Bankability issues for lenders and sponsors
Offshore wind is poised to play a critical role in Australia's energy transition. The Offshore Electricity Infrastructure Act 2021 (OEI Act) commenced on 2 June 2022 and provides a framework for the licensing, development and construction of offshore wind projects in Australia. On 5 August 2022 the Federal Energy Minister issued a notice of proposal to declare an area of the Bass Strait off the Gippsland region in Victoria as Australia’s first zone for offshore wind development.
Development of an offshore wind industry in Australia will be, in part, dependent upon access to commercial and institutional debt markets. In this Insight, our renewable energy projects and finance specialists explore some of the bankability issues that will be relevant to sponsors and lenders considering financing offshore wind projects in Australian waters.
Key takeaways
- Offshore wind is being seen as a key component to Australia's energy transition. The complexity and capital intensity of offshore wind projects means clear regulation and financial support will be critical to the future success of the industry.
- The first large-scale projects will likely be funded on-balance sheet or via multi-source capital structures which utilise a combination of grant funding, concessional and commercial debt and ECA support.
- Institutional financiers with a preference for larger ticket sizes and mainstream infrastructure investors seeking to diversify their investment portfolios into renewable/green energy projects will likely be attracted to the Australian offshore wind sector.
- The OEI Act has significant regulatory parallels with the offshore oil and gas sector. Investors will likely leverage off expertise in Australia's offshore oil and gas industry to assist with navigating the application and approvals process. Early signals suggest oil and gas majors will invest in the offshore wind industry against a backdrop of renewed focus on energy security and the transition to low-carbon energies.
- Whilst there has been significant interest in the industry, many of the projects proposed to date are noticeably absent of viable offtake solutions, and long-term government support programs will be crucial for stimulating the industry.
The situation at home and abroad
Globally
Global offshore wind generation growth amounted to 25 TWh (+29%) in 2020, with capacity additions of 6 GW. Overall, 1,592 TWh of electricity was generated from wind installations in 2020. 2030 global targets for offshore wind total around 200 Gigawatts (GWs), including 40 GW in the UK and US, 60 GW in the EU, 12 GW in Korea and 10 GW in Japan (which has a target of 45 GW by 2040).1
Offshore wind energy is now one of the International Energy Agency's (IEA) ‘big three’ in its energy scenarios—projected alongside onshore wind and solar PV to be one of the bulk sources of electricity in the clean-energy transition in coming decades.
The growth of the offshore wind industry has been cultivated in Europe and with a strong policy framework, enabling the European Union to reach nearly 25 GW of offshore wind capacity in 2021 (corresponding to 5,402 grid-connected wind turbines across 12 countries2). Alongside Europe, we have seen Brazil, China, Taiwan and the USA take strides forward on offshore wind and now stand among the market leaders. In 2021, China's offshore wind capacity increased by a staggering 16.9 GWs to 26.38 GW, accounting for 86% of global capacity.
Australia
In Australia, there are as many as 40 proposals that have been publicly announced, totalling well over 40 GW. The most advanced project is the Star of the South off the coast of Gippsland in Victoria, owned by Copenhagen Infrastructure Partners and Australian superannuation fund Cbus and which is targeting first generation by 2028.
Other proposals include Corio Generation's 1GW Great Southern Offshore Wind Farm in Eastern Victoria, Alinta's 1GW Spinifex Offshore Wind Farm in Western Victoria, and Equinor and Oceanex Energy's proposed offshore wind projects off the coast of New South Wales.
Development of an offshore wind industry in Australia will be, in part, dependent upon private-sector access to commercial and institutional debt markets. Sponsors and financiers will need to take a long-term view on the market and navigate a myriad of issues. Below we explore some of the key considerations and bankability issues.
Construction contracts
Offshore wind projects typically take two to three years to build, and require significant capital expenditure. Up to 75% of asset-life costs can be on upfront capital expenditure, which typically runs into billions of dollars. The Commonwealth Scientific and Industrial Research Organisation estimates that the likely capital costs of offshore wind in 2028 at AUD4,085/kW of capacity installed, will be more than double that of onshore wind at AUD1,915/kW.
The capital intensity of these projects, combined with their modular design, has led to an absence of EPC wraps with multi-contracting structures becoming the industry norm internationally. The typical major contract packages include:
- turbine supply and installation;
- foundations;
- substations (onshore and offshore); and
- cabling (inter-array and main transmission),
which may, depending on the project, be divided into further design, manufacturing, vessel and installation packages. The existence of a large number of critical works packages means that lenders require extensive and robust cooperation and coordination frameworks to be developed to sufficiently manage interface risk. Lenders need to undertake in-depth technical and legal due diligence to stress test the interface arrangements to determine the project's ability to absorb downside risks. Lenders will look favourably on any enhanced rights that the principal possesses to resolve interface issues and to adjust or re-sequence works as may be required.
Cost overruns and delays are common in major infrastructure projects. Lenders to projects in Australian waters will require that developers build adequate contingency packages (and time buffers) into their modelling. Internationally, a 10% modelled contingency has become the industry standard in Europe, however, until Australia has an established offshore wind market and the benefit of lessons learned (such as those seen with the difficulties encountered with early offshore projects in Taiwan), we expect financiers will likely require materially higher contingency thresholds.
There are a number of factors which lenders will take into account when determining contingency thresholds. Seabed conditions will have a major impact on the design and installation of a project. As a consequence, as part of the due diligence process, lenders place significant emphasis on the comprehensiveness of upfront feasibility studies as a key tool for mitigating risk. Lenders will often require that works packages include a baseline survey to ensure there is a clear allocation of known, day-one risks to reduce the likelihood of extension of time and compensation claims.
Risks presented by seabed conditions are particularly relevant to Australia. Fixed-bottom turbines are the industry norm and are typically utilised in waters with a depth of 60 meters or less. Fixed technology is being contemplated in Victoria where regions such as Gippsland have low-lying waters and sandbanks. In contrast, New South Wales has deep water conditions making fixed-bottom technology commercially unviable, meaning that floating turbine technology will need to employed. Floating turbines are relatively new to the industry but have the potential to bring a number of advantages, including significant time and capex savings in the absence of foundation works other than anchors and moors (although the current higher cost and smaller size of floating turbine units may somewhat offset those capex savings while the technology evolves).
Floating offshore wind technology is nevertheless complex and, from a bankability perspective, brings a higher degree of technology risk. Given the nascent state of the Australian offshore wind market, it will be interesting to see how the industry develops and whether lenders are able to take on increased technology risk or favour, at least initially, fixed-bottom technology.
Weather conditions can also have a material impact during the delivery phase. Lenders, as part of the due diligence process, will focus on the modelling assumptions adopted by sponsors and developers to predict interruptions and stoppages to the construction timetable due to high winds or poor sea conditions. P10, P50 and P90 modelling scenarios are commonly adopted (P10 being scenarios that have a 10% likelihood of occurring, P50 being 50% and P90 being 90%). Lenders typically prefer a conservative reference model as their modelling baseline as it reduces the exposure of a project to capex overruns.
The liquidated damages regime will be critical to the bankability of each project. Liquidated damages will need to be sized appropriately to respond to additional costs incurred as a consequence of a delay or underperformance. In the absence of a wrapped EPC package (and unless project contractors agree to direct recourse against each other), the liquidated damages regime would work on a horseshoe basis whereby Project Co will stand in the middle of delays caused by a project contractor—it would seek liquidated damages and/or indemnification from the defaulting contractor for delay, and be liable for delay costs to the non-defaulting contractor(s).
A single contractor can potentially delay the entire construction program, but it is unlikely to be commercially viable (and not in line with international market practice) to require that they will compensate the project as a whole. Lenders will therefore be highly focused on ensuring appropriate thresholds and caps are negotiated (together with insurances) which provide sufficient levels of cover and an appropriate deterrent to deliver their relevant works package on time. Sponsors and developers will also require detailed gap risk analysis.
Offtake arrangements
The bankability of Australian offshore wind projects will be contingent upon sponsors demonstrating certainty of underlying cashflows.
The offshore wind industry has matured considerably over recent years and it is likely that sponsors will look to utilise a stacked capital structure to strengthen their revenue stream (and IRR) and with it, the bankability of their projects.
The common forms of offtake arrangements employed in offshore wind projects abroad are:
Reverse auction processes are one of the principal mechanisms utilised by governments to incentivise investment in renewable energy. As part of its VRET1 and VRET2 reverse auction programs, the Victorian Government has utilised various government-backed support instruments, including contracts for difference (CfDs), to fund renewables projects. VRET1 and VERT2 included onshore wind and it is quite possible that a similar approach will be adopted for the offshore wind sector. CfDs provide investors with protection from volatile wholesale prices through the payment of a flat (indexed) rate for generation output over a fixed term (often 10-15 years). The flat rate represents the difference between the ‘strike price’ ($ per MWh)) and the ‘reference price’ (a measure of the average market price for electricity in the market), subject to a payment cap.
FiT schemes essentially provide a generator with a fixed price for selling its power output to the grid. Whilst widely employed internationally, FiT schemes in Australia have not been utilised to date to support large-scale projects.
PPAs continue to be favoured by financiers from a bankability perspective. Owing to the scale of offshore wind farms (often exceeding 1GW of generation output) sponsors often enter into PPAs with multiple counterparties in the private sector. In the domestic setting, traditional PPAs in the Australian market essentially operate like a CfD, with counterparties (utilities, corporates, large energy consumers etc) paying a flat (indexed) rate for generation output over a fixed term (often 10-15 years). From a bankability perspective, financiers favour long-term contracts with strong creditworthy counterparties. Financiers often look to manage offtake risk (market volatility and counterparty downgrade risk) under a PPA by requiring credit support and performance guarantees.
Proxy revenue swaps are commonly utilised in the wind industry and have been employed in Australia as a credit enhancement for some merchant solar projects. A proxy revenue swap is a financial hedge, with the swap provider paying Project Co a fixed amount and Project Co agreeing to pay a floating 'proxy revenue'. If the fixed amount exceeds the 'proxy revenue' amount for a given quarter, then the swap provider makes a payment to the project equal to the difference. If, on the other hand, the 'proxy revenue' exceeds the fixed amount, then the project makes a payment to the hedge provider equal to the difference (with such exposure often mitigated through insurance).
Given the recent volatility seen in wholesale energy prices in Australia and the strong financial gains made by generators, it is likely that sponsors will be keen to reserve a percentage of capacity output for merchant trading. The quantum of contracted revenues required by lenders will vary from project-to-project and be driven, in part, by leverage ratios and the credit strength of the sponsors, although merchant risk is less prevalent in nascent markets given the lesser revenue certainty for lenders.
Financing structures
Offshore wind projects are capital-intensive. Internationally, the most commonly adopted financing structures are on-balance sheet financing, holdco financing and traditional asset level project financing.
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On-balance sheet
HoldCo financing
Asset level financing
Export credit agent (ECA) involvementEquity
In Australia it is common in renewables financings for equity to be funded after debt, with the support of back-ended equity instruments such as bank letters of credit or guarantees from a highly rated parent. Given the increased complexity and capital intensity of offshore wind projects, it is likely (based on initial experiences in other nascent markets) that upfront or pro-rated equity structures will be preferred by lenders, at least initially. Depending on how highly leveraged projects are, subordinated equity bridge loans may also be deployed to improve project economics.
In traditional onshore wind financings, a common negotiation point is whether pre-completion revenues (PCRs) should be carved out from the cost-to-complete test and not permitted to be distributed to equity until the expiry of at least the first quarter following conversion of the construction tranche into the term tranche. Sponsors may sometimes agree to such carveouts where PCRs are not substantial, and the construction phase is short. Offshore wind farms can, however, generate a significant amount of PCRs during the commissioning phase and before the wind farm achieves its commercial operation date.
Strong sponsors will likely seek to have PCRs categorised as equity and included within the cost-to-complete test, thereby reducing the amount of 'true' equity injections that each sponsor is required to contribute to a project. The inherent uncertainty of forecasting PCRs has seen financiers in some projects accommodate PCRs, but on the basis of P50 or P90 modelling (ie a delta of equity less P50/P90 PCRs plus actual PCRs generated), sometimes up to an agreed capped amount.
Security
Whilst the OEI Act sets out a framework for regulating offshore wind projects, issues around taking security over offshore assets in Australia will need to be ironed out.
As mentioned above, in a HoldCo financing, lenders do not have direct recourse to the underlying operational assets and the security package is limited to general security over the HoldCo, including over the shares it holds in the Project Co. This may be complemented or substituted with some form of parent company support.
In contrast, in asset level project financings, lenders typically obtain security over all project assets in the form of a general security which is registered with the PPSR and mortgages over any real property registered with the relevant local land titles office. Financiers also obtain step-in rights by way of tripartite agreements with material project counterparties. The challenge for lenders in Australia will be the degree to which security can be taken over offshore wind turbines. In contrast to an onshore wind project where lenders acquire a mortgage over the land upon which the turbines sit, offshore wind projects will be fixed to the seabed or floating and, therefore, typical perfection procedures will not apply.
The security arrangements will also be impacted by the distance of a project from the land. State coastal waters are limited to three nautical miles. Therefore, rules governing the registration and perfection of mortgages over plant and structures outside of that limit will need to be developed.
There are strong parallels between the OEI Act and the oil and gas regulatory frameworks. The National Offshore Petroleum Titles Administrator (NOPTA) is the proposed registrar that will manage the administration of licences and maintaining registers, and it is likely that mortgages taken over projects in federal waters will need to be registered with NOPTA (or the National Offshore Petroleum Safety and Environmental Management Authority, known as NOPSEMA) in order to be perfected.
Taking security over floating turbines would appear more straightforward. Whilst there is currently no precedent in Australia, perfection through registration under the Personal Property Securities Act 2009 (Cth) (PPSA) may be the appropriate route. The PPSA permits registration of 'watercraft', which is defined as boats or vessels that are used, or intended to be used, in navigation by water or for any other purpose on water that has a hull identification number, or an official number, within the meaning of the Shipping Registration Regulations 1981 (Cth). A key feature of the PPSA is to focus on the substance of a transaction over the form. As such, there is no prescribed form, and while market practice and views will need to be developed in Australia, as a preliminary observation, it should be possible for security to be granted over a floating turbine through the Project Co's entry into a general security agreement.
Other key considerations
Wind risk
A key due diligence item for offshore wind projects is the commissioning of satisfactory energy yield assessments. The accuracy of energy yield assessments is of critical importance as they determine the wind farm's potential electricity generation and with it, a project's likely revenue line.
The key risk from a bankability perspective is the variability of the wind source compared to that which is forecast. To minimise this risk, the energy yield assessment includes a net yield and exceedance probability figures (P50, P90, P99) against which lenders, among other things, will determine debt sizing.
Wind reforecasting is a mechanic that strong sponsors in offshore wind financings in more developed markets often seek to incorporate to provide protection in the event of wind variability. Wind reforecasting is used to cure DSCR breaches on account of a drop in wind yield through the recalculation of project revenue by reference to a refreshed wind yield assessment which employs a P90 forecasting model. If the model demonstrates compliance with financial covenant levels, utilising the P90 assessment, the default will be deemed to have been cured. Whether lenders are willing to accept wind reforecasting in the nascent Australian offshore wind market will remain to be seen.
Commissioning
As mentioned above, commissioning of wind farms occurs over a phased period with multiple turbines becoming operational and generating electricity before the commercial operations date is achieved. Strong sponsors in more developed markets may seek to build flexibility into a credit agreement which enables the commercial operations date to occur if a minimum number of turbines become operational. In exchange for this, the achievement of conversion from construction is made subject to the re-running of the financial model to determine the level of debt that the project can support based on the reduced generation capacity. To the extent the revised model shows a shortfall, the base case is resized and a cash sweep of distributions is made until debt is reduced to a level which project cashflows can support. Again, it remains to be seen whether this feature will be incorporated into the Australian offshore wind market.
Permitting
In markets where requirements to obtain all the relevant permits necessary to build and operate an offshore wind farm sit with the developer, the ease (or not) and timing of obtaining all relevant permits has been a key due diligence item for lenders to obtain comfort that the project will not be interrupted by third parties withholding or complicating consent, either prior to or during construction. As the regulatory regime for Australian offshore wind projects is further developed, developers and lenders alike will be keeping a close watch on whether the private sector or the Government bears this risk, and lenders will likely look to include appropriate mitigants in credit agreements should this risk ultimately be borne by developers in the Australian market.
Next steps
Offshore wind is, and will be, a key component of Australia's once-in-a-generation energy transition. While the development and project financing of this asset class is at an early stage in the Australian market, it is clear that offshore wind is gathering significant momentum. Compared to onshore wind projects, there are a number of different and wider-ranging development and bankability considerations to take into account for developers, sponsors and financiers.
The Allens team has been pleased to advise on a number of offshore wind developments, and key contacts should you wish to discuss further are listed below.