UK hydrogen business model: comparison against key terms of the generic CfD

United Kingdom

As part of the long-awaited UK Hydrogen Strategy (see our commentary here), on 17 August 2021, the Government Department for Business, Energy & Industrial Strategy (“BEIS”) launched its first consultation on a business model for low-carbon hydrogen (the “Consultation”). As anticipated, BEIS’ proposed model for support is via a so-called “Hydrogen contract for difference” or “CfD”.

In this article, we focus on some of the key proposals for the low-carbon hydrogen (hereinafter “Hydrogen”) business model and the so-called “Hydrogen CfD” as compared to the better known CfD for low-carbon projects as introduced pursuant to the Energy Act 2013.

Why do we need a business model?

From the outset, it is worth reflecting on the key barriers to Hydrogen adoption identified in the Consultation, so as to understand the issues that the government is seeking to address:

Cost compared to high-carbon counterfactual fuels

Counterfactuals will depend on the specific application of the Hydrogen, and include carbon intensive (grey) hydrogen, natural gas, petrol and diesel.

Technological and commercial risks.

Technological risks – the nascent nature of large-scale Hydrogen projects creates a risk of technology becoming quickly outdated, possibly leaving investors with an undesirable asset on their books.

Commercial – effective business models will be needed to overcome market price risk and volume risk, discussed below.

Demand uncertainty

Large scale Hydrogen production is a relatively untested market for the production of a counterfactual fuel i.e. an alternative to existing fuel options. Demand for Hydrogen is therefore untested, which presents a risk for early investors.

Lack of regulatory structures supporting the nascent Hydrogen market

There is currently no long-term policy or existing dedicated regulatory framework for Hydrogen. This is both a structural barrier and a source of uncertainty for investors.

Lack of available infrastructure

There is currently a lack of distribution and storage infrastructure which will be required for large-scale Hydrogen production.

 

To CfD or not to CfD? That is the question

The Consultation indicates that the business model will be built on the principles of the low-carbon CfD. At this early stage, when heads of terms have not yet been published, how close the proposed terms for Hydrogen will be to the traditional low-carbon CfD remains to be seen and will become clearer throughout the development process. That being said, there are some early key differences - most notably in the mechanism for determining support level. We set out the similarities and differences below:

Topic

Generic low-carbon CfD

Hydrogen business model proposals

Counterparty

Low Carbon Contracts Company (“LCCC”) (a private company owned by BEIS)

LCCC

Term

15 years

Not yet determined.

The consultation notes two possibilities:

  • the 15-year contract duration of the CfD for wind (and other renewable technologies)

  • the 10-year term plus possible additional 5 years available for Industrial Carbon Capture technologies.

Target of support

Supports production of low-carbon electricity in the operating phase

Supports production of Hydrogen in the operating phase

Eligible technologies

”Eligible generating stations” are defined under the Contracts for Difference (Definition of Eligible Generator) Regulations 2014/2010.

These are:

  • dedicated biomass with CHP station;

  • energy from waste with CHP station;

  • generating station connected to a complete CCS system;

  • hydro generating station;

  • nuclear power station; or

  • station which generates electricity by the use of any of the following sources of energy:

    • gas, other than landfill gas or sewage gas, formed by the anaerobic digestion of material;

    • gas or liquid formed by gasification or pyrolysis of biomass or waste;

    • landfill gas;

    • naturally occurring subterranean heat;

    • sewage gas; solar radiation when captured by a photovoltaic array;

    • tidal movement where the station has a declared net capacity of less than 1GW;

    • tidal stream;

    • waves; or

    • wind.

     

    For each round of CfD allocations, the eligible technologies are divided into “pots” and government confirms the level of economic support available (“Pot Budget”) and the amount of generating capacity that supported (“Capacity Cap”) in respect of each pot.

Hydrogen which meets the Low Carbon Hydrogen Standard (being consulted on in parallel) will be eligible for support.

 

Specific application-based carve outs from eligibility are being considered, and are discussed in the final section of this note.

Application for CfD

Application

Applications are submitted and assessed by the “Delivery Body” (National Grid ESO) against set criteria including evidence that required project documents are in place.

Assessment

Once the Delivery Body has determined the eligible applications received, they will compare the aggregate value and generating capacity of these allocations against the Pot Budgets and the Capacity Caps. Where these are exceeded, the Delivery Body will determine that a competitive allocation process or auction is required to determine the recipients of the CfDs.

Sealed Bid

The eligible applicants then submit “sealed” (i.e. non-public) bids with the lowest priced bids required to make up the capacity for each pot being selected by the Delivery Body and awarded a CfD.

Short term – Hydrogen projects will be invited for assessment against a set of defined criteria, followed by a bilateral negotiation process with the LCCC.

Medium term – Hydrogen contracts will be awarded via competitive auction, as with the generic CfDs. The details of how the assessment and bidding will work is yet to be determined.

Determining the level of support

The generator is paid a strike price set in advance for each MWh of electricity produced.

When the actual electricity price is lower than the strike price, the LACC tops this up to the strike price. Where the actual electricity price is higher than the strike price, the generator pays back the difference.

Strike price:

The strike price is set in respect of each technology by reference to the successful bids received.

The generator is paid the difference between a strike price set in advance and the higher of (i) the reference price and (ii) the actual sales price achieved (see figure 12 from the Consultation included below).

The maximum size of subsidy available would be the difference between the reference price and the strike price, even where the actual price for hydrogen achieved is lower than the strike price.

Example 1: strike price £20/MW, reference price £10/MW, actual price achieved £15/MW = subsidy of £5/MW

Example 2: strike price £20/MW, reference price £10/MW, actual price achieved £7/MW = subsidy of £10/MW

Strike price:

  • For initial projects the strike price may be bilaterally negotiated between individual generators and the LCCC.

  • For future projects, the strike price may be set via competitive auction, as in the case of the CfD for wind.

The Consultation recognises that generators may bid higher strike prices to protect against the risk of increasing input energy costs. To protect against this, the Consultation suggests introducing flexibility into the strike price via indexation – linked either to inflation, actual input energy cost, the natural gas benchmark price or the electricity benchmark price. The Consultation does not provide a minded-to position on indexation and seeks views on this point.

Reference price:

  • For initial projects, the Consultation suggests using the natural gas price as a reference price.

  • For future projects, once the Hydrogen industry has developed, BEIS suggests using a market benchmark price set by independent experts for the reference price, as is the case with crude oil and gas.

Volume scaling i.e. the ability to increase levels of generation and receive subsidy support for those increased amounts.

None offered.

No minded-to position is offered, but the Consultation raises the issue and seeks stakeholder input on whether volume scaling should be allowed and, if so, whether this should be on the basis of ad hoc requests or applications for pre-agreed permitted increases.

Backstop PPA

Generators who are unable to find a route to market for their low-carbon electricity will benefit from a “offtaker of last resort” arrangement whereby a licenced supplier will purchase their electricity for a limited 12-month period and at a reduced price.

Government is not minded to act as offtaker of last resort.

Instead, to combat volume risk, the Consultation suggests a sliding scale of support provided indirectly through price variation, with generators recovering higher unit prices where offtake volumes are low and support declining as offtake volumes increase. It is expected that the sliding scale could be adjusted depending on project and technology.

Unlike the backstop PPA, this does not protect generators in the event that they cannot find an offtaker for their Hydrogen outputs.

Funding

The Contracts for Difference (Electricity Supplier Obligations) Regulations 2014/2014 provide for every licenced electricity supplier to make a “CfD period contribution” to the LCCC. This is designed to ensure that the LCCC has sufficient funds to meet its obligations to top up generator payments where the market price for electricity falls below the strike price.

This contribution, known as the “CfD levy”, is ultimately passed on to consumers as a charge in their energy bill.

The Consultation does not stipulate how the Hydrogen CfD will be funded, but notes that energy bills already incorporate various policy costs. It states that a call for evidence on energy consumer funding, affordability and fairness is expected to be published soon.

Total amount of support available £ and MWh

As set out above, for each allocation round the government publishes the level of financial support which will be available to each pot of eligible technologies, and how much generating capacity from each technology pot will be supported.

This means e.g. an eligible offshore wind project will not just compete against other eligible offshore wind projects for support, but against all eligible technology types in the pot.

The Consultation does not specify the level of financial support that will be available under the Hydrogen business model, or the quantity of Hydrogen generation which will be supported.

 

 

State Aid

The EU-UK Trade and Cooperation Agreement contains state aid requirements that must be complied with in respect of energy subsidies post-Brexit. These apply to the low-carbon CfD regime and include:

  • that subsidies must be awarded via a transparent and competitive process; and

  • that subsidies must not affect obligations or opportunities to participate in electricity markets.

Subsidy control is not explicitly mentioned in the Consultation, but the Hydrogen CfD will also have to comply with UK’s subsidy regime and obligations.

Interplay with other support schemes

As part of a CfD application, the applicant must make “cross-subsidy declarations” providing information on other subsidies which the generation station is in receipt of. Recipients of subsidies under the following schemes are not eligible for support via the CfD:

  • Non-Fossil Fuels Obligation;

  • Scottish Renewables Obligation;

  • Capacity Market; and

  • Subject to certain exclusions, Renewables Obligation.

In addition, the generating station cannot already be in receipt of another CfD.

The Consultation states that due to Hydrogen’s multiple possible end uses there may be interaction between the business model support and existing subsidy schemes including the RTFO and the CfD for low-carbon electricity generation.

The Consultation confirms that the government supports “revenue stacking” and will consider this in the context of the need to avoid double subsidisation.

 

UK hydrogen business model image

What’s not discussed

A number of questions remain unanswered in the Consultation, including in respect of:

  • excluded Hydrogen applications – BEIS suggests that Hydrogen for use in feedstock may not be eligible for support. Whether this and/or other application-based exclusions will be formalised remains to be seen. Given that a significant proportion of carbon intensive grey hydrogen produced today is used as feedstock, it will be important that BEIS balances the desire to apply Hydrogen to areas where it can have the greatest impact on decarbonisation (e.g. transport and heating) with the need to ensure that would-be generators are sufficiently confident in their ability to find offtakers. A further nuance of this issue is the fact that Hydrogen may change hands multiple times before reaching its end user, so determining whether use is for an excluded application may not be a simple task.

  • lack of infrastructure – as mentioned above, there is currently a lack of Hydrogen transport and storage infrastructure in the UK to support the scale up of Hydrogen production. While considering support for small-scale infrastructure, BEIS does not consider the business models to be an appropriate means for supporting large-scale infrastructure at this stage. A lack of infrastructure is a barrier to significant Hydrogen production, although without the demand from generators there will be little incentive to invest. This is a chicken and egg scenario which will need to be addressed.

  • lack of regulatory infrastructure – at present, there is no dedicated legislation for carbon intensive or low-carbon Hydrogen. Scaling up Hydrogen production may well require primary legislation, the enactment of which is likely to take significant resource and time. What constitutes low-carbon hydrogen is being consulted on in parallel under the Low-Carbon Hydrogen Standard.

  • interplay with other Government support schemes – the Consultation states that “revenue stacking” (combining revenue streams) is encouraged, but the exact rules around the permitted combination of support schemes for Hydrogen projects remains to be seen especially if these business models are being designed for Hydrogen projects that are not also eligible for CCUS cluster funding (see our commentary here).

  • Where the money will come from – The Consultation offers that a Call for Evidence on energy consumer funding, affordability and fairness will be published and that there will be further details of the revenue mechanism later in 2021. However at present the ability levy charges to fund new low-carbon infrastructure is limited to largely electricity consumers so a departure from this approach would require new legislation. [to fund the business model] will be provided later this year.”

Next steps

The Consultation closes on 25 October 2021. The Consultation provides detail on BEIS’ thinking on the revenue support structure for low-carbon hydrogen that will be required to achieve the government’s short-term goal of 5GW of Hydrogen capacity by 2030, as well as supporting deployment of Hydrogen at the levels required to achieve Net Zero by 2050.

BEIS is aiming to finalise business models during 2022 and to award the first contracts in Q1 2023. Clearly a number of questions will need to be answered, including where the powers to levy the charges for the funding of hydrogen projects will come from. The government is rumoured to be considering shifting some of the levies currently paid by electricity consumers on to gas consumers (and some ideas of their thinking is emerging through the proposals for biomethane funding as part of the draft Green Gas Support scheme) however the recent gas price spikes and concerns about the impact of high energy costs on domestic consumers makes this a politically sensitive point.

Yet, with the timetable outlined and the government’s wider ambitions for net-zero, there’s little time to lose. This remains a dynamic landscape and keeping up to date (if not ahead) of the developments is key for the success of developing UK Hydrogen projects.

Read all our commentary on Energy & Climate Change policy in the UK here.