Offshore wind will likely remain a European story for the decade to come, and one where large utility companies will likely continue to dominate. S&P Global Ratings estimates that about 72% of global offshore wind in operation at end-2020 was in Europe (including the U.K.). Looking ahead, the region will account for 60% of global installed capacity in 2025 through 2030, according to projections by S&P Global Platts Analytics.

Eight European utilities dominate the market:

• Orsted A/S (BBB+/Stable/A-2),
• RWE AG (not rated),
• Vattenfall AB (BBB+/Stable/A-2),
• Iberdrola S.A. (BBB+/Stable/A-2),
• EnBW Energie Baden-Wuerttemberg AG (A-/Stable/A-2),
• Electricite de France S.A. (EDF; BBB+/Stable/A-2),
• SSE PLC (BBB+/Stable/A-2) and
• Eneco N.V. (A-/Stable/A-2).

European utilities are the biggest players in offshore wind, compared with more widespread technologies such as solar or onshore wind, because of much higher barriers to entry, including the massive amounts of capital needed to deploy the costly installations.

Offshore wind accounts for a small but increasing 3% of the European (including U.K.) electricity mix, with about 25 gigawatts (GW) installed at end-2020: 5% in the U.K., 19% in Denmark, 6% in Germany, and 3% in the Netherlands. The share is growing where there is already a high concentration, particularly in the North and Baltic seas. There, weather conditions are optimal, with superior average capacity factors as high as 45%-65%, and reduced environmental constraints. On the contrary, Southern Europe offers less potential for offshore because of less favorable weather conditions and seabed that is suitable and available.

We see penetration of offshore wind increasing rapidly given the:

• EU's target of carbon neutrality by 2050 and investments likely supported by the European Green Deal, and
• European Commission's recently proposed "Fit For 55" package of measures to achieve a 55% reduction of CO2 emissions (versus 1990) and carbon neutrality in 2050.

We see fewer hurdles to growth for offshore wind projects than for onshore wind and solar, for example—such as permitting, land scarcity, and local opposition. However, we acknowledge the rising number of studies about the environmental impacts of offshore wind energy and that some projects, like a few in France, face significant local hostility.

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Europe will remain the region with the highest growth in the next five years, even though Orsted, Iberdrola, RWE, and EnBW have targeted international projects in the U.S. and Taiwan, for instance. Recently updated national energy policies show ambitious capacity targets totaling more than 100 GW by 2030, with the U.K. and Germany representing more than half (see table 1). This is also supported by the EC's Fit For 55 package proposal, which bases the energy transition on green electrification. What's more, we believe offshore wind is well positioned to power Europe's ambitious green hydrogen strategy: The EU targets 40 GW of electrolyzer capacity by 2030, producing 10 million tons a year of renewable hydrogen. Such volumes would require additional renewable power generation amounting to 477 terawatt-hours, according to S&P Global Platts Analytics. This is over half of total EU renewable generation in 2019.

While still immature for now, floating offshore wind technology may allow for accelerated growth in the next decade. While the technology needs to improve to become economically viable, it promises a reduced need for foundation material, quicker installation and decommissioning, as well as wind power generation at greater water depths. This technology, which features an offshore wind turbine mounted on a floating structure, allows the turbine to generate electricity in deeper water where bottom-mounted structures are not feasible. According to WindEurope, floating installations, which can unlock 60% of Europe's offshore wind resources, will allow the decarbonization of the energy systems for the region's islands and in coastal regions in deep waters (of more than 60 meters)—including the Mediterranean, the Atlantic coast, and the coasts of Scotland and Norway.

Table 1

The offshore wind pioneers--Orsted, Vattenfall, Iberdrola, RWE, and EnBW—in our view are well placed to seize a large share of the investment opportunities in the coming decade. These five have built a pronounced competitive advantage in this field, notably in project construction, management of the supply chain, procurement, weather forecasting tools, and asset maintenance optimization. Their installed asset base allows for secured cash flows from the favorable long-term pricing mechanisms in place. These companies, which restored their balance sheets in recent years, have the financial means to continue to expand--especially by attracting and teaming up with investment funds to share the risk and lower the cost of capital.

Oil companies are also accelerating investments in wind offshore, notably to acquire expertise in the sector as well as respond to stakeholder demands to diversify into offshore wind for a variety of reasons:

• The sector could provide a stable source of cash flow because of the contracted nature of the business, despite lower returns than the typical double-digit returns in their core oil and gas business.
• As a way to diversify into greener operations, in response to rising investor demands that oil and gas companies to reduce their carbon emissions (for details see "The Energy Transition: ESG Concerns Are Starting To Present Capital Market Challenges To North American Energy Companies," published on RatingsDirect on June 14, 2021).

That said, we believe their lack of defined development pipeline at this stage and to some extent wind forecast expertise will prove to be a hurdle for oil and gas companies and others to penetrate the market in a big way. Therefore, we believe offshore wind investments will continue to represent a relatively small portion of the investment portfolio of oil and gas companies, at least for the next five years. However, as floating offshore wind takes hold, oil and gas companies could leverage their expertise operating in deep and ultradeep water. Ultimately, footholds by oil and gas companies will increase competition in this field, but we believe it won't come at any cost—such as a loss of pricing discipline.

Table 2

Orsted's previous CEO, Mr. Henrik Poulsen, was realistic when he said the era of double-digit returns for offshore wind in Europe would soon be over. We see rising competition and more stringent auction processes leading to tighter remuneration and lower returns than in the past decade. Reaching double-digit returns on projects has become more difficult as technology and project management matures. At the same time, we assess construction risks on these large projects as higher than for other renewable projects, and as a result we remain mindful that execution risks could jeopardize profitability at some point.

Regarding remuneration, feed-in tariffs or other supporting (and noncompetitive) pricing mechanisms historically supported offshore wind projects, covering a relatively long period (10-20 years). This led to double-digit equity returns as evolving technology ushered in more efficient and cheaper equipment. Wind performance exceeded investment expectations of €117 billion, according to the wind developer association WindEurope (see chart 5).

Chart 5

The European market changed, however, with the transition to competitive auctions in 2017. Now that the technology is maturing and costs are dropping, governments are devising ways to reduce subsidies but still support offshore wind development. One way, which has become commonplace, are reverse auctions for offshore wind projects, where bidders compete by accepting lower and lower subsidies. This transition first resulted in a 55% drop in investment in 2017, also related to a limited number of auctions that year, but the market picked up again the following year.

What we believe is more consequential are lower returns. Fierce competition during the auction process in a race for market share, combined with a more maturing industry, is leading to more aggressive bidding, lower acceptable buffers, and ultimately lower returns In recent auctions for nearshore offshore wind in the North Sea, prices fell close to $50 megawatt-hour, including transmission costs (see table 3).

Table 3

While the competitive auction process is becoming the norm, S&P Global Ratings values the long-term visibility of the remuneration mechanisms in place from our perspective of credit risk. Although the existence of a fixed-price contract is sometimes mistaken for a subsidy, it can be seen as a long-term price swap that removes exposure to the volatile spot market. Thanks to 10-20 year contract terms, developers and owners of offshore wind installations enjoy stable cash flow streams, thus reducing risk. This cash flow predictability typically supports our credit ratings. For example, as part of our recent review of the ratings on Orsted, we lowered our downside ratings threshold because of the company's ongoing improvement of its business risk profile (please refer to "Ratings On Six European Integrated Utilities Affirmed Amid Accelerated Energy Transition; One Outlook Now Negative," published on RatingsDirect on Feb. 17, 2021).

Costs Will Fall Further, Though More Slowly

The cost of offshore wind in Europe--specifically the levelized cost of energy (LCOE)--has nosedived over the past decade and is set to continue falling--but now at a decelerated pace. That's due to the continuous optimization of industrial processes, a more experienced supply chain, and technological improvements that have increased turbine size. Also playing a role was a big increase in project size, allowing suppliers to reach critical industrial scale and ability to amortize some fixed-cost installations over more gigawatts installed, and a drop in the cost of debt. As a result, offshore wind is gradually closing the cost gap with more mature renewable technologies and becoming cheaper than some other technologies, notably new nuclear build. However, it is unlikely that the cost of capital—that we estimate is about one-third of the total cost of a project--will plunge again, given today's historically low cost of financing.

Costs for bottom-fixed offshore wind are to decrease 44% in the next decade to €38-€60/MWh and, for floating offshore wind, 65% to €53-€76/MWh, according to WindEurope (see chart 6). Offshore wind would then become almost as competitive as onshore wind (€27-€39/MWh). A key support is that offshore wind, also compared with solar, has a much better energy value since it has a more stable generation profile throughout the year and intraday. This, together with its relatively high capacity factor of at least 40%, in our view, will become a bigger differentiating factor as the share of renewable generation grows, the importance of the capacity market increases, and grid fluctuations need to be managed.

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A few recent trends, at the same time, are pushing prices higher for offshore wind--and renewable energy more generally. Due to the fourfold increase in logistics costs and commodity inflation, prices of key metals used in renewables plants have hit historical highs recently (see charts 8-10). Wind plants require about 3x more steel than a gas-fired plant per megawatt and about 2x more than a coal-fired plant, with much higher intensity per megawatt in copper and steel use. This could increase renewable installation costs by up to 5% in 2021, according to S&P Global Platts Analytics.

And at least in one case last year, commodity inflation weighed on earnings. Raw material price increases (notably for steel and copper), together with the ramp-up of costs of the 5.0x platform, led to provisions for onerous contracts of about €230 million that weighed on third-quarter results for Siemens Gamesa Renewable Energy S.A., according to its earnings call at the time. In response, the company put into place some remedy measures, such as indexation to protect from raw material price volatility, increased hedging, and back-to-back coverage with suppliers. That said, the company recognized logistics as a great challenge for the industry, given increasing demand and still-tight supply because of COVID-19 measures around the world.

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Despite the rise in commodity and logistics inflation, we believe that developers have room to reduce costs in three areas under their direct influence:

The adoption of efficient EPC (engineering, procurement, and construction) practices, such as minimizing losses on commissioning, which hinge on a more efficient and more mature supply chain in Europe.

Further streamlining of operations and maintenance, which will cut costs and prevent revenue leakage, with, for example, greater recourse to digital monitoring and use of drones for visual inspections.

A further increase in turbine size. The average turbine size of offshore wind farms increased to 8.0 megawatts for projects completed in 2020 from 2.0 megawatts in 2010. In the same period, annual capacity factors for new projects increased to 42% from 38%. New turbines of 12-15 megawatts promise to achieve capacity factors close to 60% (before wake losses), according to WindEurope. A bigger turbine can achieve a capacity factor improvement of 2-7 percentage points for the same site conditions. We believe capacity factors could improve by 5 percentage points by 2030.

Perhaps the best barometer that meaningful reductions in cost are on the horizon is the strike price from the most recent auction processes (see table 3) and recent prices in Europe for offshore wind. Indeed, while still not the norm, some strike prices embedded in contracts for differences (CFDs) are at the level of wholesale electricity prices.

Operational Risks Start To Emerge

The industry shuddered in October 2019 when Orsted stated its expectations for lower rates of return for its offshore wind projects because of weather forecasting issues. In particular, the utility revised, to 7.0%-8.0% from 7.5%-8.5%, its anticipated unlevered internal rate of return for several projects in Europe and Taiwan because of an underestimation of wake and blockage effects. Orsted insisted its assumption was not company-specific, but rather industrywide. We considered announcement to be credit neutral for Orsted, given the limited effect on our expectations and credit metrics. However, it represents a potential underappreciation of risks for a rapidly maturing industry that could weaken returns beyond current expectations, and one that we are monitoring across the industry.

Another operational flag is erosion of offshore wind installations, given the harsh environment in the open seas, where weather conditions can be more extreme than onshore, underwater operations are becoming more hazardous, and salt can deteriorate installed components. In April 2021, Orsted announced that cables connected to wind farms were damaged as they scraped rocks on the seabed, requiring investment of Danish krone (DKK) 3 billion (about €400 million) until 2022 to repair them. We note that some of Orsted's offshore wind farms have been operating for almost a decade now, with our understanding of Vattenfall and RWE also experiencing similar issues, albeit at smaller scale. The case signals increasing operational risks for a newer technology, with less than two decades of an operating track record.

As they take steps to diversify their operations in other regions of the world, offshore wind developers are exposing themselves to supply chain disruptions. With this international development, new supply chains need to be built, either because of transportation issues or because of legal requirements for a high share of local content. Today, the supply chain is based mostly in Europe. As they go elsewhere, offshore wind developers are exposing themselves to less mature suppliers, which could lead to risks related to increased cost uncertainties, operating disruptions, and bottlenecks. The infrastructure outside Europe may also need to be built or improved, including roads and ports to transport components, and that will take time. As a result, we believe the cost of offshore wind outside Europe will remain much higher than it is in Europe.

Merchant Risk: Big, But Still Far Out

One of the biggest risks we see for renewable energy, as it transitions away from the subsidized or long-term fixed-price contracts, is the growing share of exposure to merchant power . Yet, we believe this is a more remote risk for offshore wind over the coming decade. That's because existing capacity is operating under feed-in tariff schemes and current auctions, for projects to be commissioned over 2022-2025, are still being signed a secured remuneration mechanism.

Some recent auctions concluded with winning bids for no subsidy at all, but we view each of the following cases as unique, notably because they are adjacent to a plant:

• Orsted's zero-subsidy bids (or zero bids) in 2017 and 2018 for three offshore wind plants in Germany, and
• Vattenfall in the Netherlands in 2019.

Zero-subsidy auctions have been achieved due to distinctive circumstances, such as markedly bigger turbines, probably producing 11-15 MW, which should be on the market in 2024, and the opportunity for Orsted and Vattenfall to combine different projects into a large one. We also view these bids as having a high degree of optionality at this stage. Before the companies reach a final investment decision, it is likely that a big share of the capacity will be contracted through a long-term power purchase agreement (as Vattenfall recently did with BASF SA for its Hollandse Kust Zuid 1-4 project), thereby leaving only marginal exposure to merchant risk. We think this is still a prerequisite to obtaining good financing conditions. If the companies decide to drop the projects, they would pay only a relatively small penalty. Still, zero bids point to the increasing pressure on profitability, which we expect will continue to be a major risk for the offshore wind sector.

Should merchant risk increase, strong mitigants will need to be put in place for creditors, such as a floor mechanism or sufficiently long-term utility or corporate power purchase agreements (PPAs; see "Energy Transition: Renewable Energy Matures With Blossoming Complexity," published on Nov. 8, 2019). We believe European utilities are particularly well positioned to keep their dominant role in large offshore wind projects, given their balance sheet strength, and ability to lessen price risk through trading and balance output—already integrated into supply--within their broader generation portfolio.

Editor: Rose Marie Burke. Digital Designers: Jack Karonika, Joe Carrick-Varty.

Related Research

• Ratings On Six European Integrated Utilities Affirmed Amid Accelerated Energy Transition; One Outlook Now Negative, Feb. 17, 2021
• The Energy Transition: ESG Concerns Are Starting To Present Capital Market Challenges To North American Energy Companies, June 14, 2021
• Write-Downs, While Eye-Catching, Are Not The Largest Issue Facing Oil And Gas Supermajors, Aug. 3, 2020
• The Energy Transition: Is Offshore Wind Done Or Going For Other Bids? Feb. 18, 2020
• Energy Transition: Renewable Energy Matures With Blossoming Complexity, Nov. 8, 2019