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The Economics and Finance of Offshore Wind




Eamon Keane

Student Number: 05541662
Abstract
Europe has a huge offshore wind resource. The potential was estimated by the European
Environment Agency as a technical resource of 25,000TWh, which is a multiple of demand (1). The
economic potential was estimated at about 60% of European electricity demand. Achieving this
potential would require 700GW of installed offshore capacity, from a current balance of 2GW (2). At
€1,500/kW, costs would be in the order of €1 trillion. The engineering constraints are surmountable.
The binding constraint may be capital. There is frequently a disconnect between policy makers,
engineers, and financial markets. This article will explore the economics and financing of offshore
wind.
Table of Contents
Table of Figures ....................................................................................................................................... 4
Introduction ............................................................................................................................................ 5
Offshore Wind Economics and Financing ............................................................................................... 6
Conclusion ............................................................................................................................................. 13
References ............................................................................................................................................ 14
Table of Figures
Figure 1: Offshore wind upfront costs .................................................................................................... 6
Figure 2: Turbine Transaction Price ........................................................................................................ 6
Figure 3: Levelised Cost of Electricity ..................................................................................................... 7
Figure 4: Projected global investment in green technologies ................................................................ 9
Figure 5: Internal Rate of Return categorised by technology ............................................................... 10
Figure 6: Cost of debt for a euro area onshore wind project ............................................................... 11
Figure 7: Current and planned offshore wind projects by expected commissioning date ................... 12




                                                                                                                                                  4
Introduction
Harvesting Europe’s offshore wind will be challenging. Two of the foremost challenges are the
economics and financing of offshore wind. These elements are frequently left out of policy makers’
statements on energy policy. Yet they are critical. There is vast embedded capital in Europe’s energy
infrastructure. Attempting to replace that with a more sustainable infrastructure will require a
formidable effort. Harvesting Europe’s offshore wind resources is an appealing prospect but it will
not be harvested unless finance is forthcoming.




                                                                                                        5
Offshore Wind Economics and Financing
Figure 1 shows the component parts of offshore wind’s installed costs (2).


                           Offshore Wind Upfront Costs
                       Grid Connection
                             10%


                     Installation
                         15%
                                                                           Turbine
                                                                            50%


                    Substructure
                        25%




Figure 1: Offshore wind upfront costs

This contrasts with onshore wind, where the turbine comprises 75% of installed costs. The costs of
onshore wind turbines are subject to commodity prices and inflation. Figure 2 shows the installed
costs of EU wind turbines (3).




Figure 2: Turbine Transaction Price

There is clear evidence in Figure 2 of inflation in wind turbine prices. The market for wind turbines is
global, and many countries, such as China and the US, are intent on developing their wind resources.
The rise in costs from 2000 to 2008 was due to commodity inflation and an excess of demand over


                                                                                                           6
supply capacity. The offshore wind industry must compete for the same turbines as the onshore
wind industry. Any attempts to build offshore capacity too quickly will lead to inflation in not just
wind turbine prices, but also substructure costs and installation costs. There are currently only ten
jacking rigs capable of installing offshore wind turbines (2).

Figure 3 shows the levelised cost of energy (LCOE) from different power sources, as estimated by the
US Energy Information Administration (EIA). The information was adapted from the EIA’s Annual
Energy Outlook 2010 (4).


              Levelised Cost of Electricity (Natural Gas =100)
   250



   200


   150                                                                      Transmission Investment
                                                                            Variable O&M
   100                                                                      Fixed O&M
                                                                            Levelized Capital Cost

     50


      0
             Natural Gas CCGT             Onshore Wind   Offshore Wind


Figure 3: Levelised Cost of Electricity

The quantitative values of LCOE are subjective and depend on certain assumptions; however they
are useful in terms of qualitative assessments on relative costs.

 What can be clearly seen is that offshore wind is more expensive than onshore wind. It would thus
seem sensible to exhaust the onshore resource before tapping into offshore wind. Electricity
generation is about delivering the least cost solution.

In terms of climate change, the least cost solution should include the externality of carbon
emissions. The most economically efficient way to stimulate investment in renewables is to put a
price on carbon. The current European Emissions Trading Scheme (ETS) puts a limit on the quantity
of carbon that can be emitted and lets the market decide the price. This is the wrong approach. The
price of carbon has varied dramatically in the ETS, going from highs of €30/tonne to lows of
€0/tonne.

 The payback period for wind farms is measured in several years. If the developer cannot be certain
of the price of carbon, he cannot be certain of cashflow. Neither can the bank lending the money.
Thus, although carbon trading is meant to support less carbon intensive alternatives, the vicissitudes
in the carbon price do not make for an attractive investment proposition.



                                                                                                         7
The alternative is to set a carbon tax. A global carbon tax is the ideal solution. A carbon tax, set for
20 years, would provide certainty to offshore wind developers and banks alike.

Looking at Figure 3, offshore wind is significantly more expensive than either onshore wind or
natural gas CCGTs. For every €10/tonne of a carbon tax, the LCOE of natural gas increases by
€4/MWh. The current System Marginal Price (SMP) on the Irish system, for example, is around
€40/MWh for most of the day. From Figure 3, variable costs are 75% of total costs for CCGTs, so this
translates to an LCOE of €53/MWh. Baseload natural gas CCGTs, as they often set the SMP, must
currently cost in that region.

The Renewable Energy Feed-in Tariff (REFIT) for onshore wind is currently at €64/MWh (5). Ireland
has set the REFIT for offshore wind at €140/MWh. A REFIT of €64/MWh implies a carbon price of
€27.50/tonne ((64-53)/4). A REFIT of €140/MWh suggests a shadow carbon price of €217.50/tonne
((140-53)/4). The current EU ETS price is around €13/tonne (6).

No one is forecasting carbon prices above about €40/tonne. It is thus questionable that the Irish
government, and other European governments, are supporting offshore wind at such high implied
carbon prices. Offshore wind must come down considerably in price, or the price of natural gas fuel
must appreciate, in order for its LCOE to be equal to that of natural gas CCGTs. A coherent climate
change policy should set a consistent price of carbon.

 What is also noticeable from Figure 3 is that offshore wind is very sensitive to capital costs. Capital
costs, as Figure 2 shows, can be volatile. This brings into question the finance required. If capital is
considered a constraint, then clearly natural gas CCGTs perform best. A large component of the
LCOE for natural gas (about 75%) is made up of fuel costs. As the credit crunch, which still grips
energy markets, showed, abundant capital at low interest rates is probably not coming back soon.

The European Wind Energy Association (EWEA) released a January 2010 an update on offshore wind
financing (2). They state:

“Financing offshore wind farms on a nonrecourse basis has proved challenging due to the financial
crisis.”

Nonrecourse loans are those where the bank only has claim to the wind turbines. At present banks
are only offering the loans if they get more secure collateral. This means that the burden for finance
falls on governments. As a result, EWEA report:

“independent developers have been, and continue to be, severely affected by the financial crisis and
the consequent lack of availability of project finance.”

The EU offshore wind industry would likely be moribund were it not for the green stimuli
implemented by EU governments. EWEA state:

“This stimulus injection was vital, and it remains crucial that this financing is released as soon as
feasible and that the Commission’s review in 2010 of the European Economic Recovery Plan, or any
further stimulus package, continues to target the offshore wind industry as a strategic European
sector.”




                                                                                                           8
The recent World Economic Forum (WEF) at Davos discussed the issue of financing for green
investment. It was made clear that investors are only interested in one thing – return on investment.
If offshore wind cannot offer a risk adjusted return for investors, it will not be financed privately.
Figure 4 shows the projected investment in green technologies out to 2030 (7).




Figure 4: Projected global investment in green technologies

Figure 1 shows projected global investment in wind remaining relatively steady at about €50 billion
per year. This would support a global market of about 50GW onshore wind (at €1,000/kW) or 30GW
offshore (at €1,500/kW). There is still plenty of scope for onshore European wind; the move towards
offshore wind appears premature.

The WEF also showed that the venture capital returns from either onshore or offshore wind were
negative at the moment. This is shown in Figure 5 (7).




                                                                                                         9
Figure 5: Internal Rate of Return categorised by technology

Figure 5 shows that venture capitalists have on average lost 14% on their investments in wind.
Future investment depends on these yields improving.

The interest rate that wind farm developers pay is very important. A percentage point move can
dramatically change the economics of a wind project. Figure 6 shows that onshore wind finance
spreads over the central bank rate remain much higher than before the credit crunch.




                                                                                                 10
Figure 6: Cost of debt for a euro area onshore wind project

As can be seen, despite the ECB lowering its interest rate from 4% to 1%, the wind farm developer
spread has risen by over 200 basis points. If a Euro area recovery were to force the ECB to raise
interest rates to combat inflation, ceteris paribus, wind farm developer rates would rise to 8-10%.

The Davos report says of offshore wind:

“Offshore turbines have lower profit margins than onshore turbines, so manufacturers are mainly
focused on producing onshore devices, creating a potential bottleneck for offshore ones. Developers
may continue to favour onshore wind as access to capital is still limited, and the risk-return ratio on
offshore wind returns remains relatively unattractive.”

This may bring into question the steady decline in offshore costs as predicted by EWEA in Figure 2.
Figure 7 shows the projected offshore wind capacity in Europe by 2020:




                                                                                                          11
Figure 7: Current and planned offshore wind projects by expected commissioning date

This shows European offshore capacity rising from the current 2GW to 27GW by 2020. Germany and
the United Kingdom take up the bulk of the capacity. This would generate approximately 100TWh, or
2.5% of Europe’s electricity. This level of generation, even if it was interconnected, would hardly
merit the term supergrid.




                                                                                                      12
Conclusion
The economic and financial challenges facing offshore wind are sobering. Government backstopping
of investment appears necessary. However EU government balance sheets are strained, and thus the
sustainability of this support is not clear. Governments should set a price on carbon, a carbon tax,
which adequately addresses the climate change externality. If the EU is prepared to accept higher
electricity prices in return for increased sustainability, then onshore wind should be exhausted first,
with offshore following.




                                                                                                          13
References
1. European Environment Agency. Europe's offshore and onshore wind energy potential. 2009.

2. European Wind Energy Association. The European offshore wind industry - key trends and
statistics 2009. 2010.

4. Energy Information Administration. Annual Energy Outlook 2010. 2010.

5. Department of Communications, Energy and Natural Resources. REFIT Clarifications. 2009.

6. Point Carbon. [Online] [Cited: 05 March 2010.] http://www.pointcarbon.com/news/euets.

7. World Economic Forum. Green Investing 2010. 2010.




                                                                                             14

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The Economics and Finance of Offshore Wind

  • 1. The Economics and Finance of Offshore Wind Eamon Keane Student Number: 05541662
  • 2. Abstract Europe has a huge offshore wind resource. The potential was estimated by the European Environment Agency as a technical resource of 25,000TWh, which is a multiple of demand (1). The economic potential was estimated at about 60% of European electricity demand. Achieving this potential would require 700GW of installed offshore capacity, from a current balance of 2GW (2). At €1,500/kW, costs would be in the order of €1 trillion. The engineering constraints are surmountable. The binding constraint may be capital. There is frequently a disconnect between policy makers, engineers, and financial markets. This article will explore the economics and financing of offshore wind.
  • 3. Table of Contents Table of Figures ....................................................................................................................................... 4 Introduction ............................................................................................................................................ 5 Offshore Wind Economics and Financing ............................................................................................... 6 Conclusion ............................................................................................................................................. 13 References ............................................................................................................................................ 14
  • 4. Table of Figures Figure 1: Offshore wind upfront costs .................................................................................................... 6 Figure 2: Turbine Transaction Price ........................................................................................................ 6 Figure 3: Levelised Cost of Electricity ..................................................................................................... 7 Figure 4: Projected global investment in green technologies ................................................................ 9 Figure 5: Internal Rate of Return categorised by technology ............................................................... 10 Figure 6: Cost of debt for a euro area onshore wind project ............................................................... 11 Figure 7: Current and planned offshore wind projects by expected commissioning date ................... 12 4
  • 5. Introduction Harvesting Europe’s offshore wind will be challenging. Two of the foremost challenges are the economics and financing of offshore wind. These elements are frequently left out of policy makers’ statements on energy policy. Yet they are critical. There is vast embedded capital in Europe’s energy infrastructure. Attempting to replace that with a more sustainable infrastructure will require a formidable effort. Harvesting Europe’s offshore wind resources is an appealing prospect but it will not be harvested unless finance is forthcoming. 5
  • 6. Offshore Wind Economics and Financing Figure 1 shows the component parts of offshore wind’s installed costs (2). Offshore Wind Upfront Costs Grid Connection 10% Installation 15% Turbine 50% Substructure 25% Figure 1: Offshore wind upfront costs This contrasts with onshore wind, where the turbine comprises 75% of installed costs. The costs of onshore wind turbines are subject to commodity prices and inflation. Figure 2 shows the installed costs of EU wind turbines (3). Figure 2: Turbine Transaction Price There is clear evidence in Figure 2 of inflation in wind turbine prices. The market for wind turbines is global, and many countries, such as China and the US, are intent on developing their wind resources. The rise in costs from 2000 to 2008 was due to commodity inflation and an excess of demand over 6
  • 7. supply capacity. The offshore wind industry must compete for the same turbines as the onshore wind industry. Any attempts to build offshore capacity too quickly will lead to inflation in not just wind turbine prices, but also substructure costs and installation costs. There are currently only ten jacking rigs capable of installing offshore wind turbines (2). Figure 3 shows the levelised cost of energy (LCOE) from different power sources, as estimated by the US Energy Information Administration (EIA). The information was adapted from the EIA’s Annual Energy Outlook 2010 (4). Levelised Cost of Electricity (Natural Gas =100) 250 200 150 Transmission Investment Variable O&M 100 Fixed O&M Levelized Capital Cost 50 0 Natural Gas CCGT Onshore Wind Offshore Wind Figure 3: Levelised Cost of Electricity The quantitative values of LCOE are subjective and depend on certain assumptions; however they are useful in terms of qualitative assessments on relative costs. What can be clearly seen is that offshore wind is more expensive than onshore wind. It would thus seem sensible to exhaust the onshore resource before tapping into offshore wind. Electricity generation is about delivering the least cost solution. In terms of climate change, the least cost solution should include the externality of carbon emissions. The most economically efficient way to stimulate investment in renewables is to put a price on carbon. The current European Emissions Trading Scheme (ETS) puts a limit on the quantity of carbon that can be emitted and lets the market decide the price. This is the wrong approach. The price of carbon has varied dramatically in the ETS, going from highs of €30/tonne to lows of €0/tonne. The payback period for wind farms is measured in several years. If the developer cannot be certain of the price of carbon, he cannot be certain of cashflow. Neither can the bank lending the money. Thus, although carbon trading is meant to support less carbon intensive alternatives, the vicissitudes in the carbon price do not make for an attractive investment proposition. 7
  • 8. The alternative is to set a carbon tax. A global carbon tax is the ideal solution. A carbon tax, set for 20 years, would provide certainty to offshore wind developers and banks alike. Looking at Figure 3, offshore wind is significantly more expensive than either onshore wind or natural gas CCGTs. For every €10/tonne of a carbon tax, the LCOE of natural gas increases by €4/MWh. The current System Marginal Price (SMP) on the Irish system, for example, is around €40/MWh for most of the day. From Figure 3, variable costs are 75% of total costs for CCGTs, so this translates to an LCOE of €53/MWh. Baseload natural gas CCGTs, as they often set the SMP, must currently cost in that region. The Renewable Energy Feed-in Tariff (REFIT) for onshore wind is currently at €64/MWh (5). Ireland has set the REFIT for offshore wind at €140/MWh. A REFIT of €64/MWh implies a carbon price of €27.50/tonne ((64-53)/4). A REFIT of €140/MWh suggests a shadow carbon price of €217.50/tonne ((140-53)/4). The current EU ETS price is around €13/tonne (6). No one is forecasting carbon prices above about €40/tonne. It is thus questionable that the Irish government, and other European governments, are supporting offshore wind at such high implied carbon prices. Offshore wind must come down considerably in price, or the price of natural gas fuel must appreciate, in order for its LCOE to be equal to that of natural gas CCGTs. A coherent climate change policy should set a consistent price of carbon. What is also noticeable from Figure 3 is that offshore wind is very sensitive to capital costs. Capital costs, as Figure 2 shows, can be volatile. This brings into question the finance required. If capital is considered a constraint, then clearly natural gas CCGTs perform best. A large component of the LCOE for natural gas (about 75%) is made up of fuel costs. As the credit crunch, which still grips energy markets, showed, abundant capital at low interest rates is probably not coming back soon. The European Wind Energy Association (EWEA) released a January 2010 an update on offshore wind financing (2). They state: “Financing offshore wind farms on a nonrecourse basis has proved challenging due to the financial crisis.” Nonrecourse loans are those where the bank only has claim to the wind turbines. At present banks are only offering the loans if they get more secure collateral. This means that the burden for finance falls on governments. As a result, EWEA report: “independent developers have been, and continue to be, severely affected by the financial crisis and the consequent lack of availability of project finance.” The EU offshore wind industry would likely be moribund were it not for the green stimuli implemented by EU governments. EWEA state: “This stimulus injection was vital, and it remains crucial that this financing is released as soon as feasible and that the Commission’s review in 2010 of the European Economic Recovery Plan, or any further stimulus package, continues to target the offshore wind industry as a strategic European sector.” 8
  • 9. The recent World Economic Forum (WEF) at Davos discussed the issue of financing for green investment. It was made clear that investors are only interested in one thing – return on investment. If offshore wind cannot offer a risk adjusted return for investors, it will not be financed privately. Figure 4 shows the projected investment in green technologies out to 2030 (7). Figure 4: Projected global investment in green technologies Figure 1 shows projected global investment in wind remaining relatively steady at about €50 billion per year. This would support a global market of about 50GW onshore wind (at €1,000/kW) or 30GW offshore (at €1,500/kW). There is still plenty of scope for onshore European wind; the move towards offshore wind appears premature. The WEF also showed that the venture capital returns from either onshore or offshore wind were negative at the moment. This is shown in Figure 5 (7). 9
  • 10. Figure 5: Internal Rate of Return categorised by technology Figure 5 shows that venture capitalists have on average lost 14% on their investments in wind. Future investment depends on these yields improving. The interest rate that wind farm developers pay is very important. A percentage point move can dramatically change the economics of a wind project. Figure 6 shows that onshore wind finance spreads over the central bank rate remain much higher than before the credit crunch. 10
  • 11. Figure 6: Cost of debt for a euro area onshore wind project As can be seen, despite the ECB lowering its interest rate from 4% to 1%, the wind farm developer spread has risen by over 200 basis points. If a Euro area recovery were to force the ECB to raise interest rates to combat inflation, ceteris paribus, wind farm developer rates would rise to 8-10%. The Davos report says of offshore wind: “Offshore turbines have lower profit margins than onshore turbines, so manufacturers are mainly focused on producing onshore devices, creating a potential bottleneck for offshore ones. Developers may continue to favour onshore wind as access to capital is still limited, and the risk-return ratio on offshore wind returns remains relatively unattractive.” This may bring into question the steady decline in offshore costs as predicted by EWEA in Figure 2. Figure 7 shows the projected offshore wind capacity in Europe by 2020: 11
  • 12. Figure 7: Current and planned offshore wind projects by expected commissioning date This shows European offshore capacity rising from the current 2GW to 27GW by 2020. Germany and the United Kingdom take up the bulk of the capacity. This would generate approximately 100TWh, or 2.5% of Europe’s electricity. This level of generation, even if it was interconnected, would hardly merit the term supergrid. 12
  • 13. Conclusion The economic and financial challenges facing offshore wind are sobering. Government backstopping of investment appears necessary. However EU government balance sheets are strained, and thus the sustainability of this support is not clear. Governments should set a price on carbon, a carbon tax, which adequately addresses the climate change externality. If the EU is prepared to accept higher electricity prices in return for increased sustainability, then onshore wind should be exhausted first, with offshore following. 13
  • 14. References 1. European Environment Agency. Europe's offshore and onshore wind energy potential. 2009. 2. European Wind Energy Association. The European offshore wind industry - key trends and statistics 2009. 2010. 4. Energy Information Administration. Annual Energy Outlook 2010. 2010. 5. Department of Communications, Energy and Natural Resources. REFIT Clarifications. 2009. 6. Point Carbon. [Online] [Cited: 05 March 2010.] http://www.pointcarbon.com/news/euets. 7. World Economic Forum. Green Investing 2010. 2010. 14