UK hydrogen strategy update and business models for transport and storage

On 2 August 2023, the UK Government released its response to, and details of its "minded to" positions on, its August 2022 consultation on business model design, regulation, strategic planning and the role of blending in hydrogen transport and storage infrastructure.

The documents were published on the same day as the UK Government’s update to the market on its broader hydrogen strategy, which confirmed that a second allocation round (HAR2) will be launched later this year with the intention to award contracts for a significant increase of 750MW of green hydrogen capacity in 2025 (up from the 250MW of capacity expected to be awarded from the first allocation round this year). Following HAR2, the Government has announced that it intends to transition to an annual, price-based competitive allocation for Low Carbon Hydrogen Agreements (LCHA) by 2025 for electrolytic projects. There is currently a call for evidence on the subject, which closes on 11 August 2023.

The Government has an ambition to build up to 10GW of new low carbon hydrogen production capacity by 2030 (a doubling of the ambition set out in its original 2021 Hydrogen Strategy). The publication of the full draft Low Carbon Hydrogen Agreement on 9 August 2023 is progress towards the Government’s goal of awarding the first contracts under the contract for difference-style Hydrogen Production Business Model in Q4 this year, albeit that full delivery will depend on the passing of the Energy Bill (which is currently anticipated this autumn) as well as further development of industry standards and guidance.

Designing and delivering the infrastructure to transport and store this hydrogen will be critical to the broader implementation and success of the hydrogen market economy in the UK. The Government has highlighted particular barriers to the growth of hydrogen infrastructure in the UK, such as uncertainty around supply and demand, and the location and sizing of transport and storage assets.

The risk of stranded hydrogen production assets is also heightened if a strategic transport network is not effectively delivered. As part of the process of addressing these barriers and as a way of bringing stakeholders alongside in the development of the hydrogen network, the Government has emphasised in these more recent publications that it will take a holistic and transparent approach to the development of the hydrogen network, to demonstrate a clear commitment to hydrogen and expand the initial user base.

Hydrogen transport: RAB plus external subsidy top up

The Government’s business model to support hydrogen transport infrastructure (which will be designed for implementation in 2025) will initially focus support on the transport of hydrogen as a gas via large-scale onshore pipelines.

This approach aligns with the needs of early hydrogen production projects and with the view that pipelines are the most cost-effective way of scaling up hydrogen transport. Government will still work to understand the need for support for other transportation options e.g., offshore pipelines, vehicles, and as ammonia, all of which have a potential role to play in an enduring hydrogen transport network.

Government’s minded to position is that a regulated asset base (“RAB”) model will form the basis of the transport business model. A RAB model is a common feature in the UK energy and infrastructure market, used for gas and electricity transmission and distribution networks, the water sector and is being used for the CCUS CO2 transport and business models, as well as Government’s new nuclear programme.

Under a RAB model, an economically regulated “user pays” approach allows a private company owner of an infrastructure asset to receive an “allowed revenue” (covering certain building blocks, including a return on capital, depreciation, operating costs, decommissioning and tax) from charges paid by users of the infrastructure. The regulator (which, under the Gas Act 1986 is currently Ofgem for hydrogen) ensures that charges to users are fair and not prohibitive and manages efficiency incentives for the provider which aim to mimic the incentives that would be generated by the provider if it were operating in a competitive market.

More detail on the RAB model for hydrogen transport, which will be implemented pursuant to regulatory powers proposed in the Energy Bill, is expected by the end of the year. Government has noted that the hydrogen transport RAB framework will likely follow the natural gas RAB design, although it will need to be adapted during the initial hydrogen market growth phase. During the consultation, many stakeholders made the point that there would need to be compatibility between the hydrogen RAB framework and the existing gas RAB model to aid the transition from natural gas to hydrogen.

The Government has also indicated that it is minded to provide further subsidies alongside the RAB framework to avoid high up-front costs being imposed on the hydrogen transport user base during the growth phase. This external subsidy will be provided to the hydrogen transport provider by means of a private law contract (similar to the renewables Contract for Difference and the proposed Low Carbon Hydrogen Agreement for hydrogen production projects) to top up the difference between what a hydrogen transport provider can fairly recover from an initial user of the infrastructure and the allowed revenue under the RAB model. This is a model we have seen being proposed in other sectors, such as CCUS and nuclear where, as part of Government’s support package, the relevant entity has the benefit of a revenue support agreement to provide a top up in revenues. The Government’s subsidy scheme is expected to come under a great deal of scrutiny to determine whether the support offered will be sufficient to provide certainty for stakeholders.

It is not yet known how the external subsidy scheme would be funded but options include the Exchequer and/or a levy, the latter of which the Government is seeking to provide for under amendments tabled to the draft Energy Bill.

Hydrogen storage: revenue floor

The Government has previously set out its initial hydrogen storage strategy in the British Energy Security Strategy (which can be found here). Hydrogen storage will be vital to ensure that the balance between hydrogen demand and production levels can be properly managed. The Government has stated that its intention is for the hydrogen storage market to have several competing firms to create large numbers of storage facilities, on the basis that hydrogen storage as an industry does not present the same natural monopoly characteristics as the hydrogen transport industry. Government has also acknowledged that hydrogen storage is a strategic asset, meaning that it has wider systemic benefit and capacity should be oversized to accommodate potential future demand.

The Net Zero Hydrogen Fund and Hydrogen Production Business Model at present do not offer sufficient support to bring forward investment in storage facilities, particularly geological storage facilities which would have the longest lead times (up to 10 years) and be the most capital intensive. Government has, therefore, stated it is minded to offer support to storage providers under a specific business model to give confidence to investors that the storage facilities will generate sufficient revenue and enable providers to price competitively and attract users.

In line with other similar schemes, the business model will provide support in the early growth phase and be reduced over time as a competitive market develops. The key risk and barrier to investment that the Government has said it will provide protection against is demand risk, being the risk that facilities are not able to make enough revenue from sales to cover costs, on the basis that it considers this to be beyond the control of the storage developer and one that investors cannot afford to bear.

As a result, the Government is minded to implement a ‘revenue floor’ business model; a minimum revenue amount would be due to the facility provider, regardless of the extent to which the facility is used (provided the facility was available to use). The floor would be equal to the total capital costs of creating the storage facility, plus fixed operational costs, plus some return on capital investment (albeit this would be a low amount).

Consideration is still being given to a mechanism which would ensure that if revenues were particularly high, the transport provider would be expected to make payments to the subsidy provider, either in the form of a cap and floor regime (which has been successfully used for interconnectors in the UK) or a gainshare arrangement. Alternatively, the Government may look to take an equity stake in exchange for awarding a business model and thus benefit from profits made.

To mitigate any complacency risk, the Government will incentivise developers to ensure maximum revenue capabilities by only reducing the subsidy revenue by an amount less than the increase in user revenue; the net effect is that storage facilities will have greater total revenue if they are able to attract more users. The Government has also stated that part of its subsidy may factor in an availability requirement. Failure to meet the availability requirement would see a reduction in the revenue floor.

It is anticipated that the subsidy for storage will be delivered on a private law contract model (with the Government counterparty likely to be the LCCC, although this has not been confirmed), however, the Government has not entirely ruled out the possibility of using a public-law based scheme (although has set out its rejections for such public schemes in its report). The subsidy support is expected to be available for at least the first 15 years for geological storage. The Government has not indicated how long any support would be available for other storage facilities. Funding for the subsidy will either be from the Exchequer or a levy, powers for which are being sought through the Energy Bill.

We anticipate an update from Government on the hydrogen storage business model with further detail and allocation criteria by the end of 2023.

Hydrogen blending

Hydrogen blending, where hydrogen is mixed or ‘blended’ into existing gas distribution networks, may help to provide market-building benefits for the hydrogen economy by effectively providing hydrogen transport and storage providers with a “reserve offtaker” thus reducing the levels of demand risk. A broader policy decision on whether or not blending will be enabled by Government is expected later this year and will follow a further consultation on the potential benefits and risks, as well as the means of delivery.

Strategic planning

Given the geographical locations of hydrogen producers and end users as well as the complex interrelation of the wider energy system as it decarbonises, Government has confirmed that the Future System Operator (“FSO”), a new publicly-owned body to be given statutory footing pursuant to the Energy Bill, will take the lead in the strategic planning of hydrogen transport and storage infrastructure.

The FSO will also be the system operator and planner for electricity. Hydrogen market-led development will potentially play into the decisions made but to achieve the large-scale integration with the rest of the energy network, central and strategic leadership by the FSO is seen as vital. Further consultations will take place to consider the interaction of the roles of the FSO with the National Grid and Ofgem as well as Government. The aim is for the FSO to be operational in 2024.

Government’s 2026 decision on the role of hydrogen in decarbonising heat will have important implications for the scale, location and nature of any hydrogen network and further highlights the need for centralised oversight as the hydrogen transport and storage network grows. A ‘hydrogen networks pathway’ of the next steps in Government’s vision for the development of hydrogen transport and storage is expected by the end of 2023 and may well provide further insight into Government’s role and view on strategic planning of the network.

Legislative and regulatory framework

Hydrogen falls under the definition of gas in the Gas Act 1986, under which Ofgem is the economic regulator and issuer of licences. However, Government has noted that there will be ‘complex policy-trade-offs’ when considering which hydrogen projects will be built, where and when, and the Government is seeking additional powers under the Energy Bill to allow the Secretary of State to grant, extend, restrict and modify gas transport licences insofar as they relate to hydrogen.

It will be crucial to get the right support at the right time to enable the interrelated elements of hydrogen production, transport and storage to be successfully delivered as the nascent hydrogen market grows; the additional powers sought by Government in the near-term are understandable in this context. The longer-term configuration of roles between the FSO, Ofgem and Government has yet to be decided as noted above and the market will be watching closely to see how this develops.

Whether or not changes are required to existing regulatory provisions on transport, shipping, storage and supply under the Gas Act 1986 will be kept under review. Such changes will be likely in view of the Government’s aim to facilitate delivery of a successful, independent hydrogen market; they will be dealt with on an iterative basis with calls for evidence, consultation and relevant regulatory amendments as and when required. Associated industry commercial arrangements may also need to be developed specifically for hydrogen (such as an equivalent of the Uniform Network Code).

Government will continue to work closely with industry and regulatory bodies to develop the regulatory framework for hydrogen. Environmental regulations will be a key focus of this ongoing exercise, particularly given the importance of minimising leakage of hydrogen from transport and storage infrastructure now there is broader acceptance and understanding of the indirect global warming potential for hydrogen.

We will continue to monitor developments on all aspects of UK policy and regulation on the role of hydrogen in the energy transition and will provide updates in due course. Please do get in touch if you have any questions or would like to discuss any of these developments in more detail.