Green Heat Finance Taskforce: report part 1 - November 2023

1. Executive Summary

The £1.8 billion of capital funding for heat and energy efficiency measures that the Scottish Government is investing in this Parliamentary term will provide stimulus to energy efficiency and Zero Direct Emissions Heating (ZDEH) deployment. However, according to the Scottish Government’s 2021 Heat in Buildings Strategy, the total cost to transition heating to Net Zero by 2045 is likely to be in excess of £33 billion. We recognise that this cost cannot be funded by the public purse alone.

Recognising that the transformation of heat in buildings will require a mix of public and private funding, this Taskforce was established with a remit to:

• explore options for the scaling up of existing financial mechanisms;
• identify potential new financial products where there are market gaps;
• identify other mechanisms / services that may support the market to decarbonise heat sources in buildings; and
• consider potential demonstrators to pilot in the marketplace.

Scotland has around 2.5 million homes, of which over 63% are owner occupied, approximately 14% are in the private rented sector and 23% are socially rented^[3]. Many were built over 50 years ago using traditional building methods, such as solid wall construction, which can create challenges for improving energy efficiency performance. Approximately 80% of homes are connected to mains gas and are therefore currently heated by fossil fuel burning, although most off-gas properties also use a form of fossil fuels as a primary heat source.

On the other hand, roughly 50% of our 200,000 business premises already have electricity as their main heating fuel. However, poor energy efficiency levels in non-domestic buildings are a major factor leading to high energy demand, something which is costly for the bill payer and stretches capacity in the energy market. Unlike domestic properties, where the majority of buildings are owner occupied, a greater proportion of properties in the commercial sector are occupied through various forms of leasing, meaning a one size fits all solution is unlikely.

Such variety of ownership and energy performance levels, coupled with building owners’ individual financial circumstances, necessitate the need for a suite of possible finance options across both domestic and non-domestic premises to ensure that all can transition to ZDEH by 2045.

This Taskforce’s work has been focused on understanding those finance mechanisms that can support the retrofit of homes and buildings by helping individuals, businesses and organisations spread the upfront cost of installing energy efficiency measures and ZDEH systems, such as heat pumps. The Taskforce recommendations therefore aim to help address some of the existing financing barriers to installing ZDEH or energy efficiency upgrades.

However, having financing solutions in place and at scale, is just one of the many different moving parts that will be needed to ensure that this transformational change in how heat is generated in our buildings is delivered successfully. This report therefore also highlights the importance of wider measures in creating the overall conditions required for an energy efficiency and ZDEH market to flourish, with demand stimulation being a particularly critical factor, as highlighted by many private sector lenders.

Work is underway elsewhere on issues like regulation to help stimulate demand, and on developing a workforce and supply chain with the right skills and capacity to deliver the physical upgrades required. Work and public engagement is also underway separately through the Scottish Government around a Just Transition, which ensures a fair distribution of the costs and benefits associated with the transition to Net Zero. We have therefore taken into consideration the detail of those issues beyond the remit of the Taskforce, while focusing on the specific issues and questions related to financing. However, it is vital that the importance of these wider issues is not overlooked and that coordinated efforts to drive action across all of these key themes is redoubled at both Scottish and UK Government levels.

In this report we recognise the overall key themes that foster the growth of both the demand for and supply of finance in the energy efficiency and ZDEH markets:

• the necessity that all aspects of the market are developed in alignment with finance offerings (market pillars);
• the need for Regulations to provide clarity around future building requirements, as well as incentives to encourage action and give confidence for providers to invest in products and skills; and
• the scope for co-investment models to leverage public sector funding to support market development and attract / de-risk early market private financing.

The Taskforce has, and continues to, examine the current status and potential growth opportunities for a range of financial mechanisms that contribute to energy efficiency and ZDEH installations across both domestic and non-domestic markets. This report focuses on the mechanisms which, in the Taskforce’s view, are most suitable for individual properties, while our Part 2 Report will focus on mechanisms that can apply across multiple properties (Annex 2 provides a table outlining mechanisms for individual and multiple properties).

The products discussed in this report, and which private lenders are doing significant work to develop and test, are:

• Personal loans;
• Green mortgages;
• Equity release mechanisms;
• Green leases/rental agreements; and
• Property Linked Finance.

Additionally, we highlight the role that public finance and fiscal incentives could play in supporting the market to create the requisite demand and supply.

The Taskforce is aware, however, that there are serious barriers to completing retrofit works. We recognise that key amongst them are the complexity for consumers in identifying the right technology and financing option for their property, and the nervousness many people have about physical disruption that may occur while the works are underway, as well as concerns that property value enhancement from installation of new heating systems may not be fully reflective of installation costs.

For domestic and non-domestic landlords there is also the issue of split incentives, where the owner of the property incurs the costs of work, while the tenant gains the benefits of more comfortable and energy efficient properties. Underpinning this are issues of quality of data on energy efficiency levels, energy consumption and heating sources, particularly for non-domestic buildings. This is relevant for investors and finance providers trying to gauge risk levels for products they may offer. It also impacts on the monitoring and tracking of progress of the impact different initiatives can have on achieving overall carbon reduction targets.

Taking the current state of the energy efficiency and ZDEH market in Scotland into account, along with the barriers we discuss, and reflecting on the opportunities for growth that exist, the Taskforce makes nine recommendations in this report. We believe that the Scottish Government, in partnership with private sector organisations and other levels of government, can help unlock an increased flow of private finance across various mechanisms by taking action on these recommendations. This will be required alongside a wider programme of action around non-financial factors such as skills or advice provision around the correct solution for an individual property.

Collectively, these will enable individual property owners to install energy efficiency and ZDEH measures. Our recommendations, which are discussed alongside our thinking behind each in Chapter 6, are –

1. Scottish Government, from early 2024, should work with the Green Finance Institute, Scottish Financial Enterprise and others to expand current market engagement with brokers, finance providers, distributors and quantity surveyors to generate greater public awareness of financing products like green mortgages and encourage their expansion;

2. Scottish Government should begin work, from early 2024, in partnership with the Equity Release Council, to develop an information framework and guidance for Green Retrofit Equity Release products;

3. Scottish Government should research co-investment vehicles – blended finance with public and private input – with the support of the Scottish National Investment Bank, Scottish Financial Enterprise and Scottish Futures Trust, to identify by the end of 2024 where and how to test the approach in Scotland;

4. Scottish Government should collaborate with the Green Finance Institute to research the potential for Property Linked Financing in Scotland, with a view to establishing a scalable demonstrator by May 2025;

5. Scottish Government should review and publish, by the end of 2024, the potential of incentivising domestic property owners to increase levels of retrofit works through fiscal and taxation policy;

6. Scottish Government should review and publish, by the end of 2024, analysis of how non-domestic rates reliefs can better support and encourage investment in energy efficiency and ZDEH;

7. Scottish Government should seek to mitigate the split incentive issue by researching and piloting, by early 2025, the potential for green rental agreements, to encourage retrofitting in rented properties;

8. Scottish Government should immediately engage the UK Government and regulators to drive action on ZDEH and energy efficiency deployment, and support coordination of activities between parties; and

9. Scottish Government should, by mid-2024, map current heat in building data gaps and establish a framework to promote open data sharing to address these.

In our Part 2 Report, the Taskforce will focus upon communal and area-based mechanisms, including district heating networks, municipal bonds and heat as a service. We believe that broader area-based schemes have a potentially important role in achieving overall ZDEH targets, as they may be required for many properties where individual owners lack the capacity and / or willingness to fund individual solutions by drawing on the financing options available. Communal solutions, though, will not serve everyone, so individual financing options, as focused on in this report, will be important for early adopters and to complement area-based solutions.

Our Part 2 Report will also consider options for the social housing sector; its specific challenges and possible solutions. The Taskforce will consider where mechanisms discussed in this report, like co-financing, may interact with the topics we explore as we continue our work over the coming months.

We recognise that we do not have all the answers and so we would welcome any feedback, views or good practice examples you may have on the issues discussed in this report. Please get in touch via the following email address should you wish to discuss further: greenheatfinancetaskforce@gov.scot.