Part 4

Hy-Achieving – creating a suitable incentive regime

On 17 August 2020 the UK government released its much-awaited Hydrogen Strategy as part of its commitment to reaching net-zero carbon emissions by 2050. The Hydrogen Strategy sets out the UK Government’s use cases, the development of a full hydrogen value chain and the next steps to achieving a hydrogen economy. Alongside this, the UK Government published its proposed business model to incentivise low carbon hydrogen production, as well as consulting on the design of the Net Zero Hydrogen Fund and a new low carbon hydrogen standard.

Key takeaways of the Hydrogen Strategy are:

• Hydrogen targets: The UK Government has maintained its existing 5GW hydrogen production target by 2030. It will launch the £240 million Net Zero Hydrogen fund in early 2022 with a series of competitions at intervals. UK Government will finalise the Hydrogen Business Model in 2022, with first contracts to be awarded in Q1 2033. 
• Blue and Green Hydrogen: The strategy covers both “blue” hydrogen (i.e. hydrogen derived from natural gas through the process of steam methane reforming (SMR), with the associated carbon dioxide captured through CCUS technology) and “green” hydrogen (i.e. mainly produced by water electrolysis using renewable electricity, with no associated carbon emissions). Unlike the EU, which has a clear preference for “green” hydrogen, the UK sees both “green” and “blue” hydrogen being an important part of the UK’s future energy mix (i.e. a “twin-track” approach). The UK is geographically well-placed to develop CCUS projects and therefore “blue” hydrogen is likely to lead the way in the UK, allowing early hydrogen projects to be deployed quickly and more cheaply whilst, in the interim, costs of “green” hydrogen start to fall.
• Technology neutral: The UK Government has sought to remain technology-neutral in terms of the support which will be offered. The strategy recognises that a range of technologies will play a future role in hydrogen production, noting that costs for some technologies are currently cheaper (such as CCUS technology) and will be needed to scale-up production in early years.
• Contractual support model: As expected, the UK Government has proposed a contractual support model to incentivise hydrogen production, borrowing heavily from the UK’s CfD regime for renewables. By utilising a contractual support mechanism similar to the CfD regime for renewables, the UK Government hopes that it will see a clean hydrogen revolution, akin to the success and rapid expansion of renewable power generation in the UK. Under this model, the UK Government has sought to mitigate two key risks: (i) market price risk (the risk that production costs are high compared to the market price achieved); and (ii) volume risk (the risk that producers cannot sell enough hydrogen to cover their costs).
• Market price risk: The UK Government has considered three methods for dealing with price risk, its preferred option appears to be the “variable premium” model. Similar to the CfD regime for renewables, the proposed “variable premium” model will aim to mitigate market price risk by topping-up producers’ revenues up to an agreed “strike price”. Where the hydrogen reference price exceeds the “strike price”, producers will be required to repay revenues down to the agreed “strike price”. The effect of this is to provide producers with a stable revenue stream.
• Volume support: The UK Government has considered a number of volume support options, including: (i) availability-based payments (i.e. a split payment model where the production plant receives a payment covering fixed costs simply for being available and a separate variable payment based on the volume of hydrogen produced); (ii) or acting as a backstop purchaser of last resort where a producer has been unable to sell minimum quantities due to low demand. The UK Government’s preferred approach to provide volume support is through sliding scale price support. This would involve higher price support where volumes sold are low. Sliding scale support would divide production levels into tranches, with different price support levels for each tranche – the aim being to achieve a minimum economic return at lower volumes sold. 
• Reference price: In order for the “variable premium” model to work, there needs to be a reference price for hydrogen against which the agreed “strike price” can be compared. The UK Government’s view is that the reference price should ideally reflect the market value of the product. However, until there is a market price for hydrogen, a proxy needs to be developed. The UK Government has proposed a number of alternatives, but its “minded-to” position is that:
• in the longer-term, a market reference price will be developed, which represents the value of low carbon hydrogen in the market; and
• in the shorter/medium-term, the reference price will be the higher of the natural gas price and the average achieved sales price at each plant. This option gives pricing power to the producer to incentivise end users to switch to hydrogen. The inclusion of the natural gas price as a floor is because it is the most common fuel from which end users would switch so are likely to be willing to pay at least that price for hydrogen. UK Government also proposes a gainshare mechanism or periodic payment linked to achieving a certain price threshold. This is to incentivise producers to increase the achieved sales price.

• Indexation: The UK Government has considered four options for indexing of the strike price: inflation-linked, natural gas benchmark, electricity price benchmark and actual input energy cost. The UK Government’s preferred approach has not been confirmed and it plans to carry out further analysis to consider how the indexation options work across different types of projects, the impact on producers’ incentives to invest in hydrogen production and whether different approaches are appropriate for different technologies. UK Government will also consider whether to apply indexation for input fuel costs and whether there are other cost elements which also need consideration.

• Contract length: UK Government has not proposed a contract length, but acknowledges precedents set under the CfD regime (15 years) and the industrial CCUS contract (10 years).
• Allocation: UK Government is considering whether the proposed business model will be allocated bilaterally or through an auction process (similar to the CfD regime for renewables). Initially, contracts are likely to be awarded on a bilateral basis, with a competitive auction in place in the medium-term.
• Funding the business model: A difficult question which has not yet been answered is how the business model will be funded. Revenue support for electricity has been funded by passing the costs onto electricity consumers; however, the issue is more complex for hydrogen, where the end-consumers of hydrogen are more varied. It is not clear therefore whether the costs will be funded by both gas and electricity consumers.
• Demand-focussed hydrogen policies: The UK Government is considering a range of policies to create a demand for hydrogen production:
• Carbon pricing: By strengthening the UK Emissions Trading Scheme pricing, the UK Government hopes to promote investment in low carbon technologies, including clean hydrogen;
• Creation of a low-carbon hydrogen standard: To support the demand for low carbon hydrogen by providing confidence to end users that the hydrogen purchased is a low carbon alternative to existing fuels; and
• Sector-specific policies: For example the Renewable Transport Fuel Obligation (RTFO) in transport, the Capacity Market (CM) in the power sector, or the Industrial Energy Transformation Fund (IETF) in industry.
• Broader regulatory regime: Further clarity is yet to be provided on licensing requirements and roles, for example, whether hydrogen production, storage and transportation will require a licence, and whether National Grid’s role as the gas transmission operator will be extended to encompass hydrogen, or whether a new regulated entity will be created. A review of the Gas Act 1986 will also be launched to consider the future regulation of a gas industry which includes hydrogen.
• Hydrogen storage: The strategy acknowledges the need to scale up the hydrogen network and storage infrastructure in time. An update on the economic regulation and funding of storage will be announced in 2022, with a £68 million Longer Duration Energy Storage Demonstration Competition due to be launched. 

On 19 October 2021 the UK Government announced its Net Zero Strategy, key takeaways of which included: 

• the establishment of a new Industrial Decarbonisation and Hydrogen Revenue Support (IDHRS) scheme to fund new industrial carbon capture and hydrogen business models. The £140 million scheme will initially commit to providing up to £100 million to award contracts of up to 250 MW of electrolytic hydrogen production capacity in 2023 with further allocation in 2024. Eventually, the IDHRS will fund the allocation of the hydrogen business model contracts to both electrolytic and CCUS-enabled projects, resulting in up to 1.5 GW of low carbon hydrogen contracts awarded to projects;
• a funding envelope to be announced in 2022 enabling the award of the first contracts to industrial carbon capture facilities and CCUS-enabled hydrogen production projects from 2023 through the Cluster Sequencing process, to deliver up to 3 MtCO2/yr of industrial carbon capture and up to 1GW of CCUS-enabled hydrogen by the mid-2020s;
• further allocation rounds for all types of eligible low carbon hydrogen production and industrial carbon capture from 2025, so as to enable the UK to meet its 2030 deployment ambitions of 6MtCO2/year of industrial carbon capture, 5 GW hydrogen production capacity, and four CCUS clusters; and
• from 2025 at the latest, all revenue support for hydrogen production to be levy funded, subject to consultation and legislation.