Energy Policy 38 (2010) 6936–6945

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Energy Policy

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An assessment of the present and future opportunities for combined heat andpower with district heating (CHP-DH) in the United Kingdom

Scott Kelly a,n,1, Michael Pollitt b

a Department of Land Economy, University of Cambridge, 19 Silver Street, Cambridge, UKb ESRC Electricity Policy Research Group and Judge Business School, University of Cambridge, Cambridge, UK

a r t i c l e i n f o

Article history:

Received 19 August 2009

Accepted 7 July 2010Available online 4 August 2010

Keywords:

Combined heat and power

Energy sevice company

District heating

15/$ - see front matter & 2010 Elsevier Ltd. A

016/j.enpol.2010.07.010

esponding author. Tel.: +44 01223764867.

ail address: sjk64@cam.ac.uk (S. Kelly).

e authors wish to thank those people workin

nerously agreed to be interviewed for their

ledge the financial assistance of the EPSRC Fle

emain their own.

a b s t r a c t

As global fuel reserves are depleted, alternative and more efficient forms of energy generation and

delivery will be required. Combined heat and power with district heating (CHP-DH) provides an

alternative energy production and delivery mechanism that is less resource intensive, more efficient

and provides greater energy security than many popular alternatives. It will be shown that the

economic viability of CHP-DH networks depends on several principles, namely (1) the optimisation of

engineering and design principles; (2) organisational and regulatory frameworks; (3) financial and

economic factors. It was found that in the long term DH is competitive with other energy supply and

distribution technologies such as electricity and gas. However, in the short to medium term it is shown

that economic risk, regulatory uncertainty and lock-in of existing technology are the most significant

barriers to CHP-DH development. This research suggests that under the present regulatory and

economic paradigm, the infrastructure required for DH networks remains financially prohibitive; the

implementation of government policies are complicated and impose high transaction costs, while

engineering solutions are frequently not implemented or economically optimised. If CHP-DH is going to

play any part in meeting climate change targets then collaboration between public and private

organisations will be required. It is clear from this analysis that strong local government involvement is

therefore necessary for the co-ordination, leadership and infrastructural deployment of CHP-DH.

& 2010 Elsevier Ltd. All rights reserved.

1. Introduction

CHP-DH networks in UK towns and cities have not experiencedas much diffusion as they have in several other European citiessuch as Berlin, Copenhagen, Stockholm, Hamburg and Rekyavik.However, several schemes are now operating in the UK using thestructure known as the Energy Service Company or ESCO model.In order to better understand the critical success factors andbarriers to wider adoption of CHP-DH networks we present ananalysis of the present and future opportunities for CHP-DHdeployment in the UK. In this research, we examine the potentialcontribution that CHP-DH schemes can make through a back-ground analysis of existing schemes operating in the UK (furtherdetails of the individual schemes can be found in Kelly, 2008).

The paper begins with a description of the present lowcapacity of CHP-DH development in UK when compared with

ll rights reserved.

g in district heating in the UK

valuable insights. They also

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other competing technologies and with other countries. This isfollowed by a short chronology of events that have contributed tothe present low CHP capacity in the UK. We follow this with ananalysis of the benefits offered by CHP-DH networks for the widerprinciples of sustainable development and climate change. Wethen present a comprehensive discussion about the barrierspresently limiting CHP-DH deployment in the UK. The discussionis split into three distinct sections identified as the mostimportant areas contributing to CHP-DH viability, namely eco-nomic and policy frameworks, engineering design principles andorganisational structures. The paper concludes by providingtargeted policy recommendations for improving the economicattractiveness and overall viability of CHP-DH.

1.1. Combined heat and power

In the UK, aggregate thermal power generation efficiency isapproximately 40% (Fig. 1) (DUKES, 2008). If, however, low-gradeheat is not dumped and waste heat is used effectively, energeticefficiencies can exceed 80%. For instance, aggregate CHP efficiencyin the UK is almost 70% despite aging plant (Fig. 1). This low-gradeenergy can generally be used for space heating, steam production,hot water production and even cooling using absorption chillers

Fig. 1. Aggregate energy efficiency comparisons of CHP and thermal generation (1991–2006).

Source: Graph created from data available from Department of UK (Energy Statistics, 2009).

Fig. 2. End use of energy in the UK by type and by sector.

Source: (BERR, 2008; DUKES, 2008).

S. Kelly, M. Pollitt / Energy Policy 38 (2010) 6936–6945 6937

(Trygg and Amiri, 2007). By contrast, the vast majority of powerstations do not attempt to capture low-grade waste heat, and thusresulting in large system inefficiencies contributing to theaccelerated depletion of fossil fuels and pollution to surroundingenvironments. Such high proportions of generally wasted lowgrade energy provides a complementary energy resource for thelow grade energy used for space and hot water heating—presentlyaccounting for 50% of final energy demand in the UK (Fig. 2).Despite this, CHP in the UK accounts for just 6% of total UK powergenerating capacity, and of this 6% CHP capacity, less than 2% isused for community heating schemes, where the remainder (98%)is used for industrial purposes (Radov et al., 2008). Whencompared with leading international examples such as Denmark– ranked the second most energy efficient country in the worldwith over 50% of electricity derived from CHP plants – the UKappears to be wasteful and inefficient at converting primaryenergy resources into end-use energy supply (Zumbrun, 2008).

1.2. Trends in CHP-DH development in the UK

Ever since the first large CHP-DH network was built inManchester in 1911, there has been an active policy debate aroundthe development of CHP-DH networks. During the 1970s, LordWalter Marshall (1977, 1979) identified the potential benefits forwidespread adoption of CHP-DH. These reports identified that CHP-DH could be a viable economic option for providing heat to areas ofhigh-density heat demand, particularly in the long term (Boyle andEverett, 2006). The reports emphasised, however, that in the shortterm CHP could not be expected to take off on any scale, largely dueto competition from other fuels, particularly natural gas. Commit-ment to develop a national heating strategy has only recently beenforthcoming in the heat and energy saving strategy (HESS)published to meet tough new CO2 targets (DECC, 2009; BERR, 2008).

With the privatisation of the electricity sector from 1990, CHP-DH suffered a series of major setbacks, explicitly: the government

S. Kelly, M. Pollitt / Energy Policy 38 (2010) 6936–69456938

failed to establish a market for heat as was done for electricity;they withdrew CHP obligations on industry and they initiallyrefused to put CHP into the Non-Fossil-Fuel-Obligation (NFFO). Inaddition, changes to the tax system meant natural gas used inpower stations was taxed at higher rates than natural gas used forheating in homes, therefore disadvantaging CHP-DH. Regionalelectricity companies driven by competition and governmentpolicy therefore concentrated on building large, non-CHP, princi-pally gas-fired power generation plant and later CCGT (combinedcycle gas turbine). The increasingly competitive energy sectorrequired power stations to be made quickly and as cheap aspossible to build and operate. Plants were increasingly located onmain gas lines outside town centres, as land close to main centrestended to be more expensive and usually involved longerplanning delays. Constructing CHP-DH infrastructure requiredtime and extra capital to establish a customer base for the heatsupply network—time and money that may not have returneddividends for many years to come. Moreover, waste heat frompower stations displaced electric heating that could have beenseen by the power companies as cutting into their revenues(Boyle and Everett, 2006).

The government subsequently set a target, in 1993, as part ofthe climate change programme to reach 5 GW installed CHPcapacity by the year 2000 (DTI, 2007). This target was notachieved. In 2000, the government set a further target to reach10 GW of good quality CHP (GQCHP) by 2010, a target that, yetagain, is very unlikely to be met (Cambridge Econometrics, 2006).A number of mechanisms have been put in place to assist thedevelopment of CHP-DH. In 2001, the CHP Quality Assurance(CHPQA) programme was established to certify and monitor goodquality CHP within the UK (CHPQA, 2000a, b; DEFRA, 2004).Schemes meeting these requirements are exempt from theclimate change levy (CCL) and are issued levy exemptioncertificates (LECS) equivalent to about 5% of the final price paidfor gas or electricity. Schemes eligible for CCL exemption are also

Fig. 3. Growth of CHP capacity in the UK (1977–2006).

Source: Graph created from raw data taken from DUKES (2008).

eligible for enhanced capital allowances (ECA) for investment innew energy technologies, and are exempted from paying businessrates on electricity generating plant and machinery (Budden,1988; DTI, 2007).

Between 2001 and 2005, the government implemented thecommunity energy programme (CEP) investing £50 m in grantsfor the promotion of community heating. Further mechanismsinclude biomass grants, inclusion of CHP plants in the EU-ETSfor plants over 20 MWe, the adoption of a 15% target for allgovernment departments to use electricity generated from CHPand new banding of the renewables obligation (RO) for GQCHPthat use biomass and waste as fuel. In 2004, DEFRA (2004)published the governments CHP strategy that outlined possiblemarket incentives, financial assistance and legislative actionto support the growth of CHP in the UK. As shown in Fig. 3, thebenefits of these measures for increasing CHP-DH deployment areyet to be seen. More recently, the Heat and Energy Saving Strategyidentified the crucial role of renewable heat and CHP for meetingrenewable energy and climate change targets (DECC, 2009).

2. Sustainable development and CHP-DH

There are many opportunities for sustainable developmentusing CHP-DH networks. CHP is a proven technology that cansignificantly contribute to increasing energy efficiency and themitigation of carbon emissions (Torchio et al., in press; DTI, 2007;IEA, 2008). Furthermore, DH networks can reduce energy costs forthe end consumer and therefore contribute to the alleviation offuel poverty (BERR, 2008). As CHP is a form of distributedgeneration and can be operated in ‘island mode’, that is,independent from the national grid, it also has potential to offerincreased security of supply while providing guaranteed back-uppower when required (Werner and DHCAN, 2004). In addition,system reliability is increased because CHP-DH operators are able

2 This is based on the carbon intensity of the UK electricity grid in 2008.

S. Kelly, M. Pollitt / Energy Policy 38 (2010) 6936–6945 6939

to professionally manage and operate the district heating networkthereby providing continuous monitoring of efficiencies in heatproduction and distribution systems.

Aside from increased energy efficiency and related costsavings, communities also benefit from CHP-DH. In the firstinstance, electricity and heat can be generated from localrenewable resources such as biomass and waste, thus minimisingtransport distances and therefore CO2 emissions (Action Energy,2004; Carbon Trust, 2005; DEFRA, 2007). Furthermore, jobs arecreated to manage and maintain local power stations and thenewly created waste and biomass industries; this in turncontributes to local economic growth and employment withinthe community. As a DH network relies only on the production ofhot water, any number of fuels can be used within the thermalnetwork including industrial waste heat, solar hot water, biomass,combustion of waste and geothermal energy. By using local, moreaffordable fuels more efficiently, district heating allows flexibilityin the choice of fuels being used and future proofing against theeffects of ever increasing and volatile fossil-fuel prices that areincreasingly caused by exogenous economic and political factors(EDUCOGEN, 2001). Such systems offer an opportunity to future-proof and improve national energy security by providing analternative energy delivery option when fossil fuels are either tooexpensive or simply unavailable.

There are also several economic benefits. By economic andengineering necessity, CHP plants are usually located close toareas of high heat demand, a measure that usually correspondswith a high population density. In general, these areas also havean equivalently high power demand. Electrical power producedby CHP is therefore generally consumed in the immediate vicinityof the CHP plant, thus minimising transmission and distributionlosses, accounting for some 7–9% of power consumption in the UKalone (DUKES, 2008). In addition, when heat production iscentralised, cost savings are made in the operation, maintenanceand cleaning of heat systems while also providing higher overallefficiencies when compared to conventional domestic natural gasboilers (Future Cogen, 2001). CHP-DH networks also offerincreased competition because consumers of heat and electricityhave increased choice between greater numbers of differentenergy suppliers.

It is also possible to improve the power quality of transmittedpower by using decentralised CHP to correct for wider powersystem anomalies. Harmonic distortions, transients, voltagedipping and power surges all occur on a typical power network.The ability to maintain good power quality is therefore veryimportant for the working life and efficiency of all electricalappliances that draw power from the network. CHP plants havepotential to be used as a means to correct for such poweranomalies thereby decreasing further losses in the system andincreasing the life of equipment (Action Energy, 2004). Mostnotably, decentralised CHP-DH networks have the ability toprevent the development of capital-intensive large, centralisedplants, the upgrading of national grid power infrastructure andthe construction of new natural gas storage facilities.

There are also benefits accruing to the operation and balancingof the power grid. As CHP-DH networks usually operatesporadically during the summer months and continuously overthe winter months, winter peak demands are reduced by theutilisation of heat from a CHP, therefore curbing pollution frommarginal coal and gas power plants. In addition, when heataccumulators are incorporated into the network it becomespossible to produce power from CHP at times of peak electricitydemand thereby maximising the revenue potential of electricitywith the ability to store heat produced for later use. The corollaryof this is to utilise abundant cheap electricity to energise electricalresistance heating coils within the heat accumulators thereby

creating a thermal energy-battery to store energy for later use. InDenmark, this technique is being used as a means to balance thenational grid during system over-burden, but also to provide amechanism to utilise abundant cheap wind power produced attimes when there is limited demand for electricity. Innovativesystems for storing energy will become increasingly important asthe percentage of intermittent renewables such as wind suppliedto the power system increases (Palsson, 2000; EcoHeatCool, 2006;Lehtonen and Nye, in press).

Furthermore, it has been shown by DECC (2009) that CHP-DHnetworks have some of the highest technically possible CO2

savings and some of the lowest costs per tonne of CO2 saved whencompared against other competing technologies (Fig. 4). Forexample, it is shown in the Heat and Energy Saving Strategy(DECC, 2009) that CHP-DH using biomass could save approx-imately 19.3 MtCO2 annually compared with individual groundsource heat pumps saving just 2–3 MtCO2 per year whenconnected to the same homes.2 In conclusion, heat distributionnetworks that utilise CHP therefore offer the following benefits:increased energy efficiency, minimisation of pollution, lowerfossil fuel consumption, increased employment and othereconomic benefits for the community, a capacity to use localrenewable energy resources, opportunities for intelligent systembalancing and some of the cheapest and largest CO2 savings whencompared with other competing technologies.

3. Barriers to the adoption of CHP-DH in the UK

3.1. The political economy of CHP-DH schemes

It is now recognised that distributed generation can make asignificant contribution to reduce the UK’s carbon emissions(HMS Government, 2009; Ofgem, 2009a, 2007). It is also acceptedthat the present centralised electricity network inherentlydisadvantages distributed generation (DG) (Woodman and Baker,2008). ‘Lock-in’ of existing energy infrastructure and policyframeworks based on a centralised system difficilitate energyproducers from competing on an even playing field. Under thearrangements for wholesale electricity markets (NETA), small,variable and unpredictable power generators appear to incurhigher costs. Meanwhile, transmission and distribution use ofsystem charges do not reflect the benefits of local generation(Grubb et al., 2008; Ofgem, 2002). One direct example of this wasthe collapse of one Leicester citywide district-heating scheme thatfailed to secure a supply contract for the sale of its electricity.Liberalisation of the power sector is frequently blamed for thedemise of the Leicester scheme because a relaxation in electricityregulation shifted negotiating power away from CHP-DH schemesto larger centralised power plants (Bulkeley and Betsill, 2005;Babus’Haq and Probert, 1994).

There are several examples where policy and economicframeworks disadvantage CHP-DH. One is the levy structuredesigned to cover the costs for managing, maintaining andupgrading the transmission and distribution electricity networks,usually referred to as the Use of system charges (TUoS and DUoS).Transmission charges are split asymmetrically between genera-tors and consumers in the ratio 27:73 (National Grid, 2010). Notonly does this mean consumers pay a higher proportion oftransmission costs than generators but this charge is levied onconsumers irrespective of whether that electricity is producedlocally or not. Furthermore, embedded generators (connected tothe local distribution network) with capacities above 10 MW are

Fig. 4. Cost of CO2 abatement by technology in £/tCO2.

Source: (Koehler, 2009; DECC, 2009).

S. Kelly, M. Pollitt / Energy Policy 38 (2010) 6936–69456940

charged for transmission costs irrespective of whether thatelectricity is exported to the national grid. In addition to theUse of System charges there is also demand based charges knownas triad charging calculated by the National Grid (in Great Britain)using three half-hour periods of peak demand between the 1stNovember and the 28th February (the winter months). NationalGrid then levies this charge on electricity distribution networkoperators (DNOs) who then pass this cost onto energy supplycompanies. Using ‘triad avoidance’ DNOs have an opportunity toreduce their operating expenses by offsetting the importation ofpower from the national grid at peak times by encouragingembedded generation to produce electricity at these times(Ofgem, 2002). However, as DNOs are natural monopolies thesecharges are usually just passed directly onto electricity supplycompanies rather than avoided using embedded generation, thusgiving no signal to electricity suppliers to reduce demand at thesepeak periods. In the few examples where electricity suppliers doreceive a financial benefit through triad avoidance, such benefitsrarely reach the embedded generators that helped to offset theimported electricity. With the introduction of the new commondistribution charging methodologies (CDCM) – an agreementbetween all DNOs in the UK – it is hoped that many of theasymmetric and disproportionate costs for CHP-DH will beremoved making the energy sector overall more competitive.

It is not just in the operational expenses that embeddedgenerators face disproportionate costs. It is also prohibitivelymore expensive for small and medium scale CHP plants toconnect to the national transmission grid. Costs for connecting tothe grid vary across the UK and there are large differences inconnection costs depending on the location of the generator(Fig. 5). If connection charges are averaged for each of the seven

zones in the UK, it can be shown that small plant (o50 MW) haveconnection charges four times that of large plant (41000 MW)for every MW of installed capacity (Ofgem, 2009b).

One solution for generators wishing to avoid this connectiontariff is to install their own private wire network (PWN). Underthe present electricity supply order exemption (2001), generators,distributors and suppliers can supply electricity directly tocustomers within specified limits allowing them to avoid the fullcosts of applying for a public electricity supplier (PES) licence(London Development Agency, 2006). The upper limit forsupplying power to domestic customers over private and publicnetworks is presently set at 1 and 2.5 MW, respectively. Thereason these limits are imposed is to prevent PWN owners havinga monopoly over the sale of electricity to customers within theirnetwork. This rule is now being reviewed after the recent EU legalcase (The Citiworks Case) (European Court of Justice, 2009) whereit was ruled that third party access to PWN’s must be granted asthe competitiveness of the energy sector depends on openmarkets. The outcome of allowing third party electricity suppliersto have access to PWN’s does potentially raise transaction costsand concerns about stranded assets. In practice, however, theowners of private networks could charge external power suppliersfor using their network, similar in principle for how a DNOcharges for using their distribution network. As identified byPollitt (2010) when the costs of a distribution network to theelectricity supply industry are compared to the unbundled localloop (LLU) costs in the fixed line telecommunications sector, thepercentage of costs associated with the duplication of localdistribution networks is lower for the electricity sector. Further-more, the competitive benefits provided by LLU in the telecom-munications sector are widely considered to outweigh the added

Fig. 5. Connection costs for distributed generation.

Source: Ofgem (2009b).

S. Kelly, M. Pollitt / Energy Policy 38 (2010) 6936–6945 6941

costs associated with stranded assets. Put another way, thebenefits that come with increased competition through eithercompulsory access (as under LLU) or duplication of power networks(as with cable/mobile providers) can outweigh the costs of a singlesupplier and a single network. To take this analogy a step further itis conceivable that unbundling local distribution electricity net-works could provide an efficient and cost-effective method toencourage competition amongst ESCOs for non-discriminatoryaccess to local wires thereby encouraging innovation and lowerelectricity prices. This is similar to what has already been achievedin the telecommunications sector (Pollitt, 2010).

The price charged for heat and power from CHP-DH plays a keyrole in understanding the economics of CHP-DH. Electricity isapproximately three times the price of heat per kWh produced,but because CHP-DH systems are predominantly heat-led sys-tems, the technology is ‘locked-in’ to produce heat as a low valueenergy source. This effect is further amplified because powergeneration becomes unpredictable meaning it cannot be sold atpeak periods diminishing the price received for electricity evenfurther. Improving the profitability of a scheme thus requiresmaximising revenues from electricity generation but also beingintelligent with the sale of heat produced. Two major factorsaffect the revenue generation of CHP from electricity. The first isthe generation capacity of the power station. For example, CHPover 3 MW receive extra revenue through participation in systembalancing through short-term operational reserves (STOR). Thesecond method is for a CHP plant to meet periods of peak powerdemand, when the price of wholesale electricity is high. CHPoperators who utilise heat accumulators or variable heat to powerratios have much greater flexibility at meeting peak powerdemands, and are therefore in a stronger position whennegotiating energy contracts with suppliers.

CHP in the UK is predominantly gas fired thus leading analysts toconclude that the ‘spark-spread’ is an important indicator fordetermining economic viability (AEA Technology, 2004; IPA, 2005;Bonilla, 2006). The spark-spread, as shown in Fig. 6, is the differ-ence between the wholesale gas price used for electricity produc-tion and the cost of electricity sold to domestic consumers, both areinclusive of taxes. Not only does Fig. 6 show the spark spreadclosely follows the price of electricity (due to such high relativeprices of electricity) but also that the spark-spread narrowed during

the 1990s, most likely due to privatisation of the energy sector(De Paepe and Mertens, 2007; DUKES, 2008). From 2004 onwards,the spark spread has expanded and in 2007 it was at its highestlevel since 1978. If the rate of increase in electricity price is fasterthan the rate of increase in the gas price, then the financial viabilityof CHP-DH networks improves; however, this same phenomenonwill also increase the financial viability of CCGT. Because of this weargue a more accurate measure for the competitive viability of CHP-DH is the difference in price between gas sold for domestic use andgas sold for the generation of electricity (incl. tax), or what wedefine here as the domestic-wholesale gas price spread.

In sum, the market places a premium on predictable andcontrollable sources of energy with strong incentives for cen-tralised power. However, the benefits of locally produced power,or power with other associated environmental or communitybenefits are not rewarded. With appropriate pricing of negativeexternalities and stronger incentives for cost reflectivity for thedelivery of energy to end-consumers, the incentives for develop-ing CHP-DH are significantly improved.

3.2. Optimising CHP-DH engineering design principles

Economic viability (and profitability) of CHP-DH relies on goodengineering design and optimisation of resources. When selectingCHP plant, an engineer must match the demand requirements ofthe end user with the supply capacities of the plant. The scale of aCHP-DH scheme is also important as large schemes in excess of200 MW are cost effective at producing power alone butfrequently overlooked for supplying heat to surrounding townsand villages (DTI, 2007). There are two fundamental demandcycles for CHP-DH networks, a daily cycle and a seasonal cycle.Both cycles need to be understood and therefore the engineeringand economics of the system can be optimised. As would beexpected, demand for heat at night is less then demand during theday and less in summer than in winter. The most straightforwardapproach to balancing system demand is to connect constant heatloads to the system; for example, hospitals, universities, publicbuildings and shopping centres all require relatively constant heatprofiles. Swimming pools are an excellent method for dumpingexcess heat at the most economical periods.

Fig. 6. Spark-spread, electricity price and gas price for the UK (1978–2007).

Source: (ENERDATA, 2008).

S. Kelly, M. Pollitt / Energy Policy 38 (2010) 6936–69456942

There are three distinct ways to design a CHP-DH network,namely (more detail on the examples mentioned can be found inKelly (2008))

�

Summer heat lead system with back-up boilers accommodat-ing peak winter demands. This is the most common and riskfree approach, but the disadvantage of this method is that totalCHP heating capacity is minimised. Furthermore, as electricityis the most valuable commodity the amount of electricity thatcan be produced is reduced and overall revenue potential fromselling electricity is small (e.g. in Aberdeen). � Winter heat lead systems on the other hand have unused

heating capacity during summer months. The advantage withthis approach is that CHP can provide heat for the majority ofwinter demand; however, the assets are under-utilised for halfthe year. In contrast to summer heat led systems, this systemwill benefit from increased revenues from selling largerquantities of electricity (e.g. in Southampton).

� Electrically lead systems enable the CHP unit to operate at

times of peak power demand and maximise the revenuegenerated from the electricity produced. Heat accumulators orheat sinks within the system are required for this approachso that heat can be stored for later use (e.g. in Woking andBarkantine). This system may also need back-up heatingsystems such as boilers when it is not economical to produceelectricity or when heat demand exceeds CHP capacity.

Optimising the design of a CHP-DH system for the economicenvironment where it is located is one of the most crucialconsiderations of CHP-DH viability. The engineer must have goodknowledge of how to maximise revenues from the systemspecifically taking into consideration the fluctuating price of

electricity, balancing demand with supply and developing cost-effective methods for storing or dumping excess heat produced bythe system. Consequently, as CHP is a bespoke technology anengineer must always carry out full economical and technologicalappraisals verifying the viability of the system. Any such appraisalwill always analyse the energy demand profiles for the area beingserved as well as the daily and seasonal load patterns (CogenEurope, 2001; Action Energy, 2004; Intelligent Energy, 2006).Careful consideration must be made of supply and returntemperatures, heat to power ratios and the spatial boundariesand opportunities afforded by the scheme.

3.3. Optimising organisational frameworks for economic

competitiveness

Municipalities have been shown to assist DH schemes in manyways, for example, they have

�

connected their own buildings to the scheme; � leased or given buildings and equipment to the ESCO; � guided customers and provided information and incentives to

connect to the scheme;

� provided financial assistance for dwellings in fuel poverty; � developed long-term mutually beneficial relationships with

ESCOs, sometimes with agreements for service provision thatspan more than 25 years;

� instigated new planning arrangements to assist installing DH

networks;

� prepared town developments plans and long-term heat

strategies central to the long-term success of CHP-DH;

� offered long term guarantees to take heat and/or power from

the system as and when required and importantly;

S. Kelly, M. Pollitt / Energy Policy 38 (2010) 6936–6945 6943

�

allowed the expropriation of property, roads and highwaysneeded for pipelines and heat supply equipment to beinstalled.

In almost all partnerships between municipalities and privatecompanies, an ESCO was created (Kelly, 2008). The definition ofan ESCO is still only loosely defined as any company that offersexpertise or service for the supply or use of energy (Future Cogen,2001; Werner and DHCAN, 2004). ESCOs are created for anumber of reasons, namely to minimise risk, increase revenues,appropriately apportion ownership rights and act as a vehicle fordelivering on specified targets. There are presently more thantwenty ESCOs operating in the UK (Vine, 2005) and most of themare established to supply energy in the form of heat as well aselectricity; increasingly, however, ESCOs also offer services toimprove household energy efficiency or provide finance for largeprojects. ESCOs that work with local governments are oftencreated in relation to heating networks designed to operate atarm’s length from a parent company or organisation. Because oftheir unique organisational structure, ESCOs can provide signifi-cant benefits through economies of scale when bulk purchasing ornegotiating contracts for the sale of energy. ESCOs often providegreater economic efficiencies because of specialist managementexpertise, long-term capital investment and contractual guaran-tees with existing suppliers and customers. The organisation ofESCOs can be placed into five distinct categories: solely public,solely private, public–private-partnership (mixed ownership andmanagement), not-for-profit and community owned co-opera-tives. The organisational structure often associated with ESCO’scan be illustrated by the Woking ESCO structure as shown inFig. 7.

Within the aforementioned categories there are severalcommon contractual relationships typically used to define thelegal relationship between the partners in control of the ESCO. Forexample, the infrastructure and assets of a scheme can be ownedby the local authority but the operation and management of thescheme is done privately. Alternatively, different components ofthe operation may be privatised such as the provision ofelectricity or heat. Essentially the ownership and control of ascheme can be split in any number of ways between privatemanagement, the local authority, the energy consumers (througha co-operative) and external private equity (through the stockmarket). The details of each model are outside the scope of thisarticle but can be reviewed in the relevant literature (Zeman andWerner, 2004; Carbon Trust, 2005; Smith, 2007; TNEI, 2007;

Fig. 7. Organisational Structure for Thames way Energy Ltd. The Woking ESCO.

EuroHeat and Power, 2005). A more relevant analysis will be todiscuss the different legal contracts used for public–privatepartnerships when establishing an ESCO as these forms ofcontracts dominate in the UK. Within public–private partnershipsthere are two major contractual relationships an ESCO can fillenergy supply contracting (ESC) and energy performance con-tracting (EPC). Energy supply contracting (ESC) is the mostcommonly used contract and has many advantages; however,there is less motivation for the company to improve demand sideenergy efficiency, particularly when it is receiving an income forthe energy it sells. These contracts generally operate on a low-margin, low-risk basis; with business models often focused onsecuring long-term operation, supply and/or maintenance con-tracts. Two such contracts are the Chauffage contract, where theESCO is completely responsible for supplying energy to customersand the Build Own Operate Transfer (BOOT) contract, where theinfrastructure is transferred back to the client (usually amunicipality) at a pre-determined future date.

Energy performance contracting (EPC) can be defined as a formof ‘creative financing’ enabling investment in energy efficiency.With EPC methods, the future energy costs saved through theinstallation of efficiency measures finances the upfront capitalcost of the efficiency upgrade. ESCOs using this form of contractare thus able to provide energy performance guarantees for theprovision of energy, the cost of energy, and any energy savingsthat may come about. These savings can then be shared betweenthe ESCO, the public body and even the customer. This approachdiffers from pure energy supply contracting because savings inproduction and delivery are targeted. There are two mainvariations of energy performance contracting: shared savings,where profits are shared between the parties as they accrue (TNEI,2007), and guaranteed savings where the ESCO takes the profitfrom energy savings after first guaranteeing the energy savings tobe made (Zeman and Werner, 2004; Carbon Trust, 2005).

Within the UK, large up-front capital costs and high risks deterinvestment by commercial organisations in CHP-DH, while publicbodies lack the experience and financial capital for developing theinfrastructure required. This necessitates public–private partner-ships, which may be a contributing factor leading to the slowgrowth in CHP-DH schemes. The level of trust between munici-palities and commercial organisations is also an important factor(Pollitt, 2002). Two distinctly different organisations will havevery different end purposes requiring co-operation and duediligence to be completed before a partnership can be capturedwithin a legally binding contract. Drafting such contracts tends tobe a complicated, long and expensive process adding further coststo an already expensive undertaking. With correct marketincentives and appropriate use of regulation, private initiativeswould be able to undertake CHP-DH developments without beingpartnered with a local municipality and vice versa for munici-palities. Although partnerships are required in the medium toshort term, it is possible to transfer the ownership of a schemeinto private control at the end of a pre-determined period (e.g.Sheffield, see Veolia Energy, 2008).

4. Recommendations for improving CHP-DH viability

We have shown that CHP-DH economic viability is contingentupon taking an integrated approach between many interrelatedfactors. This involves implementing state-of-the-art engineeringand design principles as well as creating the political andorganisational frameworks required to encourage CHP-DH devel-opment. In the remainder of this paper, we will present a series ofrecommendations for overcoming some of the major barrierspreventing CHP-DH implementation.

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Financing CHP infrastructure is one of the first and greatestobstacles for the implementation of viable CHP-DH networks.Small government grants such as tax relief and subsidies (such asthose derived from the climate change levy or the renewablesobligation Scheme) have been ineffective at creating the environ-ment required for the level of CHP-DH deployment anticipated bygovernment (Ofgem, 2002). Because of this, we argue that manyof the barriers to CHP-DH development are systemic and furthergovernment grants or subsidies may not lead to greater CHP-DHdiffusion. Instead, an alternative approach would be to mitigatethe root cause for the slow growth in CHP-DH infrastructureidentified here as systemic long-term risk that in turn makesinvestment in CHP-DH prohibitive. Whilst many factors contri-bute to risk, we identify the following as being the mostimportant:

�

Lock-in of existing power and natural gas infrastructure reducethe cost of technologies that already rely on these technolo-gies, e.g. national gas network. � Significant upfront capital is required for development and

investment in the initial infrastructure, this represents sizeableamounts of sunk cost that may not be fully recuperated formany years.

� Energy price volatility creates uncertainty over the cost of fuel

being purchased and energy being sold; this in turn makes itdifficult for risk adverse local CHP-DH developers to determinethe profitability of a scheme over long periods.

� Uncertainty over future regulation within the energy sector has

the affect of limiting long-term investment and encouragesconservative short-term, quick profit decision-making.

It is a fundamental market principle that high-risk investmentsrequire larger financial rewards. This has the effect of increasingand compounding even further the profitability requirementsplaced CHP-DH. Consequently, schemes with high up-front capitalcosts demand predictable and sustained financial returns overlong periods (in order to service debt). However, energy pricevolatility and uncertainty over fuel supplies only exacerbate thesituation. The volatile pricing of carbon within the EU EmissionsTrading Scheme, regulation over private wire networks anduncertainty over the regulation of heat markets make it difficultfor developers to invest in long-term projects. When organisa-tions co-operate the risk for a project is mitigated as it is spreadbetween more partners. This may provide some explanation forwhy it is so common for municipalities and energy companies toco-operate on CHP-DH projects. In fact, there are many benefitsfor all partners when they co-operate that go beyond simplysharing the burden of risk. Municipalities are shown to signifi-cantly lower the risk of a project by connecting their ownbuildings to a heating network thus guaranteeing future cash flowto the ESCO in return for affordable energy. Municipalities havealso been shown to assist with financing the upfront capital costsof projects and in return benefiting from the supply of moresustainable energy to government buildings whilst also alleviat-ing fuel poverty for residents. In addition, municipalities havebeen known to use their jurisdiction over planning and regulationto support the development of CHP-DH for laying heating pipe-work and private wires, providing infrastructure to house CHPplant and co-ordinating local business to connect their buildingsto the scheme, thus providing a significant benefit to thepartnered company.

Certainty over future energy policy is critical if CHP-DH isgoing to be implemented at the scale required to meet presentenergy targets. Regulatory instruments such as a CHP obligation,feed-in tariffs for both electricity and heat or auctions for

provision of local CHP-DH capacity could significantly reduce riskfor CHP-DH operators by allowing them to use a faster repaymentschedule on debt invested in capital infrastructure. Other moredirect measures include requirements for public buildings to beheated district heating or through the implementation of mini-mum efficiency standards for power stations, which would havethe effect of encouraging existing power stations to utilise wastedheat and energy more effectively. Competition in energy marketsis also very important. Access to the local wire network for CHP-DH schemes wishing to sign their own customers needs to beimproved. This may involve improved access regulation and/orreduced restrictions on the creation of private wire networks(PWNs).

Exporting electricity from CHP-DH can also be made morecompetitive. As electricity generated by CHP is usually consumedwhere it is produced transmission and distribution charges needto be cost reflective and only charged when transmission ordistribution services are used. This in turn would lead to CHP-DHschemes being rewarded for their proximity to demand loads thusminimising transmission and distribution losses. Furthermore, the3 MW minimum capacity requirement to participate in STORshould be restructured to allow small-distributed generators to beaggregated to meet minimum participation thresholds. Thiswould provide small electricity producers with additional incomeand provide appropriate incentives for small generators toparticipate in and be rewarded for system balancing. Likewise,use of system charging methodologies need to be cost reflectiveand generators not using the transmission network should not becharged for it.

As previously noted CHP-DH competes directly with domesticgas, yet the tax on gas used for domestic heating is only a quarterof that charged for industrial use, like CHP-DH. Equalising thetaxes on all forms of energy that are used to provide domesticheat could make CHP-DH more competitive when compared withdomestic gas. Several important design recommendations forimproving the economics of CHP-DH include the appropriate useof system balancing techniques using heat accumulators, tri-generation using chilled pipe networks, variable heat to powerratios and the use of variable volume flow rates in heat networks.In order to minimise energy consumption it is also necessary toinstall heat meters in each household, so that customers are billedaccurately for the energy they consume.

The reporting of the performance of existing CHP-DH schemesis very poor (we found a lack of clear reporting for all the schemeswe examined), making it difficult to assess their overallperformance and true economic and financial viability. Inparticular, there is an obvious need for government to introduceadequate environmental policy and sustainability reportingmethods into the energy sector. Such policy needs to accountfor externalities such as pollution, resource depletion, biodiversityloss and environmental degradation and for these to be appro-priately priced recognising their future value. In addition, the useof whole-life costing methodologies for new power plants whilealso selecting discount rates that appropriately consider theenvironmental and social benefits will reward CHP-DH develop-ments for the benefits they provide for their the community.

5. Conclusion

We have shown there are many benefits to sustainabledevelopment and indeed climate change for the accelerateddeployment of CHP-DH in the UK. In addition, CHP-DH cansignificantly contribute to many of the UK’s long-term energygoals. CHP-DH has potential to prevent significant CO2 emissionsand improve energy security through the benefits of distributed

S. Kelly, M. Pollitt / Energy Policy 38 (2010) 6936–6945 6945

generation, fuel versatility and increased energy efficiency. It hasalso been shown that CHP-DH can improve fuel poverty throughthe delivery of more affordable energy to the fuel poor. However,private companies wishing to install CHP-DH face considerablerisk due to significant upfront infrastructure costs, volatility ofenergy prices and uncertainty over future government policy.Such an economic environment favours quick build, low capital-cost solutions that do not provide sufficient long-term incentivesfor CHP-DH development. Implementing CHP-DH will ultimatelyrequire the development of a robust regulatory environmentconsisting of rigorous market based instruments that support thefuture development of ESCOs and adequate support for CHP-DH.Policy measures that support and foster community ownedco-operative ventures and public–private partnerships are there-fore required. Before CHP-DH takes off on any scale, a low riskeconomic environment needs to be created that includes an openmarket for heat, adequate support for decentralised energy andthe appropriate pricing of negative externalities.

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