Will the Solar Lease Live Forever or Flame Out?

Leasing has made solar power an affordable option for tens of thousands of Americans and now account for more than 75% of the total residential solar market. SolarCity (SCTY.DL) has done more to expand the solar lease than any other company, while SunPower (SPWR -1.02%) and NRG Energy (NRG 1.57%) are following fast behind.  

But is the solar lease the future of residential solar, or is it a fad that will fade away like so many other solar products? Let's look at where the market is today and where it's going.

In California, entire communities are being built with solar pre-installed on new homes. Source: SunPower.

Why solar leases work
The solar lease became popular in large part because it made the expensive up-front cost of a solar system affordable for the average consumer. A company such as SolarCity, SunPower, and now NRG Energy, puts up the cost of building the system in exchange for a monthly payment, the same way people lease cars or houses. Generally, consumers save cost monthly because the power purchase agreement in the lease is lower than the cost of electricity from the utility, and they don't have to put any money down up front.

This is profitable for lease owners because they can efficiently take advantage of tax breaks by using tax equity partners and can get lower financing costs than a homeowner could, which results in high overall margins.

SolarCity workers install panels on a home. Source: SolarCity.

The real innovation came in taking all of these factors and packaging them in a way that's easy for the consumer to understand. Instead of trying to sell a $30,000 solar system that may have a rate of return that's difficult to understand, salespeople are selling a lower cost of electricity every month, which is easy to understand.

But there's reason to believe that the leasing business is under pressure over the long term, and that other products may dominate in the future.

Why the solar lease won't be the dominant paradigm
What many question about the current lease market, myself included, is the assumptions made in selling leases to customers. A couple of recent price quotes from SolarCity for fellow Fools Jason Hall and Wade Michels show that the company (and presumably others) is using unrealistic projections to show more cost savings to customers than they'll actually see.

The SolarCity quotes, from Connecticut and California, show huge savings of $23,942 and $5,410 over 20 years in Jason and Wade's respective locations. But they assume that electricity costs will rise 4.8% annually from rates of $0.188 per kilowatt hour and $0.178 per kilowatt hour. The problem is that assuming high growth for utility rates inflates projected savings and flies in the face of both history and the solar industry argument that solar lowers the overall cost of electricity for everyone.

You can see below that SolarCity's assumed price increases in grid electricity exceeds the historical increases by a wide margin.

Source: Quotes from SolarCity.

The Connecticut quote assumed an initial power purchase agreement rate of $0.11 per kilowatt hour, increasing in cost by 2.9% each year over 20 years. By the end of the contract, energy would cost $0.195 per kilowatt hour. Savings calculation were done assuming an $0.18.8 cost of electricity from the grid, increasing 4.8% annually to a whopping $0.48 per kilowatt hour in 20 years.

The California quote assumed an initial PPA rate of $0.176 per kilowatt hour (due to fewer state incentives), increasing in cost by 2.9% each year over 20 years. By the end of the contract, solar energy would cost the homeowner $0.312 per kilowatt hour. Savings calculations were assumed a $0.178 cost of electricity from the grid, increasing 4.8% annually to $0.455 per watt in 20 years. In table form it looks like this:

Source: Quotes from SolarCity. Author's calculations.

If we use the historical compound 20-year growth rate of electricity, the Connecticut quote still results in significant savings over two decades, but far less than the $23,942 quoted by SolarCity. The California quote would actually result in a higher cost of electricity from solar using the historical average growth rate.

What's important to understand is that the assumed growth rates of both grid and solar PPA costs matter. If PPA rates rise faster than the actual cost of power from the grid, the cost savings per month decreases rather than increasing.

This is important for leasing companies because nationwide, like I've shown in Connecticut, utility rate growth is actually slowing. This is partly due to slower demand growth around the country, but it's also helped by solar panels generating power during the day, offsetting the most expensive power purchased by utilities.

A solar home community installed by SolarCity. Source: SolarCity.

The real threat to the solar lease
I don't write any of this to suggest that the residential solar market will shrink. In fact, I think it will continue to spread rapidly across the country. I just think long term it makes more sense to use different financing.

The alternative to the lease will be the solar loan, and that's where I think we'll see real innovation over the next five years. Loans allow for a consistent monthly payment and enable the homeowner, not the leaseholder, to take advantage of tax breaks.

In the examples I've used above, the Connecticut solar PPA payment of $74 per month implies a 5.9% annual rate on the interest of a loan for the $15,158 purchase option after incentives, while the California system implies an 8% interest rate ($80 monthly/$12,005 purchase price).

Mortgage rates are currently lower than both of those rates, so it's reasonable to assume that homeowners could buy the solar system for $0 down and a lower monthly payment if solar loans can command the same rates as a mortgage. Plus, at the end of 20 years the system is yours.

If loans can be sold and structured to take advantage of federal and state incentives, and allow homeowners to go solar for $0 down, I think that will be the dominant financing product in the long term.

Why leases won't last as the dominant solar product
I think solar leases are ultimately like car leases. They'll eventually have maybe 20% market share in solar, but won't be the dominant product like they are today. Leases on cars offer similar benefits, such as lower initial monthly costs, but similar pitfalls, including owning nothing when the lease is over.

I also wonder how long SolarCity and SunPower can generate upward of $2 per watt in retained value when system costs are between $3 and $4 per watt before any incentives, and falling. That's an incredible 30% to 40% implied margin, something you won't see in any other home construction business.

There are good reasons leases have become the dominant financing product for residential solar today, but as installation costs fall and more financing options become available I think that dominance will fade.