How utilities and big oil broke the economic model of offshore wind

The "heads I win, tails I whine' business model and its consequences

Offshore wind is currently broken. There is a despondent mood in the sector, and it looks like everybody is trying to get rid of their assets or reduce their exposure to the sector (see BP, Equinor,   Shell, Vattenfall, Total,  an even Ørsted, Corio or Bluefloat). With everybody trying to sell, but often not lowering price expectations, few transactions are happening and those that do happen tend to see depressed prices. Everybody complains about higher costs and degraded economics.

And yet - they brought this on themselves, through a combination of hubris, ignorance, and reliance on lobbying rather than good business acumen.

The problem is that their behavior  has been so "efficient" that they have successfully pushed away the competition, either through undisciplined behavior in auctions, or outright lobbying to exclude smaller players from the sector, and there is no room for others to pick up the pieces (for instance many countries have pre-qualification rules that impose large balance sheet and operating MW constraints that even large financial investors cannot meet, given their fund-based structures). The worst part is that a lot of their lobbying demonstrates that they (or at least their C-suite) do not understand their own business model...

So how did we get there?

For many years during the 2010s, the sector managed to deliver both growth in volumes and a sharp decrease in costs. This came from a combination of an increasing understanding of the risks associated with the sector (installing large industrial equipment in the middle of the sea is never going to be simple), benign macroeconomic conditions (with low interest rates) and healthy competition.

The sector was split between utility-managed projects, and developer-managed projects. Utilities tended to finance projects on their own balance sheet, managing construction and operation risks themselves, and targeting cheaper supply and installation contracts by keeping a lot of the risk internally and managing these through large and experienced project teams. Developers required project finance (or “non recourse debt”), which meant that lenders had more of a say about the contractual setup of the projects. This resulted in typically more expensive contracts, with more of the risk borne by the contractors, but the resulting lower risk for the lenders allowed them to provide attractive financing terms. With cost of capital an essential driver of the ultimate cost of electricity in this capital-intensive industry, such financing structures meant that developer-led projects could be competitive against utility projects - and indeed won more than a few auctions, including for instance the emblematic Borssele 3-4 project in the Netherlands.

Such successes by smaller players has always annoyed the big utilities. In the early 2010s the Dutch utilities sued the government that had attributed the Gemini project to a small developer, claiming that it would never be able to get that project built. But that project was successfully financed, and built on time and budget, making them look like fools.

At that point, the big European utilities did two things to try to reassert their dominance.

1. They tried to move to new markets, hoping that they could get higher prices there than in Europe.

   As they competed against one another, they ended up bidding European-like prices in markets with no supply chain, no track record, and often still incomplete regulatory frameworks, crowding out local and disciplined bidders.

   That led to projects being cancelled in the US when the economics at the time of investment decision did not match the prices offered several years earlier, and serious cost overruns in Taiwan where the first generation of projects ran into difficulties (like the early generations of projects in the UK and Germany - even with the industry's experience, it is hard to transfer all the knowledge immediately in completely new and different contexts. The technical problems were solved, as they were elsewhere, at a cost that was not really covered by the low European-like tariffs they applied for).

   As regard to the regulatory delays, the European players tried their usual approach to whine to governments to give them help in various ways (increased prices, delays, subsidies, etc.) but they severely over-estimated their lobbying capabilities, and underestimated the political obstacles to increasing regulated tariffs in the US context. The US experience, in particular, led to highly visible failures and losses which generated a lot of negative publicity for the sector.

2. They lobbied for more qualitative factors than mere price-driven auction (because they can lobby how these can be assessed) and for more "zero-bid" or merchant projects.

   Through a unhappy quirk of the regulatory framework in Germany and the Netherlands, the contracts for differences (CfD) there were going only one way (ie topping up the price received by projects when it was below the market price, but not making them pay the difference back when it was higher than the market price) - so provided a floor rather than a fixed price: regulators at the time did not imagine that prices would go down so fast and could become competitive.

   In that context, with a freeze then ongoing in Germany for new offshore wind development, and just a handful of zones on offer, the temptation to bid a price of zero just to win the only project to be built in the country over the next 5-7 years could not be resisted - the winner getting a fully permitted zone, grid connection, and access to the "merchant" market price. Once that precedent was set, there was always another desperate-enough utility to bid for such contracts. The utilities convinced themselves that they would be better placed than the smaller developers to manage such projects, as power prices are very volatile and this is a risk that is hard, or expensive, for lenders to take.

   They just forgot that their own business model relied on selling minority stakes in projects to passive financial investors with low cost of capital to improve the economics of the project, and that such investors, like lenders, do not tolerate merchant risk. They then had to pay fortunes to buyers of power to give them fixed price PPAs to make the projects financeable.

   The result was a race to lower costs as much as possible, by pushing really hard on the supply chain, in particular to deliver larger turbines. That also meant larger foundations, larger vessels to install them, and larger port facilities, forcing everybody to invest for new facilities. Turbine manufacturers, somewhat recklessly (we can talk about their Stockholm syndrome approach toward their utility clients in another post...) agreed to start working on new turbine models (20+MW) even before the current generation being commercialized (15 MW) was fully tested or installed, and even before the previous generation (8-10 MW) was made fully reliable. The resulting headlong rush; compounded by the inflation of 2022, resulted in heavy losses or even quasi-bankruptcy for them, with massive technical problems on the turbines installed over the last several years disrupting projects and triggering penalties and more losses.

   Ultimately, they put a halt to these new developments brutally, stopping to take orders and renegotiating prices brutally against their existing clients. It is quite possible that one of the main players will exit the market, leaving an unhealthy duopoly, and the dangerous temptation of Chinese turbines: small developers have lost access to European turbines, as the manufacturer just won’t engage in any sales discussions if volumes are not big enough. Some of them will try to find options elsewhere, and if the Chinese offerings prove that they work - not a certainty - then that competition is inside and here to stay

3. The utilities still don’t understand project finance for construction

   In the meantime, utilities are trying to do project finance to improve the cost of capital of their projects, but they don't really “do” project finance - they still want to manage the contracting and risk taking their way, and then ask the banks to take these risks without guaranteeing them. This leads to endless fights between project finance lenders who do not like the structures they are asked to swallow, and are less sensitive to commercial pressure, and utilities who are used to slavish behavior from their lenders, as from all their suppliers - with both side endlessly frustrated and, worse for the industry as a whole, sub-optimal structures where neither the procurement nor the financing are optimized (and the two are not designed to fit together like they can in a smart structure). 

   They should stick to non recourse refinancings post-completion, which is easier and which they do well enough.

The good performance of the sector in the 2010s, coupled with the energy crisis of 2022 (which, as an aside, for the power sector in Europe, was more caused by the failure of a large fraction of nuclear reactors of uber-utility EDF than by the Russian gas crisis), generated a bubble in "green" stocks, including Ørsted, Vestas and others.

(source: invezz, Wind energy bubble is bursting as Orsted share price collapses)

The scrutiny by capital market analysts led to a focus on short term results. In an industry with 30- or 40-year assets and significant statistical variability of production for wind, this led to severe disappointments when growth did not follow the optimistic assumptions made by some.

In parallel, the relative improved performance of oil&gas stocks following the lucky increase in oil&gas prices after the Russian invasion of Ukraine led to calls to drop the "green crap" and for traditional energy companies to focus on their core businesses.

As noted above, some of the oil&gas companies dropped out of the sector. They did so very noisily, with front page headlines of them saying that offshore wind waste expensive and did not work, presumably to avoid acknowledging that they had overpaid when they came in and made poor business decisions along the way.

The only ones staying have more rational, but highly cynical policies to bet on merchant projects in markets where they expect prices to be high and volatile, ensuring that they can make money via their sophisticated trading entities, taking advantage of the still-strong link between natural gas and power prices in a spot market environment. This allows to remunerate their expensive capital properly, and also ensures that renewables appear to be more expensive than they can be with regulated long term tariffs and low-cost of capital investors.

This feeds the ongoing political backlash against renewables, usually carried by the populist politicians but almost always supported underhand (or quite openly in the US) by incumbent energy companies.

The result is a sector where costs have increased - by about 50%, which is actually not really more than what has happened to non renewable competitors. Solar has continued to go down, and onshore wind seems to have remained more stable (the increase in performance and lower risk premia compensating for slightly increased costs) and fossil fuels plants are even move expensive given the increase in fossil fuel prices.

Today, the business case for offshore wind has stabilized at a sustainable, and stable new level, with costs probably at 80 EUR/MWh for good projects in mature markets, rather than 50 EUR/MWh in 2020. That price level is a viable proposition in many markets, but you'd never believe it from all the breathless commentary about cost increases... It is true that it it not competitive in all markets, due to completion by solar or onshore wind, grid constraints, or other local realities, and that that price level is hard to achieve in new markets, so people taking a more sober approach to such new markets are reducing their ambitions, but that’s more a reflexion on past over-optimistic plans than on the sector itself. In Europe, offshore wind is firmly in the game.

With the EU firmly promoting double sided CfDs (i.e. real fixed prices, not just floor prices), the opportunity to abuse market mechanisms is going down. The issue of negative prices and the dominance of solar during daytime does need to be addressed - but offshore wind, with its production profile that is quite complementary to that of solar should actually be a beneficiary.

Regulators should ensure that competition remains healthy by not needlessly excluding smaller players via artificial hurdles, such as large balance sheets (often excluding even strong financial players) or ownership of operating assets. They should put very high bid bonds on all tenders, and enforce them if participants don't deliver - this will bite utilities more than smaller players, as utilities always tend to see their own bids as options (the "heads I win, tail I whine" strategy).

Offshore wind will not happen everywhere, as it is not always cost competitive against onshore wind and solar, but it is a competitive source of electricity and does not deserve its current doldrums. Now is the time to invest - but you have to stop listening to the often clueless public statements of utilities on the sector…