The solar power market in the US, both solar thermal and solar photo-voltaic (PV), saw huge growth over 2007, and new investment funds focusing on solar and the broader renewables sector have blossomed. But the solar industry, to an even greater extent than wind, relies on the tax system to stay viable.

The current solar investment tax credit (ITC) is set to expire at the end of 2008. A crucial new piece of legislation for the solar market, the ITC was notably left off the energy bill signed by President George W. Bush in December 2007. If the 30% tax credit is allowed to expire, new investment in the solar market would likely drop off markedly.

But investors are still hopeful that a new ITC will be put in place, and investment commitments have already begun to roll in for 2008. Yellowstone Capital Partners launched its second alternative and renewable energy fund, Yellowstone Energy Ventures II, in January. It wants to raise $50 million for initial investments in solar, wind and other renewables projects. First round funding is expected to close in the first quarter of 2008. Technology Partners also announced the formation of a new $300 million investment fund last summer for clean technology and life sciences. Solar was touted as a prime investment area for the fund.

In addition GE announced plans in January to double its renewable energy investment to $6 billion by 2010. Within the first two years of the plan, GE expects investments in solar and wind power will account for 25% of the group's energy and water portfolio, although to date tax equity investments in wind projects have dominated its renewable activity. Renewables accounted for 10% of its portfolio in 2006.

Are project banks arriving too late?

Kelley Gale, partner at Latham & Watkins, says that a number of European banks active in the wind sector are also interested in the US solar market: "It is a natural extension for them to be active in solar as well. Because of the tax benefits that are available you will have the same bigger players who buy into wind projects buy into solar projects as well to get the tax benefits."

The solar market is at a key point of evolution. "It will be interested to see how it moves along here over the next couple of years, Gale says. "I would expect that in California we will definitely see a push to do some more solar projects, since California benefits from the right climate as well as really strong tax benefits."

How the market will develop also depends on the success of existing project deals, such as Acciona Energia's 64MW Nevada Solar One project. The $297 million project was funded through interim construction finance and then refinanced with a $271 million leveraged lease The lease consisted of $138 million in lease equity from JP Morgan Capital Corporation, NorLease, and WFC Holdings and $133 million in non-recourse debt from Spanish lenders BBVA, Banco Santander and Banco Caixa de Investimento.

One banker says: "The Nevada solar thermal project, for Acciona, shows that solar capacity can be financed in a similar fashion to other power projects, but we need to see more deals go forward before it proves itself."

Solar One, the first in its class, broke new ground in persuading project bankers to back solar assets. It took some time to syndicate, since it reached close in late July, and syndicated in late December, but choppy credit markets, as much as wary lenders, accounted for much of the delay. The financing also had to contend with an offtaker, Sierra Pacific Resources, which is rated below investment grade.

But worries about the viability of solar thermal technology have not been completely muted. Says Gale. "In speaking with lenders, clients and people on the development side, there seems to be some discussion over whether there are technical risks associated with large scale solar thermal projects," he notes. There are some concerns about new technology and storing power for delivery at times when production is low, and other issues that must be addressed for solar to become a firm power option.

Materials shortages hit some technologies

In addition, lenders and sponsors express concerns about the availability of materials for solar PV, because of the current shortage of silicon. They also suggest that projects still exhibit some regulatory risk, and question how reliable promises of grants and tax benefits will be in the hands of future administrations. Lenders also have to contend with the risk that supporting infrastructure, particularly interconnection with distribution networks, will be ready and available, and whether production estimates are reliable.

The shortage of silicon has been quite a problem, but silicon suppliers and silicon wafer producers are working to alleviate the issue. LDK Solar, a Californian supplier of silicon wafers, for example, broke ground on a new polysilicon production facility last August in order to alleviate its own supply issues, and a number of other wafer manufacturers are considering following suit. The $1 billion LDK plant is expected to start production in the third quarter of 2008.

More worryingly, solar projects, much like other big-ticket energy projects, suffer from a shortage of the requisite skilled labour, and are experiencing increased capital costs. Gale says: "It is as yet unclear what kind of capital costs you can lock in with a turnkey EPC [engineering procurement and construction] structure – and you would hope to be able to do that, because solar power is still a relatively expensive proposition by comparison to fossil fuel alternatives."

However the ramp up in silicon production looks set to result in raw materials cost reductions this year, which would potentially offset some of these higher labour costs. This is good news for project developers, but not such good news for those on the manufacturing side, as it could lower margins for cell, wafer and module producers next year.

These risks do not preclude a bond financing for a greenfield solar project, though the enhancements to the project's financial structure will be onerous. Neil Griffiths-Lambeth, analyst at Moody's Investors Service, says that the ratings agency has looked at a number of transactions but has not yet rated a solar power issue:
"Most of the potential issues can be addressed in the deal structure but Moody's will expect the debt service coverage ratios and liquidity arrangements to be commensurate with the risks left within the project vehicle," he says. "Generally we think that a solar transaction is capable of achieving an investment grade rating."

Agency concerns largely echo those of the bank market. Says one banker, "We would look carefully at the production estimates and the maintenance arrangements, including the project's exposure to component failure – for instance it may take some time to replace a failed transformer."

The US government's approach to solar is not unique, since Congress has lately been dilatory in providing incentives to both wind and ethanol as well, in the face of howls of disapproval from lobbying groups for both sectors. As oil prices loiter around $85 per barrel and the US economy starts to cool off, political attention is likely to drift away from renewables. But the lesson of past wind tax credit extensions is that an extension does come – eventually.

Even in more renewables-friendly jurisidictions progress can be patchy. In Spain, for example, the end date for the current tax and tariff incentive program is September 28 2008. If the present Socialist-led government returns to power in the country's general election in March, market participants expect that the program will be reinstated. However, if the government does not extend the plan before then it is likely that this market will dry up for the first few months of 2008, as sponsors worry about meeting the cut-off in time.

US solar sponsors are fortunate in that the tax incentive regime, no matter how stop-start, is easier for developers to exploit than the wind system. The ITC, which is paid according to installed capacity rather than according electricity production, allows for much more straightforward tax credit monetization. For that, at least, lenders can be thankful.

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Packaging Solar PV

While solar thermal generation attracts project finance attention, since projects tend to be much larger in scale, solar PV is gaining in popularity for corporate America, not only as a potential way of meeting carbon compliance targets, but also as a marketing exercise. Solar PV, which is easier to install on warehouse roofs, but tends to make for smaller projects, attracts a different type of investor.

For example, Google late last year launched construction of a 1.6MW, 9,212 solar panel array covering the rooftops of eight buildings. In January it said it would invest $10 million in eSolar, a Californian solar thermal company. And Wal-Mart announced last year the roll-out of solar PV projects at 22 stores in California and Hawaii – with a goal of providing around 30% of store power through such generating systems. SunPower, BP Solar and SunEdison will provide the systems.

In addition, Kohl's, Walgreen's, Staples and a number of other large retailers reportedly have rooftop PV projects in the works. Notes one lawyer: "It is absolutely the case that we will see more and more corporate solar generating systems being announced. That is part of what is attracting such capital to the space. And we will see a number of new capital injections being made as a result."

Solar PV projects are increasingly on the radar of public agencies across the country as well. The Nellis Solar Power Plant project, launched by MMA Renewable Ventures, is a prime example. The $100 million project is the largest solar PV project ever in the US and MMA has a 20-year PPA in place with Nellis Air Force Base to purchase the 18MW output.

Investment banks have become adept at packaging up these small deals into larger transactions. For example in November 2007 Morgan Stanley closed a deal providing $190 million to SunPower to finance a pipeline of commercial and public agency solar installations in California, and Goldman Sachs has created similar funding vehicles for SunEdison. The SunPower deal uses a partnership flip tax equity structure, through which the bank receives economic benefit up to a certain yield, after which SunPower gets the majority of upside potential. The structure, unlike the leveraged lease for the Solar One thermal project, would be familiar to wind developers.

Barry Neal, director of environmental finance at Wells Fargo, says the firm is working to bring small solar PV deals together into one larger transaction. Wells Fargo participated in the SunEdison and MMA solar PV financings. "There is certainly less interest in a single $3 million dollar deal and would be more interest in several deals together worth $50 or $100 million. The two deals we did – SunEdison and MMA – are good indications of where we think the market is going. We will see a lot more of those."