How to create a hydrogen market: keep it simple

The Renewable Energies Act

It was in 1999 that a group of German parliamentarians led by green politician Hans-Josef Fell and socialist Hermann Scheer drafted the Renewable Energies Act or EEG (Erneuerbare-Energien-Gesetz). The EEG was both simple and revolutionary, perhaps because it was drafted by members of parliament and not professional law drafters from a ministry. Although initiated by the ruling red-green coalition, the EEG proved remarkably resilient even under the Christian Democratic rule of future governments. The EEG provided for a mechanism that anyone who would construct a solar PV project, a wind farm, biogas digester or other renewable electricity generator, would receive a twenty-year cost-reflective fixed feed-in tariff. This provided certainty on future cashflows so banks could finance against that once they felt comfortable with the technology. The local utility had an obligation to take the power and pay the tariff, which was higher than the average power prices at the time, but they could pass the cost differential on to the national high voltage grid. There, all the renewable power was pooled, and the financial burden equally spread over all German power customers, with some notable exemptions not to hurt power intensive industries. This system ensured fairness, because the wind-rich states at the coastal north saw a steep increase in wind projects and this would have been a much heavier burden on them if not for this redistribution. Equally important, this was not a tax and spend system as was the case in many other countries who tried to copy the German model, and the European Court of Justice in 2001 ruled that the EEG was not anti-competitive, mainly because it was not considered a subsidy.

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When Angela Merkel took over government in 2005, she quickly realized that the main initial beneficiaries were farmers, most of whom were her CDU’s constituents. Many in the north of the country installed wind turbines on their land, earning some extra cash without losing use of their land. In the south, farmers installed solar PV systems on their barns. More importantly though, the EEG was entirely budget-neutral but allowed Germany to become an early leader in the deployment of renewable energy, making it politically very robust. Of course, the German electricity consumers had to pay the bill somehow, and over time opposition against the financial burden of the EEG grew. But many chose to install systems themselves or participate in community-owned wind farms, and personally benefit from the system.

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It is fair to say that the German EEG unlocked the renewable energy revolution, with renewables now offering the lowest cost of power almost everywhere, also assisted by China’s industrialization of solar PV production. Some other countries also introduced feed-in tariffs but failed to adjust the tariffs quick enough to avoid windfall profits for developers when prices of PV panels and wind turbines dropped. This led to several countries including Spain, Italy, and Czechia to retro-actively cut tariffs or introduce taxes, leading to lawsuits and a somewhat bad reputation for feed-in tariffs. Nonetheless, I believe the simplicity of the scheme and its political robustness are beautiful examples of effective policies that have achieved the desired outcomes: cost-effective renewable electricity and increased energy security without a need for further subsidy. We now have more than 1TW of installed solar PV capacity globally and the wind sector will most likely pass the 1TW mark later this year. The EEG laid the foundation for that.

The business model for hydrogen

At the World Hydrogen Summit 2023 in Rotterdam in May this year, Executive Vice President of the European Commission Frans Timmermans called hydrogen “inevitable”. I have argued before that the end game of the energy transition will be a situation where electricity’s share of final energy demand will grow from the current 20% to 50%, and all of that must be green. Molecules will then constitute the remaining 50%, of which at least half shall be covered by green hydrogen. The alternatives to green hydrogen are biomass, CCS, or more electricity and these options are inherently limited due to environmental issues, competition with food, limited geographic potential and issues with infrastructure. The underlying assumption is that to avoid catastrophic climate chaos, latest by 2050 all energy-related emissions need to be zero.

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Despite the promise of inevitability and necessity, the bulk of hydrogen announcements are currently still that: announcements. ?More than 350 new large-scale hydrogen project proposals have been announced in 2022, according to the latest Hydrogen Insights report from consultants McKinsey and the Hydrogen Council. This brings the current number of large-scale project proposals to more than 1,000, 795 of which aim to be fully or partially commissioned by 2030. But less than 10% of the $320bn of announced investments in all hydrogen projects through 2030 represent actual committed capital in the form of FIDs or final investment decisions.

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On the supply side, many of the current project proposals are in locations where land is cheap and available and the resource is good, which promises low production costs. On the demand side there are various drivers for the use of clean hydrogen, some commercial, but many are driven by regulation such as carbon emission reductions, quotas, or obligations. On top of demand and supply there are overarching targets laid down in national and regional hydrogen strategies, such as laid down in the Hydrogen Accelerator of the European REPowerEU strategy, amounting to 20 million tons of clean hydrogen by 2030.

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To bridge the current financial gap between green hydrogen and alternatives, many countries are introducing mechanisms including India’s production linked incentives, USA’s Inflation Reduction Act and Europe’s Hydrogen Contracts for Difference, and the recently established EU Hydrogen Bank, which Europeanized Germany’s H2Global auction system.

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What is lacking in all these schemes is simplicity and replicability. In response to the USA’s IRA, which can add up to a subsidy of 3$/kg of hydrogen as tax credits, the European Commission recently relaxed State aid rules to allow member states to match funds a potential investor would receive in the US or elsewhere.?To ensure that the aid will encourage a company to remain in Europe, cross-border investments must involve projects in at least three EU countries. The companies must also use state-of-the-art production technology to reduce environmental emissions. Such support, although generous on paper, is tailor-made and complex.

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In addition to financial support, the potential producer would also need someone who is willing to sign a bankable long-term offtake agreement enabling third party financing of the investment. Producer and offtaker need to match volumes and timing and all of this requires close coordination with the support scheme. Although there are some initial attempts to solve this conundrum, and Germany’s H2Global is an interesting concept of double auctions and pooling of production and demand, there is inherent complexity in this approach.

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Why don’t we learn from the successful EEG?

A feed-in tariff for hydrogen

As explained above, the current attempts to start a hydrogen market in Europe, the US and other countries are all complex. The beauty of the German EEG was its simplicity and replicability. Soon after introduction, standardization of contracts, mortgages and loan agreements further accelerated the market introduction. It was essentially scalable. Let’s think about a similar approach for hydrogen and propose a feed-in tariff for hydrogen, starting in Europe[1]. Why Europe? In addition to the electricity grid, Europe has an elaborate gas grid consisting of 200,000km high pressure gas pipelines and a distribution system stretching multitude of that in length. According to many studies carried out in Germany, France, Spain and the Netherlands the bulk of the current natural gas grid can be converted to accommodate hydrogen at very modest cost.

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In a first phase, until the hydrogen production costs can match natural gas prices, a European clean hydrogen production tariff mechanism is proposed with a hydrogen clearing pool to distribute the cost among all gas clients. Currently, clean hydrogen is more expensive than natural gas, even considering a carbon price. However, most analyses predict renewable hydrogen to be the lowest-cost gas option by 2050 due to the learning curves of electrolysis and renewable electricity.

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A clean hydrogen production tariff mechanism is proposed that can stimulate production and create hydrogen volume by pooling the initial cost gap for clean hydrogen in the period until cost parity for hydrogen in the market has been achieved. The cumulative payment for the cost gap is distributed evenly and fairly across all natural gas customers through a clearing mechanism. Figure 1 shows the gas grid as it could evolve in the medium term in Europe, consisting of parallel natural gas and hydrogen grids, with tariff mechanism and a hydrogen clearing pool.

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A legal framework will allow hydrogen producers to feed hydrogen in the natural gas grid for blending or in the pure hydrogen gas grid. Like the EEG, they will be entitled to a 20-year hydrogen off-take agreement with a tariff ensuring a fair return on investment. The proposition is a typical utility return in the range of 10% in the beginning. The off-taker is either a TSO for large-scale high-pressure bulk hydrogen or a DSO for small-scale medium-pressure hydrogen. The DSO and TSO can pass the marginal cost, i.e. the difference between the local hydrogen tariff and the (market) price for hydrogen, on to a European hydrogen clearing pool. The marginal cost difference in the form of a renewable hydrogen surcharge is spread out evenly and fairly across all European natural gas consumers and hydrogen consumers. The cumulative surcharge associated with hydrogen volumes used by non-gas sectors such as steel and transport shall not be passed on to gas customers.?

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The concept is to socialise the costs through the above-described hydrogen clearing pool instead of using public funds, whether national or European. That way, the difference between the cost of hydrogen and the sum of the CO2 and natural gas price, which is expected to diminish over time, is fiscally neutral and not dependent on national tax money, the availability of which is likely to be volatile and in competition with other worthy causes. The intent is to create a political robustness similar to the EEG.

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Certain natural gas or hydrogen-intensive sectors operating in an international, competitive environment, may receive an exemption for paying the renewable hydrogen surcharge. I expect renewable hydrogen to be competitive by 2035, and that a clean hydrogen production tariff mechanism is no longer necessary and could be replaced by auctions and tender procedures. A review mechanism must be defined to evaluate the progress, provide a rolling forecast, and assess cost and price levels. A major review shall be carried out every three years, in line with current practices related to long-term natural gas contracts. However, a semi-annual review is required to benchmark the tariff levels to avoid over or underpayment.

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The European hydrogen strategy mentions a system of carbon contracts for difference as a possible policy instrument for scaling up hydrogen. Such a long-term contract with a public counterpart would remunerate the investor by paying the difference between the CO2 strike price and the actual CO2 price in the ETS in an explicit way, bridging the cost gap. A notable difference with that proposal is that I propose the carbon contracts for difference to be paid to the hydrogen producer, rather than the consumer. This crucially improves the bankability of hydrogen production projects.

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A strategic hydrogen reserve

The war in Ukraine has shown that strategic energy reserves are necessary. They increase security of supply and provide price stability. In the start-up phase of the hydrogen economy, they also decouple supply from demand, which will have different growth dynamics until some level of market maturity has been achieved. Europe currently has about 100 billion m3 methane storage, which is about 25% of annual demand. If Europe wants to have 20 million tones of hydrogen by 2030, the strategic reserve must be 5 million tons, which shall be underground and connected to the high-pressure hydrogen grid. The reserve shall be administered by a public body from a financial and governance perspective, the actual management can be done by a commercial market player. Market players can sell into the reserve at the same feed-in rate described above until the reserve is adequate. After that the reserve can be used as a buffer in the market.

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Conclusion and discussion

Renewable electricity received an initial boost by the German-designed EEG, which has proven to be simple, replicable, and robust. The current complex systems around hydrogen support schemes have not yet led to a markable shift from project announcements to actual investments. This paper proposes a feed-in tariff system for hydrogen in Europe, as well as a strategic hydrogen reserve. Europe is well placed for such system due to the fact that Europe has a hydrogen strategy, the natural gas infrastructure is available and close to hydrogen-ready and the energy market is integrated. Other regions with similar preconditions could consider a similar approach.

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[1] This was originally outlined by the author and Prof. Dr. Ad van Wijk in “Hydrogen Rocks - Towards the Creation of the European Hydrogen Economy” (ISBN-13 (15) 9789463663854)