Annual Report - Offshore Wind: Awash in Capital - Frank Nicklaus

Annual Report - 2017


FRANK NICKLAUS

Offshore Wind: Awash in Capital

FRANK NICKLAUS

Global offshore wind installed capacity is expected to grow 16% annually through 2030, reaching 115 GW from 18 GW today. The demand underpinning this outlook is largely attributable to a precipitous decline in offshore wind’s levelized cost of electricity, which has fallen to as low as $42/MWh in parts of Europe compared to over $100/MWh earlier this decade.

This drastic reduction in cost is the result of advancements across the offshore wind value chain, among them the favorable evolution of how offshore wind projects are perceived by the financing and investor community. The stable, long-term cash flows offered by offshore wind projects, combined with the opportunity to write large checks for each project, are attracting robust interest from a broad universe of strategic companies, infrastructure investors and commercial lenders. Viewed only a few years ago as a risky, niche alternative investment, offshore wind projects have emerged as a standalone, highly investable asset class.

Many of the largest utilities and oil & gas companies globally are investing in offshore wind at scale. While cynics may dismiss earlier investments as profiteering given lucrative government subsidies, or perhaps simply as token green investments, investment in the sector by traditional energy companies has remained strong as markets transition to auction-based and zero-subsidy remuneration schemes. The Netherlands allowed only subsidy-free bids in its 760 MW tender in December 2017, which included participation from Statoil and Vattenfall. Earlier in 2017, Germany awarded zero-subsidy contracts-for-difference representing 1,380 MW of capacity to two projects sponsored by Orsted and one by EnBW. This followed a Shell-led consortium’s successful bid in December 2016 for 700 MW in the Netherlands at a price of EUR 54.50/MWh, the third lowest for offshore wind to that point. Far from reaping the rewards of government largesse, these companies are placing calculated bets that the levelized cost of electricity for offshore wind will continue falling at a pace that will make zero-subsidy and other aggressively priced bids economic by the time the corresponding projects are commissioned in the early 2020s. Well capitalized and experienced with large, complex energy infrastructure projects, utility and oil & gas players provide an abundant source of capital to fund development and construction equity, and their sustained interest in the sector creates intense competition in tenders, driving down the cost of that equity. Meanwhile, a deep pool of lenders is providing construction and term debt on increasingly more attractive terms. 

Offshore wind has become a core asset class for numerous investors and lenders.

As the industry matures and project financing risks are better understood, offshore wind is becoming a focus for a growing number of lenders. To date, over 50 commercial banks have provided loans to offshore wind projects, with a significant majority taking construction risk. The result has been a persistent downward trend in margins, which have fallen from upwards of 350 bps only five years ago to as low as 150 bps today. With base rates near historic lows, the overall cost of debt is around just 3% for high quality projects. Also, leverage has increased, with typical gearing of approximately 75% for new projects compared to approximately 60% for early offshore wind projects. The ability to borrow such a significant portion of construction costs at such a low rate has drastically reduced the weighted average cost of capital for offshore wind projects, which has moved even further downwards due to the emergence of insurers, pension funds and other institutional investors as active investors in the sector.

Sustained low interest rates have led institutional investors to flock to the renewable energy sector in pursuit of yield during the past several years. Renewable energy projects typically have contracted cash flows of 15 years or more backed by investment grade counterparties. From the perspective of many institutional investors, equity investments in these projects offer an attractive alternative to fixed income instruments on a risk-adjusted basis, given that returns are typically well in excess of the bond yields of the underlying off-takers. As solar and onshore returns continue to compress given a crowded investor base, more institutional investors are pivoting to offshore wind. Traditionally, institutional investors such as BlackRock, CDPQ, Gothaer and Kirkbi have made passive equity investments post-commissioning alongside strong operators. Since projects are de-risked from a development and construction standpoint, the institutional investors require lower equity returns, which have plunged into the single digits, providing yield compression to the strategic companies taking those risks. As institutional appetite for higher yields has become more incessant, certain institutional investors have even demonstrated an appetite to take construction risk.

In November 2017, Danish pension managers PKA and PFA each acquired a 25% equity stake in Orsted’s 659 MW Walney Extension project under construction in the United Kingdom. The $2.65 billion investment was backed by the issuance of an approximately $1 billion investment grade, non-recourse green bond, the first for an under construction project in the United Kingdom. The bond was fully subscribed by a consortium of institutional investors. Institutional participation in the construction equity investment and the underlying green bond, as well as the bond’s investment grade rating, further demonstrates the significant progress the offshore wind industry has made in proving its bankability. The “farm-down” model of a strategic company taking a project to the start of construction or commercial operations and then bringing in a low cost of capital institutional investor is an established paradigm in Europe that is very likely to be adopted in frontier markets such as Japan, Taiwan and the United States. It enables institutional investors to gain exposure to stabilized, cash yielding offshore wind projects, allows strategic companies to efficiently recycle capital while continuing to operate projects, and lowers the overall cost of equity for offshore wind projects.

Offshore wind has become a core asset class for numerous investors and lenders. Strong interest from strategic companies, deep liquidity in project finance markets and significant appetite to deploy capital from institutional investors are providing offshore wind projects with access to efficiently priced funding across the capital stack. With more than $68 billion required to fund projects through 2020, this access to capital is critical to sustaining the industry’s growth, and to stimulating incremental demand globally by continuing to drive down the levelized cost of offshore wind.

Offshore Wind: Awash in Capital

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