Carbon Contracts for Difference To Boost Industrial Decarbonization

Table of Contents

1. Low-Carbon Alternatives Available for Industrial Production
2. Barriers to Commercial Implementation
3. Carbon Contracts for Difference: An Opportunity To Reduce Industrial Emissions
4. Approach to Designing Carbon Contracts for Difference

COP26 brought the urgent need to accelerate our efforts against climate change into the spotlight. Although the European Union’s (EU) greenhouse gases (GHG) have decreased by 28% since 1990, there is still a long way to go to reach carbon neutrality.¹

Some of these emissions are particularly hard-to-abate, especially in the industrial sector. In 2020, industrial emissions amounted to 520 Mt-CO₂ equivalents, representing 21% of the EU-27's total GHG emissions.² Chemicals, Metals and Minerals production contributes the most to industrial emissions, with steelmaking being responsible for 25% of them.³

Hence, industrial decarbonization is considered a priority in the EU’s strategy to cut its emissions by at least 55% by 2030 compared to 1990 levels. The European Green Deal is the set of political initiatives that will allow the EU to reach carbon neutrality and lead the global market for sustainable products and services. It includes the New Industrial Strategy, which supports the twin transition to a green and digital economy. Among other things, the framework has proposed to:

• Identify transition pathways for the industry,
• Support multi-country projects,
• Bring together public and private funding,
• Support the Member States in decarbonizing their energy,
• Analyze and address the steel sector.

The New Industrial Strategy is in addition to other green industrial policy instruments like the Industrial Emissions Directive (2010/75/EU) and the EU Emission Trade System (EU-ETS). Yet, they have failed to create viable business cases among others due to fluctuating and highly uncertain CO₂ price levels. Some innovative policies for carbon management in the industrial sector may be needed to bridge this gap.

This article explores how those policies could be developed, used and combined to help decarbonize the industrial sector. We will illustrate our arguments with examples taken from the iron and steel industry—one of the highest carbon-emitting industries, and thus a critical focus for decarbonization.

Low-Carbon Alternatives Available for Industrial Production

Public authorities and industrial companies are increasingly committed to climate action, and they are ready to act accordingly. The world's leading steel companies, Arcelor Mittal and Tata Steel, have committed to decrease their emissions by 30% by 2030.

Five categories of low-carbon alternatives are currently under development:

1. Biomass-based Alternatives
Biomass can be used either as fuel or a feedstock. If supplied sustainably, biomass can be considered a carbon-neutral fuel. In some steel plants in Brazil, charcoal is already serving as a substitute for coal.

2. Green Hydrogen-based Alternatives
Like biomass, hydrogen made from renewable electricity can be both a fuel and a feedstock. Germany and France have designed a dedicated plan and budget for developing green hydrogen, creating strong momentum for industrials to test this energy vector. For instance, hydrogen could be a great substitute for natural gas in the Direct Reduction Electric Arc Furnace steel-making process.

3. Renewable Electricity-based Alternatives
Electrification of processes (like the electrification of kilns) is possible. However, it may be limited to low-to-mid-temperature heat processes, whereas the iron and steel industry typically requires high-temperature heat.

4. Carbon Capture Usage and Storage-based Alternatives
Carbon capture could make it possible to cut remaining emissions while creating synergies between CO₂-emittor and CO₂-user industries. In the steel sector, CO₂ could be captured at the exhaust of the blast furnace and then be used to produce e-fuels. This is called carbon capture and utilization (CCU). An alternative would be to transport and store it (carbon capture and storage, or CCS) permanently in deep underground rock formations.

5. New Processes
Enhanced methods involving different chemical reactions or machinery are developing, such as the smelting reduction steelmaking process currently tested by the pilot project HIsarna.⁴

Adoption of these technologies will be critical to industrial decarbonization. However, several barriers prevent them from being commercially competitive today.

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Barriers to Commercial Implementation

First, several of these technologies are relatively nascent or come at a high cost. Industrial companies typically have high upfront investment and operational costs, with low and fluctuating margins. Plus, industrial assets typically have long life cycles spanning several decades, making it challenging to address existing assets and effectively plan for new investments. Companies are thus faced with complex business cases and apply no-regret investment strategies, which prevent the emergence of innovative technologies.

Furthermore, the European industrial sector is an international trade-intense economic sector. This implies that competitiveness is mainly based on low prices. This is particularly true for steel, which is over-produced in non-European countries; in 2020, the EU imported 3.5 Mt of steel (net imports) mainly from Europe (outside of the EU) and Asia.⁵ In addition, industrial products are often standardized, resulting in the price being the key purchase-decision criterion. For these types of industries, it is still difficult to find a market with customers willing to pay a premium for a green product.

On top of that, markets for industrial products are often highly uncertain due to unstable commodity prices. Since the establishment of the ETS in 2005, the EU has inserted an additional volatile commodity into industrial economics: CO₂. Priced at €5-10/t-CO₂ during the period 2011-2017, it reached €30/t-CO₂ in 2019, fell to €15/t-CO₂ in 2020, and has inconsistently escalated to €90/t-CO₂ in December 2021. Hence, the EU-ETS does not provide the price visibility and stability necessary for long-term investments.

Full decarbonization of the industry will be limited as long as organizations lack the regulatory incentives needed to evolve. For a sector with long asset lives and a set of nascent technologies, the need for clear market indicators over time to optimally invest in future-proof solutions at the right time is particularly important.

Carbon Contracts for Difference: An Opportunity To Reduce Industrial Emissions

One policy instrument that precisely counterbalances the CO₂ price volatility is Carbon Contracts for Difference (CCfD)—a project-based financial instrument that guarantees a fixed carbon price over a given period. A public administration and a private agent sign a contract fixing a carbon price level, called the strike price. On an annual basis, one party reimburses the difference between the strike price and the actual price to the other party. If the CO₂ price is lower than the strike price, then the government pays the difference to the investor, like a common subsidy. If the CO₂ price is higher, private companies reimburse the government. The commercialization contract is a variant of the CCfD in which private companies do not need to reimburse the government if the CO₂ price is higher than the strike price.

The Netherlands has used CCfD for one CCS project, and the SDE++ scheme works as a contract for difference. The recent German coalition also integrates CCfD as part of their proposals to reach carbon neutrality and, more specifically, to support green hydrogen scale-up. This support mechanism has several advantages:

• It shares the CO₂ cost burden between private companies and the government,
• It is a subsidy form that reduces the investment risk and allows long-term financial planning,
• It is cost-effective (at some point, it might lead to positive cash flow for the government, which can, in turn, be used to support the scale-up of other low-carbon technologies),
• It aligns economic interests with societal interests,
• It is flexible: the strike price can change from one year to another, and it can target a specific industry/process.

Approach to Designing Carbon Contracts for Difference

Despite these advantages, there are several challenges and pitfalls to avoid. They underline the need for a careful and objective-driven policy mechanism design.

1. Duration: Industries often prefer long-term contracts to align with their investment cycle. However, it may lock the sector into one (potentially inefficient) technology. A temporary mechanism that exists only until a certain technology reaches a specified market penetration rate could help avoid the lock-in risk.
2. Scope: The CCfD should ideally be designed at the EU level to respect the single market and enhance fair competition. However, in the current political context, national governments may not accept to hand over the industrial policy to the Commission. Countries could voluntarily join together to issue the contracts in the first phase, and additional countries could join over time.
3. Allocation Criteria: The awarding process of the funding should ensure that not only the cheapest technology wins. The most affordable technology may not result in sufficient industrial decarbonization to achieve the targeted climate goals. For example, in the steel sector, the Hydrogen DR-EAF process is currently expensive but has one of the highest abatement potentials. However, it should also ensure the competition process is fair and has numerous bidders. There are several solutions to avoid this pitfall:
   • Cluster the mechanism to help diversify the technologies subsidized (the budget could be categorized by price range, sector or technology),
   • Include a CO₂-removal criterion in addition to the price criterion,
   • Define quotas for specific sectors or technologies.
4. Allocation Process: Informational asymmetry typically exists between the funder and the developer of innovative technologies. Designing the allocation process as an auction with room for ex-ante information sharing and dialogue could help better adjust the strike price such that this matches the actual cost for the industry to decarbonize.

Considering the elements mentioned above when designing the CCfD mechanism should provide sufficient support for the optimal low-carbon industrial solutions—in other words, the cheapest ones with the highest emissions abatement capacity.

In conclusion, CCfD could offer a response to one of the toughest challenges of industrial decarbonization.

By providing a clear and stable outlook on the price of CO₂, CCfD could be complementary to a low-carbon technology support mechanism like the Innovation Fund and enable industries to decarbonize at scale. Once the sufficient scale is reached, long-term policies like the Carbon Border Adjustment Mechanism or a Green Product Material Requirement could remain in effect to prevent carbon leakage.

Illustrative Technology Market Penetration and Support Mechanism Timeline

Overcome Price Volatility With Carefully Constructed Carbon Contracts for Difference

European industry needs a supportive regulatory framework to accelerate its decarbonization process. More specifically, it needs to bridge the gap between the development of low-carbon technologies and their commercial maturity. Carefully designed Carbon Contracts for Difference could be a promising policy instrument to de-risk heavy investments by stabilizing the carbon price.

^{1, 2} ENGIE Group Strategy Department, Dashboard of Energy Transition, 2021
³ A study realized in 2020 by ENGIE Impact assesses that Chemicals, Metals and Minerals sectors represented 75% of the EU industrial GHG in 2018.
⁴ HIsarna is a pilot project of Tata Steel running since 2011 in the Netherlands. It tests a technology that removes several pre-processing steps and requires less stringent conditions on the quality of raw materials. As of 2020, it will take about 5-10 years before it can be put on the market commercially. The ambition is to have a HIsarna factory on an industrial scale by 2030.
⁵ Eurofer, European steel figures in 2021