8.2.1 Theoretical Benchmark and Market Failures

In economics, a market can be defined as a facility that allows buyers and sellers to exchange any type of goods, services, and information.Footnote ² These facilities used to exist mainly as physical marketplaces where the parties met each other in person. Increasingly, however, they exist in the form of virtual places where the parties submit their bids on digital platforms and the market operator sets the clearing prices and quantities. Irrespective of the way markets are organized in practice, they are meant to help the parties to realize the best deal for themselves. When these markets function well, one can say that the goods are produced and allocated to users in the most efficient way. This means that the goods are supplied by producers having the lowest costs, which refers to the productive efficiency in a market, and that these goods are consumed by the consumers that have the highest willingness to pay for these goods, which is referred to as the allocative efficiency of a market. The amount of goods produced is determined by the point where the marginal costsFootnote ³ of the producers equal the marginal willingness to pay of consumers. After all, if a good is consumed by a consumer with a lower willingness to pay than the marginal costs needed to produce that good, then this exchange between producer and consumer would result in a loss of welfare. This loss of welfare is seen as an allocative inefficiency, as the allocation results in lower welfare than what would be possible. One can also say that in well-functioning markets, the exchange of goods results in the maximum possible welfare.Footnote ⁴

It is important to realize that this theoretical notion of a well-functioning market is not meant to describe real markets, but it can be used as a benchmark for the assessment of actual markets. This also holds for microeconomic theories in general, which are meant to provide analytical frameworks that can be used to analyse actual behaviour of economic agents, such as consumers, producers, and traders. In practice, however, many markets suffer from fundamental shortcomings which prevent the market resulting in an efficient allocation of goods. These fundamental shortcomings are called market failures. The concepts of well-functioning markets and market failures can be used by regulators to determine to what extent and what type of regulatory intervention is needed. Below we will discuss a number of these market failures and how they can be addressed by regulators.

For a perfectly functioning market, a number of conditions have to be fulfilled. One of these conditions is that no market player is able to strategically influence the market outcomes, which means that the market prices are fully exogenous to the suppliers and consumers. If this is not the case, then market prices may get distorted by some suppliers with the result that (other) individual producers and consumers are not correctly informed about the marginal conditions of the other players. For instance, if the market price exceeds the marginal costs of the marginal supplier, then a consumer may decide not to consume a good even though that consumer’s willingness to pay may be higher than these marginal costs. As a result, an allocative inefficiency exists, which is a loss of welfare, referred to as ‘deadweight loss’. This also implies that in a perfectly functional market the only option firms have to make higher profits is to either reduce their costs or to improve the quality of their products and to sell the products to consumers with a higher willingness to pay for such products. In other words, in such markets all suppliers can be seen as price takers, as they can only respond to the market price but not influence it. Generally, one can say that the higher the number of producers in a market, the less firms are able to act strategically. The relation between market structure (degree of concentration) and intensity of competition is, however, not that straightforward as even in industries with only a few firms operating on the particular market, fierce competition may exist, while in industries with a large group of firms, these firms may be able to make joint agreements on, for instance, the magnitude of their supply to the market. Regulators address the risk of abuse of market power by general competition oversight, which consists of two main components: merger control (to prevent the establishment of dominant firms) and antitrust (to monitor and punish the abuse of market power by dominant firms or firms jointly participating in a cartel).

Another condition for a well-functioning market is that no firm has a strategic advantage over others because it is better able to access the market, for instance by using specific infrastructure which cannot be used by others. In other words, all firms should operate on a level playing field. When strategic advantage may result from the usage of essential infrastructure, regulators can implement rules regarding the usage of the infrastructure by other market players. A structural competitive advantage may also result from the presence of economies of scale or scope. This can occur in the case of activities with large fixed costs, such as investments in electricity and gas networks, which have the effect that one firm can conduct these activities more efficiently than a number of (smaller) firms. Such cost advantages result in natural monopolies, which means that the technological characteristics of a given industry results in the fact that it is most efficient to have one firm being responsible for the total supply. As is the case with other (normal) monopolies of firms having market power, unregulated naturally monopolistic firms (such as operators of natural gas and electricity grids) may abuse their position by charging so-called monopoly tariffs, which are tariffs intended to maximize the profits of the firm instead of being related to the marginal costs of production. Hence, such firms with a natural monopoly are not price takers but can be seen as price setters. These firms may also increase their profits by saving on costs for quality improvements or maintenance of their assets, which implies that the resulting higher profits come at the expense of lower quality for customers. To address this type of market failure, regulators may implement rules that restrict the freedom of naturally monopolistic firms regarding the tariffs they charge (so-called tariff regulation) and rules regarding the minimum required quality levels of service provision to customers (so-called quality regulation). In addition, it is crucial for all potential network users to get access to the network, which is called third-party access (TPA).

What is also necessary to obtain well-functioning markets is the presence of full transparency. Producers and consumers need to know what the relevant product characteristics are and under what conditions market transactions can be concluded. In practice, however, markets may fail to realize an efficient allocation in the presence of information asymmetry, which means that the parties (suppliers and buyers) cannot have the same type of information on the characteristics of the commodities. This market failure may result in so-called adverse selection, for instance when high-quality products cannot compete with products of lower quality, where the higher-quality product is more costly but consumers are uncertain about the quality of the product. Consumers are generally not prepared to pay their maximum price for a high-quality product if they are uncertain about the true characteristics (quality) of a product. This may occur if consumers cannot fully assess the quality of a commodity and, as a result, they may not be inclined to pay the full price. If this market failure occurs, coordination or regulation is required, for instance by organizing a trustworthy certification scheme.

Another type of market failure consists of externalities, which occur when economic agents do not take into account all costs or benefits of their activities. Negative externalities result in too high a level of activities from a social point of view. An example of such an externality is carbon emissions resulting from the use of fossil fuel energy. Positive externalities result in too low a level of activities of firms as they cannot capture all the benefits of their activities. This may, for instance, occur if the benefits of innovation cannot be protected by innovative firms. In that case, firms will not innovate enough, or at least they innovate less than they would do if the benefits could be fully captured. Another type of externality is called network externalities, which may result in a limited number of suppliers capturing the full market and, as a result, other firms being unable to enter the market. If network externalities exist in the market, the parties should coordinate how they want to organize the market, or a regulator should impose regulations on market design.

A final type of market failure is the presence of so-called hold-up, which is that the parties are hesitant to take actions which would be beneficial from a social welfare point of view. This may occur in the case of long-term investments without long-term contracts with customers or without the existence of liquid markets. For instance, in the case of a natural gas grid, the owner may be uncertain to what extent the users of that grid will keep using the grid and to what extent they are willing to pay the required tariffs. Because of that uncertainty, the owner of that grid may be hesitant to invest in grid extension unless users have made explicit long-term commitments about their future usage or regulators have indicated that future losses due to a lower utilization will be reimbursed. Consequently, the presence of this market failure may result in too little investment because firms are uncertain about the ex post revenues once they have made an investment. When this market failure exists, coordination or regulation is needed to give investors more certainty about the future revenues.

8.2.2 Regulatory Measures to Develop Energy Markets

If there are no fundamental shortcomings, markets just develop when individual suppliers and consumers see opportunities to start exchanging goods. In several cases, however, some factors lead to situations where markets cannot develop themselves and therefore they need regulatory help. This is true in particular for energy markets, where, because of some peculiarities, these markets cannot fully develop automatically without any help. Energy markets are based on physical networks, conveying natural gas, electricity, heat, and hydrogen and require government intervention to develop. In many countries in the recent past, the previously centrally coordinated systems for the delivery of gas and electricity have been replaced by markets through policy interventions. These interventions included various measures, which can be distinguished as liberalization by fostering competition and creating liquid marketplaces, restructuring of the industry, regulating natural monopolies and externalities, and removing bottlenecks for international trade.

With the liberalization of markets, a main goal is to develop effective competition and create liquid markets. A market is called liquid when the price of a good traded is not noticeably affected by actions taken by an individual. The liquidity depends on the transaction costs parties must put up with and the confidence they have in the market system. The latter depends on transparency of the operation of the market. When these conditions are met, the market will attract more parties, increase its volume, and further improve its liquidity. However, at times not every aspect of a market is well suited for competitive behaviour. One factor making parts of the market unsuitable for competition is the presence of natural monopolies. In electricity and gas markets, and possibly also in hydrogen markets, the networks are characterized by economies of scale, which make it unfeasible to create parallel networks. This situation requires the implementation of tariff regulation, quality regulation, and regulation of TPA.

Energy markets also require regulatory measures to address externalities, in particular environmental emissions. By imposing emissions standards or introducing emissions trading schemes or fossil-fuel energy taxes, the parties are incentivized to take the (negative) external effects into account when they are making decisions on production, investment, or consumption.

Although energy markets typically include some monopolistic elements that cannot be eliminated by increasing competition, there are other elements that are well suited for competition. To foster the entry of players in those segments of the market, authorities can choose to restructure the market in such a way that the monopolistic and competitive activities are not done by the same firm. This is called vertical unbundling of activities and is a well-known way to prevent conflict of interest. Another restructuring measure is the horizontal splitting of large incumbent firms into competitive segments. Without this, incumbent firms may have excessive market power, which will enable them to behave strategically – raise the market price to the monopoly level. A final form of restructuring is the privatization of ownership of incumbent firms. Privatizing the commercial elements of a sector gives those firms stronger incentives to be efficient as they face more pressure from the providers of equity or the capital market.

Vertical unbundling of monopolistic segments and the introduction of TPA does not automatically result in a competitive market. Effective market competition can only be achieved when the number of firms active in the market is sufficiently high while consumers are able to make a choice of their preferred supplier and the type and number of products they prefer. The benefits of such effective competition are that the market price is more related to the marginal costs. A regulatory measure that may further enhance competition is international market integration. When regional markets become more integrated with each other, domestic firms are able to operate in other markets as well. This (potentially) increases the number of players in all the regional markets which will foster competition and, therefore, the final price will be a better reflection of costs. Next to improving competition, market integration may also result in higher productive efficiency since firms with lower costs will replace those with higher costs. Second, and especially important in energy markets, there will be more flexibility to deal with demand or supply shocks. A larger integrated market has more options to deal with shocks to demand or supply than a market in a smaller region.

8.2.3 Regulatory Failures

When a market suffers from a fundamental shortcoming, like the ones described above, regulatory measures may help to improve the development or functioning of the market. However, finding and implementing the best type of regulation is often challenging. In this respect, it is important to realize that governments may also fail to implement the most appropriate regulatory measures. Such regulatory failures may be the result of various factors.

The first factor to mention is the information asymmetry between government (including the regulator) and market parties. Governments are generally less well informed than the parties about the precise characteristics of technologies (such as their costs and revenues), the actual outcomes of markets (such as profits realized by the various parties) or the (in)ability of the parties to enter into a market. Because of such information asymmetries, regulatory measures may be too generous at the expense of the public budget, or they may be too strict, with the result that the measures are less effective. Information asymmetry may also refer to a lack of information on the actual behaviour of market parties. This regulatory failure results in so-called moral hazard behaviour by regulated parties, which is, for instance, that they make less effort to realize their own objectives because of the impact on regulatory decisions. As an example, subsidies to compensate for all costs of a renewable energy project take away the incentives for firms to reduce these costs. Another example of moral hazard resulting from regulation is the so-called cost-plus tariff regulation of grid operators, which entails that these operators are allowed to raise their tariffs in response to an increase in their own costs. These operators don’t have any incentive to become more efficient, while they would have such incentives if their regulated tariffs were not related to their own costs.

Regulatory failures may also be due to rent-seeking behaviour by some parties. This can be related to information asymmetry, as an information advantage by market parties may be used to plead for regulations which are beneficial to them, but are not in the general interest, while the regulator is unable to check this. The likelihood of such behaviour is the greater, the more regulators depend on information provided by the regulated parties. Rent-seeking behaviour is also more likely to occur when parties are able to jointly act as a coherent group submitting internally consistent messages to politicians.Footnote ⁵ In such circumstances, it is more difficult for politicians to withstand such pressure from interest groups.

Regulatory measures may also not be in the public interest when politicians pursue their own (political) interests instead of the general welfare. This may occur when politicians implement measures which foster the interests of those they expect to support them. To give an example: politicians with the majority of their voter base amongst homeowners instead of renters may promote financial measures supporting the installation of rooftop solar photovoltaics systems while this measure, from an overall welfare perspective, may not be efficient.

8.3.1 Market Failures in Hydrogen Supply Chains

To determine whether the development of a market for hydrogen needs specific regulation, we first analyse the presence of market failures in the hydrogen supply chain.Footnote ⁶ This supply chain basically consists of the production, transport, storage, distribution, and consumption layers (see Figure 8.1). While the supply chain refers to how the hydrogen flows from production to consumption, the term hydrogen markets is understood in this chapter as how the commercial relations between agents in this supply chain are organized. Just as with natural gas and electricity markets, the functioning of hydrogen markets is related to the functioning of the physical infrastructure. Below we analyse for the various components of the supply chain and the markets to what extent there is potential for market failures, like economics of scale, externalities, structural lack of competition, information asymmetry, or hold-up. If such failures are found, we explore potential regulatory solutions to address them.

Figure 8.1

Supply chain of hydrogen.

Source: Author

8.3.2 Production of Hydrogen

Hydrogen is an energy carrier, not an energy source, which implies that it has to be produced from other energy carriers.Footnote ⁷ This production can be done in various ways which can be distinguished into two groups: production based on fossil energy, in particular natural gas, and production based on electricity. In the first method, the methane molecules (NH₄) of natural gas molecules are split into H₂ and CO₂. This is still the common method of hydrogen production. When the CO₂ is captured and stored (so-called carbon capture and storage – CCS), for instance in depleted gas fields, the resulting hydrogen can be almost 90 per cent carbon free (not 100 per cent as full capture is technically not possible). One of the technical methods in this type of hydrogen production is called steam methane reforming. In the second method, water molecules (H₂O) are split into H₂ and O₂ using electricity. This is called electrolysis, which can be differentiated into different types – such as alkaline electrolysis, which is the oldest technique, and proton exchange membrane (PEM) electrolysis.Footnote ⁸ Depending on how the electricity is generated, the resulting hydrogen can be called fossil-based (when the electricity is generated by fossil-fuel power plants) or fossil free (when the electricity is generated based on renewable sources or nuclear power). As electricity is a secondary energy carrier, this type of hydrogen can be seen as a tertiary energy carrier. This is relevant for the economics of hydrogen production as the costs of the primary energy carriers used and the efficiency of the conversion processes determine the costs of hydrogen supply.

To determine to what extent the production of hydrogen is characterized by economies of scale, one can look at the required investments per megawatt (MW) of capacity in relation to the magnitude of demand in the market. In this respect, it appears that production of hydrogen can be compared to the production of electricity. The installations required to convert an energy carrier into hydrogen or electricity require similar amounts of investments. An advanced combustion turbine gas plant requires about 0.5 million euros/MW, which is a bit less than the investment size of a steam-methane reforming plant, while the investment in an electrolysis plant is equal to about 1 million euro/MW. Coal-fired and, in particular, nuclear power plants are, however, much more capital intensive.

In addition, it appears that neither type of hydrogen production requires specific locational circumstances. Steam-methane reforming plants need access to the gas network, as they need gas as input, and electrolysis plants need access to the electricity grid and water network, as they need electricity and water as inputs, but access to these networks is in principle everywhere available in most countries, due to the existing TPA regulation of gas and electricity grids. In the case of steam methane reforming in combination with CCS, proximity to a transport and storage system for CO₂ is also required, and here we may find some locational constraints.

The above implies that, from a competition point of view, the supply side of hydrogen production needs no particular economic regulation as the relatively small scale of the production facilities and the absence of strong locational advantages prevent the occurrence of a natural monopoly. Hence, the existing regulation of TPA to electricity and gas networks will be sufficient along with the general competition policy oversight to realize competition in the production of hydrogen.

For the negative environmental externalities occurring through the production process, however, regulation is required. As in the case of steam methane reforming, even when combined with CCS, there are always remaining carbon emissions because of technical constraints regarding the conversion process of making hydrogen based on natural gas as well as the transportation of carbon. Hence, these emissions should be subject to environmental regulation, such as a cap-and-trade emissions scheme, in order to give the hydrogen producers incentives to take these emissions into account when they decide upon investment and production levels. In the case of electrolysis, the production of hydrogen does not generate any carbon emissions, but indirectly these emissions do occur when the electricity is generated based on fossil fuels. This negative environmental externality is (partly) addressed through environmental regulation of the electricity industry, such as through emissions trading schemes, support schemes for renewable electricity (which reduces the share of fossil-based electricity in the mix) and taxation on the use of fossil fuel energy in electricity generation. In addition, when hydrogen from various sources is transported through one network, potential users of that hydrogen are not able to determine the environmental burden during the production process of the hydrogen they want to use. Hence, regulation is needed to enable producers of hydrogen to inform their customers about the carbon content of their production process. This regulation will be discussed below in Section 8.3.7 on retail markets.

There is potentially another externality related to the supply of hydrogen in the market, which is the security of supply externality. When significant amounts of hydrogen are coming from a small number of countries, this may result in geopolitical dependence, as we have seen in the natural gas market.Footnote ⁹ In order to address this risk, governments could foster diversification of the sources of hydrogen imports by enabling parties not only to import from nearby sources at lowest costs, but also to import from sources at a greater distance.Footnote ¹⁰

8.3.3 Transport of Hydrogen

Just as hydrogen can be produced in various ways, it can also be transported through various modes: via pipelines, trucks, and ships. The different forms of transportation require different amounts of investment, which affects the economies of scale and potential sources of market power. In the first mentioned way, hydrogen is transported in gaseous form, and in the latter two in liquid form. Before hydrogen can be transported in gaseous form through a pipeline system, its volume is reduced (the energy content per unit of volume is raised) through compressing, just as is the case with the transport of natural gas through pipelines, which means that additional investments have to be made. In the case of transport via trucks or ships, the temperature of hydrogen needs to be lowered in order to raise the energy content per unit of volume, which is required to reduce the transportation costs.Footnote ¹¹

These transportation options have strikingly different economic characteristics. The transport of hydrogen by pipeline is characterized by scale economies as the investment costs per unit of energy transported decrease more the larger the capacity of the transport infrastructure. Although the capital costs of pipelines are high, the large quantities that can be transported (up to 9,000 kg/h) and the relatively low operation costs reduce the costs per kilogram (kg) of hydrogen. Hence, with large quantities of hydrogen, transport via pipelines is the most suitable and cost-efficient option. In addition, the greater the quantity transported, the lower the unit costs. For smaller quantities, however, the construction costs of a pipeline per unit of hydrogen are simply too high, which means that in such a situation transport by truck is more efficient. Therefore, transport through pipelines has to be regarded as a natural monopoly when the amount of hydrogen to be transported exceeds a minimum threshold. This in particular holds for the situation in which existing natural gas pipelines can be repurposed for hydrogen. In that case, the average costs per unit of transport are much lower than in alternative transportation modes, which gives the operator of such a pipeline system a competitive advantage.

A consequence of the cost advantages of pipeline transport compared to transport by truck is that when the hydrogen market evolves, transport will be done through pipelines. Because of the natural monopoly characteristic of pipelines, it is not efficient to have more than a single network for the transport of hydrogen, which means that competition cannot evolve in the transport business. The transport of hydrogen, therefore, needs to be subject to economic regulation, just like the transport of natural gas and electricity. This regulation should entail tariff regulation, protecting network users from tariffs that are too high, giving network operators incentives to operate as efficiently as possible, and enabling other market participants (producers and users of hydrogen) to make use of the transport infrastructure.

As hydrogen transportation infrastructure has to be developed, investors in this infrastructure need to have some certainty about future utilization and revenues. Without this certainty, they may delay their investment. Governments can play a role in providing regulatory certainty about how the future revenues will be determined and how extensive the future utilization of the infrastructure may become.Footnote ¹²

8.3.4 Storage of Hydrogen

Hydrogen can be stored in several ways. The simplest option is to store hydrogen in tanks, for which it needs to be compressed, but even with high pressures the required volumes remain large, which makes it an unrealistic option for large-scale storage. To store the same amount of energy by hydrogen compared to natural gas, the required volume is about four times greater.Footnote ¹³ The volume of the storage can be reduced through liquefaction, but this requires significant amounts of energy, which also makes it less attractive from an economic point of view. An option to store large quantities of hydrogen in an efficient way is to make use of salt caverns or depleted natural gas fields.Footnote ¹⁴ Salt caverns in particular do have great potential in many countries because of their widespread presence (although this is not possible everywhere), and their ability to provide large-scale storage which can be used with a high level of flexibility in terms of injection and withdrawal.Footnote ¹⁵

Storing hydrogen can be relevant when the timing of production and consumption are not similar. When hydrogen is mainly used for industrial processes or heavy transport, consumption will be fairly flat, which implies that the producers of hydrogen do not need to (greatly) adapt their production profile. This situation differs, of course, when hydrogen consumption is more volatile. This will occur when hydrogen is used for producing heat in households and offices, as then the demand will depend on the outside temperature. If the temperature drops, the supply side should be able to increase its supply to the market to meet demand. For competition to be effective under such circumstances, it is crucial to know what type of and how many facilities would be required to realize this increase in supply. The more facilities required to provide the flexibility in supply, the less individual suppliers are in a strategic position to influence market outcomes. To obtain a better impression of the competitive situation in case of a cold two-week winter period (as an example), one can estimate the number of facilities required for various types of techniques.

If storage were available in the form of salt caverns, then about fifty of them would be needed to meet the Dutch demand for hydrogen for heating purposes during a cold winter period as defined above. However, if depleted gas fields could be used, then only three fields would be needed. In the latter case, a monopoly may easily occur if these fields were all operated by a single firm. In such case, regulation would be required to assure that the flexibility to supply extra hydrogen during cold winter days is available to the market at reasonable prices. This regulation would be comparable to the current regulation of storage in the natural gas market because of the importance of having flexibility in the form of storage available at reasonable prices if hydrogen is used for heating homes.

The same conclusion holds when instead of depleted gas fields or salt caverns another large-scale storage option were to become available. As many technologies to store hydrogen as liquid, compressed gas, or chemical storage are under development, this may result in a storage solution which outcompetes other technologies in terms of efficiency and costs.Footnote ¹⁶ In that case, the storage side of the hydrogen market may be characterized by a few players, which would require regulation as mentioned above. However, if hydrogen is not (so much) used for heating homes but more in industry then there is less need to implement strict access regulation storage as industries generally have more options to deal with supply disruptions, while their demand for hydrogen would be less dependent on external weather conditions than the demand from households.

8.3.5 Consumption of Hydrogen

In its pure form, hydrogen is currently mainly used in industry (in particular refining, ammonia, chemicals, metals, electronics), while in a blended form (mixed with other gases), it is mainly used for creating methanol and heat.Footnote ¹⁷ In oil refining, hydrogen is used to convert crude oil into various end-user products such as transport fuels and feedstock for the chemical industry. This use of hydrogen is currently responsible for a major share in the carbon emissions of the industry, as the hydrogen that is used here is produced as a by-product of fossil energy or created through steam methane reforming. In the future, emissions stemming from the production and consumption of hydrogen have to be reduced sharply, which can be done by either using renewable hydrogen or capturing and storing the carbon emissions in the production process (see Section 8.3.2). This transition requires environmental regulation, in particular by imposing a carbon price on remaining carbon emissions or a constraint through, for instance, a cap-and-trade emissions trading scheme.

In the future, low-emission hydrogen demand will not only come from the abovementioned industries, but also from the transport sector, in particular from heavy freight transport, where hydrogen can be used in fuel cells as well as in internal combustion engines.Footnote ¹⁸ To realize this potential, more specific regulation is needed regarding the development of appropriate charging infrastructures.Footnote ¹⁹ In addition, hydrogen may also play a role in providing seasonal flexibility to electricity markets which are characterized by high shares of renewable generation. The potential of this usage depends on the competitive position of hydrogen storage combined with hydrogen power plants in comparison to other options to provide flexibility to electricity markets (such as hydropower and demand response).Footnote ²⁰ As long as electricity prices reflect the changing scarcity conditions in these markets, no specific regulation is needed to foster particular sources of flexibility, such as hydrogen. Note that this statement refers to the wholesale market, as in the retail market the end-user prices are generally less directly related to changing market circumstances. For hydrogen producers, however, the wholesale market is relevant as that is where they buy their electricity.

8.3.6 Wholesale Markets

Just as for the natural gas market, a hydrogen wholesale market could function based on a transport and storage infrastructure that is accessible by all those who want to trade in hydrogen. After all, the wholesale market will include a physical exchange of the commodities, although financial markets will also emerge, once the physical trade options exist. The latter markets are more related to the desire of parties to hedge their risks through long-term financial forward contracts or options. The physical market can exist as an over-the-counter (OTC) market with bilateral exchange through a broker or an exchange with standardized products and clearance by the exchange operator, who also takes over the financial risks. The last option facilitates the liquidity of the wholesale market as it results in standardization of the products which reduces the transaction costs, while transparency on prices and market conditions is fostered, which results in a higher volume of trades.

The hydrogen market may learn from how the market for natural gas developed over the past decade. Because of the differences in quality of various gases depending on their source, the trade in natural gas is done in uniform thermal (energy) units (in MWh), which strongly facilitates trade. To sell the commodity as a homogenous product, each type of gas is valued in terms of the energy content it carries. This means that it is not the volume (such as cubic metres – m³) of the gas that is sold, but the amount of energy it carries, since heating is the main purpose of natural gas. In addition, to reduce the transaction costs and increase the transparency of trade, market hubs have been created in many countries: for example, the Title Transfer Facility (TTF) in the Netherlands, Net Balancing Point (NBP) in the United Kingdom, NetConnect Germany and GasPool in Germany (which recently have merged into Trading Hub Europe (THE)) and Virtual Gas Trading Point PSV in Italy. These marketplaces are virtual hubs based on an entry–exit system in which parties can transfer gas already injected into the national grid to other parties. As long as the gas is within the system, it can change owner. It is common that gas ownership changes numerous times between entry and exit. This is the so-called churn rate.Footnote ²¹ In particular, the churn factor of the TTF has increased strongly over recent years, thereby indicating that this market has become highly liquid. One factor behind the liquidity of the TTF are the high quantities supplied relative to the quantities demanded. The total supply to the Dutch natural gas market has been about twice as high as total Dutch gas consumption, while in most other countries this ratio is much lower.

8.3.7 End-User Market

Consumers may have different preferences for the type of hydrogen they want to use, just as they have different preferences for various types of electricity and gas. The economics of the transport of hydrogen, however, shows that it is not efficient to have alternative transport infrastructures. In the situation of a well-developed large-scale hydrogen market, all hydrogen coming from different sources (be it on the basis of steam methane reforming with or without CCS or on the basis of electrolysis based on grey or green electricity) will have a standardized physical quality as it will be transported through the same infrastructure. Users who prefer a specific physical quality (for example, pureness) of hydrogen, may need to convert the hydrogen to a different quality level upon its arrival at their location. This will likely hold for various industries, such as chemicals, glass-making, and steel. If hydrogen is used for heating, for instance in industry, users only have to adapt their appliances to the hydrogen quality transported through the network.

A more important distinction in quality is related to the way in which the hydrogen is produced, as consumers may have a preference for low-carbon hydrogen. This quality is not related to the physical characteristics of hydrogen, but to how ‘sustainably’ it is produced. To facilitate these consumer preferences, a certification system is required, just as currently exists for electricity and gas based on the European system of Guarantees-of-Origin. This certification scheme, which is included in the European Renewable Energy Directive II, provides an internationally consistent approach to monitor carbon emissions throughout the supply chain, taking into account that hydrogen can be used in various types of end-user products, such as ammonia or fuels.Footnote ²² As countries and regions are currently developing their own certification schemes, it will be crucial for international trade to harmonize these into a global scheme.