Offshore wind is fast becoming a mainstream part of Europe’s electricity system. In 2018, the continent’s offshore wind capacity jumped almost a fifth, reaching 18.5GW, according to industry association WindEurope – generating 2% of all electricity consumed in Europe last year.
That’s just the beginning. The UK, already the world leader with 8GW of offshore capacity, is forecast to double that figure by 2025. Germany is reportedly considering boosting its offshore wind from 6.4GW to more than 20GW as it closes down its coal-fired fleet. Even Poland, a latecomer to renewables, has set a goal of 8GW offshore by 2035.
This rapid growth has been propelled by dizzying cost reductions. In 2017, two UK offshore projects agreed to supply power at government-guaranteed prices of £57.50 (US$73.55)/MWh – half the level bid at the previous 2015 auction under the UK’s Contracts for Difference (CfD) programme.
In Germany and the Netherlands, offshore projects have won tenders without requiring any government subsidy (although, in the latter's case, wind farms will have their connection to the grid provided, offering an effective subsidy). This raises the prospect of offshore wind standing on its own two feet – generating ever-greater volumes of zero-carbon power without recourse to the public purse.
On the face of it, that’s great news: but we would urge caution. Subsidy-free renewables should be the ultimate goal – and it is achievable today, in some markets, for more mature and lower-risk technologies, such as solar and onshore wind. However, removing all government support from offshore wind too soon risks growth rates plummeting, government targets being missed and, ultimately, the taxpayer facing greater costs.
The issue lies in the risk profile of fully merchant wind farms. By entering zero-subsidy bids to win tenders and therefore declining any sort of government-guaranteed payment, wind farms are taking so-called ‘merchant risk’ – relying solely on revenues from the wholesale power price to pay their operating costs and repay investors. Some wind farms can enter into fixed-price power purchase agreements to sell their power to highly creditworthy offtakers (utilities or large corporates) to mitigate this risk, but that market is limited in size.
Up until now, institutional investors have been a major source of low-cost capital for the offshore wind sector. They have been attracted by the long-term, predictable, and typically inflation-linked cash flows offered by offshore farms, which benefit – to a greater or lesser extent – from government backing. Indeed, for institutional investors, the nature of these cash flows offers a significant benefit in terms of the regulatory capital they need to hold against such infrastructure debt investments.
Once offshore wind farms forgo government-linked payments, they become conventional power-generation assets as far as institutional investors (and their regulators) are concerned. Overnight, large parts of the capital markets will be closed, dramatically reducing the volume of capital available to be deployed to offshore wind. This will increase the returns that offshore developers need to pay to attract investors, pushing up their costs and reducing the volume of offshore wind that comes on stream, and putting government targets at risk.
There is an alternative to this premature race to ‘fully merchant’ offshore wind. Under the UK’s current CfD programme, the Government effectively takes the merchant risk element and offers price security to the generator: in CFD auctions, the next of which takes place in May 2019, project owners bid a fixed strike price where they would be paid the difference between this strike price and the wholesale price (if the wholesale price is lower). If the wholesale price rises above the strike price, the project pays the Government.
If the fixed strike price is competitive with typical market prices (i.e. is not at an elevated ‘subsidy’ level), that difference can be small (or even zero), but because the CfD sets a fixed price, the project is guaranteed revenue, removing merchant risk and thereby allowing cautious institutional investors to participate.
One day, as offshore wind’s costs fall further and its track record is better established, the technology will be able to compete without government taking some risk off the table. Until that time, a bit of support – to reduce risk, rather than provide subsidy – will go a long way.
The views reflected in this article are the views of the author and do not necessarily reflect the views of the global EY organisation or its member firms.