May 21, 2008 -- Datamonitor

UK offshore wind development costs have soared over the past few years, making the economics of such projects marginal at best. However, at a time when other players are abandoning such projects on the grounds of sub-optimal returns, Scottish & Southern Energy is reportedly going ahead with the construction of the world's largest offshore wind farm.

A recent survey by KPMG International revealed that the top global power and utilities company executives fear a renewables "bubble". There are also serious industry doubts about the long-term viability of offshore wind farming. Despite this, Scottish & Southern Energy (SSE) recently confirmed that it would build the 504MW Greater Gabbard offshore wind farm off Britain's East coast. At capital costs of GBP2.58m per MW, SSE maintains that the project will meet its "rigorous investment criteria". The announcement comes just two weeks after oil giant Shell announced its intention to pull out of the 1,000MW London Array project, estimated at a lesser cost of GBP2m to 2.5m per MW. Shell cited soaring costs and difficulties in obtaining planning permissions as the main reasons for pulling out of the project.

Applying conservative UK financing standards (funding through non-recourse project finance, a project lifetime of 15 years and a discount rate of 8%), a generous turbine load factor of 45% and average offshore O&M costs for similarly large turbines, a Datamonitor cost and profitability model shows that the Greater Gabbard offshore wind farm project could run at -20% operating margin based on the reported three years lead time to power generation and the current UK Renewables Obligation (RO) framework and pricing.

Applying the same conservative UK financing standards, the current RO framework and more realistic UK offshore wind turbine load factors of 35%, a recent Datamonitor report entitled "Wind power market entry strategies - build or buy?" shows that the break even point below which UK offshore wind projects are profitable is GBP1.45m per MW capital costs and three years lead time to power generation.

It is, therefore, extremely likely that SSE is relying on the UK government's recent energy bill to be passed in its current form. The draft legislation - which introduces 1.5 Renewables Obligation Certificates (ROC) banding for offshore wind projects - would boost the project's operating margin to +20%, which would go a long way towards explaining the confidence and optimism that SSE has placed in the long-term profitability of the Greater Gabbard offshore project.

It is also very likely that SSE will be applying optimal financing structures to this capital intensive, front-loaded investment project to drive down generation costs and boost the overall economics of the project. This could also be further enhanced by the planned power purchase agreement that will see 50% of the power output of Greater Gabbard go to another party, in what could be a very lucrative deal.

Failing that, should SSE choose to sell 50% of the project equity later this year, the company is likely to make a large windfall profit due to the record wind farm valuations of late.

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