With growing unease over climate change, energy import dependence, and other environmental and economic factors, transitioning to cleaner and more sustainable energy sources has long been a priority for many nations. But when Russia made its natural gas exports a tool of brinksmanship with much of Europe last year, during the aftermath of the Ukraine invasion — and millions of consumers saw eye-popping, double-digit increases in their energy bills — a sense of renewed urgency for this need hit leaders and citizens from across the political spectrum worldwide.
And this attention isn’t likely to fade in 2023, as the immense investments utilities have made to improve the U.S. and world’s energy infrastructure continue help to push rates skyward. Further, while decreasing hardware costs and advancing technology are slowly helping to bring new options to both businesses and consumers in core areas of the sustainable energy industry, the favorable economic conditions that have helped clean energy grow in the past decade have sharply reversed in the last two years.
The robust growth of U.S. solar
The solar market in the U.S. provides a notable example. According to a February 2023 report published by Morningstar, the U.S. rooftop solar market grew by about 30% between 2021 and 2022, with rooftop installations seeing a 23% compound annual growth rate since 2018. Much of this growth was fueled by 0% loans for solar installations (which can run $25,000), rapid expansion among the largest companies providing these services, and strong regulatory support and consumer incentives in sunny states such as Arizona, Florida, Hawaii, Texas — and especially California.
Of course, the financial environment has deteriorated markedly, with an historic inflation spike and surging interest rates that will make financing a solar installation far more difficult for many Americans going forward. Importantly, the Inflation Reduction Act passed in August 2022 extended the 30% federal tax credit for solar installation until 2032 — instead of allowing it to bottom out at 10% in 2024 as previously slated. But while this tax incentive has been integral to solar adoption in the U.S., and will be even more so going forward, many analysts believe that it won’t be nearly enough to counter the new challenges facing the solar industry in the short term.
Why does California’s ‘NEM 3.0’ matter?
Morningstar’s February Rooftop Solar Report carries the subtitle “California NEM 3.0 highlights long-term state policy risks.” This fittingly showcases this major policy change in solar’s preeminent U.S. state as the most ominous headwind the solar industry will face in the near-term.
First, in the view of many investors, California is U.S. solar. “[The state] has historically been the bedrock of the rooftop solar industry,” the Morningstar report states. “Until 2015, California accounted for approximately 50% of annual rooftop solar installations. This has declined to approximately 33% in recent years, but that is nearly 3 times the next largest market.”
Accordingly, when California regulators decided on December 15, 2022 to slash the “met metering” (NEM) credit — which allows solar customers to sell excess juice back to the grid — many analysts saw it as painful blow to U.S. solar, as well as possibly the entire clean energy sector.
For more context, nearly all U.S. states offer some degree of NEM credit, and “given a typical home exports approximately 20%-40% of its solar generation…(NEM) is a meaningful boost to rooftop solar economics,” Morningstar writes in the report. Thirty U.S. states, including California, have offered “full retail rate net metering,” which gives consumers a credit for the full retail prices of their electricity. This costly incentive is effective in encouraging solar adoption, but its benefits to states logically decrease as solar penetration spreads — and utilities have long been pushing to give consumers lesser credits that are closer to the discounted “wholesale” rates (which don’t include energy generation, transmission, or distribution expenses).
California’s NEM 3.0 change seeks to accomplish this cost-efficiency, albeit only with new customers; Californians that installed solar before April 15, 2023 will keep receiving the full retail credit.
A much-criticized change
California’s NEM 3.0 has been criticized by several quarters, including clean-energy groups, which say that slashing the credit will make solar installation unviable for millions of Californians. Morningstar’s analysts largely agrees with this aspect in the short term, stating in the report:
The hallmark of [California’s NEM 3.0] change is the decision to cut the export rate of excess generation by approximately 75%. We expect this to significantly lengthen payback periods in the state. We estimate California currently enjoys some of the shortest payback periods in the country — less than five years, in many cases — but we expect this to elongate to nine years under the NEM 3.0 decision.
Additionally, Morningstar reports that its analysts expect...
...California’s NEM 3.0 decision to result in a meaningful impact to rooftop solar economics in the state.
...California [solar] demand to remain strong through the first half of 2023 in advance of NEM 3.0 rules taking effect, but they anticipate a material drop beginning in the second half.
...California installations to decline by approximately 50% in 2024 relative to 2022 as NEM 3.0 elongates customer payback periods.
Fallout to the wider U.S. solar market
As stated, given the outsized influence that California has on the entire U.S. solar industry, many market analysts fear that NEM 3.0 will damage the state of solar energy nationwide — and negatively impact investors that have been allocating to areas of the clean-energy sector that depend on solar’s performance. Morningstar also agrees that the wider solar industry will face hard consequences for at least the next few years, noting that they “expect [U.S. solar] growth to correct beginning in 2023, most notably due to declines in the California market.” The Morningstar’s report notes:
U.S. rooftop solar installations will slow dramatically in 2023 and 2024 as higher interest rates affect customer payback periods and California’s NEM 3.0 comes into effect….we expect total U.S. installations to [only increase by] 5% in 2023 before declining 2% in 2024.
...The impact of California NEM 3.0 is likely to result in low-single-digit growth for U.S. residential installations in 2023 and 2024. We also perceive a strategy shift by some larger national installers toward a focus on profitability as opposed to growth.
But Morningstar is still long-term bullish
After this slump, Morningstar believes the U.S. solar market will resume a stronger growth trajectory and again become a dependable performer in institutional portfolios — if perhaps not to the same degree it was in the last five years. Morningstar writes:
Over the long term, we expect continued inflation in electric utility rates and continued deflation in rooftop solar costs, which supports continued rooftop solar adoption.
[Investors should look for the U.S.] residential solar market to grow in the high single digits per year [and solar adoption to climb] as rising utility rates and falling solar costs improve customer economics, opening up new markets.
Other tailwinds may also spur long-term solar demand, such as the proliferation of electric vehicles. By 2030, nearly one in three new autos sold in the U.S. will be an EV, Morningstar predicts, noting that the “EV buyer is a prime candidate to adopt solar.” In fact, approximately 40% of EV owners also have solar largely because charging an EV boosts household electricity use by 25%-30%, the report adds. So as more EVs enter American highways, more solar panels should grace American roofs.
Could rollbacks like NEM 3.0 be a good thing?
While cutting NEM credits and weakening the financial incentives that have been integral to solar adoption will cause short-term pain and potentially a multi-year slump in the industry, Morningstar argues that it should be beneficial to solar energy’s long-term health. “Reduced state policy support is likely to result in a more sustainable industry,” Morningstar states in the report. “We view policies like net metering as having a finite life, maintained in states with low penetration levels but rolled back by regulators as penetration rises.”
Just one reason for this? As solar installations become more expensive — yet still offer consider savings when compared to the quickly-rising costs of traditional utilities — it can encourage consumers to purchase more elaborate solutions to increase long-term savings and maximize the versatility of their new energy system. Battery installations are a prime example. “We view battery storage as the most tangible secular growth driver for our rooftop solar coverage,” Morningstar writes, noting:
The average [battery] installation represents an approximate $10,000 revenue opportunity compared with $2,000 for a typical solar inverter installation...We view rising attachment rates for battery storage to be a particular opportunity for [certain] solar inverter companies [such as] Enphase and SolarEdge.
Hawaii lights the way...
A glimpse to the Pacific, and likely at solar’s post-NEM 3.0 future, offers support here. Hawaii cut its net metering programs in 2015, and the state now has a solar penetration of about 35% — the highest in the U.S. “Our two key takeaways from the Hawaii experience are: (1) industry installations are likely to fall sharply following reforms, and (2) battery storage attachment should rise precipitously,” Morningstar reports. “[After NEM 3.0], “we look to Hawaii as a case study for what’s next.” While challenges remain, institutional investors can glean some tactical insights from Morningstar’s vision for solar’s likely long-term path: its future looks...reassuringly relucent.