The Solar Journey
Has Solar's Price Been Discovered?
Updated: Nov 12, 2020
What is price discovery? How does it all work? Join us as we discuss the process.
Figure 1: The Grand Bazaar, Istanbul, by Amadeo Preziosi (late 19th century)
What is Price Discovery?
Price discovery takes place through the process of setting the price of an asset, security, commodity, or currency via market forces. A number of factors, including supply and demand, investor risk attitudes, and the overall economic and geopolitical environment that impacts said asset are important variables that play a part. In essence, price discovery is where a buyer and a seller agree on a price and a transaction occurs.
So why is the right price paramount for a given commodity or asset?
Pricing serves valuable functions with regards to resource and capital management:
Allocation - Scarce resources are allocated among many competing uses, where pricing affects final decision making
Rationing - Prices ration valuable resources, especially when demand outstrips supply (see price vs value article discuss the demand for clean sources of energy). Actors usually reduce the consumption of goods as prices rise.
Signal - Prices allow for signaling to occur. A screaming higher price of a commodity is begging for resources to be deployed into the sector. For example, a rise in the price of oil in the 2000s was followed by increased interest and investment in the sector. See the shale oil industry in the US as an example of this dynamic.
Incentivize – “High prices are the cure for high prices, low prices are the cure for low prices” - Rick Rule, natural resources investor. When prices rise, quantity supplied rises too due to market forces (in a free unencumbered market), which allows for more access to the said commodity. Prices should also fall due to this increase in supply.
How does it all work?
While the term itself is relatively new, price discovery has been around for millennia as a process. Ancient souqs in the Middle East and market places in Europe, the Indian subcontinent, and China brought together large collections of traders and buyers to determine the prices of goods. In modern times, derivatives traders in the pits of the Chicago Mercantile Exchange (CME) for example, continue with this timeless art called trading.
In essence, price discovery involves finding where supply and demand meet. In economics, the supply curve and the demand curve intersect at a single price, which then theoretically allows a transaction to occur. The shape of those curves is subject to many factors, from transaction size to background conditions of previous or future scarcity or abundance. Location, storage, transaction costs, and buyer/seller psychology also play a role.
There is no specific formula using all these factors as variables.
Figure 2: Supply & Demand Equilibrium
Price Discovery – A Process
Rather than consider price discovery to be a specific economic recipe to be carefully followed, it should be considered instead as the central and natural function of any unhindered marketplace, whether it be a financial exchange or the local farmer's market. The market itself brings potential buyers and sellers together, with members of each side having very different reasons for trading and very different styles for doing so.
By allowing all buyers and sellers to come together, these marketplaces allow all parties to interact and by doing so a consensus price is established. Without knowing it, all the players do it again to set the very next price, and so on. The more transactions occur, the more liquidity is said to be present in that market. A range of prices becomes ever more ‘robust’ or accepted as the chain of transactions increases over time, with large volumes remaining within a ‘trading range’.
“(Liquidity) allows one to get in or out of an investment at low costs. We want to be certain that prices reflect available information. Liquidity allows for price discovery to be effected efficiently.”
-Rick Lacaille, Global Chief Investment Officer, State Street Global
Price Discovery In the Solar Energy Market
Figure 3: Major Milestones Achieved by the Solar Industry (IRENA 2019)
With all that in mind, let us now come back to our Solar Journey. How does one currently price the solar energy market? What is the marketplace that comes to mind for Solar Asset owners and investors? How liquid are solar assets really? If a marketplace does not come to mind, has price actually been discovered? If not, can we confidently say that the solar energy market has reached maturity, with resources efficiently allocated and rationed?
Figure 4: Compared to 2018 levels, cumulative solar PV capacity is expected to grow sixfold by 2030. (IRENA 2019)
Supply and Demand (Khan Academy Youtube Tutorial)
Market Pricing (Investopedia)
Future of Solar PV (2019) (IRENA)