Value drivers in district energy transactions

Transactions in district energy have been growing tremendously over the past few years as investors recognise the huge potential of the market.

In 2021, around fifteen deals worth EUR 5.5bn were closed in the sector, while 10 transactions worth EUR 5.8bn have been closed so far in 2022 ¹ , EBITDA multiples in many transactions are at all time highs for the sector. District energy assets provide secure margins in volatile markets and are a key pillar of reaching decarbonisation targets, so are very attractive for infrastructure funds. Activity has been strong in the Nordics and is continuing with E.ON undertaking a strategic review of two large networks in Sweden ² . Transactions have also been strong in Central Europe - the latest transaction to close being the Czech MVV and Vattenfall has initiated a strategic review of Berlin district energy asset ³ .

Winning in district energy transactions is not easy. Buyers need to understand how to lever the key business value drivers into the buy-side case to be competitive. Sellers need to leverage value drivers to maximise the vendor business plan while keeping management on board. Overall, this means the business plan needs to be deeply grounded in what is feasible and achievable, both technically and commercially as the business will need to deliver on this post transaction.

AFRY has many years of experience helping clients with commercial and technical advisory on the buy- and sell-side of district energy transactions, especially in Europe but also globally. In our experience, a clear understanding of the key business value drivers is a cornerstone for a smooth and successful transaction process. Work on understanding these value drivers can already begin before the transaction starts. In this article, we highlight some of the main findings from recent cases.

Decarbonisation and Environmental, Social and Governance (ESG) profile has played a major role in recent transactions and this is set to intensify in the future.

Naturally, the overarching challenge of decarbonisation is one of the main drivers of interest in the district energy sector from investors – district heating and cooling provide an efficient means to meet heating and cooling needs for urban areas by distributing heat from where it is in surplus to where it is in demand.

A decarbonisation roadmap for the district energy asset base simply has to be in place. In our experience, significant capex is usually required - and the total amount of capex varies considerably on the roadmap content. Reviewing development programmes taking into account local conditions, the track record of the DH business, the maturity of the plans, and AFRY benchmarks allow a balanced view of what is achievable considering the amount of capex and timescales proposed. In AFRY’s experience, framing the decarbonisation roadmap holistically is critical as district energy systems are inherently flexible on both supply (multiple heat input sources) as well as the demand side.

• Where local conditions allow, district energy systems can be envisaged without fuel combustion playing a role. The network has flexibility on the supply side through the capability to take heat from a variety of different low carbon energy sources such as large scale heat pumps (e.g. 500 MW seawater heat pump planned for Helsinki ⁴ , waste heat from data centres ⁵ , electric boilers powered by renewables, waste heat recovery from city sewage etc. In AFRY’s experience, this type of system also requires advanced network optimisation, efficiency measures and flexibility of demand. In this vision it becomes clear how district heat systems support the electrification of heat and sector coupling.

• If the decarbonisation roadmap outlines a system that is a hybrid (meaning combustion in addition to electrification and waste heat), this usually means biomass or waste as a fuel (but can also mean multi-fuel capabilities to hedge fuel sourcing risks). For both waste and biomass, a strategic fuel sourcing plan needs to be in place that assesses both price and availability of fuel, including analysis of the competitive landscape. AFRY uses detailed fundamental supply-demand models to assess the future price of biomass and waste.

• In the case of waste, as well as securing feedstock, gate fees are typically paid to the operator and it is important to understand how to maximise the gate fees from a commercial and technical perspective. For example, there are technical limitations on the use of certain waste fractions in boiler conversions. This is vital to assess as waste fractions with higher gate fees heavily can heavily drive the business plan. The ESG profile is also important, especially in terms of sustainability of fuels (certified biomass, origin of biomass/waste/other fuels consumed) and also the origin of the fuels (local/domestic/imported). In this context, the non-renewable share in waste fractions and recycling rate of waste needs to be assessed.

• CCS is currently seen as a way for waste-to-energy projects to reduce emissions footprint and associated emissions costs while capturing emissions from biomass combustion leads to negative emissions. In addition to the technology assessment, CCS projects require a thorough assessment of the business case including local government support, access to storage sites etc. ⁶ AFRY looked at CCS in detail as part of the recent transactions on Oslo Varme and Stockholm Exergi for the respective successful buyer consortiums.

Revenue value drivers

The delivery of long term, stable and attractive revenues is a core part of the district energy business and commercial assessments must always thoroughly evaluate the maximum achievable commercial case for the business. This is mainly driven by the development of a customer base who consume and pay for the heat. AFRY uses a sophisticated model to assess volume and price development together. For volumes it is essential to take a highly granular approach; AFRY assess drivers such as local population growth, new commercial heat demand, demand from new building stock and existing building stock going forward. In regulated markets there is a need to understand the regulatory model and building blocks in order to form a view on future revenues. In lightly regulated or unregulated such as the Nordics, it is about finding the price that keeps revenues at an attractive level while also remaining competitive against alternative technologies. AFRY evaluates local district heat price levels with the lowest cost competition, such as heat pumps or other relevant sources of heat, to ensure pricing competitiveness while keeping customer churn at sustainable levels.

Beyond volumes and prices, the business plan should maximise the commercial offering via other services. The purpose of these services is typically more related to solidifying the market position of the district energy business compared to other heating solutions (thus being an enabler for future growth plans) and reinforcing the position of the DH companies as the local utility provider, as opposed to aiming for significant growth in absolute EUR terms, as the proportional revenue from the additional services tends to be relatively modest when compared to the total revenue of the business. Typical examples include solutions offering high synergies with the core offering:

• (District) cooling roll-out can provide opportunities for significant growth and profitability increase, if considered as feasible in the given location and within the company’s plans.
• Other classical customer offering solutions include digital service offering (for example, demand response, indoor thermal condition monitoring and optimisation, energy consumption monitoring & optimisation etc), electrical services both for the consumers (e.g. solar panels, EV charging stations) and distribution companies (flexibility services/congestion management) as well as other service offerings (maintenance of heat exchangers, financing plans for heat exchanger replacement, energy consulting etc).

AFRY also investigates other growth opportunities for the business and forms a view on which are the most realistic and builds these into a base case, and an upside case. Opportunities can cover:

• Organic opportunities such as extension and densification, for example assessing the real estate development and refurbishment plans of the city and understanding where the Target can grow their market share.
• Inorganic growth is assessed by the AFRY team analysing neighbouring heat networks or industrial networks as bolt-on acquisitions. In AFRY’s view, new growth nodes – meaning new heat supply areas, can be realised via strategic partnerships, for example with existing clients on real estate projects in new regions or participating in public-private partnership opportunities where the company can leverage its experience, knowledge and operational base.
• In certain cases the target may also seek to increase income and consider entering the consulting segment for other smaller district energy players.
• In AFRY’s view, it is wise to increase marketing efforts as value propositions for district energy are not necessarily known to the real estate developers (long-term climate impact, sustainability, reliability, costs, etc.)

Operational excellence

The majority of district energy systems have been owned by the same utility for many years, often meaning there is significant potential for efficiency improvement. As a minimum, classical operational excellence upsides must be evaluated to further improve bottom line contribution. AFRY assesses management system design and operational data utilisation to ensure that assets are being operated in an optimal way on a continuous basis.

If the company isn’t working on centralised and remote process supervision already, it must develop a roadmap and an implementation plan: there are often attractive upsides to increasing operational efficiency and performance (although local legislation should be checked).

Embracing digitalisation is essential to move forward.

A modern district energy company also needs to have a digital strategy, which addresses the overall question regarding data platforms, analytics and generic questions about digital tools. AFRY has been implementing such systems and we see that this is very much where the industry is heading - although it is not always part of the transaction perimeter as sellers keep this as an upside case. However, in order to be competitive, the buyer must develop a thorough understanding of the digital strategy. The concept includes advanced control concepts for boilers and DH networks, digital optimisation and analytics tools on the cloud and demand-side response. Digitalisation also needs to take place on the client side – this can mean providing digital solutions so that a client can track and manage their consumption and optimisation of heat and cooling consumption through smart buildings/IoT.

AFRY successfully supports clients with commercial and technical advisory on the buy- and sell-side of district energy transactions, especially in Europe and globally. In our experience, understanding the business and key value drivers and what is realistically achievable is a cornerstone for a smooth and successful transaction process. Work on the key value drivers and any potential opportunities to unlock additional value can already begin before the transaction starts.

AFRY is able to identify and develop value significantly beyond typical district energy benchmarks based on our expertise, but critically our joint approach that captures the interrelated value between commercial, technical and environmental due diligence, gives our clients a significant competitive advantage in district energy transactions.