Category: European Union Carbon Market Glossary

Published: 22 September 2020

Last Updated: 26 August 2023

Carbon Contracts for Difference (CCfD) are the subcategory of CfDs and an important element to trigger emission reductions in industry, offering the EU the opportunity to guarantee investors in innovative climate-friendly technologies a fixed price that rewards CO2 emission reductions above the current price levels in the EU ETS (European Commission Proposal of 14 July 2021 for a Directive of the European Parliament and of the Council amending Directive 2003/87/EC establishing a system for greenhouse gas emission allowance trading within the Union, Decision (EU) 2015/1814 concerning the establishment and operation of a market stability reserve for the Union greenhouse gas emission trading scheme and Regulation (EU) 2015/757, COM(2021) 551 final, 2021/0211 (COD)).

16 May 2023  Directive (EU) 2023/959 of the European Parliament and of the Council of 10 May 2023 amending Directive 2003/87/EC establishing a system for greenhouse gas emission allowance trading within the Union and Decision (EU) 2015/1814 concerning the establishment and operation of a market stability reserve for the Union greenhouse gas emission trading system published in the EU Official Journal - the Directive introduces Carbon Contracts for Difference as an instrument of the ‘Fit for 55’ package

In the Communication of 8 July 2020 (A hydrogen strategy for a climate-neutral Europe (COM(2020) 301 final, p. 13) the European Commission proposed a policy instrument for the creation of the tendering systems for Carbon Contracts for Difference (CCfD).

According to the Commission, such a long term contract with a public counterpart would remunerate the investor by paying the difference between the CO2 strike price and the actual CO2 price in the ETS in an explicit way, bridging the cost gap compared to conventional hydrogen production.

Areas where a pilot scheme for carbon contracts for difference could be applied are, in particular:

• to accelerate the replacement of existing hydrogen production in refineries and fertiliser production,
• low carbon and circular steel and basic chemicals, and
• to support the deployment in the maritime sector of hydrogen and derived fuels such as ammonia and the deployment of synthetic low-carbon fuels in the aviation sector.

It could be implemented at EU, or national level, including with the support of the ETS Innovation Fund.

 

Communication of 8 July 2020 from the Commission to the European Parliament, take Council, the European Economic and Social Committee and the Committee of the Regions, A hydrogen strategy for a climate-neutral Europe (COM(2020) 301 final, p. 13, 14) With the need to scale-up renewable and low-carbon hydrogen before they are cost-competitive, support schemes are likely to be required for some time, subject to compliance with competition rules. A possible policy instrument would be to create tendering systems for carbon contracts for difference (‘CCfD’). Such a long term contract with a public counterpart would remunerate the investor by paying the difference between the CO2 strike price and the actual CO2 price in the ETS in an explicit way, bridging the cost gap compared to conventional hydrogen production. Areas where a pilot scheme for carbon contracts for difference can be applied is to accelerate the replacement of existing hydrogen production in refineries and fertiliser production, low carbon and circular steel and basic chemicals, and to support the deployment in the maritime sector of hydrogen and derived fuels such as ammonia and the deployment of synthetic low-carbon fuels in the aviation sector. It could be implemented at EU, or national level, including with the support of the ETS Innovation Fund. The proportionality of such measures and their market impact should be assessed carefully ensuring that these comply with the State aid guidelines for energy and environmental protection.

 

However, the need to comply with the State aid guidelines for energy and environmental protection has been underlined. Guidelines on State aid for climate, environmental protection and energy 2022 (CEEAG) respond to the above regulatory challenges specifically addressing CCfD framework.

 

Guidelines on State aid for climate, environmental protection and energy 2022 (CEEAG) Aid for decarbonisation can take a variety of forms including upfront grants and contracts for ongoing aid payments such as contracts for difference. Aid which covers costs mostly linked to operation rather than investment should only be used where the Member State demonstrates that this results in more environmentally-friendly operating decisions. ... A contract for difference entitles the beneficiary to a payment equal to the difference between a fixed ‘strike’ price and a reference price – such as a market price, per unit of output. They have been used for electricity generation measures in recent years but could also involve a reference price linked to the ETS – i.e. ‘carbon’ contracts for difference. Such carbon contracts for difference may be a useful tool for bringing to market breakthrough technologies that may be necessary to achieve industrial decarbonisation. Contracts for difference may also involve paybacks from beneficiaries to taxpayers or consumers for periods in which the reference price exceeds the strike price.

 

Carbon Contracts for Difference as an instrument of the ‘Fit for 55’ package

 

On 16 May 2023 the Directive (EU) 2023/959 of the European Parliament and of the Council of 10 May 2023 amending Directive 2003/87/EC establishing a system for greenhouse gas emission allowance trading within the Union and Decision (EU) 2015/1814 concerning the establishment and operation of a market stability reserve for the Union greenhouse gas emission trading system has been published in the EU Official Journal.

The Directive introduces Carbon Contracts for Difference as an instrument of the ‘Fit for 55’ package. The respective recital of the Directive reads:  

“In order to align with the comprehensive nature of the European Green Deal, the selection process for projects supported through grants should give priority to projects addressing multiple environmental impacts. In order to support the replication and the faster market penetration of the technologies or solutions that are supported, projects funded by the Innovation Fund should share knowledge with other relevant projects as well as with Union-based researchers having a legitimate interest.

Contracts for difference (CDs), carbon contracts for difference (CCDs) and fixed premium contracts are important elements for the triggering of emission reductions in industry through the scaling-up of new technologies, offering the opportunity to guarantee investors in innovative climate-friendly technologies a price that rewards CO2 emission reductions above those induced by the prevailing carbon price level in the EU ETS. The range of measures that the Innovation Fund can support should be extended to provide support to projects through competitive bidding, leading to the award of CDs, CCDs or fixed premium contracts. Competitive bidding would be an important mechanism for supporting the development of decarbonisation technologies and optimising the use of available resources. It would also offer certainty to investors in those technologies. With a view to minimising any contingent liability for the Union budget, risk mitigation should be ensured in the design of CDs and CCDs and appropriate coverage by a budgetary commitment should be provided with full coverage at least for the first two rounds of CDs and CCDs with appropriations resulting from the proceeds of auctioning of allowances allocated pursuant to Article 10a(8) of Directive 2003/87/EC”.

Moreover, in Article 3 of the EU ETS Directive the following definitions in points (ab), (ac) and (ad) were added:

(ab) “contract for difference” or “CD” means a contract between the Commission and the producer, selected through a competitive bidding mechanism such as an auction, of a low- or zero-carbon product, and under which the producer is provided with support from the Innovation Fund covering the difference between the winning price, also known as the strike price, on the one hand, and a reference price derived from the price of the low- or zero-carbon product produced, the market price of a close substitute, or a combination of those two prices, on the other hand;

(ac) “carbon contract for difference” or “CCD” means a contract between the Commission and the producer, selected through a competitive bidding mechanism such as an auction, of a low- or zero-carbon product, and under which the producer is provided with support from the Innovation Fund covering the difference between the winning price, also known as the strike price, on the one hand, and a reference price derived from the average price of allowances, on the other hand;

(ad) “fixed premium contract” means a contract between the Commission and the producer, selected through a competitive bidding mechanism such as an auction, of a low- or zero-carbon product, and under which the producer is provided with support in the form of a fixed amount per unit of the product produced.

 

Directive of the European Parliament and of the Council amending Directive 2003/87/EC establishing a system for greenhouse gas emission allowance trading within the Union and Decision (EU) 2015/1814 concerning the establishment and operation of a market stability reserve for the Union greenhouse gas emission trading system, Recital 59 Contracts for difference (CDs), carbon contracts for difference (CCDs) and fixed premium contracts are important elements for the triggering of emission reductions in industry through the scaling-up of new technologies, offering the opportunity to guarantee investors in innovative climate-friendly technologies a price that rewards CO2 emission reductions above those induced by the prevailing carbon price level in the EU ETS. The range of measures that the Innovation Fund can support should be extended to provide support to projects through competitive bidding, leading to the award of CDs, CCDs or fixed premium contracts. Competitive bidding would be an important mechanism for supporting the development of decarbonisation technologies and optimising the use of available resources. It would also offer certainty to investors in those technologies. With a view to minimising any contingent liability for the Union budget, risk mitigation should be ensured in the design of CDs and CCDs and appropriate coverage by a budgetary commitment should be provided with full coverage at least for the first two rounds of CDs and CCDs with appropriations resulting from the proceeds of auctioning of allowances allocated pursuant to Article 10a(8) of Directive 2003/87/EC. No such risks exist for fixed premium contracts because the legal commitment will be covered by a matching budgetary commitment. In addition, the Commission should conduct, after concluding the first two rounds of CDs and CCDs, and each time it is necessary thereafter, a qualitative and quantitative assessment of the financial risks arising from their implementation. The Commission should be empowered to adopt a delegated act to provide, based on the results of that assessment, for an appropriate provisioning rate rather than full coverage for subsequent rounds of CDs or CCDs. Such an approach should take into account any elements that could reduce the financial risks for the Union budget, in addition to the allowances available in the Innovation Fund, such as possible sharing of liability with Member States, on a voluntary basis, or a possible re-insurance mechanism from the private sector. It is therefore necessary to provide for derogations from parts of Title X of Regulation (EU, Euratom) 2018/1046 of the European Parliament and of the Council (19). The provisioning rate for the first two rounds of CDs and CCDs should be 100 %. However, by way of derogation from Article 210(1), Article 211(1) and (2) and Article 218(1) of that Regulation, a minimum provisioning rate of 50 % as well as a maximum share of revenue from the Innovation Fund to be used for provisioning of 30 % should be set in this Directive for subsequent rounds of CDs and CCDs and the Commission should be able to specify the provisioning rate necessary on the basis of the experience from the first two calls for proposals and the amount of revenue to be used for provisioning. The total financial liability borne by the Union budget should thus not exceed 60 % of the proceeds from auctioning for the Innovation Fund. Moreover, as provisioning will come, in general, from the Innovation Fund, derogations should be made from the rules in Articles 212, 213 and 214 of Regulation (EU, Euratom) 2018/1046 relating to the common provisioning fund established by Article 212 of that Regulation. The novel nature of CDs and CCDs might also necessitate derogations from Article 209(2), points (d) and (h), of that Regulation, given that they do not rely on leverage/multipliers or depend entirely on an ex ante assessment, from Article 219(3), due to the link to Article 209(2), point (d), and from Article 219(6) thereof, as implementing partners will not have credit or equity exposures under a guarantee. The use of any derogation from Regulation (EU, Euratom) 2018/1046 should be limited to what is necessary. The Commission should be empowered to amend the maximum share of revenue from the Innovation Fund to be used for provisioning by no more than 20 percentage points above what is provided for in this Directive. Article 3 is amended as follows (d) the following points are added: (ab) “contract for difference” or “CD” means a contract between the Commission and the producer, selected through a competitive bidding mechanism such as an auction, of a low- or zero-carbon product, and under which the producer is provided with support from the Innovation Fund covering the difference between the winning price, also known as the strike price, on the one hand, and a reference price derived from the price of the low- or zero-carbon product produced, the market price of a close substitute, or a combination of those two prices, on the other hand; (ac) “carbon contract for difference” or “CCD” means a contract between the Commission and the producer, selected through a competitive bidding mechanism such as an auction, of a low- or zero-carbon product, and under which the producer is provided with support from the Innovation Fund covering the difference between the winning price, also known as the strike price, on the one hand, and a reference price derived from the average price of allowances, on the other hand; (ad) “fixed premium contract” means a contract between the Commission and the producer, selected through a competitive bidding mechanism such as an auction, of a low- or zero-carbon product, and under which the producer is provided with support in the form of a fixed amount per unit of the product produced

CCfD mechanics

 

One major advantage of Carbon Contracts for Difference is the reduction of financing costs, which results in lower levels of required CO2 prices to realise the investments in clean technologies (Industrial Innovation: Pathways to deep decarbonisation of Industry Part 3: Policy implications, A report of 2 March 2020 submitted to the European Commission by ICF Consulting Services Limited in association with DIW Berlin, Authors: Olga Chiappinelli, Katharina Erdmann, Timo Gerres, Manuel  Haussner, Ingmar Juergens, Karsten Neuhoff, Alice Pirlot, Jörn C. Richstein, and Yeen Chan). As the said report of 2 March 2020 underlines, the CCfD pays out the difference between the yearly average auction price of emissions allowances (EUAs) and the contract price, thus effectively ensuring a guaranteed carbon price for the project. In exchange for this insurance, investors are liable for payment if the carbon price exceeds the contract’s strike price.

Emissions reductions are calculated by subtracting the verified emissions of an installation from the emissions that would have been expected with a traditional technology calculated by multiplying production volumes with the EU ETS benchmark of emissions of the best available technology per ton of material production at the time of investment.

 

Industrial Innovation: Pathways to deep decarbonisation of Industry Part 3: Policy implications, A report submitted by ICF Consulting Services Limited in association with DIW Berlin, Authors: Olga Chiappinelli, Katharina Erdmann, Timo Gerres, Manuel Haussner, Ingmar Juergens, Karsten Neuhoff, Alice Pirlot, Jörn C. Richstein, and Yeen Chan, 2 March 2020 Numerical example with free allocation (Without free allocation linked to production and without international trade, in equilibrium the product price would increase by the carbon cost, having an equivalent effect) • Benchmark: 1 tCO2 / tProduct • Innovative project: 0.1 tCO2 / tProduct • Project signs CCfD at 50 €/tCO2 Low price example: Revenue per ton production of product at spot ETS price of 20 €/tCO2 : • Allocation: 20 € /tCO2 * (1 tCO2 /tProduct free allocation – 0.1 t CO2/tProduct emissions from process) = 18 €/t • CCfD: (50-20) € /tCO2 * 0.9 tCO2 / tProduct= 27 € /tProduct • Total: 45 €/tProduct High price example: Revenue per ton production of product at spot ETS price of 70 €/tCO2 : • Allocation: 70 €/tCO2 * 0.9 tCO2 / tProduct = 63 €/tProduct • CCfD: (50-70) €/tCO2 * 0.9 tCO2 / tProduct = -18 €/tProduct • Total: 45 €/tProduct .

 

In the case of Carbon Contracts for Difference on the EU ETS price companies would receive payments if the carbon price level is below the contract price, but are obliged to pay back money, if the EU ETS price is above the carbon price. This effectively guarantees a fixed carbon price.

The price level could be set at the current EU ETS price level, above EU ETS price level (e.g. expected price over contract duration) or determined by tender. The second and third options could be used to provide additional innovation support (if eligibility is constrained to innovative projects).  The contract price should be set in such a way that (jointly with additional innovation funding) sufficient investment incentives are given for break-through technologies. If the contract price level is set above the expected EU ETS price level over contract duration, state-aid compliance needs to be ensured via other criteria (e.g. exceptions for innovation or environmental reasons).

The contract duration could be short (e.g. 3 years) up to long (e.g. 20 years). Longer contract duration enables long-term financing, important for capital-intensive projects.

CCfDs could be combined with innovation grants, other policies or no other policies. Combining CCfDs with innovation grants would allow keeping administrative hurdles low, by setting a uniform carbon contract price, and letting projects compete on innovation grants (see below).

Other options affecting financing include:

• the exact reference price (for example the Average Monthly EU ETS auction price, which as an auction price, can be traded without basis risk; however, price averages liquidly traded common reference prices, such as end-of-year futures, might also be an option), 
• exit-options from the contract, 
• indexed contract prices (e.g. to Inflation), as well as 
• rules on collaterals and settlement (end-of-year, monthly, marked-to-market).

The said report of 2 March 2020 further indicates that the contract volume can be dynamic with realized emissions reductions or static (ex-ante). This influences operational incentives, but also financing. In operation, only a dynamic contract volume ensures incentives to deliver emission reductions at the contract price, especially if there are abatement decisions to be made in operation (e.g. in the case of CCS). These would otherwise need to be ensured via additional, complex contract clauses and be monitored. In case a risky project does not succeed in achieving its abatement target, no additional clauses are necessary, and neither the public nor the company are exposed to an additional carbon price risk. For the same reason, the contract should cover 100% of emissions reductions, although contracts could in principle only cover a share of emissions reductions.

The emission scope could be defined at company or project level, in case of project finance, the two scopes would be identical. In case carbon contracts are employed as an innovation policy, a project level scope is necessary to ensure that innovation funding is actually directed at emissions reductions by innovative processes, instead of company-wide abatement.

Delivered emissions reductions could either be monitored, reported and verified by EU ETS MRV processes or this could be done by separate MRV processes. The first option would keep administrative burdens low; however, it is only feasible if the project is an independently registered installation within the EU ETS.

As regards the contract issuer the design options are the national governments, the European Union and its institutions like the European Investment Bank, or financial markets.

Eligibility options  include compatibility with climate neutrality goals, limitation of the contracts to the industrial sector, or openness to all sectors.

Contracts could awarded via tenders (with projects bidding the carbon contract price), or contracts could be awarded to all eligible projects. The CCfD could be also coupled to an innovation grant tender.

 

Subscribe to read more …