Regulation risks raising costs for heat network customers

The government needs to get regulation of the heat network market right first time or risk raising prices rather than reducing them. Lucinda Dann takes a look at its early proposals for the sector and where unintended consequences could creep in.

The heat network sector consists of some 14,000 individual heat networks with a vast variation in both the number of customers served and the price charged.

Given the sheer size of the market, not to mention the variety it contains, introducing a regulatory model that protects and ensures fair pricing for customers will be no easy feat. But that is the task at hand for the sector’s new regulator Ofgem.

With the energy bill anointing it as the new regulator making its way through parliament, the Department for Energy Security and Net Zero (DESNZ) has started laying out its plans for how this would work.

Heat network consumer champion the Heat Trust says Ofgem and DESNZ have been on a steep learning curve to understand a sector which is very different from currently regulated areas of the energy market.

The first iteration, published in a consultation at the start of August, proposes a mix of both principles and a rules-based approach, echoing the strategy put forward just a few weeks earlier by the Energy Systems Catapult (ESC).

But the Heat Trust says there is still some way to go, as only some of the right questions are being asked, and the devil will be in the detail, as many well-intentioned proposals could backfire and raise prices for consumers.

Stephen Knight, director of the Heat Trust stresses that “price protection is going to be hugely front and centre. Ultimately if the new regulations do not deliver better value for money for consumers then they will be seen to have failed by customers regardless of what else they achieve, as there are an awful lot of customers in a dire state at the moment and facing very high costs”.

Ofgem and DESNZ do not have long to get it right. Further consultations are planned for later this year and next, before a soft launch of some consumer protection measures in Spring 2025.

Here Utility Week picks out some key areas of the proposals.

A fair price

Fairer prices for consumers is the marker against which the introduction of regulation will be deemed to have succeeded or failed. Knight says there are serious issues in the sector to address, highlighted by the recent energy crisis which saw some customers bills rise by 700%.

DESNZ is not proposing to introduce a cap on the prices that consumers pay as it says there is no clear evidence of widespread disproportionate pricing in the sector. It also believes that a cap risks a number of operator and supplier insolvencies, leaving customers without heating and hot water.

Instead, it plans to tackle disproportionate pricing by increasing transparency around prices and introducing benchmarking to the sector.

Knight says current information about prices paid is very old as it is based on the Competition and Markets Authority (CMA) study from 2017, and anecdotal evidence suggests some customers are paying as much as £1 per kWh as a result of the crisis, with typical prices around 30p per kWh. This compares to just 12p per kWh for a gas boiler.

However, he agrees that a price cap on what consumers pay would be very difficult to achieve and believes increased transparency and the ability to benchmark prices are needed.

Transparency

Currently customers are not able to compare the price they pay for heat and hot water with similar schemes across the country, but DESNZ believes that putting tariff information into the public domain will allow customers to tackle disproportionate pricing with their scheme operator.

Enabling existing consumers to compare prices against an average price or range of prices for similar networks would create pressure on operators to lower prices, it says. Creating a database of pricing information would also help influence Ofgem’s likely areas of interest and action.

Approaches include creating a full heat network register which lists price and other key characteristics, providing an average or range of prices for networks put into various groupings based on their characteristics, creating a high-level market average, or listing the best and worst performers in the market.

However, as DESNZ acknowledges, all of the approaches have benefits and disadvantages. Potential disadvantages include creating confusion amongst customers if they make unsuitable comparisons and could result in some suppliers raising their prices if they discover they are on the lower end of the market. Creating a “worst-performers” list could also disincentivise action as it would provide safety in numbers.

Benchmarking

Like increasing transparency, benchmarking is meant to arm both consumer and the regulator with the right information to tackle unjustifiably high prices.

The consultation puts forward a range of options, including benchmarking against gas boilers or heat pumps, benchmarking against a market average, comparison with heat networks with similar cost-affecting characteristics, and comparing profit margins.

Desnz recognises that some options may not tackle the issue of overcompensation. However, the ESC’s report ‘Heat Networks: Consumer Protection Regime’, which was funded by European energy company Vattenfall, suggests a serious potential unintended consequence of benchmarking could be penalising network operators who are investing in their networks, while rewarding operators who are able to keep prices cheaper in the short-term by failing to maintain their networks.

This should be avoided at all costs as industry stakeholders involved in a workshop run by the ESC as part of its research for the report warn that inefficient networks are a key driver of high prices, with some only being 30% efficient. Poor ongoing maintenance could also result in price fluctuations to cover reactive maintenance and repairs, making it difficult for consumers to budget and increasing the risk of customers self- disconnecting or rationing heat.

Tackling inefficiency

While very cheap commercial gas prices in the past masked the issue of inefficiency, now gas prices are higher, efforts to reduce consumer bills will not be effective if network inefficiency is not addressed across the sector.

“You’ve almost got a parallel with the cladding scandal where you have an industry which has built buildings which were not fit for purpose, and they may have met standards as they were as the time, but those standards were not fit for purpose, and actually now building owners are facing big bills to put things right,” says Knight.

DESNZ is developing a technical assurance scheme as part of the new regulations, with a consultation expected in early 2024, which will ensure new heat networks are much more efficient. Questions yet to be answered include how this will be applied retrospectively to existing networks, how much they will need to improve by and what the timeline for improvements will be.

“It’s got to produce a tangible improvement for consumers, otherwise it will be a failure. It’s got to be sufficiently comprehensive and result in a significantly more efficient set of heat networks in a relatively few number of years.

“There’s likely to be some pushback in terms of how long this can be phased in, but I think from the consumer’s perspective we need to see these improvements driven as quickly as possible.”

However, Knight says the real challenge lies around deciding who will pay for the necessary improvements, as costs are likely to be in the billions given almost a million homes will be affected and it would be “extremely unfair” to pass these costs onto the consumer and leave a “nasty taste in the mouth” for the whole sector.

But given many schemes needing the most improvements are run on a cost-recovery basis, customers are in line to foot the bill for any improvements. Knight concludes that government will likely have to put some money in to solve the issue or could look to big housebuilders to help fund improvements.

Compensation

Given the poor standard of design and maintenance that exist across the sector, reliability is one of the key issues that DESNZ hopes to address through the introduction of regulation. According to the government, half of all heat network customers reported having lost heating or hot water in the last 12 months – with most customers losing their supply between one and five times during that period.

Desnz says this means the sector is less reliable than other sources of domestic heating, and this reliability is decreasing.

One of the core elements government plans to use to incentivise minimising the length of these interruptions and reducing their frequency is through awarding compensation to customers for disruption, as is the case in other sectors such as domestic gas and electricity, water and broadband.

However, the ESC report says that “the nature of heat network risks could mean that traditional approaches to redress and compensation may not be viable, particularly due to the rise in heat network costs recently”.

Ultimately any compensation Ofgem awards for poor service will result in higher prices for consumers due to most networks in the sector being run on a cost-recovery basis.

Knight says that operators of the smallest networks could look to pass the buck on paying compensation to the contractors who are employed to maintain the networks on their behalf.

“I suspect landlords will seek to shift the risk onto those operation and maintenance contractors, but of course those contractors will do their due diligence, they will look at the state of the heat network and if it’s a really old and unreliable one they will say we will take on the contract and risk but its going to cost you, and of course that cost will go back onto the customer.

“There is a very real risk that some of the obligations will end up with customers ultimately paying a bit more in the short-term, and certainly in the middle term.”

A price cap

Knight says that while DESNZ is asking a lot of the right questions, he believes there is one big omission.

The heat network market can largely be divided into two models when it comes to how the price consumers pay is determined. Networks run by Energy Service Companies (ESCO), which tend to be larger schemes, are generally run on a cost-avoidance basis.

The price consumers pay is based on a formula, providing a big incentive to suppliers to keep a lid on costs to help increase their profit margins.

During the energy crisis, one of the main drivers of soaring prices for heat network customers was the rising price of commercial gas, as this was not affected by the price cap on domestic gas.

Being big buyers, ESCOs were able to negotiate better prices for their gas supplies and were incentivised to do so by their profit margins. However, the rest of the market, which makes up the majority, is run on a cost-recovery basis.

These networks usually have their gas supply bought by the managing agent via a broker. As costs are just passed onto the consumer, there is no incentive for managing agents to shop around, and they have less leverage with which to negotiate a better deal.

Knight says that because of the differences between the two segments of the market, they need to be regulated differently. For ESCOs, this could be through monitoring the formulas and profit margins.

However, for landlord-run schemes, which will be very difficult to incentivise to reduce their costs, Knight believes a cap on the price suppliers can pay for their gas is the solution.

“My concern is you could imagine a situation where you have quite a cosy relationship between an energy broker and a managing agent, I’m not suggesting necessarily corruption, but there is a very close relationship between the two teams and there isn’t really a focus on achieving the lowest possible price for consumers,” he says.

“We’ve seen during the energy crisis, the differential between what the small networks pay and what the big networks pay has grown quite dramatically and I think some part of regulation needs to address that and provide a kind of ceiling because ultimately its domestic consumers paying these costs and, therefore, they need domestic consumer-type protection.”

Knight believes such a measure ought to be a permanent feature of the regulatory model going forward.

The consultation remains open until 27 October.