In offshore wind, money isn’t everything

SUPPLY CHAINS: Why non-price factors in CfD allocation are only part of the solution to promoting a robust North Sea wind industry

By Seb Kennedy, associate editor at E-FWD and founding editor of Energy Flux News

Overview:

The story of falling CfD strike prices has been slammed into reverse
Loss-making supply chains cannot absorb more competitive price pressure
Allocating CfDs on non-price factors is a step in the right direction, but no silver bullet
Tougher penalties for non-delivery would encourage more responsible bidding behaviour
The UK lacks a wholistic green industrial strategy to rival US and EU investment incentives

The UK offshore wind industry is in search of a new narrative. The story of dazzlingly rapid cost reductions achieved at cut-throat auctions has collided spectacularly with an ugly new reality in today’s post-Ukraine, post-pandemic world. Shredded supply chains, soaring inflation and successive interest rate hikes have decimated the economics of projects that secured Contracts for Difference (CfDs) at ambitiously low strike prices in the industry’s halcyon pre-war days.

Reverse price auctions for CfDs proved highly effective at lowering deployment costs and leveraging private capital into the sector’s early growth years: clearing prices dropped 70% between the first and fourth allocation rounds while contracting more than 20 GW of capacity. But as the fifth allocation round (AR5) results make clear, this approach was always going to run its course. The economic unsustainability of pitting developers against each other on pure price metrics is now on full display.

Assessing whether the price-only CfD has been a success or a failure depends on how one understands the original policy intent. “If the objective was to procure power at the cheapest possible price, it was a resounding success. If it was to foster a thriving domestic industry, it clearly hasn't done that,” a senior wind industry executive tells E-FWD.

Headline-grabbing declines in CfD clearing prices came at the expense of supply chain companies, which faced immense pressure to reduce costs to secure a route to market. Deep and sustained losses at GE, Vestas and Siemens Energy, attributable in large part to loss-making turbine supply contracts, illustrate how margins flipped negative for major turbine OEMs. Acute financial stresses are now rippling up the turbine value chain.

Long-rumbling discontent

The supply chain effects of a price-only approach to CfD allocation evolved over time. Competitive pressures initially drove out inefficiencies and encouraged innovation in materials, processes and commercial strategies. But when ‘healthy’ cost savings were exhausted, continued cost-cutting pressure reached a point of attrition beyond which the economic wellbeing of the industry started to be compromised.

Questions were raised as long ago as the third CfD allocation round (AR3) in 2019, when strike prices cleared below £40 per MWh for the first time. The potential for non-delivery risk was apparent at the time but AR3 was nonetheless celebrated for delivering more double-digit percentage savings on administratively set strike prices. Among the winning projects was Vattenfall’s 1.4GW Norfolk Boreas (Phase 1) project, which the utility developer paused earlier this year citing untenable inflationary cost pressures.

Vattenfall’s decision to slam the brakes injected fresh urgency to a long-running debate over the unsustainability of ever-lower clearing prices. Strike price indexation has proven ineffective at adjusting for a rapid deterioration of market conditions, as the CfD’s rigid regime offers no avenue for renegotiation. This raised legitimate concerns that the CfD is neglecting, rather than nurturing, the companies and port infrastructure upon which the sector’s long-term success resides.

Endless intervention

Vattenfall’s announcement dropped shortly after the government issued yet another call for evidence on reforms to the CfD allocation regime. The latest request for input is a tacit acknowledgement that the scheme’s weak supply chain commitments have, unsurprisingly, failed to deliver a thriving and competitive domestic offshore wind turbine manufacturing and service industry.

The CfD scheme’s Supply Chain Plan (SCP) requirement was drawn up in the mid-2010s in response to concerns of the CfD triggering a ‘race to the bottom’ that promotes lower-cost overseas suppliers ahead of more costly (but value-additive) domestic rivals. The SCP was explicitly intended to foster “open and competitive supply chains and the promotion of innovation and skills”. By the time of AR3 it still only went as far as requiring developers to report and monitor progress against desired outcomes, with soft penalties for failure.

Following consultation last year, the non-delivery disincentive in the SCP rules was boosted ahead of the fifth allocation round (AR5), with the eligible generator potentially excluded from applying for a CfD in the next two allocation rounds at certain sites. Further workstreams were initiated to hike the 50% ‘pass mark’ score required against the project’s agreed SCP, and to invite generators to interview to explain their plans in more detail.

Bigger reforms loom

Following successive tweaks in recent years, the CfD could now be facing more weighty reforms. The government is looking seriously at introducing non-price factors to future allocation rounds that would replace the SCP entirely. These reforms could see strike prices adjusted, or bids re-ranked, to reflect each project’s investment in skills, innovation or capacity building, as well as other initiatives such as promoting environmental sustainability and system flexibility.

There are numerous mechanisms on the table. The call for evidence itself proposed the following:

‘Top-up’ to the CfD strike price: Extra payment on top of the bid price, possibly front-loaded to encourage early investment in the desired outcome.
Bid re-ranking. Non-price factor scores would have a direct impact upon the bid stack ranking methodology, allowing a project scoring highly to win a CfD ahead of another bidding at a lower price but scoring poorly.
Amending valuation formula: Projects scoring highly would be recalculated to have a lower estimated budget impact, potentially enabling additional projects to come in under the budget and successfully win a CfD, and resulting in an increased strike price for all successful bidders.

All approaches bring their own challenges and potential for unintended consequences. The top-up approach would need to strike a careful balance to avoid under-paying or overcompensating generators. Moreover, as the call for evidence makes clear, it undermines the government's ability to control the impact of the CfD on electricity bill payers.

Bid re-ranking is a more complex intervention to the auction mechanism that could drive up overall administrative costs and, again, impact on how the CfD subsidy pot is controlled.

Amending the CfD valuation formula goes even further, adding significant complexity that might enable a “free-rider effect” whereby projects that score low on non-price factors benefit from others that do, “since more projects could ultimately secure a winning bid through this model”. Controlling the CfD budget also becomes even more challenging under this allocation model.

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Timing is everything

The Department for Energy Security and Net Zero (DESNZ) is not yet wedded to any particular mechanism, and acknowledged the drawbacks of each in its consultation response without ruling anything out.

Responses to the call for evidence sought further guidance on the exact outcomes that it is intended to deliver in order to determine the optimum means of delivery, be that within the CfD regime itself or potential pulling on other policy levers.

“The call for evidence raised more questions than it answered,” an offshore wind industry source tells E-FWD. “Until we get a better understanding of what the non-price factor is from government, we can’t evaluate whether it is best served in the CfD allocation process or another point in the development cycle.”

The CfD award comes at the very end of the development cycle, when projects have already firmed up supply chain commitments in order to cost up their auction bidding strategy. Shoe-horning in non-price factors at this late stage leaves no time to deliver on them unless it is preceded by much earlier engagement with supply chain companies. Therefore, there is a strong case for incorporating non-price factors into the seabed leasing process too, and using CfD allocation as a means of rewarding those early initiatives.

This requires a coordinated approach between the Crown Estate, DESNZ and – ideally – the Treasury to bolster developer-led initiatives with fiscal incentives and other policy support. DESNZ understands this, saying in its consultation response that it “recognises that investment lead-in times are critical for non-price factors to be effective” and “there may be benefits to generalising non-price factors at leasing stage for offshore wind in the long term”.

DESNZ is amenable to coordinating with The Crown Estate to incorporate non-price factors at the leasing stage. However, since there is already a significant amount of seabed already leased to offshore wind, the policy would have to cover existing leases to maintain a level playing field.

We need a bigger CfD ‘sin bin’

Beyond the issues raised above, one thing is clear: penalties for non-delivery need to be beefed up across the board. This point is key to the promotion of robust supply chains.

Projects that capitulate after signing a CfD are now excluded from re-applying in the following two allocation rounds. The exclusion period was extended last year from one to two rounds. However, this merely offset the reduced disincentive from the parallel move from biannual to yearly allocation rounds, meaning the implicit time a failed project must spend in the CfD ‘sin bin’ is unchanged.

The latest call for evidence on CfD non-price factors identifies the need for “a credible disincentive to non-delivery”, without elaborating. Vattenfall booked an impairment of SEK 5.5 billion (£400 million) on its Norfolk Boreas CfD cancellation, a sum which presumably must cover both the undisclosed CfD penalty incurred and lost development expenditure, which can be substantial. Clearly this loss, which is tax-deductible, was deemed preferable to ploughing ahead with the project under the current cost-revenue structure.

Reforms must address concerns that projects that secured CfDs with overly aggressive bids were encouraged to take an irresponsible approach to non-delivery risk. Soft penalties for capitulation allowed developers to speculate on future cost reductions from suppliers, knowing that in the worst-case scenario they could withdraw and re-apply for a CfD at a future auction.

Imbalance of market power

This exacerbated the asymmetrical relationship between developers and suppliers. With only one route to market, generators can file unrealistically low bids to secure the CfD as a bargaining chip, and then force their suppliers to either cut their prices accordingly or risk losing out altogether.

The lack of a credible disincentive allowed them to view the CfD award as a low-cost option to be exercised or cancelled at their discretion, buying them time to de-risk their projects to placate equity stakeholders and project finance lenders.

With the cost of steel, copper, shipping, and labour all soaring since Russia’s full invasion of Ukraine, the lopsided power dynamic forced suppliers to take on the risk of commodity pricing. This might fly in benign market conditions, but it is not normal contracting practice in other sectors, and the harm of this approach becomes apparent when macroeconomic conditions deteriorate. Targeted reforms to CfD allocation could strike a better balance in risk allocation between project developers and their suppliers.

Global race for resources

Striking the right balance here is crucial. Global demand for capital, materials and skills needed to deliver offshore wind megaprojects has never been stronger, and tilting the scales too far in any direction risks derailing investment at a critical moment.

The UK is already facing an uphill battle to deliver its stated target of 50 GW of capacity by 2030, and the results from the AR5 auction made the goal that much harder to achieve. Meanwhile, the EU’s REPowerEU initiative and the US Inflation Reduction Act (IRA) offer substantial incentives for supply chain companies to relocate to serve these growing offshore wind markets.

Amid heightened concerns of China ‘de-risking’ and supply chain reshoring, the need for agility is acute. The North Sea remains an enviable location for offshore wind investment, but the UK cannot afford to rest on its laurels as the world’s go-to destination for capital.

Against the backdrop of heightened competition in the offshore wind space, a broader suite of reforms contemplated in the ongoing Review of Energy Market Arrangements (REMA) threatens to bog the UK down in many years of deep regulatory interventions. The potential for regulatory ‘Groundhog Day’ implicit in some of the more disruptive options on the table poses arguably a greater threat to supply chain development than the precise mechanism or criteria for scoring projects on qualitative aspects.

Decisions being made in Whitehall will write the next chapter in the UK’s offshore wind story. If government becomes paralysed by indecision, the narrative could drift into one of consultation fatigue and fallow years at the worst possible moment. If ministers seize the initiative by designing a targeted package of measures that rivals European and American investment incentives, then the story could be one of the UK North Sea reasserting its role as the global epicentre for offshore wind.

Both industry and government have been complicit in creating the sticky situation in which the offshore wind sector now finds itself. They must move swiftly to end uncertainty, unpick the mess and plot a path forward that capitalises on the phenomenal progress of recent years.

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