We all know that the wind turbine market in Europe is an oligopoly. Power resides in the hands of very few players — and, in the offshore space, just five manufacturers (OEMs) account for 100 percent of the turbines that were sold in 2014.
Of course, up until now, this hasn’t been much of an issue at all. Competition, fuelled by potential idle production capacities and stock market expectations, has created healthy price pressure. Indeed, turbine prices have been steadily declining over the past five years, on a per MW basis, despite an overall increase in MWh per turbine due to the introduction of longer blades.
However, what many fail to realize is that market dynamics are starting to fundamentally shift. This six-firm oligopoly is now behaving like one. Collectively, in the space of just a few years, each OEM has changed its business model, targeting maximum returns.
To put it simply, OEMs are using the “Xerox model;” sell the machines cheap and make money on the service.
In 2013 Consulting group MAKE conducted a study analyzing the length of manufacturer service agreements (MSAs) and the maintenance strategies of major asset owners. It produced some concerning results.
The study found that:
1) The average length of maintenance agreements signed with OEMs is significantly growing
2) The proportion of maintenance contracts managed by OEMs in Europe continues to rise
Greensolver’s analysis of recent contract negotiations has systematically corroborated these findings. In fact, the duration of service agreements is now significantly longer than MAKE’s original average.
So, to summarize, OEM’s have adapted their business models, turning wind turbines into photocopiers and service contracts into recurrent long-term maintenance revenues at high margins. What’s wrong with that?
At face value, there are a number of advantages to this arrangement. It encourages manufacturers to take responsibility for their products and underwrite the risk of sourcing spares, serial defect and long-term design flaws. Many banks, who cover 80 percent of the capex costs for an investment, see this as an ideal scenario. Banks are risk-averse by nature and prefer the certainty of one contract with one party for the long-term – even if it means rising costs.
The problem is, just like with the Xerox copiers, the user — or the investor or asset owner in this case — ends up footing the bill.
These long-term contracts are designed to exclusively benefit the OEM. In every MSA contract, costs increase over time and there are no clear incentives to boost the performance of the maintenance provider. Contracts are geared towards achieving minimum service level agreements, but nothing is built in to encourage improvement.
But why should maintenance costs rise at all? Just like taxes, everybody assumes that a continuous rise is inevitable – since, after all, costs have always risen. However, when we look more closely at maintenance cost drivers, there is no reason at all for this increase. In fact, we should be anticipating an overall decrease.
The main drivers of maintenance expenditure are people costs, system inefficiencies, failure rates, large component failure rates and inventory costs. Looking at the design improvements made by the OEMs in their latest turbine models, failure rates in general and specifically failure rates for large components have fallen considerably. Lower failure rates automatically translate into lower spare part requirements, reducing working capital costs.
Likewise, as the installed base of turbines grows, so too does the manufacturer’s ability to make efficiencies and optimize people costs — with a higher density of turbines per maintenance center, less time wasted in travel and more efficient work routines.
All in all, then, we should be seeing every major maintenance cost driver decrease over time. Yet many of today’s investors still prefer to bind themselves into increasingly expensive long-term contracts.
Any ambitious investor driving for more than single digit returns knows that there are only two ways to improve returns once a project is operational:
· Conduct very rigorous operational management of the assets to maintain high availability and optimize production – for example by engaging an independent asset manager
· Find ways to control reduce opex over time, the most significant element being maintenance costs, which alone represent 50 percent of the expenditure of an operational asset
The simplest way to control maintenance costs is to renegotiate contracts every five years or so. This approach enables project owners to test market conditions and take into account volume build up over time.
However, in the current market conditions, where the amount of equity available to fund wind energy projects far outweighs the number of projects available, this breed of investors is fast dying out. Replacing them are investors with low cost of capital and low returns expectations.
These investors actually request very long-term maintenance contracts, since they are perceived to provide security over the long haul, whilst meeting their low returns expectations.
In short, this is all very good news for turbine manufacturers, encouraging long-term, continued investment. But it signals tough times for Independent Power Producers, since the value they create increasingly finds its way into the hands of the OEM.
Furthermore, alternative maintenance providers will inevitably suffer, and, if the current scenario persists, it’s likely that the vast majority of these firms will go out of business within the next five years. Moreover, within the next 7 years or so, we are set to witness the complete disappearance of equity funds seeking returns of more than 10 percent from the sector.
This will all but kill competition in the maintenance market. While the professionalism and quality currently provided by OEM service teams is good, competition is vital to drive down costs and encourage performance improvements.
So what can project owners do to address this trend?
Firstly, avoid becoming locked into 15+ year firm maintenance contracts! Keeping one’s options open by way of regular contract renegotiations ensures the most competitive pricing.
Secondly, don’t accept rising maintenance costs! Build maintenance performance indicators into every contract, establishing bonuses and penalties that enable more effective, fairer, profit sharing with the maintenance provider.
Finally, invite offers from independent providers from day one. The value of the competition generated by these market players is not to be underestimated and they are a vital part of the industry.
After all, no project is a carbon copy of another — and the specific demands and requirements of each owner and investor differ. It’s vital that wind turbines don’t become photocopiers — so let’s maintain market competition to guarantee the long-term success of the wind power industry.
Lead image: True Costs. Credit: Shutterstock.