In the solar industry, a lot of attention goes to factors like Chinese manufacturing, trade wars, financing structures, and large utility-scale projects. But the biggest driver of the industry in 2019 may be interest rates.
Solar assets are high-cost upfront, and generate revenue (or cost savings) through energy production over 20, 30, or even 40 years. To properly value a solar system, these cash flows need to be discounted to today's dollars at an appropriate discount rate. The lower the rate, the more solar assets are worth -- and given the change in interest rates over the last six months, it should be a good year for solar stocks.
Image source: Getty Images.
Rates are dropping fast
Below, you can see the 10 and 30-year Treasury rates are both down sharply from six months ago. Slowing economic growth and the Federal Reserve putting rate increases on hold have affected rates, but for investors, it's the impact of lower rates that matters.
Why interest rates matter
When investors decide how much a solar project is worth, they discount the future cash flows at a discount rate. That rate can change over time depending on benchmarks like Treasuries or other risk factors, but has generally ranged from about 5% to 8% over the last five years based on asset sale prices.
Where interest rates fall in this range can have a big impact on what projects get built and for how much they're sold. Below is a discounted cash flow model for a hypothetical solar project with $1 million of annual cash flow contracted over the next 25 years. If we assume the value after 25 years is $0, this is the range of values when discount rates change.
|Discount Rate||Annual Cash Flow||Project Value|
|8%||$1 million||$10.7 million|
|7%||$1 million||$11.7 million|
|6%||$1 million||$12.8 million|
|5%||$1 million||$14.1 million|
Calculations by the author.
You can see that there's a $3.4 million range of values based on this one variable change alone. Now, consider the impact on the industry if this project cost $10 million to build. Would you build it? And how much profit would you require?
What if it cost $12 million to build? There's no way the project gets built if discount rates are 7% or 8%, but if they're 5% it's a no-brainer. That's why falling rates are great for solar companies.
There's a broad benefit in the solar industry if interest rates are low, but some companies will benefit more than others. The biggest beneficiaries right now will be residential solar companies like Vivint Solar (NYSE: VSLR) and Sunrun (NASDAQ: RUN). They install solar systems and finance them over decades, selling future cash flows to investors. Lower rates mean they'll get more upfront from those investors, increasing cash flow and profitability.
First Solar (NASDAQ: FSLR) also does some project development, and will see better sale prices for projects in 2019. It may also see marginally higher demand for solar panels as more projects are built.
SunPower's (NASDAQ: SPWR) business will be helped marginally, but ironically management has sold or eliminated most parts of the business that would be helped by lower interest rates. Residential and commercial projects that are sold will see higher prices, and demand may be higher for solar panels, but there won't be a major windfall for SunPower.
Solar stocks are on a tear
If there's one overarching factor impacting solar stocks in 2019 it's interest rates. Falling rates are like rocket fuel for the industry and its stocks, and as long as they stay low it'll be good for solar stocks.
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