Scaling up heat pump installation – counting the benefits

It is generally recognised that reducing carbon emissions is going to mean lots of heat pumps (or other electric heating systems) installed in homes to replace gas and oil boilers. However, heat pumps are (currently) more expensive to run and to install and not many households have been persuaded so far. The government is running a public consultation now on a market mechanism to increase the install rate [1]. By their own assessment this policy has a net social cost of £0.6 billion over 4 years. So how can this be sensible? Or is there a fundamental problem with the cost benefit analysis? - I think there is.

This chart illustrates the balance in costs and benefits – it is quite finely balanced.

Data from the consultation 'A market based mechanism for low carbon heat' cost benefit analysis [4]

We need to install 600,000 heat pump installation a year by 2028.

The government’s Heat and Building Strategy [2] target includes :

• 7-11 million homes on heat pumps by 2035 . The lower figure applies if hydrogen heating proves practical and the gas grid can be converted which means some homes can convert to hydrogen boilers instead. 
• 600,000 heat pump installations per year by 2028. Currently we have 35,000 per year[2] but most of these must be in new homes. Heat pump retrofits usually qualify for the RHI but this recorded only 12,000 installations over the year to April 2021 [3].

This will be difficult, given the additional capital costs.

Scaling up the install rate will be difficult. Heat pumps are currently more expensive to install and to run than gas boilers for most households - at least they were when the heat and buildings strategy came out. Since then, gas and oil prices have risen but electricity prices will be less affected because about half our power comes from renewables. That will help. In any case there is to be a consultation on rebalancing fuel and electricity costs - so maybe it is just the capital costs we need to worry about.

As well as increasing install rate the market mechanism for low carbon heat is supposed to achieve a large reduction in capital costs. The consultation document mentions 25-30% reductions but the cost benefit analysis (CBA) assumes 20% in the central scenario.

The mechanism proposed is a ‘low carbon heating obligation’ on heating system manufacturers.

The market mechanism proposed is to require heating system manufacturers to install an increasing proportion of low carbon heating systems over time. This is akin to the mechanism used to accelerate the build rate for large scale wind and solar electricity generation. It was called the Renewables Obligation – power generators had to present ROCs (renewables obligation certificates) to prove that the required proportion of generation was from renewable sources. More recently, the EU has used similar rules to require vehicle manufacturers to reduce emissions over time. There are lots of interesting questions in the consultation about the detail of the low carbon heating proposals but I won’t go into them here. In my response to the consultation I have suggested mechanisms to monitor quality and incentivise efficiency rather than just counting the number of installations.

What about energy efficiency improvements? These would be even more challenging.

Many clean heat activists are screaming for energy efficiency improvements before switching the heating system and there are good reasons for this. However, the same problem applies since the larger energy efficiency gains are rarely financially cost effective for householders. See (Fabric first is not the cheapest path – is it the best?) Plus, even assuming you have put in the energy efficiency measures, it is still the case that a heat pump will be more expensive to install than an equivalent replacement boiler (How much does it cost to install a heat pump? )

The CBA compares costs with business as usual.

The first problem with the CBA is the usual one – the counterfactual is business as usual. There would still be some heat pump installs: the current dribble plus a few more depending on other policies coming into the frame. However, this would make it virtually impossible to meet our carbon savings commitments. Since these are agreed, the only sensible comparison is with alternative ways to achieve the required carbon savings.

The balance of costs and benefits is sensitive to the cost of carbon which is calculated based on alternative policies.

Most of the benefits from the policy, according to the analysis provided, come from carbon savings and the overall cost balance is very sensitive to how these are valued. The analysis uses prices determined from the five yearly carbon budgets and an assessment of the cost of carbon savings to achieve them. Assuming the cheapest policies are used, what polices are needed to add up to the required savings? Then the cost of carbon is the price that means the most expensive necessary policy breaks even. It is hard to explain in a few words. This chart explains it and you can read more at [4]. 

Marginal abatement curve showing how carbon pricing works from [4]

The price of carbon increases over time. This policy will have indirect savings in the future which are ignored.

Using this methodology, the cost of carbon increases over time as we do all the easy (cheap) things first. Carbon savings in later years have a higher price. However, the proposed market mechanism has most of its effect in the future because it is going to enable lots more heat pumps to be sold in later years, when the market has grown and cost savings have been achieved. Measuring only the benefits of carbon savings from installations directly due to the policy ignores all those future ones.

Householders bear the costs, societal benefits are shared.

The other concern I have with the CBA is that it only considers the societal point of view, not the householder. I do not mean that the societal point of view should be ignored, only that the householder view is also relevant. The capital and running costs are taken on (mostly) by the householders who buy the heat pumps while the carbon saving benefits are shared by everyone. 

The Boiler Upgrade Scheme will partly correct for this.

The obvious answer to this is to subsidise the heat pumps – and indeed there is a policy for this already announced which is the boiler upgrade scheme, offering vouchers for the part of the cost of upgrading from a boiler to a heat pump. 

Sadly the budget for this scheme is currently only £490 million which is a fraction of the additional costs of this policy. However, it is a start. The consultation asks for more ideas about how financial support for consumers could work effectively alongside the market mechanism.

High income consumers are likely targets.

Given that households will incur costs, the consultation raises the concern that low income households will be disproportionately affected. However, it seems more likely that installers will target high income households who would be easier to sell to. Households that are financially comfortable are more open to taking into account non-financial benefits from using heat pumps. For those that have environmental concerns the carbon savings from the switch are worth quite a lot. More generally, there are risks from using gas boilers – air pollution, leaks and explosions – that do not apply to heat pumps. (The same goes for energy efficiency improvements, as these bring improved thermal comfort and health. However, these are only relevant for people who can afford them.)

Assuming the costs of this policy do fall onto higher income households, then the CBA finds carbon benefits increase because such households tend to have bigger heating bills and larger potential for savings.

My view.

We cannot just ban gas boilers from year XX, as that would lead to a peak in demand for replacements in advance of the ban, while doing nothing to scale up the supply chain in advance. What we need is a market mechanism that applies gradually but inexorably. Subsidy schemes can help but on their own they tend to decrease competition, as demand increases faster than the supply chain can keep up. Hence they are unlikely to lead to lower prices. Also, subsidies encourage rogue traders into the market. For these reasons, something like this scheme is absolutely essential. The existing cost benefit analysis fails to take into account a great deal of the benefits.

None the less, there is a problem with the burden of the cost falling on relatively few people who are the early adopters of low carbon heating systems. As with the Feed in Tariff scheme for rooftop solar panels, the scheme is likely to affect comfortably-off households who can afford the capital cost. However, this time there is nothing akin to the export tariff to pay back their investment. This time we are relying on households taking non-financial benefits into account in their heating choices. Appropriate subsidies will make that choice easier, but the onus is still on us.

(By the way, I had a heat pump installed last summer and I will tell you a bit more about it soon.)

[1] A market-based mechanism for low-carbon heat (www.gov.uk) Oct 2021

[2] Heat and buildings Strategy (www.gov.uk) Oct 2021

[3] RHI statistics (www.gov.uk) Nov 2021

[4] Valuation of greenhouse gas emissions: for policy appraisal and evaluation (www.gov.uk) Sep 2021