Understanding Solar Finance in India: Part 1 (Basics)

This is part of a set of articles: "Distributed / Rooftop Solar in India: A Gentle Introduction: Part 1","Rooftop Solar in India: Part 2 {Shadowing, Soiling, Diesel Offset}", "Rooftop Solar in India: Part 3: Policy Tools... Net Metering etc..." "Solar Economics 101: Introduction to LCOE and Grid Parity" , "Solar will get cheaper than coal power much faster than you think..", "Understanding Recent Solar Tariffs in India", "How Electric Scooters,... can spur adoption of Distributed Solar in India," "Solar + Ola! = Sola! ... The Coming Energy-Transportation Nexus in India", "UDAY: Quietly Disentangling India's Power Distribution Sector", "Understanding Solar Finance in India: Part 1", "Back to the Future: The Coming Internet of Energy Networks...", "Tesla Model 3: More than Yet-Another-Car: Ushering in the Energy-Transportation Nexus", "Understanding Solar Finance in India: Part 2 (Project Finance)", "Ola! e-Rickshaws: the dawn of electric mobility in India", "Understanding Solar Finance in India: Part 3 (Solar Business Models)" . 

This is the first of a set of articles on solar finance in the context of India and comparing with financial innovation in developed markets. This article covers basic ideas of solar PV capex / opex / production yield / monetization, project and equity IRR with and without debt, risk/reward characteristics that form the basis of finance, and recourse/non-recourse financing ideas. In future articles we shall cover how such mechanisms can come together into business models such as third-party ownership / solar-as-a-service (solar PPA, lease), solar loans, solar securitization, peer-to-peer financing, yield-cos, solar financing for the poor/offgrid (eg: pioneered by Selco) etc.

Lets start with the basics of solar economics in India. You want to put up a solar PV plant (either small scale rooftop, eg 3-10 kWp, medium scale (50 kWp-1MWp) or utility scale 50 MWp+). As we discussed in prior articles ("Understanding Recent Solar Tariffs in India", "Distributed / Rooftop Solar in India: A Gentle Introduction: Part 1"), a 1-5kWp system installed today in costs (i.e. CAPEX) Rs. 1L / kWp (~$1.5/Wp), a 10-25kWp system costs Rs. 75-80,000/kWp (i.e. $1.15-1.25 / Wp), a 50 kWp system costs Rs. 65-70,000 / kWp (i.e. $1-1.08 / Wp), whereas a large farm (MWp scale) costs between Rs. 48,000-55,000/kWp ($0.75-0.85 / Wp) installed including cheap land. {this does not include network transmission costs, and may include some evacuation costs}. India has perhaps THE lowest installed costs of solar PV in the world today and it is getting better with scale, local manufacturing, better supply chains etc.

A well maintained system (eg: clearing dust, avoiding shadows etc) yields 4.5 - 5kWh/day/kWp (18.75% - 20.8% capacity factor) due to the good amount and distribution of solar irradiance across India... India has "twice the sunshine, half the costs..." compared to Japan said by Masayoshi Son, Softbank CEO.  This translates to 135 - 150 units/month/kWp (1 unit = 1kWh), monthly energy yield, or 1642 - 1825 kWh/year/kWp, i.e. annual energy yield. If you have higher degree of power cuts or curtailment, shadowing obstructions for part of the day, poorly balanced system (different panels produce differently) or do not clean panels well, the energy yield can drop to 4 kWh/day/kWp. Our team at IBM Research is developing photonic harvesting technology to raise this yield to 6- 8kWh/day/kWp and beyond. The life of the system can be 25 years or more (solar PV modules are rated for 80% production at 25 years, (good) inverters need to be replaced once in 10 years) if well maintained.

The energy can be monetized on average today with power purchase agreement rate (PPA rate) at about Rs. 4.5-5.5/kWh wholesale (via PPAs with NTPC or state DISCOMs) and Rs. 6.5-7.5/kWh retail (eg: via net metering and other rooftop solar policies). If you multiply by the annual energy yield (lets pick 1825 kWh/year/kWp) with the PPA rate (lets pick average Rs. 5 / kWh wholesale and Rs. 7 / kWh retail), we get an annual revenue yield of Rs. 9125 / kWp/ year (wholesale), and Rs. 12,775 / kWp / year (retail). Remember that our capital expenses (CAPEX) numbers above ranged from Rs. 48,000/kWp (wholesale, MWp scale) to Rs. 70,000/kWp (50 kWp scale) and Rs. 1 lakh/kWp (1-5 kWp scale rooftop). If the annual operating expenses are 2% of CAPEX, we get an OPEX of Rs. 960 / kWp / year (wholesale) and Rs. 1500/kWp/year (retail, assuming a 75K average capex for businesses). Subtract this out from annual revenue yield, we get EBITDA (earnings before interest, tax, depreciation, amortization) of Rs. 8165/kWp/year (wholesale) and Rs. 11275 / kWp/year (retail or rooftop).

Divide EBITDA by CAPEX to get annual earnings yield: (8165 / 48000 = ) 17% wholesale, and (11275 / 70000 or 11275 / 100,000) = 16% (for a 50 kWp scale system) and 11.275% (for a 1-5kWp system). The earnings yield on invested capital (before depreciation or subsidies and financing) therefore rises from 11% small-scale retail to 16% medium scale rooftop to 17% utility scale.

Now that we understand how exactly our asset is a "productive" asset yielding regular cash flows, lets now think about financing. Financing is a function of risk and return; and relative to alternative returns (opportunity costs) on capital. In other words, if you as a residential investor were to take the same invested capital and put it in a bank's fixed deposit, you would get about 7.0-8.5% for 5 years in many Indian banks (see bankbazaar, or moneycontrol). In other words, if you fund the entire solar PV system with your own cash (i.e. 100% equity financing and own the system), trust the production yield / PPA numbers above, your PPA counterparty (i.e. the DISCOM) pays you on time, and you maintain the system well, you can expect a return of 11-17%. Note that the performance of the system diminishes by 0.5% per year over 20-25 years. If you compute an internal rate of return (i.e. project-IRR which in this case is also the equity-IRR), over a long term, i.e. 25-30 years, it will range from 10-16%. [Note: some of these numbers change if you assume an aggressive escalator for OPEX, and/or higher module degradation parameters etc. Also IRR is a function of the number of years: fewer years (eg: 5 years) will give you a fairly low IRR.]

Compare 10-16% IRR with 7-8.5% opportunity cost (i.e. FD rate for retail households), and 15% equity cost of capital for large-scale systems, we find that the economics are just about breakeven (3% spread for retail and 1% spread for large-scale). Observe that small-scale solar returns has lower returns and IRR, even with higher EBITDA and revenue yield since the cost of the system is almost twice that of utility scale and 33-50% above medium-scale rooftop sector. However since their opportunity costs (eg: fixed deposit rates) are lower, it is still a modest deal (positive economic value)!

As we have discussed in my rooftop policy article, the government policies on accelerated depreciation (eg: 80% in year 1; and 80% on remaining (i.e. .8x 0.2 = 16% in year 2 and so on - assuming you have other sources of earnings to offset the depreciation... AD rates are coming down to 40% from 2017), the proposed 30% MNRE subsidy for residential sector, in some states there is no tax on residential PPA inflows (eg: in Karnataka) for 10 years, UDAY reforms enforcing renewable purchase obligations (RPOs), and ensuring counterparties like NTPC or DISCOMs pay regularly and on time (eg: the UDAY reforms increase DISCOM's capacity to pay you by reducing their debt, and enforcing RPOs) can significantly improve these economics to about (note: IRR computed for 15+ years) 14-15% project IRR for residential, 20-22% project IRR for medium-scale rooftop and large-scale utility plants. Both these long term IRR numbers offer positive economic returns when considering opportunity costs (about 7 - 8.5% in residential FDs; and 15% cost of equity for commercial / utility scale for this level of riskiness in cash flows).

So, what are the risks associated with the cash flows above? The sun rises everyday with 100% probability - zero risk there! However, there may be clouds on specific days, aerosols / smog in urban areas, unexpected shadowing artifacts (neighbor's building), uneven dust / soiling and uneven balancing that reduces performance, panels that fail (quality and warranty matters!), panels could be stolen or damaged by vandalism etc. On the financial side, the DISCOMs or NTPC may choose not to pay you or dispute the amount you produced/fed-in etc. These are manageable, low risks, especially if you own the system and can put in good operational, security, contractual and mitigation mechanisms. Government policy stance and enforcement is also key. Note that the government policies both increase returns (via AD, subsidies etc) and reduce risks (via UDAY, escrow accounts, routing money via NTPC in JNNSM, Jawaharlal Nehru National Solar Mission, i.e. solar procurement). Once the solar PV system is commissioned (i.e. land acquisition, contracting / bidding risks are over), the operational risks (with good management) appear significantly lower than the general risk levels in the economy.

So far, we have considered equity financing (i.e. 100% paid by your own or your company's own spare cash). Suppose you want to set up a 500 MW farm, this will cost a capex of $375 million (at $0.75/Wp) like the SunEdison Rs. 4.63/unit bid for NTPC. Perhaps you don't have so much spare cash lying around, and therefore you need to raise debt. Remember that we started off with a 20% IRR project. If we fund 70% of it with debt, and 30% equity. Since interest expenses (for corporates) are tax deductible, a 14% pre-tax debt, at 30% tax rate is 9.8% post-tax interest rate. Now if you ask what is the levered or equity-IRR,we have to compute the cash flows to equity. This involves subtracting out debt service costs (principal & interest payments) for the term of the loan (eg: for 70% CAPEX) from the EBITDA, and allocating the equity portion of CAPEX (i.e. 30% of CAPEX) as the (negative, i.e. cash flow out) starting value in year 0.

This calculation shows an interesting phenomenon. If residential systems do NOT have subsidies (i.e. 30%), and pay roughly Rs. 1L / kWp, then taking on debt even up to 70% does NOT increase the long term Equity-IRR above Project-IRR significantly. This is because short term Project IRRs can be quite low (3-5% for 10 years) for unsubsidized, high cost residential. The only way to increase P-IRRs in unsubsidized small-scale residential systems is to increase feed-in tariffs (eg: Rs. 8/kWh and beyond).

However, for medium-scale commercial and utility-scale settings, the long term IRR (i.e. 20-30 year IRRs) can be amplified from 15-16% to about 25+% by taking on 15-20 year debt at 10% (post-tax). Depreciation (if cash flows are sufficient to utilize them) also boosts the returns, and magnifies the ratio of Equity-IRR to Project-IRR.

This boost in equity IRR is the "allure" of debt financing and high leverage ratios (70:30) for a significant term 15-20 years and why significant long-term debt-financing is sought by solar PV developers. Financiers are attracted to financing for several reasons: low overall risks (compared to say steel sector etc which are NPA ridden!), and if they can audit production, get a slice of incoming monetized production revenue directly from escrow accounts from government payments, this is almost like lending to the government at a higher interest rate.

However life is not this simple. First, the leverage (E-IRR to P-IRR) kicks in only when the capital costs are lower, and yields & monetization are good. Second, longer tenor loans are harder to obtain (esp from banks) in India, and requires some refinancing activity to emulate. Maintaining a high D/E ratio for a long term requires significant financial strength, operating excellence and financial engineering expertise. Most banks have asset / liability mismatch issues (eg: most fixed deposits (FDs) - their source of cash - are 5 years are less!), and give debt for 10-15 years max. Raising 25 year debt requires international capital or special infrastructure fund raising vehicles. Another option is to raise debt for 15 years; and re-finance the debt after 10 years for a 15 year period. If you look at your EMI (equated monthly installment) details, which includes both interest and principal repayment, the principal component of EMI tends to grow in the later stages of your loan term (eg: see JagoInvestor's site, reproduced below).

By doing this re-financing of your debt after 10 years, you are taking some interest rate and refinancing risk, and higher principal payments, but you can "emulate" a debt-equity ratio that is levered > 50-50 Debt/Equity over the 25 years of the horizon (i.e. you can get to 30%+ equity IRR or levered IRR). Also, by showing production and monetization yield data and regular EMI payment track records, the refinancing institution (perhaps the same bank) can gain confidence that their risks are low. This is what good CFOs do.

Second, the collateral we have assumed for 14% pre-tax interest rate (or 9.8% post-tax) is just the solar PV system, i.e. the banks or financiers do not have a lein on any other assets or balance sheet of a parent company. This is called "non-recourse project financing", or special-purpose-vehicle (off-balance sheet) financial for the specific project, i.e. the banks or financiers do not have any recourse beyond seizing your specific solar PV plant assets. Project financiers for utility scale projects with good offtakers may demand at least "limited recourse", i.e. lien on parent company balance sheet in the "construction" phase or for a limited time period, and convert back to just the project-as-lein for the rest of  the "operational" phase, post project commissioning.

In the rooftop sector, if you go to banks today and propose this for your rooftop solar, you will get a response that the bank wants to do recourse financing, i.e. they need collateral of more than just the solar PV system (remember you have 30% of equity in it), AND  typically a lien on other assets (eg: FDs or financial investments (eg: debt funds) you may have with the bank if you have a long term relationship, or a lien on fixed assets that THEY understand how to sell on the secondary market, i.e. a home etc).

If they can classify this as a loan under a housing-loan category, then they can piggyback on all the great regulations/fund availability for this sector to offer lower interest rates because they have powers under SARFAESI act to seize your home if you default on your payments. Renewable energy has also been classified as a "priority sector" - banks are required to do 40% of their lending to priority sector causes (and since solar PV is a "lower" risk, priority sector lending opportunity, banks should be enthusiastic).

Coming back to housing as an addition recourse collateral for solar PV -- a home (or more precisely the land underneath which is the core of value of a home) cannot walk away, whereas a solar PV plant could be dismantled and disappear! (bankers who lend at 70:30 leverage ratios are VERY risk averse and think of all of these possibilities - and they should). The bank knows how to sell off a home and monetize it; but there are no visible / well-operating secondary markets for used-solar PV systems or system assets (eg: used PV modules, inverters). This suggests an innovation opportunity that if beyond monitoring (of solar PV performance, security cameras etc), escrow accounts (where the EMI slice of the bank comes directly from the escrow account), if a secondary market emerges for solar PV equipment, it will increase the funds flow into solar loans.

All this talk of attaching your home (or real-estate) to the debt contract makes sense if we are talking rooftop solar. For utility scale solar, there is no home to attach to, and therefore, bankers want to attach leins on broader balance sheets of the developer company, or charge higher interest rate if it is a non-recourse off-balance sheet SPV.

Third, the conversion I did above from 14% pre-tax interest rate to 9.8% post-tax assumes a tax rate of 30% and a profitable enterprise. If you have 80% accelerated depreciation, unless you have additional sources of revenue that you mix with the solar PPA inflows, the tax benefit on interest payment (and depreciation) will roll over to future years. This effectively means that you don't get the full 30% discount from pre-tax to post-tax rates. This again implies that (a) you increase the yield of the assets (eg: via operational excellence or technologies like photonic harvesting that IBM is developing) or (b) bundle the earnings / cash flows from other profitable business (eg: petrol bunks, tax accountants, real-estate lease incomes etc) into the financial income statement. While this can be done on a consolidated income statement of a company with multiple businesses, it is harder then to separate out the solar PV project itself onto an off-balance-sheet SPV and finance it separately (since the interest coverage ratios, and cash flows to drive the depreciation / interest tax benefits will disappear).

In summary, we have seen how a solar PV asset procured at good CAPEX (India has the lowest installed CAPEX in the world now), good operating practices, and strong PPA counter-parties to procure power can be the basis for solar finance since it has 20% IRR (for 50kWp+ systems - rooftop or utility scale), and 14-15% IRR for residential small scale systems, once government policy support / tax frameworks are considered. Such finance can spike up leveraged or equity IRRs (internal rate of return), assuming low capital costs, high leverage ratio (70:30 financing), and long term loans (15 years+, and reasonable rate, 10% post-tax rate) making investment in solar attractive for the developer (high IRR = high RoI, return on investment).

Arranging such large upfront finance at a high leverage ratio for a longer term in the context of India today involves some clever financial engineering and negotiation of terms such as recourse / non-recourse, refinancing after 10 years etc. However, the fundamental risk profile of solar PV is low with good operational practices and security of the asset. Extracting high asset yield and monetization is very important, and can magnify the leverage effect in both directions (low yield means poor economics).The government has classified RE as a priority sector lending area as well, which means that a significant amount of domestic capital can be mobilized (in addition to foreign capital). As the capital costs of solar decline, and new ways of raising energy yield / manage asset productivity over the long run improve, the already attractive RoI and IRRs will become better for the savvy first movers in solar PV development in India. This will drive adoption rates of solar PV in India.

In future articles we shall cover how such mechanisms can come together into business models such as third-party ownership / solar-as-a-service (solar PPA, lease), solar loans, solar securitization, peer-to-peer financing, yield-cos, solar financing for the poor/offgrid (eg: pioneered by Selco) etc.

Twitter: @shivkuma_k

ps: I had made some errors in the first version of this writeup with simplistic conversions from Project IRR to Equity-IRR. The reality is more nuanced, and a function of (a) project capital costs (lower CAPEX significantly impacts) (b) project yield, & OPEX (higher yield significantly impacts economics) (c) term of debt (15 year+ loans better for utility scale / medium sized rooftops) (d) debt / equity ratio and debt rates (higher D/E ratios like 70/30 boost up returns further, but D/E will be limited by prudential debt-service-ratio norms).

Specifically, a residential project with high capex, no subsidies, low-medium feed-in-tariffs, low-medium energy yield may not benefit (i.e. neutral) from a leveraged return perspective by taking on debt; although it may be OK on economics from an opportunity costs, i.e. earnings yield perspective (> fixed deposit rates).

ps: If you like this article, please check out the companion articles: "Distributed / Rooftop Solar in India: A Gentle Introduction: Part 1","Rooftop Solar in India: Part 2 {Shadowing, Soiling, Diesel Offset}", "Rooftop Solar in India: Part 3: Policy Tools... Net Metering etc..." "Solar Economics 101: Introduction to LCOE and Grid Parity" , "Solar will get cheaper than coal power much faster than you think..", "Understanding Recent Solar Tariffs in India", "How Electric Scooters,... can spur adoption of Distributed Solar in India," "Solar + Ola! = Sola! ... The Coming Energy-Transportation Nexus in India", "UDAY: Quietly Disentangling India's Power Distribution Sector", "Understanding Solar Finance in India: Part 1", "Back to the Future: The Coming Internet of Energy Networks...", "Tesla Model 3: More than Yet-Another-Car: Ushering in the Energy-Transportation Nexus", "Understanding Solar Finance in India: Part 2 (Project Finance)", "Ola! e-Rickshaws: the dawn of electric mobility in India", "Understanding Solar Finance in India: Part 3 (Solar Business Models)" . 

pps: List of all my LinkedIn Articles