UK setting the bar for hydrogen investment support

In 2020, Europe’s aspirations for hydrogen were formally introduced. It was a year of ambitious goals and idealistic aspirations set against the tension of Covid lockdowns.

A target of 40GW of EU hydrogen generation by 2030 served as the cornerstone of the ambitious EU Hydrogen Strategy. Since then, individual country target declarations around Europe have been made that are just as ambitious.

The energy crisis of this year has increased policy momentum for Europe’s switch to hydrogen (H2). The current effort for policy includes both decarbonization and energy security. Finding a politician discussing crisis management without mentioning H2 is challenging.

Three tangible obstacles prevent capital investment in H2 projects notwithstanding the enthusiasm for the potential role that H2 may play in the next 10 to 20 years:

  • Producing low-carbon H2 is quite expensive.
  • Low carbon H2 is rarely, if ever, in demand at unsubsidized pricing.
  • There are currently no efficient measures in place to close the cost difference.

Financial assistance

For either a green or blue H2 project to have a strong investment case, ongoing revenue support is essential. This assistance closes the production cost gap.

The producer subsidy approach is the main focus in the UK. The main method to make this possible is LCHA contracts. The LCHA is built on the basis of two assumptions: I current renewable CfD principles, and (ii) that gas will primarily be replaced by H2 as an alternative fuel.

The LCHA seeks to address two significant concerns that H2 producers face:

How can investors secure a sufficient payment per unit of produced H2?
How can investors ensure they can sell enough H2 volume to support a realistic return?

The LCHA mechanism’s finer points are still being developed. Real-time investor feedback and negotiation taking place concurrently with the opening of allocation rounds effectively makes this happen. Although the proposed LCHA framework, which mainly relies on the current low carbon CfD structure, has been outlined by the UK government.

LCHA assisting investors

The framework of the current renewable CfD system revolves around a Strike Price that represents the long-term average revenue necessary to support a feasible return on investment. The wholesale market power price is then used as the CfD’s reference price. The government reimburses the asset if the strike price is higher than the reference power price (or vice versa).

There is currently no H2 market reference price, which makes it difficult to implement the renewable CfD framework for H2 projects (and there is unlikely to be a liquid reference for many years). Therefore, the project’s “Achieved Sales Price” for H2 serves as the reference price for the LCHA structure.

Since this Achieved Sales Price was agreed on a bilateral basis, there are several chances for investors to manipulate the process to maximize support payments. The LCHA design sets a floor on the reference price at the level of a front month NBP gas price index in an effort to solve this.

Given the shaky correlation between hydrogen pricing and gas prices, long-term reference price links to gas prices have some obvious problems. The government has stated its intention to provide producers with clear incentives to agree to higher H2 sales pricing.

The goal is to switch to a hydrogen-driven price signal and sever the connection between the LCHA subsidy and gas prices. In addition, as a market for H2 offtake develops, subsidy support payments should eventually stop being made.

The LCHA structure’s support will vary depending on production levels is another crucial feature. On the basis of a specified production volume, the LCHA is negotiated and signed. The producer may sell any extra production over this amount, but without receiving a subsidy. Support increases if output levels fall below the agreed-upon threshold (i.e. the strike price effectively increases). Although reducing producer volume risk is the goal here, the precise mechanism is still being worked out.

What happens to H2

The UK has proposed a preliminary version of what is expected to emerge as Europe’s first workable instrument to encourage scaling up hydrogen investment. It is unknown how much the taxpayers will pay for this or how much the cost of producing hydrogen will decrease as a result. However, it provides a structure for investors to use.

The LCHA strike price offers negotiated recoveries for project construction expenditure and opex, small scale H2 transport and storage, and an acceptable return on investment. These components can support an effective investment case, project finance, and FID.

There are still many unknowns, but the early allocation rounds’ in-depth project level agreements will determine how the mechanism develops in practice. And as a result, early investors have a certain first mover advantage.