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Drive an electric car. Use low-power lightbulbs. Eat less meat. All these things will help reduce emissions. But one of the most important changes we need to make for a successful energy transition is in something we will feel rather than see. It’s how we keep warm and how we deliver industrial goods that require heat, such as food and beverages, capital goods and so on. Almost half (48%) of all the energy consumed in Europe is for heating. And of that, 56%, or roughly a quarter of all Europe’s energy consumption, goes on space heating, rather than industrial processes or hot water.
Since 68% of the energy for heating comes from fossil fuels, that means our efforts to stay warm are effectively heating the planet. A warmer planet will not stop the need for heating—but will add other needs to our wish list as extreme climate events stress infrastructure, supply chains and migration patterns. Hence, we need to decarbonise heat as quickly as possible.
So far, heating has not been an easy sector to decarbonise. While the electrification of the power system proceeds apace, the European Commission admits the process of replacing fossil fuels with low-carbon energy in the heating and cooling sector has so far been slower than in electricity generation. A failure to tackle this problem could stymie Europe’s efforts to meet climate targets in 2030 and 2050. The EU is looking for a 55% cut in emissions by 2030, yet on current projections will only achieve 41%.
Europe’s desire to decarbonise heating has been given extra impetus by the continent’s need to move away from Russian fossil fuels. That imperative does not exist in North America, although even there, the need to decarbonise heating is moving up the policy agenda. The wide-ranging US Inflation Reduction Act, for example, include tax credits of up to $2,000 per household for the purchase of electric heat pumps. More recently, household use of gas has come under fire from a potential link between gas-fired stoves and childhood asthma. Regardless of market, moving to low-carbon heating could help move the needle on climate change while delivering additional benefits in areas such as public health.
Decarbonising heat requirements below 100˚C should not be too difficult. A glance at the energy mix for residential and commercial heating across various European nations shows significant variation in the types of fuel used, ranging from mostly natural gas in the Netherlands to largely renewably-produced electricity in Norway. The implication is that space heating is not dependent on fossil fuels in the same way that industries such as steelmaking are dependent on coal. On the contrary, low-temperature heat can come from a variety of sources.
The reason decarbonisation of the heating sector is slow is not for a lack of low-carbon options but because the choice of energy supply is usually made at the design stage of buildings and cannot always be easily or cost-effective upgraded. This can lead to important lock-in effects. It is no accident, for example, that the Netherlands and the UK—both of which have historically had access to abundant supplies of gas from the North Sea—are among the countries with the highest reliance on gas-fired heating.
With Russia’s invasion of Ukraine in 2022, having heating, ventilation and air conditioning (HVAC) systems locked into fossil fuels is no longer a good idea, and not just because of carbon emissions. Fossil fuel commodity prices, which were already exhibiting volatility before the invasion, hit record levels across Europe as Russian supplies were halted. Making sure citizens could afford to stay warm in winter became a key political priority, adding urgency to decarbonisation efforts.
Among the nations under its purview—and spurred by the need to reduce reliance on Russian coal and gas—the European Union (EU) is aiming to speed up heating decarbonisation with a carrot-and-stick approach. The stick is an extension of the EU Emissions Trading System to cover heating fuels such as natural gas. This means the cost of these fuels will be further increased by the need to pay a carbon levy for emissions.
The measure, passed in December 2022 and due to enter force in 2027, aims to provide a clear pricing signal to move away from fossil fuel-based space and process heating and thus encourage the implementation of alternatives. Mindful that fossil fuels are still important for heating in many poorer EU nations, the price of heating-related emissions will be capped at €45 per tonne of carbon equivalent up to 2030.
And the new rules, which could be delayed until 2028 if high fuel costs persist, will be accompanied by the introduction of a social climate fund to protect the worst-hit EU households. The carrot, meanwhile, is a new target and incentives for heat pump installations. Heat pump technology has existed for more than 150 years and is widely used already in residential and low-heat industrial settings.
Heat pumps take advantage of thermal gradients to deliver seemingly miraculous feats of efficiency, turning one unit of electricity into between three and six units of thermal energy. In May 2022, the European Commission increased the EU’s heat pump installation targets to an estimated 20 million by 2026 and almost 60 million by 2030.
These targets, set out in the Commission’s REPowerEU plan to reduce emissions and improve energy security, are supported by a range of measures including pricing tools, innovation finance and skills partnerships to add resources to the heat pump industry. Such actions should warrant adding well-positioned players in the heat space to any broad-based low-carbon investment portfolio. And heat pumps are just one of several low-hanging fruits for investors when it comes to decarbonising heating.
While decarbonising high-temperature applications remains a challenge, there are four pathways to take the carbon out of low-temperature residential, commercial and industrial heating, all with obvious growth potential. The first is to replace fossil-fuelled heating with heat produced by electric-powered systems such as heat pumps, and then ensure most of the electricity used comes from low-carbon sources—as is the case in many European grids already.
A second option is to replace fossil fuels with ‘green gases’ such as hydrogen or ammonia made with renewable energy. There is great interest in using green hydrogen for high-temperature heating applications such as those required in industrial processes. We agree that green hydrogen may be valuable—or even indispensable—in this context, enabling the production of heat up to 1,000 ºC for industrial processes as well as helping to power parts of the transport sector that cannot be electrified.
However, the case for using green gases to power low-heat applications is less robust, to say the least, because of the efficiency losses involved in converting electricity to low-carbon molecules. Electrification is more efficient—and safer. Another more efficient route for the decarbonisation of heat is district heating. This is where heating for entire neighbourhoods is delivered from a central source. District heating systems, which like heat pumps are an established technology, can usually achieve higher efficiencies than distributed assets.
But the real sweet spot for district heating is where the heat comes as a by-product of another process, such as industrial operations or nuclear power plant generation. Depending on the heat source, this can reduce emissions to zero with essentially no fuel costs. With Europe looking to move away from fossil fuel-fired heating as soon as possible, we expect major capital flows into European district heating upgrades.
Finally, there is the option of powering low-temperature heating directly from renewable sources using technologies such as solar water heaters and biomass-fired boilers. As stated previously, upgrading to any of these low-carbon options can be complicated because HVAC infrastructure tends to be embedded in building design, but increasingly there are advances in the ability of low-carbon heating systems to plug into existing plumbing.
Given this, which are the technology families that investors should watch out for? The success of each one depends on consumer appeal, but heat pumps are particularly attractive in terms of variable cost, technology efficiency, emissions reduction, safety and policy support. There are two other factors in heat pumps’ favour. The first, already alluded to, is the growing policy momentum behind the technology.
REPowerEU is just one of several recent EU regulatory packages favouring heat pump installations, with the Inflation Reduction Act providing similar support in the US. And the technology is not as contentious as, say, nuclear energy or natural gas, so continuing policy support would seem likely. Many European markets already offer important heat pump support packages.
In France, for example, sales tax on heat pump installations and renovations is just 5.5%, compared the standard 20%, and owners can pay for the work with a 0% interest loan of up to €10,000, or €30,000 if combined with improved energy performance measures. Outside the EU, UK homeowners can get up to £5,000 in government funds for air source heat pumps through a £450 million boiler upgrade scheme. The UK has also launched a £60 million innovation fund to make clean heating systems cheaper and easier to install.
The other important factor is that heat pumps are already at parity, from a levelised cost of heat perspective, with traditional gas boilers in several European markets, including Denmark, France and Sweden. Because of this, Europe is expected to become the growth market par excellence for heat pumps worldwide, with sales already jumping 35% just between 2020 and 2021.
The last three years have seen 6.8 million new heat pumps being sold across 21 European markets, outstripping the 6.6 million sold in the previous six years and representing a compound annual growth rate (CAGR) of 40%. REPowerEU is expected to drive a 20% CAGR up to 2031. The experience of the Nordic countries supports this massive growth potential.
A combination of incentives and building regulations have led to between 40% and 60% household penetration of heat pump technology in countries such as Sweden and Norway, compared to less than 20% currently for most other European and rest-of-world markets. For now, the growth markets have been France, Italy and Germany, which accounted for 50% of European heat pump sales in 2021. Moving forward France, UK, Germany and Denmark are forecast to be the ones to watch.
Supporting this growth is a mature supply chain and robust manufacturing base in Europe, with the European Heat Pump Association counting more than 170 members.
Heat pumps can be divided into three types depending on whether they exchange energy with the air, water or the ground. Of these, air source heat pumps have been the favoured technology in recent years, accounting for the lion’s share of installations in 2021 across most European markets. Furthermore, we already see heat pumps becoming a pillar of smart home concepts where heating and other loads are connected to digital networks and used intelligently to help deliver some degree of grid flexibility.
This trend reflects wider consolidation in the heating technology value chain, which encompasses a range of multinationals and small-to-medium enterprises in roles including heat creation and asset manufacturing, installation and maintenance, and energy consultancy and management.
We see major capital flow opportunities among energy service companies and heat pump service providers targeting the domestic, commercial and industrial low-temperature heating space, along with green gas developers aiming for high-temperature applications.
As far as investment is concerned, keeping Europe warm is a hot topic—and one that will only get hotter.
SECTOR TRADING ANALYSIS
Semiconductors
Figures in dollars millions except for share price; actuals are converted using FX rate as of the relevant fiscal year-end, estimates using the latest FX rate as of 19 January 2023
N/A: Not Applicable.
Source: Bloomberg as of the 19 January 2023.
Source: Bloomberg.
Solar
Figures in dollars millions except for share price; actuals are converted using FX rate as of the relevant fiscal year-end, estimates using the latest FX rate as of 19 January 2023
N/A: Not Applicable.
Source: Bloomberg as of the 19 January 2023.
Source: Bloomberg.
Wind
Figures in dollars millions except for share price; actuals are converted using FX rate as of the relevant fiscal year-end, estimates using the latest FX rate as of 19 January 2023
N/A: Not Applicable.
Source: Bloomberg as of the 19 January 2023.
Source: Bloomberg.
Energy Storage
Figures in dollars millions except for share price; actuals are converted using FX rate as of the relevant fiscal year-end, estimates using the latest FX rate as of 19 January 2023
N/A: Not Applicable.
Source: Bloomberg as of the 19 January 2023.
Source: Bloomberg.
Hydrogen & Fuel Cells
Figures in dollars millions except for share price; actuals are converted using FX rate as of the relevant fiscal year-end, estimates using the latest FX rate as of 19 January 2023
N/A: Not Applicable.
Source: Bloomberg as of the 19 January 2023.
Source: Bloomberg.
Mobility
Figures in dollars millions except for share price; actuals are converted using FX rate as of the relevant fiscal year-end, estimates using the latest FX rate as of 19 January 2023
N/A: Not Applicable.
Source: Bloomberg as of the 19 January 2023.
Source: Bloomberg.
European Utilities
Figures in dollars millions except for share price; actuals are converted using FX rate as of the relevant fiscal year-end, estimates using the latest FX rate as of 19 January 2023
N/A: Not Applicable.
Source: Bloomberg as of the 19 January 2023.
Source: Bloomberg.
North American Utilities
Figures in dollars millions except for share price; actuals are converted using FX rate as of the relevant fiscal year-end, estimates using the latest FX rate as of 19 January 2023
N/A: Not Applicable.
Source: Bloomberg as of the 19 January 2023.
Source: Bloomberg.
Oil & Natural Gas
Figures in dollars millions except for share price; actuals are converted using FX rate as of the relevant fiscal year-end, estimates using the latest FX rate as of 19 January 2023
N/A: Not Applicable.
Source: Bloomberg as of the 19 January 2023.
Source: Bloomberg.
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