Good things are happening in British business
Find out how some of our customers have evolved their businesses in innovative ways.
Read time : 7 mins Added: 02/11/2022
Offshore wind is a key component in the UK’s transition to net zero. As an island nation, the UK has plenty of wind. Politically, offshore wind also encounters less opposition than onshore wind (or solar farms).
The latest update to the British Energy Security Strategy, published in April – after the war in Ukraine heightened the UK’s focus on energy security – hiked the offshore wind target from 40 GW of capacity by 2030 to 50 GW – more than enough to power every home in the UK.
But despite offshore wind’s many attractions, it continues to face a number of barriers. For the UK government’s vision to succeed, these need to be addressed.
The consenting process for offshore wind has long been a bugbear for the industry, with projects taking up to four years to gain approval. The good news is that there is now a commitment to shorten the consenting process to one year.
The industry has also welcomed the switch to annual Contracts for Difference (CfD) auctions – the mechanism that ensures generators receive a fixed, pre-agreed price for the renewable electricity they produce for the duration of the contract. The first annual auction will open in March 2023 and will build on the success that CfD has already had in reducing the cost of offshore wind generation, sending a strong signal to investors.
While consenting has been accelerated, there remains scope to strengthen renewables national policy statements. In particular, the planning framework needs to take the importance of net zero and energy security into account when making decisions about consenting offshore wind farms. It is also vital that the electricity network grid is included in the planning framework as the grid is critical to accommodate the planned increase in offshore wind.
The Energy Security Strategy includes a package to identify and support the deployment of the necessary strategic infrastructure. However, a more strategic approach to network planning is required so that developers can coordinate operations to streamline the build out of transmission infrastructure. This would not only reduce costs but lessen the community and environmental impacts that can generate resistance to new developments. While national policy statements help, the relevant bodies require investment to ensure they have the skills and capacity needed to process the weight of new projects coming through the system.
Improved coordination could also help overcome limitations on the national grid, which the industry believes is one of the biggest challenges to achieving net zero.
Every offshore wind farm requires an onshore connection point; local coastal communities must therefore be consulted. However, this consultation process can be onerous for individual developers. It might be more efficient to manage the process collectively.
The UK’s point-to-point connection approach also creates limitations and needs to change if the targeted 50 GW of UK offshore wind is to become a reality. Some speculative ideas floated in the past, such as continental super grids with interconnections, are now feasible and could overcome current challenges.
The current regulatory regime focuses on delivering the lowest costs for the consumer in the short term. But to get the best available technology and support ongoing innovation, which is a big driver of long-term cost reduction, the UK needs to focus on the long-term operation and maintenance of an offshore grid.
A long-term offshore infrastructure strategic plan would be valuable in this regard and would give the UK offshore supply chain improved foresight of projects so it can invest in capacity. Developing such a plan could fall to the new Future Systems Operator, which is tasked with facilitating net zero by coordinating planning across the energy sector.
Investors are broadly positive towards offshore wind and there is strong demand for green assets, resulting in an attractive cost of capital for such assets. To date, developers have been able to source capital. Importantly, the UK is perceived as offering a supportive and transparent regime.
However, given that more than £100 billion of additional debt liquidity is needed to keep the transition towards net zero on track, overcoming existing barriers to offshore wind will be critical. The good news is that the Energy Security Strategy addresses both consenting and the grid.
While government support is essential, the industry also needs to do more. In particular, greater collaboration would be advantageous. Manufacturers face significant cost pressures and are often involved in a complex network of supplier relationships. Supply chains need to work harder at sharing information and insights in the future.
Offshore wind is a key component of the UK’s energy supply and fundamental to achieving net zero greenhouse gas emissions by 2050. In the coming decade, 30 new offshore wind projects are expected to enter construction, bringing almost 34 GW of extra capacity – enough to power more than 40 million homes.
Capital expenditure of around £42 billion will be required by 2030; if the market commits to a stricter net zero strategy, this could grow by a third to £55 billion. That would mean a potential debt financing requirement of between £38 and £44 billion – a huge ask.
The UK is competing for liquidity with the rest of Europe, the US, the Far East and even Australia. Offshore wind is also vying with other net zero technologies, including nuclear, carbon capture, hydrogen, energy storage and other established sectors such as solar and onshore wind.
Fortunately, offshore wind currently enjoys the deepest pool of liquidity of any UK project finance sector in the UK, with more than 50 banks and institutional investors involved. But the unprecedented financing required in the coming years means that capital must be used more efficiently. The debt market needs to change its approach to the sector and new sources of capital must be found.
Currently, there is over £30 billion of outstanding debt in the sector, which is largely funded by long-term project finance debt from banks. Only a handful of offshore wind farms have any meaningful institutional investment, even though these investors have large amounts of capital to invest, whether via private placements or public bonds.
Greater institutional investment, particularly in the post-construction phase, where projects are materially de-risked and could be structured as investment grade credit propositions, could transform offshore wind financing. It would allow banks to recycle some of the capital already deployed in the sector to support the more challenging construction phase of projects. There could also be an opportunity for lenders with greater risk appetites and return requirements to play a role, perhaps further up the capital structure via mezzanine debt solutions.
While projects are growing in size and risks still remain, the steep reduction in Contracts for Difference (CfD) strike prices in recent years (largely as a result of lower financing and capital costs) highlights the growing maturity of offshore wind.
This maturity needs to be better reflected by market participants, including banks, institutional investors, export credit agencies (ECAs) and rating agencies. Ultimately, a recognition of offshore wind’s maturity should result in tighter financing structures. For example, lenders might become more comfortable with tighter debt sizing criteria for fixed cash flows.
The lending market has grown accustomed to 100% CfD projects. Nevertheless, CfD for offshore wind is now seen by many developers as a price stabilising tool; they are not building offshore wind farms on the basis of a 15-year CfD alone.
Instead, developers are increasingly exploring corporate Power Purchase Agreement (PPA) strategies to provide some cashflow stability. Ultimately, projects are likely to include a level of merchant risk to make them viable – and lenders will need to take some of that risk.
There is already a template for this structure. In 2020, Seagreen Offshore Wind Farm benefited from a CfD for 40% of its capacity while 60% was exposed to power price risk. Lloyds Bank was one of 12 banks involved in the £1.5bn senior debt financing, alongside two ECAs.
In the future, offshore wind project financing is likely to combine subsidies, corporate PPAs and merchant cash flows. How much value lenders can give to the merchant cash flows will be key, both during the subsidy period and afterwards (given that the useful life of a wind farm is now more than 30 years).
For this to happen, there needs to be a strong focus on assessing the power price breaks in different wind scenarios and contextualising those levels against market trends over the last 15 to 20 years. It is also important to ensure there is an appropriate level of downside against forward-looking power price scenarios. Better liquidity support has a role to play in improving financing structures for merchant risk.
At Lloyds Bank, we will continue to play our part in shaping that market, just as we have for the last 15 years.
The prize will be a future with secure, clean and affordable British energy for all.