Dear governments - stop listening to whining utilities
they don't even know what they really want (other than your money)
Did Vattenfall really make a hard decision by stopping development on the Norfolk Boreas zone, presumably giving up its existing CfD and announcing a SEK 5.5 billion - close to EUR 500 M - hit to its accounts? And following similar decisions by Avangrid and Shell/Ocean Winds to abandon existing tariffs/PPAs, is this a signal that the industry is not doing well? Or can these be seen as a new phase in the endless saga of utilities lobbying governments for special favors?
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Is this really costing Vattenfall money (or a project)?
At this point, it’s not obvious, despite Vattenfall’s announcement and its reported accounting hit, that the project is really abandoned. This is a development zone that comes from Round 3 and was allocated to Vattenfall almost 15 years ago already (together with Iberdrola at the time - they have since shared the area between them) . "Interrupting" the development for a while now is not going to change much in the grander scheme of things, and it can always be re-started. There is a likely cost from abandoning the CfD, but as it covered only 416 MW of the proposed 1.8 GW of the zone, it was not the main economic driver of the project anyway. The penalty for abandoning the contract is not explicitly indicated under existing guidelines but from the contracts I have had access to, it’s linked to the net present value of the contract for the government, using assumptions to be made by the government as to future power prices. These assumptions have tended to be fairly low until now (as shown by the govnerment’s own estimates of the budget allocated to CfDs in previous rounds), but it is not hard to imagine that for accounting purposes Vattenfall is using the current much higher power prices to establish a conservative (higher) estimate of what the payment might be.
So this looks like an announcement that is or will be low-cost for Vattenfall, while allowing a significant tax-deductible charge to be taken. Similarly, Avangrid paid a penalty (USD 50M) to exit the PPA they had agreed to, but they did not abandon the project.
So what’s this all about?
And all it really means is that they want to put pressure on the UK government (or Massachusets regulators) to give them more favorable terms for offshore wind in general, and for the next round of CfD auctions in particular.
Despite the obvious ploy for subsidies and other forms of government help (Ørsted was already successful in such similar maneuvering this summer, getting a tax break to stick with its project in New Jersey), this is nevertheless presented as legitimate concerns as the industry deals with increased costs in wind, with worries that current regulations do not allow the sector to make money, and calls for "non price factors" and other shenanigans in future CfD auctions.
Let's unpick these:
Cost increases are real….
Cost increases are real, they come from a combination of higher interest rates, the current bout of inflation for things like steel and other raw materials, and more generally across the supply chain.
One aspect to note is better discipline from the supply chain, in particular turbine manufacturers, that have been squeezed so hard previously that they have been making heavy losses and simply would not be able to continue their business without restoring more reasonable prices. The reason they have been squeezed is that the very utilities that are whining today have pushed them hard to lower prices, in the context of zero-bid or even negative price auctions (more on that below) that require endlessly (and unrealistically) improved business cases.
But what the utilities and others that complain about inflation forget to say is that higher interest rates and higher costs have also been accompanied by (much) higher power prices, which they usually benefit from - but obviously they are a lot more discreet about that…
… but could be hedged
Whether you are a loser or a winner from the various price movements is partly a matter of luck (good or bad), and partly the result of business decisions not to hedge against certain risks.
To put it bluntly, the utilities have been squeezing the supply chain very effectively over the past several years, and bet that they could continue to extract lower prices - so they did not fix their turbine prices when they received their tariffs on projects where this was possible, like in the UK (contrary to what a bank-financed project would typically do). So the fact that they are facing inflationary costs today is, mostly, the result of hard-nosed business decisions and there is no reason for governments to help out private companies that make such decisions (and would have kept the profits if the price movements had gone their way).
Another item to remember is that in many countries, and in particular the UK, where a lot of the lobbying is happening now, the main tariff the utilities get for offshore wind - the CfD - has a price level which is indexed to inflation, and thus provides a natural hedge against the price increases they are complaining about. Some will say that the current cost increases are way beyond the headline inflation (there is talk of 40% price increases), but again - for projects that received a CfD previously, it was a business choice not to fix prices at the time; and for those that are yet to receive a CfD, they can reflect the increased costs in their forthcoming bids.
The CfD regulations and market discipline
That brings us to the second point - the rules on CfD, and the fact that the caps for allowed bids are set too low.
There is a simple answer to that: if you are actually disciplined, and do not consider the current caps to be sufficient, don't bid!
If all players do the same, no bids will be allocated, the government will get the message, and if it wants to see more offshore wind, it will increase the cap.
If utilities worry that some players are willing to bet unrealistically low numbers, and thus they "must" do the same, well, they should bear the consequences of their business decisions. Nobody is forcing them to bid (and the fact that they have spent material amounts on development of the projects is not a good enough reason to do uneconomic bets).
Governments should ensure that people that make low bets do build the projects at that price, without any additional help or favor. The multiple examples given at the beginning of this article suggest that the penalty for not going ahead with a project are not high enough…
When are complaints about price auctions legitimate?
There are some auction designs where complaints are legitimate, such as those when people are asked to bid a price without knowing when they will actually be able to build their project, because the timing to do so depends on other factors (such as permitting processes that are not complete), but the UK CfD is not one of them.
In the UK, projects that bid must be fully consented, and can build (and indeed must build) almost immediately after winning their CfD. It is possible to enter into binding contractual (and financing) arrangements that back the selected bid price, and developers should thus be fully held accountable for CfD bids they make.
Long term, fixed price tariffs like the CfD, which in addition benefit from indexation, are the safest form of price regulation one can imagine, and it makes it possible for developers to attract low cost capital to their projects from the get-go. This is the cheapest way to get projects built, and it actually encourages project finance construction, which itself is more supply-chain friendly, as banks tend to want the contractors to take a bit more risk on their goods and services (in the form of stronger and longer guarantees) in return for higher payments - the higher revenue certainty this provides allows to reduce the cost of capital, and contractors are asked to take risks on what is their core business. Historically, long O&M contracts are a reliable source of profitable revenues for contractors.
What about non-price factors?
In that context, the call for non-price factors, led by the large utilities, sounds like special pleading to reduce the competition from smaller players - not because these are less good at fulfilling the criteria (they can be better, especially at things like local stakeholder management, and focus on domestic supply chains), but because they are less good at lobbying and influencing those who must decide on more subjective factors.
Familiarity, brand names, and the innate "seriousness" (and supposed reliability) of a big player help push decisions their way. But do you ever hear the smaller players whine to obtain a better deal? They just get pushed out of the way.
And all this for what?
The worst part is that the lobbying of the big guys is not even consistent over time, and is largely driven by whatever happened in the past year or couple of years, that they are trying to get again (if good) or avoid happening again (if bad).
After the big guys lost tenders run exclusively on price, they started pushing the zero-bid tenders, thinking that the small guys could not go there (and forgetting that they generally have more conservative outlooks on power prices than everybody else, and that their business model relies on selling 49% stakes to passive financial investors with cheap capital that cannot take merchant price risk).
They won that lobbying battle, won the zero-bid auctions, realized they were in a mess, and started lobbying again for real (two-sided) CfDs. Then the war in Ukraine happened, power prices shot through the roof, making merchant projects suddenly highly profitable, dragging along the price of long term PPAs. Lobbying started anew to have merchant options and be able to exit two-sided CfDs temporarily or permanently. The current crop of UK CfDs, which show that offshore wind can be built with quite low fixed prices (around 40 GBP/MWh, indexed), look very unattractive when merchant prices regularly reach 100 or 200 GBP/MWh.
The fact that decisions should be based on 20-30 years of power prices and not just on a few months of prices seems to have been completely forgotten, but the current lobbying to find loopholes out of fixed price CfDs is likely to last only as long as merchant prices staying high (which is not a given given the increasing penetration of renewables and the increasing prevalence of zero or negative power prices at times of renewables surplus).
So - 5 years, and 3 different messages on power prices, all driven by short term phenomena.
the lesson for the UK (and other) governments
So, to the UK government: the CfD is actually is an excellent design for a tariff (as is the OFTO mechanism, as an aside), developers and financiers understand it and like it, there is no need to tinker with it on the basis of the whining or blackmail of utilities..
The design of lease auctions is something else - it could be tweaked given how it currently encourages irresponsible bidding for leases that have no connection to the reality of the price of the sector but favor the deepest-pockets players at the expense of the long term viability of the sector. I will write on that again later.
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