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The PipeCo: an alternate approach to financing heat networks

29 February 2016 | Viewpoint

District heating is booming in the UK, but to pose a serious alternative to the gas network a different funding model is needed, according to Ian Manders and Tanja Groth

Decentralised energy

The UK Chancellor’s Autumn Statement in November last year dedicated over £300 million of funding for 200 heat networks which are expected to generate enough heat to supply the equivalent of over 400,000 homes and leverage £2 billion of private capital investment.

While the new government funding is welcome, much more must be done to make heat networks a viable alternative to the UK default of individual boilers fed by the gas distribution network. Unfortunately, the history of district heating in the UK has been a cycle of mini-boom and bust as various government grant schemes were initiated and then withdrawn. In our present political climate, to achieve district heating at scale a new financial model is required which is viable without long-term government handouts. 

 

 

In the UK the term “district heating” has been a catch-all description ranging from two or more buildings sharing the same heat source, up to city-wide distribution systems with hundreds of properties such as already exists in Sheffield, Birmingham, Southampton and Woking. District heating at scale is more commonplace in eastern and northern European cities and heat supply may be regulated in a manner similar to other energy utilities.

The situation in the UK is different. Unregulated and under the radar, UK district heating scheme start-ups are small and considered as discrete projects, often based on a housing estate, a campus or a group of public buildings.


How does a Heat Network work?

A heat network consists of two separate assets – distribution (pipes) and generation (energy centre). In Denmark, where district heating supplies over 60 percent of household heating, local authorities and communities own 56 percent of all generation assets and 91 percent of all distribution assets with commercial ownership of the remainder.

The split in ownership means a mix of low or zero carbon heat generation can be used depending on availability and cost, including heat pumps, waste heat from thermal electricity generation (Combined Heat and Power), combustion of municipal waste and biomass, and ejected heat from industrial processes. 

 

The investment cost of a project in the UK can roughly be divided into 25 percent development costs, 25 percent the energy centre and 50 percent the pipe network installations. Our understanding is that most UK schemes are expected to pay back in 20 years or less despite the overall scheme having a lifetime of at least 50 years. This means that only schemes with an IRR in the high teens or better can go ahead unless someone is willing to subsidise part of the capital cost. While this can happen when property developers are forced by planning policy to install district heating in new developments, the big issue in the UK is to connecting up existing buildings, where a sponsoring body is less obvious.

It does not help that there is currently no third party institutional investment in district heating in the UK. Excluding any central government contribution, all funding comes from the partners in each scheme, who despite being able to handle the risk are limited in their borrowing by their wider corporate or local government funding limits. A UK heat networks investment market needs to be created to channel the huge quantity of low-risk low-cost long-term investment from pension funds and other institutional funds. A “PipeCo” could be one way of doing this.

 

What is a PipeCo?

A PipeCo model works on the basis of splitting the investment in a new district heating scheme into the expensive heat distribution network, which lasts for 50-60 years before refurbishment, from the energy generation plant and ancillaries, which have a lifecycle of 15-20 years before replacement.

It could work like this:

  1.     Company “A” borrows money and builds a district heating scheme. After commissioning the scheme, the overall costs are known and the income from customers “C” has been secured. At this point, A sells the pipe network to Company “B”, the PipeCo. B is backed by institutional finance which is happy with a low-risk return over several decades.
  2.     A continues to operate the system. From its’ energy centre it supplies C over the PipeCo network, for which it pays a regular (but relatively small) use of system charge to B.

A has managed in the short term to offset its biggest cost (ie the pipe network) leaving it with the parts of the project with a higher IRR that can be financed for a shorter period at higher discount rates.

A then starts looking for another project and the whole process starts again. A and B are in a symbiotic relationship but each have the funding structure suitable for their role in the project.

 

How can a PipeCo unlock greater investment?

It has also been suggested that the PipeCo model could facilitate competition on the generation side by opening up the possibility of multiple suppliers using the same distribution system, as is the case in Denmark.

Where this model is uniquely suited for the UK market is that is also facilitates refinancing of the expensive, long-term distribution asset by third-party investors – for instance by creating a portfolio of heat network investments of a sufficient scale that would appeal to pension funds and other capital investors interested in low-risk long-term investments.

This refinancing will benefit the initial heat network developer, regardless of whether they are public sector or private sector, as a substantial portion of the initial investment cost can be recouped shortly after commissioning of the network.

Creating a portfolio of distribution infrastructure across the UK will further de-risk refinancing of the asset from the view of an external investor. And by attracting investors who prefer low-risk, long-term investments, the financial viability of heat networks with a sub-commercial IRR is not compromised by requiring costs to be fully recouped in a fraction of its lifetime. This might lead to larger projects being delivered which can achieve economies of scale.

To our knowledge, at least one form of PipeCo already exists in the utility world (connected to property development) and one major player in the UK district heating market is seriously considering setting up a PipeCo. However, this will not provide the capacity to cope with the portion of the 200 heat networks coming to the commercialisation stage this year and next.

Time is of the essence, and as the UK Government is reviewing its Heat Policy this year, this should provide an opportunity to examine seriously how a PipeCo intervention could unlock the potentially large UK heat market.

 

Ian Manders is a consultant advising the Danish Embassy on UK local energy policy and former Deputy Director of the Combined Heat and Power Association (now ADE).  Dr Tanja Groth is Decentralised Energy Manager at the Carbon Trust.

 

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