The concept of systemic organizational risk is critically important in corporate governance. It arises when multiple points of potential failure take root in an organization or industry. When a breakdown occurs, it inflicts significant cost and damage. For this reason, boards have a vested interest in ensuring reliable oversight mechanisms are in place to detect and prevent such risk.

Despite its importance, systemic organizational risk is little understood. What exactly makes a risk “systemic?” What are the characteristics of systemic risk – as opposed to a general or isolated risk – and how can managers, the board, and outside observers monitor for it?

To illustrate the potential for systemic organizational risk to arise, we consider the curious case of the residential solar industry, in which complex financing, generous tax credits, generous sales commissions, and uncertain costs – coupled with widespread public interest in the adoption of solar – have created an incredibly complex industry with multiple points of potential breakdown.

Key Participants in the Residential Solar Industry

Homeowners. Homeowners purchase rooftop solar for economic and environmental reasons. The capital cost of a new system, however, can run between $26,000 and $30,000. Many homeowners, unable to fully fund the purchase price, elect to receive some sort of financing.

After installation, the long-term cost of solar is subject to factors that are mostly unknown. These include:

• Direct cost of maintaining the system
• Assumptions about its useful life and the eventual cost of replacement or removal
• The energy production and rate of efficiency decay of the panels
• The cost and effectiveness of battery systems to store excess power
• The price at which a utility will purchase excess power (net-metering rates)
• The availability of federal and state renewable energy tax credits

Furthermore, homeowners who finance the acquisition of solar are contractually required to pay the balance of their loans prior to moving. The unpaid balances become a liability against the equity value of their homes.

Corporations. Solar power corporations have adopted various business models to meet economic demand and address the realities of the marketplace. Four common models are:

• Sell the system to the homeowner for cash
• Sell the system to the homeowner with a loan originated by the company
• Sell the power produced by the system through a power purchase agreement (PPA) or lease
• Act as servicer of a system that has been sold or leased

The choice of sales model affects who bears risk. With an outright sale, risk is transferred to the homeowner. When the homeowner finances the purchase from the solar power company, the operating and maintenance risk is transferred to the homeowner, but the solar provider retains credit risk.

A power purchase agreement (PPA) presents the most curious solution. With a PPA, the solar company retains ownership of the system, even though it is installed on the roof of the homeowner. The company promises to provide electricity of a minimum amount at a contracted price. The term of a PPA is generally 20-25 years, even though the assumed useful life of the system is 35 years. At the end of the term, either the agreement will be renewed or the PPA provider will pay to remove the system.

With a PPA, the homeowner is not free of risk. If the equity partnership that owns the solar system goes bankrupt, the financial burden of removing the system shifts back to the homeowner.

Third-Party Distributors. In some cases, solar power companies rely on third-party distributors to generate sales. These distributors negotiate terms and receive incentive payments based on the deals they secure. Commissions can range from 3 to 10 percent, paid partially upon execution of the contract and in full upon installation. Agents who operate under this compensation structure do not necessarily have incentive to ensure that the customer can meet payments over the life of the contract or are in a position to utilize available tax credits in a timely manner.

Federal and State Governments. Solar credits provide significant incentive that guides consumer and corporate behavior. The most important incentives are provided under the Inflation Reduction Act, which grants an Investment Tax Credit (ITC) equal to 30 percent of the fair-market value of a solar system. Tax credits can be applied to current income, with unused credits rolled forward to future years.

A homeowner that acquires a system outright or with the support of a loan is eligible to use the credit to reduce personal income taxes.

With a PPA, the corporation retains the tax credit because it owns and operates the system. The Inflation Reduction Act allows a corporation that cannot use tax credits (because it is unprofitable) to sell them to a third party.

Without government incentives, the adoption of solar would progress at a considerably slower rate. At the same time, societal goals to transition to renewable energy sources can distract proponents from any negative economic, financial, and behavioral repercussions of these incentives. The government therefore finds itself in the position of encouraging the adoption of renewable energy while at the same time monitoring for negative outcomes that might arise from its own incentives.

Securitization and Tax Equity Partnerships. Because the solar industry is capital intensive, solar companies often rely on third-party capital to finance their businesses. Two main types of financing are asset-backed securitization and tax equity partnerships.

With asset-backed securitization, loans and leases are bundled and sold to investors. The cash flows generated by customer payments flow to the asset-backed security investor in the form of interest and return of capital.

With a tax equity partnership, the solar developer enters into a partnership agreement with a third-party corporation that provides a portion of the upfront capital to finance the sale and installation; in exchange, the tax equity partner is assigned the investment tax credit, a portion of the depreciation tax benefits, a preferred cash return, and a buyout option. Both parties benefit in that the solar company receives capital and the equity partner receives an attractive return on investment and the reputational benefits of investing in solar.

In capitalizing the partnership, solar systems are valued at fair-market value (rather than the direct cost of purchase and installation). In determining the fair-market value, the solar company makes a long-term estimation of contract payments, operating, maintenance, and removal costs. The value of the tax credit is based on this calculated value.

External Audit Firms and Valuation Appraisers. Accounting firms audit the fair-market calculations used in securitizations and tax equity partnerships.

Appraisal valuation documents are extremely extensive, commonly running to over 100 pages. One curious feature is that the fair-market calculation tends to be significantly higher than the cash purchase price of the system, which means the tax credit received is also higher than it would be if based on the purchase price. For example, while the direct cost of a new solar system typically costs around $25,000, a typical fair-market value calculation is $40,000 or more for an identical system.

This premium might reflect the economic value that the equipment creates for the homeowner, above its cost, or it might reflect aggressive assumptions about cash flows. Short sellers have accused publicly traded solar companies of making unrealistic assumptions that inflate present values. The method used to calculate the value of tax credits has also been challenged in court. Solar companies, however, have defended their methodologies.

The appraiser acts as a monitor to ensure the reliability of calculations. While this firm is not exposed to financial loss from inflated projections, it risks reputational damage and the loss of market share if projections are systematically inflated.

State and Federal Regulators. Regulators and tax authorities also monitor the residential solar industry and historically have brought actions against companies for inflating tax credits. At the same time, regulators are in the position of monitoring an industry whose growth is explicitly supported by the government. Research has shown that governments are not always effective at managing conflicts between regulatory goals.

Systemic Organizational Risk?

The residential solar industry exhibits many of the characteristics that can give rise to systemic organizational risk. These include incentives (commissions, tax credits, appraisals, and securitization) that are beneficial to corporate participants but  not tied to the economic experience of homeowners. The timing mismatch between when incentives are received (up front) and when total costs are fully known (back end) means that the financial interests of corporate parties that benefit from residential solar might not be aligned with the interests of homeowners, who primarily seek a reduction in their monthly energy bills.

Because fair value calculations – which underpin this type of securitization – are complex, corporate participants have an incentive to stretch assumptions to increase the amount of securitization proceeds and the associated tax credit. Tax equity partners, who finance a portion of the solar asset, are not exposed to the financial consequences of overstated cash flows because they receive an accelerated return of capital that lessens repayment risk; they also benefit from indemnification provisions. Because the PPAs and leases are assigned to the tax equity partnerships, the homeowner has no recourse to a corporate sponsor to satisfy the terms of a customer agreement, including removal of the solar system at the end of its useful life.

The monitoring structure of the industry is also in some ways deficient. Corporate monitors might not have full information about the risk inherent in their industry, sales or securitization activity. Appraisers who attest to the fair value of solar systems and external auditors who audit financial statements rely on information provided by the corporation that is paying them. And the government, which has determined that financial incentives are required to encourage solar, are responsible for identifying misbehavior associated with incentives the government itself has provided.

Evidence of Systemic Organizational Risk?

In the past few years, many solar companies have gone bankrupt or faced bankruptcy due to financial distress, changes in regulatory standards, or fraud. Major publicly traded companies have seen their stock prices fall in excess of 80 percent from their peak. Recently, the external auditor for SunPower resigned because the company did not have the “internal controls necessary to develop reliable financial statements” and therefore it was “unwilling to be associated with the financial statements prepared by management.” The company subsequently declared bankruptcy.

Are these harbingers of more to come? If so, who will bear the costs?

This post comes to us from David F. Larcker and Brian Tayan at Stanford University Graduate School of Business, It is based on their recent paper, “Solar Flare Up: Systemic Organizational Risk in the Residential Solar Industry,” available here.