Global Infrastructure & Project Finance Power/Europe

Construction Risk in Offshore Wind Farms Special Report Key Risk Factors Contents Background Multi-Contracting Prevails Multifaceted Supply Chain and Evolving Technologies Weather Risk Adds a New Dimension Distance and Water Depth Risks Cable Installation is a Challenge Logistical Complexities Rating Implications

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Interface Risk: The reliance on multi-contracting structures in European offshore wind farm construction projects introduces interface risk among contractors and exposes the projects to an increased risk of delays and cost overruns. Such risks can be partially mitigated by the structural elements of the contracts (eg an Interface Agreement) and the experience of project sponsors in managing the contractual packages. Multifaceted Supply Chain: Many contractors are involved in offshore wind farm construction due to the granularity of works and tasks. With the exception of some wind turbine and electrical suppliers, most contractors tend to display sub-investment-grade (IG) financial strength. Fitch Ratings will assess the contractors‘ experience and financial strength in the context of the project‘s complexity to determine if a particular contractor constrains the rating. The use of technology with limited operating track record may also constrain the rating. Substantial Weather Risk: Unfavourable weather is the main cause of delays and cost overruns during construction; this risk remains largely uncovered in multi-contracting structures. Fitch will assess the location of the project, the vessel arrangements and the scope and duration of offshore works to determine the magnitude of the weather risk. Fitch believes that the further the project is away from the shore, the greater the risk, as weather conditions become less predictable. Cable Installation: Cable installation is a critical project phase where many existing offshore wind farms have experienced problems. The parties responsible for cable installation vary across European regulations, but in most countries the responsibility lies with the project developer. Fitch views that due to the alignment of interests, project developers are best positioned to undertake cable installation, as opposed to the national transmission system operators or independent companies. Complex Marine Logistics: Vessels and ports play a substantial role in offshore wind farm construction. The vessels‘ market in Europe remains fragmented and offshore wind projects often compete with offshore Oil & Gas projects for vessels. Partnerships with marine installation companies and vessel back-up arrangements are therefore favourable to these projects. The offshore wind industry‘s move to larger turbines presents further challenges, as ports and vessels need to accommodate larger and heavier equipment.

Rating Implications

Related Research UK Offshore Transmission Operators (November 2011)

Analysts Jelena Babajeva +44 203 530 1375 [email protected] Federico Gronda +39 02879 087 287 [email protected]

www.fitchratings.com

Material Construction Risk: High project costs, complex construction work, exposure to delays (due to adverse weather) and the involvement of numerous contractors are the key risk factors in offshore wind farm construction. Fitch views that these factors materially differentiate the construction of an offshore wind farm from an onshore peer and place the associated completion risk between that of traditional thermal power plants and large Oil & Gas projects. Rarely Investment Grade: Common industry features during construction — lack of singlepoint responsibility contracts and unwrapped weather risk — do not generally support the IG rating of non-recourse debt. Construction arrangements may be considered as in line with IG features under limited circumstances, such as the involvement of strong (IG) sponsors and credible contractors with substantial experience, and prudent project structuring, including sizeable contingency funding.

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Global Infrastructure & Project Finance Background The EU is leading the offshore wind industry with 3.8GW of installed capacity at the end of 2011. Further high growth is expected as a result of EU commitments to increase energy production from renewable sources. Offshore wind farms benefit from higher and steadier wind speeds, as well as from bigger and more efficient turbines that would not be possible to install onshore; this allows investors to capitalise on economies of scale. The investment costs of offshore wind farms remain substantially higher than for onshore projects, but so are the subsidies endorsed by national governments (eg in the form of feed-in tariffs) to support these projects. To date, most offshore wind farms have been financed by utilities from their corporate balance sheets and non-recourse financing has been limited. As projects grow in scale and utilities‘ resources are used up, future projects are expected to be financed by other sources, including non-recourse project debt. Fitch updated its Rating Criteria for Onshore Wind Farm Debt Instruments in April 2012. While many considerations in the criteria also apply to offshore wind projects, the challenges associated with the offshore environment result in their risk profile differing from that of a typical onshore project. Construction risk in particular stands out; Fitch views that this risk has been one of the main obstacles to financing offshore wind projects. Operating and technology risks may also be significant and are briefly explained later in the report.

Multi-Contracting Prevails Engineering, Procurement and Construction (EPC) contracting for the construction of European offshore wind projects has been limited to date. This is due to the relatively nascent nature of the industry and the lack of experienced contractors able to take responsibility over the whole project. Likewise, the two-contract model commonly used in onshore projects — with a Turbine Supply Agreement (TSA) and an EPC contract for the rest of the works (balance of plant) — is not usually used in offshore wind projects. Multi-contracting structures are typically used to build offshore wind farms in Europe. In projects where non-recourse project finance debt is raised, the number of contracts is normally between four and eight. The main contracts include a TSA, a foundation supply agreement, a contract with a marine contractor, a contract for electrical infrastructure and a contract for cable installation (see Figure 1). Marine contractors are usually responsible for the offshore installation of foundations, wind turbines and offshore substations. Multi-contracting introduces interface risk among contractors, ie the risk of disagreements on scope and responsibilities where there is an overlap of tasks, in particular as regards critical technical interfaces (see Figure 1). The risk is heightened in projects with less than benign site conditions, where the likelihood of delays and bottlenecks — triggering contractor responsibility issues — is greater. Interface risk is generally believed to increase with the number of contracts, although this often depends on the underlying quality of the contractors. For example, a structure with six contracts with reputable companies and well-defined interfaces is preferable to a three-contract structure, where the sub-contractors do not have appropriate experience or the interfaces are not well defined. The current trend of (stronger) wind turbine manufacturers to increase the scope of their responsibilities by taking on marine transportation and installation risks, is seen to reduce interface risk. Related Criteria Rating Criteria for Onshore Wind Farm Projects (April 2012 )

Stronger multi-contracting structures are those where there are several fixed-price contracts with experienced international contractors and well-mitigated interface risk, as confirmed through technical due diligence.

Rating Criteria for Infrastructure and Project Finance (August 2011)

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Figure 1

Project Works in Offshore Wind-Farm Construction

2 1 6 5

Project Works

Onshore Substation

Onshore Cable

Port Logistics

Offshore Cables

Offshore Cable Installation

Typical Contractors

Electrical Suppliers

Electrical Suppliers

Port Operators

Offshore cable suppliers

Cable Installation Foundation Suppliers Contractors

Offshore Substation Foundation

4 3

Substation Electrical Equipment

Offshore Installation

Foundation

Wind Turbine

Electrical Suppliers

Marine Contractors for Vessels and Offshore Installation

Foundation Suppliers

Wind Turbine Suppliers

Main Technical Interfaces 1 Wind turbine - foundation interface 2 Wind turbine - electrical systems‘ interface 3 Foundation - J-tube/Inter-array cables interface 4 Substation foundation/substation electrical equipment interface 5 Offshore substation/offshore cable interface 6 Offshore/onshore cable interface Source: European Wind Energy Association (EWEA), Fitch

Measures to mitigate interface risk include: contractual responsibility allocations being explicitly mirrored in each relevant project contract; clear procedures for hand-over between contractors for each interface; and contingency in budgets and time schedules. A separate ‗Interface‘ agreement, stipulating the delineation of the respective contractors‘ responsibilities and establishing a well-defined dispute resolution process, is also viewed as important. It should provide the framework to resolve issues without causing delays or cost overruns. Fitch will also look into the sizing of liquidated damages (LDs) provisions to assess the extent to which delays on one contract triggering delays on other contracts could be compensated. However, these measures are almost ‗obligatory‘ in multi-contracting structures and are not in any way credit enhancers. Fitch will also evaluate a project sponsor‘s experience of managing contractual packages in similar projects. Fitch does not regard onshore wind project experience as directly relevant, due to the substantial marine logistics involved in offshore wind projects. Offshore Oil & Gas is considered to be more relevant, although direct offshore wind experience is preferred.

Multifaceted Supply Chain and Evolving Technologies Project works during offshore wind-farm construction are granular and interdependent. Even smaller contracts can have a critical impact on the rest of the works. A snapshot of the current status of the supply chain for the offshore wind industry (Figure 2) suggests that offshore installation and cable supply contracts are the critical pinch-points. Electrical infrastructure contracts appear to be less critical, due to standardised equipment and no evident supply chain constraints.

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Figure 2

Offshore Wind Supply Chain Wind turbine suppliers

Foundation suppliers Electrical suppliers

Marine contractors for vessels and offshore installation Offshore cable suppliers Cable installation

Usual type of contractors Industrial manufacturers, energy equipment manufacturers, specialised wind turbine manufacturers. Small- to mid-sized engineering and construction companies. Electrical equipment manufacturers, typically part of diversified industrial/energy groups. Specialised offshore wind installation companies or generic offshore installation companies. Established power, telecom and fiber optic cable manufacturers. Specialised small- to mid-sized cable installation companies, possibly part of larger construction/ civil engineering groups.

Overlap with other sectors Onshore wind.

Offshore Oil & Gas, coastal/civil engineering. Power transmission/ distribution. Offshore oil & gas, coastal/civil engineering.

Civil engineering, commodities markets. Offshore oil & gas, telecoms coastal/civil engineering.

Supply chain limitations

Complexity of works under the contract

Medium

Medium

Medium

Medium

Low

Low

Medium to High

High

High

Low

Medium to High

Medium to High

Source: Fitch

As part of its analysis of completion risk, Fitch will assess the quality and the track record of contractors (and subcontractors) involved in the construction process, including foundation suppliers, wind turbine manufacturers, electrical infrastructure suppliers, marine contractors, offshore cable suppliers and cable installation contractors. Fitch will also analyse the performance bonds and LD provisions to guarantee the delivery of the contract works on time and according to specification. With the exception of several wind turbine and electrical equipment suppliers, Fitch views very few contractors in the offshore wind industry as being of IG credit quality. Foundation suppliers, marine contractors and cable installation contractors, are typically small- to mid-sized private companies with low to medium financial strength. Fitch recognises that technologies for offshore wind are constantly evolving, with new players entering the industry. The entrance of new players with limited track record — and in some cases, weak financial capabilities — while providing advantages in terms of innovation and efficiency, is seen to further increase the uncertainty as regards the strength of contractual obligations, especially as the projects are becoming larger in size. Ultimately, whether a particular contractor may constrain a project‘s rating will depend on: the complexity of the project; whether the technology is proven; the contractor‘s direct experience in similar projects using similar technology; and the timely delivery and ease of contractor replacement, should the contractor prove to be unreliable. Fitch will also assess the reliability of the technology, as completion risk not only includes a project‘s delivery on time and on budget, but also the equipment‘s performance according to design parameters, as confirmed during commissioning. From discussions with technical advisers (TAs), Fitch understands that the current rate of technological change in offshore wind industry is significant, with technological advancements on several equipment components at the same time. Siemens and Vestas remain the leaders in the offshore wind turbine space, accounting for about 90% of the currently installed worldwide capacity, with 2-3.6MW (megawatt) turbines. RePower and Areva are gaining market share with their 5MW turbines. The industry is moving towards bigger (5MW and higher) and more offshore-specific turbine models, for which there is less (or even no) track record. Some of these are brought to market by strong investmentgrade diversified industrial companies (GE, Alstom, Mitsubishi) while some are introduced by smaller dedicated wind turbine manufacturers (Nordex, Gamesa).

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Global Infrastructure & Project Finance Fitch will assess the extent of technology modifications, the existence of onshore prototypes, as well as equipment certification to evaluate whether new technologies present an incremental risk to a project. This risk will be assessed in the context of the performance guarantees provided and the financial strength of the manufacturers providing those guarantees. In general, for a project to be considered in line with investment-grade features, technology for the main equipment has to be proven, as confirmed by an independent TA. In case of weak or no operational track record of the main project technologies (wind turbines, foundations), the project debt ratings are likely to be constrained to sub-investment grade, unless there are appropriate performance guarantees provided by credible investment-grade counterparties.

Weather Risk Adds a New Dimension Fitch views weather risk in offshore wind farm construction as high, in particular in projects located in colder and harsher climates and in projects further offshore. Unfavourable weather has been the main cause of construction delays and cost overruns during offshore wind farm construction to date. In Northern Europe, with 60%-70% of days in a year suitable for installation and the majority of works taking place between March and October, installation is extremely time critical. Fitch understands that industry standard practice involves installing the foundations in winter and the turbines in summer; this is viewed as a more prudent approach, as opposed to the parallel installation of foundations and turbines. Contractors may accept some weather risk in multi-contracting structures, subject to certain conditions and exclusions (eg the maximum number of stand-by days), but weather risk ultimately resides with the project sponsor. Fitch is not aware of any insurance products available to cover weather risk during construction. A site accessibility analysis – a probability-weighted analysis that incorporates the site‘s metocean conditions (wind speed, wave height, tides and currents) – is used to estimate the weather slots suitable for installation. Wave height and wind speed are considered the main determinants of accessibility. Weather-related delays may occur throughout the construction phase and can range from a couple of days to several months. Industry experience shows that weather conditions may be unsuitable not only during installation, but also during sea transit and even during loading of the equipment at ports. Delays are also more likely to arise during turbine installation, rather than foundation installation, as turbines require more precision work which is more susceptible to weather conditions. Onshore assembly of turbines, and even onshore testing, has been used in several projects to reduce the duration of offshore works, subject to space conditions at ports. The most critical (and expensive) delays occur when vessels booked for the installation stage remain idle — often due to unsuitable weather conditions — and consequently relocate to another project site, requiring project sponsors to find replacements at additional cost. Therefore, the contractual availability of the vessels and whether the contracts accommodate a contingency for potential weather delays, are important factors in Fitch‘s analysis of construction risk. Equally, partnerships with marine contractors for flexible vessel arrangements, or back-up plans for alternative vessels, are advantageous. Given the significance of weather risk, Fitch would consider a project‘s exposure to such risk as adequate only under limited conditions; these include: benign site conditions with low probability of storm events or extreme waves; thorough site accessibility analysis, confirmed by a TA; and the development of contingency plans (in particular, for vessel arrangements) in case of weather delays. Equally, contingency funding should be available to projects in case of cost overruns and delays caused by unsuitable weather. Such funding should be at levels significantly higher than

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Global Infrastructure & Project Finance in typical construction projects and commensurate with the risks for the particular site. Fitch will evaluate the exposure of a project to weather risk and this will also serve to assess the adequacy of the contingency funding available to a project.

Distance and Water Depth Risks With the development of new technologies, offshore wind projects are moving further away from shore to benefit from higher wind speeds, and as a consequence, into deeper waters. There are some similarities between deep-water installation of offshore wind farms and offshore Oil & Gas production platforms: however, while offshore Oil & Gas construction is more technologically complex, offshore wind construction requires greater logistical coordination of many repetitive tasks. Existing offshore wind farms typically fall within ‗20/20‘ operating parameters, ie up to 20km in distance to shore and up to 20m in water depth. While many new projects also fall within these parameters, many future builds are envisaged at water depths of between 20m-50m and distances ranging from 20km to 100km from shore. Figure 3

Offshore Wind-Farm Characteristics Average water depth (m) Average distance to shore (km) Wind farm capacity (MW)

2009 installations 12.2 14.4 72.1

2010 installations 17.4 27.1 155.3

2011 installations 22.8 23.4 200

Average of projects under construction 25.3 33.2 300

Source: European Wind Energy Association (EWEA)

Both the distance and the water depth pose additional challenges during construction. Fitch views that further distance from shore increases the risk of weather-induced delays, due to harsher and less predictable weather conditions. Water depth dictates the type of foundation, along with the ground conditions and the technical characteristics of the turbine. Monopile foundations are prevalent in current offshore wind farms, and are generally cheaper and easier to install than other foundation types. As the industry moves towards deeper water and turbine sizes of 5MW+, jacket foundations and tripods are expected to become the prevailing foundation type. The development of new concepts, such as floating structures (for water depths above 50m) is under away, but their commercial use is yet to be proven. Both the distance and the water depth may require different installation vessels and methods. That said, shallow waters and inter-tidal areas selected for offshore wind farm locations present their own challenges. Fitch regards distance from shore to be a more meaningful consideration in terms of construction risk than water depth. Subject to the use of proven technology (eg jacket foundations) and detailed surveys of ground conditions, water depth requirements can be prudently accommodated in the design and installation plans; however, weather conditions further offshore cannot be predicted with certainty. Fitch will review the installation experience of project developers and marine contractors under similar conditions when assessing the extent to which distance from shore increases weather risk.

Cable Installation is a Challenge Many of the problems encountered during offshore wind farm construction relate to the installation of export cables, which connect the offshore substation to the onshore grid. This area has to date triggered more insurance claims than the rest of the construction works combined. The installation of inter-array cables (cables that connect the individual wind turbines to the substation) has seen similar issues, but to a lesser extent, given the shorter distances involved. Typical problems during cable installation include damage or bending of the cables and the inability to achieve sufficient cable burial depth.

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Global Infrastructure & Project Finance Although cable installation accounts for just 10%-15% of offshore investment costs, it is a critical project component, without which the wind farm will not be able to transmit power. The current industry-wide shortage of subsea cables — caused by the growth of offshore installations in a capacity-constrained market, with few suppliers and lead times up to three years — makes this a critical planning consideration. The regulations which govern offshore wind farm connection to national grids vary across Europe, but in most countries responsibility lies with the project developer. Denmark and Germany are the known exceptions, where the Transmission System Operator (TSO) is responsible for the grid connection. The proposed ‗enduring framework‘ for UK Offshore Transmission Operators (OFTOs) offers project developers an option to outsource cable installation to independent companies. Fitch views that due to the alignment of interests and synergies with respect to project and vessel coordination, wind farm developers are better positioned to undertake the subsea cable installation. Therefore, where the grid connection is undertaken by a party other than the project developer, this will generally be regarded as a credit negative. For example, the regulatory timing uncertainties in Germany, where the cable installation is undertaken by TSO, are known to have caused significant delays to the commissioning of some wind farms. Ideally, work on export cable installation should commence before or at the same time as the installation of the foundations begins (the pre-requisite being the installation of the offshore substation). Furthermore, Fitch will consider projects well structured with respect to cable installation only when the seabed and the cable route have been properly assessed to determine the most appropriate burial method and depth.

Logistical Complexities Project management and logistical arrangements in offshore wind farm construction are far more complex and granular than in onshore wind projects. The cost of the wind turbines is 70%-75% of the total project cost in onshore wind projects, as opposed to 50% offshore, with the rest of the project costs related to foundations, cables, installation and civil works. Marinerelated infrastructure, such as ports, vessels, cranes and qualified marine personnel, are important considerations in offshore wind projects. At least six different types of vessels are required during the planning and construction stage, and projects often use many more vessel types due to the magnitude of installation requirements. Fitch considers it prudent to have a cushion in the vessels‘ operating limits (such as load weight, height, maximum wave height) above those expected during installation, to avoid operating the vessels at their limit of their capacity. The industry‘s move to larger turbines requires bigger vessels with more powerful lifting cranes. New, offshore-wind specific vessels are known to be entering the market to cater to the more complex installation needs of future projects. Fitch notes however that these vessels will have no installation track record and the delivery of the vessels themselves may be subject to delay. Fitch will factor this into its analysis of project delay risk. The installation vessels‘ market in Europe remains fragmented and constrained. Day rates for such vessels are not uniform and can be influenced by factors such as vessel type, the location of the project, seasonal variations and competition from other projects (including the offshore Oil & Gas sector). This will be considered as a risk factor in projects where no alternative vessel arrangements at a known price have been made. Port requirements are another logistical consideration, which have to be considered together with the vessel requirements and equipment characteristics. Fitch views positively the industry trend of shipping equipment from better-equipped manufacturing ports directly to the project site, as this reduces logistical complexity and allows the maximisation of onshore assembly.

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Global Infrastructure & Project Finance Fitch will review the project sponsors‘, the marine contractors‘ and the ports‘ experience of similar projects when assessing the risk of logistical complications.

Rating Implications Fitch views that the risk of completion delays and cost overruns in offshore wind farm projects is material. The industry‘s commonly observed features, as described in the report, do not appear to mitigate such risks to the extent necessary for the debt financing a project‘s construction to be rated investment grade. Fitch views the lack of a single-point responsibility contract during construction and the unwrapped weather risk as key constraining factors. Weak contractors, or contractors with insufficient industry experience in the context of the project‘s complexity, may be an additional rating constraint. Figure 4 shows a simplified version of the construction arrangements typically observed in investment-grade-rated greenfield projects. Due to the high project costs, the complexity of construction work and the number of parties involved, the risk associated with the construction of offshore wind farms is considered to fall between that of traditional thermal power plants and large Oil & Gas projects. Figure 4

Typical Investment-Grade Construction Arrangements Onshore Wind and Solar PV

Thermal Power

Offshore Wind

Oil & Gas

EPC

?

Completion Guarantee

Equipment EPC

Equipment 1

Equipment Equipment 1 2

EPC 1

EPC 2

Balance of Plant

Equipment 1

Installation

Equipment 3

EPC 3

EPC 4

Balance of Plant

Balance of Balance of Plant Plant

Balance of Balance of Plant Plant

Source: Fitch

Construction risk in thermal power plant projects is typically mitigated by a fixed-price and datecertain EPC agreement with a contractor with substantial experience and strong credit quality. On the other hand, the complexity of the works and the magnitude of the costs associated with the construction of large Oil & Gas projects is such that no engineering firm is willing to provide a comprehensive EPC contract with single-point responsibility. However, these projects are typically capable of achieving investment-grade ratings, as the debt is wrapped by investmentgrade sponsors until completion of construction. In the absence of similar guarantees, the financing of greenfield offshore wind farm projects is rarely expected to qualify for an investment-grade rating, unless particularly strong features are present. These would include sponsors with strong credit quality (investment grade) who are committed to the sector and have substantial experience in delivering projects under multicontracting structures, coupled with a strong equity contribution to the project. In addition, such projects would need to benefit from the presence of experienced contractors, prudent structuring in terms of interface risk, weather risk and construction schedule, and sizeable funding contingencies. In Fitch‘s view, few of the project finance transactions that have achieved financial close to date display the level of construction risk mitigation necessary to achieve an investment-grade rating. In addition to construction risk, Fitch views that the operating and technology risks are also higher for offshore wind farms compared to onshore projects. Fitch‘s Rating Criteria for Construction Risk in Offshore Wind Farms May 2012

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Global Infrastructure & Project Finance Onshore Wind Farm Debt Instruments, April 2012 lays out Fitch‘s general approach to analysing operating, technology and energy resource risks for onshore wind farms; the same principles will be followed in offshore wind farm project risk analysis. With respect to technology risk, the generally shorter track record of offshore technology, in combination with logistical challenges, will result in lower expected availability levels compared to onshore wind projects. Fitch will review to what extent the proposed technology for the main equipment (wind turbines, foundations) is proven, as well as the financial strength of equipment suppliers. Fitch notes that with the emergence of new offshore turbine models which lack operational track record, project debt ratings are likely to be constrained to sub-investment grade, unless appropriate performance guarantees are provided by credible investment-grade wind turbine manufacturers. Demanding offshore operating conditions result in a less predictable operating profile. Fitch expects to apply harsher stresses in its rating case to operating costs for offshore projects, compared to those applied to a typical onshore wind farm. The debt service coverage ratio (DSCR) threshold for an investment-grade rating – set at 1.30x under Fitch‘s rating case for a fully contracted onshore wind farm project – may also need to be higher, to compensate for the greater uncertainty affecting such projects.

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