|Offshore location map of the London Array. Click on the image to see a more detailed map from the London Array website (opens as a PDF).|
Shell backed out of its commitment to provide the financing for one third of the world’s largest offshore wind farm off the Kent coast. The London Array, expected to cost about £2bn, now needs to find a new investor. What about tapping the public? The project has reasonable economics, and private individuals could benefit from 40% tax relief by putting shareholdings into pension plans. Perhaps as importantly, such a move would raise understanding of renewable energy generation among the wider community.
The London Array is a proposed wind farm, located over 12 miles off the Kent coast in south-eastern England. Up to 340 large turbines will produce up to one gigawatt in strong winds. Actual production, taking into account periods of low winds, will average about 400 megawatts, equating to about 1% of total UK electricity needs. This is by far the largest offshore wind farm in the world.
The project has now finally succeeded in obtaining most of the consents and planning permissions necessary to build the farm and bring its electricity onshore to link to the high-voltage backbone of the grid. The remaining backers, E.ON and DONG Energy of Denmark, still face huge hurdles. Few manufacturers make turbines that can survive offshore conditions. Only a small number of vessels are available worldwide to construct the foundations of the turbines.
Nevertheless, the project should have acceptable financial returns. Much can go wrong, but a simple model shows that dividends should meet the requirements of most individual investors.
First, let’s examine the financial characteristics of the wind farm:
- Shell was due to put down one third of the money. The costs of this project have escalated substantially, but I assume that Shell’s withdrawal has left a hole of about £700m, including payments to the remaining consortium members for their efforts so far. Wind farms can be partly financed by debt – perhaps in a ratio of £300m debt to £400m shareholders’ investment in this case.
- If the debt costs 7%, then servicing will be about £21m per year.
- We cannot know accurately what the annual maintenance charges will be. A small onshore wind farm has operating and maintenance costs of about 15-20% of revenue. Expressed as a percentage of revenue, it seems unlikely that this huge project will have higher costs.
- Projected electricity generation is about 3,200 gigawatt hours. At typical electricity prices of about £45-50 per megawatt hour, the output from the entire project will be worth about £150m a year.
- This is less important than the money generated from Renewable Obligation Certificates. New rules mean that the farm will attract 1.5 ROCs per megawatt hour. At current ROC prices of about £50, the value of the output of the London Array will be approximately £240m.
We should be clear: neither the electricity price, nor the ROC value, is guaranteed. The price of ROCs is entirely dependent how much renewable energy is produced expressed as a fraction of the government’s target which rises over the years. The London Array is so large a project that its arrival will affect this ratio and this will push down the price. Nevertheless, forecasts of renewable generation still strongly suggest that the future price of ROCs will continue to be buoyant. In other words, there is little likelihood that the percentage of all electricity derived from renewable sources is never likely to rise fast enough, even with the Array, to cause a crash in the price of ROCs.
If private investors bought a one-third share in the project, the outline finances would look approximately like this for the first year of full operation. I have not included fund raising costs:
|Of which – debt||£300m|
|Other operating costs||£8m|
|Yearly operating profit||£109m|
|Depreciation over 25 years†||£28m|
|Money available for shareholders||£60m|
|Potential return on investment (before tax)||15%|
|After corporation tax||10.5%|
† This is not a cash cost, but can be used to generate a sinking fund that repays the debt and then the full investment after 25 years, with interest.
There are many questionable assumptions in this illustrative calculation; but it shows that to a private investor the returns may be acceptable. The income would be more attractive if the individual’s shares were placed in a pension fund. Such an investment would allow the higher-rate taxpayer to reclaim 40% of the cost of his or her investment, raising the effective return to 17.5%.
What does this mean for a 40-year-old investor putting money into the London Array for 28 years (a three-year construction period plus a twenty-five-year operating life) as part of pension planning? My very rough calculations suggest that an investment of £10,000 wrapped into a pension fund that accumulates all the payments from the Array would multiply the investment over 15 times after tax relief. I make the assumption that ROC and electricity prices stay constant and that the cash accumulating in the pension fund only earns 5% return. For the boffins reading this article, this is a real internal rate of return of well over 10% a year.
From the individual investor’s point of view, these figures ought to be reasonably attractive. There are substantial risks, such as cost overruns during construction and falling ROC prices, particularly during the latter half of the project life. But they are partly matched by the possibility of the Array realising higher electricity prices, and ROC prices rising over the next few years. An investment will also act as a hedge for the individual investor against rising retail electricity prices.
This quick look at the economics of the London Array shows why Shell backed out. The returns don’t match what it can hope to achieve getting oil out of the Alberta tar sands or in onshore wind projects in the US. Nevertheless, it also demonstrates that, properly packaged, the Array should be able to attract money from individual investors.
* The idea of using private investors’ money to plug the gap left by Shell was proposed by Phil England, climate change journalist. I am very grateful for permission to write about his idea.