Low emission hydrogen is expected to play an important role in global decarbonisation, though costs today are very high and must come down. Economies of scale will help, but production is yet to pick up pace as there are inadequate ‘demand signals’ which result in financial risks for project developers. Kapil Narula and Luciano Caratori of Climate Champions Team, Laurent Antoni at IPHE, and Nigel Topping (former UN Climate Change High-Level Champion) present alternative market models such as variable contracts-for-difference and the double-sided auction model which establish incentives for buyers, are economically efficient and create firm demand signals from buyers, thus improving project bankability. Examples come from Saudi Arabia, the Netherlands, the UK and Germany. The goal is to get buyers to make firm purchase commitments that catalyse the production of low emission hydrogen.
The remaining carbon budget (in 2023) to stay under 1.5 °C (for a likelihood of 50%) is 250 gigatonnes CO2, with estimated exhaustion in 2029. This gives humanity only a 5-year window before breaching this temperature limit. Hydrogen – as an energy carrier – is expected to play an important role in global decarbonisation, especially in hard to abate sectors.
IEA forecasts that global demand for low emission hydrogen in the net zero scenario will be close to 400 million metric tonnes by 2050 which could contribute to about 4 per cent in cumulative CO2 emission reductions from 2022-2050. Currently, there is a wide gap between actual, expected and required production of low emission hydrogen and electrolyser capacity as shown in Table 1.
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Table 1. Actual, expected and required production of low emission hydrogen / (Data source) (Data source)
Seeking the Hydrogen S-curve
However, there is growing evidence that exponential change is already happening in several sectors in accordance with Wright’s law which predicts that production volume rapidly increases as cost of production falls. Analysis from Systems Change Lab shows eight countries have already grown solar and wind generation at rates faster than what’s needed to limit global warming to 1.5°C. The ‘The Breakthrough Effect’ report also posits that an increase in low emission hydrogen production can rapidly bring down prices to below $2/kg in favourable locations, leading to rapid growth in accordance with the S-curve.
Key financial risks affecting final investment decision (FID)
Financial risks raise the costs of capital and hence well-designed risk mitigation mechanisms are essential to catalyse investment in low emission hydrogen projects. The Energy Sector Management Assistance Program (ESMAP) identified a set of risks including macroeconomic, political, regulatory, infrastructure, permitting and compliance risks in low emission hydrogen projects. It specifically highlighted offtake risks in different stages of the project development lifecycle, including inadequate demand, unavailability of credible off takers, uncertainties regarding the price of hydrogen, lack of hydrogen markets for trading and potential offtake defaults.
Inadequate demand signals
Although technically feasible, there is a “green” premium for low emission hydrogen which in conjunction with several barriers creates financial hurdles for reaching FID in new projects. Due to the inherent risk associated with the offtake, a firm long term offtake agreement is extremely important for investors. In response to this, hydrogen purchase agreements (HPAs) – ideally pooled from a group of buyers – provide a firm demand signal, lowers the financial risk, improves project bankability and can nudge producers and service providers to invest private capital.
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Table 2. Pipeline of low emission hydrogen projects / (Data source)
Table 2 shows the planned pipeline of low emission hydrogen projects by 2030 which is estimated at about 38 million metric tonnes per year. The BNEF hydrogen offtake agreement database that tracks 149 projects, reports that only 2.6 per cent of the projects have a binding offtake agreement. According to Rystad Energy, Spanish fertiliser producer Fertiberia, Spanish electricity utility Endesa, fertiliser maker Yara, oil major BP, steel producer ArcelorMittal, Danish green fuel company Everfuel, Dutch producer of ammonia fertiliser OCI, and Chinese oil giant Sinopec have signed HPAs.
However, 1.3 per cent of the planned projects are pre-contractual agreements (term sheets and letter of intent with a good chance of becoming binding contracts) and 16.5 per cent are MoUs or unspecified agreements which may never become binding. About 80 per cent of the planned projects have not identified buyers as yet, which is a major challenge as banks avoid risking loans to capital-intensive projects without a long-term revenue stream from sale of low emission hydrogen.
Models for market creation
Renewable hydrogen currently costs 2-3 times more than non-abated fossil hydrogen and the “green” premium for low emission hydrogen is often provided through financial incentives such as grants, unit-based production subsidies, and clean energy tax credits. One limitation of supplier side subsidies is that this does not create incentives for buyers and do not account for decreasing cost of production. Some alternative models are:
A) Self-offtake
In this model, project developers with strong balance sheets are buyers of hydrogen. This model has been successfully used by NEOM Green Hydrogen Company (NGHC) (joint venture between ACWA Power, Air Products, and NEOM) to build the world’s largest renewable hydrogen plant. Slated to be completed by the end of 2026, the plant will produce approximately 600 metric tonnes per day in the form of renewable ammonia. Air Products has an exclusive 30-year off-take agreement for all the renewable ammonia produced. Full financial closure for the project was obtained in May 2023, with a total investment value of USD 8.4 billion of which USD 6.1 billion was in the form of non-recourse financing from lenders.
Shell Holland Hydrogen 1 plant (construction commenced in September 2022), which will produce 60 metric tonnes of renewable hydrogen per day when fully operational, is also based on the self-offtake model. The hydrogen produced will be used to supply the Shell Energy and Chemicals Park Rotterdam, replacing a part of the existing hydrogen used in the refinery.
B) Variable contracts-for-difference model
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Figure 1. Variable contracts-for-difference (CfD) style producer subsidy model / (Link)
The UK has implemented the hydrogen production business model with £100 million project funding in 2023 where the government will provide a variable contracts-for-difference (CfD) style subsidy to the producer. The supplier and a government counterparty will sign a Low emission Hydrogen Agreement (LCHA) over a 15-year contract term. As shown in Figure 1, the producer will be paid the difference between a strike price (price which the producer needs to cover the cost of production and an allowed return on investment) and the higher of two reference prices – the market price for natural gas or the actual achieved sales price. Inclusion of an achieved sales price as a reference gives the producers an incentive to encourage customers to switch to low emission hydrogen. The price floor would be set at the lower of the achieved sales price and the natural gas price to prevent the producer from receiving additional support for sales below the price of natural gas. As an example, if the producer strike price is 6$/kg of hydrogen and the sale price is 2$/kg of hydrogen, the subsidy provided will be 4$/kg of hydrogen, which will reduce over time as the sale price increases.
This model will also include a mechanism to manage volume risk, as the producer will be provided with an additional subsidy per unit of hydrogen sold if its sales volumes were to fall. Hence the producer will earn a guaranteed return. Currently the contracts are awarded through negotiations between industry and UK Government, as there is no established market for low emission hydrogen making price discovery difficult, but transition to a competitive, auction based mechanism is being considered by 2025.
C) Double sided auction model
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Figure 2. Double sided auction with contracts for difference model / (Link)
Germany has implemented a double-sided auction scheme with a contracts for difference model under the H2Global funding programme where the Hydrogen Intermediary Network Company (HINT.CO) will sign long-term agreements. In this mechanism, auctions are held for both supply and offtake of hydrogen. The lowest procurement offers and the highest sale offers received in the auctions are awarded the contract, while procurement offers which are too high and sale offers which are too low are rejected (see Figure 2). The price difference between the average supply price (e.g. 4$/kg) and the sale price of hydrogen is then covered by public subsidies.
Hydrogen Breakthrough Agenda
The Hydrogen Breakthrough Agenda is aiding market creation for low emission hydrogen. Priority action H2 is strengthening demand for public and private commitments for use of low emission hydrogen. This is being done by encouraging coalitions of leading countries and companies to make increased and firm purchase commitments for low emission hydrogen. Along with market creation, it is also working to overcome other challenges for scaling up clean hydrogen production. Working closely with several partners such as the Clean Energy Ministerial Hydrogen Initiative (CEMH2I), the Hydrogen Breakthrough Agenda is enabling hydrogen market creation through the development of a hydrogen ecosystem including standards and certification, research and innovation, and financing mechanisms.
Securing offtake contracts through different models plays a critical role in market creation. Long term hydrogen purchase agreements provide confidence to project developers to invest in infrastructure and will go a long way in creating firm market demand for catalysing investment for the production of low emission hydrogen.
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Kapil Narula is Senior Analyst, Climate Champions Team
Luciano Caratori is Energy Cluster Lead, Climate Champions Team
Laurent Antoni is Executive Director, International Partnership for Hydrogen and fuel cells in the Economy (IPHE)
Nigel Topping is a former UN Climate Change High-Level Champion (COP26)