UK hydrogen ambitions get boost from energy security strategy and consultations

The government's "British energy security strategy" policy paper, which was released (7 April 2020) following delay attributed to inter-departmental wrangling, has significantly upgraded the UK's existing hydrogen production target from 5GW to 10GW by 2030, with at least half of that capacity to take the form of electrolytic hydrogen. 

That ambition, characteristic of the energy security strategy more generally, was followed-up on 8 April with the release of three responses to the current hydrogen consultations on a low-carbon hydrogen business model, on a low-carbon hydrogen standard (LCHS), and on the Net Zero Hydrogen Fund.

Of the three, the response to the government consultation on the low-carbon hydrogen business model provides the most interesting insights on the government's thinking on the nascent hydrogen sector. Although hydrogen production is still relatively modest, more than 120 organisations responded to the consultation, which demonstrates the enthusiasm and appetite for the UK's hydrogen sector.

The model discussed in the consultation and response is targeted exclusively at newly constructed facilities built for the purpose of producing hydrogen that can meet the requirements of the LCHS.

The response largely confirms the government's "minded to" position in the consultation, with four items that stood out on its position on blending, reference and strike prices, volume support and indexation.

Hydrogen blending

The hydrogen sector faces a "chicken and egg" problem where production and demand need to co-develop to mutually incentivise a fast-growing hydrogen economy. With current demand for hydrogen being modest (and largely limited to industrial purposes), many had expected the model to capitalise on blending as a "market ready" demand-sink for producers otherwise facing shallow, volatile or temporarily unavailable demand. This would be much like the electricity grid providing a ready export option for power generators.  

However, the response makes clear that government regards blending as a transitional option only and that its thinking is focussed on hydrogen as being most optimally deployed in the "hard to abate" sectors, particularly in industry, heavy transport and power generation, where (as the response notes) "other routes to decarbonisation do not exist or are limited, particularly where direct electrification is not an option." This is not necessarily surprising, as the debate rages within the sector as to how hydrogen can be best deployed across a broad spectrum of end users to most efficiently support the decarbonisation objective (given the current high costs of production and limited supply).

As such, the response concludes that there is unlikely to be initial support for blended volumes and further work will need to be done on determining how to support blending through the model, with the possibility of a contractual re-opener being retained.

Reference and strike prices

Contracts for differences (CfD) mechanisms work by reference to a market reference price. As hydrogen lacks a market benchmark, the consultation went into some detail on determining an effective proxy (pending maturing of the market and the emergence of a market reference price). The response showed positive support for the government's minded-to position of a reference price derived of three components: the achieved sales price; a price floor at the natural gas price; and a contractual price discovery mechanism. 

As the government intends to proceed on the basis set out in the consultation, the response is more useful for providing a good discussion (from the perspective of the responders) of the issues that arise in attempting to shoehorn two fundamentally different technology types – carbon capture, usage and storage (CCUS) -enabled and electrolytic hydrogen, which the response refers to as "archetypes" – into one model. 

Although the indicative heads of terms (HoTs) acknowledge that further analysis is required, the general principle is that the strike price will allow the producer to cover its production costs and make an allowed return on investment. Similarly, the reference price for initial projects (in the absence of a market benchmark), will be the higher of the achieved sales price and the price floor (which itself will be the lower of the gas price and the strike price).

Volume support

Again, the government's position on volume support largely endorses the approach set out in the response, namely that a sliding scale should be used to support low-volume production. Although the detail is not yet clear, this principle is now reflected in the HoTs: "if the producer is producing low carbon hydrogen and its offtake/sales volumes fall, the producer will receive an additional amount for each unit of hydrogen sold" (although this falls away if production falls to zero).

But it is the second aspect of the volume discussion that is more interesting: what support should be provided when demand falls to zero and what is the government's role in stimulating demand (through both funding and non-monetary support)? Examples of the latter include reducing the costs of switching for end users, supporting the storage of hydrogen, enabling blending in the NTS and communicating a clearer strategy to targeted end users and sectors. 

This is interesting because hydrogen producers face the fundamental challenge of selling into an illiquid demand market, and might therefore fairly expect some availability or offtake-related support from the government. But the response shows the government is willing to adopt a strong position on this issue, which has its roots in the much-repeated observation that the pot is a limited one and must be deployed so as to achieve the most effective outcomes. The government, therefore, believes that producers should "play an active role in promoting market development". This takes us back to the chicken-and-egg problem, and the response is clear the chicken has to do its share of the work while the government focusses on encouraging the egg –that is, securing demand in key end-use sectors.  

Indexation

The issue of indexing the strike price is in many respects an extension of the complexities of setting a reference price that works for two different production methods and fuel and energy inputs (three if you differentiate island and grid-connected electrolysis). The response offers no obvious solution to this problem, drawing out the need to address indexation of the primary fuel alongside the more generic indexation of the capex elements.

Although the response flags that government needs to do further analysis on the core cost components and their interaction with the reference price and LCHS, the HoTs suggest that CCUS projects will benefit from a combined gas market index and consumer price index (CPI) and that electrolytic projects will get the full strike price indexed by CPI. 

Adaptability of the model

A running theme of the government's consultation and response is whether one model can adequately flex across the two "archetypes". This is largely a factor of balancing the complexity of managing different schemes and introducing the risk of perverse incentives and distorting competition on the one hand with the administrative burden for smaller electrolytic projects having to manage the CfD auction process on the other (which some of the responses suggested could result in a bias in favour of larger CCUS projects). 

On this point, the government has taken the firm position that the model can accommodate both archetypes, with the "flex" provided by adopting different approaches to strike prices, indexation, and the allocation processes. Clearly, the government will have taken confidence from the success of the renewables CfD, which uses different allocation pots, budgets and processes as the solution to remaining technology agnostic while accommodating technologies of different maturity and complexity. The point about there being a limited budget to support low-carbon hydrogen deployment resurfaces here, and the government is of the view that support is best deployed through the primary variable premium design (rather than offering an additional fixed-price support model to smaller projects): "introducing multiple business models would add complexity to the policy landscape, could create market distortion and potentially delay implementation".

Almost there: where next?

The response pushes the development of the model on to the next phase. Having largely harnessed the difficult issue of how to reconcile conflicting responses across the main two technology archetypes, the response is now supported by the HoTs to show that bilateral negotiations and initial contract awards are within reach. However, although the dominant theme is that the response endorses the overall direction of the consultation, it does not fully answer the thorniest issues. For example, the response is open on the need for more analysis on:

• Price discovery and incentivisation. How will the price discovery mechanism work (incentives and risk), with the HoTs suggesting that the producer receives an amount linked to the "increment by which the Reference Price exceeds the Price Floor for each unit of hydrogen sold".
• Volume support. How will the design of the sliding scale for volume support work? Particularly, how will it link to components of the variable premium price, how will it apply to different project archetypes, and what will the shape and slope of the reprofiled strike price will look like?
• Funding. How will the scheme be funded in the longer term? Although the intention is that all revenue support for hydrogen production will be levy funded from 2025, the response does not comment on the detailed levy design nor address how it will sit with the fraught issue of reconciling non-energy costs with high energy bills (in terms of ensuring affordability and a fair distribution of costs).  

Osborne Clarke comment

Overall, there is much in the response to show that the model is moving in the right direction and that it has broad support from the nascent hydrogen sector. With it now being accompanied by the HoTs and a clear position on the low-carbon hydrogen standard, focus is likely to shift to whether the model accommodates a sufficient producer and end-user class – and how quickly the "thorny issues" can be addressed to get the early projects up and running.