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Profitable returns ahead despite higher cost

November 15 2022, Morten Christoffersen

Profitable returns ahead despite higher cost

According to industry experts, offshore wind developers still have a strong business even in a climate of increasing project costs.

"What we are seeing is a temporary situation where costs have increased but prices have been set for many projects based on the earlier, lower costs,” says Jérôme Guillet, a financial advisor focused on renewable energy projects.

“The market will adjust in the medium term as new bids reflect the actual market conditions for equipment and interest rates."

Unfortunately, throughout 2022, inflation and interest rates increases have been steep, leaving the wind industry supply chain and several developers in challenging situations.

On 24 October, it became public that developer Avangrid had filed a petition with the Massachusetts Department of Public Utilities (DPU) to pause its review of the power purchase agreement (PPA) for the company's flagship ‘Commonwealth Wind’ project, due to increased costs.

"Under the current Power Purchase Agreements (PPAs), the project is no longer viable and would not be able to move forward," Avangrid said.

Developer dilemma

This year, global interest rates have increased significantly, making project financing more expensive. According to Morten Christoffersen, Founding Partner at Naver Energy, project developers are caught in a dilemma:

"Developers will try to safeguard their bidding decision. If they are too conservative on risks, costs and revenues, they might lose to other developers, who are less conservative and if they are more opportunistic, they may win at a loss giving bid. Costs have increased significantly throughout 2022 and the big question on everyone’s minds is when it will stop.

A macroeconomic turn seems to be the obvious answer, but when that happens is a difficult prediction to make, in particular when you as a developer need to submit a binding commitment now. An opportunistic approach seems likely to result in a loss-giving bid as the tough market conditions we see now are not leaving the horizon any time soon. So, realistic business case simulations and industry insights are crucial to place a strong, realistic and profitable bid,” Christoffersen explains.

Jérôme Guillet is a former Managing Director of Green Giraffe and has been involved in the financing of a large number of offshore wind projects.
"Renewable projects are cost intensive, so the increased cost of capital and higher construction costs significantly impact the business case. Levelized Cost of Energy (LCOE) is set to go up after decades of trending down. However, offshore wind will still be competitive at the end of the day because other energy sources, such as gas or nuclear, are now even more expensive," explains Guillet.

With the fluctuating costs of the recent past, what should they base cost predictions on? The revenue side may be a more positive story with increasing electricity prices and hunger for green electricity-based PPAs, but when will it level out and come closer to the trends predicted in the past? Higher-priced PPAs can compensate for the rising costs, and they can probably also be negotiated since off-takers have stakeholders that demand green energy, although a price increase is not appreciated, then alternatives are not attractive either, as cited by Jérôme Guillet above. Developers could offer off-takers some insight into their business case and at the extreme even an open-book approach, although difficult in practice. This approach would allow to lock-in the PPA price at the time of Final Investment Decision (FID), such that the risk is shared between the off-taker and the developer, rather than locking the PPA price at the time of bid submission where project-related costs are uncertain at best.


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Power prices must go up

Bank contingency standards on offshore projects are typically 10% on the CAPEX budget and 20% on the OPEX budget. According to finance experts, Naver Energy has interviewed even as the industry matures, this will not change.


"Power prices and auction bids must go up to make the business cases viable again. Banks are not making extra money in this market. They are only making money on the margins. Earnings have not improved and project risks across the sector have not significantly improved," an investment banker told Naver Energy.

Even with contingency costs at several hundred thousand euros per Megawatt, developers should remember it is simply a reserve for unexpected expenses over the two-year construction period. If this reserve is not used, IRR will naturally improve.


Project finance is key

Industry experts are somewhat concerned about oil & gas majors entering offshore wind, who may not fully understand risks and opportunities because they are doing offshore wind project development for the first time.

Debt is still structurally cheaper than equity, so most offshore wind farms will still be project financed, helping improve the business cases for shareholders, sponsors, lenders and boards of directors.

"Many people are looking at this industry for the first time and learning what the earlier generations of participants already know. If you have a strong project finance setup that brings discipline to your risk management and a strong framework to deal with the unexpected. Ultimately that will help make your project profitable in the long term." concludes Guillet.

Room for improvement

According to Morten Christoffersen, developers should not just lean back and await the new price levels to settle in. There are plenty of opportunities for improving offshore project business cases.
Market conditions are currently very difficult for all parties involved in the offshore wind industry. While a “wait and see” approach for some years in specific markets may seem like a viable option, it does beg the question of whether that will be at the expense of losing momentum and learnings compared to your competitors?

“Developers should increase their attention towards working closely with contractors and suppliers to optimise designs, interfaces and mitigation contingencies. If developers do not manage interfaces across markets and portfolios, it will eventually push suppliers into silo development. One proven approach has contractors in the same room in joint workshops to discover synergies and potential for optimization. If you really understand their drivers and concerns, you become part of the solution to bring it all together.”