A Major Flaw in the US$100 Billion Solar Sector

A while back, we wrote about India's ability to generate 100 gigawatts (GW) of solar capacity by 2022. Increasing levels of pollution have created tremendous health hazards, most notably in New Delhi. It has also led to climatic changes. Temperatures across the country are rising (2015 was the hottest year on record). As too are draughts, unseasonal rainfall, dangerous heat levels, and so on. Action had to be taken. And it was...when PM Narendra Modi laid down an ambitious plan to create 100 GW of solar capacity by 2022 (current capacity is just 4 GW).

To achieve this goal, more and more solar projects are being put up for bidding. The bidder who quotes the lowest tariff wins the project. Bidders have begun to quote insanely low tariffs. Solar tariffs used to be as high as Rs 18, but they've now dropped to as low as Rs 4.34 per unit. This has narrowed the gap between solar and thermal tariffs. Earlier, high tariffs discouraged solar power. But with the gap now at negligible levels, enthusiasm for solar power has increased.

So far, so good. The main reason for the lower solar tariffs has been the falling costs of raw materials. The majority of raw materials are imported, and foreign manufacturers have been pumping cheap solar cells and modules into India.

However, these bids do not involve any price-escalation clause. This means the bidders are bound to provide the power at the auctioned rates. This exposes them to foreign exchange currency risks and rising equipment replacement costs.

Experts suggest that module prices, a key component for solar plants, are unlikely to fall drastically in the near term. Rather, they expect them to escalate on account of strong demand from the US and China. Now, these companies are not immune to cost escalations. Remember, Tata Power's Ultra Mega Power Project (UMPP) in Mundra became unviable because the contract didn't have a cost escalation clause regarding provisions for increased fuel costs.

A few of the solar projects are already running into financial troubles - the latest being Sun Edison. Last November, the company won a project at Rs 4.63 per unit. Now the company is looking to sell its interest. We cannot rule out a similar fate for the other solar power projects.

Thus, investors should not get carried away by the hoopla surrounding solar power projects. Exposure to increased raw material costs and foreign exchange fluctuations can turn out to be a death knell for these solar power projects.

We are not against solar power. It's a much-needed initiative to reduce the pollution levels accross the country. However, investors in this space must be extremely cautious.

Rahul Shah (Research Analyst), Managing Editor, Microcap Millionaires has led the team from the front in developing some of our most stringent and rewarding research processes. As per his own admission, the turning point in Rahul's life as a financial analyst came a few years back when he got introduced to the works of Warren Buffett and Charlie Munger. From Buffett, he understood the value of investing in good quality business with powerful moats and strong management teams. Charlie Munger on the other hand inspired him to be a lifelong learner and use mental models in order to arrive at the crux of matters across most disciplines. Rahul firmly believes that in order to be successful at investing, you have to do the big things right and possess a great temperament and a contrarian streak.