Meeting the challenges of a new market 6 min read
As the hydrogen industry begins to grow from pilot to commercial-scale projects, developers are starting to look to project finance and government funding to help pay for the mega-projects required for full commercialisation of Australia's hydrogen industry. In order for project proponents to obtain financing and funding, it is crucial they are capable of demonstrating to prospective financiers and investors their project is bankable. Secure revenue sources and offtake arrangements will be important factors for financiers and investors when determining the bankability of a project.
Robust pricing mechanisms are crucial, and the absence of an established hydrogen market and market reference price can present challenges for proponents. Natural gas and LNG proponents experienced similar challenges before the establishment of a market price for gas. This Insight looks at how that experience – and the progress made in other jurisdictions – can be drawn on when considering various available pricing mechanisms.
Key takeaways
- Bankable offtake arrangements will be crucial to obtaining finance and investors for hydrogen developments.
- There is currently no market reference price or index that hydrogen proponents can utilise in their offtake agreements. Options that parties are utilising include fixed prices, and fixed and variable cost price formulas.
- To address uncertainties in the future hydrogen price, parties may wish to incorporate a price review provision in their offtake contracts, under which they agree to review the price on a periodic basis or certain trigger events occurring (such as an increase in input prices). However, parties need to be aware that price review provisions are regularly the subject of disputes and arbitration.
Pricing options
While the establishment of a market reference price or index for hydrogen is likely still some time away, pricing mechanisms that parties could potentially seek to implement in their offtake contracts currently include the following.
A fixed price per unit of hydrogen sold is one potential option. It would reflect the proponent's anticipated costs of production plus an appropriate return on investment. As hydrogen is an untested technology, agreeing a fixed price before a final investment decision exposes the seller to cost overruns and input price increases.
However, if a view is taken that the price of producing hydrogen will reduce in future years as the industry develops, a fixed price model may allow a first mover hydrogen proponent to accept the risk associated with adopting a fixed price (and potentially being undercompensated in the early stages of a project), on the basis it will recover that profit in the project's subsequent stages (where its fixed price sits above market price and margins on cost of production continue to increase).
Another alternative is the implementation of a fixed and variable cost price formula. The formula could cover eg:
- the proponent's variable costs of production, including, depending on the type of hydrogen being produced, water, feedstock (eg natural gas) and electricity;
- the proponent's fixed capital costs (including maintenance); and
- a profit element.
This mechanism accounts for varying input prices, but may result in proponents being underexposed to increases in the market value of the hydrogen sold if the increase in market value is greater than the profit element of the proponent's price formula.
The UK Government has had to consider how it will price hydrogen in establishing its subsidy scheme for low carbon hydrogen production, similar to its Contracts for Difference scheme. Under this support model, the proponent is paid a premium that is calculated as the difference between a strike price and a reference price for each unit of hydrogen sold. Given the current lack of a market price, the UK Government looked at a number of potential options for use as a reference price, including the input energy price, the natural gas price, counterfactual fuel prices (ie the price of the fuel replaced by hydrogen for the relevant customer) or the achieved average sales price at the proponent's plant. The UK Government has indicated that its preferred reference price is, until a market reference price develops, the higher of the natural gas price and the average achieved sales price.
Proponents should also note that S&P Global Platts has launched regional hydrogen benchmark price assessments for various production pathways, which could be utilised when determining contract prices. The calculated prices reflect both the commodity production cost and the capital expenditure associated with building a hydrogen facility. Australian benchmark price assessments were launched in August 2021.
Price review provisions
As the current uncertainty around the market value of hydrogen is predicted to recede as the hydrogen industry matures, parties may wish to incorporate a price review provision in their offtake contracts. Price review provisions generally provide that the parties will review the existing price formula or mechanism on a periodic basis or on the occurrence of certain trigger events. A price review might be triggered eg on the occurrence of a milestone date or specific dates, where there is an increase in the prices of inputs such as water or electricity, or in the event a market reference price is established.
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Comparable sales contracts
Risk of disputesIndexation and changes in law
Finally, indexation and change in law provisions are also relevant. Price mechanisms are commonly accompanied by provisions that index eg the fixed price or input costs in accordance with CPI and inflation. The UK Government is looking at actual input energy costs, a natural gas price benchmark or an electricity price benchmark as potential indexation alternatives, as part of the development of its low carbon business subsidy model.
Parties should also consider the inclusion of change in law provisions, to ensure that the hydrogen price is adjusted to take account of any increase or decrease in costs that results from a change in law in the jurisdiction in which the relevant project is located.
Actions you can take now
- Those interested in developing, investing in or financing hydrogen projects should examine how price mechanisms might be implemented in their offtake agreements.
- The commercialisation of the hydrogen industry is gaining pace, and parties should monitor other jurisdictions' developments regarding common pricing mechanisms and interim reference prices.