Background
The Hydrogen Manufacturing Enterprise Mannequin (HPBM) is likely one of the UK Authorities’s assist schemes for low carbon hydrogen manufacturing within the UK, launched as a part of the hydrogen provisions inside the lately handed Vitality Act 2023 (for the element of the laws, you may learn our briefing here). The HPBM will present income assist to profitable eligible initiatives. The primary hydrogen allocation spherical (HAR1) opened in July 2022 and was restricted to electrolytic hydrogen initiatives solely. It focused 250 MW of manufacturing capability by means of income assist underneath the HPBM, which contains a bespoke Entrance Finish Settlement (setting out the important thing challenge parameters) and an ordinary kind Low Carbon Hydrogen Settlement (LCHA). On Thursday 14th December 2023, the UK Authorities introduced 11 profitable candidates from the HAR1 course of1, totalling 125 MW of manufacturing capability, who shall be invited by the Division of Vitality Safety and Internet Zero (DESNZ) to finalise negotiations on the phrases of assist on a bilateral foundation.
The UK’s second Hydrogen Allocation Spherical (HAR2) was opened concurrently with the publication of profitable bidders underneath HAR1. It goals to assist as much as 875MW of capability in 2025 (topic to affordability and worth for cash) and has elevated from the 750MW initially slated for provide, to assist maintain the federal government on observe for hitting its 1GW goal by 2030. HAR2 will once more be confined to bids from electrolytic initiatives solely, with a shortlist anticipated by Autumn 2024 and awards made in early 2025.
Along with these electrolytic hydrogen initiatives, the LCHA can also be the important thing doc underpinning improvement of blue hydrogen initiatives the place they kind a part of a “low carbon cluster” within the UK. Awards for income assist for CCS-enabled hydrogen initiatives inside clusters shall be made outdoors of the HAR course of and so for the needs of this briefing, we are going to deal with electrolytic initiatives.
The primary draft of the LCHA was revealed by DESNZ in August 2023 and is now within the late phases of being finalised, with an up to date model attributable to be launched imminently. Regardless of the settlement not being in closing kind, an understanding of the contractual framework shall be crucial for builders looking for assist within the upcoming funding rounds. On this briefing, we summarise among the key issues for these growing and financing UK hydrogen initiatives supported by the HPBM, and share insights primarily based on our work so far with one of many profitable bidders underneath HAR1.
Eligibility
To be eligible for funding underneath the HPBM, producers should produce hydrogen which meets the Low Carbon Hydrogen Customary (LCHS) in accordance with the model in drive on the time of entry into the HPBM documentation2 and should promote these volumes to Qualifying Offtakers. The idea of Qualifying Offtakers excludes the sale of hydrogen to “danger taking intermediaries” (in essence, power merchants), exporters and people who buy volumes for the aim of mixing hydrogen with pure gasoline for injection into the grid.
LCHS Compliance
The LCHS establishes what constitutes “low carbon hydrogen” on the level of manufacturing by stipulating, amongst different issues, the utmost degree for greenhouse gasoline emissions permitted within the hydrogen manufacturing course of. At the moment, the producer should be capable of report that every consignment of hydrogen (i) has a GHG emissions depth of 20gCO2e/MJLHV of produced hydrogen or much less, and (ii) has been produced by a hydrogen manufacturing facility which satisfies the “Situations of Customary Compliance” (that are additional detailed within the LCHS).
Strict compliance with the LCHS is a pre-requisite for electrolytic initiatives to obtain income assist underneath the LCHA. A breach of this requirement will end result within the related consignment of hydrogen being deemed non-compliant and due to this fact ineligible for assist underneath the LCHA. The LCHS units out the methodologies which producers should use to calculate the ability’s closing GHG depth and offers steering on the best way to deal with emissions ensuing from non-production. The LCHS is know-how agnostic, because it applies to quite a few eligible hydrogen manufacturing pathways, together with electrolysis, and can due to this fact be relevant to electrolytic initiatives in addition to these which make use of carbon seize and storage (CCS) applied sciences. The LCHS is now in its third iteration, though topic to vary over time for future allocation rounds. The LCHA will affirm which model of the LCHS is relevant to the challenge when establishing whether or not the hydrogen produced constitutes a “Qualifying Quantity”.
LCHA Overview
The LCHA is a long-term contract, entered into between the developer because the Producer and The Low Carbon Contracts Firm Ltd (the LCCC) because the LCHA counterparty, for income assist (masking worth and quantity dangers, inside limits) over a 15 yr interval. Beneath the LCHA, worth assist is about at an agreed worth for hydrogen generally known as the “strike worth” (representing the price of manufacturing plus an allowed return). The LCHA is essentially primarily based on the usual phrases and situations underpinning the Contract for Distinction (CfD) regime within the UK, which many builders and financiers could also be aware of from the CfD’s profitable assist of the UK renewables sector. While ideas within the LCHA shall be acquainted to renewable power builders, the danger allocation within the LCHA is considerably completely different from that of a traditional take-or-pay gasoline contract conventionally used to underpin the financing of gasoline initiatives. While there are lots of similarities between the CfD and the LCHA, there are some notable variations which contributors within the sector want to grasp. Beneath, we set out the important thing cashflows obtainable underneath the LCHA, and discover three key business takeaways and bankability issues, focussing on electrolytic initiatives.
Key Funds Streams
There are 3 ways by which a producer can profit from authorities assist underneath the LCHA, and we clarify these beneath.
1) Distinction Quantity
The “Distinction Quantity” payable follows the cashflow rules underneath the CfD, whereby the quantity payable to or by the producer shall be decided by the distinction between the Strike Value and the Reference Value. As there may be at present no liquid marketplace for hydrogen in the best way that there’s for electrical energy within the UK, the Reference Value is about on the increased of (i) the Achieved Gross sales Value for that interval (i.e. the precise worth achieved underneath the related offtake settlement) and (ii) the Ground Value (which is in flip set in every interval on the decrease of (a) the worth of pure gasoline and (b) the Strike Value). Given the problems brought on by record-breaking excessive gasoline costs within the current previous, it could be shocking to see initiatives dependant solely on electrical energy as an enter as soon as once more having their revenues pegged to gasoline costs, with no allowance made for fluctuating electrical energy costs. Nevertheless, this seems to be the mannequin DESNZ is most comfy with and stays the popular alternative for now.
For readability, the graph in Determine 1 helps to elucidate how the pricing works. In essence, the LCCC tops up the producer’s revenues for the distinction between the Strike Value and the Gasoline Reference Value and the Producer is required to pay quantities to the LCCC the place the Achieved Gross sales Value exceeds the Strike Value.
Determine 1
2) Value Discovery Incentive
To incentivise producers to attain a gross sales costs above the worth of pure gasoline, an upside-sharing incentive has been included within the LCHA, whereby the producer will obtain a portion of the distinction between (i) the decrease of the Reference Value and the Strike Value and (ii) the Ground Value. The Value Discovery Incentive Ratio has been set at 10%, which means that solely 10% of this extra gross sales worth shall be handed on to the producer. This degree has usually been thought-about by trade as a low threshold for incentivising increased pricing methods with offtakers.
3) Sliding Scale Prime-Up Quantity
If the overall quantity of hydrogen offered in a billing interval falls beneath 50% of the forecast reference quantity, the producer will obtain a top-up quantity for every qualifying unit of hydrogen offered. The producer won’t be able to depend on this quantity assist if the discount in gross sales is brought on by an occasion which isn’t demand-related (for instance, a facility outage). This mechanism, and the situations which apply to it, are explored additional beneath.
Key Industrial Issues
Negotiating a Strike Value
When negotiating a strike worth, builders might want to think about fastidiously which components of the capital and working prices needs to be submitted, as these shall be intently scrutinised by DESNZ to be able to fulfill the “worth for cash” requirement. A few of these prices, akin to electrical energy enter prices throughout renewables downtime, shall be arduous to cost attributable to worth volatility usually and the timing of securing a agency provide from the provider. Different prices could also be simpler to calculate, however solely provide one of the best worth when a challenge is operating at most effectivity or after a future supposed enlargement – for instance, the price of the workforce or for IT safety programs. However initiatives can not run with half of an individual or three quarters of the required IT gear, so could also be simpler to justify the place they characterize full utilisation of such employee or gear. Lastly, producers ought to think about which prices may moderately be handed by means of to offtakers as a part of the sale and supply preparations, quite than sit inside the working price calculations.
Value changes
As soon as the strike worth has been agreed and documented within the LCHA, there are restricted circumstances by which it may be adjusted. For electrolytic initiatives, the strike worth shall be adjusted for indexation yearly, calculated as at 1 April every calendar yr and utilizing CPI for January for the related calendar yr. Conversely, for CCUS-enabled initiatives, indexation is linked to the worth of pure gasoline, which acts as a pure hedge towards fluctuations within the gas prices. Consideration will doubtless must be given to the pricing mechanics of the underlying energy buy agreements, provided that electrical energy provide shall be of specific significance within the context of a inexperienced hydrogen challenge. The capital return part of the Distinction Quantity can also be topic to CPI-linked indexation annually. A qualifying change in regulation could give rise to elevated prices and, in such circumstances, compensation could also be payable by the LCCC to the producer. This may be achieved as an adjustment to the strike worth. No adjustment to the strike worth shall be made solely on account of an adjustment to the Put in Capability Estimate of the ability.
Termination Rights
In step with the CfD, the producer doesn’t profit from any termination rights underneath the LCHA. There are 5 key classes of circumstance that give rise to a proper for the LCCC to terminate the LCHA. These termination rights usually have quick treatment durations for the producer to treatment a breach, and it’s important that builders perceive their obligations underneath the LCHA forward of contracting with the LCCC. Though a breach could be remedied, there is no such thing as a absolute obligation on the LCCC to withdraw a termination discover if one has been issued, and no materiality threshold to guard the producer towards a minor administrative error giving rise to a proper to terminate. As well as, the place the LCCC terminates the LCHA, a termination cost will must be made by the producer, with curiosity, inside thirty days of termination.
(a) A failure to ship sure situations precedent and milestone deliverables by the relevant longstop dates underneath the LCHA, a few of that are deliverable shortly after coming into into the LCHA;
(b) A drive majeure occasion occurring and persevering with for a interval of eighteen months;
(c) A failure to fee 90% of the Put in Capability Estimate for the ability by the relevant longstop date;
(d) A qualifying change in regulation occurring which ends up in development or manufacturing turning into prevented completely; and
(e) The prevalence of sure different occasions thought-about to be “Termination Occasions” underneath the LCHA, akin to producer insolvency, failure to adjust to the metering necessities and non-payment.
See beneath for additional element on the termination occasions triggered by breaches of the annual and general gross sales caps.
Key Bankability Issues
Offtaker necessities
Hydrogen is just not bodily transferred underneath the LCHA (i.e. the LCHA Counterparty doesn’t act as a purchaser of low carbon hydrogen) and the producer is required to promote its hydrogen to “Certified Offtakers” by means of bilateral offtake agreements. This contrasts with European assist schemes akin to H2Global and the Hydrogen Financial institution. Because the hydrogen market is in its infancy, and the HPBM is designed solely to assist the home market inside the UK, one of many key challenges shall be securing long-term offtake contracts that align with the 15 yr time period of the LCHA. This problem is compounded by in depth necessities within the LCHA associated to the offtaker(s), together with periodic reporting obligations, the disclosure of a replica of any offtake contracts to the LCCC and the requirement that sure offtaker compliance necessities are handed by means of to offtakers underneath the offtake settlement.
Danger Taking Intermediaries (i.e. the place the authorized and useful title to the hydrogen is transferred by the producer to an entity which then contracts with one other entity to additional switch the authorized and useful title in the identical volumes of hydrogen, akin to merchants, storage suppliers, and so on.) are thought-about Non-Qualifying Offtakers underneath the LCHA. Any hydrogen offered to such entities shall be ineligible for assist underneath the LCHA. That is pushed by the overarching framework of traceability within the LCHA. This method will restrict the pool of potential offtakers and, past personal consumption and shareholder offtakers, would require the producer to have a direct relationship with the end-user offtaker. Nevertheless, given the allocation of funding is a part of a wider drive to hit the binding decarbonisation targets for the UK within the Local weather Change Act 2008, and likewise provided that decarbonisation of hard-to-abate sectors is taken into account the perfect use case for hydrogen, it’s maybe unsurprising that these strict situations have been included.
Quantity Danger
Quantity assist is made obtainable to the producer underneath the LCHA such that the producer will obtain a top-up quantity for every qualifying unit of hydrogen offered (the Sliding Scale Prime Up Quantity) the place complete invoiced volumes are lowered by occasions or circumstances aside from on account of, amongst different issues, the producer’s breach or default underneath the LCHA or offtake settlement or its negligence, operation of the ability in a way designed to maximise claims for the Sliding Scale Prime Up Quantity, or occasions or circumstances the place the hydrogen manufacturing plant is unavailable, curtailed or derated (together with full unavailability to provide hydrogen). The Sliding Scale Prime Up Quantity is just made obtainable if the volumes offered fall beneath 50% of the reference quantity (i.e. the amount anticipated to be invoiced) in a billing interval, however don’t fall to zero. Each of those thresholds have been highlighted by trade as problematic. It’s a important limitation to the assist framework as a complete {that a} discount in demand by, for instance, 40%, may have a significant financial influence on a challenge’s viability, but is just not recognised as sufficiently critical to warrant intervention. This would appear to materially limit the debt sizing capability of initiatives benefiting from an LCHA. Quantity danger and its remedy underneath the LCHA needs to be thought-about by builders when structuring the challenge’s offtake technique – for instance, a diversification of offtakers may assist to minimise the danger of no quantity assist being accessible underneath the LCHA.
A technique sellers of gasoline historically mitigate demand danger is through “take or pay” obligations. Beneath the LCHA, volumes offered on a take or pay foundation however not in actual fact delivered will not be included inside the calculation of “complete invoiced quantities” and as such, a producer could determine it’s higher to guard towards demand danger outdoors of the federal government assist provided, in order that offtakers proceed to pay no matter accepting the hydrogen, and there’s no want to attend for the 50% drop in demand till compensation kicks in.
Gross sales Cap
There are two notable gross sales caps which apply to the producer underneath the LCHA:
(a) A cap on the general volumes which shall be supported over the lifetime of the LCHA (LCHA Gross sales Cap); and
(b) A cap on the volumes which might invoiced in any fiscal yr (Permitted Annual Gross sales Cap).
In line with the LCHA Gross sales Cap, the producer shall be topic to an general cap on the amount of hydrogen that may obtain assist underneath the LCHA, representing the hydrogen manufacturing facility’s forecast complete volumes in the course of the 15 yr time period of the LCHA. While non-qualifying volumes produced and offered by the ability to not obtain assist underneath the LCHA, they’ll rely in direction of the LCHA Gross sales Cap. If the amount of hydrogen produced and offered is above the LCHA Gross sales Cap then the LCHA will expire mechanically. Will probably be essential to grasp how forecast volumes produced are modelled throughout the time period of the LCHA, to make sure that builders and financiers are comfy that these caps is not going to be breached and inadvertently set off the early expiry of the LCHA. From a bankability perspective, financiers could require the power to watch the degrees of hydrogen produced and the inclusion of money sweeps within the occasion that such obligations have been breached.
The Permitted Annual Gross sales Cap is about at 125% of the Reference Quantity adjusted for the variety of days within the yr quite than a billing interval. Any volumes invoiced in a fiscal yr above the Permitted Annual Gross sales Cap shall be thought-about non-qualifying extra volumes which (i) is not going to obtain assist underneath the LCHA however (ii) will rely in direction of the general LCHA Gross sales Cap. If the Permitted Annual Gross sales Cap is breached greater than twice, a termination proper will come up in favour of the LCCC. Except gross sales are forecast to be comparatively regular annually, the 25% buffer utilized to every fiscal yr could also be inadequate and this needs to be thought-about when modelling the challenge.
LCHS Certification
Certification schemes are a key device enabling producers of low carbon hydrogen to proof compliance of initiatives with the related low carbon hydrogen customary. The UK Authorities lately confirmed its dedication to delivering a low carbon hydrogen certification scheme by 2025, which might independently confirm satisfaction of the LCHS necessities. This scheme is initially anticipated to be voluntary and, while it is going to have a home focus, the federal government has highlighted its intention for worldwide alignment as soon as hydrogen is traded abroad. This course of will assist display compliance with the HPBM and can present certainty to offtakers that the hydrogen bought meets the requisite customary to contemplate it “low carbon”. From a financing perspective, this certification scheme may be a great tool within the context of the reporting obligations of any lenders who could make inexperienced / sustainability-linked loans obtainable to such initiatives.
