Solar photovoltaic installations are historically pricey investments, but over the past few years there have been significant cost reductions that make them competitive with other renewable, nuclear, and even fossil fuel generators. A common metric to measure the competitiveness of renewables is the levelized cost of energy (LCOE). If the LCOE is equal to or less than the cost to purchase the same amount of energy from the local grid, then it is said that the renewable resource has grid parity in that region. This is an important concept as it is a strong indicator of whether a renewable development will be viable or not. In 2016, Greentech Media (GTM) reported that residential solar has reached grid parity in 20 states of the US, and predicts that 42 states could reach grid parity by 2020 under business-as-usual conditions. The recent tariffs [ brief | dive ] will alter this trajectory of course, but most analysts consider this as a temporary setback, not an industry killer. The point is that the base cost of solar is becoming less and less expensive, allowing it to compete with other forms of energy – add on federal and state incentives and you have a very attractive investment. This series of posts will aim to clarify the many terms and types of agreements / relationships used in the financials of solar (and other renewable energy) developments.
PART 1 – Fundamentals: basic consumer-developer relationships
First, there are three fundamental structures for which the end user ⇔ developer transactions: Cash Purchase, Power Purchase Agreement, and Lease. The following evaluates each method from the perspective of the end user:
- Cash Purchase: This is just as it sounds – a complete upfront purchase of the system.
Pros: By taking full ownership of the solar system, the end user receives all of the generation, full access to whatever incentives apply, and a faster project timeline as there is no need for a third party credit evaluation.
Cons: A cash purchase is inherently the highest risk option for the end user. Full ownership of the potential gain also means full ownership of the potential risk. Without an external party managing the system, the end user will have to contract with another firm to operate and maintain (O&M) the system, or perform that work themselves. Lastly, the purchaser may not have a large enough tax appetite (ability to use the available tax credit) to take full advantage of the available incentives. In addition to these risks, because of the size of the capital investment, cash purchases usually are of residential or commercial projects.
- Power Purchase Agreement (PPA): A financing agreement which allows the end user to purchase solar electricity at a fixed price (lower than local electricity prices) in exchange for hosting the project. The solar system is installed on the host site, but the host does not own the system.
Pros: Because this is merely an exchange of goods and services (host site for lower cost of electricity), there is no capital investment needed, usually providing immediate net positive returns. The fixed price also protects against rising utility prices. Unlike a cash purchase, the third party accepts the performance risk as well as O&M responsibility. The third party usually has a larger tax appetite, making it more likely for the incentives to be received in full. These savings can then be passed down to the end user in the form of cheaper electricity prices.
Cons: It can be a very complicated and long contracting process, a credit review is required, and the project timeline will be longer than a cash purchase (by a month or so depending on the complexity of the legal agreements). Additionally, most models assume aggressive changes to utility pricing which may result in less savings over the course of the project lifetime.
- Lease: Again, this is just as it sounds – the end user will receive access to a solar system in exchange for monthly lease payments. This is similar to a PPA, but instead the lessee receives direct access to the generated energy instead of a reduced $/kW price. Often, there will be an option to buy out the system towards the end of the lease.
Pros: This requires little to no capital investment upfront, making solar accessible to a wider range of economic backgrounds. This also protects against rising utility prices and usually provides an immediate net positive return. Depending on the terms of the lease, the user may assume no O&M responsibility.
Cons: This is generally the least favorable option of the three. On top of its inherent faults, their contracts are usually the most aggressive and malicious – commonly written with hidden charges, unspecified payment increases, and other unfavorable terms. This isn’t to say that a lease is never a viable option, but that the terms and conditions should be evaluated closely. A lease requires the strictest credit requirements and the most complex legal terms, therefore they will usually have the longest project timeline. The investment is also the least efficient of the three options: unless a buyout is enacted, the investment disappears at the end of the lease; the total lease payment is likely more costly than the total payment by any of the other financing means. Finally, because the lessor receives a fixed monthly payment regardless of the energy produced, the lessor assumes very little performance risk and therefore lacks the incentive provided by a PPA.
Check out Part 2!