Memorandum by Christofferson Robb &
Company
BACKGROUND
1. Christofferson, Robb & Company (CRC)
manages the CRC Global Structured Energy Fund, Ltd., which owns
100% of Thanet Offshore Wind, Ltd. Thanet is an offshore wind
farm development located 11 kilometres from North Foreland in
the Thames Estuary. After it is commissioned in late 2009, Thanet
will be the world's largest offshore wind farm with a capacity
of 300 MW. It will generate approximately 3% of the average electricity
consumed by London and 0.2% of the electricity consumed by the
UK. When the wind blows at more than 15 m/s (34 miles per hour),
Thanet will generate 9% of London's electricity. Thanet will save
approximately one million tons of CO2 emissions per annum compared
to a typical coal-fired power plant.
2. Prior to Thanet, CRC's Energy Fund acquired
430 MW of onshore wind farm capacity in Germany and France. CRC
refinanced the construction debt for these farms by issuing a
€470,000,000 whole-business securitisation called "CRC
Breeze Finance". According to Windpower Monthly (May
2006), this was the "first international financing where
renewable energy infrastructure has been funded directly from
the capital markets".
3. CRC is a private money management firm
with offices in London and New York. Its funds are supplied by
institutional investors, primarily in Europe, North America and
Asia. Christofferson, Robb & Company LLC is registered as
an Investment Advisor with the U.S. SEC. Christofferson, Robb
& Company (UK) LLP is authorised and regulated by the Financial
Services Authority.
4. CRC has focused this submission on the
economic insights gained from the Thanet project and the ensuing
policy implications.
SUMMARY OF
OFFSHORE WIND
ECONOMICS
5. Wind is by far the least costly technology
for generating meaningful amounts of power by 2020. Solar photovoltaic
requires five times the feed-in tariff of wind to break even in
sunny places such as Spain and Italy. Tidal energy will remain
a laboratory experiment for at least the next decade; no tidal
project in the world produces commercial amounts of energy, and
history has taught us that complex technologies only take root
after years of trial and error. Only wind power—which has
benefited from 40 years of continuous improvements—is here
and now. Onshore wind is feasible in principle, but faces fierce
local opposition in a densely populated, scenic country. Offshore
wind projects are perfectly suited to the UK's long, windy coastline.
6. A back-of-the-envelope calculation summarises
the returns an investor can expect for a Round 2 offshore wind
farm:
100 turbines
x 3 MW per turbine
x 40% efficiency (since the wind does not blow all
the time)
x 93% availability (to account for downtime due to
scheduled and unscheduled repairs)
x 24 hours x 365 days
x 97% (adjusting for transmission losses)
x 85% (assuming operating and maintenance = 15%)
x [£70 per MWh (electricity) + 1.5 x £52
(ROC) + £4 (LEC)] per MWh
x 87% PPA (to account for costs of marketing power
under PPA)
= £107,000,000 per annum
7. Accounting for depreciation of the equipment
over 20 years, decommissioning reserves, income taxes, and a two-year
delay between outlay of funds and the onset of revenues, the project's
internal rate of return drops to 10%. With bank financing, the
base case return could be boosted as high as 12%. This calculation—which
already assumes 1.5 ROC per MWh—demonstrates that investors
can expect a meager return for bearing significant risks to construction,
power prices and the amount of wind. It demonstrates in general
terms why the UK build-out so far has been immaterial:
COMMISSIONED OFFSHORE UK WIND MW THROUGH
JUNE 2008
|
| Year | Project
| MW | Owner
| Turbine Supplier |
|
| 2000 | Blyth
| 4 | E.ON
| Vestas |
| 2003 | North Hoyle
| 60 | Beaufort Wind
| Vestas |
| 2004 | Scroby Sands
| 60 | E.ON UK
| Vestas |
| 2005 | Kentish Flats
| 90 | Elsam, Vattenfall
| Vestas |
| 2006 | Barrow
| 90 | Centrica, DONG
| Areva, Vestas |
| 2007 | Burbo Bank
| 90 | DONG
| Siemens |
| 2007 | Beatrice
| 10 | Talisman Energy
| RePower |
| Total | | 404
| | |
|
HIGH CAPITAL
COSTS AND
IMPERFECT INFORMATION
UNDERMINE THE
THEORETICAL BENEFITS
OF A
ROC OBLIGATION SCHEME
8. Under certain conditions, market-based schemes, such
as ROCs, can harness the efficiency of price competition without
requiring the government to select the winning technology or micromanage
the implementation. Consider, for example, a model with various
suppliers of electricity derived from bio-diesel. Assume (i) perfect
competition for electricity generation as well as for the factors
of production (ii) capital can be immediately expanded or contracted
with constant returns to scale (iii) government policy desires
a fixed amount of electricity from bio-diesel at the minimal cost
to society. Given these assumptions, the optimal subsidy policy
would require utilities to produce or purchase a fixed amount
of electricity from bio-diesel (or equivalent certificates). The
utilities would purchase this electricity at the lowest cost.
Each generator would charge its marginal cost based on the cheapest
possible feedstock and the generator's technology. In this way,
each generator would balance social costs of the factors of production,
such as alternative feedstocks, with the market price.
9. But the above model does not describe the economics
of wind. Nearly all the cost is upfront: engineering, constructing
and installing foundations, the offshore substation, inter-array
cables (between turbines), export cables (from the turbines to
the shore), the turbines and reinforcements for transmission to
the onshore grid. Either a wind farm is built or it is not, and
once built, the owner has few decisions to make. Wind—the
principal input—is free. A renewable trading scheme may
transfer wealth, but it will have no bearing on efficiency. A
similar analysis applies to solar energy.
10. With banded multiple ROC obligations, the Government
must set RO levels for each technology. This puts the Government
squarely in the business of selecting what forms of renewable
energy it wishes to promote. There is a one-to-one mapping between
RO levels and outcomes, as there is a similar mapping from feed-in
tariffs to outcomes. A ROC regime, however, maximizes uncertainty
both for investors and policymakers: for example, does 1.5 ROCs
per MWh make offshore wind economical? The answer hinges on investors'
guesses about build-out of renewable technologies, future modifications
to rebanding and the legislative obligations to present ROCs over
time. Power prices feed into the model for ROCs, since merchant
electricity, along with ROCs, is a joint output of a renewable
power plant—higher power prices stimulate renewable supply,
holding everything else constant. Policy makers, trying to assess
the effect of rebanding, must predict how investors will model
these factors. The only way to know the result of a rebanding
is to try it, wait several years, and see what happens. As argued
below in the section on Policy Recommendation, a feed-in tariff
for wind will deliver results that will be immediate and predictable.
INCENTIVES TO
FIRST MOVERS
11. Technical progress in any industry—whether
automobiles, computers, or wind farms—is incremental. The
industry learns by doing. Not only does the world gain scientific
knowledge from each project, but a wide range of service providers
and distributors evolve over time and improve efficiency. In the
case of offshore wind, the first projects are helping to educate
workers who install the foundations; each project conducts environmental
studies that are useful in the future; when the projects begin
operations, they generate data that reduces uncertainty and improves
financing terms for projects that follow.
12. The first projects cannot capture the monetary value
of these externalities, so, in an efficient market, profit-making
competitors will under-invest in the absence of transfers or subsidies.
EXPECTATIONS OF
REGIME SHIFT
13. Investors know that the current subsidy regime is
not achieving the UK's policy objectives. That knowledge creates
an expectation of more generous subsidies in the future. This
causes prospective wind investors to wait, because an investor
who starts a project now faces the risk that it might not qualify
for whatever subsidy comes next. In a vicious cycle, waiting further
reduces investment and reinforces the expectation that policy
will change.
14. The way out of this negative feedback loop is twofold:
(i) binding assurances that any project commissioned in the future
will be eligible for new subsidies that the government offers
to others; and (ii) quick action on the new plan. A lengthy debate
inhibits investment in the short-term, as rational investors postpone
their decisions until they are sure of the outcome.
SUPPLY CHAIN
15. An offshore wind project relies on specialised equipment,
including jack-up barges, heavy-lift cranes, pneumatic hammers
for pounding the foundations into the sea bed, and high-strength
gearboxes that will not corrode in humid, salty air. These, in
turn, depend on components that require heavy capital outlays
to manufacture. Today, every offshore wind farm developer must
confront an array of monopoly or oligopoly suppliers of these
specialised inputs. Many components are procured from the offshore
oil and gas industry at a premium. Each supplier contract must
be negotiated separately, and frequently presumes deployment of
a particular technology that has not been secured. Therefore,
at each stage, the supplier may try to "hold up" the
project as the price of securing the required technology, and
extract a large share of the future revenue. As an example, if
a wind farm developer has entered into construction contracts
for £675 m, and has only one £25 million contract left
to sign with the owner of a specialized barge, the barge owner
could instead charge something nearer to the price of a new barge
plus the lost revenues the wind farm would forego during the barge
construction period. A new barge would take two years to build
and cost the developer £50 million while the delay would
costs £100 million in lost revenues. Therefore, the barge
owner could demand more than £125 million and force the developer
into a loss overall. A rational developer must anticipate some
of these "hold ups"—CRC estimates that windfall
rents to monopoly suppliers might account for 10-15% of project
costs.
16. A mature industry deals with "hold ups"
in two ways. The first is vertical integration. Firms expand their
scope because it is less costly to negotiate contracts internally
than with third parties. The second is competition among suppliers.
Both vertical integration and competition will require major capital
outlays, which will not happen unless offshore wind economics
improve.
POLICY RECOMMENDATION
17. The public policy challenge is to promote the most
efficient projects using the least possible subsidy.
(i) The subsidy should be just large enough to attract the
desired investment.
(ii) It should provide certainty to investors in wind projects,
and equally, to firms further down the supply chain, to support
capital investment.
(iii) Any new policy should be decided upon and implemented
quickly, since market participants will postpone their projects
while they await the outcome of the debate.
(iv) Finally, it should provide incentives to first movers
who create know-how that benefits those who come later.
18. CRC has experience with the German model and believes
it satisfies these criteria. It provides a guaranteed feed-in
tariff for 20 years and mandates the grid operator to purchase
all the electricity a wind farm can produce at the guaranteed
price.[37] The principle
of "grandfathering" is rooted in the German constitution:
anyone who invests based on a prevailing law will be protected
if that law changes. The feed-in tariff stays fixed for 20 years
and depends on the year the farm was commissioned. The tariff
drops by 2% per annum—that is, a wind farm commissioned
in 2006 receives €83.6 per MW/h for 20 years while a farm
commissioned in 2007 receives €83.6/1.02 = €82.0 for
20 years. This annual tariff drop also ensures that technical
progress will not result in a windfall for developers, but will
preserve steady returns.
19. Specifically, CRC recommends:
Feed-in Tariff: (£160 per MWh) x RPI inflation factor
x (1.02)-t for 20 years after commissioning where t = number of
years commissioned after 2010 (t=0 for turbines commissioned in
2009 or 2010; t=1 for turbines commissioned in 2011; t=2 for turbines
commissioned in 2012 ...)
The £160 per MWh corresponds to a power price of £78
per MWh, 1.5 ROC per MWh at a ROC price of £52 per MWh and
a LEC price of £4 per MWh. Thus this proposal is not materially
more generous than the existing regime.
20. The costs of the feed-in tariff would be borne by
utilities in proportion to their share of power supply market,
and ultimately passed on to consumers in proportion to their electricity
consumption.
21. The feed-in tariff would result in the following
key efficiencies:
By reducing uncertainty, investors would be willing to accept
lower rates of return.
Projects would support more bank financing, further lowering
the (unleveraged) required returns.
Projects would save the costs connected with a power purchase
agreement.
A credible, supportive regime would justify investments along
the supply chain, including competition and vertical integration
that would sharply reduce transactions costs.
CONCLUSION
22. Thanet Offshore Wind has particularly attractive
features that, to some extent, ameliorate the weak support regime.
But the fact that Thanet can generate an acceptable return on
investment does not mean that policy is on the right track or
that UK wind energy construction is likely to surge in the near
future. Thanet's economics hold up uniquely because it is an ideal
site. The cable landing site is a decommissioned oil-fired power
plant, formerly the Richborough power station, so no reinforcements
are necessary for transmission to the on-shore grid. The offshore
substation is only 100 kilometres from the centre of London, enabling
Thanet to produce electricity near where it is consumed with minimal
transmission losses. Average water depth is about 22 metres and
maximum depth is 25 metres, well within the operating capability
of the vessels used for installation. The seabed is hard and topographically
consistent. The Thames Estuary is one of the windiest locations
in the world that is suitable for offshore wind development: Thanet's
average long-term wind speed is 9.4 m/s (21 miles per hour) at
the 80 metre hub height. Compared to the winds of 6.3 m/s (14
miles per hour) in CRC's previous onshore portfolio, Thanet will
generate more than twice the energy yield per installed MW (owing
to a nonlinear relationship between wind speed and power production).
Yet even under such ideal conditions, Thanet's expected returns
on capital barely reach the typical returns for less risky, conventional
infrastructure projects.
23. With today's subsidy regime, CRC expects the UK to
add fewer than 300 MW of new wind capacity per year. This would
lead to approximately 3 GW of capacity by 2020, which equates
to 1 GW of continuous production—less than 2% of 2007 consumption.
No other source of renewable energy is likely to contribute meaningfully
in the next 12 years.
24. However, with swift policy action, the developers
and suppliers will invest in the infrastructure needed for an
efficient, rational supply chain. Switching to a feed-in tariff
and grandfathering the early adopters will minimize the social
cost. CRC believes that a 20-year feed-in tariff of £160
per MW/h would radically transform the industry and deliver 5-7%
of the UK's electricity by 2020 while imposing a comparable social
cost per MW/h to the existing scheme.
16 June 2008
37
For extraordinarily productive farms, the tariff can run out prior
to 20 years based on a formula. In practice, this has not happened
as far as CRC knows. Back
|
