Can commercial forces heat networks
Tanja Groth and Chantalle Thomson explain how heat networks might harness the power of competitive retail forces even though they are necessarily monopoly enterprises.
A largely unregulated monopoly is usually a bad thing for consumers. It is therefore unsurprising that there is currently a lot of discussion from government about how to effectively police the heat network industry, consumer watchdogs and the companies involved in the market.
The UK needs to completely overhaul its approach to heating over the next two decades, to provide a growing population with an affordable and secure supply of heat that is also low carbon. Getting the heat network market structure right will be of critical importance to sustain the confidence needed for its growth.
This growth is already picking up pace, with the UK government committing £320 million to catalyse action in the sector across England and Wales, at the same time as the Scottish government is consulting on transformational policies to embed heat networks into local planning policy.
When customers choose – or in the case of domestic customers are required – to connect to a heat network instead of maintaining their own, independent source of heating, such as a natural gas boiler, they move from a competitive market to a monopoly. Rather than being able to select from a range of gas providers, they are locked into a specific contract with their heat network provider.
The operation of a heat network depends on the ownership and management structure for the three main areas that make up a network: supplying heat from the energy generation centre; the provision and maintenance of pipework as a transmission network for heat; and a retail interface that can manage customer metering and billing.
At present, heat networks are usually structured in four different ways (other models are possible in principle but not commonly in use).
1. Vertical Integration, where a single company provides end-to-end management of supply, pipework and retail.
2. Separate SupplyCo, which divides management of energy generation centre from pipework and retail.
3. Separate PipeCo, which transfers ownership of lower risk pipework assets away from supply and retail operations.
4. Separate RetailCo, which splits customer-facing retail from wholesale supply and pipework operations.
Under each of these models the end customer has no choice over the company from which they receive their heat supply. This will necessarily be whichever company manages the retail element within the ownership structure. And facing no competition from alternate providers, there is little incentive for that retailer to provide a service over and above the minimum required to comply with agreed contract terms and conditions – although some have now signed up to voluntary consumer protection schemes such as the Heat Trust.
This market structure is reminiscent of how the water industry operated for non-domestic customers in the UK before parts of the market were opened to competition. The big difference is that with heat networks there are far fewer safeguards in place today to protect customers from poor service, whereas there were already numerous regulations and enforcement mechanisms for ensuring water quality.
Opening up the market required breaking up the geographic, vertically integrated monopoly structure that existed within water and wastewater utilities. This happened in Scotland in 2008 and earlier this year in England and Wales. Companies retained ownership of their existing infrastructure around water supply and wastewater treatment, but they could only sell this on a wholesale basis. It was necessary to create an independent retail arm if they wanted to directly deal with non-domestic customers.
This meant that these newly created retail arms could compete for business and public sector customers without geographic restrictions. Additionally, new providers could enter the market thanks to the ability to fairly purchase water supply and wastewater treatment services at wholesale prices.
So what can be learned from changes to the water market that could be applicable to the heat network industry? The key lesson is that greater competition appears to be highly effective in unlocking efficiency and providing end customers with a better deal. While there is a RetailCo model existing today within the heat network industry, it is not yet subject to proper competitive pressures.
Retailers have the technical competence and commercial leverage that allows them to genuinely influence better performance from wholesale suppliers of heat. Because consumers can shop around, those retailers are incentivised to continue pushing for things to become better and cheaper. And this should push providers to deliver a higher quality of service and focus on savings, because they will no longer be able to just pass higher costs on to their end customers.
To give some idea of the potential savings, Scottish Water’s independent commercial arm, Business Stream, claims that in the six years following market deregulation in Scotland it was able to cut £100 million from customer bills. This was principally achieved through a combination of water efficiency measures and price discounts. These savings also resulted in an overall reduction of 20 billion litres of water.
Successful deregulation of the non-domestic heat network market could then be extended to households, with the added benefit of introducing any additional lessons learnt from that process. There have rightly been concerns raised around regulatory absences, customer vulnerability to price increases and inadequate service levels that currently exist in some cases. But strong, capable retailers with genuine commercial clout and an incentive to act should be able to seriously mitigate these concerns.
Unlocking the power of retail competition could be a hugely powerful tool to overcoming some of the biggest barriers and reputational issues that threaten the continued growth of the heat network industry in the UK. It is not the whole solution, but given its success in other regulated utility markets a similar solution should be strongly considered by the government.
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