Effects of the New Collective Heat Supply Act Determine Investment Climate for District Heating Sector

In the coming years, a significant portion of the Dutch built environment is due to switch from using natural gas to using heat delivered via district heating. The number of district heating connections should approximately double between 2020 and 2030. The Policy Program Accelerating Sustainability of the Built Environment by Minister De Jonge for Housing and Spatial Planning expresses the ambition that 500,000 new district heating connections[1] will be added to the existing built environment by 2030.[2] According to a parliamentary letter from Minister Jetten, this number should grow to about 2.6m new connections by 2050. This will require massive investments. For the infrastructure alone, this involves EUR 4.8bn to EUR 6.8bn until 2030 and about EUR 35.5bn until 2050.[3] The construction of new district heating and the installation and expansion of existing networks will contribute to reducing greenhouse gas emissions in the built environment. These emissions must fall from 22.6 megatonnes of CO_2-eq[4] in 2021 to about 10 megatonnes of CO_2-eq in 2030.[5]

[1] Measured in housing equivalents (in Dutch WEQ). A home equivalent is 27 gigajoules per year. This is an estimate of the amount of energy needed to provide space heating and hot tap water to an average Dutch home.

[2] Currently, the built environment consists of more than 8m homes and 1m other buildings.

[3] These costs do not include costs for heat sources, the primary grid outside the neighborhood, peak and backup installations, delivery sets and modifications to the indoor heating installation.

[4] CO₂ equivalent is the extent to which a greenhouse gas contributes to the greenhouse effect, converted to the effect of 1 kilogram of CO₂.

[5] The exact target is not yet set.

Unlike electricity and natural gas, the infrastructure for transporting heat has not been separated by law from the production and supply of heat. As a result, almost 85 percent of current district heating customers are connected to one of the three large, private, integrated district heating companies: Ennatuurlijk, Eneco and Vattenfall. Eight percent of the market involves a public-private partnership, see Appendix 1. The vertically-integrated chain means consumers cannot choose their own heat supplier. Therefore, the regulator, the Authority Consumers and Market (ACM), regulates heat tariffs. These tariffs are currently still based on a comparison with the costs small retail and business consumers have when connected to a natural gas grid. This is called the No More Than Otherwise Model (NMDA, in Dutch).

Unlike electricity and natural gas networks, the costs of district heating are not socialized.[6] This means that each district heating grid requires a positive business case to make an investment. However, district heating infrastructure is on average about five times more expensive than natural gas infrastructure.[7] To prevent it becoming too expensive for residents to connect to district heating, the national government, provinces and municipalities cover the financing gap of district heating grids with subsidies such as the new District Heating Grids Subsidy (WIS). Depending on the situation, governments may cover up to half of the required investment in district heating grids. In addition, governments often cover risks such as the realization risk[8] and the scale-up risk[9] to ensure that the costs for residents remain reasonable and private parties find the business case interesting enough to invest in.

[6] Socialization of costs means that all network costs (of electricity and natural gas) are allocated to all connected parties. As a result, there are hardly any differences in network tariffs paid by users in different regions.

[7] Source: Sanne de Boer (2022). De energietransitie uitgelegd – derde editie. ISBN 9789083083032. Publisher: De Groene Waterlelie

[8] The risk that a project will be delayed and/or become more expensive than previously budgeted.

[9] The risk that the number of connected customers and heat demand fall short of the expectations at the time the investment decision is made, leading to large ongoing operational losses.

The proposed Collective Heat Supply Act (Wcw) consists of two main components. First, the district heating grids must be largely in public hands. Second, heat tariffs must be based on actual costs plus a reasonable, regulated rate of return.[10]

District Heating Grids (Mostly) in Public Hands

In the proposal of the Wcw, municipalities can only designate district heating companies for a new district heating lot of more than 1,500 connections if at least 50 percent + 1 share of the district heating infrastructure[11] is owned by one or more public parties.[12] Several business structures are possible here (see Figure 1). Variants 1 and 2 involve an integrated district heating company that is more than 50 percent publicly owned. Variants 3 and 4 involve a joint venture of a heat supply company[13] and a district heating grid company. In these structures, public parties must own more than 50 percent of the shares of the district heating grid company and this company must have more than 50 percent control in the joint venture. In all cases, the district heating company is integrally responsible for the construction and management of the infrastructure, the supply of heat and the production or purchase of heat. The proposed Act does not see district heating cooperatives as a public party and therefore does not specifically name them. It is possible that the minister will still define a role for district heating cooperatives.

[10] Similar to the method for grid operators of electricity and natural gas.

[11] Infrastructure includes the following components: the primary district heating grid in the neighborhood, the heat transfer station, distribution pipes, connection pipes and indoor piping up to the delivery set. It does not include the heat source, the primary grid outside the neighborhood, peak and backup installations, delivery sets and modifications to the indoor installation after the delivery set.

[12] A public party means a party whose shares are held directly or indirectly by the state, province, municipality or other public body.

[13] A heat supply company can produce its own heat or purchase it from a third party.

Municipalities must coordinate the heat transition in the built environment. They also often cover much of the risks of district heating companies and invest in the infrastructure. Municipalities feel that they do not get enough participation and steering options in return. Public ownership of district heating infrastructure should change this. In addition, the idea is that the government can better safeguard public interests - such as affordability, sustainability and reliability of the district heating grids - through public control of the heat transition. Finally, Minister Jetten mentioned that the purpose of the Wcw is to equalize the ownership structure of district heating with that of other vital infrastructures such as natural gas, electricity, drinking water and rail.

Cost-plus Model Replaces NMDA Model

Instead of the NMDA model described earlier, the government wants to implement a cost-plus model, in which heat tariffs are based on actual costs plus a reasonable, regulated rate of return. In principle, this would make any newly constructed efficient district heating grid profitable, but to prevent residents from facing excessive connection costs or heat tariffs, a significant amount of subsidy is still needed. The switch from the NMDA model to a cost-plus model is primarily motivated by the fact that the built environment is developing to become natural gas-free, making it illogical to continue using the cost of natural gas as a price reference. In addition, it should prevent excess profit generation in the sector although the ACM has determined that on average this is not the case. In fact, the average return of district heating companies over the period 2017 to 2022 was 4.6 percent.

Planning Introduction of Wcw Under Pressure Due to Delay

The target date for the new Act is July 1, 2024. The question is whether this target date is still feasible as the process has been delayed (again). The new tariff regulation should take effect by January 1, 2025.

When the new Act takes effect, there will be a so-called seven-year phase-in period. During this period, municipalities can still have district heating infrastructure developed by district heating companies that do not comply with the Act, because it takes time for public parties to develop the necessary execution power to do this themselves. The Act will be evaluated two years before the end of the phase-in period.

For existing district heating lots, there is a 20- to 30-year transition period during which owners are given the opportunity to recoup their investments.

Comments on the Proposal

In response to the Wcw proposal, the three major district heating companies have all indicated (temporarily) halting investments in new district heating grids or renewable heat sources. A recent example is the withdrawal of Ennatuurlijk from the development of the Regional District Heating Grid Twente. The parties have decided this because it is not clear at this time how their assets and investments will be valued at the end of the transition period (and who will buy them in what way). In addition, they name the risk of the so-called patchwork effect. Some existing district heating grids consist of several lots that were tendered at different times, so they may also need to be transferred to a district heating company compliant with the Wcw at different times. This can create practical problems. Existing district heating companies also have great objections taking a minority stake in a district heating (grid) company. After all, this may not give them sufficient control over operations, and it increases dependence on (possibly capricious) political decision-making if a municipality has a majority stake. Finally, district heating companies foresee problems when only part of a district heating company is transferred. If, for example, only the district heating infrastructure and heat sources are transferred to another district heating company and the supporting business functions such as financial administration and customer service remain behind, this leads to high costs at the ‘old’ district heating company and may affect customer service.

Distribution system operators (DSOs) such as Alliander, Enexis and Stedin, on the other hand, seem to be happy with the Wcw proposal. They would like to take on a greater role in the district heating sector and also see themselves able to take on the task of rolling out and managing district heating infrastructure. To be able to do that well, however, the DSOs say it is important to adjust the group ban[14]. They also need access to sufficient skilled personnel and public financing (from the state, decentralized authorities or other public financiers).

Municipalities, through the Association of Netherlands Municipalities (VNG), have advocated for the current proposal of the Wcw. It is therefore not surprising that most municipalities are happy with this proposal that gives them more control options. An example of this is the municipality of Eindhoven, which wants to decide on establishing its own district heating company before the summer of 2024. At the same time, this proposed Collective Heat Supply Act may also be a burden for some municipalities. After all, most have little or no experience with the complex heat market. It is therefore not expected that many municipalities will act as (sole) owners of a district heating company, but that they will look for (regional) partnerships. The Gelderland Heat Infra Company is an example of this.

[14] The group ban states that a distribution system operator is not allowed to be in the same corporate group with a company engaged in the production and/or supply of energy.

To date, district heating companies finance most (large-scale) district heating grids out of their balance sheets. A balance sheet includes both equity and debt (debt to third parties, such as banks). However, district heating companies can also finance new district heating grids as a standalone project through project financing. The current proposed Wcw affects the way and conditions under which district heating grids and district heating companies can raise equity and debt capital in several ways.

Impact on the Financing Climate

Before a lender, such as a bank, provides a loan to a district heating company, the lender makes an analysis of, among other things:

We explain these points further below.

A company's creditworthiness says something about its ability to repay financing that has been provided. Financially sound companies have a higher credit rating than less financially sound companies. As a result, they can borrow money at more favorable conditions. The presence of public shareholders can increase the creditworthiness of a district heating company (especially the smaller ones), which can have a positive effect on its bankability. The creditworthiness of a company depends, among other things, on the ratio of equity to debt. In the case of joint venture district heating companies it is therefore important that the parent companies contribute sufficient equity to the joint venture. The same applies to financing of SPVs (see text box). The proportion of equity required depends, among other things, on the risk profile and maturity of the cash flows, but is usually at least 30 to 40 percent of the total financing requirement. To prevent new (small) district heating companies from becoming unbankable, the government could consider setting requirements for the capitalization of such companies similar to the Financial Supervision of Distribution System Operators Act applicable in the network sector. Another option is for the government to guarantee (part of) the debt.

A financier ultimately wants the loans provided to be fully repaid. The likelihood of that increases if the company is well managed. This is why financiers assess the quality of the management/organization. Competencies and track-record are crucial here. In the proposed Wcw, public parties are given a large role in district heating companies. These can be parties such as municipalities, provinces, Energie Beheer Nederland, drinking water companies and DSOs of electricity and natural gas. However, these parties as yet have no or limited experience in developing and operating district heating grids. This is a potential risk for financiers, which usually translates into a higher interest rate on financing and/or a higher required equity contribution. If the risk is deemed unacceptably high, a financier may decide not to provide a loan. Recent negative experiences with public ownership , such as with AEB in Amsterdam and Warmtebedrijf Rotterdam, underscore these risks, as well as the large financial interests involved in this capital-intensive sector. It is therefore essential that public parties immediately have sufficient knowledge and expertise. Cooperation with the existing district heating companies can help here, because the accumulated knowledge and expertise on the construction and operation of district heating grids is mainly with them.

The quality and value of a district heating company's existing assets , if any, are important to a lender in two ways. First, the likelihood of unexpected costs - such as maintenance costs or costs related to disruptions in providing heat to customers – is lower when the quality of the assets is good. Second, the assets can be collateral for the loan. If the district heating company is unable to repay the loan, the lender may be able to recover (part of) the loan by selling the assets. Due to the proposed Wcw, it is currently unclear what the value of the assets of private district heating companies will be at the end of the transition period. This makes financing of existing district heating companies more risky. Indeed, the residual value of assets at the end of the transition period is a relevant parameter for bankability. Minister Jetten 's parliamentary letter seems to imply that the transition period will give existing district heating companies enough time to recoup investments, making compensation on transfer unnecessary. It is important for financiers (and investors) to have clarity on the value of the assets of existing district heating companies at the end of the transition period.

How the heating company obtains the heat (and cold) it needs is also important to financiers. Purchasing heat from third parties bears a higher risk than producing it itself, because with procurement the district heating company has less control over the availability and deployment of the heat sources. Without heat, there is no business case. This risk is extra high if the integrated district heating company or heat supply company is dependent on a single supplier. The Wcw may lead to more purchases of heat from third parties and less own ownership of heat sources, which may make financing more expensive due to perceived higher risks. The government and public shareholders of district heating companies can reduce these risks by, for example, encouraging the connection of different heat sources (from different owners) to district heating grids and the conclusion of long-term supply contracts.

District heating grids are a large investment. If a grid is financed by project financing, the loan has a relatively long term (usually a minimum of five years, rising to 12 years). The business case, and in particular the risk profile and maturity of the cashflows, determine whether and to what extent financing can be provided. Financing is structured based on the expected cashflows, and the key is to obtain guarantees on as high a share of the future cash flows as possible. This can be done, for example, by concluding long-term purchase contracts with creditworthy parties such as housing corporations, or by having well-spread client portfolios, such as a large group of private individuals. With project financing, this is even more important than with balance sheet financing (see text box). The intention to base future heat tariffs on actual costs is beneficial for the business case of integrated district heating companies.

To date, almost all district heating grids in the Netherlands are owned by integrated district heating companies.[15] Financiers (and investors) generally prefer this model because joint venture structures in many cases involve more complexity, higher risks and higher costs. Indeed, the two separate business units may in some cases have conflicting interests. This has a negative effect on fundability. It is therefore important to have firm, contractual agreements on how to share the risks in the heat chain and how to align the various interests. Hedging those risks is often accompanied by requests for guarantees (by governments) and risk premiums on interest rates, which can come at the expense of profitability. In addition, splitting a district heating company into two or more companies leads to increased complexity due to an increase in contractual and operational dependencies as well as increased legal and management costs. Finally, when the district heating company is split, the market risks (in the operating phase) are on the side of the heat supply company and the maturity risk (in the development phase) is on the side of the district heating grid company. The district heating grid company does have the advantage of a fixed revenue stream because it collects fixed fees, whereas the heat supply company depends (mainly) on the sale of heat (and in some cases cold) for revenue, which provides less certainty. This can lead to financing the heat supply company being more difficult than financing the district heating grid company, especially when the supply company's higher risk is not combined with higher returns. If it is politically desirable for DSOs to play an important role in the heat sector, it would be advisable to modify the group ban, referred to earlier, to allow DSOs to participate in integrated district heating companies and avoid joint venture structures.

Impact on the Investment Climate

Parties such as pension funds, infrastructure funds and insurers invest on an international scale in all kinds of infrastructure, such as ports, airports, toll roads and also district heating grids. In doing so, these parties regularly hold minority stakes, even in structures where public parties hold a majority stake. For these types of investors, the Wcw may offer opportunities, depending on how the details of the Act are worked out. Two issues are particularly important to promote the investment climate in Dutch district heating grids, namely the distribution of risks in the heat value chain and sufficient investor control over crucial decisions. We explain these points in more detail below.

To avoid problems around the distribution of risks in the heat chain, investors probably prefer integrated district heating companies. This avoids the risk of conflicting interests and unclear chain liability. An integrated district heating company is also more manageable in terms of the distribution of fixed and variable revenues. If joint-venture structures do arise, as with financing, it is important that reliable, stable parties contractually cover the liabilities and risks. In addition, the tariff structure must be designed in such a way that it is possible to distinguish between the added value and risks of different parts of the chain.

A prerequisite for many investors to get into district heating is that they have sufficient control over certain strategy and investment decisions. In the case of a minority stake, where this cannot be done on the basis of the share ratio, shareholders often agree this contractually. Shareholders then stipulate in advance which subjects are part of this arrangement and which subjects can be dealt with by a simple majority vote. The Wcw should therefore allow room for such arrangements if the goal is to keep district heating accessible to private investors who want to play a role in the heat sector.[16]

[15] An exception, for example, is the district heating grid in Zaandam, where Firan is responsible for the development and operation of the heat grid and Equans is the heat supplier. However, these two companies operate without an overhead heating company.

[16] For heat networks with more than 1,500 connections.

The current uncertainty surrounding the exact interpretation of the Wcw is delaying the rollout of new district heating grids and is helping to make the Dutch government's ambition for the heat sector in 2030 unattainable. In order to make the investment and financing climate for district heating grids sufficiently attractive again - also for private parties - RaboResearch believes that the government needs to think carefully about a number of important recommendations, such as:

The Wcw may be disadvantageous for some (established) parties, while the proposal may offer opportunities for other (new) parties. If the recommendations just mentioned are properly developed in the final Collective Heat Supply Act, we do not expect any negative impact on the financing and investment climate for district heating in the long term.

The table below lists the largest heating companies and the number of connected parties. It does not include connections from small grids such as Eteck's, for example.