District heating is a crucial energy source in the transition economies of the former Soviet Union and central and eastern Europe, but it faces serious challenges that undermine its sustainability. Elena Merle-Béral discusses policy approaches to addressing these challenges.

District heating plays a very important role in transition economies (former Socialist countries of central and eastern Europe and the former Soviet Union). It covers up to 70% of the heating and hot water needs in many of these countries. In Russia, it accounts for over 30% of total energy consumption. Yet many district heating systems face financial and technical problems, largely because of an inappropriate policy framework.


A district heating CHP plant in the town Pruszków, near Warsaw, Poland. Well tailored policies will be essential to improving the competitiveness and efficiency of district heating in central and eastern Europe (Vattenfall)
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With a stronger policy framework, district heating systems in transition economies could save in generation alone the equivalent of 80 billion m3 of natural gas a year, roughly equal to the annual gas consumption in Germany. These savings would reduce greenhouse gas emissions from heat production by about a third. Improved efficiency in distribution systems and in buildings would yield even greater savings. District heating improvements in major energy-producing or transition nations such as Russia or Ukraine would boost energy security, both in this region and western Europe. To achieve these improvements, stronger policy measures must be put in place to encourage wise management and investment in district heating.

THE POLICY CHALLENGES FOR TRANSITION ECONOMIES

District heating systems in transition economies often face financial, technical or managerial problems largely created by an inadequate policy framework. These challenges include lack of customer focus, low efficiency, excess capacity, corruption, and an uneven playing field. Figure 1 shows how these challenges are interrelated and create a vicious circle that undermines finances and competitiveness of district heating companies, jeopardizing their long-term sustainability.

Lack of customer focus

Lack of customer focus is probably the single largest weakness in district heating systems. Dealing with this requires a cultural shift from a production model to a customer-focused model of management. The current focus on production means that companies have little incentive to provide quality service, improve efficiency, and better match supply and demand while limiting costs.

Inefficiency

Most district heating systems in former planned economies are less efficient than those in the West. This inefficiency starts in the boiler house: transition economies use a much larger share of heat-only boilers for their heat supply than western countries. Distribution systems can lose up to 30% of the heat they carry. Finally, buildings tend to be inefficient and often lack the thermostatic controls that are so important to comfort levels. Systems in the former Soviet Union and south-east Europe tend to be much less efficient than those in central Europe. This inefficiency raises costs, which puts pressure on households, particularly on low-income families.

Overcapacity and imbalance between supply and demand

Most district heating systems in transition economies are oversized. In other words, their supply infrastructure is larger than necessary to meet current demand. This problem can be exacerbated when they lose customers. The balance of supply and demand is quite important: when systems have excess capacity, their costs are greater. Losses are higher during operation at partial capacity, and maintaining a large system costs more than maintaining a small one. Such systems also have high fixed costs, which makes it increasingly difficult to lower costs when demand decreases. Service quality can also suffer, since systems that are too big are not flexible in adapting to changes in demand: apartments can end up too hot or too cold.

Finances and competitiveness

Many district heating companies in transition economies have financial difficulties, or had them in the past before reform. Management and regulatory problems are usually the main reason: heat tariffs below cost, non-payment and poor company administration. Technical problems also play an important role, in particular excess capacity and high heat losses due to outdated technologies and obsolete equipment. At the same time, a lack of financial resources prevents district heating companies from improving the technical performance of their systems.

The financial difficulties of district heating companies may lead to decreasing competitiveness because of the lack of resources to invest in essential maintenance, modernization and hence the improvement of service quality. Deteriorating equipment has forced many companies to reduce their heating season or area of service, if not to close down completely. The quality of heat and hot water supply is often low, particularly in south-east Europe and parts of the former Soviet Union. All these factors breed dissatisfaction and encourage consumers to seek other forms of heating. When customers switch to other heat sources, it raises costs and lowers revenues for district heating companies, which further undermines their financial situation. This creates a vicious circle (see Figure 1).


Figure 1. Key challenges for district heating systems in transition economies
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Reforms, particularly for tariffs, are needed to improve company finances and break the vicious circle of deteriorating competitiveness. Yet policymakers need to design the reforms very carefully for them not to backfire and make matters worse, as Figure 2 illustrates. Higher tariffs allowing full cost recovery are essential to put district heating companies on a firmer financial footing, but they can alienate customers if service quality remains poor.


Figure 2. Unsustainable tariff growth
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POLICY OPTIONS FOR MEETING THE CHALLENGES: TWO PARADIGMS

There are two paths to better balance supply and demand for heat and thus address many of the key challenges of district heating: better regulation or competition.

While policymakers should clearly select which approach to use to balance supply and demand – heat source competition or tariff regulation and energy planning – this does not mean that either approach is completely devoid of regulation or competition. A competitive regime will include environmental and safety regulation, for example, and a regulated regime may use wholesale competition to lower costs.

Markets can do an excellent job of balancing supply and demand when competition is fair and there are no major impediments to free trade in the heat market. Competition between heat sources such as district heating or local gas boilers by nature forces efficiency improvements and provides incentives for companies to improve service quality. Yet when markets are not balanced – for example, because of subsidies or lack of effective product choice – allowing the market to balance supply and demand alone can create major distortions in prices and investments. Thus, regulation can be a good policy choice in many situations, as long as the decision is made deliberately and with adequate consideration of the choices and alternatives.

If a country decides to use regulation to balance supply and demand, coherent energy plans are essential. Energy plans provide regulators with independent information to help ensure that service quality is high, costs are kept to a minimum and investments are justified, balancing the interests of heat supply companies with those of the public. If a country decides to introduce competition, it should monitor the market to make sure competition is fair and the market is balanced.

In general, competition is best able to balance supply and demand in countries that are more advanced in economic reform and have lower poverty levels. Several countries in central Europe are probably ready to allow the competitive market to set prices provided that the market is monitored. Regulating the balance of supply and demand through tariffs and energy planning is more suitable in countries that still have energy subsidies and high levels of non-payment. In areas with extensive poverty, introducing heat source competition immediately may prove unfair to consumers because large parts of the population would not be able to afford to exercise their market choice.

DISTRICT HEATING IN THE NATIONAL POLICY AGENDA

District heating is a national issue in almost all countries in transition because of its economic impact and social importance. The 70% of Russian or Latvian residents who use district heating cannot find a new way to heat their homes overnight. Yet compared with other portions of the energy sector, there have been fewer steps toward reforming district heating. This may be in part because the problems seem too socially explosive to touch upon, and as district heating is rarely a priority in western Europe, transition economies are not often encouraged to reform this sector in high-level dialogues.

Heat accounts for a large part of the energy balance in most transition economies. Dealing with heat in isolation from other parts of the energy sector leads to poorly focused and contradictory policies. It is important to consider district heating when liberalizing electricity and gas markets, but this is not often the case. For example, if district heating competes with gas or electricity and its prices remain regulated after liberalization in other sectors, the varying degrees of flexibility in setting prices creates a barrier to balanced competition in the heat market. Countries need to be aware of the impact that liberalization in other sectors has on district heating and include the latter in the overall strategy. This task is easier when district heating is an integral part of national energy policy, the same policy that defines the schedule and approach to energy liberalization.

There is also a symbiotic relationship between district heating and several other areas of national policymaking that needs to be acknowledged. Environmental, housing, social and economic policies are a few such examples. In housing policy, for instance, the interaction of policies on home ownership and district heating can have a profound influence on energy efficiency. The structure of the housing market affects how much influence consumers have with the monopoly district heating suppliers. In addition, development policies can shape housing density and the cost-effectiveness of district heating. In most countries in transition, as in Russia, social welfare policy is closely linked with district heating policy, so the two issues must be addressed in a co-ordinated way.

Given how important district heating is to so many aspects of national policy, it is surprising that until several years ago, Hungary was the only country in transition with a law on heat. Heat is mentioned in energy or electricity laws in most countries. Yet these references tend to be brief and often they treat heat like electricity, without recognizing some of the fundamental differences between the two (such as the highly local nature of district heating). Good policy requires broad discussion and clear representation of ideas.

The lack of a clear policy toward district heating in most transition economies in the first 10-15 years of democracy has led to many of the problems of the sector. This is changing as countries recognize the importance of district heating and good policymaking in this area. In the last few years, several countries have worked on heat laws or have issued new secondary legislation on how heat is regulated and managed. Today, Estonia, Hungary, Lithuania and Ukraine have heat laws and several more transition economies, including Russia, have such laws under preparation.

Countries that want to promote district heating need to have a clear policy. They need not only to integrate district heating into their energy acts and policies, but also to be aware that district heating has a profound impact on economic, environmental, social, housing and privatization policy.

RECOMMENDATIONS TO POLICYMAKERS

The International Energy Agency, an independent intergovernmental think-tank based in Paris, has done an in-depth analysis of district heating in transition countries and suggested eight key recommendations to policymakers.

First, countries should ensure that they get their policy for balancing supply and demand right, whether they use competition or regulation. They should decide clearly on the mechanism to use: regulation or the market. Heat policy or law should address the idea of investment based on least-cost planning, whether that planning occurs in the government or in companies through competitive pressure.

Second, they should encourage demand-driven business practices. Heat policy or law should also promote greater energy efficiency and customer focus, and outline how it will pursue these goals. If a country decides to regulate tariffs, it should recognize that the most important decision point is not the periodic tariff-setting, but rather investment approval. Tariffs should be structured to reward efficiency, not higher costs. And the potential benefits of competition in boosting quality and efficiency should not be ignored.

Third, there are several important prerequisites and necessary conditions common to both approaches. These include establishing social support programmes, eliminating direct heat production subsidies, instituting legislation and mechanisms to enforce good payment discipline, installing meters and controls, developing policies to promote demand-side energy efficiency and removing barriers to wholesale competition.

Fourth, if a country decides to regulate prices, an independent regulator, least-cost planning and full cost recovery are essential. An independent regulator must ensure impartiality and separate tariff setting from short-term political goals. Least-cost planning is a way to give regulators enough information to ensure that costs are as low as possible and to avoid unnecessary investments, while at the same time providing for investment in new capacity and other improvements over the long term. Full cost coverage means that district heating companies will be able to survive in the long term. Policymakers and regulators should avoid cost-plus regulation. In most cases, other regulatory approaches, such as price capping with efficiency indexes, benchmarking, or long-term competitive concession agreements can create stronger incentives for improving quality and efficiency. Also, regulations should include clear rules on allocating costs to heat in cogeneration plants, particularly when electricity markets are liberalised.

Fifth, if a government decides to use competition to balance supply and demand, it should make sure that competition between various heat sources is fair. Fair competition means no producer subsidies for any competing form of energy. It also means that companies should be able to take action against customers in arrears, since non-payment creates an implicit subsidy. If a government decides to liberalize one part of the energy sector, it should seriously consider liberalizing district heating as well to avoid market imbalances. High levels of poverty can also create a barrier to a balanced market because of the difficulties the poor face in paying the capital costs of switching to a local boiler. Social programmes, rather than producer subsidies, are a better and more comprehensive way to address poverty.

Sixth, governments should take advantage of competitive bids for new supply to lower costs in a regulated context. In larger cities, a more comprehensive approach to wholesale competition can help lower costs and ensure adequate supply long-term.

Seventh, transparency is very important, regardless of whether the policy for balancing supply and demand is based on competition or on regulation. This starts with policy transparency. Draft regulations and laws should be open for public review and discussion before they are adopted. This can enhance the quality of these documents and ensure that they consider the needs of all stakeholders, not just producers. The same holds true for tariff and investment approvals as well as local energy plans. In addition, governments should actively work to stamp out corruption in all sectors, including district heating.

And finally, countries should be proactive in policymaking. They should not be afraid to touch upon district heating and to work hard to get the policy right.

Elena Merle-Béral is an energy analyst at the International Energy Agency (IEA), Paris, France.
e-mail: elena.merle-beral@iea.org

Elena Merle-Béral is also one of the main authors of the IEA publication: Coming in from the Cold: Improving District Heating Policy in Transition Economies, IEA/OECD, Paris, 2004. The article is mainly based on this publication, which can be found on the IEA website: https://iea.org/Textbase/publications/