As the appetite for giga-scale low-carbon hydrogen projects grows, major questions arise about what it takes to actually get these projects financed, built and into production at a speed and on a scale needed to meet Net Zero objectives. Elliott Sawford, Rachel O’Reilly and Christine Yassa look at some of the key learnings from live projects across the globe.

The spotlight is on the Middle East

Middle Eastern countries, notably the UAE, Oman, Saudi Arabia and Egypt, have expressed clear ambitions to be leaders in a future global green hydrogen market.

Oman’s Hydrom (owned by Energy Development Oman) is well underway with its auction process for awarding rights to develop green hydrogen projects in Duqm and Dhofar, and the Egyptian government is pursuing a significant pipeline of projects following the signing of framework agreements with a number of developers at COP27 in Sharm El-Sheikh in 2022.

In addition, many MOUs that could see significant production capacity built in the region have been signed.

But, beyond the basics of a site that offers the right natural resources for lowest cost production and logistics to access global markets, what is involved in moving from concept stage through to financial close on a low-carbon hydrogen project?

What can be learnt from the low-carbon hydrogen projects currently under development?

Three key decisions

Three key decisions made at the outset of a project will be the most significant factors in its journey towards financial close.

(a) Project perimeter

The extent to which parts of the production chain are included or excluded from the financing perimeter will greatly impact the risk profile of the project, and its passage towards financial close. For instance, will one project company own and operate the renewable generation facilities, electricity transmission assets, electrolysers and (if relevant) ammonia production assets? If the project is divided into its constituent parts, how will the resulting complex interfaces and “project on project” risk be managed? The consequences of a non-integrated project may be reduced equity and debt capacity and this approach will almost certainly increase the need for detailed due diligence and mitigation, including potentially increased sponsor completion support. On some projects, adopting a “non-integrated” approach is unavoidable for regulatory reasons. In other cases, advantages such as being able to access different pools of liquidity may make the added complexity worth it. In any event, splitting the production chain across different sub-projects will introduce added execution risk and the project timetable will inevitably be extended.

(b) Offtake strategy

Much has been written on the topic of low-carbon hydrogen offtake agreements. It is clear that the terms of a project’s offtake agreement(s) are imperative in providing the stable and assured cashflows needed to underpin an investible and bankable project. What is less obvious is how to secure such long-term revenue certainty in the context of nascent global demand for hydrogen and its derivatives and an uncertain pricing trajectory and global regulatory environment. Projects that have been able to do so have been able to get to financial close.

In practice, projects are generally following the lead of early LNG models, seeking to obtain long-term contracts with no price reopeners and damages payable for failure to lift. In the absence of a credible green hydrogen price index, investors and lenders will be wary about taking price risks and so pricing models are likely to be based on a “cost plus” approach for the foreseeable future. Different approaches are being taken to adopting single or multiple offtaker strategies, and offtaker types vary from localised use cases through to futures traders and export markets. Aligning interests by inviting offtakers to participate in the project equity is another tool that low-carbon hydrogen projects can use to secure their offtake commitments.

(c) Construction philosophy and completion support

Low-carbon hydrogen projects require the combination of multiple building blocks, and thus the procurement of disparate equipment and engineering skill sets. Given the need to procure renewable power energy generation, electricity transmission, battery storage, water, electrolysis, H2 storage, process plant and pipelines/export/bunkering infrastructure, while at the same time minimising construction cost and risk, clarity on the construction philosophy and any sponsor support to lenders needs to be established from the start. The availability of robust completion support will increase debt capacity and facilitate a faster financing process.

While there is no single “correct” answer to each of these structuring decisions (the approach to which will largely be driven by project-specifics and developers’ appetite for risk), the outcome of these decisions will have a significant impact on the success of a project.

In general terms, the simpler you can make the structure, the easier it is to get these deals to a final investment decision and to a successful financial close.

The right government support

To make hydrogen and its derivatives a viable alternative to other energy sources, it needs to be cost competitive. There needs to be significant investment in infrastructure and innovation that will lower costs of production through economies of scale and technological improvements. This requires government action. Only with clear policies, regulations and financial incentives from policymakers can the industry succeed.

But the terms of that support are critical. Governments who see this as a long-term investment, promising significant and sustainable financial and environmental returns, are far more likely to succeed in nurturing the development of green hydrogen at scale and in attracting investment. This has been most clearly demonstrated through the impact of the U.S. Inflation Reduction Act, the generosity and simplicity of which has re-directed investment and seemingly re-shaped future trade flows of hydrogen and hydrogen derivatives.

Global competition for investment is already fierce and is likely only to intensify.

Projects that can structure themselves to access that support and which benefit from a regulatory and policy environment conducive to speedy development of projects will be better placed to reach financial close.

For example, projects that design their offtake strategies so as to direct their product to Japanese or European markets may be able to benefit from support under the Japanese subsidy programme and H2Global regimes – and while dollars or euros of subsidy per tonne of hydrogen will grab the headlines, the “one-stop shop” and 18-month maximum permitting period envisaged under the Net Zero Industry Act will help hydrogen projects in Europe move more swiftly to financial investment decision.

Alignment of interests

Given the uncertainty that surrounds green hydrogen projects (for example, question marks over their technical performance, a current deficiency in bankability precedent and unpredictable development costs, to name a few), industry players are looking to partner up through joint ventures to promote synergies, share competencies and divide the risk.

Parties may also seek to enter into such joint ventures to benefit from their partner’s access to capital. Though the industry is still emerging, there is already some evidence that projects are more likely to reach financial close or final investment decision if parties are able to secure a long-term alignment through participation in equity.

Enhancing available liquidity

The level of government financial support for projects, as well as domestic liquidity, is pivotal in inspiring other investors to join the financing party and critical in getting projects across the line. Obviously, projects that can access a deep and diverse pool of financing, both public and private, have a significant advantage.

In addition, given the nature of the supply chain for green hydrogen projects, there is particular value in including export credit agency (ECA)-supported debt in the financing mix. For example, the biggest manufacturers of electrolysers are located in regions outside the Middle East, most notably in the U.S. and Europe. So where Middle Eastern projects involve key equipment coming from these jurisdictions, ECAs have an important role to play.

The appropriate precedent

Core to an investor’s assessment of project risk is the benchmarking of risks to those it has taken elsewhere and on what terms. But what is the appropriate benchmark for early low-carbon hydrogen projects? Is it closer to a power project with a watertight state power purchase agreement and tight debt service cover ratios, or a merchant petrochemical project with less risk transfer and more fat in the project economics? The projects more likely to achieve financial close will adopt a clear and consistent view to project risk allocation and financing terms that enable the application of orthodox credit decision-making. The even more successful projects, however, will structure themselves to get the best of both worlds.

Ability to deal with new issues

This remains a young industry with players on a steep learning curve in terms of technology, regulation, risk calculation and deal structuring. Successful projects will need to overcome a number of new issues that have not been worked through before, and on which there is no “go-to” precedent.

For example:

(a) How green is my hydrogen?

In the absence of agreed international standards on what qualifies as “green” hydrogen, projects face a dilemma in making a product that will meet buyers’ environmental expectations and/or meet the standards needed to secure subsidies or a “green premium”.

In agreeing offtake contracts, project developers and buyers must decide what criteria they will use to judge how green the hydrogen being sold is. Is it best to do this contractually or by reference to some external legal standard?

How then do you take account of changes in regulation and who is best placed to take this risk?

What happens if the product fails to meet an agreed green standard? Does this result in a price reduction? Does the product get reclassified as grey hydrogen and sold on that basis? If so, what is the impact on price, and how does that affect debt sizing? Can the buyer reject the product if it fails to meet the green requirements?

And finally, should parties agree to a process of self-certification, or rely on an independent third party to carry out that process? The latter option is difficult at a time when international standards are only just beginning to take shape. Participants may want the flexibility to pivot to such a standard when it becomes available.

(b) When is the project “complete”?

Reaching agreement over when an industrial plant has reached a required level of demonstrated operations such that committed equity support can be released is a critical question on all projects. In the context of a first-of-a-kind hydrogen or ammonia production plant, this is even more challenging. Do developers have to demonstrate a level of performance from the integrated project, or can they agree to a more modular approach, signing off on the constituent parts, from renewable supply, through to production, export, and sale?

(c) What should the electrolyser supply terms be?

Funder expectations as to performance warranties and long-term service provision for renewable generation equipment is well established. This is not the case for energy transition supply chains, including electrolysers where the size of the market is expected to grow to USD3.7 billion by 2032.

Manufacturers of electrolysers sometimes argue that they do not yet have sufficient data on which to base an offer of extensive warranties, although this issue should change as the technology matures. Developers may also look for far greater flexibility in the long-term servicing arrangements for such equipment so that they can take advantage of future improvements in the technology and potentially reduced prices down the line, possibly by switching to alternative suppliers as they emerge.

This presents a challenge for lenders, who typically look for far greater financial certainty around these arrangements from the outset, sizing debt and reserves accordingly. It is important for developers and lenders to work with advisors who understand the technology and can translate the challenges it presents into appropriate and realistic contractual arrangements.

(d) Is the water supply a utility or critical feedstock?

The supply of renewable power is clearly a critical factor in any green hydrogen project, but it is not the only one. The supply of water is also a vital element, given that 9kgs of water is required to produce a kilogram of hydrogen.

Typically, water required by industrial process plants is treated as a utility supply, with contracts based on standard terms with limited risk transfer. For hydrogen projects, a key question is whether water should be treated more like a critical feedstock, with supply contracts including remedies for the project developer if there is any shortfall in supply, or if the water is of the wrong quality.

This is particularly the case where desalinated water is used, given that desalination is a carbon-intensive process, so use of water produced in this way will affect the overall carbon intensity of the hydrogen being made and potentially its ability to meet “green” requirements.

Challenges ahead but a bright future

Low-carbon hydrogen could drive cross-sector decarbonisation in transport, industry and power. While hydrogen’s exact role in a low-carbon energy system is hotly debated, we are expecting significant levels of activity in the green hydrogen market over the coming years. It has enormous potential, but we are only beginning to tap into the possibilities. This is a crucial time for the industry’s growth and its impact on the world’s Net Zero goals.

Nevertheless, this is a nascent industry and, despite early successes in getting large scale projects over the financing line, many challenges remain in bringing green hydrogen to scale. Developers, project financiers and buyers of the end product, helped by expert advisors, have many issues to work through if we are to fully exploit the potential benefits of this game-changing clean energy resource.