Recharge: Will US offshore be sustainable when tax credits expire?

Low-cost capital will help US sector flourish, even without subsidies, writes Greentech Capital Advisors’ PJ Deschenes

RECHARGE
22 October 2018
by PJ Deschenes

PJ Deschenes is a partner in the New York office of Greentech Capital Advisors, an advisory and asset management firm solely focused on sustainable technology and infrastructure.

Offshore wind has become a core asset class for numerous investors and lenders in Europe — and the same may soon be true in the US.

One of the initial large US projects — the 800MW Vineyard Wind off Massachusetts — set a record-low price for electricity of $74 per MWh for the first year of its 400MW first phase (with prices escalating by 2.5% each year over a 20-year period).

That price is expected to fall even further. Developers Avangrid and Copenhagen Infrastructure Partners (CIP) say costs will drop to $65/MWh for the start of the 400MW second phase of the project. Bloomberg New Energy Finance analyst Tom Harries described the low price as “pretty shocking”.

We see all the European trends coming to the US market — supporting technological advances, supply chains, and growth at competitive costs, even as subsidies expire.

With more than $68bn required to fund offshore wind projects globally through 2020, access to multiple types of capital is critical to sustain the industry’s growth and to stimulate demand by continuing to drive down costs.

Global offshore wind capacity is expected to grow 16% annually through 2030, reaching 115GW from 18GW today. Precipitous cost decline is a major driver, with bids dipping below the equivalent of $50/MWh in Germany last year.

Vineyard Wind says it will save power consumers $1.4bn over the project’s lifespan. However, this project leverages the federal Investment Tax Credit (ITC) among other incentives, which goes away after next year. Can the savings continue after the tax credit sunsets?

Evidence from Europe says yes, because: a) big utilities and oil & gas companies want to scale renewables, and are comfortable with development, technology, and operating risk; b) more lenders are lending at lower rates; and c) institutional investors want to own equity stakes, providing projects with funding options.

At the moment, strong interest from strategic companies, deep liquidity in project finance markets, and significant appetite from institutional investors are providing wind projects with efficiently priced funding.

Many of the largest utilities and global oil & gas companies are investing in offshore wind at scale. Cynics dismissed earlier investments as profiteering (given the lucrative government subsidies), or as token green investments. Yet investment by traditional energy companies has remained strong even as offshore wind markets in Europe transition to auction-based and zero-subsidy schemes.

Companies such as Equinor, Vattenfall, Ørsted, EnBW and Shell believe that the levelised cost of energy from offshore wind will continue to fall at a pace that makes zero-subsidy and other low energy prices economic by the time the corresponding projects are commissioned in 2020s. These large energy companies offer abundant capital for development and construction equity and have created intense competition in new tenders for energy from offshore wind.

Meanwhile, a deep pool of commercial lenders provides construction and term debt on increasingly attractive terms.

As the industry matures and project risks are better understood, the number of lenders has grown. More than 50 commercial banks have now provided loans to offshore wind projects, with a significant majority taking construction risk.

Increased subscription by lenders has put downward pressure on loan margins, which have fallen from upwards of 350 bps (basis points, or 3.5% over base interest rates) only six years ago, to as low as 150 bps. With base rates near historic lows, the overall cost of debt is around just 4% 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.

Sustained low interest rates have also led institutional investors to the renewable-energy sector in pursuit of yield. Equity investments in these projects offer contracted cash flows of 15 years or more, backed by investment-grade counterparties. They make an attractive alternative to fixed-income instruments on a risk-adjusted basis, with returns typically well over the bond yields of the underlying off-takers.

As solar PV and onshore wind project returns continue to compress, driven by strong investor appetite, institutional investors are pivoting to offshore wind.

Traditionally, institutional investors such as BlackRock, CDPQ, Gothaer and Kirkbi have made equity investments post-commissioning, alongside strong operators. Since projects are de-risked from a development and construction standpoint, these investors require lower returns — which have plunged into the single digits, providing yield compression to the project sponsors that bear the development and construction risk.

With incessant appetite for higher yields, certain institutional investors have even demonstrated an appetite to take on construction risk.

In November 2017, for example, Danish pension managers PKA and PFA each acquired a 25% equity stake in Ørsted’s 659MW Walney Extension project under construction in the UK. The $2.65bn investment was backed by approximately $1bn in non-recourse green bonds, a first for the UK market. These bonds received an investment-grade rating and were fully subscribed by a consortium.

Along with construction equity investment from pension funds, it signalled just how far the offshore wind industry has come in attracting low-cost capital.