Source: April 2020 issue of Financier Worldwide Magazine
In 1991, the Danish coastal town of Vindeby was the site of the world’s first 4.95 megawatt offshore wind park. In the late summer of 2016, 24 years later, just five 6 megawatt wind turbines started to operate in the ocean by Block Island, Rhode Island, the first offshore wind project in the US. In 2019, total wind power in the US represented 7.3 percent of the country’s overall generation capacity with 105.5 gigawatts and all but 30 megawatts onshore. In Europe, by comparison, wind accounts for 15 percent of total electrical generating capacity, with 205 gigawatts, 11 percent of which is offshore.
Offshore wind energy has a potential of more than 2000 gigawatts in the US, almost double the country’s current generating capacity. Coastal states conveniently account for nearly 80 percent of the nation’s electricity demand. States have established huge offshore wind targets. For example, Massachusetts wants 3200 megawatts by 2035 and has awarded 800 megawatts to Vineyard Wind, a joint venture between Avangrid and Copenhagen Infrastructure Partners, and 804 megawatts to Mayflower Wind, a joint venture between Shell and EDPR. New York wants 9000 megawatts by 2035 and has awarded 130 megawatts to South Fork, a joint venture between Ørsted and Eversource, 880 megawatts to Sunrise Wind, a joint venture between Ørsted and Eversource, and 816 megawatts to Empire Wind, which is backed by Equinor. New Jersey wants 7500 megawatts by 2035 and has awarded 1100 megawatts to Ocean Wind, which is backed by Ørsted. Finally, Connecticut wants 2000 megawatts by 2030 and has awarded 804 megawatts to Vineyard Wind.
However, the Block Island project remains the only commercial offshore wind project in operation. Why?
Complex regulatory framework
A complex federal and state regulatory framework governs the development of offshore wind energy. The Bureau of Ocean Energy Management (BOEM), the federal agency responsible for energy development in federal waters, has a lengthy regulatory process that entails planning and analysis, leasing, site assessment, and construction and operation planning. Each step can take years and it is only after BOEM approves the construction and operation plan that a commercial lease enabling construction of the project is granted.
Numerous federal laws, including the Outer Continental Shelf Lands Act, Coastal Zone Management Act, Clean Water Act, Fish and Wildlife Coordination Act and the Jones Act, impact offshore wind siting, permitting, planning, construction logistics, timing and costs.
Permitting can be particularly unpredictable, as demonstrated by the recent BOEM decision to extend its environmental review of the Vineyard project in Massachusetts and undertake a ‘cumulative impacts analysis’ of 35 other offshore wind projects along the East Coast. Vineyard Wind announced on 11 February 2020 that the commercial operation of Phase I of the Vineyard project is no longer expected to be achieved in 2022. The delay likely means challenges on several fronts, including tax equity and realigning contracts and supply chain commitments.
Offshore wind projects are complex and must survive rigorous environmental reviews. Potential adverse environmental impacts range from physical disturbance of the local habitat and visual impact and noise pollution, to impacts on fishing and decommissioning issues. Lessons from the Cape Wind project that died after 16 years are being applied by pushing leases 15 to 30 miles offshore. However, new challenges keep surfacing. For instance, scallop fishermen sued to stop a potential Equinor project southeast of Long Island. Though a federal judge ruled that the lawsuit was premature, additional legal challenges are not ruled out. Another example is the challenge for California given concerns from the Department of Defense.
The capital stack for offshore wind projects is typically shaped by, among other things, federal tax credits. Offshore wind projects can qualify for the investment tax credit (ITC), tied to capital costs, or the production tax credit (PTC), tied to output and paid over a 10-year period. Typically, a tax equity investor included in the transaction to monetise such tax credits will fund approximately 30 percent of the total project cost.
Given huge capital costs, offshore wind projects tend to rely on ITCs. The rules for qualification are complex and include a two-prong test. The first prong requires the taxpayer to ‘begin construction’ of the project before the applicable deadline, which may be established by commencing ‘physical work of a significant nature’ or paying or incurring at least 5 percent of the total cost of the eligible basis (the 5 percent safe harbour), which may be reduced to 3 percent in limited circumstances. The second prong requires the taxpayer to make continuous progress toward completion of the project, which is satisfied if the project is placed in service within four calendar years after the calendar year in which the construction began (the continuity safe harbour). Certain types of acceptable delays may toll the four year period. Given the capital intensity and the need for flexibility in the face of improving turbines, sponsors often rely on the ‘physical work’ test (rather than the 5 percent safe harbour), which tends to be more complicated and rigid, and not favoured by tax equity investors.
Further, the level of tax credits varies with the timing of satisfaction of the qualification criteria. The current level of PTC, as a percentage of $24/megawatt hours, and ITC as a percentage of total capital costs, respectively, based on the commencement of construction deadline, is as follows: 2016 – 100 percent and 30 percent; 2017 – 80 percent and 24 percent; 2018 – 60 percent and 18 percent; 2019 – 40 percent and 12 percent; 2020 – 60 percent (which will be adjusted for inflation) and 18 percent; and from 2021 onward – 0 percent for both PTC and ITC.
BOEM’s delay on the Vineyard project highlights the complexities of tax equity. The first 400 megawatt phase of the Vineyard project, originally scheduled to be completed in 2021, is expected to garner the 24 percent ITC and the second 400 megawatt phase, originally scheduled to be completed in 2022, is expected to garner the 18 percent ITC. Given the delay by BOEM, to qualify at the 24 percent and 18 percent ITC levels, Vineyard Wind would likely need to affirm with the IRS to take over four years to complete the project or would need to prove ‘continuous efforts’, which would be hard to digest for tax equity. Projects like the Vineyard project, that rely on tax equity, are more sensitive to delays due to tax-credit qualification deadlines and safe harbour rules.
The nuances of debt corelate to the risks and deal structures. Projects with tax equity present intercreditor issues about priority on cash flows and collateral. Construction risks and contractual frameworks, which involve multiple contracts ranging from turbine supply and installation to foundations, offshore platforms and onshore works with no overall EPC wrap, are scrutinised closely to determine bankability. The revenue stream comprises of offtake of wind energy and associated renewable energy certificates, which represent the environmental attributes associated with a megawatt-hour of offshore wind generation. The US offshore wind market is still in its infancy and strong US and European sponsors are forming joint ventures to combine knowledge, experience and skillsets to create favourable debt structures.
Grid and transmission
The implementation of states’ offshore wind targets would require new infrastructure that allows the offshore wind gigawatts to be integrated into the grid. As per Business Network for Offshore Wind, though the North East grid should be able to accept the first 4000 megawatts of power, the capacity of the grid to go beyond 4000 megawatts is uncertain. Furthermore, in densely populated regions such as New York City and Long Island, interconnection points are scarce and offshore interconnection and transmission would likely require billions in capital investment and lengthy negotiations and approvals.
Given the available tax credits and the complexity of the qualification rules, there is currently a multifaceted push to get clarity specific to offshore wind or legislative relief, but the success of those efforts is uncertain. The four-year window, originally designed for onshore projects requiring a much shorter development period, to complete construction creates challenges for offshore wind. Lobbyists are pushing for up to six years. Up to this point, the Treasury has rebuffed the request. However, on 20 February 2020, the Treasury released long awaited beginning of construction rules for a carbon capture tax credit that provides up to six years for completion, presumably because of increased development and construction complexity. This new development provides hope that the Treasury will eventually revisit the issue for offshore wind. While new guidance on the four-year window is not currently expected, new regulations addressing whether export cables connecting offshore projects to the shore are considered part of the tax credit eligible equipment, which could affect the calculation under the 5 percent safe harbour, are expected later this year. Additionally, lobbyists are looking at a potential post-election tax extenders bill in December to include a proposal to give offshore wind projects more time to start construction. The proposal would give offshore wind projects until 2024 or when 3000 megawatts are in operation in order to qualify for the full 30 percent ITC.
Generally, renewable energy costs have shown huge progress in cost cutting, and offshore wind is no exception. Despite structural costs that are greater than onshore wind, such as ocean foundations, the 804 megawatts Mayflower Wind has promised the lowest cost offshore wind in the US at 5.8 cents per kilowatt-hour. The increase in turbine scale, along with the higher capacity of larger turbines, is working to reduce costs and improve competitiveness. However, regulatory frameworks and government policies, coupled with the economics, will continue to shape the development of offshore wind projects in the US.