Heat in Buildings Strategy - achieving net zero emissions in Scotland's buildings

Chapter 7 Working Towards A Long-Term Market Framework

This Strategy sets out a proposed long-term policy framework. It is supported by ambitious targets on climate change and fuel poverty, a stretching deployment pathway for energy efficiency and low and zero emissions heating, a significant capital funding commitment over this Parliament, and creation of a regulatory framework to underpin delivery and provide future certainty to the market (as detailed in Chapter 8).

However, we know that to grow the market in line with the transformation needed, energy efficiency and low and zero emissions heating need to feel like a positive choice for households and building owners. As we scale up deployment over the course of this decade, it will be important that this transformation is underpinned by an appropriate market framework, which helps to create the demand for energy efficiency and low and zero emissions heating, helps consumers overcome the upfront investment costs and helps to attract and secure further private investment and finance to help meet the costs of the transition.

Investing in net zero

We estimate that the total capital cost of converting our building stock to zero emissions by 2045 is in the region of £33 billion^[11]. This estimate includes the costs of upgrading the energy efficiency of domestic and non-domestic properties and replacing their heating systems with zero emission alternatives. Further investment will also be required to upgrade our energy networks and ensure sufficient energy generation capacity (as identified in Chapter 5). However, it is important to bear in mind that this is the gross cost; even without decarbonisation, the building stock would require significant investment as heating systems and fabric elements reach the end of their lifespans. For example, it would cost around £5 billion to replace existing fossil fuel heating systems in the domestic sector on a like for like basis.

We expect the total annual building level investment required will rise gradually throughout the early 2020s, peaking in the region of £2 – 2.5 billion in the late 2020s, before falling throughout the 2030s as transformation of the building stock nears completion and our economy wide net zero emissions target is reached.

We recognise that higher up-front costs compared to fossil fuel incumbent systems can be a barrier and for some individuals, businesses and organisations, the cost of upgrading their home or workplace may be prohibitive, preventing them from taking action.

Building level investment

The costs of upgrading individual homes, workplaces and community buildings will vary driven by the building type and condition, materials, existing levels of energy efficiency and type of heating systems being replaced. We know that the average cost of installing a heat pump is currently around £10,000, with approximately an additional £2,000 for energy efficiency measures. This compares to around £2,500 for replacing a fossil fuel boiler^[lviii]. However, the cost of conversion to low and zero emissions heating systems is likely to vary significantly across different properties.

Some properties which are already energy efficient and using zero emissions heating systems may require little or no investment. For other properties, the costs will be lower than the typical £10,000 to £12,000 set out above because other types of zero emissions heating systems, such as heat networks, will offer a more cost-effective solution than heat pumps. However, there will also be properties where for a variety of reasons, such as constraints on technology options available, location, property type, impact on the fabric of historic buildings, space constraints, and capacity of the electricity grid, the cost will be higher than £10,000 to £12,000.

We continue to develop the evidence base on the costs of different low and zero emissions heat options suitable to different properties across the Scottish building stock.

As set out in Chapter 6, we currently offer a range of support to help individuals, SME businesses and the public sector overcome the upfront costs, including grants, as well as interest-free and low-cost loans to help overcome the upfront costs of investing. However, we know that for many, taking on more debt to fund upgrades is just not possible, and we must find new ways to help secure the upfront investment required to transform the nation’s building stock. The sheer scale of investment needed means it cannot be fully funded by government alone.

Alongside public funding and investment by individual households and businesses, we need to see increasing levels of private finance and investigate innovative finance mechanisms and business models to meet the total investment need.

New Finance Mechanisms

Public sector funding from the Scottish Government, UK Government, local authorities or investment from new institutions like the Scottish National Investment Bank will be a part of the solution to deliver the scale of transformation needed by 2045, but private investment – whether from homeowners, landlords or business paying for their own properties or from financial institutions providing financing for large scale infrastructure – must also drive progress. We must mobilise and work in collaboration with the private sector to leverage the scale of investment needed and to develop innovative and new approaches to financing heat decarbonisation and energy efficiency measures.

We will establish a Green Heat Finance Taskforce before the end of this year – a proposal which was widely welcomed in the consultation responses.

This Taskforce will forge a new partnership approach between the Scottish public sector, heat decarbonisation experts and the financial sector, working with organisations including the Green Finance Institute and financial institutions, to explore potential new and value for money innovative financing mechanisms for both at-scale and individual level investment. The Scottish Government and the Scottish Futures Trust will work together to provide co-secretariat support for the independently chaired Taskforce to demonstrate a clear government and industry partnership to drive forward the work of the Taskforce.

The Green Heat Finance Taskforce will make recommendations on the range of approaches that the Scottish Government – working in collaboration with the private sector – should bring forward to support the scaled growth in private capital needed and, where possible, pilot innovative solutions to attract investment. This will build on the rich evidence base already developed by the UK Climate Change Committee, the Coalition for the Energy Efficiency of Buildings and others. It could include looking at opportunities to expand already tried and tested models such as Public-Private Partnerships^[12] or Regulated Asset Based-type models^[13] to fund large scale infrastructure including heat networks, as well as new emerging and established business models for households and business such as Heat as a Service, Energy Performance Contracting, green mortgages and salary sacrifice models. Building on the evidence from our equity loan pilot, we will also ask the Taskforce to explore how unlocking of asset wealth for existing property owners could act as a potential financing mechanism. The Taskforce will need to be rigorous in covering the breadth and depth of potential financing mechanisms with a clear expectation from the Scottish Government that the Taskforce will shape how the heat transition is financed in the future. We expect the Taskforce to make its recommendations ahead of the introduction of regulations (as set out in Chapter 8), so that there is a clear and identified range of financial support mechanisms available to support building owners to meet proposed regulatory obligations.

To complement this work, we will also consider how our local tax powers, such as council tax and non-domestic rates, could be used to incentivise or encourage the retrofit of buildings. We will commission further analysis to identify potential options, to be implemented from the middle of the decade where appropriate, subject to consultation and public engagement.

We have already begun some of this innovative financing work. The Scottish Government is a member of the advisory council for the European Energy Efficiency Mortgage Initiative^[lix] working to create a standardised energy efficient mortgage that can help bridge the renovation gap through use of low-cost private sector financing.

Linking the mortgage market to energy performance and emissions can help to drive change over time and help to encourage positive consumer choice. We welcome the UK Government’s proposals to require lenders to disclose the average EPC performance of properties on their mortgage portfolio and to adopt a voluntary target of meeting a portfolio average of EPC C by 2030. This will help to create a market for new mortgage products helping to secure further private investment into the sector. To ensure that this approach is consistent with our net zero objectives, we urge the UK Government to ensure reform of the EPC framework for the rest of the UK, in parallel with our commitment for Scotland, so that EPCs at UK-level do not drive investment in fossil fuel heating systems – taking steps similar to those we are proposing in Chapter 8.

We are developing a new pilot for use of guarantees with mortgage providers as an effective route to market for financing emission reduction measures. This could support lenders offering additional low-cost finance to borrowers, particularly at key trigger points when borrowers are buying, re-mortgaging or improving their properties.

Securing long-term and low-cost private investment will require us to create new revenue streams to repay the upfront private capital investment that is being made. The UK Green Deal was an example of this, and was intended to help households cover the upfront cost of investing in energy efficiency through ‘on-bill’ financing. However, the UK’s Green Deal scheme failed to secure sufficient take up - owing to high interest rates, low levels of quality assurance and consumer protection and lack of regulation to drive uptake. Building on the lessons from the UK Green Deal, our Green Heat Finance Taskforce will also consider how we can create these new revenue streams, for example by use of our local tax and charging powers or by utilising powers that are already provided for in the Scotland and Energy Acts. We will consider how to use these powers alongside our planned approach to regulation.

We will explore opportunities for other market actors, such as suppliers, retailers and manufacturers to drive investment in zero emission heating and energy efficiency. We will work with the UK Government to explore options for new market mechanisms to drive investment and innovation so that an increasing share of heat comes from low and zero emission sources. These options may include new obligations on market actors, product standards and innovation funding, some of which may cut across reserved and devolved competencies.

We will also look closely at the EU’s proposals to bring natural gas (and other fossil fuels) for domestic heating into the EU Emissions Trading System^[lx], as a mechanism to drive investment to reduce emissions. We will consider whether these proposals are suitable and workable in a UK context, working with the UK Government and other devolved administrations as part of the proposed review of the scope of the new UK Emissions Trading Scheme.

New Business Models

We have commissioned independent advice on the concept of Heat as a Service and its potential as a route for decarbonisation in Scotland. The Heat as a Service model has similarities with the way in which many consumers choose to lease a mobile phone or car, with the upfront ownership costs of a new low or zero emission heating system being recouped over a period of time through regular payments, sometimes including operating and maintenance costs.

The research suggests that Heat as a Service could help overcome the two main barriers that put people off installing low-carbon heating systems: concerns about cost and comfort. We will continue to explore how this model might support our heat decarbonisation agenda by enabling consumers to purchase or run low or zero emission heating systems, while delivering the energy outcomes consumers want.

Case study: Danish ‘Heat as a Service’ Scheme

The Danish Energy Agency introduced a boiler scrappage scheme in 2020 to encourage Danish consumers to adopt heat pumps via a ‘Heat as a Service’ subscription business model. In this model, consumers pay an up-front fee to cover some of the installation and equipment costs, then a fixed price per unit of heat delivered and a monthly payment for the heat pump and maintenance. The minimum subscription period is 10 years. The Danish Energy Agency defined the pricing structure and allow providers to adjust the up-front fee, price per unit of heat and monthly payment, depending on their business model.

Four energy service providers were selected from an open tender to provide finance, install, operate and maintain heat pumps for consumers. The scheme is intended to encourage market competition, recognising that the businesses that can install, operate and maintain the heat pumps most efficiently will be able to offer consumers the lowest prices.

The scheme is still in its initial stages, but early findings are that more heat pumps have been installed than would have been without the scheme, consumers have been offered a new way of installing heat pumps without buying or leasing, and energy companies have said they would not have offered a subscription scheme without the Danish Energy Agency led scheme.

To do this, we will continue to undertake market and consumer research while working with industry and the regulator to understand when and where ‘Heat as a Service’ could be used in Scotland and consider different routes for bringing this concept to market. The Green Heat Finance Taskforce will consider its potential as a private sector financing mechanism. We will build on engagement with the Danish Energy Agency to understand how this model has been developed and rolled out in Denmark.

Creating Favourable Market Conditions

As we undertake the necessary transformation of our homes and buildings, we also want to ensure that the energy market evolves to support decarbonisation and allows energy bills to remain affordable for households and businesses alike.

Currently, primarily owing to the relatively low-cost of gas in comparison to electricity, in some situations zero emissions heating systems can be more expensive to run than fossil fuel systems like gas and oil. The impact that installing a zero emissions heating system will have on energy bills is dependent on a number of other factors, including the design and quality of system itself, user operation, the system it is replacing, and the energy efficiency of the property in which it is installed. Wider system costs, for example upgrading energy networks, will also likely have an impact on consumer bills and we will undertake further analysis on this issue.

Electricity prices in recent years have been 4-5 times greater than gas^[lxi], having risen by around 35% in real terms from December 2010 to December 2019, whereas gas prices remained virtually unchanged in real terms over this period^[lxii]. There are a number of reasons why electricity costs more than gas, including wholesale and generation costs as well as policy costs, such as social and renewable electricity obligations, which are recouped through charges and levies placed on consumer bills. Historically, the majority of these policy costs have been added to electricity bills, with comparatively little added to consumer gas bills. The figure on the following page outlines the make-up of energy bills, and illustrates that around 23% of an electricity bill is made up of environmental and social obligation costs, compared to around 2% of a gas bill^[lxiii].

As we accelerate deployment of a wider range of heating systems, it is important that the market evolves with it so as not to disincentivise households from switching to zero emissions systems and to reduce the risk of tension between our climate change and fuel poverty targets. The current imbalance of gas and electricity costs is incompatible with our net zero objectives and acts to disincentivise take up of zero emissions heating technologies. We agree with the recommendation, from the UK’s Climate Change Committee, for action to address this imbalance.

We do not have the levers to control energy prices, such as reforming the energy market or restructuring the various levies and charges that are added to energy bills. These powers remain reserved to the UK Government. We have commissioned research to understand whether rebalancing of levies and charges between electricity and gas supplies might impact the deployment of low and zero emissions heat in both domestic and non-domestic settings in Scotland. The research will be published alongside this Strategy^[lxiv].

We welcome the UK Government’s commitment as set out in its Energy White Paper^[lxv] to publish a Call for Evidence this year to begin a strategic dialogue between government, consumers and industry on affordability and fairness. We urge the UK Government to quickly progress this and issue all parts of the Call for Evidence package, so that a fair settlement for energy consumers can be achieved which unlocks our just transition to a net zero economy. We remain ready to work with the UK Government as it progresses the Call for Evidence to ensure that any reforms that may emerge do not disadvantage Scottish consumers and that they fit with and enable delivery of both our more ambitious climate targets and fuel poverty targets.

In particular, we reiterate our call for the UK Government to take urgent action to rebalance energy prices so that the running costs of zero emission systems are comparable to fossil fuel incumbents, helping to ensure that any regulations introduced in Scotland to require zero emissions heating systems (see Chapter 8) do not see Scottish building owners facing disproportionately higher running costs for those systems.

Summary of action we are taking:

75. We will establish a new Green Heat Finance Taskforce in late 2021 to provide advice and recommendations to Scottish Government on potential new financing models and routes to market.

76. We will set out options for future financing and delivery in 2023 ahead of the introduction of proposed regulations (see Chapter 8), with a view to implementing these new mechanisms from 2025 where applicable and allowed within our legislative competence.

77. We will work with the UK Government to develop new market led incentives to drive delivery of low and zero emissions heating.

78. We will continue to undertake market and consumer research while working with industry and the regulator to understand when and where ‘Heat as a Service’ could be used in Scotland and consider different routes for bringing this concept to market.

79. We will consider how our local tax and charging powers, such as council tax and non-domestic rates, could be used to incentivise or encourage the retrofit of buildings, alongside our planned approach to regulation. We will commission further analysis to identify potential options, to be implemented from the middle of the decade where appropriate, subject to consultation and public engagement.

80. We will work with the UK Government as it progresses its call for evidence on affordability and fairness to ensure that any reforms do not disadvantage Scottish consumers and that they fit with and enable delivery of our more ambitious climate targets.

81. We will publish research on the balance of consumer levies on electricity and gas bills.