You may not see it if you're watching the explosive growth of companies like SolarCity (NASDAQ:SCTY.DL) and Vivint Solar (NYSE:VSLR), who are doubling and tripling installations respectively each year, but the U.S. solar industry may be in for a rough 3-5 year stretch.
Solar energy has long been a series of booms and busts, as subsidies come and go in countries around the world, and the U.S. bust could come in 2017 when the investment tax credit, or ITC, expires. It may impact these companies more than you think, particularly those growing quickly into the residential solar market.
What is the ITC?
The ITC is simply a tax credit for 30% of the cost of installing a solar system. For example, if you install a $10,000 solar system this year, you can reduce your tax liability by $3,000 with the ITC.
The ITC has helped all solar installers, but it's been particularly useful for residential solar companies. Most homeowners don't have enough tax liability to write off a $10,000 or $20,000 ITC credit, making sales difficult, so they bundle the system into a lease for the homeowner and sell the tax benefits to investors, known as tax equity investors. This model has been incredibly successful for SolarCity and Vivint Solar, in particular.
The year 2017 is key because the ITC expires at the end of 2016, meaning 2017 could see a huge drop in solar installations.
Why this is a huge deal in residential solar
This will have a bigger impact in residential solar than other parts of the business because residential systems are more expensive than large systems and companies have stretched the value created from the ITC.
Let's take SolarCity as an example. According to their third-quarter earnings release, SolarCity's total cost to install a residential solar system is $2.90 per watt, so a typical 5 kW system costs them about $14,500. But for the purposes of the ITC, they value the system at what they might sell it for to a homeowner. In the third-quarter earnings presentation they predicted selling systems for $4.35 to $5.60 per watt. Using the midpoint of this range, let's assume that SolarCity says a 5 kW system is worth $24,875, or $4.98 per watt, when it applies for the ITC.
For the purposes of the ITC, SolarCity is assuming a $7,462.50 tax credit with the higher valuation rather than $4,350 if they just used their actual cost to calculate the ITC.
This is key because the tax credit is a near-term cash flow for the investor who owns the solar system, and when the ITC expires, that cash flow will go to $0. And this is a big initial cash flow. In the example above, the $7,462.50 that SolarCity may be writing off is over half of the cost of the solar system in the first place.
The early cash flows of the ITC reduces risk for SolarCity dramatically and has a result of lowering the down payment needed, lowering lease power rates, and bringing break-even cash flow forward -- down to just a few years.
What happens when the ITC expires?
The question in 2017 is: Who absorbs the higher cost if the ITC expires? Customers aren't likely to take on more costs versus what a solar system costs in 2016, so the burden likely falls on solar installers. To keep their businesses going, SolarCity, Vivint Solar, and even SunPower, who is the most diverse of the large residential solar companies, will have to reduce margins here in the U.S.
Cost reductions will help ease some of the burden, but I would be shocked if 2017 didn't see a drop in U.S. solar installations, particularly on the residential side. For companies used to doubling year after year, struggling to keep the number of MW installed from declining will be a reality.
The ITC is a huge subsidy that's likely going away given the political climate in Washington, D.C., and if it does, solar system costs will effectively rise 50% or more overnight. That could be a big drag for solar companies focused solely on the U.S., something all investors should be aware of.