Heat Networks Delivery Models

5. Definition and features of a delivery model

There is no generally accepted definition of the term ‘delivery model’; it has different meanings in different contexts. This section explains what we mean by a delivery model for the purpose of this report, and explains the various elements of which a delivery model is comprised. The intention is to provide clarity as to the concept of a delivery model in the context of heat networks, and therefore to facilitate the understanding of, and comparison between, different delivery models.

Definition: for the purpose of this report, a heat network delivery model is the set of role allocations to different parties, the commercial & financial agreements governing the relationships between the parties, and the applicable regulatory arrangements that collectively underpins the provision of services to customers via a heat network^[18].

The components of the definition are further explained below:

• Role allocation – the various roles that are adopted by parties to a heat network project, such as promoter, customer, funder, asset owner, land owner / landlord, installer, operator, supplier, etc.;
• Commercial arrangements - means the set of contracts between parties involved in the ownership and/or operation and/or financing of the heat network. These will include contracts relating to the provision of equipment, services to customers, etc.;
• Financial arrangements - means the financial instruments (e.g., equity, loans, grants) through which investors and financiers provide the initial and ongoing capital investment required to construct, operate and maintain the heat network;
• Regulatory arrangements - refers to the role (if any) of regulators in the construction and operation of the heat network, including the regulation of services and customer charges, the regulation of returns to investors, etc.; and
• Services - refers (in all cases) to the supply of heat to customers, and in some cases, to the supply of cooling and/or electricity, and the provision of ancillary services (e.g., grid balancing).

In any such delivery model, the sources of funding, through which the capital cost of the heat network is ultimately repaid, are assumed to be:

• Customers - via charges (e.g., connection charges, annual standing charges and volumetric tariffs) payable under heat supply agreements and any ancillary customer services; and
• Taxpayers - where an element of public subsidy is involved.

Elements of the ownership, contracting and financing arrangements, the role of the regulator, the services, and the income stream to pay for the services, will vary between delivery models. In describing these for each model, it is helpful to consider the following elements:

• Project sponsor - which organisation has overall responsibility for and control over the project? Under a given delivery model, does the project sponsor remain in place throughout the life of the project, or can it change over time? Does the delivery model provide a clear exit mechanism for the project sponsor (see ‘exit strategy’ below)?
• Funding/income stream - the sources of funding / income such as capital grant, connection charges and customer services that will be used to fund / repay the initial capital investment. Services will be project specific, and could include heat supply only (standing charges, volumetric charges), or heat supply combined with cooling, electricity and/or ancillary services.
• Project structure - distinguish between corporate structures (i.e., how the organisations involved in a project are constituted) & contractual structures (i.e., the commercial agreements between the various contracting parties). As with other types of infrastructure, the contractual arrangements will be dependent on factors such as the risk-reward profile of the project and availability of finance. Note that further information and case studies on established contracting structures, including risk allocation, is available in SFT’s guidance on Delivery Structures^[19].
• Project assets - which organisation(s) own(s) the physical assets created by the project (e.g., heat generation, distribution and supply assets)? Does this remain the same throughout the life of the project, or can it change over time? What happens to the ownership of project assets upon the expiry (or earlier termination) of a contract under which the assets are to be created?
• Financing - how is the project financed? Is all of the required finance provided by the project sponsor(s), or is some provided by third parties under financing arrangements?
  Accessing finance for heat networks can be challenging for a number of reasons, including: uncertain project revenues (managing demand risk over a long build-out period with an uncertain connection profile); high project development / transaction costs; the (current) unregulated nature of the market; and marginal project returns (with frequent conflict between meeting the strategic aims of a proposed project and creating an investable proposition).
  There are a number of finance options available, including:
  • private sector corporate finance – provided by a private sector partner, which requires a decision by the corporate sponsor to accept the risks and potential rewards of the project in their entirety, and can only be used by organisations with a significant base of assets, debt capacity and internal cash flow;
  • private project finance – generally involves the use of a special purpose vehicle to finance a specific project on a non-recourse basis;
  • sources of finance provided by or on behalf of UK government – e.g., the UK Debt Management Office^[20], the UK Infrastructure Bank; and
  • sources of finance managed by or on behalf of the Scottish Government – e.g., the District Heating Loan Fund, the Scottish National Investment Bank.
• Risk allocation - key risks for heat networks include:
  • design risk – the risk associated with the impact on a project of deficiencies in design (e.g., of heat mains, energy centres, control systems, internal heating circuits);
  • construction risk – the risks associated with the building of physical assets to a specified design;
  • operational risk – the risk associated with operating and maintaining assets to meet specified requirements;
  • demand / market risk - the risk associated with variances from anticipated demand – e.g., heat loads fail to materialise, or connection of loads to the network is significantly delayed, or loads choose to disconnect from the network;
  • performance risk – the risk associated with being able to supply customers to an agreed performance / service standard – e.g., due to demand being greater than forecast, or heat output from generation source(s) being less than anticipated;
  • financial risk – various financial risks capable of producing financial loss, including credit risk, interest rate movements, exchange rate risk, etc.; and
  • regulatory risk – the risk associated with changes to the legal / regulatory framework adversely impacting a project (e.g., licensing, planning / consents, permitting, metering & billing, consumer protection standards, technical standards).
• Control – how are decisions made as to the operation of the network - e.g., expansion opportunities / new connections / service standards / tariffs - and by whom? Outsourcing delivery to the private sector is often considered the least risk option from the public sector’s perspective. However, transferring all project risk to the private sector is likely to involve significant loss of control over key elements of the project e.g., tariff setting, service standards and the potential expansion and integration of small island networks into larger schemes.
• Regulatory role – the heat networks sector is in the process of transition from, at present, a largely unregulated state^[21], to one in which a comprehensive regulatory framework will be in place. This will be achieved by:
  • secondary legislation to give effect to the provisions of the Heat Networks (Scotland) Act 2021 (e.g., relating to Building Assessment Reports, zoning, consenting, and permitting); and
  • the enactment of the Energy Bill 2022 (and any required secondary legislations) relating to the identity of the licensing authority in Scotland, its enforcement powers, and to regulate for consumer protection for heat network customers in Scotland.
• Public sector role – this can vary considerably between delivery models. At one extreme, the public sector can have no role (other than, for example, where a local authority exercises planning powers relating to the development of heat networks). At the other extreme, a heat network can be entirely owned, operated and funded by a public body (usually a local authority, but also public sector campuses such as universities, colleges and NHS sites). Between these extremes the public sector can act in a variety of other capacities, such as facilitator, customer (anchor loads), guarantor (minimum heat demand), co-investor (in a joint venture), etc.;
• Procurement route – where the public sector has a role in a project, for example as project sponsor, co-investor (joint venture) or as a customer (anchor loads), a public procurement exercise may be required for the construction and/or operation of the heat network.
• Balance sheet treatment – Office for National Statistics rules determine whether a corporate or project structure is classified to the public or private sector. Depending on the role of the public sector within a proposed project structure, the full capital costs of the project may be classified to the public sector. If a private sector classification is considered desirable, the main limitations are:
  • Control - the public sector can only appoint a minority of the board and cannot have control of the organisation / project through other regulations or grant terms.
  • Ownership / underlying risk - the public sector can only provide a minority of the risk capital going into the company / project and cannot be seen to be the ultimate risk taker in the venture in other ways such as guarantor or demand off-taker of last resort.
• Exit strategy - the majority of heat networks in the UK to date have been established with the project sponsor retaining long-term ownership and control of most / all of the physical assets. This reflects the fact that most existing networks originated as self-supply arrangements, providing heat supply to buildings mainly under the ownership or control of a single entity (e.g., local authority buildings, a public sector campus, or a housing estate owned by a housing association). Long-term ownership of the assets allows the sponsor to retain full control over the network, including new connections, changes to heat sources, and customer charges.

There may be circumstances in which the project sponsor’s primary interest is in establishing a heat network, but once the network is operational with stable revenue streams, the sponsor may wish to dispose of its interest in the project to a third party. The sale proceeds provide a capital receipt, which can be reinvested in other projects.

The sponsor should consider at the outset whether it wishes to retain a long-term interest in the project. If it does not, or at least wishes to retain future flexibility as to the decision, this would influence the choice of delivery model, including the commercial structuring. Some delivery models will facilitate a future exit by the initial project sponsor better than others. An example is where the project assets and associated delivery contracts are held by a special purpose vehicle (SPV), which is typically a company limited by shares, owned by the sponsor. Sale of the sponsor’s interest in the project can then proceed by way of sale of the sponsor’s shares in the SPV, rather than needing to transfer ownership of each asset and novate each of the delivery contracts separately.

The various delivery models considered in section 6 below refer to the above characteristics, to the extent that they are a particular feature of the model in question.

Whilst the above list captures the main elements, it is not intended to be exhaustive. For example, tax treatment may vary considerably between different delivery models, and between the different organisations involved in any given delivery model. However, whilst tax implications need to be understood, and can influence detailed project structuring, this should not be the primary driver when developing a delivery model for a project.

Examples of where tax treatment is relevant include:

• choice of corporate vehicle, such as a limited liability company or limited liability partnership, if an ESCo is considered necessary or desirable for the project;
• choice of contracting structures, such as whether an ESCo holds property and other assets, or takes a different interest (such as a lease or licence) from a parent organisation or third party;
• liability for non-domestic rates and appliable reliefs; and
• application and recoverability of VAT for different types of organisation.

The tax treatment of alternative delivery structures is beyond the scope of this paper, but should be considered at the development stage for a preferred option (or shortlist of options).