Designing Carbon Contracts for Difference

Introduction

As European governments face up to the challenge of reaching net zero greenhouse gas emissions by 2050, they are increasingly looking at how to deal with ‘hard-to-abate’ sectors of the economy, including heavy industries such as the production of cement, steel, and chemicals. These industries, which collectively represent around 20% of Europe’s CO₂ emissions, include many processes which are not currently possible to electrify or produce CO₂ from chemical reactions inherent to the process. Approaches to decarbonise these sectors often require either carbon capture and storage or the use of zero-carbon fuels such as hydrogen; unfortunately, both of these routes currently carry a relatively high carbon abatement cost. In other words, the additional cost incurred to cut a tonne of CO₂ emissions can be greater than the cost of CO₂ under the European Union Emissions Trading System (EU ETS) – even at the record high levels reached by the ETS in 2023 (100 EUR/tonne in February).

While the ETS is expected to eventually rise high enough to drive industrial decarbonisation, many governments are now choosing to implement policies that can cover the prevailing cost gap, helping industries to cut emissions in advance. The emerging policy of choice for this task is the ‘carbon contract for difference’. Originally a concept from the financial sector, the ‘contract for difference’ has been used to great effect in the UK for deploying low-carbon power generation. The project developer offers a power price that can cover its costs (the ‘strike price’, and a government-owned counterparty guarantees to pay the difference between that price and the market power price in each year of operation. If the market price goes over the strike price, the project pays money back.

Carbon contracts for difference apply this concept to CO₂ abatement. Industrial decarbonisation projects offer a price and quantity of carbon they can cut and compete for funding based on price or other parameters. Those projects successfully awarded a contract are guaranteed to be paid the difference between the offered price and a reference price for CO₂ emissions – usually the EU ETS (Figure 1). Crucially, this means that the size of the subsidy is expected to decline over time as the carbon price rises. For projects with costs close to the carbon price, the actual subsidy can become negligible and the contract serves mainly to provide greater certainty to investors.

Figure 1. Illustrative payment flows in a carbon contract for difference. Implemented policies often exclude payment from the project to the government (asymmetric payment)

Examples of support schemes in national industrial decarbonisation policy

A CCfD-like system was first implemented by the Netherlands, where the existing SDE mechanism for subsidising renewable energy generation was expanded to the SDE++ in 2020, making it applicable to multiple decarbonisation technologies including electrolytic hydrogen and CCUS. This closely resembles a CCfD, although the project is not required to pay back the state should the carbon price go higher than the strike price. The UK has recently finalised a similar incentive, aimed only at CCS projects, known as the Industrial Carbon Capture (ICC) contract – the first of these are expected to be agreed with projects in 2024. In 2022, Denmark introduced a CCUS Fund that has awarded a similar type of contract for a full-chain CCS project, and plans further rounds under a slightly altered format. Germany is launching a CCfD scheme for industrial decarbonisation projects that is expected to include CCS in future rounds, while France has indicated plans to award CCfDs as part of a forthcoming CCUS strategy. Finally, the EU is actively considering allocating a portion of its Innovation Fund for large-scale decarbonisation projects through CCfDs in addition to the existing programme of direct grants.

Although a simple concept, CCfDs can be designed in a variety of ways, which can fundamentally affect the balance of cost and risk between the funding government and the project developer. For CCS projects in particular, design choices may need to account for the complexity of the project value chain, which relies on the delivery and availability of CO₂ transport and storage (T&S) infrastructure. This policy brief compares how the three pioneering policies in the Netherlands, the UK, and Denmark have been designed, with the aim of informing policy design choices in new countries tackling industrial decarbonisation and CCS deployment.

Overview and key entities

SDE++: A series of bidding rounds are administered by the Netherlands Enterprise Agency on behalf of the Ministry of Economic Affairs and Climate Policy. There is a cap on the total volume of CCS that can be supported, set at 9.7 Mtpa for industry and 3 Mtpa for power (reserved for generators at the IJmuiden steel plant). 

ICC Contract: Private law contracts are made between the capture project and a Contract Counterparty (expected to be the state-owned Low Carbon Contracts Company (LCCC)), based on terms established by the Department of Energy Security and Net Zero. The capture project is obliged to capture and deliver CO2 at required specifications to a regulated CO₂ transport and storage company (T&SCo). The UK targets at least 6 Mtpa of industrial CO₂ capture by 2030, across four industrial clusters, with contracts awarded from 2024.

Danish CCUS Fund: The subsidy is administered by the Danish Energy Agency (DEA) and originally aimed at procuring at least 0.9 Mtpa of CO₂ captured and stored by 2030, over two funding phases. In 2023, the first phase awarded a contract to deliver 0.43 Mtpa from 2026, under which the project ‘Operator’ must deliver an entire CO₂ capture, transport, and storage value chain, potentially by contracting some of these services to third parties.¹ Following the award of the first contract, a restructured ‘CCS Fund’ was developed, combining the second phase of the CCUS Fund with funds from a previously distinct CCS incentive. This restructured fund is expected to procure at least 2.3 Mtpa by 2029, through two tender rounds in 2024 and 2025.

Size of fund

SDE++: The size of the fund varies, with the 2020 and 2021 rounds amounting to €5 billion each, the 2022 round rising to €13 billion, and the 2023 round at €8 billion. CCS projects secured subsidies of up to €2.1 billion in the first round and €7.1 billion in the third round.²

ICC Contract: The government has allocated £20 billion to CCUS funding, the majority of which is expected to cover the ‘CCUS business models’. In addition to the ICC contracts, these include support for power plants with CCS, carbon dioxide removal, and CCS-enabled hydrogen.

Danish CCUS Fund: The total subsidy allocated to CCS development in Denmark is approximately €5 billion, with around €4 billion remaining following the conclusion of the first phase in 2023. Under the restructured CCS Fund, the first tender will be worth approximately €1.4 billion and the second €2.2 billion. Approximately €350 million is available through a separate tender under the Negative Emissions CCS (NECCS) Fund.

Technology scope and eligibility

SDE++: The scheme can be used across five technology categories: renewable electricity, renewable heat, renewable gas, low-carbon heat, and low-carbon production. These cover 23 technologies, including CCS and CCU (low-carbon production). There are 8 sub-categories of CCS, depending on the type of facility (new or existing), capture (pre- or post-combustion) and partial or full capture. Coal and gas power plants are not eligible. CO₂ must be stored in offshore gas fields on the Dutch continental shelf and projects must have a formal agreement with a T&S operator for CO₂ offtake. CCS projects also have to demonstrate they can be operational within six years of the contract being awarded.

ICC Contract: The ICC Contract is available to most industrial sectors, including oil and gas processing and refining, iron and steel, cement, lime, chemicals, and waste management.³ It also applies to combined heat and power (CHP) plants that provide heat and power to these industrial sectors. Projects must have access to one of the T&S networks developed by the UK’s cluster sequencing process⁴, deploy an eligible CCUS technology, and be able to meet high capture rates of at least 85%. The first round of projects are expected to be able to start operations by December 2027.

Danish CCUS Fund: Under the first CCUS Fund tend, applicants needed to demonstrate a project able to capture and store a minimum quantity of 0.4 Mtpa from 2026. Any CO₂ was eligible for capture and storage, provided it resulted in CO₂ reductions in the Danish National Inventory Report (this can include both fossil and biogenic CO2). Candidates also needed to demonstrate adequate financial capacity.

Selection criteria

SDE++: Contracts are awarded on the basis of the ‘subsidy intensity’ of the bids. This projects the total cost per tonne of CO₂ avoided over the contract lifetime, using the bid price, a projected ETS price, and the project capture rate.

ICC Contract: For initial projects in the first two clusters, submitted projects are scored for deliverability (30% weighting), emissions reduction (25%), economic benefits (20%), cost considerations (15%) and learning and innovation (10%). Notably, the project cost is not the principal consideration.

Danish CCUS Fund: Contracts were evaluated according to the level of subsidy requested per tonne captured and stored, project maturity, the quantity (if any) of CO₂ that can be supplied pre-2026 (ramp-up quantity), and the ‘additional quantity’ of CO₂ over the minimum (0.4 Mtpa) that can be delivered for the remainder of the contract.

Contract duration

SDE++: Contracts for CCS categories are for 15 years.

ICC Contract: Contracts are a minimum of 10 years, with the option to extend by up to five additional years.

Danish CCUS Fund: The first contract was awarded in 2023 and runs until 2045, covering up to 20 years of project operation. Future contracts under the restructured CCS Fund are expected to be for 15 years.

Reference price

SDE++: The EU ETS price, averaged over each operating year, is used for ETS facilities, while a reference of zero is used for non-ETS facilities. This ‘correction amount’ (correctiebedrag) has a price floor set at two thirds of the 15-year projection of the ETS price.⁵

ICC Contract: A fixed trajectory reference price is used for the first ten years of the contract, increasing linearly from £83/tCO₂ (2022) to £128/tCO₂ (2040). This is to provide greater predictability to government, given the immaturity of the UK ETS and potential volatility. The ETS price will be used for any additional contract years beyond the initial 10-year term. For waste management plants, a reference price derived from the UK ETS is used for the whole contract duration.

Danish CCUS Fund: The DEA’s baseline projection of the ETS price is incorporated in the offer price of the bidding projects. However, an average over the real EU ETS price in each operating year is used to adjust the payment received. Denmark’s national carbon tax is also included in this adjustment.

Bid price

SDE++: All technology categories have a ‘base rate’ which is the maximum possible bid, and represents calculated benchmark costs for each category, including T&S. For CCS categories in 2023, this varies from €109/t (existing industrial process) to €266/t (waste incineration).

ICC Contract: The ‘strike price’ is expected to include all costs associated with CO₂ capture at the plant, with CO₂ delivered to the T&S network to the required specifications. It is split into two elements: opex and capex (including an agreed rate of return).

Danish CCUS Fund: The ‘Offered Rate’ (bid price) is expected to include the total cost of the carbon capture, transport and storage value chain. This rate is valid throughout the duration of the contract and is the basis for calculating the subsidy. All monetary amounts are stated in real prices and will be adjusted for inflation.

Payments

SDE++: The total subsidy is capped based on the maximum number of full-load hours over the 15-year contract period, and on an annual basis owing to the ETS reference price floor. Payments are only made from the government to the capture facility: If the ETS price goes above the bid price, then the subsidy remains at zero.

ICC Contract: Payments are made per tonne of CO₂ captured and stored, with separate payments for capex, opex and T&S charges. Opex payments are capped when the CO₂ captured reaches 110% of a pre-determined maximum annual quantity for the capture project, and are indexed to inflation in line with the Consumer Price Index. For most industrial facilities, payments can only be made from the counterparty to the capture project for the first ten years of the contract. For the extension period of up to five years, the project pays the counterparty the difference between the strike price (plus T&S charges) and the reference price, should the latter exceed the former. For waste management plants, payments can go both ways for the full contract term, but payments to the counterparty are capped.

The opex component of the strike price can be adjusted in an ‘opex reopener’ that occurs at least a year after the start of operations, or after a minimum amount of CO₂ is captured. Subject to negotiations, this allows for the opex strike price to be adjusted should operational CO₂ quantities be materially different from what capture projects and government expected (this is subject to a cap and materiality threshold).

Danish CCUS Fund: There is an annual subsidy cap of DKK 408.4 million (€55 million) at 2022 prices, that is adjusted for inflation in each subsequent year. Payments cannot go from the Operator to the DEA. Dedicated funding is allocated annually through the Danish Finance Act, and cannot be transferred between years.

Treatment of capital costs

SDE++: Project capital costs are included in the bid price.

ICC Contract: Capex has a distinct strike price within the project bid. For industrial projects, a fixed capex payment rate on a £ per tonne CO₂ basis is designed to pay back capex in the first five years – this can be extended for up to five additional years if it is not paid off (e.g., due to lower than expected quantities captured) (see Figure 2). A longer capex repayment period is used for waste management plants.

Danish CCUS Fund: All costs associated with operation of the full CCS value chain are included in the bid price. This includes potential depreciation costs for the carbon capture facility.

Figure 2. Structure of UK ICC Contract payment components over the first ten years

Treatment of free allowances

Revenue from FAs that no longer need to be surrendered under the ETS form a potential revenue stream for industry with CCUS, affecting the level of government support required. 

SDE++: Free allowances are retained by the facilities, so associated revenue may be factored into their bid price.

ICC Contract: The contract aims to provide some certainty to capture projects on the future revenues from free allowance sales. For the initial 10 years of the contract, projects must monetise (forfeit) a number of Free Allowances in proportion to the net total CO₂ avoided by the capture facility. This requires a calculation based on the CO₂ captured and stored, the CO₂ produced by any energy source powering the capture plant, and the total emissions generated by the site including any flows of CO₂ that are not captured, to derive a ‘fixed annual capture factor’:⁶

The free allowances that can be monetised in a given year are the product of this capture factor and the total free allowances allocated in that year. The capture project is compensated for the allowances at the value of the reference CO₂ price for the year of the transaction, and is guaranteed a minimum number of protected free allowances that are eligible for this compensation (falling from 100% in year 1 to 50% in year 10). Any remaining free allowances can be surrendered by the facility to cover residual emissions.

Danish CCUS Fund: Free allowances are retained by the facilities, so associated revenue may be factored into their bid price. If this income is not factored into the bid price, it will be deducted from the subsidy following the finalisation of annual accounts, to avoid overcompensation.

Treatment of biogenic and non-ETS CO₂

SDE++: Facilities whose emissions are not subject to the ETS, such as waste incineration plants, bid into separate technology categories with different base rates (maximum bids). Subsidies to these facilities are based on an effective reference price (ETS) of zero.

ICC Contract: The sale of any negative emissions credits is initially restricted within the ICC Contract, subject to review by the counterparty. Should sales be permitted within compliance or voluntary markets, 90% percentage of gross monthly revenues will be deducted from the ICC payments. However, determination of the revenue for this calculation will vary depending on how the credits are sold, to which entities, and on which type of market. The remaining 10% kept by the capture project is expected to cover the cost of participation and reporting and administration costs.

Waste plant projects are required to report their proportion of biogenic CO₂ percentage on a monthly basis. Once the UK ETS is extended to the waste sector, payments will be adjusted according to the carbon price and the fossil percentage of CO₂ emissions.

Danish CCUS Fund: The component of non-fossil CO₂ captured and stored by the Operator is monitored and reported on. The ‘difference payment’ using the ETS reference price and national carbon tax is then only applied to the fossil-based fraction of emissions. In the event of any additional earnings associated with the sale of negative emission credits that are not included in the Operator’s submitted breakdown of cost and earnings, the DEA can reduce the magnitude of the payments accordingly, based on 90% of these additional earnings.

Performance criteria

SDE++: Capture plants are paid according to the amount of CO₂ stored, with payments made monthly in advance and then adjusted to the actual storage rate on a quarterly or yearly basis. There are CCS categories for 4000 or 8000 hours per year at full load and design capture rate. Projects that do not reach their maximum allowance can make up the shortfall in the following year, up to 25% of the yearly allowance. CO₂ storage can also exceed the yearly allowance by up to 25%, provided a commensurate reduction is realised in the following year.

ICC Contract: The capture project is paid according to the agreed opex and capex payment rates based on CO₂ quantities delivered. Over-delivery of CO₂ can receive both payments up to an agreed cap. CO₂ must be produced as part of ‘efficient operations of the industrial and capture plants’.

Start-up requirement: The project is given a year-long Target Commissioning Window and an additional year-long ‘Longstop Period’ to meet certain operational criteria, known as the ‘Operational Conditions Precedent’ (OCPs). The counterparty has the right to terminate the contract if certain operational criteria are not met in this period. The OCPs primarily include evidence that: the CO₂ capture rate is equal to the higher of 85% or 5 percentage points lower than the rate specified in the project’s application; the flowrate to the T&S Network meets the agreed level; and the CO₂ meets the required specifications. If the OCPs are not met by the end of the Target Commissioning Window, the duration of the payment term is reduced for every day of delay over the Longstop Period.

Capture rate requirement: The contract can also be terminated in the event of a prolonged breach of the minimum CO₂ capture rate (three consecutive months or three non-consecutive months within one six-month period). This minimum rate is the higher of 80% or 10 percentage points less than the CO₂ capture rate demonstrated during ‘OCP acceptance tests’.

Danish CCUS Fund: The ‘Operator’ is paid based on the ‘Delivered Quantity’ of CO₂ stored. The contracted quantity of CO₂ includes a minimum annual amount and can also include a maximum annual ‘additional quantity’ that the Operator can offer. The Operator is subject to a penalty for shortfalls below the minimum and additional quantities, for any reason other than force majeure. Shortfalls below the additional quantity are penalised at a rate of 400 DKK/tCO2 (€54//tCO₂), while shortfalls below the minimum quantity face penalties increasing to a cap of 110 million DKK (€14.8 million) for a 50% shortfall.⁷ However, any accumulated additional quantities stored over preceding years can be used to offset shortfalls in a given year.

Treatment of cross-chain risks

Temporary or permanent unavailability of CO₂ transport and storage.

SDE++: The capture facility bears the risk of T&S not being available for any reason. Private contracts between the facility and the CO₂ offtake company would be expected to address any redistribution of costs incurred. As noted, shortfalls in CO₂ can be partly compensated in following years.

ICC Contract: If the T&S Network is unavailable or not able to receive the agreed quantity of CO₂, then the contract continues to pay capex payments based on average CO₂ quantities delivered over the previous 12 months of operation. Capture projects are expected to minimise opex costs where possible (e.g., by turning off the capture plant) and opex payments are reduced by a set percentage (to reflect these measures) during the T&S outage. These measures don’t apply if the capture plant is unavailable regardless of the T&S outage. In the event of a delay in commissioning the T&S network, compensation is provided for all irrecoverable and unavoidable losses incurred by the project (not including return on investment and some inessential costs). 

For a prolonged T&S unavailability event or commissioning delay (at least 6 months) the counterparty can issue the project with a T&S Prolonged Unavailability Event Notice, which affords the right to terminate the ICC contract after 30 months. Within 6 months of this notice, the project must provide details of a solution, such as an expected return to operation of the existing network within the 30-month deadline or switching of an alternative T&S solution, or explain why this is not possible. If the T&S Network is discontinued and no other options are available (i.e., the capture plant is a stranded asset), compensation is provided to the project for costs associated with development (prior to the agreement date), construction, testing, commissioning, and decommissioning, and costs up to the remaining balance of the capex payments (excluding return on capex).

Danish CCUS Fund: The Operator can be exempt from penalties for failure to deliver the contracted quantity in the following circumstances: unplanned outages in the CO2 producing facility (if not due to negligence or misconduct); significant reduction in demand for the output of the CO2 producing facility; or process optimisation which leads to significant reduction in CO2 output. The subsidy may be reduced in the event of significant savings in costs along the value chain, or earnings associated with the CCS project (see below). The Operator has some flexibility to withdraw from the contract after 2030.

Treatment of CO₂ transport and storage costs

SDE++: T&S costs are agreed between the capture project and the CO2 transport operator (or T&S operator) receiving the CO₂. Benchmark T&S costs, based on analysis of available options, are used to determine the maximum bids for each CCS technology category, but do not necessarily reflect the actual tariff paid.

ICC Contract: Capture projects pay a regulated tariff to a T&S company which is passed through from payments received under the ICC Contract. The tariff is determined by regulator Ofgem, based on the T&S network costs, the annual capacity booked by the project, the actual quantity delivered by the project, and the size of its connection to the network. There is an annual cap on pass through of T&S charges to the subsidy, based on maximum project capacity and agreed on a project-by- project basis. The government is still considering whether the project can pass through T&S charges if it is unable to deliver CO2 as a result of something it has done or failed to do (and where the charges remain payable, such as a booked capacity charge).

Danish CCUS Fund: The Operator is required to submit an annual statement on actual costs and earnings associated with the project. If this shows cost reductions (for specific parts of the process) of more than 10% relative to the breakdown in the original offer, then the DEA can reduce the subsidy received. A reduction in offshore T&S opex of more than 10% can lead to a reduction in the subsidy; however, this is based on an extrapolated T&S cost which takes into account any increases in the quantity transported relative to the planned quantity.

Summary table: Key characteristics of three CCS incentive schemes

	Dutch SDE ++	UK Industrial CCS Contract	Danish CCUS Fund (First Round)
Allocated funding and CO2 quantity (as of Jan 2024)	€23 bn total over first three rounds, of which €9.2 bn awarded to 5.6 Mtpa of CCS projects	£20 bn for as yet undetermined Mtpa over two ‘Track 1’ clusters	DKK 8 bn (€1.1 bn) to first tender for 0.43 Mtpa DKK 27 bn (€3.6 bn) remaining for restructured fund
Project eligibility	Industrial CCS projects that can be operational within six years of contract being awarded	Industrial CCS projects operational by 2027	Any CCS project that can reduce the national CO2 inventory and be operational in 2026
Selection criteria	Competitive on basis of subsidy required	Negotiated and based on several cost and non-cost factors	Competitive based on subsidy required and additional CO2 volumes
Contract duration	15 years	10 years with option to extend by up to 5 years	Up to 20 years (future tenders expected to be 15 years)
Reference price	EU ETS price (with a price floor set at two thirds the projected price)	Pre-determined linearly increasing price for 10 years. UK ETS for additional years	EU ETS price
Bid price	Includes all cost – capped according to technology category	Capex and opex components	Includes all costs
Payment symmetry	From government to project only	From counterparty to project only, except for during extension years or for WtE projects	From government to project only
Free allowances	Retained by the facility	The facility is compensated for a proportion of allowances at the reference price	Retained by the facility
Revenue from voluntary carbon markets	Revenues are expected to be incorporated into bid price	Additional revenue is not initially permitted, but would be subject to a 90% deduction	Revenues are expected to be incorporated into bid price – otherwise subject to a 90% deduction
Performance criteria	Subsidy paid based on CO2 stored	Minimum capture rates, start-up periods and CO2 specifications apply	Penalties apply if offered minimum and additional CO2 volumes not met
Cross-chain risks	No exemption for T&S unavailability	A modified subsidy continues during T&S unavailability for at least 36 months	No exemption for T&S unavailability
CO2 T&S costs	Negotiated between project and CO2 offtaker	Subsidy includes regulated tariff, passed through to network operator	Negotiated between project and CO2 offtaker