Development of the Finance Model
The interplay between technical and financial aspects is key in making district heating a success. This insight that the Danish experts have known for decades is slowly making its way to the Netherlands. This interplay is based on the notion that through financially modelling of the different source strategies, we can discover one or more feasible strategies for the business case.
Business cases for heat projects: a technical focus
Business cases for heat projects are often technically driven. This is understandable, given that most advisors involved are engineers. Projects are calculated based on investment costs (CAPEX) and associated operational costs (OPEX). Revenue projections rely on maximum ACM (national regulator) tariffs and available operating subsidies. For convenience, financing is assumed to be 100% guaranteed by a yet to be determined government entity. However, there is more to consider. While technical aspects are crucial, financial expertise and input in the Netherlands is often missing.
Comparing the financing history of solar projects
Let’s compare this with solar projects. Initially, solar projects were also approached from a technical perspective: assessing panel output, required investment, grid connection costs, etc. While these factors remain important, the key difference between a viable and non-viable project now often lies in the hands of financial advisors and lenders. Elements such as loan duration, Debt Service Coverage Ratio (DSCR), reserve levels, repayment structures, and electricity price risk assessments determine feasibility. The same will most likely apply in the near future to district heating projects.
Background: financial modelling for large-scale renewable projects
All major renewable energy projects are modelled in specialized financial Excel models, with project financing as the foundation. Project financing focuses solely on the cash flows generated by the project itself. Lenders financing solar and wind farms secure all purchase and supply contracts as collateral and rely entirely on the project’s cash flows. Loans are structured to maximize early repayments using available cash flows. If a particular year yields lower cash flow due to unforeseen costs or maintenance reserves, repayments are adjusted accordingly. Each year, the optimal balance between interest and repayment obligations (sculpted repayment profile) is determined.
Banks always maintain a safety margin when determining cash flow distribution. This margin, known as the DSCR, calculates how many times the expected interest and repayment obligations can be covered by projected cash flows. Banks typically use a DSCR of 1.20, ensuring a 20% cash flow buffer. This excess cash flow can be distributed to financiers ranked below senior debt holders (e.g., junior loans, crowdfunding) or to risk capital/equity investors.
Insights from Denmark
In Denmark, discussions are not only about CAPEX and OPEX but also focus on electricity procurement prices, the timing of these purchases, and heat storage. A heat company that can flexibly produce heat when electricity prices are low can achieve a viable project, whereas a static approach may not. The Danish approach positively affects the OPEX as it brings electricity prices down. Other articles delve into the energy source mix and flexibility, but financial models, financiers, technical advisors, and other stakeholders must also adapt. It is time to focus not only on technical business cases but also financially driven models, analyzing various scenarios to determine viable solutions.
Case study: Sønder Felding
Sønder Felding is a small village in central Jutland, Denmark, with approximately 700 connections spread over a large area. The village consists mainly of detached, single-story houses built in the 1960s and 1970s. The district heating system is managed by employees of the local energy cooperative. Their sources include an old oil-fired boiler (long depreciated but still functional), a biomass boiler using locally sourced wood chips (fully depreciated and nearly at end-of-life), and a large air-to-water heat pump setup, supplemented with an electric boiler and the crucial heat storage. This setup includes a carport-sized structure housing the heat pump, an electric boiler the size of a delivery van, and a massive accumulation tank resembling a medium sized grain silo.
The company operates with just three employees: a maintenance technician, a customer relations manager, and an office worker who monitors wind forecasts on large screens. The heat demand is predictable, temperatures are known, and all buildings are residential. With the right energy mix and a filled heat storage tank, the operator can supply heat for three days without new production – even on cold days and longer on warmer days.
When wind power generation increases in three days, electricity prices drop, sometimes even turning negative. At this point, the storage tank is depleted, and the heat pump and electric boiler are activated. The system runs at full capacity, storing heat and generating revenue while helping balance the local electricity grid. After the storm subsides, Sønder Felding has a fully charged heat storage tank, has alleviated grid congestion, and has earned €50,000 in a single week. This showcases the synergy between technical infrastructure, financial parameters, and entrepreneurship.
The importance of a robust financial model
This interplay must be captured in a financial model that also accounts for investment timing, payment schedules, and revenue realization.
“A well-structured financial model is essential for internal management, shareholder decision-making, applying for the guarantee fund (Garantie Waarborgfonds) applications, subsidy requests, and securing bank financing. Ensure early-stage development of a comprehensive financial model that serves all these purposes.”
This can be best explained by an example. If there is a project with 1,000 connections, phased over time, where each customer contributes €2,000 in Connection Contribution Fees (BAK). In this situation, the heating company will receive these fees based on when people switch to the district heating network. The €2 million in BAK cannot simply be deducted from the required bank financing as it is not received upfront but in phases. However, investments must be made immediately. It's important to manage cash flow, reserves, and expenses carefully. Poor timing can create financial pressure and put the project at risk. A solid liquidity plan helps prevent this.
Aligning with Guarantee Fund requirements
The proposed Collective Heat Act emphasizes the role of municipal governments as owners, coordinators, and financiers. However, many municipalities face budget constraints (the so-called “cliff year”) and hesitate to undertake capital-intensive projects. To address this, the Dutch government is developing a Guarantee Fund, resembling the project finance requirements of other renewable energy projects. These requirements can be integrated into financial models and business cases. Once the Guarantee Fund is operational, projects in development can apply for guarantees. The fund will assess projects based on financial viability and only issue guarantees if the project is deemed technically and financially sound.
With this guarantee, heat companies can secure bank loans on more favourable terms (lower interest rates, longer fixed-rate periods, and a higher debt-to-equity ratio). For municipal finance departments, this reduces shareholder risks with most risks covered by the guarantee fund. This reduces budgetary uncertainties and enhances financial predictability.
Predictability builds trust
A well-structured financial model for a phased heat project must incorporate all these elements, ensuring that internal and external stakeholders can rely on it. Understanding potential scenarios, assessing their impact, and identifying mitigation strategies are crucial. Trust in financial business cases is essential for project success, both in fostering confidence and enabling project realization. A financial approach to heat projects, combined with essential technical insights, is vital for the successful transition to sustainable heating in the Netherlands.
