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Offshore Wind Costs and Auction Price Bids: A Comment

Professor Gordon Hughes, Dr Capell Aris, and Dr John Constable

In 2017 GWPF published a paper by Gordon Hughes, Capell Aris and John Constable reporting data on offshore wind construction costs that suggested the industry’s claim to have achieved dramatic reductions was unlikely to be true, and that the low strike prices bid in the Contracts for Difference auctions had other explanations.

The authors wrote:

We infer that developers see the CfD as a low-cost, no-penalty option for future development, and that, because the contract is easily broken once the windfarm has been built, they regard the price as a minimum not a ceiling. Should the market price rise above the contracted price, because of rising fossil fuel costs or a carbon tax, they would cancel the CfD contract and take the higher price that would become available. (Offshore Wind Strike Prices: Behind the Headlines 2017)

Professor Hughes confirmed these findings in 2019 with a subsequent study also published by GWPF and showing that subsequent data on additional wind farms confirmed the earlier findings, and suggested that developers were gambling on being bailed out of their unsustainable Contracts for Difference bids at the consumer’s expense.

Professor Hughes wrote:

The UK Government is being pressed by lobbyists to adopt low-carbon policies, justified by reference to CfD auction prices that are patently unsustainable on the terms presented, but which are really a one-way option on higher market prices in future. In other words, low CfD prices are a way of creating positive public relations, and are offered in the expectation that developers can get out of the contracts, because the Government is committed to the future of offshore wind and will therefore have to bail out the industry with a high carbon price in order to save face. (Who’s the Patsy: Offshore Wind’s High-Stakes Poker Game)

Other papers on offshore auctions in Denmark, Germany and the Netherlands have highlighted the option structure of bids and the effects of differences in auction design. For example, the paper by J. Kreiss et al, “Auction-theoretic analyses of the first offshore wind energy auction in Germany”, Journal of Physics Conference Series, Vol 926, 012015 (2017), examines bidding strategies with minimal reference to costs.

These studies created a good deal of interest amongst thoughtful parties, and in 2019 Aldersey-Willliams, Broadbent and Strachan published, in Energy Policy, their own analysis of offshore wind capex as part of a study arguing that Levelised Cost of Electricity (LCOE) calculations for all technologies should be grounded in data from a study of audited accounts for the holding companies involved (“Better estimates of LCOE from audited accounts – A new methodology with examples from United Kingdom offshore wind and CCGT”, Energy Policy, 128 (2019), 25–35.), rather than the public domain data widely used, and in fact used by Hughes, Aris and Constable (2017). Aldersey-Williams et al. showed that this public domain data tended to underestimate the capital cost, and that higher costs were found in audited accounts in 15 of 21 projects examined. Aldersey-Williams et al. confirmed the Hughes et al. finding, but strengthened certain aspects of the conclusion, writing:

offshore wind farm costs are still much higher than those implied by recent bids for UK government financial support via Contracts for Difference (CfDs)” (p. 25)

very significant reductions are required to wind farm costs to offer economic projects in the context of current strike prices.” (p. 34)

Taken together these studies and the data sources they presented raised important and troubling questions about the effectiveness of the Contracts for Difference auctions in reducing decarbonisation costs, and indicate, as Hughes et al. have observed, that the system was being gamed.

It is therefore as surprising as it is disappointing that Nature Energy has chosen to publish a study, (M Jansen et al, “Offshore wind competitiveness in mature markets without subsidy”, Nature Energy, 27 July 2020), that attempts to take the discussion back to a more primitive and inadequate level of analysis, in which the bid prices at various auctions in Northern Europe are taken as a reliable indicator of underlying cost.

Though they cite Aldersey-Williams et al. they fail to engage with the empirical facts presented in that paper, which includes both the audited account data and the public domain data on capital costs reported by Hughes et al.

Indeed, Jansen et al. write that their modelling exercise to harmonize auction bids “creates a proxy for the actual costs of offshore wind”, when in point of fact both Aldersey-Williams et al. (2019) and Hughes et al. (2017) show that such an assumption is straightforwardly, empirically unsound.

It is also, it must be said, naïve from standard theoretical perspectives. After all, the distinction between prices and costs is fundamental to any introductory course in economics, where a first year undergraduate is taught that the conditions under which it is correct to interpret auction bids as indicators of costs are very restrictive. Should we believe that the cost to Apple of producing a modern iPhone is over £1,000? Of course not, since we know that Apple makes a margin of close to 75% for each iPhone sold. In the opposite direction, was the cost to Amazon of selling books and goods in the early 2000s reflected in the prices they charged. Again, no because their whole business model was – and is – based on selling items as loss-leaders for their cloud computing business.

There are whole sub-branches of economics devoted to exploring the reasons for and the consequences of divergences between prices and costs precisely because it is well known to be a matter which significant implications for the parties involved. For example, as most of the participants in the 3G spectrum auctions from 1999-2002 learnt with considerable pain auctions are a notoriously unreliable guide to costs and revenues.

In this context it is striking that Jansen et al (2020) have not examined any financial models of the offshore wind bids. If they had done so their arguments might be better grounded in financial reality.  Take, for example, the Kriegers Flak project in Denmark – one of their prime pieces of evidence. The contract is structured as an option on future power prices in Denmark and Germany. Vattenfall – the operator – has placed a bet of more than €500 million which they will only recover if real power prices in the 2030s are 3 to 4 times their current level. Vattenfall is a state-owned company with a large cash flow from its distribution and generation businesses in Sweden. Rather than returning this money to it owners or customers through dividends or lower charges it is choosing to place large bets on high risk options. Again, elementary economics tells us that under-pricing risk and capital is a standard way of providing disguised subsidies for politically-favoured projects.

Anyone who wants to make claims about costs – whether of renewable energy or any other infrastructure service – must first collect and analyse data on actual costs, as Hughes et al (2017) and Hughes (2019) and Aldersey-Williams et al. (2019) did. The fact that Jansen et al. (2020) actually cite this work but ignore its implications is extraordinary, and raises questions about the quality of peer-review at Nature Energy

The topic of wind power costs and particularly offshore wind costs is a live and important area of serious concern. Jansen et al’s paper is a retrograde step both methodologically and in its conclusions, and government cannot take comfort from its optimistic assertions. On the contrary, government should note that if enthusiasts for the offshore wind industry can do no better than Jansen et al. (2020) then there is clearly a serious problem with the underlying cost trends of this sector.