The offshore wind and battery storage sectors continue to represent attractive investment opportunities and this is particularly the case in the current Polish market. By Robert Marsh, partner in London, and Tomasz Rogalski, partner in Warsaw, Norton Rose Fulbright.
Across European markets, many new projects continue to be developed, with numerous countries having recently pledged to increase the capacity of offshore wind farms and battery storage and with both becoming a key tenet of their national decarbonisation strategies, an increasingly important means by which the increased intermittency on the grid can be managed. In both sectors, the size of projects continues to increase, enabling economies of scale to be captured and the learnings from developed markets, such as the UK in the context of offshore wind and the US in terms of battery storage, to be carried into jurisdictions such as Poland, which is seeking to grow these sectors and attract investment from the international developer community.
This positive outlook is set against a backdrop of an increasing cost of debt, ever rising inflation, supply chain constraints, reducing subsidies and/or other forms of support and geopolitical volatility on a scale not witnessed in recent decades. Offshore wind faced its most challenging year in 2023, with large projects being cancelled by some of the sector’s leading sponsors, while battery storage has failed to be delivered at scale or to become the game changer for the European energy sector that so many were predicting pre-pandemic.
To date, there are no operational offshore wind projects along the Polish coast of the Baltic Sea, but the first wave of offshore wind projects is in the late stage of development and pre-construction. The Polish market faces the same challenges that these sectors experience elsewhere across Europe and globally but can share the same cautious optimism for 2024 and the medium term, as we explore below.
Challenges
* Supply chain and procurement challenges – While the renewable energy sector has been characterised by its resilience over the past three decades, weathering economic storms and a whole raft of regulatory and other challenges, the offshore wind sector stalled during 2023 in the face of severe supply chain constraints. The scarcity of vessels in the sector is a genuine issue and projects are facing increasing prices to secure the same, as well as the increased risk of losing availability should delays arise.
Projects are also having to lock in dedicated production slots with the turbine supplies and other equipment manufacturers much earlier in the development process than has traditionally been the case. Many developers are now entering into capacity reservation arrangements, sometimes up to seven years in advance of planned delivery to guarantee production slots and supply. Such is the competition for key equipment, that the terms of such arrangements are increasingly contractor-friendly and will often include requirements for payment guarantees from the relevant sponsor(s) alongside the applicable advance reservation payments, which will sit on balance sheet until a time the project can be leveraged later down the line, once ready to commence construction. As such, the earlier sunk development expenses for these projects have increased, expenses that are being incurred at this stage mean the project still faces a number of key decision gates including the award of contracts for difference (CfDs), available port infrastructure, timing of connection and various key consents and licence awards.
There are similar challenges in the context of battery energy storage system (BESS) projects, with a more compressed timeline when compared with offshore wind. There are well documented supply chain issues in the sector, driven by increased demand for batteries globally and original equipment manufacturers struggling to keep up on the supply side. This is compounded by the volatility risk exposure that comes into play with lithium prices. Most projects manage this through reservation agreements with original equipment manufacturers where feasible, which, of course, comes at an extra cost that is, in theory, balanced through minimising any delay risk.
From a general procurement perspective, offshore wind projects in mature jurisdictions such as the UK and the US are procured on a multi-contract basis rather than with one contractor wrapping the construction works and associated risks. Funders of these projects have become comfortable with these arrangements as the risks, interface risk relating to procurement, design, programme and delivery, are well understood as are the key focus areas from a mitigation perspective. We see projects in less developed markets adopting a similar approach and it is driven by the sheer scale and costs associated with these projects and the exceptional premium that an EPC contractor, should one be willing to accept such exposure, would be likely to charge if it were to wrap construction.
The development of BESS projects on the other hand, still lags behind the offshore wind sector and it is not uncommon to see projects of a certain size being procured using an EPC solution. That said, the US market has moved to a disaggregated model, multi-contract procurement being a common feature for projects in that market and making meaningful costs savings for sponsors. This is beginning to become a feature in some of the UK battery projects and we are likely to see more projects looking to disaggregate the procurement of batteries during the next 18 months.
* Affordability/construction cost constraints – Another significant challenge in both energy and infrastructure projects relates to construction costs and the volatility experienced in connection with certain commodities, such as steel and copper, as well as labour costs, in the past 18 to 24 months with contractors reluctant to assume this risk and fix their prices accordingly. In the context of offshore wind projects this has led to contractors pushing for price adjustment mechanisms in their agreements in order to factor in the possible increase or reduction in the cost of materials, labour and indexation which has an impact on price certainty.
There is a similar but perhaps less pronounced risk in the context of BESS projects given the demand for lithium-ion batteries and importantly lithium. From a project risk and bankability perspective, it is key to ensure there is some means by which this risk can be mitigated either through commodity hedging or a cap on any contract price increases and we’ve seen projects seeking to adopt either of these approaches.
* Grid infrastructure challenges – Grid connectivity continues to be another challenge facing those developing offshore wind and battery projects across Europe. The International Energy Agency asserts that grid connections are often the weak link in getting new low carbon projects underway. An evolution from fewer stable baseload dispatchable power plants to a large variety of intermittent generation sources places significant technical, financial, planning and policy pressures on decision makers and stakeholders.
The sheer volume of proposed new connections also risks clogging up the application process, resulting in delays to connection dates and a greater degree of uncertainly to those looking to develop or finance such projects. Investment in building out grid infrastructure is critical and has become an industry focus around the world, increasingly with government sponsorship. For proponents of projects, contractual provisions should outline both respective responsibilities and liabilities, as well as including realistic timelines and expectations and acknowledging potential grid capacity issues.
* The revenue stack – The long-term revenue of projects in these spaces underpins the investment case and bankability for projects looking to raise project finance or other debt. For many years, this has been heavily reliant on government support, in the form of direct subsidies, tax incentives and/or contracts for difference designed to provide projects with a hedge against power price risk. In more established markets this level of support has declined in recent years, for example in the UK the CfD strike price has dropped from £119.89 in 2015 to £37.35 in AR4 in 2022, and set against the challenges referenced, as well as considered in the context of a period of record power prices, projects have struggled to make the numbers work. Corporate PPAs can be part of the solution for offshore wind, as has been seen in the UK, providing a meaningful uplift to equity IRRs and making the projects more resilient to the wider price volatility in the market.
The battery storage sector has also struggled to make the revenue stacks work for both equity and debt in a weak revenue environment. In the UK, assets have struggled to, or not been able to, participate in the UK grid and have faced very low balancing market utilisation, with the government looking to gas-fired generation. Battery storage owners are having to shift their business model from an ancillary services model to an energy trading model, relying more on optimisation arrangements and long-term customer agreements. This has certainly led a to a slowdown in the delivery of projects, though the increased need for storage capacity seemingly remains clear in the context of the planned increased in intermittent generation through to 2030. Greater co-ordination between the transmission system operators (TSOs), governments and the industry will be required, though more direct connectivity between the battery industry and offshore wind, other generation technologies and commercial and industrial players would seem to be a logical progression.
* Challenges and opportunities for the offshore wind and BESS in Poland – The Polish offshore wind sector has attracted interest from large local and international developers following on from the contracts for the different support scheme. This is similar to the well-tested UK support for the offshore wind projects and decent investments conditions in the Baltic Sea and hopes to deliver 5.9GW of new capacity to the Polish energy mix by 2030 and 18GW in total by 2040. The Polish offshore wind projects are considered bankable by the debt market.
Challenges faced by the seven first wave projects, which are expected to become operational by 2027–2030, and more projects developed for the second wave, expected to become operational by 2040, are no different to those seen in other markets. The challenges include the complexity of the projects, time-consuming procurement in a multi-contracting strategy adopted by the developers, ongoing inflation pressure, associated capex increases requested by the contractors as well as supply chain constraints, including limited supply of the installation vessels, and specifically for the Polish market, its continued efforts to build the installation port infrastructure in time. However, the sector has a strong support from a government that is keen to gradually phase out coal in the country and shift production of electricity in a long-term scenario to a combination of renewables and nuclear power.
Intermittency of renewable energy supply , which is growing at a fast pace in Poland, and recent grid curtailments and negative electricity prices due to a large supply of electricity generated by renewables in the periods of lower demand, have increased discussions on the need for balancing supply and demand using standalone or co-located battery storage as well as the upside of storing curtailed electricity generated by co-located generating assets. Most of the battery storage assets are in an early development stage and have not yet faced most of the supply chain and construction challenges set out above.
The revenue stack available for battery storage projects in Poland resembles one seen in the UK and other European markets. It currently relies on long-term capacity market contracts whereas the wholesale energy market prices arbitrage and frequency response services have yet to be evaluated by the sponsors and the lenders. The response services will be introduced in Poland in June 2024 as part of the balancing market reform and are designed to incentivise short-term flexibility and send the right price signals to balancing power suppliers.
To see the digital version of this report, please click here
To purchase printed copies or a PDF of this report, please email shahid.hamid@lseg.com in Asia Pacific & Middle East and leonie.welss@lseg.com for Europe & Americas.
