By Mathew Carr

Nov. 15-18, 2020 (London) — The energy transition is about to be placed on steroids.

That’s because the EU and the U.K. are preparing to hand out a series of new market incentives that may well take a good portion of the political AND financial risk of climate action out of government hands.

The carbon contracts for difference (or CCfDs) will rewrite the energy landscape by driving ever-cleaner hydrogren into the mix, replacing natural gas and cutting emissions from cement and steel making.

Green hydrogen is one of several key silver bullets the energy transition has been looking for. Carbon free and magicked from water using a lot of clean electricity, it’s the perfect supplement for a world that’s set to be oversupplied with green solar and wind power. Before that, producers will make grey hydrogen from natural gas and, by adding carbon capture technology, blue hydrogen.

Carbon allowance costs already make up about half of Europe’s wholesale electricity costs, after the EU introduced a carbon market back in 2005. They also provide revenue for governments from an asset that’s previously been given away for free (the right to pollute) as well as giving an incentive to go clean.

CCfD would pay out the difference between the price of EU emissions allowances and the contract price, thus effectively ensuring a guaranteed carbon price would be protecting the hydrogen project from fossil fuels.

Whichever hydrogen project offers to produce the fuel at the lowest carbon price, would win the CCfD incentive. This competitive tension will drive down costs, as electricity contracts for difference did for offshore wind.

In exchange for the insurance, investors would pay money to the government should carbon prices be higher than the CCfD strike price, reducing financial risks for the taxpayers providing the incentive.

Companies would therefore have an incentive to make climate-friendly, innovative investments and reduce their CO2 emissions, knowing they were protected from market shifts or a counter attack from fossil fuels.

Carbon prices are likely to help determine hydrogen prices, as hydrogen competes with old energy.

Governments will become incentivised to keep carbon prices high and the carbon market tight.

This is for three important reasons:

First, they’ll want to get more money when they sell carbon allowances in auctions. These funds can help poor people navigate the energy transition and create jobs.

Second, they’ll try to keep the carbon price above the CCfD strike levels because, otherwise, they’ll have to tap indebted taxpayers to pay the difference to the makers of the hydrogen.

Third, high carbon prices (tight constraints on emissions using various policies) are the only way they’ll meet their emission-reduction targets.

“Governments prefer raising revenues on carbon than shelling out” cash to incentivize the energy transition, said Mark Lewis, chief sustainability strategist at BNP Paribas Asset Management.

Contracts for difference have traditionally been struck in the power market, but the region’s electricity prices can vary quite a lot still. The carbon price, on the other hand, is Europe wide.

The European Commission “will want this to be as standardised as possible across the EU. If it’s a CCfD, by definition it becomes a psychological anchor for the carbon price generally across Europe,” Lewis said.

If Europe can be the first in the world to use this market-based system to produce green hydrogen, it’ll potentially provide a global template as carbon markets expand in Asia, Africa and the Americas.

Agora Energiewende, the German pro-climate-action-policy thinktank, said CCfDs can help bring forward clean investments in the EU, so that dirty technology isn’t locked in during the next few years, thwarting the region’s attempt to go carbon neutral by mid century.

“With a clean-industry package that defines the right policies, pace and planning, it’s possible to accelerate technological learning, cost reduction and the development of the industrial networks of the future,” said Philip Hauser, an industry and Latin America specialist at Agora.     

“The costs for green hydrogen have been coming down as the cost of renewable power has dropped,’’ said Graham Cooley, CEO of ITM Power, a manufacturer of hydrogen-production units that’s just raised 165 million pounds ($218 million) to expand in an oversubscribed capital raising.

“There are some places in the world where you can make green hydrogen for a lower cost than natural gas,” in theory, Cooley said in a phone interview. “An example might be Portugal, where the record for solar power cost has just been beaten — down to 1.1 euro c per kilowatt hour — and in that case you can make green hydrogen for a lower cost than natural gas.”

Green hydrogen also “could work in the U.K. with offshore wind,” he said.

The clean fuel can replace fossil fuels in electricity production, factory output and as a replacement for gasoline-powered cars (though electric vehicles are still seen as base case for much of transport).

It’s a change that may take less than 10 years.

The U.K. government led by Prime Minster Boris Johnson is getting ready to announce how it might incentivise the production of the fuel, according to three people familiar with the situation. And Britain this week brought forward its plan to ban the sale of new petrol/gasoline and diesel cars to 2030 from its current target of 2040, according to some media reports. Hybrid cars could be banned by 2035.

The negotiations ahead of the end of Britain’s Brexit transition period next month may determine how fast CCfDs take off. How Britain’s new carbon market hooks into the European Union’s is set to shape how governments incentivise hydrogen production and other clean technologies — the “state-aid” rules.

Brexit is set to make the nation more nimble in implementation.

For sure, this is not just a European shift. S&P Global Platts have been assessing hydrogen prices since December last year and expanded in April, launching its first hydrogen assessments in Asia. Australia wants to become a hydrogen-making hub and the U.S. government is supporting the fuel.

The attention reflects the investor interest in driving down the production costs of hydrogen in stages.

Linking to the carbon market makes sense because the CO2 price could account for the fossil-fuel content of the hydrogen that enters the hydrogen pipeline network (whether it’s blue, grey or green) and provide a highly liquid market for investors to manage risks in futures markets.

See this chart from Lewis’s research.

It shows how a lower cost of green hydrogen production would decrease the level of carbon prices in the decade through 2040, easing the need to spend on the transition.

As hydrogen production increases, it’s set to take over natural gas pipelines. SNAM, the pipeline giant, is one of ITM’s biggest investors.

“Suddenly, there’s an incentive to switch to green hydrogen to replace natural gas in whatever process you are using, or indeed, to replace petrol or diesel — an incentive to close that gap” between hydrogen and fossil fuels if you like, Cooley said.

CCfDs could also be struck with buyers of hydrogen, such as steel plants, depending who finances the hydrogen-production facility.

Debate about precisely how they will work is moving apace, according to one person close to German policy-maker thinking.

EU carbon prices should possibly be double their current value of about 26 euros a ton right now, because carbon will need to reach about 90 euros a ton to incentivize hydrogen making in the next decade, according to BNP’s chart.

“The fact that carbon is volume traded is important,” and that it’s an EU-wide commodity, Cooley said. “We will never get to net zero unless we value carbon. I would certainly be an advocate for valuing carbon in an internationally agreed mechanism.” 

That should be high on the agenda when the world’s 200 nations meet next year in Glasgow to thrash out rules of the Paris climate accord, he said.

There’s still quite a bit of policymaking to do, and politicians have been slow so far to embrace change. This market structure may make them more brave.

“What governments around the world are now looking at is their most plentiful renewable-energy source and what incentive should be applied as those renewables make green hydrogen cost competitive” versus fossil costs in their particular market, Cooley said.

Final thoughts:

CCfDs may abate the need for carbon border adjustments and become a key energy “state aid” measure following Brexit.

(Updated Sunday night London time with BNP analysis, comments. Recast Monday morning , edited Monday evening to remove garble, blush, updates with Brexit analysis Tuesday morning, U.K. news and Agora Wednesday morning.)