On 9 August 2023, the Department for Energy Security & Net Zero (“DESNZ”) published an updated 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”).This follows on from the draft that was published by DESNZ on 19 May 2023. This article provides commentary on the key changes in this latest draft, and summarises the position in relation to key terms of the LCHA.
For further commentary on the latest developments in the UK’s Hydrogen Strategy (including electrolytic allocation rounds and business models for hydrogen transport and storage) please see our recent Law-Now article here.
What are the key changes in the LCHA?
This draft of the LCHA represents the next steps in the building out of the hydrogen production sector in the UK. Please see our previous commentary here for terms of the draft published in May as well as here for comments on the initial Heads of Terms (“HoTs”).
The key changes for investors in the latest LCHA draft centre around:
- Offtaker provisions – new categories of “Own Consumption Offtakers”, “Small Offtakers” and “Large Offtakers” introduced.
- Amendments to key termination events, including a new termination event for double-claiming volumes under both LCHA and RTFO, and for claiming free allowances under the UK ETS.
- New controls around the ownership of the producer – in particular additional KYC requirements, with LCCC able to suspend payments for non-compliance.
- Reduction of the Required Installed Capacity of Producers from 95% to 90%.
- Producers are now able to access the RTFO and EII Exemption Schemes prior to the Start Date of their LCHA, subject to notification obligations.
- Additional payments to the Producer where production outages are caused by the unavailability of CO2 T&S networks.
- Reduction in the scope of LCCC clawbacks of Difference Payments.
- Changes to the metering and data reporting provisions to account for the use of co-located battery storage by Producers.
- Additional Revenue Reporting obligations included.
Despite repeated feedback from the industry, there is little movement when it comes to ‘risk taking intermediaries’ – though please see our comment below on the drafting changes.
Changes to provisions relating to hydrogen offtakers
The May LCHA had introduced a detailed process pursuant to which the LCCC will certify the counterparties under any offtake agreements as “Qualifying Offtakers”. Without this confirmation, the LCCC can withhold payments to the Producer.
The latest draft of the LCHA expands on the concept of “Own Consumption Offtakers”, i.e. the Producer itself where it intends to use hydrogen produces as feedstock or fuel. Own Consumption Offtakers are now explicitly carved-out from the definition of “Non-Qualifying Offtaker”. Own Consumption Offtakers are not subject to the same confirmation process as Qualifying Offtakers, but instead are subject to a separate process with LCCC (with deemed agreement to the Producer acting as an Own Consumption Offtaker after no response within 5 working days of LCCC’s receipt of a notification).
A new Producer undertaking is also introduced in relation to Affiliate Offtakers, i.e. an offtaker who becomes an Affiliate of the Producer after a change in control. Any sales to Affiliate Offtakers cannot be for a price lower than under the existing offtake arrangements, with a calculation mechanism included for establishing the relevant lower limit.
The LCHA now includes a distinction between ‘Small’ and ‘Large’ Offtakers, based on whether they are forecast to purchase at least 750 MWh (HHV) of Hydrogen produced by the particular Hydrogen Production Plant in a Fiscal Year, making them a Large Offtaker (and an Offtaker purchasing less than this amount would be a Small Offtaker). This is an absolute threshold, and not relative to the size of the plant or aggregated across multiple plants. Small and Large Offtakers are required to provide different information pursuant to the Qualifying Offtaker confirmation process, with the burden on Large Offtakers being considerably more onerous.
The definition of “Risk Taking Intermediaries” in the context of Non-Qualifying Offtakers has been amended to give greater flexibility to Offtakers to resell limited hydrogen volumes (e.g. where too much has been purchased) without them falling foul of the Risk Taking Intermediaries prohibition.
While the split in requirements for the qualification of offtakers is likely intended to reduce the burden on certain smaller participants in the hydrogen market, it adds further complexity to a regime which is already far more detailed than in comparative support agreements.
New termination events
The latest LCHA includes new termination rights for LCCC where a Producer (or an offtaker) received support under both the LCHA and RTFO for the same volumes of hydrogen produced by the facility, Note there is a key relief where the Producer took specified steps to protect against an offtaker’s breach of this requirement. There is also a new termination event where the Producer claims free allowances under the UK ETS in respect of any emissions of the Facility. The termination event associated with Producer non-compliance with LCCC has been removed.
Controls on ownership and KYC requirements
The latest draft imposes additional reporting obligations on Producers, including in relation to changes to an ultimate owner or appointment of a director. Establishing an ultimate investor will require an analysis of “control” for competition law purposes (as the definition includes the exercise of dominant influence), which adds a significant and potentially complicated compliance burden on Producers.
The LCHA also includes a (separate) provision on providing general KYC information to the LCCC, with an LCCC right to suspend payments for non-compliance.
Reduction of Required Installed Capacity
The Required Installed Capacity that Producers are required to commission by the Longstop Date has been reduced from 95% to 90%. This provides greater flexibility to Producers and reduces the risk they bear of delays in construction and commissioning. This is introduced alongside an ability to conduct additional tests to satisfy the minimum conditions precedent for operation, which also provides relief where the relevant longstop date tests do not evidence the required standard.
Pre-Start Date Subsidy
Producers are able to access both the RTFO and Energy Intensive Industries (EII) Exemption Schemes (where eligible) prior to the Start Date of their LCHA. This is subject to a notification obligation on the Producers which requires them to report certain information about what is being claimed, to ensure adherence to the general principle of preventing double subsidy.
Blue hydrogen producers – new Carbon Cost Protection Amount and PILOHS Amount
The updated LCHA introduces two new payments for CCUS-enabled hydrogen Producers under the LCHA: the Carbon Cost Protection Amount and the PILOHS Amount.
The Carbon Cost Protection Amount applies to CCUS-enabled hydrogen producers. Broadly, this compensates producers on a yearly basis for the carbon emissions for which their hydrogen production is responsible during any outages of the CO2 T&S network (for which the Producer receives relief under the LCHA), with compensation taking into account the UK ETS Allowance Reference Price, the Capture Rate of the relevant blue hydrogen production facility.
The PILOHS Amount provides for payments to Producers in lieu of hydrogen sales. As with the Carbon Cost Protection Amount this will apply when a CO2 T&S Outage Relief Event has occurred in the relevant period and such event reduces a Producer’s billed volumes of hydrogen. The PILOHS Amount will be calculated on the basis of the previous 30 days of production volumes prior to the relevant T&S outage.
The introduction of two new payments for Producers implies DESNZ’s desire to reflect feedback received in relation to the interface risk between Producers and the nascent T&S Networks. While Producers are likely to be receptive to these changes, technical and commercial analysis will be needed to establish whether these payments adequately compensate for lost revenue during T&S Outages.
Cut-off date for Non-Qualifying Volumes and RTFO clawbacks
A Producer’s liability to return Difference Payments received for Non-Qualifying Volumes has been limited to three years (save where any payment information provided by the Producer to LCCC was misleading). This represents a form of relief for the Producer against the threat of a long lookback period during the entire life of the contract.
Amendment of metering specifications to take account of battery storage
The provisions in relation to data reporting (for the purposes of LCHS compliance) and metering have been amended to account for the use of battery storage by hydrogen production facilities under the LCHA.
Additional Revenue Reporting
Producers are required to provide an “Additional Revenue Report”, setting out revenue generated by the Producer outside of the sale of hydrogen. This covers, for example, revenue from take-or-pay arrangements. This represents a material additional compliance burden on Producers during the course of the LCHA.
While this latest publication is still labelled a draft, given that it is expected that LCHAs will be agreed for electrolytic projects in Q4 of 2023 this is likely to be the last such draft published prior to the finalisation of the LCHA terms. This timeline is however contingent on the progress of the Energy Bill through Parliament, and as such delays to this are not unforeseeable.
DESNZ is also currently consulting on the second allocation round for LCHA contracts to be awarded to electrolytic projects (“HAR2”), and on how to transition to price-based competitive allocation after HAR2, in the model of the renewable CfD. The intention is that annual, price-based competitive allocation will be run for LCHAs by 2025 for electrolytic projects, and potentially other specified non-carbon capture hydrogen production technologies. Where there is a move to CfD-like price-based allocation, the risks sitting with the Producer under the LCHA (for example securing offtake, managing the balance between RTFO and LCHA) will affect the bidding levels of the projects participating in HAR2.
Hydrogen producers hoping to enter into an LCHA should also be aware of developments in the UK’s Low Carbon Hydrogen Standard ("LCHS"), to which updates relating to greenhouse gas emissions and sustainability criteria were published earlier this year. As described elsewhere in this article many of the compliance obligations in the LCHA cross-refer to the requirements of the LCHS, and as such it is important that the two are considered together. DESNZ has stated that it expects a further update and review of the LCHS to be published later in 2023.
Summary of other key provisions and updates
We have set out below a key summary of the key provisions of the LCHA and any material changes to these provisions in the August 2023 update.
Standard Terms and Conditions – May 2023 position
August 2023 Update
Low Carbon Contracts Company Limited (“LCCC”).
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.
No material changes.
Producers are required to commission an installed capacity of no less than 95% of the Installed Capacity Estimate by the Longstop Date. Producers 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.A detailed process in respect of a “Qualifying Offtaker” has been set out in 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.
There has been a change to the definition of Non-Qualifying Volumes, which has been extended to include a catch-all “any other volumes which are deemed to be ‘Non-Qualifying Volumes’ pursuant to any provision of this LCHA”. This introduces an element of discretion for LCCC that may be unhelpful to producers.
The definition of Qualifying Volume has also been updated to clarify that it does not include any Measured Hydrogen Output which is deemed not to be LCHS Compliant.
There have also been changes to the process in respect of a “Qualifying Offtaker” (now set out in Condition 36). Under the LCHA, the Producer must now provide the Offtaker Confirmation Request Notice no later than 30 Business Days rather than no later than 15 Business Days.
There is also now a distinction between a Small Offtaker (purchasing less than 750 MWh (HHV) a year) and a Large Offtaker (purchasing 750MWh or more (HHV) a year). This constitutes different disclosure requirements to the LCCC, with Large Offtakers carrying a higher disclosure burden.
There is also an updated mechanism for the LCHA Counterparty to query a Producer’s Offtaker Confirmation Request Notice.
Required Installed Capacity
Producers are required to install 95% of their “Installed Capacity Estimate”. Failure to do so by the Longstop Date is a termination event for LCCC. Where no notice of the Final Installed Capacity of the Facility is given, the Final Installed Capacity is deemed at 80% of the initial Installed Capacity Estimate.
This figure has been lowered to 90% - reflecting the additional construction and commissioning risk faced by FOAK hydrogen projects benefitting from the LCHA.
Determining the level of Support
The 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 LCHA contains provisions in relation to the indexation of the Strike Price, the Capital Return Component, and certain CCUS-Enabled Non-Variable Costs.
The LCHA also contains 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.
There are no substantial changes to the calculation of the Difference Amount.
The August 2023 LCHA does, however, introduce the Carbon Cost Protection Amount and the PILOHS Amount in Conditions 19 and 20. These conditions apply to CCUS-Enabled Facilities only.
Carbon Cost Protection Amount
This is calculated with reference to the UK ETS Allowance Reference Price (calculated each year), and broadly multiplies this figure by the amount of emissions of the facility during an outage of the CO2 T&S Network.
This represents a payment in lieu of hydrogen sales during an outage of the CO2 T&S Network. It multiplies the volumes produced during the outage by the “CCUS-Enabled Non-Variable Costs Strike Price” and a “Capital Return Component”.
Price Discovery Incentive
Producers are incentivised 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.
Amendments have been made to the calculation of the Gas Reference Price (that feeds into Price Discovery Incentive).
Instead of a backstop PPA, the LCHA provides 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 Counterparty 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.
There are no significant changes to the volume support mechanism. However, the calculation of the “Sliding Scale Top Up Amount” has been amended to take into account any PILOHS Volumes and any QCiL Adjusted Revenues Volumes.
The LCHA sets out the following caps on the production of hydrogen by LCHA Producers 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 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) are included in the LCHA.
The calculations for the “LCHA Sales Cap”, the “Permitted Annual Sales Cap” and in relation to “Automatic Expiry” have all been updated to take into account PILOHS Volumes and QCiL Adjusted Revenues Volumes.
The calculation for the Permitted Annual Sales Cap has also been updated so that it applies the same formula for the fiscal year in which the Start Date occurs as the other fiscal years.
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 have not been explicitly confirmed. However, DESNZ has stated that these are 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.
Ineligible costs (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 material changes.
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 material changes.
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).
There are minimal changes in relation to billing and payment. Under Condition 21.4, the Producer agrees that it is not entitled to raise a Dispute in respect of an estimated Achieved Sales Price for each Relevant Offtaker in respect of Qualifying Volumes or Non-Qualifying Volumes or the applicable methodology. The new Condition 21.5 also relates to payments following a Payment Information Notice and accompanying Directors' Certificate.
The requirement to include the sums of the Strike Price Exclusion Amounts in respect of either Qualifying Volumes and Non-Qualifying Volumes has also been removed.
There are also new requirements in relation to KYC notifications, with a corresponding payment suspension right for the LCHA Counterparty in circumstances of breach.
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.
Indexation for CCUS-Enabled Facilities is subject to further review by DESNZ.
No material changes.
Subsidy control provisions in the LCHA follow those for AR4 CfD. The LCHA prohibits 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 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 material changes.
Qualifying Change in Law (“QCiL”)
The LCHA contained QCiL provisions mirroring those in CfD AR4, that provide relief (in the form a payment) for the Producer where there is a “Qualifying Change in Law”.
No material changes.
Interplay with UKETS
While certain facilities could be eligible for free allocation of allowances under the UK ETS, the LCHA prevents Producers to from applying for or receiving these free allowances. Breach of this prohibition would entitle the LCHA Counterparty to terminate the LCHA. DESNZ is still considering the way in which the prohibition will be detailed in the LCHA.
The updated LCHA includes further references to the UK ETS. The Carbon Protection Amount (as mentioned above) is to be calculated by multiplying the Eligible Carbon Cost Protection Emissions by the UK ETS Allowance Reference Price (each for the relevant calendar year).
Conditions 19.7 and 19.10 also provide calculations for the UK ETS Allowance Price and the UK ETS Allowance Reference Price respectively. Condition 19.11 also states that these calculations may be amended, supplemented or replaced in accordance with an annex to the LCHA.
Under Condition 34, the Producer provides a warranty to the LCHA Counterparty that at the Start Date, no UK ETS Free Allowances have been applied for, or received. The Producer also provides and an undertaking that it will not apply for or receive UK ETS Free Allowances. Failure to comply with this undertaking is deemed to be a termination event under the LCHA.
Interplay with RTFO
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 LCHA includes 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.
A new “Pre-Start Date Subsidy Notice” is required where a Producer intends to claim subsidy under the RTFO between the agreement date and the Start Date of the LCHA.
Condition 33.20 sets out circumstances where the Producer is not required to pay a RTFO Volume Clawback Amount, despite a breach of the RTFO Compliance Obligation, i.e. where the Producer (i) made all due and careful enquiries in respect of the Offtaker’s compliance, and (ii) included a compliance provision in the relevant offtake agreement.
Condition 33.21 also provides the circumstances where a Producer’s breach of the RTFO Compliance Obligation (i.e. double recovery under RTFO and LCHA) will be deemed a termination event. In simple terms this is if the breach has been intentional, reckless or repeated.
Interplay with LCHS
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.
No material changes to the principles of compliance. Annex 6 has been updated to include:
- Additional detail on PPAs used for the purchase of green electricity;
- Further detail required from Producers in relation to the content of the LCHS compliance audit reports;
- The inclusion of the “Materiality Threshold” from the LCHS into the LCHA.
- The ability for the Producer to dispute a notice of LCHS non-compliance from LCCC; and
- Termination for Misleading LCHS Report Data only where 3 such failures have occurred (across the life of the LCHA).