Are OFTOs as safe as they seem?

Availability-based and devoid of construction risk, OFTOs seem to be a shoo-in for private investors with a low appetite for risk. But they may not always be as water-tight as they seem.

Every now and then the shores of infrastructure investment are hit by a new alphabet soup. There was a time, for instance, when public-private partnerships (PPPs) and private finance initiative (PFI) projects used to be all the rage. PPPs have since somewhat retreated, but now there’s talk of offshore transmission owners (OFTOs) and competitively appointed transmission owners (CATOs) being the next best thing for investors with a low risk appetite.

The transmission cable market is indeed benefitting from double tailwinds. The UK government, like many across Europe, is seeing offshore wind as a promising power source at a time when green generation is gaining fresh momentum. Scalable and reliable, it is fast becoming an investor favourite, with multi-billion tenders expected in the years to come. In parallel to this, Ofgem, the UK power regulator, is working jointly with the Department of Energy and Climate Change (DECC) to provide better-value power to rate-payers. Their preferred tool for pursuing this – opening up transmission to competition.

Private investors and developers have good reasons to like the idea. Offshore wind farms may be maturing into a lower-risk asset class, but they remain subject to a number of uncertainties. Delays during a multi-year-long construction phase can deprive investors from early cash flows; turbines are more vulnerable to harsh weather and have more moving parts than a good old cable, potentially impacting availability. Generation assets, crucially, remain exposed to power prices.

OFTOs, by comparison, are at the lower end of the risk spectrum. Investors don’t build the cable – they take it over once completed from the power generator. Concessions, typically structured as availability-based payment schemes, are less risky than arrangements reliant on government support. The industry experts we canvassed on the theme reckon OFTOs tend to enjoy very high levels of availability (98 to 99 percent, according to one source). And yet despite all this, historical returns have averaged 9 to 10 percent, according to a KPMG note comparing OFTOs to PPPs.

Should investors therefore always expect smooth sailing? It’s probably too early to say. Just like the offshore power plants they connect to the grid, OFTOs are located in the middle of the sea (and under a fair volume of water). When a bug causes transmission to cease, accessing the asset to carry out repairs is both weather-dependent and time-consuming. When your payments are availability-based, a small fault in the system can thus turn into a meaningful problem.

Sources we spoke to underlined that system failures, though not a regular occurrence, have already happened. Mostly they were due to cable faults. Impacted investors are currently in talks with Ofgem to try and receive compensation from the power generator, under the logic that inheriting an asset that’s not functioning properly should represent a valid cause for an interruption of service.

Since most OFTOs are young assets, the argument makes sense, and the assumption is that they should be paid for the period in question. But in the end it remains Ofgem’s decision – and one with potential for a tricky discussion around risk transfer.

Another source of uncertainty revolves around the residual value of OFTOs. While transmission concession contracts with Ofgem have a fixed term (usually 20 years), investors have indefinite ownership rights over the cable. In principle, a cable should still be able to serve the wind farm it is attached to, if the latter has not yet reached the end of its life. But we will only know exactly what happens when the first OFTO concessions end in 15 years’ time. If it turns out residual value has been factored into investors’ base cases – and that residual value ends up not being realised – that might already pose a downside risk.

With two tender waves coming on stream soon, the pipeline looks strong. Sizeable equity tickets will be needed, too, as offshore wind farms get bigger and more powerful. Advisers we spoke to reckon that between £250 million (€324 million; $359 million) and £300 million could be required for each project. Today’s residual uncertainties need to be ironed out for good. Provided they are, there should no sea change in investors’ perceptions.