Decarbonizing the Future: Are Carbon Contracts for Difference the Key to a Green Industry?

As part of its goal to reach climate neutrality by 2045, the German government is seeking to transform energy-intensive industries towards less emission-heavy processes. To support the financing of the necessary transformations, the Federal government has proposed the use of Carbon Contracts for Difference (CCfDs), also called “Climate Protection Contracts”. Applying for such financing may be attractive to all German high-emissions businesses, but especially to energy-intensive manufacturers such as the steel industry.

In this blog post, (i) we provide a comprehensive overview of the German government's plans concerning CCfDs as outlined in their most recent draft funding guidelines, and (ii) examine the advantages and disadvantages of using CCfDs as a tool for change.

What are CCfDs and how do they work?

The concept of a “contract for difference” originates in the financial markets as a tool to secure against fluctuating prices. CCfDs utilize this concept for a new form of state aid:

When a company shifts to a production technology with less greenhouse gas emissions, the production costs often increase significantly. This difference in production costs is referred to as the "carbon avoidance costs". At the same time, the reduction in greenhouse gas emissions also means that the company will have to purchase and surrender fewer emissions allowances under the EU Emissions Trading System (EU ETS). However, currently, these EU ETS savings do not compensate for the substantial carbon avoidance costs. The volatility of prices under the EU ETS renders it challenging to plan long-term investments based on the anticipation of a long-term increase in emission costs. These factors reduce the attractiveness of shifting to low-emissions production technology.

This is where the proposed CCfDs come in. They distribute the carbon avoidance costs between economic operators and the Federal government. By covering the financials risks associated with carbon avoidance costs, CCfDs are meant to offer investment certainty and make the shift towards low carbon emissions just as attractive for companies as staying with conventional technology.

The typical term of a CCfD is envisaged to be 15 years. The subsidies are to be paid in annual sums. They cover the annual additional costs resulting from the use of a less CO2-emitting manufacturing process compared to a reference process that uses conventional technologies. These annual additional costs include the additional costs arising from the construction of such a manufacturing facility (so-called investment cost differences) as well as the additional costs from its operation (operating cost differences).

The subsidies are envisaged to have two components: A static component, the so-called base contract price (“Basisvertragspreis”), and a dynamic component, the so-called dynamized contract price (“Dynamisierter Vertragspreis”). The base contract price covers the additional costs of using low-emissions technology, calculated per ton of avoided greenhouse gas emissions in comparison to a reference technology. To this, the dynamized contract price is added. It is calculated by considering the indexed costs of the new energy source used per ton of avoided greenhouse gases emissions against a fixed base price. From the sum of both contract price components, the difference between the effective carbon price when using low-emissions technology and when using the reference technology is deducted. A further deduction is made for so-called green surplus revenues (“grüner Mehrerlös”). A green surplus revenue is defined as the additional revenue that the beneficiary can generate by achieving higher prices for products manufactured using the subsidized climate-friendly production process. 60% of a “lump-sum” green surplus revenue defined by the authority may be deducted from the subsidy if the authority considers this surplus revenue not to be adequately reflected in the bids submitted to obtain the CCfD.

Other subsidies received for the same project are deducted from the subsidies under the CCfD. The CCfD subsidy amount is also capped, both annually and in total, at a respective maximum amount set in the original grant decision.

If the savings from the reduced need for emissions allowances are greater than the carbon avoidance costs, the CCfD’s beneficiary will be required to repay the subsidy amount exceeding the costs incurred when using traditional technology. The exact modalities are to be agreed upon in the individual CCfD. However, both parties may be released from all payment obligations under the CCfD at the request of the beneficiary if the low-emissions technology has become an industry standard and determines the industry prices.

Which projects are eligible for a CCfD?

According to the draft funding guidelines, some of the key requirements for eligibility include:

The project must be based in Germany and produce a material that is listed in Annex I to the EU ETS Directive, for example a raw material produced through energy-intensive processes such as metal ore, steel, cement, and lime. It may not only serve the purpose of converting one energy form into another.

The current greenhouse gas emissions of the project must exceed a minimum value which is specified for each bidding process and cannot be below 10 kt of CO2-equivalents per year.

The project must align with the EU's and Germany's climate protection goals and support the company's goal of achieving climate neutrality by 2045. It must meet specific threshold values specified by the responsible authority, which must at least amount to a relative greenhouse gas emission reduction of 50% within one year and of 60% within two years, each as compared to a reference system outlined in the funding guidelines, with a continuous further emissions reduction for the remaining contractual term and the possibility of achieving a relative greenhouse gas emission reduction of 90% within the contractual term.

The CCfDs will be awarded via a bidding procedure, held by the Federal Ministry of Economic Affairs and Climate Protection (BMWK), with the option to delegate to other public authorities. Selection criteria include cost efficiency, greenhouse gas emission reduction and energy intensity. Upon selection, the winning company will receive a formal grant decision and enter negotiations with the authority to finalize the details of the CCfD.

The draft guidelines allow the BMWK to conduct an additional “preliminary procedure” (“vorbereitendes Verfahren”). This is meant to help the authority gather information for the bidding process and to give bidders the opportunity to pose questions about the process. Importantly, full participation in this preliminary procedure is a prerequisite to be eligible for the following bidding procedure.

CCfDs – the right tool?

While many are welcoming CCfDs as a tool to ease the industry’s transition towards a greener future and preventing the relocation of emissions-heavy industries away from Germany, the discussion on their utility is far from over.

In its December 2022 report, the BMWK’s scientific advisory board discouraged a broad use of CCfDs and recommended employing CCfDs only as a tool to help fund pilot projects. It stated that while CCfDs reduced the risks associated with transformative technologies for companies and thus also reduced the costs of financing such transformation processes, there were several downsides to the concept. The industry-wide usage of CCfDs comes with high costs to the public budget. The advisory board fears such funding may reduce incentives for innovation and competition in finding low-cost solutions for industry transition. The probability of pay-out from the CCfDs towards the state is considered to be low.

Looking ahead

The governing parties made a commitment to support the German industry and prevent carbon leakage in their 2021 coalition agreement, naming CCfDs as a tool to close profitability gaps. However, nothing is set in stone yet. Although the BMWK has announced its intention to start the first “preliminary procedure” to a bidding process in April 2023, this is likely to be delayed. The draft funding guidelines are still under debate within the Federal government and are also subject to approval by the European Commission under EU state aid rules. Thus, there may still be some room to address some of the current draft’s weaknesses.