What Game Theory Can Tell Us about Middle Market, Commercial and Industrial Solar
William Graves, Sol Systems
November 25, 2014 | 3 Comments
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The decisions made along the path of solar project finance and development have major implications for the growth — or stagnation — of the commercial and industrial solar market. How does a developer choose the right financier for their project, or an investor decide to interact during contract negotiations? Together, what impacts do these decisions have on the value chain?
To answer these questions, we look to game theory, specifically the Prisoner's Dilemma, to analyze and predict how decisions made in these transactions affect the interactions in the solar industry, specifically in the 200-kW to 5-MW space.
Game Theory and The Prisoner's Dilemma
In case it has been a while since your last Econ 101 class, here is a basic example of game theory.
The police catch two partners in crime, Matt and Colin, after they have been selling counterfeit solar modules. Upon return to the police headquarters, the police separate the two and question them independently. The police don't have enough evidence to charge the criminals, but a confession would be sufficient to put them away. Per the example the criminals can either confess (thereby incriminating their partner), or they can remain silent. The full breakdown of possible decisions and outcomes is below:
| Colin Confesses | Colin Does Not Confess |
Matt Confesses | Both serve a 5 year sentence | Matt is released Colin serves a 10 year sentence |
Matt Does Not Confess | Colin is released Matt serves a 10 year sentence | Both are released |
The decision structure incentivizes both Matt and Colin to confess as this improves their position in two of the four possible outcomes: 1) if they both end up confessing or 2) in the event that the other remains silent. However, the optimal group outcome only occurs if both remain silent. As the two partners individually ponder how to proceed, the dilemma becomes clear — how can one trust the other to not confess? If one can't trust the other, isn't it just better to confess?
Now, think about that in the context of solar project finance and development.
The Number of Games Played Matters
Solar industry stakeholders do not make strategic decisions in a vacuum. However, industry players do vary in the way they view time horizons — and how their decisions impact future transactions.
If a developer or investor views a deal as a one-time transaction, they are more likely to defect in search of economic gain. Players that anticipate future transactions with the same parties are more likely to opt for cooperation to protect future possible gains. In short, the number of games played matters, and directly correlates to the amount of trust between two parties. If Matt and Colin have worked together many times, they can trust the other to remain silent and will be back on the streets selling counterfeit modules in no time. However, if this is their first collective trip to the rodeo, the trust is not there and jail time is likely in store.
To put it simply, in the world of solar project finance, relationships matter. If two players treat the deal at hand as the beginning of a long-term partnership rather than a one-off transaction, they greatly increase their likelihood of achieving both short-term and long-term success. Defecting to increase returns in a one-off transaction may have a higher short-term payoff, but does not carry the same return in the long run. The more interactions that a developer and investor have with each other, the greater their chances are for cooperation — and success.
Defection Has Its [Temporary] Gains, But Hurts C&I Solar
Cooperation provides the best group-level outcome, but defection enables the greatest outcome for an individual player. Defection manifests itself in the solar industry in a number of ways. During financial negotiations, both investors and developers have the ability to protract discussions or be punitive in the name of an additional penny or two per Watt. In the greater project marketplace, industry players have the incentive to misrepresent projects or their financing capabilities in order to increase financial gain — the notorious "free look."
Defection is risky because it quickly erodes trust and the potential for any long-term gains. The opposing counterparty may also defect in retaliation and wipe out any advantage the decision maker gained by defecting in the first place. Further, and possibly more importantly, it can corrode one's reputation in a relatively small industry. If a player considers defection, there must be a very good economic case supporting this decision because the long-term results may not contain an attractive payout.
Unfortunately, defection is all too common with middle market solar projects, and thus, many projects never make it to the finish line. The most typical explanation for defection persisting in an environment of repeated games is that one party is "hyperinflationary." That is, that their personal cost of money or return expectation is so high — or their value of future business so low — that rationally they assign no value to future years. If Colin has no realistic prospect of living more than five years, he will defect every time. Similarly, if a solar industry player can't make payroll without that extra cent on a project, or has no future projects in the pipeline, they'll grind all counterparties to maximize the money they can get this time, with no thought to speedily getting to the next transaction.
In the more mature residential and utility scale solar markets, cooperation takes on a greater role as companies have engaged in multiple transactions due to the limited number of market players. In the more fragmented middle market, companies rarely conduct repeat business. Instead, many developers opt for the term sheet with the highest pricing without fully conducting due diligence on their financing partner. Then, down the line, they may realize that the financing partner misrepresented their ability to bring tax equity to the table, or later reduced pricing due to mysterious "concerns uncovered during due diligence."
Given the rapid rise of the middle market over the last five years, most transactions take place between new market entrants and/or players who are interacting for the first time. This increases the likelihood of defection as new players remain focused on short-term gains and growth, often at the expense of potential future interactions with repeat partners.
Building Trust, One Iteration at a Time
In solar project finance, as in game theory, repeat transactions build trust and enable parties to optimize returns on both sides without fear of defection. Further, a tendency to defect is a grim signal of lack of capability itself — it means a player is showing, in a way hard to fake, that they don't plan on a long future. However, game theory nirvana (aka "Nash equilibrium") is not always easy to achieve. In a nascent industry with many new entrants, the temptation is certainly always there to defect in pursuit of economic gains. However, firms with a long-term focus recognize that the industry is small, reputation matters, and that success requires repeat interactions with a similar cast of partners.
The cornerstone of building a sustainable relationship first comes through trust. Once two players cooperate, they open the door for future cooperation. It is important to note that players do not cooperate for the sake of cooperation. They cooperate to unlock all of the benefits that come with cooperation: growth, sustainable revenue streams, access to additional resources, and (most importantly) the ability to achieve things that a single industry player could not achieve on his or her own.
What Game Theory Can Teach Us about Middle Market Solar
Developing and financing middle market projects is not easy. The sales cycle is long, and fraught with risk. Most projects don't even make it to the finish line. In addition to this, looming industry challenges lie in wait, including a reduction in the investment tax credit (ITC) at the end of 2016. We view partnerships as the most efficient and effective way to overcome these challenges. To do this we must work together, building trust one iteration at a time.
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