Contracts for Difference in Shipping: The Zero-Emissions Catalyst?
Although more typically associated with the renewables space, Contracts for Difference (CfDs) are increasingly being considered as a key part of the puzzle in achieving a zero-emissions future in the shipping sector.
The discussions and initiatives for a shift to green fuel solutions in the maritime sector are well underway, but the industry still has a long way to go in order to reach decarbonisation and to meet its national and international emissions targets. With target milestones fast approaching, including those set by the EU and the Paris Agreement, industry stakeholders are struggling with the pressing need for acceleration towards the first key decarbonisation goals in 2030.
The shipping industry is inherently competitive and in many respects characterised by capital-intensive investments in long-term assets. This creates a challenging environment for investors to venture into to develop and produce new green fuel solutions necessary for achieving the required zero-emissions future. A vicious circle is formed where uncertainty as to demand for green fuel hampers investments in green fuel solutions, creating uncertainty for green fuel availability and price, which in turn impedes investments in vessels for which such green fuel would be purchased. Increasingly, stakeholders are looking to CfDs as potentially being part of the solution, by acting as a viable supporting tool to effecting and incentivising coordinated investment to secure production and availability of green fuel at scale in combination with other initiatives to support decarbonisation of the shipping fleet.
What are CfDs?
A CfD is a policy instrument in the form of an asset derivative contract, typically entered into between a private developer / investor and a government or government-backed counterparty. Under the CfD the supplier of a new, high-cost commodity (e.g. green fuel such as hydrogen or ammonia) is paid the difference between a pre-determined reference price (e.g. the cost of fossil fuels) and a set fixed “strike price”. The strike price is usually set at a level required for the new technology to be viable and attractive, and can be decided either administratively or by way of a competitive auction. If the reference price is lower than the strike price then the supplier will receive the difference, thereby effectively securing a guaranteed minimum price during the term of the CfD. Conversely, if the reference price is higher than the strike price then the supplier would in a two-way CfD repay the subsidy. In this way CfDs mitigate market risks faced by suppliers and in turn incentivise investment at scale in the commodity in question.
Transitioning to zero-emissions fuels (including both zero-carbon and net-zero-carbon alternatives) is thought to be key to the shipping industry reaching its emissions targets. In order to reach the Paris Agreement decarbonisation goals it is estimated that zero-emissions fuels must make up 5% of the international shipping fuel mix by 2030 (Figures from the Getting to Zero coalition and UMAS (University Maritime Advisory Services, UK).). For this to become a commercial reality, the significant costs gap between fossil fuels and zero-emissions fuels needs to be bridged within a short space of time, and CfDs could be a key component in making this happen.
Are fuel-based CfDs the way to go?
CfDs based on fuel cost or production cost have been identified by multiple industry stakeholders as the most relevant and fit-for-purpose contender to accelerate movement towards zero-emissions shipping.
In Norway, the Zero Emission Resource Organisation (ZERO) has identified hydrogen as a viable zero-emissions fuel source to be targeted with CfDs. Overall, ZERO concludes that competition based CfDs aimed at producers or end-users of hydrogen would likely be the most feasible solutions to implement in the maritime sector. ZERO considers how each such CfD would conceivably be implemented:
- CfDs for producers of hydrogen would be awarded through reverse auction or administratively, with producers competing on the basis of the lowest production cost per tonne of hydrogen. The reference price would be the actual or estimated market price for hydrogen in general, which could be restricted by a floor price connected to the natural gas price. The difference between the reference price and the production cost would then be calculated and paid to the producer on an annual basis up to a maximum annual production volume (assuming the reference price is lower than the production cost). The proposed contract term for producer CfDs is 10 to 15 years in order to provide producers with sufficient visibility in respect of their investments.
- CfDs for end-users of hydrogen as a fuel, on the other hand, would be based on a strike price tied to the hydrogen-based zero-emissions fuel cost and a reference price linked to the cost of fossil fuels. Similarly to producer CfDs, the difference between the reference price and strike price would be calculated and paid to the end-user on an annual basis. The proposed contract term would be slightly shorter at 5 to 10 years.
The Getting to Zero coalition, a partnership between the Global Maritime Forum and the World Economic Forum, has further proposed that CfDs for end-users of hydrogen could be coupled with the end-users entering into offtake agreements with fuel producers on the basis of the fixed strike price, which in turn would encourage fuel producers to reduce costs to maximise profits.
Time is of the essence
Each of the CfD mechanisms set out above has the potential to propel the shipping industry towards its zero-emissions goals. Policymakers will however need to make several detailed considerations in relation to the structuring of the CfDs. An overarching consideration for governments, international organisations and other industry stakeholders looking to push for the implementation of CfDs, will be whether to focus on producers or end-users. A user-based focus has the potential to have the widest market impact, but it risks leading to delays in investments in production. A producer-focused approach, on the other hand, would secure investments in production to a larger degree.
Whichever route is taken, in order to capitalise on the potential CfDs have to act as a catalyst towards zero-emissions, it is key that decisions from governments and/or industry bodies are made quickly. An announcement regarding the use of CfDs in principle, could be a beneficial way to kick start the process without having all details in place. Thereafter, it is vital that the process is characterised by transparency and foreseeability, in order to incentivise early movers, maintain momentum and at the same time retain the required flexibility as markets develop and the need for governmental support shifts.