Some offshore wind innovation risks we really shouldn’t overlook

Published February 2016

Everoze partner Jo de Montgros asks how do we prevent innovation and new entrants to offshore wind from unsettling the strong levels of confidence in the finance sector?

Since the first commercial-scale offshore wind project (Horns Rev) came to fruition, the offshore wind industry has demonstrated rapid innovation and investment diversification. Turbine sizes have grown quickly, there have been pioneering new contracting packages and pension fund engagement is now mainstream. Such developments are often celebrated as impressive signs of progress, all part of the UK industry’s grand mission of achieving the £100/MWh target – a target mirrored in some form in most major offshore wind markets.

But is this success story as clear cut as it seems?

At Everoze, we have identified 2 potential unintended consequences that, if ignored, could damage the industry’s ability to deliver anticipated cost reductions.

Risk 1. Cost reduction and innovation could push up risk and financing costs

The UK government has clearly stated that future CfD support is contingent upon continued cost reduction – this puts great pressure on developers and the supply chain to drive down costs.

The unintended consequence?

It may be tempting for developers of next generation sites to reduce capital expenditure by shouldering increased risk during contract structuring e.g. reduced warranty terms, lower contractor limits of liability or increased allocation of ground and weather risks at the project-company level.

At face value, this type of innovation is necessary and welcome, but we must be careful to ensure that it does not knock investor confidence. Current levels of competition in the investment markets appear strong, but it is difficult to predict the impact of project design choices on ultimate financing costs. We must be vigilant and monitor this impact as it will play a significant part in projects’ overall lifetime costs. It is crucial that industry avoids inadvertently knocking hard-won confidence through the introduction of large step-changes to risk profiles in the name of cost reduction.

Risk 2. Large fund investment in operational offshore wind projects crowds out construction finance

To date, many equity investors in offshore wind have ‘dipped their toes in the water’, choosing to invest in operational projects before gradually gaining in the confidence and knowledge required to invest during construction and take on the associated risk. In some cases, investors have been willing to move into construction under the protection of a sponsor wrap (i.e. the sponsor taking a contract role similar to that of an EPC contractor), shielding their investment from many of the key construction considerations.

Investment in offshore wind has become much more competitive and there is a chance that, over time, divestment transactions could become dominated by parties or structuring arrangements with only an operational focus – witness the recent purchase of 50% of the Burbo Bank Extension project to Danish pension provider PKA and KIRKBI A/S (parent company of the LEGO Group).  Such parties will not necessarily have an appetite for financing construction phase projects in the future.

The unintended consequence?

There is a real risk that high levels of competition for operational projects could stifle the stream of investors willing to dip their toes in with operational investments, in order to develop a financial appetite for the construction phase of the next generation of projects.

To date, the Green Investment Bank (GIB) has gone a long way towards mitigating this risk, acting as a facilitator to help draw in further funding. At a time when the GIB is in the process of determining its future structure and market role, it seems important that their role is recognised by the industry and good entry points for new money are secured for the future – particularly in light of the wave of innovation and development for future sites.

Cost reduction, competition and confidence

Of course, the risk of these unintended consequences does not mean that we should discard technical innovation or erect barriers to pension fund investment. But they do provoke us to think more holistically about the impact of innovation and the balance required to maintain investor confidence through construction and into the longer term.

In addition, the impact of new players entering into the investment arena must be carefully considered. Engagement from pension funds should of course be encouraged, but not to the exclusion of other parties who may have longer term aspirations for construction financing who are crucial to the healthy future of the industry.

Much progress has been made on reducing the cost of capital for offshore wind projects and there is scope for further reductions. With debt at historically low levels and pension funds holding through the operational phase, much of the gain yet to come will be in the cost of construction finance.

The conclusion?

The offshore wind industry needs to be mindful of unintended consequences caused by innovation and be sure to balance cost, competition and confidence to shape the direction of the market advantageously over the longer term. It’s complex – but the sector looks to be up for the challenge.