Hydrogen Production Business Model - Heads of Terms

United Kingdom

On 13 December 2022, the Department for Business, Energy & Industrial Strategy (“BEIS”) published the updated heads of terms (the “Heads of Terms”) for the Low Carbon Hydrogen Agreement (“LCHA”),  the principal contract between the hydrogen producers and LCCC as the government owned counterparty. The contract structure will follow that of the AR4 CfD and the CCUS Programme Contracts, comprising of a front end agreement and standard terms and conditions.

As a reminder, the UK is aiming to have up to 10GW of low carbon hydrogen production capacity by 2030.

What are the key aspects of the Heads of Terms?

On 8 April 2022, BEIS published indicative heads of terms for the Hydrogen Business Model (the “Indicative Heads of Terms”, the details of which can be found in our previous article: Hydrogen Business Models details of the Low Carbon Hydrogen Agreement begin taking shape. This latest publication sets out the terms in more detail, though many of the key aspects remain the same.

Topic

LCHA Indicative Heads of Terms

Heads of Terms (13 December update)

Counterparty

Undetermined.

The Heads of Terms state that BEIS anticipates that the Low Carbon Contracts Company Ltd (“LCCC”) will be the LCHA Counterparty, as it is for the CfD.

Term

Between 10 and 15 years.

Confirms the term will be 15 years, starting from the earlier of the Start Date and the last day of a specified Target Commissioning Window.

However, while the term will commence regardless of whether the Producer commissions the facility, payments under the LCHA will not commence until the Start Date occurred

For the Start Date to occur, the Producer must satisfy a number of Operational Conditions Precedent, including:

  • Evidence that the Producer has commissioned an Installed Capacity of not less than 80% of the Installed Capacity Estimate;
  • Evidence that the Facility can produce hydrogen that meets the LCHS;
  • The Data Collection Plan;
  • Evidence that the Facility complies with specified metering requirements;
  • Written confirmation from the Producer to the LCHA Counterparty that no subsidy has been received by the Producer or by any other person in relation to the costs of the Project (excluding the subsidy arising under the LCHA and/or any other Approved Scheme of Funding); and
  • For CCUS-Enabled Facilities only, evidence for connect to the COT&S Network.

As with the CfD, it will be critical to understand and comply with the various pre-Start Date milestones, by the Milestone Delivery Date, so as not to lose any of the Term.

The Milestone Delivery Date will be:

  • for CCUS-Enabled Facilities, 18 months; and
  • for Electrolytic facilities, 12 months,

after the Agreement Date (though this can be extended in instances of, e.g., force majeure).

Eligible technologies

Hydrogen which meets the Low Carbon Hydrogen Standard (“LCHS”) will be eligible for support (a GHG emissions intensity of 20gCO2e/MJLHV of produced hydrogen or less).

This is a single threshold using absolute emissions set at the point of production, and covers upstream emissions from the feedstock, such as natural gas, input materials, and emissions from the production process (including energy supply emissions).

Additionally, projects must:

  • be located in the UK;
  • achieve COD by end of 2025;
  • utilise core technology that has been tested to Technology Readiness Level of at least 7;
  • be a new build, electrolytic Hydrogen production facility;
  • have identified at least one offtaker;
  • have identified an electrolyser supplier;
  • have a minimum Hydrogen production capacity of 5MW; and
  • have demonstrated access to finance.

As well as the criteria identified in the Indicative Heads of Terms, the Heads of Terms further require that the Producer demonstrates that it has commissioned an Installed capacity of no less than 95% of the Installed Capacity Estimate by the Longstop Date. The Producer can opt to reduce the initial installed capacity estimate up to a maximum of 10% in the first 12 months of the LCHA.

The Heads of Terms also provide clarification in relation to Qualifying Volumes and Non-Qualifying Volumes of hydrogen.

Qualifying Volumes are volumes purchased by a Qualifying Offtaker and that comply with the LCHS. Producers will be eligible for payment under the LCHA for these volumes of hydrogen produced.

A Non-Qualifying Volumes are those purchased by a Non-Qualifying Offtaker (including offtakers that export hydrogen for use outside the UK and/or inject hydrogen into the Gas Transportation System for blending), and which do not meet the LCHS. The volumes of hydrogen will only be taken into account when calculating the payment that is to be made back to the LCHA Counterparty.

RTFO Volumes, being those produced by the relevant facility in respect of which Renewable Transport Fuel Certificates are claimed, will not be eligible to receive subsidy under the LCHA.

Determining the level of Support

The Indicative Heads of Terms envisaged a premium, calculated as the difference between the Strike Price and the Reference Price for each unit of hydrogen sold, which would be paid to the Producer.

The payment was also set out to be two-ways, with the Producer paying the Hydrogen Counterparty the difference between the Reference Price and the Strike Price if the Reference Price exceeds the Strike Price.

The Heads of Terms confirms that Producer will be paid a premium (the “Difference Amount”) for each unit of hydrogen that is a Qualifying Volume when the Strike Price exceeds the Reference Price for Qualifying Volumes.

The Difference Amount is calculated as follows:

(Strike Price – Reference Price for Qualifying Volumes) x Qualifying Volumes

Non-Qualifying Volumes will be taken into consideration only when the Reference Price for Non-Qualifying Volume exceeds the Strike Price, meaning an amount will be payable by the Producer to the LCHA Counterparty.

The Difference Amount here will be calculated as follows:

(Reference Price – Strike Price for Non-Qualifying Volumes) x Non-Qualifying Volumes

The payments will be made on a £ per MWh (higher heating value) basis and it is expected that the size of the Difference Amounts payable by the LCHA Counterparty will decrease as the hydrogen market develops.

RTFO Volumes will not be taken into consideration when calculating the Difference Amount.

In short, if the price for Non-Qualifying Volumes is above the Strike Price, the difference received for the Non-Qualifying Volumes will be set off against payments due or owed to the producer (or is part of the amount payable to the LCCC).

Price Discovery Incentive

N/A

The LCHA is to include a mechanism designed to incentivise Producers to achieve prices for Qualifying Volumes above the Floor Price.

The mechanism will operate so that the Producer receives an amount linked to the increment by which the Reference Price for Qualifying Volumes exceeds the Floor Price for each unit of hydrogen.

Where the Reference Price for Qualifying Volumes is high than the Floor Price and is equal to or lower than the Strike Price, the Producer will receive 10% of the difference between that Reference Price and Floor Price.

Where that Reference Price exceeds the Strike Price, the Producer will receive 10% of the difference between the Strike Price and the Floor Price.

Volume Support

The Indicative Heads of Terms set out the government’s minded-to position that it would not act as an offtaker of last resort.

Unlike the backstop PPA that is included in the Low Carbon CfD, this does not protect generators in the event that their offtake contract has terminated without replacement.

Instead of the backstop PPA, volume support will also be provided where the Producer is producing hydrogen and its offtake/sales volumes fall.

In these instances, the Producer will receive an additional amount (the “Sliding Scale Top Up Amount”) for each unit of hydrogen sold which is a Qualifying Volume.

This Sliding Scale Top Up Amount will be set by the LCHA and will not be negotiable at project level, though BEIS is considering whether the parameters for when the Sliding Scale Top Up Amount is paid will need to be adjusted to accommodate different hydrogen production technologies.

The offtake/sales volumes will include all volumes of hydrogen produced by the relevant facility, including Non-Qualifying Volumes and RTFO Volumes.

No support will be provided where the Producer’s offtake/sales volumes fall to zero.

The drafting makes this of limited comfort so achieving credit-worthy long term hydrogen sales agreements will still be key.

Volume scaling

BEIS was considering whether a Producer should be permitted to increase the volume produced within an existing Facility above any level initially set out in the LCHA. However, it was envisaged that any additional volumes would not be subsidised through an existing LCHA.

The Heads of Terms introduce an LCHA Production Cap and Annual Volume Cap, which is intended to still allow producers to have the flexibility of producing and selling hydrogen to match demand.

Each billing period all the volumes of hydrogen produced, including both Qualifying and Non-Qualifying Volumes and RTFO Volumes, will be aggregated into a “Total Aggregate Volume” and will be compared to the LCHA Production Cap.

For each Fiscal Year, the total volumes of hydrogen produced and sold by the relevant facility must not exceed the Permitted Annual Volume Cap. Producers will not receive LCHA payments in respect of volumes exceeding this cap. It is not clear if FM provisions would be a carve out to this.

Volumes that exceed the Permitted Annual Volume Cap will be multiplied by 150% for the purposes of calculating the Total Aggregate Volume.

When the Permitted Annual Volume Cap is exceeded in 2 consecutive years or non-consecutive fiscal years, the LCHA may terminate the LCHA. This would clearly have an impact on the hydrogen sales agreements.

Where the Total Aggregate Volumes are equal to the LCHA Production Cap, the LCHA will expire in a no-liability basis.

Total amount of support available

The total support for funding under the LCHA was not stated under the Indicative Heads of Terms.

Costs that are to be eligible for support under the LCHA and are not to be automatically excluded from the Strike Price have not yet been confirmed. However, BEIS had stated that these are likely to include:

  • capex and opex associated with the construction and operation of the relevant facility (excluding capex funded by the NZHF or other approved funding scheme);
  • an allowed return on investment;
  • input energy costs;
  • capex associated with the construction of hydrogen transport infrastructure, but not the opex associated with operating it (excluding capex funded by the NZHF or other approved funding scheme)*;
  • capex and/or opex associated with the construction and/or operation of hydrogen storage infrastructure (excluding capex funded by the NZHF or other approved funding scheme)*; and
  • leasing costs associated with specified hydrogen transport and or storage infrastructure*.

*Whether these costs will be included in the Strike Price will be negotiated on a project-by-project basis.

Ineligible costs will include:

  • indirect and direct taxes;
  • capex and/or opex associated with capturing additional revenue streams;
  • costs in relation to Electricity Storage pursuant to the Electricity Storage negative undertaking; and
  • any costs associated with the provision of ancillary services.

Ineligible costs will not be included when calculating the Strike Price.

Indexation

N/A

CCUS-enabled facilities:

The natural gas component of the Strike Price will be calculated by multiplying the monthly Gas Reference Price by an agreed proportion of up to 1.15 MWh (HHV) of hydrogen produced and sold each month.

All other components will be CPI indexed.

CO2T&S charges fall outside of the Strike Price.

Electrolytic Facilities:

The full Strike Price will be indexed to CPI.

Billing and Payment

N/A

The main payment for each Billing Period will comprise of the following:

  • the Difference Amount – payable either by the LCHA Counterparty or the Producer as applicable,
  • the Price Discovery Incentive Amount – payable by the LCHA Counterparty to the Producer,
  • the Sliding Scale Top Up Among – payable by the LCHA Counterparty to the Producer,
  • the CO2T&S Outage Relief Event Strike Price Deduction Amount – payable by the Producer to the LCHA Counterparty (for CCUS-enabled facilities only), and
  • the Monthly CO2T&S Charges Amount – payable by the LCHA Counterparty to the Producer (for CCUS-enabled facilities only).

The full payment terms can be found here.

Charges for CCUS-Enabled Facilities

N/A

For CCUS-Enabled Facilities connected to a CO2T&S Network, the LCHA Counterparty will be required to pay the Producer certain CO2T&S Charges in proportion to the Qualifying Volumes/Total Volumes ratio. The CO2T&S Charges Amount will comprise of:

  • Flow Charge;
  • Capacity Charge; and
  • Network Charge.

Application for LCHA

Applications are submitted to and assessed by BEIS. against the following criteria:

  • deliverability - the level of confidence government has in the delivery plan put forward by the project and the date at which the project can, credibly, be operational by;
  • emissions - the extent to which the project delivers carbon savings to the economy and contributes to the UK government’s 2030 aim and emission reduction targets, including CB6 and net zero;
  • cost considerations - whether the project will deliver cost-effective hydrogen;
  • economic benefits - the contribution the hydrogen plant will make to the economy;
  • market development and learning - the extent to which the project offers growth and learning opportunities in the production and usage of hydrogen; and
  • additionality of electricity source - whether a project’s low carbon electricity source is met by new low carbon generation and does not divert low carbon electricity from other users to avoid negative impacts on wider decarbonisation.

Sealed Bid or bilateral negotiations

Agreeing the LCHA will be subject to due diligence, engagement and likely to involve strike price bids. BEIS is considering both bilateral negotiation and “sealed bid” processes.

No further information was provided in the Heads of Terms.

State Aid

Under the Indicative Heads of Terms, the approach seemed to follow that of the AR4 CfD.

The Heads of Terms confirmed that the subsidy control provisions would follow those for AR4 CfD. The LCHA will prohibit subsidy cumulation in respect of the costs of the Project and an obligation for Producers to repay any subsidy it receives other than the LCHA subsidy.

Exemptions to the no subsidy rule will include: (i) Net Zero Hydrogen Fund funding; (ii) Renewable Transport Fuel Certificates; and (iii) any Approved Scheme of Funding.

Specific carve-outs are still being considered by BEIS.

Breach of this undertaking will give the LCHA Counterparty the right to suspend all payments under the LCHA.

Interplay with other schemes

The government stated that it supports “revenue stacking” and would consider this in the context of the need to avoid double subsidisation.

UK ETS

While certain facilities could be eligible for free allocation of allowances under the UK ETS, the LCHA will prohibit Producers to from applying for or receiving these free allowances. Breach of this prohibition would entitle the LCHA Counterparty to terminate the LCHA.

BEIS is still considering whether the scope of this prohibition will cover Producers or only relevant facilities.

RTFO

The LCHA permits Producers from also participating in the RTFO obligation, however, claiming under both schemes in respect of the same volumes of hydrogen will not be permitted.

To this effect, the LCHA will also include a third party claim prohibition, which means Producers will be required to use all reasonable endeavours to ensure that volumes subsidised by the LCHA are not subsequently claimed under the RTFO scheme by a third party.

LCHS

BEIS is still considering the interaction between the LCHS and the LCHA. However, the LCHA will include enforcement rights for the LCHA Counterparty, including suspension and termination rights.

Next steps

The Heads of Terms have clarified important elements that had were lacking in the Indicative Heads of Terms, particularly in respect of payment provisions, contract length and indexation. However, there are still aspects that are yet to be determined, including how support for own consumption projects will be operate.

BEIS is also due to develop a certification scheme for hydrogen in 2025. It is still unclear how such a scheme will interact with the LCHA and, in particular, how any revenues and/or costs arising from the certification scheme will be treated under the LCHA. We know however that to receive any LCHA payments, the hydrogen produced must always meet the LCHS

BEIS are looking to release a draft full form LCHA to industry in May 2023.

For advice on UK hydrogen projects both blue and green and how we are advising clients who are investing, building or looking to sell/offtake hydrogen from UK projects, please contact the authors listed here.