Offshore Wind Tender Design in Need of Overhaul to Meet Climate Ambitions

Record high auction results for the most recent German offshore wind tenders, and the decision to increase maximum bids for new Dutch tender arrangements, have resulted in strong criticism from industry representatives. They have expressed a number of concerns about the future of EU offshore wind energy, as they fear that:

This article discusses potential consequences of high-capped or uncapped auctions (referred to as ‘negative bidding’ in some recent publications), as well as various other design aspects of tenders for offshore wind parks. We conclude that a number of qualitative aspects of tenders deserve more attention in auction design, for example the safeguards that ensure a timely construction of wind parks, innovation, and strategic autonomy in the offshore wind supply chain. Incorporating these aspects directly into the evaluation process (e.g. awarding points for performance on these aspects) could be a more effective and efficient way to reach these goals than capping price competition.

Revenue maximation has generally been one of the key parameters for authorities in the design of tenders and auctions. This explains why governments have quickly moved from tenders based on a subsidy level, via zero-subsidy tenders, to pay-to-build tenders, translating into higher government revenues than before. In the past, governments have been called out for putting too much focus on revenue maximation in auctions – including electricity-market-related auctions – rather than on qualitative aspects. These, for example, include timeliness, technical aspects, environmental impacts, system integration or knowledge sharing. A positive development has been that more and more governments around the world, especially in Europe, have been experimenting with non-price criteria in their wind energy auction design.

In July 2023, German tenders for offshore wind parks were awarded to newly-created subsidiaries of BP and TotalEnergies, who bid close to EUR 2bn per GW of installed capacity. The sites are not pre-developed by the government and the companies pledged to develop the wind farms without any state support. This prompted an additional “dynamic bidding procedure” in which developers pay for the right to develop the project. This meant developers entered a second round of uncapped bidding and the tenders were awarded based on a ‘price only’ basis.

In this new set-up, auction winners have to pay 10 percent of the bid upfront, whereas the remaining 90 percent will be paid during the 20-year exploitation period, starting in 2028. When taking into account a 3.24 percent discount rate (equal to the 10-year eurozone SWAP-rate at the moment of writing), the net present value amounts to EUR 1.35bn per GW and is thus – due to the long time horizon – substantially lower than the nominal bid. As the total costs of developing offshore wind projects excluding licensing costs are EUR 2bn to EUR 2.5bn per GW, this implies that the entry fees increase investment costs by about 60 percent. The German government will spend 90% of the revenue to fund the grid connection costs, 5% to protect maritime biodiversity, and the remaining 5% to support sustainable fishing.

In the remainder of 2023, Germany will also tender 1.8 GW offshore wind energy projects on pre-developed sites. The new tenders will not apply the uncapped “dynamic bidding procedure” and will include non-price criteria such as environmental conservation, contribution to a skilled workforce and the existence of PPA contracts. Figure 1 shows an overview of German and Dutch offshore wind auctions between 2023 and 2026.

The Netherlands was the first country to apply non-price criteria in its offshore wind tenders (Hollandse Kust West, awarded in November 2022). In the upcoming Dutch IJmuiden Ver offshore wind tenders, qualitative aspects taken into account include the knowledge and experience of the project parties, the circular design of the wind farms, knowledge sharing, and restoring the marine wildlife and ecosystem. However, the Dutch government noted that it expects that there will be little variation between bids based on these qualitative aspects. If there is little expected variation on qualitative aspects, the most efficient outcome from a societal perspective is increased competition on price. If prices are not very high and/or are capped, this could result in increased competition on qualitative aspects, with more resources invested to make wind energy production more sustainable.

To allow for variation between the applications for the IJmuiden Ver tenders, the Dutch government therefore decided to increase the financial bid cap. That changes the dynamics from qualitative bidding to increasing focus on financial bidding. Bidding for the Hollandse Kust West site was capped to EUR 66m per GW, in a one-off payment. For the upcoming IJmuiden Ver Alpha & Beta tenders, the Dutch government has increased the maximum financial bid to EUR 8.4bn per GW, to be paid over a period of 40 years. The winner must start payment during construction. The requirement of up-front payments increases costs and risks to developers (as it imposes additional costs on them before income is generated and it increases the costs of pulling out of a project when market conditions change), but it could also incentivise the contract winner to develop the wind park in a timely fashion.

Even though it is possible that the winners of the German tender bid high, due to a fear of missing out, for example, higher auction results could also signal increased interest by oil and gas companies in offshore wind projects. There are various reasons for the increased interest by large oil and gas companies in offshore wind projects. This could be due to high expectations about future energy prices and due to lower return requirements. The increased interest by large oil and gas companies may have also resulted in more competition for recent tenders in Germany and the Netherlands, and thereby – given the scarcity of available locations – in higher auction prices. Also, as investors are increasingly attentive to the effects of the energy transition for the – longer term – declining core business of oil and gas companies, some of these companies are diversifying into the growing renewable energy market.

The other main reason that oil and gas companies are interested in renewable electricity generation is to produce green hydrogen that can be blended with other gases into the existing EU gas grids. There is a strong momentum for hydrogen in the EU, for example due to consumption targets in REDIII (for industrial use of hydrogen) and the ambitions in REPowerEU that, among others, aims for the production of 10 megatons (Mt) of renewable hydrogen by 2030. This will require the deployment of 120 GW of electrolysercapacity, powered by an estimated 500 TWh of new renewable power generation sources like offshore wind. Some EU countries have also defined hydrogen blending targets for 2030.

The hydrogen blending strategy would give the fossil fuel industry the opportunity to gradually infuse a compatible energy carrier into their existing fossil fuel infrastructure rather than shifting to a completely new business model. In addition, oil and gas companies can also use their own produced green hydrogen in their refineries to, for instance, lower the sulfur content of diesel fuel. Having the possibility to use their own green electricity for this purpose provides opportunities to create an integrated business model, which is an advantage that traditional offshore wind developers do not benefit from. It is also relevant to add that oil and gas companies have a lot of experience in large offshore projects, which could give them an advantage in developing offshore wind projects. Increased attention from large oil and gas companies – with deep pockets – is therefore not necessarily a bad thing and may actually help the transition of this sector toward greener energy.

The situation is not favourable, however, for the traditional offshore wind developers without high cash flows from a fossil fuel business. Typical developers will find it challenging to provide bids in the same range as oil and gas companies due to the different financial profiles of these companies. Thus, if uncapped or high-capped bidding becomes a trend, there is a high risk that offshore wind developers with no fossil fuel business would be out of the game. Due to the technology involved and the scale of investment required to build offshore wind parks, the market for offshore wind parks is already a concentrated market that does not involve many players. It is not clear how this new trend would affect market concentration in the long term and whether (and how) increased concentration of ownership of offshore wind parks would result in sufficient market power to distort the total electricity market. Thus, it is important that governments ensure that the electricity market remains sufficiently competitive.

Another criticism from the traditional offshore wind industry players against high-capped or uncapped bidding is that it would increase electricity prices for the end users. In the EU, wholesale prices of electricity are determined mostly on the European Power Exchange (EPEX), where electricity is traded on intraday, day-ahead, and forward markets. EPEX covers 13 European countries: Austria, Belgium, Denmark, Finland, France, Germany, Luxemburg, the UK, the Netherlands, Norway, Poland, Sweden and Switzerland. Market coupling (of both the markets for electricity generation and of cross-market transport capacity in and between the various coupled markets) within EPEX is designed to minimize price differences between markets and ensure an optimal use of cross-market transport capacity. Electricity market coupling is also taking place with various other European countries, even though these use different exchanges.

In a competitive market like EPEX, the match between supply and demand based on the marginal costs of the most expensive – in terms of variable production costs – operating power plant is what determines the electricity prices. This mechanism is called merit order. Owners of plants with lower variable production costs, will earn a premium (also known as an inframarginal rent) that allows them to cover their fixed costs and profits, while owners of plants with higher variable costs could opt to not produce electricity, because the selected electricity price will not cover their variable costs in the short-term nor their fixed costs in long-term.

An important implication of the way this market works is that fixed costs – including entry fees for offshore wind parks – do not impact short-term electricity prices. If investors pay high entry fees for offshore wind farms and as a result are incurring a negative return on their investment, they will not be able to pass these costs on to end users of electricity. Once offshore wind parks have been built, their developers – regardless of the entrance fees that were once paid – have few options beyond selling electricity that is produced at the maximum possible price.

While high fixed costs do not directly affect electricity prices in the short run, they do have a possible effect in the long run. Increasing fixed costs could increase the Levelized Cost of Electricity (LCOE) of offshore wind energy, which has decreased by 59% between the first half of 2010 and the first half of 2023 (see Figure 2). The offshore wind industry is concerned that uncapped or high-capped bidding could increase offshore wind LCOE.

If returns on investment in offshore wind parks turn out to be unfavorable, this would reduce the appetite to invest in future projects. However, if these unfavorable returns are due to overpaying for entry fees rather than an insufficient net operating surplus (income from electricity sales minus operating costs, including depreciation), the market is likely to recognize this. Therefore, it is unlikely that there will be no parties willing to invest in future offshore wind projects. Rather, auctions will result in lower bids (or no bids). We saw this with auctions for telecom and radio frequencies in the past, for example. It is important to note here that the auction results can be observed by market players on a project-by-project basis, which means they are able to make a distinction between projects that are losing investors’ money because of high entry fees and projects that are performing poorly for other reasons.

The high-capped or uncapped bidding system could also make the market unattractive for new investors and developers, especially the ones without sufficiently deep pockets. In a recent case, Ingka Investments' head of renewable energy investments stated that even though their plan is to expand their offshore wind business in Asia and European countries, it is abstaining from investing in markets that deploy high-capped or uncapped bidding in their tenders. However, even though high-capped and uncapped bidding is likely to affect the structure of the market, it is not clear whether it will result in market failures.

The increased risk of projects not being built is one of the most convincing points of critique on the high entry fees resulting from (uncapped) auctions. As offshore wind parks are generally developed within SPVs (Special Purpose Vehicles), losses to the ultimate owners are limited in the early project phase. In this phase, the costs of abandoning a project depend on equity commitments and loans made by parent companies. The recent pulling out of Vattenfall from the UK Norfolk Boreas offshore wind project – after the costs of developing the project increased steeply – illustrates this risk. The UK's latest CfD (Contract for Difference) auction (AR5) for renewable energy projects that resulted in zero offshore wind bids, is the most recent case in which the industry flagged the disproportion between the soaring costs and the auction price of the UK’s CfD mechanism. However, the fact that the tenders for these projects were based on a CfD – where the operator pays the government if electricity prices are high and receives a subsidy if electricity prices are low – also illustrates that this risk is not limited to high-capped or uncapped bidding auctions.

BloombergNEF has recently calculated that the high entry fees in the recent German auctions could decrease developers’ unlevered, pre-tax equity internal rate of return by as much as 4.4% compared with projects that are not subjected to similar development costs. This could make such projects financially unattractive for developers and could result in another no-show auction similar to the recent UK case.

If a higher share of expected profits of offshore wind parks goes to governments, the probability that project owners will pull out of a project when market conditions change after a tender is awarded becomes larger. If companies use the option to pull out, the government will need to restart the auction process, which will inevitably result in delays and therefore slows down the energy transition. Also, if pulling out goes together with the bankruptcy of an SPV, this might impose costs on the supply chain, thereby increasing supply chain risks.

To ensure a timely completion of offshore wind projects, it is therefore important that governments design their tenders in such a way that the option to pull out is limited. This can be done by requiring an up-front payment or by requiring sufficient equity commitments from parent companies, for example. This aspect of tender design should also take into account the costs to society of delays in the achievement of climate goals, that are caused when a project is delayed when an offshore wind park developer pulls out. A downside of limiting the option for companies to pull out when adverse market development occur, is that it reduces expected returns. High upfront payments are likely to reduce the appetite of investors for tenders and will also result in lower bidding. Therefore, governments are wise to balance the aim to reduce the risk that companies pull out against the aim to ensure there’s enough appetite from prospective bidders and the aim to maximize auction results.

A related risk is that of a “no-show” in offshore wind auctions. This happened in a recent UK CfD auction, which failed to attract any bids at all. While the consequences – delays in the construction of planned offshore wind parks due to redoing the tender process – are similar to that of parks not being built after a successful tender auction, the causes are different. In the UK CfD auction, the maximum price that the winner could get for electricity was fixed at a relatively low price compared to the high – and uncertain – construction costs of building the park. If there would have been more flexibility, the UK auction would have been far less likely to result in a no-show outcome.

As noted in our recent article, the EU offshore wind industry is facing significant supply chain challenges, despite the positive outlook originating from EU and national targets. Project cancellations or project delays could amplify these challenges, as they take away order volume that the supply chain players, such as the wind turbine manufacturers, were expecting to help improve their financial situation. This is another reason to ensure that auction winners have sufficient incentives to discourage them from pulling out. Given the EU-aim of strategic autonomy in developing renewable energy, governments could design tenders in ways that favor the European supply chain. Improved financial conditions within the supply chain are likely to increase investments in innovation and product optimization. In contrast, further stress on the European offshore wind supply chain will most likely delay required investments, which could start a reinforcing feedback loop leading to more delays even if the financial situation would improve for the wind industry. In this situation, the delays in projects would lead to delays in the supply chain (for example, due to insufficient capital to invest in expansion and upgrade of the supply chain) and this could lead to further delays in project development and an increased dependency on foreign suppliers.

Delays in the global supply chain have already affected the financial viability of some offshore wind projects, and have been highlighted as one of the main reasons for Ørsted's recent major write-down of more than EUR 2bn. It should be noted that due to the scale and complexity of offshore wind energy projects, developing the supply chain does not happen in a short timeframe and it is capital intensive. Therefore, to make a balance between supply and demand if the offshore wind targets are to be achieved, it is important to strengthen the European supply chain, avoiding the risk of increasing dependency on non-European actors.

The wind industry is under pressure due to the bottlenecks in the supply chain. High inflation, capital costs and rising interest rates are threatening the financial viability of already-planned offshore wind projects (with developers starting to negotiate for tax reductions and renegotiating offtake contracts). Some developers have encountered unwanted delays and even cancelled projects bearing financial losses. Slow permitting, geopolitical unrest and Covid-19 are also to blame for making the EU offshore wind industry and the supply chain vulnerable. At the same time, it should be considered that insufficiently revenue-driven auctions may result in implicit transfer of public money to private investors, which would not be desirable from a public perspective.

Uncapped or high-capped offshore wind auctions, and a number of recent cases where already-tendered offshore wind parks are delayed because of developers pulling out, have raised valid concerns about risks to the speed of the energy transition (due to a lower pace of realising new offshore wind farms) and about strategic autonomy (requiring a healthy European offshore wind supply chain). With the very ambitious climate targets that the EU has, and to keep the region’s wind industry a notable “success story” as described by the current president of the European Commission, Ursula von der Leyen, it is even more critical for EU governments to support the regional wind industry and achieve strategic autonomy in offshore wind development. Therefore, rather than large financial payments being the central goal of auctions, government would be advised to redesign their bidding systems in ways that increase incentives to finish the construction of projects in a timely manner, and that support the development and innovation of a European offshore wind supply chain. It will be a balancing act for governments as they need to take both the public interest – financially, but also with respect to climate ambitions – and business interests into account when (re-)designing tender processes. In the recently announced “Wind Power Package”, the European Commission pledged to support the European wind industry through fast-track permitting, by focusing on skills, access to finance and a stable supply chain and by improving the auction systems in member states. Further details published on the wind power package will reveal whether high-capped and uncapped bidding will be addressed in the new EU supporting policy.