D8.4 Economic aspects of Mandatory Hydrogen Blending Quota Schemes

Both the EU and some governments of EU Member States recently formulated proposals to green the gas system with the help of mandatory blending schemes, i.e. mixing natural gas with greener gases such as biobased gases and/or clean hydrogen (independently if the different types of gases are mixed within the same pipes, and/or mixed by allocating specific parts of the gas grid for specific types of gases). The underlying idea is to stepwise turn the natural gas system into a green gas system. In most of the proposals certificate trading is part of the suggested blending strategy recognising that any certificate-based blending can only be realized on the basis of physical introduction of the renewable gases.

Currently blending is applied in various markets but in gas markets it only exists by admixing biobased gas on a voluntary basis. That is why the concept to blend clean hydrogen into the natural gas mix on a mandatory basis is lacking any real life experiences, and therefore will have to be developed. This paper assesses how such a regime could be introduced such that it really works well from an economic and societal perspective by screening the existing literature on critical points regarding similar blending practices in other energy markets. In doing so a particular issue turned out to be how to deal with the policy dilemma’s that characterised all options to try to deal with quota scheme ‘weak spots’.

We found three issues to be the dominant concerns that need to be carefully considered in the design of any mandatory blending scheme.

A first key issue relates to the certificate market that is a crucial component of almost all suggested blending schemes. It seems crucial to make sure that the certificates are accepted to be completely reliable and environmentally sound right from the beginning, i.e. the blending scheme introductory phases. Also the certificate trading process needs to be transparent as possible from the beginning which means that transparency is key even in the introductory trading stage that likely is dominated by bilateral or ‘over the counter’ trading, long-term contracts, and a limited number of market parties. An example how the market transparency can be increased without providing sensible information of individual trades, is periodically publishing total traded volumes and average certificate prices, for example by brokers or exchange platforms.

The main dilemma’s one is facing is to get trading and market development off the ground if trading margins are very thin while trading volumes are still small. In such conditions public support may needed to set up professional trading platforms and bear related costs before the market spontaneously develops towards maturity, because private traders enter the scene. Another dilemma relates to traded products. Investors may prefer long-term contracts to mitigate their risks, which may be required in the beginning but a market consisting of long-term bilateral contracts is one where existing, powerful players will dominate and no new entrants see a chance to enter. In other words, it is in conflict with the wish to create market liquidity and transparency so that also in this regard one has to find the proper balance as the market matures. A final dilemma may be to create a first class certificate reputation right from the start. This requires watertight processes of validation and verification based on authorised and advanced schemes that are accepted throughout the trading area. Having all this in place, however, may be time consuming and costly such that it unduly slows down the development of quota and start of quota pilots. The same applies for getting international consensus on quota design and certificate specifications: getting there may take very long but seems at the same time indispensable for opening up international certificate trading.

A second key issue relates to the risk of heavy certificate price volatility. This may be a serious risk not only in the early stages of certificate trading where volumes are still small and relatively large volume shifts in supply and demand may occur easily causing strong certificate price movement, but also in the mature stages as experiences in various emission trading schemes have shown. The reason is that mandatory blending quota essentially are based on volume driven policies leaving price formation to the market in which elasticities both of demand and supply are often low and regulatory risk high. Certificate price volatility therefore may typically be a systematic characteristic of mandatory blending quota schemes, which may frustrate the ultimate scheme target namely to incentivise investors to turn towards greener technologies. Their risk aversion may cause them to take a wait-and-see attitude.

That is why measures may be needed to try to restrict certificate price volatility, especially at the start, either by introducing minimum and maximum certificate prices, or by trying to steer price formation, or a combination of multiple measures. All options to do so, however, also have their backdrops. Guaranteeing minimum prices does require a fund and therefore lender at last resort to be able to purchase certificates against prices above market price levels; maximum prices may cause the quota to be surpassed and set a limit on the revenues that producers can make; and steering certificate prices via a flexible allocation regime increases regulatory risks which may paralyse investors. Yet a carefully balanced cocktail against undue volatility seems necessary. The measures can be stronger in the beginning and decline as the maturity and stability of the market evolves over time.

A third key issue relates to the degree of quota differentiation. This again may give rise to dilemma’s. One perspective is to start from technology neutrality based on the notion that the market, not the policymaker should determine which production technologies are chosen to achieve the ultimate target, which is emission reduction. Another perspective, however, could be that one wants to prevent a lock in of an assumed ultimately most cost-effective technology by introducing a quota differentiation giving some priority to a currently less cost-effective but expected future more cost-effective technology. This perspective can even go a step further by, besides economic, distinguishing even more categories of technologies based on other reasons, or if it is perceived important that the future portfolio requires a mix of different technologies. There are multiple measures described to apply quota differentiation, including their advantages and disadvantages. The dilemma clearly is that the support for future cost-effectiveness of technologies is inherently uncertain and that at short notice less cost-effective technologies are prioritised via quota on the one hand, but that risks of lock-ins are prevented.

The paper has clarified all the above dilemma’s based on experiences from real-life quota schemes and indicated the pro’s and cons of the various choices. The advice of this report is to take into account the three issues described above very carefully, if mandatory blending of hydrogen is implemented. How the dilemma’s will be solved ultimately, by weighting the advantages and drawbacks, will require political decision making.