Earlier this year the Department for Business, Energy and Industrial Strategy (BEIS) published its thoughts on a financial support mechanism (Business Model) to promote the development of hydrogen in the UK. Those involved in developing hydrogen projects and in the hydrogen market going forward in the UK need to be aware of the likely design of the model. The key points are as follows:
- The good news, of course, is that there will be a financial support mechanism. It will be focussed around the production of hydrogen rather than demand for hydrogen. It is also clear that BEIS prefers a single mechanism for all forms of Low Carbon Hydrogen. Whether this works for different forms of hydrogen and different types and sizes of project is debatable.
- BEIS has recognised that when it comes to the hydrogen market, at least in the early days, it will be characterised by a limited number of buyers and sellers and could be largely localised. The first projects are likely to need to match together production, distribution and end use. Many users of hydrogen in the early days cannot readily switch to hydrogen without upgrades and costs. Whilst there have been studies and demonstrations that have looked at blending hydrogen into the existing gas distribution networks, it is fair to say that hydrogen distribution is more challenging than renewable electricity distribution and transmission.
- End users will only switch to Low Carbon Hydrogen, or will likely only switch to Low Carbon Hydrogen, if it makes financial sense. So this business model is focussed on making hydrogen cost competitive to stimulate a hydrogen market which in turn will result in the costs of hydrogen production coming down.
- CfD for Production of Hydrogen - BEIS have been at pains to point out that this is a bespoke price support mechanism for hydrogen, yet at its heart it is based on a private law Contract for Difference (CfD) of the type already deployed for renewable electricity and proposed for carbon capture use and storage/energy generation. It is no secret that BEIS favours CfDs. It likes the competitive auction nature of them which it sees as having worked well to drive down costs for the renewable electricity sector. Whilst there is a nod to other price support mechanisms in the consultation (akin to the Feed in Tariff and Renewables Obligation that existed prior to the CfDs for electricity generation) there is clearly very little desire on the part of BEIS to adopt these. Many of the short reasons given for disregarding these other options don’t bear too much scrutiny which is disappointing.
- For hydrogen production to benefit from the Business Model, the volumes of hydrogen produced must meet the UK’s Low Carbon Hydrogen standard which is being developed and consulting on.
- Existing hydrogen production plants will not qualify for the price support mechanism.
- The Business Model is intended to support domestic production and consumption of hydrogen rather than exports.
- What is the Pricing Mechanism? Under the CfD the price support model that seems to be finding favour with BEIS is the so called 'price support option 3 variable premium'. In this model, a producer of hydrogen is paid a premium calculated as a difference between a strike price and a reference price for each unit of hydrogen sold. The strike price is intended to cover the fixed and variable costs of production, financing and equity return and will be indexed. The reference price is intended to represent the market price received by the producer for each unit of hydrogen, but clearly for different uses of hydrogen there will need to be flexibility in setting the reference price. Similar to other CfDs, if at any point the reference price is higher than a project’s awarded strike price, the producer will pay back the difference.
- What is the CfD Reference Price? The reference price proposed by BEIS is therefore going to be absolutely key and the BEIS document discusses a number of ways in which this can be set. BEIS consider that in the 'near term' the reference price should be set by the so called 'achieved sales price'. The theory behind this is that the market for hydrogen is not sufficiently liquid at the moment to move or point to, a market benchmark price. The sales price will allow hydrogen producers to incentivise end users to switch to hydrogen, but it has also recognised that the disadvantages to this approach is that without certain checks, it can encourage a producer to over rely on Government subsidy and does not necessarily reward the producer for trying to get the maximum value from the sales contract for the Hydrogen it produces. As a result, BEIS is proposing to include a natural gas price floor which would prevent a producer from receiving support for sales below the natural gas price. To incentivise producers to get the best price for their hydrogen BEIS is also considering a mechanism such as a gain share or periodic payment linked to achieving or exceeding a pricing threshold or benchmark.
- Whilst the price support mechanism is intended to encourage production for all forms of hydrogen, BEIS considers that where hydrogen is used as a feedstock the price support might distort that particular feedstock market. There is a spectre of capping support to feedstock uses of hydrogen.
- Offtake Volume Support - One of the most interesting aspects of the proposed design is an element of volume support. It is recognised by BEIS that early producers of hydrogen face the risk of low customer volumes before the development and availability of an extensive hydrogen distribution and storage infrastructure etc. A sliding scale has been proposed whereby the producer of hydrogen earns higher unit prices where offtake volumes are low to help recover the fixed and marginal costs of establishing the project. However, over time this support will decline as offtake volumes increase. The key with this sliding scale is that a production plant will have to be producing hydrogen to benefit for the support, because the sliding scale design will not provide any protection where a hydrogen plant’s offtake falls to zero. Government was considering whether it should act as an offtaker of last resort, but it has clearly considered that this is high risk for them and it could also result in distorting of the hydrogen market and crowding out commercial end users.
- CfD Term - The effectiveness of any support mechanism will depend on the contract term and the Government is still considering this issue.
- What About Other Existing Incentives? Certain subsidy regimes already exist for hydrogen such as the Renewable Transport Fuel Obligation and CfDs for renewable input electricity. It is recognised that the Business Model will need to work alongside these and be compatible. This does not mean that double subsidy will be allowed. We await further thinking on this important point.
- How will CfDs be Allocated? One of the key areas to consider is how will these contracts be allocated? At present, to stimulate the market for CCUS enabled Hydrogen projects (Blue Hydrogen) there has already been and is, a process involved in cluster sequencing. For those projects outside of CCUS enabled, for example Green Hydrogen projects, BEIS is proposing to establish a set of defined evaluation and eligibility criteria and invite project applications in 2022. BEIS has since clarified that it will hold a separate allocation for Green Hydrogen Projects. Those projects that qualify through the evaluation and eligibility criteria rules will then enter into a bilateral negotiation programme with the final awards proposed to be made in 2023. Of course, the end game in relation to this financial support mechanism will be competitive auctions as we seen with the renewable electricity CfD allocation rounds, but fortunately it seems that Government has recognised that at this stage, competitive allocation for hydrogen production under this new mechanism is not yet appropriate.
- How will the Hydrogen CfD be funded? This is still open to debate, but the initial thinking appears to be that the end consumer will fund this. Whether this is the gas or electricity end consumer or both, we will need to wait and see.
Burges Salmon sits on the Executive of the UK Hydrogen and Fuel Cell Association and is advising and number of developers on UK hydrogen projects. We are experts in energy law and regulation. If you would like to know more about the advice we provide or have any questions on the BEIS Business Model for hydrogen please contact Ross Fairley.