Originally published in the Structured Finance Industry Group (SFIG) Newsletter
Following the conclusion of our three part series on Solar ABS, SFIG invites you to attend the following Solar ABS panels at ABS Vegas:
Solar ABS 101 – Sunday, Feb. 28, 3:50pm
Solar ABS: Understanding Market Potential and the Role of Securitization – Tuesday, March 1, 1:30pm
Solar ABS: Risk Management and Structuring Considerations – Tuesday, March 1, 2:20pm – Moderated by T-REX’s CEO, Benjamin Cohen.
Market Update
The U.S. solar industry has grown tremendously over the past 15 years. Annual installations of photovoltaic (“PV”) systems have grown from 4 megawatts (MW) in 2000, to over 7,000 MW today, resulting in a compound annual growth rate of over 60 percent. After the recent extension of the investment tax credit, the industry is well-positioned for continued rapid growth in the immediate future.
On January 13th, 2016, the solar ABS market saw its sixth deal price, SolarCity 2016-A. Notably, this transaction was the industry’s first to feature residential solar loans—not leases or power purchase agreements (“PPAs”)—as the underlying collateral. One of the interesting discussions regarding the deal has been around rate risk, after changes to net metering policies in Nevada had a substantial impact on the state’s solar industry.
In our first article in this “Spotlight on Solar” series, we provided an in-depth look at the drivers of growth and financing trends in the solar industry. In our second piece, we analyzed the rise of the solar loan, and how solar loans were affecting structures in solar ABS transactions. In this piece, our third and final in the “Spotlight on Solar” series, we provide an explanation of rate risk, how rate changes affect cash flows to solar companies, and how investors can assess and quantify this risk.
Which Rates Matter?
We will discuss two rates in this piece whose fluctuation can alter cash flows to solar companies. The first is the prevailing utility rate. The solar lease and PPA are based on the notion of allowing solar customers to pay less for solar energy than they would if they purchased electricity directly from the utility. The assumption in this value proposition is not only that PPA rates will be lower than utility rates in the short-term, but that PPA rates will also be lower 20-30 years in the future.
An example of rate risk posed by fluctuating utility rates presented itself in July of 2015 when the California Public Utilities Commission voted to alter the state’s utility rate structure from a four-tiered structure to a two-tiered structure. The reform implemented a time-of-use structure that raises electricity prices for energy-efficient houses, and reduces prices for larger energy consumers. Lower prices reduce the economic benefit of solar for customers that fall in this group, and increase the likelihood of contract renegotiation (as will be explained further in this article, contract renegotiation reduces cash flows to the solar company). While customers in existing contracts are unlikely to halt payments as long as PPA rates remain below utility rates, lower utility rates can increase the probability of renegotiation and decrease the likelihood of reassignment. If a solar customer sells his/her home, the new homeowner will be less likely to assume the solar contract connected to the home if lower electricity rates prevail, as the value proposition for solar with a lower cost of electricity would be weakened. For this reason, even if utility rates do not dip below PPA rates, lower utility rates can pose a risk to solar companies.
The second rate that is important to solar companies and consumers is the net metering rate. Through net metering, solar customers can sell unused energy back to the grid. When the rates that solar customers may receive for unused capacity are reduced, as occurred recently in Nevada, the value proposition for solar is diminished.
What is Rate Risk?
Rate risk is based upon the potential for changes to either one of these two types of rates. If utility rates dip below (or close to) PPA rates, or net metering rates are reduced, customers may re-evaluate and renegotiate their PPA. In SolarCity 2016-A, despite the small concentration of the portfolio in Nevada (0.1 percent of the aggregated discounted solar balance), there were some investor concerns regarding Nevada’s net metering reform potentially setting a precedent in net metering. However, due to the backlash the Nevada Public Utilities Commission has faced regarding the decision (particularly with respect to the lack of grandfathering), it is not likely that future reforms will be as extreme as those in Nevada.
Rate risk is different from other classes of risk, such as performance risk, in that it is not tied directly to the function or performance of the physical asset. Yet, rate risk has come to be acknowledged as one of, if not the most, significant risks for solar ABS investors. Investors must be able to quantify rate risk accurately to understand the risk and reward of investing in solar assets.
Quantifying the Impact of Rate Risk on Investor Returns
To properly assess and quantify rate risk, investors must analyze credit and rate risks. The following example demonstrates suggested steps in working through an analytical approach to quantify rate risk.
To understand the impacts that fluctuating rate levels have on cash flows, it is first necessary to compare contracted PPA rates to projected electricity rates in order to determine the probability of default.
Based on historical utility rate escalators with data from the U.S. Energy Information Administration, this illustrative example looks at four scenarios of projected electricity rates:
Under each scenario, utility rates increase at varying rates based on the assumed escalators. The following graph shows how an example PPA compares to utility rate levels in each of the aforementioned scenarios. In this example portfolio, we begin with PPA rate of $0.14/kWh, and an annual escalator of 2.9 percent. Utility rates begin at $0.16/kWh.
As the above graph demonstrates, mapping out sample utility rates against PPA rates can provide insight as to when default is more or less likely to occur in a portfolio of PPAs. The higher the escalator on the utility rate, the more likely it is that the PPA will be below the prevailing utility rate, thus the lower the probability of default.
Investors can use this information to analyze the level at which the PPA will be in the money or underwater in various scenarios. Note that with a utility escalator of 3 percent, the PPA rate always remains below the utility rate, and the contract will never be underwater.
After going through the first phase of analysis by determining the level of customer default based on rate analysis, it is then necessary to forecast what percentage of the defaulted customer base will be recovered and sign back on. Additionally, it is important to consider and account for the potential that the renegotiated rate could be at a discount to the utility rate. Another factor is the timeline for the customers to sign on to a contract, or the “lag.”
The following table illustrates the yield sensitivity of this sample portfolio of PPAs, isolating the impacts from the utility rate escalator and lag. Note that this particular example assumes a base case yield of 6 percent on the PPAs. In the body of the table below are the yields on the sample portfolio for various rate escalator scenarios and lags.
As the utility rate escalates more slowly, the probability of the contract defaulting increases, which is reflected in the reduction in yield as the utility rate escalator declines. This effect on the yield is reduced with lower lag: The faster a company is able to renegotiate a contract with a customer, the less of an adverse impact on cash flows.
Conclusion: Scientific Approach to Rate Risk
The recent extension of the Investment Tax Credit will drive incredible growth and cost reductions in the solar industry. The 2020 volume in the solar market is forecasted to be twice the size that it would have been without the ITC extension, and this growth presents an exciting opportunity for investors with the ability to analyze solar assets. In the next five years we expect that the sources of financing to drive this growth will diversify, as loans gradually overtake PPAs and leases in the solar industry as the primary financing mechanism.
As the solar industry matures, structures in solar ABS transactions will continue to evolve. The industry recently saw the first deal to be backed by solar loans, rather than PPAs and leases; as solar loan volume increases, so too will the number of ABS deals backed by solar loans. In order to become comfortable with these varying structures, and solar as a growing asset class, it is important that investors know how to stress the types of risks specific to solar. This includes both performance risk of the solar panels themselves, and exogenous factors, such as rate risk.
Rating agencies involved in solar securitizations have recently emphasized the importance of rate risks. Continued customer payments on PPAs and leases rely on solar contracts’ value propositions, which is subject to utility and net metering rate levels. To accurately assess the risk-return profile of solar investing, it is necessary to understand the yield sensitivity to rate levels, customer default probability, and renegotiation timelines.
Written By: Robert Bray – Associate, Product at T-REX