How Will China’s Woes Impact Its Solar Industry?

Concerns about the Chinese economy have mounted in recent months, amid lower growth forecasts (below 7% for 2015), industry overcapacity, slowing exports and the ongoing decline in the stock market. The country’s solar industry may appear particularly vulnerable to the downturn, since rising domestic shipments have been the biggest growth lever for most manufacturers over the last two years. China accounted for about two-thirds of the revenue growth for Trina Solar (NYSE:TSL), the largest Chinese manufacturer, over the last two years. Moreover, there are fears that the government could dial back its renewable energy subsidies, diverting funds into more pressing areas of the economy. Trina Solar has seen its stock price fall by about 38% in the last 3 months, roughly in line with the broader Shanghai composite index, while Yingli Green Energy (NYSE:YGE) has declined by about 30%. So should solar investors worry about the current state of affairs in China? While there is certainly cause for concern, investors should find some comfort in the fact that the crisis is also bringing about some tailwinds such as the devaluation of the Yuan and commodity price deflation – both positive factors for an industry that is still largely export-oriented and cost-driven.

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Domestic Demand Could Decelerate If Subsidies Are Cut

China is the world’s largest solar market, with installations standing at over 12 GW in 2014. The government is targeting about 18 GW of new capacity this year, accounting for close to a third of projected global solar demand. The rapid installation growth has been underpinned by attractive policy initiatives. Per the United Nations Environment Program, China spent a record $83.3 billion in green energy subsidies in 2014, up 39% from 2013, and a large percentage of this is likely targeted at the solar market. ((Renewables Re-energized: Green Energy Investments Worldwide Surge 17% to $270 Billion in 2014, UNEP, March 2015)) Coming to specific incentives, on the demand side the government offers feed-in-tariffs – as much as 1 yuan ($0.16) per kilowatt-hour (kWh) as of 2014 – for utility-scale and distributed generation installations, making solar an attractive proposition for customers and investors. On the supply side, manufacturers have benefited from tax breaks and low-cost funding from the country’s state-backed banks. Many manufacturers have also benefited from loans and incentives at the state level as well.

Now, there is a chance that the Chinese government could tighten its purse strings for renewable subsidies, as the economy transitions into a slower growth phase. These subsidies account for roughly 3% of the country’s annual budget – not an inconsequential sum – and the government could decide to deploy some of these funds into more pressing areas of the economy such as the manufacturing sector. Moreover, the massive solar capacity additions brought about by incentives appear to have created some structural issues – such as a lack of grid capacity for solar, and surplus electricity supply. Electricity consumption grew at the slowest rate in three decades during the first half of the year, with supply surpassing demand; coupled with a lack of grid capacity, this resulted in about 9% of solar capacity being unused during the first half of the year, according to the National Energy Administration. Consequently, the government could look to tackle these fundamental issues before providing further subsidies going forward. 

Even if the government does cut back on solar subsidies, however, the country’s banks will likely continue to support the domestic solar manufacturers, many of which have significant debt loads. The debt of most Chinese players is Yuan-denominated (listed as short-term liabilities on most balance sheets) and these loans are perpetually rolled forward by state-backed lenders; that is likely to continue regardless of the government’s subsidy policies.

Some of the large Chinese solar players that recently published Q2 earnings actually increased their fiscal 2015 shipment guidance – Jinko Solar and Trina Solar raised their midpoint guidance by 20% and 11%, respectively – citing higher demand from the Chinese market as one of the reasons. While this may seem counterintuitive, there is a possibility that installers want to take advantage of the current incentives, fearing that subsidy cuts may be around the corner. 

With that said, the longer-term prospects for solar in China remain intact, in our view. China is the world’s largest polluter, by far, and there is likely to be a sense of urgency for the government to address environmental issues while continuing to meet domestic electricity needs. Additionally, the landmark climate deal that China inked with the United States last year requires China to reduce its carbon emissions beginning from 2030 or earlier, while increasing energy use from zero-emission sources to 20% by 2030. This should also ensure that the government stays committed to renewables over the long term.

Lower Commodity Prices, Yuan Devaluation Could Actually Help

Chinese solar companies have generally competed on the basis of cost leadership rather than product differentiation; accordingly, the current environment in China actually bodes somewhat well for them for two reasons. Firstly, the Chinese Central Bank’s recent move to devalue the Yuan will prove beneficial to most tier-1 Chinese players such as Trina Solar and Yingli Green Energy, since they incur a substantial portion of their costs in Yuan, while about two-thirds of their revenues and contracts are denominated in foreign currencies. Since most of these companies have substantial cost bases, the lower dollar costs should prove to be a net positive, making their products more competitive in export markets while potentially helping margins. Second, unlike many western solar manufacturers such as First Solar (NASDAQ:FSLR), which have used technology and panel efficiency improvements to move down the cost curve, most Chinese players have leaned on their respective supply chains to cut costs. The current downturn in the commodity markets provides an opportunity for these companies to improve their cost-competitiveness. For example, Trina Solar noted that the price of polysilicon and other commodities fell by roughly 10% over the second quarter. ^[1]

The Net Impact Still Remains Hazy 

The combination of lower costs (in both Yuan and dollar terms) may appear to be a positive for most tier-1 firms, since margins are typically a bigger lever of a solar manufacturer’s valuation compared to volumes. With all of this said, it is difficult to definitively predict how the current turmoil will pan out for Chinese solar stocks. Competition in the global solar market is mounting, with countries such as Malaysia and India planning to increase their solar manufacturing capacity, and as a result there is likely to be further pressure on pricing. Additionally, solar panel costs now account for a smaller portion of the installed cost of a solar system (below 25% for many residential systems in the U.S.), meaning that customers could increasingly opt for technologically differentiated panels instead of cheaper Chinese ones.

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1. Trina Solar’s (TSL) CEO Jifan Gao Discusses Q2 2015 Results – Earnings Call Transcript, Seeking Alpha, August 2015 [↩]