How to make heat pumps a financial no-brainer

The best route to net zero is to make green products cost less than polluting ones. If, by the next election, electric vehicles or heat pumps are much cheaper than combustion-engined cars or gas boilers, maybe even Nigel Farage will struggle to oppose them.

For EVs, despite the much higher upfront costs, this is already true for some motorists, particularly those charging at home. Advances in battery technology and cheap Chinese EVs are likely to make EVs a financial no-brainer in the next five years. Can heat pumps follow the same trajectory?

We are still a long way off the kind of heat pump take-up needed. According to the Climate Change Committee, the number of heat pumps installed each year must increase more than seven-fold from 60,000 today, to 450,000 by 2030, when roughly one in three people replacing their boilers need to choose a heat pump. By 2035, installations will need to rise to 1.5 million per year.

Heat pump momentum

Momentum in the heat pump industry is growing. The numbers installed last year are up by over 40%. Satisfaction is high, with over 80% of people who got a heat pump installed while living in their home satisfied - about the same number as for gas boilers. Planning barriers, according to Octopus Energy, cause a third of their customers to drop out of the process, but the rule requiring heat pumps to be one meter away from a property boundary will be removed at the end of May.

Heat pumps, largely through improved installation processes, are also getting even more efficient. I spent a morning with installer network Heat Geek a few months ago, who showed me that the 200 heat pumps they’d installed recently were achieving an average heat pump efficiency of 4.3. The often-repeated claim that heat pumps are three times more efficient than a gas boiler may soon become misleading. With boilers, depending on their age, achieving efficiencies of 80-90%, Heat Geek’s heat pumps are closer to five times more efficient.

The spark gap problem

So if heat pumps are so much more efficient than gas boilers, why are they not much cheaper than gas boilers to run? Unfortunately almost all the efficiency savings are eaten up by electricity being so much more expensive than gas. The so-called ‘spark gap’ - the ratio of electricity to gas prices - is currently sitting at 3.9, although, as the graph below shows, electricity has been over five times more expensive than gas.

There are many ways of reducing electricity prices in the long term. We could decouple renewables from gas prices by moving all older renewables onto long term contracts. Zonal pricing could help reduce the growing amount of money spent paying wind farms to switch off when the grid cannot take the power. But what I want to focus on here is the shorter term fix of shifting the levies applied to electricity bills.

Electricity, unlike gas, has a carbon price applied to it, from both the UK Emissions Trading Scheme and a separate carbon tax, known as ‘Carbon Price Support’. But what makes the biggest difference is the levies on renewables, including the Feed-in Tariff (FiT) and the Renewable Obligation (RO).

The impact of levy rebalancing

At Nesta, we’ve modelled moving the RO and FiT from electricity bills to gas bills. While this is revenue neutral, it will leave some poorer households, with leaky homes worse off overall, so we’ve modelled a second change, which is to provide a 0.5 pence per kWh discount on both gas and electricity bills for low income households. By basing this social tariff on the criteria for Cold Weather Payments, bill support would be extended to 800,000 more households than currently receive the Warm Homes Discount.

If you look at what this does to the spark gap, the results are dramatic. Instead of a unit of electricity costing 3.9 times the cost of gas, this falls to 2.7 at current prices. Even under a low gas price scenario, where ordinarily the spark gap would widen to 4.7, with levy rebalancing, the spark gap narrows because the fixed levies on electricity help cushion the impact of falling wholesale gas prices.

What really matters to consumers, though, is what this means for the lifetime costs of owning a heat pump. The graph below shows that if we did levy rebalancing with current gas prices, consumers would be £400 a year better off. This should provide the financial incentive for people whose boiler is coming to the end of its life to seriously consider a heat pump, particularly if they know that at some point they will have to make the shift anyway. It also provides a path - once the technology has become normalised and up-front costs have fallen further - to reduce or remove the Boiler Upgrade Scheme.

A compelling offer might be to say: a) if you switch to a heat pump you will be on average £400 a year better off; b) we are guaranteeing the £7,500 Boiler Upgrade Scheme until 2030, after which we will taper it down before we close it in 2035, so early adopters will get more help; c) by 2035, we expect all new heating installations to be low carbon, so buy now while subsidies are in place.

Winners, losers and what to do about them

The political problem with simply shifting levies from electricity to gas, even with a social tariff, is that it creates winners and losers. Eight million households would be significantly better off. For example, the 600,000 people who are purely on electric heating and in fuel poverty would be at least £200 a year better off. Unfortunately, the average bill payer will be around £75 worse off.

We’re in the middle of finalising a report on how you might mitigate this, so we’ll share more next month. When you start from first principles, you find a lot of options. But there are significant trade-offs between four objectives: net zero, fuel poverty, cutting average consumer bills, and constraining public spending. To illustrate the dilemma - or is it a quadlemma? - I’ve laid out a few of the key options below.

Staged transition

The simplest option is to stick with the proposal above but be smart about the timing of it. Gas bills remain high following the Ukraine war, but if and when they fall, you could introduce levy rebalancing, possibly in stages. Energy bills have risen and fallen by much more than £75 per year and, in any given year, there are policy changes that increase or reduce bills.

Targeted rebalancing

Another transitional measure could be what is known as ‘targeted rebalancing’. This would mean shifting levies from electricity to gas, but only for people using heat pumps. Initially, this would have a negligible impact on overall bills, although over time this would change.

In our modelling, it would result in a spark gap of 3.2, rather than 2.7 with full rebalancing so would not have quite the same effect on affordability. There are also questions about how feasible it is to implement given that it requires separating out electricity use for heat pumps versus other appliances. It rather reminds me of the challenges experienced under the Renewable Heat Incentive of tracking accurate usage (when people cite examples of unintended consequences in policy, few get close to the RHI in Northern Ireland, where the ‘cash for ash’ scandal brought down the power-sharing government in 2017).

Removing the Energy Company Obligation from bills

The Energy Company Obligation (ECO) is a government scheme that places a legal requirement on energy suppliers to fund energy efficiency upgrades for households in or at risk of fuel poverty. It currently costs £1.7 billion and adds over £50 to energy bills. If this was removed from energy bills - either by funding it through general taxation, or cutting the scheme - it would result in the average bill payer being better off and millions of households saving substantial sums.

This option has obvious drawbacks. While the current ECO programme has substantial weaknesses, removing it altogether would be bad for fuel poverty. It would leave the government paying for ongoing subsidies through the Warm Home Discount, but not subsidising efficiency improvements that lower bills permanently. Moving ECO onto general taxation will be opposed by the Treasury due to the fiscal situation.

Reforming ECO - by creating an obligation on Distribution Network Operators

The most radical option is to reform the Energy Company Obligation. Two problems are worth addressing. First, every penny spent through the ECO is currently levied on energy bills in the same year, even though the value of insulation accrues to households over many years. Second, improvements delivered through ECO are funded by all billpayers. This results in cross-subsidies between recipients of ECO help and other low- or middle-income households. This is in part because energy companies have no ongoing connection to any individual home, so cannot attach some or all of the cost to an individual property.

About 20 years ago, I explored shifting the predecessor to the Energy Company Obligation, which was known as the Energy Efficiency Commitment, onto Distribution Network Operators. The rationale was that, by doing so, the costs of energy efficiency measures could be capitalised and spread over the lifetime of the asset just like traditional network infrastructure. If energy efficiency investments were included in the DNOs' Regulated Asset Base (RAB), they could earn a regulated return on those investments, creating a strong commercial incentive to fund measures such as insulation, smart heating controls and other demand-reducing technologies. By treating efficiency as a system asset, DNOs would be encouraged to reduce overall demand, relieve grid pressure and defer expensive upgrades.

Crucially, this model also allows for more nuanced cost recovery: rather than socialising the entire cost across all billpayers, some or all of the investment could be recouped from the households that directly benefit.

Threading the needle

The options above involve difficult trade-offs. It is not obvious which is the right answer. We are still wrestling with these choices and will be publishing our recommendation next month. I’d love your views on what trade-off you’d make or other creative options. (My favourite creative option is that suggested here by my colleague Tim Leunig who suggests rebalancing but only applied to the winter months)

The worst option, however, would be to duck the need to do levy rebalancing. It is the single biggest thing the government can do to unlock rapid heat pump adoption. There is no credible path to meeting the UK’s carbon budgets which does not involve levy rebalancing.

Politically, too, it is important. At the next election, Nigel Farage wants to put net zero on the ballot box. If the government can go into it with EVs and heat pumps being unequivocally cheaper than combustion engines and boilers, and with electricity bills lower than today, it will be a fight that can be won.

What I thinking/reading/watching

Brain-implants and generative AI: This is a fascinating piece on the third person to have had a Neuralink brain implant. As he puts it: “I am the 3rd person in the world to receive @neuralink brain implant. 1st with ALS. 1st Nonverbal. I am typing this with my brain”. The article also reveals how Grok is helping him answer questions and speeding up the rate at which he communicates.

The political economy of education research: The brilliant Stefan Dercon reflecting on why politicians and governments choose programs that clearly do not work, such as One Laptop Per Child, even when there is good evidence of what does.