HKZ is not "the first subsidy-free offshore wind farm" (it's not even subsidy free)

And why it matters

Vattenfall and BASF have been getting a lot of coverage for the first power generated at the HKZ offshore wind farm, with headlines like: Subsidy-Free Offshore Wind Power Starts Flowing into Dutch Grid

This is doubly annoying, as HKZ is actually not subsidy-free, and what it is “free” of is not a subsidy. But continuing to use these terms is ultimately damaging to the industry, because it hides the real economics of the project, and it perpetuates a highly damaging view that long term prices are a form of subsidy.

First, HKZ is not subsidy-free in the sense that it is not paying for its grid connection, which is built for it by TenneT, the grid operator. When one remembers that the cost of the grid connection can easily be 20-25% of the construction costs for an offshore wind farm in the North Sea, this is not a small rebate on the project. (To give a recent point of comparison, the Hornsea 1 offshore wind farm in the UK, of a size similar to HKZ, sold its transmission assets for more than a billion pounds - now that’s a bit more than it cost to build it, but it still gives pause when the cost of building HKZ is estimated to be around EUR 3 billion).

The offshore wind industry can pay most of the costs of integrating in the system, like transmission costs, balancing costs and system security requirements, and in some countries it does pay them in full, so it is not helpful to claim that it’s also the case in place where it’s not. There may be good reasons for countries to decide to have the grid operator build the grid connections (better planning of the grid and the works, for instance) but that does not mean that the projects should not pay for that (for instance a France, the grid connection is built by RTE and paid via a specific fraction of the tariff of the wind farm), and when they don’t, they should acknowledge the support they are receiving - and in that case it actually is a subsidy.

Now the reason HKZ claims to be “subsidy-free” is that it will not benefit from a fixed price tariff, and will sell its electricity in the wholesale market. The only thing it is “free” of is a long term price regime. Of course, this is such an unfavorable situation for an offshore wind investment that Vattenfall sold half of the project to BASF without any meaningful profit just to benefit from a long term off take agreement - and BASF was able to sell half of its share to Allianz at an immediate profit - its remaining half cost it only EUR 600 M, according to its accounts, ie the sale to Allianz was for close to EUR 1 billion). So Vattenfall gave away significant value to BASF to be able to pay for its investment in the wind farm.

If a merchant price regime is unfavorable, then surely any form of fixed price contract (like FiTs in the past, or CfDs more recently) is “favorable” and thus a “subsidy”, as the “subsidy-free” wording suggests?

But clearly, BASF, when it provided a long term fixed price contract to the project (in the form of a PPA, power purchase agreement), did not provide a subsidy to Vattenfall. So what matters is what the price level is, and how it has been reached. Any commercial agreement between two independent parties can be deemed to be fair and thus a “market” price. Any arrangement that refers to an existing publicly traded good or financial derivative, such as long term interest rate swaps, can also be deemed to be a subsidy-free market rate. Your mortgage rate, a long term fixed price for the lending and borrowing of money, is not a subsidy.

The difficulty with power is that there is no organized market for very long term deliveries (financial derivatives are not liquid beyond 5 years), and those long term contracts that exist (such as those entered into by Google, Microsoft et al.) do not publicize their price levels, nor the detailed characteristics of the power deliveries, which can often be bespoke.

The value of a long term fixed price regime is obvious: Vattenfall let BASF make a EUR 400 M profit (more than 10% of the cost of building the wind farm) from Allianz just to get a fixed price regime. If it had been able to secure a publicly-regulated CfD at the same price as BASF is buying the power, it could have built the wind farm with the same economics and made a EUR 400 M profit on top. That means that it could have actually bid a lower price under a CfD (by more than 10%) than what BASF was willing to give, as a sophisticated market player. So, structurally, we see that putting in place a CfD leads to a price lower than the “market” price - the exact opposite of a subsidy!

That cost increase may amount to a transfer form Vattenfall to BASF, but ultimately, it means that developers of offshore wind farms need to pay such “tax” to whoever is available to buy power on a long term basis at a fixed price (today, that’s mostly Big Tech, which means that countries without CfDs are effectively subsidizing the GAFAM) - and such demand is finite, meaning that at some point it will become increasingly hard to find new buyers, and developers will be unable to build new offshore wind farms, or will start whining again to get actual subsidies.

The reason long term fixed price contracts matter is that price volatility is a hard risk to take when you are a fixed-cost generator (renewables have no fuel costs and most of their cost is repayment of the upfront investment, spread over a lifetime of generation), and it makes investors require a higher return on capital to take the risk, making the electricity more expensive in turn. Providing a long term fixed price allows to make the investment cheaper, which is why developers are willing to pay BASF or Google a fortune to get that price stability when it’s not available from the regulatory framework.

Fixed long term power prices are a derivative, a swap, just like long term interest rate swaps. The instrument itself is not a “subsidy” - it deserves that term only when the agreed fixed price is “out of the market”. When the market for long term prices don’t exist, this is hard to determine. So people, lazily, look at the short term price. But just like short term interest rates do not always move in lockstep with long term ones, long term power prices have no reason to be identical to short term ones. Whether the swap was a good deal is something that you will know only at the end of the period, cumulatively - and when you see for instance that French renewables are paying back in just two years the past 15 years of “subsidies” they received under their feed-in tariffs (set at levels that definitely looked like they were subsidies because they were a lot higher than spot prices, or than EDF’s purported cost of generation in its nuclear plants), things are not so simple.

Maybe one way to look at fixed priced power is like an insurance premium: small yearly payments that protect you against a massive loss that can happen at any point in the future. In the highly volatile power market, where extreme price spikes are a feature of the system, this is an economically sensible instrument to use - both for producers and consumers. So long term prices should generally be a bit higher than “normal” spot prices. But as there is no aggregator for future demand, it is up to the regulators to create that in the shape of the counterparts for fixed price contracts like CfDs.

The use of the word “subsidy” for such contracts suggests there is a handout, and that renewables will always be an inefficient power supplier, when it’s actually an instrument that reduces risk for all, and allows to generate cheaper power. It also shows a poor understanding of the economics of wind power, which is something that industry players should probably avoid…