With more than 17 GW of new seabed rights to be tendered across the UK starting in 2020, analysts at Wood Mackenzie believe merchant or ‘quasi-merchant’ projects will become commonplace, potentially starting with the UK’s upcoming Round 4 auctions
If developers are prepared to look beyond subsidies and pursue fully or quasi-merchant routes to market the UK could build 43 GW of offshore wind by 2030, Wood Mackenzie believes. That would enable the UK to exceed the new, higher 40 GW target only recently set by the UK Government and enable offshore wind to provide around 50% of UK power demand by that date.
Analysts at Wood Mackenzie said that with The Crown Estate expected to release up to 8.5 GW of seabed rights alone in the upcoming Round 4 auction, projects awarded contracts in Round 4 ‘will almost certainly follow a merchant or quasi merchant route to market.’
This could include projects in which capacity is only partly funded by a contract for difference (CfD) and others that are the subject of a power purchase agreement or in which storage and/or the production of green hydrogen play a growing role mitigating risk and reducing the effect on prices of a fast-growing amount of wind energy in the UK power market.
Unless interrupted by the coronavirus pandemic, the competitive bidding process for the Round 4 leasing tender is likely to conclude by Q3 2021. Because it focuses on project development, rather than zonal development like Round 3, it should facilitate a robust pipeline of delivery.
Wood Mackenzie said it expects competition for Round 4 to be ‘fierce,’ as a result of which option fees will also increase significantly as established developers and oil and gas companies planning to get further involved in the offshore wind market attempt to bolster their pipelines.
Wood Mackenzie research director offshore wind Rolf Kragelund and colleagues said they see significant unsubsidised offshore wind potential emerging in the UK. “Merchant exposure is already inevitable for a number of projects that will come out of a CfD and increasingly likely for new projects and for extensions to existing projects,” Mr Kragelund said.
He highlighted the beneficial economic effects that extensions to existing windfarms and ‘clustering’ of offshore windfarms being pursued by leading developers would bring about, further reducing the cost of offshore wind.
Mr Kragelund highlighted the Hornsea offshore wind cluster of ‘up to 10 GW’ and the significant economies of scale that would result. Extension projects will benefit from the fact that many are in relatively shallow water, and relatively close to shore, said Mr Kragelund; for new projects further from shore, increased water depth could pose challenges ‘but would not be a deal breaker.’ Cluster projects will provide developers with ‘unprecedented’ economies of scale.
“Subsidised projects in the UK will on average have 29.6 years left on their lease terms, allowing for lifetime extension and repowering,” Mr Kragelund said, “which would further extend the merchant tail of offshore wind projects.
“But a number of developers are already looking beyond subsidies for new projects, and more are expected to do so.” Wood Mackenzie believes that, depending on how the global economic situation develops in the coming months, and when final investment decisions are taken, the ‘first movers’ for merchant or quasi-merchant projects could embark on subsidy-free projects much sooner than anticipated.
Mr Kragelund and his colleagues cited the example of SSE’s Seagreen project, only 42% of the output of which is covered by a contract for difference (CfD), the rest of which will be farmed down to investors, including, potentially, well known oil companies interested in offshore wind.
Others that Wood Mackenzie believes could pursue a merchant or quasi-merchant approach include the Red Rock Power-owned Inchcape project that failed to secure a CfD in Round 3, and the Moray West project, which is aiming to start construction in 2022/23. Both have indicated their intention to participate in Round 4.
The latter secured all the necessary paperwork (planning permissions, marine consent, grid connection agreement, Supply Chain Plan and lease from Crown Estate Scotland) to ensure the project was eligible for Round 3 but was unsuccessful in securing a CfD.
Both project sponsors, Engie and EDPR, have stated their support for the project and readiness to continue investing in it to develop engineering and commercial solutions and state that despite the setback the project remains viable.
‘Going merchant’ will not be without its challenges, however, and revenue certainty will be one of the keys in order to sustain gains from farm-downs, Wood Mackenzie said. It highlighted the potential impact of price cannibalisation – which would grow as more offshore wind enters operation – and that an increasing amount of demand would be met by a fast-growing amount of wind energy and nuclear generation.
In such a scenario, the differential for capture prices for offshore wind could widen, but the effect of that could be ameliorated by developers focusing on energy storage linked to offshore wind capacity, by growing use of interconnectors, which would enable surplus power to be exported to other countries, and by growing demand for clean energy. A lack of interconnection capacity could also increase the risk of curtailment, said the energy industry analysts.
In a merchant scenario, the weighted average cost of capital for projects would also increase, which could create a ‘funding gap’ unless developers find ways to mitigate risk. However, the UK’s growing focus on decarbonisation of the power system and growing demand for clean energy will mitigate the effect on prices when there is excess wind in the system. Pairing new offshore wind with storage would limit exposure to low price hours, Mr Kragelund and his colleagues believe.
Developers could also be challenged by lower internal rate of returns (IRRs) in a merchant or quasi-merchant environment, especially as lower capture prices and higher cost of capital squeeze project IRR. Wood Mackenzie expects that in a zero-subsidy environment with more purely merchant projects, with a lot more wind in the system, IRR falls below 4% and thus increases risk, but new and modified revenue streams also have potential upsides, both for project developers and the UK grid.
Most of the company’s analysis of the market was undertaken prior to the declaration of the coronavirus pandemic, but it believes that whatever the short-term effects of Covid-19 on the market, in the medium to long-term the virus will have relatively little effect on the offshore wind industry overall. China is already ramping up production again, said Wood Mackenzie. It is possible that FIDs may be delayed, and that currency risks my play into discussions about finance, but this is likely to be a temporary phenomenon.