Winner’s curse or the New Normal? The UK’s R4 offshore wind seabed auctions

The results are in

The UK has held its first ever offshore wind seabed lease auction. The results are seismic and will have wide-reaching implications for the offshore wind industry both in the UK and globally. Almost 8GW of potential offshore wind projects were awarded by the Crown Estate to four bidders or consortia:

• BP & EnBW won 3GW in the Irish Sea (2 plots of 1.5GW)
• RWE won 3GW in Dogger Bank (2 plots of 1.5GW)
• Total & GIG won 1.5 GW in the Eastern Regions
• Cobra Instalaciones y Servicios, S.A. & Flotation Energy plc won 480MW in the Irish Sea

The clearing prices ranged from £76,203 /MW/year up to more than twice that at £154,000 /MW/year for sites ranging from 480MW to 1.5GW. The Crown Estate will be collecting annual revenues of around £880 million until the sites reach FID or for a maximum of 10 years.

The winners are all new entrants to UK offshore wind apart from RWE and GIG. Many of the biggest names in offshore wind have not obtained any seabed leases in this round – including Orsted, Iberdrola/Scottish Power, Equinor, SSE, Vattenfall, Ocean Winds (EDPR/ENGIE), EDF, Shell.

Industry reaction has been varied. The winners have all issued positive press statements, some include details about how they plan to maintain reasonable return levels despite the high prices (e.g. see BPs press release stating they will protect returns by cutting the time it normally takes to get consent, grid connection and a CfD to FID). The response from incumbents has been more measured. Renewable UK, the trade body representing wind developers and generators cautioned that the high prices showed there was too little supply of seabed (8GW compared to the 32GW awarded in R3 in 2010) and that costs for developers and consumers would rise. The FT took a balanced view of the arguments either way.

This article kicks of a discussion about whether these prices represent the new valuations for offshore wind projects based on new business models, whether they show strategic value, or whether they show bidders overpaying to secure market share in a global industry crucial to reaching net zero.

The price of a seabed lease option

Clearing prices for The Crown Estate R4 Seabed Lease Auctions 2021

£/MW/year

Note: the order of the winners reflects the Crown Estate reporting of the results and not necessarily the order of winning bids in the auction

The prices paid are eye-watering. For a single lease of 1500MW this translates into an option fee payment of around £114 million for the lowest price up to £231 million per year. It is possible that the developer will have to pay this option fee for up to 10 years which would mean a total option fee payment of £1.1-2.3 billion (excluding inflation). This is a phenomenal sum of money for an offshore wind developer to pay upfront up to a decade before there is actually a project generating any electricity or revenue. These endeavours are already high CapEx infrastructure projects and developers face a lot of uncertainty and risk. The high prices imply a near doubling of the upfront cash requirement, which is typically £2-3 billion for a large offshore wind project. This is a significant financing requirement whether on or off-balance sheet.

The last time the Crown Estate allocated seabed to offshore wind developers (Round 3, in 2010) there was no option fee payment, just a rental payment agreed upfront and due once the wind farm was operational and generating revenue.

In the US (which has held seabed lease auctions for offshore wind for several years) the latest clearing price in Massachusetts in 2018 was $135 million per site (around £7,000-10,000 /MW/year based on our analysis). In other words, the UK auctions have cleared at a maximum price that is in round numbers 15-20 times higher than in the US. Clearly, the UK offshore wind market is far more established in terms of regulation, supply chain etc. But many in the industry will be asking themselves whether these high prices are sustainable and what business or revenue models must have been assumed to support them. If they are not sustainable, they risk undermining the long-term prospects of the booming offshore wind sector, and the UK’s transition to a net-zero energy system. Moreover, other countries looking to introduce their own processes for allocating seabed for offshore wind will be pondering how to interpret these numbers.

The location of the winning projects

The value of scarce seabed or winner’s curse?

The very high prices are clearly a result of high demand chasing after limited supply. In particular, traditional oil and gas companies are clamouring to invest in offshore wind as a way of diversifying their business and transform themselves into broader energy companies as the world pivots away from fossil fuels and towards a net zero model. There may also be an element of strategic value, acquiring market share and securing infrastructure in what is a rapidly growing global sector is likely to be high.

However, the high prices will also pose a challenge to the winners. Will they be able to build these offshore wind farms and make a reasonable return on them once they start generating in the 2030s? Or is what we’ve seen an instance of winner’s curse?

The problem of winner’s curse is well known in economics and auction theory since the 1970s when researchers analysed bidding for oil drilling rights in the Gulf of Mexico. They found that the winners were systematically those who were willing to make high, often unrealistically high, assumptions about the oil yield at these sites, or about future oil prices. As a result, the winners suffered below par returns for many years until more sophisticated auction bidding strategies and auction formats were developed. In short, the winner’s curse arises from value uncertainty and difficulties in predicting future revenues associated with an asset.

The auction format in this case also made it harder for bidders to benefit from price discovery and thus adjust their bids according to market information. The Crown Estate ran this as a sequence of daily sealed bid, first price auctions where the winner pays the price they bid. This has the benefit of maximising revenue but may not be optimal if you want to ensure efficient and welfare maximising allocations. The US seabed lease auctions by contrast are more dynamic with an ascending price that bidders can respond to in shorter bidding cycles and a second price format, i.e. the winner pays the price of the first loser (like an eBay auction). If that format had been adopted here the winner could have saved around £77,000/MW/year (or £230 million per year).

If it turns out the winners have overpaid for the seabed leases, and they struggle to raise finance or to make a good return on their investments, this will undermine the offshore wind industry and the attempt to reach 40GW by 2030 (and potentially 75GW by 2050).

The long-term consequences for the industry

The industry will need to take some time to digest the results and to analyse what they mean for future strategies, business models and return expectations. One potential consequence could be that when the winners come to bid in a CfD auction in the future, they will need to factor in this additional substantial cost item in their financial models – and therefore bid a higher CfD price than they would otherwise. Ultimately it is electricity consumers who will foot the bill for any CfD subsidies.

Of course it is also possible that there will not be a CfD regime any more by the late 2020s when these projects reach FID, and that the winners have in fact built their business cases and valuation models on the basis of new revenues from hydrogen production, battery storage attached to the wind farm or similar models that are currently being developed.

One thing is certain, this is a paradigm shift and will have major strategic implications for all the companies currently pursuing offshore wind as well as those considering entering this exciting and dynamic sector.

Alon Carmel, Carl Gustav Gordon, Quentin Potts

#offshorewind #renewableenergy #energytransition