By Dirk Michels

According to GTM Research, the U.S. solar PV market was at an installation pace of 878 MWp (DC) with 636 MWp (DC) in residential and commercial distributed installations in 2010. The research also indicated that the U.S. solar PV market will grow to annual installations of more than 5,000 MWp (DC) by 2015. If the majority of new installations are utility-scale solar facilities, the residential and distributed commercial/municipal sectors could fall behind in overall growth.

To prevent that loss of market share, the sectors will need to address the most significant factor affecting their success: cost competitiveness. The installed costs for residential and distributed commercial/municipal installations are rather high, at approximately US$5.71~US$6.98. That compares to utility installations, which are already at a much lower price point of between US$4.05 and US$4.80 for the year 2010. Further, it is expected that a large number of the currently available state and federal incentives will terminate, which further complicates ‘small-scale’ solar’s attempt to achieve cost competitiveness. In the coming years, the residential and distributed commercial/municipal sectors still have some catching-up to do before they can claim their fair share of future growth in the market.

Before we can project the future, it is instructive to consider the not-so-distant past. At the advent of the distributed U.S. solar industry more than half a decade ago, the chief challenge was reducing upfront costs for the installation, operation and maintenance of solar PV for consumers. Therefore, the emergence of solar Power Purchase Agreements (PPAs) was hailed as an enormous opportunity, enabling corporations, municipalities, and utilities to purchase solar electricity as a service. Since reducing the costs for consumers posed a financial risk for the distributed solar sector itself, another innovation was necessary. PPAs for many small projects were then aggregated into larger, financeable solar portfolios that could entice both debt and equity investors to deploy large pools of capital across discreet sets of solar assets.

Unfortunately, even with the bundling of projects, the growth of the U.S. solar sector is hampered by a project financing system that is excessively time-consuming and costly, particularly as compared to Europe.

In European countries with high-growth solar PV sectors, such as Germany, Spain and Italy, investors are paid a more direct incentive through feed-in tariffs. Closer to home, the state of Ontario, Canada has successfully implemented feed-in tariffs to grow its solar sector. Unlike these models, the U.S.A. offers indirect Federal incentives for renewable energy projects through tax credits to investors investing into these assets. Indirect incentives such as the Investment Tax Credit or loan guarantees add a level of complexity unseen in Europe, where a rather straightforward leveraged cash flow financing is the norm.

Here in the U.S.A., one has to contend with rather complex financing structures colorfully named ‘partnership flip’, ‘inverted lease’, ‘lease-pass-through’, or ‘sale-leaseback’─all names suggesting to the reader that complex also equals costly. As a result, players in the distributed solar PV sector divert what should be developer profit to banks and consultants as fees. Reducing the transaction costs per kilowatt of installed capacity or per kWh of production is a critical factor for the growth of residential and distributed commercial/municipal solar PV installations.

Therefore, the question is “How can we reduce the developer’s financing costs for these installations?” Scott Clavenna, CEO of Greentech Media Inc., aptly summarized the challenge at SolarTech’s Leadership Summit when he commented, “I think the solutions that jumped out at this meeting centered on educating the whole financial industry on the investment value of commercial and residential solar systems, and continuing to standardize the processes”

In addressing this challenge, I offer three possible solutions:

1. Make Solar an Asset Class (Like a Mortgage).

One of the first complex financing structures to be applied to the distributed solar sector was the ‘inverted lease’ structure─a structure previously available only in the affordable housing and historic building markets and never before used for any renewable energy projects. With this structure, which is now commonplace, I was able to help my client finance more than 30 solar projects and secure more than US$160 million in project financing during the worst recession in decades.

Structuring an inverted lease financing on a portfolio basis, where one pools a number of distributed projects, adds complexity and increases legal and other costs. Reducing these costs would have been possible if each project could have been financed as a stand-alone investment opportunity, just like mortgages on residences or commercial buildings are financed. Such a change requires that debt providers, are able to securitize their paper in a secondary market, which is currently not possible as distributed solar facilities are not recognized as an asset class.

2. Standardize Credit Qualifications and Documents.

The first step in the standardization process was recently completed with the drafting of standard PPAs and Engineering, Procurement and Construction (EPC) contracts, available through SolarTech. While the wide use of these standard forms is still new, their cost-benefit was demonstrated first by one of my clients who found that by using the standard forms, for each project averaging US$2 million in investment, the legal costs for securing project agreements were brought down to less than US$10,000 on average. These standard forms accelerate the financeability and affordability of commercial distributed solar projects.

However, additional costs and delays arise because credit qualifications, necessary documentation and individual terms in PPAs and other agreements are interpreted differently depending on the lender. The next step, then, is to bring lenders and tax equity providers into the dialogue around standardization so that both solar companies and lenders have the predictability necessary to reduce risk, increase profitability, and eliminate costly delays in project development.

3. Conduct Education and Outreach Targeting Local and Regional Banks.

When I first started working in this sector, I worked with a large national bank as tax equity investor in connection with a US$75 million combined debt and equity financing. This was the first time that the inverted lease structure was applied to the financing of solar facilities. The bank providing the tax equity was willing to use a structure new to the solar industry only because the bank was familiar with this structure from prior investments in other sectors, such as affordable housing and historic buildings.

Since then, other large national banks and smaller regional banks in the Silicon Valley and Southern California have followed. In fact, our firm’s solar finance team had a hand in familiarizing some of these banks with the inverted lease structure in numerous meetings with loan officers and credit committee members. With careful consideration of the risks and rewards these were convinced of the sector’s potential and have shown flexibility and leadership in this sector. While local and regional lenders may have fewer resources than the national players, with education and outreach they may be able serve as another reliable funding pathway, especially when financing smaller local projects with energy off takers that are known to the bank.

The solar industry is one of the fastest growing sectors in the U.S.A. According to a 2010 report by the Solar Energy Industries Association (www.SEIA.org), residential and commercial distributed solar sectors represented almost two-thirds of the grid-tied PV capacity. As more utility-scale projects come on line in the next three years, distributed solar’s dominant market share will certainly be overtaken. However, to increase solar’s share of the U.S. energy mix, a balanced combination of utility scale and distributed solar projects is necessary. More now than ever, cost reduction through innovative and simplified financial, legal and regulatory frameworks is critical to continued success.

Dirk Michels is a corporate and project financing partner in K&L Gates’ Palo Alto office (www.klgates.com). He works with clean technology clients throughout California and was recently honored as one of the Daily Journal’s ‘Top 25 Cleantech Lawyers in California’.