Why China is losing the solar wars

August 2, 2012, 2:56 PM UTC

FORTUNE — The numbers are so awful that you can hardly believe your eyes. Punch up any of the major China based solar energy companies and take a look (unless of course you’ve been, God help you, a long-term holder of these stocks, in which case you already know all too well what the charts show).

LDK Solar (LDK), down 80% in the past year, Suntech Power Holdings (STP) down 87%. The numbers for other big Chinese names, Trina and Yingli among them, are almost as bad.

But don’t stop there. Go back four years or so, and look at where these stocks were trading then. For a brief moment at the beginning of 2008, Suntech traded at over $80 a share. Eighty dollars a share! Earlier this week, after a conference call in which it alleged it had been defrauded to the tune of 554 million euros, possibly threatening its ability to make future debt payments, it dipped under $1.00. LDK Solar once traded at over $60 per share. Now it’s $1.39. On and on we could go with all the other alleged Chinese powerhouses in the supposed industry of the future.

These are epic, historic collapses in market valuation, made all the more stunning by the assumption, so prevalent just four years ago, that “clean” energy’s time had come. How ironic it is that Barack Obama’s insistence that the United States invest government money into the creation of so called “green jobs” — which led to the debacle of Solyndra and other wasted investments — was predicated on the fact that if the U.S. didn’t do so, the industry of the future would be Made in China. A credulous political press, egged on by the environmental lobby,  swallowed the reasoning wholesale.

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So now we sit, four years later, and China’s solar energy industry has become nothing less than a capital destruction machine, with some of its most prominent companies now desperately flailing for lifelines. On July 12, the municipal government in Xinyu, a town in Jiangxi province, 415 miles southwest of Shanghai, where LDK has its headquarters, said it would cover the $118 million debt it owes a Chinese bank, the Huarong International Trust Co. In May, LDK said in an SEC filing that if it couldn’t improve its access to funds it might be unable to remain a “going concern.”

Suntech, which accounted for 10% of the solar module and panel market globally last year, has its own troubles. Earlier this week it alleged that it may have been had been defrauded of 556 million euros by GSF Capital,  the general partner in an Italian solar firm called Global Solar Fund S.C.A, of which Suntech owns 80%. After the credit crunch of 2008, when traditional sources of financing dried up, GSF turned to the China Development Bank, a state owned institution run by the State Council in Beijing, the country’s central policy-making body. In order to provide a loan to GSF, the CDB needed a Chinese guarantor. Suntech, in May of 2010, agreed to put forward 554 million euros as a loan guarantee. In order to protect itself, it then asked GSF Capital to post collateral for the funds, which it said  it did, in the form of 560 million euros worth of German bonds. GSF claimed to have placed the funds in a “reputable custodian bank,” as David King, Suntech’s chief financial officer put it this week.

Fast forward to the present: Suntech, laboring under a huge debt burden, with large payments coming due next year, was looking to “monetize” its investment in GSF; that is, it wanted to cash out in order to pay down some of its debt next year. But Suntech discovered — allegedly — that the German bonds supposedly put forth as collateral by GSF capital didn’t exist. Suntech’s stock slumped to less than $1 on the NYSE earlier this week, a humiliating moment for a company that was supposed to inherit the earth. A market cap that was once north of $14 billion has now been slashed to a mere $188 million. Suntech is now suing GSF Capital.

Not all Chinese solar companies are in quite as dire shape as Suntech; but they’re close. And while it’s true that the rout in solar is not limited to just Chinese companies — Tempe, Ariz.-based First Solar’s (FSLR) stock has plunged 87% in the last year — the longstanding fear among their foreign competitors was that the China-based firms were going to separate themselves from the pack; they could  combine technology no worse than anyone else’s with rock bottom costs, as well as government support in a domestic market that would eventually, everyone assumed, become the world’s largest.

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So why did these alleged world-beaters instead become the capital destruction machine they’ve turned into, and what does the future hold for them? The solar industry has been, as Michael Parker, a senior analyst at Sanford Bernstein put it earlier this year, “a $25 billion mechanism to extract subsidies from Western European and North American governments.” That is, given that solar has been uncompetitive relative to coal, hydro and natural gas, it relied on government subsidies—granted in the name of environmental protection—to exist. The global financial crisis, and the deep recessions that have ensued, blew that world apart. First—as we have seen in Suntech’s case— for a time it made access to capital nearly impossible in a capital-intensive industry. Worse, it meant countries like Germany and Spain, out of necessity, had to slash subsides as pressures on their national budgets increased. Later,  the U.S. placed tariffs on some China made solar products, and Europe filed its own anti-dumping complaint, adding to the downward pressure on the Chinese industry.

In the short run all that hurt, to be sure; but it wasn’t necessarily a deathblow. Because over the past few years, Chinese companies and their global counterparts made enormous progress in reducing the installed cost of solar energy. The Holy Grail in the industry is to meet what’s known as “grid parity,” the point at which solar could go mano a mano with coal or gas or hydro-driven power plants, without subsidy. Grid parity, Sanford Bernstein estimates, would transform solar from a rent seeking $25 billion industry to a serious competitor in the $5 trillion global power generation market. Companies like Suntech, despite its deteriorating finances, have been drawing closer and closer to that magical place.

The problem for the industry is that almost every other major competitor has too. As Bernstein’s lengthy research report earlier this year argued, “good” industries (from an investor’s standpoint) are ones in which clear winners emerge, and losers exit, thus enabling the winners to earn bigger profits and generate positive returns on capital. Solar to date has not been a “good” industry. It’s one at which any number of competitors keep throwing capital, driving down costs, but not making much (if any) money, and not driving many competitors out of the business.

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In this, the Bernstein analysts put forth the heart stopping (for solar investors, that is) notion that solar is turning into the DRAM industry: a business which for decades was a capital intensive, low profit tong war, waged between Japanese competitors and, later, Korean companies, led by Samsung—which  eventually emerged as the clear industry leader.

The comparison, as the Bernstein analysis notes at length, is compelling; and it’s a potential nightmare for Chinese solar companies, not to mention for the government that has supported them. For none other than Samsung has identified solar energy as one of its five core business going forward. And Samsung has a balance sheet which absolutely dwarfs that of any current Chinese competitor. That means, just as it did in memory chips, it can invest heavily even during frequent downturns in the market, upgrading its technology and driving down costs so that someday it clears the field of competitors. In an industry in which so many speculated that Chinese firms would dominate, there isn’t a single one out there at the moment that seems capable of competing long-term with Samsung.

That means one of two things needs to happen in China; either the government needs to allow– or even prompt — consolidation in the industry, something that hasn’t happened yet despite the astonishing declines in market cap. Or, it could wall off the massive Chinese market from powerful foreign companies, like Samsung and others who might be tempted to play in the space (Bernstein suggests GE may be tempted.)

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But even that might not help in the long run. Remember always that grid parity, nirvana for the solar industry, is a moving target. The stunning price decline for natural gas, coming in the wake of huge discoveries in North America, demonstrates that. Bernstein analyst Michael Parker notes, accurately, that the natural gas price in China is still five times higher than what it is in the U.S. The point being that while solar is simply not close to being cost competitive in the United States, it still can get there in China, and it if it does, the potentially massive domestic market will provide salvation for Chinese solar companies.

Maybe. But remember that in terms of potential natural gas reserves, the United States is only surpassed by one country on the planet: China. And while the geology here is more difficult than in North America, and there are other constraints (a lack of water being the most significant– water being critical in the fracking process), oil and gas industry executives interviewed for this story believe these issues are eminently surmountable. Which means, in ten years or so, the price of natural gas in China might be much lower than it is now.

So the crash in solar equity values in China — China’s solar eclipse — might be telling us as much about the future as it is about what’s happened over the past four years. It’s just possible that solar is the industry of the future in China—and always will be.