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Heat supply contracting in a regulated environment

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Summary: This blog focuses on the potential impact on future supply relationships between heat suppliers and customers and how operators/suppliers may need to adjust their current arrangements.

Background

The Competition and Markets Authority has issued the Final Report of its Heat Networks Market Study[1]. It will now be up to Parliament to take the recommendations forward and pass appropriate legislation.

The Final Report makes wide-ranging recommendations which, if enshrined in legislation, will impact on all aspects of heat networks from design and construction to supplier insolvency.

The timetable for that is not known, but in the interim the CMA has indicated that Government or a sector regulator is likely to consult on regulations that could apply, which will give operators of networks an insight into the likely regime and a period in which to ready themselves for the new arrangements.

Take-aways

  • Suppliers should start work soon on assessing the extent to which their current supply arrangements are likely to conform to a regulated regime and which points they should focus on in responding to any BEIS consultations;
  • Larger scale ESCO operators who are not members of the Heat Trust may have the most work to do;
  • Property managers and landlords who run supply through leases will need to map out how to bring leases into conformity with a regulated regime and in particular how to amend leases to do that;
  • Accommodating regulatory requirements is second nature to electricity and gas suppliers. Their terms and conditions can provide useful guidance to heat suppliers.

Translating the CMA's recommendations into regulated supply arrangements

Inevitably there is some vagueness around how the CMA’s recommendations will be translated into a mandatory regime. For example the Final Report is “heat heavy”, but many of the issues identified by the CMA apply equally to cooling.

 It is probably safe to say that we can assume the following:

  • Any regulated set-up will affect both existing schemes and future schemes – it will be retrospective;
  • Contractual supply relationships with customers will be overlaid with a regulatory matrix likely to be administered by OFGEM;
  • Protections are aimed primarily at domestic customers;
  • Regulation is likely to be tougher for ESCO/concession schemes (“for profit” schemes as the CMA badges them) than leasehold schemes (badged as “cost plus/not for profit”);
  • For operators who already provide pre-contractual information packs and supply contracts and/or comply with Heat Trust standards, the task of ensuring compliance with the likely regulated regime will be an easier proposition than operators who to date have relied on relatively informal arrangements.
  • The focus of regulation will be on four main areas:
    • Charging – and a “principles based approach” will apply, not a heavy handed price capping regime;
    • Performance standards, for example around outages and heat temperatures;
    • Billing – it is likely that billing regimes will need to be of a higher standard than under the Heat Network (Metering and Billing) Regulations 2014; and
    • Dispute resolution – with consumer recourse to an ombudsman who can investigate suppliers and make binding recommendations.

It would not be surprising if the Heat Trust regime on performance (including for vulnerable customers) and billing is heavily borrowed from in creating future regulation. The regulated tariff provisions and dispute resolution via an ombudsman will be more bespoke.

In the letter accompanying the Final Report[2] the CMA reminded operators of their current obligations under consumer law. As a first step to aligning terms and conditions with new regulations it may be worthwhile also reviewing whether current terms and conditions comply with the Consumer Rights Act 2015. Creating a fair set of terms and conditions in a monopolistic environment is harder than undertaking that task in a competitive market.

Conforming supply terms and conditions to a regulated regime

New schemes post implementation of the regime

The CMA identified two main business models in the sector – the ESCO/concession model and the leaseholder model.

ESCO/concession model

For those suppliers who either do not use written terms or, more likely, have a skeletal set of conditions, their supply arrangements will have to be put on a more sophisticated footing. Those operators who currently supply on a relatively informal basis are likely to be smaller scale or “not for profit” operators. The CMA has indicated that they will be subject to a lighter regulatory approach.

Template terms and conditions between supplier and customer will need to be drafted to comply with the new legislation and regulatory guidance.

Additional obligations on suppliers may be contained in any licensing or authorisation regime - for example compliance with performance standards – and these too may need to be reflected in supply terms and conditions for the benefit of customers.

Most resource will be applied to drafting the following provisions:

  • Charging – the CMA recommends that charging be based on a benchmark gas price plus boiler cost. It will be the regulator that determines the benchmark and the CMA recommends that the benchmark should reflect a suitable average of tariffs that are offered by gas suppliers, to prevent benchmarking only against expensive single variable tariffs.
  • Performance standards and recourse – across the industry there are a multiplicity of performance metrics and recourse mechanisms, ranging from financial compensation to temporary supply or a combination of the two. The regulations will seek to achieve consistency across schemes in the same way as customers of currently regulated utilities are entitled to equivalent and identical recourse.
  • Billing - billing provisions will likely include, as a minimum, information on bill period, unit cost, quantity consumed and transparency as to the make-up of standing charges. Ideally we would suggest a template form of bill should be included in any supply agreement.
  • Disputes – beyond the dispute resolution process operated by the relevant supplier, terms and conditions should refer to the right for customers to take disputes to the proposed independent ombudsman.

The CMA has also proposed a “supplier of last resort” regulated regime to deal with supplier insolvency.  This may remove the need to negotiate provisions in supply agreements dealing with novation of those agreements to concession employers where concessionaires become insolvent. .

Supply terms and conditions will need to be future proofed so that they contain appropriate mechanisms to bring in changes required by the regulator from time to time. Depending on the change proposed, unilateral change provisions may be vulnerable to challenge under the Consumer Rights Act 2015, but this is unlikely where changes are required to meet legal or regulatory requirements designed to protect the consumer.

Leasehold model

The ESCO/concession model is predicated on direct, self-contained arrangements between supplier and customer. The CMA has, from a consumer protection perspective, looked on  leaseholder arrangements, where supply is run through a lease, more favourably than ESCO/concession style arrangements as charging tends to be based on a “cost plus” model.

But the level of detail contained in lease documentation opposite tenant customers is often very limited and borrows heavily from equivalent provisions for electricity/gas where landlords on supply to individual tenants. From a cost perspective the regulator may adopt a light touch approach but the leasehold model gives customers no greater performance related protections than the ESCO/concession model. Our experience is that lease provisions, unlike ESCO/concession supply terms, are generally inadequate and provide very little comfort to consumers in this area.

Therefore where a network distributes heat for supply through a lease, the lease will likely need to include specific provisions relating to heat supply standards, billing and dispute resolution that, to a greater or lesser degree will sit outside other lease provisions dealing generally with landlord obligations.

One of the guiding principles for the CMA is that consumers should receive no less protection from heat suppliers than they do from other regulated utility suppliers. Ironically, by the CMA insisting on incorporating direct regulated obligations into leases, tenants may receive greater protection taking a heat supply than if they were receive a landlord’s on supply of electricity or gas.

Existing schemes – supply terms and conditions 

Depending on the effect of the regulatory requirements, suppliers that already have a pool of customers have two options to incorporate a new regulatory regime into existing supply contracts:

  • Terminate existing terms and conditions and impose new terms and conditions to comply with the new requirements; or
  • Amend existing terms and conditions specifically to incorporate the new requirements.

The route chosen may be driven by how existing terms and conditions accommodate change.  If a viable variation; compliance with law; or change in law clause exists then it may be relatively easy to amend those provisions most likely to be affected by new regulation.

For operators seeking to achieve consistency across their pre and post regulatory regime customer base, the best way forward may be to use a variation clause in the existing terms and conditions to vary wholesale the entire terms and conditions, so that they precisely reflect the template terms and conditions used for new customers signed up post implementation of regulation.

Provided the changes are to reflect regulation designed to protect consumers, there should be little resistance to varying contracts to incorporate new provisions.

Varying ESCO/concession supply agreements is likely to be less problematic than varying leases. Heat provision under a lease is just one aspect of a multi-faceted and complex property document. Variations may require consent of superior landlords or funders and property managers are unlikely to be as well versed in the intricacies of the new obligations as ESCOs.

The secondary network

The CMA Report does not deal with the complexity of the primary/secondary network interface and its impact on supply performance. It assumes that models are broadly ESCO/concession or leasehold. In practice many schemes are mixed – for example an ESCO may supply to a development plot boundary, with the developer (and its successors) having responsibility for maintenance and operation of the on-site secondary network. Or the ESCO’s network may terminate at the on-site plant room with the landlord taking responsibility for the downstream secondary network.

Typically and correctly the ESCO carves out from its supply liability any interruption or suspension in the supply to a customer due to a defect in the secondary network where that network is not controlled by the ESCO. That leaves a black hole from the customer’s perspective. It is not a “customer” of the secondary network operator and does not contractually take a supply from that operator and yet its quality of service is dependent on the correct functioning of the secondary network. It will be interesting to see whether and how that is dealt with so that consumer protection provided by the ESCO is not negated by secondary network performance. It may be addressed by importing into the lease equivalent performance provisions applicable to the secondary network to those in the ESCO supply terms applicable to the primary network. Alternatively the lease may simply require the landlord to hold the tenant harmless from interruption or suspension of supply caused by failure of the secondary network.


[1]         Competition and Markets Authority – Heat networks market study – Final Report 23 July 2018.

[2]         Letter from the CMA to heat suppliers/heat network operators – July 23rd 2018.

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