Pick your power: wind, solar, nuclear or biofuels? Each is unique in its attributes, but as of yet, none alone has been able to displace our reliance on oil and natural gas as our main sources of energy for electricity and transportation. The expectation is that alternative energy sources will shatter our dependence on fossil fuels when they can be scalable and cost-competitive with today's energy sources. This creates an interesting and compelling investment opportunity - one not without risks, but one that can result in high growth and significant rewards.

When investing in the alternative energy space, an investor must be able to tolerate the potential for huge volatility in a stock's price. Picking the alternative energy source that will satisfy or partially satisfy our future energy demands is the key to receiving returns on your investment. In this article we'll explore everything you need to know about the solar power industry to decide if its your alternative energy of choice. (To learn why an alternative energy source must be found soon, read Peak Oil: Problems And Possibilities.)

Introduction to a Crisis
There are three burning questions on the minds of the American people and its leaders right now:

  • How do we meet our energy needs?
  • What will the price of oil be in the short, middle and long term?
  • How do we reduce carbon dioxide emissions and save the environment?

All three questions are commingled, yet finding a solution for each one generally has been to the detriment of the others. A solution that answers all three questions simultaneously has remained elusive. Compounding the issue is the expectation of increasing demand due to global growth. It is forecast that world energy demand will increase 37% between 2010 and 2030, according to the 2006 edition of the Energy Information Administration's annual report. The solution may lie in the many sources of alternative energy being developed to satisfy our growing energy needs without compromising the environment.

Solar and wind power seem to be the alternatives with the least public resistance. Biofuels, particularly ethanol, have been criticized for disrupting the world's food sources and subsequently causing agflation. While nuclear energy is a viable, efficient and cost-competitive source of power, there is hesitation from fears related to safety, which results in NIMBY (not in my backyard) attitudes. According to a report prepared in part by the U.S. Department of Energy in May 2008, wind could possibly contribute 20% of U.S. power by 2030, but it can be unreliable. That leaves solar as a highly renewable, more reliable energy source with no carbon by-products. (For more on the pros and cons of turning corn into fuel, read The Biofuels Debate Heats Up.)

The Cost Of Solar Power
Solar photovoltaic (PV) technology converts sunlight into electricity using solar cells, which are made from polysilicon. The first incarnation of a silicon PV-related technology was developed in 1954. Historically, solar tends to remain cost-uncompetitive, having a generation cost greater than all other sources of alternative and conventional energy. However, this technology may be extremely scalable. According to the "Renewables Global Status Report - 2006 Update" (.pdf), PV production worldwide increased from 1150 megawatts in 2004 to two gigawatts in 2006, and for each doubling of installed capacity, production costs have dropped by approximately 20%. Cost-competitiveness relative to fossil fuels and reaching grid parity (discussed in detail in the next section) are the most significant barriers to widespread adoption.

The cost of solar is driven equally by the module costs and the balance-of-systems costs. The costs of the module are primarily driven by the raw material polysilicon. Given technological advancements and the high demand for personal computers and other chip-based technologies, polysilicon has been in high demand and in short supply. New supplies of polysilicon, in addition to substitutes such as metallurgic silicon, could create a surplus which would drive down the cost of the raw material and result in cheaper solar modules.

The cost for the balance of systems includes the land requirements, cables and other substructures where the modules reside. Technological advances that create more efficient solar cells result in fewer cells required to produce the same power output and less balance of systems. As both of these cost components trend down, achieving grid parity becomes more easily attainable.

The Importance Of Grid Parity
Grid parity is achieved when the cost of photovoltaic electricity equates to the cost of generating conventional electricity on the grid. It is the key to profiting from an investment. Grid parity can be achieved if the cost of solar is lowered to 10-12 cents/kWh, assuming that natural gas costs stay above a threshold of $8/MMBtu (million British thermal units), according to a Goldman Sachs research report "Alternative Energy: A Global Survey" (.pdf).

The biggest risk is that the price of natural gas falls below the $8/MMBtu level, and reaching grid parity will require a proportionate reduction of costs on the solar side. This has been the most onerous condition for the industry to meet to maintain a stable investor base and has resulted in volatile capital ebbs and flows. To stabilize the capital volatility, the industry has relied on government policies, in the form of feed-in tariffs, tax credits and renewable fuel standards, which provide a backstop and continued technological investment to improve systems and lower costs.

Investing In Solar Energy
Investing in the solar industry requires a comparison of the fundamentals of the industry with other alternative and conventional energies, and of the individual companies. As with all investments, an understanding of the industry dynamics and the company's competitive advantage is vital to earning returns.

Prospective investors should realize that industry dynamics focus on grid parity as well as keeping up-to-date on government policy decisions in order to determine the psychology of the market. Government subsidies are also an important part of the economic equation as they provide a backstop to compensate companies for continuing to develop better technology and also make the energy source an economic solution. However, during difficult economic times or just as a course of the legislative process, the subsidies may not be renewed or renewal may be delayed. This creates uncertainty that customers will be willing to enter into contracts until the subsidy picture is clarified. This creates a lot of fits and starts in the industry.

There are two basic groups to invest in within the solar industry: the manufacturers of the modules and the raw material companies.

  • Manufacturers
    On an individual-company basis, investing in the manufacturers necessitates an understanding of the company's business model: does it have a competitive advantage or a technological advantage? Those with competitive advantage would include low-cost providers and companies with economies of scale; meanwhile, a company with a technological advantage would be one with the highest cell efficiency for example. (For help finding the industry leaders, read Competitive Advantage Counts and Economic Moats Keep Competitors at Bay.)
  • Raw Materials
    Investing in the polysilicon producers is a little more complicated because companies that produce polysilicon for the solar industry also produce it for the semiconductor industry. Many of these companies tend to focus on the semiconductor operations, as solar is a relatively small contributor to profitability. However, the growth in solar can be many-fold that of semiconductors. Similarly to other commodity or raw-material investments, understanding the supply/demand dynamic, including use of substitutes, is the basis for determining a company's profitability. (For related reading, check out Who sets the price of commodities? and Commodities That Move The Market.)

Lastly, examining how the company is trading relative to its history and peers will determine whether an investment is under- or overpriced. New technology tends to be a growth industry and thus analyzing trading multiples relative to a historical range may be misleading. If industry fundamentals are strong and growing, using the median multiple for the peer group rather than a stock's historical average or range may be a better gauge of whether a stock is under- or overvalued. The median multiple determines the relative cheapness of one stock versus another stock in a particular industry, without being limited by historical ranges for an industry that has shown tremendous advances in technology and adoption as it moves along the product life cycle. In time, reaching grid parity should stabilize capital flows and stock performance. (To get started on your own valuations, begin with our Fundamental Analysis Tutorial.)

Finding energy sources to meet our current and growing needs has caused governments, environmentalists and the general public to join together in a movement away from the traditional energy sources of oil and natural gas. Although this movement is in the inaugural stage, the support is gathering and steamrolling it forward. There are many different sources of alternative energy, but solar has been gathering steam due to its renewability, scalability and environmentally friendly principles.

Investing in this industry requires knowledge of government policy, both in the U.S. and abroad, and understanding of the competitive advantage of the company. For investors who are willing and able to withstand the large swings in stock performance in this historically volatile sector, the solar industry may be a good option as the push toward alternative energy sources continues.

To learn about the other energy options, check out our Green Investing Feature and Clean Or Green Technology Investing.

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