was at a homebuilder called Lennar, and we were running focus groups to ask whether they wanted granite counter tops or solar on their roofs. At that time, people wanted granite counter tops, not solar. I suspect that has changed. Financing is becoming commoditized. When I was at Morgan Stanley, we thought that solar loans to make direct purchases would emerge as a new product, and we are seeing that right now. The industry is evolving.
Monetizing cash flow
MR. ALEXANDER: Mina Kim, the solar rooftop companies had been looking to the ABS market and securitizations as a way to monetize the cash flow from rooftop systems. Seven solar securitizations have been done to date, but that market appears to be in a temporary stall. Spreads have widened in the broader ABS market to a three-year high. How is inability to place paper in that market affecting your strategy, if at all?
MS. KIM: We did a securitization in July 2015 on what we thought were very attractive terms. We had an A tranche and a B tranche. The A priced at something like 240 over and the junior piece priced at something like 340. It was a very attractive financing for us.
I know there has been a lot of speculation about what the market has been doing recently and, frankly, the bankers in the room are better placed to talk about what is going on there in terms of the trends. The important point is that the underlying assets remain high-quality assets. Since inception for us on our fleet, we have collected 99% of billings. We are replacing an existing household debt load. Our customers are basically paying us the utility bill, but at a discount to what they were already paying. There is no new debt created for the homeowner.
In the long term, putting aside the market noise, there is no reason our service won’t continue to find a strong market. We are offering an easily recognizable benefit to consumers.
MR. ALEXANDER: Jorge Vargas, how large a portfolio does a rooftop company need to have before it can start thinking about a securitization?
MR. VARGAS: We were in the market with a C&I portfolio of $100 million and that was considered small, so I think you need to be at least at that level.
MR. ALEXANDER: How many different installations do you need?
MR. VARGAS: I can’t remember all the numbers, but ours was about 2,500 residential systems and about 250 C&I installations. It was small. There were some concentration issues. The securitization ended up not going forward.
MR. ALEXANDER: David Field, does the securitization market have appeal to you?
MR. FIELD: It has served the industry well so far. It is still at an early stage. We think there are good opportunities in the bank market, and they are a lot less time consuming and complicated to realize.
Other financial tools are becoming available. Everyone is trying to put in place more warehouse facilities to amass assets long term.
At the same time, we have an investment climate that does not value the players in this industry from a pure asset aggregation perspective. That is why we have seen a number of companies try to raise equity against assets recently.
So I think, A, securitization is a valuable tool, B, we are seeing other tools becoming available because, C, there are different ways of valuating these platforms, and that issue is still in flux.
MR. ALEXANDER: So why do you think we have seen the recent slowdown?
MR. FIELD: There is a tremendous amount of pressure right now for profitability in the residential rooftop sector. Nobody is immune to it. It has caused everybody to look differently at how we are monetizing or liquidating assets in order to fund ongoing working capital needs, as opposed to the traditional method of raising equity and being cash flow positive.
MR. ALEXANDER: Let’s move to commercial and industrial solar. The press has been focused lately on strains in the residential rooftop sector, probably because it is of more immediate interest to newspaper readers, but the C&I sector is under the same pressures. How has the increased scrutiny brought on the industry by the SunEdison travails affected your business?
MR. SCHEUERMANN: We are part of a larger company, and so our financials stay blended within Edison International, but there is tremendous pressure to grow earnings and not to be a residual cash flow valuation in the larger scheme of things.
We see a trend moving in the opposite direction from what you are seeing in residential solar, where more and more of our customers are really looking for PPA solutions. SoCore has historically done a lot of EPC work. It is a good cash flow business. The construction progress payments over the two or three months that it takes to build a project are commensurate with the cash outflows. The earnings look good. However, more and more of our customers are saying they would rather sign a long-term PPA to buy electricity than have to spend money upfront on installing solar equipment.
Or we have new customers who say, “This is a great value proposition. I can save X% on my power bill. You will own the system. You will take care of it.” This is easy to get approved.
The trend has been toward PPAs, which makes us think about our financing structures and how much of the value in the company we want to be a residual play.
When you are building an operating company, you have to cover the cost of overhead. Luckily we are part of a much larger organization. Where others are constantly seeking external capital to fund their operations and are under more pressure and scrutiny after SunEdison collapsed, it is not as much a challenge for us.
MR. ALEXANDER: How large a discount do you have to offer a C&I customer from its current electricity rate to get it to talk to you?
MR. SCHEUERMANN: I am guessing we have a few competitors here, so it will be a range between 0% and 100%. [Laughter] Look, if you cannot save your customer at least 10% out of the gate, then you are probably not going to get any traction.
In some markets, like New Jersey with the way the SREC pricing has gone lately, there are huge savings for customers. In other markets, if you can get 10% to 20% savings out of the gate and the escalator in the contract price for electricity is lower than the projected tariff increases, then the customer could have substantial savings over time, as well.
MR. ALEXANDER: Jorge Vargas, you are also chasing C&I. Do you have anything to add about originating business, and what type of pressure do you feel in this market segment?
MR. VARGAS: You have to show up with a good value proposition. Our C&I effort is with community solar. It is a little different because we are building a utility-scale solar array. One of the things we struggle with is the long lead time between when we sell the C&I customer power and when the electricity starts to flow. It can be 12 to 18 months before the electricity starts to flow. We have a warehouse debt facility, but you have to show subscriptions before you can draw on it. We are looking in the meantime for other sources of revenue to be cash positive.
AMP has been cash-flow positive for the last few years, but last month we acquired a small EPC contractor to diversify our revenues and to be able to have some cash flow intermittently through long development cycles for solar. We are definitely feeling the same pressure to show positive cash flow as the residential rooftop companies.
MR. ALEXANDER: Where does the financing come from?
MR. VARGAS: At AMP, we are doing an equity warehouse. We use it to acquire projects and that way we don’t have to deal with construction financing. It is like a credit card that we use to acquire projects. Then we layer on the tax equity.
MR. ALEXANDER: Let’s talk big picture about the industry. One thing I find very interesting about residential solar is the companies have fantastic websites. You think you are buying solar, but it is almost as easy as buying a book on Amazon. You put in your address, and you find out what the cost is. When you see a whole industry moving to this point, then it becomes a question of who is the lowest cost provider. The customer is buying a commodity. This argues for large scale.
On the one hand, you could view residential solar as competing against retail rates. On the other hand, you could view it as a competition against everyone else who is providing residential solar because customers can get on the internet and solicit and compare offers.
Does this suggest the residential rooftop market is headed toward having just a few champions? People will know them like they know Amazon is the place to buy a book?
MS. KIM: I think fundamentally we feel that we are competing against retail rates. That is fundamentally the customer proposition and the customer value. I think the differentiators are in quality of installation and customer service. We believe that we put the customer at the center.
We don’t know that the utilities do that or are good at delivering the kind of customer service that we think the rooftop industry is moving toward.
We continue to believe that the best value for the customer is in the third-party-owned product, and we do not see that changing over time. It is hard to say what that means for some of the smaller players.
MR. ALEXANDER: Nick Mack, can I count on you to disagree?
MR. MACK: I am not going to disagree entirely. I agree that fundamentally the value proposition is in offsetting the retail utility price.
What is interesting is you are starting to see a little bit of a step back from vertical integration. See what has happened with SolarCity and its MyPower loan product that was supposed to finance direct sales. Granted, that product had some challenges just in the way it was structured, but it is also an indication that it is difficult to run an origination and installation business and a financing business and a long-term asset management business all under one roof.
Sunrun is one of the few examples remaining in the industry of a company that is doing it all, and it seems to be doing well. This is a capital-intensive business. It is challenging to do it all in a vertically-integrated company. That is where companies like Spruce have a great opportunity because we focus on one segment of the overall residential market, which is providing financing, and we work with partners who want to focus on other segments.
There are companies that are very good at origination. That is all they want to do. There are companies that are very good at installation. That is all they want to do. Having such companies work together gives consumers more choice.
It is interesting to look at how consumers make their buying decisions. Some definitely want a brand name, and Sunrun and SolarCity have both spent a lot of time building brands. They have broad name recognition. They spend a lot on marketing. It drives up their costs, but it also increases their deal pipelines.
There are a lot of consumers who view home improvement as a much more personal interaction where they want to deal with somebody local. They get recommendations from their friends. Some of those recommendations are going to be for the big vertically integrated companies. Others are going to be for smaller contractors who have worked in the neighborhood for many years and who may offer financing through another source.
MR. ALEXANDER: David Field, are people shopping among websites or is it really a matter, as you said earlier, of who comes knocking on the door?
MR. FIELD: You are going to see a much more competitive market. Understand that residential solar is still a cottage industry. The first solar lease was written in 2008 by SolarCity. That was just eight years ago. Today, real professional sales and marketing companies are coming into the space, guys that sell 15,000, 20,000 customers a month for competitive energy on the east coast.
These guys know how to market energy. They have existing books of business between 200,000 to a million customers. These guys know how to convert potential customers into buyers. They are migrating to the space because they can make 10 to 15 times more money per customer.
What that should tell us all is this is electricity. It is not rocket science. It is a commodity, and the lowest cost wins. Right now in most markets, if a solar installer sets up an appointment to sit in your home and pitch you solar, it will walk out of your home 40% of the time with a contract signed.
That tells you that homeowners do not go out for bids. They do not know who you are. They do not even know what brand equipment you are using. It is an impulse buy. Most Californians will tell you that they have had their doors knocked on at least eight times, and they do not open the door anymore. More than 50% of solar in the United States is sold door-to-door like the Fuller Brush salesman.
That model is not scalable, and it is not low cost. If you really believe that it is going to become competitive energy, because it is electricity, then customer acquisition techniques will change, and you are going to see a different type of vertical integration. It will not be the classic form that we have seen in the past. You will see vertical integration around the sales and the customer-capture side, and you are going to see more platform-oriented companies.
When I say platform-oriented companies, if a major energy retailer sells something to a homeowner who wants to get into solar, it will not set up a solar division. That is way too complicated. It will never figure out tax equity structures or asset management or you name it.
It will come to one of us and say, “Can we partner with you? We know nothing about solar, but we know that we can make a ton more money doing it. So tell us how to do it.”
If you look at the largest solar dealers in the United States today, the largest guys, they simply cannot exist on the margins they are earning today.
They are constantly running out of cash and their margins are razor thin, and prices are continuing to come down. The prices that Sunrun or Spruce or we are willing to pay them go down, which is why they migrate to cash and loans. If that is how a good part of the market is selling solar today, then it tells you that the business model is ripe for change.
We are at an inflection point where I believe you are going to see a lot of new players come into the space. You will see more of the Amazon-type of approach. You will see more brands because brands increase conversion ratios for homeowners and that lowers your cost of customer acquisition.
MR. ALEXANDER: Rob Scheuermann, the C&I companies have had a problem because their projects are small but each deal is separately negotiated, so the deals are expensive to do. What do you see as the trend there?
MR. SCHEUERMANN: I think there will be a much bigger transformation in the C&I business than just vertical integration or consolidation. The changes will be driven by the need to get to a lower-cost product.
The market will not be limited to long-term owners like SoCore. That is a thin slice of what the customer base wants. The customers are looking for comprehensive solutions. They want energy as a service.
We are part of a broader push within Edison to roll out integrated solutions to Fortune 500 companies. Solar will be only a part of these solutions. The solutions will also include battery storage, micro-grids, energy efficiency and energy procurement.
We see a long-term trend toward a broader platform of services, at least for commercial and industrial. You will still see some smaller solar players, but it is very difficult to make money to support the cost of the machine. If you are just rolling out 30 to 50 megawatts of projects a year, it is very hard to create enough value to cover the overhead.
The C&I solar business has not grown the way residential has. It is a crowded space as well. It is very tough to install 150 to 200 megawatts a year of C&I.
MR. ALEXANDER: Jorge Vargas, what is the future for C&I? It seems to suffer from high transaction costs relative to the size of the deals. It is difficult to standardize.
MR. VARGAS: I think the issue is financing. There are a lot of potential customers for C&I, but there are a lot of unrated credits. There are a lot of small strip malls and others that, when you take the projects to tax equity, they say, “No way.”
To me, the key to C&I is unlocking the financing so that you can offer a meaningful discount to customers. Finding a solution to that is the biggest current challenge.
MR. SCHEUERMANN: It has been a constant struggle to get financiers comfortable. Eighty to 90% of the customers are not investment-grade corporates. They are real estate developers who have really solid office buildings on which they are looking for solar, but they are not going to put a corporate credit behind it, and their tenants stay for an average of five years.
Opening up that part of the market is key. A lot of times, it is a couple megawatts here and a couple megawatts there, and you tuck them into an investment-grade portfolio, and your banks say, “Okay, we can live with that.”
I think the real solution is if some financiers come to the table with a whole platform. They say, “Give me your five or 10 or 20 megawatts. We will combine them with another 200 megawatts that we have from other sources.” Build the diversity that way.
MR. ALEXANDER: Let me change topics to net metering. You see a lot of the utilities complaining that the rooftop solar companies are picking off their best customers with the highest FICO scores and then using the grid basically as a battery for the excess power generated by the solar systems during off-peak hours, but not paying full fare for this use of the grid. We saw the utilities in Nevada succeed in rolling back net metering. Where do you see the net metering debate headed, and what effect will any changes have on the C&I and residential solar companies?
MR. FIELD: It is no secret that there is a lot of pressure on net metering across the country. The pressure will continue. At the same time, I think that you will see states like California come out with more balanced approaches and serve as a bellwether for most states. Not all states. There will always be outliers like Nevada.
By and large on the residential side, we still see growth at rates of 50% to 100% year over year, which is pretty phenomenal. This has become a populist issue, which is why it was such a no-brainer for the California Public Utilities Commission to do what it did. You end up with a lot of homeowners that are vested in the space and believe in energy independence. Utilities are usually not well liked by their customers.
MR. VARGAS: How do you fend off the utility argument, though? There is a logic to it.
MR. FIELD: No, no, what I am saying is this. The system has to change because there is a logic to the utility argument that you cannot ignore. But as net metering changes, it will change in a balanced way. It will change through appropriate rate design at the same time that costs for delivering solar continue to come down.
You will see progressively over the next three to five years real change throughout the system, but it will not come at the expense of one or the other is all I am trying to say.
MR. ALEXANDER: Will solar customers have to pay fixed monthly charges to help support the grid? How will we reach a new equilibrium now that the amount of residential solar is growing to a scale where it is having an effect on the overall system?
MS. KIM: There is no one in the world who is more tired of talking about Nevada than I am. But I am going to do it again. Nevada is an outlier. There are 42 states today that have net metering. I think 95% of them have been supportive of net metering. There may be a shift. I think California is a model for the future. It is one that supports our industry, and we think it is a great outcome.
MR. ALEXANDER: What in particular do you like about California versus Nevada or the other states that have revisited their rules in this area?
MS. KIM: It is a matter of appropriate rate design. There is time of use. There is a non-bypassable charge. The rate regime still supports savings in residential solar. We think it is a model that works for us.
California has been a leader. Nevada was an outlier. A lot of attention was focused on the lack of grandfathering in Nevada for homeowners who had already installed solar. Even Arizona, which has not been terribly friendly to rooftop solar, has been very clear that any changes will not affect existing solar customers.
MR. ALEXANDER: Nick Mack, what do you see as the impact if net metering rules are changed, and what are the overall opportunities for growth in this industry?
MR. MACK: I agree with my fellow panelists that net metering reform the way that California has done it is good for the industry, and I think it is also good for the utilities. A connection charge and some sort of base-level customer bill charge to support the grid make sense.
Net metering in its initial conception was kind of a blunt instrument, and it is being refined in ways that ultimately may not support solar in a few states. This will be a temporary glitch. This industry has gone through plenty of those and figured out ways to overcome them.
I will be curious to see how distributed storage plays into this. Over time as the solar equipment, including batteries, becomes cheaper, you will see more customers adding storage, allowing them to drop off the grid altogether, making net metering less important.
MS. KIM: That is a really important point. We have already started seeing this in Hawaii. We have launched a solar-plus-storage solution in Hawaii in response to what has happened there on the regulatory side.
MR. ALEXANDER: Battery storage is always a hot topic when people talk about renewables. You just touched on it in Hawaii. Is battery storage ready for prime time and, if the answer is not currently, how long will it be before there is widespread deployment?
MS. KIM: We launched a product in Hawaii. It works there. As for the pace of adoption in other places, that will be driven by cost. The cost of storage is expected to come down by 40% by 2020.
MR. VARGAS: AES has been incredibly successful in California deploying big batteries. In Mexico and Puerto Rico, for example, some solar projects have had to have batteries to be considered for utility RFPs. You are already seeing it.
MR. FIELD: There is already a business case for batteries in the residential sector in two places. One is in Hawaii, and the other is on the east coast for backup generation for homeowners who do not want to lose power after the next storm.
Costs are coming down. As costs continue to come down, there will be more and more business cases for it.