US offshore wind: On track to join the major markets

At 12GW, Europe makes up the lion’s share of the existing 17GW of global offshore wind capacity, the remainder deriving from Asia. But the US is set to make inroads, with over 13GW of capacity currently under initial development. And despite the upcoming expiration of a key tax credit, the Investment Tax Credit (ITC), the US market’s pace of growth, albeit ponderous, is unlikely to slow anytime soon.

The first US offshore wind project came online in December 2016, the 30MW Block Island OSW farm off the coast of Rhode Island. Although the global offshore wind market is forecast to grow by nearly 32GW by 2020, almost doubling today’s capacity in just three years, the US is unlikely to make up much of that growth. It will however come into its own in the ensuing decade, when its 13GW of projects start to come online.

In a bid to spur that growth, North-Eastern US states like New York, Massachusetts and New Jersey have established policy targets for the development of 7.5GW of capacity before 2030. The states are also in the process of tendering 3.3GW of capacity. “In the North-East there’s a been a big push towards renewables,” says Moody’s analyst Lesley Ritter. “For example, New York is looking to get 50% of its energy from renewables by 2030. There’s a similar goal in other New England states. And they are adopting subsidies to achieve those goals.”

Barring Maryland, which awarded two projects totaling 368MW in 2017, Massachusetts’s market is developing fastest. In the spring, the state awarded the 800MW Vineyard Offshore Wind Project to a joint-venture between Europe’s Avangrid and Copenhagen Infrastructure Partners. The Bureau of Ocean Energy Management (BOEM) will hold the next auction for the Massachusetts Wind Energy Area on 13 December, with 19 companies having qualified to participate.

BOEM will also publish a Notice of Intent to prepare an EIS report for the South Fork Wind Project off Rhode Island. The project, located 19 miles southeast of Block Island, proposes up to 15 turbines to connect the east end of Long Island. The Bureau is also set to publish a Call for Information and Nominations to identify companies interested in commercial wind energy leases within three proposed areas off central and northern California.

Both New York and New Jersey launched their own solicitations for up to 800MW and 1100MW, respectively, in the last couple of months. Similar to Maryland, New Jersey passed legislation supporting the use of Offshore Renewable Energy Credits for its procurement process.

Prices are falling fast in the sector. The power purchase agreement for Block Island was priced at $244/MWh in 2016, while the long-term procurement contract for Maryland's Skipjack and Ocean City projects the following year came in substantially lower, at $132/MWh. However, Massachusetts's Vineyard project has since priced at just $65/MWh. “The price really surprised the market,” says Ritter. “From $244/MWh to $132/MWh and now $65MWh — you can see the rapid and steep decline that’s happening. And as the supply chain develops in the US, the prices will keep falling.”

At today’s prices, US offshore costs remain high, even relative to the premium US wholesale markets of New York City, Long Island and Boston. However, forecasts from the National Renewable Energy Laboratory (NREL) see costs declining to more competitive ranges in the years ahead. In the North-East in particular, the difference between the cost of offshore wind and forecasted market prices will narrow to $30-80/MWh, with some of the lowest-cost sites located in Massachusetts, Maine, Rhode Island and New York. As for the overall market “deployment of US offshore at scale, particularly at the low end of the $80-130/MWh range, appears feasible within the next ten years,” said an International Renewable Energy Agency (IRENA) report earlier this year.

New England, New York and New Jersey offer the most potential. The states have many sites favourable to development and benefit from natural attributes such as good wind speed, relatively shallow waters and proximity to shore and demand centers, all of which help reduce cost. NREL forecasts the North-East’s unsubsidized, economically-viable available capacity to reach 144GW by 2027, with Maine and Massachusetts representing the largest share at 65GW and 55GW respectively.

Europe First

European investors have been flocking to the US offshore wind market in recent months. The only US developer, Deepwater Wind, was acquired in October for $510 million by Danish developer Orsted. Deepwater owned Block Island, three development projects with combined capacity of 810MW, and a potential 2.5GW from three BOEM lease areas in Massachusetts and Delaware.

Barring a couple of Asian firms, all the developers in the space are European. Orsted is acting as the contractor for the Dominion Energy project in Virginia, and also owns sites in Delaware and New Jersey. Avangrid has the lease for Vineyard. US Wind, which is owned by an Italian private family, owns the leases off Maryland and New Jersey. And Equinor, formerly Statoil, owns a site off New York.

“One of the main drivers for the European developers is the fact that the US offers scale 10-15 years earlier in the cycle compared with Europe,” says Ross Tyler, executive director of the Business Network for Offshore Wind. “The easy European offshore wind farms, the ones that close to shore, are pretty much taken.”

European developers have consequently broadened their horizons in search for easily-developable areas in other parts of the world, and their sights have landed on Taiwan and the US. “I think the US has the added appeal over Taiwan because it has the scale,” says Ross. “They should be able to reach low cost through economies of scale and achieve a strong indigenous supply chain, which again will be a contributor to low cost.”

Similarly European financiers, equipped with prior experience of financing offshore wind, have been quickest to show an interest in the embryonic US market. Block Island, the only project to reach financial close thus far, involved a $290 million project financing provided through Societe Generale (SG) and KeyBank in 2015, but Citibank and GE came in with tax equity a year later.

“The European project financiers are very happy in any changes in technology, and are happy to have a consortium of investors of up to say 12 parties,” says Tyler. “Whereas in the US there’s still novelty to that perceived risk; there is a greater emphasis on having less partners so that there’s more control over the contracts.

“There is an awful lot of interest in the contractual side, not just in regards to the developers but also the offtake agreements. Those are determined by the state government, which obviously vary, so there are some confusing mismatches there.”

There is group of 20-30 European lenders experienced with offshore wind that are keen to use their existing knowledge in the US market, according a report from the Business Network for Offshore Wind and SG earlier this year.

Those lenders, however, are less familiar with US tax equity. According to the report, there are roughly 35 active and familiar tax equity investors in the market for renewables transactions, but there are also several other smaller players that may get involved in transactions selectively. Regional banks, for example, have been seen committing to deals that have been pitched out by syndicators.

Credits where they’re due

There are two tax credits in the space: the Investment Tax Credit (ITC) and the Production Tax Credit (PTC). Generally speaking the ITC is more favorable for offshore wind and the PTC for onshore wind. The ITC is easier to raise for the offshore project sponsor as the credit is received in the year the project gets to its commercial operations date (COD) rather than a 10-year stream like the PTC, which requires long forecasts. Until the end of 2016, the ITC was worth 30% of an offshore wind farm’s cost, but like the PTC it is being phased out and will expire for all new projects after 2019.

“No-one is expecting the ITC to be reintroduced, so it will disappear,” says Tyler. “There are a few investors looking to take advantage of the last tranche of it before it runs out.” But David Burton, head of the renewable energy in Mayer Brown’s New York office, points out that the tax credits will not disappear after 2019, rather a project must “start construction” before the end of 2019 to qualify for the credits. The difference meaning that tax equity investors will still be attracted to the market.

For example, if a project starts construction on 1 November 2019, so long as it was “placed in service” (operational) by 31 December 2023 it would qualify for 40% of the tax credit — or in ITC terms 40% of 30% (or 12% of the project’s eligible tax cost). Furthermore, that deadline is only to meet an Internal Revenue Service safe harbour.  “The actual statute for the phase out of the wind tax credit does not have a service deadline, so if you want to go beyond 31 December of the year that includes the fourth anniversary of the start of construction, you could fight the Internal Revenue Service in court about it,” explains Burton.

If a project started construction in 2018, it would have until the end of 2022 to be placed in service and would be entitled to 60% of the ITC (or 18%). “Now, you are probably thinking that “starting construction” must mean driving steel beams into the ocean floor,” says Burton. “Well, actually, the Internal Revenue Service rules can be satisfied with far less than that.”

The rules offer two ways of starting construction without doing anything involving the ocean floor. The project owner could spend 5% of the ultimate cost of the project on equipment in the year it wants to start construction. So if the ultimate cost of the project is $1 billion, that would mean spending $50 million on equipment. The equipment would have to be delivered to the project owner within three and a half months of the payment and the $50 million would have to be paid by 31 December of the year in which the project owner wants to be seen to have started construction.

Alternatively, the project owner could contract with a manufacturer to construct a custom step-up transformer for the project. “The physical work (not designing or other office work) would have to start by the end of the year in which the project owner wants to be deemed to have started construction,” Burton says. “The project owner and the manufacturer must have a binding written contract before the work on the transformer starts. And if the project owner terminates the contract, its liquidated damages cannot be capped at less than 5% of the total value of the transformer contract.”

If a project started construction in 2016, it would have qualified for 100% of the ITC (or 30%).  “There are few offshore wind projects started construction in 2016. But an owner of an offshore wind project could partner with an onshore wind developer who started construction in 2016 but did not complete the project,” says Burton. There are however a couple of caveats: the 5% safe harbour equipment or the custom step-up transformer the onshore developer purchased in 2016 must actually end up in the offshore project, and the onshore developer must own at least 20% of either the project company’s capital or profits. “That requirement can be tricky after layering in a tax equity investor, but I believe it is feasible,” adds Burton.

Whether investors take advantage of the tax credits or not, the sale-leaseback structure will eventually be widely deployed for US offshore wind. The instrument is a more tax efficient structure than a partnership as 1% of the tax benefits do not have to be allocated to the sponsor, there is no depreciation haircut due to a “short” first tax year, and the capital account rules are not applicable. “There is a robust sale-leaseback market for equipment that does not qualify for tax credits (trucks and aircraft for example), and there is no reason that market will not eventually embrace offshore wind,” says Burton.

Add into the mix the sector’s already-cascading prices and the recent explosion in ESG investing worldwide, and there appear sufficient tailwinds to allow the US offshore wind market to sail through the loss of the tax credits and onto its destined seat among the major global players.

“In the long term, I think we have to find alternative mechanisms to get the costs down, but given the overall descending costs of power, the tax credits are becoming much less essential to the industry,” concludes Tyler.