Low carbon hydrogen could play a significant role in the UK’s decarbonisation strategy, but delivering viable hydrogen projects depends on securing the financing needed to make them a reality. Hydrogen offtake agreements sit at the heart of that process, being a key consideration in determining whether a project is bankable.
Given the hydrogen market is in the early stages of development, the structure and allocation of risk in hydrogen offtake agreements continue to evolve. In this article we highlight why these offtake agreements are so crucial to project success and detail the key elements that parties should consider when negotiating hydrogen offtake arrangements.
The importance of offtake agreements is best understood in the context of the lifecycle of a typical hydrogen project. Today, developers will generally participate in the UK Government’s Hydrogen Allocation Rounds (HARs), through which successful projects are awarded a Low Carbon Hydrogen Agreement (LCHA).
The LCHA provides contract for difference style support over a 15 year period, bridging the cost gap between low carbon hydrogen and fossil fuel alternatives. In addition, successful projects may apply for partial upfront capital expenditure (CapEx) support through the Net Zero Hydrogen Fund.
While the LCHA significantly enhances revenue certainty and the Net Zero Hydrogen Fund may contribute to upfront CapEx, a developer must still secure substantial additional financing to cover the remaining CapEx and deliver the project.
Lenders and investors will require evidence of adequate and predictable demand for the hydrogen produced. This is where offtake agreements become critical. Developers will typically need to demonstrate credible offtake demand at the bidding stage. Following the award of an LCHA, developers will often need to finalise offtake agreements in order to secure project financing and reach a final investment decision. In this way, offtake agreements are not simply commercial arrangements but a fundamental component of the project’s bankability and ultimate commercial viability.
Developers typically require long-term contracts to support financing, but offtakers in the hydrogen market may be reluctant to commit to extended periods in the context of:
uncertain demand from customers for hydrogen;
rapidly-evolving technologies that may produce hydrogen in a more cost effective manner;
concerns that competing alternative fuels will prevail over hydrogen, eroding demand from customers even further,
all within an ever-changing political landscape where net zero mandates are decreasingly part of the political consensus.
Accordingly there is often a real tension between the developer’s need for certainty into the medium and long-term, and the offtaker’s desire for agility in a rapidly-changing market.
The need to adequately address the impact of changes in the regulatory environment goes hand-in hand with deciding an appropriate contract duration. In particular, changes to the gas licencing regime are to be anticipated (the current licencing regime is set to be repealed once the relevant section of the Utilities Act 2000 is brought into effect).
Careful consideration needs to be given to whether an offtake agreement should be terminable if regulatory changes undermine the original intent of the agreement, or whether suitable risk-sharing mechanisms can enable the agreement to continue.
Offtakers in particular may be unwilling to assume risks (whether supply or pricing risk) associated with regulatory changes that solely relate to the specific supplier and/or its technology.
Conversely, developers and lenders will require a degree of certainty around revenue streams requiring the sharing of some regulatory risks with limited “escape chord” termination rights for the offtaker (especially any offtaker termination rights that relate to the commercial viability of the supply from the offtaker’s perspective).
Pricing may prove a complex element of a hydrogen offtake agreement. While the LCHA provides a degree of revenue support to producers, this does not eliminate the need for commercially viable pricing arrangements between developers and offtakers.
Parties may find it relatively easy to agree on a price at “day one”, but long-term offtake agreements will often provide for some kind of price review.
Price review clauses can be beneficial to developers (particularly where the cost of inputs is uncertain and cannot be secured for an equivalent period to the offtaker agreement) but the mechanism needs to ensure that the price post-review secures the developer’s required costs and margins.
Offtakers will often push-back against such pricing mechanisms: they shift the economic risk of viability of the developer’s process onto the offtaker.
On the other hand, an offtaker may want to include a price review mechanism that keeps the cost of supply in-line with market conditions, so as to avoid a significant divergence from the future market price of hydrogen and the price attained under the offtake agreement. Without careful boundaries, such mechanisms can undermine bankability, exposing the developer to too much market pricing risk.
Closely linked to both duration and pricing is the allocation of volume risk.
Developers, and their lenders, will typically require a minimum level of committed offtake to ensure predictable revenue streams, often reflected in take or pay obligations. However, in a developing market where demand for hydrogen is still maturing, offtakers may be reluctant to commit to fixed volumes, or propose minimum volumes that are low.
This creates a fundamental tension: firm volume commitments support project bankability, but may be commercially unattractive to offtakers.
The juggling act between the parties in seeking to mitigate the risks to both will determine whether an offtake agreement is bankable to the developer's lender.
As the UK hydrogen market continues to develop, the importance of robust and bankable offtake agreements is expected to increase.
While government support mechanisms such as LCHAs and Net Zero Hydrogen Fund funding provide critical foundations by addressing revenue risk and providing support for CapEx funding, they do not remove the need for additional finance or the financial certainty to attain this additional funding, and that requirement for additional funding will usually result in a carefully structured offtake agreement.
In terms of offtake agreement terms and structures, there is unlikely to be a “one-size-fits-all” approach. The terms of any offtake agreement will need to reflect the specific characteristics of each project, the nature of the offtaker and account for an evolving regulatory framework and the maturity of demand in the relevant sector.
One thing that will apply across the board is this: early engagement between developers, offtakers and financiers will be key to identifying potential points of tension at an early stage so that expectations and requirements are pitched at a realistic level. Such an approach will help avoid delays, reduce development timescales and costs and ultimately contribute towards achieving the UK’s decarbonisation objectives sooner.
For further advice on hydrogen offtake agreements, please contact our energy team.
