Are solar panels a good investment? | by Carl Westerby | June 2022

Photo by Nuno Marques on Unsplash

I recently went through the process of installing solar panels on my house. My motivation was to reduce monthly expenses and help the environment. This article analyzes the financial aspects of panels as an investment. I live in southeast Wisconsin, so some of the cost, solar, and tax break estimates are region dependent (your region may be different).

Looking at the cost per unit of energy produced will allow us to compare systems of different sizes. This $/Watt ratio is similar to that of houses in $/square foot. The typical cost in Wisconsin is $3 to $5 per watt. I received several quotes through Energy Sage, and ended up picking one that landed at $2.8/Watt. The installer offered the best price and was great to work with. As we will see later, keeping the $/Watt low is key to making the solar system a great investment.

It depends on your budget, your state’s net billing policy, and the size of your home. Energy Sage and the various contractors provided recommendations on this and we discussed several options. We can do an analysis using some US averages. The median size of US homes is 2,261 square feet and consumes 10,715 kWh of energy each year.

My utility has a monthly net metering policy. This means that they will pay full price on any energy up to the level you consume, but only pay around 25% of the normal price on excess generation. This means that to maximize our return on investment, we want to size the system based on our energy consumption for each month. We can estimate the total energy based on the amount of sunshine we expect to get (1300kWh for WI) plus the efficiency and area of ​​the panels (20.7%, 2.3m²).

Energy from sunlight each year per m² (Source: NREL)
Image source: author

We would need 18 panels to cover our power consumption, which gives us a system size of 8.64 kW (480 W/panel, costing $25,920 at $3/Watt).

Do I get tax relief?

Currently, the federal government gives you a tax credit of 26% on the total cost of the system, after you file your taxes (it drops to 21% in 2023). The state of Wisconsin provides a $500 credit at tax time, but the amount varies by state. I also got a 5% discount by paying cash in advance.

Can I finance it with a loan?

Yes, there are several options to do so. The best option I saw was to cash out the equity in your home through a refinance. The rates you can get on a home that is your primary residence are about as low as you can get. Personal loans were another option I considered, but the rates are generally higher and have shorter terms (15 years was the longest I could find). This made it difficult for the solar panels to cover the cost of the loan and be cash flow positive. Some credit unions offer solar-specific loans, but you need to pay attention to the details, as some include inflated or explosive payments as part of the loan terms.

I wanted to do a discounted cash flow (DCF) analysis to see how good an investment in solar panels can be. For those unfamiliar with this approach, I explained discounted cash flow analysis in depth in a previous article:

An important point included in the DCF is that solar panel production typically drops by 2% after the first year and by 0.5% each year thereafter over the guaranteed 25-year lifespan. Energy prices in Wisconsin have risen 4.1% annually. I created the table below from the historical data for the year and the last 2 years of my utility bills. You can see that the value varies from month to month, but from year to year increases quite steadily. You can also see the recent jump from $0.16 to $0.187 which is the result of inflation and rising energy prices globally.

Worst case:

Let’s do a worst-case cash flow analysis with the average 18-panel example above. Assume there is no growth in energy prices, a discount rate of 7% (historical return of a large-cap index fund), and assume the inverter fails right after the end of its 15-year warranty. With these assumptions, we buy the system just below its intrinsic value, with a margin of safety of 0.8%. The return on investment is 5.5% over 25 years (9.2% in operation). The system pays for itself in just over 9 years. That’s pretty good considering we assumed a lot of things wouldn’t break us.

Best case:

Let’s repeat the analysis, but make more optimistic assumptions. We can maintain our discount rate at 7%, but assume that the average historical growth rate of energy prices is 4.1%. I also assume that the system works for the 25 year warranty period of the panels. Under these conditions, the average ROI jumps to 13.1%, the panels are amortized over 8 years, and we buy the solar system at a significant discount compared to the DCF valuation ($41,500) giving us a safety margin of more than 60%.

Average case:

This time, let’s assume we only get 20 years of equipment use and energy costs only increase by 3%. Here, we are able to repay the system in another 8 years, the ROI is on average 9%, and we have a safety margin of 32%.

What I take away the most is that given the system guarantees and the low $/Watt price, we are practically guaranteed to be able to make the panels profitable even in the worst case. Running, the system should provide 7-13% ROI with more stable returns than the stock market (no down years).

Worst Upfront Costs

The math changes dramatically if the system costs the high end of $5/W. In the same “worst case” scenario from above, you have no safety margin and you never end up getting the system to pay back.

The average case also stinks, since you’re paying more than the discounted cash flow value. The system pays for itself in 13 years, but fails to cross the 7% discount rate.

As government tax incentives fade away, you find yourself in a similar situation where the worst-case scenario barely breaks even and has a negative margin of safety.

Home Equity Financing

Let’s analyze whether we paid for the system using a home equity loan. The current 30-year fixed rate is 5.5% at the time of writing. Because of the tax incentives, even with a 0% increase in energy costs, you end up making money on this offer. The cash flow starts to become negative 9 years after the start of the transaction. If the inverter fails right after 15 years, you end up losing money paying off the loan for the last 10 years.

The situation improves if we assume the historical increase in the price of energy, but if the inverter fails after 15 years, you end up losing money. Since the tax incentives are prepaid, in theory you could still win if you could invest the earrings kept over the 15 years.

In the best case scenario, you end up making over $36,000 without having invested your own money.

Specific Solar Loan

A renewable energy-focused credit union is offering a 15-year loan at 6% APR. The analysis does not change much from the home equity analysis. The 15 year term means you have more years of negative cash flow. Ultimately, both types of loans are a gamble that energy costs will rise over time. In order to reach the break-even point of the agreement, energy prices must increase by 2% each year.

If you don’t have leverage, you won’t be in trouble. It’s the only way for a smart person to go broke, basically. And I always said, ‘If you’re smart, you don’t need it; and if you’re stupid, you shouldn’t use it. —Warren Buffett

Conclusion:

I am including the excel file that I used for all the analyzes in this article on GitHub.

If you can pay cash and the purchase price is right, a solar panel system can be a great investment. As tax credits decrease over time, total installation costs will also need to decrease for the investment to make sense.

With a good purchase price and under worst-case assumptions about equipment life and energy prices, you end up buying the equipment at less than its discounted cash flow value. Under optimal conditions, the system has an average return on investment of 13% and pays for itself after 8 years.

If you finance the cost of the installation, you negotiate the spread between the rate of return on the panel and the loan rates. If equipment breaks down early or energy prices don’t rise, you can end up with negative cash flow and potentially lose money on the transaction.

As in other types of investments, buy at a discount and avoid leverage are two prudent rules to follow.