Prisoners to petrol: why Americans only drive hydrogen vehicles in California
Remember that classic game theory problem, the prisoner’s dilemma? The development of the hydrogen transportation industry mirrors it. In the original dilemma, two prisoners struggle with coordination – if both coordinate and withhold their confessions, they both go free. However, without knowing what the other will do, it is better to confess, leading to both parties remaining in prison and ultimately being worse off. While coordination may be a better equilibrium solution, aligning on that solution in advance is challenging when each actor makes the decision that is best for them.
At its core, the development of a hydrogen transportation market is also a coordination failure, with unpriced externalities. Hydrogen is a potential solution for reducing carbon emissions from energy production, as it produces just heat and water as byproducts. New technologies can produce emissions-free hydrogen using renewable power, where previously it was made from natural gas. Hydrogen for transportation is an attractive proposition, with potentially longer range, faster refueling times and lower weight than electric vehicles.
Yet, hydrogen has not been adopted at scale because the cost of producing and transporting it is significantly higher than alternatives like petroleum or electricity. There is a trade-off between cheaper production and transportation – producing near the point of use eliminates shipping costs, but can be more expensive because it lacks scale.
The coordination problem lies in the economies of scale required to make hydrogen fuel use economic, and the demand from hydrogen vehicle users. Hydrogen production requires significant capital expense to build production facilities, shipping infrastructure and refueling stations. It is difficult for an investor justify the infrastructure expense without knowing whether they will have consistent vehicle customer demand. Similarly, vehicle manufacturers face a high capital expense to develop a new vehicle. If hydrogen refueling infrastructure is not widely available, no customers will be willing to buy their hydrogen vehicles, which would render their investment in R&D and manufacturing redundant.
Market data reflect these challenges. 2023 annual global hydrogen vehicle sales were ~14,500, making up 0.02% of new car sales globally. In 2019, IEA reported that there were 470 hydrogen fueling stations globally. As of 2024, there are still just 56 in the US, all of which are in California, representing 0.3% of American gas stations.
Meanwhile, despite recent tariff wars sowing doubt on the electric vehicle market, electric vehicles have seen a dramatic uptick in adoption. Almost 14 million units were sold in 2023, ~20% of global sales. Many governments initially subsidised electric charging stations and vehicle sales, however the dominance of EVs is partly driven by reduced coordination problems when using existing electric grid infrastructure and home charging.
Coordination problems in low-carbon transport are exacerbated by the unpriced externality of carbon emissions. The World Bank estimated that a carbon price of $40-80/tonne would be necessary in 2020 to meet carbon emissions targets from the Paris Accord, while S&P Global estimates that it could increase to $120/tonne by 2030. As of 2024, Europe’s carbon price for electricity markets is indeed trading at over $80/tonne. These prices are not incorporated at a US federal level into the energy market, though “cap-and-trade”[1] carbon pricing schemes are active in 12 states in the electricity sector, a figure unchanged since 2021. This means that, in general, the price of petroleum versus hydrogen does not capture the externalities of carbon emissions, making petroleum artificially cheaper than alternatives because of its higher carbon emissions.
California is the only US state that has made any strides in deploying hydrogen for transportation through addressing coordination failure and unpriced externalities. The first lesson from California’s hydrogen policy approach is that it, itself, is coordinated with the rest of its decarbonisation policies. California has carbon emissions reduction targets, along with air quality standards, transportation infrastructure policy, storage requirements for utilities, among other policies.
California has tackled the coordination problem with both incentives and penalties for customers, infrastructure providers and car manufacturers. Under the prisoner’s dilemma framework, a subsidy will lower the cost of coordinating if one player coordinates while the other does not, and a penalty will increase the cost for the player who does not coordinate.
California launched a Zero Emissions vehicle scheme that supported consumers with cash rebates and refueling subsidies if they buy a hydrogen vehicle, though it appears this was wound down in 2023. Automakers also offered free refueling for the first three years (valued at $15,000), helping customers to defray these costs in anticipation of them coming down in future and to compensate for the inconvenience of fewer refueling stations. Another example is discounted parking for those who drive ‘alternative fueled vehicles’.
Car manufacturers benefit indirectly from consumer subsidies, but regulations have also imposed higher costs of not coordinating. California introduced requirements for manufacturers to meet an average carbon emissions level across their fleet. They also banned the sale of petroleum-fueled light vehicles from 2035 onwards and require manufacturers of medium- and heavy-duty vehicles to sell an increasing amount of their fleet as zero-emissions vehicles starting at 5% in 2024 to 55% or more by 2035 and 100% by 2045.
Infrastructure grants were offered to construct hydrogen refueling stations, with $125 million of funding offered for the first 64 stations and a further $115 million committed in 2020 for a further 111 stations. Even if no one purchases fuel from these hydrogen facilities, much of their capex has been covered through grant funding, reducing their cost if hydrogen vehicle sales are low.
California’s emissions cap-and-trade scheme also supports a transition to cleaner fuels by pricing in emissions from petroleum and sets aside revenues from this scheme for the California Climate Investments Fund in a Pigouvian transfer[2]. They also levied a $0.12/gallon tax on petrol to reinvest in clear transportation infrastructure.
These policies can have downsides. California’s highly targeted programs help to develop the hydrogen industry by improving the coordination failure within the technology but may lock the state into a technology that never realizes its cost reduction potential.
California banked on hydrogen vehicles eventually reducing in cost as the infrastructure costs become spread over more vehicles. Indeed, the gap in car prices has closed since 2019, when new cars cost ~$36,000 while hydrogen cars cost ~$48,000. As of 2024, new cars cost $47,500 on average in the US, and electric vehicles are on par at $50,800, while Toyota’s Mirai hydrogen car cost $50,200.
However, charging using an electric vehicle is currently cheaper than petrol in most markets, while refueling with hydrogen is still more expensive. In 2019, this cost was estimated as three times higher than fueling with petrol. As of 2023, fueling with hydrogen was 14 times more expensive than electric.
Hydrogen’s low emissions level also rests on being able to generate hydrogen with renewable power cost-effectively, rather than using hydrocarbons in the electricity grid.
California’s policies also do not fully address the coordination issue. It changes the cost and benefit decisions for each actor in the system but does not tie one actor’s decisions to the other explicitly, and thus may not tip the scales enough for heavy investment. A private market alternative that could be explored is creating a “take-or-pay” scheme that requires both parties to deliver on minimum volume requirements and pay a significant penalty if they are unable to meet them. Anecdotally, Shell, Toyota and Honda have signed such an arrangement in California.
Subsidising hydrogen vehicles also does not fully internalize the cost of carbon for petrol vehicles in California. This is politically difficult to achieve but could be a more market-efficient solution to change incentives and increase adoption of zero emissions vehicles. Transitioning to hydrogen vehicles may also require tax re-design for investments that are typically funded by petroleum taxes, such as roads infrastructure. California has started to remedy this with $100 road usage fees for zero-emission vehicles.
California’s policies stimulated the only hydrogen refueling infrastructure network in the US and the fifth largest globally. If cost reductions do not materialise or if hydrogen production turns out to be less ‘green’ than planned, it could be an expensive and overly targeted policy that does little to curb emissions.
This bet looked prescient in 2021 when I first wrote a version of this piece for an HBS class – China had set a target to sell 1 million hydrogen vehicles by 2030 and the European Union was ramping up clean hydrogen commitments. Three years on, however, the rise of EVs has eclipsed hydrogen vehicles, and the hydrogen hype is sputtering.
I still think there is potential for hydrogen vehicles in long-range transportation, where battery-powered vehicles are less suited than for passenger vehicles. Coordination problems are also easier to solve with B2B companies as there are fewer counterparties and large fleets. Startups like Verne are developing innovative hydrogen solutions for heavy transport, and vehicle manufacturers are developing hydrogen truck products. But without addressing coordination issues in the sector, it seems unlikely that hydrogen transport, even for long distances, can take off.
[1] Cap and trade refers to “capping” the amount of permissible carbon emissions in a given year per participant in a sector, and “trading” these with other participants (e.g. a low-carbon-intensity power plant can sell credits to another power plant). This allows the market to set the price of carbon (versus a tax) based on the allowable emissions target.
[2] Pigouvian taxes aim to price externalities that negatively affect society in order to shift behavior away from these activities