Risk/reward ratio transparency as a driver for offshore development

Offshore wind power has the potential to make a serious impact on the energy industry, but growth has been stunted by a lack of transparency in the risks and rewards for investors. The market is also experiencing a technology stalemate in which further development is slowed by the lack of dedicated technology, and at the same time the development of such technology is not getting funding due to a slow market. Policy makers can and ought to provide the catalyst to break the technology stalemate and to minimize the uncertainty that investors face with policy-driven risks.

Introduction
This article aims to highlight some of the current barriers to the ongoing growth of the wind energy industry. In particular, special attention is given to the issues and risks confronting investors and developers when evaluating the feasibility of an onshore or offshore investment prospect. Consequently, the investor/developer’s potential risks and rewards will be specifically addressed. That said, however, the investor’s risks inherently take into account the risks of other stakeholders in the endeavor, including the construction company, the asset owner, and a large selection of other stakeholders. Each of these organizations face unique risks and challenges at different stages of the project. For the purpose of this article, these issues will be addressed at a high level – taking a risk management point of view.

Black Swans in Offshore Investments
The risk management community in the financial sector is currently debating how to reliably deal with “black swans,” or incidents with very low probability but potentially catastrophic impacts. Black swan incidents are also characterized by the fact that, in practical terms, it is impossible to foresee how they will precisely unfold. The September 11th terrorist attack is an example of a black swan; the current credit crisis is another example.

While the black swan discussion is a key risk management challenge across the wind industry, it is especially pertinent to offshore projects. This is due to the fact that offshore developments have a number of attributes that could feed into a black swan situation: they are massive constructions that can potentially cause substantial damage to themselves and/or nearby structures or vessels; they are remotely located and can be difficult to access; they are a part of the European or national infrastructure; and safety risks that materialize may have more severe consequences than they would in other settings since infrastructure, especially medical infrastructure, is usually hard to reach. Compounding these factors further is the sheer scale of economics and the physical size of the equipment. As a result, any contingency strategy – which is a common method to handle risks of this nature – will be stretched in the sense that conventional commercially applied methods may not offer a feasible solution.

Uncertainty in Risk/Reward Ratio
It is important to recognize that the perception of risk, whether accurate or not, is a real issue investors need to consider. Politicians, media, environmental activists, bankers, insurance brokers, the general public and the work force involved in the development all have a perception of risk. This perception needs to be addressed as a tangible risk contributor, as any perceptions of unacceptable risks can turn into realized risks for the investor in terms of increased costs and failing income. This could take the form of, for example, unions with the perception of unacceptable risk levels related to work force safety, or environmental activists with the perception that the project has a potential (and unacceptable) impact on the environment. In these situations, the very notion of uncertainty contributes to the sum of risks that a potential investor faces.

A decision-maker makes decisions based on the risk/reward ratio of a given dilemma. The risk/reward ratio is a measure of what is perceived as a fair reward given the risks involved in the undertaking. In offshore development, both the risks and rewards are clouded with what is perceived as uncontrollable uncertainty. On the reward side, it is unclear whether the market mechanisms, such as spot market trading and the variable input/output mechanisms, are sufficiently designed to tolerate wind energy-specific qualities such as variable power output. In addition, the policies governing environmental issues, shipping routes, permitting procedures, etc. are perceived to be unstable and, given enough political incentive, are prone to change. Such changes could result in project losses, both in terms of lost income and increased costs related to the effort required to adhere to policy.

There is also perceived uncertainty as to what the risks really are. Cost of capital is now a risk factor needing consideration, along with other uncertainties pertaining to the capital markets. The supply chain, in terms of manufacturing, transportation, on-site assembly, operations and decommissioning, are also clouded with some uncertainties because the variables and trigger events are not fully mapped and understood.

Given the above discussion, it is fair to state that the lack of transparency into the risk/reward ratio stifles investment in offshore development. Investors instead turn to projects that are intuitively easier to understand, have a long track record, and in which all the stakeholders are comfortable entering into the project. In this discussion, offshore developments have been used as a specific example since the issues clouding their risk/reward ratio are easy to see and understand. However, the same argument applies to onshore wind development, albeit with less gearing of the risks.

The above discussion does not take into account investors who are making decisions based on political agendas, ideology, or similar.

Technology Drivers for Offshore Development
While the research and development (R&D) community and the industry in general invest time and resources in developing new wind energy technologies, it is clear that the dedicated technology for offshore-specific wind energy projects is not receiving enough funding. As with many markets in the early development stages, there is a “chicken and egg” dilemma involved: the lack of dedicated, tested, and reliable technology and manufacturing capability is holding the market back, and at the same time, the development of such technologies and capabilities is largely driven by market. Such a stalemate can rarely be overcome without implementing government measures, such as direct funding, ownership of assets, regulation and policies.

On the manufacturing capability side, one can argue that a critical level of demand needs to be reached before a manufacturer can justify investment in manufacturing capability and technology for offshore equipment. The same argument holds true for manufacturers of service and support equipment for installation and operations of offshore assets.

Such a development stalemate phenomenon has been seen before, and parallels can be drawn to earlier large infrastructure investments, such as telephone cable networks and electricity grids. In these cases, infrastructure was being stalled under a free market regime and a catalyst was necessary to propel development out of the early stage stasis. There were less complex mechanisms working around the telephone and electricity grid technologies than there are in offshore wind; the need and problem were so clear that the decision for government involvement was made intuitively without necessarily involving long considerations in risk/reward ratios and other related issues. The catalyst in these examples was more often than not some form of direct involvement and possibly ownership of the assets by governments.

The offshore wind industry shares common characteristics with the telephone cable and electricity grid industries, and should be provided with technology and capability catalysts through focused policies or other direct governmental involvement.

To facilitate educated policy making, an understanding of the risk landscape is required.

Macro Risks: Policies and Procedures
While companies can and will navigate risks through continued prudent management of their activities, they should understand that there remain external risk factors that are more difficult to influence directly. These risks are primarily political and procedural. An example would be where politics may dictate whether clean energy has priority over the general financial situation. In some countries in Europe, energy and environmental policies are based on firmly established values, and the risk of fundamental changes is low. However, in other countries decisions are based more on rational calculations or changing political agendas, and as the underlying variables change, so may the politics. Affected policies may include, for example, energy incentive programs, environmental protection, and more pragmatic areas such as relations and proximity to shipping lanes.

Considering these macro risks, it is clear that something can and probably must be done to accelerate onshore and offshore wind energy asset development if the political ambitions that have been voiced in recent years (for example, those based on environmental and security of supply considerations) are to be realized. It is necessary to pay attention to the motivation of investors, and to stimulate that motivation, while seeking to strike a balance that ultimately results in sustainable renewable energy succeeding. Thus the question becomes: what are the feasible options for this type of stimulation?

There is no easy answer to this; however, various interest organizations work tirelessly to influence and inform both national and EU political decision makers on the problem. The most visible and predominant stimulant used today are price subsidies (referred to as feed-in tariffs in the electricity industry) where the government adds an additional premium per unit sold and thus increases the margin. Such subsidies result in a pricing structure that makes the investment more attractive for investors. This, however, assumes that the project reaches a state where it is capable of producing power, is connected to an adequate grid, and has access to a market place where the power can be sold.

Dealing With Risks Going Forward
DNV engages with clients, partners, research institutes, policy makers and universities on an ongoing basis to remain up-to-date on issues across the industry. Through these relationships, DNV has been engaged in conversations about whether macro-level initiatives would be able to address these wind industry risks as a whole.

A more direct involvement of government could be beneficial, for example by taking a direct interest in wind energy project development, and by taking a share in the associated risks and profits. DNV would like to promote that line of thought, given that the project development is done in an intelligent and thoughtful manner. Such initiatives could result in a total aggregated market demand that reaches the critical mass to spur manufacturers and R&D entities to prioritize offshore R&D and related manufacturing capability. Though this opinion is based on some speculation, it would be a worthwhile exercise to spend time and effort on further analyzing the scenario.

Another initiative, with the potential to holistically address wind industry risks, could be the establishment of a European central R&D center for wind energy to support the development of wind energy, or, more broadly, renewable energy in general. Such a center could play a vital role in many areas: providing advice on policy and market place designs; defining standards for components, service providers, and workforce skill levels; and also by functioning as a central intelligence hub coordinating research efforts and publishing data such as a wind resource atlas. This center, conceptually similar in nature to the European Organization for Nuclear Research (CERN), would need public funding and sponsorship, and as such would live and die with political intent and power.

On the more pragmatic level, a study mapping the risks related to the lifecycle of onshore and offshore wind power, from concept to decommissioning, should be initiated. Such a study could be funded by interest organizations, governments, the EU, or other stakeholders with an interest in the expansion of offshore wind power. Such a study could be carried out today, but is contingent on the successful collation of industry knowledge (in terms of incidents, information on assets in operations, and related data), the risk management competence currently available in the industry (from operators, advisory services, manufacturers, etc.), and the required technical competence.

Any of these initiatives – either consistent government involvement, coordinated R&D efforts, or informed project risk mapping – have the potential to holistically address many of the risks associated with wind power project and indeed industry development. Specifically, initiatives of this kind could help solve the stalemate in offshore wind energy development by increasing the risk/reward transparency of offshore endeavors and consequently minimizing the risk uncertainty for potential investors.