Investing in Offshore Wind

Offshore wind hits multiple major investment themes.

For one, any serious offshore wind company is an excellent investment choice for both retail investors who care about the environment and are looking for zero-carbon investment solutions and institutional investors who have to meet their ESG mandates.

This applies for both equity and fixed income – green bonds are a great way to issue debt and at attractive rates.

Additionally, the clean energy angle is not just attractive from an environmental perspective – but also a cost perspective. Many people do not know, but wind energy has moved up the technology curve and down the cost curve far faster than nuclear (which is expensive) and solar. It is reliable (unlike solar – and offshore wind is particularly reliable due to higher wind speeds out in the ocean) and has the attractive characteristic of not requiring a fuel such as oil, gas or coal. As such, operating costs are minimal and fixed costs are reduced on a per unit basis through scale.

Offshore wind is quickly moving from an innovative and development driven industry to a mature market that is well understood. Costs to build offshore wind farms have decreased to the point where they no longer need subsidies to compete in price auctions for power grid capacity. In September 2019, bid prices for the UK’s Contract for Difference (Cfd) Allocation Round 3 was below $50/MWh. The levelized cost of energy (LCOE) has fallen to sub-$50/MwH – this is important as it is now competitive with coal and natural gas and hydro.

The Offshore Wind Addressable Market

Offshore wind will add approximately 10 gigawatts (GW) per year for the next 5 years and double that for the five years after that. Much of the growth will be in Europe, China (including Taiwan, that has its own market), Japan, the U.S. and Korea. However, any country with a coast that is looking for cheap electrical power will be able to take on several large offshore wind projects.

Bloomberg New Energy Finance (BNEF) is projecting that renewables will be 62% of the world power generation mix by 2050 with wind and solar being 48%. Of the $3 trillion (!!!) that will be invested in power generation capacity to 2050, 49% will be onshore wind and a substantial portion will be offshore.

It is a huge opportunity! But even though the addressable market is huge, we have to figure out who the winners are in a growing offshore wind market. After all, the airline industry is huge (who does not fly on a passenger flight?), but when was the last time an airline proved to be a good stock investment (and didn’t go bankrupt)?

Likewise, there are many players in the offshore wind value chain with widely different competitive moats and business profiles.

Offshore Wind Project Life Cycle

Wind is a maturing market where the projects end up with very similar cash flows to fixed income instruments with option value.

For example a typical offshore wind development starts with an auctioning off of grid capacity where developers bid for prices with certain development plans. After securing the capacity and land, they will start the development process to secure PPAs – this is where the largest component of the value add is as it requires a deep understanding of the industry and how to deal with stakeholders.

Securing a power purchase agreement (PPA) is through negotiations with viable counterparties. This is similar to getting pre-sales before constructing a new apartment complex where condominiums will be sold by unit. A wind farm developer will try to contract electricity sales for 15 or 20 or 25 years at a predetermined electricity price for a set quantity. This secures the cash flows of the project. Of course, counterparty risk is important – a major electrical utility will be much safer than a small one. If they default, the wind farm will take merchant risk by selling to the grid and thereby jeopardizing returns.

Once the PPA is secured and other licenses are obtained, the development is derisked except for financing. Many of these projects depend on project financing from major commercial banks and corporate banks. With strong legal frameworks and remedies for non-performance as well as backing through letters of credit, project financing is a huge part of the investment. Once all of this is done and financing is secured, the company can make a Final Investment Decision (FID).

At this point, only the construction remains before the commercial operation date (COD). Construction is riskier than an operating asset but generally not too risky as it is commoditized and well known once all of the engineering is in place.

Usually, offshore wind developers will derisk the project by farming down their stake in a project. This is useful for capital recycle as most of the value is added in the development stage. They are getting 8-10% unlevered returns as developers and then can sell an operating entity at 5% IRR, leading to large profits (also known as a promote once a project reaches a derisking milestone).

Offshore Wind in Developing Markets and China

Offshore wind is featured prominently in Chinese government planning for reducing carbon intensity going forward (and reducing fossil fuel dependence when it is a net energy importer). As with many other sensitive markets, China’s offshore wind market is protected while domestic champions form. However, these domestic champions will eventually scale and compete for global mandates.

However, almost all jurisdictions will have Local Content Requirements, and successful offshore wind companies will have offices and integration plans in the countries that they operate in.

Offshore wind is also a huge opportunity for developing markets in a rapidly growing global economy. For many developing countries, offshore wind can suddenly be a viable option to make up the majority of their generating capacity.

However, problems arise when it comes to the tried and tested project financing that these wind farms require. Project finance is highly contingent on bankability – where banks will require the surety of commercial protections in order to have confidence in the preservation of their investment.

In developing countries with weaker legal protections, projects may not have recourse for an early termination or loose interpretations of force majeure. If this happens, developing countries may not be able to build out offshore wind rapidly or will have to use a large amount of equity financing, where the returns for wind projects may not justify the risk.