Solar energy has historically been a series of boom and bust cycles.
For example, in 2008, Spain introduced a feed-in tariff, and installations boomed to 40% of total global installs. As a result, the government realized the subsidy was too high, cut subsidies, capped the market, and the solar market died. This has happened over and over again from Italy to the Czech Republic to Germany.
Subsidies that drive solar growth are exploited by the industry, and when there's too much solar installed, governments react by slashing the subsidy. That's why diversification is important in solar companies. For every boom, there's a bust and if you're dependent on the boom market, you could be holding the bag when it busts.
Today's boom markets
The hottest locations in solar today are the U.S., Japan, and China. The U.S. has been driven by falling costs but is also fueled by a 30% investment tax credit, or ITC, which essentially lowers the cost of a solar system by 30%. Japan is fueled by a feed-in tariff that may be slashed in 2015 because it's driven so much growth. And China is always driven by the whims of the Chinese government, who has been pumping money into renewable energy recently but may change plans in the future.
Being too reliant on any one market can be a recipe for disaster in solar. If you're in the wrong market when the bust comes, there's nothing to do to save your business.
Why the U.S. is dangerous today
These boom and bust cycles are notable today because the U.S. market is booming, and there could be a bust on the horizon. The investment tax credit expires for residential systems and is reduced to 10% for larger systems in 2017. When that happens, the cost of a solar system will effectively rise 50% overnight.
This could be very damaging for companies like SolarCity (NASDAQ:SCTY) and Vivint Solar (NYSE:VSLR), who rely on the U.S. for 100% of their revenue. If the U.S. market size falls, they could quickly turn from growth companies to shrinking companies. At the very least, they'll likely see margins plunge if they maintain their pricing for consumers.
The government could extend these tax incentives, but given the current political environment, I have doubts the ITC will (or should) be extended. As investors, it would be safer to be in solar companies with exposure to the U.S., but with diverse businesses that can move elsewhere if the U.S. market suffers.
Diversification has value in solar
For companies like First Solar, SunPower (NASDAQ:SPWR), and SunEdison, which develop solar projects around the world, diversification is of great value. They can shift and adapt to markets that have favorable economics and adjust if a market dries up. I recently talked to SunPower's CEO Tom Werner about exactly this type of flexibility (full interview can be seen here).
SunPower actually keeps a foot in markets that may be less economical in the short term in order to stay diversified. Long term, this keeps the company's business more steady.
Diversification certainly has value in solar, and investors should consider it when evaluating companies. SolarCity and Vivint Solar might be at a huge risk in two years if the investment tax credit isn't extended, and that's something to consider when deciding how you want to build your solar portfolio.
Travis Hoium manages an account that owns shares of SunPower and is personally long SunPower shares and options. The Motley Fool recommends SolarCity. 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.