Following on from my blog on LCOE basics, I thought we should now look at the complexities of WACC. In the context of offshore wind, WACC is important. If we use typical values for CAPEX and OPEX, a 25-year life and a WACC of 10%, then over half of LCOE comes from the cost of finance. This figure from my white paper of last year on technology and WACC in offshore wind shows the relationship between WACC and LCOE for a typical offshore wind farm. Reducing WACC from 10% to 5% drops LCOE by over 30% and the LCOE share of finance cost to below a third. Taking WACC to zero more than halves the LCOE in this situation!
Is it realistic, though, to think in terms of such large differences in WACC? The answer is yes, and the reason is the quiet revolution that has been going on in offshore wind finance over the past 5 years or so. When BVG Associates led the first LCOE technology pathways work for The Crown Estate in 2012 , the cost of finance had been stable for a while, and it was unremarkable that we used 10% as the baseline WACC for this work. This was consistent with developers owning projects and partially re-financing them after construction. The revolution has come through the adoption of new project finance structures which are accessing high proportions (up to 75%) of debt funding through the construction phase, at low rates (less than 5%). Coupled with softening expectations by the equity holders, this has driven WACC down to 7% and below in some cases.
With TenneT securing bond finance in May this year for offshore wind transmission projects in Germany at 2% interest over 20 years, the evidence is there that finance costs could fall further. Yes, a transmission asset like that is something of a one-way bet, but even with a suitable risk premium for offshore wind assets, there seems scope for further significant reductions.
So WACC is important, but what actually is it?
Simplistically, WACC is the weighted average cost of finance, where the weighting is based on the share of funds provided from different sources. Using this method, an equity provider supplying half the funds to a project with an expectation of realising 15% and a lender providing the other half as debt at 5% interest leads to a calculated ‘WACC’ of 10%. Well, yes and no!
This calculation works fine when you get your capital back at the end of the period. But in offshore wind, and in most other power generation sectors, the value of the asset reduces to effectively zero over its life. So the finance payments have to cover the repayment of the capital as well as the interest. This means the true WACC is higher than the simple calculation above.
Lenders providing funds for much less than the full life of the wind farm – say for 15 years rather than 25 years – further complicates this situation, and increases the true WACC. As everyone who ever had a credit card debt knows, it’s always cheaper to pay off the high-interest rate debts first if you can!
So what, for offshore wind?
In the case of offshore wind, then we can see that:
• Reducing WACC has already had a significant impact on LCOE
• There is still plenty of scope left to reduce LCOE further by even lower WACC (assuming interest rates remain low and reasonably stable)
• There is evidence that further WACC reductions will be seen
• It’s not just about borrowing cheaply – you also need to borrow that cheap money for as long as possible, or plan to re-finance with cheap debt when the original debt is paid off.
I suspect that the competitive auctions coming up in Netherlands and the UK will provide confirmation of further progress in reducing WACC and hence the LCOE of offshore wind.
BVG Associates and LCOE.
BVG Associates has been at the heart of modelling levelised cost of energy for offshore wind and other energy systems for over 7 years.
We have delivered landmark analyses and reports for RenewableUK, The Crown Estate, the Committee on Climate Change and IRENA (in final edit).
We have delivered strategic-level LCOE analysis for major developers and energy companies, covering subject such as the potential for floating foundations, the opportunities presented by large project pipelines and the spatial variation of LCOE across multiple national waters.
Our analyses of the LCOE impact of specific innovations has successfully guided technology suppliers involved in advanced modular blades, airborne wind systems, offshore foundations, condition monitoring technology and complete new turbines.
Our approach has become the industry standard, and is used by DECC, ETI, ORE Catapult for offshore wind, and by KIC Innoenergy for onshore and offshore wind, solar power (PV and STEG) and other technologies. We are using it in the H2020 Maribe project to compare combined wind and wave platforms .
Giles Hundleby
Director
BVGA
