Tesla-SolarCity merger: why Elon Musk is playing chess while everyone else is playing checkers

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Tesla recently put out a $2.8B bid to acquire SolarCity. The initial reaction was less than favorable. Here are some of the headlines:

Is Tesla’s SolarCity Move Actually a Bailout? – Bloomberg

Why Tesla and SolarCity Have an Elon Musk Problem – Fortune

Tesla’s Deal With SolarCity Is A Remarkably Bad Idea – SeekingAlpha

At this point, a lot has been written about the short term impact of the deal. However, I haven’t really read anything that explored the long term potential of the product that the combined company can build together.

By putting solar panels together with battery storage, the 2 companies can create an end to end solution that allow people to produce, store and consume clean energy at a cheaper price than what they would have otherwise paid for.

I think in order to understand the value and feasibility of it, the most important thing is to figure out the unit economics of solar panels and batteries. Electricity isn’t sexy or entertaining. In order to achieve mass adoption, the solution needs to save people money and be viewed as an asset. To get a high level understanding, let’s start ask a few basic questions about solar panels and batteries.

What would be an economically feasible cost to live off the grid?

To calculate this, we want to make sure that over the lifetime of the system, the household would spend less than what they would have otherwise had to pay to the utilities. To do this calculations, we need to make a few key assumptions:

  1. Current energy usage and cost: An average American household use about 11,000 kWh of electricity per year, or 30 kWh/day. The number vary dramatically by season. Typically, peak summer electricity usage is twice as high as winter usage. Broadly speaking, we can assume that an average household use 20 kWh of electricity per day during winter and about 40 kWh during summer (mostly due to air conditioning). In terms of cost, the average cost of electricity is around $0.12/kWh, though it also varies dramatically by state. The energy prices range from $0.08/kWh in Idaho to $0.33/kWh in Hawaii (link). Historically, energy prices has increased at a rate of 2.5% per annum
  2. ROI requirement: Let’s assume that we are willing to take a 3.5% ROI, same as a 30 year mortgage. Let’s also assume that we qualify for the 30% ITC tax credit on both the solar panel and battery storage system.

After figuring out all the assumptions above, the calculation is straightforward. To find the economically feasible cost to live off the grid, we simply need to calculate the Net Present Value (NPV) of the the household’s total electric bill over 30 years. If you don’t know what NPV is, it’s basically a way to calculate whether it’s worthwhile to incur a large expense today, or a series of smaller expenses repeatedly in the future (link). After running the numbers, we can come to the conclusion that in order for off-grid living to be economically viable, the solar panel + battery system would have to cost less than $63,000 in Hawaii and less than $18,000 in Idaho.

How much would this system cost today?

The is probably the more interesting question. It is actually fairly easy to calculate as well with some basic assumptions. To get a reasonable estimate, we need to understand how big a system you need to build and how much each component is going to cost.

Components requirements:

  • Solar panel power generation requirement: To power an average American household’s energy usage, we need roughly 10 kW of solar panel installed. By googling a bit and speaking with solar panel owners I know, a 1 kW solar panel can typically generate 3 kWh of electricity during winter. During summer when the days are longer, we can expect to generate  5 kWh. One notable fact is that during overcast or rainy days, solar panels cam only operate at 10% of normal capacity. During those days, a 10 kW system can only be expected to generate 3 to 5 kWh (link). We should also assume that the  solar panel’s useful life is 30 years.
  • Batter storage requirement: Because the sun doesn’t always shine, a energy reserve is needed to power the home during elongated periods of rain/overcast. Conservatively, let’s put a safety factor of 3x daily usage during summer overcast days, which means that we should be planning to have a battery storage of 105 kWh. We can also assume the  battery’s useful life is 10 years.
  • Inverter requirement: Inverters are required to convert DC power into AC power. Usually, inverters last about 10 years as well.

Component costs

  1. Solar panel cost: According to SolarCity, their installation cost is ~$2.63/W and the panels have a useful life of 30 years (link). Assume that SolarCity needs to retain a 30% gross margin, a 10kW system would cost around $38,000.
  2. Battery cost: According to Greentech Media, Tesla’s current battery production costs is about 150/kWh, Assuming a 30% gross margin and useful life of 10 years, a set of 105kwh battery that last 30 years would cost $90,000
  3. Inverter cost: According to Greentech Media, inverter costs about $0.14/W and have a useful life of 10 years as well (link). This implies that for a 10 kW inverter, it would cost about $4,200.
  4. Labor cost: the cost of labor is already accounted for in SolarCity’s solar panel cost. Assuming that the customer get the panel and battery installed at the same time, I think any additional labor cost for installation is negligible. Most of the labor cost actually is from traveling to and from the customer’s location.

Given the above set of assumptions, we can calculate that the total cost of system today would be a whopping $132,200, making the prospect of living off the grid entirely uneconomical, even in state like Hawaii.

Will it ever become economical?

I don’t think it’s a surprise that living off the grid is not an economical decision today for most people. There is a silver lining in all of this. Both the cost of solar panels and batteries are expected to drop dramatically. Recent analysis by Deutsche Bank projected that solar panel cost will drop by 40% within the next 2 years and batteries by 50% within the next 5 years (link). If you assume the same rate of cost reduction and a 2.5% increase per annum in electricity price, then living completely off the grid will become economically feasible within the next 5 years in Hawaii and 13 years across the entire US. In the grand scheme of things, that is actually a remarkably short amount of time. If you take this train of thought to its logical conclusion, that means utilities as we know it today (which by the way is a trillion dollar market), will become obsolete in the next 15 years. Talk about disruption.

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You aren’t seriously suggesting that 15 years later, everyone will live off the grid are you?

Practically speaking, I actually don’t think going off the grid is the best long term option either, particularly in developed countries with established transmission infrastructure. This is because being part of a larger network is inherently more efficient. I actually think the future of energy is more along the lines of having networks of distributed solar panels and batteries. Each household can store and sell any excess electricity they don’t use to other households in need of them. But that’s probably a post for another time. There are lots of technical and regulatory issues that need to be ironed out there. The current grid does not really support having energy fed back to it. All the excess energy are dissipated as heat. Also, unlike the stock market, there isn’t a market where a resident can go and sell their electricity. Building those out will take a lot of effort from a lot of different stakeholders. However, if meaningful headway can be made on this front, then solar panel + battery storage adoption will occur even faster. This is because the grid can effectively act as a giant battery storage. Instead of storing 3 days worth of electricity, customers may only need to store 1 day or even half a day, dramatically reducing the cost barrier required to benefit from solar.

What will be the primary drivers for battery cost reduction?

It’s very easy to dismiss these fantastical projections about the cost to make solar panels and batteries. They almost feels too good to be true. However, upon closer examination, it becomes very obvious that there are clear levers to pull that will really move the needle on cost reduction. There are many factors, but 2 trends stand out the most.

  1. The advent of electric cars is increasing battery production capacity exponentially
    In 2015, there were 15 million vehicles produced in North America and 91 million in the world. Of those, only 1% are electric cars. However, adoption is growing quickly. In the same year, International Energy Agency (IEA) estimated that 1.26 million electric cars were sold, which is an 80% YoY increase (link). Also, this growth rate isn’t a one-off. Over the last 3 years, electric car production volume has grown by 6x, which works out to 81% CAGR over that time period.EV-growth-2010-2015-VoxMoreover, all the major auto manufacturers are now jumping in the fray. Volkswagen plans to introduce 20 new electric vehicles by the end of the decade (link). Mercedes is creating an EV sub-brand (link). GM will be launching the Chevy Bolt in 2017, even ahead of the Tesla Model 3 (link). There are a lot of momentum for vehicle electrification. If the growth rate continues through the rest of the decade, and global vehicle production stays relatively flat, we can expect electric cars to account for ~15% of global production. This means that over the next 4 years, capacity is expected to increase by ~10x.This is an important point because battery manufacturing is a capital intensive endeavor with high fix costs. People much smarter than me have projected that the cost of the plant, machinery, and people account for 40% of the current battery production cost (link). As a result, any meaningful increase in production volume has major impact on unit cost reduction. Moreover, with scale, manufacturing process will become more efficient; energy density of batteries will improve. Historical benchmark of consumer grade lithium-ion battery cost suggests that for every 10x increase in capacity, you can expect a 3x reduction in cost (link). By that metric, a 50% reduction in 5 years actually seems really conservative.
  2. Recycling and re-use of electric car battery for storage can double its useful life.
    One thing that’s probably less talked about, but equally important long term is that the battery from electric cars can be recycled and reused for storage. In fact, Daimler (parent company of Mercedes-Benz) is already building 13 MWh system using this approach (link). If we assume that the useful life of the battery is 10 years and it cost 50% of the original cost to recycle and repackage the battery, then by definition, battery cost will be reduced by 25% over its 20 years of useful life. While the current cost of recycling is actually more than the cost of making the battery from scratch, this is mainly due to the lack of infrastructure in place to support it. Lithium-ion batteries have only started being used in automobiles over the last 5 years, so not enough batteries have reached the end of their useful life for people to build recycling plants specifically for them. Over the next decade, that will change and recycling should become a significant lever for cost reduction.

What wall street doesn’t get about SolarCity

Wall street has been skeptical about this deal from the start. From the reports that I have read, there are mainly 2 objections. The first is related to cash, the second is related to potential synergy and savings.

Objection 1: SolarCity is burning through cash. Why would Tesla acquire a company like that when it can barely fund its own growth plan with the model 3 launch coming up.

This is a valid one. The solar industry as a whole has taken a hit in 2016. For example, Nevada decided to end its net metering program completely (link), and many other states are discussing the same. Basically, net metering is a program implemented by the state that require utilities to credit their customers money for electricity that they add to the grid. This way, if Bob used 1000 kWh of electricity last month and generated 800 kWh through his solar panels, then he would only be billed for the 200 kWh. As more solar panels are put on roofs, utilities aren’t seeing as much revenue from their customers. To fight against it, they have targeted net metering policy. This is because without net metering, residential solar (people putting solar panels on their roofs) becomes entirely uneconomical at the moment. Since the decision was made, SolarCity and its competitors have all pulled out of Nevada.

This issue has hurt sales. As a result, the losses have been piling up, and the weakness in its balance sheet and cashflow is alarming. It only has $145 million in the bank at the end of the most recent quarter. Moreover, it burned through an eye watering $240 million in Q2 alone (link). On the call, they blamed their inability to secure financing on the pending Tesla acquisitions, but that’s probably not the whole story. The company had more than $400 million in cash at the same time last year and saw their position dwindle in each subsequent quarter. This suggests that the cash burn is not a one-off and SolarCity’s ability to secure financing has not kept pace with their installations.

While the current numbers aren’t pretty, I actually think this problem will be solved more quickly than people think. The key is the solar loan product SolarCity introduced back in Q1. The solar loans will significantly reduce the company’s cash needs, as all of the cash for the system sale will be paid upfront.The proceeds can then be immediately plowed back into the business to fund growth. Furthermore, it’s easier to sell loans in the financial market. This mean that the company can borrow more money at a cheaper rate. For consumers, solar loans are actually more economical in the long term, because they own the assets, and can take full advantage of the 30% ITC tax credit. I would not be surprised if solar loans make up 60%-70% of overall sales by end of the year.

Objection 2: Tesla is a auto manufacturer, there’s absolutely no synergy between the 2 companies. It’s like saying Ford cars consume gasoline. Therefore, Ford should acquire Exxon Mobil. 

To me, this is a very short sighted view. If google just focused on search, it would have never invented gmail, or google maps. Similarly, if Amazon just focused on e-commerce, it would have never built AWS, which now has an estimated worth of $160 billion (link). In each of those cases, people at the company saw an unfilled need and built a product that solved the problem.

Tesla’s mission is to accelerate humanity’s exit from the fossil fuel era, it just happens to make really nice electric cars. There’s a compelling argument that battery storage is the key technology that will transition our society away from fossil fuel. Batteries make electric cars run, which cuts down our dependence on oil; they make solar panels more useful, which eliminates the need for coal and natural gas. In order for both of these products to reach mass adoption, the unit cost of battery must come down. The easiest way to drive down unit cost is to produce more. Tesla is currently doing this by selling more electric cars. I think Elon saw an opportunity to produce exponentially more batteries by combining it with solar panels, and the best way to do it is to partner with the number 1 solar panel installer in the U.S., which he also is the Chairman of the board. However, it became increasingly difficult for the 2 companies to work at arms length because the systems needs to be tightly integrated. If you take this train of thought to its logical conclusion, it becomes fairly obvious that the ideal outcome (where both SolarCity and Tesla succeeds) is more likely if the 2 companies are combined. Elon himself said so as much in subsequent conference calls.

The difference between chess and checkers

The difference between chess and checker is the pieces. Bobby Fisher, the great chess champion, once said, “Winning in this game is all a matter of understanding how to capitalize on the strengths of each piece and timing their moves just right.” In checker, all the pieces are the same, and the goal of the game is to capture all of the opponent’s pieces. In chess however, the end goal is to checkmate the king, and different pieces have their strengths and weaknesses. This means that generally speaking, checkers is more tactical (short-term decision making) while chess is more strategic (long-term decision making).

I think this is the fundamental difference between the way Wall Street and Elon Musk is wired. Wall street is very focused on short term profitability. As a result, they spend all their energy thinking about how Tesla can hit the delivery target for the Model X and Model 3. The way Elon operates, he’s thinking about how to ultimately transition our society out of the fossil fuel era. The Model 3 is a necessary step, but only part of the equation. In order for that reality to happen, renewable energy like solar has to become a significant part of our lives. Once you understand the differences in their thinking, it becomes clear as day why the 2 sides came to completely different conclusions given the same set of facts. Which side are you now?

Other Sources:

https://www.teslamotors.com/powerwall

http://www.greentechmedia.com/articles/read/How-Soon-Can-Tesla-Get-Battery-Cell-Cost-Below-100-per-Kilowatt-Hour

 

 

 

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3 thoughts on “Tesla-SolarCity merger: why Elon Musk is playing chess while everyone else is playing checkers

  1. Thanks for this blog post regarding Tesla; I really enjoyed it and am definitely recommending this blog to my friends and family. I’m a 15 year old with a blog on finance and economics at shreysfinanceblog.com, and would really appreciate it if you could read and comment on some of my articles, and perhaps follow, reblog and share some of my posts on social media. Thanks again for this fantastic post.

  2. Excellent article with thorough analysis laid out very easily for anyone to understand. I believe these are very exciting times we live in with Tesla and Solar City merger leading us to the forefront of freedom from fossil fuels.

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