An offshore wind farm in the U.K. The Crown Estate's first-of-its-kind seabed leasing auction showed a divergence in outlook and risk appetite, with oil majors seeing value in entering the market. Source: Crown Estate

Developers in the U.K. are coming to terms with new competitive pressures in the world's largest offshore wind market after a leasing round for sections of the seabed fetched sky-high prices and saw incumbents outbid by market newcomers.

Nearly 8 GW of potential new capacity was awarded to bidders including oil majors BP PLC and Total SE — the former making its first offshore wind play in the U.K. — as well as German utilities RWE AG and EnBW Energie Baden-Württemberg AG, and Macquarie Group Ltd.-backed financial investor Green Investment Group Ltd.

Players that already have access to significant amounts of the U.K. seabed for offshore wind, such as Ørsted A/S, Iberdrola SA or SSE PLC, were not awarded any new zones.

As the dust settles on the auction, industry observers now see a pivotal moment for the sector, one that highlights divergence in risk appetite and return expectations among developers.

The auction, administered by the Crown Estate, which owns the seabed in England and Wales, showed that some developers are confident in production costs coming down and electricity prices climbing higher, said Daniel Radov, director at Nera Economic Consulting, who advised one of the winning parties. There will have also been expectations of continued access to cheap capital, sell-down opportunities and a healthy pool of corporations to sell power to.

"You need to make optimistic assumptions about the way in which a number of different variables will be moving, or you have lower return requirements," Radov said.

After shunning renewables for years, oil and gas majors are indeed now piling into the market with different expectations, said Simon Clement-Davies, partner at advisory boutique Augusta & Co. Ltd. "Oil and gas majors used to pursue hurdle rates of 15% plus for renewables. They've torn this up over the last couple of years; it has been squeezed down to between 5% and 10%," he said.

A big players' game

BP and partner EnBW won two 1.5-GW projects in the Irish Sea, which the oil major said will yield returns in line with its 8% to 10% hurdle rate. The joint venture will pay a total of £462 million per year for the two plots, or £1.85 billion over the four years until a final investment decision.

Observers say the fact bidders ramped up the price of their bids was in part evidence of the attractive U.K. market, and their desire to get involved.

"Bidders may have factored in a significant amount of strategic value, to enter the market and gain market share," said Alon Carmel, senior director of corporate finance in the clean energy practice at FTI Consulting, who has advised bidders in these kinds of auctions.

There might also be other factors guiding decision-making. An increased drive toward co-locating offshore wind with power-to-gas or storage solutions could open new opportunities to generate revenue, as Royal Dutch Shell PLC and Eneco BV showed with their winning bid for the Hollandse Kust Noord offshore wind park in the Netherlands.

"I would expect that at least some bidders have factored in additional revenue models such as hydrogen and batteries," Carmel said.

Still, the calculation is not guaranteed to square up. "These are early-stage projects with many risks still attached. If certain risks go the wrong way, that will hit the project returns," he said.

Paying a significant amount per year to hold the right to continue pursuing their projects will focus developers' minds in speeding up the journey to final investment decision. Bernstein analysts say the process usually takes an average of about five years, though BP is hoping to cut this to four years.

"Time is of the essence" for boosting returns, Total CEO Patrick Pouyanné said on the company's Feb. 9 earnings call, adding that incumbents may be getting intimidated and companies like his with large balance sheets are able to take on the risk. The French oil major will pay £124.6 million in annually with its partner, Macquarie's GIG, for a 1.5-GW site in the North Sea.

Clement-Davies said the lease auction shows U.K. offshore wind is not for the faint-hearted: "It reinforces the fact that it's a big players' game in any case. It's a utility game and and oil and gas major game."

Sunk costs offshore

Some incumbents are disgruntled about the outcome. Martin Neubert, chief commercial officer and deputy CEO of Ørsted, said "excessive costs" for securing slices of seabed risked driving unsustainable financial returns for developers and passing higher energy costs on to future consumers.

Given the long lead times between securing seabed rights and ultimately bidding projects into contracts-for-difference auctions, any potential higher costs would not be passed onto consumers until the mid-2020s.

The result also led to the Crown Estate's counterpart in Scotland to review the structure and timings of its own leasing round in Scottish waters. "The unprecedented outcome ... has overnight, changed the market dynamics around offshore wind leasing," Amanda Bryan, chair of Crown Estate Scotland, said in a Feb. 11 news release.

But Radov does not think the seabed lease sale indicates a reversal of falling costs in the U.K. offshore wind market, not imminently and not even necessarily in the longer term.

"The further away from these leasing round auctions all of the developers get, the more the leasing auction payment will need to be treated as just a sunk cost," he said. Future CfD auctions are still set to be very competitive, and developers will not necessarily be able to fully recover those sunk costs, he added.

Many in the industry bemoaned the amount of seabed that was made available for the auction by the Crown Estate. Giles Dickson, CEO of trade association WindEurope, pointed out that the U.K.'s last seabed allocation round 10 years ago was four times larger, a time when industry interest was much lower.

The Crown Estate's limited issuance was likely inspired partly by a 2018 seabed leasing round in Massachusetts, U.S., which yielded record-high bids, though the scope and approach there were different. "What happened in Massachusetts made it very clear [to the Crown Estate] that they are sitting on a very valuable asset," said Radov.

So valuable in fact that prices in the U.K. round were between seven and 13 times higher than those in the U.S., assuming a four-year payout period, analysts at Bernstein estimated.

With the U.K.'s seas already heavily used by energy, shipping and other sectors, the Crown Estate does in fact have a shrinking amount of space left to offer. But that is not everything driving the bidding behavior. The Crown Estate has been relatively tight-lipped about the longer-term trajectory, such as when the next auctions will take place. "I'm fairly certain that's deliberate," Radov said.

All to the dismay of some in the sector: "The U.K. has done a great job so far on offshore wind," said Dickson. "But now with their new seabed leasing auction, they're getting it badly wrong."