Offshore wind: Navigating through ‘a perfect storm’

With the outcome of the latest Contracts for Difference auctions due to be revealed in early September, Utility Week speaks to industry experts about the cost pressures facing the offshore wind sector, the likely impact on the auctions results, and how the government can respond to ensure the success of future auctions.

In previous rounds, the results of Contracts for Difference (CfD) auctions have been largely celebratory events for the offshore wind industry, which has been able to boast about the large volumes of generation that has been procured at lower and lower prices. This time around, things are expected to be a bit different.

For allocation round five (AR5), the administrative strike price for offshore wind projects – the maximum allowed – has been dropped slightly from £46/MWh to £44/MWh (2011/12 prices). Although this is higher than all of the winning bids in AR4, which came in at a new record low of £37.35/MWh, the industry has been facing a surge in costs over the last year or so due to a combination of factors.

Indeed, a few months ago Vattenfall announced it was shelving one of the winning AR4 projects – the 1.4GW Norfolk Boreas wind farm – due to a 40% rise in supply chain costs, which meant it was no longer viable at that strike price. “It’s not very surprising,” says Ana Musat, executive director of policy and engagement at Renewable UK. “It’s not something that’s isolated to Vattenfall.”

Musat says the sector is in the midst of a “perfect storm” of cost pressures coming from both the supply and demand sides of the equation. She says the risk that no offshore wind is procured in the auction is “definitely a possibility that we’re preparing for.”

As a capital intensive industry with high upfront costs repaid over a long period, Musat says rising interests rates have “obviously” had a “significant impact” on the finances for both new and existing projects.

The CfD strike prices are linked to inflation but the industry has seen the cost of installing and manufacturing turbines rise above the rate of general economy-wide inflation.

Tom Smout, a senior associate at Aurora Energy Research, says the sector is quite exposed to the current energy prices.

“The thing about the turbine industry is that it’s actually quite a conventional industry,” he explains. “Offshore wind turbines are an exciting technology, but they’re also a surprisingly mundane one.

“It’s a big chunk of steel sunk into a big concrete foundation with big copper wires. So, when you have increase in energy costs, one of the consequences is that it feeds directly through to the costs of stuff which is being manufactured.”

Musat says even before Russia’s invasion of Ukraine and the resulting energy crisis, the renewables sector was facing supply constraints: “Ever since the pandemic, we’ve seen bottlenecks in international supply chains and we already knew that we had to do more in the UK in terms of bolstering our supply chain capability.”

She says supply chain capacity has not kept up with the rapid growth in demand, which has been amped up by the Inflation Reduction Act passed last year by US president Joe Biden as well as the Green Deal Industrial Plan launched in response by the EU.

“Now that competition for these supply chains is going up, there’s even more of an onus on us to do so, in particular because we’ve got those really large fiscal packages from the US and the EU.”

Musat says that “basically everything” – from blades to towers to foundations – is now in “fairly short supply.” Installation vessels are a “really big pinch point” that is affecting a number of projects.

In this context, Musat says a lot of developers will consider the administrative strike price of £44/MWh as “not very realistic given how much my supply chain costs have gone up; given all the uncertainty around even getting those supply chain providers in place.

“And the fact that we don’t know where inflation’s going to go, where interest rates are going to go, means it just seems very risky to commit to a contract like that right now.”

The results of the auction are due to be released in just over two weeks on 7/8 September. Smout says Aurora has not published any official forecasts but he expects that the results will be “less than ideal.” He says any offshore wind projects that do secure contracts are likely to do so at the full administrative strike price, which is “very, very tight.”

He says a lot of the developers bidding into the auction are also developing projects in other geographies such as the US and the EU, which may appear more attractive options by comparison.

However, Smout also notes that there may be some older projects that have been “stuck around for a while,” perhaps after failing to secure contracts in previous auctions: “Maybe there are some projects that already have a good chunk of their costs realized and those could come through comfortably at the administrative start price.”

He says another possibility is that more projects adopt a hybrid funding model, which combines CfDs with power purchase agreements. This model has already been tried by SSE for its Seagreen project and by Engie and EDPR for their Moray West project.

“Some level of merchant exposure right now feels really good because the power price is just so high,” adds Smout. “Generally, the dynamic of power prices is the extent to which they can drop is kind of limited and the extent to which they can climb is a lot less limited.”

He says getting investors comfortable with merchant risk on multi-billion-pound projects may be hard but covering some of the costs with an “iron-clad government contract” could help to soothe their nerves.

Earlier in August, the government did increase the annual top-up payment budget for the pot 1 auction by £20 million to £190 million. But Musat says this increase is not very significant and will not translate into much additional capacity: “It’s a drop in the ocean. It doesn’t really shift matters in any significant way.”

The £190 million budget for all established technologies is still less than £200 million budget reserved entirely for offshore wind in AR4.

As onshore wind and solar have higher administrative strike prices of £53/MWh and £47/MWh respectively, Musat says it could be that these technologies deliver the “lion’s share” of capacity and there’s “hardly any offshore wind, which is not great news because we’ve got really good eligible projects. It’s an area where we’ve got a competitive advantage. We just can’t risk this gap in the pipeline.”

She says a gap in development will increase the hesitancy of companies to invest in the manufacturing capabilities we desperately need: “Again, if we take into account the international context, it’s an even harder selling point.”

Filling this gap will mean cramming in more build out into a smaller period of time. “If you think about your demand long term in the UK, we know we’ve got a target to decarbonize the power sector by 2035,” says Musat.

“But the amount of time it takes to get that factory investment, to get the factory operational and to recoup that investment, it’s over 10 years. And then you’re wondering, well what’s coming after 2035?

“Are we still going to build quite as much or is this going to fall off a cliff? Not having that certainty or that visibility of the long term pipeline is making stuff very difficult from an investment perspective.”

Musat says the difficulties of building up the supply chain are made more challenging by the ongoing “race of in terms of making bigger blades, making bigger towers and just scaling up everything to make the technology more efficient, which is understandable.

“Again, it’s putting quite a lot of pressure on those supply chain companies that can’t just standardize and then deliver the same product for everyone. They’ve got to keep adapting.”

“That race kind of needs to be put on hold for a minute because I think unless we standardise it’s going to be impossible for these manufacturers to make money,” she adds.

“It’s not like there is a single ‘Model T’ turbine that is getting mass produced,” agrees Smout. “There is a supply chain that produces each turbine.”

He says this phenomenon has made the industry particularly susceptible to cost increases: “We’ve seen similar things happening with battery prices in the last couple of years. When the underlying commodity becomes more expensive, the supply chain is not super flexible because it’s not that mature.”

Nevertheless, Smout believes the benefits of building bigger – increased load factors and fewer turbines per unit of capacity – mean that “people are going to be pushing for bigger turbines for a while. The evidence from the market is not that we’ve reached the end of the turbine size arms race.”

Given all of these concerns, Musat says it is crucial that the government provides an early indication that the parameters of future auctions will be tailored to the economic conditions at the time, especially now auctions are taking place on a yearly basis: “We need a signal from government now that they’re committed to looking at those parameters and will be more transparent about how they are developed and how they’re taking into account market circumstances.”

Musat says the parameters of future auctions will also need to take account for any gaps that have already been left in the buildout of offshore wind. She points out that, having pulled out of the CfD for Norfolk Boreas, Vattenfall will have to skip one of the auction rounds, and that: “From this year, if anyone receives a contract that then they’re unable to meet and they hand it back, they will need to skip two auction rounds.

“In addition to this, you have all these potential projects that might not have been into this auction round but they’re still ready to go. If an auction with better parameter parameters comes up, they will most likely bid into that. But if you think about what that means for the future auction rounds, they’re going to be really, really massive.”

She continues: “It’s going to be really important to be alive to these market realities and not just try to do more of the same because we could have a much bigger pipeline.”

Musat says the Treasury’s autumn statement will provide an opportunity to provide an early signal that “things are going to be improved and the investment environment is going to look a bit better.”

One of the things she would like to see is an extension of the 50% first-year capital allowance for special rate assets, including renewables, which was announced in the Spring budget and will remain in place for three years until the end of March 2026: “Three years is a very limited amount of time. You can hardly claim anything given the longer lifespan of these projects and how the expenditure is planned out so making those more permanent would be great.”

She says renewables should also be made eligible for the main rate of the write-down allowance, rather than the special rate: “Right now you qualify for a discounted rate of just 6% rather than 18%.”

Musat says there’s already been a lot of discussion between the industry and government about this issue: “Across the energy space, and this is not just renewables, everyone’s grappling with these cost pressures. There was a round table with the secretary of state and Number 10 of a couple of weeks ago where we all talked about the fact that inflation’s really taken a toll on a lot of projects.”

Nevertheless, Musat says there’s “a bit of a question as to how much they’re willing to commit. There’s a lot of pressure on them to be perceived as saving consumers money.”

“Now obviously we’re going into winter and bills are going to go up,” she remarks. “We’re going into a general election in just under a year.”

But even with the recent cost increases, Musat says renewables will help to bring down bills, whilst also creating high value jobs. She warns that attempting to keep CfD costs “artificially low” over the short term represents a “false economy” that will ultimately “come at the expense of us having a thriving renewables industry further down the line.”

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