There have been a lot of concerns for the future of wind and solar energy in the U.S. heading into 2017. Most notably, the Investment Tax Credit (ITC) extension late in 2015 has led to very little utility urgency to sign solar Power Purchase Agreements (PPAs), and the new Trump administration may not take a favorable view of renewable sources of energy.
But the bigger concern may actually lie in the Federal Reserve and the monetary policies ahead of us. The central bank controls interest rates, and its words and actions go a long way in determining the rate of return investors require on energy projects. Required rates of return for investors have been falling, and with interest rates at historic lows, the Fed's policies have been very favorable to renewable energy. But if investors expect higher returns in the future, it'll have a cascading effect on renewable energy companies and projects across the country.
How interest rates impact the renewable energy industry
First, I think it's important to lay out why interest rates are important to renewable energy projects. When an energy project is built with the backing of a power purchase agreement, what a developer is really doing is ensuring the future cash flows of a project. If I know that my solar farm is going to generate $1 million in cash flows annually for the next 30 years, I can then predict what an investor might pay for those cash flows.
Where this impacts wind and solar developers is that as interest rates rise, which the almost certainly will over the next year, the value of projects in today's dollars declines.
Let's say two investors are looking at the projected cash flows from the project I outlined above. Investor 1 is willing to accept a 6% return on their investment and would therefore be willing to pay $13.76 million for the project today.
Investor 2 has a higher return requirement and wants an 8% return on their investment. The higher return means they'll only pay $11.26 million for the project.
A 2% increase in the required rate of return means an investor will pay 18.2% less for the project. This is how interest rates affect solar companies very quickly. And we're already seeing the seeds of higher interest rates in the market today.
Interest rates are already rising
Thinking about the impact of rising interest rates isn't a theoretical exercise in today's energy market. Since Election Day, the 10-Year Treasury bond's yield -- a benchmark for everything from mortgages to corporate bonds -- is up from 1.88% to 2.47%, a 59 basis point rise in just one month. And as the Federal Reserve raises rates, we could see the 10-Year rise further.
If President-elect Trump appoints a Federal Reserve chair in 2018 (when current chair Janet Yellen's term is up) who favors tighter policy or publicly nudges the central bank to take a tighter view of fiscal policy (something he's already done), it could mean further rate increases in 2017 and beyond. And the result will be a decline in value for nearly every part of the renewable energy supply chain.
Wednesday's 25 basis point increase in the short-term federal funds rate to 0.5%-0.75% was accompanied with an announcement that by the end of 2017 rates are expected to be 1.4%, in 2018 they'll hit 2.1%, and in 2019 the federal funds rate will hit 2.9%. Tighter monetary policy and higher interest rates are already on the horizon.
The impact on developers and suppliers is widespread
There aren't many parts of the wind and solar supply chain that won't be impacted by rising rates. Developers will have to lower costs on existing PPAs to come close to previous profit projections and we may see some projects go uncompleted because the economics no longer work. In the future, bids for power purchase agreements will incorporate higher rates, meaning all else equal, a renewable energy project's bid to supply electricity will be higher than it was under lower rates. This makes projects large and small less competitive with fossil fuels.
Suppliers could be hit on two sides if rates rise. On one hand, developers will want to squeeze out costs in any way possible, putting further pressure on components like solar panels, wind turbines, and inverters. If rising rates mean renewable projects are less competitive with fossil fuel plants (who have more of their costs spread over the life of the project through fuel purchases), it could mean a reduction in volume as well. Both would have a negative impact on the industry as a whole. This isn't a theoretical impact, either.
First Solar (NASDAQ:FSLR) and SunPower (NASDAQ:SPWR) have both announced delays in project sales in the second half of 2016 and SunPower lowered guidance because it overestimated the value it could sell projects for. And the value of projects they're selling to yieldco 8point3 Energy Partners has gone down as interest rates have gone up. At 8point3 Energy Partners alone, the Kern project sale, which was announced in January, had an implied cash yield of 7.7% and the Stateline dropdown announced in November had an implied rate of return of 9.7%. The 2% increase in rates I highlighted above may not be so crazy after all.
If this dynamic of rising rates and shrinking profits sounds ominous, it's because that's exactly what happened to SunEdison in 2015. When low-cost financing dried up, the company quickly went into bankruptcy and threw the entire industry into chaos for a few months. Rising rates can be dangerous if renewable energy companies aren't prepared for the impact.
Don't underestimate the power of the Fed
Low interest rates have been a massive tailwind for renewable energy companies over the past decade, driving PPA bids lower and helping make renewables competitive with fossil fuels. If the Fed continues to raise rates over the next few years, as planned, it won't make renewable energy completely noncompetitive, but it'll impact everything from component prices to the price developers will bid for new PPAs. That makes this one policy tool that shouldn't be overlooked by anyone in the renewable energy industry.
Travis Hoium owns shares of First Solar and SunPower. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.