Greatly reduced offshore wind costs have created the possibility of subsidy-free project development. Indeed, the Dutch government have already launched a zero-subsidy auction for the right to develop the 700MW Hollandse Kust Noord offshore wind farm.
Government subsidy or long-term power purchase agreements (PPA) provide project owners with a stable price over most of a project’s lifetime. Without these, owners are exposed to what the doyen of free market economics, Adam Smith, called the ‘invisible hand’ – the unseen force that ensures supply and demand match in an optimal way.
Moving to a merchant market framework is likely to prove popular with politicians. The embracing of a more laissez-fairer approach is also likely to appeal to any renewable energy sceptics. However, to remain viable when reliant on power market prices needs a significant shift in project owners' business models. Revenue received becomes much more volatile. The addition of revenue risk and variability is not something usually welcomed by investors.
Even with cost of capital at historically low levels, investors look at relative risk and returns when making decisions and if this risk is perceived to increase the overall risk associated with offshore wind farm projects, investors will demand higher interest returns. Project owners will have to accept lower margins or decide whether they can achieve further cost reductions to compensate for any rise in cost of capital.
Of course, as any trader knows, business risk has upside as well as downside. The electrification of transport, the decommissioning of coal generation and the general shift away from fossil fuels, all present upside price risk for electricity prices. It is possible that subsidy-free projects could generate more revenue that those with a fixed price for their electricity. This upside does not diminish the perceived innate riskiness of a project but could increase the possible returns.
Rather than willingly submit to the icy grip of the invisible hand, project owners have other options. The rapid development of storage technology, including hydrogen generation, could allow owners to ‘play the market’. They could only sell electricity during times when sufficient returns are available. Regulation is likely to limit owners engaging in arbitrage to fully exploit the market in this way, with governments insisting on fair end-user pricing and always keeping the lights on. That means that such options are only allowed for project owners to avoid ‘wasted’ generation rather to maximise revenue. Even so, they would be able to achieve greater lifetime returns from projects.
There are more sustainable ways for owners to optimise their business models in a merchant world. For one, increasing the total amount of generation when wind speeds are low, using methods such as overplanting, increasing rotor size and honing control strategies. Interestingly, such 'merchant world' tactics are not generally justified using ‘subsidy world’ methodologies such as levelised cost of energy (LCOE).
In markets where wind is a significant share of total generation, increasing generation has a potential ‘double whammy’ for owners. Not only will they be able to generate more total revenue, but by ramping up output when other supply is low, they produce relatively more when merchant prices are high. Of course, the wonders of the invisible hand mean that if all owners of generation assets can generate more when supply (wind) is low, any spike in prices will be short-lived.
To an extent, it is disingenuous to refer to the invisible hand in markets as regulated as electricity generation. There is a need to ‘keep the lights on’ for the economic, physical, and political wellbeing of a nation. Governments will not let go of all their power for such a vital market. As that more contemporary economist, Nobel laureate Joseph Stiglitz said, ‘The reason why the invisible hand often seems invisible, it’s often not there’. To mitigate supply and grid risk, governments will play a key role in the development of interconnectors, smart networks, and storage technologies.
The desire for politicians to insulate communities from all the implications of a subsidy-free world at does not negate the business challenge of merchant pricing. Project owners will need to re-examine their business models in a merchant world. This new world requires a new outlook, new analytical tools and new ways of doing things.
·Kate Freeman is managing consultant at UK renewable energy consultancy BVG Associates