• The offshore wind sector has gone through a remarkable period of value-destruction.

• Low capital costs and deceptively volatile project economics combined to cause a perfect storm for equities.

• The capital cycle approach helps identify such situations in advance and avoid the fallout. Could opportunities now be emerging from the rubble?

“Let it work, / For 'tis the sport to have the enginer / Hoist with his own petard.”

Prince Hamlet, in Hamlet, Act 3, Scene 1

Two blue-chip wind companies, Ørsted and Siemens Energy, are now 75% below the all-time high prices they achieved in 2021. This fall from grace is a stark reminder of why eagerness to support ‘the next big thing’, especially when intensified by political momentum and financial opportunism, must be carefully weighed against fundamental economic principles before considering investment. A core tenet of our approach is that by focusing on supply rather than demand, we reduce the distortive effect that powerful narratives can have on valuation. This article uses this lens to explore the recent boom and bust in the offshore wind sector, explain how our approach helps to avoid such situations, and ask where emerging opportunities might be found.

The bubble

The International Energy Agency (IEA) predicts that wind energy will surge to over 30% of global power generation by 2050. This represents a significant jump from its current 6-7%. To achieve this, capacity needs a dramatic expansion, with a 400% increase in the annual addition rate to 350 gigawatts (GW) per year by 2030 (1). This translates to installing approximately 35,000 modern offshore turbines annually, requiring offshore wind capital spending to match that of gas and coal combined. The numbers seem compelling. If the remarkable cost deflation that the IEA predicts materialises – suggesting wind energy could compete on a levelised basis with Chinese coal and US natural gas by 2050 – then the opportunity seems too good to be true. This trajectory, fueled by market interest and historically cheap capital, led to soaring valuations in the sector, exemplified by Ørsted's P/E peaking at almost 100x in early 2021.

How did the market reach such valuations? In essence, the problem was a simple one –future cashflows were mis-valued. The internal rate of return (IRR) of a typical offshore wind project was modelled at around 6-8% (2). This is lower than a typical oil and gas project IRR of 15-20% (3), but was long-dated, and perceived as having both low operational and financing risk. After all, unlike oil and gas, as a form of renewable energy offshore wind is perceived as a growth industry with regulatory tailwinds including substantial tax incentives. Furthermore, capital costs were exceptionally low, and the perception was that rates would remain near-zero. Ørsted targeted a spread of 150-300bps over the weighted average cost of capital (WACC), which they claimed was future-proofed against rising rates thanks to selling purchasing agreements indexed to inflation (4). They claimed that absolute revenues would rise above cost, thus preserving their margin. When analysts plugged these numbers into their discounted cashflow models, the low-risk, long-dated IRR with a positive spread over WACC yielded a stream of positive free cashflows disappearing far into the future. The excitement was compounded by near-zero discount rates which hiked up the present value of this future income. Combined with the IEA’s well-publicised predictions of drastically falling costs, the outlook looked rosy and equity valuations soared. Predictably in such circumstances, capital flooded into the industry and wind producers started taking on large amounts of debt to finance further growth, as present-day revenues – and margins – remained low. Ørsted’s EV/Sales drifted north of 12x in early 2021 (see Figure 1, below).

The bust

What was wrong with these cashflow valuations and the models that drove them? There are three principle interconnected problems. (1) The projected cost deflation associated with technological advancement was misunderstood and overestimated; (2) both headline and operating cost inflation was underestimated, and; (3) the possibility of sharply rising capital costs was overlooked. We will address each in turn.

Throughout history more efficient forms of energy generation have superseded established technologies. The question is whether wind can become more efficient than what it seeks to replace. Wind energy has a net energy return on energy invested (EROEI) of about 20x, which means over time an average wind asset outputs twenty times more energy than it took to build it, factoring in efficiency. This is reasonable – it is about four times better than most oil products – but still lower than gas, coal, hydro, nuclear, and the overall global energy system’s average of 30x (5). More problematic is that wind’s energy return is not only lower, but also slower than many alternatives. The capital, material, and energy intensity of constructing a wind asset takes years to pay back, and the overall return does not reach 20x until you measure the asset over a 30-year lifespan. This contrasts unfavourably to fuels like coal, where the energy output of combustion pays back the energy cost of extraction many times over in mere months.

The lofty valuations achieved by many wind companies assumed cost deflation was being driven by technological innovations that drove up efficiency. In turn, this would increase net EROEI, and resultantly drive down levelised costs. This assumption is the root of our first problem. It is an understandable assumption. This is the playbook for solar, which is a semiconductor technology and therefore subject to Moore’s Law-type efficiency gains. Photovoltaic cells, like transistors, benefit from increasing semiconductor miniaturisation. This has allowed them to capture more and more energy from across the spectrum of incoming light, boosting efficiency and promoting positive feedback loops. Investors can reasonably expect such progress to continue; at the very least, there is a scientific justification for such an expectation. But despite the media’s insistence on lumping ‘wind and solar’ together, they are very different technologies. The basic physical and technological principles behind wind power have not changed in 700 years. The focus for achieving efficiency gains has been increasing blade and turbine size, but this is a two-sided coin. In short, while wind’s power generation rises as a linear function of swept area, the force required to overcome air resistance rises as a cube function of velocity. So, while bigger is better up to a point, the marginal gains of greater size eventually shrink exponentially.

Not only do ever-larger turbines present engineering problems, they also raise costs. This brings us to our second problem: cost underestimation. Headline costs for UK wind projects have been inflating at a 2.5% compound annual growth rate since 2000, on a dollars per watt of capacity basis (see figure 2, above). Meanwhile, in the models that underpin the 6-8% project IRRs, degradation rates and operating costs were estimated as low and not expected to inflate. In fact, many thought these metrics would only fall further as technology improved. Instead, industry data revealed the reverse. Larger turbines increase mechanical stress, while rough seas caused unexpectedly severe weathering. Research suggests annual degradation rates reach 2-4%, versus the 0-1% modelled when calculating expected returns (6). This not only raises maintenance outlays but also feeds back into headline capex costs, as higher degradation rates lead to shorter asset lives.

Compounding both issues was the overlooked impact of rising rates on the cost of capital. This is our third problem, and it was the most severe. Capital costs are particularly relevant for energy assets that take a long time to generate a positive return, because they are long duration. Small changes in discount rates can dramatically affect the present value of their cashflows. Offshore wind is especially highly exposed to this type of risk because it is so capex intensive, at about $4000 per kilowatt-hour (kWh). At this level, each 1% rise in long-term capital costs adds about 1.3c/kWh to the levelised cost of the energy generated (see figure 3, below). As rates rose precipitously from zero to 5%, the basic cost of wind energy re-inflated dramatically (by about 30%) (7).

These three factors combined to spell a death knell for wind projects around the world. Relatively minor changes in modelled assumptions torpedoed project IRRs (see figure 4, below). While some purchasing agreements between utilities companies and wind producers had been indexed to inflation, nominal revenues would not rise enough to offset the dramatic increase in forecast costs. Many PPAs were cancelled outright, as producers failed to renegotiate at offtake prices 50-60% higher than initially quoted (8). In the UK, one major offshore wind auction failed to receive a single bid (9). Future cashflows flipped negative. High leverage increased the pace and severity of value destruction as these changes fed through into equity valuations.

Greener pastures?

Now that the cycle is turning, could opportunities be peeking from the rubble? Perhaps. On the one hand, we remain concerned about even the longer-term prospects for offshore wind. The interaction between capital cost inflation and a lack of technological momentum suggest that the IEA’s forecasts of 2c/kWh wind energy seem worryingly optimistic, unless the financing capital is practically free. On the other hand, the general direction of travel towards greater renewables deployment seems clear. The bust in valuations will apply a brake to the pace with which new capacity and the capital that funds it can be brought to bear, while simultaneously catalysing rationalisation. The supply picture is still far from tight, but certain companies may now be positioning to capitalise on the overall market opportunity at lower risk premia than the pure-plays.

One such company that has recently entered the Hosking Partners portfolio is Altius Renewables Royalties (ARR). The brainchild of a bankruptcy-lawyer-come-renewable-energy expert Frank Getman, ARR half-owns Great Bay Renewables (GBR) alongside private equity firm Apollo. GBR provides project financing to renewables projects in return for a new class of renewable royalty. This offers exposure to the theme, but without the sorts of risk which have decimated the returns of offshore wind investors over the past twelve months. By taking a clip off the topline of the most promising renewables projects, ARR’s income is not exposed to cost volatility, and as time goes by its revenues should increasingly concentrate in the most economically robust renewables ventures (by definition, the ones that survive). To create this class of royalty, Mr. Getman had to gain legal recognition for a perpetual contractual interest which is not a land interest, and acquire royalties over unbuilt development projects. These rights are then converted into royalties as each project reaches completion, until a return target (8-12% pre-tax unlevered IRR) has been achieved.

The second of these innovations was critical for launching the company. Unlike mineral royalties whose resource is eventually depleted, renewable royalties should theoretically last forever. In fact, they may even become more valuable over time as the infrastructure used to capture the energy (solar panels, wind turbines, etc) is replaced with more technologically advanced and efficient upgrades.

Furthermore, a renewable project’s connection to the grid creates free optionality for the royalty holder from future projects on that land. This will become increasingly relevant as nimbyism asserts itself. The portfolio approach to development projects breaks the link between where capital is allocated and where the royalties come from. Once sufficient royalties have been created, GBR retains an ongoing option to acquire royalties in the remaining projects in the developer’s portfolio at a predetermined 10.5% IRR, which in simple terms is a valuable option on interest rates. Overall, Altius’ model allows us exposure to the renewable energy theme, while providing protection against the short-term, unpredictable swings driven by the macro environment.

Conclusion

Hosking Partners’ capital cycle approach is focused on the flow of capital and the likely trajectory of returns as a result. Our long-term and generalist mindset helps us take an outside view, whenever possible. In Charlie Munger’s words, “to invert”. When offshore wind companies began taking on debt despite poor returns while their equity traded at extraordinarily high multiples, the red flags were waving. Instead of participating, we saw more attractive opportunities in legacy ‘old energy’ industries which were starved of capital and trading on low valuations. That approach bore fruit in recent years, as the renewable bubble burst and the cold realities of supply bit back against unsustainable narratives around demand and macro conditions. In 2024 we will continue to search for opportunities amidst the wreckage, as we apply our capital cycle lens in the new energy revolution.