Head start or head wind: will the ‘Hydrogen Headstart’ Program be the promised springboard for the Australian hydrogen industry?

In its recent annual budget, the Federal Government announced the $2 billion Hydrogen Headstart Program to catalyse Australia’s green hydrogen industry and position Australia as a global leader in hydrogen production and export. On 7 July 2023, the Consultation Paper was released. In this article we explore key aspects of this initiative and its challenges. We also provide some insights drawn from our experience of international revenue support models and look at how the program could be optimised to maximise investment and accelerate industry creation.

How will the Program work?

• The funding is expected to be deployed by the Australian Renewable Energy Agency (ARENA) in consultation with the federal Department of Climate Change, Energy, the Environment and Water (DCCEEW).
• In its Consultation Paper, DCCEEW is seeking feedback on the design of the Program. The Consultation Paper provides an overview of the Program’s proposed objectives, merit and eligibility criteria for projects, and most significantly the Program’s proposed revenue support mechanism.
• The Program is expected to involve a two-stage competitive process (Competitive Round) to select projects that produce either green hydrogen or derivative products of green hydrogen (e.g. green ammonia). The selected projects will then receive a HPC over a 10-year period. This credit is designed to ‘bridge the gap’ between the costs of producing green hydrogen and its market price.
• This Program is anticipated to help support the development of up to 1GW of hydrogen capacity through two or three large-scale projects.
• The proposed eligibility requirements for the Competitive Round include:
  • projects must involve a new deployment of electrolysis or be new renewable hydrogen production facilities. However, projects can use existing energy generation or hydrogen end use infrastructure;
  • hydrogen production must be entirely powered by:
    • ‘behind the meter renewables’;
    • grid electricity (where large-scale generation certificates created within one year of the hydrogen production or other eligible certificates are surrendered); or
    • electricity from a renewable generation power purchase agreement;
  • projects must be for a single site deployment and meet a minimum electrolysis deployment of 50MW;
  • projects must be located within Australia (however, do not need to be in a Federal or State ‘hydrogen hub’);
  • projects must comply with the Guarantee of Origin scheme that is being developed by DCCEEW and the Clean Energy Regulator; and
  • applicants must have a valid commercial case for the hydrogen’s end use.

After the consultation period closes, we can expect further eligibility guidelines to be published by the end of the year, with expressions of interest to open by early 2024. Following this, from 2026-2027 the competitive hydrogen projects will be awarded contracts with up to 10 years of revenue support.

How will the revenue support be provided?

While the revenue support model is still being developed, it is expected that successful applicants will receive the HPC for each kilogram of renewable hydrogen (or equivalent metric for hydrogen derivatives) produced by their facility. Key features of this proposed mechanism include:

• applicants nominating a HPC value (per kg or equivalent) that represents the difference between the applicant’s cost of production and the expected sale price of green hydrogen;
• applicants specifying a total volume cap for hydrogen which they expect the facility to deliver over 10 years, which represents the facility’s estimated production capacity. The HPC value will be multiplied by this cap to determine the maximum revenue support that will be available, and any additional output beyond this cap will not be eligible for funding;
• the potential upside for projects that may arise from increased sale prices or reduced operating costs will be shared with the Government on a ‘50/50 basis’, however, there will be no sharing in potential downsides associated with higher capital or operating costs for projects;
• HPC payments will be made in accordance with a template Funding Agreement developed by DCCEEW, and payments will be made quarterly in arrears over a maximum 10-year term, commencing on an agreed date linked to commencement of commercial operations; and
• once funding is awarded, recipients must agree to a development timeline and provide monthly confirmations that their projects will achieve financial close and commissioning by their relevant proposed milestone dates.

DCCEEW has also indicated that funding will not be provided to support the upfront capital costs of projects and that funding may be terminated if projects cease production for prolonged periods (unless due to technical outages).

Is this the right approach for Australia?

When the Program was first announced there were question marks around whether Australia would follow the CfD model, or a US-style renewable energy production tax credit (PTC).

The proposed HPC model is more akin to the CfD model in that it will be an actual payment flowing on a quarterly basis, rather than a tax credit. This is a welcome development, as in our view the PTC model would have several shortcomings in the Australian context, including:

• not providing a bankable revenue stream capable of attracting debt finance;
• reducing competition by creating an investment environment that favours larger players with sizeable tax liabilities; and
• allowing tax credits to be used to reduce tax liability arising from income sources that are heavy CO2 emitters, thus undermining the broader policy intent of the incentives (i.e. to facilitate the net zero transition).

As with CfDs, the 10-year contract period for HPCs is essentially a long-term offtake arrangement that will be attractive to debt financiers. As payments are made at the project level, the focus will likely be on participants offering the best prospect of developing the Australian hydrogen industry, rather than larger players looking to divert the benefits elsewhere within their organisation.

However, there is a key difference between the HPC and a true CfD which, in our view, hampers its impact as an accelerator of the Australian hydrogen industry.

With a CfD, the amount of the payment is the difference between the ‘market price’ and a pre-agreed ‘strike price’ (i.e. the ‘floor’ price at which production is considered commercially viable). The CfD payment therefore fluctuates depending on changes in the market price, and if the market price goes above the strike price, the producer is required to make a payment to the government. We note that some of the earlier revenue support models in Europe operated as a ‘one way’ CfD, and that resulted in the generators receiving significant windfalls to the detriment of the program. While the HPC is a credit as opposed to a two way payment model, the 50/50 upside sharing is a helpful mitigant against excessive windfall gains.

The CfD model therefore links the revenue support to market pricing: over time, as a market develops and pricing becomes more closely tied to production costs, the CfD payment should reduce. Accordingly, the CfD model encourages cost reduction and technological innovation, freeing up government funds for other uses as the CfD payments reduce.

Under the proposed HPC model, rather than suggesting a ‘floor’ price, the applicant will propose the actual value of the payment to be made. This will be a fixed amount representing, at the time the application is made, the difference between the expected sales price and the applicant’s expected cost of production.

This means that the HPC will not have a dynamic market link, and does not seem to incentivise cost reduction or innovation during the 10 year period. This fixed subsidy also does not encourage a phasing out of high carbon competitor fuel sources as it ultimately just keeps hydrogen from 1 or 2 projects competitive, rather than encouraging a wider shift to clean fuel. This may slow maturation of the industry, with hydrogen costs and pricing taking longer to reach a sustainable level. This will in turn hamper new market entrants.

Another potential limitation is that the HPC value is set by reference to the expected ‘sale price’ of the hydrogen from the supported project. This implies applicants with long term hydrogen offtakes in place may be favoured. However, securing a long term hydrogen offtake is in itself a challenge given the nascency of the sector. Applicants may therefore need to be more creative about how the expected ‘sale price’ is set.

One approach could be to adopt a CfD style ‘market price’. While determining the ‘market price’ for hydrogen is seen as one of the biggest challenges of a hydrogen CfD, our view is that this could be set by reference to the end usage of the hydrogen in question. This would reflect the difference between the production cost of low-carbon hydrogen and the relevant high-carbon alternative, which means that the market price will be different depending on the specific project. For example, support for a green hydrogen project targeting end use in the maritime sector could use the cost of bunker fuel to determine the ‘market price’. Likewise, a green ammonia project could use the price of non-green ammonia to determine the applicable ‘market price’, and hydrogen to be exported offshore for use in other jurisdictions could be set by reference to an LNG benchmark such as JKM or TTF (depending on the destination market). This approach could also encourage the development of a hydrogen spot market in time.

Other obstacles

In addition to the limitations of the HPC model, there are two key obstacles to the creation of an Australian hydrogen industry that remain unaddressed by the Program.

Lack of transport and storage infrastructure

As we are seeing with the electricity sector’s transmission infrastructure challenges, one of the biggest obstacles that remains largely unaddressed is the lack of hydrogen transport and storage infrastructure. Without this infrastructure, there is no way to get the product to market. This could prove to be a significant bottleneck for the development of the industry, and is a real barrier to hydrogen production at scale. However, without established generators in place to make use of the infrastructure, there will be little incentive for private sector investment in the midstream infrastructure. This is a chicken and egg scenario which needs to be addressed as a matter or priority. Providing government funding and other incentives that are specifically targeted at infrastructure development is one way to do this. In the US, they are hoping to address this issue by requiring that hydrogen PTC projects provide both their own renewable energy generation and a clear route to market for the end product. In the Australian context, looking at ways to leverage and/or repurpose our existing midstream fossil fuel infrastructure would be a great place to start.

Too few projects targeted

While the Program represents a step in the right direction, two or three projects do not make an industry, especially when the federal Government is targeting 1000MW of electrolyser capacity by 2030, yet, most planned or in construction hydrogen projects have an electrolyser capacity of 10MW or less, and most electrolyser stacks in production are 5MW or smaller. Even FFI’s Gladstone Electrolyser Factory will initially only produce 1MW electrolysers.

Arguably, spreading the $2 billion across a larger number of smaller projects targeting a wider range of end uses (and leveraging off the knowledge sharing that has been a key component of ARENA’s prior funding programs) could have a greater impact in terms of industry creation and leveraging private sector investment.

A way forward

The key to catalysing Australia’s hydrogen industry is closing the gap between the cost of hydrogen and that of its competitor fuels. The HPC is likely to achieve that. But that is not the only ingredient. The key to creating a sustainable and long-lived industry is providing a revenue support model that allows for a transition to market-led pricing as the industry matures. On this measure, the HPC currently falls short. Thankfully, the consultation process provides an opportunity for refinement.

The consultation period is now open and runs until 3 August 2023. DCCEEW’s Consultation Paper and further information on the Program can be found can be found here.

How we can help

We have a wealth of experience advising clients on funding arrangements and other revenue support mechanisms with government entities, including ARENA and DCCEEW. We have also advised on a number of recent hydrogen projects in the Australian market and have a deep knowledge of the sector and its challenges. We are available to assist clients to best take advantage of this unique opportunity.