Ensuring that heat is supplied at a fair and transparent price is a key objective of the regulator. This article examines Ofgem's proposals around pricing and how this may impact heat network operators and suppliers.
This article is part of our Heat Network Regulation series which looks at key issues under the latest round of consultations published by Ofgem and the Department for Energy Security and Net Zero on 7 November 2024. If you have any involvement with a heat network, check how regulation will apply to you and whether you will be considered a heat network "operator" or "supplier".
Fair Pricing
Heat networks are natural monopolies, with consumers typically having no other choice over who provides their heating, hot water, or cooling. In a developing market, Ofgem need to balance protecting domestic consumers from excessive pricing whilst allowing investment and growth in the heat sector.
Ofgem is proposing a "principles based" approach to pricing, acknowledging that costs and prices vary across different networks depending on their technical and commercial characteristics.
It is important to note that any pricing standards imposed by regulation will apply in addition to any contractual rights – for example, where a property developer or landlord has appointed an ESCO but retains the right to oversee price setting or benchmarking.
Fair Pricing Framework
Heat network operators and suppliers will have a general obligation to provide "fair and not disproportionate prices". Further consultation will develop a "fair pricing framework", with guidance setting out minimum expectations, principles, and good practice. The intended outcome is for customers to pay reasonable and fair prices that are easy to understand and compare.
The consultation indicates reference to external price benchmarks and/or a reasonable rate of return could be used to determine whether pricing is "significantly above" actual costs or where the supplier is making "excess profit". The approach to benchmarking is expected to be addressed as part of a further consultation on pricing later this year.
Ofgem intervention – will there be a Price Cap?
The consultations propose that Ofgem will have pricing investigations and powers, including the ability to impose scheme-specific pricing restrictions and introduce price cap regulation in future.
At present, Ofgem considers the benefits of introducing a price cap are outweighed by risks to consumer given the current state of the market – however this remains a technical risk. Ofgem will be running a further consultation later this year that will focus in detail on its price protection proposals.
Improving efficiencies
Heat networks will need to ensure that customer charges reflect the underlying costs of the network and take steps to improve both cost and technical efficiencies.
The cost of providing heat and cooling is usually distilled into fixed and variable charges:
- The variable charge represents the cost of the fuel used to generate the heat/cooling subject to an efficiency ratio (to reflect the efficiency of the plant converting fuel to heat or cooling).
- The fixed or standing charges will cover the known costs of providing the service, which may include operation and maintenance, metering and billing, capital replacement, tariff setting and administration costs.
To improve efficiencies, this will require heat network operators to procure fuel supply contracts competitively and ensure that any outsourced service contracts (such as appointing operating and maintenance or metering and billing service providers) represent good value for customers.
Fuel procurement
The 2023 consultation highlighted that often landlords procure fuel supply contracts on a fixed annual basis, to avoid having to comply with leaseholder consultation requirements under Landlord and Tenant legislation. This often results in higher prices for consumers compared with larger ESCO providers that can hedge energy purchases by securing longer term contracts with energy suppliers or brokers.
This issue has not been specifically addressed in the subsequent 2024 consultations but Ofgem's proposals on "unbundling" heat charges from other service charges are intended to avoid poor outcomes for consumers arising from conflict with existing legislation – our article on heat contracts and billing will look at these proposals in further detail.
Sinking Funds and Capital Investment
Long-term efficiency of the network will need to be prioritised, including investment to improve technical efficiencies. A separate consultation on technical standards is expected to be published in early 2025, which may require upgrades to existing plant and infrastructure. It is not clear how these improvements are expected to be financed and whether upgrades will be required before existing equipment is due to be replaced.
Capital replacement costs are often recovered from customers – through the fixed element of tariffs or as a contribution towards a separate sinking fund – but there are often restrictions on how these amounts can be used. The consultation also refers to protecting consumers from the "improper recovery" of capital expenditure from sinking funds – particularly where there is a discrepancy between the consumers paying into the sinking fund and those who are benefitting from the improvements.
Further guidance will be required from Ofgem on how this is intended to work in practice. For existing developments, the lease provisions will often dictate how sinking funds can be used and will require careful consideration.
Capital Contributions
A number of ESCOs in the market offer upfront investment to property developers towards the heat network infrastructure (a capital contribution) – similar to asset value payments made by IDNOs in the regulated electricity market. The ESCO will recover these costs through the standing charge element of customer tariffs.
The consumer protection consultation specifically refers to shielding customers from the "improper recovery of significant initial capital costs in the development phase". Capital contributions were previously addressed in the Competition and Markets Authority's Market Study (published in May 2018), which concluded that it would not recommend a ban on capital contributions if ESCOs could still offer tariffs that remain market reflective (by reference to a reasonable benchmark price). Further detail is required from Ofgem to confirm if this approach will continue.
Developers and landlords of schemes that have already taken capital contributions (or are considering them) should review customer tariffs to ensure they are able to justify that these are proportionate in the market and that their customers are not unjustifiably impacted.
From a PR perspective, there is the potential for reputational damage if customers perceive that the developer is making additional "profit" from a capital contribution. This will be important to consider in light of proposals to require greater transparency on the breakdown of variable and fixed costs, which may mean that capital contributions will need to be displayed on customer bills.
This article is part of our Heat Network Regulation series. Read our overview of the proposals under the latest round of consultations.
If you are concerned about any of the issues raised under the consultations or how regulation may impact you, please get in touch with a member of our Energy and Sustainability team.
