Carbon Contracts for Differences (CCfDs): A Game-Changer in Mitigating Regulatory Risks in Climate Policies

Introduction

A long-term delivery contract that mitigates regulatory risks in climate policies. By agreeing on a fixed strike price or alternative pricing mechanism, parties ensure investment incentives for recycling and primary production technologies aligned with the 1.5-degree target.

Figure 1: Basic functioning of a two-sided CCfD (Source: TheGreens/EFA)

These contractual security benefits agents operate industrial plants, reducing financing costs and risks. The concept, inspired by Contracts for Differences (CfDs) in the electricity sector, applies to emission reductions in industrial projects. Carbon Contract for Differences (CCfDs) provide a stable carbon price signal, supporting zero-emission investments and fostering the development of export-oriented European supply industries. With CCfDs, uncertain future emission allowance prices and free allowance allocation become manageable for sectors in the EU ETS.

These contracts are particularly suitable for industrial emitters and promote investments in novel recycling technologies and primary production facilities. CCfDs secure a revenue stream corresponding to the value of saved emissions and can accelerate the transition to a more circular economy. They are part of a broader policy package to drive sustainable material production and use.

Design Elements

CCfDs are currently in their early stages of implementation, lacking extensive experience or established best practices in their design. However, by analyzing academic, policy, and government reports, we can identify potential design elements for CCfDs. These design elements are illustrated in Figure 2.

Figure 2: Design elements for contract design (Source: TheGreens/EFA)

• Strike Price: This is the key element of CCfDs, representing the remuneration for emissions savings per tonne of material produced. It can be fixed or variable, providing long-term certainty or addressing operational cost uncertainties.
• Award Criterion: CCfD strike prices can be indexed to developments in relevant input costs, such as coking coal or natural gas prices. This indexing ensures that additional support for novel processes aligns with market prices of conventional production, making them competitive.
• Contract Award: CCfDs can be awarded through public auctions, where agents bid on their required strike prices. Alternatively, negotiations can be conducted, especially for complex projects, to avoid costly renegotiations.
• Contract Type: CCfDs can be symmetric two-sided contracts or one-sided put-option designs. Two-sided contracts involve payments to the agent when the carbon price is below the strike price, while put options establish a minimum price floor.
• Duration: Contract durations can vary from shorter terms for piloting to longer terms for providing long-term investment signals. The duration should align with the economic design life of the project while considering investment risks and funding efficiency.
• Signing Parties: CCfDs are typically signed between public institutions and private businesses (P2B), but there is potential for private sector stakeholders to sign contracts (B2B) with government facilitation.
• Tender Design: Competitive tender designs can avoid excessive subsidization and discrimination. It is important to strike a balance between project-specific, technology-specific, and sector-specific tenders to promote emission reductions at the lowest cost while avoiding carbon lock-in.

It's worth noting that CCfD design elements should be context-specific and purpose-driven, taking into account the specific objectives, maturity of technologies, and regional considerations. Ongoing discussions and developments continue to shape the design options for CCfDs.

Economic aspects of CCFD

CCfDs (Carbon Contracts for Difference) have economic aspects that encompass both public costs and social value.

Public Costs:

In terms of public costs, CCfDs involve two elements. Firstly, there is a cost associated with hedging carbon price risk, where the government assumes part of the uncertainty and reduces overall social risk. However, there remains an exogenous risk that the CCfD must cover. This risk can be evaluated using traditional economic tools like Value at Risk (VaR). The expected annual public costs for CCfDs follow a similar trend observed in other technology support schemes. Initially, high transfer payments are necessary due to the limited first mover capacity, requiring long-term support. However, as the technology is progressively implemented on a larger scale, the support payments per capacity installed decrease.

Flex-fuel technologies, such as the DRI-EAF route for primary steel making, present an additional complexity. These installations can operate initially with grey hydrogen, reducing emissions compared to the traditional blast furnace route but not achieving near-zero emissions. The number of emission allowance certificates that can be sold at the agreed strike prices in the CCfD is limited. Once green hydrogen is utilized for Direct Reduced Iron (DRI), emissions reduce significantly, but this increases the allowances that can be sold at the strike price, consequently increasing public costs.

Overall, the cost of CCfDs for the government might be relatively inexpensive at the beginning, but follow-up costs could escalate over the coming decades as more plants transition to clean technologies, unless the ETS (Emissions Trading System) price aligns with CCfD strike prices.

Social Value:

On the other hand, CCfDs offer social value through two main channels. Firstly, they provide revenue certainty for a portion of the project revenues, reducing investment risk and lowering the cost of financing. This effect has been observed in the case of renewable CFDs, resulting in a 30% reduction in the overall costs of renewable technologies. While the impact of CCfDs on revenue streams is not as significant, they still contribute to a higher debt ratio for low-carbon projects, reducing the carbon price required to make the investment competitive. This, in turn, lowers the Weighted Average Cost of Capital (WACC) for the project.

Secondly, CCfDs support the improvement of the learning curve and knowledge spillovers associated with low-carbon technologies. By acting as commitment devices, CCfDs strengthen the signal for innovation, leading to welfare enhancement. This aspect has been demonstrated in research that highlights how CCfDs can drive innovation, as they provide a steady support mechanism.

In summary, the economic aspects of CCfDs encompass public costs related to hedging carbon price risk and direct technical support, with the latter decreasing as the technology becomes competitive. The expected annual public costs follow a trend similar to other technical support schemes, with higher transfer payments initially and lower support payments as the technology scales.

Flex-fuel technologies face limitations in emission allowance certificates sold at agreed strike prices, but the use of green hydrogen can increase the allowances sold, thereby increasing public costs. Socially, CCfDs provide value by offering revenue certainty, reducing investment risk, and lowering financing costs. They also contribute to the improvement of the learning curve and knowledge spillovers, fostering innovation and increasing welfare.

Understanding the Role of National CCfD in the European Transition toward a Zero-Emission Economy

The design of national Carbon Contracts for Difference (CCfDs) within the context of the European Union plays a crucial role in shaping the transition toward a zero-emission economy. As governments call for the implementation of CCfDs, they not only demonstrate a commitment to supporting the commercialization of low-emission technologies but also make a public pledge to the future significance of emission pricing. However, the development of national CCfD designs must navigate the complexities of European industrial policy, ensuring that they do not conflict with the principles of fair competition in the EU's single market.

Here are five key highlights showcasing how the European Union is effectively leveraging CCfDs for maximum impact.

• Strong commitment: Governments implementing national CCfDs demonstrate a strong commitment to industrial policies that promote the transition to a zero-emission economy and emphasize the future importance of emission pricing.
• National autonomy and EU coordination: Member states have the autonomy to design their individual national industrial policies, as long as they comply with EU state aid rules. The EU's role is primarily coordinative and supportive, allowing for national policies within the framework of a competitive and fair EU single market.
• Balancing competitiveness and climate objectives: The challenge lies in designing national CCfDs that support zero-emission basic material production without creating unfair competition within the EU single market. Trade-offs between competitiveness and climate objectives are evaluated on a case-by-case basis by the European Commission.
• Subsidy classification: CCfDs can be considered a form of subsidy and state aid, which is allowed when it facilitates certain economic activities within the EU. The revised State Aid Guidelines specifically mention CCfDs as measures contributing to the 2030 energy and climate targets.
• Ensuring competitiveness: National CCfD tender designs should include mechanisms to avoid overfunding and safeguard competitiveness. Approval from the European Commission is required, and competitive tendering procedures are encouraged. However, ensuring competitiveness may be more challenging for technology diffusion in basic material production due to limited scalability and a small number of industry players.

Case Studies: Successful Implementation of CCfDs in National Industrial Strategies

Many national governments are actively working on or considering CCfD schemes. In this overview, we provide information on existing and planned CCfD schemes in the EU and the UK, as well as insights from discussions with policymakers and stakeholders from multiple countries. While there is high interest in CCfDs, key implementation questions remain to be answered at both the national and European levels before these schemes can be effectively implemented.

Overview of National CCfD Schemes:

Netherlands: SDE++ - A scheme supporting sustainable energy production and climate transition with project-specific price floors for various renewable energy sources, including carbon capture and storage (CCS). The funding distribution and inclusion of innovative projects have received mixed feedback.

Germany: KLIMASCHUTZVERTRÄGE - Germany is developing project-specific CCfDs through a multi-step competitive award procedure. The design and timeline for the first tender are still under development, with key elements yet to be clarified.

UK: The UK government has evaluated CCfDs as an option for supporting CCS and hydrogen production. However, concrete plans or support schemes specifically targeting the industrial sector are not yet in place.

Other National Initiatives: CCfDs have gained political attention in various EU member states. Belgium, Poland, France, Spain, Sweden, Italy, and Hungary are exploring CCfDs as part of their climate and industrial policy discussions. However, specific plans, financing mechanisms, and alignment with EU regulations are still being developed.

Shaping a Sustainable Future: The Path Forward for Carbon Contracts for Differences

The path forward for the implementation of Carbon Contracts for Differences (CCfDs) in the context of the European Union involves several key steps and considerations. These include:

• Policy Development: National governments and the European Union need to develop comprehensive policies and frameworks for CCfDs. These policies should outline the objectives, eligibility criteria, and evaluation processes for CCfD schemes. They should also address the potential conflicts with fair competition in the EU's single market and ensure compliance with state aid rules.
• Stakeholder Engagement: Engaging with various stakeholders, including industrial players, renewable energy developers, environmental organizations, and financial institutions, is crucial for the successful implementation of CCfDs. These stakeholders should be involved in the design and evaluation processes to ensure that CCfDs align with their needs and priorities.
• Pilot Projects and Demonstration Initiatives: Conducting pilot projects and demonstration initiatives can provide valuable insights into the practical implementation of CCfDs. These projects can help identify challenges, evaluate the effectiveness of different design elements, and build confidence among stakeholders. Lessons learned from these initiatives can inform the scaling up of CCfDs in the future.
• Evaluation and Monitoring: Continuous evaluation and monitoring of CCfD schemes are necessary to assess their effectiveness and make necessary adjustments. This evaluation should consider the economic, social, and environmental impacts of CCfDs and their contribution to the transition toward a zero-emission economy. Regular reviews can help identify areas for improvement and ensure that CCfDs remain aligned with evolving market conditions and policy objectives.
• Further Research and Development: Given that CCfDs are still in their early stages of implementation, it is important to continue conducting research and analysis to refine their design elements and identify best practices. This research should involve collaboration between academia, policymakers, and industry experts to gather insights and lessons learned.