Shifting Dynamics: Competitive bidding calls for new wind EPC strategies

Competitive bidding calls for new wind EPC strategies

The increasing size of wind turbines and the growth of the offshore industry have made it necessary for wind power developers to undertake careful planning and execution at each stage of the project, from concept to commissioning. In order to ensure the smooth implementation of projects, developers have worked out various strategies to award the entire works including equipment sourcing, civil works and erection, and pre-commissioning testing and maintenance.

There are several options available to wind farm developers. The first is to sign separate contracts for the supply, installation and commissioning of wind turbines and for the balance of plant works including foundations, substations and cabling. This makes it possible to reach a wider range of participants and select companies with expertise in different areas of operation. However, the model suffers from several flaws such as complex project management, increased risk for the developer, and difficulty in attributing project delays to a particular party.

The second is engineering, procurement and construction (EPC) contracting in which the principal contractor carries out the detailed engineering design of a project, procures the necessary equipment and materials, and then constructs and commissions the plant. The contractor commits to deliver the completed plant for a guaranteed price within a stipulated period and with a guaranteed performance level. In this case, the developer bears no interface risk and is in fact eligible to receive financial compensation from the contractor in case the latter fails to comply with any of the clauses agreed upon. The downside is that the project cost increases as the EPC player adds his margin for bearing the risk. Moreover, the process is time consuming and entails significant legal costs.

The third option is forming an unincorporated joint venture in which multiple contractors deliver the project without forming a separate legal entity. There is a single contract between the wind farm developer and the consortium of suppliers. Although this option offers the same advantages as the EPC one, it comes with more security safeguards as more companies are involved in the consortium.

Although the multi-contract approach clearly offers the best opportunities for cost reduction, it requires the developer to have vast experience, engineering expertise, as well as tendering and negotiation skills. However, with a competitive tender process and pragmatic approach, the strategy of awarding a smaller number of contracts can also lead to considerable cost reductions.

EPC model in onshore and offshore wind development

EPC contracting is more prevalent in the onshore wind industry while multi-contracting is preferred in the offshore wind market. EPC contracting is less common for offshore projects owing to the risks involved in their development and the fact that very few commercial entities are large enough to go ahead with those risks. Further, the inability of EPC contractors to predetermine the scope of offshore project development leads to delays and disruptions in project execution.

On the other hand, multi-contracting helps in dividing all the responsibilities of a pure-play EPC provider among various contractors on a project-to-project basis. Here, the developer can choose different contractors for various stages of project development. Such contracts require greater involvement of the developer during the design and construction phase. Splitting contracts is, therefore, the preferred option for experienced project developers. However, lately, a shift is being noted from multi-contracting to limiting the number of contractors to two or three (similar to the EPC model) in the European wind offshore market. This is mainly due to the various project financing options being offered by banks and other institutions, which compel developers to reduce project development risks. Limiting the number of contracts is likely to bring down the potential overrun costs in the project compared to the multi-contracting approach, where delays by one contractor have a ripple effect on other contractors. Focusing on two or three contracts often carries a higher risk premium upfront because it spreads the interface risks related to all the awarded packages among the contractors.

Wind EPC models in India

Traditionally, wind project development in India has been dominated by the concept-to-commissioning model, under which projects were fully developed by manufacturers and offered as end-to-end solutions to asset owners. Wind project development practices, however, changed with the emergence of independent power producers (IPPs) following the introduction of generation-based incentives (GBIs) and the hike in feed-in tariffs (FiTs) in key wind states. The IPPs sought to generate the maximum output at the lowest possible cost in order to optimise returns and hence shifted from the concept-to-commissioning model to the self-development model, engaging in site selection, land acquisition, securing of permissions, etc. With the emergence of this model, wind turbine manufacturers increased their focus on delivering efficient and cost-effective technologies and undertaking only installation, commissioning and operations and maintenance, without participating in early-stage project development activities. A shift to the IPP-based model also paved the way for the entry of pure-play EPC companies that provide a wide range of services across different product categories.

The Indian wind energy segment is now moving away from a regime of awarding wind energy contracts and signing electricity purchase agreements on a preferential basis with FiTs to the competitive bidding mechanism for project allocation. In February 2017, the Solar Energy Corporation of India auctioned 1 GW of wind capacity based on the viability gap funding mechanism. The tender was oversubscribed by 2.6 times and resulted in the tariffs falling to Rs 3.46 per kWh. This winning tariff was in sharp contrast to the average wind FiT of around Rs 5 per kWh across the country. The success of the tender encouraged the government to come up with another tender for the allocation of 1 GW of wind capacity through competitive bidding.

The shift to a competitive bidding-based model was necessitated by the fact that the old model of wind procurement had become dysfunctional. Significant delays in signing power purchase agreements, the growing incidence of grid curtailment and payment delays of up to 18 months were hurting developers badly and damaging the segment’s prospects.  Further, a key objective of the government for taking up the reverse auction route was to ensure project continuity, which may have otherwise been adversely impacted by the phasing out of accelerated depreciation benefits and the removal of GBIs.

While competitive bidding is expected to help expand the wind energy market, low tariffs can compress the returns for wind project developers. According to ratings agency ICRA, at a capital cost of Rs 65 million per MW, capacity utilisation of 24 per cent, debt tenors of 18 years and interest rates of 10 per cent, the internal rate of return for wind energy projects would be less than 10 per cent at the tariff discovered in the latest auction. Such low returns would force project developers to strike a hard bargain on equipment as well as EPC prices. Moreover, due to auction-based allocation, developers would choose the most cost-efficient turbines rather than buying a package of land, machine and construction works at a premium from EPC contractors as was the case in the FiT tariff regime. This will allow developers  to command a significant price premium and dominate the market.

Low returns will force developers to cut down on their costs by undertaking the EPC works themselves, thereby denting the market for pure-play EPC companies. Moreover, the changing dynamics are also likely to lead to consolidation in the EPC space, which will be driven by the players’ attempt to increase sales and reduce costs.

Future outlook

The Indian wind energy segment is likely to shift entirely towards the auction-based allocation route in the near future. If implemented in a planned manner, the auction route will not only ensure project continuum but also provide greater clarity on the pipeline of projects.

Since capacity addition through the tendering process often takes a long time, there is likely to be a short-term demand hiatus in the market. However, in the long term, the EPC segment stands to gain as the players would make up for what they lose in terms of number of contracts with increased project volumes.