Green Heat Finance Taskforce: report - part 2

5. Social Housing

5.1 Overview and context

Almost a quarter of Scotland’s domestic properties are socially rented homes. The approximate 600,000 social homes are provided by local authorities (52%) or Registered Social Landlords (RSLs) (48%). Local authority housing stock is ring-fenced within overall local authority accounts so that it cannot operate at a financial loss, whilst also not being able to cross-subsidise wider council programmes. Housing Associations are privately owned, not-for-profit organisations that provide and manage affordable homes.

Income sources for local authority housing and RSLs are a combination of tenant rent and government grants, as well as revenue generation through asset sales. Outgoings are related to managing and maintaining their existing stock (including empty properties which are not generating rental income), repaying debt and delivering capital expenditure programmes to invest in new houses and / or upgrade existing stock. In 2023-24, local authority housing income was over £1.4 billion, of which around £910 million was spent on the supervision, management and maintenance of housing, and almost £344 million was spent on loan charges, leaving a surplus of just £120 million for investment in capital programmes^[44].

The sector has, however, been leading the way on energy efficiency in recent years, with 65% of Scotland’s social housing stock rated EPC band C or better^[45]. This will have been supported by the Social Housing Net Zero Heat Fund (SHNZF) which was initially launched in 2020 under the LCITP and ran for one year before becoming a standalone fund. The standalone fund was subsequently extended to 2026 to provide support for energy efficiency and low carbon heating projects.

However, over 500,000 gas boilers continue to heat socially rented properties^[46], meaning that, while the sector is performing better than Scotland’s housing stock overall in terms of energy efficiency, a significant amount of work remains to be done if Scotland is to achieve its clean heat (and wider net zero targets) targets.

Retrofit of the social housing sector also presents a significant opportunity to influence the wider clean heat transition, as it can offer a scale that can underpin growing market demand, therefore providing an initial boost for trades that deliver upgrade works. Social landlords can play an influential role in building broader support for clean heat installations and delivering community benefits, as they are already heavily embedded in, and trusted by, the communities in which they operate. Social housing cannot, though, play this leadership role to its full potential in the absence of policy certainty, technical assistance and funding support.

5.2 Policy Background

This relatively strong energy efficiency performance across the social housing sector has been aided by the clear regulatory framework that has been in place. This was initiated by an Energy Efficiency Standard for Social Housing (EESSH^[47]) which was designed to encourage social landlords to remove poor energy efficiency as a driver of fuel poverty, and to contribute to achieving the Scottish Government’s climate change emissions reductions targets. Its successor, EESSH2, sought to build on this by requiring all social housing to meet (or could be treated as meeting) EPC Band B, or be as energy efficient as practically possible by the end of December 2032. It also stated that no social housing below EPC Band D should be re-let from December 2025, subject to temporary specified exemptions.

The Scottish Government has in recent years been working closely with the social housing sector on a Review of EESSH2^[48]. This work led to the co-development of proposals for a new SHNZS. While the Scottish Government has yet to set out details on how it will take forward the Standard, it should provide a helpful boost to clean heat installations, and we would encourage it to set out the practical way forward with the Standard as soon as possible.

The Zero Emissions Social Housing Taskforce (ZEST) report^[49] in 2021 explored what is required to achieve zero emission social housing in a way that balances supporting tenants with reducing energy bills and carbon emissions. Its recommendations covered eight main themes and identified 35 actions it considered necessary to achieve a just net zero in the sector. In its response, the Scottish Government identified this Taskforce as the most appropriate route to follow-up on the finance related actions from ZEST^[50]. This has therefore provided a starting point for our consideration of social housing retrofit finance challenges and opportunities.

Barriers and challenges for retrofitting social housing

Many of the challenges impacting on installation of clean heat and energy efficiency measures in social housing mirror the type of considerations that organisations have to wrestle with in making investment decisions around any programmes. These include factors such as financial cost and return over time, funding availability, confidence in deliverability, and prioritisation relative to competing pressures.

Financial case challenges

Local authority housing departments and Housing Associations have to make longer-term plans based on high confidence levels that income streams ensure expenditure is affordable. This creates natural financial pressures of matching expenditure to revenue. However, these have become more pronounced over this decade as the rate of increase for a range of costs, including maintenance and repair, insurance and energy, have all outstripped the headline rate of inflation, which itself has sat at a consistently higher level than the rate of increase in rental income. This means that social housing providers have been facing steadily increasing costs against a background of limited revenue growth, therefore limiting flexibility for increasing expenditure on what could be considered non-essential or non-core activities.

The forces acting to increase costs, while limiting revenue increases, also impact on decision making around borrowing. Higher interest rates, as have been the case in recent years, make the cost of borrowing higher, and, combined with the difficulty in generating additional revenue, can mean adhering to financial covenants related to existing lending constrains further borrowing. Or, at the very least, makes it highly unattractive to organisations seeking to manage their finances prudentially.

The split incentive challenge discussed in our Part 1 report is relevant here, as the costs of installing clean heat and energy efficiency fall on the social landlord, while the benefits in terms of reduced energy bills and warmer, better insulated homes accrue to tenants. Mechanisms need to be developed, tested and scaled for monetising the benefits from upgrades to create a reliable revenue stream for social landlords, which can then be used to repay the initial costs of borrowing taken on to fund the upgrades.

Energy efficiency measures would reduce bills by reducing energy usage, all else being equal, while heat pumps can also reduce bills by being more efficient than gas boilers. However, behavioural changes required to reap these potential benefits may not always occur, and with electricity being relatively expensive compared to gas in the UK, there is a risk that tenants are pushed into fuel poverty by having their primary heating source converted to electricity. Some social landlords highlight this as an important consideration, noting that installation of battery storage alongside clean heat installations is often necessary to enable tenants to take advantage of the lowest cost energy tariffs required to generate bill savings.

Management case challenges

Regulatory clarity, as was provided through EESSH and EESSH2, has helped provide the confidence in planning work, which has resulted in social housing stock being notably more energy efficient than Scotland’s overall housing stock. However, that ability to confidently plan for the longer-term is currently being impacted by the delay in announcing next steps with establishing the SHNZS. Without clarity on the new Standard, it is difficult for social landlords to plan confidently.

Social landlords also need to think about sequencing of work and to determine the most appropriate clean heat technology for their stock. In particular, they are keen to avoid installing heat pumps in properties that could subsequently be served by a heat network, and where connection to a heat network would be lower cost per property. The financial case for development of a heat network would also be strengthened if social housing within its reach could help provide anchor loads.

Social landlords would benefit from greater clarity on the forward pipeline of locations that will actually be served by a heat network. Taking the next steps with LHEES to develop local delivery plans as well, as creating the enabling structures for heat network development, will support social landlords in prioritising their retrofit plans.

Social landlords also have to deal with challenges of upgrading individual properties within mixed ownership blocks. This can limit their ability to install whole building upgrades unless agreement can be reached with other owners around the nature of the works and sharing of costs.

The place-based models discussed in section three of this report may provide a solution to this mixed ownership challenge by avoiding the requirement for upfront contribution to costs. Indeed, social housing retrofit projects may provide the best initial testbeds for place-based approaches with a “no-regrets” offer being made to owner-occupiers and private rental landlords in the shared ownership blocks to test potential approaches.

In an echo of the challenges local authorities and other project sponsors face in developing place-based models, social landlords may lack the resourcing capacity (given other competing priorities) or technical expertise to develop and deliver detailed retrofit programmes. This is especially likely to be the case for smaller RSLs and it is unlikely to be cost effective for each organisation to contract the specialist expertise needed on an individual project basis. Indeed, this challenge is arguably greater in social housing than for the development of wider place-based initiatives because individual projects are likely to be of a smaller scale with social housing.

5.3 Taskforce insights from financing mechanisms considered

Critical to the success of all options we have identified for financing retrofit in social housing is the ability to create a revenue stream to enable the upfront financing to be repaid. Without such a revenue stream it will only be possible to finance retrofit at scale through grant provision (a situation which is unlikely to be affordable to the Scottish Government and which would be more generous than the current SHNZF, which provides 50% funding towards energy efficiency projects and 60% funding towards clean heat installation).

No one model is likely to work across the social housing sector given its diversity in terms of organisational structure, size, rural compared to urban nature, and differing property archetypes. A range of models will therefore need to be developed and tested to provide all social landlords with the opportunity to utilise the approach that is most relevant to their particular circumstances. Notable potential models range from approaches which are most familiar to the sector (charitable bonds) to those which are more complex, and which would take longer to establish, yet potentially offer a more complete solution (such as an off-balance sheet sustainable infrastructure vehicle model).

Extension of a charitable bond model

Social landlords are currently able to borrow from the Scottish Government funded Charitable Bond Programme^[51], which is administered by Allia, but for investment in new build properties only. Through the programme social landlords can borrow sums over £1 million for up to 15 years at a rate of interest set slightly above gilt yield rates, and which is therefore more attractive than commercially available rates.

As a version of the charitable bond model already exists, it is something the sector would be familiar with and therefore an extension to enable borrowing for energy efficiency or clean heat upgrades would not appear overly complex or daunting for social landlords. The Scottish Government would retain the overall risk around repayment, although the loans would remain on the social landlord’s balance sheet, meaning it would impact on their general financial position, including potentially with covenants associated with existing borrowing.

Funding for the extension of the charitable bond model would not necessarily need to be supplied directly by the Scottish Government. Other potential sources of funding for such a programme could include banks, insurance companies and pension funds, the UK Wealth Fund, or a combination of these sources. At least initially it would be expected that some level of Scottish Government funding would continue to be required to reduce the risk profile of the investment for other parties, and help to keep the level of interest charged to social landlords as low as possible.

Off-balance sheet special purpose vehicle

An off-balance sheet model would seek to address the challenges social landlords face in taking on more borrowing, while still enabling the delivery of energy efficiency and clean heat upgrades, without the social landlord having to pay the full costs upfront. This approach would involve establishing a special purpose vehicle (SPV) that can contract with individual social landlords to deliver upgrade projects which the social landlord then pays for through a service charge.

As the SPV raises the financing, coordinates the work, and installs the upgrades, the social landlords do not have to secure the full funding costs upfront, and therefore do not incur additional debt on their balance sheet. Instead they would contract with the SPV to make payments over time for a service charge, an ongoing cost that would not be treated as a debt on their balance sheet. The SPV would then repay the investors at an agreed interest rate, using the service charge received from social landlords, to cover their management costs and make those repayments.

Again, Scottish Government funding would be required, at least in the initial phases, to finance the SPV and leverage financing from other private sector sources to create a blended finance structure. This Scottish Government financing could be in the form of first loss capital, therefore reducing the risk for other investors and allowing the overall finance package raised by the SPV to attract a lower rate of interest than would be the case if expecting the private sector to carry the full risk. This, in turn, would allow a lower service charge to be levied on social landlords.

A further potential benefit of this type of model is that the SPV could attract and maintain the technical and professional expertise required to develop and deliver energy efficiency and clean heat upgrades. This could include establishing relevant procurement frameworks to make it easier and quicker to draw down the services, specialist expertise, and accredited installers.

An SPV type model is, however, more complex, and would therefore take time to establish. It would also be something that the sector was less familiar with and could therefore be more nervous about utilising its offering, at least until the approach had been demonstrated and proven. A number of other considerations would also need to be worked through as part of the detailed design and testing of this approach. Factors that would require further exploration include:

• how the SPV should be structured and the nature of the relationship between shareholders;
• who owns the assets and is responsible for their maintenance;
• what happens with the assets at the end of their lifespans; and
• how to effectively allocate and manage risk across parties over time, so that the Scottish Government does not bear all the risk (through first risk capital) while ensuring the risk profile is commercially attractive for private investors.

Energiesprong^[52]

Some of the concepts outlined above, as well as the considerations discussed in the section of this report on wider place-based models, have been put into practice by Energiesprong, a not-for-profit organisation funded by DESNZ, along with UK Research and Innovation (UKRI) and Innovate UK. Being an independent team of retrofit experts, Energiesprong work with local authorities, housing providers, building firms and the supply chain to:

• develop and test innovative retrofit strategies, models and tools;
• aid the delivery of innovative schemes to upgrade homes, and;
• showcase real-life examples of transformation.

Building on their experience in the Netherlands, Energiesprong work with both social landlords and with suppliers to coordinate and deliver upgrade programmes, which install energy efficiency and clean heat in social housing. This includes procurement and quality assurance support, which helps the supply chain to get matched with landlords, as well as helping social landlords develop robust project business cases.

Those business cases are focused around the Energiesprong comfort plan model, which replaces some or all a tenant’s energy bill post-retrofit, and is underpinned by a performance guarantee that promises them a comfortable, healthy home for the same (or less than) they paid before. This comfort plan is a type of heat as a service approach, something that is not generally available in Scotland on a commercial basis at present. However, social housing does offer the strongest opportunity to develop and test the heat as a service offering, which could then potentially be launched on a commercial basis to other residential properties.

Box 1 – Heat as a Service

Heat as a Service

The Scottish Government commissioned a research study into Heat as a Service (HaaS) in early 2023^[53]. This study assessed the case for encouraging a range of HaaS business models in Scotland^[54], models based on a service provider covering the upfront costs of installing a clean heat system, then charging a monthly fee for the equipment and / or energy provision and / or maintenance. The research confirmed that only Denmark currently has an operational full subscription-based model, although Denmark’s experience may not readily transpose to Scotland.

The research did not anticipate that HaaS models would generate substantial new demand for heat pumps. Rather, they could offer a different option for people already considering the installation of a heat pump. This is particularly the case as they can help to simplify heat pump installation for individuals by providing an end-to-end service, from installation right through to maintenance and energy supply.

The research concluded that the HaaS market in the UK is currently not sufficiently developed for it to offer a short-term option for installation of clean heat systems in any substantial numbers. This reflected the fact suppliers had not developed workable models that could easily be rolled out while overall demand for heat pumps was low. There were also concerns expressed around contractual issues and how they would be dealt when properties changed ownership (although Property Linked Finance might offer a solution to the changed ownership challenge).

Raising funding through sale of carbon credits

Some Housing Associations have sought to raise funding for energy efficiency and clean heat installations through the sale of carbon credits, utilising the Retrofit Credits scheme which has been developed by HACT, a social housing charity. Under the scheme, a methodology has been developed to measure both the carbon savings and social value created by retrofit activities. This is then used to issue retrofit credits which are sold on the market to provide the Housing Association with revenue to offset the upgrade costs they incurred. To quality assure the retrofit credits, they have been developed under the Verified Carbon Standard, the world’s leading certification programme for emissions reduction projects.

While an interesting approach, we are aware of concerns about the ability for a retrofit credits model to be scaled, with some parties believing it can only ever provide a niche solution, rather than become a regular route to unlock finance across the sector. There are also a number of issues linked to the environmental integrity of offset credits, particularly within the voluntary offset market. The future regulatory path and evolution of international markets for carbon credits was also highlighted as a risk associated with this model.