Heat Networks Delivery Models

4. Attributes of a successful delivery model

Having regard to the specific challenges of the heat networks market in Scotland, this section identifies and explores the core attributes that we consider a delivery model would need in order to make a significant contribution to the Heat Network (Scotland) Act 2021 deployment targets.

In section 6, we analyse the features of each delivery model, and in section 7 we summarise how each model performs against these attributes. The nature of the attributes means that the evaluation is primarily qualitative in nature, and hence mainly in narrative form.

However, we also uses a basic scoring matrix to provide a visual indicator alongside the narrative commentary.

The scoring matrix used follows a simple 0 – 3 score or ‘RAYG rating’ as follows:

An evaluation table was used to record the scores and commentary (advantages / disadvantages) for each model against each attribute. Note that for the purposes of the evaluation, the attributes were all equally weighted. Were different weightings to be attached to individual attributes (to reflect a more nuanced prioritisation of attributes), the scores, and potentially the overall ranking of models, would be affected.

The attributes of delivery models considered to be most desirable are detailed below. These were agreed with Scottish Government during the development of this paper.

4.1. Ease of deployment

This attribute asks whether the proposed model could be deployed easily and quickly, for example using existing corporate structures and broadly within the anticipated regulatory framework, or whether there are more complex steps (e.g., legislative changes) required or recommended. Where models would require a more complex authorisation route to be delivered fully, we (as far as is practicable) comment on whether the most beneficial elements or attributes of the model could be achieved in other ways, or enhanced within other existing structures.

4.2. Potential for private sector investment

This asks whether the model supports private investment in heat networks. There are a number of specific features which may be present in a model to encourage this. For example, does the model have a clear risk profile? Does it allow large scale investments to be made (by encouraging larger projects or providing a mechanism by which smaller projects can be aggregated)? Does it provide a clear exit strategy for any public sector ownership? Does it offer an opportunity for the investment to grow over time? Models which risk ‘crowding out’ private investment would be less favourable, for example those which propose large scale Government ownership of heat networks.

4.3. Supports development of skills and capacity

Engagement with local authorities prior to the preparation of this paper highlighted the degree to which local authorities feel that they do not have appropriate capacity or staff with the right skill sets to be delivering heat networks. We also note that, although local authorities are required under the Heat Networks (Scotland) Act 2021 to consider areas likely to be suitable for heat networks, and to consider designating heat network zones, there is no statutory obligation on local authorities to deliver (or coordinate the delivery of) heat networks in their areas. Within the private consultancy sector, there is also an increasing capacity constraint, whereby a limited number of consultants and advisors with the relevant skill sets are called upon to support a significant increase in projects. As noted above, there are also concerns about supply chain capacity.

When evaluating models we therefore consider the extent to which models could either help to address, or be less vulnerable to, these skills and capacity challenges. For example: whether the model would reduce pressure on local authority teams by outsourcing or centralising this workload; or make more effective use of private sectors skills, for example by procuring support to deliver a larger number of projects together or via one delivery vehicle.

4.4. Simplifies delivery

Engagement with local authorities prior to the preparation of the paper highlighted the challenges and delays associated with actually delivering individual heat network projects. Concerns focussed on the coordination of multiple stakeholders (often with different objectives), the lack of standardisation, and the need for, and complexity of, procurement processes. We consider, in relation to each model, whether the model helps to provide a solution to, or can circumvent or find efficiencies around some of the delivery obstacles faced in the market today.

4.5. Contributes to wider policy objectives

In most nascent or developing markets, the goal of any Government intervention is primarily to ‘grow’ that market sustainably. In that scenario, development may be facilitated initially (e.g., via grants), and managed via regulation, but would then take place at its own pace and in the form that the market deems most appropriate. For heat networks in Scotland, current indicators suggest that this approach will not be sufficient to catalyse the pace and scale of investment required to meet targets. This paper is therefore exploring how delivery models could help address this market failure.

Given the required pace of change around how we heat our buildings, and the wider impacts of that change, choices around delivery models for heat networks could also have a significant impact on other related policy goals. There is therefore scope for models to be evaluated against other related policy priorities, to provide insight into how the choice of model could support (or undermine) wider policy goals over the long term.

We therefore include high level commentary on the extent to which the delivery models evaluated may support delivery of other related polices and targets. We limit our commentary to the provision of insights specific to the delivery models, based on our understanding of how these models and structures work in practice, and the degree of public sector involvement. In providing our scores, we have considered ‘compatibility’ of each of the models with three policy areas:

• ability to address issues of fuel poverty;
• the degree of control/ability to support consumer protection via procurement processes and public ownership and control (noting that legislating on consumer protection is a matter reserved to the Westminster Parliament); and
• the degree to which a model would help support the ‘Just Transition’ to a zero carbon economy.

Although we have focussed on these policy areas as particularly relevant to heat networks, scoring against this attribute is likely to be similar notwithstanding the policy areas which may be a priority or focus. This is because it is primarily the nature and degree of public sector involvement that dictates whether, and the degree to which, policy priorities can be pursued through delivery.

4.6. Reduces demand risk

Demand assurance is often cited as the most important factor to making heat network projects ‘investible’ for the private sector. ‘Demand assurance’ is an umbrella term for various approaches to reducing demand risk. Some approaches take steps to guarantee customers (e.g., mandatory connections), others may instead seek to guarantee revenues (in lieu of customers, should connections not materialise as envisaged). Guaranteeing a portion of project revenues (in some form or other) reduces risk and, in turn, reduces the cost of finance.

We assess whether a model is less sensitive to, or helps provide a solution to, demand assurance challenges. For example: does the model support the commitment of public sector anchor loads to projects? Would central Government control of, or investment in, projects be more likely to be accompanied by policies or actions that promote and support connections to heat networks ? Would the model better facilitate ‘guarantor’ type financing where risks could be in some way underwritten by the public sector to reduce risk for third-party investors?

4.7. Supports transition to self-sustaining market

This attribute recognises the developing nature of the heat network market and supply chain in Scotland, which at present lacks capacity to deliver heat networks at the pace and scale required to meet policy targets. Transitioning to a developed market has practical and financial elements:

Practical: we consider whether the model would help develop networks and build confidence in the market, providing certainty to supply chain and consumers. For example, does the model support or make more likely the giving of specific, significant and long-term delivery commitments in relation to areas or zones for which heat networks will be the dominant technical solution.

Financial: we consider whether the model would help develop commercially self-sustaining heat networks, which represent a cost-competitive alternative for building owners and are not reliant on Government financial support in the longer term.

4.8. Supports replicability

This attribute considers whether the proposed model can be easily replicated across different geographies, which would help to drive efficiencies and promote standardisation. Some models require significant up-front investment of time and effort to establish, but which can then be repeated or expanded relatively easily, whereas others may require similar amounts of initial effort every time they are deployed. Developers and investors strongly favour models which are standardised, tried and tested, and with a well-understood risk profile.

We also consider whether the proposed model works across projects of different size, or whether is it more suited to projects of a particular or minimum size. For example, models dependent upon additional regulation (such as the Regulated Asset Base model) will involve additional regulatory costs, which would ultimately need to be recovered from customers. This tends to require a large customer base for projects to be financially viable.

4.9. Supports expansion/interconnection

This attribute considers whether the model would allow networks to expand and/or interconnect and/or unbundle in the future, and the likely degree of difficulty of doing so when compared with other options. Models which are less profit-driven, and more focussed on the best outcomes for customers, may come up against reduced friction when seeking to connect with other networks, but equally may lack the expertise or commercial skill set to achieve the best outcomes.

4.10. Facilitates installation of heat networks ahead of demand

In its review of international heat networks^[16], BEIS identified that in all markets it had evaluated there was little appetite (without specific support or investment protection) for ‘building ahead of demand’, i.e., investing in infrastructure significantly in advance of when that infrastructure is likely to be used. This is as a result of high up-front capital costs, with uncertain revenue and return timelines. Developers face strong financial incentives to size networks strictly according to contracted demand.^[17]

As a result of the pressing need to meet Net Zero targets in Scotland, and in particular to ensure that decarbonised sources of heat are available when householders begin to move away from gas boilers, building heat networks ahead of demand will be much more important than in a ‘normal’ market environment. It is likely to be key to ensuring that connections can be reliably made when homeowners are looking for alternative sources of heat, noting that this shift will be gradual and (unless mandatory connections are introduced) uncertain across any given area.

We therefore evaluate and comment on the ability of various models to support this kind of investment ahead of demand.

4.11. Balance Sheet Treatment

It is often important that a corporate or project structure is classified to the private sector under Office for National Statistics rules. The reason for this is that any private sector investment / borrowing within that structure does not then score against Scottish Government capital budgets. This process of classification is often referred to as ‘balance sheet treatment’. Factors which can influence classification are summarised in section 5 below.

Classification is important, because if an investment or borrowing does score against the capital budgets, then this reduces funds available to be spent on other spending priorities. Models which allow for projects to be kept ‘off balance sheet’, i.e., to be classified as private sector, would therefore be considered more favourable.