DOI: http://dx.doi.org/10.7488/era/5898

Context & challenge

Sector policy experts are developing emissions-impact estimates for a large number of climate change policies. For each policy, sector teams are asked to provide:

• A best estimate (most likely outcome)
• A plausible best-case estimate (optimistic but realistic)
• A plausible worst-case estimate (pessimistic but realistic)

From this, an overall uncertainty estimate, or confidence level is to be determined for the portfolio of policies. A simple approach to this would be achieved by summing the total best and worst estimate cases across all policies and calculate the difference to provide a single numerical range value. That is,

∑( plausible worst-cases) – ∑( plausible best-cases).

This would allow statements of the following form to be made:

“Based on expert estimates the total emissions reduction could plausibly go from 10 MtCO₂e to 50 MtCO₂e, with a range of 40 MtCO₂e”

While this gives a basic measure of spread, it has two major limitations:

• It assumes all policies meet their respective extremes simultaneously, which is highly unlikely.
• It does not convey how likely any given value within the range is – it’s a bounding box, not a probability distribution.

Thus, a more robust way is needed to present a meaningful range and confidence interval for the aggregated emissions reductions.

Proposed approach

A Monte Carlo simulation is well-suited for this type of uncertainty analysis. It improves upon the simple range aggregation method by:

• Capturing the combined effect of many policies without assuming extremes occur simultaneously.
• Providing a probabilistic estimate that better represents likely outcomes.
• Allowing sensitivity testing (e.g. exploring the impact of policy correlations if relevant)

The key steps for conducting the Monte Carlo simulation are:

• Define probability distributions – Each policy’s emissions impact is modelled using a probability distribution based on sector team inputs. Pragmatically, a triangular distribution (peaked at the best estimate, with plausible best/worst case as the range) is a practical and transparent choice given limited data.
• Run simulations – Random values are drawn from each policy’s distribution and aggregated. This process is repeated potentially thousands of times to build a distribution of total emissions outcomes.
• Analyse the output – The resulting distribution of aggregated policy impacts allows us to:
• Derive a probable range (e.g. 10^th – 90^th percentile) rather than an extreme max-min spread of the simplified approach.
• Identify a central estimate (e.g. the median or mean of the distribution).
• Calculate confidence intervals (e.g. 95% confidence that total reductions fall within a specific range).

It is important to consider methodological choices before undertaking the analysis, including confidence in the policy estimates that are made by the experts, probability distributions chosen and treatment of policy dependencies.

The Monte Carlo simulations can be implemented using widely available tools, for example, Python, R, or Microsoft Excel (with appropriate plug-ins or add-ins).

Following the analysis of the outputs of the Monte Carlo simulations, specific commentary can be made on emissions-impact estimates for the full policy package, ensuring clarity in the communication of uncertainty.

Dependence on expert inputs

An important caveat in the robustness of the Monte Carlo results is that the method depends entirely on the quality of the underlying inputs. Since the method uses expert-provided worst-case, best estimate, and best-case values, any biases, inconsistencies, or overly optimistic/pessimistic assumptions will be carried through to the results. It is therefore essential to:

• Encourage sector teams to provide realistic and well-considered bounds.
• Be clear that the results reflect expert judgement about what could happen, rather than measured variability based on observed data.
• Revisit and refine inputs as more data or evidence becomes available.

Outputs from Monte Carlo simulation

The Monte Carlo simulation approach would allow statements of the following forms to be made:

In relation to central estimates (median or mean):

“The median estimated emissions reduction from the policy package is 29 MtCO₂e.”

For confidence intervals:

“We estimate with 95% confidence that total emissions reductions will fall between 18 and 43 MtCO₂e.”

For percentile ranges:

“The 10^th–90^th percentile range for total emissions reduction is 20 to 40 MtCO₂e, reflecting where most outcomes are concentrated.”

For risk-based statements:

“There is less than a 5% chance that the policy package will achieve less than 20 MtCO₂e in emissions reductions.”

_____________

How to cite this publication:

Galloway, S. (2025) ‘ Briefing: Accounting for uncertainty in aggregated emissions – Impact estimates ‘, ClimateXChange. DOI: http://dx.doi.org/10.7488/era/5898

© The University of Edinburgh, 2025
Prepared by University of Strathclyde on behalf of ClimateXChange, The University of Edinburgh. All rights reserved.

While every effort is made to ensure the information in this report is accurate, no legal responsibility is accepted for any errors, omissions or misleading statements. The views expressed represent those of the author(s), and do not necessarily represent those of the host institutions or funders.

This work was supported by the Rural and Environment Science and Analytical Services Division of the Scottish Government (CoE – CXC).

ClimateXChange

Edinburgh Climate Change Institute

High School Yards

Edinburgh EH1 1LZ

+44 (0) 131 651 4783

info@climatexchange.org.uk

www.climatexchange.org.uk

If you require the report in an alternative format such as a Word document, please contact info@climatexchange.org.uk or 0131 651 4783.

Research completed March 2025

DOI: http://dx.doi.org/10.7488/era/5740

Executive summary

Background

Over 72% of buildings in Scotland still rely on mains gas as their primary heat source. Scotland must further decarbonise heating in homes and buildings to achieve its climate change targets. The Scottish Government’s 2021 Heat in Buildings Strategy identified clean heat networks as a strategic decarbonisation technology. However, given the significant levels of capital investment required to transform Scotland’s buildings and limited public sector budgets, additional investment will be needed from the private sector.

Aims

This study examines present and potential future financing models in the heat network sector (“the sector”) and identifies suitable levers and actions for incentivising private finance. Findings are based on a series of interviews with stakeholders, including operators, funders, advisors and public sector representatives, as well as desk-based research. We draw comparisons and insights from other relevant utility sectors and from other countries (the Netherlands, Germany, Finland, Sweden and Estonia) as well as England and Wales.

Findings

Challenges facing the sector

In Scotland and across the UK, the heat network sector has typically been funded by early-stage financing from developers and significant levels of subsidy from the public sector. These public subsidies have encouraged private investment in the sector and supported the roll out of heat networks across Scotland.

The most impactful barriers in the sector are demand uncertainty, revenue instability and the evolving regulatory environment. This limits investment appetite, restricting the roll out of heat networks at scale in Scotland. The barriers are illustrated in Figure 1.

International comparisons

• Maturity – Scotland, the rest of the UK and the Netherlands have a developing heat network sector. Germany is expanding its market. Sweden, Finland and Estonia have mature markets where the sector is tried, tested and trusted.
• Regulation – Many of the developed and mature markets are unregulated: they use self-governing frameworks and technical codes. This is coupled with high levels of local governance, greater pricing transparency and consistent contractual delivery and routes. These markets can focus on consumer pricing that supports investment and stimulates the sector’s development. Additionally, mandatory connections are being used in some circumstances in other countries, to make projects more investible and create demand assurance, which encourages private investment.
• Ownership profiles and private finance – The more developed markets (including Sweden, Finland and Estonia) have a mixed degree of public ownership. More mature markets are likely to have a higher level of private finance penetration. In Finland, public sector ownership remains at a high level, whilst still seeking investment from the private sector. In Germany there’s a growing commitment to re-municipalise infrastructure and reverse privatisations. In the Netherlands, where over 90% of sector finance is private, the government proposed legislation to part-nationalise the sector in 2022 to mitigate concerns around the affordability and reliability of the sector.

The developed markets are mainly regulated by standard frameworks. These markets can access private finance due to the established nature of the sector. However, the technology has been embedded in the culture of these countries for much longer and so regulators can focus on price transparency and fairness for the end user rather than a framework for developing the market.

• Financial levers – Most of the comparator countries have adopted a range of financial levers. Many have applied a similar approach to Scotland, including the continued use of capital grant funding, project development funding or individual grants for expanding and upgrading heat networks. Grant funding is still widely used in the less mature sectors. As the sector matures, intervention rates reduce or there is greater requirement for a higher degree of renewable heat sources to be used. Additionally, state-owned infrastructure banks have been investing in the sector to help refurbishments or provide debt financing for expansion.

Utility sectors

Various regulatory regimes and financial support mechanisms have been used in other sectors to stimulate private sector investment in the development of new infrastructure. The Scottish Government must consider the costs and practical challenges of pursuing financial support mechanism models that are not being adopted in England and Wales:

• Contracts for Difference (CfDs) have proved very successful in securing the necessary investment in a wide range of renewable energy technologies. This approach could provide revenue support to heat networks to incentivise the transition to more sustainable forms of heat generation. In particular, CfDs could support heat networks that use decarbonised heat sources (e.g. heat pumps), which are likely to have a higher cost than conventional gas boilers or heat networks using waste heat. Therefore, as well as providing revenue certainty, a CfD has the potential to subsidise the increased cost of decarbonised heat for end users.
• A Regulated Asset Base (RAB) model, alongside periodic price reviews, can protect consumer prices whilst also encouraging ongoing capital investment, supporting asset maintenance and providing predictable revenue streams. The model would, however, involve significant administrative and resource cost. Prior to the sector maturing, a RAB model might not result in financially viable heat networks without additional capital or revenue support.
• The Renewable Heat Incentive (RHI) model is a well understood revenue support mechanism previously used in the energy sector. Similar to CfDs, an RHI model would subsidise the cost of heat for consumers if it was based on the amount of heat generated (as opposed to consumption of heat). It would therefore contribute to the cost of deployment, helping to address the increased cost of installing this technology and at the same time, mitigating demand risk. A cap on payments could also be introduced to avoid over-incentivisation. However, the value for money of previous schemes has been questioned.

Market feedback

The private sector views heat networks as an attractive investment opportunity but there are areas of uncertainty that must be resolved, including the need for greater clarity on the development of future regulation. To facilitate private investment, stakeholders highlighted the need for continued grant funding support to de-risk project cashflows. They also emphasised the importance of clear regulation on key topics, including heat zoning, mandatory connection policies, planning and building regulations, as well as a definitive policy direction on phasing out gas boilers.

Recommendations

We recommend that the Scottish Government:

1. Maintains capital funding support for the sector, either via existing programmes, or new bespoke capital schemes. Explore opportunities for extending the timescales for drawing down grant funding.

2. De-risking future revenues is key to unlocking heat network development – private capital is available for projects, but they need to be financeable. More detailed analysis of a revenue support model, such as CfD or a RHI equivalent, is merited. However, the Scottish Government must address the challenges of establishing such schemes, including the significant administrative and resource implications of previous schemes.

3. Explores the benefits of implementing a RAB model, following further regulatory developments and the creation of an established asset base (over 10-15 years). However, consider the complexity and feasibility of this model.

4. Continues to work closely with the Scottish National Investment Bank (SNIB) and the UK National Wealth Fund to explore investment opportunities, create a shared understanding of each party’s objectives and ultimately unlock the capital that has been made available to invest. Both organisations are committed to investing into the sector.

5. Maintains and increases support for pre-construction projects, via the Heat Network Support Unit (HNSU) and specific development funding programmes.

6. Monitors the implementation of the UK Government’s zoning approach and, where appropriate, leverage best practice from the Department for Energy Security and Net Zero (DESNZ). This should be used to complement Scotland’s existing zoning approach.

7. Reviews its approach to regulation to help reduce regulatory uncertainty. Where appropriate, this should include leveraging best practice from England and Wales.

8. Continues to work with the UK Government on rebalancing electricity and gas prices. However, this will not eliminate the price difference between electricity and gas.

9. Develops a national Heat Network Strategy setting out a clear long-term vision for heat networks in Scotland.

Glossary / Abbreviations table

Introduction

Research aims

This report examines the heat network sector (also referred to as “the sector”) and will contribute to the Scottish Government’s ambition to accelerate the pace and scale of heat network rollout in Scotland. The report:

• Summarises current financing models, structures, and barriers in the sector and establishes a baseline for the Scottish heat network landscape
• Draws comparisons and insights from relevant utility sectors
• Draws comparisons with international heat networks and their financing models
• Provides insight into how heat networks are currently viewed by the private and public sector
• Recommends suitable financial levers, models and policies for the sector

“Heat Network” definition

The definition of a “heat network” in the Heat Networks (Scotland) Act 2021 (HNSA) covers both district heat networks and communal heat networks. A district heat network distributes heat from one or more sources to more than one building. In a communal heating system heat is supplied to one building comprised of more than one building unit (for example, a block of flats).^[1]

The majority of the findings in this report refer to district heat networks, but we have included both communal heating and district heating in our definition of a heat network.

Heat networks can be powered by a range of different technologies. Historically, heat networks have often utilised fossil fuels, including gas boilers. As a result, many legacy networks still rely on fossil fuel-based technology. Our analysis considers these legacy networks; however, we recognise that the Scottish Government is committed to supporting the roll out of clean heat networks and supporting the reduction in emissions from the sector. This is important context for the conclusions in this report.

Methodology

Our findings are based on extensive desk-based research conducted by sector specialists. The analysis also draws on insights from a series of interviews with sector stakeholders, including operators, funders, advisors and public sector representatives. This information has been used, together with our own sector experience and evidence from existing literature, to set out the existing baseline position in Scotland (and the rest of the UK) and to develop our recommendations for suitable financial levers, models and structures for the heat network sector in Scotland. Finally, the stakeholder feedback also informed our approach for drawing comparisons with other utility sectors and international comparators.

Our stakeholder engagement methodology and questions were agreed with CXC and the Scottish Government Steering Group. The engagement exercise consisted of 20 meetings and Microsoft Teams calls. In advance of the sessions, participants were issued with the questions and given the opportunity to share feedback either in writing or verbally.

Policy Context

Scotland’s ambitious climate change targets are to achieve net zero greenhouse gas emissions by 2045. To deliver this, Scotland must instigate a step change in decarbonising the heating of its homes and buildings. Domestic buildings account for 15% of Scotland’s total greenhouse gas emissions and around 27% of its total energy consumption^[2]. The scale of this decarbonisation challenge is significant – Figure 2 shows that in 2022, over 72% of Scotland’s homes relied on mains gas as their primary heating fuel^[3].

Figure 2: Breakdown of primary heating fuel vs number of homes

The Scottish Government’s 2021 Heat in Building Strategy identified clean heat networks as a key strategic technology which is tried and tested and can be scaled up.

The Heat Networks (Scotland) Act 2021 established statutory targets for heat supplied by heat networks, requiring that they supply 2.6 Terawatt hours (TWh) of output by 2027, 6 TWh by 2030 and 7 TWh by 2035. In 2022, the Scottish Government estimated that heat networks supplied 1.35TWh of output^[4]. To meet Scotland’s ambitious statutory targets, a significant acceleration in deployment is necessary.

Source: Scottish House Condition Survey 2022

The public sector plays an active role in the sector’s development, both at the national and local level. Local Heat and Energy Efficiency Strategies (LHEES) are local authority-led plans to decarbonise heat and improve energy efficiency, including rolling out heat networks in suitable locations. Momentum is building, with Scottish local authorities publishing their LHEES strategies, which include establishing the role of heat networks as a key decarbonisation measure.

The capital investment required to transform Scotland’s buildings (between now and 2045) is expected to be in the region of £33bn^[5]. Given the size of this investment and the limited nature of public sector budgets, significant levels of finance will need to come from the private sector.

Current financing structures and models in Scotland’s heat networks

Scotland’s heat network sector

Heat networks distribute heat from a central source, avoiding the need for individual heating systems (such as gas boilers). There are over 1,090 known heat networks (the majority being communal heat networks) supplying heating and cooling to domestic and non-domestic properties^[6]; however, most of the larger networks with significant heat loads are in Scotland’s larger towns and cities. Although recent projects have introduced clean heat sources, the sector still relies on mains gas as its primary heat source^[7].

Figure 3: Heat networks in Scotland

The number of heat networks, both district and communal, is increasing across Scotland. Figure 3 illustrates the distribution of heat networks in Scotland, but the sector is still immature, especially compared to counterparts in Europe, where heat networks have played a central role in heat infrastructure since the 1940s.

Sector growth has been slow, and in recent years, the focus has been on a series of “demonstrator” projects, across a range of sizes and driven by early adopters in both the private and public sectors.

Source: Map – Heat Network Support Unit

Scottish and UK regulatory landscape

There is an emerging focus on the regulation of heat networks within Scotland and the rest of the UK. For the first time in the UK the sector is set to become regulated, like many other utility sectors. Given the decarbonisation requirement and recognising the growing importance and potential of heat networks, the Heat Networks (Scotland) Act 2021 (HNSA) created a regulatory framework for the sector in Scotland.

The regulation of consumer protection (including for heat networks) is reserved to the UK Government. In 2024, the UK Government and Ofgem jointly consulted on regulations to establish an authorisation system to protect heat network consumers under the Energy Act 2023. Ofgem will be the future regulator of that consumer protection regime across England, Scotland and Wales. Ofgem’s will also be responsible for heat network licences and authorisations in Scotland, as set out in the HNSA.

The HNSA includes a series of measures to support the sector and promote growth. These are summarised in table 1 below, alongside the relevant UK position. The UK Government has proposed a regulatory regime but has yet to introduce secondary legislation. For those measures not in force in Scotland, these will also be introduced by the secondary legislation.

Table 1: Scottish and UK regulatory landscape

The HNSA and the new UK Energy Act both aim to introduce legislation that has the potential to align the regulatory landscape across the UK. However, our stakeholder engagement process found that significant regulatory uncertainty currently exists, including the diverging timetable for introducing legislation and the lack of clarity regarding the differences in proposals between Scotland, England and Wales. Without further developments on specific regulatory areas, such as permitting/zoning, this uncertainty will remain. We also acknowledge that there is a complex regulatory landscape, with input required from both the Scottish and UK Governments to clarify the balance between devolved and reserved powers. These observations are further developed in section 4.4.

The HNSA has created an opportunity for Scotland to benefit from a robust regulatory framework that builds trust for consumers and creates certainty for operators. In order to stimulate sector growth, the market requires further clarity on the ongoing process to regulate the sector and more detailed information regarding the introduction of secondary legislation. This should provide clarity regarding investment opportunities, reduce the complexity of the dual regulatory frameworks and make Scotland a more attractive investment proposition.

The sector is also impacted by other Scottish regulation, including the New Build Heat Standard, which requires new homes and buildings to install clean heating systems, rather than relying on mains gas. Additionally, the National Planning Framework 4 includes policies which states that development proposals (within or adjacent to a heat network zone) will only be supported if they connect to an existing heat network.

Existing financing models in the sector

In Scotland and across the UK, the sector has typically been funded by early-stage financing from developers and significant levels of subsidy from the public sector. The Scottish Government has supported clean heat networks through:

• Grant support (also in the form of repayable assistance), including:
  • Scotland’s Heat Network Fund (SHNF) – The SHNF offers capital grant funding to support the roll out of new clean heat networks and communal heating systems, as well as the expansion and decarbonisation of existing heat networks across Scotland.
  • Low Carbon Infrastructure Transition Programme (LCITP) – From 2015 until it was replaced by the SHNF in 2022, LCITP provided grant funding support to several heat networks, including Queens Quay and Torry heat network.
  • Both programmes also provided project development and commercialisation support.
• Loans via the District Heating Loan Fund (DHLF) – Managed by the Energy Savings Trust, the fund provided capital loan funding to support low emission small scale district heating in Scotland until it closed in April 2024.
• Non-domestic rates reliefs – since April 2024 heat networks (where 80% of the thermal energy in any given year is generated from renewable sources) have been eligible for a 90% rates relief.^[9] There is also a 50% rates relief if a premises is wholly or mainly being used for a district heating network.^[10]
• Many demonstrator projects also benefitted from historical UK Government revenue support through the Renewable Heat Incentive (RHI), now closed to new applicants.

These public subsidies have encouraged private investment in the sector and supported the roll out of clean heat networks across Scotland. Many clean heat demonstrator projects have been self-funded by operators (or funded through bespoke delivery vehicles). However, grant funding is required to bridge funding gaps and enable projects to achieve the internal rate of return – often referred to as a hurdle rate – required by operators. This is more important for clean heat networks than for fossil fuel-based systems, where the requirement for public subsidy is less pressing given the lower capital costs.

The hurdle rate is different for each operator and project. It is impacted by an operator’s cost of capital and project specific risks, but our analysis indicates that, at the time of this report, it tends to range between 8% and 12% (although this range will be impacted by several external factors and will vary on a project-by-project basis). This is explored further in section 0.

Grant support is among several financial mechanisms (or “financial levers”) which the Scottish Government has historically used. Such support could continue to de-risk heat network projects and help incentivise private sector investment. Figure 4 highlights some of the key mechanisms used to date and others which are considered further in this report. A summary of each mechanism can be found in Appendix B.

Figure 4: Funding levers the Scottish Government could deploy to attract private investment

In order to understand how a step change in private investment might be instigated, it is important to highlight the key factors which drive investor confidence, namely:

• Certainty of demand
• Revenue stability
• A stable regulatory environment
• A clear understanding of project risks with shared ownership and mitigation strategies

These factors and wider deployment barriers are explored in the following section.

Heat network deployment barriers

Overview

The analysis contained in this section includes feedback from our stakeholder interview exercise, as well as our own professional observations. While many of these barriers are well understood in the market, key stakeholders confirmed that they continue to present significant live obstacles for private sector operators and investors, limiting their investment appetite and restricting the roll out of heat networks at scale in Scotland. Following stakeholder feedback, we have grouped these barriers (shown in figure 5) into four categories:

• Financial
• Regulatory and policy
• Technical
• Social and market barriers

Figure 5: Heat network deployment barriers

Within these categories, we present the barriers in order of importance (based on the strength of stakeholder feedback). It is important to note that whilst our report is primarily focussed on financial barriers and the private sector, many of these non-financial barriers add further uncertainty and therefore need to be taken into consideration. All these barriers – financial and non-financial – must be addressed in order to instigate a step change in private investment.

Financial barriers

Heat networks involve significant levels of financial risk and uncertainty, making it extremely challenging to forecast a project’s cashflows, thereby deterring private investment. These financial risks are highlighted below:

Demand uncertainty

Demand uncertainty is the biggest factor inhibiting private sector investment. For a heat network to be financially and commercially viable, it should generate a minimum level of committed revenue in order to meet the operating costs of the network and contribute to the repayment of the initial capital investment. This can be challenging if it is unclear when and how many buildings will connect to the network, their heat offtake requirements and the resulting revenue that will be generated.

For many Scottish “demonstrator” projects, demand and revenue risk have been reduced by securing anchor loads via public sector buildings, which require large heat offtake requirements and therefore to provide some revenue certainty. Developers and investors prioritise the de-risking of revenue flows as it provides greater certainty in a project’s ability to service the repayment of any debt or shareholder loans and/or equity return. As a result, securing longer term supply agreements with customers is a critical step in securing additional investment.

Operators stated that investment decisions are not speculative – the extent of committed revenue and certainty of connections are critical considerations to a potential developer and/or investor. To date, projects have typically been funded using balance sheet finance of the project sponsors (corporate finance) in the form of shareholder loans and equity, rather than more conventional third-party debt finance in the form of limited or non-recourse debt finance. When a heat network project reaches critical mass with mature connections and revenues, this provides an opportunity to refinance and secure more competitive finance terms due to reduced lending risk.

Long development and construction times

Many heat network projects have significant development and construction timescales, which present barriers to funders. In some cases, projects can take two or more years to develop and several more years to construct. This results in significant development and commercialisation costs, requiring high levels of upfront finance.

Historically, as a means of mitigating these development costs, the public sector offered support through the Heat Network Support Unit (HNSU) and specific grant funding programmes. However, stakeholders identified a misalignment between the grant funding drawdown profile (the existing grant funding programmes have shorter funding windows, typically four years) and the long construction cost profile (upwards of 5-7 years). This means that operators have had to condense the delivery programmes to meet the grant drawdown deadline or seek additional sources of financing.

High capital costs

Heat networks require significant levels of capital investment. Several recent Scottish heat network projects have had capital cost estimates of between £10m and £50m^[11]. This barrier is exacerbated in times of high inflation and cost uncertainty. The high levels of capital investment are commensurate with other utilities such as water, gas and electricity. All require significant investment in underlying infrastructure prior to connection with residential, commercial and public sector buildings.

Large capital projects are often regarded as higher risk and therefore more challenging to finance. Due to cash flow uncertainties, this sector has historically relied on significant levels of grant funding. Public support (including Scottish Government programmes such as LCITP and SHNF) has been essential for improving private sector returns and sharing the risk of the high capital costs. When this support is unavailable, operators mitigate this risk in other ways, for example, by seeking increased connection fees for end users.

Diverse delivery models and procurement approaches

The lack of standardisation in procurement approaches and delivery models adds complexity, time and cost to a project’s development timeline. Projects develop bespoke approaches that are not necessarily repeatable for new projects. This inhibits the market’s ability to understand the investment landscape and reduces confidence. Investors are far more likely to pursue projects where there are standard procurement approaches and tried and tested delivery models, where the risks are understood.

The availability and access to financing

Debt lenders have been reluctant to invest in the sector due to the risks noted above. Current stakeholder feedback confirms that this remains the case. Typically, large infrastructure projects would look to include both equity and debt to optimise financing costs and spread the risk on investment. However, heat network projects typically struggle to demonstrate that they will have sufficient free cashflows to service the cost of debt. As such, debt lenders will seek to invest their funds in alternative sectors where they have more confidence in the cashflows. If these other sources of financing cannot be brought into the sector, the ability to roll out new projects at scale will be limited.

Regulatory and fiscal challenges

Although the financial barriers are significant, they must be considered alongside regulatory and fiscal challenges. These have created uncertainty in the market and have negatively impacted the private sector’s investment appetite. Stakeholder feedback highlighted the importance of these areas in unlocking Scotland’s heat network ambitions. However, as we discuss below, the Scottish Government does not have the ability to resolve all these issues.

Regulatory uncertainty

The Heat Networks (Scotland) Act in 2021 introduced powers to regulate the Scottish heat networks market for the first time. The Energy Act 2023 was passed by the UK Parliament in October 2023. Differences in implementation, content and timing of regulation between Scotland and the rest of the UK are negatively impacting investor sentiment and creating uncertainty. Developers and funders are also looking for clarity on the future GB-wide consumer protections and technical and service specifications for operators.

Without further clarity on the future secondary legislation in Scotland, operators stated they are more likely to focus resources outside Scotland – for example, in other UK areas – where there is more demand for larger urban heat network opportunities.

This uncertainty also extends to other relevant policy areas, such as the phasing out of domestic gas boilers, which presents barriers to operators. The Scottish Government has introduced the New Build Heat Standard, which states that by 2045, all homes in Scotland will need to have converted to a clean heating system. Across the rest of the UK, there is political uncertainty about this phase out. No equivalent legislation is currently in place, meaning heat networks operators are unclear when customers will be required to adopt low emission heating solutions.

Structural pricing considerations

Reducing the gap between the price of electricity and the price of gas may help support the rollout of low carbon heat networks. Under the current domestic^[12] electricity pricing model, electrified low carbon heating solutions are unlikely to offer cost savings to consumers when compared against traditional gas boilers.

Historically, electricity has been more expensive than gas, partly due to the greater proportion of environmental and social obligation costs (green levies) placed on electricity (23%) compared to gas (2%), as shown by the figure 6 below.

Figure 6: Breakdown of domestic electricity and gas bill

The UK Government is currently consulting on the “Review of Electricity market arrangements” (REMA), which includes proposals for reducing electricity costs for consumers. Removing these levies from existing energy tariff structures would reduce the running costs of electrified heating solutions and encourage the uptake of low carbon heating.^[13] However, there are many complexities involved in this change and the impact of rebalancing these costs must be understood further before it can be proven to be an effective mechanism for reducing electricity costs.

In addition to the impact of the levies, electricity prices (and gas prices) also include significant distribution and transmission charges (network costs). Electricity bills could be reduced by permitting heat networks connected to the electricity grid to pay lower network charges (recognising their ability to use electricity at times of low demand).

Regardless of these potential mechanisms, relatively low gas prices will continue to disincentivise the rollout of low emission heat networks, as they make any change to an alternative heat source appear more expensive. This is proving to be a significant barrier in the private sector.

Technical challenges

Operators and funders pointed to several heat network-related technical barriers which create further uncertainty and investor reluctance. The high-level technical challenges noted below are not an exhaustive list but rather provide important context for the rest of this report.

The need for density

In high density urban areas where there are large levels of heat demand, heat networks often provide the lowest cost low carbon heating option. The alternative is for properties to use individual air source heat pumps (ASHPs), which would place greater electricity demands on the grid and may result in higher customer costs and increased operational costs. Scotland has several areas where there is significant scale and suitable density levels for heat networks. However, operators noted that there are a greater number of large urban areas with multiple opportunities in England. This naturally provides significant competition for investment that might otherwise be made in the Scottish locations, especially for operators (operating both in England and Scotland) exploring opportunities across the UK. Additionally, smaller scale communal heating solutions may be appropriate for lower density areas; however, we do not explore this in detail as it is outside the scope of the report.

Technical complexity

Many of the existing heat network projects utilise different heat sources and technological solutions, including things as basic as pipework sizing. As projects increase in size, this lack of standardisation can present challenges for heat networks integrating and/or scaling up.

Decarbonisation challenges

Historically, many heat networks across the UK (and internationally) have been powered by carbon-based heat sources. However, operators consistently noted that customers now expect heat networks to use low emission heat sources. Low carbon technology is typically more expensive, and technologically complex than legacy carbon-based fuel sources and this therefore represents an additional factor impacting the commerciality of new projects.

Social and market challenges

The sector also experiences wider challenges in the development of the market for heat networks.

Consumer experience and scepticism

Operators and funders highlighted recurring customer concerns, including security of supply, pricing and consumer protection, that provide challenges to operators attracting potential domestic consumers to their heat networks.^[14] Additionally, countries with a long history of operating heat networks, have an established culture of valuing and trusting the technology meaning consumers better understand the benefits. These factors have supported the development of international heat networks and have resulted in reduced levels of negative consumer experience and scepticism.

Lack of standardised commercial models

The lack of a standard delivery and operating model for heat networks results in developers and public sector partners (e.g. local authorities) having to invest significant time and resources developing proposals for their projects. This is explained further in section 4.5. This additional time and complexity increase development timescales.

Supply chain – the sector has a limited number of heat network developers

There are a limited number of private sector operators in Scotland, which in turn have a limited supply chain. The current developer landscape includes a number of balance sheet backed developers (SSE, EON, Vattenfall) and some infrastructure fund backed developers (Hemiko, 1Energy and Bring Energy).

This places a high dependency on a very small number of corporates relative to the scale of the heat network opportunities in the wider UK. Additionally, local authorities have a significant role to play in developing networks but they have limited in-house capacity and resource and therefore, rely on a small number of financial, technical and legal advisors.

Heat network delivery models – summary/overview

To address some of the barriers restricting the roll out of heat networks at scale, the Scottish Government is exploring a range of levers, including financial, technical and regulatory, and considering the optimum delivery models to support the sector. Although this report does not undertake a detailed assessment of these models, our overview provides context for the financial levers explored further in this report.

In 2022, the Scottish Government commissioned the Scottish Futures Trust (SFT) to undertake analysis on potential delivery models that could accelerate the pace and scale of heat network deployment in Scotland. The subsequent Heat Networks Delivery Models (HNDM) report, published in February 2024, identified four models that warranted further detailed development and consideration, namely:

• Regional Heat Partnership / Regional Energy Services Company (RESCo) model
• Local authority-led joint venture
• Local authority-led delivery, with Scottish Government stake
• Centrally-led delivery

Following the HNDM report’s publication, Scottish Government has collaborated with SFT to further develop the Regional Heat Partnership and Centrally-led models.

Overview of international experience

The Scottish Government can draw insight from comparable European and other international markets. It can be particularly helpful to consider how these sectors are developed, financed and regulated. To develop this insight, we have reviewed approaches in countries with high levels of market maturity, as well as those with characteristics similar to Scotland’s.

Our analysis is primarily based on five international examples, referred to in this section as the “comparator countries”. As shown in Figure 7, these are the Netherlands, Germany, Finland, Sweden and Estonia. During our shortlisting process, we considered jurisdictions such as the USA, Canada, Belgium, Ireland, Latvia and Poland, but found a lack of relevant data from which meaningful conclusions could be drawn. Our analysis will refer to these other countries where relevant.

Source: EY Analysis

Denmark has a mature and successful heat network sector and is often considered a valuable source of insight for Scotland. It is deliberately excluded from our analysis as the Scottish Government has a detailed understanding of the factors that have contributed to its success. These factors include cultural acceptance of heat networks and high consumer trust. Additionally, it has established regulatory levers such as mandatory connections.

This section provides an overview of:

• The history of comparator countries’ heat networks with a brief market overview
• The availability and impact of public financing levers
• The regulatory structures
• The market ownership profile and level of private finance penetration
• The financial composition of heat network assets

0B provides supplementary information for each international example.

History of international heat networks and market overview

Figure 8 summarises the maturity of each country’s heat network sector, based on the definitions developed by Department for Energy Security and Net Zero (DESNZ)^[15]:

• Emerging – the market is still a nascent sector with lots of growth opportunity
• Expanding – the sector is established but is continually growing
• Consolidating – the market is mature and technology is being refined, updated or refreshed
• Refurbishing – the market is very mature and heat network technology is on the n^th generation, but the networks are aged and require significant replacement and/or refurbishment

The comparator countries have a range of heat network maturity levels, with Finland and Sweden widely acknowledged as having mature and well-established sectors, while the Netherlands has an emerging heat network sector with many similar characteristics as Scotland.

DESNZ classified the UK and therefore by implication, both Scotland and the rest of the UK as emerging markets. 0B provides a brief historical overview of each international comparator.

Figure 8: Maturity of international heat networks

Source: DESNZ (BEIS) “International review of heat network frameworks” (2020)

Key findings

The Nordic countries (Sweden and Finland) and Estonia are in the “consolidating” and “refurbishing” categories. In each country, the sectors are mature and the technology is tried, tested and trusted.

Overall, the Nordics have been leaders in district heat networks since the 1940s. The 1970s oil crisis stimulated a transition to alternative fuel sources and acted as a catalyst for rapid expansion in the sector. This early adoption is a significant factor driving the higher degrees of maturity in their district heating networks. Familiarity of the technology has supported the cultural acceptance. By 2015, 46% of Sweden’s heat networks were supplied by biomass and only 7% utilised oil or gas^[16].

Heat networks are common in Germany, with the first pilot system having gone live in the 1950s. The sector has grown over the last decade with significant numbers of large-scale heat networks. Therefore, the market has surpassed the initial emerging phase of high growth but strives to continually expand toward becoming a mature market.

Germany is in the expanding category. Compared to Scotland, Germany has been using heat networks for much longer and the initial rapid growth phase has taken place. There is now a focus on continuing to add connections to existing networks.

Although the Netherlands implemented its first heat networks in a comparable time frame to Germany (Utrecht in 1923, followed by Rotterdam in 1949) this early adoption was not built upon, and no new networks were constructed in the 1950s and 1960s. However, there has been a moderate uptake of district heating schemes since the late 1980s.^[17] The market is therefore relatively small but undergoing rapid change driven by a political commitment to decarbonise heat and reduce emissions from buildings. Therefore, there are strong similarities between Scotland and the Netherlands both in heat network market size and nascency and the Government’s ambition to decarbonise heat in buildings using district heating.

The scale of heat networks in most of the comparator countries differs significantly from Scotland. Figure 9 illustrates the cumulative length of heat networks in kilometres in each country^[17]. While country size plays a role, Germany has nearly 35,000km of heat network infrastructure, whilst Estonia, although highly developed, is limited by its comparatively smaller size. Notwithstanding that, Scotland’s relative position to the comparator countries is clear.

Figure 9: Cumulative kilometres of heat networks

Source: EY analysis

Across Europe, the maturity of the sector varies, with countries such as Sweden, Finland and Estonia building on the successful implementation of decades worth of investment in the sector. The sector is still emerging in Scotland, like the Netherlands, where it does not demonstrate many of the characteristics of the more mature countries, such as cultural acceptance of heat networks and scale in the market. This provides important context for the following section reflecting on the appropriateness and availability of financial levers.

Impact of public financing levers

Public financing levers significantly influence the implementation and expansion of heat networks internationally. Financial levers serve as catalysts for innovation, growth and the adoption of low carbon technologies.

Table 2 provides an overview of the financial mechanisms that aid the development and expansion of heat networks. The levers include capital grants, tax exemptions and incentives, revenue grants, individual connection grants and decarbonisation incentives (for example, grant funding for decarbonised technology). Each country is discussed further in Appendix B.

Table 2: Summary of public financial levers used by international comparators

Source: EY Analysis

In addition to the financial levers shown above, most comparator countries also benefit from a state-owned infrastructure bank investing in their district heating sector. State-owned infrastructure banks operate on similar terms to commercial lenders but may have the ability to adopt an increased risk appetite. This enables them to support heat networks in circumstances where commercial banks cannot. Additionally, EU member states benefit from access to EU funding where there are no bespoke heat network funding pots.

Recent investments reflect a growing appetite to engage across different markets with varying levels of maturity. For example, banks like the Nordic Investment Bank (NIB) provide investment support to help refurbish existing heat network assets across the Nordics and Baltics, while Germany’s infrastructure bank (KfW) is providing grants to help continue the transition to a more mature market in Germany.

Stakeholder engagement confirmed that both Scottish National Investment Bank (SNIB) and National Wealth Fund (NWF) have ample capital to deploy. The issue was reported to be a lack of investible projects.

0 provides a summary of state-owned infrastructure banks and relevant examples across the chosen countries.

Key findings

As illustrated by Error! Reference source not found., most of the comparator countries have adopted a range of financial levers. Many have applied a similar approach to Scotland, including the continued use of capital grant funding, project development funding or individual grants for expanding and upgrading heat networks.

Grant funding is a common financing lever, especially for the countries who are growing their heat network sectors. For example, in 2022 Germany introduced a €3bn fund to support the development and construction costs of new decarbonised heat networks (where 75% of the heat is sourced from decarbonised heat sources)^[18]. This provides grant funding up to 40% of the eligible capital costs. The fund also provides feasibility support to projects. Additionally, the Netherlands is using a €400m fund to support the capital costs of new heat networks. The analysis shows that capital grant funding continues to be popular as an effective funding lever available before the sector reaches maturity. Regarding the UK market, there is continued funding from the Green Heat Network Fund (GHNF), with £288m initially made available and an additional £485m allocated in December 2023. The GHNF is expected to run until 2028, however operators expect that this will continue past 2028.

Another common lever in more mature countries is using individual grants or connection grants to incentivise connection to heat networks. For example, KfW helps deliver anchor loads to networks by offering increased grant support to local authorities for the connection of public sector buildings. Examples of individual incentives include the Estonian Business and Innovation Agency grant, which offers up to €10,000 for small residential buildings to connect to existing networks.

Estonia also offers a phased compensation scheme for the use of heat networks versus existing carbon-based alternatives. The Estonian Government provided compensation of 80% of the additional costs faced by heat network users because of increased energy prices.

Finland is developing a tax credit scheme which projects will be able to benefit from after they become operationally profitable. This has the aim of making project cashflows more appealing to investors, helping increase early returns by reducing the tax expense.

It is clear that many countries are promoting the use of grant funding to varying degrees. Significant levels of support are provided in jurisdictions with less mature sectors, while more mature countries use and develop other forms of support. The use of grant funding in Scotland and the rest of the UK is well established. Similarly, the Netherlands with its less mature sector also provides significant grant funding programmes. In Germany (an expanding country), grant funding continues to be a well utilised financial lever but intervention rates have decreased from predecessor programmes. Additionally, there is a requirement for a much larger proportion of the heat to be from renewable sources. The example of other emerging countries in Europe indicates that the market in Scotland will continue to rely on grant funding, even if the intervention levels decrease (like Germany) or grant funding is targeted at specific areas of sectors.

Regulatory structures

Our international comparator countries employ a range of regulatory structures (regarding operation, pricing and decarbonisation requirements) and national oversight. These range from self-governing municipality frameworks with a limited role for national regulators to nationwide regulatory frameworks governing the entire heat networks market. Whilst regulatory landscapes differ, the varying regimes offer interesting lessons for heat networks in Scotland.

Table 3 provides an overview of the international regulatory landscape and each country’s approach to mandatory connections. Detailed findings for these countries are shown in 0.

Table 3: Overview of international regulatory landscape

*DESNZ is currently shaping its policy approach to mandatory connections. It is expected mandatory connections will be enforced on certain buildings in defined zones to be connected to heat networks by a given deadline^[19]. However, details are yet to be fully confirmed.

Key Findings

Across our comparator countries, many of the developed and mature markets (e.g. Finland and Germany) are unregulated. The heat networks have a self-governing framework and abide by technical codes and industry standards but no third-party regulatory oversight. Municipalities have their own governance procedures; they are self-governing with greater pricing transparency, consistent contractual delivery and contractual routes. The evidence suggests that these countries focus on consumer pricing and that introducing standardisation supports investment and stimulates the sector’s development.

Mandatory connection to heat networks is used in some of the comparator countries, establishing base heat loads and reducing demand uncertainty. Mandatory connections are primarily applied to new developments, but barriers exist to using them in the retrofit market. For example, in relation to timing of connection for retrofits: where buildings may have recently installed new carbon-based technologies, connection to a heat network may not be considered for many years until their heat source needs replaced. Finland decided to repeal mandatory requirement having concluded they could be deemed anti-competitive given other decarbonised heating options are also used successfully.

Clear government policies on decarbonisation and the phasing out of carbon-based fuels are evident among the comparator countries. Germany’s Building and Energy Act 2020 requires municipalities to have heating (including heat networks) powered by 65% renewable energy from January 2024 onward and to phase out existing oil and gas heating systems. The German Government is incentivising the transition via KfW and offering bonus support for an accelerated switch to heat networks or other renewable sources. Similarly, the Netherlands has banned new developments from connecting to the gas grid from 2028 via amendments to Gas Act 2018.

Market ownership profile and private finance penetration

Our comparator countries also tend to have different ownership structures, with ownership split between the public and private sector in different ways.

Figure 10 below shows the current profile of heat network ownership across each country, with Finland’s ownership largely public, the Netherlands and Estonia mostly private, and rUK, Germany and Sweden demonstrating mixed ownership structures.

Figure 10: Asset ownership profile

Key findings

Ownership profiles differ across the selected comparator countries with several observable themes. For some comparator countries, there is a high proportion of private sector finance. For example, in the Netherlands more than 90% of heat networks are managed by the private sector. This has helped to scale up investment. Established heat networks offer attractive, stable investments to institutional investors looking for long term consistent returns – as evidenced by Dutch pension institution PGGM investing in Swedish networks.

In other countries, including Finland, public sector ownership in the sector is at a high level. However, they are still seeking investment from the private sector to support established municipally owned heat networks, where budget restrictions limit upgrades and refurbishments. This ownership profile provides an interesting reference point for Scotland, as it allows the sector to benefit from additional investment.

The analysis shows significant levels of public ownership in many of the mature and maturing countries. In Germany, for example, Berlin’s municipality acquired the Berlin heat network for €1.4bn from Vattenfall. This demonstrated a commitment to re-municipalising infrastructure and reversing privatisations to gain more influence over the city’s district heating and gas supply. The municipality believes the Berlin network to be profitable and that it will play a significant role in moving toward climate neutrality.

In the Netherlands, the high levels of private sector ownership have resulted in the Dutch government proposing legislation in 2022 to part-nationalise the sector. Municipalities will have the opportunity to own up to 51% of networks, thereby bringing market ownership into the public sector. The proposal is designed to mitigate concerns regarding the affordability of heat for end users, the reliability of the services and the need to safeguard public sector climate change ambitions and public values. However, this initiative has led to significant concerns from several operators who feel that it will lead to a significant downturn in private sector investment^[20]. During our stakeholder interviews, one European operator warned that this move will make the Netherlands “uninvestable”.

Overall, more mature markets tend to have a greater level of private finance penetration due to reduced risks and more stable operations. However, public sector ownership still allows local government to maintain more control regarding price and climate targets. Operators in the Netherlands indicated that the introduction of legislation to restrict private sector investment (and therefore control over the heat networks) can have a significant negative impact on the market and reduce investment security in the private sector. Under the new Dutch model, the incentives for private companies to invest in public projects are small and short term, as the private sector will lose control of the decision making while retaining significant levels of financial risk. Scotland should consider the impact that future regulatory changes may have on private sector investment appetite while balancing this with its broader objectives of reducing fuel poverty and supporting clean heat networks.

Financial composition of heat networks

The upfront capital expenditure expected revenue receipts and cash flow for other asset classes can be estimated with enough certainty to attract debt financing. In contrast, heat networks under development tend to have multiple expansion options and uncertainty around which end users will connect and when. This means costs or revenue inflows are not certain enough to allow a traditional project finance approach.

Rabobank, a Dutch multinational bank, highlighted that district heating companies self-financing their heating grids is a common approach in developing markets like the Netherlands. Their balance sheets typically include a mixture of debt and equity. Additionally, they also identify that traditional project financing is much harder to implement as it requires a significant portion of a project’s cashflows to be secured (by having contracted demand), which is an inherent problem for heat networks.

Rabobank also stated that whilst large credit worthy companies may be able to raise finance to fund heat networks and reduce their equity component of a project, smaller less bankable heat network developments may require government guarantees over any debt to help improve their attractiveness to private sector.^[21]

The stakeholder engagement sessions also reflected the view that corporate balance sheet financing will remain the main source of financing in developing markets in the near-term.

Mature markets like Sweden, Finland and Estonia, benefit from more traditional forms of debt financing because they are well established and understood by lenders. For example, the NIB provided a €12m loan repayable over 10 years to help finance the heat network in Pirkanmaa, Finland.^[22] These mature markets can also access EU financing to reduce dependence on carbon-based fuels. For example, the Finnish energy company Helen Ltd received a €150m loan in April 2024 via REPowerEU^[23] for building a new heat pump plant and converting fuel use from coal to biomass pellets.

Consequently, developing heat networks are often funded purely from equity financing until they reach operational profitability. Only once stable profits are achieved can network operators consider refinancing and attracting debt lenders to expand their networks. Private Equity firms often take an equity stake in a heat network, but the composition of their fund could be a mixture of institutional debt and equity.

Conclusions

Our comparator countries present a mix of maturity levels, various ownership profiles, regulatory structures and financing levers. Those with more developed sectors have a mixed degree of public ownership and the ability to access private finance. They are mainly regulated by standard frameworks within the municipalities with regulators adopting a back seat approach. However, these countries with less regulation have had the technology embedded in their culture for much longer. Therefore, the regulators can focus on price transparency and fairness for the end user rather than a framework for developing the market.

Scotland has the opportunity to overcome the barriers faced by the sector by adopting solutions that have been successful elsewhere, including regulation, clear direction on decarbonisation and financing levers:

• Regulation: Standardised and practical regulatory frameworks help to ensure consistency across the market. They make it simpler for operators to undertake projects by reducing project complexity. Additionally, standardised frameworks and agreements provide greater certainty and transparency regarding control and responsibility of heat network assets. This provides operators with confidence over the assets.
• Decarbonisation: All of the countries on our shortlist are actively moving away from fossil fuel heat networks and incentivising clean heat networks through policy choices. For example, sector development may be encouraged through connection subsidy or a phased ban on carbon-based alternatives. Additionally, mandatory connections provide a baseline for investment cases, making projects investible as demand assurance can be satisfied. Equally, contracted revenues obtained as part of the demand assurance may provide enough certainty to encourage private investment into heat networks.
• Financing levers: Comparator countries have provided financial incentives for connecting to existing heat networks offering further incentives for accelerated uptake. Capital grant support is the most common lever used by international comparators across all market maturities as it can make the investment decision for expansion of heat networks more viable. Similarly, when networks are seeking connections, individuals need to be incentivised to connect. For example, by bridging the gap on cost to their current heat sources, particularly when there are no regulations requiring individuals to connect. Additionally, state-owned infrastructure banks can be used to leverage these solutions as the market develops. For example, if connection fees are mandatory, a connection fee facility could be rolled up into the overall financing solution as there will be enough clarity on contracted revenue cashflows to reduce demand assurance risk.

The key considerations can be summarised as follows:

• simple and standardised frameworks to ensure consistency within the regulations
• clear direction on decarbonisation
• the use of mandatory connections (such as on new developments) to provide certainty
• public financing levers to develop projects and also to incentivise individuals to connect.

Review of financing mechanisms in selected utility sectors

Introduction

The UK utilities sector is a multifaceted industry that provides essential services for the protection and maintenance of modern daily life and commerce. These services include the provision of electricity, gas, water, telecommunications and transport. Each segment and subsector of the utility sector is integral to the economy’s stability, growth and societal well-being. Regulation of such sectors ensures that individuals, and businesses have access to the critical resources they require at a reasonable cost.

Each UK utility sector is governed by a specific regulator responsible for consumer protection (including pricing), safety, reliability and sustainability, ensuring a well-developed network of public services provided under regulatory regimes, as outlined in Appendix C. The primary regulators include:

• The Office of Gas and Electricity Markets (Ofgem)
• The Water Services Regulation Authority (Ofwat) in England and Wales
• The Office of Communications (Ofcom)
• The Office of Rail and Road (ORR)
• The Civil Aviation Authority (CAA)

The global shift towards net zero, with an emphasis on clean heating systems, requires the development of regulatory regimes to incorporate new energy solutions.

Regulatory oversight will remain crucial for balancing the objectives of climate change mitigation with continued access to reliable and affordable utility services. As a result, heat networks are planned to be subject to formal regulation across England, Wales and Scotland by 2024/25 in line with primary legislation introduced as part of the Energy Act 2023 and the Heat Networks (Scotland) Act 2021.

Purpose

This section of the report examines the origins and current characteristics of other regulated utility sectors. We also explore if specific aspects of the regulation of other sectors can inform the regulatory and financial environment, which will help accelerate the development of heat networks in Scotland.

To aid in understanding how potential heat networks regimes may develop, we outline how the sectors have historically been financed and how the regulatory structures have facilitated the deployment of capital.

Methodology

We performed analysis to identify regulated utilities which offer a good comparator to heat networks. This included examining the characteristics of a long list of 39 regulated sectors covering electricity, water, telecommunications, rail and air regulation against the criteria listed in Appendix D. Based upon the preliminary analysis, we progressed 17 utilities for further examination which is discussed in Appendix K.

Further to the completion of the detailed analysis (Appendix K), we determined that offshore wind electricity generation, household water & sewerage undertakers and Carbon Capture, Utilisation and Storage (CCUS) demonstrated relevant attributes for heat networks. The key characteristics of each sector are summarised in Appendix E. This includes risk profile, type of sector the utility operates within and the investment time horizon for each utility.

These three utilities are used to understand how the utility sector is regulated and how investment supports ongoing development. They are also used to explore how heat networks might be regulated and how regulatory approaches impact levels of financing. Each sector is analysed separately below before evaluating how aspects could be applied to heat networks. A summary of regulatory timelines for these sectors is shown in Appendix F.

Offshore wind

Overview

The UK’s offshore wind sector is rapidly expanding and plays a pivotal role in the nation’s transition to renewable energy. Between the UK’s first offshore wind allocation round (AR1 2015) and AR 6 (2024), a total of 21 GW of offshore wind capacity has been supported by Contracts for Difference (CfDs). CfDs are explained in more detail below.

Regulatory Structure

Following the Energy Act 2004, Ofgem has continued to regulate the sector and is adapting its approach as offshore wind projects continue to be deployed, offering new support mechanisms. Ofgem’s regulation of offshore wind is structured around several key elements. It is designed to promote the development of the sector whilst ensuring efficiency, competition and the protection of consumers interests. Regulations cover, licensing, support mechanisms, grid connection, market oversight and consumer protection. Further details can be found at Appendix G.

Ofgem’s remit also extends to the provision of Innovation Funding to support the transition to net-zero energy systems. This includes support to accelerate technological advancements, improve efficiency and reduce costs.

Regulatory Financing Mechanisms

Offshore wind is characterised by large upfront capital expenditure, availability risk (wind variability) and exposure to a competitive and volatile electricity market. All these factors impact the sector’s ability to secure much needed investment. The investment time horizon is around 15 years commensurate with the term of a CfD. Unlike the deployment of heat networks, offshore wind is not exposed to demand risk as it operates on a wholesale basis whereby electricity is exported directly to the national grid.

CfDs provide long-term stable and predictable revenue for offshore wind developers, thus making offshore wind attractive to investors, creating optimised financing structures that can reduce the overall cost of capital. A CfD has the effect of providing a fixed price for each MWh of electricity that the project generates over a specified period (typically 15 years) referred to as the “Strike Price”. The Strike Price typically reflects the price per MWh a developer considers necessary to achieve its applicable return on investment over the period of the CfD. CfDs are awarded through a competitive auction process (Allocation Round) administered by the Department of Energy Security and Net Zero (DESNZ).

The Strike Price is different to the actual market price, known as the “Reference Price”, which is calculated based on the average market price per MWh over a given period. When the Reference Price is lower than the Strike Price, a top up payment of the difference in price is made by the Low Carbon Contracts Company (LCCC) to the offshore generator. Conversely, if the Reference Price is greater than the Strike Price, then the generator must pay the difference to LCCC.

CfDs were originally introduced in 2013 and replaced the Renewable Obligation Certificate (ROC) regime, which was the main support mechanism for renewable energy prior to CfDs. CfDs are an evolution of the support mechanism for renewable energy projects that increases competition and whereby the Strike Price better reflects the underlying levelised cost of the technology.

Household water & sewerage undertakers

Overview

The household water and sewerage sector in the UK provides essential water supply and wastewater services to residential and commercial customers. The sector operates as a natural monopoly and is therefore highly regulated across England and Wales and Scotland.

Regulatory Structure

England and Wales

In England and Wales the sector is regulated by Ofwat. The regulator aims to ensure high-quality services, fair pricing, compliance with environmental standards, and the financial viability of water companies. The regulatory structure has evolved over time to address priorities such as infrastructure investment, customer service improvement and environmental concerns.

Key changes include the introduction of competition to drive efficiency, periodic price reviews by setting price limits and service targets, increased customer engagement, and innovation funding. These changes aim to create a more outcome-based regulatory regime that encourages water companies to be customer-oriented, efficient, and forward-thinking in their operations and investments, ensuring high standards of water quality and environmental stewardship.

Scotland

Scottish Water is regulated by the Water Industry Commission for Scotland (WICS), which ensures value for money and efficiency without a profit motive. This aligns with Scottish Government policies on affordability and public ownership. WICS is governed by the Water Industry (Scotland) Act 2002, as amended by the Water Services etc. (Scotland) Act 2005 and the Water Resources (Scotland) Act 2013.

WICS’ role is to set charge caps, monitor performance, facilitate retail competition for non-household customers, and support the Hydro Nation vision. Price reviews are conducted every six years. Reviews set price limits based on Scottish Water’s business plan, customer input, and factors such as debt service and operational efficiency, with a transition away from the RAB model since 2010.

WICS also sets efficiency targets and, while independent, can be influenced by Scottish Ministers on financial matters, potentially impacting long-term infrastructure maintenance if charges are set too low. Scottish Water receives government loans or grants for large capital projects, reducing reliance on customer charges. However, this funding depends on the impact on the Scottish Government’s balance sheet, requiring careful management for long-term sustainability. Further details on this can be found at Appendix H.

Regulatory Financing Mechanisms

England and Wales

The water and sewerage sector relies on long-term investment provided by the capital markets, typically in the form of shareholder equity and bond finance. Most utilities are highly geared and therefore very sensitive to adverse changes in credit ratings (via Moody’s, S&P and Fitch). Nearly all utilities aim for an investment-grade credit rating to secure optimum lending terms with the primary objective of lowering the company’s Weighted Average Cost of Capital (WACC).

Ofwat’s regulation and associated pricing reviews provide a stable financial environment for investors. They ensure reliable demand due to the monopolistic nature of the customer base despite some revenue risk from bad debt. The application of a Regulated Asset Base (RAB) model (discussed below) along with the submission of Asset Management Plans (AMPs) that contribute to periodic price reviews, is designed to incentivise investment in infrastructure and services whereby the water companies are required to manage risks related to capital programmes, asset maintenance and operational costs similar to those in the heat network sector.

Regulated Asset Based (RAB)

The RAB model regulates water company prices while ensuring infrastructure maintenance and service quality. The RAB represents the value of a company’s capital assets based on historical costs, depreciation, and new investments. Ofwat uses the RAB value to set allowed revenue requirements, applying a WACC to determine the maximum revenue companies can charge, incentivising efficient investment and continual infrastructure improvements. This model is effective in the water sector due to the manageable number of operators, encouraging companies to invest efficiently and include new investments in future revenue streams.

Periodic Price Reviews

Ofwat’s price reviews, conducted every five years, determine the revenue water companies can earn. They take into both capital and operational expenditures into consideration to set price controls and encourage large-scale investment projects. The submission of AMPs contributes to the periodic price review process, which includes performance incentives through Outcome Delivery Incentives (ODIs), rewarding companies for meeting targets and penalising underperformance, aligning financial interests with high-quality service delivery. The periodic pricing reviews, coupled with limited demand risk provides greater revenue certainty for investment.

The latest Asset Management Plan (AMP8) for 2025-2030 focuses on climate change, emissions reduction, water quality improvement, leakage reduction, and reliable services. It also introduces innovative funding solutions such as the Direct Procurement for Customers (DPC) programme to support significant infrastructure investments.

Innovation funding

Although there are many external innovation funds available to water companies, Ofwat has established its own Ofwat Innovation Fund. The aim of this £200m fund is to encourage collaborative initiatives and partnerships within the water sector to tackle the larger challenges the sector faces such as climate change, leakage and affordability.

Scotland

Whilst Ofwat regulates the water sector in England and Wales, privatisation of the sector has resulted in high debt leverage which can give rise to value leakage to shareholders and risk of under investment of infrastructure. Thames Water, England’s largest water company, has requested that Ofwat approves an increase in water bills of up to 40% by 2030.

Scotland has sought to mitigate these specific risks through the water services being publicly owned. Services are operated by Scottish Water which remains accountable to the Scottish Government and its customers. This helps to ensure profits are reinvested in the infrastructure rather than distributed to shareholders. WICS is an Executive Non-Departmental Public Body whose principle statutory functions are to:

• Determine charge caps;
• Monitor Scottish Water’s performance, encouraging efficiency and sustainability;
• Facilitate competition by encouraging the entry of retail water and sewerage providers for non-household customers in Scotland; and
• Support the Scottish Government’s vision of ensuring that Scotland is a Hydro Nation and meet their obligations under the Water Resources Act 2013.

Water charges are set by WICS and remain relatively stable as profits are reinvested. The domestic charges are linked to council tax bands, with prices increasing as bands increase. Historically charges were calculated using a version of the RAB model. However, since the price review in 2010, WICS has moved away from the RAB based model towards looking at business requirements as the basis for setting prices.

Price Reviews

Similar to Ofwat in England and Wales, WICS performs Strategic Reviews of Charges to set price limits for the next regulatory period, usually every six years. The Strategic Reviews of Charges is initially based upon Scottish Water’s long term business plan. This encompasses short and long-term infrastructure investment requirements, debt repayments and operating costs. WICS subsequently evaluates the business plan, with a focus on Debt Service Cover Ratio (DSCR), alongside multiple other factors including inflation, investment needs and operational efficiency to determine annual price caps for customers. These may be adjusted annually within the limits set by WICS to account for inflation or other changes.

Although a proxy RAB continues to exist to act as an internal comparator to England and Wales water sector, Scottish Water’s customer-focussed business plan helps align Scottish Water with Scotland Government objectives.

Government Grants and Incentives

Scottish Water receives loans or grants from the Scottish Government to finance large capital expenditure projects. These reduce reliance upon customer charges, improving affordability for households and businesses. While government-backed loans could offer more favourable terms than private market financing, such a mechanism could impact the Scottish Government balance sheet (borrowing requirement). This impact could mean funding is not granted for infrastructure development and maintenance projects and instead a short-term increase in customer prices would have to be required. As such, any borrowing is carefully managed to ensure long term financial sustainability for both Scottish Water and Scottish Government.

Carbon Capture, Utilisation and Storage (CCUS)

Overview

CCUS is an emerging sector in the UK, crucial for achieving the net zero emissions target by 2050. The government is actively developing a regulatory framework to support its deployment. This framework, shaped by legislation such as the Energy Act 2023, aims to ensure CCUS projects are financially viable, environmentally effective and resilient. It provides regulatory oversight from bodies like Ofgem, the Oil and Gas Authority, and the Department for Energy Security and Net Zero (DESNZ).

Regulatory Structure

The UK’s CCUS sector is in its infancy and, to date, no significant facilities have been developed. As a result, it is referred to as a First of a Kind (“FOAK”) project. To facilitate the development, financing and deployment of CCUS technology, a robust regulatory landscape is required, coupled with effective funding support mechanisms. This includes the need to address the revenue uncertainty associated with demand risk from emitter connections. Further details on this can be found within Appendix I. The proposed regulatory framework aims to enable the sector’s development while contributing to net zero goals, with current proposals including a RAB-based model with revenue support to encourage initial investment and asset maintenance, anticipating evolution as technology and risks develop.

Regulatory Financing Mechanisms

Similar to the water and sewerage sector, the proposed regulatory RAB model for entities developing, owning, and operating CCUS transport and storage infrastructure (T&SCo) aims to provide long-term reliable revenues in order to secure the private sector funding necessary to construct the infrastructure and meet ongoing operational costs. The allowed revenue is determined similarly to other RAB models. DESNZ will initially administer this for CCUS before Ofgem takes over shortly after commercial operations begin. Despite the significant resources and time required to administer a RAB model, it is considered appropriate and effective for attracting private sector investment in T&SCo projects due to the anticipated limited number of such projects. Further details on how a RAB model operates can be found at Appendix H and Appendix I.

Revenue Support Agreement

Due to the uncertain uptake of CCUS technology in the early years, there is significant risk that T&SCos may not generate sufficient allowed revenue under the RAB model. To mitigate this risk, the regulatory structure includes a revenue support agreement, like CfDs in sectors such as offshore wind, until the market matures. The Low Carbon Contracts Company (LCCC) is the proposed counterparty to this agreement, responsible for covering any shortfall in actual revenue compared to the forecasted allowed revenue, thereby mitigating demand and revenue risk until the sector matures.

The CCUS regulatory framework addresses risks associated with FOAK projects by combining previous regulatory support mechanisms and encouraging investment through long-term, predictable revenue for equity investors supported by a contract with LCCC. The RAB model ensures continual maintenance of assets by increasing allowed revenue to cover maintenance costs, promoting adequate net revenue and visibility for future projects. However, this amalgamation of support mechanisms is still in development and remains untested until large CCUS projects begin construction.

Integration of regulatory models with heat networks

For each model described above, the aim has been to provide an economic and financial environment that stimulates private sector investment and develops new infrastructure. Furthermore, it should be noted that such regimes and financial support have evolved over time depending on the maturity of the sector and UK Government’s priorities and policies.

Each energy or utility sector is very different, with unique characteristics necessitating a bespoke approach to both regulation and financial support mechanisms. Such differences can include the maturity of the sector or technology intervention, including FOAK projects such as CCUS, nature of service provision (e.g. wholesale versus retail) such as electricity and water, the extent and maturity of regulation and the quantum of investment required.

Furthermore, each sector will be heavily influenced by legislation, such as Section 92 of the HNSA that sets targets for the combined supply of thermal energy by heat networks, to reach 2.6 TWh by 2027 and 6 TWh by 2030.

Offshore Wind – Contract for Differences (CfDs)

The purpose, mechanism and award process for CfDs is very well understood and has proved very successful in securing the necessary investment in a wide range of renewable energy technologies, in particular Offshore Wind.

CfDs have evolved over time. Its predecessor was ROCs, which were in place between 2002 and 2017, and before that the Non-Fossil Fuel Obligations (NFFOs) and Scottish Renewables Obligation (SRO) launched as early as 1990.

CfDs’ primary purpose, like that of its predecessors, is to provide price assurance to the developer and associated investors in relation to each MWh of electricity generated and sold to the grid. In the majority of cases, the projects utilise proven technology such as Solar PV, On-Shore and Off-Shore Wind, together comprising c.96% of the CfD allocation within AR 6.

Construction and availability risks are both borne by the developer. While offshore wind generation can be reliably estimated, heat networks depend on gradually increasing connections over time, introducing demand uncertainty. With Solar PV and On-Shore and Off-Shore wind generation, capacity broadly remains the same over the operational life of the asset. For these reasons, a CfD may not be an appropriate mechanism at this moment in time for managing the demand risk associated with heat networks, which is currently a key inhibitor to the deployment of more private sector funding.

CfDs could however play a role in providing revenue support to those heat networks seeking to utilise decarbonised heat sources (other than industrial waste heat or heat from energy from waste plants). This type of mechanism could incentivise the transition from fossil-based heat sources (e.g. gas boilers) to more sustainable forms of heat generations (e.g. heat pumps). At present, residential customers are unlikely to be able to afford the increase in the cost of heat compared to conventional gas boilers or heat networks using waste heat.

Household water & sewerage undertakers – RAB-based Model

The RAB model utilised in the water sector, in conjunction with the associated price reviews, has proven to be an effective mechanism for encouraging investment and securing funding from the capital markets. This approach provides a tried and tested framework for recovering the costs of the investment over a period of time. This in turn encourages utilities to embark on much needed infrastructure development. Ofwat is also looking at new mechanisms such as Direct Procurement for Customers (DPC) for much larger scale capex projects.

Integral to the regulation and application of the RAB based model, is management of the inter-generational risk of customer charges. This means today’s customers should not feel any greater financial burden from new investment than the customers in the future. In the water sector, utilities still bear the risks associated with inflation, construction and operation costs, interest rates and to a lesser degree demand and bad debt risk within England and Wales.

The RAB model is widely used across sectors where revenue forecasting is relatively stable due to low demand risk. However, demand risk is highly uncertain for heat networks as a result of the uncertainty of connections. A key risk for potential investors is the heat network sector’s inability to manage demand risk and therefore a RAB model-based approach may not be a viable solution in the short term to incentivise investment. A RAB model could, however, play a key role in the regulation of the sector once it achieves critical mass and the impending regulation of the sector has had sufficient time to evolve and prove effective in the sector.

Key considerations for any RAB model are the resources and time required to regulate a sector effectively. The model and associated regulation works effectively in the water sector not least due the limited number of water utilities (11). Given that the heat network sector will comprise thousands of heat networks of various sizes, a RAB model may not be practical for all projects unless projects are first consolidated on a regional basis, or are subject to a minimum MW size requirement prior to utilising a RAB model. We do understand, however, that the impending regulation of the heat network sector will focus on tariffs (regarding Value for Money) and customer service, but it is unclear whether this will extend to a RAB-based model approach.

Carbon Capture, Utilisation and Storage (CCUS) – RAB Model and revenue support

The CCUS programme comprises T&SCo projects and carbon capture technologies developed at industrial and Energy from Waste (EfW) facilities. They are at a very early stage in the development cycle and as such referred to as FOAK projects. Furthermore, CCUS projects are not only exposed to technology and construction risk (i.e. the technology is considered unproven at such scale) but also are exposed to significant demand risk as industrial and waste emitters decarbonise over time. Such connections to the T&SCo infrastructure are therefore uncertain. Heat network technology is relatively tried and tested, but the issue of timing and quantum of connections is the same dilemma for both the heat network sector and CCUS. The CCUS sector has had to adapt its regulatory framework to address the issue of “demand risk” not mitigated by utilisation of a RAB model alone. A combination of RAB model and revenue support helps mitigate demand risk within CCUS.

This could potentially be largely replicated within heat networks, in particular to support the upfront capital expenditure. However, were this method to be adopted, extensive regulatory and legislative discussions would be required to ascertain a suitable counterparty to the revenue support mechanism. Furthermore, the positioning of who bears bad debt risk would need to be established. However, this risk is generally accepted within the water sector and arguably should be no different for heat networks. While this combination of regulatory support is planned for CCUS, it remains an untested regime with the potential for inefficiencies. This is particularly the case for heat networks given the limitations of a RAB model identified above.

Alternative regulatory structures for heat networks could include offering grants to offset upfront costs and revenue support mechanism to mitigate demand risk. This and other combinations of mechanisms, such as a cap on payments to reduce the risk of over-incentivising, could incentivise investment in heat networks without too great a departure from regulatory norms.

Renewable Heat Incentive (RHI) specifically for heat networks

It may be possible to develop a RHI specific to heat networks. This could bridge the price gap between gas and electric networks whilst encouraging investment. The RHI was a UK Government financial support scheme designed to encourage the uptake of renewable heat technologies. Since 31 March 2021 it has been closed for new applicants. A similar type of incentive for the deployment of heat networks would aim to promote the development and expansion of the sector and could include the features listed in Table 4.

Table 4: Summary of features for a potential RHI-type heat network incentive

An RHI-type incentive in heat networks would aim to stimulate market growth and help achieve net zero emissions through the integration of carbon-based fuels to renewable energy. It could provide a financial impetus for the adoption of heat networks and making them an attractive option for developers, local authorities and consumers particularly if coupled with grants.

Stakeholder insight

This section summarises stakeholder feedback from the stakeholder interview exercise. The methodology underpinning this exercise is set out in Section 3.3. Stakeholder feedback also informed conclusions in other sections of this report, including:

• Overall views and attractiveness of the sector
• Key investment risks
• Key initiatives that are required to move to a predominantly privately financed model

The private sector views heat networks as an attractive investment opportunity. However, there are areas of uncertainty that must be resolved, including the need for greater clarity on the development of future regulation. To facilitate private investment, stakeholders highlighted the need for continued grant funding support (which will help de-risk project cashflows), clear regulation on key areas such as zoning and mandatory connections, and clear direction on future policy banning carbon-based heat systems. Table 5 below summarises the detailed views of each stakeholder group.

Table 5: Stakeholder Engagement Summary

Private capital and operator stakeholders were also asked specific questions regarding financial returns, types of financing, key financial metrics and shareholder structure. A summary of responses for each subcategory is provided below.

• Rates of return: Stakeholders gave a consistent view of the minimum internal rate of return (IRR) requirement range for heat network developments. This was between 8% and 12% depending on a project’s specific risk profile (which can vary significantly). For example, established trunk/core developments can have lower IRR where demand assurance and contracted revenues are satisfied, while a higher IRR is required on expansions to make the developments feasible and appropriately mitigate risk.
• Types of financing: Stakeholders unanimously agreed operators would likely use their own balance sheet for financing the short to medium term. Private Equity funds and infrastructure funds would predominantly continue to use equity to invest in the heat network sector. For the reasons outlined in earlier sections, the existing barriers around demand and revenue uncertainty limits debt investment in the sector.
• Financial metrics: Stakeholders noted that they have certain size requirements when investing and deploying capital. For those stakeholders investing in the sector, the minimum investment required ranged from £10m to £25m+. These stakeholders highlighted this can limit their involvement in Scotland as, compared with rUK, there are fewer projects that meet their investment scale requirements. However, stakeholders did say this issue could be mitigated by investing in multiple projects rather one large project.
• Scale: Similarly, stakeholders commented that rUK offers more opportunity due to the number of large city scale projects available. Scotland offers significant potential for large city scale networks but the greater number of cities and urban areas in the rest of the UK is more appealing as it offers more connection opportunities and a greater customer base.
• Shareholder structure: Private capital and operator stakeholders were open to collaborating with Local Authorities in a Joint Venture structure; however, they flagged key legal areas that would need additional scrutiny. For example, clear roles and responsibilities regarding asset risk and reward.

As illustrated by the stakeholder engagement, stakeholder subgroups all highlighted similar risks and themes and what support mechanisms exist for the heat network sector. The engagement exercise identified key issues and barriers that must be addressed to attract private sector investment. The exercise has therefore helped inform our recommendations as set out in the next section.

Recommendations

Summary

The evidence from this report indicates that the Scottish heat network sector is still maturing and, in the short to medium term, requires significant financial support from the public sector. In the medium to long term, we also recommend models for securing private sector finance and for scaling and speeding up the roll out of large heat networks in Scotland.

Figure 11 summarises our recommendations, indicating the suggested timeframe and expected impact of each.

Figure 11: The impact of mechanisms over time

Recommendations for rollout of mechanisms or policy initiatives

The recommendations are explored in more detail below.

Recommendation 1

The Scottish Government should maintain capital funding support for the sector through existing programmes or new bespoke capital schemes. The Scottish Government should also explore opportunities for extending grant funding drawdown timescales.

Timescales – short to medium term e.g. 1-10 years

This recommendation addresses barriers related to high capital costs, demand uncertainty and long development and construction times.

• Stakeholders unanimously agreed that the large-scale deployment of heat networks requires continued public support. There is also precedent from other emerging countries to support the sector in this way.
• Future grant funding programmes must reflect a heat network’s significant development and construction timescales. The Scottish Government aims to avoid piecemeal developments and the development of large-scale heat networks can be significantly longer than the existing grant funding windows. Although cross party support for the sector exists, the Scottish Government could consider secondary legislation which extends timescales. This would provide long term certainty to the market. However, we recognise government funding and budgetary restrictions will make this challenging. We also note that current schemes have open funding windows and seek to create as much flexibility as possible for applicants. Further sub-recommendations could also be considered including:
  • Reducing intervention rates. The level of grant support is subject to numerous factors, but any grant support should be sized to provide developers with a reasonable project IRR (noting that this is already standard practice). This will help support a greater number of projects, with lower levels of capital. There is precedent from the GHNF for lower levels of support, but differences between the GHNF and SHNF must be considered (including the varying volume of applications received through both programmes and different assessment criteria).
  • Targeting intervention at specific geographical areas or aligning with local regional strategies. This could include aligning support to regional zoning activity or targeting support at specific geographic areas where there are significant opportunities for future heat networks.
  • Target grant funding in other ways, for example, to support connection fees and/or enabling costs for end users of new residential areas. There is international precedent for this, including grant support to incentivise anchor loads. Further support for the public sector to meet connection fees could also be considered. Public Sector enabling costs are already supported through the Green Public Sector Estate Decarbonisation Scheme.
  • Grant funding could be exclusively targeted at district heating projects rather than smaller communal heating schemes.

Recommendation 2

Our review has found that de-risking future revenues is key to unlocking HN development – private capital is available for projects of this scale, but it must be financeable. Our initial analysis therefore concludes that more detailed analysis of a revenue support model, such as Contracts for Difference (CfD) or a Renewable Heat Incentive (RHI) equivalent, is merited. However, the Scottish Government must address the challenges of establishing such schemes, described below.

Timescale – Medium 5+ years

This recommendation addresses the barriers associated with demand uncertainty.

In section 6 we review the benefits of these models in the context of other relevant utility sectors. However, there are additional factors that the Scottish Government must consider before pursing this further. For example, it must consider the significant administrative and resource costs of establishing such schemes. Additionally, constrained revenue budgets mean that the creation of a new revenue model will represent a significant budgetary challenge for the Scottish Government. Lastly, with differences in regulation, policy and powers, the Scottish Government must also consider how a revenue model could be introduced in isolation from the rest of the UK. Additional CfD and RHI considerations are summarised below:

1. Contracts for Difference – Although this is a well-established model, certain complexities must be resolved before it can be deployed in the sector:
   • Calculating a reference price – heat prices are bespoke, and cannot be benchmarked to a national market price, unless there is regulation on the price of heat. This must be explored further before the model can be introduced.
   • Generation versus consumption – a CfD should be based on the generation of heat, rather than consumption of heat. This will help mitigate demand risk, as the model is not reliant on future unknown connections to the heat network.
   • The CfD could also subsidise the additional capital cost of installing expensive clean heat network technology.
   • Additionally, the higher cost of underlying electricity (compared to gas) could be mitigated and passed on to customers thereby reducing price risk. However, before introducing an alternative mechanism to grant funding, the CfD cost (compared to the level of grant) must be further understood.
2. RHI model – The RHI model is another well understood revenue support model, which has previously been used in the heat network sector. However, previous RHI schemes have been criticised, for example, the National Audit Office stated the UK Government did not achieve value for money.

RHI subsidises the cost of heat generated from clean heat networks, compared to alternative forms of heat generation. However, complexities remain that must be addressed before it can be deployed:

• • Generation versus consumption – Similar to CfD, an RHI model would need to be based on the amount of heat generated, rather than consumption of heat, and would therefore act as a contribution to the cost of deployment. It would help to address the increased cost of installing a more expensive heat network technology, and at the same time mitigate demand risk.
  • A payment cap could be introduced to avoid over-incentivisation within the sector.
  • Before adopting an alternative to grant funding, the RHI cost (compared to the level of grant) must be thoroughly assessed.

Recommendation 3

Following further regulatory developments and the creation of an established asset base (possibly 10-15 years), the Scottish Government could explore the benefits of implementing a RAB model.

Timescale – Long term e.g. 10 years +

This recommendation addresses barriers associated with consumer experience and regulatory uncertainty.

• The RAB model (coupled with price reviews) has been shown to be helpful in protecting consumer prices whilst encouraging ongoing investment and maintaining assets.
• However, the cost and resource implications of administering RAB models across a large number of very diverse projects will be significant. This may be mitigated through minimum generation requirements, but this must be explored further. EY and many stakeholders agreed that a RAB model may be appropriate / beneficial in 10-15+ years but only after certain market characteristics are met.
• The Scottish Government must assess the feasibility of developing a Scottish RAB model, which may diverge from the approach in England and Wales.
• A transition from one regulatory mechanism to another could occur in the future. However, for this to occur, the sector must mature and must focus on large scale capital investment. This will impact whether a RAB model alone could be introduced to provide consumer protection or whether it will need to be supported with a revenue support mechanism. Furthermore, the market must be economically feasible (meaning the sector is more mature and financially viable) to regulate the assets themselves prior to introducing a RAB model.
• Importantly, without capital or revenue support, a RAB model will not by itself result in a financially viable heat network. It would therefore need to be coupled with other support mechanisms, as pioneered by CCUS. This reinforces the requirement to pursue short term sector support, including public sector capital funding.

Recommendation 4

SNIB and the UK National Wealth Fund are committed to investing in the sector. The Scottish Government must continue to work closely with these organisations in order to explore investment opportunities, create a shared understanding of each party’s objectives and ultimately unlock the capital that has been made available to invest.

Timescales – short term e.g. now -1 year

This recommendation addresses the barriers associated with access to funding.

• The Scottish Government must also consider infrastructure bank restrictions, including who they can support (e.g. local authorities) and minimum lending requirements.

Recommendation 5

The Scottish Government should maintain and increase support for pre-construction projects, via the Heat Network Support Unit (HNSU) and specific development funding programmes.

Timescales – short term e.g. 1-2 years

This recommendation addresses the barriers associated with access to funding.

• To support the sector’s development a strong pipeline of projects is required. In Scotland, and across the UK, there are a growing number of pre-construction projects that require commercialisation support.
• All stakeholders commented on the need for improved funding to develop heat networks until there are sufficient cashflows enabling networks to support themselves and attract other forms of funding.
• This could include expanding the role of the HNSU to take a more active development role similar to the UK Government’s Heat Network Delivery Unit. However, the HNSU would require additional resources and financial support before it could expand its remit.
• The Scottish Government could also consider engaging with national development banks, e.g. SNIB or the NWF to co-develop development funding programmes.

Recommendation 6

The Sottish Government should monitor the implementation of the UK Government’s zoning approach, and where appropriate, leverage best practice from DESNZ. This should be used to compliment Scotland’s existing zoning approach.

Timescales – short term e.g. 1-2 years

This recommendation addresses the barriers associated with demand uncertainty.

• Robust zoning regulations, with mandatory connections will help reduce demand risk and support private sector investment. Ultimately this will support the roll out of larger heat networks at scale by reducing demand uncertainty for operators and investors.
• Regional Zones, across local authority boundaries, could be used to identify area of high heat demand, and key heat sources.
• These proposals could leverage the Advanced Zoning Programme (AZP) model adopted by DESNZ, where pilot heat network zones have been identified to supply.
• The HNSA creates the opportunity for local authorities and the Scottish Government (in some cases) to designate zones. This should be explored in more detail, including the number of zones required in Scotland. The Scottish Government could also use this route to create larger strategic zones across Scotland.
• However, zoning proposals must account for heat costs and the risk that consumers are forced to connect to a heat source that is more expensive than alternatives.
• The Scottish Government must also consider that its limited resources will reduce its ability to replicate the regulatory developments in England and Wales.

Recommendation 7

We recommend that Scottish Government reviews its regulatory approach to help reduce regulatory uncertainty, simplify delivery and align with the wider UK framework where appropriate.

Timescales – short term e.g. 1-2 years

This recommendation addresses the barriers associated with regulatory uncertainty.

• The introduction of secondary legislation, including further details on consenting and authorisation, will help to reduce the existing uncertainty in the market.
• The lack of standardisation in procurement approaches and delivery models adds complexity, time and cost to a project’s development timeline. The Scottish Government should accelerate its activity to provide more clarity to the market. The UK Government is also developing its delivery models. The Scottish Government could consider aligning with the UK Government approach to ensure a consistent landscape for the private sector.
• As part of the Advance Zoning Programme for Heat Networks in England, DESNZ issued template delivery model guidance for the procurement of Heat Network delivery partners. The purpose this is to assist project sponsors in the identification of opportunities for the acceleration of the scale and pace of zonal heat network delivery. Template documentation provides greater clarity in the marketplace leading to quicker and more effective procurement processes, improving market appetite and reducing bidder fatigue. The guidance for the promoters of AZP projects sets out the principles of three potential delivery models and sets out the characteristics to consider when determining the delivery model to adopt. This includes Development Agreements, the Golden Share and Co-investor models.

Recommendation 8

We recommend that the Scottish Government continues to work with the UK Government on rebalancing electricity and gas prices; however, this will not eliminate the price difference between electricity and gas.

Timescale – Medium 5+ years. However, the Scottish Government does not have the developed powers to implement this recommendation by itself, and therefore further discussions with the UK Government are required.

This recommendation addresses the barriers associated with structured pricing challenges.

• The UK Government is continuing to explore opportunities for rebalancing electricity and gas prices, to reduce electricity costs and support the affordability of clean heat networks for consumers. This initiative is not a devolved matter, so the Scottish Government should continue to work with the UK Government on the proposals. If unsuccessful, a revenue support model should be considered as an alternative to address pricing risk.

Recommendation 9

The Scottish Government should develop a national Heat Network Strategy setting out a long-term vision for Scotland’s heat networks.

Timescales – short term e.g. 1-2 years

This recommendation addresses multiple barriers.

• Not only will this help provide further clarity and confidence to the private sector, but it will also help to educate and explain the benefits of heat networks to the wider Scottish public.
• This view was shared by specific stakeholders and mirrors the recently published Scottish Renewables Heat Network Vision.
• This strategy could also leverage the Scottish Futures Trust (SFT) analysis on sector delivery models which could accelerate the pace and scale of heat network deployment in Scotland.
• Additionally, the strategy should provide:
  • Clarity on national and regional Heat Network implementation, crossing local authority boundaries.
  • A strategy for future public sector support, including where and how grant funding, should be targeted. This should also include Scottish Government’s external commitment and its ability to invest in the sector.
  • Inform the ongoing development and implementation of regulation.
  • Plans for engaging with the UK Government on recommendations reserved to the UK Government, e.g. structural pricing plans.

Appendices

Appendix A – Financing mechanisms

There are a number of financing mechanisms that the Scottish Government could utilise to help de-risk heat network investments. These mechanisms, or “financial levers”, could increase the attractiveness of heat network projects to private investors and ultimately increase the pace and scale of their deployment. They may achieve this through reducing investment hurdle rates (by decreasing risk), increasing gearing levels to reduce the overall cost of capital and/or improving the project’s IRR to meet the investors’ thresholds. However, the need for these levers and the decision on which (if any) to employ, will vary from project to project and these factors should be assessed as part of the financial structuring of a project.

The financial levers available to Scottish Government can be broadly grouped into the following categories:

• Capital funding;
• Revenue funding;
• Investment; and
• Business model support.

The need for these levers and the decision on which (if any) to employ, will vary from project to project and these factors should be assessed as part of the financial structuring of a project. This section will summarise the key elements of these funding mechanisms and discuss their implications for resource demand, balance sheet treatment and exist strategy.

Capital funding

Capital funding uses capital budgets to provide gap funding for heat networks. This may be in the form of, for example, a capital grant or repayable assistance.

Capital grant

Capital Grants are allocated to fund activities aligned with government priorities, benefiting public or private entities that contribute to specific public outcomes. These grants come with conditions that must be met to avoid repayment obligations. In Scotland, Repayable Assistance is typically preferred over Capital Grants for heat networks, with the possibility of repayment if profitability exceeds expectations. Administering Capital Grants demands significant resources, particularly during application assessment, construction monitoring and post-commissioning for a period of 3-5 years. The treatment of Capital Grants on balance sheets depends on various factors, including the grant’s size and terms, which may affect asset classification. After fulfilling all grant conditions, the grantee is released from obligations, but the grantor may benefit from maintaining a relationship for continued data access and to support future expansions.

Repayable assistance

Repayable Assistance functions similarly to Capital Grants, with the distinction that it must be repaid partially or in full if the project exceeds certain performance-related thresholds in the initial years of operation. This mechanism is designed to prevent grantees from benefiting excessively from public subsidies. Managing Repayable Assistance requires additional resource to evaluate and challenge financial returns and reports from grantees. The treatment of Repayable Assistance on the balance sheet is comparable to that of Capital Grants, with the classification determined by the delivery model, the proportion of Repayable Assistance to total capital costs of the project and the terms of risk allocation. The exit strategy involves ceasing monitoring once grant conditions are satisfied, which may take longer than for Capital Grants.

Revenue funding

Certain financial levers utilise revenue budgets to fund heat networks, such as revenue grants, heat purchase agreements (or demand guarantees) and outcomes-based funding.

Revenue grant

Revenue Grants fund activities that support government priorities and public benefits, with both public and private entities eligible as grantees. In Scotland, Revenue Grants have often been combined with Repayable Assistance and, from an investor perspective, can help mitigate revenue risk which is one of the most significant barriers to heat network investment. The grants, which are not typically repayable unless certain grant conditions are not met, can be performance-linked to ensure drawdowns align with financial need. The administration of Revenue Grants can be resource-intensive, as they require stringent monitoring across the project lifecycle. The treatment of these grants on government balance sheets is influenced by several factors, including the grants’ size and the delivery model. After fulfilling grant conditions, which may take many years, the grantor’s monitoring ceases, but a continued relationship with the grantee can be beneficial for gathering data and supporting future expansions.

Heat purchase

Heat Network developers require a level of assurance to ensure there will be a sufficient customer-base to make their investment viable. This assurance is crucial as it influences the decision to invest and the capacity to future-proof networks for anticipated demand growth. Anchor loads (significant heat demands that are likely to be the first connections to the heat network, typically large public buildings with sustained high heat demand) are essential for making networks investable. The Scottish Government could provide demand assurance through mechanisms such as Heat Purchase Agreements, where public buildings are offered as anchor loads without a guaranteed minimum demand and Demand Guarantees, which involve a “take or pay” commitment for a minimum quantity of heat.

These agreements require resources for due diligence, negotiation and ongoing monitoring, often requiring specialist expertise and governance to effectively manage the associated risks. The balance sheet treatment of these agreements may lead to on-balance-sheet classification of project assets, if risk transfer is diluted. The exit strategy for such agreements is to have a fixed contract term, after which they can be re-procured or renegotiated, with “take or pay” guarantees being time-bound and including withdrawal clauses under certain conditions, such as when sufficient third-party demand is secured.

Outcomes based funding

Outcomes based funding is a financial mechanism that focuses on achieving specific, pre-agreed outcomes rather than outputs. It operates on the principle of “payment by results”, where organisations (typically local authorities, though could also apply to a private company) invest in infrastructure to deliver set outcomes. If these outcomes are met, Scottish Government would make regular payments over a set period, reflecting the pre-agreed value of the outcomes achieved. For example, these outcomes may be successful commissioning of the heat network, the number of heat network connections, carbon savings and/or the social value created. This model shares risk between the organisation and the government, however it is resource-intensive, requiring careful project selection, development and ongoing monitoring to ensure that the agreed outcomes are met. While it may not be efficient for smaller projects due to the resources needed for monitoring, Outcomes Based Funding can support infrastructure without being classified on the Scottish Government’s balance sheet, if the delivery risk is fully transferred to the grantee. The monitoring period is predefined, often spanning 20-25 years, with revenue payments contingent on achieving these outcomes.

Investment

Equity

Special Purpose Vehicles (SPVs) are often formed for infrastructure projects. SPVs allow for project assets and risks to be held within the vehicle itself and enable investors to make more targeted investments into specific asset classes that align with their desired risk/return profiles. SPVs require one or more shareholders to own the company, appoint its board of directors and provide the necessary funding, typically through equity or shareholder loans as subordinated debt. These SPVs can be solely owned by one entity or jointly owned by multiple organisations, which may include a mix of public and private sector shareholders and can also take the form of corporate joint ventures.

The Scottish Government can participate in SPVs as an equity investor, either independently or in collaboration with private sector partners. This model affords Scottish Government a degree of control over the project’s strategic direction and the opportunity to share in the profits, but also exposes government to the associated investment risks. In heat network projects, government might invest in the network’s distribution assets and later recoup this investment through ‘use of system’ fees from other parties utilising the network. Managing such equity investments requires a long-term commitment and specialised expertise in investment structuring, due diligence and governance, ensuring that the government’s interests and public funds are appropriately safeguarded. The impact of these investments on the government’s balance sheet is influenced by the degree of control the government has as a shareholder, the size of the equity stake and the risk transfer mechanisms in place. In terms of exit strategies, the Scottish Government could sell its equity stake in the SPV once the project reaches a stage of profitable operation, allowing for the recycling of capital into other projects.

Debt finance

Debt finance is a financing mechanism where the government lends money to public or private sector borrowers, who are then obligated to repay the loan with interest according to the terms set out in a loan agreement. There are three key features of debt financing: the seniority of the debt, which determines the order of repayments from project cash flows between debt and equity holders; the security of loans, which may be secured or unsecure; and financial covenants that serve as safeguards for the lender by monitoring the borrower’s financial health and triggering repayment in case of covenant breaches.

Scottish Government could establish a revolving loan facility aimed at supporting projects during their riskier construction and early operational stages, with the possibility of refinancing by the private sector once more stable operations are achieved. This approach facilitates the recycling of capital into new projects and aligns with the preferences of long-term investors seeking lower-risk opportunities. Administering such finance requires significant resources for project selection, development and monitoring, with the balance sheet treatment determined by factors such as loan terms, size and risk. The exit strategy allows for the recovery of investments through repayments or refinancing, potentially leading to capital receipts that can be reinvested or the sale of loan portfolios to investors, thus enabling ongoing economic development.

Loan guarantee

A Loan Guarantee by the Scottish Government provides a safety net over debt repayments to lenders, covering either the entire loan or a portion, with the aim of reducing the cost of capital for borrowers, such as heat network developers. This can make investments more feasible and enable access to loans that might otherwise be unavailable due to risk considerations. While initially having limited budgetary impact, provided the risk of the guarantee being called upon is low, there are Subsidy Control implications that may be offset by charging a fee for the guarantee. Implementing a Loan Guarantee scheme requires resources for design, project assessment, due diligence and ongoing monitoring, requiring specialist expertise and governance to manage financial and reputational risks. The balance sheet treatment of a Loan Guarantee is influenced by various factors, including the delivery model and the size and terms of the guarantee. The Scottish Government’s exit strategy involves offering guarantees for a specific term with withdrawal clauses, allowing for the possibility of refinancing and withdrawing the guarantee once the project is operational and profitable.

Business Model Support

This section outlines common business model support mechanisms in the UK, such as Regulated Asset Base, Cap and Floor and Contracts for Difference, which could potentially be adapted for heat networks. These Business Model Supports would draw upon revenue budgets to heat networks. While these models are theoretically adaptable, they face significant challenges that require careful consideration to tailor them to the heat network sector.

Regulated asset base

A RAB is a regulatory framework that measures the capital used in a regulated entity, where companies are granted a licence by an economic regulator to charge users regulated prices for services linked to an infrastructure asset (operating on a “user pays” model). The regulator sets or caps the charges that the operator can levy for a certain period, reducing pricing risk for investors and ensuring charges allow for the efficient recovery of costs incurred by the operator in the interest of customers. Charges can be controlled through a revenue cap, which protects investors from both price and market existence/demand risk, or a price cap, which only shields from price risk.

Hybrid RAB models, combining a price cap with government cash injections, are being explored for Carbon Capture, Transport and Storage infrastructure to mitigate market existence/demand risk. The RAB operator’s prices are calculated to enable recovery of operating expenditure, depreciation costs and an allowed return on capital, balancing risk reduction for investors with cost-efficiency incentives. Charges are reviewed and reset periodically by the regulator in consultation with the operator and customers, protecting investors from subsidy risk within each regulatory period. If applied to heat networks, a RAB model could significantly shield investors from price and market existence risks. However, current regulatory and policy frameworks for heat networks are not conducive to the model’s deployment at this time.

Cap and floor

The cap and floor mechanism aims to offer investors a degree of revenue certainty while maintaining incentives for efficient operation. The floor guarantees a minimum revenue, covering at least operating costs and senior debt service, thus limiting investors’ risk and enabling financing. Conversely, the cap sets a maximum revenue, with any excess being repaid, limiting the investors’ returns.

A revenue sharing arrangement can be incorporated, where excess revenue is split between investors and user/taxpayers, rather than being fully retained by investors or returned to funders. The mechanism’s terms, including cap and floor levels and the applicable period, are contractually agreed, reducing subsidy risk as the support cannot be abruptly withdrawn. This arrangement mitigates price risk and market existence/demand risk by assuring minimum revenue, independent of demand, although it does not protect against cost variability.

Currently utilised by Ofgem for financing electricity interconnectors and considered for electricity storage in the UK, the mechanism is funded by electricity users or, alternatively, could adopt a ‘taxpayer pays’ model with government involvement. For heat networks, while ‘Cap and Floor’ offers some risk protection, it requires careful implementation to avoid disincentivising network operators from acquiring new customers or charging competitive rates. Additionally, the ‘taxpayer pays’ model could lead to significant financial exposure for the Scottish Government.

Contracts for difference

CfDs are a support mechanism that offers investors a fixed, contractually agreed ‘strike price’ per unit of output. This helps to mitigate potential subsidy risk for investors due to the subsidy being a binding, contractual obligation. The strike price may be fixed or index-linked and CfDs can be signed with the government or a government-backed third party, with funding from taxpayers or users. The ‘reference price’, generally the market price, determines the subsidy level during each CfD period, with investors receiving a subsidy if the market price is below the strike price, or paying back if it’s above. This support incentivises operational efficiency, as investors are exposed to cost variability risk and only receive support once the project is operational.

Although CfDs are used extensively for renewable electricity generation in the UK, applying this mechanism to heat networks poses challenges. It is difficult to define a reference price due to the absence of a wholesale heat market and the localised nature of heat network pricing, which relies on local factors such as the availability of low carbon heat sources and customer demand. Without regulated heat pricing or an accepted methodology for setting a wholesale price, the application of CfDs to heat networks remains complex.

Appendix B – International experience supplementary information

The supplementary narrative below provides a brief historical overview, a summary of the public financing levers available and a summary of the regulatory framework for each country. Additionally, the supplementary narrative is followed by additional information regarding the use of state-owned infrastructure banks.

Rest of the UK (rUK)

Overview

Heat network technology has been in the UK since the 1950s where the Pimlico District Heating Undertaking was the first true district heat network in the UK. The network connected 1,600 council homes to the waste heat generated by Battersea Power Station. However, heat networks fell out of popularity in the 1980s and 1990s as the UK shifted away from high rise flats but regained attention in the 2000s as energy prices increased and financial investment cases became more attractive^[24].

Public financing levers:

The UK Government is aligned with international comparators offering up front capital grants in addition to grants for existing underperforming heat networks to encourage efficiency upgrades. These are as follows:

England and Wales have a designated heat network fund, the GHNF which was set up by DESNZ and managed by Triple Point Heat Networks Investment Management^[25]. The GHNF is the next iteration of grant funding succeeding the Heat Networks Investment Project (HNIP) loans. The GHNF aims to provide up to 50% of upfront construction costs with the aim of making projects more investable for private sector. The GHNF initially had £288m of capital available but further funds of £485m has been additionally allocated.^[26]

DESNZ has also recently published the Heat Network Efficiency Scheme (HNES)^[27] which provides both capital grants to part fund installation and revenue grants to fund procurement or mobilisation of external third-party support to carry out Optimisation Studies. This scheme is targeting existing district heating or communal heating projects in England and Wales that are operating sub-optimally and resulting in poor outcomes for customers and operators.

Regulatory structures

Refer to section 4.2 for the UK regulatory structure overview.

Market ownership

The rest of the UK has a mixed market ownership profile with local authority owned, joint ventures and privately owned heat networks. For example, The London Borough of Enfield own the Energetik heat network, a growing network with its own energy from waste plant providing the heat for the network. Vattenfall own Bristol City’s heat network and work in partnership with Argent and Barnet council^[28]. There are also private equity backed heat network developers such as 1Energy backed by Asper Investment who have four projects under development, including the Bradford Energy Network. Local authority budget constraints will mean a continued role for private sector involvement. For example, the UK Government’s routes to market proposals focus on the Concession and Joint Venture models.

The Netherlands

Overview

The Netherlands started exploring district heating in the 1920s, but the sector developed significantly following the 1970s oil crisis which prompted a search for more efficient and sustainable heating solutions. The country has since been expanding its heat network infrastructure, focusing on sustainability and the use of residual heat from industrial processes.

Public financing levers

The Netherlands is expanding its heat network market by providing capital grants for qualifying projects and incentivising individuals to connect to heat network via individual grants.

This includes the Heat Networks Investment Grant (referred to as the WIS programme), which supports the construction of new, efficient heat networks. This €400m programme was open between July 2024 and December 2024 and specifically targeted heat networks that help existing homes transition away from natural gas (capped at €30m available per project). The programme funds up to 45% of capital costs and aims to bridge the ‘unprofitable top’ of heating network investments (the difference between the eligible investment costs and the operating profit)^[29]. The subsidy can never be more than 100% of this ‘unprofitable top’. WIS can provide support to full projects as well as individual consumers, as it also provides up to €7,000 for small scale consumer connections.

Regulatory structure

The sector has been regulated in the Netherlands since 2014. The legislation was updated with the 2020 Heat Act 2.0, which outlines the requirements for creating a reliable, affordable and sustainable sector. The Act oversees pricing (including price regulation for smaller customers), licensing, private sector profits and customer protections. The Act also sets price caps to ensure that all heat network operators provide price information in a standard format, allowing for greater transparency to consumers.^[30] Regarding tariff setting, the Authority for Consumers and Markets (ACM) ensures that costs for a household with a district heat connection are less than an individual condensing gas boiler.^[31]

The Netherlands is also developing the Collective Heat Supply Act which aims to bring the heat network sector into public ownership. The Act will look to incorporate a ‘cost plus’ model where tariffs are based on actual cost plus a reasonable regulated rate of return^[32]. However, the Act still needs to finalise ownership arrangements between heat generating companies and operators.

Additionally, the Netherlands mandates connections. Municipalities are required to prepare heat plans for their respective areas. This specifies that new buildings have to be connected to a heat network for ten years as part of a heat plan.³¹ Furthermore, the Dutch Building Code states that a house will get a mandatory connection to a heat network when the network is within 40 metres.

Lastly, the Netherlands amended the Gas Act in 2018 to ban new buildings from connecting to the gas grid and introduced a new incentive scheme (SDE+). SDE+ provides subsidies to companies which generate renewable energy or reduce their CO2 emissions on a large scale. Similarly, the Netherlands will ban new fossil fuel-based heating systems from 2026.^[33]

Market ownership

The Dutch heat network market has a large level of private finance penetration with more than 90% of heat networks managed by private heat companies (partly through Public-Private Partnerships) and less than 10% are owned fully by public sector heat companies. For example, Vattenfall (a Swedish state-owned company), Eneco Energy (privately owned) and Ennatuurlijk (Dutch utility company) dominate the market owning approximately 90% of the country’s district heating networks as heat infrastructure has not yet been separated by law from the production and supply of heat (unlike gas and electricity).^[34] As such, in 2022, the Dutch government first considered part nationalisation of heat networks via the Collective Heat Supply Act (WCW) with the intention of protecting public interests such as affordability, reliability and sustainability.^[35] The intention is that municipalities could own 51% of the network, to help encourage consumers to stop using gas fired central heating. The Dutch government believe more citizens would be willing to switch to heat networks if they are not forced into a model that requires the use of a private sector supplier.

This initiative was met with hostility from operators. Ennatuurlijk withdrew from development of the regional district heating grid Twente, as they were not clear how their assets and investments would be valued at the end of the transition period. Whilst the private sector supports opportunities to give more important roles to local authorities, there are concerns about losing control of the strategy and operations of the heating assets whilst remaining financially responsible for them.

Details and practicalities are still being refined, but it is envisaged that existing private network operators would be given a 20-30 year grace period to recoup their initial investments made before transferring ownership to municipalities³⁵.

GERMANY

Overview

Germany’s district heating has its roots in the late 19th century, but it became more widespread after World War II, particularly in East Germany. Today, Germany continues to invest in district heating as part of its energy transition, with a focus on integrating renewable energy sources and improving efficiency.

Public financing levers

The German Government supports the development of heat networks up front via feasibility, capex funding and additionally operating cost subsidies for renewable projects. Individuals and building owners are also incentivised via grant funding to upgrade heating or connect and further rewarded for an accelerated transition. The levers include legislation where there is €3bn to support the development of 5^th generation heat networks^[36]. The previous legislation provided funding covering feasibility (up to 60% of costs) and construction (up to 50%). A new BEW fund provides 50% or €600k and 40% of eligible investment/operating cost subsidy, however this is only applicable to projects with 75% renewable heat sources.

Additionally, companies, landlords of rented family homes and condominium owners are now eligible for financing from KfW (Germany’s state-owned infrastructure development bank) for installing low carbon heating systems or connecting to existing heat networks. The scheme can provide up to 30% of investment costs (plus an additional 5% for more efficient heat pumps)^[37]. A €2,500 fixed support payment for efficient biomass heating systems is included and a speed bonus is applied if existing gas or oil heating systems are replaced by 2028. The scheme also can support individual home-owners with up to 70% of costs and municipalities will also be able to apply for support in late 2024.

Regulatory structures

Germany has the largest scale heat network market in Europe (illustrated by Figure 9) but it is unregulated. Instead, Germany has regulated electricity and gas markets and operates in a similar manner to Finland, with oversight from competition authorities. Standard terms and conditions for supply of heat networks are defined by Federal law.

Additionally, Germany amended the Building and Energy Act 2020 in September 2023^[38] requiring municipalities to:

• Phase out oil and gas heating systems
• develop heating plans by 2028, including a regional heating approach
• that all heating systems installed in Germany after 1 January 2024 must be powered by at least 65% renewable energy

Initially the amendments will apply to new builds but extend to existing and under construction properties too.

The Local Heat Planning Act (WPG) also legally obliges district heating companies to decarbonise their networks^[39]. Therefore, residents within these areas are removed from the transitioning process with responsibilities outsourced to professional entities such as private companies or municipal utilities. The WPG also requires building owners to switch from fossil fuels to renewable heating technologies and municipalities with a population over 100,000 to have draft heat plans by June 2026 (smaller municipalities by June 2028) identifying which heating technologies are available to connect to^[40].

Market ownership

The German heat network market is in transition with several large heat networks becoming municipality owned. For example, in December 2023 Berlin’s municipality acquired the Berlin heat network for €1.4bn from Vattenfall, showing how one of Germany’s largest heat networks has moved into public sector ownership^[41]. The heat network was bought by the state of Berlin as they are committed to re-municipalising infrastructure and reversing privatisations to gain more influence over the city’s district heating and gas supply.^[42] They also believe the company will be profitable and key in moving toward climate neutrality. The state was able to buy the heat network via a state-owned financing company which received equity from the state budget and loans from Investitionsbank Berlin which the senate backed by a state guarantee.^[43]

As it stands, private companies, for example large energy suppliers, hold a significant share of the market and municipalities owning and operating the other significant proportion of the market.^[44] The small remainder of the market is made up via large industrial companies who operate their own networks for industrial processes and heating factory buildings. Whilst market share is small, it is significant in industrial areas. Large public buildings also have their own networks, for example, universities, hospitals and other public sector buildings.

FINLAND

Overview

Finland has a long history of district heating, dating back to the 1950s. The country’s cold climate makes district heating a practical choice for urban areas. Finnish district heating has evolved to use a mix of energy sources, including a significant proportion of renewable and waste energy and it is considered a key component of Finland’s strategy to reduce greenhouse gas emissions.

Public financing levers

The mature Finnish market is upgrading, refurbishing and decarbonising existing networks and is less focussed construction of new networks. The Finnish Government is facilitating the heat transition upgrades by Investing €21.8m across six projects for waste heat recovery, heat pump solutions and energy storage solutions to help move away from carbon-based heating^[45]. Similarly, the Ministry of Economic Affairs and Employment has allocated €469m of energy aid from EU funding for renewable projects via the national Recovery and Resilience Plan^[46]. However, there does not appear to be a bespoke heat network capital grant fund. Additionally, Finland is providing grant support for end users – €2k-€4 for heat exchangers and €0.5k-€2k for balanced and adjusted heating systems. Furthermore, the Government are introducing a new tax credit scheme to give projects up to €150m worth of tax credits.^[47] The idea is once green projects (renewable projects aiding the transition to net zero) become operationally profitable, a tax credit would aid cash flows making the project more feasible and investible.

Regulatory Structures

Finland established a self-governing framework, where there is no official national regulation but instead a clear set of technical codes which form the industry standard^[48]. Finland did have legislation with mandatory connections, which was repealed in 2019, as mandatory connections were deemed anti-competitive. Finland has alternative renewable energy heat sources to choose from.

The Finnish government also introduced a €90m scheme to incentivise the move away from carbon-based fuels to biomass CHP networks and €45m to non-combustion technologies (e.g. heat pumps).

Market ownership

The Finnish market currently has a low level of private finance penetration with heat networks being predominantly municipality owned. However, the Finnish Government is seeking foreign investment into the sector, as it recognises public sector budget pressure and the need to attract private sector investment. For example, an important driver behind the introduction of private finance is the requirement to refurbish existing networks as they become old and inefficient.

Private investors note that Finland is very attractive due to the stability of the heat network sector which allows institutional investors to gain comfort and certainty in their investment.^[49]

Additionally, Finland has seen private equity infrastructure funds acquire individual networks. For example, the largest heat network owned by Fortum Energy (a state-owned energy company) was recently acquired in 2021^[50] by a private equity infrastructure investor (Partners Group) demonstrating the shifting landscape.

Therefore, Finland is demonstrating both the need for private investment as local authorities are capital constrained and offers a stable asset class to invest in an established market.

SWEDEN

Overview

Sweden has been a pioneer in district heating since the early 20th century. The first commercial district heating system was introduced in 1948. The oil crisis of the 1970s also accelerated the transition to district heating, which now utilises a high proportion of renewable energy sources. Sweden’s extensive use of district heating is often cited as a model for other countries.

Public financing levers

The Swedish market is well developed and mature. The Government are using a range of capital funding, personal grant incentives and tax exemptions to expand and refine the heat network market. For example, the Swedish government can provide small grants up to 60,000 SEK (approximately £4,300) for conversion to a new heating system moving away from direct-acting electricity or gas for single family homes^[51].

Additionally, Sweden also provides tax exemptions where renewable energy heating sources are exempt from energy and carbon dioxide taxes.^[52]

Regulatory structures

The Swedish district heat market was deregulated in 1996 which brought issues surrounding high prices and lack of transparency. Subsequently, light-touch voluntary regulation was reintroduced via the District Heating Act (2008)^[53] and overseen by the Swedish Energy Markets Inspectorate (who also regulate electricity and gas). For example, voluntary initiatives for pricing transparency where the Swedish Competition Authority can investigate any signs of potential market abuse. Additionally, the Swedish Energy Market Inspectorate also have standard contract terms for delivery of district heat networks to ensure a consistent delivery approach across the market.

Whilst there is regulatory oversight, connections are not mandatory in Sweden. Although Swedish municipalities are responsible for developing energy plans and have a monopoly planning of district heating developments, building owners decide on their sustainable heating source as long as they follow environmental standards^[54].

Market ownership

The heat network sector in Sweden currently has a mixture of privately and publicly owned networks and operators. For example, the heat network assets are owned by the local authorities and municipalities or the state-owned operator Vattenfall, but there are also private sector operators such as Eon and Fortum. Additionally, Sweden also has some joint venture structures for example between the City of Stockholm and Achiale (private investors).

A recent example of private investment was the sale of 50% of the Fortum (a Finnish state-owned energy company) holding in Stockholm Exergi to a group of European institutional investors including pension funds.^[55] This demonstrates institutional investors recognising the stable returns provided by established heat networks and the opportunity they present to private investors.

ESTONIA

Overview

Estonia’s district heating systems were developed during the Soviet era, with the first systems established in the 1940s and 1950s. After regaining independence, Estonia reformed its district heating sector, improving efficiency and incorporating more renewable energy sources. The country has one of the highest rates of district heating coverage in Europe.

Public financing levers

As Estonia’s heat network sector is well advanced, there are limited grants and subsidies available. However, Estonia is encouraging refinement of their heat network market via investment support, compensation schemes and individual connection grants. Examples include the recent €20m investment by Gren (a private energy company) into Tartu, Parnu and Ida-Virumaa heat networks. Gren also received €4.2m of financial support from the Estonian Environment Investment Centre via the European Cohesion Fund and European Regional Development Fund^[56].

Other forms of public funding included the Government compensation scheme for household energy consumed to counter the rising energy prices^[57]. For example, the state compensates up to 80 percent of the part of the average monthly price that exceeds 80 euros/MWh for district heating. The subsidies are automatically applied to the district heating bills.

Additionally, the Estonian Business and Innovation Agency will provide up to a €10,000 grant for small residential buildings for facilitating the connection to an existing heat network^[58].

Regulatory structures

The Estonian district heat sector is regulated by the District Heating Act 2003 where heat operators must coordinate the price of heat sold to the consumer with the Competition Authority. Additionally, Estonia uses a dynamic pricing structure where changes in the heat price are influenced by changes in the underlying fuel prices and also the required investment that needs to be made in the heat network sector. The District Heating Act also stipulates that within district heating regions connection to the network is mandatory for all located in the region^[59]. Furthermore, municipal governments within Finland, for example Tartu, mandated new and renovated buildings in district heating zones must be connected to a heat network.

Market ownership

The Estonian market has a high degree of private finance penetration as many heat networks are owned by private equity infrastructure funds. For example, Utilitas is the largest operator of heat networks in Estonia and is majority owned by an infrastructure fund. Similarly, recent transactions such as Gren acquiring Viljandi district heating company^[60] and Partners Group acquiring a stake in the Finnish state-owned operator Fortum operating in Estonia demonstrate the attractiveness of a mature and developed heat network sector to private investors.

The role of state-owned infrastructure banks

In addition to the public financing levers noted in section 5.2, there are also state-owned infrastructure banks that can support the heat network sector. Table 7 provides a summary of the banks and their financing products. Examples relevant to heat networks are discussed below.

Table 7: State-owned infrastructure banks

Source: EY analysis

Relevant Examples:

• rUK: National Wealth Fund (NWF) was set up in2021 and allocated £27.8bn of capital to deploy from the UK Government. Heat networks are a key strategic pillar for the bank.
  
  NWF explored a connection charge facility^[61] to incentivise and fund connection to heat networks and give demand assurance. However, whilst the public sector like the facility to help develop a heat network with the cost of connection rolled into the capex facility, the private sector need clarity on who the risk and responsibility sits with (e.g. project co), and proof of concept to buy in.

NWF also look to provide project gap funding development expenditure and capital expenditure to make heat networks commercially viable for private sector investors. Similarly, the bank is considering early phase guarantees/loans to help crowd in private finance by bridging up front development risk and the early years of projects.

NWF has heat networks as a strategic investment pillar and has the capital available to deploy. However, from our stakeholder engagement sessions an additional barrier to deployment is that heat networks are not yet commercially viable enough to enable what NWF can offer.

• Germany: KfW is the state-owned development bank with a commitment to sustainable infrastructure. The bank has recently introduced support for landlords, homeowners and municipalities to claim grant funding for connecting to existing heat networks or other renewable heating sources. The scheme supports those installing/gaining access to low carbon heating systems with up to 35% of investment costs.^[62]
• Nordics & Estonia: NIB was established as an intergovernmental bank between Denmark, Finland, Iceland, Norway and Sweden in 1975. Estonia, Latvia and Lithuania become members of the bank in 2005. The bank has approximately €8.4bn in authorised capital^[63]. Whilst not a country in focus, NIB provided €18m loan to finance upgrades^[64] to existing heat networks in Riga, Latvia in October 2024, demonstrating how infrastructure banks can support established heat networks.
• Scotland: Scottish National Investment Bank (SNIB) has net zero as one of its key missions. The bank has identified there could be opportunities around decarbonising and expanding existing heat networks as well as financing new networks and connections^[65]. The bank does not have any publications regarding bespoke financing solutions for heat networks yet. This presents the opportunity to shape heat network solutions by analysing the market looking at other international innovations.

Appendix C – Major UK regulators: a summary of objectives

Ofgem (The Office of Gas and Electricity Markets)

Ofgem are responsible for regulating the electricity and gas markets, implement measures that protect consumers and promote competition within the sector. Within the UK, there is a well-established group of entities who operate across the generation, transmission and distribution landscape. Generating firms provide the power, transmission networks transport the power and distribution networks move it into residential and commercial premises with electricity and gas retailers being the interface between the energy market and end consumers. The natural gas sector follows a similar delivery structure where gas is extracted, refined and piped into buildings for heating and energy generation (Ofgem, 2024).

Ofwat (The Water Services Regulation Authority)

Ofwat oversees the water and wastewater sector ensuring that water companies provide high quality services at fair prices to consumers whilst ensuring the security of long-term water supplies. Water utilities are responsible for treating and supplying clean water, as well as managing the collection and processing of wastewater. Entities provide these services under strict regulatory supervision to maintain public health and environmental standards. The waste management sector addresses the collection, treatment and disposal of waste, including recycling (Ofwat, 2024).

Ofcom (The Office of Communications)

Ofcom is responsible for regulating the broadcasting, telecommunications and postal industries through maintaining the integrity of communication services. Telecommunications serve a critical role in maintaining connectivity within an ever-increasing digital environment, providing phone services, mobile networks, internet access and the infrastructure that underpins them all (Ofcom, 2024).

ORR (The Office of Rail and Road)

The ORR is responsible for ensuring the safety, reliability and efficiency of the railways whilst protecting the interests of rail and road users. They supervise network operators, such as Network Rail, through licensing to ensure compliance with health and safety law as well as competition law whilst also enforcing economic regulation (ORR, 2024).

CAA (The Civil Aviation Authority)

The CAA maintains a high level of safety in the aviation industry whilst representing the interests of consumers and wider public. It regulates various aspects of airline operations and aircraft management whilst also enforcing economic regulation through controlling pricing at major UK airports to prevent the abuse of market power and ensuring fair charges for passengers and airlines (CAA, 2024).

Appendix D – Overview of utility comparators methodology

The different characteristics of utility sectors have been examined acknowledging the following key attributes associated with the development of heat networks:

• A sector that is immature and in the early stages of its development and growth cycle within the UK
• A sector that provides services direct to its customers (retail in nature) and therefore exposed to a degree of demand, payment and operational risks akin to more conventional services provided in the private sector
• A sector that will be subject to incremental development of heat network infrastructure that will be dependent on accelerated connection of residential and commercial customers, ideally supported through zoning and policy in regard to the mandating such connections
• A sector that must address the affordability challenge of decarbonisation, particularly the cost of transitioning from conventional fossil-based energy sources like gas boilers; noting also that air source heat pumps are increasingly used as the counterfactual cost benchmark when developing an economic case
• The nature of the investment in heat networks, that involves significant upfront capital expenditure, requires funding that can be invested or repaid over extended time of 25 to 40 years, thus requiring investors and developers to take a long-term view of expected return on capital
• A sector that has historically and for the foreseeable future (3 to 4 years) been supported by investment support from the Scottish and UK Governments

Initial analysis was undertaken which focussed on the maturities and similarities between various utility sectors and heat networks across 39 regulated utilities covering electricity, water, telecommunications, rail and air regulation against the criteria listed below, in Table 8. Based upon the preliminary analysis, 17 utilities were taken forward for further examination, which is discussed in Appendix K.

Table 8: Criteria for longlist analysis of maturity and similarity between utility sectors and heat networks

A shortlist was then derived in accordance with an assessment of the following criteria set out in Table 9.

Table 9: Assessment criteria for the shortlist

Appendix E – Key characteristics of utility sectors evaluated

The table below summarises the key characteristics of each utility sector evaluated within Section 6.

Sources: EY, Ofwat (2024)

Appendix F – Timeline of regulatory developments

The figure below represents a timeline of regulatory development across CCUS, offshore wind and household water & sewerage sectors.

CCUS

Offshore Wind

Household Water & Sewerage

Appendix G – Detailed overview of offshore wind sector

The below provides a detailed overview of offshore wind regulation within the UK alongside the regulatory structure and financing mechanisms within the sector.

Overview

Offshore wind electricity generation in the UK is a rapidly expanding sector which plays a pivotal role in the nation’s transition to renewable energy and the achievement of its climate change goals. The regulatory framework is overseen by Ofgem who ensure that the sector operates efficiently and contributes to the UK’s energy security since the early development of the sector, with regulation becoming more prominent following the significant expansion of the sector in the 2000s. Ofgem is aided by the Crown Estate and Crown Estate Scotland who own the seabed around the UK and are responsible for awarding leases to developers for offshore wind development.

Offshore wind farms are subject to a range of regulations, from environmental impact assessments to marine spatial planning, ensuring that developments are carried out responsibly. Ofgem’s regulatory activities encompass various aspects of offshore wind generation. These include connections to the national grid and ensuring that the market operates effectively to facilitate investment and main secure and sustainable electricity supplied.

Regulatory Structure

Following on from the Energy Act 2004, Ofgem has continued to regulate the sector and is adapting its approach and offering new support mechanisms as deployment continues to grow. Ofgem’s regulation of offshore wind is structured around several key elements designed to promote the development of the sector whilst ensuring efficiency, competition and the protection of consumers interests:

• Licensing – generation licences are issued to offshore wind farm operators which set out the conditions operators must meet to legally generate electricity;
• Support mechanisms – provide long term price/revenue stability and encourage investment in offshore wind through guaranteeing a fixed price for the electricity generated;
• Grid connections and access – administrating the connections from offshore wind farms to the national grid through Offshore Transmission Owners (OFTOs) who own and operate the transmission assets;
• Market oversight – monitoring of the market to prevent anti-competitive practices whilst also ensuring offshore electricity generation is integrated safely to aid in the security of electricity supply;
• Financial incentives and penalties – through the RIIO (Revenue = Incentives + Innovation + Outputs) model, Ofgem sets price controls and performance incentives for offshore wind network entities;
• Consumer protection – ensuring costs associated with offshore wind generation are reflected fairly on consumer bills, with the benefits of low carbon electricity generation passed on to consumers;
• Innovation funding – innovation technologies and practices which reduce generation costs can be funded by Ofgem. The aim is to accelerate technological advancements, improving efficiency and reducing costs to support the transition to net-zero energy systems whilst ensuring best value for consumers. As part of RIIO-ED2, Ofgem extended their Strategic Innovation Fund to cover electricity distribution companies with £450m of funding across RIIO-ED2 alongside £68.4m of additional allowances for smaller scale innovation projects through the Network Innovation Allowances.

These structures collectively create a regulatory environment that supports the growth and investment in offshore wind development while managing costs and ensuring the electricity system remains reliable and sustainable.

Regulatory Financing Mechanisms

Offshore wind offers investors long term equity returns over a period of c.15 years commensurate with the term of a CfD. Offshore wind is characterised by large upfront capital expenditure, availability risk (wind), a competitive and volatile electricity market, all of which impacts the sector’s ability to secure much needed investment.

Offshore wind is not exposed to demand risk, given it operates on a wholesale basis. However, to aid in the mitigation of electricity price volatility, availability risk and premium over and above the wholesale price of electricity for the development of Offshore wind, Ofgem awards Contracts for Difference (CfDs) to provide long term stable and predictable revenue for offshore wind developers. The reduced revenue risk attributable to a CfD make Offshore wind attractive to investors resulting in optimised financing structures reducing the overall cost of capital.

CfDs represent an evolution in the Offshore wind sector from Renewable Obligation Certificates (ROCs) which were originally used as a support mechanism to promote investment in the sector. Further to CfDs offering stable and predictable revenue, continual development of offshore wind assets is promoted through government grants and incentives for innovation and infrastructure development.

Renewable Obligation Certificates

The ROCs framework was designed to promote investment across a number of different renewable energy technologies by providing a financial reward for renewable energy generation. It achieved this through the creation of a renewable energy certificate market whereby for each megawatt hour (MWh) of renewable electricity granted, generators would be eligible to claim ROCs.

These could then be traded on the open market to suppliers who did not meet ROC generation obligations imposed by Ofgem. If suppliers failed to present enough ROCs to meet their obligations, a buy-out fee would be imposed for the shortfall of ROCs. The buy-out fee was set by Ofgem and increased annually with inflation. The money collected by Ofgem from buy out fees was then redistributed to suppliers who had met their obligations to effectively incentivise renewable electricity generation.

ROCs were the main support mechanism for renewable energy before being gradually phased out and replaced by CfDs for new projects in 2013 with the aim of improving the regulatory regime. One of the reasons ROCs were phased out was due to the relatively primitive nature of the support mechanism whereby different technologies received varying amounts of ROCs per MWh produced in addition to the wholesale power price. In 2012, offshore wind typically received 2 ROCs per MWh compared to onshore wind which typically received 1 ROC per MWh.

The difference in ROC allocation by technology was arguably quite arbitrary and did not necessarily correlate with the underlying levelised cost of the technology. This potentially stifled the deployment of some technologies or encouraged the development of other sectors, resulting in windfall gains for developers

Contract for Difference

Offshore wind projects are eligible to participate in a competitive auction process to obtain a CfD. The auction determines the “Strike price”, which effectively equates to a fixed price per MWh of electricity that the project generates over a specified period (typically 15 years). The Strike Price is the price per MWh a developer considers necessary to make its applicable return on investment over the period of the CfD.

The Strike Price is different to the actual market price, known as the “Reference Price”, which is calculated based on the average market price per MWh over a given period. When the Reference Price is lower than the Strike Price, a top up payment of the difference in price is made by the Low Carbon Contracts Company (LCCC) to the offshore generator. Conversely, if the Reference Price is greater than the Strike Price, then the generator must pay the difference to LCCC.

By providing a guaranteed price for electricity, CfDs mitigate price volatility risk within the wholesale electricity market. This helps make offshore wind more attractive to investors and lenders as it reduces financial risk of the project whilst also incentivising generators to produce electricity efficiently and at lowest costs to maximise margins.

CfDs were originally introduced in 2013 whilst the sector was focussing on scaling but have enabled the sector to develop into a mature one. Recently, the CfD allocation round 6 has been completed. It included three new CfDs for offshore wind alongside seven offshore permitted reductions which allows projects previously awarded a CfD contract to withdraw up to 25% of their original capacity and apply to a future CfD round.

The balance in setting the correct Strike Price can prove difficult as demonstrated in allocation round 5 in 2023. Figure 11 highlights that there were no successful CfDs awarded for offshore wind in allocation round 5. This was a result of no bids being submitted by developers for offshore wind, which could have been due to the administrative Strike Price set by UK Government of £44/MWh. This Strike Price remained unchanged from allocation round 4 which made offshore wind developments economically unfeasible due to impacts of inflation on development costs.

Figure 11: Total renewable energy awarded during CfD allocation rounds

Government Grants & Incentives

Government grants and incentives are critical tools used to promote the development, operation and maintenance of offshore wind assets. Government grants can help to reduce the upfront capital required for the development of offshore wind farms including research, design and construction helping to mitigate some of the financial risks that developers face. The UK Government, often through Ofgem or other bodies such as Innovate UK, provide this funding and includes grants for innovation in turbine design, foundation structure, grid integration and operations alongside maintenance practices.

In addition to 21 GW of wind farms benefiting from CfDs through to allocation round 6, another example of government funding is the Strategic Innovation Fund (SIF). This aims to help transform gas and electricity networks for a low-carbon future. It provides funds to projects that could speed up the transition to net zero at the lowest cost to the consumer. After launching in 2021, Ofgem expects to invest £450m by 2028 through partnering with Innovate UK to deliver the programme. Innovate UK offers multiple innovation funding such as the Net Zero Living Pathfinder Places. Oldham Council has secured funding from this to develop an Oldham Green New Deal Delivery Partnership, focussing on delivering the £5.6bn of low carbon infrastructure Oldham needs to achieve Net Zero.

Appendix H – Detailed overview of household water & sewerage sector

The below provides a detailed overview of household water & sewerage undertakers within the UK alongside the regulatory structure and financing mechanisms within the sector.

Overview

Household water & sewerage undertakers within the UK are a well-established utility sector which provides residential and commercial customers essential water supply and wastewater services. The sector encompasses the entire process of sourcing, treating and delivering water to households and businesses alongside the collection, treatment and disposal of wastewater and sewage. The household water and sewerage sector within England and Wales is typically characterised by a natural monopoly due to the inefficiencies of having multiple sets of water and sewerage infrastructure competing in the same geographic area.

As a result, the sector is subject to economic regulation which, within England and Wales, is regulated by Ofwat to ensure the provision of high-quality water alongside reliable water and wastewater services at fair prices for consumers. The two main issues Ofwat regulation aims to address are service quality and tariff prices. Service quality is less important than in other sectors like electricity. Ofwat oversees the performance of water companies, enforces compliance with environmental standards and ensures that the sector remains financially viable.

Regulatory Structure

The regulatory structure for household water and sewerage companies within England and Wales has evolved over time to adapt to changing priorities in the sector, such as the need for increased investment in infrastructure, improving customer service and addressing environmental concerns. Some of the key changes in the regulatory structure include:

• Introduction of competition – whilst the water industry in England and Wales has been privatised since 1989, there has been a gradual move to introducing competition within the household water sector to drive efficiency and innovation.
• Periodic price reviews – Ofwat has moved towards conducting periodic price reviews (such as ‘PR19’ or ‘PR24’) typically every 5 years to set price limits and service targets for water companies. These reviews establish the framework within which water companies must operate and balance the need for investment in infrastructure with the protection of consumer interests.
• Performance commitments – Ofwat has introduced performance commitments and outcome delivery incentives (ODIs) to ensure water companies focus on delivering outcomes relevant to their customers.
• Resilience and sustainability – regulatory changes increasingly emphasise the importance of long-term resilience and environmental sustainability through encouraging water companies to invest in approaches that mitigate the risk of drought, flooding and other long term climate related challenges.
• Customer engagement – a greater emphasis is now placed on customer engagement within the regulatory process with water companies required to consult with customers and consider their preferences in the development of their business plan.
• Innovation funding – Ofwat has introduced mechanisms to fund innovation within the sector to encourage water companies to develop and adopt new technologies and practices.

These changes reflect a broader shift towards a more outcome based regulatory regime which encourages water companies to be customer orientated, efficient and forward thinking with their operations and investments. The regulatory framework is designed to incentivise water companies to invest in their networks, improve resilience, reduce leakage and maintain high standards of water quality and environmental stewardship.

Regulatory Financing Mechanisms

Within England and Wales, the water & sewerage sector is predicated on a long-term investment time horizon whereby balance sheets are supported by the capital markets in the form of debt (including bond finance) and shareholder equity. Typically, water utilities seek an investment grade credit rating in order to secure the most competitive form of lending within a highly optimised financial structure, most notably gearing. Regulation by Ofwat in England and Wales provides a stable financial environment for investors, whereby the monopolistic nature of the customer base for each utility provides a reliable level of demand assurance, albeit in a retail market that does result in an element of revenue risk from bad debt.

Ofwat uses various financial levers to encourage initial investment in water infrastructure whilst also encouraging water companies to invest in their infrastructure and services. These financial levers are primarily through a Regulated Asset Base (RAB) model, as well as through the existence of price reviews to adapt to market conditions and innovation funding. Key risks that are borne by utilities in the water sector is that of managing capital programmes, maintenance and operational costs. These risks will be similar in nature to those of the heat network sector.

Regulated Asset Base (RAB)

A RAB model provides a structured approach to regulating the prices that water companies can charge alongside ensuring they maintain and improve the infrastructure, whilst delivering high quality services to customers. The RAB represents the value of a water company’s capital assets, such as pipes and treatment plants and is calculated based on historical investment costs, depreciation and new qualifying capital expenditure. The general value of the RAB can be expressed as:

However, for previously privatised UK network infrastructure sectors such as water, the RAB is generally lower than the current replacement cost of the net book value as when privatised, the assets were sold at a substantial discount to the replacement cost. Within the water industry, the current replacement costs of the assets in 2010 prices are greater than £200bn but the privatisation proceeds were just £10.3bn in 2010 prices. This difference is a combination of the privatisation discount and the capital investment net of depreciation undertaken since privatisation. As such, for UK infrastructure industries privatised after 1980, such as water, the RAB value is further defined as:

Ofwat then uses the RAB value to derive the allowed revenue requirement, which is used to ultimately set prices for consumers, to cover the costs of operations, maintenance as well as providing a fair return on the capital investment on the RAB. This is done through the regulator setting a Weighted Average Cost of Capital (WACC)% which is then applied to the RAB value to calculate the total amount of allowed revenues each company can charge to its consumers. This process, albeit simplified and not considering inflation, is expressed as:

The RAB model inherently encourages water companies to invest efficiently in their assets as a company retains some of the savings as profit if it can deliver the required services at a lower cost than the allowed revenue. Furthermore, since depreciation is active in the RAB, unless ongoing capital expenditure is made, the allowed revenue dwindles. This incentivises water companies to continually invest in their infrastructure, with these investments eventually being included in the Regulated Asset Value (RAV) and therefore in future revenue streams (Frontier Economics, 2010). The RAB model works particularly well within the water sector due to the limited number of operators within the sector (11 regional water and wastewater companies in England and Wales) meaning the time and cost requirements of administrating this regime is manageable.

Price reviews

The price reviews performed by Ofwat determine the revenue that water companies can earn from customers, usually lasting for a 5-year period. Price reviews adopt a total expenditure approach, considering both capital expenditure and operational expenditure when setting price controls. Price reviews promote the development of new assets by providing a framework for recovering the costs of the investment over a period of time. This in turn encourages companies to undertake necessary large scale capex projects.

Furthermore, the price review process also includes performance incentives, through ODIs which reward companies for meeting or exceeding targets set by Ofwat. Conversely if targets are not met, water companies are penalised for underperformance. This system helps align the company’s financial interests with the delivery of high-quality utility services.

Every 5 years each utility must submit an Asset Management Plans (AMP) to the regulator Ofwat. Ofwat will then use the AMP to set price increases and review the quality of services provided which take the form of Key Performance Indicators (KPIs).

The latest AMP is AMP8 for the period 2025 to 2030. AMP 8 will have a greater focus on climate change & emissions reduction challenges, improving water quality, reducing leakage and ensuring reliable water supply and wastewater services. Ofwat has highlighted a strong desire to find new and innovative funding solutions to meet the significant investment in infrastructure required to achieve these goals. An example of this is the Direct Procurement for Customers programme (DPC) which involves the utilities competitively tendering services in relation to the delivery of large new water and wastewater assets. It is envisaged the projects will be similar in nature to Design, Build, Finance and Operate (DBFO) whereby the chosen Competitively Appointed Provider (CAP) will be paid essentially a service fee for a period of between 25 and 30 years.

Innovation funding

Innovation funding impacts the financial environment by providing the means and incentive for water companies to invest in the future. It supports an approach to asset management and service delivery which is proactive in nature. Although there are many external innovation funds available to water companies, Ofwat has established their own Ofwat Innovation Fund. The aim of this £200m fund is to encourage collaborative initiatives and partnerships within the water sector to tackle the larger challenges the sector faces such as climate change, leakage and affordability. Most recently, 17 projects have been awarded funding in the fourth round of the Water Breakthrough Challenge (‘Breakthrough 4’), sharing in approximately £40m towards solutions that will bring benefits to water customers, society and the environment. One example of this is the award of £1.6m to Pipebot Patrol. This aims to develop an autonomous sewer robot which constantly inspects sewers, raising alerts to the precise location of blockages as they begin to form. This proactive approach allows maintenance teams enough time to respond before sewer flooding occurs, potentially contaminating the environment.

Although Ofwat regulates the water sector in England and Wales, due to the privatisation of the sector combined with regulatory models used, profits made by companies can be either distributed to shareholders or reinvested in infrastructure. If too great an emphasis is placed on the former, issues can arise in under-investment in infrastructure, impacting the long-term viability of the sector. Thames Water, England’s largest water company, over the years has significantly borrowed debt totalling over £15 billion under the RAB model, creating about 80% leverage in the company. This has allowed owners of Thames Water to take billions of pounds out the company as loans or dividends within the last 5 years, including over £200m in dividends to other group entities. However, the debt servicing requirements, alongside the need for infrastructure investment to meet efficiency targets, has led to Thames Water requesting Ofwat to allow water bills to rise by 40% by 2030. Ofwat has however rejected these proposals and has currently suggested a rise of 23% as part of its 2024 price review and suggests further capital injection from shareholders to develop infrastructure and service debt payments. As such, without careful regulation throughout the years, potential mismanagement of utilities can arise leading to price increases for consumers.

Scotland has mitigated these specific risks through the water services being publicly owned and operated by Scottish Water who remains accountable to the Scottish Government and its customers. This helps to ensure profits are reinvested in the infrastructure rather than distributed to shareholders.

Water Regulation Within Scotland

Scottish Water remains economically regulated by the Water Industry Commission for Scotland (WICS) which ensures Scottish Water delivers value for money whilst achieving efficiency targets. Regulation ensures that public funds are used efficiently with no profit motive influencing decisions. The social focus of WICS places an emphasis on affordability and maintaining public ownership which is aligned with Scottish Government policies. Furthermore, since Scottish Water is the sole provider of water within Scotland, regulation can be simplified as it benefits from economies of scale.

WICS is governed by the Water Industry (Scotland) Act 2002, as amended by the Water Services etc (Scotland) Act 2005 and the Water Resources (Scotland) Act 2013. WICS is an Executive Non-Departmental Public Body whose principle statutory functions are to:

• Determine charge caps and, in so doing, promote the interests of customers of Scottish Water both in terms of quality of services and the charges that have to be paid;
• Monitor Scottish Water’s performance, encouraging efficiency and sustainability;
• Facilitate (in a manner not detrimental to Scottish Water’s core functions) the entry of retail water and sewerage providers that want to supply non-household customers in Scotland;
• Support the Scottish Government’s vision of ensuring that Scotland is a Hydro Nation and meet their obligations under the Water Resources Act 2013.

Water charges are set by WICS and remain relatively stable as profits are reinvested. The domestic charges are linked to council tax bands, with prices increasing as bands increase, and historically were calculated based off a version of the RAB model. However, since the price review in 2010, WICS have moved away from the RAB based model and instead moved towards looking at business requirements as the basis in setting prices during price reviews.

Price Reviews

Similar to Ofwat in England and Wales, WICS performs Strategic Reviews of Charges to set price limits for the next regulatory period (usually every 6 years). The Strategic Reviews of Charges is initially based upon Scottish Water’s long term business plan which encompasses short- and long-term infrastructure investment requirements, debt repayments and operating costs. As part of this business plan, Scottish Water also works with the Customer Forum to ensure that customer views influence the business plan and pricing requests. WICS subsequently evaluate the business plan, with a focus on Debt Service Cover Ratio (DSCR), alongside multiple other factors including inflation, investment needs and operational efficiency to determine annual price caps for customers. These may be adjusted annually within the limits set by WICS to account for inflation or other changes.

Alongside setting price caps, WICS will also set efficiency targets for each period based upon what it deems Scottish Water should be able to achieve. Although a proxy RAB continues to exist to act as an internal comparator to England and Wales water sector, this customer focussed business plan helps to align Scottish Water with Scotland Government objectives.

Although WICS exercises these functions independently of the Scottish Ministers, whose power to direct WICS, is confined to matters relating to the WICS financial management and administration, ministers can potentially influence agreed charges to customers. If agreed charges are lower than Scottish Water’s requirement, the cash surplus may be insufficient to meet required investment and maintenance programmes. This in turn could impact the long-term lifecycle maintenance and development of new assets meaning the extension of useful economic lives of existing assets is required. There is a risk that, despite it being a public body, if agreed charges are continually lower than what Scottish Water deems as necessary, the integrity of the network in the future is compromised.

If a cash shortfall is present for infrastructure expansion or maintenance of assets, public borrowing could provide the required capital for required expansion or maintenance of assets.

Government Grants and Incentives

Scottish Water receives loans or grants from the Scottish Government to finance large capital expenditure projects such as upgrading treatment plants, replacing aging pipes and building flood defences. This aids in reducing the reliance upon customer charges to fund these large capital expenditure projects helping to ensure affordability for households and businesses. This could provide an advantage over private companies as government-backed loans typically offer more favourable terms than private market financing resulting in further cost savings being passed onto consumers. However, this funding route depends upon the impact this borrowing would have upon Scottish Government balance sheet. This impact could mean funding is not granted for infrastructure development and maintenance projects and instead a short-term increase in customer prices would have to be required. As such, any borrowing is carefully managed to ensure long term financial sustainability for both Scottish Water and Scottish Government.

Appendix I – Detailed overview of CCUS sector

The below provides a detailed overview of CCUS within the UK alongside the regulatory structure and financing mechanisms within the sector.

Overview

CCUS is an emerging sector within the UK and is expected to play a crucial role in the UK achieving its net zero emissions target by 2050. The UK Government has recognised the importance of CCUS in reducing carbon emissions from industrial processes and power generation and as such is actively developing a regulatory framework to support the deployment of CCUS related projects.

This framework aims to ensure that CCUS projects are financially viable, environmentally effective and financially resilient to market uptake. The regulatory environment is shaped by multiple pieces of legislation including the Energy Act and the Infrastructure Act which establish the legal basis for CCUS operations and the regulatory role of bodies like Ofgem, the Oil and Gas Authority and Department for Energy Security and Net Zero.

Regulatory Structure

The CCUS sector is in its infancy within the UK and as such projects are unlikely to be at full operating capacity at the point the facilities are commissioned, in terms of emitter uptake. As such, any proposed regulatory structures will need to take into account:

• Financial incentives: Providing financial incentives to encourage investment in CCUS technology and making it cost effective;
• Economic regulation: To provide stable and predictable revenue streams for CCUS infrastructure investments;
• Licensing: Licensing and permits for CCUS operations including the capture, transport and storage of carbon;
• Safety Standards: Safety and environmental standards to protect public health and the environment;
• Liability Frameworks: Liability and risk management frameworks given the first of a kind nature of CCUS;
• Market Development: Facilitating the development of markets for carbon utilisation and promoting innovation in CCUS technologies; and
• Infrastructure Planning: Planning and developing the necessary infrastructure for carbon transport and storage, including considering shared access and usage to maximise efficiency and reduce costs.

The proposed regulatory structure will need to enable the growth of the CCUS sector whilst ensuring it contributes effectively to net zero goals. It is anticipated that the regulatory framework is likely to evolve as technology and risks develop. Current regulatory proposals to encourage initial investment, development and maintenance of assets include having a RAB based model with revenue support.

Regulatory Financing Mechanisms

Regulated Asset Base

Similar to the RAB model used within the water and sewerage sector, it is proposed that the entities that will develop, own and operate the transport and storage infrastructure (T&SCo) will have a regulatory RAB model as the basis to provide long term reliable revenues to service the initial upfront expenditure and ongoing operating costs.

The process for establishing the amount of allowed revenue is derived in the same way as that used in other RAB models, such as that used in water and sewerage. The difference between the RAB model in water and sewerage sector when compared to CCUS is that the allowed revenue and qualifying operating and capital expenditure, will initially be administered by DESNZ prior to Ofgem fulfilling this regulatory role a short period after commercial operations date. RAB based models require significant resources requirements and time to administer. However, on the basis there is not anticipated to be a large number of T&SCo projects, a RAB based model is deemed an appropriate and effective mechanism to provide an attractive financial proposition (environment) to attract investment from the private sector in a cost-efficient manner.

Revenue Support Agreement

As uptake of CCUS technology is uncertain due to the maturity of the market there is a significant risk associated with T&SCos being able to generate sufficient allowed revenue under the RAB model based upon number of emitters committed to CCUS on day one. As such, the regulatory structure, at least until the market is more mature and developed, includes a revenue support agreement which acts in a similar manner as CfDs in other sectors such as offshore wind. LCCC is the proposed counterparty to the revenue support agreement responsible for paying T&SCo any shortfall in actual revenue generated when compared to the allowed revenue forecast as per the RAB model. This support mechanism helps to address demand risk as the sector develops.

The CCUS regulatory framework helps to address risks associated with a First of a Kind (“FOAK”) project through the amalgamation of previous regulatory support mechanisms. Although the current mechanism is likely to evolve as the sector matures, it currently encourages investment within the CCUS sector through providing long term and predictable revenue for equity investors which is supported through a contract with LCCC. Furthermore, it is predicted continual maintenance of assets will occur due to the RAB model and increasing allowed revenue to enable a return on maintenance expenditure. This helps to encourage the adequacy of the level of net revenue alongside the visibility of sufficient value of future similar projects. However, this amalgamation of support mechanisms is not yet practically tested and remains in development until construction beings on large CCUS projects.

Appendix J – Possible implications of regulatory regimes

Appendix K – Regulatory regime overview

The table below includes analysis performed over regulatory regimes and serves as a basis in selecting comparators for heat networks. The analysis includes typical characteristics of the regulatory sector, timeframe of returns, stakeholders typically involved, key differences in the sector alongside the risk profile of each sector.

The table can be accessed by downloading the report as a PDF (see top of page).

How to cite this publication:

Thomson, N., Davidson, H., Smallman, J. (2025) ‘Funding and financing heat networks in Scotland’, ClimateXChange. DOI: http://dx.doi.org/10.7488/era/5740

© The University of Edinburgh, 2025
Prepared by EY on behalf of ClimateXChange, The University of Edinburgh. All rights reserved.

While every effort is made to ensure the information in this report is accurate, no legal responsibility is accepted for any errors, omissions or misleading statements. The views expressed represent those of the author(s), and do not necessarily represent those of the host institutions or funders.

This work was supported by the Rural and Environment Science and Analytical Services Division of the Scottish Government (CoE – CXC).

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1. Heat Networks (Scotland) Act 2021 ↑

2. Scottish Energy Statistics Hub ↑

3. Scottish House Condition Survey 2022 ↑

4. Heat Networks Delivery Plan: review report 2024 – gov.scot ↑

5. Heat In Buildings Strategy: Achieving Net Zero Emissions in Scotland’s Buildings ↑

6. 2. Overview of policy & regulatory landscape – Heat Networks Delivery Models – gov.scot (www.gov.scot) ↑

7. Heat In Buildings Strategy: Achieving Net Zero Emissions in Scotland’s Buildings ↑

8. Heat networks – Renewable and low carbon energy – gov.scot ↑

9. Heat Networks Delivery Plan: review report 2024 – gov.scot ↑

10. District Heating Relief – mygov.scot ↑

11. Heat Network Projects Quarterly Report : Scottish Government Supported Heat Network Projects – September 2024 ↑

12. Heat networks are often driven by non-domestic pricing arrangements. Green levies on non-domestic bills represent a smaller proportion of the total costs but are still a driver of higher electricity prices. ↑

13. Review of gas and electricity levies and their impact on low carbon heating uptake (climatexchange.org.uk) ↑

14. The Future of Heating: Meeting the challenge (publishing.service.gov.uk) ↑

15. DESNZ (BEIS) “International review of heat network frameworks” (2020) ↑

16. CXC “Lessons from European regulation and practice for Scottish district heating regulation” (2018) ↑

17. Euroheat & Power “DHC Market Outlook 2024” (2024), CXC “Lessons from European regulation and practice for Scottish district heating regulation” 2018, Ministry of Economic Affairs and Communications “Possibilities of efficiency in heating and cooling in Estonia” (2016) ↑

18. Solarthermalworld.org (2022) – Fund of EUR 3 billion for decarbonising German district heating | Solarthermalworld ↑

19. Burges-Salmon (2024) – The Heat Network Zoning Consultation: Will you be required to connect? ↑

20. Dutch state set to take control of district heating schemes – DutchNews.nl ↑

21. Rabobank “Effects of the New Collective Heat Supply Act Determine Investment Climate for District Heating Sector” (2023) ↑

22. Nordic Investment Bank “NIB finances investments in electricity distribution and district heating in Finland” (2023) ↑

23. European Investment Bank “Finland: EIB makes loan to replace Helsinki’s fossil-based heating plants with renewable energy” (2024) ↑

24. AECOM “The rise of energy-efficient heat networks in the UK’s public sector” 2023 ↑

25. Triple Point Heat Networks – “Green Heat Network Fund – guidance for applicants version 8.0” (2024) ↑

26. Gov.uk – “Full Business Case for Green Heat Network Fund GHNF” (2023) ↑

27. DESNZ– “Heat Network Efficiency Scheme (HNES) – Guidance for applicants version 5.0) (2024) ↑

28. Vattenfall (2024) – We’re working to deliver low carbon heat to homes and businesses across the UK. – Vattenfall Heat UK ↑

29. RVO.NL (2024) – “Heat network investment subsidy (WIS)” Heat Networks Investment Subsidy (WIS) ↑

30. DLA Piper (2024) – The Decarbonisation of Heat – what can the UK learn from the US, Germany and the Netherlands? | DLA Piper ↑

31. Interreg HeatNet North West Europe (2020) “Netherlands – national policy framework” ↑

32. Rabobank “Effects of the New Collective Heat Supply Act Determine Investment Climate for District Heating Sector” (2023) ↑

33. EIBI (2024) – The Netherlands to ban fossil fuel installations from 2026 – EIBI ↑

34. Dutch News (2022) – Dutch state set to take control of district heating schemes – DutchNews.nl ↑

35. Rabobank “Effects of the New Collective Heat Supply Act Determine Investment Climate for District Heating Sector” (2023) ↑

36. Solarthermalworld.org (2022) – Fund of EUR 3 billion for decarbonising German district heating | Solarthermalworld ↑

37. BMWK (2024) – BMWK – New heating subsidies ↑

38. DLA Piper (2024) – The Decarbonisation of Heat – what can the UK learn from the US, Germany and the Netherlands? | DLA Piper ↑

39. DBDH (2024) “The missing actor in the heat market: how to fill the gap in Germany” ↑

40. Linklaters (2024) – District heating, heat pumps and hydrogen – how Germany plans to decarbonise its heating sector, Ruth Losch ↑

41. Vattenfall (2024) – Vattenfall completes sale of its heat business in Germany to the State of Berlin – Vattenfall ↑

42. Berlin (2023) Berlin considers purchase of Vattenfall’s district heating business – Berlin.de ↑

43. Berlin (2023) State of Berlin takes over heating network from Vattenfall – Berlin.de ↑

44. DBDH “The missing actor in the heat market: how to fill the gap in Germany” (2024) ↑

45. Euroheat & Power (2024) – New projects granted Recovery and Resilience Facility Funding in Finland – Euroheat & Power ↑

46. Finnish Government (2024) – EUR 72.6 million in investment aid granted to 13 clean energy projects – Finnish Government ↑

47. Bird & Bird (2024) – Significant tax aid for green investments in the pipeline – Bird & Bird ↑

48. BEIS (2020) – International Heat Networks – Masrket frameworks research – Regulatory document review ↑

49. Abrdn (2024) – abrdn: Feeling the heat in Finland ↑

50. Partners Group (2021) – Partners Group acquires District Heating Platform in Northern Europe ↑

51. Ulma (2023) – Contribution to the energy efficiency of single-family houses: This means the government’s new proposal ↑

52. RES Legal (2019) – Renewable energy policy database and support: single ↑

53. CXC “Lessons from European regulation and practice for Scottish district heating regulation” (2018) ↑

54. Salite et al (2024) “A comparative analysis of policies and strategies supporting district heating expansion and decarbonisation in Denmark, Sweden, the Netherlands and the United Kingdom – Lessons for slow adopters of district heating” ↑

55. PGGM (2021) – PGGM acquires minority stake in Swedish heating company Stockholm Exergi | PGGM ↑

56. Gren (2024) – Gren in Estonia invests over EUR 20 million in upgrading heating networks – Gren Finland ↑

57. IEA.org – “Energy price compensation for households” (2023) ↑

58. EIS Estonia (2024) – Grant for upgrading heaters for small residences | EIS ↑

59. Riigi Teataja District Heating Act- District Heating Act–Riigi Teataja ↑

60. Gren (2024) – Gren acquires Viljandi district heating company ESRO – Gren Energy ↑

61. Triple Point Heat Networks “Unlocking Private Finance in heat networks” (2023) ↑

62. Clean Energy Wire “Germany opens heating transition support scheme to all groups of building owners” 2024 ↑

63. Nordic Investment Bank – Member countries, governing bodies and capital – Nordic Investment Bank ↑

64. Nordic Investment Bank – NIB and Rīgas Siltums continue cooperation for efficient heating – Nordic Investment Bank ↑

65. The Scottish National Investment Bank “Scotland’s transition to net zero heat” (2022) ↑

Research completed July 2024

DOI: http://dx.doi.org/10.7488/era/4863

Executive summary

Aims

The buildings sector in Scotland accounted for approximately 20% (8.6 MtCO2e) of the country’s greenhouse gas emissions (GHG) in 2020. To help meet Scotland’s climate change emission reduction targets measures to decarbonise heating and deployment of energy efficiency measures will be required. The Scottish Government has consulted on proposals for a Heat in Buildings Bill, setting out how Scotland plans to use its regulatory and policy levers to incentivise deployment of clean heating technologies and energy efficiency measures. The proposals would enforce minimum energy efficiency standards for Scottish homes and, after 2045, prohibit the use of polluting heating systems.

This study investigates potential impacts of the Bill on the housing market, through a literature review, interviews with stakeholders and a qualitative assessment. We considered potential impacts on a range of metrics, including property and rental prices, length of time properties spend on the market, the number of properties sold or privately let, geographical or archetypical distributional effects and the impact on the mortgage market. We assessed the following four different scenarios against a policy-free baseline:

• Heat in Building Bill (S1-A): assumes the implementation of all proposals consulted on to form a Heat in Buildings Bill, which sets minimum energy efficiency standards for owner-occupiers and private landlords by the end of 2033 and 2028 respectively and prohibits polluting heating systems after 2045. It also assumes inclusion of the proposed early action trigger points including a requirement that properties replace polluting heating systems within a grace period of two years from the point of purchase, and that properties within a Heat Network Zone end their use of polluting heating systems by a certain date and with a minimum notice period.
• Heat in Building Bill with a five-year grace period (S1-B): assumes the same regulatory measures as in S1-A, but includes a longer, five-year grace period following both early action trigger points.
• No-trigger points (S2): assumes the same regulatory measures as in S1-A, but with the removal of early action trigger points.
• First-time buyers’ exemption (S3): assumes the same backstop dates and early action trigger points as in S1-A, but with an exemption for first-time buyers from compliance with early action trigger points.

Findings

While the Heat in Buildings Bill scenario ensures earlier compliance with the regulation, it may also result in a slowdown in activity of the Scottish housing market.

In the rental market, tenants are likely to bear some of the upfront costs of energy efficiency retrofits in the form of higher rents. Following the introduction of the proposed Bill, landlords may decide to exit the market if they do not want to comply with the regulations.

Extending the grace periods to five years is not expected to affect compliance rates, compared to a two-year grace period. However, it could delay clean heating installation timings, as homeowners often defer action until the deadline.

If there were no early-action trigger points, compliance with the regulatory framework may be postponed, leading to delayed action in achieving emissions savings. This could result in a significant increase in demand for energy-efficient homes specifically around the backstop dates, potentially causing a shortage of energy efficient properties.

The market slowdown where an exemption for first-time buyers is introduced is relatively modest compared to the Heat in Buildings Bill scenario where there are no exemptions.

Policy implications

The potential introduction of heating decarbonisation and energy efficiency regulation could decrease purchasing activity in the Scottish housing market, particularly in the Heat in Building Bill scenario (S1-A). Deferring or setting varied deadlines for vulnerable segments of the market (i.e., first-time buyers, low-income households, small-scale private landlords etc.) could partially mitigate this downturn.

Additionally, extending the grace periods could partially mitigate the adverse market effects induced by the proposed early action trigger points.

Pairing the regulatory framework with targeted financial support programmes could help lessen these impacts, particularly where they are designed to safeguard vulnerable individuals and help ensure they are able to adhere to the regulations.

First-time buyers might still encounter difficulties with the additional costs required to meet minimum energy efficiency standards when purchasing properties that are not energy efficient. Extending the deadlines for first-time buyers to meet energy efficiency standards, even when they are exempt from trigger points, could be explored as an option. Additionally, integrating these exemptions with support from help-to-buy schemes could maximise market activity.

Glossary

Introduction

Background

Through the Climate Change Act 2019, Scotland has committed to reach net zero greenhouse gas (GHG) emissions by 2045, across all sectors of the economy.

The buildings sector in Scotland accounts for approximately 20% of the country’s total GHG emissions (Scottish Government, 2024a), hence representing a major source of emissions. GHG emissions in the residential sector are caused mostly by polluting heating systems, such as gas and oil boilers, which produce emissions when used to heat buildings or produce hot water. Decarbonising the residential building stock by 2045 is therefore key to reducing Scotland’s contribution to climate change and achieving net zero targets.^[1] However, the current installation rate of clean heating systems falls short of what is needed for Scotland to reach net zero. Taking no action to accelerate the transition to clean heating technologies is expected to lead to missing the 2045 net zero target.

In this context, effective regulation is expected to accelerate actions towards achieving desired climate and energy efficiency goals, by encouraging property owners to carry out necessary improvements to decarbonise homes. In November 2023, the Scottish Government published a consultation on proposals to make new laws around the energy efficiency of residential buildings and how they are heated (Scottish Government, 2023a). The proposals include homes across Scotland being required to meet a new Heat in Buildings Standard, encompassing both a minimum energy efficiency standard and a prohibition on the use of polluting heating systems. Specifically, the Consultation on proposals for a Heat in Buildings Bill includes the following proposals:

• Use of polluting heating systems to be prohibited after 2045.
• An early action trigger point to ease the transition to 2045, whereby those purchasing a home are required to end use of polluting heating systems within a grace period of 2-5 years following completion of the sale.
• A further trigger point requiring properties within a Heat Network Zone to end use of polluting heating systems (by a certain date, and with a minimum notice period).
• A minimum energy efficiency standard to be met by owner-occupiers by the end of 2033 and by the end of 2028 for private landlords.

Objectives of this study

This study aims to investigate the potential impacts of the Consultation proposals for a Heat in Buildings Bill on the Scottish housing market with a particular focus on the following key indicators:

• Sales and rental prices;
• Length of time properties spend on the market;
• Number of properties sold or privately let;
• Geographical or archetypical distributional effects;
• Impacts on the mortgage market, particularly focusing on changes in supply and demand for green mortgages.

Specifically, it explores the implications for the housing market associated with four different scenarios of potential regulatory measures. These include the introduction of heating and energy efficiency regulations at proposed backstop dates and trigger points (S1-A), extension of the grace period for trigger points (S1-B), removal of point of purchase trigger points from regulatory proposals (S2), and potential exemptions for first-time buyers from trigger points (S3).

Data limitations hinder quantitative assessment, so the study included a systematic desk-based review to capture a wide body of evidence, followed by stakeholder engagement and an extensive qualitative assessment. These were used to infer potential housing market implications associated with the introduction of heat and energy efficiency regulatory measures. We consulted with a wide range of housing market actors, including Scottish Property Federation, Property Mark, Scottish Association of Landlords, Charted Institute of Housing, ESPC, Zoopla, Rightmove, Rettie, RICS, UK Finance, Lloyds Banking Group, Nationwide, and Savills (see Section 8.1).

A review of linkages between heating and energy efficiency regulations and the housing market

This section presents the evidence on the linkages between heating and energy efficiency regulations and the housing market. We carried out a literature review, examining both academic and grey literature sources to inform our work^[2]. The key findings of this research are presented below. However, a more detailed summary of the literature review can be found in Section 8.3.

The literature review focused on the impact of domestic energy efficiency on house sale and rental prices and other elements of housing market dynamics, more specifically on whether and to what extent heating and energy efficiency regulations affect the housing market. We considered several different housing market impacts, including price premiums or discounts, and the time it takes to sell or let a property depending on its energy efficiency and the type of heating system (i.e., clean or polluting). The variation in these indicators was considered based on geography and property archetypes. Additionally, we carried out research on the potential impact of different grace period lengths on the housing market and on homeowners’ behaviours.

Only a very limited number of studies were found to assess the impact of the installation of clean heating systems on property prices. Also, the number of homes sold and the number of properties available for short-term let were found to be largely understudied in the reviewed literature. While we found no evidence of the impact of energy efficiency and the installation of heating systems on the Scottish housing market specifically, there is a body of relevant academic and grey literature that contains important findings:

• Energy efficiency matters when purchasing or renting a home. Properties are sold or let at a higher price if they are more energy efficient. However, the green premium and brown discount (see Glossary) are less pronounced in the rental market than in the sales market. Also, it is difficult to decouple the green premium and brown discount from other property characteristics (i.e., style, quality, newness, decoration).
• Limited information is available on the price impact of installing clean heating systems. While clean heating systems tend to increase property prices, studies have assessed this impact in climatic and market conditions that differ from Scotland. Some factors can significantly influence the existence and magnitude of green premiums and brown discounts. These include the region, climate conditions, urban-rural differences, local property prices and dwelling archetypes.
• Longer grace periods associated with clean heating system installation trigger points reduce the perceived costs of installation.
• There is a convincing business case for green mortgages and green retrofit mortgages, yet market availability in Scotland is currently quite low.

How different heating and energy efficiency regulation scenarios could affect the Scottish housing market

In order to assess the impact of different policy options for heating and energy efficiency regulations, we developed a policy-free baseline, which assumes that no proposed policies consulted in the Heat in Buildings Bill are introduced. Four regulatory scenarios were considered:

• Heat in Buildings Bill scenario (S1-A), assuming all proposals included in the consultation on a Heat in Buildings Bill are implemented.
• Heat in Buildings Bill scenario with a longer grace period for the proposed early action trigger points (S1-B).
• Heat in Buildings Bill scenario with the removal of the proposed early action trigger points (S2).
• Heat in Buildings Bill scenario with first-time buyer exemption from proposed early action trigger points (S3).

These are illustrated in Figure 1 and assessed in detail in the following sections.

We conducted a qualitative scenario analysis to compare each regulatory scenario against the policy-free scenario. The assessment draws upon important findings from the literature review (discussed in Section 4 and further explored in Section 8.3) with further insights from the stakeholder consultation process (see Section 8.1). The qualitative assessment reveals the relationship between different proposed regulatory measures and their expected impacts (e.g., the direction of the impact and potential consequences), but does not quantify them due to the scope of the research and limitations around data availability. As the scenarios differ only in their policy assumptions and assume the same evolution of other factors, only the impact of the policy is assessed.

We use the terms “(green) premium” and “(brown) discount” to refer to the price difference between comparable energy efficient (equivalent to EPC band A-C) and energy inefficient properties (equivalent to EPC band D-G), and the price difference between comparable clean heating system and polluting heating system properties (see Glossary).

Notes: The Heat in Buildings Bill scenario (S1-A) assumes the implementation of the proposals outlined in the Scottish Government’s consultation on a Heat in Buildings Bill. Trigger points refer to early actions requiring (a) property purchasers to install a clean heating system within a grace period after purchasing a property (property purchase trigger point) and (b) homeowners to join a heat network or install an alternative clean heating system after a notice period when a heat network is available.

Policy-free baseline

The policy-free baseline has been designed to capture the key underlying trends against which the other scenarios are compared.

Our policy-free baseline assumes that no further Scottish or UK-wide policies are introduced up to 2045 to regulate the installation of clean heating or energy efficiency in the residential buildings sector. However, this does not imply that decarbonisation of the residential building stock will stop. Several market drivers and behavioural changes are expected to continue driving energy efficiency and clean heating uptake without policy intervention. These drivers refer to regulations already in force, including changes to Building Regulations which require that all new build properties meet strict energy efficiency requirements from 2023, and the New Build Heat Standard (NBHS) which prohibits the installation of polluting heating systems in new buildings applying for a building warrant from 1 April 2024^[3] (Scottish Government, 2024b). Drivers also include increasing climate awareness, greater awareness of the comfort enjoyed in energy efficient buildings and the expected reduction in the installation costs of clean heating systems.

Other key drivers including electricity and gas prices or general macroeconomic conditions (e.g., GDP growth rate, inflation) also affect the decarbonisation rate of domestic buildings. However, it was not within the scope of this project to make assumptions about the future evolution of these drivers.

Heat in Buildings Bill (S1-A)

The Heat in Buildings Bill scenario (hereafter S1-A) includes the proposed policies in the consultation on a Heat in Buildings Bill (hereafter: policies) (Scottish Government, 2023a), and assumes that all proposals as consulted on are introduced. It includes the following measures:

• All domestic buildings achieve a minimum energy efficiency standard, which is broadly equivalent to EPC band C, before the end of 2033 for owner-occupied homes and before the end of 2028 for privately let properties.
• Polluting heating systems are phased out by 2045, with trigger points ahead of this date in the following circumstances:
  • Point of purchase trigger point: all sold dwellings must end the use of any polluting heating systems within 2 years of purchase^[4].
  • Heat network zones trigger point: properties within a Heat Network Zone end their use of polluting heating systems with a 3-year specified notice period^[5].

This section first describes the expected impact of this scenario on the property market (for owner occupiers), followed by the rental market. Finally, the intra-market effects between the property and rental market are discussed.

Owner-occupied homes

The expected impacts of the policies are illustrated in Figure 8 (see Section 0) which separates owner-occupied homes into two categories: homes which do not meet the requirements of the policies (referred to as energy-inefficient properties, with EPC rating of D to G, without clean heating systems); and energy-efficient homes with an EPC rating of A-C (with or without a clean heating system)^[6]. While several housing market impacts are described in this section, an in-depth analysis about the price premium of installing energy-efficiency retrofits and clean heating systems is included in Section 5.6.

The proposed property purchase trigger point, which requires clean heating systems to be installed within a set grace period following the purchase of a property (assumed to be 2 years in this scenario), is expected to place an additional financial burden on purchasers. This may substantially influence the decisions of individuals considering moving, as they will face an additional cost when moving to a new property without a clean heating system installed. The proposed property purchase trigger point affects both individuals living in energy-inefficient and energy-efficient homes. However, the proposed regulation is likely to particularly impact owner-occupiers currently living in energy-efficient properties. These owner-occupiers are not required to retrofit their homes under the proposed policies, which may result in them being discouraged from moving elsewhere (however, they are still required to install a clean heating system by 2045). A study by Zalejska-Jonsson (2014) indicates that people living in green properties are less likely to move to a non-green property^[7]. As a result, the regulation could result in a reduction of the number of energy-efficient homes put up for sale.

Alternatively, trigger points may shift the demand towards properties where clean heating systems are already installed. Therefore, the prices of properties that have already had a clean heating system installed are expected to rise, reflecting the costs of installation in the property’s value^[8],[9].

As a result, future homebuyers are likely to postpone or abandon their plans for moving, leading to a lower number of properties sold in the market. In other words, by raising the overall cost of moving for all potential buyers, early action trigger points may behave akin to a tax on a house purchase, reducing the number of transactions. As the housing market slows down, the time properties take to sell is also expected to increase. The housing market impacts of trigger points can be likened to the UK Stamp Duty Land Tax, which the literature deems to be an excessively distortive tax (Scanlon et al., 2021), causing market slowdown and ensuing housing inefficiencies (people do not move as expected when there is a change in their living circumstances, e.g., when children move away).

From a policy point of view, when people move from an energy-inefficient home to a new property, they face three options:

1. Moving to an energy-efficient property with clean heating system. When people move from an energy-inefficient property to an energy-efficient home with a clean heating system, they will not be required to carry out any further retrofitting after moving in. As a result, energy-efficient properties with a clean heating system can become more attractive when people are looking to buy. Retrofitting a home (either due to energy efficiency backstop dates or the property purchase trigger point) involves additional financial and non-financial costs. These include the time and effort spent making arrangements with professionals to carry out the retrofitting and installation works, as well as the general disruption the work causes. In fact, backstop dates in general may incentivise some people to move to an energy-efficient home with a clean heating system instead of retrofitting their own property to avoid these non-monetary burdens^[10]. As a result, backstop dates may increase the number of homes sold ^[11].
   Theoretically, regulation may also lead to a shift in the demand from houses to flats as they are typically more energy efficient than other building archetypes^[12]. Some stakeholders could also imagine a shift towards different archetypes. However, they emphasised the high uncertainty behind this and the fact that energy efficiency is not a key driver when people buy (or rent) a property. Therefore, the proposed policies are expected to have only a marginal impact on demand for different building archetypes. As a result of the regulation, more people are expected to search for an energy-efficient property with a clean heating system when considering moving. This may lead to an increased demand for energy-efficient properties, while the supply of energy-inefficient properties may also increase. Ultimately, this may lead to greater brown discounts for energy-inefficient properties or properties without a clean heating system. Over time, however, energy-efficient properties with clean heating systems are expected to represent a higher proportion of the residential building stock due to the policies. This may lead to greater supply of these properties^[13], counterbalancing the increased demand to some extent. For more discussion of the evolution of the price premium due to energy efficiency and clean heating system see Section 5.6.
2. Moving to an energy efficient property without a clean heating system. People moving into these types of properties are required to install a clean heating system within a defined grace period. This purchase trigger point will place both financial (i.e., the cost of installing a clean heating system) and non-financial (i.e., finding the optimal solution) costs on purchasers. This can lead to a higher brown discount for properties without a clean heating system. Purchasers comparing similar homes with or without a clean heating system may demand a discount for properties with a polluting heating system. This is because they are required to install a clean heating system within 2 years of the purchase, which is in addition to the purchase price.
3. Moving to an energy inefficient property without clean heating system. Moving to an energy-inefficient property without a clean heating system will activate the purchase trigger point and requires the owner to install a clean heating system within the grace period and meet energy efficiency requirements by the backstop date^[14]. However, people are likely to factor in the upfront costs of retrofitting as an additional burden on the top of the purchase price. This is particularly important close to the energy efficiency backstop date. Higher additional costs due to the energy inefficiency of the property could lead to a harder negotiation when purchasing these kinds of properties, since people depreciate the value of the property to some extent. As a result, the brown discount could increase. This is broadly consistent with one of the key findings of the stakeholder interviews highlighting that closer to the backstop dates, fewer people will be willing to move to an energy-inefficient property, resulting in the brown discount increasing over time (see Section 8.1).

When people decide not to move, they will not be affected by the proposed property purchase trigger points and will only have to meet the policy requirements by the backstop dates. Others, who would not move anyway, will also be unaffected by the purchase trigger point but required to meet requirements by backstop dates.

However, properties that are not sold or purchased between the introduction of the regulations and 2045 may be affected by the proposed heat network zones trigger point and are still required to comply with the minimum energy efficiency standards by the end of 2033. If the owner of a property is notified (e.g. by the local government) that a heat network is available for connection, they need to stop using a polluting heating system within a specified period of time, such as 2 or 3 years. It is proposed that owner-occupiers would have a choice of either joining the heat network or installing alternative clean heating solutions within the same grace period. While this trigger point is important in accelerating the decarbonisation of the residential building stock, it is challenging to assess its impact. The First National Assessment of Potential Heat Network Zones study (Scottish Government, 2022) assessed the potential geographical areas for heat networks based on different criteria, but no decision has been made on the final area. Some stakeholders also mentioned that there is uncertainty about the extent of heat network zones. They also reported that current and potential future homeowners have a poor understanding and awareness of heat network technology and its potential zones. Therefore, in this study we assume that homeowners do not consider a heat network as an opportunity when looking for a new property or as a potential future cost if they decide not to move from their current home. This assumption significantly diminishes the potential housing market impacts of the heat network zones trigger point, but it may still affect it to some extent.

Due to the uncertainty around the future extension of the heat network zones, the heat network zone trigger point may interact with the housing market in three cases:

• People may decide to purchase a property without a clean heating system installed in an area where connection to the heat network is not possible at the time of purchase. In this case, they will be required to install a clean heating system within the grace period, and they are likely to negotiate the price similarly to any other property without a clean heating system. If the heat network becomes available for connection within the grace period, the purchasers can decide to join it (or install a different type of clean heating system), but this is not expected to have an impact on the housing market as it was not known at the time of purchase. It is important to note that the proposed policies do not require a home located in a future heat network zone to join it if that home already has a clean heating system installed.
• Alternatively, people may decide to move into a home which is located in an announced heat network zone but has not joined it. In this case, purchasers are free to install the most appropriate clean heating system option, such as joining the heat network or installing a different type of clean heating system^[15]. If connecting to the heat network is cheaper than installing another type of clean heating system, the seller and the purchaser may agree on a higher price compared to a similar home not located in a heat network zone: the purchaser could offer a higher price because of the expected lower financial burden of connecting to a heat network.
• For owner-occupiers who have not moved since the policy was introduced, the heat network trigger point could accelerate the phase-out of polluting heating systems. Notified owner-occupiers are required to connect to the heat network or install a clean heating system within a grace period which could be earlier than the backstop date. This requirement could increase the supply of homes with clean heating systems. However, most heat network zones won’t be available for connection until after 2035. Most owner-occupiers would therefore be phasing out their polluting heating system (due to the backstop dates) when most heat network connections become available (around 2040). The overall impacts of the heat network trigger point for existing owner-occupied homes are therefore likely to be minimal.

The proposed policies are also expected to increase the demand for green mortgages. The increase is expected due to the additional burden of covering the upfront costs of retrofitting (due to the trigger points or backstop dates). When people cannot fully finance the retrofit, they may apply for a loan^[16]. If the supply of green mortgages is sufficient and the product is competitively priced, it is expected that the regulation could lead to the growth of the green mortgage market. Stakeholders involved in green mortgages also expect an increase in the total value of green mortgages over time.

One caveat is that, without further measures, the policies included in this scenario can have a disproportionally high cost on people in lower income groups. Due to their lower incomes, they are less likely to be able to afford the upfront costs of retrofitting and to get a green mortgage at a competitive price. In addition, the increase in the brown discount could have a negative impact on them as they may need to sell their homes at a lower price if they want to move.

Rental market

The proposed policies in the consultation on a Heat in Buildings Bill (hereafter: policies) also require private landlords to carry out energy efficiency retrofits (equivalent to EPC band C) before the end of 2028 and to install a clean heating system by 2045. The property purchase trigger would also be required to be met by landlords wishing to enter the market or expand their portfolio.

Three main factors can drive the impacts on the private rental market as a result of the policies, which are illustrated in Figure 9 (see Section 0):

• Retrofitting due to the policies. The policies require landlords to retrofit their properties. A key issue is whether and to what extent landlords and tenants bear the upfront costs (in the form of higher rents). Stakeholders reported that there is a significant housing shortage in the Scottish rental market, particularly in larger cities. Therefore, an increase in rents is expected to have a low impact on the demand for rented properties. In other words, renters would have little or no opportunity to move to another property if they do not want to or cannot afford to pay a higher rent. This implies that tenants are expected to bear the costs of retrofitting, at least to some extent, in the form of higher rents.
  It is important to note that at the time of writing there were temporary modifications in place to the way in which applications for a review of a rent increase are determined by Rent Service Scotland, which limit rental increases to some extent where a review is sought. These measures are intended to support the transition away from the rent cap under the Cost of Living (Tenant Protection) (Scotland) Act 2022 which ended on the 31 March 2024. (Scottish Government, 2024c).
  Also, due to the shortage of rental properties, landlords may not be concerned about losing their tenants while carrying out refurbishments (i.e., tenants need to bear some non-financial costs, such as the general disruption installation work causes)^[17],[18] as they expect new tenants to move into the property following completion of the works.
• Exiting the market. Landlords who do not want to carry out or cannot afford the cost of retrofitting have the option of selling their properties. Stakeholders agreed that this option may be considered by many. According to interviewed representatives in the Scottish rental market, many landlords plan to reduce the size of their portfolios, as a result of market interventions during the pandemic and the energy crisis^[19]. The heat and energy efficiency regulation might lead to a similar effect, particularly if the housing shortage in the sales market is taken into account (i.e., a high price in the property market can be achieved). According to a recent Rightmove report (2023), 33% of all landlords in Great Britain who own a property with an EPC rating below C would choose to sell rather than retrofit. If some landlords do decide to leave the rental market, this could exacerbate the rental housing shortage and lead to higher rental prices.
• New dwellings can enter the market. Properties which meet the requirements of the policies may enter the rental market. These are likely to be new builds or already retrofitted homes which were owner-occupied or unoccupied prior to entering the rental market^[20]. High rental prices can create an incentive (among other considerations^[21]) for new landlords to enter the market and for the landlords already holding buy-to-let properties to expand their portfolio. As a result, these properties can reduce the shortage in the rental market (increase the supply) and, therefore, reduce rental prices.

Interactions between the sales and rental market

The policies proposed in the consultation on a Heat in Buildings Bill (hereafter: policies) are expected to have an impact on the number of homes sold and let. There are two main interacting impacts, partly outlined already in Sections 5.2.1 and in 5.2.2 and depicted in Figure 11 (Section 0):

1. Landlords may sell their properties due to the implementation of the regulation. This can have a negative impact on the rental market since it can reduce the supply of properties for letting and, therefore, rents may increase. Conversely, these properties can appear on the sales market. They therefore can increase the supply of properties for sale and may reduce sales prices.
2. New buy-to-let properties may enter the rental market. Properties that meet the policy requirements are more likely to enter the rental market, particularly when local rental prices are high. In this case, they can increase the supply in the rental market and, therefore, rent prices may be reduced. Conversely, these properties would not enter the sales market (e.g., new builds would not be sold for owner-occupation but used as buy-to-let properties). This can lead to a reduction in the housing supply and therefore can lead to higher sales prices.

The number of properties on the rental and sales markets is not affected by decisions made by owner-occupiers and landlords to retrofit their homes (while retrofitting is likely to affect the rental prices and/or the value of the property).

In conclusion, the rental and sales markets are strongly linked to each other. Policy-induced actions (e.g., exit or entry to the rental market) can have a converse effect on the other market (e.g., increase or decrease in the number of homes sold). However, determining the relative magnitude of these impacts is challenging and therefore the overall impact on the rental and housing market cannot be concluded at this point.

Heat in Buildings Bill with 5-year grace period (S1-B)

The Heat in Buildings Bill with 5-year grace period (hereafter: S1-B) includes the same policies as the S1-A scenario, but the grace periods for the property purchase and heat network trigger points are set to 5 years (compared to 2 and 3 years, respectively) (see Figure 1). The reason for exploring S1-B is to consider the impact of a longer grace period for both early action trigger points on the housing market. For this reason, the outcomes of S1-B are compared against the outcomes of S1-A, and not against a policy-free baseline.

While key housing market impacts of the S1-B scenario are presented below, a more in-depth analysis about the price impact of installing energy-efficiency retrofits and clean heating systems are included in Section 5.6.

Sales market

We based findings from the literature presented in Section 8.3, which draws heavily on the findings of behavioural economics, and on the stakeholder interviews (see Section 8.1). Implications of a longer grace period for the heat network zone trigger point are discussed later in this section. Three key housing market drivers in the sales market associated with a longer grace period of the proposed property purchase trigger points have been identified (see also Figure 10 in Section 0).

• Lower average cost per year. In the case of a longer grace period, the average cost per year of installing a clean heating system (the salient cost of compliance) is lower compared to a 2-year grace period (in the case of the purchase trigger point) as owner occupiers are expected to spread out the perceived costs over the longer 5-year period. This may result in a lower perceived financial burden for purchasers. In addition, some homeowners may expect further innovation in clean heating solutions (in particular a reduction in price) in future, which may lead to lower real cost of installation.
• More time to plan and install the optimal solution. A longer grace period allows people to better plan their finances. Stakeholders agreed that a two-year grace period may rush people into decisions, and they may not properly consider their options in this period. This could lead them to install a clean heating system which is more expensive or less efficient than another solution.
• Poorer understanding and/or appreciation of future costs and opportunities. Based on the findings of behavioural economics, supported by the views of stakeholders, it is realistic to assume that a longer grace period may lead to a poorer understanding of costs. This means, for example, that purchasers are more likely to see the installation of a clean heating system as a future problem. Purchasers would be more biased about how much the installation would cost and would have less incentive to track these future costs. This contrasts with the previous point, i.e., that people would plan more carefully if the grace period were longer. Instead of rational planning, many people may rush to install a clean heating system at the end of the grace period. Stakeholders mentioned that most purchasers are often unaware of the available clean heating system solutions and their financial and non-financial costs. Also, the type of the heating system in a property is not the primary focus of the purchasers and they may not be aware of or realistically consider the requirements of the policy.

These three drivers all lead to a lower perceived cost of installing a clean heating system in a newly purchased home and to a lower perceived value of an installed clean heating system. As a result, a longer grace period may reduce the green premium for properties with a clean heating system installed compared to a shorter grace period from the proposed property purchase trigger point. In addition, the purchase of a new home can be perceived to be relatively cheaper in the case of a longer grace period, compared to S1-A, due to the lower average cost per year and to the lower perception of future costs. Therefore, more properties are expected to be sold when the grace period is longer. In other words, the 2-year grace period for the property purchase trigger point can be a stronger disincentive to move than a 5-year grace period, as highlighted by stakeholders when interviewed^[22].

It is also important to note that a 5-year grace period can make it more likely that people move into a different property before the end of the grace period. As highlighted by the interviewed stakeholders, this is especially the case for first-time buyers, who are the most likely to move multiple times in a shorter period of time compared to others, due better financial circumstances or a growing family. Those individuals who purchased a property after the introduction of the policy and are required to install a clean heating system within the grace period are more likely to resell their property prior to the installation of a clean heating system at the end of the grace period. This can lead to less intense negotiation when they buy a property without a clean heating system: they may consider moving again in a 5-year period, so they would not fully assess the cost of installing a clean heating system^[23]. This can result in a smaller brown discount (i.e., a smaller difference in price between similar homes with and without a clean heating system). However, stakeholders mentioned that owner-occupiers are more likely to use this opportunity than landlords. This is due to the relatively high tax on purchase (which significantly diminishes the return on the property investment in the short term) and the general view that landlords purchase properties as a form of long-term investment.

The S1-B scenario also includes a longer grace period for the proposed heat network trigger point (i.e., 5 years compared to 3 years in the S1-A scenario). However, the extension of this grace period is expected to have little impact on the housing market under the assumption made in Section 5.2. As people are not aware of the future geographic extent of the heat network and the potential time when connection will be available, they cannot consider the potential costs and benefits of connection. This uncertainty is independent of the length of the grace period. However, when a home is purchased in an area where the connection to the heat network is possible, but not yet carried out, the purchasers have a longer period to comply with the regulation. Similar to the property purchase trigger point, this longer grace period can lead to a lower average cost per year, more time to plan and a poorer understanding of the benefits of connecting to the heat network^[24]. This may result in a lower green premium for these homes compared to the S1-A scenario. As a key finding, the overall impact of the 5-year grace period on the heat network trigger point may lead to a smaller green premium compared to a 3-year grace period.

Rental market

The length of the grace period does not directly affect most rental market participants. Landlords who already own a property at the time of the introduction of the policy and those landlords who decide to leave the rental market (for any reason) are not affected by the property purchase trigger point and are therefore not affected by the length of the grace period (see Figure 12 in Section 0). However, a clean heating system needs to be installed by 2045.

The length of the grace period could affect the potential for new entrants to the rental market and therefore can have a direct impact on the supply of homes let. Potential new landlords (or landlords expanding their portfolio) considering buying a property to let, would face similar market drivers to owner-occupiers. These could include, in a case of a longer grace period, more time for financial and non-financial planning^[25]; finding the optimal clean heating system without rushing to install one and a poorer understanding and lower perception of actual costs. In addition, some landlords may delay the installation due the expectation of lower future costs, driven by innovation (price reduction) or, if they manage a portfolio, through learning-by-doing effects (i.e., they can gain experience in installing a clean heating system in one property and apply it later in another property). As a result, a 5-year grace period could reduce the disincentive for landlords to purchase a property compared to a 2-year grace period, resulting in a relatively higher supply of rental properties. However, most stakeholders highlighted that the property purchase trigger point is likely to discourage landlords from entering the market in the first place, irrespective of the length of the grace period.

The aforementioned housing market impacts can also affect rental prices. Stakeholders agreed that most purchasers do not perceive a value in having a clean heating system installed in their rental property, and therefore landlords cannot fully pass on the cost to the tenants through higher rents (although there will of course be value-driven tenants in some cases). In other words, when comparing two similar properties with and without a clean heating system, landlords cannot fully differentiate through rents based on the type of clean heating system installed. However, the type of local housing market is also relevant here: if it is supply-driven (there is a shortage of rental properties), landlords have more power to pass on the upfront costs to the tenants in the form of higher rents. Conversely, in a demand-driven local market, where tenants have more power and choice, less differentiation in rents is possible. Ultimately, this means that in a supply-driven housing market, landlords can pass on the upfront cost of installing a clean heating system to the tenants, which can be higher if the grace period is shorter. Alternatively, a 5-year grace period may reduce the disincentive for new landlords to enter the market, resulting in a relatively higher supply of rental properties, ultimately leading to reduced rental prices.

No-trigger points (S2)

The ‘No-trigger points’ scenario (hereafter: S2) includes the same policies as the S1-A scenario but excludes both early action trigger points (see Figure 1). While key housing market impacts of the S2 scenario are presented below, a more in-depth analysis about the price impact of installing energy-efficiency retrofits and clean heating systems are included in Section 5.6. Figure 13 in Section 0 illustrates the main changes in the S2 scenario.

As discussed in Section 5.2, early action trigger points can raise the total cost of moving. This could be through the cost of installing a clean heating system where it had not been installed yet, or through the costs being included in the price where the installation had already been carried out. In the S2 scenario, this increase in costs is not present, so the sales market is not expected to slow down, and the time it takes to sell a property on the market is also expected to remain unaffected.

As buying and selling properties does not trigger any further actions from the buyers’ side, the main question owners of energy inefficient homes face is how they want to meet the energy efficiency requirements before the end of 2033 and later the clean heating system requirement by 2045. The closer in time a given backstop date is, the more it is expected to matter to buyers. Since the backstop date for clean heating systems is likely perceived to be far into the future, initially only a small fraction of buyers may take this into consideration and with a relatively small weight compared to a policy-free baseline. However, as the backstop dates approach, a growing fraction of market players could account for them, and the ensuing market dynamics impact everyone who participates in the housing market or is considering participation.

Owner-occupiers of energy-inefficient homes without a clean heating system face the choice of carrying out the retrofitting works and/or installing a clean heating system in their own homes, but they also have the option to move to another home in which the required works have already been carried out. This latter option can be attractive as not only have the financial costs of retrofitting been covered, but owner-occupiers can also avoid the non-financial costs associated with retrofitting (such as the time and effort spent on searching for and arranging professionals to carry out the installation, and the stress and disruption the work can cause). If owner-occupiers choose to move, the demand for energy-efficient homes with clean heating system and the supply for energy-inefficient homes can increase, while the demand for energy-inefficient homes would tend to decrease. This would bring about an increased brown discount. Although the backstop dates only directly concern owner-occupiers of energy inefficient properties, owners of energy-efficient properties moving for other reasons might also be increasingly inclined to look for energy-efficient properties. This could reinforce the increase of the brown discount.

If owner-occupiers choose to stay and carry out energy efficiency retrofitting in their homes as the relevant 2033 backstop date approaches, it is arguable that there are efficiencies to exploit if they also decide to install a clean heating system. Should they not do so, by the end of 2045 they will have to undergo further work to replace their heating system with a clean technology or move to a home with a clean heating system.

First-time buyer exemption (S3)

The final scenario (hereafter: S3) includes the same policies and trigger points as the S1-A scenario, but with an exemption from the property purchase trigger point for first-time buyers. In other words, first-time buyers would not need to replace polluting heating systems within the grace period (assumed to be 2 years in this scenario)^[26]. Figure 14 in Section 0 illustrates the main changes in the S3 scenario.

Since the removal of help-to-buy schemes, first-time buyers cease to be financially supported by the government in buying a property. As their relative purchasing power is likely to be lower compared to those that have already owned a home, potential first-time buyers either have to remain in their current living arrangements (on the rental market or with family) or settle for more affordable, likely energy-inefficient properties (without a clean heating system).

Especially in the early years of the policy, a first-time buyer exemption from the proposed property purchase trigger point is similar to the 2017 Stamp Duty Land Tax First-time Buyers’ Relief in England and Northern Ireland. This amounted to a reduction of up to £10,000 of overall costs of moving. A report published by the UK Government (2023) suggests that the relief resulted in an 11% and 18% increase in transactions over and above the volume of the transactions of first-time buyers that would have taken place in absence of the policy for the two relevant discrete mortgage value bands studied. Although first-time buyers are subject to the clean heating system backstop date of 2045, the exemption from the proposed property purchase trigger point is likely to enhance their purchasing power in the housing market compared to S1-A and S1-B scenarios. It follows that exempting first-time buyers from the trigger point could make homes with a polluting heating systems more attractive to first-time buyers as it postpones the burden of having to upgrade to a clean heating system. Moreover, the brown discount for polluting heating system homes could still be present on the market, as the additional cost of the heating system upgrade would still remain for the majority of buyers. As a consequence, properties with polluting heating systems could be cheaper on the market. However, as first-time buyers are only obliged to install a clean heating system by the backstop date (the end of 2045), they do not bear the cost of installing a clean heating system in the near future. As a result, they would face a lower effective price for properties without a clean heating system. Although the costs of installation are expected to continue to affect first-time buyers in the long run, they could receive some short-term financial relief from their liquidity limitations.

Property price premium associated with energy efficiency and clean heating systems

In this section, the price premium associated with energy efficiency retrofitting and the installation of clean heating systems is analysed in greater detail.

Property price premium associated with installing a clean heating system

The expected property price premium associated with installing a clean heating system over time by scenario is visualised in Figure 2 below. Figure 2 is illustrative only, as no quantitative assessment has been carried out to estimate values. The blue line in the chart shows the main trend in the evolution of the price premium. The shaded area represents the degree of uncertainty: the larger the area is in a given year, the greater the expected uncertainty.

Stakeholders interviewed agree that there is currently no price premium for properties with clean heating systems in the Scottish housing market (see Section 8.1). This is due to several factors, including the fact that clean heating technologies are not yet widely used in Scotland, which leads to a lack of understanding about and confidence in these technologies. The most valued heating system is gas central heating as it is perceived to be easy to use and households are familiar with it. For these reasons, the price premium in Figure 2 starts at zero in all scenarios.

In the policy-free baseline, we expect a slow increase in the price premium for properties with clean heating systems. The main drivers include the expected decrease in installation costs due to forthcoming innovation, increased supply of trained installers and the lower running cost due to the greater efficiency of clean heating systems (subject to the relative price of electricity to gas at any point in time). Additionally, the increasing climate consciousness and the increased confidence in new technologies (due to higher installation rates and awareness) could contribute to a slowly increasing price premium. These are supported by a study carried out in Finland, where heat pumps are already widely understood and used. Vimpari (2023) reported a significant price premium for homes with ground-source heat pumps compared to other heating technologies in Finland^[27]. Also, properties with an air-source heat pump tend to have a higher price premium in those US regions where climate consciousness is higher (Shen et al., 2021).

In S1-A and S1-B, there are two main drivers of the premium:

1. Time effect: As the backstop date of the prohibition on polluting heating systems (2045) approaches, more people are expected to realise that they need to comply with the clean heating regulations. As shown earlier, this could lead to harder negotiations on price for properties without clean heating systems and higher demand for properties where they are already installed. As a result, the premium for properties with clean heating systems may increase over time.
2. Impact of trigger points: If the proposed property purchase trigger point is introduced, buyers are required to retrofit their heating system within a proposed grace period after a house purchase. However, close to the introduction of this proposed regulation, only a limited number of properties are expected to be equipped with clean heating systems. Those people who want to avoid retrofitting their home after moving will likely need to pay a higher premium for these homes as the supply is constrained. However, in time, the number of homes with clean heating systems will increase (e.g., due to the trigger points and due to the New Build Heat Standard (Scottish Government, 2024b) enforcing the installation of clean heating systems in new builds from 1 April 2024). This could lead to a jump in the green premium at the introduction of the policies, but it is expected to decrease over time.

The effects of time and trigger points are expected to work in the opposite direction over the regulatory period (i.e., from the introduction of the proposed regulations to 2045). This could lead to a ‘U’ shape over time, as visualised in Figure 2 below. However, it is important to note that there is a high degree of uncertainty in the magnitude of the different impacts. This uncertainty is particularly pronounced in the case of the impact of the trigger points (introduced in the second point above) as the housing shortage on the property market is a key driver. In addition, while buyers do consider the heating technology when purchasing a property, many stakeholders emphasised that other factors, such as characteristics of the neighbourhood, property archetype, size, etc. can be more important to buyers.

In S2, only time has an impact on the price premium. Therefore, a constant increase is expected in the price premium. As people become aware of the approaching backstop dates, the installation of clean heating systems cannot be postponed any longer. This is why the shaded area below the main trend in Figure 2 is shrinking: a relatively higher premium is expected for properties with clean heating systems, with less uncertainty. It is also important to note that the installation rate of clean heating systems (see Figure 4 in Section 8.2) is also a key driver of the premium. If only a limited number of properties have clean heating systems installed, and the backstop date for the prohibition on polluting heating systems is close (2045), potential purchasers are likely to pay more for a property with a clean heating system – otherwise, they will have to install it themselves. In S2, we expect the installation rate of clean heating systems to be relatively lower than S1-A due to the lack of trigger points resulting in the majority of installations taking place around the backstop date. This may inflate the price of properties with a clean heating system, as their supply is expected to be limited.

Finally, in S3, we expect the price premium to be a mix of the S1-A and S2 scenarios. This means that we expect first-time buyers to behave as in the S2 scenario, i.e. to postpone the installation of clean heating systems to some extent. Other buyers would (and are required to) behave similarly as in the S1-A scenario. As first-time buyers represent around 25% of the market (calculated from Scottish Government, 2023c and Bank of Scotland, 2024), the premium is expected to be closer to the premium observed in the S1-A scenario.

Note: Price premium on the y-axis refers to the premium compared to the value of the property; blue line and shaded area indicate the mean estimate of the price premium, and the degree of uncertainty around it. The figures are illustrative only, as no quantitative assessment has been carried out to estimate their values.

Property price premiums associated with energy efficiency

In the case of the energy efficiency price premium, there are no differences between the S1-A&B, S2 and S3 scenarios (there are no relevant trigger points for energy efficiency, and the backstop dates are universal). As a result, these three scenarios are referred to in this section as the ‘Heat in Buildings Bill scenarios’ (S1-S3).

In the case of the policy-free baseline scenario, we expect a constant, and relatively low price premium for more energy-efficient homes. This is supported by the majority of academic sources and some of the stakeholders we consulted. However, many stakeholders were in disagreement that there is currently a green premium in the Scottish housing market (e.g., due to the housing shortage or because levels of energy efficiency are less important to buyers and renters). The lower band of the shaded area of Figure 3 is therefore zero^[28]. Stakeholders also reported that energy efficiency (usually measured by EPC rating) is a good proxy for the quality of a property (e.g., having a high quality interior). It is therefore difficult, if not impossible, to disentangle the price impact of energy efficiency from the impact of quality.

In the case of the S1-S3 scenarios, the proposed backstop dates to achieve a minimum energy efficiency standard (i.e., before the end of 2028 for rented homes and before the end of 2033 for owner-occupied homes) can drive an increase in the price premium for energy-efficient homes. Investors of buy-to-let properties could have a higher interest in energy-efficient dwellings as they will have to install energy-efficiency retrofits before the end of 2028. Therefore, they would include these costs when investing in an energy-inefficient property.

However, as the majority (62%) of the residential building stock is owner-occupied (Scottish Government, 2023a), a steeper increase is expected close to 2033. Stakeholders mainly agreed that the proposed regulatory policy will create a green premium in future, even if they do not think that a green premium currently exists. However, the size of the potential price premium is uncertain, and stakeholders rather reported a discount for energy inefficient properties. This is explained by the fact that fewer people are expected to be willing to move into an energy-inefficient property as the backstop dates approach.

Additionally, we expect the price premium to decrease after the backstop dates. Some properties in the owner-occupied market are expected to remain energy inefficient (e.g. some people will not be able to afford to retrofit their home and may have been considered as temporarily exempt from the regulations). However, these properties will slowly be taken off the market (e.g., sold or retrofitted after the backstop date) and only a very limited number of them could remain. As the majority of homes are expected to meet the minimum energy efficiency standards, the price premium is expected to fall sharply after 2033. A few years after the policy comes into force, it is expected that there could be no price premium on the market as most homes will comply with the policy requirements^[29],[30].

Figure : Price premium of energy efficiency over time in different scenarios, compared to properties which does not meet minimum energy efficiency standards.

Note: Price premium on the y-axis refers to the premium compared to the value of the property; blue line and shaded area indicate the mean estimate of the price premium, and the degree of uncertainty around it. The figures are illustrative only, as no quantitative assessment has been carried out to estimate their values.

Key takeaways

We created four scenarios to be compared against a policy-free baseline to analyse the potential housing market impacts of the proposed regulations in the consultation on a Heat in Buildings Bill. The main findings are as follows:

• In the sales market, an increase in the brown discount for energy-inefficient homes without a clean heating system is expected as the energy efficiency and clean heating backstop dates approach under the Heat in Buildings Bill scenario. The proposed property purchase trigger point may lead to a jump in the green premium after the introduction of the proposed regulation. A longer grace period for trigger points is expected to lead to a smaller difference in the price of similar homes with and without a clean heating system. Without trigger points, a steadily increasing premium is expected, which is ultimately higher than in the Heat in Buildings Bill scenario.
• In the rental market, tenants are likely to bear some of the upfront costs of energy efficiency retrofits in the form of higher rents (particularly in supply-driven local rental markets). Some landlords may decide to exit the market to avoid complying with the regulations. This would lead to further housing shortages and higher rents. However, high rental prices could also incentivise investors to enter the rental market, mainly purchasing new builds and already retrofitted properties, leading to an increase in the supply of rental properties and subsequently lower rents. A longer grace period for early action trigger points may be less of a disincentive to enter the rental market and increase supply compared to a scenario with shorter grace period. However, according to the interviewed stakeholders, the proposed minimum energy efficiency standard requirement and the proposed property purchase trigger point can be a significant disincentive for landlords to enter the market and an incentive to exit. The overall effect on the rental market depends on the strength of each impact.
• The time properties take to sell is increased by the introduction of the proposed property purchase trigger point, as the increase in the overall costs of moving slows the market down.
• We found that several factors may affect the number of homes sold as a result of the proposed policies. On the one hand, some factors could disincentivise purchasing a property. For example, the additional costs of installing a clean heating system required by the proposed trigger points mean an additional burden on purchasers. This burden is expected to decrease if the associated grace periods were set longer. On the other hand, other factors would increase the demand for energy-efficient properties and the supply of energy-inefficient properties (e.g., those who would rather prepare for the backstop dates by moving to an energy-efficient property from an energy-inefficient one). Due to these opposing impacts, the joint impact on the total number of sales is unclear.
• The proposed policies are also likely to affect the number of homes let. On the one hand, proposed policy interventions (i.e., policy requirements) may cause some landlords to sell their properties. The proposed property purchase trigger point could be a significant disincentive to landlords entering the market or expanding their portfolio, but a longer grace period may partially mitigate its negative impact. On the other hand, new properties (particularly energy-efficient ones) may enter the rental market if rental prices are a good incentive to enter. Again, the joint impact on the number of homes let is ambiguous.
• When considering geographical differences, we found that larger cities are more likely to face housing shortages. This shortage may override the potential positive price impact of energy efficiency as purchasers have limited options to select a home. Therefore, we expect a smaller difference in the price of energy efficient and inefficient homes and/or between homes with and without a clean heating system in urban areas, where the local market is more supply-driven (i.e., the supply of available homes for rent is more limited).
• In considering the impacts of the policy we could not identify clear differences in the housing market impacts by dwelling archetype. While there may be a moderate shift from houses to flats (i.e. more people would prefer to choose a flat instead of a house when moving, as flats are in general more energy-efficient), this impact remains uncertain.
• Regulation is expected to stimulate the green mortgage market if appropriate products are offered at a competitive price.
• A first-time buyer exemption from the proposed property purchase trigger points is expected to give this group of buyers an advantage on the housing market by lowering potential financial pressures associated with the purchase of properties without a clean heating system installed.

Conclusions

• The presence of strict backstop dates for energy efficiency standards is expected to ensure that actions to comply with the proposed Heat in Buildings Bill regulations are taken early on. This could lead to a green premium in the value of energy-efficient properties occurring gradually after the introduction of the regulatory frameworks, and then accelerating as the backstop dates approach in both sales and rental markets. However, the green premium attributed to efficient properties can be expected to diminish over time, as the market adjusts to a higher availability of such properties.
• The introduction of the proposed early action trigger points can be expected to result in an additional financial burden for property purchasers. By raising the overall cost of moving for all potential buyers, trigger points behave akin to a tax on property purchases, reducing the number of transactions in the housing market. The inclusion of trigger points may ultimately reduce the number of owner-occupiers deciding to move as well as the number of landlords purchasing buy-to-let properties, likely leading to decreased activity in the Scottish residential housing market. Deferring or setting varied deadlines for more vulnerable segments of the market (i.e., first-time buyers, low-income households, small-scale landlords etc.) would mitigate this. The regulatory framework could be adjusted to extend the grace periods, thereby partially mitigating the adverse market effects induced by the property purchase trigger points.
• In the rental market, tenants are likely to bear some of the upfront costs of energy efficiency retrofits in the form of higher rents. Following the introduction of the proposed Heat in Buildings Bill, landlords may decide to exit the market if they do not want to comply with the regulations. This could lead to potential housing shortages and higher rents. It then follows that high rental prices could also incentivise investors to enter the rental market, mainly purchasing new builds and already retrofitted properties, leading to an expected increase in the supply of rental properties and subsequently lower rents, which partially offsets the adverse effect of landlords exiting the market.
• Although homeowners may postpone the installation of clean heating systems until the deadline looms, extending the grace period for trigger points from two to five years could alleviate their immediate financial strain and partially mitigate a potential slowdown of the housing market. However, in this context, the market slowdown is relatively modest compared to a scenario with a two-year grace period. A longer grace period can ease the financial burden on homeowners by providing more time for planning and by spreading compliance and cost over a longer period.
• Not introducing early action trigger points could lead to delayed actions in complying with the proposed regulatory framework, resulting in a more gradual adoption of clean heating technologies. The absence of trigger points leads to both owner-occupiers and landlords postponing necessary actions until closer to the backstop dates. This causes the demand for properties with a clean heating system to surge significantly around the backstop dates, potentially leading to supply shortages, and a peak in the green premium for properties with a clean heating system during the same period, reaching higher levels than if trigger points were used.
• The absence of trigger points prevents any distortion in property purchasing decisions. This contributes to keeping the Scottish housing market broadly as active as it would be in a scenario without any regulatory interventions.
• An exemption for first-time buyer could assist individuals with lower purchasing power within the housing market, and who are more likely to be long-term renters, by lowering barriers to enter the property sales market. In the absence of targeted help-to-buy schemes, exempting first-time buyers from the property purchase trigger point is still expected to result in a slowdown in transactions in the Scottish residential housing market. However, this effect is less pronounced compared to scenarios where the property purchase trigger point applies to all homeowners, as it eases the financial burden on first-time buyers by granting exemptions from the proposed property purchase trigger point. Although the first-time buyer exemption aims to support these buyers, they might still encounter difficulties with the additional costs required to meet minimum energy efficiency standards when purchasing properties that are not energy efficient. Combining trigger points exemptions with extended deadlines for meeting energy efficiency standards could mitigate this.
• While green mortgages only represent a niche segment of the Scottish mortgage market, the introduction of proposed heating decarbonisation and energy efficiency regulations and the need to comply with them, is expected to lead to a substantial increase in the demand for efficient properties and clean heating solutions, ultimately boosting the green mortgage market in Scotland. It may also boost demand for other financial products, including unsecure personal loans, where these are available. Targeted products and financial support schemes for first-time buyers and lower-income individuals could help these groups comply with the regulation, reducing the potential disproportionate impacts.
• In the absence of additional financial assistance programs, the proposed implementation of heating decarbonisation and energy efficiency regulations could disproportionately impact those with lower incomes as well as the ‘late adopters’ of energy efficiency measures and clean heating systems. Targeted financial support could help lessen these impacts, particularly where they are designed to safeguard vulnerable individuals and help ensure they are able to adhere to the regulations. This can be achieved by offering a range of financial incentives to owner-occupiers, such as grants, subsidies, low-interest loans, favourable financing options, and tax credits. These incentives could be provided both by the UK Government, with the aim of leveraging additional private investment, or by private sector entities, particularly in the case of loans and financing options. Additionally, the Scottish Government could work in close collaboration with the clean heating and energy efficiency industries to identify and implement solutions that could help reduce costs for owner-occupiers.
• The design of an effective regulatory framework requires consideration of various, and sometimes conflicting, priorities, including timely installation of clean heating systems, ensuring all homeowners can bear the costs of compliance and mitigating adverse effects on the housing market.

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Appendices

Appendix A: Stakeholder consultations

Stakeholder interviews were carried out to gain an in-depth understanding of the Scottish housing market dynamics, to obtain views of different stakeholders on the impact of the proposed policies and to validate the findings of the literature review, specifically when the eviudence review was not Scotland-specific. The participants of the stakeholder interviews are listed in Table 1. As the S1-B scenario was decided to be added to the study later (to analyse the potential housing market impact of a longer grace period), it involved a second round of stakeholder interviews – the participants of the second round is noted in the last column.

Table : List of interviewed stakeholders

The main topics covered in the stakeholder interviews included:

• The assessment of the impact of energy efficiency and clean heating systems on the sales and rental market. The expected impact of the proposed regulation was also considered;
• Any new, emerging trends due to the pandemic, energy crisis, climate change or any other factors;
• The time it take to sell or let a property depending on its energy efficiency or on type of heating system;
• Geographical differences, such as climatic conditions, local property prices in the neighbourhood, and urban-rural differences;
• Differences between archetypes, potential shift to some types of properties due to the regulation;
• Differences between the Scottish and English housing markets;
• The current state of the green mortgage market, credit risks by EPC rating and the expected growth of the green mortgage market (e.g., key products, increase in the supply of them);
• Discussion of fuel poverty and the expected impact of the proposed policies on it;
• How first-time buyers behave in the housing market and the key challenges they face.

The second round of the interviews focused on the potential housing maket impact of a 5-year grace period of the purchase and heat network zone trigger points. This included more detailed questions on the difference between a shorter and longer grace period:

• Perceptions of the financial and non-financial costs of installing a clean heating system (including differences between owner-occupiers and landlords).
• The timing and compliance rate of installing a clean heating system (including differences between owner-occupiers and landlords)
• The impact on financial planning
• The potential impact of moving or reselling a home within the grace period
• Impact on the green premium of properties with clean heating systems
• Impact on rental prices and the number of homes let
• Impact on the mortgage market

While most of the points were discussed with all stakeholders, the depth of their insights depended on their expertise and background. For instance, we had a closer look at the rental markets with the Scottish Association of Landlords, while stakeholders from financial institutions, such as Lloyds or UK Finance were able to provide more detailed information on the state of the green mortgage market in Scotland. Real estate agents could better assess the impact of energy efficiency and clean heating systems on property prices and provide further insights into customer decision making processes.

Appendix B: Installation rate of clean heating systems and rate of energy efficiency retrofit

Figure 4 illustrates the installation rate of clean heating systems by scenario from the current rate to 2045. The main factors driving the trends are summarised below:

• In the case of the policy-free baseline scenario, a steady but small increase is expected in the installation rate of clean heating systems, as described in section 5.6.1. The main drivers are the prohibition on polluting heating systems in new builds from 2024 (Scottish Government, 2024b), the expected decrease in the installation costs, the lower running costs due to the high energy efficiency of heat pumps and other clean heating systems (subject to the relative price of electricity to gas at any point in time), the increasing climate consciousness and the increased confidence in new technologies due to higher installation rates and awareness.
• The highest adaptation rate over time occurs in the Heat in Buildings Bill scenario (S1-A). This is due to the proposed property purchase and heat network zone trigger points, which increase the installation rate of clean heating systems.
• In the case of the no-trigger point scenario (S2), only a very moderate increase is expected in the installation rate of clean heating systems prior to a few years of the backstop date (2045). It is only expected to be slightly higher than in the policy-free baseline, as some people will realise earlier that they eventually need to comply with the clean heating regulation. However, there is expected to be a greater increase close to the proposed backstop date, as all homes are expected to face the prohibition on polluting heating systems by 2045.
• In the first-time buyer exemption scenario (S3), the installation rate is the mix of the S1-A and S2 scenarios. First-time buyers are expected to behave as in the S2 scenario. Conversely, other buyers are expected to behave as in the S1-A scenario. As first-time buyers represent a smaller share of the purchasers, the joint impact is closer to the S1-A scenario.
• It is important to note that we assume that all homes that are not exempted from the regulations will be fully adapted to clean heating by 2045. Failure to meet this target is likely to mean that Scotland would not fully meet its net zero target in the buildings sector.

Figure 5 illustrates the installation rate of clean heating systems under different grace periods in the Heat in Buildings Bill scenario from the current rate to 2045. If there is a grace period of five years (S1-B) as opposed to two (S1-A), the installation rate could be impacted by the following factors:

• The longer grace period would allow for later installation of clean heating systems or joining a heat network zone, so effectively adaptation is shifted to three years later in time (see Appendix 8.3.3 on procrastination).
• A grace period of five years means more homeowners are expected to move again within the grace period without having installed a clean heating system or joining a heat network zone, further slowing adaptation.
• As described in Section 5.3.1, more properties are expected to be sold under a longer grace period due to the lower perceived costs. Therefore, take-up is expected to be somewhat accelerated by those that do not move again within the grace period.

All in all, the first impact is expected to dominate the emerging installation dynamics, so a significantly slower take-up is expected in scenario S1-B, bringing about a steeper increase in take-up at the years right before the clean heating system installation backstop date at the end of 2045.

Figure 6 illustrates the expected share of properties meeting the minimum energy efficiency standards. The policy-free baseline is driven by similar factors as in the case of clean heating systems: higher comfort of homes, lower running costs and increasing climate consciousness. The other scenarios, which do not differ in the case of the energy efficiency regulations, are visualised as the Heat in Buildings Bill scenario. As the private rented sector is required to meet energy efficiency standards by the end of 2028, an increase in the retrofits is expected in the following years. However, the majority (62%) of the residential building stock is owner-occupied and does not need to be retrofitted by the end of 2033. Therefore, we expect a sharper increase in the retrofits between 2028 and 2033 than between today and 2028.

Unlike the case of the clean heating system regulation, we do not expect that all homes which are not exempted from the policy will meet the policy requirements by the backstop date. This is due to the relatively short time to the backstop date (less than 10 years): fewer properties are expected to be sold in that time, and fewer people are likely to afford to retrofit. The consultation on proposals for a Heat in Buildings Bill also mentions that no ban on the sale of energy inefficient homes will be introduced to avoid people being unwillingly left in energy inefficient properties.

Appendix C: Additional findings from the literature review

Property and rental prices

When analysing the impact of the installation of energy efficiency and clean heating systems in residential buildings on the housing market, we are interested in the existence of a green premium and/or brown discount. The main body of the literature defines a green premium (brown discount) as a term indicating the price premium (discount) of properties with high (low) energy-efficiency compared to their counterparts of EPC band D. The country or region where the impact is assessed is also important. While the focus of this study is solely the Scottish housing market, we found no Scotland-specific analysis available. However, the evidence gathered across the UK and in other countries in the northern hemisphere (e.g., Ireland, Finland, the US) is also relevant and is therefore used to inform our study. Indeed, it is reasonable to assume that energy efficiency has a similar impact on housing markets across various developed markets, particularly if the climate and the cost of energy is similar to those in Scotland.

Property sales prices

In the case of property sales prices, most UK-specific academic and grey literature sources report the existence of a green premium and brown discount based on the level of energy efficiency of properties (in England: Fuerst et al., 2015, 2020; in Wales: Fuerst et al., 2016; grey literature using more recent data: Lloyds Banking Group, 2021; Rightmove, 2023). Academic sources in other European countries also agree with the existence of green premiums and brown discounts (e.g., Brounen & Kok, 2011 in the Netherlands, and Jensen et al., 2016 in Denmark).

However, grey literature sources do not always agree with the existence of the green premium and brown discount. For example, most property agents surveyed by Propertymark (2023) reported that they do not think higher energy efficiency leads to a price premium. For example, 66% of them said that the property price does not increase more than the cost of the retrofitting. The controversy between the academic and grey literature sources can partly be explained by the fact that studies cannot fully control for the quality (i.e., overall condition, presentability) of a property^[31]. Energy efficiency is usually correlated with the quality of a property: more energy-efficient homes tend to have other desirable characteristics, such as a high-quality interiors and design. This bias is difficult, if not impossible, to disentangle in a quantitative assessment.

A summary of the magnitude of the green premium and brown discount, based on different sources, is shown in Table 2. The different columns show the price difference due to energy efficiency compared to EPC band D by source. For example, a property with an EPC band ‘A’ or ‘B’ is sold at a premium of 5-11% compared to a property with an EPC band ‘D’, assuming all other factors equal (e.g., age, location). Conversely, less energy-efficient homes (in bands F or G) are priced 1-11% lower than comparable properties with an EPC band ‘D’.

Table 2: Price impact of energy efficiency on property prices

Note: Some sources only report results for merged categories (e.g., for F and G combined). Positive values indicate a green premium, while negative values indicate a brown discount compared to EPC band D. If the results are not significant, ‘no impact’ is reported.

A Swedish report used surveys and found that people who live in energy-efficient homes are willing to pay a higher green premium when buying or renting a new home (Zalejska-Jonsson, 2014). This indicates that people are less likely to move from an energy efficient home to an inefficient one.

Not only do energy efficiency measures impact property prices, but the type of heating system used also can affect the value of homes. While no Scottish or UK-specific evidence were found on this, some studies have assessed this impact in other developed countries, albeit, under different conditions. In Finland, where, unlike in Scotland, heat pumps are already widely used and gas heating is not common, ground-source heat pumps and district heating have a positive impact on property prices, particularly in the largest city, Helsinki (Vimpari, 2023). In addition, under different climatic conditions, air-source heat pumps (ASHPs) are associated with positive impacts on US sales prices, particularly in warmer regions (where cooling is more important, as ASHPs can provide cooling as well as heating) and where climate consciousness is higher (Shen et al., 2021).

Rental prices

In the rental market, price impacts follow a similar pattern to that of sales prices, although their magnitude differs. While both buyers and renters attribute a monetary value to the energy efficiency of homes, buyers place a higher value on it. Therefore, the green premium in rental markets (in a form of higher rents for more energy efficient properties) is smaller (Hyland et al., 2013).

While the premium for energy-efficient rental properties with EPC band A-C can range from 3% to 18%, the discount for energy-inefficient properties is often insignificant in various parts of the UK (Wales: Fuerst et al., 2016; England: Fuerst et al., 2020). In other words, energy efficiency is a factor in determining rental prices for properties in EPC band A-C, but rarely for those in bands E-G. This may be explained by sharper competition for the most energy-efficient properties between owner-occupiers and buy-to-let landlords (Fuerst et al., 2016). In Ireland, Hyland et al. (2013) found a significant brown discount (2-3). Table 3 summarises the key findings of the impact of energy on the rental market by source, similar to Table 2.

Table 3: The impact of energy efficiency on rental prices

Note: Some sources only report results for merged categories (e.g., for F and G combined). Positive values indicate a green premium, while negative values indicate a brown discount compared to EPC band D. If the results are not significant, ‘no impact’ is reported.

Time to sell

The length of time a property spends on the market is a key factor to consider when evaluating its value. Properties that sell quickly are generally considered more liquid assets.

Academic sources usually report a reduction in the length of time properties spend on the rental market, if characterised by higher levels of energy efficiency. In other words, higher energy efficiency reduces the time taken to secure a tenant. For example, in England more energy efficient properties are let up to 35% faster compared to those with F or G ratings (Fuerst et al., 2020)^[33]. In the rental market of the seven largest German cities, less efficient homes were found to spend 17% more time on the market, controlling for rent, living area, property age as well as hedonic, spatial and socioeconomic variables (Cajias et al., 2019, pp. 188-189).

On the sales market, a Santander study (2022) had a similar conclusion, reporting that 75% of agents in the UK think that properties with a higher EPC band rating can be sold two to four months quicker.

Regarding the installation of clean heating systems, no sources have been found which report its impact on the time to sell or let a property given the early stage of policy and the availability of technologies.

Geographical and archetypical considerations

Section 4.1. focused on the impact of the installation of energy efficiency and heating systems on property and rental prices in general. However, these price impacts may vary depending on other factors such as location (regional and urban-rural differences) and housing archetypes.

Our desk-based research did not discover any Scotland-specific evidence. Nevertheless, Irish, English and Welsh studies and findings from other developed countries in Europe describe impact mechanisms which can be applied to Scotland.

Geographical distribution

There is substantial variability in the impact of energy efficiency on property sales prices in England (Fuerst et al., 2015 and UK Government, 2013). Typically, the green premium is higher in the northern part of the country (see Figure 7). The evidence suggests that this variation can be attributed to the following drivers of regional differences:

• Variation in climatic conditions: It can be expected that energy efficiency is valued more highly in regions where the average temperature is colder.
• Variation in property prices: In areas where house prices are above average, a fixed amount of annual energy saving accounts for a smaller proportion of total property price. Therefore, the impact of higher energy efficiency is smaller in relative terms.
• Variation in housing supply: In the south, where housing supply is more severely constrained, energy efficiency may be pushed down the list of pricing determinants. As there are relatively fewer housing options of given size and location in these areas, the cost savings due to energy efficiency are reflected less in prices.

In Germany, the rental price impact of energy efficiency was found to be less pronounced in more densely populated cities compared to other cities. This is likely driven by more severe housing shortages in big cities (Cajias et al., 2019). Although in a different climatic setting, evidence available from Spain shows that regions with more weather instability have a higher green premium for energy efficiency (La Paz et al., 2019). In the US, the price impact of air source heat pumps, which provide cooling as well as heating, was higher in regions with a warmer climate (Shen et al., 2021).

Urban-rural differences also have an impact on the magnitude of the green premium and brown discount. In Ireland, lower energy efficiency ratings have a significant negative impact on sales prices. This impact is smaller in urban areas than in rural areas. Also, green premiums and brown discounts are smaller in the rental market (Hyland et al., 2013). Urban-rural differences can be explained by stronger demand for houses in urban areas, for example due to increasing demand for living in the agglomeration of larger cities, and the increasing number of new job opportunities in larger cities^[34]. Therefore, energy efficiency has a higher impact on sales prices where the supply of properties is higher (in rural markets) and a smaller impact where demand for properties is stronger (in urban areas) (Hyland et al., 2013).

Archetypal distribution

It is also important to examine whether there are significant green premiums and brown discounts for different types of dwelling. In Scotland, the usual archetypal categories include detached, semi-detached, terraced houses, tenements and other flats (Scottish Government, 2024d). To our knowledge, no Scottish study has yet been carried out on the price impact of energy efficiency by different archetypes. Also, due to the early stage of clean heating systems adoption, we encountered a lack of literature on the property price impact of installing clean heating systems by different archetypes. Therefore, this section focuses solely on evidence related to the impact of energy efficiency.

Table 4 presents the key findings on whether the price impact of energy efficiency (i.e., the green premium and brown discount) was found to be significant for different archetypes. In general, studies using property sales data in England (Fuerst et al., 2015) and in Wales (Fuerst et al., 2016) report a significant brown discount for less energy efficient properties (EPC band E-G) for almost all archetypes. However, there is greater variability in green premiums. In England, there is a significant green premium for flats, terraced and semi-detached houses with EPC rating A-C. In Wales, only terraced houses and A or B rated semi-detached houses have a green premium – there is no green premium for detached houses and for flats. The variation in the price premium for different archetypes may be explained by other factors, as for example the local housing shortage^[35]. If the supply of properties is severely constrained, purchasers may place less value on energy efficiency.

Notes: In the case of a green premium, ‘Positive’ and ‘Negative‘ indicate that there is positive or negative price impact of energy efficiency in EPC band A-C, compared to D. In the case of brown discount, ‘Negative‘ indicates that there is a negative price impact of lower energy efficiency in EPC band E-G, compared to D.
When there is ‘Negative‘ or ‘Positive’ sign and ‘no impact’ is also added to a cell, it means that results depend on the model specification
Source: England – Fuerst et al., 2015 (Table 4); Wales – Fuerst et al., 2016 (Table 2)

Due to the large variety in the stock of detached houses, they are often divided into two categories, depending on whether they are located in urban or rural areas. In the case of rural detached houses, energy efficiency has a less pronounced or counterintuitive impact (i.e., in England there is a price discount for more energy efficient detached houses). The explanation might be that buyers are willing to pay more for inefficient rural detached houses due to their aesthetic characteristics and emotional values this fosters, without evaluating their energy performance (Fuerst et al., 2016). For example, a Georgian house is likely to be less energy-efficient than a modern home, but the buyers do not consider it as key barrier due to its historic charm.

In the case of rental markets, there is less evidence on differences across archetypes available. Fuerst et al. (2020) report that energy-efficiency has a higher premium for semi-detached and terraced houses, as well as for flats, compared to detached houses^[36].

In summary, the price impact of energy efficiency varies for different types of dwellings. However, a brown discount for reduced energy efficiency is usually reported for almost all dwelling types, while a green premium is not significant in many cases. Emotional and aesthetic characteristics of properties can override the valuation of energy efficiency standards, especially in the case of detached houses. This impact is stronger in the case of rural detached houses, therefore urban-rural differences are relevant.

Grace period length

Our desk-based research covered a substantial range of academic and non-academic literature on policies encouraging the take-up of clean heating systems but have found no inquiry into the marginal effect of differing grace periods. Despite widening our scope to learn from the analysis of other policies which included grace periods, we still did not find any reliable policy-focused study. Therefore, we have directed our attention to theoretical and empirical studies of behavioural economics in the context of timing decisions and cost.

In standard economic thinking (including the so-called neoclassical models of mainstream economics), the timing of cost incurrence is mostly relevant because of liquidity constraints: not having enough available money to meet all consumption needs temporarily. A grace period is an instrument driving the timing of cost incurrence, as it defines the latest point in time when the cost of installing a new heating system after purchasing a new property will be incurred. The so-called ‘life cycle hypothesis,’ widely accepted in economics, would predict that consumers even out consumption throughout their lifetime. In other words, this means that spending behaviour is not affected specifically when costs are incurred, as people will optimise their borrowing and saving decisions to smooth consumption over time. However, as borrowing and saving is not possible for everyone and can be costly, the timing of costs would indeed become a relevant factor to consider.

Consequently, the prediction of the standard economic thinking is that a longer grace period alleviates some of the burden on liquidity-constrained consumers. In the context of the proposed Heat in Buildings Bill regulations, this would mean that buyers could save more money due to the longer grace period either to purchase a clean heating systems or to save enough for a down payment for a retrofit remortgage.

However, as Carter et al. (2022) show in the context of payday loan repayment, contrary to standard economic theory, consumers do not really benefit from a longer grace period. Borrowers who are granted an extended grace period exhibit repayment behaviours that are largely comparable to those who are not, with the primary distinction being the extension provided by the longer grace period. One driver they attribute this result to is “naïve present bias” as described by O’Donoghue and Rabin (1999): overweighting present costs and benefits, even slightly, leads to a procrastination of payments. Regardless of the length of the grace period, the necessary reduction in consumption would take place immediately before the end of the grace period. So, although this reduction in consumption could be spread out over a longer period, alleviating the liquidity burden, present biased consumers would not make use of it. In the context of the Heat in Buildings Bill, this means such present biased consumers would not benefit from a longer grace period.

Akerlof (1991) characterized present bias as occurring when “present costs are unduly salient in comparison with future costs, leading individuals to postpone tasks until tomorrow without foreseeing that when tomorrow comes, the required action will be delayed yet again” (p. 1). The lack of attention to the future costs of postponed tasks is very relevant in the context of our study, as for many people longer grace periods would indeed cause inattention to the costs of clean heating system installation. As these costs are to be incurred further in the future, many people will not fully account for the cost of installation of the clean heating system. Therefore, the price premium for properties with clean heating systems will be significantly smaller. Altmann et al. (2019) provide evidence that reminders increase the probability of timely compliance.

Another important behavioural phenomenon that could be relevant is described by uncertainty in the cost of retrofitting, in which case an individual may wait and delay incurring the cost in the hopes of lower costs in future. However, separating this driver (usually dubbed ’the option value of waiting’) from simple naïve present bias is very challenging (see Heidhues and Strack, 2021).

In summary, standard economic thinking (i.e., neoclassical theory) and behavioural economics both suggest that a longer grace period is less of a disincentive to purchase a property. As the costs of clean heating system installation is less salient and can be spread out over a longer period of time, potential buyers perceive a lower effective price. According to behavioural economics theories, installation can be expected to be carried out close to the end of the grace period due to present bias and the option value of waiting.

Mortgage market

In the US (Kaza et al., 2014) and Dutch (Billio et al., 2022) mortgage markets, higher energy efficiency of homes leads to lower energy bills, which in turn reduces the risk of default. Therefore, taking energy efficiency into account in the mortgage underwriting process has clear benefits for lenders via reduced financial risk. Moreover, in the Netherlands, three plausible impact mechanisms underlying the relationship between energy efficiency and the probability of mortgage default have been identified (Billio et al., 2022), namely:

• personal borrower characteristics captured by the choice of an energy-efficient properties;
• improvements in building performance that could help to free-up the borrower’s discretionary income;
• improvements in dwelling value that lower the loan-to-value ratio.

Energy efficient mortgages or green mortgages that exploit this exact relationship have been on the market for decades (The New York Times, 2006). Recently however, they have become more available in the EU, gathering attention from policymakers (Euractiv, 2021, EEML, 2024)^[37].

A high-level review of the current UK green mortgage market shows that some mortgage lenders offer better deals for borrowers that buy energy-efficient homes in the form of green mortgages. Green mortgages to finance retrofitting, so called ‘retrofit mortgages’, are also offered at the point of purchase and as a remortgage. Nevertheless, as green mortgages are still scarce, there continue to exist cheaper non-green mortgages available in the UK that can be more attractive options (Green Finance Institute, 2023; Money Saving Expert, 2024).

Fuel poverty

The Scottish Government has pledged to lift people out of fuel poverty^[38]. The Fuel Poverty Act (2019) set out interim targets for 2030 and 2035, as well as final targets for 2040 to reduce the proportion of households in fuel poverty and extreme fuel poverty^[39] to 5% and 1% respectively. In this study it is therefore useful to also touch on the fuel poverty implications of energy efficiency regulation.

According to the 2019 Scottish house condition survey, fuel poverty is most prevalent among households living in energy-inefficient homes and remote rural locations.

• 40% of households living in dwellings rated EPC band F or G are fuel poor
• 38% of households living in dwellings rated EPC band F or G are extremely fuel poor
• Remote rural areas have the highest rates of fuel poverty and extreme fuel poverty:
  • 43% of remote rural households are fuel poor
  • 33% of remote rural households are extremely fuel poor

Appendix D: Theory of change – figures

The following pages includes the key theory of change charts. These are fully explained in the appropriate sections of the main report.

How to cite this publication:

Benyak, B; Heilmann, I; Dicks, J and Dellaccio, O (2024) Housing market impacts from heating and energy efficiency regulations in Scotland, ClimateXChange. http://dx.doi.org/10.7488/era/4863

© The University of Edinburgh, 2025
Prepared by Cambridge Econometrics on behalf of ClimateXChange, The University of Edinburgh. All rights reserved.

While every effort is made to ensure the information in this report is accurate as at the date of the report, no legal responsibility is accepted for any errors, omissions or misleading statements. The views expressed represent those of the author(s), and do not necessarily represent those of the host institutions or funders.

This work was supported by the Rural and Environment Science and Analytical Services Division of the Scottish Government (CoE – CXC).

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1. The scope of this report is to provide evidence on the impact of heating and energy efficiency regulations on the residential housing market, while excluding considerations of the non-residential sector. ↑

2. Grey literature refers to non-academic publications and documents, usually published by various types of organisations, such as agencies, government bodies or experts. Examples include reports, studies, technical papers or conference proceedings (e.g. slides). ↑

3. The New Build Heat Standard (NBHS) is currently being reviewed, as announced by the Scottish Government on 28 May 2024. ↑

4. The Scottish Government consulted on a grace period of 2-5 years for installation of clean heat systems following the purchase of a property. For the purpose of this study, we have assumed a grace period of 2 years, in all scenarios except for S1-B which assumes 5 years. ↑

5. The Scottish Government did not specify a grace period for the proposed heat network trigger point in the consultation on a Heat in Buildings Bill, but for the purpose of this study, this scenario assumes a grace period of three years. ↑

6. Based on the consultation on proposals for a Heat in Buildings Bill, owner-occupied homes are not required to carry out energy efficiency improvements if they have clean heating systems installed (as they have no direct emissions). This can potentially create a loophole where owner-occupiers can avoid making energy efficiency improvements. ↑

7. The paper defines green properties as energy-efficient properties with low environmental impact. ↑

8. Hence, while people living in clean heating system homes are more likely to sell them at a competitive price, they would face more competition when searching for another clean heating system home. ↑

9. A few homeowners may install a clean heating system before they sell their property in order to increase its value. However, based on the stakeholder interviews, this effect is expected to be marginal. ↑

10. It is important to note that people are unlikely to move just to avoid carrying out energy efficiency retrofits as the financial (e.g., stamp duty, solicitors fee) and non-financial (e.g., the burden of moving or the emotional cost of leaving a familiar environment) costs can be high. However, those considering a move may advance their plans due to the backstop dates. It is also likely that most owner-occupiers will choose to stay and bear the costs of retrofitting, especially if the financial and non-financial costs of moving outweigh the costs of retrofitting. ↑

11. This also means that there are two opposing impacts (i.e., a driver increasing and a driver decreasing the market activity), but the slowdown due to the purchase trigger point is expected to be stronger. ↑

12. Based on the 2022 edition of the Scottish House Condition Survey (Scottish Government, 2024d), tenements and other flats had an average energy efficiency rating by 3-7 percentage points higher (on a scale of 100) and 67-68% of them were in EPC bands A-C, compared to 40-48% for other archetypes (detached, semi-detached, and terraced houses). ↑

13. As shown earlier, the proposed regulation could discourage people from moving out of energy-efficient properties with clean heating systems, resulting in a lower number of these types of properties being put up for sale. However, as the share of energy-efficient properties with clean heating systems in the residential building stock is expected to increase (also due to the policies), the supply of these homes is still expected to increase. ↑

14. If owner-occupiers install a clean heating system (e.g., due to the purchase trigger point), they are not required to meet the minimum energy efficiency standards. Therefore, the purchase trigger point can reduce the installation rate of energy efficiency retrofits. However, it is not expected that a large number of owner-occupiers will choose to install only a clean heating system without energy efficiency retrofits. ↑

15. A recent CCC study (2021) found that the low carbon heat network technology has the lowest average investment cost per home across the clean heating system options in the UK, both in 2020 and in 2035. Therefore, it is likely that most homeowners will choose this option if available. If the purchasers are aware of this cost difference, the price discount on these polluting heating system properties may be lower compared to properties which are not located in a heat network zone (as the upfront cost of installing a clean heating system is lower). ↑

16. This may be in addition to the mortgage they would have taken out anyway for a new home, or a green mortgage customised for green retrofitting. Some stakeholders mentioned that they already offer products for green retrofitting. ↑

17. However, landlords might face other non-financial costs, such as time spent finding workers to carry out the retrofitting work. ↑

18. Some types of retrofitting works do not cause major disruption to the lives of tenants, e.g., changing light bulbs, glazing windows. ↑

19. These interventions included the increase of eviction time (removed from April 2024) and a 3% temporary rent cap which is replaced by a new rent adjudication mechanism from April 2024 (Scottish Government, 2024c). ↑

20. For example, based on a Rightmove report (2023), 61% of landlords in Great Britain would not buy a rental property below an EPC rating of C, which is a significant increase from 47% in 2022. ↑

21. Potential new landlords may have to consider several other factors when deciding whether to enter the rental market. These may include financial (in particular, second home tax) and non-financial considerations (for example, potential issues with new tenants). ↑

22. Stakeholders emphasised that the purchase trigger point is expected to slow down the market in general. However, a shorter grace period can have a higher negative impact. ↑

23. Moreover, individuals who would typically move after a period slightly longer than the grace period (e.g., in 6 years) may advance their relocation plans (e.g., to 5 years) due to the purchase trigger point, thereby further stimulating the housing market. ↑

24. If the heat network zone trigger point has a longer, 5-year notice period, purchasers in areas where connection to the heat network is possible but not yet carried out, are more likely to postpone the decision whether they want to connect to the heat network or to install an alternative type of clean heating system as perceiving it as a future problem. Similar to a longer grace period after a purchase of property, this can lead to a delayed planning and to a poorer understanding of costs and benefits of alternatives. ↑

25. Landlords need to consider that tenants might need to be relocated elsewhere for the period of time when a new heating system is installed, particularly in colder periods. ↑

26. First-time buyers are not assumed to be exempted from the Heat Network Zone trigger point for the purpose of this scenario. ↑

27. Gas heating is not widely used in Finland. ↑

28. In the case of some specific properties, such as Georgian and Victorian houses, stakeholders agree that despite their low energy efficiency, there is a price premium for them due to their historic charm and aesthetic value. This could lead to a price premium for inefficient homes in some sub-groups of properties. ↑

29. We do not consider those properties which will be exempt from the policy. ↑

30. While all properties are required to meet a minimum energy efficiency standard, some variations in the extent of energy efficiency could remain. This may still lead to some price premium for more energy-efficient homes (e.g., an EPC rating of A compared to C). ↑

31. Also, grey literature sources usually rely on the qualitative assessment of market participants (e.g. agents), while academic sources are based on quantitative methods. ↑

32. A more precise sample period is not mentioned in the study. ↑

33. The impact is only significant in the case of B and E rated properties, but insignificant for C and D. The authors explain it with statistical bias (e.g., missing variables, such as the number of listed properties or tenant mobility), and with individual over- and under-pricing. ↑

34. The study assessed price impacts around the time of the 2008 financial crisis (i.e. between 2008 and 2012). ↑

35. Local, as housing supply is strongly linked to settlements – a housing shortage in one city does not necessarily mean a shortage in another one. ↑

36. The study compares the price premium of different archetypes to detached houses and reports significantly higher rental price for higher EPC ratings on a scale of 0-100. ↑

37. Policies that facilitate green mortgage products include the Energy Efficient Mortgage Label. This was developed by the Energy Efficient Mortgages Initiative to drive the upgrade of the housing energy efficiency profile of lending institution portfolios and to act as a global benchmark for energy efficient mortgages (EEML, 2024). ↑

38. Defined by the Scottish Fuel Poverty Act 2019: “A household is in fuel poverty if the fuel costs necessary for the home in which members of the household live to meet reasonable fuel needs and requisite temperatures are more than 10% of the household’s adjusted net income, and if after deducting such fuel costs, benefits received for a care need or disability (if any) and the household’s childcare costs (if any), the household’s remaining adjusted net income is insufficient to maintain an acceptable standard of living for members of the household. ↑

39. Defined as costs of reasonable fuel needs (e.g. adequate heating; detailed definition at paragraph 4 and 3 of the Fuel Poverty Act 2019) exceeding 20% of the household’s adjusted net income. ↑

    
    

Research completed: February 2023

DOI: http://dx.doi.org/10.7488/era/3385

Executive summary

Background

Decarbonisation of domestic heating systems is crucial for achieving the Scottish Government’s ambitious climate change targets of net zero emissions by 2045. The transition to zero direct emissions heating systems (e.g., heat pumps, district heating) will require a suite of changes to the Scottish housing stock, including preparing it to operate at lower flow temperatures than the current majority of 70-80°C. Flow temperature is the temperature a wet heating system warms water to before sending it to radiators in different areas of a building.

This study summarises the current evidence for flow temperature reduction in hot water (wet) systems and considers how this might be applied to the Scottish housing stock. Suitability is defined as a dwelling’s ability to reach thermal comfort for a range of external temperature test criteria. We assess the suitability of the present housing stock as it is today and then with two different cost levels of retrofit. The assessment method includes a literature review, stakeholder interviews and scenario modelling to test different temperature cases.

Findings

We have found that most of the Scottish housing stock is currently unsuitable for flow temperature reduction to 55°C or below on a winter peak day (see Figure 1).

Many dwellings in Scotland could reach suitability for 55°C flow temperatures after the inclusion of retrofit(s). Effective retrofit measures include efficiency measures such as wall and/or loft insulation, upgrading radiators or a combination of smaller efficiency measures such as hot water tank insulation, draughtproofing and reduced infiltration measures.

In our higher cost retrofit scenario, 76% of homes become suitable for a flow temperature of 55°C on a winter peak day (see Figure 2). This could prepare the housing stock to be ready for zero direct emissions systems without requiring gas boilers to be removed from homes immediately.

Figure 1 Absolute number of dwellings suitable to meet thermal comfort at each flow temperature (°C) on a winter peak day with no retrofits

Figure 2 Absolute number of dwellings suitable at each flow temperature (°C) on a winter peak day with more extensive, higher cost, retrofits

We find that 30% of the overall housing stock is unsuitable for a flow temperature below 75°C, and 20% require a flow temperature above 75°C. This suggests these dwellings are either running at temperatures higher than 75°C or are currently unable to reach thermal comfort during periods of peak demand.

Fuel bill savings and emissions reduction from reducing flow temperature is significant and range from £151m to £501m in the stringent external temperature test cases. The associated greenhouse gas emission savings are estimated to be 6.17–10.18 MtCO₂ equivalent per year, depending on external temperature cases and retrofit scenarios. Exploring the potential for varying flow temperatures throughout the year could be one way to increase savings.

The most important factor when assessing suitability for flow temperature reduction is in setting temperature criteria that captures the needs of occupants. We used particularly stringent criteria in our assessments, requiring a dwelling to be heated to 20°C during the coldest hour of an average or 20-year winter peak. This may not reflect the reality of how heating systems should be, or are currently, expected to perform but it was selected to ensure the heating needs of the most vulnerable households were considered.

Technical Glossary

Introduction

Domestic heating system decarbonisation is crucial for achieving the Scottish Government’s ambitious climate change targets of 75%, 90% and net zero emissions, relative to 1990, by 2030, 2040 and 2045 respectively. The transition to zero direct emissions heating (ZDEH) systems will require changes to the Scottish housing stock. This will potentially including preparing the building stock to operate at the lower flow temperatures that ZDEH options such as heat pumps operate.

Currently, the majority (approximately 85%) of dwellings in Scotland are heated by water based (wet) boiler systems, which typically operate at flow temperatures between 70-80°C. The remaining dwellings are heated by a mix of communal, heat pump, electric and off-grid systems. Flow temperature reduction has the benefit of reducing the energy required to meet the same internal room temperature, thus leading to reduced emissions and fuel bill costs in gas boiler and ZDEH systems alike.

We summarise the current evidence base for reducing flow temperature in the existing housing stock. We consider how flow temperature reduction might be applied to Scottish housing by modelling a range of lower flow temperature and assessing the potential suitability with varying degrees of retrofits.

Findings from literature review and stakeholder interviews

Range of temperatures for consideration

Evidence base for 55°C

According to the Heat Pump Association (see Appendix 8.1), 55°C is considered the “target” temperature for transitioning existing residential heating systems to lower-flow temperature systems. This is because it is an effective and relatively feasible “middle ground” between flow temperatures of current residential gas boiler currently (>70°C) and the direction of travel towards ZDEH technologies such as heat pumps (which operate optimally between 30-55°C).

At 55°C, most condensing boilers will run more efficiently (because more latent heat can be transferred from the flue gases at lower return temperatures) and there will be a reduction of wear and tear caused by cycling at current flow temperatures. Heat pumps, on the other hand, will reach the limits of their peak efficiency at approximately 55°C; at higher flow temperatures, efficiency will drop below quoted performance.

We found wide agreement in the stakeholder interviews (see Appendix 8.1 for stakeholder engagement overview) that most homes in the UK, and most homes in Scotland, will be able to run heating systems at 55°C without significant retrofitting. According to the CCC (2022), based on a report conducted by Nesta and Cambridge Architectural Research (2022), approximately 27% of homes in the UK currently are suitable for flow temperature reduction based on assumed ancillary attributes (namely radiator and pipework suitability). It is our understanding that a property assessment was not undertaken as part of the Nesta/Cambridge work. This estimate is about half of that found in previous research (Element Energy, 2021), which found that 53% of the UK stock was able to run at 55°C on a typical winter day (the percentage is reduced to 10% to reach thermal comfort on a winter peak day).

It was the opinion of our interviewed stakeholders that most homes in Scotland can successfully be run at 55°C, and that there were few attributes that would rule out this flow temperature (see Appendix 8.4).

Potential for further reduction

It is difficult to transition the housing stock to even lower flow temperatures below 55°C. The proportion of homes which are suitable without any works (or without major works) is significantly lower. Stakeholders suggested that some homes may not be suitable at all, but it is unclear if there was any tangible evidence or guidelines this was based on.

Our previous work (Element Energy, 2021) showed that the percentage of stock suitable for reduced flow temperatures reduces from 53% to 25% at 50°C, 6% at 45°C and <1% at 40°C. On a winter peak day (with an assumed external temperature almost 10°C lower) these proportions of houses suitable reduce to 3% at 50°C, 1% at 45°C and <1% at 40°C.

At lower flow temperatures, the specific heat loss of a property becomes increasingly important. Specific heat loss, in practice, is an indicator of how much heat will be required to maintain thermal comfort. Heat loss tends to have an inverse relationship with efficiency – a home with a low specific heat loss rate will be highly efficient, while homes with a high heat loss rate tend to be less efficient.

This is an important consideration when assessing the suitability of reducing flow temperature because in a home without retrofitting, a reduced flow temperature will decrease the amount of heat delivered to a room. If a room is difficult to heat because the home has a high heat loss rate, it becomes increasingly difficult to reach the desired temperature of that room because the system cannot adequately deliver or retain heat.

In this situation, one or both of the following paths can be taken to make a home suitable for a lower flow temperature:

Increase delivered heat. To do this, specific components of the heat system may need to be replaced or adjusted. The two key components are pipework, which impacts the flow rate of water through the system; and radiators, which emit heat transferred from the water. Existing pipework may need to be replaced to allow for a higher flow rate (which would help move more heat through the radiator in a given time period). Radiators could be replaced with larger units, which will allow more heat to be emitted due to an increase in absolute surface area. One or both options will increase delivered heat.

Decrease specific heat loss. To do this, a home needs to become more efficient through retrofitting to increase efficiency and airtightness. The two most important retrofits that can be undertaken are insulation (loft or wall) and window glazing. In addition, draughtproofing can be applied to windows and doors. These measures will lead to a higher rate of heat retention, meaning the absolute amount of heat that needs to be transferred to reach thermal comfort in a home is decreased.

Building envelope measures to increase suitability for flow temperature reduction

Increasing the efficiency of the building envelope decreases specific heat loss, thus supporting flow temperature reduction. Stakeholder interviews emphasised the importance of home retrofitting and maintenance, especially where homes are poorly insulated, as it also leads to heat demand reduction.

Home insulation

In general, more insulated homes will be more suitable for lower flow temperatures, due to the lower heat demand to reach thermal comfort. It is unlikely that there is a situation in which a home is “too insulated”, except if this insulation does not allow for moisture to be driven from the masonry.

Interviewed stakeholders considered insulation as one of the most influential aspects for suitability to operate at lower flow temperatures. Despite a general concern that traditionally built homes were unlikely to be suitable for a lower flow temperature, one stakeholder suggested loft and wall insulation is likely to be sufficient. It makes little difference if the loft is used as a room (CCC, 2022), as insulating in either case will decrease the home’s heat loss, but additional care should be taken due to the likely increased cost.

Window glazing

Similar to insulation, improving window glazing to double glazing or secondary glazing, is always beneficial for increasing the suitability of homes for reduced flow temperatures because they reduce the specific heat loss of a property. While triple glazing may offer benefits, it can introduce ventilation concerns and results in a lower marginal efficiency gain for flow rates compared to the adoption of double glazing.

Both double glazing and secondary glazing can effectively lower heat loss, but double glazing is a more expensive process and involves replacing entire units. Replacing existing windows with double glazed windows may be more difficult or restricted in traditional homes due to conservation/listed building status or for aesthetic reasons. Care should also be taken to balance ventilation requirements with increased glazing.

Ancillary components for the reduction of flow temperature

Ancillary components are key to effectively increasing delivered heat and/or decreasing specific heat loss. The overall efficiency of the heating system and, more generally, home energy efficiency will increase the suitability for flow temperature reduction. Some ancillary components are particularly important to a home’s suitability, and these are discussed in the following sections.

Radiators

When radiators are fitted, the size of radiator suitable for a home is determined with consideration to the flow temperature the heating system runs at, alongside flow rate, to determine an adequate size to meet thermal comfort. If all else remains constant but the flow temperature is reduced, it is possible that the heat transferred to the radiator will not be sufficient. To mitigate this, existing radiators can be replaced with larger units which can transfer more heat, but this may be more expensive than other retrofit measures.

Pipework

Pipework is likely to be a key attribute for suitability of a home to increase the flow rate of the heating system. Like radiators, piping tends to be sized for the heating distribution system. Pipework may need to be replaced to account for a lower flow temperature, but our previous work (Element Energy, 2021) and stakeholders consulted had mixed opinions as to whether increased flow rate was an effective counterbalance to reduced flow temperature, and whether it would be required.

During our engagement with Renewable Heat (see Appendix 8.1, it was suggested homes were built or had heating system replacements between the 1980s and 2002 are more likely to require pipework replacements. During this period, a copper shortage led to smaller piping instalments across the industry. Due to an update to buildings regulations in 2002 this is not an issue for newer builds.

Pipework, compared to other ancillary components, is particularly susceptible to maintenance problems leading to inefficiencies. For example, past analysis (Element Energy, 2021) found that efficiency reductions due to sludge (15%), hydraulic imbalance (10%), air (6%) and limescale (15%) can impact the ability for a heating system to reach thermal comfort.

Other considerations

The efficiency improvements possible for pipework highlight the importance of regular maintenance for heating systems. Heat distribution systems should have annual maintenance servicing, but our recent analysis (Element Energy, 2021) found that currently only 20% currently participate in this. Proper maintenance would increase overall system efficiency, thus making reaching thermal comfort at lower flow temperatures more feasible.

Key risks to reducing flow temperature

Thermal comfort (human and fabric)

Reaching adequate thermal comfort is the goal of assessing the feasibility of lowered flow temperatures. There are clear guidelines (British Gas, 2022) set by knowledgeable bodies (including the Lullaby Trust, Energy Savings Trust, World Health Organisation and Age UK) for temperatures homes should be heated to depending on the occupant, including:

• Homes with new-borns should be heated between 16–20°C
• Homes with healthy occupants should be heated to 18°C
• Homes with occupants which are old, young or unwell should be heated to 20–21°C (some recommendations state homes can be warmed to 18°C as long as the main living space of the older occupant is heated to 21°C)

In practice, there are many instances where these temperature thresholds are not met, for technical and behavioural reasons. This complicates suitability assessments, because setting the above thresholds may require heating systems to perform to temperatures that are not used in practice. Some behavioural reasons homes are not heated to the above thresholds may include:

• Turning heating on/off in bursts, instead of maintaining a constant temperature
• Regularly keeping heating at a comfortable temperature below the guideline temperature (for example, 18°C instead of 21°C)
• Refraining from heating despite discomfort (often associated with fuel poverty)

The disconnect between recommended thermal comfort and behavioural practice makes assigning a temperature threshold for lowered flow temperature complex, but previous reports and stakeholders generally agree a reasonably lower flow temperature will not cost consumers’ thermal comfort. It should be noted that special care may need to be taken for identified vulnerable consumers.

Nesta and The University of Salford (2022) suggests lower flow temperatures may lead to longer warming times, if flow rate and radiator size are not changed at the same time, due to the decrease in transferable heat. The acceptability of increased warming times would likely require a behavioural study.

Reduced flow temperature could also mean that room temperature cannot reach thermal comfort guidelines. It is not clear by how much and if this would cause a reduction from current practice. In the Nesta and The University of Salford (2022) study, homes with boilers and reduced flow temperature were able to reach within 0.5–2°C of thermal comfort (set at 21 °C in the living room, 22°C in the bathroom and 18°C in all other zones) on an average heating day, which is likely to be sufficient for most homes with healthy consumers.

Similarly, reduced flow temperature may make reaching thermal comfort on peak heating days more difficult. Further testing is likely to be required to better understand the impact of heating during periods of lower external temperatures. It could be the case that systems with reduced flow temperatures are within 2°C of thermal comfort on these peak days, which may be acceptable to occupants, but this is masked by the binary threshold of reaching thermal comfort.

Stakeholders agreed that buildings generally do not suffer from damp, moisture, and mould when the home is heated to human thermal comfort levels. Ensuring thermal comfort for humans is likely to provide adequate heating and avoid impacts on the building structure as well.

Unsuitable ancillary components

In many homes, reducing flow temperature without also retrofitting (e.g., adding insulation, replacing pipework, upgrading radiators) may cause the system to under-perform. The home would not reach thermal comfort due to the reduction of transferable heat and unimproved specific heat loss or system efficiency. Conversely, if the heating system is replaced before the home is retrofitted (insulation and window glazing, for example) the heating emitter could be oversized, causing increased cycling or inefficiency. To ensure this is not the case, retrofitting measures should be implemented before or in tandem with reducing flow temperature for an individual property.

Concerning the building masonry, the level of energy efficiency retrofitting should be balanced against the need to ventilate the home properly and drive moisture out of the walls to avoid deterioration of the home’s exterior. This is a particular concern in older dwellings but should be considered for all dwellings. One stakeholder suggested approximately 100mm of wall insulation would be a good balance, but previous analysis suggests this may not be adequate insulation for energy efficiency. More research may be needed to understand this balance better.

Costs incurred by significantly lower temperatures

The Heat Pump Association suggests homes which are not properly retrofitted to increase heat delivery or decrease specific heat loss could be required to heat their homes for significantly longer periods of time, and thus higher overall energy consumption. This, in turn, would lead to an increase in both energy usage and the absolute value of energy bills.

Our engagement with the Heat Pump Association suggested that lower temperatures will require increasingly airtight, well-insulated homes with larger radiators to ensure the heat loss doesn’t rise above 150W/m². For most homes, a flow temperature reduction to 45°C should not incur significant financial costs. To reduce flow temperatures further, homes must be increasingly efficient and airtight, potentially with larger radiators. These costs are likely to be prohibitive for many without financial support.

Key benefits to reducing flow temperature

Energy savings

When combined with required retrofits, reducing flow temperatures is expected to reduce energy use significantly. Previous work suggests savings are roughly correlated to the degree of change between the baseline temperature and new flow temperature. There are continued savings to be achieved by lowering flow temperature below 55°C.

Nesta and the University of Salford (2022) found 16–23% energy savings in gas used for heating when flow temperatures as low as 48.2°C were tested. This correlates to roughly 12–17% of overall gas savings at household level (assuming heating accounts for 75% of gas use in residential buildings). At low flow temperatures, care must be taken to ensure a boiler’s intended operating regime is maintained, for example maintaining efficiency of a condensing boiler.

These energy savings will lead to savings in in fuel bill costs at the household level, due to the lowered energy required to heat the distribution system. The level of fuel bill savings will depend on a combination of flow temperature and fuel prices.

Emissions savings will also be a result of flow temperature reduction. Most homes in Scotland are heated with natural gas, so the direct reduction in natural gas use will reduce emissions. For homes heated with electricity, reducing electricity use on a grid that is not completely zero carbon will have indirect emissions reductions.

ZDEH readiness

The Salford Energy House (2022) study shows that even homes using boilers can benefit from reduced flow temperatures. The retrofits and system upgrades required for such a switch are often “no regret” decisions, no matter what future heat source the home will use (whether it be natural gas, hydrogen, electricity or district heating) because these changes improve the overall efficiency of the homes.

In general, low carbon heating systems run on lower temperatures, so all ancillary works, maintenance and upgrades will smooth the transition to a low carbon heating system across all home archetypes. There was agreement amongst stakeholders that ancillary works and reducing flow temperatures prepare houses for ZDEH systems. Systems with lower flow temperatures (including those currently using gas) use less overall energy to meet demand because the whole home system is more efficient.

Methodology for assessing flow temperature reduction

Overview

This study seeks to model the suitability for potential flow temperature reduction in heating systems in Scottish homes. The ideal methodology for an assessment of flow temperature reduction potential would include a property-specific heat loss calculation. In lieu of this, our method uses heat demand and property characteristics as a proxy for current ability to meet demand.

Property characteristics including levels of insulation, current heat distribution systems and heat demand was provided by the Home Analytics Scotland (HAS, 2022) dataset. The HAS dataset provides characteristics of the Scottish housing stock based on a compilation of datasets and modelling. This dataset is the result of whole-stock modelling conducted by the Energy Saving Trust. It should be noted that there is a discrepancy between the number of properties modelled as part of the work in this report (2,747,067 dwellings) and data in the Scottish House Condition Survey (Scottish Government, 2021) which accounts for approximately 10% less homes. We believe this is due to the modelling method used by Home Analytics Scotland.

Our assessment of suitability was led by stakeholder interviews and previous work (Element Energy 2020b, 2021). The previous work developed a suitability assessment for the UK housing stock based on dwellings’ current oversizing factor.

Retrofit options were modelled using prices for materials and labour for individual retrofits taken from previous work for the CCC (Element Energy, 2020a).

Results from suitability modelling were then translated into energy demand reduction using heat demand profiles from the National Energy Efficiency Data-Framework (NEED), Scottish weather data and heat system efficiencies. Cost and emissions savings were calculated using up-to-date fuel prices and emissions data from recent Element Energy analysis.

Modelling approach

Defining suitability

The first step in this study’s methodology was defining suitability, which considered both internal temperature and external temperature. Both sets of temperatures were based on previous work commissioned by BEIS (Element Energy, 2021).

The target internal temperature was 20°C, which is the lower end of the World Health Organisation’s (WHO) recommended internal temperature range for dwellings with vulnerable occupants. While not every home has vulnerable occupants, there is no robust way to predict what homes will be occupied by vulnerable consumers, and as such an internal temperature target was chosen which could meet the needs of any consumer at any hour of a given year. This temperature is also aligned with the Microgeneration Installation Standard (MIS) 3005 (MCS, 2019), which recommends living zones maintain a temperature of 18–22°C.

We tested a dwelling’s ability to reach thermal comfort (20°C) at various external temperature cases:

• Winter peak, our central case which tests suitability during the peak heating hour of an average year.
• 20-year peak, which tested a dwelling’s ability to reach thermal comfort during the peak heating hour of a historic cold snap. Also referred to as a historic cold snap.
• Winter average, which tested a dwelling’s ability to reach thermal comfort during an average heating hour in an average winter (as opposed to the peak heating hour in the winter peak).
• November average, which tested a dwelling’s ability to reach thermal comfort during an average heating hour in an average “shoulder season” (the heating hour used in this study is taken from an average November).

Suitability at a set internal and external temperature test case was measured based on the dwelling’s oversizing factor, which is the ratio of peak radiator capacity to peak demand. See Appendix 8.2 for more information on why oversizing factors were used in lieu of specific external temperatures. Based on this oversizing factor, we know what minimum flow temperature each dwelling can operate at and still meet thermal demand. Oversizing factor ranges are set out in the BEIS study (Element Energy, 2021). Oversizing factors of between 1.00 and 1.20 suggest a dwelling’s radiator capacity is adequately sized for the dwelling, while an oversizing factor under 1.00 suggests a heat distribution system will not be able to reach thermal comfort and a factor of over 1.20 suggests a heat distribution system is larger than required for the dwelling at a given flow temperature.

Archetyping and radiator mapping

The housing stock was aggregated into seven archetypes with the aim of modelling the suitability and impact of flow temperature reduction for a set of “average” homes. These archetypes were primarily based on stakeholder insights on the key determinates of flow temperature reduction based on their experience (age and house type). These were compared to the archetype design of the BEIS study, which used similar archetypes. The seven archetypes were:

• Pre – 1919 flats (approximately 10% of stock)
• Pre – 1919 houses (approximately 7%)
• 1919 – 2002 flats (approximately 23%)
• 1919 – 1949 houses (approximately 6%)
• 1950 – 1983 houses (approximately 27%)
• 1984 – 2002 houses (approximately 10%)
• Post – 2002 dwellings (flats and houses) (approximately 14%)

All dwellings in the HAS database were assigned an archetype, which was used for energy demand reduction, fuel bill and emissions savings calculations. We then assigned oversizing factors. Extrapolation of BEIS (Element Energy, 2021) survey data to the entire UK housing stock provided a distribution pattern across archetypes. This was used to assign oversizing factors for Scottish dwellings across the archetypes. Dwellings surveyed in the BEIS study were assigned archetypes from the above list and reassigned a proportion of the archetype stock that they represented based on extrapolation from the original study which maintained the robustness of the original study’s housing stock mapping.

The clearest relationship observed in this data was that between building footprint and radiator capacity, with larger dwellings tending to have larger capacities. Dwellings in the BEIS survey and HAS dataset were ordered by archetype and building footprint. The radiator size, building peak demand and oversizing factors were assigned to dwellings from smallest to largest building footprint, maintaining the correct proportions in the housing stock. For example, if the smallest surveyed home in the pre-1919 flats archetype was found to represent 2.7% of the stock, this dwelling’s data was assigned to the smallest 2.7% of HAS dwellings in the same archetype, and so on. This allowed the data to maintain the same oversizing factor distribution.

Suitability modelling

The suitability of the current housing stock portfolio was modelled based on the minimum flow temperatures each HAS dwelling could operate at using the oversizing factor. Retrofit packages were assigned to dwellings based on their archetype and existing levels of insulation. Two retrofit scenarios were modelled:

• The Lower cost retrofit scenario, where retrofit package costs could total approximately £2000 per dwelling, and
• The Higher cost retrofit scenario, where retrofit package costs could total up to 10% of the cost of a whole-home renovation. To determine this cost, the average price of a whole home renovation was taken for an “average” home, which was then scaled up or down for each archetype. This led to a range of costs between £6,000 – £12,000 (see Table 1 for these costs).

Table 1 Retrofit costs for dwellings in the Higher cost retrofit scenario, by dwelling type

Dwellings were assigned retrofit packages based on the specific dwelling attributes in the HAS dataset. Because these attributes are in the original dataset, retrofit packages were assigned regardless of what external temperature case or radiator sensitivity was being tested.

Each dwelling was assigned two packages, one for each retrofit scenario (see Appendix 8.3 for list of retrofits). In both scenarios, most homes are assigned standard energy efficiency measures and/or radiator upgrades (75% and 71% in the Lower and Higher cost retrofit scenarios, respectively, see Figure 3 below). For many dwellings, additional insulation measures are required based on current level of insulation modelled by HAS. In some of these cases, dwellings can be insulated within the approximately £2000 price bracket, while other homes are more expensive to insulate. In these situations, the cost to insulate falls within the more expensive retrofit scenario.

Retrofit packages took a fabric first approach, prioritising measures with higher efficiency gains (mostly wall and loft insulation), then measures with lower-efficiency gains (increased draughtproofing, reduced infiltration measures and hot water tank insulation) and finally radiator upgrades where applicable. See Appendix 8.3 for details.

After a retrofit package was assigned to all dwellings in each retrofit scenario, the efficiency increases are applied to the dwellings assigned oversizing factors. This study assumed a direct relationship between energy efficiency increases and demand reduction, so an efficiency increase of 18% was applied by reducing the oversizing factors by 18%. These new oversizing factors were used to reassign dwellings to minimum flow temperatures. In practice, this may not reflect how efficiency increases are observed in dwellings, but an implementation-based study would be required to accurately capture this.

Fuel bill and emissions modelling

Results were aggregated at archetype level and used to find archetype-level energy demand reduction for fuel bill and emissions savings modelling. To calculate energy demand reduction at the archetype level, the average energy demand was calculated from the NEED (BEIS, 2022). Hourly energy demand profiles were calculated using the Watson method (Watson et al., 2019). We assumed all dwellings currently operate at 75°C flow temperature. The difference between 75°C flow temperature and lower temperatures (down to 50°C) was calculated based on the proportion of the stock which could support this for different external temperature case and retrofit scenarios. All dwellings suitable at temperatures below 50°C were modelled using 50°C savings, due to uncertainty over some boiler’s efficiency at lower temperatures. The cost and emissions modelling outputs were expected to be conservative estimates for fuel bill and emissions savings, due to not capturing the potential savings from 85°C to 75°C and temperatures under 50°C.

To calculate fuel bill savings, two fuel prices (representing a historic average and more recent fuel costs) were used to give a range of savings based on the energy demand reduction on national, archetype and archetypal individual dwelling levels.

To calculate emissions savings, the average natural gas emissions in Scotland were applied to the energy demand reduction on national, archetype and archetypal individual dwelling levels. In this calculation, all dwellings were modelled as gas boilers due to the overwhelming majority of boilers in the breakdown of heat distribution systems in the Scottish housing stock. Only 15% of homes do not currently use gas boiler systems, instead running on electricity or off-grid heating systems. Due to higher price per kWh for electricity, we expect these modelled results to be conservative estimates.

Method limitations

This study sets out to model flow temperature reduction suitability, for which practical research has not been conducted previously on Scottish housing stock. Our study aggregated several data sources and relied on previous research to assess suitability in lieu of property-by-property heat loss calculations and real time case studies for retrofitting and monitoring. As such, the method has several limitations that should be acknowledged when considering findings and conclusions (see Table 2 below for an overview of these limitations).

Table 2 Summary of method limitations and key assumptions with rationale and impact

Modelling results

Overview

We find that the majority of Scottish housing stock is currently unsuitable for flow temperature reduction to 55°C or below on a winter peak heating hour. However, more than half (60%) of the stock is suitable for a flow temperature reduction during the less stringent test case using the winter average. Both retrofit scenarios considered increase suitability for flow temperature reduction across all external temperature cases and home types. With Higher cost retrofits, between 64% (winter peak) and 97% (November average) of homes become suitable for a flow temperature of 55°C or below.

Table 3 Suitability for Scottish housing stock for flow temperatures of 55°C for different temperature cases

Winter peak

The winter peak temperature case measures a heat system’s ability to maintain thermal comfort during the peak heating hour in an average year.

Before Retrofit

Without retrofits, 15% of the housing stock (approximately 410,000 dwellings) in Scotland are suitable for flow temperature reduction to 55°C (See Figure 4 and Figure 5). Most of these dwellings are flats and post-2002 properties. 30% of post-1919 flats are suitable for flow temperature reduction, and 27% of post-2002 flats and houses. Combined, these two archetypes represent 75% of the suitable stock, and 11% of the overall stock. These two archetypes also capture the portions of the stock that can reduce to the lowest flow temperature without retrofits. In both archetypes, a small subset of homes is suggested to be suitable at a 40°C flow temperature without retrofits (7% of suitable post-1919 flats and 1% of suitable post-2002 flats and houses).

Figure 4 Proportion of stock suitable for 55°C, by archetype (no retrofit scenario)

Figure 5 Dwellings suitable for each flow temperature (cumulative, no retrofit scenario)

Pre-1919 houses and flats and mid/late-century houses (1919-2002) are least suitable for 55°C flow temperatures, all having less than 10% of the archetype stock suitable. The majority for each archetype would be able to reduce flow temperature below 75°C (Figure 5). For example, among pre-1919 flats, 58% of homes are suitable for flow temperatures between 60°C and 70°C.

Pre-1919 houses are not suitable for flow temperatures of 55°C. This result is directly related to the archetype’s lower proportion of adequately sized radiators from the mapping exercise and may also be related to the high heat loss rates in these dwellings. This archetype will require more significant energy demand reductions for homes to reach lower flow temperatures. Despite this, there is a proportion of the stock suitable for a more modest flow temperature reduction, with 30% of the stock being suitable to reduce to flow temperatures between 60°C and 70°C.

30% of Scottish housing stock is currently unsuitable for flow temperature below 75°C. 20% of the stock may also be unsuitable to run at 75°C. This suggests these dwellings are either running at temperatures higher than 75°C or are currently unable to reach thermal comfort during periods of peak demand.

Lower cost retrofit scenario

Figure 6 Proportion of stock suitable for 55°C, by archetype (Lower cost retrofit scenario)

Lower cost retrofit packages are effective in increasing the proportion of homes suitable at a range of lower flow temperatures. After retrofits of around £2k, the proportion of homes suitable for 55°C increases to 55%. In addition to homes being suitable for 55°C, 36% of homes are suitable for lower flow temperatures.

Figure 7 Dwellings suitable for each flow temperature (cumulative, Lower cost retrofit scenario)

Post-1919 flats and post-2002 archetypes continue to be most suitable, while the pre-1919 flats and houses and mid/late century (1919-2002) house archetypes had lower suitability, see Figure 6 and Figure 7. While the archetypes maintained the same relative standing, there are large differences in terms of proportions of the archetype stock that become suitable at lower flow temperatures.

The biggest beneficiaries of lower cost retrofits are the 1919-2002 house archetypes and the pre-1919 flat archetype. The absolute value of suitable homes increased between factors of 5x and 11x (pre-1919 flats and 1919-1949 houses, respectively).

Before retrofits are applied, older dwellings are generally less suitable for lower flow temperatures (see Figure 4). When retrofits are applied, the age of a dwelling appears to matter less than dwelling type (flat or house) with the suitability of pre-1919 flats being similar to houses built from 1950-2002.

The large proportion of the stock that becomes suitable after lower cost retrofits suggests that many dwellings in Scotland may be close (in monetary terms) to suitability for flow temperatures of 55°C. If 55°C is chosen as a “target” temperature, this suggests many homes in Scotland could achieve this target, even with stringent suitability criteria, for a relatively small amount of money. One or two larger efficiency measures (wall and/or loft insulation), an ancillary upgrade (radiators) or three smaller efficiency measures (hot water tank insulation, draughtproofing and reduced infiltration measures) would be required.

Higher cost retrofit scenario

After more extensive retrofits, 76% of the housing stock reaches suitability for reduced flow temperatures of 55°C. Similar, to the base and lower cost retrofit scenario, the post-1919 flats and post-2002 dwellings have the highest rates of suitability (see Figure 8). All archetypes other than pre-1919 houses are above 66% suitability for 55°C flow temperatures within their respective archetype stocks. The archetype with the largest change between scenarios is the pre-1919 homes, with suitability increased by a factor of over seven. In this scenario, almost half of the stock in this archetype reaches suitability (46%).

More homes in this scenario can reach even lower flow temperatures (i.e., flow temperatures between 30°C and 50°C). However, the lower cost retrofits changed the proportion of suitability for 55°C for a higher absolute number of homes than the higher cost retrofits (an additional ~1 million homes suitable, compared to an additional ~600,000 homes).

Figure 8 Proportion of stock suitable for 55°C, by archetype (Higher cost retrofit scenario)

Figure 9 Dwellings suitable for each flow temperature (cumulative, Higher cost retrofit scenario)

20-year peak (historic cold snap)

The 20-year peak temperature case is our most stringent external temperature case, testing the ability for a dwelling to meet thermal comfort in a historic cold snap (the coldest day recorded in a given postcode for the past 20 years).

Without retrofits, the proportion of homes suitable to reduce to a flow temperature of 55°C include is only 7% of the stock (see Figure 10 and Figure 11), mostly consisting of post-1919 flats (4%) and post-2002 houses and flats (2%).

Some housing remains suitable for a flow temperature reduction below 75°C. Most suitable homes are post-1919 flats (15%), 1950-1983 houses (11%) and post-2002 flats and houses (10%).

In this case, over half (52%) of dwellings cannot meet thermal comfort below 75°C. In addition, 33% of the stock is not suitable for 75°C and is either currently operating at a higher flow temperature or would be unable to meet thermal comfort during a 20-year peak/historic cold snap.

Figure 10 Proportion of stock suitable for 55°C, by archetype (no retrofit scenario)

Figure 11 Dwellings suitable for each flow temperature (cumulative, no retrofit scenario)

Lower cost retrofit scenario

The application of lower cost (~£2k) retrofits also brings a significant portion of the housing stock to suitability for 55°C flow temperatures. 40% of the total housing stock could reach suitability even during a 20-year peak/historic cold snap (see Figure 12 and Figure 13).

Post-1919 flat and post-2002 dwellings archetypes continue as most suitable archetypes, both increasing by just over a factor of four. Combined, the suitable stock in these two archetypes represents almost one quarter of the total housing stock (23%).

Figure 12 Proportion of stock suitable for 55°C, by archetype (Lower cost retrofit scenario)

Figure 13 Dwellings suitable for each flow temperature (cumulative, Higher cost retrofit scenario)

Before retrofits, a correlation between age and suitability could be observed, with newer homes having slightly higher rates of suitability. After retrofits, the 1919-1949 homes and 1984-2002 houses have similar rates of suitability (24% and 27% respectively), while 10% more houses in the 1950-1983 archetype are suitable (36%). This suggests more houses in this archetype had oversizing factors on the higher end of each range, thus the same retrofit measure could have transitioned one home to 55°C and a house from one of the other archetypes to only 60°C. It could also suggest that more houses in this archetype required wall or loft insulation, and thus benefited more than other archetypes which received smaller energy efficiency uplifts from the “standard” measures.

Higher cost retrofit scenario

The archetypes with the highest proportions of suitability continue to be the post-1919 flats and post-2002 dwellings (78% and 92% of their respective stocks, and 32% of the total stock, see Figure 14 and Figure 15). All archetypes other than pre-1919 houses improve suitability for 55°C flow temperatures to above 51% of their respective archetype stock. In total, 64% of the stock becomes suitable after more extensive retrofits.

The change in suitability across the archetypes between the lower and higher cost retrofits are larger than in the winter peak case. Therefore, if the 20-year peak was chosen as the external temperature case to assess dwelling suitability, higher cost retrofits would be required achieve a high degree of suitability for lower flow temperatures. The absolute number of stock suitable would still be lower than in the other external temperature cases considered.

Figure 14 Proportion of stock suitable at 55°C, by archetype (Higher cost retrofit scenario)

Figure 15 Dwellings suitable for each flow temperature (cumulative, Higher cost retrofit scenario)

Average external temperature cases

The two ‘average temperature’ cases (winter average and November average) were tested to gauge the suitability of dwellings under less stringent criteria. The results show that with less stringent criteria, much larger proportions of the stock are already, or can be made suitable, for 55°C and lower flow temperatures. See Appendix 8.5 for full archetype results.

The results show that 60-80% of homes are already suitable for 55°C flow temperatures for these less stringent external temperature cases. Lower cost retrofits increase this to 85-92% (for winter average and November average respectively). Higher cost retrofits result in almost all homes being suitable for 55°C (94-97%).

Importance of radiator upgrades

In half of the model runs, we investigated a reduced potential for radiator upgrades in all dwellings. The intention was to model the potential for flow temperature reduction when there were significant barriers to radiator upgrades (which could be caused by impracticalities or aesthetics).

In the winter peak cases, reducing radiator uptake decreases the suitability of the stock at every flow temperature tested. This demonstrates that upgrading radiators could be a key retrofit measure for facilitating flow temperature reduction.

Figure 16 Comparison of dwellings suitable at each flow temperature (cumulative) when reduced and recommended rates of radiator uptake are tested in peak external temperature cases, Lower cost retrofit scenario (above) and Higher cost retrofit scenario (below)

Fuel bill and emissions modelling

The final step in this study is translating energy demand reductions from lower flow temperatures into fuel bill and emissions savings estimates by archetype.

Fuel bill modelling

At a flow temperature of 55°C, dwellings can save between £50 and £300 per year depending on the archetype and fuel cost scenario. The ranges for each archetype are set by applying low and high fuel costs to the archetype’s average annual heat demand from the NEED database (BEIS, 2022). As such, this is reflective of the archetype’s average energy demand patterns as opposed to being reflective of anything tested or modelled in the suitability assessment detailed above. Based on the NEED data, the flat archetypes and 1984-2002 houses will potentially save the most in fuel bills on a per dwelling basis (see Figure 17).

Figure 17 Cost savings when moving from 75°C to 55°C (showing cost range from 4.5p/kWh and 10.3p/kWh)

When aggregated, the potential for fuel bill savings is significant (Table 4). At the lower fuel price, savings range from £151m-£249m depending on the temperature case and retrofit scenario. Higher fuel prices increase this to £345m-£624m.

Table 4 Aggregated total fuel bill savings per year for all temperature cases and retrofit scenarios (at both fuel prices)

Table 5 shows the potential savings if all dwellings’ flow temperatures are reduced as low as they are suitable higher cost retrofits are applied at archetype level. In this temperature case, highest savings come from the post-1919 flats and the 1950-1983 houses.

The winter peak temperature case results in higher savings than the 20-year peak. This is due to a higher absolute number of suitable homes at increasingly lower flow temperatures in the winter peak case, which uses less stringent suitability criteria.

Table 5 Potential for fuel bill savings (£m/yr) in peak external temperature cases when all suitable dwellings reduce flow temperatures to 55°C, aggregated to the archetype level (Higher cost retrofit scenario)

Table 6 Potential for fuel bill savings in peak external temperature cases when all suitable dwellings reduce flow temperatures to 55°C, on a per dwelling basis (Higher cost retrofit scenario)

When assessed on a per dwelling basis (see Table 6), the archetypes with the highest fuel bill savings include the pre-1919 flats, post-1919 flats and 1984-2002 houses. These all have the highest rates of savings per dwelling as a direct result of their archetypes’ NEED data. The other archetypes have similar savings per archetype, and the pre-1919 houses have the lowest potential savings at the household level.

Table 7 shows the impact of reducing flow temperatures a further 5°C, to 50°C. Estimates for total fuel bill savings are given. Dwellings suitable for reduction beyond 55°C are assigned savings from reducing to 50°C. The range of savings is increased to £181m-£802m (from £151-£624m at 55°C) depending on the temperature case and retrofit scenario.

Table 7 Aggregated total fuel bill savings per year for all temperature cases and retrofit scenarios (at both fuel prices) when all suitable dwellings reduce flow temperatures to 50°C

Emissions modelling

At 55°C, dwellings can save between 2.5 kgCO₂/year and 5.5 kgCO₂/year depending on the archetype. The emissions saving estimate for each archetype is set by applying the archetype’s average annual heat demand to the carbon intensity of natural gas used for residential heating in Scotland. Based on this, the flat archetypes and 1984-2002 houses have the highest potential emissions savings (see Figure 18).

Figure 18 Emission savings when moving from 75°C to 55°C – showing emissions based on 0.184 kgCO₂/kWh for natural gas

When aggregated to the archetype level, the potential for emissions savings ranges from 8.10 MtCO₂/yr in the 20-year peak to 8.95 MtCO₂/yr in the winter peak for higher cost retrofits. The November average and winter average result in higher emissions savings than the winter peak and 20-year peak temperature case (see Table 8). This is expected due to the increasingly stringent suitability criteria meaning that more homes are suitable for reduced flow temperatures in the average cases compared to peak cases. Lower cost retrofits also reduce potential emissions savings, with a range of 6.17 MtCO₂/yr (in the 20-year peak temperature case) to 9.96 MtCO₂/yr (November average temperature case).

Table 8 Potential emissions savings across all temperature cases and retrofit scenarios when all suitable dwellings reduce flow temperatures to 55°C

Table 9 shows the potential savings if all dwellings’ flow temperatures are reduced as low as they are suitable after higher cost retrofits are applied. Most savings come from the post-1919 flats, followed by the 1950-1983 houses and pre-1919 flats.

Table 9 Potential emissions savings in peak external temperature cases when all suitable dwellings reduce flow temperatures to 55°C, aggregated to the archetype level (Higher cost retrofit scenario)

Table 9 shows the breakdown of the emissions savings by archetype for all temperature cases with higher cost retrofits. The pre-1919 house archetype has the lowest potential savings at archetype level while post-1919 flats and 1950-83 houses provide the highest emissions savings.

Table 10 shows the impact of reducing flow temperatures a further 5°C, to 50°C. Dwellings suitable for reduction beyond 55°C are assigned savings from reducing to 50°C. This shows that emissions savings increase at the lower flow temperature.

Table 10 Potential emissions savings in all external temperature cases and retrofit scenarios when all suitable dwellings reduce flow temperatures to 50°C

Conclusions

The evidence base for flow temperature reduction

This study finds a strong theoretical case for broad flow temperature reduction in heating systems and suggests that 55°C is a suitable temperature target, which could result in reductions in energy demand and emissions at individual dwelling level.

While previous work and stakeholders suggest many dwellings will be able to run at 55°C without significant retrofitting, we note the importance of assessing suitability with property-by-property specific heat loss calculations. Our study and others use a variety of factors including ancillary component characteristics, building insulation levels and oversizing factors as proxies for a dwelling’s suitability. However, minimum flow temperature potential should be based on a property-level assessment where possible.

Suitability of the Scottish housing stock

This study has found a lower current level of suitability than suggested through the literature review and stakeholder engagement process. We found 15% of the current housing stock would be suitable for reduced flow temperature at present in our winter peak temperature case, which decreases to 7% in the 20-year peak case.

Suitability increases significantly after retrofits, reaching 55% and 76% of the total stock in the winter peak case after lower cost and higher cost retrofits, respectively. In the 20-year peak case, overall stock suitability rises to 41% to 64% after lower cost and higher cost retrofits, respectively.

There is also potential for dwellings to lower flow temperatures below 55°C, potentially into the 30–50°C range (60% of dwellings in the winter peak, higher cost retrofit scenario), given the heat distribution system’s operating regime is properly maintained and sufficient retrofits are undertaken. This may be more straight forward in some dwelling types than others, particularly flats and recent properties.

The most important factor when assessing suitability for flow temperature reduction is setting suitability criteria that adequately captures the needs of occupants. Our two key temperature cases use particularly stringent criteria, requiring that dwellings should be heated to 20°C during the coldest hour of an average or historic year. This is an ambitious goal and not one currently being met by many heating systems operating between 70°C–80°C, as evidenced by the significant portion of homes that could not meet thermal comfort while operating at 75°C in the scenarios modelled in this study. Care should be taken to ensure that suitability is sufficiently, but not overly, stringent.

The other temperature cases tested in this study (winter average and November average) test a dwelling’s ability to meet suitability during a heating hour in average winter temperatures. Significantly larger proportions of dwellings are suitable for low flow temperatures in these cases suggesting that for most of the year, many homes are suitable to run at lower flow temperatures than in our stringent test cases. Exploring the potential for varying flow temperatures throughout the year could be one way to increase the fuel bill and emissions savings overall, only increasing the flow temperature when heat distribution systems need to meet thermal comfort in peak hours.

Varying internal temperatures may also bring more homes into suitability for lower flow temperatures but this was not modelled in this study. If the internal temperature was lowered (for example to 18°C, which is in the healthy living range for healthy, not vulnerable, occupants) during peak heating hours, more homes could be made suitable. In practice, this would imply an acceptance that domestic heating systems are not expected to meet the higher end of thermal comfort during peak heating hours, which is already the case in many dwellings.

Our study suggests some dwelling archetypes will have higher proportions of the stock already suitable at lower temperatures and that these archetypes will also likely be easier to retrofit for flow temperature reductions. These dwellings tended to include flats and post-2002 dwellings. This could be due to multiple factors, including building footprint in the case of the flats and better building regulations which mandate higher levels of efficiency in the newer dwellings.

Conversely, some dwellings are likely to be harder to prepare for flow temperature reduction and will have a smaller proportion of the stock able to transition without retrofits. This study showed the difficulty in transitioning the pre-1919 houses, which are currently unsuitable for 55°C. These are larger, built with solid walls and tend to have undersized heating systems. This means more expensive retrofits will likely be required to support these dwellings in transitioning to lower flow temperatures. Our modelling identifies that after higher cost retrofits than for other dwelling types, almost half of homes in this archetype can reach suitability for reduced flow temperatures to 55°C.

Retrofitting the housing stock

A consistent finding from this study is that across archetypes and scenarios, retrofits significantly improve the proportion of the housing stock suitable for flow temperature reduction. We have found that building envelope retrofits (insulation, window glazing) and ancillary upgrades (pipework, radiators) are complementary in the transition to ZDEH systems. This means that building retrofits could be a reliable way to increase suitability for reduced flow temperatures and, at a later date, ZDEH systems.

To prepare a dwelling for lower flow temperatures, we suggest that building envelope measures are prioritised to reduce the overall energy demand of the home. Where this is not possible (because dwellings are not adequately insulated, for example) ancillary upgrades should be implemented. Radiator upgrades could be implemented, and the same goal of flow temperature reduction could be achieved but this does not improve energy efficiency in the domestic heating system.

Increased budgets for retrofits lead to increased gains in fuel bill and emissions reductions by allowing dwellings to achieve lower flow temperatures. Even the lower cost retrofit packages resulted in significant fuel bill savings (£151m–£580m depending on temperature case and fuel cost) and potential emissions savings (6.17–9.96 MtCO₂/year depending on temperature case).

Benefits to flow temperature reduction

Our findings indicate that there is potential for fuel bill and emissions savings across all archetypes. With higher cost retrofits, fuel bill savings from transitioning the stock to lower flow temperatures could total between £198m and £501m depending on the winter temperature case. Emissions savings are suggested to follow the same trends, with potential to save between 8.10 MtCO₂/year and 10.18 MtCO₂/year (depending on the winter temperature case).

The fuel bill savings and emissions reduction modelling undertaken in this work supports the view that any flow temperature reduction, whether around 55°C or lower, will bring benefits.

Appendices

Stakeholder engagement summary

Targeted stakeholder engagement was carried out to source further quantitative information and qualitative insights from industry experts. Stakeholders were selected due to their expertise on specific areas of interest and practical experience in this area. A summary of the relevance of the organisation and topics discussed for each stakeholder organisation is shown below.

Organisation: Historic Environment Scotland

Relevance: Knowledgeable government agency

Topics discussed:

• Thermal comfort of occupants and building fabric (with an emphasis on maintaining enough ventilation in the dwelling to avoid moisture build-up, resulting in damp and mould).
• Potential to reduce the flow temperature in historically built dwellings (in our study, this means the pre-1919 flats and houses) and what insulation measures might best support this aim.
• Suitability for historically built dwellings to maintain lower internal temperatures than occupants can safely live in, thus suggesting internal temperature is not a concern for the health of the building envelope.
• Potential difficulty in renovating historically built homes, particularly challenges around floor insulation and double/triple window glazing.
• Benefits to lowering flow temperatures and heating the house more gradually.

Organisation: Heat Pump Association

Relevance: Industry organisation

Topics discussed:

• Confirmation of HPA’s assertion that 55°C is the “target” flow temperature for all dwellings, and reasoning behind this (discussion around 55°C as the “compromise” between the increased efficiency of boilers at lower flow temperatures and heat pumps’ ability to operate efficiently at up to approximately this temperature).
• The trade-off between benefits of reduced flow temperature and increasingly stringent requirements for air tightness and increased energy efficiency measures in the dwelling, which also played a role in HPA’s selection of a “target” flow temperature.
• Discussion of risks of legionella, and components of heat pumps which will guard against legionella risk (including a broader discussion on factors causing legionella).

Organisation: Renewable Heat

Relevance: Heat pump installation specialists

Topics discussed:

• Potentially for the Scottish housing stock to reduce flow temperature, based on experience and monitoring efforts by renewable heat (this include a conversation regarding how to best consider whether dwellings might be suitable for flow temperature reduction based on their type and age, then being further segmented by insulation measures and specific heat loss rates).
• Discussion around credibility of HPA’s target flow temperature across homes, which Renewable Heat thought was a generally sound target.
• Discussion around potential to reduce flow temperature beyond 55°C, and the difficult of preparing the housing stock for temperatures this low, including what potential considerations may need to be taken for various dwellings, particularly the historically built dwellings.
• Rules of thumbs for what heat loss rates are required for reducing the flow temperature in 5°C increments, and at what point underfloor heating would be required regardless of building envelope and a low heat loss rate, based on the company’s installations.
• Potential for pipework replacement required as part of ancillary upgrades to the dwelling due to pipes with smaller diameters being common in the late 20^th century (this would be relevant if the flow rate of the heat distribution system needed to be increased to improve heat transfer).

Organisation: Ovo Energy

Relevance: Energy company, heat pump trial participant

Topics discussed:

• Potential for boiler and heat pump systems to reach flow temperatures of 55°C or lower, and the difference in low temperature versus high temperature units.
• Impact of refrigerant type on heating system performance.
• Importance of prioritising building envelope retrofits to increase energy efficiency as a means of overall energy use reduction.
• Potential oversizing of radiators in the housing stock today.
• Importance of retrofitting the dwelling before/as the heat system or ancillary components are being replaced, to avoid an unnecessarily large oversizing factor.
• Ability for homes with heat pumps and lower flow temperatures to meet thermal comfort, with discussion of case studies in cold-weather climates (i.e., Scandinavia).

Organisation: Energy Saving Trust

Relevance: Knowledgeable company

Topics discussed:

• Validation of topics discussed in above stakeholder engagement.
• Potential oversizing of radiators in the housing stock today.
• Building envelope efficiency measures versus ancillary component (mainly radiators) upgrades for flow temperature reduction.
• Importance of prioritising overall energy efficiency over ancillary upgrades as a means of overall energy use reduction (and the importance of preparing the stock for flow temperature reduction as a means of achieving other goals such as overall energy reduction, decarbonisation, etc.).

Peak external temperature cases

In this study, we used external temperature cases assigned to specific properties from previous analysis for BEIS (Element Energy, 2021) to inform oversizing factors for heating systems. Oversizing factors for properties, which included the relationship between peak external temperature and radiator capacity, were used instead of assigning specific peak external temperatures to each home. Homes are not explicitly assigned peak external temperatures because this would require granular data about the heat system capacity of individual homes, which was not available in the HAS data.

The temperatures in the original modelling (Element Energy, 2021) are more akin to Scottish central belt temperatures. The external temperatures from the original study would not be an accurate reflection of average Scottish temperatures across the whole country, so were not used in this work. Instead, we extrapolated the relationship between external temperature and the ability for heat systems to meet demand in homes.

These temperatures, and the distribution of homes they were applied to in the original BEIS modelling, were used with other factors, e.g., heat system capacity, to determine oversizing factors under different external temperature cases to determine suitability for lower flow temperatures.

Although specific external temperatures were not used directly in this work, the approximate temperatures represented by the four external temperature cases would be in the order of:

• Winter peak: around 0 to -10°C
• 20-year peak: around -10 to -20°C
• Winter average: around 1 to 3°C
• November average: around 3 to 5°C

Retrofit package data

Building-envelope led method for suitability assessment

A central finding from our stakeholder engagement is the estimation of a dwelling’s suitability based on a combination of the dwelling’s building envelope (i.e., levels of various insulation) and peak heat demand. This approach is based on the following principle:

• In pre-1919 dwellings (flats and houses), operating at 55°C is possible with double/triple window glazing, loft insulation of at least 100mm and draughtproofing measures.
• In flats, operating at 55°C is possible with double/triple window glazing and wall insulation. These conditions are the same to operate at 50°C (only achievable in homes built after 1984) and 45°C (only achievable in homes built after 1992).
• In houses, operating at 55°C is possible with double/triple window glazing, loft insulation of at least 100mm and wall insulation. To run at lower temperatures, houses must have 250mm of loft insulation and floor insulation. Temperatures below 45°C are not suitable without underfloor heating or a heat demand threshold below 45Wm².

Based on this, dwellings could be roughly designated a minimum flow temperature based on their archetype and insulation levels. See below for an estimate of what dwellings are considered always suitable (green – always), suitable depending on insulation measures (yellow – depends) and unsuitable without underfloor heating or peak heat demand below 45W/m² (red – unsuitable).

The results of our modelling generally agree with the finding that all dwelling types could, in theory, reach lower flow temperatures (45 – 55°C). Our study additionally finds that many dwellings in all archetypes, after some level of retrofits, could operate at even lower flow temperatures (35 – 45°C). This contrasts the stakeholders’ assumptions that for older dwelling types these low temperatures may not be attainable. It is important to note that while this approach was discussed with us by stakeholders with ample experience in home retrofitting, it is not backed by any quantitative study and as such may best be considered as “robust rules of thumbs”. In practice, dwelling suitability should be based on a quantitative assessment undertaken at the property level.

Detailed results – suitability modelling

Winter peak – suitability now (all winter peak scenarios)

Winter peak – Lower cost retrofit scenario

Winter peak – Higher cost retrofit scenario

Winter peak – Lower cost retrofit scenario (reduced radiators)

Winter peak – Higher cost retrofit scenario (reduced radiators)

20-year peak – suitability now (all 20-year peak scenarios)

20-year peak – Lower cost retrofit scenario

20-year peak – Higher cost retrofit scenario

20-year peak – Lower cost retrofit scenario (reduced radiators)

20-year peak – Higher cost retrofit scenario (reduced radiators)

Winter average – suitability now (all winter average scenarios)

Winter average – Lower cost retrofit scenario