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UTILITY Week 26th February 2016

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UTILITY WEEK | 26Th FEbrUarY - 3rd march 2016 | 21 Finance & Investment Market view T he chancellor's Autumn Statement last November allocated more than £300 million to fund 200 heat networks, expected to generate enough heat to supply the equivalent of more than 400,000 homes and leverage £2 billion of private investment. While the money 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in the UK has been a cycle of mini-boom and bust as various government grant schemes have been initiated and then withdrawn. In our present political climate, to achieve dis- trict heating at scale a new financial model is required that 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 exist in Sheffield, Birmingham, Southamp- ton and Woking. District heating at scale is more commonplace in eastern and north- ern 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 con- sidered as discrete projects, oen based on a housing estate, a campus or a group of pub- lic buildings. The investment cost of a project in the UK can roughly be divided into 25 per cent development costs, 25 per cent the energy centre and 50 per cent the pipe network installation. Our understanding is that most UK schemes are expected to pay back in 20 years or less despite the overall scheme hav- ing a lifetime of at least 50 years. This means that only schemes with an internal rate of return in the high teens or better can go ahead unless someone is willing to subsidise part of the capital cost. While this can hap- pen when property developers are forced by planning policy to install district heating in new developments, the big issue in the UK is 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 fund- ing comes from the partners in each scheme, who despite being able to handle the risk are limited in their borrowing by their wider cor- porate 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 split- ting 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: a company bor- rows money and builds a district heating scheme. Aer commissioning, the overall costs are known and the income from cus- tomers has been secured. At this point, it sells the pipe network to a second company, a PipeCo, which is backed by institutional finance happy with a low-risk return over several decades. The first company contin- ues to operate the system, supplying custom- ers from its energy centre over the PipeCo network, for which it pays a regular (but rela- tively small) use-of-system charge. The developer has managed in the short term to offset its biggest cost (the pipe net- work), leaving it with the parts of the project with a higher internal rate of return, which can be financed for a shorter period at higher discount rates. It can then start looking for another project and the whole process starts again. Where this model is uniquely suited for the UK market is that is facilitates refinanc- ing 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. This refinancing would benefit the initial heat network developer, whether public sec- tor or private sector, because a substantial portion of the initial investment cost could be recouped shortly aer commissioning of the network. Creating a portfolio of distribution infra- structure across the UK would 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 internal rate of return is not compromised by requiring costs to be fully recouped in a fraction of its lifetime. This might lead to larger projects being deliv- ered which can achieve economies of scale. Time is of the essence, and as the gov- ernment is reviewing its heat policy this year, this should provide an opportunity to examine seriously how a PipeCo intervention could unlock a potentially large 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). Tanja Groth is decentralised energy manager at the Carbon Trust. Could a PipeCo take the heat? District heating is booming in the UK, but to pose a serious alternative to the gas network a different funding model is needed, say Ian Manders and Tanja Growth. Welcome to the PipeCo. AnAtomy of A heAt network A heat network consists of two separate assets – distribution (pipes) and generation (energy centre). In Denmark, where district heating supplies over 60 per cent of house- hold heating, local authorities and communi- ties own 56 per cent of all generation assets and 91 per cent 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 electric- ity generation (combined heat and power), combustion of municipal waste and biomass, and ejected heat from industrial processes.

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