Small bank clubs offering tenors that match 20-year concessions have been the financing method of choice for the UK’s offshore transmission owner programme. But the UK’s power regulator, the Office of Gas and Electricity Markets (Ofgem), is looking for the buyers of OFTO concessions to pay larger upfront acquisition fees, and for concessions to feature greater levels of construction risk.

In June 2009, Ofgem launched the competitive tender process for the first transitional tender round for offshore transmission projects in the UK. Since then, four projects out of the first round have closed and another five have been awarded. Ofgem also named a preferred bidder in May this year for Lincs, the first out of the second transitional tender round.

The tender process has helped increase competition in the UK transmission sector and mitigated some of the risks that offshore generators face in building transmission. The strong regulatory regime underpinning the tender process and the stable availability-based revenue stream have resulted in strong interest from lenders, with some bids reporting margins of around 200bp over Libor, and tenors that came close to the length of the contracts under which the OFTOs were awarded.

The new regulatory regime underpinning the offshore transmission networks dates back to 2004, when the Energy Act 2004 inserted section 6C into the Electricity Act 1989, which allows Ofgem to tender the licence for the transmission of electricity from offshore wind projects with connections of voltages of 132kV or more. The programme was designed to create a more stable and competitive regulatory regime, and also remove the some of the burden of developing transmission infrastructure from developers.

Following a lengthy consultation period, Ofgem launched its first transitional tender for nine projects, which together will connect up to 2,000MW of electricity, as a first step in a £15 billion ($23.5 billion) programme to ensure links to future offshore wind farms. The nine projects are Barrow, Robin Rigg, Gunfleet Sands, Sheringham Shoal, Ormonde, Greater Gabbard, Thanet, Walney 1 and Walney 2.

The initial tender prompted a lot of interest from potential operators. The assets have low risk profiles and promise predictable, regulated returns over 20-year terms. The operator of the transmission link is not subject to the performance of the wind farm, since it receives annual availability payments from National Grid, fully linked to RPI, and with potential deductions capped at 10%.

To encourage owners to maintain performance towards the end of the concession, they are required to post a performance bond from a suitable third party but bidding costs are low, which also explains why the tender process attracted so much interest. In August 2010, Ofgem, advised by Ernst & Young, named preferred bidders for seven of the nine transmission concessions and awarded the other two over the following 12 months.

Balfour Beatty will own and operate links for the Thanet offshore wind farm and the Greater Gabbard wind project. Macquarie Capital won three concessions, Sheringham Shoal wind farm, Walney 1 and Walney 2. Transmission Capital Partners, a consortium comprising Transmission Capital, INPP and Amber Infrastructure won the remaining four: Robin Rigg, Gunfleet Sands, Barrow and Ormonde. So far four of the projects out of the first tender round – Barrow, Gunfleet Sands, Robin Rigg and Walney 1 – have reached close.

Transmission Capital Partners closed the financing for Robin Rigg in March last year, the first project out of the initial tender to reach close. The deal served as an important benchmark for the financing of other OFTO projects. Transmission Capital Partners had to pay a £65.5 million fee for acquiring the asset, although the project costs were slightly higher, around £76.5 million, once transaction and other costs were included. The deal closed through £66.1 million in 19-year debt from a club of three banks: Barclays, BNP Paribas and Lloyds.

Robin Rigg is the only offshore transmission project out of the first tender not to comprise maintenance of an offshore substation. Nevertheless, the asset’s relative simplicity and the absence of any construction risk meant that the deal served as a template for other projects from the initial tender. Transmission Capital Partners used the same banks and a similar structure for the financing of both Barrow and Gunfleet Sands.

The average margin on the Robin Rigg deal was rumoured to be around 220bp over Libor, and although there are step-ups over the life of the loan, the sponsors are not subject to any refinancing risk. Most of the remaining projects out of the first tender are expected to be financed also by small bank clubs with tenors roughly matching the 20- year contracts and pricing towards the low end of the 200-250bp range.

The larger offshore transmission projects and those that entail some construction risk may struggle to match these terms. For Lincs, which was awarded to Transmission Capital Partners in May and was the first project from the second round to be awarded, the transfer fee is £310.5 million. Ofgem is also expected to name a preferred bidder imminently for London Array, which has a transfer fee of £475.5 million. Ofgem also plans to conclude its consultation process by the middle of July this year for its enduring regime, under which offshore developers will be able to decide whether they or the transmission owner constructs the transmission assets.

One option would be for the sponsor to finance the project, or at least its initial acquisition or construction phase, with equity. Transmission Capital Partners is expected to finance its acquisition of the transmission cable connection for the Ormonde offshore wind farm entirely through equity. INPP recently raised £200 million from issuing new ordinary shares and said that the proceeds would be used to purchase assets in the UK.

But whether all bidders would have the means or willingness to finance acquisitions on their balance sheets is not certain, especially for those that carry construction risk. One option mooted is for the sponsors to finance construction through a bridge loan and then issue project bonds later. “The assets are structured in such a way that they are very attractive for institutional investors” says one UK-based infrastructure professional.

“The technology risk is low, the availability risk is low because of this 90% floor, and there’s also an RPI linkage and a 20-year fixed-price revenue stream. But as always the devil is in the detail.”