What are Carbon Contracts for Difference (CCfD)?
We are going to be hearing a lot more about Carbon Contract for Differences (CCfDs) over the next few months.
As Europe looks to wean itself off Russian gas and accelerate its timetable for decarbonisation, CCfDs could be a powerful tool for unlocking investment in industrial decarbonisation, and in particular the uptake of green hydrogen technologies.
The revised REPowerEU plan, launched last week, sets a target for 10Mt of green hydrogen to be produced in the EU by 2030, with plans for a further 10Mt to be imported. The combined 20Mt would require approximately 600GW of new wind and solar power, and 200GW of electrolysers. To support hydrogen uptake and electrification in industrial sectors, the Commission:
“will roll out carbon contracts for difference and dedicated REPowerEU windows under the Innovation Fund to support a full switch of the existing hydrogen production in industrial processes from natural gas to renewables and the transition to hydrogen-based production processes in new industrial sectors, such as steel production.”
What are Carbon Contract for Differences (CCfDs)?
A Carbon Contract for Differences (CCfD) works by setting an effective guaranteed or “strike price” for CO2. The strike price would be set at a level that covers the incremental capital (“capex”) and operating (“opex”) cost of the technology.
For example, assume a project developer (say a chemical producer looking to adopt green hydrogen) agrees on a CCfD with the government where the strike price is €90 per tonne. If at the end of the year the average annual EU carbon price was €70 per tonne the project investor would be guaranteed that for each tonne of avoided CO2 from the project, the government would provide the difference (i.e. €20 per tonne). If the average annual ETS price was at or above €90 per tonne, the project owner would not receive any payment in that year.
That’s an example of a one-way payment mechanism. Alternatively, the government could offer a two-way mechanism whereby the project owner would also be required to pay the government the difference in the event that the average annual ETS price is above the €90 per tonne strike price.
Why do we need CCfDs?
The carbon price is the ‘Currency of Decarbonisation’. Jurisdictions need to keep it high enough to incentivise investment in low carbon technology, but not too high that it becomes socially unacceptable.
Achieving a stable high price of carbon is one thing, but without the ability to hedge against future carbon prices it is very difficult to leverage the investment necessary to build-out the required capacity.
Carbon prices can be very volatile due to the fixed allowance supply and volatile demand. The supply of allowances is highly price inelastic which means that small changes in demand can result in large swings in the price of carbon.
That’s fine if you are able to trade it, but not so great for businesses that rely on the carbon price as a source of revenue (for example, by selling excess allowances), or to make their business commercially viable against more carbon intensive competitors. This is vitally important when investing in industrial decarbonisation since the level of funding required is enormous and given the lifetime of the assets involved, the investment is irreversible.
Currently, there is very little in the way of futures hedging in Europe further than three years. CCfDs enables very long-term carbon price hedges to be put in place, i.e. one that covers several years or more. The CCfD also allows the agent to hedge against adverse regulatory risk, of the kind that could occur in the event that a new government was elected and decided to rip up the entire existing climate change legislation. Unlikely perhaps, but not impossible. Being protected from carbon price volatility over the long-term means that the investment becomes a lot more bankable in the eyes of investors.
A secondary benefit of CCfDs is that they can be used by the government or institution to support and incentivise innovative, but untested technologies. For example, one technology might need higher levels of support in the early years, but less later on in the contract period. This is especially important as the variable costs of novel technologies cannot be known in advance. This could take the form of the government or institution offering a higher strike price early in the contract in return for public investment in the project, giving rights to a share of the profits in the longer term.
CCfDs also act as commitment devices for governments and institutions to keep the price of carbon high and stable. If it were to fall then that represents a cost which the government will need to pick up and recompense the project developer as part of the contract. Equally, the government have an incentive to ensure carbon prices are broadly stable, as otherwise the potential future cost to the government is more difficult to predict and budget for.
Potential downsides to CCfDs
One argument against CCfDs is that they could interfere in the functioning of the carbon market. The argument being that the existence of CCfDs would result in less trading in the longer dated carbon futures market and existing forward markets, damaging price discovery and making it more costly for other market participants to hedge their risks.
The risk of that occurring is probably overstated. CCfDs exist to enable hedging over periods of several years or more. As I mention earlier, the private sector does not currently offer the ability to do that, apart from isolated deals by large utilities hedging the future compliance related carbon exposure of their power generation (see, Hedging carbon risk).
Another argument is the existence of information asymmetries. This could make it difficult for governments to gauge the true cost of bidding technologies and the required carbon strike price. In theory the private sector - perhaps as part of a competitive bidding processes - will arrive at a more realistic price estimation of the true cost. However, the private sector may not be in a position to stump up the initial capital required to accelerate ‘learning-by-doing’ efficiencies - which can rapidly lower costs as markets becomes more established (see, The long term price of emission).
CCfDs are a powerful tool. By leveraging and reinforcing existing regulations and the powerful signal that high carbon prices provides, CCfDs should accelerate industrial decarbonisation. Their adoption will create opportunities for investors, eager to benefit from investing in the decarbonisation of steel, chemicals, cement and other large emitting sectors of the economy.
