The “free” power of the sun has given hope to renewable energy investors but until now solar power hasn’t been able to compete head-to-head with most traditional power generation technologies. But solar has a big backer in the U.S. government’s SunShot Initiative.

The government has set an audacious goal of reaching $1 per watt for solar installations by 2017 with SunShot helping push costs down industry-wide. According to SunShot, a system cost $3.80 per watt to install in 2010, so a 74% reduction in cost in just seven years is about as aggressive as you can get.

Solar power is already competing with peak power production in places like Japan and California, and if costs are cut anywhere near 74% from current levels it would be a game changer. Bloomberg New Energy Finance thinks SunShot is a little ahead of itself and reality will be closer to $1.45 per watt by 2020, but either estimate is a big step in the right direction.

Is this just a dream made of pipes?
The first question we should ask: Is this is even possible? In an industry where costs are falling rapidly, venture capital money is pouring in, and innovative technologies are introduced regularly, the conditions are ripe for solar. Trends over the last several years suggest the cost reduction goals for SunShot have a fighting chance.

First Solar (Nasdaq: FSLR) reduced cost per watt from $2.94 in 2004 to $0.75 in 2011, a 75.5% reduction in cost in seven years. Thin film CIGS manufacturers are also claiming to have broken $1 per watt, and crystalline silicon panels are getting close to breaking the $1 threshold. But how steeply will panel costs' downward trajectory continue as we approach 2017? Ten years ago module costs were the low hanging fruit, so while continued cost reductions are necessary, costs beyond the panel will play a more important role. 

The low hanging fruit for solar installations now are the balance of system, or BOS, costs. These costs include land, inverters, installation, and regulatory costs. SunPower (Nasdaq: SPWRA) claims that its Oasis Power Plant design will cut BOS costs 25% by creating standard modules, using tracking technology to increase capacity factor, and cutting land costs.

Regulation and permitting are also becoming a huge thorn in solar developers' sides. Regulators often take years to go through environmental hoops and other wrangling that costs time and money for installers. So if SunShot is going to be successful, this government program is going to have to cut its own red tape to help solar developers.

Residential solar developer SunRun claims that cutting the red tape could save $0.50 per watt and that similar savings would be available on utility scale projects. The SunShot Initiative has targeted $0.76 in “soft cost reductions,” so regulatory changes are on the table -- although details are scarce right now.

Just $1 per watt may be a little aggressive, but manufacturers have demonstrated that large scale cost cuts are possible. In the next six years, we may have to rely on regulators and installation efficiency to play a bigger role in cutting cost from the system.

There will always be winners and losers
SunShot isn’t designed to pick company winners -- but no matter how funds get doled out, there are winners and losers. A few weeks ago, I highlighted the Department of Energy’s backing of thin-film solar in grants so far. That puts First Solar in the mix but leaves out some of the fastest growing companies in solar. In particular, Chinese companies will have to find ancillary benefits.

LDK Solar (NYSE: LDK), Trina Solar (NYSE: TSL), and JA Solar (JASO) are all cutting costs quickly but will likely be left out of direct benefit from the SunShot Initiative. Unless they build U.S. manufacturing facilities, they will have to count on lower BOS costs to help sales.

Innovation at product suppliers will also help manufacturers across the board. Suppliers like 3M -- which makes Ultra Barrier Solar Film -- are getting grants to explore cost-reducing technologies. The separation between manufacturers may come in the lab, where engineers are trying to come up with the next great solar idea and leverage new products from suppliers.

First Solar and SunPower have proven the ability to innovate and spend on research and development -- $27.6 million and $49.1 million, respectively, in 2010. As Chinese firms like Yingli Solar (NYSE: YGE) and Suntech Power (NYSE: STP) increase sales and build R&D departments, they may improve their competitive positions.

It’s also possible that the biggest innovations will come out of a company that is currently privately held. So investors should keep an eye on a company’s ability to make large acquisitions if the opportunity presents itself. Again, I point to First Solar and SunPower, which have $766 million and $722.9 million, respectively, on their balance sheets. Trina and Yingli also have the ammunition to make acquisitions if complimentary technology is available. 

Foolish bottom line
Keep an eye on innovation, a strong balance sheet, and continuously falling costs to see who will benefit most from solar costs falling to $1 per watt.

The $1 per watt goal itself is a stretch, but SunShot improvements in BOS costs and regulatory costs should help all solar manufacturers. First Solar and SunPower are this Fool’s pick, but Trina Solar and Yingli Green Energy are among the Chinese manufacturers providing investors plenty of value in solar.

Who do you think will benefit most from the SunShot Initiative? Leave your thoughts in our comments section below.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.