Contractual payments and regulatory returns models may be the best way to support the deployment of low carbon hydrogen, according to a report.
On 17 August, BEIS published a report commissioned from Frontier Economics, which set out to explore how the government can best support hydrogen production facilities with a capacity of 100MW or more in the near-term. It examined potential business models that could primarily support the use of low carbon hydrogen in industry, with the decarbonisation value likely to be higher in this sector. This is due to industrial end users having fewer cost-effective alternative decarbonisation options to other end user groups.
It looked at multiple technologies, including methane reformation, bioenergy with carbon capture and storage (BECCS) and electrolysis, before designing business models with the overriding aim of offering an incentive to invest in low carbon hydrogen production, while limiting costs to consumers and taxpayers.
To design these models, it looked into the risks and barriers associated with the technologies, value produced, markets and existing policies associated with the low carbon hydrogen production sector. Based on this analysis, it identified nine key considerations for business model design: subsidy to cover externalities; a focus on uses where the decarbonisation value is highest; technology-specific support in the near-term; transfer of demand away from investors; reducing the risk of policy change; separate switching support for users; reductions in support for successive investments; compatibility with existing policy; and reduced risk of market power.
Four categories of business models were then assessed. These included contractual payments to producers, such as premium payment models or CfDs, regulated returns, such as a Regulated Asset Base (RAB) or Cap and Floor models, obligations, where an obligation is imposed on parties outside hydrogen production to supply or consume a certain quality of low carbon hydrogen, and end user subsidies, where an on-going technology neutral subsidy would be handed out to end users for carbon abatement.
It found that the priorities could be best delivered through contractual payments to producers or regulated returns models. Under an obligation model, investors were found to continue to be exposed to policy model, while through end user subsidies, demand risk would remain with the producer and in a sector where long-term contracts could be difficult to secure, this would prove difficult for producers to manage. In contrast, the contractual and regulatory models can be designed to accommodate a range of detailed design features aimed at meeting the nine priorities.
The contractual approach could be perceived to give more certainty to investors over a regulatory approach, the report said, while the regulatory model may be easier to set up. It further noted BEIS analysis in the context of nuclear investment which had shown the benefits of hybrid models, combining regulatory and contractual approaches. It suggested hybrid approaches should therefore also be investigated further for hydrogen.
In designing contractual payments or regulatory returns models, three key design features were assessed. It concluded that a split structure is likely preferable to manage demand risk, rather than applying a backstop or a guaranteed purchase of low carbon hydrogen. This is due to consumers being exposed to potentially very high payments per unit of hydrogen produced under a backstop approach. It found that this support could be provided through either a revenue stabilisation model, such as a CfD, or paid as a premium to sales revenue. Revenue stabilisation models were found to be easier to deploy across all technologies.
It also said that indexing support payments to the input fuel price is something that should be considered further. This is because, depending on the impact on producer’s cost of capital, it could reduce support costs. Indexing was noted as potentially being particularly helpful if a revenue stabilisation approach is taken to avoid placing excessive input cost risk on investors. It did stress that the decision for indexing a premium is not something that is clear cut and will depend on the impact that leaving such a risk with producers could have on their cost of capital.
