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Structured Finance

ABS Commentary

Evaluating Credit Risks in Solar Securitizations

Analytical Contacts:
Andrew Giudici, Director 646-731-2372 Anthony Nocera, Senior Director 646-731-2350 Glenn Costello, Senior Managing Director 646-731-2332 Brian Ford, Associate Director 646-731-2329

October 17, 2012

Table of Contents

Executive Summary ............................................................................................................................. 3 Financing of Solar Installations ........................................................................................................... 4 Forecasting Default Rates in Solar Securitizations.............................................................................. 4 Minimal Recovery Rates Are Expected ................................................................................................ 5 Operations and Maintenance (O&M) Services Could be Provided by a Financial Institution ................ 6 Annual Escalators Could Result in Increased Credit Risk ..................................................................... 6 Energy Sales to the Grid ...................................................................................................................... 7 Conclusion ........................................................................................................................................... 7

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Executive Summary
This report provides a snapshot of the current state of the rooftop solar sector and a summary of the credit risks associated with solar securitizations. The solar sector has experienced unprecedented growth over the past five years due to declining panel prices, federal and state tax incentives, and renewable portfolio standards (RPS) that require a certain percentage of a utilitys power generation to come from renewable energy sources. According to the Interstate Renewable Energy Council, approximately 1,845 megawatts (MW) of photovoltaic (PV) capacity was installed in 2011, which is more than ten times the capacity installed in 2007. In terms of MW capacity, installations on non-residential buildings accounted for approximately 45% of the 2011 installations, followed by 38% from utility scale projects and 18% from residential properties. While residential homes accounted for the smallest percentage of total installations from a capacity perspective, they represented the largest number of 2011 installations. There were approximately 64,000 installations in 2011 of which approximately 56,000 were on residential properties, a 30% increase over the previous year. Similarly, about 220,000 photovoltaic systems were connected to the grid at the end of 2011 and approximately 188,000 of those were on residential properties.

2000 1800 1600 1400 1200

Annual Installed Grid-Connected PV Capacity by Sector


1000 800 600 400 200 0 2007 2008 2009 2010 2011

Source: Interstate Renewable Energy Council



Kroll Bond Rating Agency, Inc. (KBRA) expects the rate of growth of utility scale installations to slow over the next few years as many utilities have complied with their short to medium term RPS mandates. However, installations on residential properties will likely continue to increase at record rates as panel prices remain depressed and homeowners benefit from relatively inexpensive solar electricity. The drastic decline in panel prices is largely attributable to the increased production of Chinese solar panels, which have flooded the market and depressed pricing. China is able to produce panels at a below-market cost because their solar industry is subsidized by the government. Despite U.S. imposed import tariffs on Chinese manufactured panels, there has not been a sharp rise in panel prices as Chinese manufacturers have shifted the purchasing of certain panel components outside of China to avoid the tariff. KBRA believes this trend will continue and the price of solar panels will remain depressed for an extended period of time.

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The purchase of rooftop solar systems requires a significant upfront capital investment and it may take a number of years before the costs are recouped. KBRA believes that residential property owners could expect to pay as much as $6-$8 per watt for a system, which, depending on the size of the property, may require an initial investment of $20,000-$40,000. Because of the large investment and long payback period, many residential and commercial property owners have decided to enter into leases or power purchase agreements (PPAs) with solar developers. Under these agreements, the consumer receives solar electricity at below-retail rates and the project developer receives a predictable ongoing revenue stream. The developer also retains all state and local tax incentives associated with the solar system because ownership has not been transferred to the consumer. Most developers favor leases over PPAs because monthly payments are fixed and not dependent upon the amount of electricity the system produces.

Financing of Solar Installations

Many project developers have relied on tax equity investments from large financial institutions or credit facilities from banks to finance their growth strategies. KBRA believes new sources of capital are needed as federal and local tax incentives are expected to be reduced or eliminated and as many banks limit their participation due to regulatory restrictions. Tax benefits related to solar financing in the U.S. include five-year accelerated depreciation and a 30% investment tax credit (ITC). Further, the American Recovery and Reinvestment Act of 2009 allowed project developers to receive a cash grant of 30% of eligible project costs in lieu of an ITC. Although the cash grant has played a critical role in the growth of the solar sector, the cash grants expiration at the end of 2011 left many project developers, who often do not have a sufficiently large tax liability to fully utilize an ITC, searching for tax equity partners that could effectively monetize an ITC. There are a limited number of banks and insurance companies who have sufficient tax liability to be able to fully utilize an ITC. In addition to the expiration of the cash grant, the ITC is scheduled to decline from 30% to 10% in 2016. At present, about half of a systems value comes from tax incentives and half from receivables. However, KBRA anticipates that receivables will account for approximately 70% of a systems value in 2017 with the remaining 30% deriving from a combination of ITCs and accelerated depreciation. The financing landscape for the solar sector continues to evolve and it is becoming apparent that project developers will utilize securitization as one of their financing options. Securitization allows project developers to monetize future cash flows and expand their businesses. While securitization has the ability to revolutionize the way rooftop solar projects are financed, there are credit and structural risks that must be considered.

Forecasting Default Rates in Solar Securitizations

A key consideration in determining the probability that securitization debt service payments will be made is an evaluation of the offtaker (i.e. the party who has agreed to purchase the energy production from a solar system). In a solar securitization, PPA or lease payments from residential homeowners or commercial properties are used to pay interest and principal on the securitized debt. Although there are a number of approaches to evaluate an offtakers credit quality, no standard approach fits perfectly within a solar securitization context because of the limited payment history of the contracts and the essential nature of the service being provided. Use of rooftop solar panels grew significantly starting in 2008 when financial innovation changed the way systems were financed. After four years of expansion, the industry has only recently reached a critical mass and diversification needed to securitize the contracts. The limited historical

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data make it difficult to predict how an offtaker will perform over the typical PPA contract period of twenty years. As the sector evolves, KBRA believes that the behavioral patterns of obligors may change. The initial market for alternative energy was motivated by environmental considerations. As solar power is marketed to a wider audience it is likely that motivations may shift from green benefits to economic concerns, which may change payment behavior. Absent historical data, KBRA believes that utility default rates may be a good proxy for forecasting PPA or lease default rates. However, utility data is not reported by specific consumer groups or by FICO score, two data points needed to assess consumer credit quality. While utility default rates may be used to gain insight into future performance, they are of limited use in isolation because current solar consumers have the ability to forego solar power and purchase electricity from the grid. The option to purchase electricity from two different sources may result in a higher level of defaults among solar consumers when compared to property owners whose only option is to purchase power from a local utility. In KBRAs view, techniques used to evaluate residential mortgage backed securities could also be used to assess the creditworthiness of PPAs and leases relating to residential homeowners. However, an assessment based strictly on mortgage analysis may overestimate future defaults because it does not incorporate the essential service that is being provided. Given the critical service that solar power is providing, it is likely that a consumer will continue to purchase solar electricity as long as they remain in their home and the price of solar power is cheaper than the local utility. For this reason, even if a homeowner defaults on their mortgage, they may continue to stay current on their solar power obligations until they vacate the property. It is also common for a financial institution to continue to pay for solar power after it takes control of the property, as it is less expensive than the local utility. KBRA believes that mortgage default analysis used in conjunction with borrower specific utility data may be used to forecast payment defaults from residential PPAs or leases whereas traditional corporate credit analysis may be used to evaluate PPAs or leases from commercial properties.

Minimal Recovery Rates Are Expected

KBRA anticipates that recovery rates on defaulted PPAs or leases may be minimal because of technological advancements that render older panels obsolete. Therefore, recoveries in securitization transactions may be limited to legal action against the consumer, with little or no credit applied to removal of the panels for sale in the secondary market. In addition, there are significant costs associated with the removal of the panels such as labor and the recapture of tax incentives, which may deter project developers from reselling the systems. Rather than remarketing panels from a defaulted party, KBRA believes that a project developer will likely modify the terms of the PPA or lease agreement in order to incentivize a new or existing offtaker to continue to purchase the systems electricity. This strategy is more likely when retail electricity rates decline and are lower than the original PPA or lease rate. Upon a foreclosure of a property, a project developer may have to alter the terms of a PPA or lease agreement. During this scenario, there will likely be a temporary disruption of cash flow followed by a reduction in rates in order to attract a new offtaker. While KBRA expects that cash flows will cease until a new owner purchases the property, the financial institution that controls the real estate owned property may continue to purchase the propertys solar power in order to market the property to a new owner even though there is no legal obligation to do so. Finally, consumers who default on their PPA or lease agreements would likely experience a reduction in their credit scores. This may motivate them to repay their outstanding balances when they attempt to make a significant purchase, such as an

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automobile, at a future date. This may provide the securitization with unexpected recoveries that could be used to repay debt.

Operations and Maintenance (O&M) Services Could be Provided by a Financial Institution

Solar power systems require ongoing monitoring and periodic maintenance in order to ensure that optimal energy production is achieved. Most solar developers have proprietary monitoring software in each system that provides real time energy production data. When a systems energy output falls below a certain threshold, maintenance personnel are sent to the property to identify and correct the problem. Monitoring software provides solar consumers with comfort that the systems are operating correctly and energy production is maximized. In a securitization of solar contracts, an O&M provider will be responsible for the operations of all systems included in the transaction. KBRA believes that the O&M provider in securitization transactions should have a national presence or a vast network of subcontractors so it can properly maintain the systems. The collateral supporting most solar securitizations will likely be originated by one developer, who will often act as the O&M provider as well. The dual role creates additional credit risks as developers are often noninvestment grade or unrated companies. KBRA believes that there are only a few solar developers who have a sufficiently broad, national presence to effectively manage a large, geographically diverse portfolio. A further concern is that if the O&M provider becomes insolvent, its monitoring equipment might be characterized as intellectual property by a bankruptcy court, thereby complicating transfer of this property to a replacement O&M provider. KBRA believes some of these risks can be mitigated within a securitized structure. For example, a back-up O&M provider could be retained for the term of the securitization. Although a back-up O&M provider does not need to be a solar developer, it should have experience with operating assets. A financial institution that has knowledge of the industry and receives ongoing support from an independent engineer would be a candidate for a replacement O&M provider since it would be able to develop a maintenance schedule, monitor the systems output and create a large network of subcontractors to service the systems.

Annual Escalators Could Result in Increased Credit Risk

PPAs and leases typically include annual pricing escalators to offset higher costs in the future. The escalator protects the transaction from rising expenses, but it can also result in increased credit risk. If the annual escalator is high enough, and the original discount to prevailing retail rates is minimal, it is possible that at some point over the securitizations tenor the PPA or lease rate could exceed the then prevailing retail rate. If this does occur, KBRA predicts that some consumers may selectively default on their PPA or lease agreement and turn to the grid for their energy needs. There should be a significant cushion between the two rates at origination in order to mitigate the risk that the solar lease or PPA becomes uneconomical. Securitizations that have high annual escalators should have a higher cushion, while transactions with minimal or no escalators may have a lower differential. Lastly, a realistic forecast of retail utility rates should be compared against the contracted PPA or lease rate to ensure that energy production from the solar systems remain economical throughout the term of the securitization.

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Energy Sales to the Grid

Some developers have stated that they could sell power back to the grid if it is not used by a property owner. The ability to generate additional cash flow is positive from a credit perspective; however, legal opinions should be provided confirming that utilities are actually required to purchase the power and confirming what the purchase price will be (i.e. avoided cost). KBRA believes that revenues generated through energy sales to the grid will be at a much lower price than the PPA or lease rate because a utility is likely to purchase solar power at wholesale rates. Furthermore, many utilities compensate property owners for excess energy through a net metering arrangement, which allows unused power to flow back to the grid. In this scenario, a property owner may receive a credit on their utility bill if the amount of power delivered to the grid exceeds energy usage from the utility. While this approach is sufficient to compensate owners of solar systems who remain in their property, it is unclear how a securitization could monetize the benefits of a net metering arrangement if a property becomes vacant.

Solar securitization offers the potential to transform the way rooftop solar systems are financed. Project developers will have access to low-cost financing, allowing them to improve their liquidity position and expand their businesses. The ability to tap into the securitization market will also expand the number of market participants who wish to invest in renewable energy, a development KBRA believes the solar industry needs given the likely future reduction of tax incentives and regulatory changes that will limit the financing of long-term assets by many banks.

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Copyright 2012, Kroll Bond Rating Agency, Inc., and/or its licensors and affiliates (together, "KBRA). All rights reserved. All information contained herein is proprietary to KBRA and is protected by copyright and other intellectual property law, and none of such information may be copied or otherwise reproduced, further transmitted, redistributed, repackaged or resold, in whole or in part, by any person, without KBRAs prior express written consent. Ratings are licensed by KBRA under these conditions. Misappropriation or misuse of KBRA ratings shall cause serious damage to KBRA for which money damages may not constitute a sufficient remedy; KBRA shall have the right to obtain an injunction or other equitable relief in addition to any other remedies. The statements contained in this report are based solely upon the opinions of KBRA and the data and information available to the authors at the time of publication of this report. All information contained herein is obtained by KBRA from sources believed by it to be accurate and reliable, however, KBRA ratings are provided AS IS. No warranty, express or implied, as to the accuracy, timeliness, completeness, merchantability, or fitness for any particular purpose of any rating or other opinion or information is given or made by KBRA. Under no circumstances shall KBRA have any liability resulting from the use of any such information, including without limitation, for any indirect, special, consequential, incidental or compensatory damages whatsoever (including without limitation, loss of profits, revenue or goodwill), even if KBRA is advised of the possibility of such damages. The credit ratings, if any, and analysis constituting part of the information contained herein are, and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell or hold any securities.

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