The outcome of the UK’s latest auction for renewable energy will soon become clear, but whatever transpires, Allocation Round 4 is likely to be a pivotal moment for the UK offshore wind industry
In recent years, offshore wind has enjoyed a stellar period characterised by rapid technology development in a low inflation, low interest rate environment.
But the macro-economic situation has changed dramatically since the last renewable energy auction in the UK, Allocation Round 3 (AR 3), and AR 4 – the results of which are due to be announced shortly – could be an inflection point.
So much has changed since AR 3 and so significant are the effects of inflation and supply chain issues that AR 4 could be the point at which the fast pace of decline in the cost of energy from offshore wind stabilises.
In addition to the effects of inflation, turbine manufacturers are struggling and the supply chain is stressed, leading some to predict that strike prices could increase compared with AR3, rather than fall, although intense competition could still lead to lower prices. But if prices don’t fall further, that might not necessarily be a bad thing, industry observers told OWJ.
PA Consulting energy transition expert Alon Carmel, who leads the firm’s work on offshore wind told OWJ, “This is a pivotal auction for the UK renewables industry, with wider impacts across the global sector.
“It is likely to be the biggest allocation of renewable CfDs ever in the UK and potentially in the world, including – for the first time since 2015 – onshore wind and solar. It will also be the first time CfDs are allocated to floating offshore wind, opening up a whole new technology that will be critical for net zero.
“It is also pivotal for a second reason – it is hopefully an opportunity for prices to stabilise and allow the industry to consolidate. It is a paradox that in this globally booming industry, the leading turbine manufacturers are loss-making.”
As Mr Carmel noted, the CfD scheme has been incredibly successful at driving down prices for consumers – and acting as a hedge against high gas prices – but the relentless downward trajectory may not be sustainable for much longer.
Mr Carmel – who has advised bidders in all the CfD auctions since 2015 – said there is a complex trade-off that developers have to make between growing market share and keeping an IRR buffer to deal with unknown future cost pressures.
“This is natural in an industry that is growing and innovating technologically at the pace renewables has,” he explained. “But at some point, the entire value chain needs to be able to earn a reasonable return on these massive infrastructure projects – or the sector will not be able to accelerate towards our 2030 and net-zero targets.”
Mr Carmel said it is a sign of a maturing industry if prices remain flat or even go up in certain years – to deal with inflation in input costs for turbines and foundations, and rising financing costs. “We saw that happen in RESS 2 in Ireland recently, and historically we’ve seen this happen in Germany and in Brazil who have held onshore wind auctions for many years,” he told OWJ.
“The Government should not see this as a failure in any way, but rather as success – that the industry is more established and ready to scale up towards net zero.”
Opinions differ as to exactly how much inflation might or might not affect prices and the amount of capacity awarded in AR 4. Cornwall Insight analyst Lee Drummee said his company had modelled several possible outcomes and predicts that, with an administrative strike price of 46/MWh, 2.9 GW of offshore wind capacity could be supported.
“The lowest strike price we assessed is £37/MWh (US$45/MWh),” he told OWJ, “which would support much more capacity, in the order or 9.3 GW. In contrast, AR3 saw strike prices of £/MWh and £/MWh. £/MWh would support 5.7 GW and £/MWh would support 4.4 GW of offshore wind capacity.”
Mr Drummee agrees that supply chain issues will almost certainly create some upward pressure on AR4 prices. “It has been widely reported that supply chain costs for renewable technologies have risen since the pandemic, compared with levels observed in 2020, amid elevated commodity, freight and raw material prices,” he told OWJ.
“The magnitude of the impact on CfD AR4 remains uncertain, but we have already seen increased renewable auction prices in the RESS 2 auction in Ireland. Supply chain issues were cited as one reason for this, but there are also many other RESS-specific reasons as to why prices were higher there.”
Mr Drummee said the factors driving an increase in costs and supply chain risks need to be managed by CfD AR4 bidders, where possible. “Large generation projects will typically also have a significant amount of debt finance, and so increased borrowing costs will add further upward pressure for many projects,” he said.
CMY Consultants’ Charles Yates told OWJ he hopes AR4 will award CfDs for more than 4 GW of offshore wind projects, “but the capacity will depend upon how cautious bidders are.”
Mr Yates believes that if bidders react to major increases in steel and copper prices over the last 18 months by including significant contingencies in their bids, and if bids reflect the increasing cost of capital, the amount of offshore wind capacity awarded CfDs could fall to less than 4 GW.
Asked how much capacity might be supported if bids in AR4 are as low as the winning CfDs in AR3, Mr Yates noted bids need to be around 5% less than CfD 3 for all eligible capacity to clear. About 6 GW of projects would be awarded CfDs if bids are at the AR 3 level, he believes.
He noted that the immediate effect of supply chain challenges will be for developers to increase contingencies – so increasing bid prices – which would reduce the amount of offshore wind, and other technologies, awarded CfDs.“In the longer term,” he said, “supply chain problems may push up capex and delay delivery.
“Making local content rules more flexible would help to manage supply chain issues,” he told OWJ, noting that for 2023’s AR5, the capacity of the supply chain will be a major challenge, especially for the delivery of floating wind projects at scale. “If rising inflation and interest rates increase the cost of capital and bid levels,” he told OWJ, “this would lead to less green power being generated and so cut energy security and endanger the ambitious 2030 targets.”
Asked what options there are for developers to work around some of the challenges they face in the current environment, Mr Yates said they might consider hedging the price of commodities – which are a significant part of the cost of a windfarm and are volatile – such as steel. “In the longer term,” he concluded, “the industry will look to reduce the use of costly commodities with innovation in the design of turbines and foundations.This will help to reduce the exposure of the industry to materials for which security of supply is an issue.”
Mr Carmel noted that the capacity affordable at any given strike price can be calculated using a valuation formula contained in the Allocation Framework – which also specifies key input parameters such as capacity factor and reference price per valuation year. For historical reasons, he explained, the budgets are given in /12 prices and need to be uprated with inflation to make them comparable to the strike prices which are in 2012 prices.
Having used a standard model for CfD budget impact calculations, he anticipates the £210M budget for fixed-bottom offshore wind could yield allocations of between 2.9 GW and 12.4 GW if the strike prices clear at between £36/MWh and £46/MWh. A strike price of £37/MWh gives 9.4 GW of capacity; £40/MWh could see capacity of 5.4 GW awarded; and £46/MWh would allow for 2.97 GW.
Mr Carmel believes the £24M minimum budget for floating could yield allocations of between 55 MW and 105 MW, if the clearing price were between £80/MWh and £/MWh, the latter price being the administrative strike price for floating technology. A CfD clearing price for floating of £80/MWh would facilitate 105 MW of floating wind, he calculates. £/MWh could allow for 74 MW, and a clearing price of £/MWh for 55 GW of floating wind capacity.
Whatever the price and however much capacity is awarded in AR 4, higher raw material costs and rising interest rates are not likely to be temporary phenomena, and their effects will be felt well beyond this latest auction.
AR5 is due to be launched in March 2023 and plans for floating windfarms, the opening up of new offshore provinces such as the Celtic Sea and the Johnson administration’s extremely ambitious target of 50 GW of offshore wind by 2030 could all be affected by macro-economic and industry-specific issues.
