Reliable revenue streams a must
The cornerstone of a project finance transaction is a robust, stable and reliable revenue stream that is sufficient to service debt, pay operating costs and provide a return to equity.
Components that feed into the revenue stream of a hydrogen project include:
- demand for hydrogen
- uses of hydrogen
Demand for hydrogen key to the nation's strategy
Fostering demand for hydrogen in domestic and export markets is one of the key rationales for hydrogen hubs recommended in Australia's National Hydrogen Strategy.
Large corporates with good credit or governments will need to stand behind the offtake. Given the strength of the players involved in the hydrogen feasibility projects, this is likely to occur to some extent. However, whether these offtake agreements will be sufficiently robust to pay out debt and provide a return to equity is unclear.
Carbon emission reduction targets and renewable certificate trading schemes were used effectively to create demand for renewable energy at a time when renewable energy was not price competitive with fossil fuels. They may help promote a project finance market for hydrogen.
Many of the pilot hydrogen projects have an inbuilt captive demand base – including distributing blended hydrogen to existing gas customers or the supply of hydrogen vehicles for use on existing mine sites.
Diversity of use. No one size fits all.
The use of hydrogen will vary across projects. So there will not be a 'one size fits all' project finance solution.
No matter the use of hydrogen (ie replacement feedstock for ammonia production, as reticulated natural gas replacement or to supply electricity markets), there needs to be an understanding of prices and market conditions of the adjacent industries.
This diversity may enable excess hydrogen to be put to other uses such as fuel cells for remote and emergency power or to the vehicle and transport sector. As a result, arbitrage opportunities across different markets may exist where demand in one hydrogen market falls and demand for another market rises, shifting supply to take advantage of increased prices. However, the cost and lead-time of any other infrastructure needed to shift from one customer segment to another may limit these opportunities.
From a project financier's perspective, understanding the industry and locking down the operational aspects of a project will be important. Any flexibility of operations will need to be contractually controlled in the financing arrangements.
Price may differ
An existing spot market for electricity enabled some level of accepted merchant risk for renewable generation projects. This will not be the case for hydrogen projects. Given the experience in the LNG sector and the difficulty establishing a liquid independent gas market, it is unlikely there will be a hydrogen spot market in the near term.
The price for hydrogen may differ depending on its use, location, means of production and the alternative source of energy with which it competes.
The current gas price will cap the price for hydrogen that is used as a gas replacement. The price of diesel will be more relevant for hydrogen used as a fuel for transport. So developing an indicative pricing benchmark to adjacent industries will be required to understand the market for hydrogen and for the financial model underpinning the project finance.
Emissions targets of corporates and governments may encourage customers to pay a premium for green products - such as the green premium on the green aluminium spot price - improving the bankability of green hydrogen projects.
Reverse feed-in tariff auctions were used to create a market and an offtake price for renewables. Competitive tension saw offtake prices reduce as costs decreased over time. There could be a similar scheme for hydrogen.
Key risks to be aware of
A project faces the most significant risk during its construction phase. If the project runs over time or budget, there is an impact to revenues, and the ability to repay debt. Similarly, if the technology does not perform to at least the standard projected in the base case financial model, the project will not be viable.
Constructing new infrastructure is more risky than constructing known infrastructure.
Expected delays are known for infrastructure transactions that have been completed many times. Risks can be mitigated with liquidated damages set to market standards that compensate for the period of the delay. Robust completion testing standards also assure lenders that completed infrastructure will perform as expected.
When construction risks are not well known, contractors may be unwilling to assume price or schedule risk, or accept rigid performance standards or liquidated damages. As a result, more risk is likely to remain with the project.
Non-recourse project finance will not be available until construction risks for hydrogen projects are understood and market accepted mitigation solutions are pioneered. Sponsor support may be needed (eg sponsor completion guarantees used in LNG project financings).
New technology and emerging industry go hand in hand.
A project using unproven technologies without clarity around performance standards is not bankable. Technology risk is an integral component of completion risk. If the technology does not perform, the project will not meet the commissioning requirements to progress to operations phase.
Demonstrating that technologies work at scale will be essential for developing the hydrogen sector. Government funding, sponsor support and more risk-accepting venture capital will be required to fund early projects until technology performance across projects is demonstrated.
Interface issues to know
Another cornerstone to project financing is ring-fencing of project assets and mitigating risk from external sources - to quarantine the project's revenue stream. With each external interface, project risk is increased.
Depending on the type of hydrogen project there may be several external interfaces. Projects may be separately financed, creating a 'project on project' risk.
For example, if hydrogen is used as a gas replacement, there will be interface with the existing gas pipelines and infrastructure. If hydrogen is used as a fuel for fleet vehicles, there will be interface with the owner of the fleet vehicles and the refuelling infrastructure. Ideally, ownership of all of these project components would be the same. However, for pre-existing or shared infrastructure this will not be possible.
Determining which party accepts what risks will be a negotiation point for each transaction. How risks are allocated and mitigated will involve complex intercreditor and interface agreements.
Inputs: power and water
The key inputs to a green hydrogen project are power and water. Ensuring a reliable and cost-effective power supply and access to water rights will be important. As will access rights to key infrastructure (ie gas pipelines, road, rail or ports). All of these rights must be capable of being secured and transferred to third parties.
Suitably located hydrogen hubs are a way to ensure cost-effective access to key inputs.
Global decarbonisation commitments are driving Australia's hydrogen industry together with bank mandates to move away from fossil fuels. Hydrogen offers the prospect of capitalising on Australia's renewable power resources of wind, solar and hydro to produce green hydrogen.
The cost of power is the largest cost-component of producing green hydrogen. Sourcing this energy in a cost effective way and ensuring that it is sufficiently firmed to produce hydrogen effectively will be important to the bankability of a hydrogen project.
Water rights are a hot political topic. Recent droughts, water theft, and debates about environmental allocations highlight the importance of good water management.
Ensuring a cost-effective, stable supply of water will be essential for any hydrogen project. Using recycled wastewater or desalinated water may help with reliability of supply, but will involve added infrastructure costs.
Regulatory compliance a must
The hydrogen industry will require its own regulatory framework. Ensuring regulatory compliance will be key to any project financing - as will the transferability of licences and approvals.
Educating financiers on the relevant regulatory frameworks will be important, as will ensuring that domestic regulation is consistent with world best practice.
Financing our hydrogen future
Early stage hydrogen projects are unlikely to be project financed without government and industry support.
Government funding agencies
Consistent with the experience of the large-scale solar sector, we expect that this support will come from government funding agencies such as Australian Renewable Energy Agency (ARENA) and Clean Energy Finance Corporation (CEFC). This is already evident with ARENA's oversubscribed A$70 million Renewable Hydrogen Deployment Funding Round and CEFC's A$300 million Advancing Hydrogen Fund. These agencies' commitments will not be enough to meet the full funding requirements of all hydrogen projects. Following the lead of the large-scale LNG projects, funding from export credit agencies is also a likely option.
Export credit agencies (ECAs) such as The Japan Bank for International Co-operation, The Export-Import Bank of China, and Export Finance Australia are governmental agencies that provide finance for export related transactions. ECAs must fund in accordance with their government imposed mandate. Securing domestic energy supply or key commodities is often included in mandates and large, export oriented Asia Pacific LNG projects have benefited from ECA funding.
ECAs can often provide larger commitments, with longer tenors at reduced funding costs to commercial lenders. They may also accept risk profiles that commercial lenders cannot. So, for export focused, large-scale hydrogen projects, tapping into ECA funding seems like an obvious choice. Particularly where a key sponsor or supplier is from the ECA's home jurisdiction.
There has been strong industry support in the feasibility stage hydrogen projects. Continued support to the hydrogen sector in the form of development funding, equity and offtake agreements is expected. This will give the hydrogen industry the boost it needs to move from emerging status.
Large industrial entities may also be a source of financing support. From:
- those seeking 'first mover advantage', typically technology providers and construction contractors.They can provide support in the form of fixed price contracts, warranties, indemnities and robust liquidated damages regimes
- end-use customers who are prepared to pay a green premium for green hydrogen products to meet their own corporate climate change targets
- those with energy interests in jurisdictions with expected strong hydrogen demand (eg Japan, Korea and Germany). These jurisdictions have growing energy demand, limited domestic energy sources and alternative fuels, and governments with an agenda for a greener, more sustainable future.
As with all new industries, early projects will need financing support from governments, government funding agencies and key industry participants. Over time, bankability principles and risk mitigation strategies will be developed.
How MinterEllison can help
As the hydrogen industry takes off, project proponents and their financiers will face many legal and commercial issues. The MinterEllison team can provide support across the whole project life-cycle – from land tenure, regulatory, approvals, water access, network connection, logistics, equity, commercial, financing, export and safety.
To find out more, or to discuss your particular issues and needs, please contact us.