INTERVIEW: Capital cost hikes pressure UK offshore wind developers: K2 Management

UK offshore wind projects awarded Contracts for Difference last year are at risk of not proceeding unless strike prices are revised to reflect rising costs, engineering consultancy K2 Management said in an interview March 3.

Five large offshore wind projects totaling 6.994 GW were awarded strike prices at GBP37.35/MWh ($44.67/MWh, 2012 prices) in 2022's Allocation Round 4, undercutting the previous UK low for offshore wind of GBP39.65/MWh in 2019's AR3.

Now, however, the market is saying an offshore wind ceiling price of GBP44/MWh in this year's AR5 is barely enough to justify investment.

"We may be reaching a tipping point where there is a risk UK developers will pull out of projects," K2's Director of Analysis and Due Diligence Will Sheard told S&P Global Commodity Insights.

"There are developers talking to government bodies saying projects can't fly in this landscape, we're going to need to revisit strike prices. I don't think they are being opportunistic, it's a significant moment," he said.

Driving the squeeze was a mismatch between the sector's multiyear cost reduction drive and suppliers of turbines, foundations and cables "simply trying to be profitable".

"Project costs have increased by orders of 10% to 20% within the last couple of years, mainly due to rising steel costs in turbines and foundations," Sheard said, noting these two elements can represent around 60% of overall project capex.

Meanwhile inflation had increased general operational costs and rising copper prices had hiked cabling costs.

Where before falling costs had encouraged competitive bidding, now the time dislocation between agreement of a strike price and agreement of supply prices was fraught with danger.

"It can be at least a year, sometimes two or three, before prices are nailed down. Projects hoped those prices would continue to decrease over that period, but we're seeing the opposite happen," Sheard said.

As such a ceiling price of GBP44/MWh in AR5 "will be pretty tight for a number of projects," and it remained to be seen whether lobbying to increase AR4 prices "could point to a revision" in AR5 pricing, he said.

UK allocation Round 4 offshore wind projects

Merchant nose

While winning a CFD remained a pre-requisite for project financing as downside protection, in the medium term Sheard did not see wholesale prices coming back down to GBP50 "so these projects can perform really well without a CFD, as we've seen with the merchant nose examples."

This was a reference to operational projects delaying the triggering of CFDs in order to benefit from high prices, a practice that has drawn criticism from the government.

Even with a supportive mid-term outlook for merchant earnings, "I honestly can't see how strike prices can continue to go lower," Sheard said.

"So far developers have been successful in passing the pressure onto the turbine supplies [GE, Vestas, Siemens]. Although they have a semi-monopoly market they need to maintain their order books, and have been willing to sacrifice profitability. That needs to turn into a profitable position soon. It would be detrimental if one of our three big turbine suppliers were to fail," he said.

Meanwhile, the Chinese supply chain was coming down the track with some compelling offerings that projects were starting to look at.

If Goldwind or Mingyang could support lower price level, and Vestas, GE and Siemens could not, "that may be a turning point in the market," he said.

Under current electricity prices, however, the government did not need to be so cost-constrained.

"It's very low risk for the government to underwrite a higher floor price for offshore wind. The problem has been the highly competitive nature of the process has incentivized an aggressive cost approach, chasing an unnecessary target in my view," Sheard said.

This had seen offshore wind projects underbidding onshore wind and solar in the last auction, despite demonstrably higher capital costs, while on the continent offshore wind auctions has seen zero-subsidy bids, with the latest in the Netherlands (RWE's HKZ concession) including electrolysis.

Lower returns

This has resulted in lower returns for investors still keen to get into wind.

"Returns in some cases have come down over 10 years from 10%-12% in 2015, with some investors looking at 4%-5% on projects today. That changes the appetite and the kind of investor willing to come in. We still see the pension funds comfortable with that, but the bigger institutional investors need a lot of volume at that rate, so we are seeing more platform and portfolio level deals rather than individual project transactions," Sheard said.

Looking ahead, the UK's 50-GW offshore wind target by 2030 remained hugely ambitious despite its global leader status and relative ease of building versus other jurisdictions, notably the US.

"But the UK is not alone in having an ambitious target and while we are constrained by having three turbine suppliers, the turbines simply can't be supplied," he said.

Upcoming offshore wind tenders and auctions, 2023/2024