Turn up the heat

With Decc's Heat Strategy imminent, Stuart Campbell tells the government to provide firm policy and help with financing if it is serious about district heating and CHP.

The government has made it clear that to hit its challenging medium and long-term carbon targets, prioritising decarbonised heat is central to its strategy. The Combined Heat and Power Association (CHPA) recently published The Heat Revolution, which sets out a compelling vision for an integrated energy approach where decarbonised heat and power work together. What would this mean for the electricity and heat market, and what are the implications for the big six utilities who currently dominate?

In 2010, heat generated in the UK from renewable sources stood at 1.8 per cent of total energy. The government’s target is to increase this to 12 per cent by 2020. The Department of Energy and Climate Change (Decc) is due to publish its Heat Strategy next month, when it is expected to signal a major role for combined heat and power (CHP) and district heating (DH). However, no policy framework currently exists to support expansion, and the market appears sceptical that any new policy initiatives will be outlined.

The energy market is likely to evolve to become increasingly localised, with more electricity and heat generated closer to the end-consumer. This will drive the emergence of new energy supply business models, with the big six utilities that dominate the current centralised status quo standing to lose out.

New specialist providers are likely to enter the market and existing bioenergy CHP, anaerobic digestion, biogas and energy service company (Esco) providers are likely to expand operations. Community energy companies may emerge, and DH providers will spring up and scale operations. Ultimately, this bottom-up approach may lead to consolidation and begin to provide meaningful amounts of energy, shifting the existing balance of power away from the big six.

It is therefore decision time for the big six. Will they evolve their core centralised generation models to embrace this change, and hopefully use their scale to help resolve the very real barriers that need to be overcome to deliver the heat revolution? Partnerships and joint ventures to develop Escos could be winning business models going forward, with the big six bringing technology, licensing, customer IT and billing systems expertise, in tandem with smaller project developers. There are encouraging noises coming from many of the big six. However, there is much more to be done.

The principle barrier is that policy and regulation do not support the economics of heat projects, because current economics favour maximising electrical output. Support for renewable heat will decline going forward, via the reducing Renewables Obligation Certificate (Roc), while the Renewable Heat Incentive (RHI) large biomass tariff of £10/MWh is just not enough.

At present, heat is often not bankable because it is an immature market, funders are less experienced and offer shorter payment periods, the creditworthiness of offtakers fluctuates, regulatory risk exists, and heat grids are not there for long distance heat export. Often on a CHP project, the debt is sized on the electrical offtake only, with heat revenues seen as equity risk. Therefore funders tend to require guarantees over heat revenue streams to lend. The public sector and local authorities have a role to play here in helping overcome market failure.

Planning is also a problem. CHP and DH projects suffer from the same delays as any other infrastructure projects.

On financing, continued constraints on utility balance sheets and lack of liquidity in project finance markets, both of which will continue for the foreseeable future, present significant challenges to financing all new energy infrastructures, including heat generation and heat distribution assets. As new business models evolve to provide customers with new forms of energy, so too will financing models.

Deeper pools of capital, such as structured finance, debt capital markets and institutional equity markets, will need to be accessed to deliver the level of expenditure required. As these longer-term sources of capital begin to familiarise themselves with energy sector investments, interesting interim solutions are appearing for experienced retail investors participating in small-scale energy assets through existing or new tax-based funds. During this period, we would also expect an increased role for multilaterals and potentially government via the Green Investment Bank.

Innovation in creating efficient and effective conduits for long-term capital, and structuring to create the right risk and reward profile, will be key features of successfully providing long-term capital to the sector.

The reality is that the heat revolution has not arrived yet. Some of the following measures could help to move this forward:

· introducing a secure and stable regulatory environment to reassure funders and developers;

· developing new policy to aid financing. Let us see what the Decc Heat Strategy says in April, but encouraging words without concrete policy will not help. Will the combination of Rocs, RHI, Green Investment Bank, and Allowable Solutions close the gap in project economics?

· RHI phase 2. The Decc consultation is due soon, and any tariff uplifts for heat from CHP and support for distribution networks in DH would be welcome.

· financial guarantees. There is a de-risking role for the public sector to provide guarantees for the volume and price of heat produced.

· standardisation and procurement. Government promotion of schemes via public-private partnership could drive scale and standardisation, identifying schemes that can act as catalysts for major urban transformations, allowing credit risk to be spread as more connections are made. Remember that gas, electricity, water and sewerage networks were originally developed in the public sector, then transferred to the private sector as regulated assets.

· CHP feed-in tariff (FIT). A CHP FIT could nullify the increased costs of CHP versus fossil fuel alternatives, and counteract the increased risks associated with heat offtake.

However, if government is really serious about hitting its environmental targets, and believes that CHP and DH have a central role to play, then it is time to get serious about promoting their use.

Government could mandate the use of CHP and DH in appropriate new industrial, commercial and residential developments by forcing the planning regime to approve them as the default response. The public sector should take the lead using public-private partnership, especially on DH projects. Finally, “son of private finance initiative” style credits could be introduced to enhance project economics – to close the affordability gap with fossil fuel alternatives. If set at the right level, the whole complex list of other incentives could be scrapped to simplify the process.

Stuart Campbell is assistant director for environmental finance at Ernst & Young

This article first appeared in Utility Week’s print edition of 30 March 2012.

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