Offshore Wind Cost Reduction Recent and future trends in the UK and Europe

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1 Offshore Wind Cost Reduction Recent and future trends in the UK and Europe Gavin Smart November 2016 TLI-SP Summary Over the last few years, the UK s levelised cost of energy (LCOE) for offshore wind has been steadily falling. It is estimated that projects reaching works completion in 2020 will have a 25% lower LCOE than those completed in 2010/11. However, recent strike prices awarded in the Netherlands and Denmark are 60-70% lower in real terms than the lowest strike price awarded to date in the UK. This significant gap can be explained by site-specific conditions, regulatory approach, developments in financial markets and supply chain competition, and strategic sector investment by experienced project owners. A number of these factors are expected, or have the potential, to be effective in the UK. However, it is crucial to bear in mind that a number of these factors are also unlikely to be long-term drivers of cost reduction. Key findings The low strike prices recently awarded in the Netherlands and Denmark have been achieved as a result of a wide variety of factors; there is no single, high-impact, reason for the difference in implied costs between the UK and these geographies. The reductions appear to be the result of the perfect storm of financing, site conditions, centralised project de-risking and strategic bidding. The current availability of low-cost debt finance and the increasing levels of debt being brought into offshore wind projects early in the construction phase reduces the overall cost of capital, which has a significant impact on LCOE. Base rates are currently at an all-time low, and the all-in cost of funding is likely to increase in future. Recommendations The exclusion of transmission costs in the Netherlands and Denmark removes a substantial element of LCOE compared to the UK, which is reflected in the strike prices bid. Importing this to the UK would see headline strike prices reduce, but would be a significant shift in how offshore transmission is planned and paid for. Centralised de-risking of projects can be a major driver of cost of capital, reducing LCOE. Availability of near-shore, shallow-water sites with good wind resource brings cost reduction from capital and operating expenditure - The ability to develop and construct such sites lends itself to lower strike prices. 1

2 Strike price, LCOE, and the cost of capital In order to fully understand changes in the levelised cost of energy (LCOE), it is important to start with a brief explanation of the relationships between strike price, LCOE and the cost of capital. Strike price is the /MWh amount paid to an offshore wind generator, usually for a fixed length of time (e.g. 15 years in the UK), for each megawatt hour (MWh) of electricity produced. LCOE is the /MWh amount the generator must earn for each megawatt hour produced over the full life of the assets, to cover its capital and operating costs and its cost of capital. The cost of capital can also be described as the return on investment required for the generator to take the decision to build and operate the wind farm. The extent of this difference between strike price and LCOE is governed by a number of factors, including the difference between the strike price and the underlying wholesale power price which will be earned after the strike price period, and the level of strike price indexation relative to assumed cost inflation. In this analysis, where it is assumed that the project owner is achieving a lower strike price by accepting a lower return, this is fully reflected in the LCOE. If the strike price is fixed, the generator can improve returns by reducing costs and/or increasing output. In this case, the LCOE is roughly unchanged since the reduction in costs is offset by the resulting higher return. With a fixed strike price, if costs increase (or electricity output reduces), the generator must accept a lower return. Again, the LCOE is roughly unchanged since the increase in costs is offset by the resulting lower return. Similarly, in broad terms, once a generator has confidence in its cost base and electricity generation performance, the required return (as well as power price and other macroeconomic assumptions) will be the key driver of what the strike price must be to make the wind farm an attractive investment. UK context The Cost Reduction Monitoring Framework (CRMF) 1, published by ORE Catapult in February 2015, provided evidence that the LCOE for UK offshore wind projects has decreased from 140/MWh for projects commissioned in to 121/MWh for projects reaching final investment decision (FID) in Further evidence of cost reduction was provided in the results of the UK s first CfD auction rounds, announced in February 2015, which saw Round 3 projects being awarded strike prices in the region of /MWh 2, for which we estimate LCOE in the region of /MWh. 1 ORE Catapult s Cost Reduction Monitoring Framework 2 Awarded strike prices subsequently increased after removal of the Climate Change Levy for offshore wind 2

3 Works commencing (W/C) assumed as CRMF FID LCOE 121. LCOE of UK Financial Investment Decision Enabling for Renewables projects has been estimated from awarded strike prices. Round 3 CfD awards (LCOE has been estimated from awarded strike prices) W/C W/C 2026 LCOE has been estimated from Government s stated future strike price ceilings. Recent developments Recent strike prices awarded in the Netherlands and Denmark have made headlines throughout the offshore wind industry: The Netherlands Borssele I and II were awarded a 15-year, non-index-linked price of 72.70/ MWh (commercial operation date (COD) 2020). In Denmark, Vesterhav Nord and Sud, also known as the near-shore projects, were granted an approximately 12-year (or 50,000 full load hours), non-index-linked price of 61.75/MWh (DKK 0.475) (COD 2021). These headline prices are in the region of 50 60% lower than the lowest UK strike price awarded to date. However, as these prices are not linked to any inflation index (UK strike prices are pegged to the consumer price index (CPI)), in real terms these prices are 60 70% lower than the lowest UK strike price. At first sight this is a staggering difference, but a reconciliation is possible. This analysis provides a bridge between the estimated LCOE for CfD-awarded Round 3 sites and that for Borssele, and gives a view on further reductions required to make the Vesterhav wind farm economic at the awarded strike price. While this paper includes specific LCOE figures, these are intended to be indicative of the level of impact from various factors, rather than definitive numbers. Comparison of LCOE between UK and the Netherlands Differences in site conditions and regulatory regimes make a like-for-like comparison difficult, but it is important to begin with a UK figure which people can understand and agree on. This analysis begins with the strike prices awarded in 2015 for Round 3 sites. We then examine the key factors driving the difference between a Round 3 level of price and the Borssele I & II price of 72.70/MWh, which was awarded in July These factors are grouped into: Developments in the European market which apply equally in the UK. Further developments expected to be applicable to UK wind farms in the near-term. Impacts driven by the Netherlands approach to offshore wind. Other factors. 3

4 A brief comparison of key country-specific regulations, including a high-level star-rating assessment of whether these are more or less favourable from an investor s perspective, is shown below. Country UK Netherlands Denmark Support Duration 15 years 15 years Volume Guarantees Price Indexation None P50 output None CPI None Lower of 20 yrs/50,000 full load hrs None Tax Rate 20% 25% 22% Capital Allowances 18% reducing 20 years straight-line 15% reducing Summary comparison Figure 1 illustrates the impact of each cost driver in reducing LCOE from an estimated /MWh for Round 3 to an estimated 40/MWh for Borssele. These impacts are explained in more detail in the following paragraphs. Figure 1: Round 3 to Borssele LCOE ( /MWh) bridge 4

5 Starting point The LCOE from Round 3 sites is estimated at /MWh, based on a set of estimated capital expenditure (capex), operational expenditure (opex) and output assumptions, which achieve an acceptable equity internal rate of return (IRR) with the awarded strike prices. Since the Round 3 CfDs were awarded in Q1 2015, there have been developments in both the UK and the wider European market: turbine and vessel supply is becoming more competitive, and there have been further decreases in interest base rate and debt margins. Offsetting this to a large extent is the weakening of the British pound sterling against the euro and other currencies, as well as uncertainty in the wake of the Brexit vote. If a representative Round 3 site were to bid in a UK auction today, it can be estimated that its LCOE would be in the region of 103/MWh (at the low end of our suggested range). Improvements applicable to the UK A number of improvements assumed to apply for the Borssele sites are not necessarily unique to that project and could, or even should, apply in the UK under the right circumstances. Combined, these would result in a UK LCOE, in the near term, of 66/MWh. Excluding the favourable site conditions outlined below, the UK near-term potential LCOE is estimated at 86/MWh. Finance Financial sector feedback is that project financing is moving towards, and in some cases already achieving, 75% debt. This is not specific to the Netherlands; rather it is a result of banks becoming more comfortable with the risk profile of offshore wind, aided in the UK by the move to fixed price CfDs, and utilities needing to sell down larger shares in order to maintain balance sheet ratios and be able to recycle funds. In addition, equity stakes are increasingly being taken at construction stage by financial investors, whose business models rely on maximising gearing. Technical Industry feedback is that turbine capacity factors are expected to rise over the next few years as the current generation of 6MW+ turbines are optimised, and integrated wind farm control systems improve. Site factors Borssele is closer to shore and in shallower water than EA1. The biggest impacts are from shorter export cables, and from using monopiles rather than jacket foundations. Sites demonstrating this mix of favourable characteristics would bring similar benefits in the UK. Approach It is possible that a relatively aggressive approach is being taken on contingency levels for the Borssele project, reducing its LCOE. In addition, lower insurance premiums are expected due to the benign site conditions and the developer s experience and track record. This could be applied in the UK with the appropriate combination of developer and site conditions. 5

6 The Netherlands offshore wind regime The following features of the Netherlands regulations relevant to offshore wind further reduce LCOE by an estimated 23/MWh, from 66/MWh to 43/MWh. Strike price Applying the Borssele-awarded CfD of 72.70/MWh with no CPI link does not impact LCOE, but it does significantly impact the level of IRR (see Appendix, Figure 3). The Netherlands offshore wind regime Regulations in the Netherlands reduce investor risk through removing developer risk (preconsented sites) and providing for revenue stabilisation (generator paid for P50 output and allowed to bank over and under production each year; total P50 15-year output is guaranteed). The costs of equity and debt are assumed to reduce as a result. Transmission and use of system The LCOE does not include transmission or balancing costs (these are borne by the network operator). This represents a significant reduction in LCOE at the generator level; however, as socialised costs, these are still borne by the state or taxpayer in some form. Netherlands-specific factors There are also the following wider Netherlands factors not specific to offshore wind which reduce LCOE by an estimated 2/MWh. Tax A higher tax rate and less favourable capital allowance rules impact IRR. The minor LCOE impact shown is due to assuming that the cost of capital is affected by the revised effective tax rate. Market in the Netherlands The estimated benefits of being close to a number of vessel bases and foundations fabrication facilities. Borssele As a final adjustment, we assume that the project developer is able to reduce the overall cost of equity for a combination of reasons, including: Its ability to sell-down a portion of the project at or around the point of FID. Reduced risk from contract wrap approaches. A strategic decision to secure the Borssele sites in order to enter a new market, maintain project pipelines, and maximise use of framework agreements. With all the above impacts, we arrive at an LCOE estimate of 40/MWh. This is the LCOE required to achieve a reduced, but strategically acceptable, equity IRR with a 15-year unindexed strike price of 72.70/MWh. 6

7 Further reductions to Vesterhav The strike price of awarded to the Vesterhav wind farms in Denmark marks an estimated 15% further reduction in LCOE. Nearly all of the positive factors described above for Borssele are expected to apply equally for Vesterhav with a number of notable exceptions and additions, as outlined below. Figure 2: Borssele to Vesterhav LCOE ( /MWh bridge) Site Vesterhav has slightly more favourable site characteristics, being closer to shore, in shallower water and with stronger wind resource. This LCOE reduction, though, is partly offset by potential loss of some economies of scale: Vesterhav has a capacity of 350MW, compared to Borssele s 700MW. Turbine We have assumed that an 8MW turbine will be deployed at Vesterhav, which brings further reductions in capex and improvements in output. In addition, the developer has stated its expectation of reducing wake losses. DK CfD Applying the lower Vesterhav strike price of 61.75, with output eligible for revenue support capped at 50,000 full load hours, does not impact LCOE. It does, however, significantly impact the level of IRR. An impact on LCOE has been modelled from assuming that the lack of a P50 guarantee, as in the Netherlands, will increase risk and therefore the cost of capital. 7

8 Tax A lower tax rate, and more favourable capital allowance rules compared to the Netherlands, impact on IRR. The minor LCOE impact shown is due to assuming that the cost of capital is affected by the revised effective tax rate. Local synergies Some level of synergy and efficiency-driven cost reduction is expected from the Vesterhav sites being located in close proximity to other operating wind farms. Strategic view Similar to the case in Borssele, we assume that there is some element of strategic intent in the bid pricing. The impact of this assumption could be increased to offset negative impacts elsewhere if it were felt, for example, that the impact of not having the P50 guarantee would cause a greater increase in the cost of capital, and therefore LCOE. This final reduction in returns will potentially be offset by other factors, including: Other technology innovation. New finance structures on turbine contracts. Further pressure on the supply chain. Conclusions and further thoughts Reduced cost of finance is a key driver of LCOE and strike price reduction. The current low levels of interest rates generally in the financial markets are driving down cost of capital this is applicable across Europe (and wider) but, looking forward, it is important to recognise that base rates are currently at an all-time low, and the all-in cost of funding is likely to increase in future. The current favourable conditions cannot be viewed as a long-term cost reduction solution. The UK LCOE could fall by up to 20% in the near-term through more aggressive approaches to gearing, contingency and insurance, and through turbine and control optimisation. These developments require continued collaboration between developers, supply chain, financers and insurers in order to push through technology innovations and ensure that risk is priced appropriately. Site conditions are a significant driver of cost difference between geographies. The prospect of transferring this benefit to the UK is limited by the conditions of already-consented sites and by regulations governing the location of future offshore wind zones. Removing transmission costs has a significant impact on LCOE importing this to the UK would be a significant shift in how offshore transmission is planned and paid for. Centralised de-risking of projects can be a major driver of the cost of capital, reducing LCOE. This would require a fundamental redesign of the UK s planning, consenting and auctioning processes, but the success of auctions to date in the Netherlands and Denmark provides insight into the benefits of a more centralised system. Strategic bidding accepting a lower return than on previous projects in order to maintain project pipelines and maximise use of framework agreements is likely to be a component in building and operating projects at low strike prices. It is unclear to what extent this reduced level 8

9 of return can be maintained in the longer term, and there is no guarantee that auction clearing prices in any country will follow a smooth downward trajectory. Appendix In order to analyse the impact of cost-reduction levers and relate these to strike price, it is crucial to understand the relationship between strike price, cost and returns. It is also very difficult to show these impacts and relationships in one place, but Figure 3 attempts to do just that. Figure 3: LCOE, strike price and IRR from Round 3 to Borssele and Vesterhav The chart shows four sets of separate, but related, metrics. The dotted grey line is the awarded strike price in each country, shown in GBP. As these are the actual awarded prices, these are unchanged regardless of LCOE changes, with a step change as we move from the UK to the Netherlands and then to Denmark. The orange line shows the strike price in GBP, which would be required to maintain equity IRR at the target levels, given the assumed costs at each stage. As expected, this line largely follows the blue LCOE line, but it is critical to note that the differential between strike price and LCOE is significantly impacted by moving to lower, unindexed strike prices and different tax rates. The blue line tracks the decreasing LCOE in GBP as we apply each impacting factor. The light blue bars show the equity IRR resulting from the awarded strike price and the estimated LCOE at each stage. This is, crudely speaking, the inverse of the orange required strike price 9

10 lines as LCOE reduces, the awarded strike price will provide a higher return (shown by the blue bars); conversely, as LCOE reduces, strike prices need to fall (orange line trends) to avoid supernormal returns. Recommended reading Cost Reduction Monitoring Framework: Summary Report to the Offshore Wind Programme Board, ORE Catapult, Ferbuary 2015, available online here. Author Profile Gavin Smart holds the post of Investment & Financial Analyst at ORE Catapult and is responsible for developing and maintaining ORE Catapult s financial and economic modelling, which feeds directly into the organisation s commercial strategy. Gavin spent three years as Senior Investment Analyst for a major European utility, developing models and analysis tools for UK and European offshore wind and marine projects. Prior to this, he worked as a Valuation & Business Modelling consultant in the Middle East for one of the big four accounting and consultancy firms. Disclaimer While the information contained in this report has been prepared and collated in good faith, ORE Catapult makes no representation or warranty (express or implied) as to the accuracy or completeness of the information contained herein nor shall be liable for any loss or damage resultant from reliance on same. ORE Catapult Inovo 121 George Street Glasgow G1 1RD T +44 (0) National Renewable Energy Centre Offshore House Albert Street Blyth Northumberland NE24 1LZ T +44 (0) Fife Renewables Innovation Centre (FRIC) Ajax Way Leven KY8 3RS T +44 (0) info@ore.catapult.org.uk Web: 10