If these out-of-date beliefs are to be called myths, then myths can be produced by the same sort of methods and held for the same sort of reasons that now lead to scientific knowledge. If on the other hand, they are to be called science, then science has included bodies of belief quite incompatible with the ones we hold today. Given these alternatives, the historian must choose the latter. Out-of-date theories are not in principle unscientific because they have been discarded. That choice however, makes it difficult to see scientific development as a process of accretion. …
… The extraordinary episodes in which that shift of professional commitments occurs are the ones known in this essay as scientific revolutions. They are the tradition shattering complements to the tradition-bound activity of normal science. (Thomas S. Kuhn, The Structure of Scientific Revolutions, p.p. 2-3, 6)
In business we know paradigm change as creative destruction, which can certainly be a revolutionary process. Sometimes we don’t even realize it until it is too late. Distributed solar is currently navigating such a paradigm change and its business model will have to undergo a revolutionary change that is not yet reflected in the market. For the moment most things in green energy, and certainly green finance, are based more on myth than method. Rooftop solar has been promoted as some sort of silver bullet, when it is no such thing, and now a new $55 billion dollar energy retrofit program for federal buildings will set the tone for the maturity phase of the energy retrofit market, where real economic performance, not green mythology, will set the tone.
The biggest hold-up in the current paradigm is the focus on incremental energy efficiency and/or energy savings as an objective, combined with a focus on the component level and the false hope of any single technology being the silver bullet for our energy and climate change problems. Until someone comes up with an alternative to the second law of thermodynamics, the law of entropy, the hope for that kind of a simplistic solution is ill founded, and integration is the name of the game.
The old paradigm of incremental energy savings is good for utilities, for it lowers the cost of their service, but it does little for the environment, or for property owners. Value must be created with a make or buy decision at the property level, based on all the options for on-site generation. It must be a holistic, life-cycle evaluation of all retrofit options. The new Energy Savings Performance Contract (aka ESPC) from DOE will set the tone for this new, more mature approach. In IT also, there was a time that hardware seemed to be the “value,” but then we moved to integration: “What can it do for my business?,” and that proposition included business process re-engineering. With $55 billion in integration contracts, the market will move past the “silver bullet” approach of this or that technological fad, and integration will become the name of the game, and building value will become the driver.
What about real estate values?
Net-zero construction has been growing steadily over the past decades, and California’s title 24 net-zero mandate will set the tone eventually for the whole country. All this is only possible because with today’s multiple options for renewable energy retrofits, and on-site generation, even existing properties realistically face “make-or-buy” decisions about energy. Renewable energy retrofits move energy from liabilities to assets. Current financing models are inadequate, if not counter productive. In the long run, energy retrofits should become a part of regular mortgage finance, or second mortgages.
While the wrangle over Fannie (OTCQB:FNMA) and Freddie (OTCQB:FMCC) continues, and they are once again becoming part of the problem, and not part of the solution. Disastrous political influence has made itself felt again with a renewed lowering of the downpayment requirements, likely to buy the next real estate crisis and more capital destruction with a short term stimulus. Energy retrofits, however, if done right, can raise property values, and will become increasingly important in the future. They could be helped with adequate financing solutions.
Energy being one of the biggest expenses associated with property ownership, it should be noted that the growing imperative of reducing Green House Gas (aka GHG)-emissions actually goes hand in hand with lasting value creation in real estate – both residential and commercial. Instead of depressing real estate values with more low/no down payments, the focus should shift towards combining the two issues in the process of the new single security mortgage initiative, as I have argued here. The country of India already incorporates solar retrofits in the normal mortgage process. The rational way forward in the USA would be incorporating a finance option for a Pareto-optimal retrofit that maximizes real estate values and minimizes GHG-emissions, and not be concerned with specific technology choices.
‘Energy savings’ produces capital destruction
The last few decades we have been stuck in a model of marginal energy savings, which of necessity produces diminishing returns, and therefore capital destruction. Property owners are spending money forever on ‘energy efficiency’ without ever solving the problem, and instead it is becoming more intractable, but they keep throwing good money after bad. The government in general, and EPA (Energy Star), DOE (component level energy efficiency specs), and IRS (ITC for specific technologies), have all figured in this obfuscation, but the new ESPC program breaks the mold and shifts us toward property-level integration and a holistic approach.
Here is how the bad, old ‘energy efficiency’ program works, and why it is good for vendors of energy savings gadgetry, and for energy companies, but financial suicide for property owners – a stylized example:
We discover that our energy bills are out of control and ma gives pa a setback thermostat for Christmas. He may resent having to install it, but lo and behold for $250 or less, they reduced their energy bills by 10%, our new base line is now 90% of the original.
A few years go by, energy bills keep going up, and now the utility or the state has an incentive program for ‘energy efficiency.’ We do some insulation and weather-stripping, and net after subsidies, we spend $2,500. Lo and behold we now reduce energy bills by another 10%. (Notice the base is now 90% of the original base line, so the 10% reduction is really 9% for ten times as much money). The resulting new base line is now 81% of the original.
Once again a few years go by, and we could not find anything else to do, but now a happy shiny sales person arrives bearing the news of “free” solar panels, and they can reduce our electrical bills by 10%, and the whole neighborhood can see how green we are. We now commit to $25,000, hidden in a 20 year energy contract or solar lease, and we may save 10% over our electrical bill, give or take. So we spent again ten times more than last time, but now our net reduction in our bills was only 2.4% (electricity was 30% of our energy bills, oil being 70%, and our base is now 81% of or original base line).
After these three iterations of this, we are have now reduced our energy bills to 78.6% of the original base line, for incremental investments totaling $27,750. Of course, the next major step will likely be a boiler replacement, or an oil to gas conversion, and so on and we will spend incrementally tens of thousands more on energy star appliances, and at the end of all that, our bills might have come down to 65% of the original.
Meanwhile, down the street there is a new development going up with net-zero homes. Will buyers care if we can produce documented proof of spending $60,000 over 20 years of ‘energy efficiency’ spending, and reducing our bills by 35%? Instead, won’t the premium go to the net-zero development down the street, or vice versa, a discount for our property based on roughly the NPV of 30 years worth of energy bills?
I once was that home owner, and I did not realize my mistake until I sold (1997). Hilariously, in my professional life I was very proficient at understanding the economics of energy, being in a very energy intensive industry, but privately I was not paying attention, until I looked back and realized the trap I had walked into by following the latest government programs instead of doing my own financialand engineering analysis. Most homeowners do not treat their largest asset as an investment, and the sellers of ‘energy efficiency,’ and ‘green energy,’ appeal to the emotions, not good economics.
In short, the Energy Star program is good for Christmas shopping without guilt, but not for property values. The DOE’s new ESPC program will set the standard, and property owners would be well advised to stop all the energy efficiency nonsense immediately, and figure out if their property is capable of a meaningful and economically viable energy retrofit, or else sell it. A sensible program should be based on a 30-year life-cycle capital budget that takes into account the economic life of major energy infrastructure, boilers/furnaces, A/C, water heaters, insulation, insolation, etc. If it can’t be done, sell the property while the selling is good!
In effect, the federal government is now also showing the states how to do it: energy retrofits for all state buildings, based on ESPCs, and get out of the business of promoting individual technological silver bullets, but focus on material progress by subsidizing, where necessary, projects that achieve 50+% percent reduction in GHG-emissions.
The economics of energy retrofits
Naturally, in a government building, the only useful parameter is the energy budget, and energy savings. Hence the name Energy Savings Performance Contracts. Once the systems are paid off, the savings accrue to the building however.
For commercial buildings or residential real estate, there is a more immediate impact, and that is property value. As the number of retrofits goes up, real estate values will begin to reflect the energy issue more accurately. Net-zero will become the benchmark, and in general there will be a premium for the highly “green” buildings with low energy costs, and increasingly a discount for buildings that have not done an energy retrofit, and the buildings that are not capable of retrofits at all will be destined for demolition sooner rather than later. The principles of valuation will become location, location, and location, and energy independence (low carbon footprint).
Meanwhile, from a pure engineering and economics standpoint solar PV pretty much drops to the bottom of the list in terms of generating technologies, for while it may be “cheapest,” it is least space efficient and generally only economically worthwhile if nothing else works. Screwing solar panels on leaky buildings makes no sense, and solar thermal delivers five times more energy for the same square area, and in different ways, so do geothermal, and wind turbines.
The Baucus energy tax proposal is the right idea
The Baucus energy tax reform proposal introduced some sanity into the discussion by focusing on reducing GHG-emissions compared to the status quo. It proposed that government should get out of promoting individual technologies, and focus instead on total project outcomes, with a band of incentives between 25% and 50% reductions in GHG-emissions. Its limitation was that it addressed only the supply side of the grid, utility scale energy generation, and transportation fuels.
To get energy tax structures right, government should include the demand side, and simply stipulate incentives as necessary for projects that achieve 50% to 80% GHG-reductions compared to the base line, which means that only top-to-bottom renewable energy retrofits would qualify. The typical marginal ‘energy efficiency’-style projects that are now the norm, are not worthy of being subsidized. They are purely a matter of operational savings, not structural change. The typical savings range is 15%-25% of GHG-reductions, and most rooftop solar projects in mixed fuel properties (oil or gas for HVAC) fall in this range.
For a more in-depth treatment pertaining to the folly of distributed solar, see my article on Distributed Solar and the metastasis of GHG-emissions.
The current sales paradigm for distributed solar is obsolete
To a degree rooftop solar is solving a problem for the states, but hardly for property owners, in as far as turning part of the electrical supply green. On the whole however, it is regressive, and renders the bigger problem of Green House Gas (GHG-) emissions more intractable, at the expense of property owners who were duped into signing for these “free solar panels.”
The major (public) players in distributed solar PV, SolarCity (NASDAQ:SCTY), Vivint Solar (NYSE:VSLR), NRG Home Solar (NYSE:NRG), and RGS Energy (NASDAQ:RGSE), are all operating within the sales paradigm of energy savings. They imagine they compete with your utility rates. To their defense, the current sales paradigm probably resulted largely from the wrongheaded energy policies at the state and federal levels, which are a holdover from the energy shocks of the 70’s and 80’s, and tend to focus on energy as an economic problem, not an environmental problem, and moreover date from a time when on-site generation was less of an option. I.e. structural change with on-site generation was not very prominent, and absent viable options for on-site generation, energy efficiency was about all you can do.
Presently, the Department of Energy is setting the tone for the next phase, and the onset of maturity for the energy retrofit market, and we might note, it is thereby putting all the states on notice as to how it is done. The new initiative aims to retrofit federal buildings, with Energy Performance Contracts.
The value-based sales paradigm
The only valid reason for a property owner to undertake a renewable energy retrofit is because it adds value to their property, not because panels are cheap or even ‘free.’
If a woman sends her husband to the store for dishwashing liquid and he brings home laundry detergent instead, because it was on sale, we’d all side with her. But in distributed solar this is the normal sales model. Or to put it in graphic terms, whenever someone is looking at solar PV, I ask them if their real estate is for free. After all, solar thermal generates five times the amount of energy per square foot than does PV. Steinway figured it out, and so could you… (I said that).
Specifically, the focus should be on a Pareto-optimal outcome, based on life-cycle planning and a 30-year capital budget for energy infrastructure in a property, which minimizes GHG-emissions and maximizes property values. I have in fact proposed this model to the DOE in lieu of the obsolete energy efficiency model, here.
The myth of the addressable market for distributed solar
We’ll take an example of two homes in the NY suburbs, one an older one that has not been seriously retrofit, and it is about 4,000 sqft. in size, with oil heat and everything else electrical. The 2014 bills averaged out to $400/mo for oil and $250/mo for electricity, or, 62% oil, 38% electric, totaling $7,800. The second one is 3,500 sqft., 2007 built and has forced air heat (2 furnaces), central cooling, kitchen mixed gas and electric. and the owner reports to me: “In the last 12 months I spent $1881.35 for electricity and $1,687.31 for natural gas to power and heat my home.” That amounts to 53% electric and 47% gas, for a total of just under $3,600.
Ignoring for the moment that both homes are situated so they could not use solar, let’s assume they could, and they got a visit from our friendly Solar City rep., who promises he can reduce their electrical bills by 10%.
In the first case, the vaunted 10% savings on electricity (IF it works out that way over 20-30 years), amounts to a 3.8% reduction in the energy budget, for the cost of giving up the roof, and assuming an unbending 20-30 year liability.
In the second case, the proposition adds up to a 5.3% reduction in the energy spend, with the same commitments of space and money.
Is it any wonder that one of my friends, whose house looks more like #2 above, told the Solar City rep: “Call me back when you can save me 50%!” Is it any wonder that a party who recently pulled back from solar marketing confided in me that the ‘addressable’ market was 20% of homes in the 10 states where they operated?
Where there is smoke, there is fire
Consumer complaints have been heard for some time, with a brief flurry of activity at the tail end of 2014 when a number of politicians in Arizona and Texas complained about solar PPAs and leases that were apparently under water. I have been hearing similar issues in my area (NYSEARCA:NYC). While for now the noise seems to have subsided, there are several factors at work which are likely to bring this issue to prominence:
Utility tariffs in several states are being revised to share the cost of a basic grid connection more easily, see AZ and NM. This will become a trend, since the grid is a shared resource, and the owners of solar panels could not assume they can opt out, or pay less than their fair share, let alone go off-grid and still be able to come back at the drop of a hat if a tornado or a hail storm destroys their solar panels. Granted, batteries can solve part of the problem, but in the end we all like 24/7 reliable power. We are not going camping. In other words, rooftop solar and utility companies are in conflict over the same revenue dollars, but the societal benefit will tend to favor the utilities.
Escalators feature in most solar PPAs and leases, and we are now in a 11-year low of wholesales electricity, so that the chance improves that your free solar panels may cost you more than electricity from the grid.
Notice that the initial securitizations of e.g. Solar City (one in 2013, two in 2014), are all comprised of panels with efficiencies in the mid to high teens, while the market is moving to the low to mid 20’s). As the portfolio ages, more and more changes of ownership will ripple through those portfolios, with home owners who have to sell facing the reality that they have to pass on the remaining liability for technologically obsolete panels. Combining the technological obsolescence with the low energy rates for the next two years, the issue of ‘underwater’ solar leases and PPAs is likely to get traction. Bloomberg already reported on it last summer: Rooftop Solar Leases Scaring Buyers When Homeowners Sell.
The Climate Change Picture
New York State is certainly trying to take the lead in far-sighted innovations in energy, including a heroic effort at revising its utility regulation. However, with the view from 30,000 feet, we would have to observe the following:
With a forecast of three times the number of 90 degree days by 2050, and A/C generally electrical, those solar panels that today could cover your electrical needs are not going to be sufficient.
The better solution, for properties that are suitable for solar, is solar thermal HVAC and Domestic Hot Water (DHW), which is a much more difficult integration job, but will be better able to handle the coming changes, and remove the A//C load from the grid entirely. In New York, the down-state grid already suffers from congestion, and permanently removing load from the grid should be a priority.
All the same arguments apply that only a holistic property-level energy retrofit can add value to the property. Piecemeal solutions will cause property owners to paint themselves into a corner.
In general, NY State has the right objectives: 50% GHG-emissions reduction by 2030, and 80% by 2050, but the current set of programs, taken together, ensures failure. The state cannot afford to continue to subsidize and promote piecemeal solutions that make the problem more intractable in the long run.
The better solution for NY State would be to dismantle most of NYSERDA and the Green Bank, and instead to copy the federal government by contracting for performance-based retrofits for all state buildings. The state should institute an energy incentive program that harmonizes the incentives to achieve 50%-80% GHG reductions, on a sliding scale. Such projects can be undertaken with a positive NPV, and therefore should be readily financible, while the state could provide certification of such retrofits. Since NYPA supplies all government buildings with power, the state would see an enormous revenue increase from selling NYPA’s very green energy (Niagara Falls!), on the open market as green energy.
Obviously, the issues are going to be similar in many states. A solar PV solution may be attractive and sensible today in homes that are mostly electrical, and have enough roof space and insolation so it is economical today, and into the future. In most other cases, it is more decorative than economically worthwhile.
The retained value fata morgana
Let me see if I can get this “retained value” concept right: I used to run a division of a global shipping company, and I am just trying to imagine a world in which our long term contracts, instead of just yearly recognition of revenues, as we earned them, would be put on the books as the net present value of future years… revenues minus servicing costs, minus finance costs, discounted to a positive NPV. We would have been laughed out of court. To put it differently, when I discussed SolarCity’s plans to reflect “retained value” in their financial reporting starting 1Q15 with an old accounting friend with extensive global experience and an ACAUS member, from the time of the “big eight,” and the “big six,” which are now down to the “big three,” his response to the idea was: “I guess we’ll soon be down to the big two.”
It is very clear that SolarCity’s management believes that their real accomplishment is this best expressed by this “retained value” metric. However, the more you look at it, it is a mirage, an accounting artifact, and it has all the hallmarks of a financial scam. It creates a management focus in which securitization of these SPVs is the real object of the exercise and the retail customers are just the victims who rent out their roofs to this racket.
First of all these are not remotely marketable securities, because they depend on a service contract from SolarCity itself.
If you had to mark these positions to market, the question becomes who is that market? Who would buy that inventory, unless they were willing to service the contract, and if they could service the contract, why should they want to take over SolarCity’s (technologically obsolete) portfolio of old business unless it were at a steep discount?
The present three deals from 2013 and 2014, for a total of $320 million are all of older panels, just when the market is moving towards efficiencies in the low 20’s (21-25%), including SolarCity itself, courtesy of Silevo (22-24% efficiency).
All at the same time gas and electric markets seem to destined to stay flat for the foreseeable future and as they are currently at 11 year lows, putting pressure on the escalations in those contracts, and
The problem of home owners moving is going to be growing, with more and more people experiencing that their proud solar panels may detract from the value of the property.
I suspect, so much for this accounting innovation. Ernst and Young may have to think twice before they endorse this particular ‘improvement.’
Conclusion
The market for renewable energy retrofits is maturing with an $55 billion big bang, in the form of the DOE’s ESPC program. Sellers of single point solutions that do not address the economics of total building economics, will lose out to integrators who add more value to properties. Properties that cannot undertake total energy retrofits economically will be at a discount to net-zero, for it will become the benchmark.
As a direct result of these developments, the rooftop solar companies that do not have any strong presence in commercial sales, and/or are unable to compete at that level by virtue of their business models, are on the endangered species list as of March 23rd, 2015. This includes SolarCity , Vivint Solar , RGS Energy . NRG Energy , has a much more interesting and diversified energy portfolio, and might be able to change its business model for rooftop solar to address the new realities. For now NRG has indicated that they are trying to out SolarCity, but that is a condition subject to change as the market shifts.
Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…)The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.