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Low carbon heat: if not now, when (and how)?

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Decarbonising the UK’s heat supply is a massive challenge, but like other aspects of the energy transition, it also presents significant opportunities for investors, developers, consumers and others. On 3 July 2018, an Energy Breakfast event at Dentons’ London office explored the subject of investing in low carbon heat.  The speakers were Richard Taylor of E4Tech, co-authors of a recent study on future heat infrastructure costs for the National Infrastructure Commission (NIC), Stuart Allison of Vattenfall’s newly established UK heat business, Jenny Curtis of Amber Infrastructure and Nick Allen of the Department for Business, Energy and Industrial Strategy (BEIS).  We summarise here some of the key issues from their presentations and the lively discussion that followed, as well as one or two related subsequent developments.

Why decarbonising heat is important – and difficult

It may seem perverse to try to debate policy on any form of artificial heating at a time when much of the UK has been enjoying near-record high temperatures for what feels like several weeks, but it was only a few months ago that the country saw an almost equally notably cold start to spring. The heat sector, at present mostly fuelled by burning natural gas, accounts for about one-third of UK greenhouse gas emissions.  The sector’s emissions will have to be largely, if not completely, eliminated by 2050 if the UK is to meet the emissions reduction targets set under the Climate Change Act 2008 – let alone the more demanding targets that may flow from the 2015 UNFCCC Paris Agreement objective of keeping increases in average global temperatures well below 2oC.

One way of decarbonising heat would be to substitute hydrogen for methane as a fuel. It is possible to mix some hydrogen (or biomethane) with natural gas and still use existing pipeline networks and appliances.  But full decarbonisation by this route would require significant investment at both the wholesale and end user levels (replacement of metal with plastic pipes, new boilers).  And that is just the start.  The hydrogen has to be produced on a large scale – probably using methane as a feedstock, which would produce a stream of CO2 that would need to be captured and either stored or used in a way that avoids its being released into the atmosphere: in other words, more investment in substantial infrastructure, and the commercialisation of technologies (such as CCS) which have so far been slow to develop, even though they would appear to be an important part of the future of the oil and gas industry.  Significant changes to existing downstream gas regulation are also be required, to accommodate both blending of hydrogen with methane and full conversion.  And all this assumes that popular misconceptions about the safety of hydrogen do not prevent its widespread deployment.

Alternatively, decarbonisation of heat could be achieved by switching from boilers to a system built around heat pumps and storage, and running the heat pumps on decarbonised electricity. This would require significant action at the wholesale level (e.g. additional generating and network capacity) and a radical change in infrastructure at the end user level (e.g. each household either acquires a heat pump of its own or becomes part of a district heat network attached to a much larger heat pump).

Between the scenarios focused primarily on hydrogen or electrification, there are some hybrid options, and it is arguable that the replacement of existing natural gas-based heating could efficiently take different forms in different parts of the country (for example, those areas not connected to the existing gas grid are likely to be more cost-effectively served by heat pumps than by hydrogen). But it is clear that unlike in the case of electricity generation, where the Government has been able to adopt a broad policy of encouraging a range of low carbon technologies and regulating the pipeline of new capacity by adjusting the level of subsidy and the ease or difficulty of obtaining planning permission for each of them, in relation to heat it is likely to have to make some fundamental, long-term choices at the outset between the competing pathways to decarbonisation.  Put at its starkest, in the next 30 years, existing gas pipeline networks are likely to have either to decarbonise or cease to operate.

All of this points to the conclusion that decarbonising heat will be harder than decarbonising the generation of electricity.  At the wholesale or system level, it will be very hard for Government to avoid making major strategic choices between competing heat technology options, rather than just letting the technology mix evolve within a managed framework.  End users will have to take (or be coerced into taking) a much more active role in the heat decarbonising process than the vast majority of them have had to play in decarbonising electricity.  Finally, as further explained below, the interaction of decarbonising heat with adjacent areas of activity is likely to be harder to predict and manage.

Expert assessments

In one sense, none of this is news. In the ten years since the Climate Change Act, the independent Committee on Climate Change (CCC) have repeatedly highlighted the challenges of the heat sector in their reports.  In their latest progress report to Parliament, published on 28 June 2018, the CCC invite the Government to “apply the lessons of the past decade or risk a poor deal for the public in the next”.  Examples from the heat sector feature in support of each of the four key messages that the report delivers: support the simple, low-cost options; commit to effective regulation and strict enforcement; end the chopping and changing of policy; and act now to keep long-term options open.

The CCC note that progress on decarbonisation to date has been heavily focused on electricity generation. Heat and other sectors will need to catch up if the fourth and fifth carbon budgets (set under the Climate Change Act for the years 2023-2027 and 2028-2032 as staging posts on the way to the final 2050 target of 80% emissions reduction against 1990 levels) are to be met.

The CCC identify a number of specific actions required of Government to be on track to meet the fourth and fifth carbon budgets.  In the shorter term, they highlight the need for further action to deliver cost-effective uptake of low-carbon heat, including low-carbon heat networks in heat-dense areas (e.g. cities) and increased injection of biomethane into the gas grid.

The long-term choice between heat decarbonisation technologies and the desirability of low-regrets measures such as energy efficiency measures and low carbon heat networks in areas of dense heat demand are reviewed in an Imperial College report for the CCC (the executive summary of which was published alongside the CCC’s 28 June 2018 report as well as in E4Tech / Element Energy’s report for the NIC.  Both cite the CCC’s 2016 visual representation of these measures and choices.  Element Energy / E4Tech’s version of this is reproduced below.

In his presentation of the E4Tech / Element Energy conclusions, Richard Taylor stressed that although the hydrogen scenarios appeared to be slightly cheaper, significant uncertainties remained around the level of additional costs associated with each of the long-term options, shown below in comparison with the “no change” option of maintaining a natural-gas based heating sector.

Both reports have a wealth of more detailed analysis.  For example, this chart from the Imperial College report highlights the potential implications for the optimal levels of installed capacity in the electricity generation sector of different heat technology / intensity of emissions reduction scenarios (the figures 30, 10 and 0 underneath each bar refer to target CO2 emissions in Mt).  Unsurprisingly, significantly more capacity is required in the electricity based scenarios, but it is also interesting, for example, how much the nuclear element in the mix varies between options, and that even the electricity based scenarios include a substantial hydrogen component in the form of open and combined cycle gas turbine plant using hydrogen rather than natural gas as a fuel.

All of this, and related issues such as the role of “flexibility” technologies (some of which, like thermal storage of energy, have implications for both the heating and power production technology mix and the way that heat and power networks are developed) highlights the interdependency of infrastructure investment choices across different parts of the energy sector.  The CCC are clear on what this means. They observe: “If emissions from heating are to be largely eliminated by 2050, a national programme to switch buildings on the gas grid to low-carbon heating would need to begin by around 2030 at the latest, requiring Government decisions on the route forward to be made by the mid-2020s.” (emphasis added).  At the same time, they highlight one of the obvious points that threatens the taking of that decision in the timeframe that they recommend, noting that “There will be important questions to be resolved around how to pay for heat decarbonisation.

Heat networks: how low is the low-hanging fruit hanging?

Why is the development of heat networks identified as a “low regrets” option for the shorter-term, more or less regardless of what choices the Government may make about heat in the longer term? A heat network is a system comprising a heat production unit and a network of pipes and heat exchangers through which the heat that it produces is distributed, in the form of steam or hot water, to the heating and hot water appliances in a number of different customers’ premises (rather than each customer’s system of such appliances having its own heat production unit).

The concept of a heat network is technology-neutral. The heat production unit could, for example be a boiler (fuelled by methane, woodchips or hydrogen) or a heat-pump (sourcing its heat from the air, the ground, or a body of water such as a river or lake, or the water that collects in old mine workings).  Broadly speaking, whatever technology you use to produce heat, in areas where the demand for heat is sufficiently dense, it is likely to be more efficient (and – where the technology involves combustion –to result in lower carbon emissions) if the heat is generated in bulk and distributed to individual buildings or households around a local network (as steam or hot water) rather than each building or household having its own heat production equipment (e.g. boiler or heat pump).

Heat networks are obviously easiest to install when a building is first constructed, although retrofitting may also be cost effective in some cases.  If care is taken in designing a heat network, it may well also be possible to switch between heat production technologies at a lower overall cost at a network level than it would be for an individual building or household to do so (for example, by replacing a single large gas-fired unit with a single large heat pump or a hydrogen-fired unit, rather than replacing the heat production equipment in each individual customer’s premises). Moreover, consumer research commissioned by BEIS shows that those served by heat networks are overall as satisfied with their heating as those who are not.

Heat networks, then, have much to commend them.  There is considerable investor interest in heat networks.  BEIS has even published a list of 10 infrastructure investors who are actively interested in investing in them.  Planning policy both at central and local government level has for many years encouraged the installation of heat networks in new residential and commercial developments and the seeking out by those building new thermal electricity generating plant of potential network uses for their waste heat.  And yet, at present, only 2% of UK demand is connected to a heat network, although as much as 20% of demand may be sufficiently densely located to benefit from a heat network solution.  An increase in heat network capacity features in all three clean growth pathways in the BEIS Clean Growth Strategy.  But connecting 20% of demand to a heat network by 2050 would imply an annual growth rate of 8-10%.  Will this be feasible?

The short answer is: feasible, yes – but not easy, for a number of reasons.

  • Complexity:  It is easier for a developer to arrange a gas supply to a group of new premises and fit each of them with its own natural gas-fired boiler than to establish a heat network to serve them.  Opting for a network solution immediately raises a series of questions and requires a much wider range of issues to be taken into account.  Who will design, build, own and operate the network?  Whoever does each of these things, more contracts will need to be negotiated than for a non-network solution, where all that is needed is a gas connection and a contract to supply / fit some boilers.  In many new developments, there are a lot of different stakeholder interests to balance (the developer, others with responsibility for the network, different landlord and tenant interests, local authorities and so on).  If the same organisation does not have responsibility for all aspects of the network, agreement will have to be reached on a whole series of risk allocations.  One common solution is for a developer to install a network but then to seek to recover some of the expense of doing so by selling it (or the right to operate it) to an energy services company (ESCO), but the building of a network by a party that will not operate it in the long-term can result in poor quality installation.
  • Lack of standardisation: Heat network projects can therefore quickly develop lengthy risk registers, but there is no universal approach to or methodology for allocating those risks, and, as a result, not as much standardisation of contractual provision – on terms that strike a fair balance between competing stakeholder interests – as is desirable to keep costs under control in a sector where most transactions have a relatively small value.
  • Economics: The economics of what may at first appear to be promising heat network projects sometimes do not quite stack up. The relatively small size of transactions can make it hard to leverage debt in.
  • Perceived shortcomings of the technology: Notwithstanding that there appears to be no overall problem of customer satisfaction with heat networks, concerns remain about the lack of customer control (e.g. over heating, in networks where the necessary valves have not been fitted in individual premises).  As in any consumer market, one or two prominent bad reports, e.g. of poor service or over-charging, can unfairly skew stakeholders’ views of the technology as a whole.

However, none of these problems is insuperable and, as we shall see below, steps are being taken to address all of them.

Go Dutch – and regulate for growth?

Discussion about the UK’s failure – so far – to make the most of heat network opportunities often includes reference to other countries, including a number in Continental Europe, where their use is widespread and longstanding. The inference is that since we have failed to see the benefits of heat networks for so long, it will be an uphill struggle to do better now: it’s too late for us to become Denmark / Poland / [insert your European heat network exemplar country of choice].

However, Vattenfall’s experience suggests that it is possible to spread heat networks through a major European city, starting from scratch. Before 1994, Amsterdam had no significant heat network provision.  Since then, starting with the use of waste heat from a new energy from waste plant, the city has been steadily building out a heat network which is expected to help it to go “gas-free” by 2050 –  and the trend is spreading elsewhere in the Netherlands as well.

There are perhaps only three major structural differences between the UK and Netherlands markets. The first is that the supply of natural gas in the Netherlands is taxed more heavily, providing an additional economic incentive for heat networks, particularly those using non-methane energy sources.  The second is that strategic planning for the rollout of heat networks in Amsterdam is considerably facilitated by a joint venture between a Vattenfall entity and the city itself.  The third is that heat supply / networks are regulated in the same way as electricity and gas networks / supply.

In the UK, the heat networks sector is not currently subject to the same kind of regulations as comparable services such as electricity and gas, and this has raised concerns about standards of quality and consumer protection.

The Heat Network (Metering and Billing) Regulations 2014 offer some consumer protection including by imposing billing obligations and the requirement for all new heat network customers to be given a heat meter, however they do not provide for a standard of customer service or recourse to an independent complaints review process for unsatisfied customers.

The heat network industry also has its own consumer protection scheme, the Heat Trust, which sets a common standard for the quality and level of customer service, and provides for a complaints handlings system, including access to an independent complaints review by way of access to the Energy Ombudsman. However, the scheme has no statutory underpinning, membership of it is voluntary and it currently only covers a small proportion of the existing heat network customer base.

In December 2017, the Competitions and Markets Authority (CMA) announced they were launching a market study into domestic heat networks to ensure that consumers using heat networks are getting a good deal.  The study set out to examine whether consumers are aware of the costs of heat networks both before and after moving into a property; whether heat networks are natural monopolies and the impacts of offering different incentives for builders, operators and customers of heat networks; and the prices, services quality and reliability of heat networks.

  • The CMA published its initial findings on 10 May 2018.It notes that, overall, the average prices on the majority of heat networks within the sample considered were the same or lower than that of comparable gas-heating, and the overall satisfaction (and dissatisfaction) of customers was in line with that of consumers not on heat networks. Nevertheless, there were instances of poor service quality and cases where customers were paying “considerably more” than for non-network heat.
  • The CMA is concerned that the factors driving instances of poor performance or unduly high pricing should not become “embedded”, to the detriment of customers, as the sector expands.  Specifically, it looks at “misaligned incentives between property developers, heat network operators and customers of heat networks”; the monopoly nature of heat networks and the delivery models used for them; and lack of transparency on prices “both pre-transaction and during residency”.
  • It finds that regulation is needed to ensure that heat network customers receive levels of protection comparable to those afforded to customers in the gas and electricity sector.  The report recommends the introduction of a statutory framework, which would give formal powers to a sector regulator.  This conclusion echoes some of the recommendations and analysis of a 2017 report by Citizens Advice Scotland.
  • The CMA’s recommendations also go beyond the imposition of a regulatory framework for network operators to encompass possible changes to planning and building regulations, leasehold arrangements and property sales disclosures (including energy performance certificates) to take into account the specifics of heat networks. Changes to regulations in this area would give greater pre-contractual transparency to purchasers and tenants of properties to understand the implications of living in properties serviced by heat networks.

A consultation on the CMA’s initial findings closed on 31 May 2018, with a full report expected by the end of the summer. There is clearly at least a substantial body of opinion in the industry that supports the conclusion that it would benefit from sectoral regulation: a well-designed regulatory scheme, rather than unduly burdening operators, would boost consumer confidence and help the industry to expand.  Regulation could ultimately mean that operators’ returns may be capped, but the predictability that comes with well-designed and administered regulation could encourage investment.  There would likely be other benefits as well: operators in economically regulated industries are typically also given a range of statutory powers that makes it considerably easier for them to do their jobs – such as compulsory purchase powers and “statutory undertaker” rights under legislation governing planning and street works.

It seems unlikely that a sectoral regulation scheme for heat networks could be introduced without primary legislation, and there must be some doubt as to whether the Government will find the policy resource and Parliamentary time necessary to put such legislation in place in the short term.  For the moment, the CMA has decided not to launch a formal “market investigation” – a step which would open up the possibility of imposing some remedies (but probably not an overall scheme of regulation) on the sector itself for any adverse effects on competition it found.  However, the CMA has reserved the right to revisit this decision and those setting up heat network schemes may do well to take account of the conclusions of the current market study in any event.

More immediate Government support

Attention to the CMA’s work and its possible inconclusive outcome in the short term should not distract from the valuable work that BEIS has been undertaking to remove or reduce some of the other key barriers to expansion of the sector.

Earlier in 2018, BEIS provided details of a scheme to provide “gap funding” for heat network projects. The Heat Networks Investment Project (HNIP) is the vehicle for disbursing £320 million of Government money that was first earmarked for this use some time ago, building on the results of an earlier pilot scheme, and leveraging in about “£1 billion of private and other investment”.

Following the appointment of a delivery partner, the scheme will formally launch in the autumn. Funding may take the form of grants, corporate loans or project loans.  A number of criteria (both economic and technical / environmental) have been established for applicants to satisfy, perhaps the most important of which are those relating to “additionality”, designed to demonstrate that the applicant’s project would not go ahead without HNIP support – either because it could not otherwise raise the capital or achieve an adequate IRR, or because it would not otherwise be possible to fund additional technical or commercial features that are not required through planning obligations.

On the same day as our Energy Breakfast took place, BEIS published over 750 pages of useful guidance for those contemplating heat network schemes, comprising:

The intention is that HNIP funding will create a pipeline of investable projects that will help the sector to become self-sustaining by 2021. As ever, success will lie in the quality of the implementation, but HNIP is a well-designed scheme that addresses many of the key issues facing heat network projects.

Two other initiatives, not focused on heat networks, but also aimed at reducing barriers to lower carbon heat investments in the near term, are also worth mentioning.

  • On 5 July 2018, BEIS published a response to consultation the confirmed the Government’s intention to help to introduce a support scheme to “overcome key barriers, and increase industry confidence to identify and invest in opportunities for recovering heat from industrial processes” (the Industrial Heat Recovery Support Programme).
  • As part of a series of reforms to the Renewable Heat Incentive (RHI) subsidy regime for domestic premises, BEIS has brought into force changes to the rules on third party funding for heat pumps and other renewable heating systems. From 27 June 2018, under a procedure known as “assignment of rights”, the owners of such systems may assign the RHI subsidy payments to which they are entitled to a “nominated registered investor”.  A model form of contract will be provided for doing so.  It remains to be seen whether this will have the desired effect of encouraging more third party finance of heat pump installation and therefore materially greater uptake of heat pumps as a technology.

A long-term, holistic approach

At a time when it is easy to criticise Government for an apparent lack of action on some aspects of energy policy, this series of concrete steps taken towards encouraging investment in low carbon heat is a positive development in an area where action is much needed and has been long awaited.  Of course, much also remains to be done.  For example, the CCC point out that:

  • there is no financial support framework for heat pumps and biomethane in place yet for the period after 2021 (when the current funding for the RHI comes to an end – the RHI as currently constituted being dependent on direct Government grants rather than a more or less automatic system of funding from a levy on energy suppliers like the historic renewable electricity generation subsidy schemes, the Renewables Obligation and Feed-inTariffs);
  • international comparisons suggest that the use-based payments for renewable heat systems such as the RHI might not be the ideal way of encouraging uptake and that a system of capital payments may be preferable;
  • whilst the Government’s acknowledgment of the need to look at the long-term technology options for moving towards a much lower carbon heat sector and to make some choices between them is welcome, there needs to be a more formal governance framework to drive enduring decisions on heat infrastructure in the early 2020s.

In short, Government has made a good start, but must follow through.  Moreover, in looking at the next steps for heat policy, Government and others need to take a holistic approach.

  • We noted earlier the apparent importance of hydrogen in all three long-term heat decarbonisation pathways. Work carried out by Alstom also indicates the potential for hydrogen (which is much more energy dense than any battery) to be used in fuel cells to replace diesel as the fuel for trains on lines that have not been electrified and that it may never make sense to electrify.  Is there not a case for incentivising the large-scale production of hydrogen (and CCS for the associated CO2 by-product) – perhaps through a contract for difference where the strike price is benchmarked against wholesale natural gas prices?
  • Government is not just responsible for energy and transport policy. It has other, currently under-used levers at its disposal to encourage technologies that will decarbonise heat.  The embedding in building standards of tougher rules on energy efficiency and an absolute requirement for low carbon heat supply to be part of all new buildings (and the rigorous enforcement of such standards), are obvious – but as yet untaken – steps that would increase demand for low carbon heating technology.  There is of course an important interaction between energy efficiency improvements and heat networks, particularly in retrofitting situations where significant reductions in heat demand driven by improved building energy efficiency could undermine the business case for a marginal heat network project.
  • With as with other areas of energy policy, sharper incentives from carbon pricing would speed up decarbonisation. In the heat sector, ways of preventing any higher taxation of gas from increasing the burdens on vulnerable customers would have to be part of the package.
  • Finally, any long-term decision-making by Government or the private sector will also have to consider the need to accommodate, and perhaps encourage, the introduction of new business models, and the possibility that the market of the future may, and perhaps should, be less uniform than it is at present.  Now, most consumers buy kWh (or cylinders) of gas (or in some cases, heat) and kWh of electricity (with a few of them generating a proportion of their electricity demand).  Energy efficiency is largely a separate market, with the occasional imposition on gas and electricity suppliers of obligations to undertake a certain amount of more or less targeted energy efficiency improvement works for consumers.  In the future, consumers might specify a set of outputs (e.g. availability of up to X amount of electricity, maintenance of indoor temperatures within a certain range) and sets of constraints or variables (e.g. payment profiles, willingness to allow the installation of particular equipment or energy efficiency measures, or to accept occasional deviations from the prescribed temperature range) and invite a range of suppliers to offer them a monthly price for home energy-related services for a certain period of time.  These services could include anything from utility supplies of energy to the installation of new energy production equipment or energy efficiency measures.  In a market where it will become ever easier for consumers to become “prosumers”, generating, storing and using their own electricity, companies that currently simply retail electricity and gas to consumers on a £/kWh basis may need to diversify their offering and learn a number of new skills if they are to maintain their relevance play a full part in the energy transition of the heat sector.

If you would like to explore any of the issues raised in this post further with us, please get in touch.

The assistance of Jennifer Cranston, a trainee in our London office, in the preparation of this post, is gratefully acknowledged.