Issue Briefs | NEXT group

Overview

Executive Summary

HIGHLIGHTS

• Studies have pointed out that low carbon prices and high price volatility in the emissions trading system (ETS) market may explain why commercialization remains challenging despite active research and development of low-carbon production methods.

• In order to encourage companies to adopt low-carbon technologies, several European countries, including the Netherlands and Germany, have introduced or are planning to introduce the carbon contract for difference (CCfD)

• The CCfD is a long-term contract in which the government and companies agree on a strike price for a single project. If the carbon price in the market falls below the strike price, the government will pay the difference. If the carbon price exceeds the strike price, companies will pay the difference to the government. This creates a stable revenue flow structure that reduces uncertainty and lowers total and project funding costs.

• To effectively introduce and operate the CCfD in Korea, the following elements should be considered in the system design:

- Selection of candidate technologies to be supported and recruited

- Determination of the CCfD strike price and fund allocation methods

- Determination of the CCfD support scale and budget procurement methods

0. Introduction

National greenhouse gas (GHG) emissions in 2021 were tentatively counted at 680 million tons, a 3.0% decrease (21 million tons) compared to 2019[1]. The conversion sector contributed significantly to this decrease. Despite an increase in total power generation, GHG emissions from power and heat generation decreased by 27 million tons compared to 2019 due to a reduction in coal-fired power generation. However, the efforts of industries have not yet been statistically confirmed. GHG emissions related to energy in the steel and petrochemical industries increased by 1.1 million tons and 6.3 million tons, respectively, compared to 2019 due to product demand recovery and the expansion of domestic facilities.

As the industrial sector is responsible for around 35% or more of national GHG emissions, Korean industries play a crucial role in achieving the Nationally Determined Contributions (NDC) and implementing carbon neutrality. In addition, political and economic risks, such as the introduction of the EU’s Carbon Border Adjustment Tax, could potentially harm the competitiveness of domestic carbon emission industries, which are heavily reliant on exports. Therefore, it is important for industries to start implementing low-carbonization as soon as possible. However, low-carbonization is accompanied by the development of low-carbon technology and large-scale investments, which present some challenges that cannot be overcome solely by companies' efforts.

Hence, to encourage companies to adopt low-carbon technologies, several European countries, including the Netherlands and Germany, have introduced or are planning to introduce the carbon contract for difference (CCfD). The Korean government also mentioned plans to review the introduction of carbon price incentives like CCfD in Germany in the “Vision and Strategy for a Large-Scale Conversion to Carbon-Neutral Industry” in December 2021. This issue brief summarizes discussions, operation status, and plans for the CCfD in Europe in order to enhance the understanding of the CCfD in the Korean context and provide insights into factors that need to be considered regarding its application to domestic industries

1. Concept and Background of CCfD

As the urgency of the climate crisis becomes more widely recognized, research and development of low-carbon production methods is being actively pursued, but these efforts often do not lead to commercialization. This is due in part to the difficulty of getting projects beyond the pilot stage to overcome the “valley of death”[2], as well as low carbon prices and high price volatility in the emissions trading system (ETS) market. Additionally, reliability issues with the government and the fact that the investment period extends beyond the emission allocation period make it challenging to promote investment in low-carbon technology (Helm and Hepburn, 2005).

To address these limitations and increase incentives for investing in low-carbon innovative technologies, the concepts of the carbon contract and the carbon contract for difference (CCfD) have been proposed. The carbon contract compensates for the cost of reducing carbon emissions, and was first proposed by Helm and Hepburn (2005). The CCfD, which was developed from the initial discussion by Richstein (2017) (Agora Industrie et al., 2022), is similar to the carbon contract in that it aims to increase incentives for companies to adopt innovative low-carbon technologies by compensating for the cost of emission reductions, but it is different in that it is directly linked to the ETS market[3].

The detailed mechanism of the CCfD is described in Box 1[4]. The CCfD is a long-term contract in which the government and companies agree on a strike price. If the carbon price in the market falls below the strike price, the government will pay the difference. If the carbon price exceeds the strike price, companies will pay the difference to the government. This creates a stable revenue flow structure that reduces uncertainty and lowers total and project funding costs. In addition, a decrease in funding costs lowers the required CO2 price level that the project requires (Richstein and Neuhoff, 2019).

2. International Operation Cases and Plans

The CCfD has been the subject of active discussion in Europe, as it is believed that it is difficult to achieve climate goals and induce a transition to low-carbon production methods through the current ETS alone. Therefore, there is a general consensus on the need to improve the ETS and provide additional support.

As of July 2022, the Netherlands is the only country operating a CCfD-type system, called SDE++, which expands upon the existing CfD, SDE+, by adding low-carbon production technology items. In 2020, Germany announced plans to pilot a CCfD program for the steel and chemical industries in its National Hydrogen Strategy report[5]. In addition, the European Commission has suggested the possibility of operating an EU-level CCfD system by including it in the ETS amendment bill[6].

2.1. SDE++ of the Netherlands[7]

2.1.1. System Overview

The Netherlands has been operating the CfD-type SDE+ for renewable energy-based electricity generation technologies and expanded it to include various qualified technology items in the second half of 2020 through SDE++. As shown in Table 1, in addition to renewable energy-based electricity and heat generation, technologies such as industrial heat pumps, electric boilers, hybrid glass furnaces, carbon capture, utilization, and storage (CCUS), and hydrogen electrolysis were included. The requirements for each technology are also disclosed in brochures every year.

2.1.2. Method of Selecting CCfD Support: Strike Price Competitive Bidding and a First-Come-First-Served Basis

SDE++ is operated through a competitive bidding process based on subsidy intensity and a strike price. The calculation formula for subsidy intensity is described in Box 2. Here, the long-term price refers to the price prediction for energy (electricity, heat) or emission rights. In other words, SDE++ is a technology-neutral system that supports technologies that are expected to receive a small amount of payment per unit.

At this time, a bidding process is conducted with upper limit sections for subsidy intensity (refer to Table 2), and projects are selected based on the bidding within the same section for each required upper limit for each technology on a first-come-first-served basis[8]. Additionally, since the budget is limited, only projects that fall within the total budget range are supported.

Selected projects receive actual subsidies every year by multiplying the amount of energy generation or carbon dioxide reduction by the difference between the individual strike price and the market price. In other words, the actual subsidy for each year is determined by correcting sales at the price that the actual energy generation or carbon dioxide reduction is multiplied by the strike price. Here, sales include revenue from actual energy sales and emission rights sales, and the reduction in the amount of emission rights purchased.

An example is presented below (refer to Box 3). According to the SDE++ 2022 brochure, the maximum bidding amount in Phase 1 for a project that installs post-combustion equipment in an existing waste incineration plant and transports carbon dioxide in gas form is 114.7464 €/tCO2. In 2022, the corrected amount was determined to be 52.2510 €/tCO2. Therefore, if a company is selected for the maximum bidding amount for project A in this category, project A will receive a payment of 52.2510 €/tCO2 multiplied by the actual collection in 2022.

2.1.3. Operational Status

In 2022, the total budget for the Netherlands’ SDE++ program was 13 billion euros, a significant increase from the 5 billion euros in 2021. In 2021, there were a total of 4,109 applications (totaling 12.1 billion euros) for the bidding process. Of these, solar power-related projects accounted for 3,915 cases (around 2.2 billion euros based on the application amount). Meanwhile, CCS projects accounted for the largest share of applications, at 6.1 billion euros. Based on this, Aurora Energy Research (2022) predicted that the entire budget for SDE++ in 2021 would be settled at 75 euros per ton. Since 2020, the SDE++ budget in the Netherlands has mainly been allocated to photovoltaics and CCS projects.

In July 2021, the European Commission suggested the possibility of operating an EU-level CCfD system by including it in the ETS amendment bill. This amendment bill was partially revised and passed by the European Parliament on June 22, 2022. Additionally, in May 2022, REPowerEU, a plan to reduce dependence on Russian fossil fuels, announced that existing hydrogen production methods using natural gas would be fully converted to renewable energy, and CCfD would be introduced in industries such as steel to convert to hydrogen-based production processes[10].

As of July 2022, a detailed operation plan has not been announced, so this issue brief summarizes the content mentioned in the bill and Impact Assessment Report of the European Commission, as well as the partially amended bill passed by the European Parliament[11].

2.2.1. European Commission (Draft)

The amendment bill proposed by the European Commission emphasizes that CCfD is an important element for reducing emissions in industries by guaranteeing investors in climate-friendly innovative technologies a price that exceeds the amount derived from the current EU-ETS price level. It also suggests expanding the support scope of the Innovation Fund[12] to support projects through price-competitive bidding processes such as CCfD.

If this is implemented, contracts will be concluded between producers and public institutions at the individual country or EU level, and the contracts will follow the formula described in Box 4.

2.2.2. European Parliament (Draft)

The European Parliament specifies more detailed conditions for the introduction of CCfD than the European Commission. In addition to the draft proposed by the European Commission, the draft proposed by the European Parliament emphasizes that CCfD is an element that triggers GHG emission reduction in industries by scaling up new technologies. It also states that CCfD bidding should consider the principles of technology neutrality and geographic balance, as well as price competition. The existing Innovation Fund that supports CCfD has also been changed to the Climate Investment Fund. This fund supports innovation in technologies and processes that significantly contribute to the goals of decarbonization, zero pollution, and circularity in sectors covered by the EU-ETS bill. It aims to scale up technologies and processes that are no longer innovative but can contribute to achieving the 2030 climate goal because they have significant GHG reduction potential.

3. Design Options for Domestic Introduction

3.1. Selection of Candidate Technologies to be Supported and Recruited

To systematize and implement CCfD in Korea, it is first necessary to determine which technology groups to support. This is because, even though a technology-neutral system is pursued, technology items in a large frame are decided in advance and recruited, as seen in the case of Europe. The Netherlands’ SDE++ program started with CfD in the electricity industry, supported the dissemination of innovative technology in the electricity and heat generation sectors, and expanded to include CCUS. This is in line with the Dutch government's goal of early commercialization of CCS technology based on oil fields in the North Sea. Meanwhile, Germany sees CCfD as a strategy to expand hydrogen demand in the national hydrogen strategy and focuses on supporting the steel and chemical sectors. Therefore, the policy goals and context of CCfD introduction should be clear in order to set the technology candidates to be supported.

In Korea, no discussions on CCfD are being held beyond “supporting companies to induce decarbonization.” Ultimately, to effectively implement CCfD in Korea, it is important to set clear goals for the program and determine which technology groups to support. If the goal is to establish a domestic hydrogen economy like in Germany, technologies such as hydrogen reduction ironmaking, fuel cells, water electrolysis, and cement kilns using hydrogen may be suitable candidates for support. On the other hand, if the goal is to maintain international export competitiveness in the face of strengthening global carbon trade barriers, industries to be supported may be chosen based on their carbon intensity and export dependence.

It is also important to consider that the ultimate goal of CCfD operation is to achieve carbon neutrality by 2050, and therefore the program should support projects that contribute to this goal. McWilliams and Zachmann (2021) suggested that incremental emission reduction technologies through improvement of energy efficiency should be excluded from CCfD support, and technologies that can lead to production cost reduction due to a steep learning curve should be preferred first. Meanwhile, Climate Strategies et al. (2021) argued that the maximum emission criteria of each technology should be determined, and only projects that satisfy the criteria should be allowed to participate in the competition.

3.2. Determination of CCfD Strike Price and Fund Allocation Methods

3.2.1. Competitive Bidding

The main issues currently being discussed in the context of Europe are determining the strike price through an auction and selecting projects. The SDE++ system is a cost-effectiveness-oriented auction system, and the European Parliament’s ETS amendment bill also mentions that CCfD is a technology-neutral and price-competitive bidding system. However, the maturity of low-carbon technologies varies across industries, so it may not be efficient to have a single auction market for all areas covered by ETS. This is because, if the focus is only on cost-effectiveness, technologies with high reduction potential but relatively high costs may be excluded, which could ultimately delay the spread of innovative technologies with large expected ripple effects. In fact, it has been pointed out that after the inclusion of CCUS in SDE++, a large budget was allocated to CCS, which means that large-scale photovoltaics and wind power generation cannot secure enough SDE++ budget.

To address these issues, McWilliams and Zachmann (2020) suggest classifying bidding rounds according to technology maturity. Fewer bidding rounds can support the most efficient technologies at the time of bidding, while more bidding rounds can support a wider range of technologies. However, policymakers may not have complete prior information on technologies, so the classification of bidding rounds can be adjusted based on collected information on marginal abatement costs in the future. Meanwhile, Fabra and Montero (2020) propose an auction that provides minimum quotas for certain desired technologies, rather than classifying technologies in advance.

3.2.2. Negotiation

In general, auctions are a suitable way to induce price competition for standardized products and services. However, it is important to reduce re-negotiation risks for projects that have insufficient prior information due to technical, legal, and financial complexity. This is especially true if there are fewer expected bidders, as the advantage of competitive bidding is further diluted.

Climate Strategies et al. (2021) warn that bidders’ opportunistic behaviors may violate the purpose of GHG emission reduction. One such behavior is the low-balling strategy, in which a bidder submits a very low price, but then incurs additional costs related to new technology performance (e.g., maintenance and failure rates) after being selected for support. This strategy is common in actual national infrastructure construction projects and can lead to significant extra costs and pressure on providers to deliver, due to the difficulty of re-bidding. The procurer (e.g., government) may then tolerate cost overruns and delays. Therefore, if this uncertainty cannot be reduced in advance, it may be reasonable to have detailed negotiations between the two parties beforehand, including determining an upper price limit. However, even with negotiations, there will still be inefficiency due to information asymmetry between contractors. One way to address this issue is to properly combine negotiation and competitive bidding, such as by determining candidates through negotiation first and then proceeding to bidding. Additionally, by using multiple contracts, the government can learn about low-carbon technology innovation and innovative technology providers can increase their experience. This may allow for a gradual reduction in the proportion of negotiation and an increase in the proportion of competitive bidding.

3.3. Determination of CCfD Support Scale and Budget Procurement Plan

Once technology candidates or industry candidates have been selected, it is necessary to determine the goal of GHG emission reduction through CCfD operation, which is linked to the budget scale. It is also necessary to determine where the budget will be procured, which is linked to the detailed goals and governance of CCfD operation. While SDE++ in the Netherlands is funded by the budget of the Ministry of Economic Affairs and Climate Policy, the EU plans to support CCfD with the ETS revenue fund from emission rights (currently known as the Innovation Fund and set to be renamed the Climate Investment Fund in the future) as outlined in the ETS amendment bill.

As a result, when introducing CCfD in Korea, the budget of competent authorities such as the Ministry of Trade, Industry and Energy, the Ministry of Economy and Finance, and the Ministry of Environment, or revenue from emission rights could be used. However, if revenue from emission rights is used for the CCfD budget, it should be linked with K-ETS, as is the case in Europe. This is ultimately linked to the plan for free/paid allocations of emission rights, and there will be a need to gradually reduce free allocations and expand paid allocations in order to operate CCfD on a sufficient scale.

4. Conclusion: Discussions on the CCfD Introduction Suitable for Domestic Situations is Necessary

CCfD can serve as an effective policy basis for industrial efforts to decarbonize because it helps to improve the feasibility and expand the dissemination of new technologies by providing a stable revenue stream. However, because a large number of projects will need to be funded for at least 10 years or longer once introduced and implemented, it is necessary to design a detailed system that is suitable for the domestic situation.

As previously mentioned, similar systems are already being operated or discussed in Europe, including in the Netherlands, and the European Commission and European Parliament are preparing a legal basis for CCfD operation. The legal basis and content related to the introduction of CCfD in Germany have not been disclosed, so this issue brief could not cover it. The Next Group will summarize and update this information as soon as it becomes available. The Next Group hopes that this issue brief will be the start of detailed discussions about the introduction of CCfD in Korea.

[1] This was a 3.5% increase compared to 2020. However, considering that 2020 was a year when the global economy was depressed and industrial activities were slowed due to the COVID-19 pandemic, it is reasonable to compare national GHG emissions with 2019.

[2] This term refers to a situation where, despite the success of technological development at the initial stage of innovation, continuing development is hindered due to the lack of funding and support, such that commercialization eventually fails (Ellwood et al., 2022).

[3] A carbon contract can also be indirectly linked to the emission trading system in that the government sells it to the carbon market.

[4] In fact, the operating principle of the CCfD is very similar to the contract for difference (CfD). However, the trading target of CfD is renewable energy-based electricity and trading target of CCfD is carbon dioxide.

[5] Federal Ministry for Economic Affairs and Energy (2020)

[6] European Commission (2021)

[7] Stimulering Duurzame Energieproductie en Klimaattransitie; Stimulation of sustainable energy production and climate transition

[8] The bidding is conducted on a first-come-first-served basis according to bidding dates, and there is no difference in bidding time. For example, if company A bids 55 €/t CO2 at 11 a.m. on June 28, company B bids 53 €/t CO2 at 2 p.m. on the same day, and company C bids 50 €/t CO2 at 11 a.m. on June 29, respectively, the budget is allocated in the order of B-A-C.

[9] Although the amendment bill refers to “Carbon Contracts for Difference (CCDs),” the meaning is identical to that of CCfD, so this issue brief indicated as CCfD.

[10] European Commission (2022)

[11] In June 2022, the European Parliament confirmed its position on the EU ETS, and now it remains for the Council of the European Union to confirm its position and negotiate a final compromise. Many media sources expect that these processes will all be completed by the end of 2022.

[12] As a fund raised from revenue from emission right auctions, it is mainly used to develop technologies such as innovative low-carbon technologies and processes within energy-intensive industries, CCUS, renewable energy innovative technologies, and energy storage.