Heat Networks Delivery Models

6. Delivery models

This section describes a ‘long list’ of potential delivery models for heat networks. The main features of each model are identified and (as appropriate) contrasted with other models to highlight their similarities and differences.

The delivery models are categorised as follows:

• Existing / well-established delivery model – models which are well-established in the UK and for which there are multiple examples of heat network projects deployed under this model (albeit with minor variations):
  • Public sector (non-Scottish Government) in-house delivery – the heat network is wholly owned and operated by a public body (either directly, or via a wholly owned arm’s length entity), usually based on self-supply arrangements (e.g., local authority buildings, or a public sector campus) (DM1);
  • Service concession – the heat network is owned and operated by the private sector under a long-term service concession tendered by a public body, where the public sector offers anchor loads, and a concessionaire takes demand risk (DM2); and
  • Third party ESCo – heat network owned and operated by a private sector third-party ESCo appointed by a private sector land owner / developer, generally to serve new development (DM3).
• Existing delivery model / limited examples – models which have been used in the UK on a relatively small number of heat network projects, but for which there are as yet insufficient examples to consider the model as well-established:
  • Local authority led joint venture – a local authority procures a partner and forms a JV to serve an initial project (including one or more local authority anchor loads) and potentially additional projects and/or other energy projects within the local authority area (DM4);
  • Community led project – a community leads heat network development and owns the network, subcontracts O&M, supplies buildings within community (DM5);
  • Unbundled model – a family of models involving separate ownership of generation, transmission / distribution and supply assets, e.g. where heat generators contract directly with customers and pay a use-of-system charge to the owner of heat transmission / distribution infrastructure (DM6); and
  • Merchant model – a private sector heat network operator contracts with off-takers to supply existing buildings, without having either being appointed by a private sector land owner / developer in connection with a particular development site, or having followed a public procurement exercise (DM7).
• New delivery models for heat networks – models for which we are not aware of any UK examples of heat networks delivered in this way, though the model in question may be established in other sectors:
  • Centrally led delivery – Scottish Government (Scottish Government) takes lead on development and delivery of projects (without need for local authorities to lead development). Scottish Government could have initial ownership / part-ownership of schemes (alongside private sector) but with potential for sale / transfer of government stake once scheme is established (DM8);
  • Local Authority led delivery, with Scottish Government stake – local authorities lead development and delivery of projects, with Scottish Government / central support and co-investment (which may be in addition to an element of grant). Scottish Government would have part-ownership^[22] of schemes, but with potential for sale / transfer of government stake once scheme is established (DM9);
  • Regional ESCo – local authorities and other public bodies^[23] (e.g., NHS, universities / colleges) come together on a regional basis and jointly procure a delivery partner for each region (similar to Hub model). The local public partner use the delivery partner to scope projects and deliver according to pre-defined contracting structures (DM10);
  • Public Private Partnership (PPP) - heat network operated by private sector under a long-term contract tendered by a public body, where the public sector retains the majority of demand risk, but availability risk lies with the PPP contractor (DM11);
  • Regulated Asset Base – private sector ownership model in which heat network assets are constructed, owned and operated by a monopoly supplier on a long-term basis. Investment plans, operating performance and returns (which are capped) are subject to regulatory oversight. The model is intended to incentivise private investment in large-scale heat networks, with a cost of capital comparable to other regulated utilities (DM12).
• Enabling structures / mechanisms - this section describes a number of enabling structures / mechanisms that share some, but not all, of the characteristics of a delivery model, but which could complement and/or enable the implementation of one or more delivery models outlined above:
  • Demand assurance – a form of guarantee to project developers to mitigate demand risk, with the intention of attracting private investment whilst reducing cost of capital and encouraging developers to invest ahead of need;
  • Private company with public purpose – private company established with a public purpose (and potentially charitable status), similar to the current ownership model for Welsh Water. Profits are re-invested or used to cut customer bills rather than distributed to shareholders;
  • Heat as a Service – a business model for heating in which consumers pay for outputs such as guaranteed room temperature / comfort levels / hot water volumes rather than inputs such as energy costs. This can involve improvements to the building fabric and controls, as well as the form in which energy is supplied to the building .
  • Procurement efficiency – a range of approaches that could be used to reduce the time and bid costs for procurement of delivery contracts for heat networks. These include a two-stage process to appoint a delivery partner for the commercialisation stage; use of frameworks; and standardisation.

We note where these structures / mechanisms could be used in conjunction with other models.

6.1. Established delivery models

DM1: Public sector (non-Scottish Government) in-house delivery

Overview – the sponsor public body is typically looking to supply only (or primarily) a group of buildings under its direct ownership or control. In other words, this model is predominantly a self-supply arrangement, though in some cases can involve an element of third-party supply. Public bodies such as universities, colleges and NHS Boards, who tend to have buildings clustered in a purpose-built campus, may procure a heat network to supply the buildings. The model can also apply to a housing association) where it has housing stock concentrated in a relatively small area and controls the heat supply to tenants.

Project sponsor - in this model, deployed extensively across the UK, a public body acts as project sponsor, leads the development of the project and takes full financial risk, managing it through design & build contracts, and operation & maintenance contracts.

Funding/income stream – funding is provided from the sponsor public body and usually involves an element of subsidy (e.g., Scottish Government capital grant). Income is typically internal re-charging arrangements for self-supply element, but will also involve third party income (connection fees, standing charges and variable charges) if supplies are made to third parties.

Project structure - In the context of local authority-owned schemes, there are two main variations on this ‘in-house’ delivery model:

• the public body operates the scheme directly, with sub-contracts for design & build, operation & maintenance, & (potentially) metering & billing. Examples include the Dunfermline Community Energy Scheme, owned and operated in-house by Fife Council, and the Bunhill district heating network, owned and operated by Islington Borough Council; and
• the public body sets up a wholly-owned, arm’s length vehicle, to which it transfers (or leases) the heat network assets, and which assumes responsibility for the operation of the scheme, including any sub-contracts. Examples include West Dunbartonshire Energy LLP.

There are a variety of reasons for operating a heat network through an arm’s length company. These typically relate to the ability to trade; limitation of liability (by ring-fencing operations and financial risk within a separate entity); the ability for the entity to have operational independence, including dedicated resources, budget and its own business plan; and to facilitate a future sale or transfer of the network. Detailed guidance on this subject has been published by SFT, but it is important to note that Scottish local authorities, unlike their counterparts in England and Wales, are not required to set up a separate arm’s length vehicle in order to trade in heat. Scottish Local authorities can sell heat directly to third parties, but do need to obtain Scottish Minister’s consent prior to any trading activity.

This model offers flexibility of sub-contracting structures, with construction and operation typically outsourced to the private sector through turnkey asset delivery contracts. Generally the infrastructure contracts are split into two packages: design & build, and operation and maintenance. A separate contract for metering and billing may be issued, or this aspect could be managed in-house by the Council or its arms-length body (as appropriate).

Asset ownership – project assets are owned throughout their lifecycle by the public sector project sponsor (or, as the case may be, an arm’s length body under the sponsor’s ownership and control).

Control / risk - financial risk (e.g., cost overruns or lack of demand, resulting in the forecast return on investment not being realised) sits with the project sponsor throughout the lifetime of the project. Some risks, e.g. relating to design, construction, operation and maintenance, can be managed via fixed-price sub-contracts.

Financing - for public sector led self-supply schemes, financing either comes directly from or is paid for by the public sector. This may be the local authority investing its own funds, or the local authority accessing finance. The public sector can often provide cheaper finance, or access funds specific to public bodies^[24]. It may have lower return thresholds than a commercial operator, with a focus on other priorities for the project e.g., providing affordable heat to social housing tenants.

Procurement – the turnkey asset delivery contracts noted above will usually fall within the scope of the public procurement regime, and are typically procured under the Public Contracts (Scotland) Regulations 2015. The restricted procedure is generally used.

Regulation – public sector led self-supply schemes will be subject to the Heat Networks (Scotland) Act 2021. Operators of existing networks will, unless granted exemptions, be required to obtain a heat networks licence, and a project-specific consent. New networks and expansions of existing networks will require consent. New operators will also need a licence.

Balance Sheet treatment - given the public sector sponsor’s ultimate ownership and control over, and provision of the entire risk capital for, projects delivered under this model, project assets will appear on the sponsor’s balance sheet. Projects led by central bodies such as colleges and NHS Boards are likely to have implications for Scottish Government capital budgets and the potential to impact spending on other priorities.

Exit strategy – if the project sponsor wishes to transfer ownership of the network to a third party in the future, this can be achieved either by an asset sale (if the assets are under direct ownership of the sponsor) or by transferring ownership of any arm’s length company in which the assets are held.

Example – Athletes’ Village, Glasgow^[25]; Bunhill Heat & Power Network, Islington^[26].

DM2: Service concession

Overview - a concession is a long-term contract under which exclusive rights are conferred on a supplier (concessionaire) to provide a service. In return for such exclusive rights, the concessionaire designs, constructs, finances and operate the assets used to provide the service, within a defined area and for a defined period of time. The concessionaire is required to take financial risk in relation to the profitability of the assets. In the context of heat networks, the project sponsor may offer its own buildings within the concession area as anchor loads, but the concessionaire takes demand risk associated with supplying these and any other buildings within the concession area. In other words, the concessionaire takes the economic risk of generating an acceptable return on investment from any heat network(s) it installs in the concession area during the agreed concession period.

Project sponsor – concessions are normally tendered by a public sector body (the procuring authority). The procuring authority can either be a single public body acting alone (usually a local authority), or several public bodies, in which one (again, usually a local authority) agrees to act as lead authority and will tender the concession for itself and on behalf of the other public bodies. The sponsor controls / regulates (through the concession agreement) the service to be provided, including performance standards, tariffs and to whom services must be provided.

Concessions can also be private sector led, for example when the owner / master developer for a large development / regeneration site wishes to appoint a long-term private sector partner to provide energy services to properties on the site as it is developed over time. In this paper, private sector-led concessions are separately noted as an important example of a ‘Third party ESCo’ model (DM3).

Funding/income stream – funding may involve an element of subsidy (e.g., Scottish Government capital grant), which may be secured by the procuring authority. Income is from customer connection charges and heat sales (annual standing charges, variable charges) during the concession period.

Project structure – the project sponsor outsources delivery and subsequent operation of the assets to the concessionaire. The concessionaire therefore assumes responsibility for the design, construction, operation and maintenance of assets throughout the concession period, and to a large extent the financing of such assets.

Asset ownership - the assets will typically be owned by the concessionaire throughout the concession period, and revert to the project sponsor at the end of the concession period. The project sponsor inherits any residual value in the assets, and can decide whether to operate them in-house, or re-tender a further contract for their continued operation.

Control / risk - the project sponsor acts as promoter/facilitator and customer (in relation to its own buildings within the concession area). It does not need to provide the majority (or in some cases any) capital, and delivery risk is substantially transferred to the concessionaire. This type of arrangement tends to suit authorities that do not have in-house delivery capacity and/or capability, investment capacity and/or appetite to take on delivery risks.

A key characteristic of such contracts is the transfer of economic risk (including significant demand risk) to the concessionaire, in return for the exclusive right to exploit the assets created under the concession. In other words, the concessionaire is granted the exclusive right to exploit the physical assets constructed under the concession, and takes the associated financial risk of doing so.

One of the key financial risks facing the concessionaire is demand risk. This can be mitigated by the procuring authority offering its own buildings for connection (with or without guaranteeing a minimum level of aggregated demand).

The concession agreement will specify the agreed outputs, including buildings to be connected, the methodology for determining heat tariffs, service standards and performance indicators. In order to manage the risks that it is required to accept under the concession agreement, the concessionaire will require substantial control over how it implements the agreement and provides the required service.

Given the long-term nature of a concession arrangement, the agreement will need to provide a mechanism to accommodate change (e.g., regulation, technology, demand, heat sources).

The concession agreement should be clear as to the procuring authority’s requirements for connecting / offering connections to third parties within the concession area. Otherwise, the concessionaire may ‘cherry pick’ profitable customers (e.g., large, public sector anchor loads), but be reluctant to connect smaller, less profitable customers, at least without an additional financial incentive to do so.

Financing - the concessionaire finances the assets from its own balance sheet and/or commercial borrowing. In some cases, the procuring authority may offer a subsidy to increase the investability of the project (and hence attract market interest) whilst ensuring affordable tariffs for customers. However, a key characteristic of the model is that there is no guaranteed financial return to the concessionaire.

Procurement – service concessions generally fall within the scope of the public procurement regime, and require a public procurement in accordance with the Concession (Scotland) Regulations 2016. Note, however, that the degree of risk transfer actually achieved in relation to a project will affect whether the project is actually classified as a concession.

Regulation – existing projects operated under concessions will (as with all other types of projects) be subject to the Heat Networks (Scotland) Act 2021. Operators of existing concessions will, unless granted exemptions, be required to obtain a heat networks licence, and a project-specific consent. New networks and expansions of existing networks will require consent, and new operators will require licences.

The Act contemplates the tendering of permits for certain designated heat network zones. Permits will confer exclusive rights on the permit holder to develop and operate heat networks within the zone boundary for a defined period of time, and hence will operate in a similar way to concession contracts. The details of the permitting regime are still to be developed (as secondary legislation) and consulted upon.

Balance sheet treatment – this will depend on the level of risk transfer achieved, and any control that the project sponsor can exert, under the terms of concession agreement.

Exit strategy - upon expiry or earlier termination of the concession, the assets normally revert to the procuring authority, who will either continue to operate the assets itself, or by appointing a new service provider (e.g., by retendering the concession). When deciding on an appropriate concession period, the procuring authority should take into account the likely residual value of the asset at the end of the period. In some cases, the concession period is aligned with the useful economic life of the assets, so that upon expiry the asset is assumed to have no residual value.

Example – Birmingham District Energy Company^[27]; Cranbrook^[28]; Queen Elizabeth Olympic Park^[29].

DM3: Third party ESCo

Overview – a private sector landowner / developer appoints a third-party ESCo to install and operate a heat network for a substantial new development, e.g. a regeneration site. The public sector has no role, other than through regulation / planning policy and potentially subsidy (e.g., grant funding).

Project sponsor – typically a private sector land owner / developer, with ownership of a large site where there is a requirement to install a heat network under planning policy.

Funding/income stream – funding may involve an element of subsidy (e.g., Scottish Government capital grant), which may be secured by the landowner/developer. Income is from connection charges from plot developers and heat sales (annual standing charges, variable charges) from customers.

Project structure – the project sponsor enters into an energy services agreement with a third party ESCo, which confers on the ESCo the exclusive right and obligation to install a heat network and provide a long-term heat supply to the building owners on the site. The third-party ESCo uses its supply chain to design, install, operate and maintain the heat network. This is essentially a concession arrangement, in which the grantor is a private sector entity rather than a public sector body.

Asset ownership – projects assets are owned by the third-party ESCo throughout the project lifecycle. The project sponsor will be required to grant appropriate land rights to the ESCo for the construction of the energy centre, installation of pipes, heat substations etc.). The energy services agreement will include rights for the project sponsor to step-in and operate the assets itself or to appoint a new operator in the event that the third-party ESCo fails to fulfil its obligations to deliver the network and/or provide the required service (e.g., due to insolvency).

Control / risk – project-related risks sit with the third party ESCo. There are no public sector bodies exercising control (other than by regulation / planning policy) or taking project risk.

Financing – the project is private sector financed, usually in one of two ways:

• connection / contribution model – the heat network is financed by the third party ESCo, which then receives an agreed connection fee from plot developers and/or project sponsor as plots are built out and connected to the network; or
• adoption model – the sponsor finances and constructs the heat network to a design specified / agreed by the third party ESCo. Following commissioning of the network, the third party ESCo pays the project sponsor an agreed amount to adopt the network.

Procurement – no public procurement is required with this model. The project sponsor has freedom to appoint its preferred third party ESCo.

Regulation – there is no public sector control over tariffs or service standards. Many operators agree to sign up to the Heat Trust scheme for privately-operated schemes, but are not required to do so. Existing projects operated under concessions will (as with all other types of projects) be subject to the Heat Networks (Scotland) Act 2021. Operators of existing networks will, unless granted exemptions, be required to obtain a heat networks licence, and a project-specific consent. New networks and expansions of existing networks will require consent, and new operators will require a licence.

Balance Sheet treatment – the project assets are owned by the third party ESCo and will appear on its balance sheet. The project does not involve any public sector ownership or control - the public sector’s role is limited to planning policy (which may require the installation of a heat network in certain areas), consenting (planning conditions), and potentially grant funding.

Exit strategy – the public sector has no involvement in the project. The project sponsor may or may not wish to retain a long-term interest in the site once it is fully built out. Provisions for the sale of the sponsor’s interest, or the transfer of the third-party ESCo’s interest, will be set out in the energy services agreement.

Example – Leicester District Energy Company (LDEC)^[30].

6.2. Existing delivery model / limited examples

DM4: Local authority led joint venture

Overview – the model involves a local authority procuring a private sector partner, with whom it forms a joint venture to undertake one or more heat networks and potentially other types of energy projects. The model is not limited to a single local authority; several local authorities could jointly procure a JV partner (one of them would act as lead authority). Other public bodies could also potentially participate in a variety of ways, e.g., as a potential customer to the JV, or as a shareholder, depending on interest, investment / risk appetite, and having the necessary legal powers.

The JV model can be used to leverage private sector investment in schemes with limited financial returns that might not be sufficiently attractive to the private sector as service concessions. The sharing of risks & returns inherent in the model can result in a scheme being investible by the private sector at a slightly lower level of return than would be possible if the private sector were taking (and pricing) all delivery risk (as in a service concession).

Project sponsor – local authority. Where two or more local authorities wish to come together and jointly procure a JV partner, one of them would agree to act as lead authority.

Funding/income stream – funding may involve an element of subsidy (e.g., Scottish Government capital grant), which may be secured by the procuring authority. Income to the JV is from customer connection charges and heat sales (annual standing charges, variable charges).

Project structure – a joint venture is a type of legal relationship between organisations. Joint ventures (JVs) can be public-public, or public-private, or private-private. In this model, the JV is public-private.

Although a JV can simply be a contractual relationship between the parties, most JVs involve the creation of a new corporate entity (JV Co). In the latter case, both parties agree to co-invest in the entity, and its financial returns or losses are shared according to the parties’ respective investments. Most corporate JVs involve the establishment of a new company (typically limited by shares), and a number of contracts (including a shareholders’ agreement) documenting the governance arrangements, the partners’ financing obligations towards the JV Co, services to be provided to JV Co by the individual JV partners (e.g., the day-to-day management might be carried out by the private sector partner), etc. The JV Co has its own brand and contracts directly with customers / developers for connections, heat supplies, etc.

Asset ownership – the heat network assets developed under projects carried out by JV Co would normally be under its direct ownership.

Control / risk - the public sector partner’s shareholder rights in a public-private JV Co can allow it a greater degree of ongoing control and influence (proportionate to its shareholding) than under a concession arrangement. The JV Co will hold regular board meetings, at which the public and private sector partners will agree decisions around new and ongoing investments. In general, financial risks and returns are shared between the parties, with any exceptions to this principle documented in the shareholders’ agreement. Hence the public sector partner has the potential to share in the JV’s profits alongside the private sector partners, but also risks losing its some or all of its investment.

Financing – both parties co-invest in the JV Co, and share financial risks and returns in proportion to their respective shareholdings. Investment can take the form of capital, land rights, skills, and need not be the same for both parties. Indeed, a benefit of the model is that both parties can play to their respective strengths in what, how and when they each invest in the JV.

Procurement – the selection and appointment of a private sector JV partner by one or more local authorities would fall within the public procurement regime, and hence involve a competitive tender. Public-private JVs can facilitate the ability of the parent public sector partner (and any other public bodies involved) to procure heat supplies from the JV. This may involve the entering into of ancillary agreements (e.g., concession agreements in respect of heat supplies to buildings owned by the local authority / other public bodies by JV Co) procured at the same time and as part of the main procurement.

Regulation – existing projects operated by joint ventures will (as with all other types of projects) be subject to the Heat Networks (Scotland) Act 2021. Operators of existing networks will, unless granted exemptions, be required to obtain a heat networks licence, and a project-specific consent. New networks and expansions of existing networks will require additional consents. New operators will also require a licence.

Balance Sheet treatment – this will depend on the individual structuring of the JV Co, including the parties’ respective shareholdings, rights, degree of control and approach to risk sharing. As the public sector partner is a local authority this is unlikely to score against Scottish Government capital budgets (other than any grants and potentially other financial support provided), but would sit on the local authority balance sheet.

Exit strategy – unlike a service concession, a JV need not be set up for a fixed period. However, the shareholders’ agreement needs to make provision for how the JV can be brought to an end, either when it has met the objectives for which it was established, or at the instigation of one of the parties. This could include the scenario where one party wishes to dispose of its interest in the JV, with pre-emption rights for the remaining shareholder, and/or restrictions on the type of organisations to whom the interest could be transferred.

Example – Midlothian Energy Limited^[31] (JV between Midlothian Council and Vattenfall); Bristol City Leap^[32] (JV between Bristol City Council and Amaresco, with Vattenfall as heat networks subcontractor).

DM5: Community led project

Overview – community projects are generally of a small scale, for example set up to serve an existing village or a new development adjacent to an existing settlement^[33]. A community company is set up to manage the project and act as heat supplier. The residents would be the main customers of the new company.

Project sponsor – a community body of some kind leads the development, and is central to the governance of the scheme. Whilst not acting as project sponsor in such schemes, local authorities can still play an important role, for example in facilitation, providing technical or financial support and potentially providing anchor loads.

Funding/income stream – funding may involve an element of subsidy (e.g., Scottish Government capital grant). Income to the community company is from customer connection charges and heat sales (annual standing charges, variable charges).

Project structure – the community body would generally establish a new corporate entity to hold the project assets, and enter into turnkey asset delivery contracts for the construction, operation and maintenance of the scheme.

Various corporate structures can be used as the legal delivery vehicle, including a Community Interest Company (limited by shares or by guarantee)^[34] or a Community Benefit Society (CBS). A Community CBS is a legal corporate form that benefits a wider community. It is regulated by the Financial Conduct Authority (FCA) and has a cooperative membership structure that adheres to the principle of ‘one member, one vote’.^[35]

Many of the legal and structural considerations for a community led scheme are similar to a privately led and owned scheme. The scale of any scheme is likely to be small, given the challenges around funding, resourcing and managing risk.

Asset ownership – the heat network would typically be owned by the corporate entity established by the community body to deliver the project. The community body that formed the entity would hold the ultimate beneficial ownership of the assets.

Control / risk – the corporate entity established by the community body exercises control of the project. The community body would retain a high level of control over the project, with the ability to set tariffs and take on new connections. Risks that cannot be subcontracted would be retained by the entity.

Financing – the community is responsible for raising finance. Any special purpose vehicle (such as a CIC or CBS) set up would have low capitalisation, with the main assets of the company being the assets of the scheme itself. Funders of the scheme will be putting their money at risk, and contractors will require assurance as to the entity’s ability to pay for works once completed^[36].

Procurement – corporate entities such as CICs and CBSs are not subject to the public procurement regime. If public buildings are to be connected to a community scheme, the relevant public body / bodies will need to consider how they procure the heat supply from the network (as would be the case with any third-party network).

Regulation – existing community-led heat networks will (as with all other types of projects) be subject to the Heat Networks (Scotland) Act 2021. Operators of existing networks will, unless granted exemptions, be required to obtain a heat networks licence, and a project-specific consent. New networks and expansions of existing networks will require additional consents. New operators will require a licence.

Balance Sheet treatment – the heat network assets would appear on the balance sheet of the corporate entity established to take forward the project, which is the asset owner.

Exit strategy – the community group may wish to retain a long-term interest in the project, in order to retain control over tariffs, connections, fuel sources etc. However, if its interest is limited to establishing the network, but with a view to a future sale to a third party, this should be factored into the decision around the type of corporate entity used (some entities, such a CIC, have an in-built asset lock, which limits the type of entities to which the entity’s assets can be transferred).

Example - Springbok Sustainable Wood Heat Co-Operative^[37]; Swaffham Prior Heat Network^[38].

DM6: Unbundled model

Overview – the ‘unbundled’ model is a generic term to represent any arrangement in which the ownership and/or operation of the different types of physical assets of a heat network is distributed across two or more organisations, rather than (as is currently the norm) undertaken by a single entity.

The main business operations for a heat network are:

• heat generation – including heat recovery, construction of energy centre(s);
• transmission – of thermal energy via insulated pipes from generation sites to customer sites; and
• management/retail – on-plot secondary / distribution pipework, metering, billing, general customer contract management.

This type of arrangement is similar to how large energy networks are now operated (e.g., gas and electricity networks) following their privatisation and the introduction of regulation. As heat networks are also a type of energy network, it is relevant to consider the situations in which this model can arise – for example, where a local authority owns the network and takes a heat supply from a third party heat source, or where existing networks interconnect to form a city-wide network. Scale is a key factor for the model to work: each operation needs to be big enough to support a separate business.

The BEIS International Review of Heat Network Markets^[39] notes that in markets outside of the UK, nearly every heat network had integrated supply and distribution components, and the vast majority were also integrated either wholly or partly with generation. They also observed some limited Third Party Access (TPA) for generation and/or heat recovery, i.e., heat supply to the heat network from an entity that is not owned by the heat network provider. They noted that TPA access between heat networks, and heat sales between separately owned networks, was very rare and limited to very large interconnected heat networks.

The paper states that “There seems to be agreement that vertical integration is acceptable and even necessary for all but the largest, city and regional wide schemes”. Three separate reviews from different countries (Sweden, Germany and the Netherlands) conducted between 2012 and 2018, all came to the same conclusions.

The BEIS paper notes that there is significant expenditure associated with separating out different functions and ongoing transactional costs between the interconnected parties. It concludes that, for the UK, unbundling is unlikely to make sense at this stage because the costs of breaking up the industry will only prove worthwhile if there are significant savings from doing so.

Project sponsor – can be public or private sector, and depends on the circumstances under which the separate heat network operations arise (see further below under project structure).

Funding/income stream – funding may involve an element of subsidy (e.g., Scottish Government capital grant). Income will depend on the project structure, and could include ‘use of system’ charges and/or customer connection charges and heat sales (annual standing charges, variable charges).

Project structure – as noted above, the unbundled model is a generic term used to describe a variety of commercial arrangements. The commercial structure will be project-specific, and linked to the circumstances in which the separate operations arise. This can happen in several ways, the main ones of which are as follows:^[40]

• integration of third-party heat sources into a network – for example sewage heat recovery, energy from waste facilities, other industrial heat offtake, where the supply of heat into a network is by way of a contractual arrangement rather than via a transfer of ownership of generating assets;
• interconnection of heat networks – e.g., where a number of property developers create site-specific networks, with a design intention (from the outset) for their eventual inter-connection into a wider network. The subsequent interconnection is via the construction of a transmission network. In the case of networks that were not designed with subsequent interconnection in mind, a number of issues can arise, such as compatibility of network operating temperatures, controls, etc; and
• separation of a heat network into distinct business operations - for example, an operator of a large network sells one or more assets in order to focus its business operations on one activity (e.g., generation or transmission) and/or release capital for subsequent re-investment.

Each of these scenarios can have different underlying structures. For example, a heat generator may or may not also be a heat supplier to end customers. If a generator is not also a heat supplier, it will simply be paid by the network operator for heat supplied to the network in accordance with a heat purchase agreement. If it is also a heat supplier, in addition to entering into heat supply agreements with end users, it will also pay a ‘use of system’ charge to the network operator.

Asset ownership – project specific, but the key distinguishing feature of this model is that ownership of the various heat network assets is, unlike most existing schemes, not held by a single organisation.

Control / risk – project specific. Unbundled networks need robust contractual frameworks between the various parties to co-ordinate the distinct operations and ensure that heat can be appropriately delivered from one part of the system to the next, and ultimately to the end consumer. BEIS Guidance notes that “contracts will need to provide adequate commercial benefits to parties and adequate recourse for failure to perform to ensure all parties are incentivised to deliver a working scheme”^[41].

If smaller, independent networks become integrated into city-wide networks, the role of the system operator will be crucial. It will need to ensure that supply and demand are balanced across the network according to appropriate criteria (such as lowest carbon heat source, or lowest cost to customers), giving suitable market signals to heat generators.

Financing – project specific, depending the circumstances under which the separate operations arise.

Procurement – project specific, depending the circumstances under which the separate operations arise.

Regulation – existing heat networks will be subject to the Heat Networks (Scotland) Act 2021. Operators of existing networks will, unless granted exemptions, be required to obtain a heat networks licence, and a project-specific consent. New networks and expansions of existing networks will require additional consents. For unbundled networks, careful consideration will be required as to which operations will be subject to regulation under the Act, and therefore which organisations will need to apply for licences and/or consents. New operators will require a licence.

Balance Sheet treatment – project specific, depending on the circumstances under which the separate operations arise. The balance sheet treatment under this model will reflect that fact that different assets are owned by different organisations.

Exit strategy – project specific. If a sponsor wishes to develop a large-scale network, but wishes to recycle some of its capital by selling certain assets in a secondary market once the network is operational with established revenue streams, it may wish to ringfence the assets from the outset.

Example – Glenrothes Heat Network^[42] – RWE owns the main heat source, a biomass CHP plant, which supplies a heat network owned and operated by Fife Council. The Council self-supplies in respect of its own buildings, but in respect of certain large commercial customers, RWE has the supply relationship with the customers, takes demand risk, and pays the Council an annual use-of-system charge in respect of such supplies. Other examples include Stirling Forthside^[43], in which Scottish Water Horizons owns the wastewater heat source and supplies heat to a network operated by Stirling Council.

DM7: Merchant model

Overview – this model is a purely ‘merchant’ approach, in which a private sector ESCo enters into heat supply agreements with building owners, without the ESCo being appointed either by a private sector developer / landowner to serve a large new development, or by a public body pursuant to a public procurement exercise.

The model relies on the ESCo being able to secure sufficient demand from customers such that, in conjunction with any available grant funding, and in anticipation of future regulation of building emissions, it is prepared to proceed with the investment.

Although uncommon, we understand that at least one market operator is pursuing this approach, and exploring ways of securing anchor contracts with existing building owners such as offices / other commercial buildings and bulk heat supply to residential developments, without relying on being appointed following a competitive tender under the public procurement regime.

The model could also be applied to shared ground arrays, where an investor is prepared to proceed on the basis that building owners will eventually be required by regulation to switch from gas boilers to a low carbon heating solution, and believes its solution is cost competitive with building level solutions (typically, ASHPs).

Project sponsor – a private sector ESCo.

Funding/income stream – funding may involve an element of subsidy (e.g., Scottish Government capital grant). Income is from customer connection charges and heat sales (annual standing charges, variable charges).

Project structure – the ESCo installs the heat network and provides a heat supply using its supply chain.

Asset ownership – the ESCo owns the heat network assets.

Control / risk – the ESCo controls the project, and takes all risk. As with other models, some asset delivery contracts may be sub-contracted, but residual risk will sit with the ESCo.

Financing – the ESCo is responsible for securing finance for the project. As with other models, it will usually seek grant funding in respect of a proportion of initial capital costs.

Procurement – this model does not involve a public procurement exercise to construct the heat network, although in most cases public sector bodies will still be required to undertake a procurement exercise to purchase a heat supply from the network for their buildings.

Regulation – existing heat networks will be subject to the Heat Networks (Scotland) Act 2021. Operators of existing networks will, unless granted exemptions, be required to obtain a heat networks licence, and a project-specific consent. New networks and expansions of existing networks will require additional consents. New operators will require a licence.

Balance Sheet treatment –the project assets will be on the ESCo’s balance sheet.

Exit strategy – no public sector entity is involved. The private ESCo may set up a special purpose vehicle in which to ringfence the assets and operations associated with particular projects, in order to facilitate a future disposal, if so desired.

Examples – Bradford Energy Network^[44].

6.3. New heat network delivery models

DM8: Centrally led delivery

Overview – “Public sector owned and led” models are commonly deployed across the UK, including Scotland. These tend to be promoted by local authorities (see section 6.1), and hence are reliant on local authority skills, resource, investment capacity and risk appetite. Other public and quasi-public sector bodies such as universities also build, own and operate heat networks, but do so primarily to decarbonise their own estates and typically have little, if any, appetite to expand the network to incorporate buildings owned by external parties. Private sector developments are concentrated on development / regeneration sites, with little investment in networks to serve existing buildings without commitment of local authority or other public sector anchor loads. The result is development not taking place at the pace and scale required to meet policy targets.

In this model, Scottish Government (either directly, or through an agency) would take a lead role on the delivery of certain projects, focussed on areas with significant potential for heat network potential development, but in which local authorities are not acting at the pace and scale required. Scottish Government / agency could develop and hold initial ownership of schemes, or take a stake in individual projects alongside private sector partners. Scottish Government could sell its (part-) ownership in schemes at a future date, for example when first phase networks are built and have established revenues streams. This would allow Scottish Government capital to be recycled into further heat network investments, thus accelerating progress.

Project sponsor – Scottish Government, either directly, or acting through an agency. As project sponsor, Scottish Government would set up one or more wholly owned ESCos to deliver heat networks. The decision could be taken to set up one national organisation or multiple regional bodies. This decision would be informed by assessing which structure would provide optimum scale to attract the resources and investment whilst also providing sufficient focus to prioritise local opportunities.

The future Energy Agency “Heat and Energy Efficiency Scotland”, if established as a central body and with this purpose, could potentially develop, own and operate heat networks. It could also be given the powers to set up ESCos to facilitate project delivery^[45].

As sponsor, Scottish Government / agency would need to work with the relevant local authority (which would retain responsibility for LHEES, heat network zoning and planning) in relation to potential heat network developments in the area. It would need to secure the commitment of any local authority and/or other public sector bodies whose buildings could become anchor loads for a heat network.

Hence the local authority would still be involved under this model, but would not need to provide the project management resources for project development, which would be centrally led, or the funding required for investments, or take project-related risks. These would be managed centrally, at least in the short term.

Funding/income stream – funding may involve an element of subsidy (e.g., Scottish Government capital grant). Income is from customer connection charges and heat sales (annual standing charges, variable charges).

Project structure – existing delivery structures (in particular, DM1, DM2, DM4 and DM6) could, in principle, each be adapted, with Scottish Government / agency acting as project sponsor instead of the local authority. Hence Scottish Government could, in principle, own and operate networks (DM1), let service concessions (DM2), enter into joint ventures (DM4) or own particular assets (e.g., distribution assets, to take a heat supply from a third-party heat source) (DM6). The owners of public sector anchor loads would need to agree to Scottish Government procuring heat supplies for the relevant buildings on their behalf (in addition to Scottish Government procuring the heat network)^[46].

Asset ownership, Control / risk, Financing, Procurement – would all follow the relevant delivery model (adapted as noted above) – see text relevant to each model, but with Scottish Government / agency substituting for the local authority as the project sponsor.

Regulation – Scottish Government should consider whether it would be appropriate to become an investor in projects. If it decided to proceed it would need to consider putting ethical walls in place, or housing the investments in a separate vehicle (the Energy Agency for example).

The model would be deployed for new networks and potentially for expansions of existing networks. Were Scottish Government to operate heat networks (most likely through an agency), it / the agency would require a heat networks licence under the Heat Networks (Scotland) Act 2021. Similarly, in respect of any new heat network or extension to an existing network, a heat network consent would be required. Scottish Ministers would initially be the licensing and consenting authority. Issues around whether Scottish Government / agency could hold a heat networks licence and/or consent, the potential for self-regulation, and conflicts of interest, would all need to be carefully considered.

Balance Sheet treatment – this is likely to score against Scottish Government capital budgets.

Exit strategy – Scottish Government could sell its (part-) ownership in schemes at a future date, for example when first phase networks are built and have established revenues streams. This would allow Scottish Government capital to be recycled into further heat network investments, thus accelerating progress.

Example – Transport Scotland provides an example of centrally led delivery by Scottish Government through its national transport agency.

DM9: Local authority led delivery, with Scottish Government stake in projects

Overview – in this model, local authorities would continue to lead project development, with Scottish Government both supporting project development and taking an equity stake in projects (either directly or via an agency, and which may be in addition to an element of grant). This model shares certain features with, and could be considered a hybrid of, DM1 (locally led project development), DM4 (formation of a joint venture vehicle) and DM8 (Centrally led delivery).

Special purpose vehicles would be established for investments into specific projects. By becoming a co-investor alongside the local authority and/or a private sector partner, the Scottish Government would have shareholder rights in proportion to its equity stake, representation on the board and the ability to transfer its stake (by sale of its shareholding) and therefore to recycle capital into other investments.

The reasons for Scottish Government taking an equity stake would primarily be to de-risk a project and allow it to proceed faster and/or at a greater scale than would otherwise happen, but with Scottish Government having a role in the project’s governance and a greater degree of control and influence (proportionate to its investment)^[47] than would be achieved via grant funding, Scottish Government would also have the option to exit and recycle capital into other schemes.

As noted in the commentary on DM4, financial risks and returns would be shared between the parties in accordance with their respective investments. Hence Scottish Government would have the potential to share in any profits, but also risks losing its investment. In the latter scenario, the Scottish Government investment in the project would in effect become a grant.

This model could support the roll out of heat networks at greater pace and scale, with the potential for a financial return on investments and to recycle capital. It also comes with a number of risks including financial, procurement and reputational, all of which would need to be carefully considered.

Project sponsor – a local authority (or other local public body) would lead the project and act as project sponsor, with Scottish Government providing development support and co-investment.

Funding/income stream – funding may involve an element of subsidy (e.g., Scottish Government capital grant). Income is from customer connection charges and heat sales (annual standing charges, variable charges).

Project structure – Special purpose vehicles (SPVs) would be established for investments into specific projects, with Scottish Government as a minority shareholder (providing equity investment, potentially alongside an element of capital grant). The project would be structured to allow Scottish Government to sell/transfer its equity stake to a project partner or third party. The asset delivery contracts relating to design, construction, operation and maintenance, would be entered into by the SPV.

Asset ownership – assets would be owned by the SPV. Hence Scottish Government would have beneficial ownership of assets in proportion to its shareholding.

Control / risk – delivery risks would be sub-contracted, with residual risks sitting with the SPV.

Financing – the SPV would be responsible for financing the project. This would be provided by equity investments from project partners and Scottish Government.

Procurement – as the model is public sector led, delivery contracts would fall within the scope of the public procurement regime, and would initially be procured by the project sponsor. Consideration would need to be given as to whether SPVs would also be subject to the procurement regime.

Regulation – As Scottish Government set policy and are introducing regulation to the sector, there is a risk of a conflict of interest or perceived conflict (see comments on DM9). Therefore, Scottish Government should consider whether it would be appropriate to become an investor in projects. If it decided to proceed it would need to consider putting ethical walls in place, or housing the investments in a separate vehicle (the Energy Agency for example).

Balance Sheet treatment – depending on the size of Scottish Government’s equity stake, and the degree of control conferred by its shareholder rights, there is potential for projects to appear on Scottish Government’s balance sheet (until such time as Government’s shareholding is sold to a project partner or third party) and therefore reduce funds available to be spent on other priorities.

Exit strategy – Scottish Government could build up a portfolio of investments in projects. These could be managed by a centre of expertise, which would facilitate the efficient and effective management of the investments. Returns on investments could help defray the cost of centrally-provided resources. Scottish Government could sell investments, either individually (such as when a project is operational and has reached a viable scale) or as a portfolio (to attract institutional investors).

Examples – Scottish Government holds investments in a range of projects / assets, through organisations such as Scottish Enterprise, the Scottish National Investment Bank and Scottish Futures Trust Investments.

DM10: Regional ESCo

Overview – this model is analogous to the Scottish ‘Hub model’ for community infrastructure, in which public sector bodies came together on a regional basis to participate in joint procurements of private sector partners to deliver infrastructure projects such as schools, libraries, health centres, etc. In the Hub model, the successful bidders and the public bodies then formed regional “HubCos”, in which the private sector partner took a majority stake, and the local public sector bodies (and SFT’s investment arm) hold minority stakes. There are 5 HubCos in Scotland, each operating on a regional basis. In each region, the public sector partners can choose (but are not obliged) to use the HubCo to assist with initial scoping and project development and then project delivery. Projects can be delivered under different contracting structures (design and build contract, or design, build, finance and maintain (DBFM)), depending on the public sector project sponsor’s preference.

By analogy, under the regional ESCo model, local authorities and other public bodies could come together and jointly procure a private sector partner to deliver heat networks (and potentially other types of energy projects). The successful bidder and the public bodies in the area would then form a regional ESCo (“RESCo”), in which the private sector partner takes a majority stake, and the public sector bodies (and potentially Scottish Government / agency, equivalent to SFTi for HubCo) hold minority stakes. The extent to which the delivery partner is given exclusivity over certain types of projects within each area, and for how long, would be a key consideration.

In each region, the public sector RESCo partners would be able to use the RESCo to assist with initial scoping and project development and then project delivery. As with Hub, projects could potentially be delivered using different contracting structures, depending on the public sector project sponsor’s preference (having regard to control, risk, funding availability, etc.). This means that heat networks could still be owned by the public sector, or jointly under a joint venture arrangement, depending on the preference for each project. We would expect that preferred approaches would emerge and could be standardised and promoted.

Project sponsor – local authorities and other public bodies represented within the RESCo would act as project sponsors in relation to identified projects within each region.

Funding/income stream – funding may involve an element of subsidy (e.g., Scottish Government capital grant). At individual project level, income is from customer connection charges and heat sales (annual standing charges, variable charges).

Project structure, Asset ownership, Control / risk, Financing – these would be on a project-specific basis, depending on the project sponsor’s preferred contracting structure. In the Hub model, ownership of project assets always rests with the relevant public sector sponsor, and financing for the project is provided either by the public sector sponsor (if the project is commissioned via a Design & Build contract), or by the private sector investors (if the project is commissioned by a DBFM contract).

Procurement – there are two stages: firstly, procurement of a private sector delivery partner for each region, and secondly, the procurement of individual projects to be delivered by RESCos on behalf of the participating public bodies.

• Procurement of private sector partners for each RESCo
  • Procurement could be led by one of the public bodies within the region, procuring for itself and on behalf of the other public bodies.
  • Alternatively, the procurement could be led by Scottish Government / SFT / energy agency on behalf of the public bodies in the region. (The 5 HubCos were procured by SFT on behalf of the local authorities, NHS Boards and blue-light services in each region.)
  • Each procurement would result in the appointment of a private sector partner for the region, that would take a majority stake in the RESCo, with the remaining stake held by the public bodies (and potentially Scottish Government / agency).
  • The RESCo would be a long-term delivery partner, with the ability to use a range of suppliers for design services, construction, operation & maintenance, metering and billing, etc. (Hub does this via Tier 1 contractors).
  • The delivery partner could be a heat network developer, or it may be more appropriate for the partner to be an investor partner, who would then bring one or more heat network developers into the RESCo supply chain. The latter might be more appropriate if an ‘energy partnership’ type model (where the partner could deliver a range of energy/heat solutions, not just heat networks) was preferred.
• Procurement of individual projects to be delivered by RESCos
  • A public body (or a collaboration of public bodies within each region) would be able to initiate a project with the RESCo. This would involve scoping and discussion around the preferred contracting structure for the project (e.g., D&B, DBFM).
  • Following agreement, the public sector body / bodies would appoint RESCo to deliver the project based on an agreed scope and contracting structure.
  • Depending on the contracting structure, project-specific SPVs may be established by RESCo.
  • Following any initial period of exclusivity, the public bodies within each region would not be obliged to use RESCo for any particular projects, but would have the option to do so.
  • RESCo would act as a local project development & delivery partner for heat networks (and potentially for other energy services) within each region.
  • For each project, RESCo would be obliged to demonstrate value to the commissioning public body by carrying out a mini-competition for key work packages (e.g., design services, construction, O&M). But this would not require additional public procurement exercises on a project-by-project basis, as the projects would have been contemplated in the procurement of the private sector partner for the RESCo.
  • For projects above a certain value in which the relevant public bodies were not providing all of the funding (in conjunction with Scottish Government grants / loans), RESCo could be obliged to run a funding competition.

Regulation – this model would require careful consideration of how it would integrate with the licensing, zoning and permitting regimes to be introduced under the Heat Networks (Scotland) Act 2021, including:

• which organisation(s) would require a heat networks licence?
• If RESCo were to be given exclusivity over projects of a certain type, or for a certain period of time in order to attract bidders (as was done for Hub procurements), how would this interact with the local authority’s duty to consider designating heat network zones, and the potential for zones to be permitted (which would confer exclusivity on the permit holder)?

Balance Sheet treatment – depending on the size of Scottish Government’s equity stake, and the degree of control conferred by its shareholder rights, there is potential for projects to appear on Scottish Government’s balance sheet (until such time as Government’s shareholding is sold to a project partner or third party) and therefore reduce funds available to be spent on other priorities.

Exit strategy – for the project sponsor, this will depend on the contracting structure under which individual projects are delivered by RESCo. If the sponsor contemplates a future exit, it should consider setting up a project-specific vehicle in which to ringfence project assets.

Example – The Hub programme^[48].

DM11: Public Private Partnership (PPP)

Overview – PPPs have been used for a wide range of public assets, including schools, hospitals, colleges, roads, waste management facilities. We are not aware of any heat networks procured under this model.

There is no generally accepted definition of a PPP, which covers a spectrum of different types of long-term contracts, with a wide range of risk allocations and funding arrangements.

For the purpose of this paper a PPP involves:

• a long-term contract between a public body and a private sector contractor for the development and management of a public asset;
• the contractor designs, builds, finances, operates and maintains the asset and uses the asset to provide a service to the public body;
• the public body pays service payments to the contractor, based on the level of service provided, including the availability of the asset;
• the service payments are used to repay the majority or all of the required finance for construction of the asset, and to provide a return for the contractor;
• the contractor bears availability risk and management responsibility through the life of the contract, but the public sector takes the majority of demand risk. This, and how the project is financed, is the main difference between a PPP and a concession: in a concession, the public sector also transfers demand risk to the contractor.

In some PPPs there is public involvement in funding (a capital contribution once the asset is operational), governance or as an anchor customer. Private user charges can also apply, although these payments tend to be relatively small in comparison to the total payments received.

A PPP is essentially an alternative means to finance the provision of new infrastructure. PPPs are intended to encourage efficient delivery and operation, deliver an appropriate quality of service and allocate risks appropriately between the parties (investors, the public sector and users of the asset).

Under a PPP the focus is on service delivery. In the case of heat networks the service would be the delivery of low carbon heat when and where the user required it.

Project sponsor – the public body acts as project sponsor for a PPP.

Funding/income stream – funding may involve an element of subsidy (e.g., Scottish Government capital grant). Income for PPP contracts is typically based on payments by the authority from its revenue budget based on the contractor meeting strict availability and performance criteria. There can also be an element of income in respect of third-party use of PPP assets.

Project structure – the successful private sector bidder forms a special purpose vehicle (SPV), which holds the PPP contract, and through which the finance required to construct the assets is channelled. The SPV will be controlled by the private sector contractor, which will subcontract asset delivery contracts through the contractor’s supply chain.

Asset ownership – the assets created under a PPP contract are usually owned by the public sector sponsor. The PPP contractor is granted access rights over the PPP assets in order to provide the services to the sponsor. The PPP assets are required to be handed back in an appropriate condition upon expiry of the contract. Following hand back, the public sector sponsor can choose either to retender or take back service provision in house.

Control / risk – the PPP contract forms a detailed risk allocation that fixes the private sector provider’s revenues at the outset, based on meeting an agreed service specification and meeting a defined performance regime. This can facilitate effective competition for the contract award because it is clear what is being competed for. It can also provide strong incentives for efficient delivery after contract award because payments are typically directly linked to the level of service provision and only commence when the service starts to be provided. However, PPP contracts are relatively inflexible, which is the key reason that PPP projects can fail or be expensive to finance where there is uncertainty over key exogenous parameters that could affect profitability.

Financing – PPP projects are typically financed from a combination of equity from the private sector contractor and debt from sponsors / third-party finance providers, on a non-recourse basis. To attract third-party / non-recourse debt requires a stable and well-understood risk profile, operating in a stable long-term policy environment.

Procurement – PPP contracts are high-value, long-term contracts, and as such fall within the scope of the public procurement regime. PPP contracts tend to involve lengthy procurements and high bid costs for both the public sector sponsor and bidders. The PPP approach focuses its primary efficiency incentives on the initial competition for the contract.

Regulation – existing heat networks will be subject to the Heat Networks (Scotland) Act 2021. Operators of existing networks will, unless granted exemptions, be required to obtain a heat networks licence, and a project-specific consent. New networks and expansions of existing networks will require additional consents. New operators will require licences. In PPP contracts, the public sector generally takes the risk of future changes in law and regulation, i.e., is required to compensate the contractor for any additional costs incurred to comply with changes in law.

Balance Sheet treatment – assets constructed under PPP contracts can be recorded on or off government balance sheet, depending on the allocation of risks and reward (factors such as construction risk, demand risk and availability risk being key). PPPs have typically been used by the Scottish Government to achieve additionality of investment where the costs of the assets are not scored to capital budget.

Exit strategy – a PPP is a long-term arrangement – typically 25 or more years - in order for service payments, through which the initial capital investment is ultimately repaid, to be affordable for the public body. The contract will include detailed termination provisions. It is costly for the public sector to terminate the arrangement voluntarily (i.e., without the contractor being in default or becoming insolvent). If the public sector voluntarily terminates, the contractor must be repaid in full, including the value of future lost profits as well as repayment of the contractor’s outstanding finance. If the public sector terminates due to the contractor’s default or insolvency, the private sector stands to lose some or all of its investment.

Examples – PPPs have been widely used in infrastructure projects for sectors such as education, health, transport, waste and defence.

DM12: Regulated Asset Base

Overview – Regulated Asset Base (RAB) models are commonly used in the UK as a form of economic regulation of companies operating in environments in which there are natural monopolies. Under a RAB model, one or more companies are granted a licence from an independent regulator to charge regulated prices to users in exchange for the efficient provision of services linked to an infrastructure asset or set of assets.

This regulatory framework is an arrangement that seeks to balance flexibility with commitment. The adherence by regulators to clear regulatory principles (with rights of appeal where regulatory action is considered to be in breach of such principles) has helped RAB regulated sectors in the UK to attract over £230bn in private investment since the late 1980s.

A RAB model has some similarities with a PPP model, in which a long term contract is agreed between a public entity and a private company for the development and management of an asset. However, RAB regulated models tend to cover the full life of assets, which for infrastructure assets is typically much longer than contracts agreed for PPPs.

RAB models tend to have more flexibility than PPPs, because key parameters can be periodically reset (at the end of each price control period), subject to regulatory principles, whereas in a PPP the key parameters as fixed at the outset.

Heat networks have several features that could make them a suitable asset type for a RAB model, i.e. the need to regulate service provision and charges where there is effectively a monopoly provider of infrastructure, with limited consumer choice and the potential for stranded assets. In principle, a RAB type approach would provide greater assurance to investors of a return, and drive down the cost of capital.

However, the RAB model relies on a monopoly environment / exclusive rights to achieve a low cost of capital. The grant of exclusive rights is not part of the RAB model. In the context of heat networks, the model would therefore need to be accompanied by a form of demand assurance in order to achieve a low cost of capital comparable with other utility-type RAB environments.

Funding/income stream – funding may involve an element of subsidy (e.g., Scottish Government capital grant). Income is from customer charges, which are regulated under a RAB structure.

Project structure – regulated, privately owned companies would invest in heat networks in a given geographic area, with some form of exclusive rights / monopoly position. The regulated entity would, through its supply chain, develop, finance, own and operate networks and charge customers. The role of the regulator would be to set a performance framework of economic incentives for the company to operate efficiently, and to cap (and periodically reset) customer charges / return on investment to ensure the company does not exploit its monopoly position.

Asset ownership – assets within a RAB structure are owned by the regulated entity, which is assumed to be owned by private sector investors.

Control / risk – the regulated entity has control over the delivery and operation of the assets that comprise the regulated asset base. Its return on investment (or tariff) is capped by the regulator within each price control period. It takes the risk of meeting the efficiency incentives set by the regulator. It is also subject to uncertainty around future price control periods (e.g., as to allowable capital expenditure and return on investment). This risk is managed through the regulator being bound to follow clear regulatory principles, combined with a right of appeal. The RAB structure relies on a natural monopoly to attract low cost of finance – hence some form of demand assurance would be required in order for the RAB model to be investable.

Financing – assets within a RAB are usually financed with private capital. In general, the cost of finance for a RAB is generally low (for example, compared to PPPs). As the regulated entity’s return on investment is capped by the regulator in any given price review period (though may be adjusted upwards or downwards by the regulator between such periods), the company can only generate additional revenues by growing the asset base. There is, therefore, a risk that the regulated entity will seek to over-invest in the assets, which would provide a larger base on which the capped return can be made.

Procurement – a RAB model for heat networks would require legislation to establish a new economic regulator with appropriate regulatory powers. Further work would be required to determine whether Scottish Government would have the devolved competence to enact such legislation.

Regulation - the RAB structure requires a regulator, who is responsible for ensuring that charges by regulated companies allow for the efficient costs of running the company and a reasonable return on the capital invested in the business.

The regulatory model that has traditionally applied in combination with the RAB concept includes the periodic resetting of some regulatory parameters (such as the allowed return on capital, and the determination of future cost recovery). This means that the returns to the company beyond the current regulatory period are subject to regulatory uncertainty. However, the periodic resetting of parameters is based on a fixed set of regulatory principles, such as not expropriating the investment value once it has been approved and sunk. It is also subject (in UK) to appeal to the Competition and Markets Authority. The performance framework set by the regulator operates as a proxy for the pressures associated with a competitive market, in which the entity would need to operate efficiently and not charge excessive prices in order to survive.

Whilst the legal and other barriers to adopting a RAB for heat networks are not insurmountable, the regulatory framework would need to be developed within the context of existing and planned regulatory developments in the sector. Aspects of current and planned regulation that could significantly impact the introduction of a RAB model include: the local authority development of LHEES and designation of heat network zones; development of the consenting, permitting and licensing regimes, and the forthcoming Heat in Buildings Bill.

Setting up the structures to facilitate a RAB is likely to involve the use of both devolved and reserved powers. Therefore, discussions with UK government would be required. This could have significant programme implications for implementing the Heat in Buildings Strategy.

Balance Sheet treatment – RABs structures are designed to encourage private sector investment in infrastructure, and can be designed in a way that is off balance sheet for government.

Exit strategy – the RAB model assumes ongoing investment in long-term infrastructure assets. Investment in the regulated entity is by equity, with investors being able to trade shares.

Examples – the RAB model has been used extensively as a method of financing large-scale infrastructure investment in utilities such as electricity, gas, water & sewerage (including the recent Thames Tideway Tunnel). It has also been used for airport expansion (Heathrow Terminal 5) and is being considered by UK government as an option to fund future nuclear projects.

6.4. Enabling structures / mechanisms

This section describes a number of enabling structures / mechanisms that share some, but not all, of the characteristics of a delivery model, but which could complement and/or enable the implementation of one or more delivery models analysed in sections 6.1 to 6.3 above.

We have included this section in order to comment on structures or mechanisms which are potentially relevant for heat networks, and were raised in our stakeholder engagement, but which do not warrant full review as a ‘delivery model’.

The enabling structures/mechanisms we have considered are:

• Demand assurance / guarantee to incentivise private sector activity – a form of guarantee to project developers to mitigate demand risk, with the intention of attracting private investment whilst reducing cost of capital and encouraging developers to invest ahead of need;
• Private company with public purpose – private company established with a public purpose (and potentially charitable status), similar to the current ownership model for Welsh Water. Profits are re-invested or used to cut customer bills rather than distributed to shareholders;
• Heat as a Service – a business model for heating in which consumers pay for outputs such as guaranteed room temperature / comfort levels / hot water volumes rather than inputs such as energy costs. This can involve improvements to the building fabric and controls, as well as the form in which energy is supplied to the building; and
• Procurement efficiency – a range of approaches that could be used to reduce the time and bid costs for procurement of delivery contracts for heat networks. These include a two-stage process to appoint a delivery partner for the commercialisation stage; use of frameworks; and standardisation.

We note below how these structures / mechanisms could impact on aspects of delivery models described in sections 6.1 to 6.3 (e.g., how they may affect project structuring, finance options, etc.).

Demand Assurance

Demand assurance is not a single mechanism, but could take several forms. The underlying aim is to reduce the risk, or to mitigate the impact, of forecast demand on a heat network not arising. This can happen due to anticipated connections being delayed or not occurring, or, following connection, actual heating demand being less than forecast.

Contractors are generally much more comfortable with the latter scenario, as they are well placed to estimate heating demand from a future connection based on building type, footprint and usage. However, they have much less control over connection risk, which is commonly cited as the single biggest risk facing developers. Mitigating this risk has the potential to improve investability and reduce the cost of capital, hence this should be the focus of any intervention in this area.

Heat networks require significant upfront capital investment. Due to the nature of the main assets (heat mains installed below ground, with high civils cost and a long asset life), they should be sized for anticipated future demand. However, the amount of demand that can be secured by the sponsor at the time of financial close is often significantly less than the potential future demand, allowing for planned new developments, and connection from additional existing buildings (where owners subsequently elect, or are eventually required, to switch to low carbon heating systems).

Demand assurance could therefore have a role to play in “future-proofing” networks to meet anticipated network growth. A form of demand assurance would particularly benefit delivery models involving private sector sponsorship and/or co-investment, but would also benefit larger, public sector led schemes, where demand risk is still present.

Connection risk could potentially be addressed by a number of mechanisms, including:

• a clear framework of trigger events and a backstop date by which building owners will be required to install zero emissions heating systems;
• mandatory connection of certain types of buildings - e.g., public buildings, large commercial buildings and buildings with communal heating systems within heat network zones;
• planning policy - requirement for new developments in heat network zones to install heat networks or connect to existing / planned third-party networks;
• financial incentives to connect - e.g., a levy on buildings within a heat network zone that do not connect within a given time period; and
• a form of guarantee available to heat network developers.

The forthcoming Heat in Buildings Bill consultation should provide clarity over trigger events/backstop dates for installation of zero emissions heating systems. Scottish Government’s heat networks policy and regulation teams are already considering the potential role and scope of mandatory connections and/or financial incentives to connect. National planning policy (NPF4) makes provision for new developments (though is predicated on heat network zones being identified in Local Development Plans).

The remainder of this section therefore focuses on the potential for a form of guarantee being made available to project developers. The intended outcomes for such a guarantee would be to mitigate the impact of connection risk on developers, to increase private investment in heat networks, whilst reducing cost of capital and encouraging developers to invest ahead of need. The guarantee would be dependent on the developer agreeing to certain commitments, for example to build-out the network in accordance with an agreed programme, to meet customer service standards, etc.

A demand guarantee could be provided in different ways – alternatives would need to be considered at detailed design stage, if there was an appetite to take this forward. One mechanism would be for a guarantor to underwrite a proportion of forecast project revenues against a pre-agreed revenue growth profile. The guarantee would be called upon in the event that forecast revenues do not materialise in accordance with the pre-agreed profile (e.g., if a planned housing development is significantly delayed), due to circumstances outwith the heat network operator’s control, and with the developer having demonstrated that it had taken all reasonable steps to mitigate the shortfall. The proportion guaranteed could be limited to debt repayments only, to provide assurance to investors that in a scenario where revenues are less than anticipated, debt can still be repaid. This reduction in risk should also reduce the cost of capital.

We would expect the guarantees to be offered during the commercialisation stage and agreed at financial close, potentially in conjunction with existing support mechanisms such as grants/loans. Guarantee schemes could be made generic, and available to all qualifying projects, or could be bespoke and agreed on a project-by-project basis.

Project structure – the underlying project structure would not be changed by the provision of a guarantee, other than the addition of the guarantor, the guarantee itself, and potentially the nature of the financing agreements. The potential structuring of any guarantee scheme is not covered in detailed in this paper but, for example, guarantees could be provided directly by the Scottish Government, or by another body (which would probably need to be underwritten by Scottish Government to achieve an acceptable credit rating). An example of the latter type of structure is provided by the Low Carbon Contracts Company, which is wholly owned by the Secretary of State for BEIS and which manages Contracts for Difference (CfD) and the Supplier Obligation Levy, which funds CfD payments. The Low Carbon Contracts Company is led by an independent board on which the UK Government is represented.

Control / risk – the distribution of most control and risk in a project would still be dictated primarily by the underlying delivery structure, with demand risk partially borne by the entity providing the guarantee. The amount of risk guaranteed could be adjusted to suit the project, and could change over time. The expectation would be that demand risk would be shared between the project sponsor and guarantor, so that the sponsor remains appropriately incentivised to mitigate demand risk by seeking alternative sources of revenues.

Financing – the financing options available to any individual project would broadly follow the project delivery structure being used for the project, but could be enhanced if a demand assurance guarantee is available, increasing likelihood of private investment being available, and at a lower cost of capital than would otherwise be achievable.

Regulation – the provision of demand guarantees is not incompatible with forthcoming regulation under the Heat Networks (Scotland) Act 2021. Whether existing Scottish Government procedures for providing guarantees could be used, or additional legislation / regulation would be required, would depend on the scale and complexity of any proposed guarantee scheme.

Balance Sheet treatment – whether or not the provision of a guarantee to a project would bring that individual project onto Government’s balance sheet would need to be considered. This would depend on the structure of the guarantee and the nature of the conditions associated with it, and the level of control over the project (if any) the guarantee afforded to the Scottish Government. In respect of any body set up to administer guarantees, its balance sheet treatment would depend on the Scottish Government’s shareholding and/or control over that body. For example, the Low Carbon Contracts Company is wholly owned by the Secretary of State for BEIS and is categorised as an arm’s length governmental body.

Exit strategy – the length of any guarantee commitment would depend on the specific arrangements of the scheme, but would be expected to expire when the risk being guaranteed had fallen away, either through passage of time or by the introduction of regulation (e.g., mandatory connections or obligations being placed on homeowners to decarbonise their heat supply).

Private company with public purpose

This involves a privately owned company that is established with a public purpose. The ‘public purpose’ element requires that cash surpluses arising from operations are reinvested in the company and/or used to reduce customer charges. There are no distributions of profits to shareholders or officers.

This type of company may be beneficial for delivery models in which the focus is on network growth and/or minimising customer charges, with no requirement for equity investors. It principle, it could be used in the context of a variety of delivery models, including a service concession (DM2), a third party ESCo (DM3), a community led project (DM5), an unbundled model (DM6), or a merchant model (DM7)). In practice, the ‘public purpose’ element would be better suited to models such as a community led project, or an unbundled model in which certain assets (such as transmission pipes) were considered to be a ‘public good’. Models such as a service concession, third party ESCo and merchant model are more likely to require equity investors in order to absorb project risk.

The corporate structure does not involve any shareholders, and should contain an appropriate ‘asset lock’, to prevent the structure being changed in the future in a way that would undermine the public purpose.

A company limited by guarantee is a suitable vehicle for this purpose. It has no shareholders, and is owned by its members, who guarantee a nominal sum of money to the company in the event of its becoming insolvent or winding up. Its corporate governance functions are the responsibility of a Board appointed by the members.

As there are no equity investors, the model is heavily reliant on debt finance. This could include commercial loans, and corporate bonds issued on the capital markets. To achieve large-scale bond finance at a low cost of capital, with no equity investors to absorb losses, the company would require a well-understood risk profile, and high degree of certainty around both the cost of providing services and of revenue streams. This would almost certainly require a form of demand assurance, which is not part of the company structure itself. The structure would therefore only be suitable as a vehicle through which to secure large-scale low-cost finance for heat network investments if it were accompanied by a form of demand assurance / exclusive rights.

Example – Glas Cymru is the primary example of this model in the infrastructure market. It was set up as a not-for-profit, single purpose company. It acquired Welsh Water in 2001, financed by a £1.9bn bond issue. Welsh Water is a licensed provider of water and sewerage services, regulated by Ofgem under a RAB structure.

Glas Cymru’s corporate governance functions are the responsibility of its Board (which has a majority of independent non-executive directors), and its members, around 50 individuals appointed following a process undertaken by an independent membership selection panel. Members are not representatives of outside stakeholder groups but rather are unpaid individuals whose duty is to promote the good running of the company, in the best interests of its customers.^[49]

As it has no shareholders, assets and capital investment at Glas Cymru are financed by bonds issued in the capital markets, and retained financial surpluses, which are used for the benefit of its customers. No government subsidy is involved. This model aims to reduce asset financing costs. Glas Cymru states that its strategy is to deliver a secure, long-term credit quality to investors (such as pension funds and insurance companies) so as to raise finance required at the cheapest possible cost and therefore minimise customer charges. Around a third of bill costs are used to service finance costs.

Heat as a service

Heat as a Service (HaaS) is not in itself a delivery model for heat networks, but a term used to describe a range of different business models for heat supply to (usually) individual buildings. This can include asset leasing through to alternative ways of paying for heat. Elements of these models could potentially be combined with heat network delivery models, to expand the traditional supply arrangements and combine them with the provision of other services to end consumers.

There are a number of variants of HaaS. The following is a risk-based definition used by LCP Delta^[50]:

“A business model where the service provider takes on all five of the following risks – all of which (other than energy price risk) have historically been borne by the customer:

1. Financial risk: service provider takes on credit risk by providing a heating appliance for a monthly fee and little or no upfront payment.

2. Technical risk: the monthly fee charged by the service provider includes: routine maintenance, repairs, and appliance replacement if necessary within the contract period.

3. Performance risk: service provider charges per unit of output (heat) or for the outcome (warmth) provided by the heating appliance (or guarantees savings on heating costs).

4. Behaviour risk: service provider charges for the outcome (warmth) provided, thereby taking on the risk that customers use heating inefficiently by, for example, opening windows. This also includes the risks associated with timing of demand, which are related to energy price risks.

5. Energy price risk: service provider offers a fixed price per unit of heat or warmth generated for a period of time, typically a year.”

Control / risk – of the five risks identified above, heat network operators can/do take some financial risk, technical risk (for the supply of heat to the building, but generally not within it), and energy price risk (for defined periods, but subject to periodic tariff adjustments). It is rare for performance risk in terms of warmth or guaranteed savings, or behaviour risk, to be assumed by a heat network operator. Depending on the nature of the HaaS model deployed, there is potential for elements of these additional risks to be taken by a heat network operator (and its supply chain).

Comprehensive HaaS packages are yet to be tested at a commercial scale either via heat networks or other technical solutions. Some Danish heat network operators offer some degree of HaaS by providing, owning and maintaining the heating appliances within customers’ homes, charging a fee for this service, which is incorporated into customer bills.

In principle, most of the models described within this paper would have the flexibility to deliver elements of HaaS (as against a ‘simple’ heat supply agreement). However, the additional scope associated with taking on responsibility for equipment within the building (i.e., going beyond the heat interface unit), and the measures needed to manage the risk of guaranteeing outputs (rather than supply), would represent a significant departure from current service offerings.

Procurement efficiency

As noted in section 3, public procurement of heat networks is perceived by many in the market as unnecessarily long, complex and expensive. Procurements can take over a year, requiring bidders to commit significant resource and cost, even at an early stage in the process (prior to preferred bidder appointment).

The market perceives the ‘standard’ project development process as time-consuming and inefficient, resulting in reference designs developed by local authorities that are of limited value, and seldom adopted and used by the private sector, who prefer to rely on their own designs. There is a strong demand in the market for procurement to be streamlined.

One proposal for how procurement could be streamlined is a ‘Joint Development Agreement’ (JDA). This is a type of two-stage procurement involving appointment of a development partner at a relatively early stage of the process. The development partner would enter into a JDA with the authority. The JDA would provide a period of exclusivity within which the development partner would produce designs / costs, engage with key customers, owners of heat sources, the DNO etc, and with its own supply chain. The intention would be to provide greater certainty at an earlier stage around both financials (and hence affordability) and deliverability. The output would be a set of delivery contracts, to be entered into if the authority confirms its intention to proceed. There is no obligation on the authority to do so, but if the authority does not proceed it is likely that the authority would be required to pay the development partner for the work done to date, which the authority would then get the benefit of.

The obvious difficulty with such an approach is determining a set of robust criteria by which a development partner can be appointed, and value for money of subsequent delivery contracts can be demonstrated.

An alternative approach would be to establish a procurement framework for heat networks. In England and Wales, the BHIVE Dynamic Purchasing System enables public bodies to procure funding and related services for heat network projects from a range of potential funding providers. BHIVE allows developers to raise finance for a new heat network, to finance the expansion of an existing network, and to facilitate the sale or refinancing of a heat networks. The framework acts as a marketplace for developers to access funding, and for funding providers to access projects seeking finance. The framework does not, however, include the ability for projects to award delivery contracts such as construction, operation and maintenance.

As the market matures, increasing standardisation of delivery contracts will also reduce procurement timescales and associated tender costs. A range of delivery contracts has been commissioned by BEIS. and published as the “Sales, Operation and Maintenance Set” (SOMS). The suite of templates includes land rights such as leases (for energy centres) and easements (i.e., wayleaves for pipe routes); delivery contracts such as concession agreements, DBOM, O&M; use of system agreements; connection and supply agreements, various heat supply agreements, and a metering and billing agreement. The templates do not include templates relating to project structuring and ownership (such as a shareholders agreement for a joint venture).

A “Standardised Due Diligence Set” (SDDS) has also been developed, to provide heat network sponsors and developers with un understanding of the due diligence requirements of project finance lenders and investors.