Solar Costs Continue to Plummet

Despite the performance of solar stocks over the past two years, the fundamental cost of installing solar power continues to fall rapidly. Long term, this is great for the industry and should drive sales and eventually (surviving) solar stocks higher in the future.

The question is, when will we pass grid parity, and when will demand be self-sustaining? The answer may surprise you.

A long way in two short years
The latest numbers out of GTM Research show that in the U.S. utility scale solar has driven the cost reduction over the past two years. The cost for these installations has fallen 54.8% since the first quarter of 2010, driven by massive projects being built by First Solar (Nasdaq: FSLR  ) and SunPower (Nasdaq: SPWR  ) .

Type	Q1 2010	Q1 2012	Cost Reduction
Residential	$6.98	$5.89	15.6%
Non-Residential	$6.36	$4.63	27.2%
Utility	$6.42	$2.90	54.8%

Source: GTM Research.

What hasn't fallen nearly as quickly is the cost of residential solar. These installations vary across the country, so there are likely locations where the cost is lower, but we do know that the regulatory environment and financing has hampered this progress for residential solar. These "soft costs" can add up quickly and will be a major area of focus for the industry in the next few years.

The president's SunShot program is trying to address some of these costs, including installation, design, permitting, and financing of solar projects. States are also taking on the task with Vermont being one to institute a 10-day approval period for solar installations.

Solar has a long way to go when it comes to cost, but it's also come a long way in two years.

Cruising past grid parity
People often talk about grid parity as the point when solar will become truly competitive, but few realize that we're approaching and passing that point in certain areas of the world already. Germany has become so efficient in installing solar modules that the average system now costs $2.24 per watt, an incredible number considering 70% of installations are residential. So, what does this mean for the competitiveness of solar on a per kW-hr basis?

I have created the table below to put the cost numbers I've given into context. The calculation I used to figure out cost per kW-hr assumes a 25-year life, a 10% annual return on investment, and the capacity factors I've used give a range of outputs depending on sunlight conditions. These are conservative assumptions, and the return on investment number probably overestimates the cost of solar at current rates.

Type	Cost per kW-hr 15% Capacity Factor	Cost per kW-hr 20% Capacity Factor	Retail Electricity Cost
Germany -- $2.24/Watt	$0.19	$0.14	$0.35
U.S. Residential -- $5.89/Watt	$0.49	$0.37	$0.12�������������
U.S. Utility -- $2.90/Watt	$0.24	$0.18	$0.12

Even without any subsidy the cost structure in Germany would lead to nearly grid parity in most of the world, showing tremendous upside. But it isn't module cost that will help us reach this cost in the U.S.

Modules not the problem anymore
We often hear about the cost of modules as the driver for solar costs, but this is becoming a smaller piece of the pie with modules selling for around $0.90 per watt, especially in residential installations. That has a number of effects on the solar industry.

First, it puts pressure on everyone beyond the module to lower costs. This is putting revenue and margin pressure on companies like inverter makers Enphase (Nasdaq: ENP  ) and Power-One (Nasdaq: PWER  ) and explains why the market hasn't given them much love in recent months.

It also provides a premium for module makers with higher efficiency and integrated designs. Two companies pushing these innovations are SunPower and Canadian Solar (Nasdaq: CSIQ  ) . SunPower is the highest efficiency module maker, and Canadian Solar is one of the leading Chinese manufacturers in efficiency. Both have introduced modules that have integrated inverters, allowing for easier installation on site.

It's these costs, beyond the module, that will help drive the cost of solar in the U.S. closer to Germany.

Foolish bottom line
Understanding the cost structure for installing solar energy is just as important for solar investors as reading financial statements. The rapidly falling cost of solar has made it far more cost effective in many parts of the world, and as soft costs fall, the trend will continue.

From the perspective of manufacturers, we see that those who can innovate will be in the strongest position. Integrating inverters, creating new form factors, and increasing efficiency will all help lower balance of system costs and make modules more attractive to investors.

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