(Carbon) Contracts for Difference - the basic principles

The European Union (EU) is introducing new regulation to reduce GHG intensity and emissions from the shipping industry under the ‘Fit for 55’ package to achieve the decarbonization goals set out in the European Green Deal. Fit for 55’ should be designed and implemented with a target of having commercially viable zero-emission vessels operating along deep-sea trade routes by 2030. A key barrier to achieving these targets is the significant competitiveness gap that exists between fossil fuels and zero emission fuels.

The inclusion of shipping in the EU Emissions Trading System (ETS) will result in a reduction to the cost gap between SZEFs and fossil fuels. However, the expected ETS prices will be insufficient to create price parity with traditional fuels, which means that a significant cost gap will remain due to SZEF production technologies still being in their emergence phase. Therefore, in addition to putting a price on emissions from fossil fuels, the EU ETS should be complemented by support mechanisms that will reinvest a portion of shipping related ETS revenues into incentives for the production and use of SZEFs. This will drive down the cost of SZEFs, in a similar way to programs that supported renewable electricity such as wind and solar as explained by University of Oxford researchers in a June 2021 report.

A CfD program that supports at least five per cent SZEFs in EU shipping would cost an estimated 1.2 billion euro annually according to the Global Maritime Forum. This can comfortably be funded using shipping related ETS revenues which are estimated at 5 to 9 billion euro annually depending on the ETS price. This strategy of carbon pricing combined with the reinvestment of revenues through CfDs could also provide a useful template for other regions and for eventual global action through the International Maritime Organization. A CfD program should target different SZEFs in separation from each other to account for the fact that different fuels are at different stages of their development cycles.

A CfD mitigates the market risks faced by suppliers of a new, high cost commodity by paying the supplier the difference between a predetermined reference price reflecting the old technology (in this case, the cost of conventional shipping fuel) and a ‘strike price’ set at the value required for the new technology to be viable. The strike price can be determined either administratively or through a competitive auction, in which bidders submit prices and the lowest bid(s) is awarded the contract, subject to meeting specified conditions. When the reference price is lower than the strike price, the supplier is paid the difference. This ensures that the supplier receives a guaranteed minimum price for the duration of the CfD. In most CfD mechanisms, if the reference price exceeds the strike price, the supplier repays the subsidy (support payment). CfDs would allow the EU to subsidize the difference between what it costs to produce SZEFs (strike price) and the price at which SZEFs can be sold to energy users (reference price). Since subsidies are only paid to the private sector when there is a difference between the strike price and the market reference price, the EU would not be required to pay subsidies if factors such as oil price volatility suddenly made SZEFs competitive with fossil fuels.

A CfD model for the shipping industry would most likely focus on the cost of fuels, with ship operators directly receiving government subsidies for the cost difference between the strike price for SZEFs and fossil fuels. In turn, ship operators would sign offtake agreements with fuel producers based on this fixed strike price. A fixed strike price means that fuel producer revenues would also be fixed (with the potential for some revenue enhancement through ‘green premiums’ paid by customers). Therefore, regardless of market dynamics, fuel producers will be driven to reduce costs to improve profits. This will likely result in a virtuous cycle, where optimization drives fuel prices down, which in turn lowers the cost of the shipping industry’s energy transition.