Large-scale hydrogen use is seen as important to decarbonising hard-to-treat sectors of the economy. Some countries, like Great Britain and Germany for example, are embarking on major policy initiatives to try to kick start a large-scale hydrogen value chain. Discussions in Norway are still at an early stage. Much of the current debate surrounds the potential use of CfDs to support the development of a hydrogen value chain. Below we set out what CfDs can and cannot do and seek to provide some insight into what a functional support regime might look like.
Barriers to large-scale hydrogen
There are multiple barriers to the large-scale use of hydrogen. Ideally policy needs to be designed to address multiple barriers in parallel.
- High costs relative to alternatives
Most production and use-cases for low-carbon hydrogen are more expensive than their high-carbon alternatives
- Policy and regulatory uncertainty
Potential investors in hydrogen projects face uncertainty related both to long-term political ambitions to support the hydrogen market and the future development of the carbon price
- Supply/demand uncertainty
The immature hydrogen market has an inherent coordination challenge, in which the lack of relevant counterparties on the opposite side of the market hinders investors from establishing
- Commercial immaturity
There is a need to develop standards, marketplaces, exchanges, etc. to achieve a market with well-functioning trade
- Distribution and storage
Finally, proper distribution and storage facilities need to exist to allow the market to expand beyond self-supply and local markets
The potential role for contracts for difference
One of the crucial barriers is the issue of competitiveness with high-carbon alternatives and there has been considerable discussion of Contracts for Difference (CfDs) as a means to address this.
CfDs are financial contracts involving two parties, one usually being the state and the other a market actor. The contract concerns the difference between two prices: a market-based reference price and a contractual strike price. The owner of the contract, e.g. a producer, will sell its product and receive both the market price (from the market) and then the remaining difference between the market price and strike price (from the state under the contract). As a result, the producer will effectively receive the contractual strike price for each unit sold. Over time, the size of the payouts under the contract will vary with changes in the market price. If the contracts are designed as a two-way CfD, then, if the market price exceeds the strike price, the producer must pay back the difference to the state.
CfDs secure a specific price (the pre-defined strike price) for each unit sold or purchased, thus transferring price risk between the parties in the contract. If the strike price is high enough, they can increase the effective price and be used as a support mechanism. This combination of price certainty and financial support can help trigger private investment and may therefore be a useful tool to help kick-start the development of a hydrogen market.
Creating a functional support mechanism
There are, however, a lot of details that need to be worked out:
- Are we supporting emissions savings or traded hydrogen volumes?
- Who are we actually paying?
- How do you even assess the market price for hydrogen?
The unit in the contract that defines the volumes on which payouts are made should reflect the intended policy objective. Linking payouts directly to emissions reductions might encourage interventions that replace existing grey hydrogen use in closed industrial processes, with potentially limited support for the use of hydrogen in new sectors. This might therefore not be the best choice for unlocking broader decarbonisation potential. In contrast, linking support to hydrogen sales might better reduce barriers to hydrogen’s use as an energy carrier more broadly and thereby support lower-cost emission reductions in the longer term. You could even have the basis of the support regime change over time to reflect the changing emphasis of the policy.
In theory, it should be irrelevant whether support is provided to either the producer or consumer (or in combination to both). Eitherway, the sum of this support will be used to fill the cost gap between low-carbon hydrogen and the high-carbon alternative. There are, however, some practical considerations relevant to where support is paid. For example, one needs to consider how the choice of where support is paid might alter commercial investment decisions, performance against the intended policy objective, whether competitive tendering is possible and the implied administrative complexity of the scheme.
Assuming the contracts are linked to hydrogen volumes, and given the absence of an obvious market reference price for low-carbon hydrogen today, there will be a need to use an alternative approach to establish a reference price in the contract. Ideally, this should reflect the difference between the production cost of low-carbon hydrogen and the consumer value of buying it.
An illustrative support mechanism
So, what might a support system look like? Well, these issues need looking at more closely but one possible model could be as follows:
- A CfD scheme is introduced with the expressed aim of covering the operating cost disadvantage of low-carbon hydrogen relative to high-carbon alternatives. The scheme is part of a package of measures designed to support large-scale use of hydrogen in multiple areas as a means of opening up strategic options for the more widespread decarbonisation of hard-to-treat sectors
- The CfD is paid per kg of hydrogen
- Support levels are set with a formula estimating the price gap between low-carbon-hydrogen and a high-carbon-alternative. For example, support for a green hydrogen project targeting end-use in the maritime sector may use power prices and the cost of bunker fuel as possible cost inputs into this formula for the support requirement
- Projects are selected through an open tender process with a beauty contest to select projects that best meet the strategic objectives
- The level of support is agreed by negotiation between the state and the selected project and varies in line with the benchmark (i.e., with the level of power and bunker fuel prices)
Contracts for difference can, in theory, trigger private investments in hydrogen with minimal public support. This makes them a potentially useful policy tool, but they are not a cure-all. Other policy measures should ideally be put in place in parallel to address some of the other challenges faced. If CfDs are to be implemented, policymakers and industry need to set to work deciding on the detailed implementation questions highlighted above, learning from and potentially adapting the experience of other markets.