Description

SUMMARY

During the past decade, Ørsted A/S (Ørsted) underwent a sweeping and successful transition toward a tight focus on offshore wind development.  Due to the economic nature of offshore wind development (i.e., awarding the PPA terms years before the long construction period even begins), however, Ørsted and other offshore wind developers face a crisis on awarded-but-not-yet-constructed projects that the market has not yet acknowledged.

TOPICS

• Ørsted’s Pivot to Offshore Wind
• How an Offshore Wind Project Resembles a Bond, and How It Doesn’t
• A Bond vs. An Offshore Wind Project
• The Problem for Ørsted
• Valuation and Sizing
• Personal Industry Experience

(1) ØRSTED’S PIVOT TO OFFSHORE WIND

During the past decade, Ørsted A/S (Ørsted) underwent a sweeping and successful transition toward a tight focus on offshore wind development.  Due to the economic nature of offshore wind development (i.e., awarding the PPA terms years before the long construction period even begins), however, Ørsted and other offshore wind developers face a crisis on awarded-but-not-yet-constructed projects that the market has not yet acknowledged.

From Oil & Gas to Offshore Wind

In the past decade, Ørsted reinvented itself from an oil and gas company to a full-fledged renewables company, with a tight focus on offshore wind.  The company began as Danish Oil and Natural Gas (DONG) during the 1970s oil crisis.  In response to oil prices spiking in the Middle East, Denmark began drilling in the North Sea.  In the 2000s, DONG made an ill-timed bet on natural-gas power plants, but as part of the merger picked up a company that had built the world’s first offshore wind farm.  In 2012, during an internal review, then-CEO Henrik Poulsen decided DONG only had an edge in offshore wind.  DONG took radical action and over time set out to divest all of its carbon-producing assets to focus on wind for the most part—with a tight focus on offshore wind.  (The Danish public was unhappy, arguing the oil and gas assets were sold too cheaply.)  Since the transition, Ørsted has produced admirable ROCEs on its offshore wind projects.

Ørsted’s ‘Farm-Down’ Maneuver

A signature technique that has goosed Ørsted’s returns is ‘farming down’ the project once it has reached a certain level of development.  The ‘farm down’ typically entails Ørsted selling 50% of the project ownership to a financial buyer with a lower risk appetite and a lower hurdle rate (e.g., a utility earning regulated returns, an institutional buyer, etc.).  This approach enables Ørsted to intensify its financial performance around the development, bidding on, and construction of projects.  When the strategy works, it supercharges Ørsted’s returns (or allows it to bid substantially lower than a competitor that chooses not to farm down).

One might compare it to house flipping.  A house flipper could bid on a home (analogous to bidding in an offshore wind RFP), fix it up (analogous to constructing the wind farm), and rent it out for 10-30 years (analogous to selling the wind power to, say, PSE&G customers via a 25-year offtake agreement).  But the house flipper prefers to relinquish the asset and find the next deal.  Ørsted has a similar appetite and discusses that explicitly in its materials and investor calls.

(2) HOW AN OFFSHORE WIND PROJECT RESEMBLES A BOND, AND HOW IT DOESN’T

In many ways, an offshore wind project resembles a bond.  For a certain upfront cost, the developer receives a stream of payments—typically via a pre-established power purchase agreement (PPA).

However, an offshore wind project and a bond are different in important ways, particularly: (1) the price certainty and (2) the lag between upfront payment and the first cash flows (“cash-flow lag”).  With a bond, the investor knows the price to the cent.  With an offshore wind project, engineers estimate the permitting and construction costs, but cost overruns are common.  Relatedly, with a bond, the cash flows begin after the purchase.  With an offshore wind project, a 4-to-7-year lag between when the developer decides upon the acceptable power price and when the revenues (or “coupons”) start to flow post-construction.

The screenshot below from an older Engie SA presentation below illustrates this dynamic—and provides color on the expected cash flow profile of a wind project.  The first few years reflect construction costs; then the project spends the first 20 operational years paying down 20-year debt; and then the project enjoys debt-free cash flows for the remaining 5 before retirement.  (The cash flow profile of a US offshore wind is more complicated.  The combination of an upfront federal income tax credit, bonus depreciation, and the 5-year MACRS drastically accelerate the cash flows to equity, then cash losses for many years, before seeing positive cash flows in the final 5 years once the debt is repaid.)

Viewed through this lens, winning an offshore wind project in 2021 is a bit like if an investor agreed to pay for a long-term bond, say, 3 years from then (2024), except the amount due (i.e., the construction costs) is unknown rises (or declines) with inflation (or deflation).  For years, this trade worked.  Developers benefitted from declining turbine costs.  In fact, bidders might even gamble a bit, officially bidding with a 10 MW design but pricing their bid based on a better, yet-to-be-invented 12 MW design.  Then, after winning, the developer requests and is granted permission to swap in the 12 MW design.

Today, the rise in inflation and interest rates wallops pre-established offshore wind project economics.  The expected construction costs, to be incurred years after establishing the agreed-upon PPA revenues, have substantially risen relative to when the developer bid into the RFP.  And the then-agreed-upon revenues now look way too low relative to current interest rates and equity hurdle rates (though in some cases they may have a market-price-of-power element to them).

(3) THE PROBLEM FOR ØRSTED

Constructed Projects (Good) vs. Under-Construction/Awarded Projects (Bad)

To appreciate the dynamic at play for Ørsted, one must separate (1) Ørsted’s constructed projects and (2) Ørsted’s under-construction/awarded projects into separate buckets—as shown below (with my red markings on it).

The constructed projects are performing well financially.  When Ørsted won those projects, not only did Ørsted face less competition generally, but it enjoyed a bigger wedge between its operational expertise vs that of competitors (i.e., could deliver projects at lower cost and on time).

The under-construction/awarded projects face headwinds.  Prior even to inflation spiking in 2022, offshore wind developer managements have acknowledged that due to increased competition, the ROICs baked into the winning bids have been decreasing globally—and that investors should expect lower returns for newly awarded projects.  In other words, to start, they were slated for lower returns due to competition, but now they also face the walloping effect of rising inflation and interest rates described at the end of the prior section.  (Fortunately for Ørsted, at least, its existing debt does not come due for a while.  Note that Ørsted uses balance-sheet financing for its projects, rather than project financing.)

The US Market

As the above Ørsted “Offshore wind build-out plan” chart shows, Ørsted won two big US offshore wind projects prior to the big inflation onset—the first two purple bars.

Certain dynamics for US projects exacerbate the problems.  In the US, offshore wind developers must participate in two separate auctions to play in the game.  First, a developer must win a BOEM lease just to get in the game (like buying a greenfield without being sure who will want to buy power from you and at what price).  Then, once the developer has the BOEM lease, it must win a state-level RFP to establish an offtake agreement.  In my view, this two-state auction structure causes humans to behave wildly.  It’s simply too difficult to model what appropriate behavior should look like.  (For example, imagine if upon entering senior year of high school, within a school the student’s parents had to competitively bid on the right for their children to go to college.)  I have spoken with industry executives who were shocked at the prices paid for the federal lease areas in recent BOEM auctions.

Second, bureaucratic red tape in the US has lengthened project development and increased costs.

Recent Examples of US Offshore Wind Developers Trying to Escape PPAs

As a current example of this whole dynamic at play, in late October two developers requested relief from their PPAs, but were rejected by regulators.  Avangrid has requested that the Massachusetts Department of Public Utilities (DPU) to consider renegotiations of PPAs for its 1,232-MW Commonwealth Offshore Wind Project (one of the earliest big awards).  They complained that the wind farm was not economically feasible under the existing contracts due to rising project costs, supply chain constraints, and interest rate increases.  Shell and its partner followed suit for their MA-based Mayflower Wind project—another early award.  The electric utilities slated to receive the power—Eversource Energy, National Grid PLC, and Unitil Corp.—told the DPU they did not intend to renegotiate the PPAs.  The DPU rejected the renegotiation request.

The rejection makes sense because (1) a deal is a deal and (2) the regulators are answerable to end-use customers who are feeling the bite of inflation too.

(4) VALUATION AND SIZING

Ørsted’s decade-long transformation has transfixed its business on the offshore wind industry.

The market hailed Ørsted for its profitable offshore (and onshore) wind project development, and its earnings multiple today reflects the continuation of its past solid economic performance.  But my experience with the underlying economics of offshore wind development—that it’s like fixed income, but even more sensitive to changes in inflation and interest rates—combined with increased competition more generally, means that investors should be bracing for difficult times ahead, given Ørsted’s tight focus on offshore wind.

If it was possible to short the offshore wind division of a ‘me-too’ offshore wind developer—instead of Ørsted—I’d recommend a sizeable position.  (But offshore wind reflects a minority of their business vs a substantial majority for Ørsted.)  The non-Ørsted offshore wind developers in particular are in for a ride in the coming years—particularly since managers at those companies have faced substantial internal pressure to move aggressively into the space.  But with Ørsted it’s wise to play something like this conservatively since, having personally worked on several big offshore wind development projects on a consulting basis, I can confirm that Ørsted is the most respected operator by a meaningful margin.  Ørsted’s balance-sheet financing lends more financial stability than the typical 70/30 project financing that’s common in the industry.  The fundamental economics of offshore wind project development for locked-in uncompleted projects will work heavily against Ørsted in the coming years, but the company has proven operational success compared to its peers.

(5) PERSONAL INDUSTRY EXPERIENCE

I have conducted detailed financial modeling on behalf of oil majors, advising them on how to bid into offtake agreements based on construction costs, project timing (which can affect tax credits and bonus depreciation), regulatory rules, farm-down opportunities, and resulting implied IRRs.  Sometimes I’d use Monte Carlo simulation to model competitors.  I’ve also done competitive research across the industry around targeted investment returns and so forth.  It’s an interesting area, and I’m happy to field questions in the messages.

Catalyst

• Continued inflation.
• Rising interest rates.
• Recognition of the poor economics of the projects in the Under-Construction/Awarded bucket.