Low-Carbon Ammonia Offtake Agreements Require Special Scrutiny
In this article for Bloomberg Tax, Kirkland partners Marcia Hook, Sam Kamyans, Tatiana Monastyrskaya and Jim Dolphin discuss how to identify and manage risks when drafting offtake agreements for low-carbon ammonia projects, which have become increasingly attractive thanks to the Inflation Reduction Act's production tax credit for clean hydrogen.
Parties have gotten much more interested in developing low-carbon ammonia projects since the Inflation Reduction Act’s enactment of the production tax credit for low-carbon hydrogen. However, certain bankability and contractual considerations must be addressed in the context of low-carbon ammonia projects.
It’s possible to identify and manage the challenges and risks when drafting offtake agreements for such projects.
Ammonia is a key input to fertilizer, with some estimating that 50% of the world’s food production relies on ammonia fertilizer. Most hydrogen is produced through steam methane reformation of natural gas. Low-carbon hydrogen facilities, such as those that produce hydrogen using electrolyzers powered by renewable energy, are more expensive to develop than the SMR facilities, and therefore are still uncommon.
The 10-year PTC for clean hydrogen aims to incentivize production. The value of the credit, which can be up to $3 per kilogram of qualified hydrogen, varies depending on the lifecycle greenhouse gas emissions associated with the production of the hydrogen.
Facilities that produce hydrogen by using electrolyzers powered by renewable energy, or combining SMR with carbon capture, are well-positioned to utilize the higher PTC values and obtain traditional financing. Clarifying guidance from the Treasury Department will enhance these projects’ financeability, giving banks and sponsors greater legal certainty, and enabling them to focus on the offtake agreement, which is a critical revenue contract.
Conventional ammonia offtake agreements may need to be reworked substantially to be bankable precedent, wherein a party will lend money to a project, the repayment of which depends on cash flows from the offtake. This poses a challenge for development-stage low-carbon ammonia projects in connection with obtaining third-party financing. Drafting offtake agreements for such facilities requires an understanding of the US ammonia market as well as incorporating concepts more commonly seen in other commodity spaces.
Emissions intensity is one structural area that may need to be addressed in offtake agreements for low-carbon ammonia projects. Purchasers of low-carbon ammonia often value its green attributes, so low-carbon ammonia offtake agreements should set expectations for emissions levels.
The agreements also should consider a seller’s obligations with respect to delivering and substantiating the quality of conforming product, as well as remedies if those expectations aren’t met.
It’s important to harmonize information provided to ammonia offtakers with the information the seller receives from its suppliers. This is especially true of power suppliers, as emissions associated with power production will substantially and directly impact emissions intensity of the ammonia.
The seller’s power purchase agreements should require sufficient information reporting for the seller to prove the value of environmental attributes and other incentives to offtakers, plus the PTC value to its financing parties.
The seller also should develop a program to mitigate the financial impact of reduced PTC values if emissions intensity requirements aren’t met. Sellers relying on monetizing PTCs should ensure robust recordkeeping and substantiation to withstand both offtaker and IRS scrutiny.
Another challenge is that low-carbon ammonia projects have what project finance lenders refer to as “project-on-project” risk. A large-scale, low-carbon ammonia facility requires a significant development timeframe for the ammonia production facility and any attendant sequestration facilities or renewable energy facilities that will supply power.
Low-carbon ammonia offtake agreements therefore must address such project-on-project risks by providing a cushion in the construction schedule of related facilities, including well-articulated development milestones, and specifying bankable remedies if those development milestones are delayed or aren’t achieved.
A third area of risk is offtaker creditworthiness. There isn’t a liquid market for low-carbon ammonia, so lenders don’t have a tool for evaluating or mitigating merchant risk. If an offtaker defaults, the seller doesn’t have meaningful remedies—it can’t expect to sell the product merchant and receive the same compensation as under the original offtake agreement.
Accordingly, lenders place substantial emphasis on the offtake agreement and offtaker’s credit. In the absence of an investment grade credit rating, lenders may require that offtake agreements include liquid credit support backstopping offtakers’ obligations.
The hydrogen PTC will support the formation of low-carbon ammonia projects, which present certain challenges and risks that can be managed through careful drafting and harmonization of agreements.
