Investing Public Money in District Heating

2 December 2019

Author: Steve Gummer and Catherine Maddox

Due to central government policy and funding, public authorities are increasingly supporting and investing in district heating schemes. A district heating scheme is a pipe network that allows centralised heat sources to be connected to multiple heat consumers. Frequently heat sources used for district heating are sources where heat would otherwise be wasted – e.g. energy from waste plants. Such schemes are commonly cheap, cost-efficient and environmentally friendly.

The establishment, operation and maintenance of district heating schemes frequently require financial support – this may include government grants and loans. There is an exemption from State aid rules for certain forms of funding to certain categories of district heating project. However frequently public funding is provided to such schemes in reliance on the more general market economy operator principle (MEOP).

A recent European Commission decision has provided some helpful guidance. The matter related to the public purchase of a district heating scheme but the principles set out in that decision provide more guidance that all public authorities may find to be of assistance.

Summary

In 2013, a decision was made by the city of Hamburg to purchase a district heating network. At the time, the district heating network was owned and operated by Vattenfall Wärme Hamburg[1] (VWH), whose majority shareholder was Vattenfall GmbH. The city of Hamburg had a 25.1% share in VWH.

In 2014, Vattenfall GmbH agreed to sell to Hamburg the remaining share of the district heating network[2]. The purchase option defined a minimum purchase price of EUR 950 million, corresponding to 100% of VWH’s equity value.

The Commission considered that the purchase was in line with the MEOP test and therefore was State aid compliant. The Commission’s decision focused on whether a private investor would have entered into a comparable transaction.

The Market Economy Operator Test

In order to comply with State aid law and satisfy the MEOP principle, Germany needed to demonstrate that the decision to purchase the district heating network was taken on the basis of economic evaluations comparable to those which, in similar circumstances, a ‘rational market economy operator’ would have had carried out.

Suitable assessment methodology approaches

In considering whether the MEOP test was satisfied the Commission took in to account a number of factors.

According to the Commission’s Notice on the notion of State aid[3], whether a transaction is in line with market conditions can be established on the basis of a generally-accepted, standard assessment methodology. Such a methodology must be based on the available objective, verifiable and reliable data, which should be sufficiently detailed and should reflect the economic situation at the time at which the transaction was decided, taking into account the level of risk and future expectations.

The Commission’s views on the assessment methodologies used to arrive at the equity value provides helpful guidance for points to consider when assessing whether investment in district heating and other energy infrastructure schemes is in line with state aid principles. The main issues considered by the Commission are set out below.

Assessment methodology areas

  1. 1. Hamburg obtained the expert opinion of a number of consultants

This included LBD, BDO and PWC. Developing a range of supporting evidence regarding whether a transaction complies with MEOP will be important for any public sector authority seeking to rely on this exemption to State aid law.

  1. 2. Discount rate

The price paid by Hamburg relied on a discounting of dividends forecast to be received. It was possible to take differing views of the level of the discount rate. Hamburg took in to account the range of possible discount rates (some of which included longer-term views on profitability). In terms of the discount rate to be used in reaching a price, the Commission considered that a median value was a reasonable assumption that a private market operator would make.

  1. 3. CHP support – subject to state aid approval

In reaching a price a view was also taken as to the continuity of generation subsidy support.

The German authorities applied a probability factor of 90% in relation to support being given to the first CHP-plant, taking into account that the German parliament decided on CHP support until 2025, subject to state aid approval.

The German authorities applied a probability factor of 50% in relation to the second CHP, relying on the recommendations of the Coal Commission which recommended CHP support until 2030.

The Commission considered that this probability approach reflected an economic assessment that a private investor would be likely to make.

  1. 4. Heat pricing increase

The pricing approach took account of projections of heat price increases.

One of Hamburg’s core advisers identified a potential to increase prices by 10 %, while concluding that a prudent market operator would limit the price increase to [2-4] % in 2024 in order to reduce the competition law risk of being deemed to abuse a dominant position in the market. The Commission considered the assumptions that informed the purchase price to be very optimistic, however, could not exclude that a private market investor would make this assumption when evaluating the equity value of VWH.

  1. 5. Sales volumes

When projecting likely sales volumes, Germany demonstrated that it considered consultant assessments of likely sales volumes and adjusted its assumptions accordingly.

The Commission acknowledged that it is for a private investor to define its business plan and to pursue ambitious targets in terms of sales volumes, the prospect of which cannot solely be determined on the basis of historical figures, in particular where the investor intends to implement a new energy generation concept.

  1. 6. Maintenance cost

Germany used both historic maintenance costs and data about maintenance costs from the wider market when making cost assumptions.

The Commission found it plausible that assumed maintenance costs would factor in both consultants’ experience of maintenance costs and historic maintenance costs for the district heating network in question.

  1. 7. Cost of debt

Germany considered both consultant information and current rates when calculating the likely cost of debt.

The German authorities proposed to apply the value of 2.5 % for the cost of debt when evaluating the equity value of the VWH. 2.5 % was within the ranges identified by PWC as well as contemporaneous rates and the Commission considered that this assumption was justifiable from a private market operator perspective.

  1. 8. Tax advantage

The Commission acknowledged that optimising the tax burden by acquiring a profit-making company together with operational synergies constituted considerations that a private investor would take into account when deciding to invest and could inform the level of the price paid.

Commission conclusion on State Aid

The Commission considered that the reacquisition was in line with the market economy operator test. Consequently, the Commission concluded that no advantage was granted to Vattenfall as a result of the purchase and there was no breach of state aid principles.

The range of issues considered in this case show some of the factors that authorities can take into account when financing or purchasing district heating schemes/companies. There is certainly a degree of discretion within a number of these factors. The critical thing for public authorities relying on MEOP is to take an evidence-based approach and document how decisions have been reached.

Steve Gummer is a Partner at Sharpe Pritchard who specialises in complex infrastructure projects, from renewable energy projects to sewerage and waste transactions.

Catherine Maddox is an Associate solicitor in the Commercial Contracts team who advises on matters including procurement documentation, evaluation criteria and questions, bidder clarifications, debriefing and standstill.

[1] Vattenfall Wärme Hamburg GmbH

[2] Vereinbarung Wärme

[3] OJ 2016 C 262/01, point 101.

This article is for general awareness only and does not constitute legal or professional advice. The law may have changed since this page was first published.

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