Energy

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

SunEdison going bankrupt barely a week after Peabody Energy probably counts as some sort of cosmic joke.

Despite their differences, though, their near-simultaneous crashes share some common causes -- and lessons to be learned.

One concerns corporate hubris and its great enabler, cheap capital. Back in July -- less than a year ago -- SunEdison announced the deal that finally unraveled it, to buy Vivint Solar. At the time, SunEdison's stock was trading at almost 12 times trailing revenue but was rated a "buy" by almost 90 percent of the analysts covering it, according to data compiled by Bloomberg. With that kind of blank check, who wouldn't go out and build an empire?

Have Multiple, Will Spend
SunEdison's acquisitions
Source: Bloomberg

Peabody, along with other coal miners, did much the same. They geared up to feed China's never-ending appetite for coal to power its electricity and feed its steel mills. The market was then just as willing to finance coal as it later was to finance solar. In 2006, Peabody was able to sell 35-year convertible bonds at virtually zero spread to Treasuries -- and the price shot up from there.

Mining a Rich Seam
Peabody Energy's 4.75% convertible bonds due Dec. 2041
Source: Bloomberg

Now that both companies have ended up in bankruptcy court, it doesn't mean the end for either of their industries.

Sure, Peabody's industry definitely faces more structural challenges on emissions regulations. But chapter 11 doesn't equal liquidation -- almost half the coal mined in the U.S. comes from bankrupt companies, according to Wood Mackenzie. The industry must shrink, but given it still supplies 30 percent of the world's primary energy consumption, that will take a while.

The renewable energy sector, in contrast, has the wind and the sun at its back when it comes to regulatory and technology trends -- albeit not always consistently. And like Peabody, while SunEdison's descent into chapter 11 will mean pain for its investors and creditors and probably doom some planned projects, it won't sink solar power altogether. As solar equipment manufacturer First Solar can attest, there can be life after a boom and bust.

Still Here
Stock price
Source: Bloomberg

But the industry can't shrug off SunEdison's failure, either.

Solar developers, in particular, are still grappling with the thorny problem of how to finance projects that require big upfront investments with long payback horizons in an inherently deflationary business.

There's been plenty of ingenuity on this front. For example, a year before it announced the ill-fated attempt to buy Vivint, SunEdison launched TerraForm Power, one of two listed yieldcos it controlled. Yieldcos capitalized on investors' heightened appetite for cash distributions in an environment of ultra-low interest rates. For companies like SunEdison, they were a great way of getting paid up front for long-term development projects by selling them to a captive subsidiary enjoying easy access to capital. The old win-win, as it were.

The problem is that yieldcos, similar to master limited partnerships in the pipeline sector, have long come with a promise of high growth, too. When that is thrown into doubt, the investors back away, eroding the yieldco's ability to buy its parent's projects at a premium.

Living Up to Their Name
Dividend yields for major yieldcos
Source: Bloomberg

TerraForm demonstrated another risk in the yieldco structure: potential conflict of interest. To help SunEdison swallow Vivint, TerraForm was roped into buying the latter's rooftop solar portfolio for almost $1 billion -- a huge price for a business that didn't even fit with TerraForm's objectives. SunEdison went on to replace several directors at TerraForm who objected, prompting a lawsuit from activist David Tepper.

The timing mismatch between upfront investments and returns has shown up in other ways. Vivint, for example, touts a retained value metric when it updates investors every quarter. It's commonly used by solar leasing companies that show consistent losses on a GAAP basis and is essentially a calculation of the net present value of expected income from the panels they deploy.

But like all such models, it lives and dies by its assumptions. And one in particular looks very suspect: That customers will, at the end of their 20-year contract, sign up for another decade at 90 percent of the cost of their previous contract.

To which the obvious response is: Show me a piece of technology worth 90 percent of its original value 20 years later. That's especially so when you consider the whole notion of solar power displacing traditional energy rests squarely on the idea that the technology keeps getting better and cheaper.

Even utility-scale solar projects potentially face a similar issue. Many are financed on the basis of power-purchase agreements that last for 20 years. Often, the implicit assumption is that those agreements get renewed or the project simply starts selling its output in the wholesale electricity market.

But again, why sign a new lease at favorable terms to the developer on a 20-year old solar project? If anything, the owner of the land the panels sit on will demand a higher price if it has proven a viable site.

And again, solar power is a deflationary force in the wholesale electricity business because of its low variable costs and tendency to smooth out price spikes. So if solar takes off over the next two decades, what sort of pricing power will a 20-year old merchant solar project have in a market crowded with ever more panels? Look at what the productivity gains of the shale business -- aided by years of plentiful cheap finance -- have done to oil and gas prices.

These problems aren't necessarily insurmountable. Yieldcos, for example, could reset investors' growth expectations and even set aside some cash flow as a reserve fund to preserve dividends when, say, a wind turbine doesn't get enough puff or a new solar project falls through. Meanwhile, solar leasing companies can focus on cutting back the bloated sales organizations they built up in the dash for growth, as SolarCity is doing already.

Utilities, with their access to captive rate-payers and very cheap capital, are also stepping up renewables development. And as-yet-unforeseen regulatory changes -- such as the implementation of widespread carbon pricing -- could lift all boats.

SunEdison's bankruptcy should give everyone in the renewables business at least a moment of pause, though. As in the mining business -- and, for that matter, the oil business and pipelines business -- SunEdison's mission creep, governance failure, and sheer recklessness exemplify what can happen when cheap capital hooks up with a can't-lose story. Like the old energy businesses it seeks to replace, the renewables industry has to sharpen its pencils and convince the market all over again.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in San Francisco at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net