One of the biggest reasons I think the solar industry has an incredibly bright future is the fact that it's one of only a few energy sources (i.e., wind) that is consistently and fundamentally lowering costs.
Fossil fuels, which are the solar industry's biggest competitor, are getting more expensive to extract from the ground in the long term, and nuclear costs continue to come in higher than anyone expects, making them noncompetitive with wind or solar. What's remarkable is the pace at which solar costs are coming down.
Solar costs becoming more competitive every day
A recent report from the Solar Energy Industries Association and GTM Research called "U.S. Solar Market Insight Report Q1 2015" showed that residential systems were 9.7% less expensive than a year ago, commercial system costs were 13.1% lower, and fixed tilt utility projects were down 7.6%.
That's an incredible pace for cost reductions considering the fact that solar energy is now competitive with the grid in all three segments. SolarCity (NASDAQ:SCTY) and Vivint Solar (NYSE:VSLR) can sell residential system leases or power purchase agreements for less than the cost of electricity to a home, even for small solar projects. Meanwhile on large solar projects, companies like First Solar (NASDAQ:FSLR), SunPower (NASDAQ:SPWR), and SunEdison (NASDAQOTH:SUNEQ) are winning projects based on the cost of the electricity they're selling, not mandates that used to drive solar installations.
More cost reductions are needed
The progress above is indeed impressive, but the industry needs to do a lot more in the way of cost reductions to stay competitive over the next decade. The investment tax credit (ITC) that gives project owners a 30% tax credit of the project's cost, effectively giving solar projects a 30% discount. But that subsidy will fall to 10% (0% for residential solar owners) in 2017 if it's not extended and GTM Research is expecting a big drop in solar installations when it does.
According to GTM Research Senior Vice President Shayle Kann, commercial and utility scale projects are most price sensitive because they're going head to head with grid and natural gas plant prices respectively. Margins will be slashed if costs aren't reduced in the next year and a half or installations will drop because projects can't be built competitively.
Residential solar will also be affected but according to Kann the residential solar market isn't going to be as sensitive to the ITC because it has higher margins and companies will focus on a small number of markets where they're still competitive with grid prices.
The ITC dropping from 30% to 10% will effectively make each solar project about 25% more expensive overnight, so the industry needs to cut costs by about 20% just to stay where it is today. That may be tough, but given the trajectory solar installers are on it looks possible even if it makes for a challenging couple of years.
A bright future for solar
Even if there's a blip in installations between 2017 and 2020 what investors should be focused on is the cost trajectory solar installations have. If costs continue to come down over the long term, the industry will be beat competing energy sources on cost more and more. It's that reason I'm bullish on solar and I see more and more opportunities to cut costs in years ahead.
Travis Hoium owns shares of SunPower. 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.