BEIS has just published an update to the Heads of Terms (“HOTs”) for the Agreement for the Low Carbon Hydrogen Production Business Model (“LCHA”) expanding on a number of previous principles and introducing new ones. For those looking at bidding into the allocation round for the Hydrogen Business Model it will be important to familiarise yourself with these HOTs.
As trailed by government, the LCHA will be modelled on the standard Contract for Difference (“CfD”) for low carbon electricity, but it appears we are unlikely to see the full contract terms until Q2 2023. This is surprising as hydrogen developers will be wanting to progress and finalise their offtake contracts early next year and issuing the full contract so late on in the allocation process will mean significant time pressure.
The key aspects of the HOTs to consider for electrolyser hydrogen projects are below;
- The contract will be a private law contract between the hydrogen producer and what is anticipated to be the Low Carbon Contracts Company Limited (“LCCC”)
- The contract will last to the earlier of 15 years from the Start Date or the date on which the LCHA Production Cap is reached. The LCHA Production Cap is a figure agreed at the award of the LCHA which represents the total amount of hydrogen the plant is likely to produce during the term of the contract.
Note; the contract although generally described as 15 years of support, may end early if more hydrogen is generated annually than expected and the Production Cap is reached. This will need to be factored into a producer’s discussions and thinking for offtake contracts and sizing of plant.
Start Date and Commissioning Longstop
Those familiar with the CfD will recognise the principles around the Start Date for the LCHA support. The producer will indicate a likely commissioning date which must fall within a Target Commissioning Window of 12 months. If the plant is not commissioned by the last day of the Target Commissioning Window the term of LCHA will be deemed to begin, meaning that the maximum 15 year support from the LCHA starts to erode. Whilst not specified, it is an understood principle in the CfD that if the plant is commissioned in advance of the start of the Target Commissioning Window, the support will not begin until the first day of that window.
There is also a Longstop Date for commissioning (12 months from the last day of the Target Commissioning Window) which if not achieved by the project gives LCCC a right to terminate the LCHA.
Note;Producers, therefore, need to be familiar with the commissioning milestones and how the target commissioning window works so as to maximise their support under the LCHA.
Conditions Precedent
For the Start Date for support to occur, certain operational conditions precedent must have been achieved. Many of these are similar to the electricity CfD, but include at least 80% of the installed capacity estimate of the project having been commissioned; the producer being able to demonstrate that the project can produce hydrogen meeting the Low Carbon Hydrogen Standard (“LCHS”); the producer demonstrating to LCCC that no subsidy has been received in relation to the cost of the project, other than through an “Approved Scheme of Funding”(which is a funding scheme with prior approval from the LCCC and negotiated on a project by project basis).
Note; The key points here are to make sure that key dates on building the project are flowed down to contractors and to understand whether the project being constructed has benefitted from any other government support or funding, which may impact on this condition precedent. If for example, there is other funding which is not approved, the Start Date may not occur, support payments do not flow and there is the risk that the Longstop will be reached and a termination event may arise for LCCC.
Milestone Requirement
This will, again, be familiar to those in the low carbon electricity sector, but the producer must demonstrate by a Milestone Delivery Date ( 12 months from signing the LCHA) that it is committed to the project by either spending a minimum 10% of the total project commissioning costs or by demonstrating that key equipment contracts have been entered into. If this is not achieved LCCC may terminate the contract.
The electricity industry will tell you that achieving this milestone requirement should not be underestimated. Producers should instigate detailed collation of projects costs on an ongoing basis and monitoring to ensure that the milestone can be evidenced. They will also need to take into account exactly what categories of costs may be allowed as spend against the 10% requirement. The timing logistics of the build out necessary to meet the first allocation round for hydrogen (2025) may mean that the construction and equipment contracts will have been put in place, but it does focus the mind.
Achieving the Installed Capacity
By the LCHA Longstop Date (see above) the producer needs to demonstrate that, not less than 95% of the installed capacity estimate (the capacity that the producer said the project would achieve) has been commissioned. If they are unable to demonstrate this LCCC has the right to terminate the LCHA.
There is an ability for the producer to adjust the initial installed capacity estimate of the plant downwards up to a maximum of 10% prior to the Milestone Delivery Date (i.e.in the first 12 months of the LCHA).
Termination Rights
There are the typical rights of termination for producer default, some of which are described above but which also include; claiming payments for volumes sold to Non-Qualifying Offtakers and claiming support for any volumes of hydrogen for which renewable transport fuel certificates have been claimed.
There is also an obligation not to breach and exceed a Permitted Annual Volume Cap on any two fiscal years during the term of the LCHA (see Volume Caps below).
BEIS has also noted that it is considering including an extra two termination events; where a Net Zero Hydrogen Fund Agreement applies to the project and it is terminated due to producer breach or default; and if the producer fails to sell any, or a de-minimis threshold, of hydrogen volume produced by the facility for a period of two years.
On termination, a default termination payment is payable by the producer which currently is £2 per MWh (HHV) indexed by CPI x the Annual Volume Cap which applies to the project.
There will be no right for the producer to terminate the LCHA unilaterally.
Note; the termination rights applying to volumes of hydrogen are important to consider in the context of planning your offtake contracts. If your offtaker fails to take because their facility or boilers are down for example, and that lasts for 2 years, the LCHA could be terminated.
Volume Caps
We have already noted above that it is envisaged that there will be a LCHA Production Cap which will operate to cap the amount of hydrogen produced which receives support.
The Annual Volume Cap is calculated by dividing the LCHA Production Cap by 15 (the notional number of years the LCHA will last and then multiplying that figure by 125% to give some leeway. As described above, there is a termination right if the Annual Volume Cap is breached for 2 fiscal years.
If the volumes of hydrogen sold by the project fall to lower than 75% of the Annual Volume figure then a floor operates and the producer is deemed to have sold 75% for the purposes of it counting towards the LCHA Production Cap and in the event that the project produces amounts of hydrogen which exceed the Annual Volume Cap in a fiscal year, the excess amount will be multiplied by 150% for the purposes of counting it towards the LCHA Production Cap.
Note; you will see from above that these volume mechanisms can have the effect of eroding the hydrogen volumes that can benefit from support under the LCHA. These provisions will also result in less flexibility for discussions over take or pay and volume fluctuations in offtake contracts. Note also that it is not clear that any force majeure relief apply to these provisions.
Payments, Strike Price and Reference Price
This is effectively a contract for difference and, therefore, for electrolytic hydrogen the LCCC will pay the producer for each unit of Qualifying Volume, when the Strike Price exceeds the Reference Price, the difference amount. Conversely, when the Reference Price for Qualifying Volumes exceeds the Strike Price, the difference amount becomes payable by the producer back to the LCCC.
Non-Qualifying Volumes (those volumes where hydrogen has been sold to a Non-Qualifying Offtaker; volumes not complying with the LCHS; or volumes where renewable transport fuel obligation certificates have already been claimed) will be taken into account in calculating the difference amounts payable under the LCHA. So, if the price achieved for Non-Qualifying Volumes exceeds the Strike Price, the amount of money representing that difference received for the Non-Qualifying Volumes will be set off against any payments due or owed to the producer and if money is not owed to the producer, the producer will end up paying back to the LCCC.
The Strike Price will be set in a bilateral negotiation, expressed as a per MWh (HHV) figure and will be the unit price required by the producer to enable it to recover the costs of producing low carbon hydrogen and making an allowed return on investment.
The Reference Price for qualifying volumes will be the higher of the achieved sales price for those qualifying volumes and the Floor Price, (set at the gas reference price for the relevant billing period).
Payments are made monthly and prices are indexed at CPI.
Price Discovery Incentive
There will be included within the LCHA a price discovery incentive, which is designed to encourage producers to achieve prices for their qualifying volumes above the Floor Price. This will be set at;
- 10% of the difference between the Reference Price and Floor Price (when the Reference Price is equal to or lower than the Strike Price) or
- 10% of the difference between the Strike Price and the Floor Price (when the Reference Price exceeds the Strike Price).
Sliding Scale Volume Support
As has been widely publicised, there will also be an element of sliding scale volume support, designed to assist the producer if the hydrogen offtake sales volume falls. This will, effectively, operate to give the producer a higher payment for the low volumes of hydrogen sold, but will only operate in certain circumstances.
It will only be triggered if sales volumes fall below 50% (to be confirmed) of the Annual Volume Cap and, if there is no offtaker at all, that is entirely a risk for the producer. The Volume Support is only set to cover certain fixed costs.
Note; in reality the volume support may not provide large amounts of comfort to producers. The support needs to be considered alongside the Volume Caps above and producers will have to seek suitable protection from creditworthy offtakers rather than rely on this mechanism.
Low Carbon Hydrogen Standard
It is a requirement to receive payments that the volumes of hydrogen comply with the LCHS. The LCHS will change over the years but it is recognised that it would be unfair to impose future amendments of this standard onto the project. Therefore, the requirements of the latest standard applicable at the time of signing the contract will be grandfathered for the particular project.
Subsidy Cumulation
These provisions will follow the CfD which require repayments of grants etc. received by a project before business model support will flow. It is however, recognised that support via the Net Zero Hydrogen Fund or arising from the Renewable Transport Fuel Obligation is exempted.
Supply Chain Reporting
It will be a contractual requirement to report regularly on the economic and supply chain benefits which flow from the project.
The majority of the remaining provisions follow the CfD and so have not been repeated here.
Burges Salmon is advising on UK hydrogen projects both blue and green and is playing an active role in tracking the regulation and policy. We sit on the UK Hydrogen and Fuel Cell Association Executive and Renewable UK’s Green Hydrogen Working Group. We have guided developers through all allocation rounds of the low carbon electricity CfD and we are actively considering these LCHA terms in the context of the offtake agreements we are drafting for hydrogen projects. If you would like to discuss any aspect of this briefing or our wider services to hydrogen and Net Zero projects contact Ross Fairley.