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Why Carbon Contracts for Difference could be the policy measure Europe needs to decarbonise industry

August 25, 2022 Work Area: Carbon Capture, Zero-Carbon Fuels

The EU has set a comprehensive plan to achieve its goals under the Paris Agreement, committing to achieve net-zero greenhouse gas emissions by 2050.  

Decarbonising Europe’s industry is essential to achieving these goals, considering industry is responsible for about 22% of the bloc’s emissions – according to UNFCCC and European Environment Agency data. Industrial decarbonisation is also an opportunity for Europe to secure the long-term competitiveness of its industrial sector in the global marketplace. 

However, industrial decarbonisation is far from an easy task to achieve and the longer we ignore it, the harder it will become. Heavy industry is particularly challenging to decarbonise as many production processes rely on fossil fuel combustion to generate high temperatures, which are difficult or impossible to reproduce with electricity. Other industries release CO2 from the core chemistry of the process – accounting for 60% of emissions from cement production. To significantly reduce emissions, technologies like carbon capture and storage and low-emission hydrogen will be vital. But deploying these technologies at sufficiently large scale has not been a policy priority yet. 

Comprehensive climate policies need to be a priority 

Sound low-carbon technology innovation and deployment policy frameworks are a guiding component of any effective climate-neutral strategy. The fast and large-scale deployment of mitigation technologies is only possible if we commercialise them, achieving cost reductions and required infrastructure build out.  

Overcoming cost-related barriers will have to be achieved through learning-by-searching (i.e., the development of cutting-edge technological solutions), learning-by-doing (i.e., cost reductions associated with scaling production and technology development), and other innovation processes that can significantly reduce costs and guarantee comparability in terms of economic viability. For this reason, we must broaden and enhance innovation policies that support the uptake of low-carbon technology, with the ultimate goal of allowing comprehensive climate policy to drive technology deployment. 

In order to bridge this commercialisation gap, a variety of policy options are currently being put forward: the EU taxonomy, Carbon Border Adjustment Mechanism (CBAM), the revision of state aid guidelines for energy and climate and the EU Energy Taxation Directive, as well as green public procurement or carbon price floors. 

Although these options can prove potentially very helpful for enabling cross-sectoral emission reductions, we need further targeted action to tackle the problem at its core: there is currently no viable business case for commercial-scale investments in some low-carbon technologies. Additional instruments are necessary that, on the one hand, promote and foster the innovations needed, and on the other, support the investments required.  

Introducing Carbon Contracts for Difference 

One potentially attractive policy instrument, first described by Helm and Hepburn (2005) and first recommended by Richstein et al. (2017), could be for public bodies to award “Carbon Contracts for Difference” (CCfDs).  

The idea behind CCfDs is for national governments to offer long-term contracts to pay for the difference between the current carbon price and the actual CO2 abatement cost. 

At the EU level, the commission is planning to roll out CCfDs as part of its REPowerEU scheme and its proposed EU Emissions Trading System (ETS) revision to support a switch of the existing hydrogen production in industrial processes from natural gas to renewables and the transition to hydrogen-based production processes in basic materials industries such as steel-making. 

Although the discussion around CCfDs is relatively new, they are receiving widespread recognition as one of the most promising options to decarbonise Europe’s industry. Policymakers, industry, and academia recognize them as useful bridging instruments to spark the development of decarbonised industrial sectors, without having to wait until Europe is politically and economically ready to accept higher carbon prices, pay a premium for low-carbon products, or implement an internationally negotiated set of carbon border adjustments. 

How do Carbon Contracts for Difference work? 

CCfDs can be an effective and economically efficient tool to trigger emission reductions in various industrial sectors by incentivising the adoption of decarbonisation technologies. While existing CfD (Contract for Difference) schemes are primarily designed to support the deployment of low-carbon electricity generation linked to already established technologies, CCfDs mark a cross-sectoral, technology open approach that allows sufficient targeting. 

They also guarantee investors in innovative low-carbon projects a stable revenue stream from carbon savings by providing a certain fixed price that compensates for the additional cost of CO2 emission reductions above current carbon price market levels. By doing that, CCfDs cover the additional costs of climate-beneficial production technology and serve as a long-term security mechanism for investors in an uncertain nascent market. 

CCfDs can be utilized as a policy instrument to spark the development of markets for low-carbon hydrogen and basic materials such as steel, cement, and chemicals, by creating contracts for difference on the actual associated emission reduction cost and the carbon price producers would pay when sticking to the conventional high-carbon production.  

Essentially, they function in a similar way as current tendering systems for renewable energy do, but instead of paying the difference between the electricity strike price and the electricity market price, the public counterparty would pay the difference between a fixed competitive price (CO2 strike price) and the actual CO2 reference price in the EU ETS

So, in a CCfD, a commercial entity and a public body agree on a carbon strike price (in €/t CO2 eq) for a specified time period. In each year over that period, if the actual variable reference price is below the agreed contractual price, the public counterparty would pay the company/investor the difference between the strike price and reference price (e.g., realized average EU ETS allowance price). If the actual reference price is above the agreed contractual price, the commercial buyer compensates the contract seller for the difference (see also graph below). 

Source: graph based on “Carbon contracts for difference: an essential instrument for European industrial decarbonization,” Climate Policy Journal, 2020 

CCfDs bridge the gap in costs (linked to the carbon abatement cost of the technology) between conventional and low-carbon alternative technologies, compensating the investor for cost differences between a low-carbon product and a conventional carbon-intensive product.

Switching production from a conventional, carbon-intensive reference technology to a low-carbon emitting/carbon-neutral technology adds additional costs: transformation costs.

Allocating these transformation costs per tonne of raw material/basic commodity (e.g. steel, cement, etc.) results in additional costs (EUR/trm). Additional costs for investments (Δ CAPEX) need to be annualized and together with additional operating costs (Δ OPEX) allocated to the production volume. 

The CO2 abatement costs are the ratio of additional costs (EUR/trm) and the carbon abatement that results from switching production from a reference technology [x] to a low-carbon technology [y]. 

The average CO2 abatement costs set the contract price (CO2 strike price). 

On this basis, a company and public body (e.g., national government) conclude a Carbon Contract for Difference

A simplified example to illustrate how CCfDs can work in practice

Consider two energy-intensive industrial companies which produce steel within the EU.  
Company X produces steel using conventional technology and has production costs of EUR 500 per tonne and must additionally spend EUR 75 on emission allowances (EUR 50 per tonne of carbon dioxide) for the carbon emissions generated in the production process (1.5 tonnes of carbon dioxide per tonne of steel produced). So, the total production costs for company X amount to EUR 575 per tonne of steel.  
Company Y uses a (near) CO2-neutral manufacturing technology (e.g., green hydrogen-based direct reduced iron) and therefore has higher production costs of EUR 680 per tonne. To support the adoption of this technology, it has been awarded a 10-year CCfD with a carbon strike price of EUR 120 per tonne of carbon dioxide. Each company produces 1 million tonnes of steel per year. 
Since company Y and the government concluded a CCfD, which balances the difference between the average market price for emission allowances per year (EUR 50 per tonne of carbon dioxide for the starting year) and the agreed carbon strike price (or carbon abatement costs), the annual subsidy for company Y can be calculated as follows (see also illustration below): 

Source: graph based on Agora Energiewende, 2019 
Carbon strike price (EUR 120 per tonne of carbon dioxide) minus average emission allowance price (EUR 50 per tonne of carbon dioxide) = 70 x 1.5 million (multiplied by 1.5 million tonnes of abated carbon from producing 1 million tonnes of steel per year) = EUR 105 million. 
A ”carbon price risk” in the amount of EUR 105 million is removed from company Y’s innovative climate-beneficial production making it cost-competitive with company X’s conventional production technology.  
If we fast forward five years and assume an average emission allowance price of EUR 100 per tonne of carbon dioxide for the contract’s halftime (and assume all other parameters remain unchanged), then the payment to company Y would reduce to: Carbon strike price (EUR 120 per tonne of carbon dioxide) minus average emission allowance price (EUR 100 per tonne of carbon dioxide) = 20 x 1.5 million (multiplied by 1.5 million tonnes of abated carbon from producing 1 million tonnes of steel per year) = EUR 30 million. 
To cut the cost of decarbonisation significantly, the best solution is to provide investors with a predictable carbon price, which puts a broad portfolio of low-carbon technologies on an equal footing in competitive terms with high-carbon technologies. As long as the carbon strike price is set at an appropriate level, upfront capital investment becomes attractive. 

Decarbonising Europe’s industry, specifically its basic materials production, is crucial to achieving the goal of climate neutrality. As the bulk of emissions originates mainly from cement, iron, steel, and a few chemical feedstocks, any new investment in these industries must be compatible with the EU’s climate ambitions. Carbon Contracts for Difference can be the instrument that directly supports these investments, and they offer the potential to fill the gap in the current policy framework to decarbonise Europe’s energy intensive industries. CCfDs are also critical as they can provide for risk and cost sharing between public administrations and industry, while at the same time ensuring the joint goal of industrial decarbonisation. Ultimately, their significance lies in creating a successful business environment for commercial-scale investments in low-carbon technologies, a prerequisite for Europe’s path towards deep industrial transformation, which is why their swift implementation is essential. 

This is part one of a series of posts exploring CCfDs. Please find part two here: Why are Carbon Contracts for Difference gaining popularity in Europe? 

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