Carbon Contracts for Difference: A Solution to Investment Uncertainty or not?
Our latest Joule commentary (co-authored with Kenneth Bruninx and Erik Delarue) highlights that while CCfDs can reduce carbon price risk, no design fully eliminates it. How an investment’s return is affected by the carbon price depends on various external factors and is prone to change throughout time. In this blog, we summarise the main findings of our commentary.
Decarbonising industrial sectors like steel, cement, and chemicals is vital for achieving climate goals. However, investment decisions face postponement due to carbon price risk and uncertainty. Carbon Contracts for Difference (CCfDs) aim to address this challenge by providing financial guarantees and stabilising revenues for low-carbon investments.
Background on CCfDs
A CCfD works by guaranteeing, for a certain period, a fixed carbon price for an industrial project, reducing uncertainty about future CO₂ prices. The price guarantee may be defined in an auction, where different project developers bid in their required CO₂ price guarantee to realise their investment. A CCfD normally operates as a two-way contract between the government and a project developer, which means that reverse payments back to the government are also possible.
What does a CCfD aim to accomplish?
The goal is to de-risk investments in innovative, CO₂-reducing technologies by ensuring their relative competitiveness against traditional, carbon-intensive technologies is no longer dependent on the fluctuations of the carbon price.
The cost of emitting CO₂ is a fundamental driver for the competitiveness of a company that invests in a low-carbon technology compared to a company that relies on a traditional, carbon-intensive technology. If the carbon price is low, the cost advantage of avoiding emissions is minimal, making it harder for the company investing in a low-carbon technology to be competitive.
A CCfD helps in two ways: it reduces the uncertainty of carbon pricing and provides financial support to close the cost gap. CCfD’s payouts depend on the difference between a pre-agreed strike price and the actual carbon price, multiplied by a benchmark that reflects the considered industrial product’s carbon intensity.
Selection of the benchmark
A benchmark in a CCfD determines the reference emissions level or cost against which the contract compensates the project. It determines by how much the payout should fluctuate with the carbon price. It is essential because it defines how much CO₂ a project is expected to avoid compared to the traditional technology. The CCfD then pays the project based on the difference between the CO₂ market price and the strike price agreed in the contract, multiplied by the difference between the benchmark emissions factor and the project’s emission intensity. A well-chosen benchmark ensures fair compensation and prevents over-subsidisation.
In the case of hydrogen production, for instance, the benchmark could be based on the emissions from Steam Methane Reforming (SMR), which is currently the dominant method for producing hydrogen. SMR typically emits around 10 kg CO₂ per kg of hydrogen, so a CCfD for electrolysis-based hydrogen could compare its emission savings to this benchmark. In steel production, a benchmark could be set using traditional blast furnace emissions, which release approximately 1.8 tonnes of CO₂ per tonne of steel. In the chemical sector, defining benchmarks is more complex due to the diversity of processes and global market conditions. Ethylene trade, for instance, occurs on a global scale where CO₂ pricing is inconsistent, making it difficult to establish a meaningful benchmark that ensures fair compensation while maintaining competitiveness.
What is important in the contract design?
The contract design of a CCfD is crucial for ensuring its effectiveness in reducing CO₂ emissions while maintaining economic efficiency. Three elements are particularly important: the selection of the benchmark, the allocation of risk, and the clawback on the payout.
Benchmark selection is a critical element, as it sets the reference emissions level used to calculate payouts. Defining an appropriate benchmark is particularly challenging in sector-wide applications. In that case, benchmarks need to be selected for each industrial product within the sector that is eligible in the auction. Setting them poorly might lead to a product being favoured or disadvantaged. Selecting the right benchmark is essential to avoid overcompensating projects while ensuring adequate financial support.
Risk allocation is also a key consideration in contract design. A fundamental question is whether the CCfD should cover only CO₂ price risk or extend to operational cost risks as well. Striking the right balance is difficult, as a broader coverage increases financial security for low-carbon investments but raises the cost of the program. Including an opt-out clause or exploring alternative mechanisms, such as unilateral CCfDs, can enhance flexibility and make the scheme more adaptable to changing market conditions.
Finally, implementation complexity must be managed carefully. Compared to simpler subsidy schemes, CCfDs require more administrative effort due to their more complex design. However, their two-way nature, which allows excess profits to be clawed back when market prices exceed the strike price, enhances their political appeal. This feature enhances public acceptance by ensuring that subsidies do not result in excessive windfall profits for the industry, while still providing downside protection against volatile CO₂ prices.
We elaborate on these issues in our recent commentary in Joule.
