For the hydrogen economy to reach its enormous potential, one key challenge is the ‘chicken and egg’ problem of growing supply and demand in tandem. Development of the hydrogen economy will require large investment commitments for both producers and consumers—with each depending on the success of the other. This is quite different from the growth in renewable electricity—while the production technologies have been new, the ‘product’ had a large, mature physical market to support long-term volume commitments. The development of commercially viable agreements for producers and customers in the hydrogen economy will be a key challenge.
While hydrogen is already used in large volumes, this is predominantly in captive industrial markets, where production directly feeds an industrial process without a third-party commercial agreement or price.
In the hydrogen economy of the future, market structures will be essential to connect production and supply between multiple separate commercial entities, with disparate geographies.
The UK’s recently published hydrogen strategy has identified model archetypes to explore potential customer production and offtake scenarios.
Investments in low-carbon hydrogen production and consumption are already happening. However, these are at a scale and stage of the market where investors take a greater level of risk and would generally be considered pre-commercial.
At this scale, we are seeing producers able to secure some fixed volume offtake through government or blue-chip corporate customers. With a low credit risk and the ability to access a range of customers, this is supporting early-stage investment in low-carbon hydrogen production.
However, as investment volumes grow, the challenge of securing bankable offtake agreements will also intensify. In this truly commercial phase, hydrogen producers and consumers will need to manage the key factors which are a feature of commercial-scale commodity contracts—volume, price, credit risk and quality.
Key considerations
Volume: One mechanism which breaks the chicken and egg position on volume is grid blending—where a large volume of hydrogen can be accommodated in the current methane grid, creating a very large physical market for a new producer. Whilst this can solve the problem of a high-volume offtake for the producer, it does pass a challenge to the grid operator to manage blending and ensure that no consumers are impacted in terms of quality requirements. The Government is pushing hard for a grid blend of up to 20pc hydrogen into the gas grid by 2023.
Another route to large demand volume is meeting large-scale existing industrial demand. This is the case with the Gigastack project, a consortium of energy companies, which aims to demonstrate low-cost zero carbon hydrogen at an industrial scale.
Similarly, multi-model transport hubs offer another model archetype, such as the Tees Valley Transport Hub. The hub will consist of facilities for the production, storage, and distribution of green hydrogen to supply a network of refuelling stations and bring a number of hydrogen vehicles to public roads and waterways.
As production scales grow, long-term volume commitment will be key to underpin new investments. Whilst some models can provide this volume certainty, it is likely that government support will need to play a role here to give confidence to producers and consumers.
Price: We have seen in the development of renewables that rapid and significant cost reduction is possible. Whilst we expect to see this in hydrogen production, there will inevitably be a cost premium which needs to be bridged as the market develops. There are high-value end markets for hydrogen, but government price support will be needed to support larger-scale investments.
The Department of Business, Energy and Industrial Strategy (BEIS) is currently consulting industry experts on a variable premium model. Under this model, the preferred approach for the reference price for initial projects would be a mechanism deploying the highest of the natural gas price and achieved sales price as proxies for a benchmark for a low-carbon hydrogen sales price, with indexation under consideration.
Credit risk: As investment volumes grow, successful offtake agreements must also carefully assess and manage credit risk. Producers will need assurance of the creditworthiness of customers. Offtake agreements where low-carbon hydrogen replaces the supply of grey hydrogen for industrial customers can alleviate credit risk since market demand is already present and is expected to continue long-term. Ongoing consultation by the Government with regulators and industry is expected to spark new regulatory support that addresses producers’ concerns related to credit risk.
Quality: As with any new technology, customers will want assurance in quality. BEIS is collaborating with the industry to develop a UK standard for low-carbon hydrogen giving certainty to users that the hydrogen produced is consistent with net zero.
One element of quality relates to the product’s credentials on sustainability. We have seen in the market for corporate PPAs that the green credentials of the production technology are a critical factor for sustainability conscious customers. In this case, nuclear has not always been an attractive low-carbon production technology for electricity.
With different production methods, this could also be a factor for hydrogen. For instance, will customers view blue hydrogen as being as positive for their own sustainability position as green hydrogen?
Putting the pieces together
The current market for low-carbon hydrogen is pre-commercial. As investment volumes grow, producers and consumers will need to manage the risks associated with these investments. As discussed, there are many factors to be considered and line of sight to solutions and mechanisms to support large-scale investments. However, it is expected that government support will be crucial for producers and consumers to manage the step up in volume, the bridge to cost competitiveness and the requirement for product and quality standards.
We have seen this be successful for offshore wind and the UK is in the midst of designing the £240mn ($326mn) Net Zero Hydrogen Fund, as well as consulting on production support mechanisms. Clearly, the building blocks are being put in place for commercially viable hydrogen offtake agreements that will drive the hydrogen economy forward.
For more details, please contact Tim Calver tcalver@uk.ey.com
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