GUEST JUICE Regulatory Milk Bones By Michael Carboy

By Published On: October 27, 2006

As a financial analyst observing the Solar Power 2006 Conference in San Jose last week, I found it gratifying to see the industry emerge as a producer of commercially viable and necessary products. Regulatory posture is forward-thinking and sensible: buy-down incentives will, rightly, shift in the coming years to performance-based incentives. Such a transition will serve to protect the regulatory investment made by dispersing incentive dollars and will keep pressure on equipment producers to continue innovation leading to higher solar conversion efficiencies and lower module costs. Rather than regaling you with the oodles of statistics offered in the dozens of heavily attended panel discussions that demonstrated tremendous interest and prospects for continued growth, I thought that sharing with you a financial markets perspective on the key discussion themes might be more interesting. Over the course of the conference, I noted four major thematic issues distilled from the many conversations and presentations: coal/carbon issues; photovoltaic panel efficiency/cost issues; residential/small business financing methods; and concentrated solar plant (solar-thermal/electricity) technology/project finance dilemmas. First, carbon generation from conventional sources, coal in particular, must be dealt with as a clear and present threat to increased global warming. Solar power is a terrific solution. Let’s recognize, though, that while some might wish that coal would cease being used, it will continue as a fuel source for some years to come. Instant transitions are far too disruptive. When we discuss major shifts in energy sourcing, it is important, I think, to recognize that we are also working to change human nature. Humans, however, can be slow to change their ways and sadly often require either a proverbial Hobbesian stick applied to the side of the head or a dangled carrot of self-interest to stir movement. In addition to being a financial analyst, I am also a photographer, so visual metaphors come to mind when I observe the current state of the solar market. Several iconic images capture the nature of crowds transfixed by some event. Other images, however, make clear that those same crowds can fix their attention on and follow key issues just as a dog pays exquisite attention to a proffered biscuit. I think there is now adequate public awareness, despite the pabulum to the contrary from the “No Kyoto” apologists such as Senator James Inhofe (R-Oklahoma), Representative Dana Rohrabacher (R-California), and other elements of the Washington noise machine, that we, as a species, had better find ways to shift our power needs away from those sources that pour billions of tons of carbon into the atmosphere each year. Sensible regulatory policy has been that carrot of self-interest, and it will continue to be an important element of the equation for buyers and financers of photovoltaic and concentrated solar systems. I believe that while the various regulatory actions to encourage photovoltaic adoption have been successful, there remains opportunity for further regulatory action on the coal and natural gas side: specifically, policy and actions to encourage investor-owned utilities and munis to shift their appetites away from coal as rapidly as is feasibly and economically possible while working to mitigate the adverse emissions consequences of the baseload level of coal generation that, in my opinion, will be with us for some years to come. Despite the tremendous stock market responses to the stocks of solar energy equipment vendors, substantial portions of the institutional investor community remain on the sidelines as they work to understand the transitions occurring at the regulatory level. While the notions of “speedy” may differ between Wall Street and the State House when evaluating the pace of regulatory activity, clarity with regard to regulatory intention and well-defined timetables can provide some of the confidence investors need to supply capital into this hungry and growing market. Wall Street, although comprising many players ranging from institutional investors, bankers, financiers, and venture capitalists on through mom-and-pop retail brokerage clients, behaves in a pretty Pavlovian manner: show profit potential, get lots of attention. That hunger for profits is constantly weighed (and balanced) against the fear of loss. Investors, seeing end-market opportunities, clamor for more ways to invest; venture capitalists and investment bankers are pleased to oblige them by bringing companies through the breach and into the public markets via the initial public offering (IPO) process. Stock price performance following the IPO is more a matter of perception and expectation than just actual performance. Not surprisingly, stock prices reflect the collective investor consensus regarding expected growth. Regulatory action has a great influence on those perceptions of both opportunity and risk. Initially, investors I spoke with expressed concerns like “Does the stuff work?” and “Is it really time this time?” Most believe those questions to have been answered resoundingly in the affirmative. Now the questions are related more to regulatory process and how and at what rate incentives will change. Make no mistake: regulatory action is the key factor in most institutional investor minds. While technology risks are understood and end-market desire for clean power appears genuine, concerns remain that ill-timed and poorly formulated regulatory activity could scuttle the strong start now before us. For all their bravado, investors spook easily, and the impact of regulatory pratfalls can be tremendous. Favorable regulatory policy, to date, is akin to a giant hand parting the canopy of tall trees to allow sunlight to fall to the ground, enabling new trees to grow. The concerns about those proverbial hands vanishing unexpectedly or providing less assistance than expected are the palpable fear touch points of today’s investor, large and small. The second nexus of commercial interest and regulatory policy is related to PV efficiencies and incentives. Certainly, California Public Utilities Commission president Mike Peevey’s efforts to put in place an enlightened regulatory model are welcomed by customers and investors as necessary actions to spur volume adoption. Wall Street understands the efficacy of the up-front buy-downs as a first step. Future performance-based incentive models make logical sense to most investors. Of no great surprise, though, is the concern that we should not move too quickly to the performance-based incentive model before scale economies are achieved by the equipment manufacturers and installation trades. Once those savings are achieved, the reduction in incentive payments can be offset by the lower system costs. Obviously, moving exclusively to a performance-based incentive scheme before system costs are reduced enough to provide offset and before the necessary smart-grid monitoring systems are reliably scaled and deployed could spook the institutional investor community. The third topic, system financing, becomes more pressing as a transition to performance-based incentives occurs. How to provide financing for the up-front cost of systems? I believe Wall Street will work with the equipment manufacturers and installers to craft economical financing packages. The key will be to coordinate implementation of regulatory action with the pace of development for financing options. Don’t forget the old adage “It takes two to tango.” The financing methods created will have to provide the necessary cushion to soften elimination of the up-front buy-down incentives as performance-based incentives come into force. The tremendous adoption of distributed solar systems arose, in part, from the critical buy-down subsidies that made systems affordable for leading-edge users. As we shift to performance-based incentives, the financing packages will need to shift the cumulative economic value of the performance incentives, earned over time, back to the moment of initial purchase to offset costs. Obviously, as system costs continue declining and as efficiencies rise, the use of financing instruments as a way to mitigate up-front costs will similarly decline. The financing instruments are, however, not costless since money does have a time value. Perhaps the financing instruments will be small “solar mortgages.” Regardless of the names and types of financing instruments, it will be essential to coordinate the rate, magnitude, and timing of incentive revisions with the evolution of the financing techniques. As solar module production volumes grow and as critical process expertise is gained, costs will decline further. Until the industry matures to the point where incentives are no longer necessary, carefully timed regulatory incentive actions are needed and must be implemented with a sensitivity to the state of evolution of the financing mechanisms to ensure that a broad and reasonable market for such products is available to all potential users rather than select demographics. With a half-dozen concentrated solar plant deals in the works and proposals for another 1,000 MW of concentrated solar capacity being sought, we need to consider how to finance these plants. Public equity, in the near term, is not likely to be an option. The notion of public venture capital is one thing; public project financing is something else and far more difficult. The utility industry – investor- and municipally owned – will have to work with the engineering community to craft new construction contracts. Pointing back to my stick and carrot analogy earlier, the regulatory bodies can play a critical role in this process by recognizing the inadequacy of typical project financing mechanisms to grapple with technology risks and working to craft regulatory remedies to mitigate such concerns. We have a great start with sensible and enlightened regulatory policy creating an economic environment that rewards risk taking and has driven volume adoption of solar power installations. Recognize, though, that the role of regulation and incentives is far from over. Just as Congress was instrumental in cracking open the telecom industry with the Telecom Act of 1996, thus fostering tremendous advancement in the telecom and technology markets, so too can the role of regulation act as the catalyst for the reformation of our national power supply. Solar Power 2006 reflected the tremendous and broad-based interest in the solar power solution available for the residential, business, and commercial utility markets in last week’s packed solar conference in San Jose. If anyone is wondering, an almost fivefold increase in participation from last year’s conference is a big deal. To cap that, more than 55 percent of attendees hailed from outside the solar power industry, a very important “first” for a conference dedicated to a rapidly emerging industry. These statistics may seem mundane; they are not. If there were any lingering concerns about how broad and deep is societal interest in solar power, this conference shattered those illusions. – Michael E. Carboy is an equity research analyst covering the Green Tech sector for Signal Hill Capital.

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