- Wind energy is exceeding market expectations at all fronts.
- The fast learning curve is signalling the end of the subsidy stimulus and the rise of competitive auctioning…
- …but is Europe prepared for this fast transition?
- Given the increase in exposure to market dynamics, different structuring options are available, but new challenges are emerging.
The development of wind energy in Europe
In 2016, the share of renewable energy as a percentage of total energy consumed was roughly 17% in the EU. Of the total renewable energy sources, wind energy ranks third (12.4%) after wood and other solid biofuels, and hydropower (figure 1). A total of 10.4% of EU’s electricity generation originates from wind energy. This energy source has come a long way and has exceeded market expectations. This is evident by the 154 GW of total installed wind capacity in 2016 (figure 2), of which 92% is onshore and 8% is offshore. In the EU, the cost of onshore and offshore wind energy bids went below €50/MWh (Wind Europe, 2017). A combination of factors has been driving the decrease in the cost of wind energy: (1) the availability of subsidies, (2) technological advances, (3) the cheap and abundant availability of financing that has pushed down the cost of capital, and (4) mergers and acquisitions that have allowed economies of scale in turbine production and deployment.
In Europe, the offshore industry is still in its early stages (12.4 GW cumulative installed capacity by end-2016) but has undergone a compound annual growth rate of 36% since 2008. According to figures from Wind Europe, the cumulative installed capacities of onshore and offshore wind have the potential to surpass 180 GW and 25 GW respectively by 2020 on the back of: stable regulations, a continuous decrease in the cost of development, a decrease in operation and maintenance costs, an increase in transmission and supply chain efficiency (Wind Europe, 2017) (figure 2).
Given the fast drop in wind energy costs, the need for subsidies is decreasing and the wind energy sector is driving itself towards subsidy free. This is a huge tipping point for the wind sector. However, some may think that this transition might be going too fast and new issues are emerging. To understand the development of offshore and onshore wind within the EU, and the underlying main factors facilitating or hindering its growth, it is essential to consider the markets that contribute the most to wind energy (Germany, France, the UK, Italy, Spain, and the Netherlands) and their current schemes of support as well as barriers to development.
This article will outline the current position of subsidy schemes and the decrease in dependency on subsidies as a result of stimulating auctions. Within this scope, issues like stability of revenues of generators come into focus, and therefore different structuring options are outlined, with specific emphasis on power purchase agreements (PPAs).
The life cycle of wind energy barriers in the EU
Given the increase in wind energy deployment, and as the sector continues to mature, it is inevitable that the sector continues to face various challenges. These depend on the stage of maturity and the market-specific regulatory framework (figure 3). The diagram below illustrates that:
(1) the first barriers are feasibility and development impediments that can be overcome by site evaluation, resource assessment, technical evaluations etc.;
(2) as these barriers are eliminated, social barriers (public resistance) emerge;
(3) once permits are granted, access to finance and subsidies are settled;
(4) as wind energy deployment grows, socialization costs start to weigh heavily on consumers;
(5) high penetration levels trigger grid capacity restrictions. This issue will not be further addressed here as it is out of the scope of this article.
With the tendering scheme and feed-in tariff in place, France has developed a substantial pipeline of onshore wind projects. However, the average development time for wind projects is seven to nine years due to opposition from French activists. This is twice as long as in Germany and means these projects may not materialise soon. The French government has proposed shifting the related decision-making power of local councils to the local prefects, which are state representatives. It is hoping this will speed up wind development. Similarly, in the Netherlands, control is being shifted from a provincial level to a national level to expedite the deployment of wind energy.
In more mature wind energy markets like that of Germany and the UK, we see that electricity prices are weighing heavily on consumers due to socialization costs (Germany’s consumer electricity price is around 30 euro cents/kWh, among the highest in the EU) (Eurostat, 2018). In order to address this rise in the electricity price due to a high renewable energy levy, in 2017 the German government launched competitive auctioning to reduce or replace subsidies. While competitive auctioning has shown to bring down the price of renewable energy, critics argue that the removal of subsidies may endanger the financial viability of wind farms. In the UK, the low costs of onshore wind farms and the high energy bills have prompted the government to cut subsidies for onshore wind parks to protect consumers from such high energy costs. However, it is argued that this will slow down the onshore wind development and consequently the government is reviewing the cut on onshore wind subsidies (The Guardian, 2018).
These mixed experiences in the EU led us to investigate the current types of subsidies, the signals towards subsidy-free, the rise of auctioning, and the risks that are emerging with this transition.
Subsidies brought a lot of renewable capacity online but did not allow renewable energy producers to react to market signals
Subsidies are implemented to lower the cost of a new technology until this technology is cost-efficient and competitive. The subsidy scheme is deemed healthy if its general benefits outweigh the costs. This has proven to be the case for wind energy, given that the learning curve depicts a substantial decrease in energy generation cost (€ cents/kWh) as turbine capacities and production increase.
Governments are opting for different subsidy designs in attempt to compensate the producer without offering an upside and therefore shielding consumers from overcompensating producers. Among the different types of subsidies, the following three are defined below:
1- Feed-in Tariff (FIT) is a fixed payment per MWh to renewable energy generators set by the government, providing a stable cash flow that facilitates financing.
2- Contract for Difference (CfD) is a dynamic form of subsidy. It remunerates the producer when the wholesale price falls below the strike price , and in return the generator must pay back the government when the wholesale price surpasses the strike price (figure 4).
3- Feed-in Premium (FIP) is similar to CfD but the producer does not return the difference when the market price exceeds the strike price (figure 4).
In the course of the last few years, FIP was launched in numerous European countries and CfD in the UK in order to replace FIT. In FIP and CfD schemes, the producer is compensated based on the difference between the strike price (the price needed to recoup the investment) and the market price (wholesale electricity price) (figure 4). Such schemes have helped renewable energy investors reduce their exposure to market prices and secure revenues. As a result, FIT, FIP and CfD have brought a lot of renewable capacity online by providing a stable cash flow. However, they did not allow renewable energy producers to react to market signals. Nor did they encourage a response to the decrease in renewable energy costs or congestion on grids. This is the case because no matter how low is the wholesale electricity price, producers are given a premium to secure the strike price (figure 4).
Subsidies will continue to take different forms and sizes as market specifications vary across countries. This is especially true given that countries have different renewable energy targets, different energy mixes, grid capacities, public support, etc. However, in light of the continuous increase in wind energy and decrease in cost, subsidies are shrinking and in some European countries they are phasing out.
The fast learning curve is signalling the end of the subsidy stimulus and the rise of competitive auctioning
In some countries, the cost of wind energy has fallen to such an extent that subsidy-free onshore wind projects are now being developed (such as the Big Field in the UK). Surprising to many, subsidy-free offshore wind projects in Germany and the Netherlands have been auctioned or awarded, giving rise to optimism that subsidy schemes may come to an end. Indeed in March 2018, Vattenfall was awarded two 350MW offshore projects (the Hollandse Kust Zuid offshore wind farm) in the Netherlands on a “subsidy-free” basis. Competitive auctioning (tendering schemes) is increasingly used to push down the cost of wind projects and therefore reduce the need for subsidies. This, in turn, cuts the cost for consumers. This means that wind energy generators are exposed to market signals in a subsidy-free environment. However, this implicates some new challenges.
The ability to lend / invest against a stable stream of cash flows, thanks to subsidies, has provided a level of comfort for lenders and investors. Given that a reduction or even disappearance of subsidies is looming, achieving a positive and stable revenue stream will be a key challenge as producers are increasingly exposed to market price volatility. The higher exposure to wholesale electricity prices, with no subsidy guarantee, is expected to be factored into the price of capital. This will result in a higher cost of financing. Investors may anticipate a stable income if their assumptions are correct on moderate / higher electricity prices, a further reduction in development costs, and bigger capacities. So basically, the subsidy-free projects are speculating that these trends will continue. Otherwise, low electricity prices may threaten the advancement of wind energy.
On another note, competitive auctioning puts a ceiling on the cost of onshore / offshore projects and drives costs down. However, critics argue that this will be at the expense of small companies that do not have the capability nor the risk appetite to bid aggressively for such projects. Therefore, they argue that in the long run, this will limit competition, which is counter-intuitive to the purpose of competitive auctioning.
A centralised tendering scheme can be supportive to competitive auctioning
Other factors can have a significant impact on wind energy efficiency and cost. Examples include the type of tendering structures. In the Netherlands, offshore wind energy projects are developed according to the centralised approach versus onshore wind projects, which are developed according to the developer-responsibility approach (figure 5). Centralised tenders are those in which the site and access rights / permits are pre-arranged and set by the government. For example, in the recently awarded contracts to build the Hollandse Kust Zuid offshore wind farms in the Netherlands, the government pre-selects the site, arranges the permits, and is responsible for grid connection. This means that the bidder is only responsible for delivering the project on time. This type of auction allows a partial reduction in the initial expenditure and lowers development risk. As a result, it lowers the tender price compared to the developer-responsibility approach.
In the developer-responsibility approach, the developer takes the responsibility for choosing the site, seeking access rights and permits, and building grid connections in addition to capacity planning and timely delivery. Such a tender system is costlier and more time consuming. Experience with the developer-responsibility approach led to concerns that only large players can tolerate such high level of initial risk in the pre-development stage, leaving little room for small investors or neighbourhoods wishing to invest in local onshore wind farms.
The centralised tender scheme can provide room for more competition, as it can be appealing for smaller developers wishing to bid on wind projects, knowing that access to the grid and permits are secured and in place. This can support competitive auctioning that promotes offshore wind cost reductions, certainty in delivery and efficiency in development. Respectively, it can directly increase bankability and investment.
Given the increase in exposure to market dynamics, different structuring options are available, but new risks are emerging
The advent of subsidy-free projects may affect the appetite of lenders and investors, as generators will be exposed to market prices. Price stability is important to give investors enough confidence that projects are investable and for banks that projects are bankable. Different structuring options are available to gain price stability, such as: corporate power purchase agreements (PPAs), utility power purchase agreements, and power price hedging. Corporate PPAs are gaining more attention lately, as PPAs can guarantee long-term fixed power prices. Corporates hedge their power prices by paying a fixed price per MWh to the generator.
So far, corporate PPAs have been prominent in the UK and are emerging in other countries like Netherlands, Spain, Ireland and Scandinavian countries. Given the volatility of electricity prices in the EU over the last decade, hedging against high volatility would have been advantageous, especially for the consumer. Likewise, from a generator and investor perspective, seeking financing against a stable and certain stream of revenue via PPAs is an advantage, especially with the increase in exposure to market dynamics. However, several complexities still need to be overcome, and opportunities need to be priced appropriately.
Corporate PPAs aim to achieve a level of comfort among consumers and generators. Theoretically, this sets them apart from the traditional purchase of power, where a utility company acts as the go-between (buying from the generator source and sending energy to the grid for consumers to buy) (figure 6). However, practically, this two-way interaction (generator-consumer) is not as simple, as the utility or distribution company is still a necessity due to: (1) the intermittent nature of wind energy, (2) the need for balancing, (3) the need for a responsible party to nominate the generator into the grid, and (4) the relative lack of affordable storage options (figure 6). Consequently, the PPA contracts can be complex and utility companies need to be familiar with this new composition.
A second challenge is that, due to the disappearance of subsidies, there is shift from low government risk to high corporate credit risk exposure. Depending on the evolution of wholesale electricity prices, a corporate can effectively go out of the money if electricity prices drop. As always, it is an absolute requirement to have a credit worthy producer. But to support a long term PPA obligation, it is equally important to have a credit worthy corporate.
The European seas and lands hold a lot of potential when it comes to wind energy. Subsidies have played a role in its proliferation but did not allow it to respond to market changes and technology cost development. More recently, competitive auctioning is allowing wind energy to gain exposure to and interact with market signals. Indeed, we are navigating towards the next phase. The fast learning curve is signalling the end of the subsidy stimulus. Wind energy in Europe is slowly getting prepared to the subsidy-free environment, but new challenges are emerging. Given that a reduction or even disappearance of subsidies is looming, achieving a positive and stable revenue stream will be a key challenge as producers are increasingly exposed to market price volatility.
As any new regulation or policy can be a double-edged sword, it is important to attach value to the benefits of the different structuring options available to gain price stability. Among other structuring options, corporate Power Purchase Agreements (PPAs) are gaining more attention lately. After all, PPAs allow consumers to hedge against the variability in the wholesale electricity price while enabling generators to secure predictability of revenues. But it is also important to assess the risks inherent to PPAs (as lower electricity prices pose a threat to their proliferation and a credit worthy corporate becomes an absolute requirement). Backing competitive auctioning and PPAs with tendering schemes that shift part of the risk from developers to governments (centralised tenders), is seen as a positive development. This provides room for competition among small and big players, promotes a reduction in the cost of wind energy, encourages timely project development and delivery, and consequently increases investment and bankability.