UK Low Carbon Hydrogen Business Model - Update

Last week, the Department for Business, Energy and Industrial Strategy (“BEIS”) published an updated heads of terms for the low carbon hydrogen business model (the “Low Carbon Hydrogen Agreement” or the “LCHA”).

The LCHA is closely based on the latest Contract for Difference (“CfD”) standard terms and conditions, which has been successful in incentivising renewable power generation in the UK over the last decade. The aim had been to finalise the hydrogen business model in 2022 and to allocate the first LCHA for projects reaching final investment decisions from 2023. However, at around 50 pages, the LCHA is some way off the full draft agreement and therefore it is likely that the full draft will not be available until later in 2023.

Notwithstanding this, the updated heads of terms and continued development of key areas of the business model, will be welcomed by industry.

Key points to note:

• Parties: The LCHA will be a private law contract between a hydrogen producer and a counterparty, expected to be the Low Carbon Contracts Counterparty, who is also counterparty to the renewables CfD.
• Term: 15 years from the Start Date or until the date on which the “LCHA Production Cap” is reached. This cap is the total forecast hydrogen production expected during the term of the LCHA and effectively places an envelope around the amount of subsidy that a producer can receive for hydrogen production under the LCHA.
• Start Date: Much like the CfD, producers will need to commission their project within a Target Commissioning Window (being a 12 month period). If the project is commissioned late, the 15 year term will begin from the end of the Target Commissioning Window (thereby eroding the term of support). If the project is not commissioned by a Longstop Date (12 months after the end of the Target Commissioning Window), the LCHA Counterparty has a right to terminate the LCHA. The commencement of the Start Date will be subject to meeting a number of operational conditions precedent.
• Qualifying Volumes: The LCHA will only subsidise “Qualifying Volumes” – these are hydrogen volumes which meet the Low Carbon Hydrogen Standard (“LCHS”), which are sold to Qualifying Offtakers and which are not volumes which receive support under the Renewable Transport Fuel Certificates regime. This is important for investors to note. The LCHS will change over time, however BEIS has agreed that the LCHS applicable at the date of the LCHA, will be grandfathered for the relevant project. Qualifying Offtakers are those which are not Non-Qualifying and have been confirmed as qualifying by the LCHA Counterparty. Producers and investors will therefore require certainty that the proposed offtakers are confirmed as qualifying. Non-Qualifying Offtakers include risk-taking intermediaries (though this remains under consideration by BEIS), offtakers which are exporting for use outside the UK and offtakers using hydrogen for blending with natural gas.
• Strike Price: Like the CfD, producers will bilaterally agree a strike price (in £/MWh (HHV)) under the LCHA. The producer will be topped up to the strike price where the reference price for Qualifying Volumes is lower than the strike price. Where the reference price exceeds the strike price, the producer will pay the difference to the LCHA Counterparty.
• Reference Price: Unlike the CfD for renewable power, there is currently no market reference price for hydrogen. BEIS therefore intends to use a proxy reference price which will be the higher of:
  • the gas reference price (which acts as a floor price) – being the daily average end-of-day value for the month ahead natural gas contracts. Producers and investors will need to consider whether this method of determining the gas reference price properly represents its likely gas costs, particularly where day-ahead markets are also used for gas and also in light of recently volatility in gas prices; and
  • the achieved sales price for those Qualifying Volumes.

Where hydrogen is sold for feedstock purposes, the floor price will not be the gas reference price, but instead there will be an Alternative Floor Price which is 1.2 times the gas reference price.

• Indexation: The strike price will be indexed to CPI.
• Sale of Non-Qualifying Volumes: A producer will be permitted to sell Non-Qualifying Volumes (i.e. hydrogen which does not meet the LCHS or which is sold to a Non-Qualifying Offtaker), however, where the price for such Non-Qualifying Volumes exceeds the strike price, the difference will be set-off against sums owed by the LCHA Counterparty to the producer. Where producers have both qualifying and non-qualifying offtakers, they will need to carefully model the impact of non-qualifying sales on their revenue under the LCHA.
• Volume caps: As noted above, the volumes of subsidised hydrogen production will be capped under the LCHA. The total volume cap is divided by 15 to give an annual volume cap, plus a 25% buffer. If the annual volume cap is exceeded in two consecutive or non-consecutive years, the LCHA Counterparty may terminate the LCHA. Where the total volume cap is reached, the LCHA is also terminable. There is also a volume floor – where annual volumes are less than 75% of the annual volume cap (i.e. the volume floor), the volumes produced will be deemed to be equal to the annual volume floor. It is important to note that the volume caps include both qualifying and non-qualifying volumes. This creates a number of issues which investors will need to consider in terms of the potential effect of non-qualifying volumes on the overall value of the LCHA and the ability of a facility to make up for low volumes by selling greater volumes in subsequent years or the inclusion of take-or-pay clauses in offtake agreements.
• Sliding Scale Support: As well as providing price support through the strike price and difference payments, the LCHA seeks to provide volume support, recognising that the hydrogen industry is nascent and some protection against volume risk is needed. The LCHA aims to support producers selling low volumes, by providing additional payments for each unit of hydrogen sold which is a Qualifying Volume. This will be equivalent to paying a higher strike price, although the strike price itself will not be adjusted. The sliding scale support will apply only when two conditions are met:
  • the offtake volumes must be less than 50% of the annual volume cap, pro rated on a monthly basis; and
  • the sum of such offtake volumes plus the amount by which offtake volumes were reduced as a result of a Qualifying Event is more than or equal to 50% of the annual volume cap, pro rated on a monthly basis.

A Qualifying Event is one which reduces “all volumes of hydrogen produced” (i.e. qualifying and non-qualifying volumes) except where this is caused by the producer’s breach or negligence or an outage. This sliding scale support mechanism will be key for investors and lenders. We understand that the sliding scale support is intended to apply where offtake is significantly reduced, but not where it is reduced to zero. This suggests that the support will apply so long as the producer is producing some hydrogen, but no support will apply if the producer produces zero. Lenders will also be keen to ensure that the timing of any volume support payments is prompt in order to allow the producer to meet debt service.

• Price Discovery Incentive: The LCHA includes an incentive on producers to achieve sales prices greater than the floor price (i.e. prices greater than the gas reference price). This incentive payment is set at 10% of the difference between the reference price and the floor price (where the reference price is equal to or less than the strike price) or 10% of the difference between the reference price and the floor price (where the reference price is more than the strike price).

Whilst the LCHA heads of terms provides further details on key areas of the pricing mechanism, there remains a number of areas which require further consideration and development. If you would like to discuss our more detailed analysis of the LCHA and the potential implications for your projects or investments, please get in touch.

As one of the world’s leading energy transition practices, we are tremendously excited about the potential for clean hydrogen to transform global energy systems. Over the years, we have advised numerous clients on hydrogen projects and businesses. This includes the recent significant step-up in relation to the development of the new hydrogen economy as part of the drive to net zero. This is a nascent and rapidly emerging industry, and we have been investing heavily worldwide to ensure we are at the forefront of developments. This includes our thought leadership publication Getting Hy? Ambition and the art of the possible in the search for a new Hydrogen economy, and also our participation in the UK Government’s Hydrogen Expert Group.