Green Heat Finance Taskforce: report - part 2

4. Heat Networks

4.1 Overview and context

Heat networks have been established as a reliable heating solution for the past 50 years across Europe, most notably in Scandinavian countries, where, in certain cases, heat networks are supplying more than 70% of a nation’s annual heat demand. In Scotland, they will have an important role to play in achieving clean heat, especially in dense urban areas. The Scottish Government has identified heat networks as a key ‘low-regret’ technology that will help deliver the transition to clean heat^[31].

There are, however, gaps in policy limiting certainty needed by investors to invest in them. In Scotland there are heat network targets of 2.7 TWh (terawatt-hour) by 2026, 6TWh by 2030 and 7TWh by 2035^[32], and yet it is estimated that heat networks currently supply around only 1.5% of heat^[33].

What are heat networks?^[34]: heat networks distribute heat or cooling from a central source and deliver it to public buildings, shops, offices, hospitals, universities and homes. Economies of scale mean that heat networks are also uniquely able to use local sources of low carbon heat which would otherwise go to waste, such as from factories, data centres, the ground or rivers^[35].

Heat networks include both district and communal heating, as defined by the Heat Networks (Scotland) Act 2021 (“the 2021 Act”). A ‘district heat network’ is defined as a network where thermal energy is distributed from one or more sources of production to more than one building. A ‘communal heating system’ is a system where thermal energy is distributed from one or more sources of production to one building comprising more than one building unit.

We focus on district heating schemes, as communal heating, such as systems servicing a single block of flats, will most likely be defined by financial structures that are more akin to those discussed as part of the place-based approach in Chapter 3. In contrast, district heating schemes are typically large-scale infrastructure projects that service multiple non-domestic buildings with high heat demands, alongside clusters of domestic consumers (including social housing stock).

4.2 Broader benefits

The value of heat networks is not just as cost-effective providers of low carbon and low cost heat to residents, public sector organisations and businesses. They have a range of other benefits, including providing:

• a valuable grid-balancing service by being able to store excess renewable generation, avoiding curtailment costs, and subsequently providing cheaper heat. Curtailment costs between January 2021 and April 2023 were £1.5 billion and are expected to rise significantly^[36].
• storage for excess heat provided by other industrial processes. Hydrogen generation, for example, is only 60-70% efficient, with the remaining energy being lost as heat. By pairing these other components of the energy transition with heat networks, the cost of heat for surrounding consumers can be further reduced.
• cooling services for new economy infrastructure such as data centres. By selling cooling to these facilities, not only can they operate more cost effectively, but cheap heat can then be provided to heat consumers.

4.3 Financial context

District heating networks are able to connect and service large anchor loads with predictable heat demand over multiple decades, providing investors in turn with stable, long-term financial returns. Due to the scale of the investment, district heating schemes in the UK have historically been financed through project finance, under long-term contracts (typically 40 years).

In the past two decades in particular, the UK has experienced a substantial increase in deployment of larger scale district heating. Powered mainly by gas-fired Combined Heat and Power engines (CHP) those heat networks have been able to produce cheap heat more efficiently to serve connected customers, whilst also producing electricity to cover local needs, or export electricity to the grid for additional revenue.

In the past, projects were also able to benefit from the non-domestic Renewable Heat Incentive (NDRHI) a UK Government subsidy based on the amount of renewable heat generated. This substantially improved a project’s viability and returns to investors. The NDRHI was closed to new applications in March 2021.

Scotland saw a few good examples of CHP powered district heating schemes, most notably the Aberdeen Heat and Power schemes, which continues to expand and service customers across the city, with the core aim of providing affordable heat and reducing fuel poverty.

Drawing on national and international examples, it is safe to say that district heating is an established and reliable solution for area-wide heat provision, whilst their economics and risk profile have made private finance more accessible compared to other means of heat decarbonisation. Crucially, given current technologies, district heating might be the only cost-effective and technically feasible solution in dense urban areas with many pre-1920s buildings.

However, with the advent of the need to provide low carbon heat as well as the closure of the NDRHI, heat networks have had to change their approach, with more focus on waste heat. Low carbon heat networks face new challenges, which have aggravated their risk profile, seemingly making the sector a less profitable investment opportunity.

For example, a recent report by Burges Salmon^[37] surveyed 80 investors and developers in the heat network space. It found that 69% of investors said that heat networks represent an attractive prospect and over 60% said that heat networks can generate sustained investment. However, investors and developers alike noted important barriers that need to be addressed through appropriate policy and regulation in order to attract finance similarly to other sectors. The report also noted that investors sought ‘large margins’ and ‘incentives’ from government.

We have identified a series of challenges that permeate the heat network sector.

4.4 Cost of capital

The Scottish Government aimed to bridge the transition and demonstrate the viability of low carbon infrastructure through the Low Carbon Infrastructure Transition Programme (LCITP), which was open from 2015 to 2021 and made financial support available to innovative low carbon infrastructure projects that have potential for replication. This approach led to the successful delivery of renewable heat network projects like the Queens Quay heat network in Clydebank, and the Advanced Manufacturing Innovation District Scotland (AMIDS) heat network in Renfrewshire.

Those two schemes are the first of their kind in Scotland and the UK: Queens Quay being the first large-scale district heating scheme to extract heat from a river using a water source heat pump; and AMIDS using fifth generation low temperature heat to power their heat networks. However, the schemes required high upfront capital investment, having total capital costs of over £12 million and over £7 million respectively.

As the LCITP had a wide scope, and to help meet the ambitious targets for heat network deployment contained in the 2021 Act, Scotland’s Heat Network Fund (SHNF) was launched to focus high value grant funding on low carbon heat networks.

The SHNF can offer grant at up to 50% of the project’s total eligible capital costs, helping bridge the funding gap required to reach target investment levels, which typically revolve around 10% over a 40-year period. This is essential because, even in mature markets like Denmark, there is continued government grant support to build and expand heat networks. The Scottish Government will therefore need to consider options for extending the available grant funding offering to reassure and encourage investment.

Both the private and public sectors appreciate that current levels of grant support are unlikely to be sustainable longer-term. Hence, it is imperative that the Scottish Government, in collaboration with industry and institutions like the SNIB and the National Wealth Fund, starts exploring and developing the financial mechanisms of the future. These could include a role for blended finance models to mobilise private capital, as set out in the Green Finance Strategy^[38], where UK Government committed to working with the GFI to explore blended finance models.

Private investors and developers, though, have shown a substantial interest in heat networks that can provide long-term returns, provided there is a stable and supported market.

However, we would note that long-term ownership of heat networks does not have to be conflated with provision of long-term funding or indeed the delivery of the network itself. National, municipal and cooperative ownership models can be considered, paired with long-term debt funding and outsourced delivery and operation contracts.

Experience from a number of industries, such as the privatised English water companies, the rail system and the short-lived privatisation of the UK’s nuclear assets in British Energy in the 1990s, suggest that private capital may at times prioritise shorter-term returns for shareholders that conflict with the longer-term investment needs of these types of assets, leading to infrastructure underinvestment and degradation of service levels^[39].

4.5 Scale and demand risk

For heat networks to be investible, developers need certainty that sufficient customers will connect to the network. This is one of the biggest factors restricting private sector investment. The GFI makes this point in its 2020 report^[40], which found that projects have been of smaller scope and scale historically, with difficulties in securing connections from key off-takers, making it challenging to minimise the risk of investment.

One route, as evidenced through Scotland’s Midlothian-Vattenfall Joint Venture example in Shawfair, is ensuring connection by leveraging public-private partnerships. SFT, in collaboration with the Scottish Government^[41], published a report in February 2024 that assessed the potential roles that a range of delivery models (alongside a number of complementary enabling structures / mechanisms) could play in helping to accelerate the pace and scale of heat network deployment. The report found that Joint Ventures and Strategic Partnerships can bring about many advantages for the deployment of heat networks, including demand assurance. Under those models, demand assurance stems from the fact that the public sector commits its buildings to connect in return for an agreed and contractually fixed long-term tariff.

SFT also advises that most developers will not invest significantly without customer contracts to provide assurance that there will be sufficient demand to recover its investment. The absence of such ‘demand assurance’ is a key reason why developers can be unwilling to invest in large-scale heat networks. This is generally true for both public and private sector developers, although their objectives, investment criteria and risk appetite tend to be different. Sufficient demand assurance can be achieved by developers entering into long-term agreements with owners of anchor loads. The most attractive anchor loads are usually large public buildings, such as hospitals, where there is confidence in a high heat demand that will be sustained over many years, combined with low counterparty risk.

However, this means that residential demand is often entirely ignored when developing the business case for heat networks, with the exception of new build and potentially large blocks of single ownership existing housing, such as concentrations of social housing.

We would therefore note a key potential synergy with the previous section of this report on place-based approaches. Heat network zoned areas could seek to secure mass sign-up of multi-tenure properties, including of residential housing, to provide anchor loads for the network, strengthening the business cases and further derisking the heat network by allowing overall cheaper provision of heat. How this might work in practice would need explored further with industry.

In the absence of regulatory levers, developers have relied on negotiations to attract long-term contractual agreement with large heat loads, such as public sector buildings, before investing in a heat network. This has been demonstrated to work for the construction of new heat networks, but it has not been effective for the expansion of heat networks. We believe consideration of the case for mandatory connections to heat networks should be a top priority in exploring ways to provide demand assurance, albeit this would also require careful consideration of any potential impacts on consumers.

4.6 Cost to the consumer

Low carbon heat networks predominantly use electricity to run large-scale heat pumps to transfer heat to and circulate water around properties. The cost of heat for low carbon heat networks is therefore driven by the cost of electricity, which costs approximately 4-5 times the price of gas. Anecdotally, the electricity costs to run a heat network can contribute up to 80-90% of the total lifecycle costs of the network.

The need to rebalance relative gas and electricity prices is therefore crucial to support decarbonising of heat networks. We have made this point about the importance of rebalancing prices throughout this report, and the CCC, in its Seventh Carbon Budget report, also highlights that making electricity cheaper is a key theme underpinning most of its recommendations.

Heat from heat networks needs to be low-carbon and low-cost to attract consumers. To make heat affordable, more needs to be done to capture significant amounts of waste heat^[42] from industrial processes, distilleries and electricity generation. Innovation can support greater use of waste heat (that would otherwise be lost into the atmosphere or sea) and support the business case for heat networks and their expansion.

District heat networks also offer other opportunities to reduce cost such as seasonal thermal storage and solar thermal. Tanks situated onsite stabilise the systems and enhance flexibility, both for the district heating system, and for the wider energy system.

4.7 Long-term regulation and engagement

The 2021 Act introduced powers to regulate the Scottish heat networks market for the first time. Specifically, the Act proposed a regulatory framework which would include powers on:

• Zoning (designation);
• Building Assessment Reports (BAR);
• Consenting;
• Licensing; and
• Permitting.

So far, zoning and BAR secondary legislation has come into force. We understand that consenting and licensing are currently being explored. Permitting, which would give exclusivity rights to a developer for a zone alongside the potential for mandatory connection, is still being considered. Scottish Renewables, the renewables trade association, called for the permitting regulations to be consulted on and passed into law. To provide certainty for investors, the 2021 Act must be fully operational.

In parallel, the Energy Act 2023 was passed by the UK Parliament in October 2023. This proposed a full regulatory framework for heat networks in England & Wales, whilst also affecting key reserved areas for Scotland such as heat network consumer protection.

The UKG’s regulatory framework has largely been welcomed as helping to provide certainty for the sector. At the same time, some perceive Scottish regulation as lagging behind, lacking the clarity of the rest of the UK. This may be negatively impacting investor interest by creating uncertainty. The Scottish Government has indicated that it plans to introduce the heat network regulations, however industry is moving forward with local, district and regional projects. There is a high risk that action overtakes policy, leaving the sector disjointed, with poor investment potential.

In its recent report^[43], Scottish Renewables specified the policy gaps in Scotland’s heat network policy landscape. We urge the Scottish Government to take heed of this report’s recommendations.