How the Fed Could Crush Solar Stocks

Image source: SunPower.

Quietly, solar stocks have been a major beneficiary of low interest rates over the past few years. Low rates or required returns for debt and equity help make long-lasting solar projects more economical and allow for solar companies to make competitive bids for new projects. 

If the Federal Reserve begins raising short-term interest rates in September (as many speculate) it could also raise longer-term rates and have an adverse effect on solar companies.

How discount rates impact solar energy
A solar project built today can last 20 years, 30 years, or even longer. So, to calculate a value or return for that project, we have to use discount rates to project the value of cash flows decades from now. This is similar to what's done for all kinds of projects, but for solar energy the low discount rates we've seen recently could lead to a rapid change in values if discount rates rise.

In the example below, I've taken a look at the hypothetical value of a project that a company may sell. Let's assume that the project will generate $100 of cash flow annually for 20 years and have zero value at that time. Below I've calculated the value of that project based on three different interest rates. 

Calculations by author.

As rates rise, the value of the project goes down. What's incredible is the rate that the value goes down. Between a 6% and 10% discount rate, the value of the project falls by 26%. This can be a huge impact to companies like SunPower (SPWR -3.17%), First Solar (FSLR 0.71%), and SunEdison (SUNEQ) all of which sell projects both to third parties and to their own yieldcos. For those three companies and SolarCity (SCTY.DL), which keeps most of its solar systems itself, the rising rate will have a direct impact on the value investors put on the stock as well. 

How interest rates impact project bidding
The prior example shows how the value of a known project can change, but changing interest rates will also impact what a builder can bid for a new solar project's power purchase agreement.

Let's assume a project can generate 1,000 kWh of electricity per year, costs $1,000 to build, and has a 20-year useful life. Changing only the required rate of return of cash flows has a big impact on what a company can bid for the energy they sell. 

Calculations by author.

The column on the right shows the power purchase rate per kWh these projects would require given the interest rates on the left. There's a huge difference between bidding 8.72 cents for a project today and 11.75 cents. The likelihood of getting a deal with a utility at the higher price drops.

Image source: First Solar.

This is the conundrum that will face SunPower, First Solar, SunEdison, and SolarCity in each company's attempt to grow as interest rates rise. Unless fuel costs rise or costs come down quickly each company will actually be less competitive.

Complicating matters further
On top of rising interest rates, the investment tax credit is set to decline from 30% to 10% for commercial projects and to be eliminated entirely for residential homeowner-owned solar systems in 2017. If interest rates rise and the industry's biggest subsidy drops, it could be a double whammy for everyone involved.

Given the solar industry's history of lowering costs and dealing with challenges in energy, I don't think rising interest rates or the dropping ITC is a deal breaker for any of the companies I've mentioned, but it's a risk investors should be aware of. On the flip side, the longer interest rates remain low, the more reprieve solar companies have from this pressure. Maybe the Fed's statements will be worth watching, even for an industry getting its energy from the sun.