Heat regulation is building up a head of steam

Over 480,000 UK customers receive supplies from heat networks, and this is set to increase to 4 million by 2050, but the market is almost entirely unregulated. Unlike electricity and gas, anyone can build a network, be a supplier, tie customers into long-term contracts and charge what they can.

However, in late December 2021, BEIS (the Department for Business, Energy and Industrial Strategy) took a long-awaited a step towards disrupting this market by setting out its proposals for regulation in its response to the “Heat Networks: Market Framework” consultation. The key focus areas are consumer protection, technical standards, supply prices, security of supplies and decarbonisation, all administered through an authorisation scheme. If it comes to pass, this will have a momentous impact on all stakeholders, including suppliers, operators, customers, developers, landlords, asset owners, investors and local authorities. There is no timescale yet, but in due course, we will undoubtedly see a rush to review current contracts to ensure compliance, particularly the change of law provisions and who may be responsible for any capital investment needed. In the meantime, all new contracts will need to be future-proofed as much as possible.

The current dilemma 

Heat networks have a central heat source and distribute it to multiple domestic and business customers (often in the thousands) via networks of pipes for space heating and hot water. Many schemes are run efficiently, reduce carbon emissions and save customers money. However, a lack of regulation and small number of badly-run schemes have led to concerns around consumer protection, cost of supplies and lack of accountability. This is exacerbated by the fact they are natural monopolies and customers can be tied into a supply contract for around 25 years without the ability to switch supplier.

The proposals

To address the above concerns, heat will become a regulated utility. This require a licence akin to the electricity and gas sectors, but network operators and suppliers will both need to be authorised and registered with Ofgem. BEIS is considering whether asset owners should also be regulated in some way. Authorisation for a scheme or a portfolio of schemes could be revoked in the event of continued non-compliance.

The regulator

BEIS has chosen Ofgem to administer the authorisation scheme and it will have the power to set rules, monitor compliance, impose penalties and issue customer redress orders. The cost of regulatory oversight will be spread across heat, electricity and gas consumers, as the heat sector alone is too small to absorb it. BEIS estimates that this will add £1.40 per year to heat bills and £0.10 per year to gas and electricity bills.

Consumer protection

All schemes will have to meet some minimum standards, but domestic and micro-business customers will be the focus of consumer protection.Suppliers and scheme developers will be required to provide customers with transparent information prior to the sale or lease of a property. This is not a new concept, but both parties would have accountability which needs to be reflected in contractual arrangements. BEIS acknowledges that landlords are already bound by service charge and heat infrastructure requirements in the various Landlord and Tenant Acts, so any additional obligations will build on these.  Landlords will have to keep a keen watch on these developments. The Energy Ombudsman will be appointed by Ofgem to provide an independent and free service for resolving customer complaints. Supply contracts may have to be amended to reflect the right for customers to refer disputes.

Heat pricing

BEIS is keen to enforce transparency of heat prices and how costs are allocated, but will not impose price caps or profit regulation at this stage, although it hasn't ruled it out if there is a future need. Ofgem will have the power to set price benchmarking methodologies, as well as investigate and take enforcement action where prices seem disproportionately high. This is a big departure from the current position, which relies on voluntary pricing standards and controls through contracts. Undoubtedly, all existing supplier appointments and heat supply contracts will need to be reviewed to ensure compliance, and amended where they fall short, which may seriously impact supplier financial modelling.

Step-in 

Given the high rate of electricity supplier insolvencies, BEIS is keen to ensure security of heat supplies, acknowledging the difficulties of complex contractual structures and project ownership arrangements. The authorisation scheme will likely require contracts to contain accountability for heat supply failures, through business continuity plans, KPIs and transfers to new supplies for serious failures. These concepts are often already baked into contracts, but will become the norm and existing provisions will have to be scrutinised.

Technical standards

The authorisation scheme will mandate technical standards for all existing and future networks, driving quality, reliability, low cost, and decarbonisation. They will likely be based on a quality assurance certification scheme and will build on current standards such as the CIBSE Code of Practice 1. This will have an impact on all long-term network operation contracts currently in place and operators will need to consider how increased standards will affect its financial models and service provision.

Decarbonisation

BEIS has identified heat networks as a key part of achieving its 2050 net-zero targets. It intends to regulate carbon emissions through the authorisation scheme, but this will be done incrementally in order to work with the replacement cycle of existing plant and not deter investment. BEIS believes that this will impact technology choices in the 2030s. It will also work with the Environment Agency and Defra to reform the Environmental Permitting Regulations.

Rights and powers

Heat network operators do not currently have the same statutory undertaker benefits as the electricity and gas sectors, such as street work permits and access rights. Once regulated, operators will be able to apply for a statutory undertaker licence, although Ofgem will need to be confident that the operator will have sufficient financial resources to compensate for any damage caused whilst carrying out works.

The immediate future 

Although we are lacking detail, there are some strong themes that can be built into contracts appointing suppliers and operators, and into customer heat supply contracts. Anyone building, owning, operating or off-taking from a heat network needs to be mindful of future-proofing their arrangements with robust provisions and accountability, so as to minimise the impact of changes in law which are looking more certain to transpire.