An important step outside the comfort zone – the time has come for private capital in district heating

January 2022  |  SPECIAL REPORT: ENERGY & UTILITIES

Financier Worldwide Magazine

January 2022 Issue

In 2019, the UK became the first major economy in the world to pass legislation to achieve net zero greenhouse gas emissions by 2050. In 2021, the government set an ambitious climate change target to reduce greenhouse gas emissions by 78 percent by 2035 compared to 1990 levels.

Heat is one of the biggest sources of greenhouse gas emissions in the UK, accounting for around 33 percent of total emissions. Decarbonising heat is a key part of the government’s strategy to achieve these ambitious targets.

Heat networks

Although there is no single solution to climate change, heat networks will be vital to the UK achieving net zero. Heat networks deliver heat from a central source to a variety of buildings. They benefit from economies of scale and utilise low-carbon sources of heat, including energy from waste and from industry or environmental sources, such as ground and river source heat. As such, heat networks can provide demand flexibility to the energy system, balancing supply and demand and alleviating network constraints as the UK decarbonises heat.

Uptake of heat networks so far is sparse. Where schemes do exist, they are either delivered on a small scale by public authorities or as part of single new build blocks with captive tenants. Heat networks currently provide approximately 2 percent of UK heat demand, but with government support it is estimated that they could provide 18 percent of heat demand by 2050. As government support for these projects emerges, it is hoped that the investment of private capital will follow, and the scale of projects will grow.

Problems for heat networks

Historically, the prevalence and cost of gas in the UK has adversely impacted demand for heat networks. More recently, the rollout of heat networks has been stymied by significant start-up costs and capital investment and long payback periods. This challenge has been exacerbated by the closure of the Non-Domestic Renewable Heat Incentive Scheme to new applicants in March 2021.

However, the biggest issue with heat networks is demand risk. Essentially, there is uncertainty as to whether there will be sufficient demand (in terms of sign-ups and customer retention) to recover the capital invested. This has been the biggest single deterrent to building large scale retrofit district heating schemes and attracting private capital to support these schemes.

There is currently no compulsion for consumers to join heat networks and there is widespread reluctance to diverge from the status quo (i.e., a single home with a single gas boiler) – as ever, new technologies are met with suspicion from a marketplace unsure of what to expect. Without a guaranteed revenue stream or certainty of demand, the business and investment case for heat networks is often marginal. Government initiatives, such as the Heat Networks Delivery Unit, the Heat Networks Investment Project and the Heat Network Transformation Programme, provide financial support and guidance to developers to deliver heat networks, but strategic intervention is necessary to encourage real investment in the sector.

The solution: mandatory heat networks

Certainty of demand is essential to make heat networks feasible at scale. While consumer choice remains, investing in heat networks is not financially viable. For heat networks to deliver meaningful environmental impact and attract sufficient investment, compelling consumers to join heat networks is essential.

Denmark is a good example of this working in practice. National bans on electric heating in new and existing buildings (where connection to district or gas heating is available) have existed in Denmark since the 1980s, and Danish law gives municipalities the option of requiring new and existing buildings to connect to a district heating network. As a result, Danish energy companies have certain income for their heat networks, renewable heating projects have proliferated, with 63 percent of all private Danish houses connected to a district heating network by 2015, and consumer heat costs have reduced.

Heat network zoning proposals

The 2020 Energy White Paper committed to introduce heat network zoning in England by 2025 and on 8 October 2021 the Department for Business, Energy and Industrial Strategy (BEIS) published a consultation on heat network zoning and identifying areas in England where heat networks are the most appropriate solution for decarbonising heating.

The BEIS proposals envisage central and local government working together with industry and local stakeholders to identify and designate areas (heat network zones) within which heat networks are the lowest cost solution for decarbonising heat. In a heat network zone, all new buildings, large public sector buildings, large non-domestic buildings and large domestic premises which are currently communally heated or undergoing major refurbishment would be required to connect to a heat network within a prescribed time frame. There would be exemptions to the requirement to connect, for example where it would not be cost effective to connect compared to an alternative low carbon solution or where a building already has a low carbon heat source installed. The proposals also suggest introducing low carbon requirements for new heat networks built within heat network zones.

Analysis – is this enough?

Heat network zoning will demonstrate where heat networks are the most viable solution for decarbonising heat, drive demand for heat network connection and grow the market by requiring certain buildings in heat network zones to connect to heat networks. This will enable better long-term planning and coordination between stakeholders and increase investor certainty, in turn reducing cost, increasing the pace of deployment, and supporting the delivery of viable large-scale heat networks.

Key ideas set out in the consultation are described below.

Requirement to connect. BEIS proposes that all new buildings, large public sector buildings, large non-domestic buildings and large domestic premises which are currently communally heated or undergoing major refurbishment would be required to connect to a heat network.

This means that domestic premises within a heat network zone which do not have communal heating systems installed will not be required to connect to heat networks. In time, however, owners of domestic premises may choose to connect, recognising that heat networks are the most cost-effective way to decarbonise their buildings.

Timescales and triggers for connecting. The requirement for specific buildings within a heat network zone to connect will be timebound – although it is important to balance achieving investor certainty and acting reasonably.

BEIS is considering various trigger points for sign up, including: (i) delivery dates of the network to provide heat; (ii) construction and completion dates for new developments; (iii) major refurbishments of existing properties; (iv) when existing heating systems are replaced; and (v) other changes or regulatory requirements, including those relating to property sales.

In Denmark, where there is a requirement to connect within a zone, a grace period of nine years is allowed prior to connection of an existing building to account for the condition of existing heating systems.

BEIS proposes that a building within a heat network zone which is required to connect should (as a minimum) be required to connect within 10 years from the point it is requested to connect by the network operator.

Consumer protections. Heat network zoning inherently creates monopolies. As such, regulation is required to protect against the abuse of a dominant position. BEIS intends to establish a regulatory framework for heat networks which protects consumers, promotes technical standards, and drives forward the growth and decarbonisation of the heat networks market. All heat network domestic consumers, and some non-domestic consumers, such as those operating microbusinesses, should have ready access to information about their heat network, a good quality of service, fair and transparently priced heating and a redress option should things go wrong. It is hoped that the introduction of mandated technical standards will drive efficiency, reliability and quality of service. BEIS also intends to use regulation to ensure continued heat supply to consumers in the event of supplier or operator failure.

Heat network schemes will only be authorised to operate if they demonstrate compliance with certain minimum consumer standards. There will be an optional licence for entities wishing to become ‘statutory undertakers’, enabling these entities to have certain rights and powers, such as permitted development rights, linear obstacle rights, street work permits and ancillary easements and wayleaves. Again, this is a hugely positive step.

The heat network regulator will take enforcement action in cases of non-compliance causing significant consumer detriment.

BEIS also proposes that the regulator would have powers to mandate and enforce price transparency and set requirements on cost allocation for domestic and micro-business consumers. The regulator would need data collection powers and the ability to conduct investigations into heat networks where prices for consumers appear to be disproportionately high compared to systems with similar characteristics. BEIS considers that the regulator will also have powers to introduce rules and guidance on fair and consistent pricing, powers to take enforcement action against disproportionately high pricing, and the ability to set price comparison and benchmarking methodologies.

However, given the nascent state of the heat networks market, BEIS does not intend to introduce price caps or direct profit regulation.

The time is now

The need for low carbon heat networks is self-evident. The challenge has always been attracting private sector capital and growing networks at scale. Despite the forthcoming availability of grants for individual heat pumps, the collective solution appears to be the best. Networks in heat zones have the prospect of becoming the new regulated water type investment as they become quasi-monopolistic. Fetters that have previously prevented large scale development of retrofit heat networks are beginning to fall away with the potential for game changing rewards for the first investors in large-scale rollout.

 

Steve Gummer is a partner at Sharpe Pritchard LLP. He can be contacted on +44 (0)20 7405 4600 or by email: sgummer@sharpepritchard.co.uk.

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BY

Steve Gummer

Sharpe Pritchard LLP

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