District heating – yesterday's concept; tomorrow's energy future

To celebrate Out-Law's 15th birthday we are looking ahead to the big changes facing business in the next five years. Read more and follow our celebrations on Out-Law and on Twitter.

According to government estimates, approximately 210,000 UK households are already connected to district heating systems with the figure predicted to rise to as many as eight million by 2030.

But it is not just homes that can be connected; public sector buildings, commercial properties, communal facilities, such as swimming pools, and factories are all good customers for a district heating scheme.

It is a market that local authorities, developers and energy companies will be increasingly engaged in.

What is district heating?

District heating is the provision of heat and hot water to multiple properties from a single 'energy centre', operated by an energy services company (ESCO). The energy centre houses the centralised heat generators and the pumps which deliver the heat in the form of hot water to connected properties via a network of pipes and heat exchangers. Heat generators can take different forms, but the most common are gas-fired combined heat and power (CHP) boilers, biomass boilers and ground-source heat pumps.  Certain heat generators, for example CHP, also produce electricity by harnessing the steam created as water is heated.

The concept of district heating can be traced back centuries, but many schemes that had been operating in the UK in the early parts of the 20th century were discontinued during the 1970s and 80s as individual gas boiler central heating systems grew in popularity among property owners and the schemes no longer became financially viable.

How is district heating financed?

The upfront capital costs involved in district heating projects are significant. District heating networks should eventually pay for themselves, but it can take 8-10 years for the initial outlay of the design and build to be recovered and for any profits to be generated. This means that district heating projects need investors who are looking for a relatively secure long-term revenue stream rather than a quick return on their capital.

District heating operators have three main mechanisms for bringing in revenue, and recovering capital expenditure: (1) charging a connection charge to connect a customer to the network – this charge would need to cover at least the capital cost of the connection but should also contribute to the overall cost of the network; (2) heat and service tariffs – to cover the cost of generating and supplying the heat but also the maintenance of the network; (3) electricity sales from the electricity generated by the generator – this is often what makes a district heating scheme viable.

Return on investment is entirely dependent on the customer base of the network, so it is imperative that a scheme targets customers who can pay. This makes public sector buildings, communal facilities and large manufacturers ideal customers because they should be able to pay their bills.  Individuals, on the other hand, have a much greater credit risk.

Funders can see that the current climate is ripe for district heating to thrive again.  The government is pushing energy efficiency, traditional energy bills are rising, technology has improved and the market is yet to be regulated.

Who is behind the comeback in district heating?

District heating schemes are already in operation or planning in cities such as London, Glasgow, Aberdeen, Norwich and Exeter. The re-emergence has predominantly been driven by local 'green' planning requirements for new developments and the need to improve heating systems in existing social housing schemes.

In London alone, mayor Boris Johnson has committed to ensuring that 25% of London's energy is delivered by 'decentralised energy' by 2025. The mayor's office is behind a programme identifying potential district heating opportunities and helping local authorities implement them through planning policies that encourage and sometimes even require decentralised energy use in new developments.

Increasingly, local authorities are seeing the district heating market as an opportunity to combine efforts towards meeting energy efficiency targets with the creation of a long-term revenue stream, particularly in an environment where local government budgets are under pressure. These local authorities are willing to fund the project and take offtake risk, which they can mitigate by connecting public sector buildings, such as civic buildings, schools, affordable housing, community centres, to the network, while outsourcing the operation and maintenance of the system to the private sector. 

The future of district heating

Local authorities have the benefit of being able to use lower cost financing and the ability to secure long-term public sector customers, but many lack the technical expertise to develop and run a district heating network. As local authorities become more engaged in the market, we are likely to see more public-private partnerships, with local authorities and ESCOs sharing both the cost and risks involved in building district heating networks and the profits that can be derived.

The rise of joint ventures is also likely to drive different legal and ownership structures. We are already seeing ESCOs, local authorities and developers weighing up the benefits of disaggregating ownership and lifecycling of the heat assets from the operational responsibility. The heat infrastructure therefore becomes a bankable asset, as the heat operator would pay a charge for use of the pipes, creating a long-term revenue stream.

City-wide schemes, particularly in dense cities such as London, are being considered by city planners and planning authorities. The Lee Valley Heat Network (LVHN) in Enfield aims to be a model for city-scale schemes across the capital. In its first phase, LVHN will deliver heat to 6,000 homes and business, taking heat from a local energy from waste plant. Planning authorities are already requiring new networks to be future-proofed to facilitate the connection of local individual networks on a city-scale, as a means of delivering heat more efficiently. This will have its own source of legal problems as schemes with different requirements, different customer types and different key performance indicators merge.

Much depends too on the way the market will be regulated. Currently, no specific regulatory and licensing regime applies to the generation and supply of heat. This means that there are no restrictions on pricing or who can own and operate a district heating network. This contrasts with the position in the electricity market where rules designed to maintain competition mean that one organisation cannot act as the generator, supplier and distributor of electricity. The electricity and gas markets also have strict requirements on pricing in the domestic sector.

The lack of regulation has allowed the market to re-energise and to a certain extent self-regulate. This has caused some debate amongst competition lawyers who are concerned that the current tendency for long-term operators – circa 25-40 years to allow investors to recover their capital expenditure – translates to a lack of consumer choice on their heat supplier and a potential lack of transparency on pricing.

Although the Heat Trust has set up some voluntary requirements for ESCOs operating in the domestic market, the requirements are light touch and most developers and local authorities would expect ESCOs to provide a higher level of service to customers. Developers are becoming the de facto regulator for their own schemes, ensuring that pricing is appropriately benchmarked and indexed, so as not to discourage potential purchasers.

There is little doubt that heat regulation will be introduced at some point in the future, particularly if growth in the marketis similar to the levels that the government is predicting. Regulation could force ESCOs to decouple their existing schemes and sell off one or more of the generation, distribution or supply elements of their business. Untangling long-term ESCO contracts to fit with future regulation will bring its own challenges.

Becca Aspinwall is a commercial lawyer with a specialism in district heating and ESCOs at Pinsent Masons, the law firm behind Out-Law.com.