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In this quarter’s CIO View, we talk about the Offshore Wind being sector hit by a perfect storm of rising costs of materials along supply chains, rising interest rates and increased technical challenges.

EdenTree CIO View: Q3 2023

Charlie Thomas Charlie Thomas Chief Investment Officer (CIO)
Opinion

EdenTree CIO View: Q3 2023

Charlie Thomas

Charlie Thomas
Chief Investment Officer (CIO)

Navigating offshore crosswinds

Offshore wind appears to have been blown off course in recent months. In September, the UK’s annual auction for new offshore wind developments failed to yield any bids. Then in early November, Danish offshore wind giant Ørsted pulled out of two US projects, resulting in an impairment of $5.6bn.

So, what’s happening? In short, the sector has been hit by a perfect storm of rising costs of materials along supply chains, rising interest rates and increased technical challenges.

Developers have been further impeded by low pricing from governments who have been slow to respond to new pricing conditions, in part due to cost-of-living pressures for consumers, and have been reluctant to raise all-important price floors to levels that sustain margins and incentives for expansion in the sector.

The pricing approach has also been problematic. Prices are often struck during the bidding phase of the project with government providing a price floor. Although these are inflation-linked they effectively lock the developer in to prices set years ahead of the end the project. Indeed, the recently completed Seagreen wind farm off the coast of Scotland which has 114 turbines with spans as large as 164 metres took 14 years to complete.

Inflation, de-globalisation, increased engineering challenges associated with scale – each has put pressure on costs. Notably, costs for some projects have increased by as much as 40% in the recent inflationary period.

So, for developers, the price agreed at the start of a project carries a great deal of risk, yet towards the end of the halcyon days of the 2010s, some developers were willing to strike unrealistically low prices. These prices effectively assumed a continuation of low borrowing costs, technology advancements at a reasonable price and deflationary pressures – a stark contrast to today’s environment.

A further concern against this backdrop has been a reduction in standards during the innovation phase, with component problems coming to light that should have been picked up at the testing stage. Fortunately, this has been a rare occurrence.

What does this mean for the future of the sector?

Although the industry is going through a painful reset, there is little doubt offshore wind remains a vital tool for the energy transition. It can be more productive than onshore wind and solar farms, especially in populated North American and European locations where offshore wind farms can be built close to major cities, such as London and New York.

For this reason, governments have introduced ambitious installation targets in recent years, with parts of Europe (including the UK) looking to expand offshore wind from about 30 to 120 gigawatts (GW) by 2030, and the Biden Administration aiming at 30GW of offshore wind capacity by 2030. Europe wants wind (both onshore and offshore) to make up about 40% of electricity consumption by 2030, up from 17% today. The UK is already a standout in this regard, with some 40% already coming from combined sources of wind power.

Given the recent pullback in projects, some of these targets seem like they would be challenging to meet. But if governments are serious about meeting them, they will need to support a reset in the industry.

Some further context is also needed: offshore wind is still a relatively nascent technology. It accounted for only 13% (less than 3GW) of installations in Europe in 2022, and around 9GW globally, compared to around 350GW of new capacity in solar last year. To reach 2027 targets, annual installations globally (excluding China) would need to reach 77GW (Source: Wood Mackenzie) – a sharp increased on the average of 3GW installed annually between 2015 and 2021 (excluding China). Indeed, IRENA suggests offshore wind capacity needs to growth from about 70GW globally to 2,000GW by 2050, to support the Paris Agreement, although targets of that scale are not currently in play.

What does a reset look like?

We are seeing some positive signals from Europe, where there is a push to simplify the permitting process, with further revisions expected to the Renewable Energy Directive. The current auction model is not working effectively and governments will need to consider how to accommodate higher prices to support the market. In our view, it is unlikely governments will pull back from offshore wind targets, either on political and economic grounds, given their obviously long term benefits and ability to contribute meaningfully to the Paris climate goals.

Grid connectivity remains an ongoing challenge, with significant investment required to update grids to enable faster connectivity. And investment needs to ramp up in the offshore wind supply chain. Analysis from Wood Mackenzie suggests $100bn needs to be invested in the supply chain to reach 2030 targets, but also that targets beyond 2030 need to be firmed up to give the supply chain confidence about demand longer term. An easing of trade tensions with China could also significantly improve supply chain dynamics.

What does this mean for investors?

As specialist investors in the renewable energy sector across a range of funds at EdenTree, we have watched these dynamics play out for considerable time, with many key developers experiencing severe margin compression. For that reason, we have avoided investment in pureplay wind farm developers for considerable time in our portfolios – keeping true to our investment philosophy and the flexibility we have in our diversified portfolios to avoid entire sectors where risk-return profiles don’t add up – preferring businesses such as utilities with matched revenues (SSE, for example) or specialist component manufacturers such as Italian cable company Prysmian. Similarly, our investments in listed green infrastructure are focused on asset owners, rather than manufacturers; these are assets with solid (predominantly) inflation-linked cashflow. The current slowdown in installations could make these incumbents more valuable.

As a team, we continue to watch developments closely and are encouraged by signs that today’s crosswinds are starting to be worked through in a constructive way: for example, the UK government recently revealed plans to increase its ceiling prices at the next auction. Longer term, we continue to see offshore wind as a vital component in the green revolution.

Charlie Thomas CIO, with contributions from fund managers Tommy Kristoffersen and David Osfield

IMPORTANT INFORMATION

The views contained herein are not to be taken as advice or recommendation to buy or sell any investment or interest. Please note that the value of an investment and the income from it can fall as well as rise as a result of market and currency fluctuations, you may not get back the amount originally invested. Past performance is not necessarily a guide to future returns. EdenTree Investment Management Limited is authorised and regulated by the Financial Conduct Authority and is a member of the Investment Association. Firm Reference Number 527473.