Last weeks I was working on an article on the changes zero-subsidy brought to the Chinese wind market, after an interview with the boss of a leading Chinese turbine maker.
The OEM head summarized one of the changes as the market would “move from Capex-emphasized to LCOE-focused.”
When putting the article to edit, my colleague in Recharge found the expression very confusing and came back with questions: What do you mean? How can any wind project allocation or equipment tender not centered on LCOE? How can the auctions focus on Capex?
It came to my realization that these questions touched upon a distinguishing feature in the Chinese wind and renewable market: up till now, equipment/technology tenders and procurement in renewable market (as well as other sectors) are mostly focused on the one-off costs required for the equipment/technology purchase, rather than diving into the cost from a full lifecycle perspective or factoring in the pay-back period, efficiency, etc.
In other words, the procurement cost has been treated isolatedly and procurement decisions often disregard other costs in the full lifetime cycle. I think this is what the OEM boss mean when he talked about the market being “Capex-focused.”
A typical case in wind turbine tenders: Developers compare turbines/equipment on the basis of the initial capital expenditure, but the operational cost was not often reflected in their thinkings.
The Chinese way is clearly different from the “western” approach in which the standard comparison metrics is LCOE (Levelized Cost of Electricity) either in renewable project allocation or in equipment procurements. The feature baffled companies that just stepped foot into the Chinese market and blocked their success.
But as the Chinese market is moving to zero-subsidy, or grid parity, this mechanism is up for a change.
This shift may be a huge deal to foreign stockholders.
From CAPEX Heavy to OPEX Factored-In
Follow the example of wind turbine procurement: so far, developers have adopted different metrics/mechanisms to compare and select turbine suppliers. The historical progression of these metrics/mechanism can be summarized in three phases:
- 1989-2012 Single-factor Capex-Oriented Selection: wind power is burgeoning in China, with robust subsidy schemes (feed-in tariff) backed by the government. The internal rate of returns for wind investment has been high, and developers had been gradually moving from replying international turbine suppliers to fostering domestic players like GW, SV, and UP, etc. During this time spam, developers tend to, when purchase turbines, focus on the product cost and effectiveness. The specific comparison metrics include turbine’s cost, power curve, and load factors, with costs/prices as the most important factor for the decision. As prices were weighed more than 50% in developers’ decision, cut-throat price competition became the market norm. Developers tend to use “Retention Money Guarantee” (10% of total contract value for five years) to hedge quality risk. Still, this mechanism brought cashflow challenges to the suppliers and is also risky for developers when serious incidents occur. Essentially, tenders in this phase focus on capital expenditure of the equipment, or CAPEX-oriented.
- Since 2013 Multiple-Factors Capex-Emphasized Selection: revenues for new wind investment have been in decline, pushing developers to look into procurement and finance more carefully. While in the previous stage, the cost of turbines has been treated as a separate element in an investment, developers gradually aware of the importance to look into the composite cost factors regarding turbines. More and more tenders thus require turbine suppliers to provide integrated design plan (turbine+tower, or turbine+EPC, turbine+PC, etc.) and compare them on these more integrated cost basis. OEMs need to compete on “customized turbine designs” that take into account micro weather, site conditions, and other factors, to improve power output and thus the LCOE. As a result, suppliers need to provide customer turbine layout design, road construction, tower designs, and other wind-farm design elements. Developers, later on, reviewed the power performance of the products to determine whether suppliers have lived up to their promises. Essentially, tenders in this phase start to consider “cost” in more dimension, but they still focused on capital expenditure.
- Starting from 2018 OPEX Factored-in: some recent wind turbine tenders show that developers have incorporated operation cost in their procurement decision. In the famous Ulanqab tender this year, developer SPIC compare the suppliers based on their bidding prices inclusive of include 20-year turbine service agreement and warranty (for maximum fees of ¥25 /KW and ¥10/KW). Ulanqab is among the first zero-subsidy demonstration arrays. Essentially, a full-lifecycle view on wind farm investment means an emphasis on LCOE. And the shift to LCOE-focused is destined to be the future.
Grid Parity Pushes For Changes
Beijing’s policy that requires the industry to achieve grid parity or zero-subsidy brought the change. As companies feel the squeeze of lower revenue from renewable investment, they are under pressure to adopt a more well-rounded (sophisticated?) mechanism to look at their cost. Looking at cost only at the initial investment dimension is short-sighted.
Experience and problems encountered in tenders may contribute to the shift, too. As mentioned, current equipment tenders (stage-2) is still focused on the initial capital expenditure, even though taking into consideration more factors. In reality, the cost of suppliers failing to deliver their promises sometimes outweighed the amount of retention guarantee. Developers could not adequately control the supply-chain risk factor.
Another factor leading to the stir is the internal organizational reform of Chinese state-owned enterprises: in this case, the developers. SPIC, for instance, is picked by Sasac to reform its way of business operation and to adopt international management structure. We know that, in the past, the separate teams of procurement and project operation in many state-owned companies is one of the factors of the focus on one-off cost for the procurement side. The internal reform to spur efficiency and synergy in these companies may have contributed to the change. (In that sense, it is not surprising to see SPIC as the one to set a precedence. )
From IRR to LCOE?
Certainly, LCOE is not a strange concept to the Chinese power sector. Quite the opposite, we hear it all the time. But when it comes to renewable investment decision, the most common metric used in China is still IRR (internal rate of return).
Why? A simplified answer is the change of pricing mechanisms. China had embarked fixed feed-in tariff (FIT) pricing mechanism roughly a decade for renewable sectors (the starting time for each sector are slightly different). Only since last year, Beijing determined to scrap that and replace with competitive pricing for wind/solar allocation, intended to put the industry in a glide path to zero-subsidy “on time” (onshore/solar 2021, offshore undetermined…)
In the old way, prices are fixed and given. In competitive ways, prices are not set. [Although grid parity means adopting fixed provincial coal-fired rates in China, in long-term China’s generation sector is expected to become fully competitive. ]
The calculation of IRR—to put it in an oversimplified way—requires a known electricity price, while that is not the case for LCOE.
Moreover, China’s electricity benchmark price was calculated based on a fixed/given IRR from the start (generally 8%). And SOEs tend to use 10-12% as the minimum benchmark for its investment decision—though in reality, due to the heavy curtailment issue—this IRR, in reality, maybe far from the expected.
As future wind/solar allocation would be based on price competition (essentially LCOE reflects electricity price), the market is designed to move to focus on LCOE.
A Good Omen to Foreign Stakeholders?
To the industry, it is positive news. That means the market will be more sophisticated in looking into renewable’s true cost. And as companies care more on cost in the lifecycle, more measures will be adopted to improve efficiency, like this helping the industry to further lower price.
LCOE is also an internationally well-adopted metrics. The shift thus signifies a move towards international standards and gameplays.
Theoretically, fo foreign suppliers, this is good news as the LCOE-oriented game that focuses on lifetime quality and efficiency is what international players have been accustomed to.
However, I do see raising challenges for foreign suppliers in the OEM and other areas where Chinese firms have assumed a dominant position–especially in wind turbine market. This is because the emphasis on LCOE, in reality, pushes stronger ties and collaborations among turbine makers, developers, as well as design institutes (and installers in the case of offshore wind). OEMs will see their role transformed into a solution provider; selling machine alone would not work well anymore. As a result, it is the players with stronger local presence and ties with the market to stand out.
The result of Ulanqab tender is an indication. The previously expected outcome of a western turbine winner did not occur. The three western OEMs’ higher cost for 20-year maintenance is one of the reason, and whether they have taken part in the project investigation (which already took place pre-2017) is another angle to look into.
The change may present a tough question to the international suppliers: whether they are genuinely prepared to blend in and tailored for their potential Chinese customers?
READ MORE on Asia’s Collective Move to Renewable