Regulation of heat — 2020 and beyond

Introduction

Following on from our insight piece on what the future of heating regulation may hold, the Government has now published the consultation document titled “Heat Networks: Building a Market Framework” which sets out its preferred approach for regulating district heat networks and the supply of heat in the UK. We have set out below the key points of the consultation and the impact that this could have on new and existing district heating schemes.

Regulator

It comes as no surprise that the Government proposes to appoint Ofgem as the regulator given its experience in regulating gas and electricity markets. Ofgem would be given appropriate powers to conduct investigations into regulated entities and to enforce regulations, including through the ability to levy fines. To fund these new activities, the Government proposes to grant Ofgem the power to raise fees from regulated entities, the amount of which will be scaled according to the size of the regulated entity or the scope of its activities.

Regulatory structure

The Government intends to adopt a general authorisation model for regulating heat with the option to apply for specific licences for certain rights and powers. This is similar to the model of regulation used in financial services as opposed to the full licensing regime for gas and electricity. Under a general authorisation, entities are entitled to perform the regulated activity provided that they meet a set of conditions and requirements specified by the regulator. This facilitates market entry by not requiring entities to apply for a licence upfront and allows the regulator to take a consistent approach towards all regulated entities.

It is envisaged that all district heat networks would be covered by a general authorisation. However, optional licences would be available to any entities that required certain rights and powers for the purposes of developing or operating a district heat network. These licences would focus on granting powers which are equivalent to those granted to statutory undertakers in the gas, electricity and water markets.

Who will it apply to?

A key consideration for stakeholders in district heating projects will be the extent to which they are caught by any future regulation. This has a number of interesting implications given the range of stakeholders that may be involved on any given project. By way of example, depending on how it is structured, various aspects of the regulatory regime could feasibly apply to:

• Asset owners — owners of the actual heat network infrastructure, including those with no direct involvement of the day-to-day running of the heat network, could have overall responsibility for ensuring that heat networks are designed built and operated correctly, delegating their responsibilities through contractual arrangements;
• Property developers — organisations that develop and build the network or buildings connected to the network play a critical role ensuring technical standards are met and have an impact on the quality of service that consumers receive;
• Project sponsors — this could include local authorities, housing associations or building management companies that initiate or direct the development of the district heating network and who play a pivotal role at each stage of the network’s development;
• Heat network operators — the operators that have day-to-day responsibility for operating and maintaining a network have a direct influence over the quality of service that consumers receive and may also have direct contractual relationships with consumers; or
• Heat suppliers — the organisations that are contractually responsible for delivering heat to end consumers have significant influence on issues affecting the supply of heat to consumers.

The current proposal is that asset owners, property developers and project sponsors would be the regulated entities for all activities up to the point of commissioning and operation of a district heat network. From the point of operation, responsibility for regulatory compliance would then shift to the network operator and/or heat supplier. While this sounds neat, in practice, the split may not be so simple given that entities may be responsible for a number of the roles described above, depending on how the project is structured.

This could result in some entities being responsible for activities from a regulatory perspective that they thought they had delegated to a third party under contractual arrangements. This would require an audit of the existing contractual arrangements to see if any regulatory obligations have been adequately flowed down.

Demand risk

In a move that will likely disappoint developers and funders, the Government does not intend to provide any central support to underwrite the so-called demand risk — i.e. the risk regarding the levels of heat consumption (and so revenues) that will be achieved from a heat network. Options under consideration had been: (i) some form of demand assurance mechanism — whereby the Government would effectively guarantee the heat demand of approved schemes and make up any shortfall; or (ii) a Regulated Asset Base model to determine permitted returns for operators of heat networks.

Instead, the Government believes local solutions should be used to promote the development of district heat networks using a combination of zoning schemes, supportive planning policies, granting appropriate concession arrangements, using public sector buildings as “anchor-loads” and developing local energy efficiency strategies. The Government is also considering whether or not to grant powers to local authorities to mandate that certain buildings connect into heat networks in designated zones.

Supplier of last resort

An important feature of the consultation is the proposal to implement some form of step-in or “supplier of last resort” arrangements to protect consumers in cases where their heat supplier becomes insolvent or is significantly and persistently failing to perform its obligations. Currently this risk is left to whatever contracting arrangements are in place for a particular scheme, but there is no form of standardisation. The consultation indicates that the final step-in arrangements may include a number of components, including:

• a requirement on regulated entities to evidence contingency plans;
• a requirement on regulated entities to hold reserved funds to manage a transition;
• the right for Ofgem to seek an alternative company willing to take over supplying to consumers on a relevant scheme; and
• provisions for an administrator of the scheme to be appointed where there is no appetite among existing regulated heat network operators to take over operation of the scheme.

This is a complicated area, especially given the range of different project structures that exist for different district heat networks. In cases where a local authority or property developer is responsible for a district heat network — either itself or through an ESCO — then they may be better placed than Ofgem to step-in and ensure contingency arrangements are applied. This could have significant implications for developers or local authorities.

Pricing

As expected, the Government does not propose to introduce any direct price regulation such as introducing price caps or regulating the profits of district heating network operators. Instead, the focus is on radical transparency and the Government is proposing to give Ofgem the power to mandate and enforce that suppliers publish their fixed charges, tariffs and unit rates together with providing clear explanations as to how they have been set. There are also expectations that Ofgem will work with industry to design an effective system for reporting and benchmarking prices given that costs can, legitimately, vary significantly due to the nature of individual district heat networks. The other main proposal is to allow Ofgem to set upfront pricing requirements which set out what costs can be recovered by heat suppliers through their fixed and variable charges. This is further intended to improve transparency and eliminate inconsistencies within the market.

Consumer protection

As expected, in addition to pricing, the main thrust of the proposed regulations to protect consumers focuses on (i) improving transparency; and (ii) setting minimum performance requirements to drive up quality. In terms of transparency, the proposals centre around heat suppliers making available clear information and guidance to customers before they move into a home connected to a district heat network. The other proposal is to give Ofgem powers to set and enforce requirements around billing information and frequency and also requirements regarding the provision, and content, of heat supply agreements. Regarding minimum performance requirements, the Government is suggesting granting Ofgem powers to set outcome-based quality of service standards (as opposed to prescriptive minimum standards). It argues that this could allow for a greater flexibility and allow for innovation. Clearly, an implication for operators of existing schemes will be to ensure that they are providing a service in line with these new standards or have suitable contractual arrangements in place which adequately pass this liability down to a third party.

Rights and powers

It is recognised in the consultation that developers of district heat networks face a disadvantage as compared to gas, electricity and water companies who are given a special status in law as “statutory undertakers” and which entitles them to exercise certain rights and powers to facilitate their operations. These powers include access rights over private land, the power to excavate roadways, the right to lay pipes under roadway and being granted permitted development rights in respect of certain infrastructure. The Government proposes to grant heat network developers similar powers in order to give investors greater certainty that projects will proceed on time and on budget and to ensure that they have the ability to respond to critical consumer issues — e.g. being able to access piping for maintenance.

Technical standards

The options under consideration are (i) adopting the existing ADE-CIBSE Code of Practice; (ii) developing a new Publicly Available Specification (PAS) by the British Standards Institution; or (iii) develop national standards for heat networks. In terms of demonstrating compliance, the current preference is to introduce some form of regulated certification scheme. This could be achieved through organisations providing independent assurance schemes. The Government also proposes that the organisations that provide such assurance schemes should be monitored by the UK National Accreditation Body (UKAS). Importantly, the technical standards that are adopted will not be applied retrospectively to networks that are already operating. However, the Government is looking into whether there should be some form of phasing in of minimum standards if it could be reasonably expected to improve end-consumers’ outcomes.

Next steps

The consultation closes on 1 May 2020. In terms of next steps, the consultation document does not commit to a specific timeline for the Government to respond, except to say that there may be further consultation in 2020 once policy has been developed and that legislation will be introduced when parliamentary time allows. We anticipate that the contents of the eagerly awaited Energy White Paper — due to be published in the first quarter of 2020 — will need to be properly digested before the Government is able to bring forward legislation to regulate the heat market.