Re-Set or Game Over?

The solar industry, like many young industries, depends on substantial government subsidies to fuel growth and profitability. Weaning the industry off these generous subsidies, though, is proving to be a bumpy process.

Germany has long been at the core of the solar industry’s growth, driving installations with generous Feed-In Tariff schemes (FIT) that reward project developers who generate solar electricity. The country’s FIT structure incorporates a yearly decline in subsidies, designed to spur technological innovation and cost cutting in the solar industry. This is critical to keep in mind since Germany accounts for roughly 40 percent of the industry’s consumption, and each of the major publicly traded solar companies, including, First Solar (FSLR), SunPower (SPWRA), Trina Solar (TSL), and Suntech (STP) derive at least a third of their sales from Germany. First Solar still derives over 70 percent of its revenue from Germany.

As Germany’s subsidy declined eight percent in 2009 and 2010, the cost of solar panels was cut in half over the past year, driven in no small part by plunging raw materials costs. Selling prices have fallen at the same rate, now below $2.00 per watt versus over $4.00 at this time last year. With a new political party in control in Germany, the government decided that strengthening solar demand, if left unchecked, would put too much financial pressure on the country.

On January 20, 2010, the government proposed the following adjustments to the FIT:

- A 15 percent one-time reduction to rooftop systems rates effective April 1, 2010.
- A 15 percent one-time reduction to free field systems rates effective July 1, 2010.
- A 25 percent one-time reduction to free field “farm land” systems effective July 1, 2010.

In addition, if demand surpasses 3.5 GW annually, the FIT will be reduced by a further 2.5 percent. The next step down will occur if demand surpasses 4.5 GW, at which point the FIT will fall by another 2.5 percent. On the other hand, if demand is below 2.5 GW, the FIT will increase by 2.5 percent. These adjustments, though, will be finalized at the end of March.

Germany’s response seems to be as much a reaction to its own expense control as to the progress of the solar industry. Solar is becoming a larger part of the government’s bill since it is growing so fast, and in recessionary times it is not surprising that the government would look to cut back on its subsidization. Not purely a financial reaction, it is also a sign that the industry is progressing and is able to operate without training wheels. The solar industry has indeed lowered costs dramatically over the past year as polysilicon prices fell and technology improved.

All else equal, the effect of the cuts would be felt primarily by project developers, who would be compensated at a lower rate for the electricity they sell to utilities. Developers are currently making above-average returns on solar plants (since module prices are low), so it has been theorized that they could absorb the effect of the FIT cut without bringing about a drop in demand. A more realistic scenario, though, is that demand will drop as the adjustments are enacted in Q2, prompting sharp pricing declines beginning in the second half of 2010. We think this will be exacerbated by the fact that most solar companies claimed high visibility into the first half and have built up inventories in anticipation. The April timeframe of the subsidy cut is also three months earlier than many companies had expected, potentially sweeping the legs out from under their Q2 estimates. Battle Road Research is now predicting anywhere from a 15 to 30 percent drop in selling prices over the 2010 year, necessary to incentivize project developers and spur demand.

As Average Selling Prices (ASPs) fall, solar companies will feel pressure to reduce their manufacturing costs to maintain profitability. We will likely see increased investments in research and development to revitalize what seems to be stalled efficiency levels. Yingli Green Energy (YGE), for example, is now investing in the research of a high-efficiency solar cell in a project dubbed PANDA. Companies will also continue to absorb any leftover high-cost polysilicon and look to reduce grams used per watt in production in order to prop up gross margin levels.

It is also notable that France recently announced that it would cut its FIT by 24 percent and Italy may be the next country to decrease its support of the industry. The cuts call into question the likelihood of recently-announced solar IPOs coming to fruition over the next year. Though the industry was poised for a strong first half of 2010 predicated on robust German solar installation ahead of the feed-in tariff reduction, looming subsidy cuts in three of the largest geographies may cause Daqo New Energy, Solyndra, and JinkoSolar to alter their equity plans.

The new subsidy environment will also put pressure on smaller and weaker solar players, especially those bogged down by debt, since cleaning up their balance sheets would require solid cash generation stemming from improving demand and profitability. Subsidy cuts will make this task much more difficult.

While the reduction of solar subsidies will cause substantial near-term pressure on the solar industry, calling into question some of the bullishness predicated on an unusually-strong first half of 2010, we think it is also a sign of a maturing industry that is becoming more self-sufficient and it will serve to separate the weaker from the stronger players. As a temporary demand reset, we see the reduction as a speed bump in the long-term scheme of the solar industry.