Unraveling the Regulatory Maze in the Emerging Hydrogen MarketNovember 30, 2023
Hydrogen Market – Regulatory Risks
Regulatory Frameworks – important but often overlooked
Regulation is typically the less glamorous, and often overlooked, aspect of project development, yet regulatory frameworks play a key role in attracting both debt and equity investment. Well-considered regulation provides stability and certainty, crucial foundations for any market, but particularly in a developing one – where capital expenditure is high – and other risks, including operational risks and downstream market risks, are present.
Regulatory frameworks are important in terms of setting the scene for basic risk allocation and structure necessary for the development of an efficient market. They can also present additional risk if the regulation itself changes or lacks the necessary clarity.
Importance of a Regulator
One of the first things that a regulatory framework can do is to establish the office of regulator. An independent, appropriately resourced, regulator can provide important oversight, facilitating the development and efficient functioning of a market. Regulation that is overseen and consistently enforced by a regulator can help promote competition which, in turn, is crucial in ultimately driving costs down. Overall, a strong and independent regulator with a consistent approach to the implementation and application of regulation can serve to mitigate regulatory risks.
The consistent application and enforcement of regulation by a regulator is of vital importance to developers and investors alike, as it ensures no participant is (without objective justification) preferred over another.
Health & Safety Regimes and Public Confidence
Safety is a key concern when dealing with a combustible gas such as hydrogen. There is a recognition that the hydrogen industry needs to win over the hearts and minds of the public – building public confidence is a vital requirement to general acceptance of hydrogen in the energy mix. Poor health and safety standards resulting in accidents, death, personal injury and damage to property could potentially deter the industry from moving forwards. Regulation has a key role to play in setting relevant standards the industry needs to comply with.
Any regulatory framework needs to be sufficiently broad to cover transportation, storage and the other infrastructure necessary to support the hydrogen industry holistically – when regulation is limited to hydrogen production activities only this creates potential issues.
The key regulatory risk that the hydrogen industry is currently facing is the lack of bespoke regulation at both an international and also individual country level.
Regulation – Global Harmonisation
Hydrogen is a global market. Harmonisation of standards globally is important to enable market participants to expand their businesses. Without harmonisation there is a risk of disparity between jurisdictions, creating narrower markets which, in turn, deprives market players with the cost efficiencies and risk mitigation that could be achieved from operating at a global scale.
Setting a Global “Green Standard”
A consistent, international, approach is particularly relevant when it comes to determining the “greenness” of hydrogen. An ability to audit the “green credentials” of hydrogen is important in enabling producers to be confident that the green element of their product is appropriately recognized and priced in the market.
Approach to Local Regulatory Frameworks
At a local level, most jurisdictions do not have bespoke hydrogen legislation. There are some countries that are looking to develop specific hydrogen frameworks, but the majority rely on existing regulation, amending the current rules as necessary to accommodate hydrogen and its particular qualities.
Advantages & Disadvantages of using existing regulation
The advantages of using existing regulation is that it is already established and, to some extent, tested thereby reducing uncertainty and risk over interpretation and application. It also potentially avoids some of the delay that would otherwise be encountered in developing and drafting regulation from scratch. The need to access markets quickly and reduce the risk of delay is of fundamental importance to developers and lenders. It is also important to individual countries who want their hydrogen markets up and running quickly – an important consideration given some of the aggressive national targets set by governments.
The risk and potential disadvantage of adapting existing regulation is that the regulatory framework is not quite “fit for purpose” for a nascent market involving new technologies and processes and one which is also trying to accommodate “project on project” risk.
Consents and Permits
Regulatory frameworks establish the consents and permit regime applicable to market participants. Consents and permits are an important part of protecting the environment and communities, providing developers with clarity as to what is required which is an important consideration when managing project costs and timelines.
Local Content Requirements
Any requirements concerning local content can also be set out in regulation. Local content provisions can set important parameters ensuring value flows back to the jurisdiction and communities in which a project is located. Clarity in this regard is important for project developers, equipment suppliers and service providers alike, enabling them to factor in these requirements from the outset which, in turn, is important from a timeline and costs perspective. This is particularly relevant in a world where supply chain issues are a particular sensitivity. Developers need to structure supply chains appropriately from the outset to avoid risks of change in scope, delays and increased costs.
Piecemeal Change and Change in Law Risk
There is an increased likelihood of piecemeal change when adapting existing regulation. This results in an increase in the frequency of change in law provisions being triggered. Ultimately such an approach makes the regulatory framework a patchwork of provisions which is cumbersome and difficult to use, with market participants often having to dedicate additional resources to keep up with regulatory changes. In such a situation market players risk falling foul of regulatory requirements as they struggle to understand what is required of them. The result of regulatory breaches is often lengthy disputes, delays and additional costs.
Who should bear Change in Law Risk?
Whilst a developing regulatory framework does have the potential advantage of being responsive to technology change as well as evolving climate change requirements and legislation, it introduces an element of instability and enhanced change in law risk. This in turn leads to the question of where, within the project structure, should change in law risk lie? Which of the project participants should bear the risk of a change in law and the additional costs that may arise as a result?
When considering this question we need to go back to our “project finance 101” approach to risk, namely that risk should be allocated to the party best able to manage and mitigate it. It is arguable that change in law risk should be taken by the relevant government. Such a risk allocation is easier to accommodate in a project where one of the project parties is a government-owned entity, for example the offtaker may be a state-owned enterprise and the cost of any change in law could be passed down into the price it pays for the hydrogen product. However, a government-owned entity may well not be involved in the project, making change in law risk allocation more difficult.
Government Subsidies and Support – Taking a long term view
Regulatory frameworks are also an important way of setting out and providing for government subsidies and support which, currently, given the nascent nature of the hydrogen industry and high costs of development, are key to supporting the development of projects and encouraging investment into the market.
Whether tax allowances, subsidies, government funding or loans are provided – all forms of government support will be established by way of regulation. Such support will be critical to the economic fundamentals of a project.
The key here is not just to have a regulatory framework in place but also to have a framework that is stable. Hydrogen projects need certainty and stability into the future; they are large capital-intensive projects with long term debt obligations. Stable revenue streams are needed over the longer term to enable projects to meet their debt service obligations. Change in law risk has the potential to upset this long-term stability. This is particularly the case in terms of government support and subsidies in circumstances where change is suddenly introduced. Sudden changes in subsidies and support create shocks in the market that are difficult to manage and risk undermining investor confidence.
We need to learn lessons from past subsidy regimes, for example in the solar space, where sudden withdrawals and reductions in subsidy support resulted in the failure of projects and alienated future investors for a number of years.
Finally, the importance of regulatory frameworks should also be considered in the context of assisting with the efficient and appropriate resolution of disputes. Regulatory frameworks can help identify the appropriate forum to hear a dispute as well as provide clarity as to the requirements that market participants need to comply with.
Without this clarity, the onus is on the parties to a project to assess and develop their own mechanism for resolving disputes and to include the details thereof in their project documents.
Beyond Statements of Strategy
Stable and sensible regulatory frameworks are key to the development of hydrogen markets. They encourage debt and equity investment, ensure environmental requirements are respected and provide for value to be retained by jurisdictions and communities hosting the hydrogen industry.
Regulatory frameworks do, however, need to go beyond basic statements of government strategy, providing sufficient detail to facilitate the delivery of that strategy in an efficient and bankable way.
Author: Kirsti Massie, Partner and Co-Head of Projects and Infrastructure at Mayer Brown