Investor views about the opportunities that heat networks offer are changing. What’s driving their growing confidence? In this article, we explore the opportunities that heat networks offer for investors; the likely impact of the latest legal developments; and explain why investors have good reason to feel confident.
The investment opportunity
Heat networks currently provide around 3% of total UK heat. However, the Department for Energy Security & Net Zero (DESNZ) believes that by 2050 they could provide up to 18%.
At that scale, heat networks represent a major low-carbon heat solution for the UK and a significant opportunity for investors to contribute towards achieving net zero, while making stable and long-term returns. Investors are interested. In our recent report, “Getting to Net Zero: The potential for heat networks in our communities”, the majority of investors surveyed confirmed that heat networks are an attractive prospect, capable of generating sustained investment.
Previously, investment appetite had been hampered by various factors including:
- demand risk driven by a limited and uncertain customer base;
- a lack of customer confidence in this emerging (and largely unregulated) energy solution; and
- the challenge of providing low-carbon heat at a competitive price, compared to the cost of a gas-fired solution.
Together, these factors made it challenging for investors to model healthy returns and make the case for investing in heat network projects.
Why now?
The shift is in large part due to the Energy Act 2023, which includes a framework for secondary legislation (or regulations) about heat networks aimed at addressing those factors which have hampered investment. This includes regulating heat networks (putting them on an equivalent footing to other utilities) and introducing heat network zones (mitigating demand risk, as discussed further below).
To inform development of the regulations, DESNZ has conducted a number of consultations, the most recent being the heat network zoning consultation (which closed on 26 February 2024). The Government’s response to the consultation is set to be published soon, however, the final regulations are expected to go a long way towards addressing factors which have so far suppressed investor appetite. We expect provisions to include:
1) Heat network zoning: creating certainty of customer base and addressing demand risk
In a previous article in this series, we discussed what DESNZ regards as the main barrier to investment in heat networks: the lack of certainty (for investors) concerning which buildings will connect into networks. This is an obstacle which has led to investment being limited to smaller schemes, in which the necessary certainty is achieved by owners of individual buildings committing to connect in individual contracts - a costly process which takes time.
Heat network zoning is designed to address this in two ways:
1: By requiring certain categories of buildings within a designated geographical area (called a heat network zone) to connect to a heat network. (Note that this does not include a requirement for connected buildings to take a supply of heat. That will be subject to separate arrangements negotiated between the heat network developer and the connecting customer).
DESNZ’s intention is to give investors confidence that sufficient aggregate demand will connect to the heat networks in which they have an interest, within an acceptable timeframe. The categories of buildings subject to the requirement are expected to include:
(a) new buildings;
(b) existing communally heated buildings; and
(c) large existing non-domestic, non-communally heated buildings within the heat network zone.
(You can find out more about how the ‘requirement to connect’ rules might apply to these building types here).
2: By giving a single heat network developer the exclusive right to design, construct, operate and maintain heat networks within a defined geographical area, effectively conferring on them the benefit of the requirement to connect. This is intended to give investors the confidence that buildings which are subject to the requirement to connect, will connect to their network (and not to a competitor’s). In order to benefit from these exclusive rights, investors (or their development vehicles) will need to win an expedited competition run by the relevant Zone Coordinator.
Combined, these two legal mechanisms are expected to address demand risk and significantly improve the commercial viability (and investment prospects) of heat networks within these zones.
2) Heat network regulations: building customer confidence
Historically, customer confidence in heat networks has been compromised (in some cases) by a lack of professionalism in delivery and operation. Customers’ main criticisms have included comparatively high prices and unreliability (when measured against individual gas boilers).
However, this needn’t be the case. In neighbouring jurisdictions (including Denmark and Germany) heat networks have proven themselves to be a technically effective and fairly priced low-carbon solution when developed and operated at scale by an experienced commercial business. They generate correspondingly high levels of customer satisfaction. The question is, therefore: how can UK heat networks inspire customer confidence on a more consistent and widespread basis?
The Government’s answer (and that of many in the heat network sector) is, in part, regulation (which is expected to start from Spring 2025).
The Energy Act 2023 provides the basis for a new regulatory framework. It is designed to set minimum standards across the heat network sector and inspire customer confidence. The key features of this framework include:
- Ofgem acting as the heat networks’ regulator;
- the introduction of an authorisation regime for heat networks, subject to specific conditions. Heat network development and operation vehicles (i.e. the recipients of investment) will be required to obtain authorisation to carry out “regulated activities”. This is expected to contain conditions (set by Ofgem) including:
- standards for setting fair prices and transparent information for consumers,
- service quality requirements, and
- requirements to achieve minimum low carbon standards;
- step-in arrangements to protect consumers (for example, if their heat network supplier becomes insolvent) and to ensure their heat supply is maintained.
Further customer protections and technical standards will be introduced via regulations which Ofgem is currently developing. These will include specific standards and duties which organisations involved in the heat networks sector will need to comply with. Ofgem is expected to introduce the regulations in three phases. This will give the market time to transition and prepare for full regulatory implementation - without facing immediate enforcement action for non-compliance.
Importantly, Ofgem is not currently proposing to introduce profit regulation or a price cap in the near future. This is due to the nascent and diverse state of the heat network market, as well as the risk that a cap could threaten supplier solvency (and therefore customers). However, Ofgem has stated that its position should remain under review. This means that investors are strongly advised to keep an eye on Ofgem’s approach to price caps and profit regulation on an ongoing basis.
3) Competitive pricing: making heat networks the lowest cost low-carbon heating technology
The cost of heat supplied from some heat networks has also had an impact on their wider adoption and the expansion of the heat network market. Easy access to cheap gas-fired heating has provided a dilemma for investors and developers:
- stick with historically cheap high-carbon gas heating systems; or
- opt for lower carbon solutions such as heat networks.
However, the cost of running building-level gas heating systems is now on the rise. Fossil fuel prices have also been volatile (internationally) and there is also a growing push from both the public and private sectors to decarbonise the heat sector. These factors make investing in heat network solutions more attractive. Increased scale of investment should, in turn, enable heat networks to increase profitability, whilst offering the lowest cost, low-carbon solution to a wide customer base in towns and cities across the UK.
How will this be realised? The good news is that heat network zoning should enable investors to invest in the most attractive opportunities to deliver low-carbon heat at a competitive price. Zoning will identify the areas where heat networks represent the lowest cost, low-carbon heating technology. Starting in 2025, these areas will be designated as heat network zones and investors will be in a position to develop and operate at scale, driving cost efficiencies and increasing returns.
Conclusion: investors have good reason to be confident
Investors should be confident about the opportunities which heat networks offer. Zoning will significantly mitigate demand risk by creating a more certain customer base and conferring exclusive rights. The scale of heat network zones is also expected to drive cost efficiencies, allowing heat network developers to supply heat at a fair and competitive price.
Incoming regulation is likely to further build customer confidence, encouraging them to be more open to agreeing connection and supply terms with heat network developers than they might otherwise have been. This will further grow the customer and revenue base for investment.
Combined, all these factors are expected to de-risk heat network opportunities, making them an attractive prospect for investors; especially where those opportunities fall within a designated heat network zone. However, we recommend investors keep a close eye out for the Government’s consultation response - and stay on top of developments.
Read our latest report Getting to Net Zero: The potential for heat networks in our communities
The report collates the views of 80 UK-based investors and developers, as well as in-depth interviews with Equitix, Related Argent, Hemiko, SSE and Asper, to gather insights and experiences of funding and developing heat networks projects in the UK and Europe.
Read our Heat Networks Report here.