By Rachel Crouch

Green hydrogen appears to be on the verge of transforming from an idea into projects on the ground. While many green hydrogen efforts are pilot projects that require government support to be economic, sponsors, investors and governments around the globe are starting to outline a vision for a mature hydrogen market developed on the back of bankable hydrogen projects that will be built over the next decade.

Financing these projects will require cataloging and allocating risks in a manner that is familiar to project financiers, but it will require them to pull tools from disparate toolkits.

The predominant use of hydrogen today is as a feedstock, primarily for the production of ammonia for fertilizer and for producing gasoline and diesel fuel from crude oil in refineries.

Hydrogen is expected to be key to the energy transition because of its potential applications to difficult-to-decarbonize sectors, including industrial production and heavy transport.

It can also be used in the power sector, notably for storing energy over the long term, complementing intermittent renewables and allowing for greater renewables grid integration with less curtailment.

To date, the overwhelming majority of hydrogen has been produced using fossil fuels (so-called "grey hydrogen"). Production of hydrogen using fossil fuels can be paired with carbon capture (so-called "blue hydrogen").

This article — and much of the current industry and regulatory attention to the development of a hydrogen market — focuses on "green hydrogen" produced using electrolysis powered by renewable energy to split water into oxygen and hydrogen molecules.

Existing use cases

There is no merchant market for hydrogen. To be financeable, a hydrogen project must have a bankable offtake scheme.

Existing use cases for hydrogen may be among the first green hydrogen opportunities to be financeable, because the offtake picture will be clearer and easier to model.

Ammonia is one such area. A market already exists for ammonia, and green ammonia projects have been proposed or are in early stages of development, including a project under development in Saudi Arabia benefitting from an offtake arrangement with Air Products, a project in Louisiana sponsored by CF Industries, the world's largest ammonia producer, and a project being undertaken in western Australia by Engie and Yara, a major fertilizer manufacturer. (See "Greening the fertilizer sector" in the October 2019 NewsWire.)

Petroleum refining is another area where bankable early hydrogen projects are most likely. Refineries are among the largest users of hydrogen as a fuel stock, and early-stage hydrogen projects may contract with refineries as offtakers. Several pilot projects are being developed in this sector. For example, a high-profile effort by BP and Ørsted aims to produce green hydrogen using offshore wind to power a 50-megawatt electrolyzer, replacing natural gas-produced hydrogen at BP's Lingen refinery in Germany.

The third area showing early promise is fuel for specialty vehicles. Hydrogen is already being used to power fuel cells. Fuel cells are used in specialty vehicles like forklifts and by energy consumers to complement electricity from the grid, to smooth energy costs and to ensure reliability. Today, they rely largely on grey hydrogen.

As an example of offtake opportunities involving fuel cells, Plug Power — a leading supplier of fuel cells for use in forklifts and other specialty working vehicles — has entered into partnerships with Apex Clean Energy and Brookfield Renewable Partners. The two developers will build utility-scale wind and solar projects whose output will be used to generate green hydrogen for use by Plug Power.

While fuel cells are a commercial technology employed today in certain sectors, as discussed below, major opportunities and challenges remain for applying fuel cells to other mobility sectors and for developing offtake structures to facilitate the financing of fuel cells put to such use.

Emerging use cases

Five areas are promising emerging use cases.

Electricity generation is one. Existing offtake structures can be readily applied to hydrogen in the power sector. Project developers and utilities are exploring options for hydrogen production, storage and use as a necessary piece of the net-zero emissions puzzle.

Hydrogen will benefit from lessons learned from the development of offtake contracts for battery energy storage, some of which employ a "Swiss Army knife" model for employing, and compensating project owners for, the multiple use cases of battery energy storage. (See "Energy storage: unique PPA considerations" in the October 2017 NewsWire.)

In areas with high renewables penetration, hydrogen projects may be particularly appealing to both offtakers and developers as a way to avoid curtailment.

Batteries will probably remain more efficient for relatively short-term storage — for example, for storing electricity generated during the sunnier parts of the day and discharging during peak-use hours in the evening — but using electricity to produce hydrogen will allow for the energy in electricity that goes unused to be deployed at a different season of the year altogether — for example, on the hottest days of summer when air conditioners are cranked up for days or weeks at a time across entire regions.

Several such power projects are underway in the United States. Municipal utilities in Utah and California are spearheading the conversion of a 1,900-megawatt coal-fired power plant in Utah owned by the Intermountain Power Agency into an 840-megawatt blended natural gas-and-hydrogen plant, with the intention of converting it into a 100% hydrogen plant in coming decades. NextEra has also announced plans to build a 20-megawatt electrolyzer to produce hydrogen to be used in an existing Florida Power & Light natural-gas-fired power plant.

Another emerging use case is heavy transport.

Fuel cells have advantages over batteries for powering heavy transport. Hydrogen refueling is generally much quicker than recharging batteries, and fuel cells are generally much lighter than batteries. Fuel cell bus fleets are being rolled out in China and Europe. The world's first fuel cell train, operated by Alstom, has seen a successful trial in northern Germany and shows promise for transporting passengers over routes that may be difficult to electrify.

The amount of hydrogen needed and the locations for refueling buses and trains are predetermined, so their operators can foreseeably constitute stable offtakers that may serve as the backbone for project financings in the transport sector.

While efforts to develop hydrogen-powered trucks have generated a lot of buzz lately, financing the infrastructure for, and producing hydrogen to service, a disperse refueling network for fuel cell long-haul trucks presents a more difficult case.

There is a clear chicken-and-egg problem related to the development of fuel cell trucks and hydrogen refueling infrastructure that may require government intervention to solve. Project financing, if ultimately feasible in this area, will probably become viable only once infrastructure plans have been established with government input and support.

Industrial heating holds promise.

Industrial processes requiring high-grade heat are notoriously difficult to decarbonize through electrification, so hydrogen strategies are particularly focused on deploying hydrogen for this purpose. Major, creditworthy manufacturers of industrial products like steel or concrete could become a large market for bankable offtake arrangements in the hydrogen sector. In some regions, project developers may be able to develop bankable multi-project facilities combining large renewable generation projects and electrolyzers on-site or near major industrial producers or clusters of industrial producers.

Mining is another emerging use case. Mining companies often operate in environments where other energy sources may be expensive, dirty and subject to disruption, making them important potential corporate offtakers. In South Africa, Anglo American, Ballard and ENGIE have partnered in a project to retrofit an ultra-heavy-duty mining truck with fuel cells. Plug Power and Nel Hydrogen are developing a refueling system and an electrolyzer for use on-site.

Another potential market for hydrogen is as a replacement for natural gas for residential and commercial heating. In this market, even where there are longer-term contracts, prices are generally based on the spot market, making offtake structures in this sector more difficult to finance for early-stage hydrogen projects.

Risks

The gold standard for project financings, particularly in nascent industries, is a long-term, fixed-price offtake contract with a utility or other public or quasi-public purchaser. The power and public transportation sectors provide probably the best early opportunities for hydrogen project developers to sign such contracts.

However, many offtake structures will depend on corporate offtakers. While lenders have become accustomed to financing corporate PPAs in the power sector, many early hydrogen projects may have more in common with the analysis and treatment of offtaker risk in the LNG and mining sectors, where molecules or metals are physically delivered to a specific customer, and where the set of potential replacement offtakers may be more limited if a contract were to be rejected in bankruptcy or cancelled.

This counterparty risk will be particularly stark where the electrolyzer is located on-site or adjacent to the customer the project is designed to serve.

Financiers will also be focused on technology risk. While the market for green hydrogen is only on the cusp of viability, electrolysis technology has existed for some time. Its fundamentals are relatively well understood, and the technology may be in some respects less risky than, for example, solar photovoltaic technology was 15 years ago. As with any technology beginning to be commercially deployed, different variations of electrolysis technology are competing for preeminence. The cost has been declining in recent years and will probably do so more dramatically as deployments accelerate in number and scale.

Still, given the limited track records in electrolyzer deployment, financiers will carefully examine manufacturer and EPC warranties.

While some very large companies have entered the sector and partnerships are being announced at an accelerating pace, several of the principal technology suppliers in the market do not have very large balance sheets.

Major maintenance reserves may be required by lenders, and manufacturer warranties may need to be backed by insurance or other financial instruments to provide credit support. Given the limited track records of early projects, such security will probably be expensive (and could be an area in which government support may play a role in the early stages of hydrogen project financing).

Multi-project opportunities

An electrolyzer used to make green hydrogen is of no use without a sufficient source of renewable energy to power it, a way to store and transport the output, and an offtaker to buy and use the output.

Lenders to any part of the chain will have to ensure that all the linked elements will be developed as intended and on time to ensure debt repayment. At the same time, to find financing under a project finance model, hydrogen projects will have to be discrete enough that a revenue stream allocable solely to the individual project to be financed can be lent against, with a collateral package comprised of assets in which the special-purpose entity owning the project has an indivisible ownership or other property interest that can serve as security for the financing.

In some scenarios, end-to-end financing will be most appealing. An example of a relatively self-contained project is an electrolyzer together with a fleet of buses that will use the hydrogen fuel produced. More complexity arises when the power source and transportation of hydrogen are considered separately.

Financiers trying to evaluate and manage multi-project risk can look to knowledge developed through structuring other complex projects containing multiple elements.

For example, in LNG-to-power projects, the regasification, port infrastructure, pipeline and power plant components may be financed with the same debt package, which makes the most sense when the regasification facility is only intended to serve the associated power plant. Alternatively, separate special-purpose vehicles may be established for the separate financing of the power plant and the regasification facility, which may be financed by the same or different lender groups. The separate borrowers may or may not be jointly and severally liable for the loans. (See "Growth area: Regasification and LNG-to-power projects" in the February 2017 NewsWire.)

Another useful analogy is to the project financing of mining-related infrastructure. In some instances, a mining company may choose to develop a mine and related infrastructure (e.g., rail, port, power, water and communication-related infrastructure) under a single or related EPC contracts, to be financed as a package. In other cases, this infrastructure may be financed separately, developed through a public-private partnership or shared with other mining companies in the same region.

Where there are linkages between several projects, careful attention will have to be paid by technical advisors to timelines and the allocation of responsibility, by legal advisors to inter-creditor and security-sharing issues, and by both to the wrapping of construction contracts. As in other sectors, the more completely a contractor is required to wrap all elements of construction, the more costly the contract will be.

Creating a market

Government support will be essential to get the green hydrogen market off the ground.

In some respects, hydrogen today can be compared to renewables 10 or 15 years ago, when government support in the form of feed-in tariffs, tax credits or guarantees was essential for accelerating the pace of deployment and, in turn, cost reduction.

Developers of electrolysis technology and projects anticipate a similar reduction of costs as deployment accelerates. Support for deployment will be necessary, but likely insufficient by itself for the development of a hydrogen market.

The demand side of the equation is less clear for the hydrogen market than it was for renewables at the beginning of the wind and solar revolution.

Hydrogen is not a broadly traded commodity and is today often produced on-site by its users. Governments have begun to tackle the need for creation of a market by providing support to projects using green hydrogen in industry and otherwise. It may go without saying that the broad adoption of carbon prices or taxes would accelerate the development of a market for green hydrogen.

Unlocking green financing

The rise of green or ESG-linked bonds and loans has been a major story in finance in recent years, but the wave of green liquidity that has overtaken the power industry has, for the most part, passed by the heavy transport, mining and industrial production sectors. Financiers and project developers targeting these sectors that can find answers to the challenges described in this article will be well positioned to catch this wave.

Hydrogen as an asset class defies current classifications in most banks. As early hydrogen projects are financed, developers and financiers will need to consider the credit story to tell about each project, including on which desk it should land within a financial institution.

In each case, financiers and their advisors will do well to take a multi-disciplinary approach by drawing on institutional experience in financing power, oil and gas, infrastructure transport and mining projects to analyze hydrogen project risks and structure financings.