Heat Networks Delivery Models

Executive summary

1.1 Introduction

Heat networks are one of a number of low/no regret technologies for heat decarbonisation identified in Scotland’s Heat in Buildings Strategy^[1]. Scottish Government has set ambitious targets for their deployment, supported by a range of policy initiatives, financial incentives and regulatory measures. These will help to build skills and capacity, facilitate the identification and development of projects, and the regulation of heat network operators. However, based on the current rate of deployment and outlook on project pipeline, it is unlikely that statutory targets will be achieved without further intervention.

This report, prepared by Scottish Futures Trust (SFT) for the Scottish Government in May 2023, assesses 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. It makes recommendations on interventions Scottish Government could make in relation to certain models.

The methodology for this report included: consideration of how delivery models should be defined and characterised in the context of heat networks; stakeholder engagement with local authorities, contractors, investors and advisers to understand the challenges to deployment at the required pace & scale within the current policy and regulatory environment^[2]; identifying the features that a successful delivery model should encompass; analysis and evaluation of a broad range of established, emerging and new (for heat networks) delivery models against the agreed success criteria; and developing a set of recommendations in relation to the various models.

1.2. Challenges to achieving pace & scale

This report identifies some significant challenges to achieving greater pace and scale of deployment of heat networks in Scotland. These were informed by SFT’s own experience, together with stakeholder engagement carried out by SFT with a number of local authorities, contractors, investors and advisers. Within each stakeholder group, a variety of views were expressed, but the following broad themes emerged:

• Multiple & competing policy objectives

Heat networks support multiple policy objectives: developers promote heat networks for a variety of reasons, including decarbonisation / emissions reduction; security of supply and certainty around future energy costs for the sponsor’s own estate; fuel poverty alleviation; as a redevelopment / regeneration project; and as a commercial investment. Where multiple stakeholders are involved (as is usually required for a network of any scale), objectives may not be aligned.

Increasingly, national and local planning policy is driving low carbon development. However, there remain significant uncertainties, including lack of clarity around: a backstop date by when existing buildings will need to switch away from gas; the potential role of mandatory connections within heat network zones; and the potential role of hydrogen in heating. This all creates significant risk for larger-scale heat network developments.

• Lack of knowledge, skills & capacity

Whilst there is strong awareness of, and political support for, net zero initiatives, local authorities are spreading limited resource across a range of different types of projects, including fabric improvements, EV charging infrastructure, as well as heat networks.

Local authorities have only recently been given statutory duties relating to heat networks. Many are still struggling to build and retain the required technical and commercial knowledge, skills and capacity. LHEES and Delivery Plans are still in development, and there is a recognised gap in proceeding from the output of LHEES / Delivery Plans to the identification of projects. Although development support from the Heat Network Support Unit (HNSU) is available, alongside extensive guidance, standardised contracts and capital funding, the process is still perceived as long and resource-intensive for authorities; some have little or no engagement in the process.

Given most authorities’ lack of in-house skills and capacity relating to heat networks, there is a high degree of reliance on a relatively small pool of external technical, financial and legal advisers. Although the advisory (and wider contractor) market is aware of Scottish Government ambition and supportive policy for heat networks, the lack of visibility of a clear project pipeline means it is difficult to justify recruitment to build delivery capacity in Scotland.

• Demand assurance to encourage investment

The market can readily identify potential projects. For such projects to be investable, developers need certainty that sufficient customers will connect to the heat network when it is available. Most developers will not invest significantly without customer contracts to provide assurance that there will be sufficient demand to recover their investment.

The absence of such ‘demand assurance’ is a key reason that developers are 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.

Stakeholders, both public and private, are clear that policy & regulation need to provide greater demand assurance in order to de-risk potential projects and unlock investment at scale. There is no fixed view as to how this should be done.

Demand assurance is commonly achieved by developers entering into long-term agreements with owners of anchor loads. The most attractive anchor loads are usually large public buildings, where there is confidence in a high heat demand that will be sustained over many years, combined with low counterparty risk. However, the high dependence on public sector anchor loads usually translates to a requirement for some form of public procurement exercise to allow the public sector body to procure a connection for their buildings (see further below).

• Public procurement

Public procurement of heat networks is perceived by many stakeholders in the market as an unnecessarily long, complex and expensive process. Procurements can take over a year, requiring bidders to commit significant resource and cost. Contractors recognise resource and cost need to be incurred to develop designs etc., but consider that too much bid resource is required at a relatively early stage in the process, when multiple bidders can be carrying out design development and financial modelling simultaneously. There is a strong market demand for procurement to be streamlined.

Contractors are increasingly selective when screening opportunities, and will favour projects where the procurement process is streamlined, has a clear timetable and a competent and well-resourced local authority project team. In a market with relatively few contractors and an increasing pipeline of projects, authorities need to think carefully about how to structure not just the project, but also the procurement, to ensure a good market response.

A minority of the private sector stakeholders we spoke to questioned the need for, and benefit of, local authorities designating heat network zones, leading project development and/or procuring heat networks. Their preference was for local authorities’ role to be limited to facilitation (through supportive planning policy, granting land rights for energy centres / pipes, and leveraging local stakeholder relationships) and acting as a customer by offering anchor loads. This was, however, a minority view. Most private sector stakeholders were broadly accepting of a wider role for local authorities in heat network projects.

1.3. Summary of approach & methodology

Delivery models: definition, core characteristics & desirable attributes

This report assesses the potential roles that a range of delivery models could play in accelerating the pace and scale of heat network deployment.

There is no generally accepted definition of the term ‘delivery model’; it has different meanings in different contexts. We used the following definition in the context of heat networks, to facilitate the understanding of, and comparison between, different delivery models.

Definition: for the purpose of this report, a heat network delivery model is the set of role allocations to different parties, the commercial & financial agreements governing the relationships between the parties, and the applicable regulatory arrangements that collectively underpins the provision of services to customers via a heat network.^[3]

In describing specific delivery models in this report, we use a set of characteristics to structure the model description, i.e. the various elements of which a delivery model is comprised. These characteristics are: Overview; Project sponsor; Funding / income stream; Project structure; Asset ownership; Financing; Risk allocation; Control; Regulation; Procurement; Balance sheet treatment; and Exit strategy. These are further explained in the main report.

In order to evaluate and compare delivery models, we also identified a set of 10 core attributes that we consider a delivery model would need in order to make a significant contribution to the Heat Networks (Scotland) Act 2021 deployment targets. We developed these attributes having regard to the specific challenges of the heat networks market in Scotland and agreed them with Scottish Government.

The attributes we used, which are described further in the main report, are:

• Ease of deployment;
• Potential for private sector investment;
• Supports development of skills & capacity; Simplifies delivery;
• Contributes to policy objectives;
• Reduces demand risk;
• Supports transition to self-sustaining market;
• Supports replicability;
• Supports expansion / interconnection; and
• Facilitates installation ahead of demand.

Models were evaluated and scored against these attributes. In the evaluation of each model, we have also commented on (but not scored) the likely balance sheet treatment of the model.

Long list and categorisation of delivery models

We agreed a long-list of delivery models with Scottish Government to evaluate for this report. These delivery models were categorised as follows:

• Existing / well-established delivery model – models which are well-established in the UK and for which there are multiple examples of heat network projects deployed under this model (albeit with minor variations):
  • Public sector (non-Scottish Government) in-house delivery – heat network wholly owned and operated by a public body (either directly, or via a wholly owned arm’s length entity), usually based on self-supply arrangements (e.g., local authority buildings, or a public sector campus) (DM1);
  • Service concession – heat network owned and operated by the private sector under a long-term service concession tendered by a public body, where the public sector offers anchor loads, and a concessionaire takes demand risk (DM2); and
  • Third party ESCo – heat network owned and operated by a private sector third-party ESCo appointed by private sector land owner / developer, generally to serve new development (DM3).
• Existing delivery model / limited examples – models which have been used in the UK on a relatively small number of heat network projects, but for which there are as yet insufficient examples to consider the model as well-established:
  • Local authority led joint venture – a local authority procures a partner and forms a JV to serve an initial project (including one or more local authority anchor loads) and potentially additional projects and/or other energy projects within the local authority area (DM4);
  • Community led project – a community leads heat network development and owns the network, subcontracts O&M, supplies buildings within community (DM5);
  • Unbundled model – a family of models involving separate ownership of generation, transmission / distribution and supply assets, e.g. where heat generators contract directly with customers and pay a use-of-system charge to the owner of heat transmission / distribution infrastructure (DM6); and
  • Merchant model – a private sector heat network operator contracts with off-takers to supply existing buildings, without having either being appointed by a private sector land owner / developer in connection with a particular development site, or having followed a public procurement exercise (DM7).
• New delivery models for heat networks – models for which we are not aware of any UK examples of heat networks delivered in this way, though the model in question may be established in other sectors:
  • Centrally led delivery – In this model, Scottish Government (or an executive agency of the Scottish Government, or some other centrally controlled public body) takes the lead on development and delivery of projects, without need for local authorities to lead development. The central body could have initial ownership / part-ownership of projects (potentially alongside private sector partner(s)) but with potential for the onward sale or transfer of government stakes in projects once they are operational with established revenue streams. As with other delivery models, this model could be adjusted to perform slightly differently against a number of attributes. (DM8).
  • Local Authority led delivery, with Scottish Government stake – local authorities lead the development and delivery of projects, with Scottish Government / central support and co-investment (which may be in addition to an element of grant), in a joint venture arrangement. Scottish Government would have part-ownership^[4] of schemes, but with potential for sale / transfer of the government stake once a scheme is established. JVs could be bipartite – local authority & Scottish Government, or tripartite - local authority, Scottish Government and private sector (DM9);
  • Regional ESCo – in this model, local authorities and other public bodies^[5] (e.g., NHS, universities / colleges) come together on a regional basis and jointly procure a private sector delivery partner for each region (similar to the Hub model, which was established in Scotland to deliver community infrastructure). The local public partners then use the delivery partner to scope, design and deliver projects, according to pre-defined contracting structures, drawing on the delivery partner’s supply chain. (DM10);
  • Public Private Partnership (PPP) – the heat network is operated by the private sector under a long-term contract tendered by a public body, where the public sector retains the majority of demand risk, but availability risk lies with the PPP contractor (DM11); and
  • Regulated Asset Base – a private sector ownership model in which heat network assets are constructed, owned and operated by a monopoly supplier on a long-term basis. Investment plans, operating performance and returns (which are capped) are subject to regulatory oversight. The model is intended to incentivise private investment in large-scale heat networks, with a cost of capital comparable to other regulated utilities (DM12).

The report includes a detailed description of each of these delivery models. Each model description is structured by reference to the ‘characteristics’ referred to above.

For existing delivery models, we have provided UK examples of heat networks using that model.

• Enabling structures / mechanisms

In collating the long list of delivery models, we identified a number of ‘enabling structures / mechanisms’ that share some, but not all, of the characteristics of a delivery model, and which could complement and/or enable the implementation of one or more delivery models. These were not evaluated as delivery models, but their potential role in complementing other models was considered.

The enabling structures considered in the report are: Demand assurance ; Private company with public purpose ; Heat as a Service ; and Procurement efficiency.

1.4. Summary of evaluation findings & recommendations

We evaluated each of the twelve delivery models against the ten attributes described above. Each model was given a score of 0 – 3 against each attribute, to help determine a high-level ranking. The evaluation was informed by our own experience combined with stakeholder engagement. A full table of scores is provided in Appendix B.

Our conclusions and recommendations are categorised as follows:

1. a set of general, overarching recommendations and conclusions which are not specific to individual models;

2. a set of recommendations relating to implementation of the four highest-scoring models in our evaluation, should Scottish Government wish to pursue any of these models further;

3. recommendations and conclusions in respect of each of the remaining eight models considered in our evaluation; and

4. recommendations relating to ‘enabling mechanisms’, which could complement and/or enable the implementation of other delivery models.

The remainder of this section summarises these four sets of recommendations.

(1) Overarching conclusions & recommendations

Through our evaluation and engagement with stakeholders, we have identified general, overarching recommendations and conclusions which are not specific to individual models. These are set out in full in the main report and can be summarised follows:

a) The models can be further refined and the optimal solution (which may include attributes from a number of models), should be developed to support Scottish Government objectives.

In order to be able to evaluate, score and contrast the different delivery models, we had to make certain assumptions about existing models and how each ‘new’ model could be deployed. Key assumptions are included within the description of each model.

In practice, there are features of existing models which can (and do) vary, and features of the potential ‘new’ models that could be flexed to support different outcomes or meet different attributes. Where this is the case, we have identified it in the evaluation text and reflected it in our summary conclusions and recommendations below. The inherently flexible nature of the four top-performing models we are recommending for further consideration should be borne in mind when reviewing this report.

If Scottish Government wished to promote a new model, the top four models we identified could be refined, adjusted and adapted to develop an optimal solution and ensure any new model appropriately balanced the most important attributes. We have framed our recommendations to reflect this flexibility and the range of choices around how new models could be deployed.

b) A long term ‘Vision’ for heat networks in Scotland should be developed

There would be significant value for Scottish Government in developing a ‘vision’ for how heat networks in Scotland should operate in the long term. For example, does Scottish Government envisage significant ongoing public sector involvement, or a largely private sector owned and operated market? Understanding the ‘vision’, or even preferred outcomes (beyond deployment targets), would help inform decision making around the creation of any new delivery model, and would also help inform the ongoing development of forthcoming regulation under the Heat Networks (Scotland) Act 2021.

Steps should also be taken to future- proof current activity to facilitate any potential future consolidation of assets (whether into public or private (local) monopolies or unbundling of the market). This will retain future flexibility as to how Scotland’s heat network market can evolve over time.

c) Existing models can be optimised in the short term, regardless of any medium or long-term intervention.

We recognise that the existing suite of delivery models, both those that are relatively well-established and others that are emerging, will still have an important role to play.

Hence, although our focus is on the four models which performed best in the evaluation against the attributes, we have also considered what, if any, recommendations should be made in respect of the other 8, lower-scoring models. Recommendations include, for example, developing case studies or the preparation of further guidance and templates.

These recommendations seek to optimise and future proof the networks delivered using more traditional routes, or prepare for new and emerging private sector models.

d) Budget implications and Government risk appetite

Private sector investment is fundamental to achieving the necessary scale of deployment. The highest-scoring models all enable (or could allow for) private sector investment to varying degrees, but at least two of the four highest-scoring models would require some degree of central Government investment, either directly or indirectly, via Government owned or controlled entities.

To inform the detailed design for any potential new delivery models it wishes to take forward, Scottish Government should therefore consider and determine its risk appetite for investment in heat networks, and the time period over which it may wish to hold investments, including whether investments should be categorised as on or off Government balance sheet.

Where investments are on balance sheet, it may be appropriate to develop an exit strategy such that investments would transition to off-balance sheet (through a sale/disposal of all or part of an investment in a project) after a period of time.

e) Ongoing stakeholder engagement will be required.

We undertook high-level, principle-based stakeholder engagement to help inform our evaluation and recommendations in this report. Based on the engagement undertaken with both public and private sector stakeholders, we think the following attributes (as described in section 5) should be a priority for any new models: potential for private sector investment, ability to respond to current challenges around skills & capacity, ease of deployment and simplifying delivery (in particular to promote improved procurement efficiency).

Should Scottish Government be minded to develop models further, additional, stakeholder engagement (and involvement in development) will be important to inform the design and implementation of any new model(s). Engagement would need to be more detailed, and involve more refined proposals for market engagement. For major changes or interventions, public consultation may be advisable.

(2) Highest Scoring Models

Of the twelve models we evaluated, we identified four delivery models that we propose warrant further detailed development/consideration, namely:

1. Regional ESCo (DM10);

2. Local authority led joint venture (DM4);

3. Local authority led delivery, with Scottish Government stake (DM9); and

4. Centrally led (DM8).

These models scored highest in the evaluation. A full table of scores is provided at Appendix B.

Given the element of subjectivity inherent in scoring against qualitative evaluation criteria, we would not at this stage wish to prioritise these further based on scores alone. Although scores have been moderated, good arguments can be made for an increase or decrease in an individual score against an attribute by 1 mark. It is therefore important to consider the qualitative evaluation findings in section 8, alongside the scores in Appendix B. Any prioritisation of models should take into account these qualitative comments.

Note that the Regulated Asset Base (RAB) model (DM12) scored equally with Centrally led (DM8), but has not been short-listed above due to the negative assessment of the potential for the model to be deployed at the present time, given the current regulatory and policy framework.

Regional ESCo (RESCo) (DM10)

We recommend that this model is taken forward and resources are put into its further development/consideration.

This model, in which local authorities and other public bodies^[6] (e.g., NHS, universities / colleges) come together on a regional basis and jointly procure a private sector delivery partner for each region to form a ‘Regional ESCo’ (RESCo), is analogous to the Scottish ‘Hub model’ for community infrastructure, in which public sector bodies came together on a regional basis to participate in joint procurements of private sector partners to deliver community infrastructure projects. In the Hub model, the successful bidders and the public bodies then formed regional “HubCos”, in which the private sector partner took a majority stake, and the local public sector bodies (and SFT’s investment arm) hold minority stakes.

Although further work is required to determine whether a ‘Hub style’ RESCo model would be as effective for heat network delivery as the existing Hub model has been for community infrastructure in Scotland, there are numerous core components of this model which perform very well against many of the evaluation attributes and have the potential to offer significant benefits to heat network delivery.

Key benefits

The RESCo structure provides a mechanism by which, on a regional basis, a single procurement unlocks multiple projects. These future projects are contemplated in the initial, regional procurement, reducing costs and delay. The structure involves a long-term relationship with a private sector delivery partner, who would establish resources and expertise within the RESCo, so that it can develop and deliver projects. The delivery partner would procure its supply chain, which can be flexed over time. Based on the Hub experience, benefits for local and regional skills and supply chains are also likely to be significant.

The ‘partnering’ nature of the model, where other public sector bodies have a stake in the RESCo (in addition to being named on the Contract Notice) should help to catalyse development, by bringing a larger number of public sector entities (with responsibility for potential anchor loads) to the table in a more proactive role. The benefits of this partnering approach have been very apparent in Hub.

The potential for scale through a pipeline of projects can promote both economies of scale in terms of strategic investments, purchasing power and facilitate access to a lower cost of finance.

If taken forward, the process of setting up this model could draw upon and benefit from the extensive experience and learning from the Hub programme. Similar challenges to those identified below have been overcome in the Hub model.

Key risks

As this is a new model for heat networks, it would require multiple regional procurements (although a single suite of documents could be developed), preceded by a significant development period, including more detailed market testing of the concept and to test/gain the support of the relevant public bodies in each area. Scotland’s HubCos took around two years to establish, although some efficiencies may be possible in delivering this model if learning from the Hub programme can be applied. Project development under existing models could continue during this development period.

The boundaries of each ‘region’ would need to be carefully considered to balance the need for scale and a sufficient pipeline of projects, whilst ensuring that the private sector partner had sufficient delivery capacity. The potential scale of investment for a region (as against a single local authority) may point towards the delivery partner being an investor (with ability to use multiple contractors) rather than a (single) contractor. In order to attract market interest in each region, a degree of exclusivity for the private sector partner would likely be required over certain types of projects for a minimum period. This needs to be carefully considered in the context of forthcoming regulation (although the need to consider the interface between commercial/procurement and regulatory processes is a challenge that is not unique to this model, and needs to be evaluated for all models).

The regional public bodies will require visibility of how the delivery partner provides value for money to the RESCo if it contracts services and delivery contracts through its own group companies. This can be dealt with by open book accounting or a requirement (as happens on Hub) to tender sub-contracts.

Depending on the size of Scottish Government’s equity stake in a RESCo, and the degree of control conferred by its shareholder rights, there is potential for projects to appear on Scottish Government’s balance sheet (until such time as its shareholding is sold to a project partner or third party) and therefore reduce funds available to be spent on other priorities. A significant amount of work and preparation went into the Hub balance sheet treatment, and those lessons could be applied here.

A full evaluation of this model against the attributes and detailed recommendations in relation to this model are set out in the main report.

Local authority led joint venture (DM4)

We recommend that this model is taken forward and resources are put into its further development/consideration.

Although there are relatively few examples of joint ventures (JVs) in the heat network sector, the JV model is based on a well-understood corporate structure that can be deployed without requiring any Scottish Government intervention.

Key benefits

All of the JV-style models we evaluated which involve a private sector partner offer significant benefits in terms of simplifying delivery, because a single procurement can unlock multiple projects: after the initial procurement for a partner (which is usually backed by a well-defined initial project), the JV partner can proactively develop business cases for additional projects, which do not need a separate procurement exercise.

In a JV, private and public sector JV partners can each ‘play to their strengths’. The local authority can bring a project pipeline, land (e.g., for energy centres), anchor loads, local stakeholder relationships and supportive planning policy. The private sector brings delivery capacity and expertise to develop projects more efficiently from an early stage. Both parties bring investment, and share in risk and returns.

Ongoing public sector involvement via a JV can allow a degree of focus on policy objectives to be maintained, and will support the identification and delivery of new projects which rely on local authority anchor loads. The risk/return sharing inherent in the JV model tends to promote a collaborative rather than adversarial relationship, in which the partners’ interests are suitably aligned. Some investors/developers will also accept a lower rate of return via a JV model because risks are shared, reducing the scale of grants required and supporting the transition to a self-sustaining market.

In addition to Midlothian Energy, there are examples of successful ‘energy partnership’ JVs in England and Wales which are focussed on, or include, the delivery of heat networks. We see significant potential in this model as a way for local authorities to procure heat networks. This approach could help with co-ordination of wider LHEES delivery across the local authority area, and should better ensure that the most optimal energy solution is identified for each building^[7].

Key risks

In order to attract market interest, a degree of exclusivity for the private sector JV partner would be required over certain types of projects for a minimum period. The requirement for exclusivity would need to be carefully considered in the context of heat network zoning, and in particular the designation of permitted zones.

The local authority will require visibility of how the JV partner provides value for money to the JV if it contracts services and delivery through its own group companies. This can be dealt with by open book accounting or a requirement for the JV to tender sub-contracts competitively.

A full evaluation of this model against the attributes and detailed recommendations in relation to this model are set out in the main report.

Local authority led delivery, with Scottish Government stake (DM9)

We recommend that this model is taken forward and resources are put into its further development/consideration.

Feedback from local authority stakeholders indicated that an ongoing Government commitment to projects, which was more proactive than offering grants, would help support delivery and could encourage local authorities to invest in heat networks. One way of doing this would be for Scottish Government to take a stake in projects. We believe this model has significant potential and should be explored further.

Key benefits

Financial risks and returns would be shared between the parties in accordance with their respective investments. Scottish Government taking an equity stake (potentially alongside capital grant) would help to de-risk a project and allow it to proceed faster and/or at a greater scale than would otherwise happen. Scottish Government would also have the potential to share in any profits.

Scottish Government would have a greater degree of control and influence (proportionate to its equity stake) than would be achieved solely via grant funding, and would have the option to exit and recycle capital into other schemes. Centrally held stakes could be retained for the longer term or sold on when the market was more mature.

Some authorities would welcome Scottish Government being more closely involved in projects than with a ‘grant only’ structure, and see value in a Scottish Government appointee with suitable experience being involved in helping to steer the project and ensure its long-term success.

Developing a central body of skills and experience, whilst working with local authorities who can develop expertise locally, would help build skills across Scotland. Shared central knowledge of multiple projects also offers potential to identify expansion and interconnection opportunities, while sharing lessons learned.

Although a minority of investors were not in favour of sharing ownership with central Government, many were supportive.

Key risks

Scottish Government’s ongoing role in projects would expose it to reputational risk in the event that the project failed to deliver the desired objectives. As a shareholder, Scottish Government would also risk losing its investment if its equity stake had no value. In this scenario, the Scottish Government investment in the project would in effect become a grant, meaning the additional risk (compared to current grant support) is more reputational than financial.

Not all potential co-investors would welcome an ongoing Scottish Government role in projects. Some do not see this as a natural government role, and would prefer intervention to be limited to policy and regulation rather than getting involved in project delivery.

An ongoing role in projects through SPV (Special Purpose Vehicle) Board appointments would provide greater insight to Scottish Government of the practical issues facing projects, and may help to guide the SPV in interpreting and applying any pre-agreed policy objectives, and add value beyond purely profit-led decision making. However, if the Scottish Government’s appointee was a director, any such appointee would be bound by directors’ duties, including to act in the best interests of the SPV. If the appointee was not a director (e.g., an ‘observer’ role), Scottish Government would not have sufficient influence and control in order to protect its investment.

A shareholding in project SPVs risks bringing the relevant project(s) onto Scottish Government balance sheet, thus reducing funds available to be spent on other spending priorities.

A full evaluation of this model against the attributes and detailed recommendations in relation to this model are set out in the main report.

Centrally led delivery (DM8)

We recommend that this model is taken forward for further consideration and resources are put into its further development/consideration.

The rationale for this model is to provide a delivery route for projects in areas for which heat networks have been identified as an appropriate decarbonisation pathway, but where local authorities are not actively taking forward development, and no other organisations are doing so at scale (e.g., on a merchant basis). The model has the potential to unlock development in such places, but could also be scaled up to deliver more commercially attractive projects as well, in order to deliver consolidation and control. This model has some positive attributes which we believe are worth considering further.

Key benefits

Consistent and significant central ownership via this model (noting that JVs with a private partner would still be possible) offers the potential for control and future consolidation and the opportunity to focus on wider policy priorities across all of Scotland. It could also remove barriers to expansion and interconnection in the future, and provide an opportunity for installation ahead of demand (provided the central body had the required investment capacity and risk appetite).

Depending on Scottish Government’s investment capacity and risk appetite, a central delivery body would have the potential to invest ahead of need, for example by making strategic investments in transmission / trunk mains in anticipation of future connections in heat network zones.

A central delivery body would allow significant knowledge sharing and efficient allocation of resources, with delivery expertise building up over time.

Any investments made by Scottish Government in projects could have future value, with potential for such investments to be sold in due course (most likely when projects are operational with established revenue streams), and the proceeds of sale available for reinvestment in other projects.

Key risks

The version of this model we evaluated assumed no local authority role in developing or delivering projects (other than in offering/connecting their own anchor loads). This would be a move away from the current policy around LHEES, where local authorities are responsible for identifying appropriate heating solutions for their area. Scottish Government’s role in leading project development would expose it to reputational risk in the event that projects failed to deliver the desired objectives.

A risk of creating a central body is that those local authorities who are currently active in heat network developments may step back and re-prioritise limited resources on other initiatives. It is difficult to say whether the net result would increase or decrease the overall pace and scale of delivery.

Deciding where to prioritise spending, and how to address any imbalance in areas where local authorities are pursuing their own projects, would be politically challenging - local authorities active in heat networks will need reassurance that subsidy will continue to be available to support their own developments, so they are not adversely impacted by the introduction of the delivery body.

This model would require significant capital investment (assuming that Scottish Government will need to provide capital that might otherwise have been provided by local authorities), and ongoing revenue budget. A shareholding in project SPVs risks bringing the relevant project(s) onto Scottish Government balance sheet, thus reducing funds available to be spent on other spending priorities.

As a shareholder, Scottish Government would risk losing its investment if its equity stake in a project had no value. In this scenario, the Scottish Government investment in the project would in effect become a grant, meaning the risk (compared to current grant support) is more reputational than financial.

There may be a risk of ‘self-regulation’ in respect of the Heat Networks (Scotland) Act 2021, where Scottish Government is developing and operating projects, whilst holding regulatory functions in respect of heat networks. This issue could be reduced if a separate statutory entity was set up to hold the heat network assets and apply for the relevant approvals, but setting up an independent entity in this manner could require further legislation.

A full evaluation of this model against the attributes and detailed recommendations in relation to this model are set out in the main report.

(3) Other models – conclusions & recommendations

Of the remaining eight models not described above, we reached varying conclusions in our evaluation findings and recommendations.

For some established models (i.e. Public Sector Led (DM1), Concession (DM2) and Private ESCo (DM3)) we have concluded that they still have a role, can be supported, and that their delivery could be optimised or improved:

• Public Sector Led (DM1): We recognise that this model will continue to play a useful role for those authorities with the skills & resources, investment capacity and risk appetite to develop, own & operate networks. However, given most local authorities’ limited investment capacity and competing priorities for investment, this model is highly unlikely to result in the scale of investment necessary to contribute meaningfully to deployment targets. Hence we do not recommend that this model be actively promoted further by Scottish Government. Where existing local authority projects are finding it difficult to expand – e.g., due to operational challenges, competing priorities and limited resources – Scottish Government / HNSU should work with the projects to explore whether a different ownership model would be more advantageous, and how to transition.
• Concession (DM2): The concession model continues to offer a successful route to the procurement and delivery of heat networks for authorities which are less willing to take on any investment risk. Concessions are well-understood and offer a relatively straightforward route for bringing in private investment. Although procurement can be lengthy and costly, there is potential to improve this. Concessions offer only contractual control for the procuring authority, meaning it can be harder to manage wider policy objectives over the longer term. Developers and investors will generally seek a higher rate of return to reflect the greater amount of risk being passed on to them. At present, this tends to require higher levels of subsidy to support the investment, and also means that this model is only really suitable for more profitable opportunities. The traditional concession model generally only delivers a single investment, rather than offering an entry-point for ongoing investment through multiple subsequent projects. It is therefore less efficient at deploying private investment than some other options. We believe that there is scope to provide guidance and support that ensures better long term outcomes for the public and procuring authority, and to ensure that concessions contribute to (and do not detract from) any longer term vision developed for heat networks in Scotland. We have made recommendations in relation to monitoring actions and development of standard forms for concessions.
• Private ESCo (DM3): This model (as defined) is generally limited to smaller, contained sites in order to respond to planning conditions requiring the construction of a heat network. It does not involve any substantive role for the public sector beyond regulation. While it is positive to see heat network being provided for new development, and heat networks should be encouraged for new developments, this kind of project does not generally go on to expand or serve existing buildings, and so will not deliver the pace and scale of development that is required. We do not believe this model should be actively promoted beyond promoting policies that are supportive of new heat networks. For example, we recommend that Scottish Government should continue to promote planning policy that supports or requires the installation of new heat networks (or connection into existing or planned heat networks) at all new development sites in specified areas. In practice, this will require local authorities to develop pro-heat network policies at a local level. Scottish Government may wish to consider how this can be further encouraged/supported e.g., via the sharing of experiences and best practice examples from elsewhere in the UK as part of the proposed HNSU ‘strategic heat network planning’ initiative.

For some other ‘new models’, we recommend that they should not be actively promoted or supported at this time, but that ‘watching brief’ type actions could be considered (Merchant model (DM7)), or consideration given as to how they might be used in the future (Unbundled (DM6) and Regulated Asset Base (DM12)):

• Merchant model (DM7): We do not recommend that this model is promoted by Scottish Government as a means to achieving a step change in pace and scale of deployment of heat networks. Whilst we recognise the potential for private sector investment under the merchant model, we do not believe this will lead to the development of large-scale strategic heat networks aligned with intended policy outcomes. This model carries a significant risk of ‘cherry picking’ of anchor loads, resulting in uncoordinated and small-scale developments, misaligned with Scottish Government policy ambitions. It risks first-mover advantage in an area, potentially inhibiting future, larger-scale, development (e.g., in areas likely to be designated as permitted heat network zones). However, we recognised that this model may have a limited role for towns or suburban residential schemes (e.g., shared ground loops). We recommend that further analysis should be undertaken to identify the potential for this model in certain locations, and whether/how it should be accommodated in forthcoming wider commercial and regulatory arrangements (including LHEES, zoning and related exclusive permitting).
• Unbundled (DM6): In an unbundled model, generation, distribution and supply are operated as separate businesses. The development of new networks, or unbundling of existing networks into separate businesses is generally only viable and practicable where sufficient scale has already been achieved. It would therefore be premature to promote this delivery model in a relatively immature heat network market such as in Scotland. In due course, heat networks may reach a scale at which unbundling their components becomes commercially viable. With this in mind, Scottish Government should promote the future-proofing of delivery models to facilitate any potential future unbundling of networks (e.g., by holding assets in SPVs). Partially unbundled networks may develop naturally where there is an obvious industrial / third-party heat source wishing to connect to an existing network, and supply of surplus / waste heat from environment / industry into networks (e.g., Stirling Forthside, Glenrothes, Clyde Gateway, Millerhill energy-from-waste) should be encouraged and facilitated. This can be done via the HNSU. Examples would include the provision of a template supply agreement currently being developed by SFT.
• Regulated Asset Based (DM12): The Regulated Asset Base model offers a good long term regulatory model for large infrastructure operating in a monopoly environment. There is significant experience of this model from other sectors in the UK. It supports investment in assets by providing a guaranteed return for investors on approved investments, and mitigates demand risk by spreading costs across the entire customer base. However, it requires a large asset base to support the model, is time and cost intensive to regulate, and is not compatible with forthcoming regulation for heat networks in Scotland: current market and regulatory arrangements would not support the immediate roll out of this model. However, both existing and any new delivery models could be future-proofed to retain this option in the long term, by facilitating any future consolidation of heat network assets (whether into public or private (local) monopolies). We have recommended that Scottish Government should develop a long term ‘vision’ for heat networks in Scotland, including determining whether consolidation of certain types of heat network assets is desirable as a long-term structure. If long-term consolidation of ownership is deemed to be desirable, consideration can be given to how all delivery models being used could be future-proofed to facilitate this outcome.

We do not consider that the PPP model (DM11) or Community Led (DM5) would offer any delivery advantages, and recommend that they should not be pursued.

• Community Led (DM5): Although community led projects can have very positive policy outcomes for small communities when delivered successfully, community led projects tend to be small, challenging to deliver and often harder to fund. They can absorb skill and resource (including Government grant and advisory support) without delivering projects at scale. Whilst we recognise there may be other policy reasons for promoting community led projects and that they are likely to have some role to play, we do not recommend that this model is promoted by Scottish Government as a means to achieve scale and pace of deployment of heat networks. However, if encouraging community involvement in projects is a priority for Scottish Government, case studies or guidance could be prepared. Scottish Government may also wish to investigate and promote alternative ways in which communities could be engaged in (and benefit from) heat networks, other than ownership (e.g., via the development of a community fund, funded by the heat network operator). HNSU could develop ‘best practice’ guidance for delivering community benefits, which could feed into larger procurements.
• PPP (DM11): The PPP model has many features similar to a concession model, and offers no additional advantages in the context of heat networks, but is more costly and complex to deliver than a concession. We therefore do not consider this model as suitable as a means for the deployment of heat networks at pace and scale. Unlike the merchant model, we are not aware of any market actors promoting or suggesting this model, and therefore no further steps are recommended.

Proposed recommendations for each of these 8 remaining models include: to consider further the interaction with forthcoming regulation; to prepare updated guidance for local authorities for delivering various models; to prepare contract templates for various models; and horizon watching / capturing lessons learned from developments / projects across the UK.

Various recommendations relate to more than one model, and can be ‘packaged’ accordingly.

(4) Conclusions & recommendations in relation to enabling mechanisms

There are a number of enabling structures / mechanisms which, if implemented, would also help to increase the pace and scale of delivery of heat networks. These mechanisms would, to a large extent, apply independently of the choice of delivery model for a particular project. These supportive mechanisms relate to demand assurance and procurement efficiencies.

The report describes the various ways in which demand assurance could be achieved, and its fundamental role in de-risking investments in heat networks from a developer perspective (both public and private sector). As part of the on-going work to develop policy and regulation, we recommend that the Scottish Government should continue to seek opportunities to provide greater demand assurance to projects. Although stakeholders we spoke to were not universal in their views on which form of demand of assurance would be most welcome (e.g. support for mandatory connections appeared to be reducing), there was clear feedback that more could be done to reduce risks around demand assurance, and that steps taken did not need to be radical. For example, some stakeholders suggested that clearer policy advising that public sector buildings should connect to heat networks would go a long way to encouraging anchor loads to connect.

The report outlines stakeholder concerns about procurement efficiency, including procurement procedures, time-scales and associated bid costs. We have described a range of approaches intended to increase the efficiency of procurements. We recommend t he Heat Network Support Unit should facilitate the development and implementation of procurement efficiency on a project-by-project basis. This could include, for example, piloting a two-stage procurement process on a live project, evaluating the outcomes and disseminating lessons learnt via a case study, and/or establishing a procurement framework.