Project Finance International: Unsustainable Offshore Wind

Published on 24 May 2023

Allen Leatt, CEO at IMCA, writes for Project Finance International on the financial challenges for offshore wind.

Developing significant electrical power generation from offshore wind farms is a relatively new industry with new challenges, but with very familiar construction technologies and practices. Hence, it is a good fit with marine contractors that have been engaged in the offshore oil and gas industry for the last 50 years.

This is a niche market with few contractors that have the large-scale specialist marine construction vessels, the track record, and the engineering and project management skills to undertake large projects on a fixed price basis.

However, there is a significant problem in that large parts of the offshore wind supply chain are unprofitable today, which puts the sustainability of the industry and government targets at risk. Every government wants energy security, lower costs, lower carbon, and local job creation. These are all admirable goals; but are unlikely to be achieved unless the industry becomes economically sustainable. In order to do so, the industry will need to address the structural problems created in part by highly leveraged project finance.

The pure-play renewable energy developers have been leading the way, but now the oil and gas super-majors are running fast and will be highly significant in this space going forward.

This is a positive development, which will create opportunities in a much broader market.

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Scale of investment

The scale and rebalancing of investments in offshore energy are impressive. Exploration and production capital expenditure in offshore oil and gas in 2021 was around US$150bn, although only half of that in 2014. Yet despite global investment halving, production levels of about 100 million barrels/day have been maintained through improved technology, standardisation, and cost savings. In comparison, investment in offshore wind in 2021 was around US$45bn and is estimated to almost double to US$80bn in 2027 (source, Rystad Energy).

To achieve that, the same productivity formula used in oil and gas is needed in offshore wind.

With the 2014 downturn in the oil industry, the supply chain naturally increased its exposure to the embryonic offshore wind sector, but this could now be reversed due to significantly improved conditions in the oil and gas market.

The limiting factor on growth in offshore wind may well be the supply chain rather than capital, as a serious imbalance of supply and demand is now taking place. The supply-side is today asset constrained and is unlikely to invest further until normal and sustainable investment returns look achievable. Simply put, our current prognosis is that there will not be enough specialist vessels, experienced people, and industrial capabilities to meet the ambitious demand and delivery expectations.

The problem

Despite the hype and momentum surrounding offshore wind, the industry is not structured in a long-term sustainable way. The supply chain, which includes the leading Tier 1 turbine manufacturers and marine contractors, has experienced significant losses that cannot be sustained. There are several contributing factors to this situation:

1 – Highly leveraged debt secured on the field assets and the future cashflows of a wind farm provide a ready market for green finance at scale. This puts the banks and developers in a powerful negotiating position in flowing-down risks to the supply chain. This record of overwhelming buying power combined with a bottom dollar philosophy now risks the sustainability of the whole market, as contractors are no longer willing or able to play this particular game.

2 – The assembly of the components of a wind farm are well understood, but the operational risk profile has been greatly magnified by the rapid prototyping curve in developing ever-larger turbines: growing from 2MW–3MW to 12MW–15MW in 10 years. This five-fold increase drives the corresponding increased scale of foundations, towers, turbine blades, infield electrical arrays, electrical export cables, etc. All require the deployment of larger and larger specialised vessels on an equally steep investment curve.

For example, a high-end foundation installation vessel can cost up to US$1bn, and a wind turbine installation vessel in the order of US$300m–$400m or more depending on specification.

3 – The serial nature of the construction risk profile can have profound implications for project economics. For example, a typical wind farm has about 100 turbines and a foundation problem on one turbine could be magnified 100-fold across the entire field, with dire contractual and financial consequences. Clearly, project budgets are not robust enough today for the numerous risks of developing multi-billion-dollar production facilities offshore.

4 – In essence, developers have taken uncovered risks in their project budgets and have looked to compensate for inadequate budget allowances and contingencies by squeezing their supply chain. This is understandable business but is no longer sustainable.

Contract arrangements

Surprisingly, there is no standard contract in the offshore wind industry. Instead, developers have used a highly modified FIDIC onshore civil engineering contract model that is completely inappropriate offshore and unheard of in the oil and gas world – a world where contractors are extremely experienced and competent in successfully delivering large projects in hostile marine environments, with all the challenges they present.

Offshore contracting mechanisms are typically either for straightforward transportation and installation services (T&I) or integrated into an all-encompassing engineering, procurement, construction, and installation (EPCI) arrangement.

Both have served the oil and gas industry for decades and are well understood by all stakeholders, including the financial and insurance markets.

With EPCI contracts the contractors take full responsibility for their work, provide warranties on their performance, and are compensated accordingly. Wind energy developers have looked to mix T&I and EPCI obligations together within a FIDIC contract, which has led to chaos.

Developers have expected contractors on a T&I contract to accept design warranties for equipment that they have neither designed, specified, nor procured. This would be normal in an EPCI contract but has no place in a T&I contract. The same applies for the soil risk of foundation designs and the drivability of foundation piles, for which the contractor has no control but is expected to be liable.

Some wind developers and utility companies appear to be indifferent to maintaining or managing the supply chain on a sustainable basis – perhaps under the assumption that the supply side is unlimited, and others will quickly fill the gap if there are shortages. This may be so in some commodity markets onshore but is certainly not the case in offshore marine contracting.

The solution

Poor economics would normally result in price corrections and inflation, resulting in decreased demand. We are seeing this start to develop in the USA, where a number of developers are looking to renegotiate their power purchase agreements, which puts project FIDs at risk.

Simply increasing prices and making the industry less competitive is not the answer; the answer is to address these structural problems and take unnecessary costs out of the system to make the industry more efficient. These challenges are not without precedent in offshore contracting and can be managed.

The North Sea oil and gas industry faced similar problems in the 1990s, with crude oil in the teens and the high cost of money creating an environment where little development took place. This changed with the introduction of a programme called CRINE – Cost Reduction Initiative In the New Era. CRINE created new ways of developers and the supply chain collaborating to take unnecessary costs out of budgets and get projects off the drawing board.

This was very successful and led to the creation of a suite of standard contracting models under the LOGIC banner (Leading Oil & Gas Industry Competitiveness), which is still in use today.

A similar approach can be taken in offshore wind, by creating a Leading offshore Wind Industry Competitiveness programme (LOWIC).

Solutions are readily possible with developers, contractors, and suppliers working closely to achieve a common alignment on project cost, schedule, and quality objectives, and thereby allocate the risks and rewards accordingly.

The International Marine Contractors’ Association (IMCA) has conducted an extensive in-depth study of the contractual problems and developed a set of contracting principles that IMCA feels are necessary to level-up the allocation of risk. Central to this approach is to allocate risk to the party that created it or is best placed to manage it and take responsibility for it. We are engaging with other industry bodies and associations to bring this about.

Without a change in contracting strategy to remove the risk premium and economic wastage, the ambitious targets set by governments, investors, and developers will not be achieved.

Allen Leatt is CEO of the International Marine Contractors Association (IMCA). This article originally appeared in Project Finance International’s April edition.