UK braced for super-competitive CfD auction

On the back of several strongly-contested offshore wind tenders on the continent, the UK market is eagerly poised for what promises to be a super-competitive, and highly intriguing, second CfD auction. Financing heavyweights chewed over the dynamics at an inspiratia briefing hosted by Watson Farley & Williams last week 

The market conditions in which the UK's second contracts for difference (CfD) auction will be held create an intriguing financing environment for those projects that win.

The consensus is that offshore wind – which made headlines with record low prices in the Netherlands and Denmark last year [2016], and then again with zero-subsidy winning bids in Germany more recently – will be the round's biggest winner.

The auction results from Germany in particular may, for some, call into question the necessity of the CfD altogether, if wind farms can seemingly stack up on a merchant basis. But in reality, such projects will not be built until at least 2024, and the bids are based on a variety of assumptions, including around future power prices and turbine technology.

For Dong Energy, one of the two developers to win with zero bids in Germany, the UK market has sufficiently different dynamics that warrant keeping the CfD in place.

"We probably characterise what we did in Germany very specific to the project, the regime and also the market environment in terms of the power price," said Kunal Patel, Dong's head of structured solutions, at the inspiratia briefing last Thursday [27 April].

"It wouldn't make too much sense from our perspective to cut the feet off the market before it's fully demonstrated it can [operate without a subsidy] across the industry."

Mark Dooley, head of infrastructure, utilities and renewables at Macquarie Capital Europe, agreed that the German auction gave out a "false signal" to the market.

"Not a false signal as to where the market is going over time," he explained, "but certainly a very false signal if anyone has concluded from that that you can do an offshore wind project without subsidy or without revenue underpinning it in today's circumstances."

While the inspiratia panel agreed that zero bids were unlikely in the CfD, they were unanimous in believing prices would be significantly lower than the first auction in 2015. Indeed, a straw poll of attendees in the room had the clearing price for the 2021/22 delivery year at somewhere between £70-80 per MWh.

"It's not just the developers that are taking the pain [at those prices] – the financial community is expected to bear its share," said Allan Baker, global head of power and project finance at Societe Generale.

"The result is a downward pressure on terms – on pricing, but also on gearing and other terms that banks have got used to as standard in the industry – to get to the sort of return levels the developers are expecting."

Waste dynamics

An interesting side-story in this year's CfD is around how the fuelled technologies – particularly gasification/ACT – will react to having to compete at the levels being talked about. Such projects came away with tariffs worth at least £114.39 per MWh in the first round.

In the end, the fortunes of the 30-40 gasification projects that are expected to bid may well depend on their tactics in the auction.

"I'm aware of quite a few projects that are bidding into this round as a 'nice-to-have' and that creates an interesting bidding strategy for them," said Chris Holmes, a managing director at the UK Green Investment Bank (GIB), where he heads up the waste and bioenergy team.

"Whilst there might be a few disappointed bidders, a few will still have a project regardless."

The question then is whether the winning projects can secure financing. Two years on, only two of the five ACT or energy-from-waste projects from round one have made it to financial close or taken a final investment decision.

Indeed, the period since the first auction has been a rocky one for the waste sector, with EPC contractors exiting the industry and certain gasification technology providers entering administration. In addition, the 12-month window to secure financing has proved to be inadequate timeframe for the less-developed projects.

Holmes said, "That's the big challenge for ACT developers in this round – to make sure they have a fully-developed project going into the CfD auction process so they can hit the ground running should they be successful."

Holdco structures

Three offshore wind projects are expected to bid in the CfD – Dong's Hornsea 2, EDPR's Moray Firth and Statkraft and Innogy's Triton Knoll.

While Moray Firth is seen as the most obvious project finance opportunity at this stage, the others may be suitable for holdco financing structures, whereby debt is raised above the asset level.

Dong's model in particular, of selling 50% stakes either during or after construction, lends itself well to this strategy. Indeed, the Danish utility has done so on Gunfleet Sands, Westermost Rough and – most recently – with incoming investor Macquarie on Race Bank.

"The main advantage [of a holdco financing] is it allows unlevered equity participants to sit alongside levered equity participants," said Henry Stewart, a partner in the energy and infrastructure group at Watson Farley & Williams (WFW).

"That means you can attract wider pools of capital on both the debt and equity side. When you get these bigger projects, there's more liquidity generally."

Banks have shown to be comfortable with funding deals in a holdco structure, exemplified by Macquarie's £1.2 billion debt raise for Race Bank, though it remains to be seen whether that represents the limit in terms of liquidity.

Financing availability

While the banking market is liquid for offshore wind, the same cannot be said for those gasification projects that may come away with CfDs.

The GIB's Holmes noted a gap in the ACT market on the senior lender side. "Banks are taking a very dim view of the risks until it's operational," he said, adding it will probably take 12-24 months of consistent operation to attract lenders to the space.

It is a different story when it comes to the availability of equity in ACT, with an increasing number of investors prepared to understand the risks inherent in the sector.

The CfD's 150MW cap for fuelled technologies may allow somewhere between six and 10 projects to be supported, so the question then becomes whether there are enough projects to go around.

The situation is similar in the offshore wind sector, which is attracting a broadening range of investors in all stages of development. Competition for operational assets is particularly fierce.

"If we're talking about construction risk or late-development risk, when it comes to pure financial investors we are seeing people participating but often with some kind of wrap from the utility-developer," said WFW's Stewart.

"This means they're not taking pure development risk or even full late-development risk, and that obviously has a knock-on effect on IRR."

One interesting dynamic for both offshore wind and the waste sector will be the role of the GIB, which earlier this month was acquired by Macquarie Capital in a £2.3 billion deal. The bank has generally entered projects at or after financial close until now, but could play more of a developer role going forward.

"One of the incremental things that we bring that wasn't in the GIB playbook is development capital – a willingness to get exposed to the development phase," said Dooley of Macquarie.

"We see that as being a natural evolution for what the GIB will be doing as our green investment vehicle in Europe going forward."

Gearing up to bid

Prospective CfD projects are set to be notified whether their applications have been accepted on 16 May. After that, the timeline can follow one of five scenarios, depending on whether there are any non-qualifying applicants, and whether they appeal.

In the shortest timeline, the sealed bid window will run from 25 May to 1 June, while in the longest, it will be open from 14 August to 18 August.

Of the other technologies eligible to compete, biomass is said to be uncompetitive because – unlike ACT – projects have to pay for their fuel supply, while anaerobic digestion plants must be at least 5MW in size, which is said to be too large.

Tidal and wave have been set administrative strike prices three times as expensive as offshore wind, so their fortunes may be limited, and the market isn't aware of any geothermal projects that will bid.

So the consensus appears to be that offshore wind and ACT will likely scoop up the majority – if not all – of the CfD budget this time around. The result will be fascinating to follow, and if prices get as low as expected, there may be pressure on the government to revise upwards its installation targets, especially if the price is significantly below Hinkley's £92.50 per MWh strike price.

Panel:

• Allan Baker, Global Head of Power & Project Finance, Societe Generale
• Chris Holmes, Managing Director, Waste & Bioenergy, UK Green Investment Bank
• Mark Dooley, Head of Infrastructure, Utilities and Renewables, Macquarie Capital Europe
• Kunal Patel, Head of Structured Solutions, DONG Energy
• Henry Stewart, Partner, Watson Farley & Williams

Partner: Watson Farley & Williams

Date: Thursday, 27 April, 2017