On 19 May 2023, the Department for Energy Security & Net Zero (“DESNZ”) published the draft full-form front end agreement (the “Front End Agreement”) and standard terms and conditions (the “Standard Terms and Conditions”) for the Low Carbon Hydrogen Agreement (together the “LCHA”), which serves as the primary contract between the hydrogen producers and LCCC, the government-owned counterparty.
The contract structure will mirror that of the AR4 CfD and the CCUS programme contracts (i.e. the DPA), with the Front-End Agreement containing project-specific details and incorporating the Standard Terms and Conditions. The final version of the LCHA is expected to be published in Q3 2023, with a view to the first LCHAs for electrolytic projects in Q4 of 2023.
What are the key changes in the LCHA?
The publication of the draft LCHA builds on the provisions of the Heads of Terms (“HoTs”), on which please see our previous commentary here.
Termination for exceeding Permitted Annual Sales Cap
The termination right for exceeding the “Permitted Annual Sales Cap” in any two fiscal years during the life of the LCHA has been increased to three fiscal years. While not entirely risk free, the now renamed aggregate “LCHA Sales Cap” gives the Producer additional flexibility in meeting demand for hydrogen and managing production volumes over the life of the contract.
The LCHA has introduced a new and very detailed process pursuant to which the LCCC will certify the counterparties under any offtake agreements as “Qualifying Offtakers”. Without this confirmation LCCC may withhold payments. Producers will need to pay close attention to the list of requirements as to both the identity of their offtakers and the contents of their offtake agreements to ensure compliance with the LCHA. To the disappointment of many, the prohibition on selling to “Risk-Taking Intermediaries” (i.e. those who take title to the hydrogen and pass that title on to a purchaser) has been retained. This severely restricts the kind of business models that the LCHA supports.
Removal of volume floor and termination for insufficient sales
The LCHA does not include a volume floor (i.e. where annual volumes are less than 75% of the annual volume cap and so the volumes sold would be deemed to be equal to the annual volume floor). Additionally, the termination event for circumstances in which a Producer fails to sell any (or volumes above a de minimis threshold) hydrogen for a period of two years is also omitted from the LCHA.
Conclusions on the changes made
The LCHA terms depart in a number of areas from the terms of the AR4 CfD and the DPA. Most notably, DESNZ seeks a level of scrutiny of offtakers and the terms of offtake agreements not seen in comparator contracts. The LCHA also remains restrictive on the kinds of projects the government is willing to support. For example, the over-building of capacity is discouraged by the right of termination for exceeding the LCHA Sales Cap (rather than just limited the level of support). Similarly the administrative burden places on producers for the types of offtakers with whom they may contract limits the flexibility one would expect to see as support of a nascent market.
The consultation period for feedback on the draft closes on 16 June 2023, and DESNZ is accepting written feedback on the draft during this time, and engaging with industry stakeholders in a series of consultation sessions over the course of May and June.
The final version of the LCHA is expected to be published by DESNZ in the third quarter of 2023, with an update anticipated from the end of July, with a view to the agreement of LCHAs for electrolytic projects in Q4 of 2023.
Summary of developments
We have set out below a key summary of the key provisions of the LCHA and how they have developed from the Heads of Terms (“HoTs”) published in December 2022.
HoTs – December 2022 Position
Standard Terms and Conditions – May 2023 Update
Low Carbon Contracts Company Limited (“LCCC”).
Confirmed as LCCC.
The term was confirmed as 15 years, starting from the earlier of the Start Date and the last day of a specified Target Commissioning Window, with payments under the LCHA will not commencing at the Start Date has occurred.
For the Start Date to occur, the Producer must satisfy a number of Operational Conditions Precedent by the relevant Milestone Delivery Date, including:
- evidence that the Producer has commissioned at least 80% of the Installed Capacity Estimate;
- evidence that the Facility can produce LCHS-compliant hydrogen;
- evidence that the Facility complies with specified metering requirements;
- written confirmation from the Producer to the LCHA Counterparty that no other subsidy has been received in relation to the costs of the Project (excluding subsidy under the LCHA and/or any other Approved Scheme of Funding); and
- for CCUS-Enabled Facilities only, evidence of connection to the CO2 T&S Network.
The Milestone Delivery Date will be (i) 18 months for CCUS-enabled facilities or (ii) 12 months for electrolytic facilities, in each case after the date of the LCHA.
The standard term of the LCHA will be 15 years. This may be shorter where the Producer exceeds the LCHA Sales Cap or the Permitted Annual Sales Cap in 3 fiscal years (see below).
DESNZ is considering the treatment of hydrogen produced prior to the Start Date, for example as part of the Commissioning process.
The HoTs set out the requirement to commission an installed capacity of no less than 95% of the Installed Capacity Estimate by the Longstop Date. The Producer can opt to reduce the initial installed capacity estimate up to a maximum of 10% in the first 12 months of the LCHA.
Under the LCHA Qualifying Volumes are volumes purchased by a Qualifying Offtaker and that comply with the LCHS. Producers will be eligible for payment under the LCHA for these volumes of hydrogen produced.
Non-Qualifying Volumes are those purchased by a Non-Qualifying Offtaker (including offtakers that export hydrogen for use outside the UK and/or inject hydrogen into the Gas Transportation System for blending), or which do not meet the LCHS. The volumes of hydrogen will only be taken into account when calculating the payment that is to be made back to the LCHA Counterparty.
RTFO Volumes (i.e. volumes in respect of which Renewable Transport Fuel Certificates are claimed) will not be eligible to receive subsidy under the LCHA.
No change to provisions around Installed Capacity Estimates and reductions, or those in relation to Qualifying Volumes, Non-Qualifying Volumes, and RTFO Volumes.
Note that a detailed process in respect of a “Qualifying Offtaker” has been set out in condition 33 of the Standard Terms and Conditions. Producers will have to give notice to the LCCC requesting confirmation of any new offtaker as a “Qualifying Offtaker”, and provide details in respect of the offtaker’s identity, corporate structure, details of the facility at which the hydrogen will be used, details of the offtake arrangement (including disclosing a copy of the relevant agreement), and other compliance requirements.
Determining the level of Support
The HoTs set out that Producer will be paid a premium (the “Difference Amount”) for each unit of hydrogen that is a Qualifying Volume when the Strike Price exceeds the Reference Price for Qualifying Volumes.
The Difference Amount is calculated as follows:
(Strike Price – Reference Price for Qualifying Volumes) x Qualifying Volumes
Non-Qualifying Volumes will be taken into consideration only when the Reference Price for Non-Qualifying Volume exceeds the Strike Price, meaning an amount will be payable by the Producer to the LCHA Counterparty.
The Difference Amount will be calculated as follows:
(Reference Price – Strike Price for Non-Qualifying Volumes) x Non-Qualifying Volumes
The payments will be made on a £ per MWh (higher heating value) basis and it is expected that the size of the Difference Amounts payable by the LCHA Counterparty will decrease as the hydrogen market develops.
RTFO Volumes will not be taken into consideration when calculating the Difference Amount.
In short, if the price for Non-Qualifying Volumes is above the Strike Price, the difference received for Non-Qualifying Volumes will be set off against payments due or owed to the producer (or is part of the amount payable to the LCCC).
The calculation of the Difference Payment is substantially unchanged from the full-form provisions set out alongside the HoTs.
The LCHA introduces new provisions in relation to the indexation of the Strike Price, the Capital Return Component, and certain CCUS-Enabled Non-Variable Costs.
The LCHA also introduces a clawback right for LCCC where the Producer has received a Difference Amount payment in respect of Non-Qualifying Volumes – amounts will either be set off against other payments to the Producer or repaid.
Price Discovery Incentive
The HoTs describe a mechanism designed to incentivise Producers to achieve prices for Qualifying Volumes above the Floor Price.
The Producer receives an amount linked to the increment by which the Reference Price for Qualifying Volumes exceeds the Floor Price for each unit of hydrogen.
Where the Reference Price for Qualifying Volumes is higher than the Floor Price and is equal to or lower than the Strike Price, the Producer will receive 10% of the difference between that Reference Price and Floor Price.
Where that Reference Price exceeds the Strike Price, the Producer will receive 10% of the difference between the Strike Price and the Floor Price.
Note that the Floor Price for “feedstock offtakers” is different to other offtakers, being the lower of either (i) the Strike Price or (ii) the Gas Reference Price multiplied by 1.2. DESNZ’s intention is that this ensures that it better reflects the cost of unabated hydrogen.
As above – the Price Discovery Incentive mechanism is substantially unchanged from the full-form provisions set out alongside the HoTs.
Instead of a backstop PPA, the HoTs envisaged volume support where the Producer is producing hydrogen and its offtake/sales volumes fall.
In these instances, the Producer will receive an additional amount (the “Sliding Scale Top Up Amount”) for each unit of hydrogen sold which is a Qualifying Volume.
This Sliding Scale Top Up Amount will be set by the LCHA and will not be negotiable at project level.
The offtake/sales volumes will include all volumes of hydrogen produced by the relevant facility, including Non-Qualifying Volumes and RTFO Volumes.
No support will be provided where the Producer’s offtake/sales volumes fall to zero.
As above – the volume support mechanism is substantially unchanged from the full-form provisions set out alongside the HoTs.
The HoTs proposed an LCHA Production Cap and Annual Volume Cap, which was intended to allow producers to have the flexibility of producing and selling hydrogen to match demand which might be inconsistent across the life of the LCHA.
The HoTs proposed that each billing period all the volumes of hydrogen produced, including both Qualifying and Non-Qualifying Volumes and RTFO Volumes, will be aggregated into a “Total Aggregate Volume” and will be compared to the LCHA Production Cap.
For each Fiscal Year, the total volumes of hydrogen produced and sold by the relevant facility must not exceed the Permitted Annual Volume Cap. Producers will not receive LCHA payments in respect of volumes exceeding this cap. Volumes that exceed the Permitted Annual Volume Cap will be multiplied by 150% for the purposes of calculating the Total Aggregate Volume.
When the Permitted Annual Volume Cap is exceeded in 2 consecutive years or non-consecutive fiscal years, the LCHA may terminate the LCHA.
Where the Total Aggregate Volumes are equal to the LCHA Production Cap, the LCHA will expire in a no-liability basis.
Note that a separate volume floor was proposed (which applies where annual volumes are less than 75% of the annual volume cap and so the volumes sold would be deemed to be equal to the annual volume floor). These volumes below the annual volume floor would be forfeited for the purposes of the LCHA Production Cap.
DESNZ had stated it is considering the introduction of a termination event where a Producer “fails to sell any (or potentially a volume above a de minimis threshold) of the hydrogen volumes” it produces for a period of two years.
The LCHA sets these out as follows:
The “LCHA Sales Cap”: Where the “Total Accrued Volume” (i.e. the total volumes of hydrogen invoiced under the LCHA, as adjusted) exceeds the LCHA Sales Cap, the LCHA will automatically expire on a no-liability basis.
The “Permitted Annual Sales Cap”, which (as set out in the HoTs) precludes any LCHA payments for volumes above the cap, and gives the LCCC a termination right where this is exceeded in 3 consecutive or non-consecutive fiscal years.
Notably neither the proposed “volume floor” nor the termination event for failure to sell sufficient volumes of hydrogen (both included in the HoTs) have been included in the LCHA.
Total amount of support available
Costs that are to be eligible for support under the LCHA and are not to be automatically excluded from the Strike Price were not confirmed in the HoTs. However, DESNZ had stated that these were likely to include:
- capex and opex associated with the construction and operation of the relevant facility (excluding capex funded by the NZHF or other approved funding scheme);
- an allowed return on investment;
- input energy costs;
- capex associated with the construction of hydrogen transport infrastructure, but not the opex associated with operating it (excluding capex funded by the NZHF or other approved funding scheme);
- capex and/or opex associated with the construction and/or operation of hydrogen storage infrastructure (excluding capex funded by the NZHF or other approved funding scheme); and
- leasing costs associated with specified hydrogen transport and or storage infrastructure.
Ineligiblecosts (which are excluded from the Strike Price calculation) will include:
- indirect and direct taxes;
- capex and/or opex associated with capturing additional revenue streams;
- costs in relation to Electricity Storage pursuant to the Electricity Storage negative undertaking; and
- any costs associated with the provision of ancillary services.
No change from HoTs – details have not been provided in the May 2023 update to the LCHA. Note that strike price inclusions and exclusions will be set out in Annexes to the Front End Agreement.
The natural gas component of the Strike Price will be calculated by multiplying the monthly Gas Reference Price by an agreed proportion of up to 1.15 MWh (HHV) of hydrogen produced and sold each month.
All other components will be CPI indexed. CO2 T&S charges fall outside of the Strike Price.
The full Strike Price will be indexed to CPI.
No change from HoTs.
Billing and Payment
The main payment for each Billing Period will comprise the following:
- the Difference Amount – payable either by the LCHA Counterparty or the Producer as applicable,
- the Price Discovery Incentive Amount – payable by the LCHA Counterparty to the Producer,
- the Sliding Scale Top Up Among – payable by the LCHA Counterparty to the Producer,
- the CO2 T&S Outage Relief Event Strike Price Deduction Amount – payable by the Producer to the LCHA Counterparty (for CCUS-enabled facilities only), and
- the Monthly CO2 T&S Charges Amount – payable by the LCHA Counterparty to the Producer (for CCUS-enabled facilities only).
No change from HoTs.
Charges for CCUS-Enabled Facilities
For CCUS-Enabled Facilities connected to a CO2 T&S Network, the LCHA Counterparty will be required to pay the Producer certain CO2 T&S Charges in proportion to the Qualifying Volumes/Total Volumes ratio. The CO2 T&S Charges Amount will comprise of:
- Flow Charge;
- Capacity Charge; and
- Network Charge.
No change from HoTs.
Indexation for CCUS-Enabled Facilities is subject to further review by DESNZ.
The HoTs confirmed that the subsidy control provisions would follow those for AR4 CfD. The LCHA will prohibit subsidy cumulation in respect of the costs of the Project and an obligation for Producers to repay any subsidy it receives other than the LCHA subsidy.
Exemptions to the no subsidy rule will include: (i) Net Zero Hydrogen Fund funding; (ii) Renewable Transport Fuel Certificates; and (iii) any Approved Scheme of Funding.
Breach of this undertaking will give the LCHA Counterparty the right to suspend all payments under the LCHA.
No change from HoTs.
Interplay with other schemes
While certain facilities could be eligible for free allocation of allowances under the UK ETS, the HoTs propose preventing Producers to from applying for or receiving these free allowances. Breach of this prohibition would entitle the LCHA Counterparty to terminate the LCHA.
The LCHA permits Producers to participate in the RTFO scheme, however, claiming under both schemes in respect of the same volumes of hydrogen will not be permitted.
To this effect, the HoTs envisage a third party claim prohibition, which means Producers will be required to use all reasonable endeavours to ensure that volumes subsidised by the LCHA are not subsequently claimed under the RTFO scheme by a third party.
DESNZ was still considering the interaction between the LCHS and the LCHA.
Position unchanged from HoTs.
DESNZ is still considering the way in which the prohibition will be detailed in the LCHA.
Position unchanged from HoTs. DESNZ is still considering how to address the potential risk of Producer overcompensation that may arise due to future changes in law relating to the RFTO Scheme.
DESNZ is also still considering whether to include reference to RTFO in the definition of Total Invoiced Volumes.
Volumes of hydrogen produced must be compliant with the LCHS to be a “Qualifying Volume” and therefore be eligible for support under the LCHA. Annex 6 of the Standard Terms and Conditions contains data collection and monitoring provisions in relation to compliance with the LCHS, and Annex 10 contains provisions in relation to the Producer’s participation in the scheme itself.
DESNZ is considering the position that Producers should be required to estimate emissions using pre-approved methodologies (e.g. default values from the LCHS), failing which the LCHA Counterparty will determine the emissions. In the case of missing data or supporting information, the LCCC will have the right to deem that the relevant consignments are not compliant with the LCHS and therefore suspend payment under the LCHA.