Wind farm with turbines on-shore and off-shore

11 Aug 2023

Offshore electricity: why calculations are being thrown to the wind

Harold Hutchinson | Managing Director, Alternative Energy at Investec

Summer heatwaves may be fading, but gales are blowing through the UK offshore wind sector. The connection is climate change, and the costs of addressing it.

 

Economic headwinds are stiffening in the UK offshore wind sector. The UK Government presented an ambitious investment plan for the sector in March this year, highlighting a longer-term project pipeline of nearly 80GW (a GW is a measure of capacity in the power sector). By 2030, it aims to more than triple offshore wind capacity to up to 50GW from 14GW today, as part of its plan to decarbonise the power market fully by 2035.

However, in the very same month, Keith Anderson, the CEO of Scottish Power, was quoted in the Financial Times as saying: “It only takes us two years to physically build an offshore wind farm but the planning process is fundamentally flawed and means it takes us more like ten years”.

By 2030, the UK Government aims to more than triple offshore wind capacity to up to 50GW from 14GW today, as part of its plan to decarbonise the power market fully by 2035.

In June, Mads Nipper, the President of Ørsted, developer of the 2.8GW Hornsea Three project, was also quoted as saying: “electricity prices offered by the UK government to developers are not high enough to absorb surging costs”. In July, Vattenfall, announced it had halted work on Phase 1 of its 1.4GW Norfolk Boreas site after a 40% rise in project costs. Both Hornsea Three and Norfolk Boreas had previously been awarded inflation-linked Contracts for Differences (CfDs) over 15 years struck at £37.35/MWh (2012 money), with a delivery year 2026/27.

Can we reconcile continuing government enthusiasm with growing industry concerns?

An important metric to assess profitability that is used in the industry is the Levelised Cost of Electricity (LCOE). The LCOE is the discounted lifetime cost of building and operating a power plant, expressed as a cost per unit of electricity generated (£/MWh). A MWh is simply a wholesale ‘unit’ of electricity output, 1000x greater than the kWh we are more familiar with in our domestic electricity bills.

For offshore wind, key inputs into LCOE include overall investment costs, the cost of capital demanded by debt and equity providers, turbine sizes and technologies, capacity usage, and average wind speeds. The latter dictate power available via a cubic equation. Consequently, a modest change in average wind speed (say from 4m/s to 5m/s) almost doubles the power available (4x4x4 = 64 versus 5x5x5 = 125). Moving from a site with an average breeze of 5m/s to one with a briskier 10m/s sees the power available going up by a factor of 8x.

The US investment bank Lazard regularly publishes transparent LCOE estimates for electricity generating technologies. For offshore wind, it currently estimates a wide US$3-5m/MW range for capital costs. Plugging in technology and location assumptions implies a range for the LCOE of US$72-140/MWh (mid-point US$106/MWh), assuming a weighted-average cost of capital (WACC) post-tax of 7.7% at the project level. The WACC itself can vary depending on a range of factors including project gearing. For example, assuming the mid-point LOCE of US$106/MWh above, but a higher 10% WACC, the LCOE moves to over $120/MWh.

In short, for final investment decisions in offshore wind, LCOE is best thought of in terms of (fairly wide) ranges, not point estimates. Ultimately, rather than anchoring on particular model inputs and outputs, imagination is as important as anything else - as any good sailor knows when he tries to use a simple map to navigate the realities of the ocean in front of him.

That is what is happening in the UK now, with unforeseen investment clouds around our shores. Supply chains are disrupted, with anecdotal evidence of equipment delays measured in years not months, and continuing hold-ups in grid connections. Banks and investors are tightening their terms. For the UK, there is a further factor - the offshore wind market is globalizing fast, with significant government support for the technology being offered across the main global economies including China, the US and EU. International capital will inevitably flow to the best risk/return prospects.

In my view, the future for UK offshore wind may unfold as follows. The technology remains integral to the future UK energy mix given its locational advantages, but auction prices are going up, significantly, to reflect the real costs of green energy. The UK Government’s aspirations in terms of pace and extent of rollout are now extremely challenging, with policy increasingly incoherent. That impacts not just the offshore wind sector, but the whole UK net zero path - the decarbonisation of heat and transport rely heavily on rapid green electrification.

Any solutions? One thought brings me back to our recent Investec Energy conference. The best UK onshore sites cannot normally match the advantages of offshore wind on criteria such as average windspeed. However, they remain much cheaper in terms of capital costs, they can more easily tap innovative, local, lower-cost finance, and offer a range of community benefits.

As someone who enjoys sailing, I am tempted to reflect that there is not much point complaining about headwinds. The best answer is to adjust the sails – in this case, coming closer to shore might not be such a bad idea.

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Disclaimer: The blog does not aim to give investment advice, but is designed to afford relevant longer-term context to investors, encouraging a broad perspective where uncertainty is high and a spirit of learning is important. The views expressed are those of the author, not those of Investec.