Price setters for the hydrogen market – the question of indexation

The hydrogen industry is undergoing a significant transformation, requiring a shift from high-emission processes to cleaner production methods, such as electrolysis with renewable or low-emission power. The demand for hydrogen is also expected to change, with applications expanding beyond traditional uses like fertilizers and petrochemicals to more challenging sectors like steel, high-heat combustion, and certain forms of transport.

The market is looking to other, more traditional markets for guidance, and that may be forthcoming from the natural gas arena. In the past, the lack of information and transparency of natural gas markets posed challenges for financing new projects related to natural gas. Long-term sales contracts were sought to determine the fair market value of the commodity and secure financing. These contracts often used indexation to track market changes over time.

Oil was the more established commodity used for indexation in the case of natural gas. This article compares the historical use of oil as a reference for natural gas pricing and the current challenge of finding a comparable connection for hydrogen pricing. The choice of a reference commodity for hydrogen indexation is complex due to its diverse applications and production methods. Hydrogen can be derived from water electrolysis or natural gas reforming, with the latter being a dominant method but producing emissions.

Supply chains need to adapt to the new world order

The intricate and well-established supply chains are at the heart of this transition to a low-carbon energy future. These supply chains must be completely overhauled from high-emissions processes to cleaner, greener production methods such as electrolysis powered by renewable or low-emissions power. Natural gas reforming processes must also adapt to utilise carbon capture and storage (CCS) technology with high capture rates.

Further, the demand for hydrogen is also expected to change globally. Currently, hydrogen is predominantly used in fertilizers, refining, and petrochemical processes – markets that will absorb a lot of new, lower-carbon hydrogen supply as it comes online. But there is also the question of using hydrogen for other applications, specifically markets that are hard to decarbonise, such as steel, high-heat combustion, and certain forms of transport. In addition, some markets also consider hydrogen as a means of storing electricity, blending hydrogen, and potentially hydrogen heating.

Multiple large-scale investments will characterise this transformation. New hydrogen-producing projects need to be financed, with off-takers of the low-carbon hydrogen needing to invest in new technologies to adapt. Developing the core infrastructure to support transport and storage will prove critical to the broader development of the market. This highly dynamic landscape means market participants will require a consistent reference point to pivot projects.

Looking to natural gas market evolution for answers

Hydrogen markets today face a similar predicament to the development of the natural gas markets in Europe across the 1960s and 1970s. There is massive potential but a lack of information and transparency to bring that potential to reality.

During the mid-20^th century, after the discovery of natural gas at the Dutch Groningen field and later in the British section of the North Sea, project developers recognised the potential to extract and sell this supply into European energy markets. However, to do so would regularly require some kind of financing.

With any new commodity, there comes a question of fair market value. The logic is that, given the commodity is entering established markets, participants will struggle to measure its specific value. The absence of such price transparency can be particularly problematic when seeking financing, as leaders or investors would hope to understand their potential return on investment (ROI). Yet, without a clear understanding of the value of a commodity and how it might respond to fluctuations in supply and demand, such ROI is challenging to determine, meaning the chances of receiving finance could be impacted.

In the case of natural gas, to persuade banks to lend the money required to get projects off the ground, producers sought long-term sales contracts as proof of consistent and steady revenue. As these long-term contracts (LTCs) would generally be written for 20 years or more, market parties are required to track the sales price to capture market changes as time progresses.

The requirements for indexation

Were such LTCs to be written today, market parties would find no difficulty indexing them to gas hub prices, such is the established nature of the gas markets in Europe in 2023. However, tracking market developments from a price perspective for a commodity with a distinctive lack of pricing transparency can be problematic, as was the case for the first European LTCs. As such, market parties would seek to write into these contracts' formulae, referencing a more established commodity. In the gas of natural gas during the early years, the more established commodity was regularly oil.

Indexation requires two conditions if it is to work in a long-term contract. Firstly, the reference being used in the LTC should apply to a more liquid commodity that is established enough to accurately and speedily reflect changes to supply and demand across its price. Secondly, the market information used for indexation should be linked in some sense so that movements to the indexed commodity would justify a change in price under the LTC. In the case of natural gas, not only was oil a more established commodity with price transparency but at the time of initial LTCs, oil and gas were considered competing fuels. Therefore, movements in the oil price, which would reflect supply and demand fluctuations in energy markets, could also be considered to change the value of gas.

The success of such indexation meant that initial gas projects were financed, the European market grew, and liquidity increased to a level where gas pricing could be used for future LTCs. This was explicitly the case in northern Europe following the development of spot trading for natural gas towards the end of the 20th century and the progression of liberalised gas hubs in the early 2000s. Oil indexation is still used in southern Europe, where long-term contracts remain for gas deliveries from North Africa to Spain and Italy. However, the development of gas markets means that formulae can be balanced between oil and gas prices.

What does this mean for hydrogen pricing?

If this model is to be deployed for hydrogen pricing, then it needs an established commodity to link to, in effect, its oil. Unfortunately, this is a rather tricky question. Hydrogen has often been regarded as a silver bullet, a key to unlocking a decarbonised world. The reasoning behind that is hydrogen can be used across most sectors, meaning what could be considered a related commodity may differ depending on the buyer and use case.

Before reviewing potential leaders for hydrogen indexation, it is essential to consider support mechanisms. Hydrogen is primarily made, not found; it is a derivative of feedstocks and chemical processes. Some endeavours aim to change this dynamic, but the predominant means of acquiring hydrogen is, in simple terms, by extracting it from established chemical compounds. The clearest example is the separation of water, splitting the chemical bond between oxygen and hydrogen, H₂O, into just H₂ and O. However, hydrogen is also made from hydrocarbons, with the leading means of producing hydrogen being the reformation of natural gas (CH₄), resulting in CO₂ and H₂.

The point to be made here is that, given the two most-referenced means of considering hydrogen production, water electrolysis or natural gas reforming, hydrogen will always cost more than its feedstock and, therefore, likely more than the fuels or feedstocks market participants currently use. In the case of market participants who already use hydrogen, it is almost certain that such hydrogen will be made as cheaply as possible, implying it is natural gas-based hydrogen without CCS – the emissions worsen climate change.

The role of support mechanisms

Because of this, support mechanisms proposed by governments are vital to the adoption of low-carbon, clean, or renewable hydrogen, as they specifically aim to bridge the cost gap between high-emissions products and environmentally friendly hydrogen. As such, project developers and buyers of hydrogen face already see contractual structures being suggested because of support mechanisms themselves. For example, a contract for difference (CfD) type structure would likely imply that the subsidy is linked to an alternative commodity, such as natural gas or carbon, which would already set clear terms on the potential for indexation. CfDs have so far been suggested by the UK and German governments.

The European Commission's support mechanism, the European Hydrogen Bank (EHB), uses a fixed subsidy mechanism whereby a hydrogen producer is paid a set amount per kilo of hydrogen produced without linkage to another commodity. The Danish government also takes this stance. Between the two approaches, CfD and fixed subsidy, there remains greater flexibility for indexation for participants opting for the latter.

Parallel to these support mechanisms is the H2Global initiative, which operates via a double-auction programme. H2Global will purchase hydrogen or hydrogen derivatives from sellers, buying from the lowest-priced offer, and then distribute the hydrogen it purchases to the highest-paying bidders.

Searching for a liquid commodity to index hydrogen

All the above is crucial for considering hydrogen during the initial phase of the market. However, discussing indexation as a thought experiment also implies the absence of support mechanism structures and a return to the considerations of gas-market participants in the 1960s and 1970s: a related but more liquid commodity.

From speaking to multiple market participants on the prospect of indexation, there remain some apparent front-runner commodities for indexation, each with benefits and weaknesses. Natural gas was the primary commodity discussed for indexation across different producers (renewable and low-carbon hydrogen).

When considering the conditions mentioned, namely a related commodity with greater liquidity, natural gas regularly ticks both boxes for hydrogen market participants. However, it is essential to consider which market participants this would best apply to.

For most current hydrogen market participants, namely those buying high-emissions hydrogen, natural gas stands to reason as a solid base for indexation. This is because high-emissions hydrogen is predominantly made using natural gas, and when speaking to producers of such hydrogen, natural gas prices were a key influence in determining value. From a buyer's perspective, at least, maintaining a link to the natural gas market would carry a wealth of familiarity. Operations managers purchasing hydrogen from natural gas today would already be familiar with gas markets, their drivers, and critical considerations for the evolution of such markets from a price perspective, leaving less uncertainty on the table.

When considering natural gas for new market participants, namely participants seeking to switch feedstock from alternative fuel to hydrogen, the basis for natural gas as a point of indexation is slightly different and depends on the use case. Transport market participants may well take issue with the use of natural gas as a point of indexation following decades of price referencing to oil.

Notably, participants expressed a need for some indexation across multiple production types. In the absence of indexation, participants suggested that initial contracts would need to be set up with the opportunity to re-negotiate after five years. This is because the market is in such a significant growth phase that technology developments, such as higher efficiency or more accessible transportation, could reduce the overall cost, leaving the buyers at a disadvantage.

There is no doubt an urgent need for indexation across various production types or, in the absence of indexation, allowing for contract renegotiation after a certain period. This flexibility is crucial due to the dynamic growth phase of the hydrogen market, where technological advancements may impact costs, putting buyers at a potential disadvantage.

Read the article online at: https://www.globalhydrogenreview.com/hydrogen/18062024/price-setters-for-the-hydrogen-market-the-question-of-indexation/