Offtake agreement
Offtake agreements are negotiated between a supplier and a buyer to establish the agreed terms for purchasing a set amount of the supplier’s future output. These contracts support project bankability and are essential to a development project reaching final investment decisions.
How it works:
An offtake agreement, or advance purchase agreement, is critical as it is unique in providing a legal agreement by a customer to buy something that isn’t yet commercially available. Such agreements provide project lenders the security of knowing there is a credible customer for a nascent technology, product and/or service. Offtake agreements set out the terms associated with volume, price, delivery and product specifications over a specific period. For nascent products, lenders typically require a long-term (10+ years) offtake to provide revenue certainty and hedge against nascent market risk.
The following offtake agreement components are essential to a supplier’s ability to reach its final investment decision:
Duration: Long-term offtake commitments are required to support project bankability. Lenders want to see a 5-year minimum, preferably 10+ year, offtake term. Most projects take 1 – 3 years to build out; anything below 5 years is unrealistic in meeting the supplier timeline.
Volume: The agreement regulates the parties’ obligations regarding the volumes of low-emissions products traded. Suppliers need to enter contracts to sell sufficient volumes of the clean technology solution they produce to cover their fixed production costs and provide a steady revenue stream for bankability.
Price: Offtake agreements can employ different pricing structures, such as under a ‘fixed’ price or nominated ‘floating’ price models. Here, the contract is priced by referencing a market index or market ‘spot’ price. If applicable, the parties will determine which market index or spot pricing they will adopt. The supply side needs revenue certainty to underpin projects.
Technical definition: Robust standards, accounting methodologies and certification schemes are essential when purchasing low-emissions products. A supplier requires clear, credible, adopted definitions to differentiate its product. A corporate buyer will always seek zero- or low-carbon certification due to regulatory compliance, reputational concerns and trade opportunities.
Delivery: Offtake contracts can be expected to specify the delivery terms, such as the schedule, delivery point and deadline for receiving low-emissions products. Delays may result in liquidated damages or termination rights. In negotiating offtake agreements, project developers and their customers consider which counterparty is the best positioned to store, transport and deliver the clean technology solution and to bear the risks associated with those activities. Suppliers may seek tolerance in supplying a certain level of products that fail to meet zero-/low-carbon definitions, i.e., in the event of outages.
What sectors can leverage this mechanism?
What challenges does it solve?
Duration
Companies do not normally lock themselves into long-term purchasing commitments of ~10 years when the availability and price of the product remain uncertain.
Volume
There is often misalignment between the buyer’s desire for flexibility to accommodate operational and market cycles and the demand profile certainty suppliers require to design and develop a capital-intensive project. Offtakers are reluctant to commit to long-term ‘take or pay’ clauses that underpin project bankability. While the ‘send or pay’ clauses address a corporate buyer’s volume certainty, any shortfalls are likely to cause material issues.
Price
There are limited reference points on the price of low-carbon products in an illiquid market and the factors influencing the price will change over the duration of the agreement. For buyers, a well-developed power purchase agreement (PPA) hedge strategy can mitigate pricing uncertainty in an illiquid market.
Delivery terms
Suppliers seek robust termination terms to address the risk of a lack of alternative offtakers. A corporate buyer will be reluctant to cover lost margins, seeking its own termination rights for material business issues. Offtakers often require flexibility to reduce volumes or terminate due to strategic business decisions.
Technical definition
Low-carbon products lack commonly accepted standards and certification schemes. Alignment is needed between the supplier and offtaker on product specification, i.e., what constitutes ‘near/net-zero emissions’ and whether the agreed definition aligns with relevant regulatory/market access definitions.
Enabling infrastructure
Many of the ‘products’ depend on associated infrastructure – pipelines and storage depots for new fuels, and robust electricity grids sourcing renewable energy. The availability of enabling infrastructure, such as ports, storage and grid networks, can become a bottleneck in project delivery.
Regulatory uncertainty
Regulatory uncertainty and market fragmentation delay investment decisions. As it is challenging for suppliers and offtakers to navigate the complex policy landscape, this variability poses challenges for contracting parties as they negotiate the terms of offtake, seeking to minimise their exposure to change-in-law risk.
Trust
Improving trust between negotiating parties is essential to accelerating low-carbon investments, as divergent expectations and assumptions pose challenges to the offtake negotiation. For example, it is important to discuss assumptions early in the negotiation phase to foster trust, for example, the circumstances infrastructure, such as storage, should be used and if there is a mutually beneficial regime that can be agreed upon.
C-Suite and board buy-in
Driving industrial decarbonisation across the value-chain requires C-suite and board leadership. This involves translating high-level decarbonisation goals into internal policies, practices and incentives that effectively address internal barriers that may be preventing commercial-scale, clean industrial projects. Pre-commercial decarbonisation solutions present complex challenges for senior leadership. For example, a board can assess the quantum of ‘take or pay’ liability as a material financial risk. These strategic investments can also exceed a board member’s tenure.
Procurement capability
A predominant focus on the short-term still guides most procurement decision-making. Purchasing functions are by nature designed to be risk-adverse and they are used to employ a relatively short-term framework when procuring key commodities. Currently, many baseline assumptions are predicated on continued fossil fuel use; this means that low-carbon solutions must achieve price parity with incumbent fuel sources. It is crucial to provide a benefit weighting for low-carbon production so that purchasing decisions uphold decarbonisation targets.
Mechanism challenges
Despite widespread recognition that long-duration offtake agreements are needed to rapidly scale global investment in low-carbon technologies and drive industrial decarbonisation, the scale and speed of signed agreements remains woefully low. For example, Bloomberg NEF research shows that only 10% of the clean hydrogen capacity planned by 2030 has identified a buyer. And only 13% of the contracted volume (or 1 million metric tonnes/year) is legally binding.1 While private sector demand for clean technologies is continuously growing, there are several challenges that undermine corporate buyers’ efforts to develop and secure long-duration offtake agreements.