HOT|COOL NO. 1/2020 - "How to District Energize your City"

Capital Available Project 1 only represents a £3m opportunity; whereas Project 2 is 6 times larger. Assuming that the investor can only invest in one project then she must have less than £21m of capital available (or else she might consider investing in both) – let’s assume she has exactly £18m. If she opts to invest in Project 1 then the investor will have £15m of capital that remains unemployed. The investor really will not want that capital sitting in a bank account earning next to 0% interest! Let’s assume that she was successful in finding other projects but it all took a bit longer than hoped. Let’s also assume that the investor was able to find a comparable investment every two years until the £15mwas fully invested (referred to as staggered investment in the chart below):

Understanding how a given market performs is essential. This can be achieved through market analysis, acquiring/investing in companies in the sector with historical performance data or a combination of the two. Getting this kind of intelligence can be challenging. One of the many hopes of our £320m capital budget: the Heat Network Investment Project (HNIP) ( investment-project-hnip-scheme-overview) is to encourage a wider pool of investors into the sector to enable them to better understand how DH performs in the UK context. This is hoped to help stimulate a self-sustaining UK DH market that delivers low/zero carbon heat at a deployment rate necessary to achieve our 2050 aspirations in this area . Looking at the Heat Network Delivery Unit’s portfolio of live projects which are at techno-economic feasibility stage (and for which we have usable data) we can see a distribution of forecast returns with an average Project IRR of 6.8%:

Figure 1: Chart showing that capital that is undeployed (grey bar chart – i.e. sitting in a bank) has an opportunity cost as it could have been invested elsewhere to generate a return. The yellow bar chart shows the staggered investment of that undeployed capital.

Figure 2: This chart shows the distribution of forecast returns of a sample of the portfolio of UK heat networks supported by the UK Government’s Heat Network Delivery Unit

The investor’s blended pre-tax project return on this staggered investment approach would be estimated to be 7.1% on the assumption that every new investment was able to achieve a 12% return (no easy feat in UK DH!) and unemployed capital earning nothing. The investor would need to have been confident that a sufficient pipeline of such projects would be forthcoming to rationalise the potential additional 1.1% IRR benefit. Were Project 1 only appraised over a 15-year period then the estimated blended pre-tax project IRR falls to 6.6% - only a 0.6% IRR benefit over Project 2 (although forecast to be realised 10 years earlier). The portfolio benefit of the projects developed (spreading risk across a number of projects and gaining learning) might still push the investor in this direction but this could easily be outweighedby the transaction costs associatedwith appraising each opportunity (not included in the analysis above). As such, opting for a higher IRR in this case may have been cherry picking – the rational investor needs to ensure that all capital available is being employed as efficiently as possible. Investor responsibilities Investors have competing responsibilities with regards their disposable capital. We have seen in the previous example the importance of employing capital available and the impact on returns when that is not achieved. Making a sufficient return on capital employed is important, but it is understood that not every investment will achieve the desired return. The key is that across a portfolio of investments the blended return is at or ideally above market trend.

The average forecast returns of UK DH are no secret: it is difficult tomake double digit returns as typically energy generation and energy distribution capital costs both need to be recovered in a single investment appraisal. The HNDU portfolio of projects suggests a standard deviation to the average might be in the region of +/- 3%, which, assuming normal distribution (the blue curve), would suggest that a little less than 70% of new DH projects should perform between 3.8% and 9.8% . The “alpha” that an investor should bring is an ability, through good due diligence, to better ensure that forecast returns are achieved – e.g. through tighter contractual terms – and/or enhance returns – e.g. through stacking revenue streams such as combining a DH with agricultural processes, bidding into electricity market mechanisms etc. This should mean that lower than perhaps expected project IRRs can be acceptable to, yes, private investors. Our own market intelligence and publication of investors has confirmed that at least some are certainly willing to consider them for UK DH ( overview#investing-in-heat-networks).

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