Can solar energy survive a price war?

Only one statistic really matters in the green energy war: $2 per watt. That's how cheaply a brand new coal-burning plant can deliver electricity. It's also the figure that makes scientists working on wind and solar technology wake up in a cold sweat at night. For the last 20 years, they've been racing to come up with a technology that matches coal watt for watt.

Solar scientists think they're getting closer. The progress of solar technology is measured against the initial cost of the panels. Silicon-based photovoltaic (PV) panels dominate the industry, selling at around $3 a watt in recent years. But a new generation of thin-film technology has brought the cost of manufacturing down to $1 a watt. That doesn't mean parity with coal. Taking installation costs into account, industry leader First Solar reckons it has to bring manufacturing costs down to $0.65 per watt to achieve that. But the lower cost of thin-film panels had threatened to make PV cells relics of the green energy war.

But not anymore. One thing has held back PV cell manufacturers the cost of their raw material. As mass production of cheap PV solar cells started, the surge in demand saw the price of silicon soar, and solar manufacturers were forced to scour the earth for new supplies. But after three years of misery, there is now an abundant supply of silicon. On the one hand, high prices caused producers to ramp up production. On the other, the recession hit demand for the material. That's hammered the material's price the new contract price of silicon for delivery in 2009 is down 50% on a year ago. At these levels, leading makers of crystalline silicon PV panels can now afford to sell at below $2 a watt and still make a profit, according to New Energy Finance.

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That heralds the start of a price war in the solar industry. As PV manufacturers threaten the cost advantage of thin film cells, the price of panels will be slashed. Thin film producers have already cut production. First Solar has taken aggressive action sacrificing profit margins by introducing rebates in a bid to cling to its cost advantage.

The price war comes at a bad time for the solar industry. As credit has been choked off, demand for solar panels from businesses and homes has plunged. Yet "despite PV demand shrinking 17% this year, so much cell manufacturing equipment was ordered and installed over the past year that capacity is still expected to grow 56% this year", says Charles Annis of research group DisplaySearch. The risk now is that huge over-supply could result in the failure of several cell manufacturers.

And there's another potential problem. It may be getting cheaper, but solar power still has little chance of competing with coal without government subsides. But with governments ratcheting up debts to kick-start their economies, the generous tariffs they've been offering to install solar power are under threat as they come under pressure to cut spending. Spain, which accounted for more than 40% of solar installation last year, has cut aid to the sector. Germany will probably soon scale back its feed-in-tariff policy, which offers to buy electricity from solar installations at inflated prices. But China and America have promised huge support for solar in their recent stimulus packages.

Those left standing after the shakeout should profit as demand for solar power recovers. As thin film pioneers (see below) keep innovating, they will have the upper hand as the solar industry goes to war. We look at the key stock to watch in the sector below.

The best bet in the sector but don't buy in just yet

First Solar (Nasdaq: FSLR) is now producing solar cells at $0.87 per watt. The pioneer in thin cell manufacturing is also the industry's clear leader on costs. The group recently announced that second-quarter earnings had doubled, beating Wall Street's estimates. Despite falling prices, its gross profit margin rose to 56.7% from 56.3% last quarter.

Unfortunately, those results were boosted by accounting jiggery-pokery, reckons Bill Alpert in Barron's. Earnings were partly lifted by realising $84m in revenue as a result of reclassifying an investment in a German solar farm as debt rather than equity.

The real story for now is that First Solar is burning through cash, with cash flow turning negative in March. That raises concerns about how long it can afford to pay rebates to hold onto clients in Germany a key market for the firm, accounting for 74% of sales last year. On the upside, the stock has fallen a long way amid the market turmoil (down 50% since we tipped it last year), and aims to move into the US and China to diversify.

And as the leader when it comes to low-cost solar power, we reckon First Solar will be one of the major survivors in the sector when solar bounces back. But if you don't already hold it, wait for the price war to play out before buying in.