Energy Intelligence - May 2024

By 2050, the cost of producing low-carbon hydrogen is expected to be five times higher in the most expensive regions than the least expensive regions, according to the Hydrogen Council. This significant cost gap will require certain countries to import cheaper, low-carbon hydrogen to satisfy their demand, leading to established low-carbon hydrogen trade routes. In the near-term, demand will focus heavily on meeting mandated low-carbon hydrogen targets and ensuring subsidy support. Offtakers will be focused on ensuring projects meet the specifications of their domestic market.

Taking note of where this key demand will emerge, and the specifications of low-carbon hydrogen within each region, will be pivotal to developing a project that is able to secure buyers for the offtake. This article will examine the key drivers of low-carbon hydrogen demand, identify potential challenges posed by specifications that vary between regions and highlight key considerations for project developers’ offtake strategies.

Cheap Renewable Energy Availability

Key demand centers will emerge in regions where it is economically unviable to produce low-carbon hydrogen due to competition from lower-cost imports. In 2030, the price of low-carbon hydrogen in Japan and South Korea (Far East Asia) and Central Europe is expected to be between €3.50 ($3.77) and €4.00 per kilogram, according to data from PricewaterhouseCoopers, five times the cost in lower-cost regions. This will lead to increased import requirements.

One key driver of this higher price is a lack of cheap and widely available renewable generation. Japan is one of the most expensive countries in the world when it comes to solar energy, and land use restrictions have impeded the construction of onshore wind farms. Coupled with a segmented electricity grid and weak interconnections, it is unsurprising that Japan is positioning itself as a low-carbon hydrogen import market. Meanwhile, while some countries within Europe have access to cheap solar (Portugal, Spain) and wind (Norway) generation, this supply will not be great enough to satisfy the entire region’s demand. It will be more economical to import low-carbon hydrogen rather than diverting renewable generation away from more efficient end-uses.

Regulatory Framework and Government Support

These key demand regions are implementing supportive regulatory frameworks. This includes mandated targets: the European Union aims to import 10 million metric tons of low-carbon hydrogen by 2030, Japan plans for consumption to reach 12 million tons by 2040, and South Korea hopes to achieve 7.1% of power generation through low-carbon hydrogen by 2036.

There are also measures that specifically target imports. In the EU, the introduction of the Carbon Border Adjustment Mechanism (CBAM) and the phase out of free allowances under the EU Emissions Trading System will require importers of hydrogen and hydrogen derivatives to pay for each ton of CO2 equivalent released during production through the purchase of CBAM certificates. The definitive period will run from 2026, with 100% of embedded emissions covered by CBAM certificates from 2034. The incentive for importers to switch to low-carbon hydrogen from non-renewable hydrogen is, therefore, expected to take off in the next 5-10 years.

Demand-Focused Subsidization

Governments tend not to want to get involved with bilateral agreements between private companies, so it is not surprising that support schemes have so far focused on the front-end, awarding financial incentives to project developers through tax incentives or contracts-for-difference auctions. A notable outlier here is Japan, which offers support not only to hydrogen producers, but also to Japanese companies that import low-carbon hydrogen from overseas. Suppliers will be able to enter into long-term supply contracts, locking in fixed revenue to be determined based on manufacturing, transportation and other operating costs, as well as a reasonable profit level. Offtakers will enter into shorter term offtake contracts under which they will pay the reference price, which is set at the highest of (i) alternative raw fuels in Japan, (ii) the actual sales price of hydrogen in Japan, or (iii) a price based on previous transactions.

Lack of Low-Carbon Hydrogen “Standard”

Regions are determining the specifications that low-carbon hydrogen must meet to be included in targets, or to receive support. These vary greatly from region to region. CO2 thresholds range from 2 kg of CO2e per kg of hydrogen in India, to 4 kg in Korea and nearly 5 kg in China. The EU sits comfortably in the middle of this range at around 3.4 kg.

Project developers must also consider how the CO2 threshold is calculated. Typically, this will include the emissions associated with the hydrogen production process including electricity consumption. It may also include emissions associated with feedstock growth, gathering, extraction, processing and delivery to the production facility.

There may also be restrictions on the method used to produce low-carbon hydrogen. Within Europe, low-carbon hydrogen falls under the umbrella term, “renewable fuels of non-biological origin.” This is focused on hydrogen produced via water electrolysis. Depending on the type of connection — whether grid connection or direct line — producers must show that the renewable generation used in the production process is coming from new renewable capacity, and is geographically and temporally correlated to the site of production. Product will not be considered on-spec if existing renewable capacity is being redirected away from more efficient uses.

Certification of Low-Carbon Hydrogen

To ensure traceability, countries are adopting low-carbon hydrogen certification schemes. Of particular relevance to project developers is the development of the EU’s Union Database, which will track all renewable gases and fuels. To this end, the EU has proposed that all gases passing through a gas grid outside of the European Economic Area (EEA) would not qualify towards the EU’s targets. This would drastically reduce the commercial viability of projects outside the EEA — for example, the US — with no physical connection to the EU.

This suggests that the EU will satisfy significant demand through local production and pipeline imports from countries with physical interconnections. While exporters from further afield, such as the US, will still target the EU to an extent, they will also have to consider the needs of importers in Far East Asia.

What This Means for Project Developers

While a number of factors underpin the commercial viability and bankability of a project, offtake agreements play a pivotal role. Traditionally, non-renewable hydrogen has been sold pursuant to long-term offtake contracts whereby the buyer takes a pre-agreed amount of hydrogen from the seller or else the buyer must pay a set fee.

To date, low-carbon hydrogen projects that have reached financial investment decision have secured fixed long-term offtake contracts, guaranteeing revenue. Nevertheless, such a rigid contract structure is a key obstacle to securing offtakers, given both the relatively nascent technologies underpinning these projects, as well as the wide-ranging specifications across jurisdictions.

Given the developments discussed in this article, project developers will need to address a number of issues when negotiating with buyers. These include clearly allocating financial incentives; the consequences of off-specification product; and the consequences of changes in subsidy or specification regimes in the offtaker’s domestic market. While there may be significant obstacles to the development of a low-carbon hydrogen trade market, it is the only way to ensure production is scaled cost-effectively. It should not be forgotten that low-carbon hydrogen has the potential to abate 80 gigatons of cumulative CO2 emissions through to 2050.

*Trainee Solicitor