A PV array has a once-and-for-all capital cost and then delivers power for up to 35 years with minimal other costs. This means that the cost of finance for solar has a startlingly important effect on the cost of electricity generated. As interest rates around the world fall to zero and below, the cost-competitiveness of solar power is improved.

The reason is that the developer of the PV farm doesn’t need to pay much interest. The only substantial cost it faces is paying back the capital over the 35 year life.

If a new large solar farm faces a cost of finance of 7%, a figure typical of a few years ago, today’s underlying cost of electricity is about 7.4 pence per kilowatt hour in a good location in the UK. (Assumptions in the footnote).[1] But at 4%, the figure is 5.5 pence and at 2% the cost is 4.4 pence per kilowatt hour.

The implications are fairly obvious. Any developer able to finance an installation at 2% annual interest rate can afford to accept a price for the electricity produced of 4.4 pence per kWh, or £44 a megawatt hour. This figure is below the cost of any competing source of power. With this price, solar is already at ‘grid parity’, even in the UK. (Today’s market price for electricity is lower than this level but no new capacity will be built at these prices. The UK government says a new gas-fired power station requires an average price of £65 a megawatt hour to make it possible to finance construction).

Solar will continue to get cheaper and cheaper over the next decades. Today’s report from IRENA suggests that PV will fall in price by a further 59% by 2025. Low interest rates, longer and longer asset lives and cheaper prices for the panels and other equipment needed for solar farms all point in one direction. Solar power is going to become the dominant energy source of the future. But, even if you accept this, 2% finance probably seems inconceivable. However I suspect we are getting closer by the day.

What are the finance costs incurred by developers today in the UK? In my book on PV, to be published in the next few weeks , I interview some of those who were financing solar assets in the UK late last year. Gage Williams, a director of West Country Renewables, which builds medium sized PV installations and wind developments, told me that he was able to borrow from a commercial bank at about 3.5%. This is only part of the financing cost because West Country Renewables also needs to pay dividends on the money invested by its shareholders and this percentage return will typically be somewhat higher. But the overall cost of the mixture of bank borrowing and shareholder funds was probably something about 5% or slightly more.

Since the interviews, interest rates in the wider economy have dipped sharply again. Governments can now borrow at less than 0% interest in many countries, including Germany and much of Europe. In Britain, most government bonds, which set the baseline rate below which no entity can hope to borrow, still have a small positive return. However the figure for a 30 year government bond is now below 2%.

But if the bond also promises to reimburse the owner for the effects of inflation, the interest rate can now be well below 0%. [2] In fact, UK bonds of 35 year duration are now delivering negative 1% returns. One of the most important reasons for this is that many pension plans promise the owner that his or her payments will go up with inflation each year and there is a shortage of assets that providers can buy that can reliably guarantee to honour the link. So the price is bid up and the effective return reduced.

Like index-linked gilts, feed-in tariff payments in the UK are also linked to inflation. Because they are highly secure, they also provide opportunities that are suitable for pension funds, similar to inflation protected government bonds. A developer today with PV prospects that were accredited for tariffs before the sharp recent cut in the rates payable can therefore obtain remarkably cheap finance. Community share offers on the market today make this clear. For example, Low Carbon Hub (LCH) in Oxford is offering investors (but, sensibly, not promising) 3% returns above inflation on PV installations on schools and factories. If inflation jerks upward, investors therefore get higher returns.

Separately, LCH is building PV installations on local factory roofs for companies wanting renewable power. Without giving me specific numbers it says it can offer these businesses PV electricity at a price that is slightly higher than open-market electricity today. It is therefore almost at ‘grid parity’ already. However if the business agrees to inflation link its power purchase price, then the overall cost over the life of the installation will be lower than suggested by government estimates for future open market electricity prices.

North Star Solar, a business set up by bankers rather than the usual eco-types, goes even further. It is taking money from pension funds to back an extremely imaginative scheme to put PV, batteries and LED lights into homes. The first customer is Stanley town council in County Durham. North Star tells me it is able to obtain its financing for these installations at ‘less than 2%’, although it is cagey about the actual numbers. These funds are used to provide free installation to tenants, with the business making its return via a monthly charge intended to be less than the savings made by the householders.

In other countries, particularly the US, responsible corporations are also helping to reduce the costs of financing renewables by committing to purchase the energy produced. Marks & Spencer has just announced what I think may be the first scheme in the UK that raises external private shareholder money for PV on store roofs, with the retailer buying the electricity produced. The new entity also proposes to pay an inflation-linked return to small investors, who may well also benefit from the government’s new tax policy of allowing people to earn £1,000 of interest before paying any tax.

Once feed in tariffs have completely disappeared in the UK, which is probably only a matter of months, the returns for PV investors will cease to have the automatic inflation link. Shareholders will demand somewhat higher returns as a result. But the underlying rate is unlikely to go up much, as recent history in the US makes clear. In recent weeks, Fannie Mae, the provider of much of the US wholesale mortgage financing, has said it will allow borrowers to get extra finance to cover the cost of installing new PV on home roofs. The cost of this to borrowers will be about 3.5%. SolarCity, the largest US domestic solar installer, has announced a financing deal that offers their customers a chance to buy an array at less than 3% financing.

Solar and wind are costly in terms of initial capital and very cheap to operate so financing charges often determine whether a project is economic or not. The reverse is true for gas power stations. Tumbling interest rates around the world are unambiguously good news for the future of renewables.

[1] £800 a kW for a large solar farm, 35 year life and £10 annual operations cost per kW. 11% capacity factor. Figures calculated on the NREL web site at http://www.nrel.gov/analysis/tech_lcoe.html

[2] When I refer to ‘inflation’ here, I mean Retail Price Inflation or RPI. The RPI overstates actual inflation by 1%, which is why governments should have replaced it with CPI many decades ago.