Green Heat Finance Taskforce: report part 1 - November 2023

4. Finance context and constraints

4.1 Financing supply context and influences

The finance market for supporting the transition to green buildings is currently relatively immature, reflecting a range of unknowns around longer term demand, returns and general performance data. This combines to heighten the perception of risk amongst finance providers and investors.

Wider market factors, such as the availability of skills to deliver physical work and the supply chain’s ability to scale up materials at pace, also affect risk decisions for finance providers. There are, however, indications that the range of green financing products available to support decarbonisation of domestic properties is expanding. This is being influenced by broad market changes across the UK, as discussed below.

4.1.1 Overarching Macro-Economic Drivers

We are currently witnessing rates of inflation not seen in the last forty years and this presents serious economic and social challenges for Scotland and the UK. The high rates of inflation have contributed to a cost crisis impacting both living costs and the costs of doing business. This cost crisis follows challenges created by the COVID-19 pandemic, Brexit and a period of prolonged austerity.

The negative impacts of rising costs are already being felt in Scotland and are likely to remain high in the public consciousness as an issue of significant concern. The Taskforce is also aware that these issues are likely to have an impact on the future path and costs of decarbonisation Scotland’s buildings.

However, market forces, encouraged by increased environmental awareness amongst individuals and the increased importance of Environmental Social Governance (ESG) amongst businesses, are already establishing the necessary building blocks for a thriving market in green finance. ESG provides a set of criteria which guide business operations by measuring the company’s sustainability and ethical impact on the environment, people and leadership structures. Positive action by regulators and investors can further encourage this trend.

The growth in importance of ESG over recent years gives grounds for optimism that the supply of financial products that fund environmental improvements will continue to grow and flourish where they can demonstrate a sound commercial case. Increased demand from domestic and non-domestic customers, the later motivated by gaining a market advantage through delivering on their own ESG strategies, will help strengthen the commercial case for finance providers.

Embedding ESG in organisations’ operating models and articulating this as part of their corporate strategies will help them to meet the increasing demand from consumers, society and investors for involvement with a business which recognise the importance of their ethical responsibilities. It will also support organisations to attract and retain talent. Many investors are increasing pressure on companies to substantiate their impacts on society and the effects of their ESG strategies before agreeing to any investment. Some large investment providers have now even introduced preferred rates or packages for business that can substantively demonstrate a strong ESG strategy delivery^[18].

4.1.2 Changes Within the Lending Market

At the beginning of 2021, the UK Government undertook a consultation to seek views on proposals to set requirements for lenders to help homeowners to improve the energy performance of their homes – initially through reporting of the EPC profile of their loan books. Implementation of any approach to require mandatory reporting of EPCs on lenders loan books would need to be carefully structured to avoid creating a situation where only the most energy efficient homes are able to access finance. However, developing a metric which encourages improvement in EPC of each home in a mortgage portfolio, rather than just encouraging lending to the most efficient homes, could be helpful. This would need to be implemented at a UK level.

4.1.3 Green Taxonomy

Any proposed reporting of ‘green’ assets or investments by lenders requires a means of classification of such assets. The UK Green Taxonomy is a common framework for investments that can be defined as environmentally sustainable. It is aimed at helping to scale up sustainable investment and will provide companies, investors and policymakers with appropriate definitions for which economic activities can be considered environmentally sustainable. This can create security for investors, protect against ‘greenwashing’, help companies to become more climate-friendly and help drive investments where they are most needed^[19].

Reporting requirements for lenders and financial institutions influence the strategic decisions made and products offered by those organisations. These reporting requirements will become mandatory by the end of 2023 for larger organisations, to meet financial regulatory requirements, or voluntarily for smaller companies wishing to signal to potential customers particular values it prioritises. For retail finance providers, this reporting could be to attract customers or to secure investment from institutions committed to reducing the emissions of their asset books.

4.1.4 Other Influences from Government and Other Markets

Alongside this, for private sector finance to flow at scale, responsibilities to clients and financial regulators must be met. Investors have fiduciary responsibilities for clients’ money, to make best decisions on their behalf, while regulators are clear on how assets and liabilities are matched off, and what level of risk is appropriate. These regulatory boundaries are established at a UK level. While Solvency II^[20] reform, which is currently underway, may help to make it easier to invest in green programmes like ZDEH measures – possibly by reducing the risk margin capital buffers required for insurance companies – it is unlikely to lead to substantial changes in practice and culture in the shorter term.

At this time, however, the Taskforce believes that, unless confidence can be offered around credible paths to delivery of Net Zero goals, investment asset owners and managers cannot confidently invest in areas where the overall join-up, scale and level of risk/return do not meet their requirements. As capital is mobile across international borders, the UK needs to be conscious of the environment other countries are creating to make it more financially attractive to invest in green retrofit and environmental sustainable programmes.

4.1.5 Challenges constraining financial sector provision of finance

Substantial academic and applied literature has identified the barriers to channelling private finance for energy efficiency and green heat projects^[21]. The literature has identified a number of barriers that have posed challenges across both investment and debt finance including:

• Challenges to assessing the cash-flows of projects: financial market participants are typically unfamiliar with estimating the cash flows based on energy conservation, and, in turn, returns from savings. Additionally, these assessments often require an in-depth technical understanding of the context of the investment (building typology), technologies or conservation approaches being deployed and to what extent, as well as the potential for rebounds in energy demand that may reduce overall savings. Furthermore, there is only a limited historical track record of this type of investment to use as a basis for comparisons or as a benchmark. Finally, returns may also be exposed to different sources of volatility, such as fluctuations in national policy frameworks and changes in energy market prices.
• Challenges around structuring transactions: financial market actors have noted that energy efficiency and related investments often involve significant transaction costs corresponding to either their size (typically relatively small), a lack of standardisation of project structures, assessment approaches and contracts, as well as the assessment of specific legal and performance-related risks. As a result, these transactions may be seen as overly novel and bespoke, thus requiring relatively long approval and structuring timeframes. This has been noted as an issue both for traditional forms of debt and investment, as well as co-investment and blended finance.
• Challenges to integrate investments into investor portfolios: mobilising finance from investors into this area often faces a number of additional challenges, given that energy efficiency and ZDEH investments tend to be relatively small in size, implying both high transaction costs and being inconsistent with the typical size of investment deals that are regularly in the tens or even hundreds of millions, rather than tens of thousands of pounds. As a result, aggregation or securitisation of a large number of ZDEH and energy efficiency investments may be seen as necessary, although they may also run into issues of liquidity and tradability as they may not fit into traditional assets classes.

4.2 Finance demand constraints and challenges

There are, though, a range of barriers that currently constrain the levels and pace of private finance offerings for energy efficiency and ZDEH. Some of these barriers will apply across domestic and non-domestic buildings, while some will apply across ownership models, for example, owner-occupier and private rental landlords. Others will primarily impact on a specific ownership model. Taken together, though, they explain why the demand for, and supply of, financing for ZDEH is currently an immature market in the Scotland and the UK.

4.2.1 Complexity of Making the Right Choice

Whilst not a finance challenge, the complexity involved with retrofit – including uncertainty about making the right choice, unfamiliarly with the available technologies, a confusing advice and installer landscape, and the disruption of the physical work – discourages people taking action. The need for many properties to undertake substantial internal work for piping and radiators when installing a heat pump is also daunting and off-putting for many.

In contrast, installing a new gas boiler is more straightforward, as people are familiar with the technology, can utilise a range of traditional funding options and can readily access a range of potential suppliers, as well as easily access aftercare service. The Taskforce is therefore strongly of the view that simplifying customer journeys, including making them easy to access trusted advice on energy efficiency and ZDEH investment, is an essential prerequisite to stimulating the demand required to meet targets.

The Taskforce also recognises the current economic context, with the cost crisis leading to increased mortgage costs, rising energy bills and high food prices. In such an environment it is understandable that many households may feel that they cannot make further financial outlays with potentially long-term payback periods. The Scottish Government is aware of the immediate challenges in this area and will need to continue to work to ensure that the right mix of future funding support and private finance is coupled with helping those who need it the most.

At the core of this, the Scottish Government, working with other trusted voices, will need to win the hearts and minds of individuals across Scotland to secure buy-in and convert that buy-in to clear action. In addition to understanding what to do and why, support and clear advice in an accessible format for people will be essential in helping people understand how to take the most appropriate actions for their property.

4.2.2 Perceived Impact on Property Value

A key barrier to investing in ZDEH across all property types and for all owners, is the difficulty in understanding how they will recover the value of their investment over the longer term, through a combination of valuation enhancement (should this materialise) as well as potential future energy savings. For tenanted properties, the focus of the tenant will be on the latter.

It is generally accepted that investing in visible improvements, like a new bathroom or even redecorating, can boost the value of a property. For heating and energy efficiency upgrades the benefits remain uncertain and would accrue over time by a combination of possible property value enhancement (relative to an unimproved property) and potential future energy bill savings. The realisation of property value enhancement from heating and energy efficiency investment has yet to be achieved at scale and is influenced by wider market factors, including property supply and demand, as well as UK level regulatory decisions around the relative costs of gas compared to electricity. The wider health and comfort benefits from having a better heated home may also not fully translate through to property value.

The Taskforce also noted that the presence of regulations in the future, which specify standards for different properties, may have an impact on property valuation. When retrofitting measures are voluntary, they can be viewed by the market as a ‘nice to have’, but are not fully reflected in valuations.

Notwithstanding, there is cause for optimism, with emerging indications that this is starting to change in parts of the market where heating improvements are leading to enhanced property values, reduced energy bills and lower credit risks for institutions^[22]. This is strengthened by research from Rightmove, which shows a greener home attracts an additional price premium on top of local house price growth, with an average of almost £56,000 more for homes that have improved from an EPC rating of F to a C, sometimes referred to as the ‘EPC Premium’^[23].

4.2.3 Poor financial returns

For many homeowners and organisations, the key financial calculation will be whether the annual cost of borrowing money to finance the retrofit is larger or smaller than the resulting reduction in the energy bill. That is, are they (the householder or organisation) left in a better or worse financial position by carrying out the work?

Whilst heat pumps are more efficient than incumbent gas and oil systems, due to the current structure of pricing – with gas cheaper than electricity – their overall impact on bills will be determined by the levels of energy use before and after retrofitting. Energy efficiency improvements will reduce energy consumption, and would therefore reduce bills on their own. However their impact when combined with ZDEH, which changes the main source of fuel to electricity, means that in reality most households are unlikely to be in a better overall situation once the upgrade costs are taken into account.

The current relative cost of electricity compared to gas is therefore likely to reduce appetite to borrow and only incentivise fairly superficial retrofit, rather than the deep retrofit required by Net Zero targets. This is particularly the case with increased interest rates leading to increased costs for repayment of any borrowing, both for individual consumers as well as for finance providers, the latter borrowing on wholesale markets and making commercial considerations that will likely limit their ability to offer low enough interest to make the overall case for upgrading attractive to most households or organisations.

Clearly, government subsidies are one way of reducing the required borrowing costs by providing part of the upfront capital, but collective schemes that are area-based may provide ways to access cheaper capital and deliver economies of scale that would reduce the requirement for public sector subsidy. These will be explored in the Taskforce’s Part 2 Report. Reformation of the UK electricity market, to reduce the cost of electricity relative to gas, would also help incentivise retrofit works by increasing the value of savings for a given reduction in energy consumption as a property moves from heating via fossil fuels to ZDEH. Powers to reform electricity prices sit with the UK Government and regulators.

4.2.4 Split Incentives

A key challenge for the private rental sector, and for many leased non-domestic properties, relates to ‘split incentives’, whereby the landlord bears the cost of retrofit work, but the tenant pays for energy bills and benefits from any savings. Alongside this, there is little incentive for landlords to invest if the improvements are not reflected as an increase in property or rental value. Depending on demand for properties in a particular area, landlords can be reluctant to upgrade and increase rent as rentals may appear uncompetitive compared to other similar properties. This is even more pronounced if a landlord is likely to sell their private rental property in the short to medium term, as there would be even less time to recover the costs of any ZDEH or energy efficiency improvements made through growth in the property price market overall.

For tenants, the incentives to invest are negligible because the payback period to recover installation costs through savings generated by more efficient use of energy is too long compared to typical tenancy duration of around 1-2 years^[24].

The split incentives challenge is further complicated in the non-domestic sector as investment in energy efficiency and ZDEH systems can attract a ‘green rental premium’ for landlords. Given nearly 60% of non-domestic properties have electricity as a primary heating source (compared to just over 10% of domestic properties) energy efficiency improvements may be particularly beneficial in helping reduce energy bills. However, upgrades by landlords can be counter-productive as they can increase the rateable value of the building and hence Non-Domestic Rates bills for tenants. This in turn can offset any potential energy bill savings for the tenants who may also face higher rents than in less energy efficient buildings.

Additionally, the complexity of ownership to tenant structures in the non-domestic sector can make the split incentive challenge even more pronounced than is the case domestically, particularly in larger buildings like shopping centres or office blocks with multiple tenants. In such instances, the building owner may be a formally structured property fund, with building managers responsible for general running of the building and tenants located in specific plots. Responsibilities for heating provision and energy efficiency may be split across all parties and are likely to be defined in legal contracts between each party.

4.2.5 Lack of Promotion of Green Mortgage Products

As discussed in section 5.4, while green mortgage products currently exist, the Taskforce does not believe they are as widely understood or promoted as they might be. We consider this a missed opportunity to grow the green mortgage market, as over 70% of annual house purchases in Scotland involve owners taking out a mortgage. An overwhelming majority – 80% – of mortgages taken out in the UK are sold through mortgage brokers. When the number of property owners renewing or switching mortgage products each year is taken into account, the scale of the potential market for ‘green’ mortgage products will be substantially greater than the annual £13 billion for new house purchases ^[25].

While the Taskforce acknowledges that mortgage brokers have to weigh up a range of factors when offering customers advice, and ensure they provide appropriate advice to each customer, we consider that more can be done to improve understanding of the benefits of green mortgages. This applies to the public in general, but also to mortgage advisers who perform the role of a trusted messenger in the mortgage market.

Work has already begun to educate brokers about green mortgage product solutions and retrofitting technologies, such as the Green Finance Institute’s Broker’s Handbook, which was published in February 2023^[26]. This has been followed up by the inaugural Green Mortgage Summit, which brought together stakeholders from across the sector, including brokers, to convene and join up the thinking on progress within the market. Broker awareness and engagement remains a key priority of the Green Finance Institute’s Green Mortgage Campaign.

While most mortgages are sold on the basis of cost – and customers prioritise affordability in most decisions – it may be misleading to look at just the interest rate when making a comparison between a product identified as a green mortgage and a more traditional mortgage. A Green Mortgage, for example, might offer cashback that could act to offset any small differences in monthly repayments, or to provide owners with a cashback sum at a time when they are incurring significant costs associated all aspects of property purchasing. We also anticipate that the volume and variety of green mortgage products will expand in the coming years, so it will be important to ensure coordinated and coherent messages around their features and benefits.

4.2.6 Legislative barriers

Personal loans are a form of credit regulated in the UK under the Consumer Credit Act 1974 (CCA). The CCA was a landmark piece of legislation that provided comprehensive protections for consumers in relation to how credit was used at the time. Since then, however, use of and ambition for credit has evolved dramatically.

Some sections of the CCA (particularly sections 56 and 75) create risks for lenders developing green personal loans. Sections 56 and 75 apply when finance is used for a particular good or service (such as energy efficiency or ZDEH solutions). Both sections cause a lender and supplier to be equally responsible for any purposeful or accidental mis-selling, misrepresentation, or breach of contract. Any successful claim under section 56 or 75 could be a one-off payment or a series of payments, which can lead to high claims (liabilities) and potential claims (contingent liabilities) costs for lenders.

The complex nature of energy efficiency and ZDEH solutions make them more exposed to any mis-selling, misrepresentation, or breach of contract risk. The potential impact of sections 56 and 75 on green home finance was realised in the UK during early lender activity associated with financing solar panels. A continuing legacy arising from this time has been a perception by many lenders that energy efficiency and ZDEH solutions represent a prohibitively costly risk to them.

4.2.7 Quality of Data

One of the features of an efficiently functioning market is the reliable availability of robust and transparent information or data, which allows all parties to make informed decisions around what and when to make investments, while understanding the associated risk profile. Data is also important for tracking progress against strategic targets and to inform monitoring and evaluation activity. This supports creating effective feedback loops that allow schemes and products to be refined in response to delivery experience, and/or resources to be refocused on the most effective measures.

In our discussions, the Taskforce has found that, as a relatively new and developing area, there is currently a range of gaps in the data available to track progress with improving the energy efficiency and ZDEH levels of Scotland’s buildings. Domestic and non-domestic buildings have different challenges. Whilst domestic buildings have EPCs that measure the energy efficiency of buildings, they can often be out-of-date, either by being unreflective of property’s true environmental impacts or by virtue of the subjective process involved in assessment making an EPC rating inaccurate. Some ZDEH measures, such as air-source heat pumps, could even have an adverse impact on the EPC of a property.

Non-domestic buildings face a different challenge, since reliable data on features such as EPC ratings for buildings of different types is not easily accessible or particularly relevant. For instance, similar properties of a similar age, such as community primary schools, may have very different energy consumptions because of differences in the way they are used, for example, through the extent of additional ‘out of hours’ use of the building.