The Real Reason Tesla Needs to Buy SolarCity

If Tesla wants to be a big player in energy storage, it may need SolarCity's help. Image source: Tesla Motors.

There have been a number of reasons given about why Tesla Motors' (NASDAQ: TSLA) should acquire SolarCity (NASDAQ: SCTY) and make a vertically integrated renewable energy company. One argument is that Tesla's retail footprint will help sell more solar power systems. Another is that a combined company will make it easier to integrate solar with energy storage.

I think the real driver of this proposed merger is much bigger than those early synergies. It gets at the future residential energy storage market and how solar will both be sold to customers and be compensated for by utilities. Residential energy storage may take years to become a big business, but Tesla might need control of SolarCity for it to succeed.

How energy storage will work

When rooftop solar came on the scene, it was driven by two relatively simple concepts. The first was net metering, which allowed customers to export any excess solar energy they generated during the day to the grid at the same value as the power they pulled from it, and only pay for their net consumption each month. This created a mechanism solar companies could use to show cost savings for customers.

After cost savings were defined, customers could be sold solar with a lease or power purchase agreement that reduced their electric bills each month. Installers could then finance those contracted cash flows to make the installation profitable. Net metering led to financing, which led to significant residential solar growth. This business model innovation was key to the evolution of the residential solar industry as we know it today.

A Tesla energy storage system in California, which is testing the value creation models of energy storage. Image by the author.

Energy storage doesn't have the same savings or compensation structure today, especially for individual homeowners. That isn't to say that energy storage isn't valuable. It can provide a way to store energy generated by a solar power system during daytime hours for use later, provide backup or peak power to reduce the need to built expensive peaker plant, and even reduce the need to run transmission and distribution lines, because it's a distributed asset close to demand sources. There's a lot of value in energy storage, but it's very difficult to calculate a return on investment for those values. Plus, the benefits generally accrue to the companies operating the grid, not the homeowners themselves.

What's becoming evident is that utilities and regulators are starting to see the value of energy storage, and are willing to pay for that value. In New York, a power company was able to delay a $1 billion substation upgrade partly by investing $200 million in customer-side energy management, including energy storage. In California, 50 MW of energy storage is being rushed into service to help offset the impact of the massive Aliso Canyon natural gas leak. Value streams for energy storage will continue to emerge as utilities and regulators adapt rate structures and figure out how to put a dollar value on storage.

The challenge for homeowners is translating the value of energy storage into compensation for their investment. The kind of business model innovation that took solar mainstream needs to take place in energy storage. And that's where Tesla needs SolarCity's massive network of customers.

Where the value will be created in energy storage

The valuable aspect of energy storage to utilities won't be in the batteries themselves -- those are just simple commodities. The value will be in the network of batteries that could be used as assets at a moment's notice. If a homeowner in California had a Tesla Powerwall in their home, there wouldn't be a great way to generate value, but if 100,000 Powerwalls were in SolarCity customers' homes, the utility would see a lot of value. Batteries could be used in peak summer hours to reduce peak power plant costs, could take energy off the grid when there was a surge, and could even perform arbitrage when prices are high or low.

So the value is in the network of batteries and the algorithms that control the network. Tesla has the battery, but SolarCity has the ability to build the network. Musk needs to combine them to create value in energy storage. Otherwise, Tesla is selling a commodity battery to whoever wants it, with little control over the value streams that come from the energy storage system itself.

How this plan could come undone

It makes sense that Tesla/SolarCity could build a network of thousands, or even millions, of residential energy storage systems and provide a lot of value to utilities and regulators in the process. This could then create a business model that would allow them to finance energy storage systems with the same type of $0-down model that was so successful in solar. The pieces to create a successful business are there.

The question is if SolarCity's scale is helpful and if regulators will make rules open enough that a network of batteries would be able to provide services to the grid? Potentially, commodity batteries could be installed, and the control algorithm that communicates with the utility and makes money could be run by a tech start-up that doesn't have any installation staff at all.

What Musk is betting on with his plan to merge Tesla and SolarCity is that the network of sales people and installers will be key to building the scale needed to add value in energy storage. It worked in solar. Could it work again in energy storage? That's the billion-dollar question.

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Travis Hoium has no position in any stocks mentioned. The Motley Fool owns shares of and recommends SolarCity and Tesla Motors. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.