Clean hydrogen – what you need to know

Opportunities and risks of a clean hydrogen economy

• Clean hydrogen and its derivatives are widely seen as key enablers for the decarbonisation of many hard-to-abate parts of the industrial, transport and energy sectors. Applications include chemicals, petrochemicals, steel, glass, but also shipping with hydrogen-processed methanol and ammonia, aviation with hydrogen-processed e-kerosene, and power generation with hydrogen-fired peak-load plants.
• The emergence of markets for clean hydrogen requires regulatory incentives. We see four pillars: a rising CO2 price, company-specific hydrogen quotas, hydrogen subsidies, and a regulatory framework that incentivises the construction and operation of sufficient hydrogen transport and storage infrastructure.

Carbon pricing

• The price of CO2 has risen significantly in both the EEA and the UK in recent years. While the price of an EU ETS allowance was €3 in 2012, it cost more than €100 for the first time in February 2023. As part of fitfor55, the EU has decided to gradually phase out free allowances for many hard-to-abate industries over the coming years. The number of auctioned allowances will also be linearly reduced each year, with the result that the EU member states will no longer bring any allowances onto the market from 2039. Based on current legislation, ETS prices will therefore be so high in the 2030s that, despite recent increases in costs for power plants and electrolysers, in many sectors the CO2 costs associated with fossil fuel technologies will be higher than the CO2 avoidance costs resulting from the use of (more expensive) clean hydrogen. 
• However, investing in a clean hydrogen economy in light of the current ETS framework is not without risk, as rising CO2 prices are accompanied by increased risks of carbon leakage. The recently introduced Carbon Border Adjustment Mechanism (CBAM) in the EU is limited in its ability to mitigate these carbon leakage risks, as it does not protect business models designed for export to third countries, and it currently only applies to raw and semi-finished products of particular sectors, but not to downstream products. To illustrate, the carbon footprint of crude steel imported from China will be subject to an ETS-equivalent carbon price, while, based on the current legislation, the carbon footprint of the steel inputs that have been processed into a wind turbine and then imported to the EU will not be subject to such a price. We see a significant risk that if the EU does not address such issues, it will either face significant carbon leakage effects, which would divert demand away from a clean EU hydrogen economy, or it will intervene in the ETS price to prevent these effects, which would also reduce demand for clean hydrogen. The other scenario, and in our view the more likely one, is that both the EU and the UK will extend CBAM, thereby plugging the leakage holes and allowing the carbon price to drive the clean hydrogen economy and benefit developers who have saved and built capacity in the right places at the right time.

Hydrogen quotas

• The EU is focused on transforming these price signals into incentives for the use of hydrogen and hydrogen derivatives produced by electrolysis of water, which qualify as Renewable Fuels of Non-Biological Origin (RFNBOs). Hydrogen and hydrogen derivatives are RFNBO compliant if they are produced using electricity from qualified renewable sources and have a greenhouse gas emission reduction of 70 percent compared to applicable fossil fuel comparators. Recent amendments to the Renewable Energy Directive II (REDII) require each Member State to ensure that 42 percent of the hydrogen used in industry is RFNBO-compliant by 2030 and 60 percent by 2035. Especially for the chemical industry, which already consumes large amounts of hydrogen in countries such as Germany, France and the Netherlands, this could be a significant incentive to use renewable hydrogen. However, this will eventually depend on whether Member States implement these obligations through company-specific quotas with sufficiently deterring penalties. In addition, company-specific RFNBO quotas or GHG reduction commitments with RFNBO compliance options have been adopted for the aviation and maritime sectors, largely effective from the 2030s.
• The specific definition for RFNBO-compliant hydrogen is spelled out in Delegated Regulations (EU) 1184/2023 and 1185/2023. Compliance with these criteria is challenging in practice and causes a significant increase in the unit cost of the electrolyser. This is because, in principle, grid electricity consumed by electrolysers commissioned after 1 January 2028 will only qualify as renewable if it comes from a power plant that is new, does not receive government support and produces electricity from renewable sources other than biomass. In addition, unless special circumstances apply, the power plant must be located in the same bidding zone as the electrolyser and, from 1 January 2030, produce the electricity in the same hour as it is either consumed by the electrolyser or stored next to the electrolyser. Furthermore, there is a rather sophisticated methodology for calculating the GHG emission reduction and the RFNBO mass balance. The combination of these rules means that certain business models in the hydrogen economy are prohibitively expensive. This is particularly true for the production of e-kerosene due to the requirement to proportionally allocate renewable hydrogen inputs under the Fischer-Tropsch procedure to co-products such as e-diesel, for which there is simply no market. Other RFNBO criteria create a high degree of uncertainty. An obvious example is the mandatory configuration of third countries into virtual bidding zone equivalents under the geographic correlation criterion, which de facto requires an examination of whether system-detrimental structural congestion exists in the transmission grid area of the third country concerned. 
• However, the RFNBO rules also offer opportunities: for countries with renewable or low-carbon bidding zones, such as France, Sweden, Norway, Uruguay or parts of Brazil, the requirements are significantly relaxed. In addition, there are some countries where weather conditions are particularly favourable for hydrogen production and where market design and grid topography make them well placed to qualify as a single bidding zone equivalent. Furthermore, a smart and well documented definition of grey and renewable intervals arguably allows the constraints of temporal correlation to be overcome, enabling the electrolyser to operate at full load almost 24/7. Moreover, it is rumoured that the Commission will approve the first voluntary schemes later this year to provide more clarity on the interpretation of the RFNBO criteria.

Subsidies

• Subsidies will be the main incentive for the clean hydrogen economy in the ramp-up phase. In the EU in particular, there is a plethora of different EU and member state subsidies for electrolysers, mid-streamers and customers. Prominent examples are the electricity price compensation for electrolysers, the H2Global programme in Germany and the Netherlands, the European Hydrogen Bank, but also the Important Project of Common European Interest (IPCEI) aid for direct reduction plants for steel producers, or in Germany the promotion of hard-to-abate industries through carbon contracts for difference, but also the promotion of hydrogen-ready power plants currently being considered by the government. Most of these subsidies are conditional, requiring the production or purchase of RFNBO-compliant or, in some cases, blue hydrogen. Challenges in practice arise from the fact that the various subsidies limit each other due to cumulation rules under national subsidy and state aid law.
• Meanwhile, in the US, the Inflation Reduction Act of 2022 offers tax credits for the production of clean hydrogen on US territory. The US Treasury Department first published its proposal for what should be considered as clean hydrogen in December 2023. The US approach focuses solely on the emissions released per kilogram of produced hydrogen. In this way, the concept of clean hydrogen is not limited to hydrogen produced using renewable electricity, but also open to technologies combining fossil energy sources with carbon capture and storage. However, with respect to the production of hydrogen by water electrolysis, the eligibility conditions under the Treasury proposal are very much in line with the EU RFNBO rules, making it a viable option to produce subsidised hydrogen in the US, process it there into ammonia or methanol, and then export it to the EU where it would be eligible under domestic schemes.

Transport and storage infrastructure 

• A well-functioning hydrogen economy requires the availability of sufficient transport and storage infrastructure. This is an area where we are seeing dynamic development in Europe. On the one hand, the EU legislators have agreed on a rather flexible unbundling approach compared to the Commission's initial proposal, which will make the transformation of natural gas networks into hydrogen networks easier in practice. On the other hand, significant progress is being made at country level.
• In Germany for example, the legislator is in the process of creating a legal framework, including a ramp-up concept, for the construction of a hydrogen core network; €20 billion is expected to be invested. Some final adjustments necessary to ensure the capital market viability of the concept are currently being discussed, but we see good prospects for the legislative process to be completed in Q2 2024.

We support our clients in all areas - on strategic advice, joint ventures, regulatory and state aid as well as commercial contracts. Our teams would be more than happy to support you on your energy transition journey and discuss any aspects with you. Please feel free to contact your usual Freshfields contact or one of the key contacts below if you have any questions.