We're looking at the biggest evolution in electrical energy since Thomas Edison built a small electrical grid in Manhattan in 1882. Since then, the electrical distribution model -- centered on the construction of a large fossil fuel power plant and a network distributing electricity to consumers -- hasn't changed a whole lot. It's about to.
Solar power enters this stagnant industry as an underdog, challenging everything from the business model of utilities to the theory that the world will rely on fossil fuels forever. Households have become generators of energy, not just consumers, and it's having a destructive impact on the whole sector. This provides an opportunity for investors willing to get out in front of this energy revolution.
Solar changes the energy game
The growth of the solar industry in the US began with giant projects in the middle of the desert. First Solar (NASDAQ:FSLR) and SunPower (NASDAQ:SPWR) have led the industry into utility-scale projects, creating internal demand for modules and generating industry-leading margins along the way.
When projects like Blythe Solar Project (pictured below) hit the grid they require some adaptation from the utility, but that's usually forced by state renewable energy standards. Power purchase agreements signed with solar developers require that the grid pays for power coming out of these projects, even though output varies when clouds roll in. Utilities have to adjust by using natural gas power plants to fill the gaps in the grid.
These projects are usually built in the middle of deserts, so power is fairly consistent. The variable energy source is a new challenge for utilities, however.
This is where the future becomes extremely scary for the entrenched energy industry. While utilities can control how many utility-scale projects are built and how they fit into the grid, the distributed solar market (which includes residential and commercial solar) poses a different kind of challenge. When a solar system goes up on a rooftop, it not only reduces demand from that point on the grid, but is capable of reversing and generating power for the grid.
This is a completely novel concept for an industry that's used to feeding power to consumers and doing so under the cover of a regulated monopoly. The regulated returns a utility gets for building power plants and transmission and distribution lines are upended when customers can generate their own power. And we're just starting to see the impact of distributed solar power generation.
The tip of the iceberg
Distributed solar power is growing quickly, but it's just barely scratching the surface of its potential. SolarCity (NASDAQ:SCTY.DL), the largest residential solar installer in the U.S., had 54,650 lease customers at the end of last quarter, and competitor SunPower had 18,400 residential leases.
This may seem like a lot, considering the fact that both are only a few years into leasing solar systems. There are about 114 million homes in the US, so that means two of the leading companies in distributed solar have only reached about 0.06% of American households. If we assume that they control about 20% of market share, the entire industry has only reached about 0.3% of households.
This creates a problem for utilities, which are forced to take the extra power distributed generation creates and provide power when the sun isn't out. Arizona Public Service is the most vocal in fighting against this net metering, but it's being challenged in California and other states.
Utilities just aren't built to handle distributed power generation, and that creates a problem for the entrenched energy industry. SolarCity, SunPower, Sunrun, Clean Power Finance, and others are already making it possible to get rooftop solar with $0 down, so the economic incentive to keep the industry growing is there.
It will take years to sort out how the utility and solar industries will get along, but ask yourself if you want to invest in the disruptive technology or the industry being disrupted? The latter rarely wins.
Falling costs create more momentum
The cost of solar power is also rapidly falling below grid parity, a key point for the industry. SunPower and First Solar have signed utility scale projects for 10.4 cnet/kW-hr in California and 5.79 cents/kW-hr in New Mexico (about 8 cents after state incentives) respectively, which is well below the cost of the grid. So, while the industry is already breaking through grid parity, its costs are falling, creating more momentum.
Residential installers already offer leases below the cost of electricity, which is why net metering is viewed as such a threat to the traditional energy model. You can see that no matter how large or small, solar is becoming more cost-effective, driving growth and continue to upend the energy industry.
For some perspective on progress, GTM Research and the Solar Energy Industries Association report that PV solar system prices are down 40% since the start of 2011, and the cost of a module is down 60% in the same time. No other major energy source can claim that kind of progress in the past 2.5 years.
A paradigm shift in energy
Solar power is a paradigm shift in the way we think about energy, and it creates a great opportunity for investors. Utility-scale projects are being build at competitive wholesale prices around the world, and First Solar and SunPower are leading the way.
On the residential and commercial side, SolarCity is the clear leader in the US, and SunPower sprinkles in some residential leasing as well. These are the two leading stocks in solar this year, and they're my top picks for profiting in solar long-term.
Fool contributor Travis Hoium manages an account that owns shares of SunPower and personally owns shares and has the following options: long January 2015 $5 calls on SunPower, long January 2015 $7 calls on SunPower, long January 2015 $15 calls on SunPower, long January 2015 $25 calls on SunPower, and long January 2015 $40 calls on SunPower. The Motley Fool owns shares of SolarCity. 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.