Why the German tender for offshore wind is bad news

Germany just announced some spectacular tender results in their 7 GW offshore wind tenders, with more than EUR 12 billion in lease payments committed by the winners:

BP OFW Management 1 GmbH was awarded the contract for the N-11.1 zone with a bid value of 1.83 million EUR/MW (EUR 3.66 billion total), and bp OFW Management 3 GmbH for the N-12.2 zone with a bid of 1.56 million EUR/MW (EUR 3.12 billion total). 

North Sea OFW N12-1 GmbH & Co. KG was awarded the rights for the N-12.1 area with a bid value of 1.875 million EUR/MW (EUR 3.75 billion total). 

The winner of the O-2.2 area in the Baltic Sea is Baltic Sea OFW O2-2 GmbH & Co. KG with a bid of 2.07 million EUR/MW (EUR 2.07 billion total). 

Baltic Sea OFW O2-2 GmbH & Co. KG and North Sea OFW N12-1 GmbH & Co. KG are reportedly special-purpose companies owned by TotalEnergies. 

That means bid values are close to 2 MEUR/MW. Under current best practices, it also costs roughly 2 MEUR/MW to build these wind farms (excluding the offshore cable, which is built by the grid operator). So the licence payments will almost double the total investment to build these projects (from 2-2.5 billion euros per GW to roughly 4 billion euros per GW), which will de facto translate into a close to doubling of the LCOE of the electricity produced (only O&M costs are not doubled, but these typically represent 20% of the overall generation cost excluding licences).

Another way to look at it is that these projects (7GW) will generate roughly 30 TWh/y, or close to 600 TWh over the first 20 years of their useful life. That 12 billion euros translates into 20 EUR/MWh additional cost over that 20 year period.

That power will be sold on the wholesale market and will require prices in the 70-80 EUR/MWh range, on average, for the wind farm to ever be profitable. Either the oil companies are betting on very high power prices for a long time in Germany, or they will find some other way to get their money back. 

One item partly protects consumers:

90 per cent of the proceeds will go towards reducing electricity costs, and five per cent each into marine conservation and the promotion of environmentally friendly fishing, the Federal Network Agency said. The proportions of the bid values awarded for sustainable marine protection must be paid into the federal budget within one year. The electricity cost reduction component is to be paid over a period of 20 years in equal annual installments to the transmission system operator who is obliged to connect, starting with the completion date of the wind farm from 2030. 

Ratepayers will benefit from an annual reduction in the price they pay, via the licence payment, if the wind farms are built - as we are talking EUR 500 M per year over ca. 500 TWh of German consumption, that's a 1 EUR/MWh reduction. But that needs to be compared to the oil companies betting that wholesale prices will jump (ignoring the movements caused by the war in Ukraine, which are most likely temporary) from 40 EUR/MWh to 80 EUR/MWh...

So either (i) the oil companies are right in their bet (that despite the massive increase in zero-marginal cost renewable power generation that increasingly drive spot prices to low or negative levels, average spot power prices go up substantially), which probably means that there is something wrong with market design (how do you get price hikes when most of your production is (i) low average LCOE and (ii) zero marginal cost) or (ii) they are wrong with their bet and ... (if you thought: "their shareholders will bear the losses", you are quite naive) they will do one of two things: a) lobby, openly or discreetly, for tax breaks (see a recent precedent:  https://www.usnews.com/news/us/articles/2023-07-06/new-jersey-governor-to-sign-tax-break-for-orsteds-offshore-wind-farm), holding their investment in clean energy capacity hostage, to get financial support or b) making a lot of noise (big headlines in the FT!) that offshore wind is unprofitable and unreliable, that they are focusing on their "core business" in oil&gas.

Either way, offshore wind will get the (undeserved) reputation that it is expensive and requires subsidies.

The other bit of bad news is that the German government (and neighbors like the Dutch, Belgians and Danes) will feel comforted that negative bid auctions work, and will continue to use that mechanisms for future offshore wind auctions. All serious industry players hate them (because no-one knows how to make a fully merchant project be economic, other than by preemptively bankrupting the European supply chain, and then asking for subsidies anyway), but there will always be a participant (usually an oil company) desperate enough to bid in, and others feel obliged to participate as it's one of their "core markets". If only market players had the discipline to refuse to bid when requirements are unreasonable (and in that respect, market leader Ørsted should be commended for refusing most times to bid unreasonably high numbers into auctions), governments would get the message, but there's always someone that finds  a reason to do it - and will not be held accountable for it.

Fundamentally, negative bids, or any auction that relies on merchant prices, are a bet on electricity spot market prices far into the future - nobody knows what these will be, but nobody in a big corporation will ever be held accountable, at the time it actually hurts, for the crazy bets they are taking now. This is a one-way bet for executives - win the auction and be a king, or lose and be a nobody - if you win you may bankrupt the company, but as it is a utility or a vital national corporation, it will always get public support in some way or shape and survive...

For oil companies, the bets on offshore wind, however large, are still massively dwarfed by their investments in the traditional oil&gas sector, so they don't really care about the eventual monetary losses (net of the public subsidies they manage to scrounge) and they are worth it just for the PR value, and maybe the option value.

For utilities or renewables pure players, it's a tougher situation - be disciplined and lose out on generation capacity (and shrink), or bet against the oil companies, with the risk of losses that are much more visible (and while they will also be backed by public money, it's a bit more embarrassing) - but for current executives, it's still far enough in the future that it's not their problem.

For governments, it looks like you are getting (i) money upfront, and (ii) investment in more renewables at no cost to the public, but this is an illusion. the electricity generated, even though it is largely fixed cost, will be sold at the wholesale price determined by marginal producers (fossil fuel generators, usually gas-fired) and, more importantly, will cost more to produce as (i) they need to pay additional amounts for the licenses, and (ii) it is more expensive to finance projects that rely on merchant revenues - either the utilities will find a buyer of their power at a fixed price, which will be at a significant discount to spot prices, or they will have to remunerate expensive capital to take the merchant risk. In both cases, the benefits of the largely fixed cost of production will not go to the general public, contrary to what would happen if you had a CfD or similar mechanism that allows to attract cheap capital to the sector (and the return of the licence payments to consumers, while a smart idea, is only a very partial compensation).

The apparent success of this auction will unfortunately encourage more governments to do the same.