Heat pumps are an important part of the UK’s response to the energy crisis. The UK must urgently reduce its gas consumption, and heat pumps are among the most effective measures available to do that. Replacing a gas boiler with a hydronic heat pump reduces a home’s gas use by over 70%, assuming the makeup of the electricity grid remains constant. For every heat pump installed, the UK can save around £1,100 in wholesale gas costs at current prices. If all 23 million homes with gas boilers switched to a heat pump without any change in the share of gas in the electricity grid, the savings in wholesale gas costs would be equivalent to around 1.2% of GDP. Because the UK imports around 60% of its gas, this saving is likely to significantly benefit the economy and the government’s finances.

However, most of the savings from heat pumps are not directly passed on to consumers, because UK electricity prices track gas prices. This means installing heat pumps is highly beneficial to governments and to the economy, but not to households. As a result, the government must make heat pumps more financially attractive for households.

The energy crisis is making the financial case for heat pumps for consumers slightly stronger, though in the context of increasing costs for all types of heating. As gas prices have increased, the ratio of electricity to gas prices has fallen, making heat pumps relatively cheaper to run. Under the UK government’s Energy Price Guarantee, the ratio of electricity to gas prices is due to be around 3.3 from October 2022. This means that efficient heat pumps (those with an efficiency around 2.9) will have similar running costs to a gas boiler.

Despite the changes caused by the energy crisis, policy action is still needed to make heat pumps more attractive. A heat pump bought today will still have a higher lifetime cost - when both upfront costs and running costs are combined - than gas boilers without policy intervention. However, our analysis shows that the relative cost of heat pumps can be reduced by:

• permanently shifting levies on electricity bills on to general taxation;
• “decoupling” electricity prices from gas prices by market reforms; and
• installing heat pumps to run at their most efficient (with an efficiency above 3.2).

If these policies are in place and combined with a £5,000 subsidy, a heat pump could cost £120–£160 less per year over its lifetime than a gas boiler.

This report has four sections.

1. How heat pumps can help tackle the energy crisis, by reducing gas use
2. How the energy crisis has affected heat pump running costs
3. How the energy crisis has affected heat pump whole life costs
4. Policy recommendations

As part of this report, we have updated the analysis in our March 2022 paper How to reduce the cost of heat pumps to take into account the latest energy prices. This report focuses on air-to-water/hydronic heat pumps, but the general messages apply equally to other types of heat pump and low carbon heat networks.

The UK is currently in an energy crisis caused by the high price of gas, and urgently needs to use less gas. Because the UK imports around 60% of its gas, this is having a serious impact on the UK economy, draining the money spent on energy bills out of the economy. Home heating is the single biggest use of gas in the UK, accounting for around 37% of use in 2021, more than electricity or industrial use (see chart 1).

Replacing gas boilers with electric heat pumps is one of the most effective ways to reduce gas use. That is partly because heat pumps run on electricity, rather than burning gas directly - and more than half of the UK’s electricity is produced by renewables and nuclear. And it is partly because heat pumps use energy more efficiently than boilers; for every unit of gas it takes to heat a home with a boiler, heat pumps use three to four times less energy.

Table 1 below shows how a gas boiler and a heat pump compare in terms of gas use in a typical medium-sized home. It assumes the gas boiler has an efficiency of 0.87 (ie, it produces 0.87 units of usable heat per unit of gas used), while the heat pump has an efficiency (Seasonal Performance Factor) of 2.76. It also assumes wholesale gas prices are at £3.11 per therm, which is their average price since the start of August 2022 [1]. The table suggests that:

• Heat pumps save more than 70% on gas use compared to a gas boiler, once the gas used to produce electricity is accounted for. This figure is based on the current electricity grid with 40% of electricity generated from gas [2]. As the electricity grid moves further towards renewable energy in future this saving will increase even more.
• A heat pump would reduce wholesale gas costs (ie, the amount of money UK energy suppliers spent buying gas) by over £1,100 per year if gas remains at current gas prices, and assuming the makeup of the electricity grid remains constant.

This saving could be hugely beneficial for the UK economy, because the majority (60%) of gas is imported to the UK. Assuming that any marginal reduction in gas use is used to reduce imports, the £1,100 per year saving from installing a heat pump is a direct benefit to the UK economy. Given that the UK government is now subsidising energy itself as part of the Energy Price Guarantee, any savings on wholesale gas costs could directly benefit the exchequer.

At current prices, every one million heat pumps installed could save the equivalent of around 0.05% of GDP (£1.1 billion) in wholesale gas costs every year, assuming the electricity mix remains constant. If all 23 million gas boilers could be replaced with heat pumps while the price of gas remains this high, the savings would be worth around 1.2% of GDP (£26 billion).

[1] ONS System Average Price of gas. This is the average daily price from 1 August 2022 to 9 October 2022.

[2] UK Energy Flow Chart 2021. In the very short term, it is likely that extra electricity demand from heat pumps would be met by more use of fossil fuels. However, as the grid is gradually increasing its share of renewables over time, we have assumed that the makeup of the grid remains constant for simplicity.

Notes:

* Source: Nesta analysis of home archetypes

** This calculation is based on the UK Energy Flow Chart for 2021. It shows 24.6 mtoe (million tonnes of oil equivalent) of usable electricity produced, with 30.2 mtoe lost in conversion or transport. It also shows gas producing 21.8 mtoe of electricity, 39% of the total. That means that for every unit of usable electricity generated, 0.89 units of gas was used in 2021.

*** Source: ONS System Average Price of Gas

The energy price crisis has made the case for heat pumps stronger compared to gas boilers. The price of gas to UK households has increased by around 4 times over the last 12 months, while electricity prices have increased by around 2.5 times. This has made gas boilers relatively more expensive to run.

The ratio of electricity to gas prices - which is crucial in comparing the costs of running a heat pump to a gas boiler - is now at around 3.8, compared to over 5 in 2021. Under the UK government’s Energy Price Guarantee, the ratio will be around 3.3 from October 2022. This means that more efficient heat pumps will have similar running costs to gas boilers under current energy prices.

This improvement in the position of heat pumps relative to gas boilers should last for as long as gas prices remain high. The UK government’s Energy Price Guarantee will influence this ratio for the next two years, but after that market forces are likely to return. The latest forecasts suggest gas prices will begin to fall substantially after 2025, which will make the ratio of electricity to gas prices rise once again. This means that government policy to reduce the long-term cost of electricity relative to gas remains crucial to the roll out of heat pumps. Our recommendations on how to do this are in the Policy recommendations section at the end of this report.

The chart below shows how efficient a heat pump needs to be to match a gas boiler on running costs at different electricity to gas prices ratios. The lines in the chart show the effective ratio of electricity to gas prices, while the shaded areas show the points at which heat pumps with different efficiencies can match gas boilers on running costs. The green shaded area represents heat pumps with good efficiencies, the orange area below-average efficiencies and the red area poor efficiencies. The chart uses calendar year averages.

The efficiency of a heat pump can vary depending on how well it is installed and how low its flow temperature is, but SPFs for well-installed heat pumps are typically between 2.7 and 3.2 at present. That means a well-installed heat pump is likely to have lower running costs than a gas boiler for the next 3-4 years, while even heat pumps with below average efficiency should have similar or lower running costs to a gas boiler.

Chart 3 repeats this analysis but adds in some extra scenarios for future electricity and gas prices.

• Nesta’s current forecast of energy prices from 2022 to 2037, without policy action but including the Energy Price Guarantee, as used in chart 2 above [1].
• Current forecasts but with policy changes, with levies on electricity permanently shifted onto taxation after the Energy Price Guarantee ends.
• An effectively decoupled electricity market scenario, in which the price of renewable and nuclear electricity is separated from gas-generated electricity by a voluntary pot zero Contract for Difference (CfD) auction in 2023 [2].

In the current forecast scenario, efficient heat pumps are likely to remain competitive with gas boilers on running costs until around 2027, at which point they may become more expensive to run unless they are very efficient. However, in the scenarios where policy changes - both removing levies and ‘decoupling’ the electricity market - efficient heat pumps remain competitive with gas boilers on running costs for most years out to 2037. This suggests that permanently removing or shifting levies off electricity bills and effectively decoupling the electricity market (while maintaining responsiveness to demand) should be priorities for the UK government.

[1] This forecast is based primarily on Cornwall Insight’s Benchmark Power Curve, Ofgem’s tariff cap structure and component trends, National Grid’s Future Energy Scenarios, hedged energy costs from large firms, and averages from a few investment firm projections and analysts concerning natural gas and oil futures.

[2] As proposed by UKERC, with possible refinements on CfD structures, such as mechanisms which still allow a response to demand increases and decreases. Slightly higher strike prices than in previous CfD auctions will likely result if aiming to capture most generators from the Renewable Obligation scheme. But total savings to the UK over the lifetime of the CfD contracts should be greater.

Using these forecasts, we can also update our estimates of the whole life cost of installing a heat pump and a gas boiler under each of our scenarios. This estimate includes the upfront costs of installation and ongoing maintenance costs alongside running costs.

The whole life cost per year measure we use includes the upfront costs of installation as well as running costs and maintenance costs of a heat pump or gas boiler. Table 2 below shows the difference in whole life cost per year between a heat pump and a gas boiler. The analysis uses an efficiency (SPF) of 2.76 for heat pumps, and 0.87 for gas boilers (apart from in the high efficiency system scenario). It is based on our current market forecasts of energy prices.

The table includes different options for policy changes to encourage heat pumps, running horizontally across the table.

• Baseline – no changes from current policy. Includes the Energy Price Guarantee from October 2022 to October 2024.
• Levies adjusted and flexibility payments – under this scenario, levies on electricity remain removed to general taxation following the Energy Price Guarantee, and heat pump households receive a 2% discount to their heating bill for using electricity flexibly from 2025 (~£33/year for a typical home).
• Plus high efficiency system – this scenario includes all changes above, and adds a more efficient heat pump system on average, with an SPF of 3.28 [1].
• Plus £5,000 grant – this scenario includes all of the changes in the levies and flex scenario above and adds a £5,000 subsidy (equivalent to the Boiler Upgrade Scheme) for air-to-water heat pump installations.

Where the values are positive, this means a heat pump is more expensive over its lifetime than a gas boiler (these numbers are red); where values are negative, this means a heat pump is cheaper (these numbers are green).

[1] High efficiency refers to any system which is either: a) designed for low flow-temperatures (< 50oC); b) includes a properly sized and high-performance heat pump; or, c) a hybrid system (solar PV/T).

Table 3 repeats the same analysis but using a decoupled electricity markets scenario, in which more existing electricity sources are switched on to Contracts for Difference (CfD).

Impact of energy prices

Our analysis shows that:

• the energy crisis is likely to have improved the case for investing in a heat pump, moving the whole life cost of a heat pump closer to a gas boiler. Before any policy changes are considered, the energy crisis has moved heat pumps closer to the cost of gas boilers by £100 - £250 per year compared to pre-crisis prices.
• decoupling renewables from gas in the electricity market, by placing nearly all renewables on a Contracts for Difference scheme, further improves the case for heat pumps; within the baseline, the whole life cost of a heat pump relative to a gas boiler is reduced by £70-£160 per year.

Impact of policy changes

Our analysis shows that:

• moving environmental levies off electricity bills reduces the whole life cost per year of a heat pump relative to a gas boiler by £100-£240 under our central forecast of energy prices.
• improving the efficiency of heat pumps reduces the relative whole life cost by £120-£290 per year in our central forecast of energy prices
• the £5,000 subsidy reduces the whole life cost of a heat pump by £333 per year relative to a gas boiler under all scenarios.

Scenarios where heat pumps have a lower whole life cost

Once these policy and energy prices changes are combined, heat pumps begin to get much closer to gas boilers on whole life cost.

In our analysis, heat pumps are cheaper than a gas boiler over their lifetime when:

• a high-quality heat pump installation delivers high efficiency

AND

• a £5,000 grant is available

AND EITHER

• levies are removed or shifted

OR

• electricity prices are decoupled from gas.

If the full range of policy scenarios – including removing levies, a £5,000 subsidy, high heat pump efficiencies – is combined with a decoupled electricity market, heat pumps are £120-£160 per year cheaper over their lifetime than gas boilers. This shows that there are clear policy routes to making heat pumps more affordable than gas boilers.

Accelerating the installation of heat pumps should be a key part of the UK government’s medium-term response to the energy crisis. Heat pumps meet two crucial objectives for government: they significantly reduce carbon emissions, tackling the climate crisis; and they reduce gas use, tackling the energy crisis.

However, even though the energy crisis has slightly improved the financial incentives to get a heat pump, more government action will be required to accelerate their roll out. The direct economic benefits of this action will be significant, including potentially reducing net gas imports by over £1,100 per year for each heat pump installed.

The price of electricity remains far higher than gas, and has risen significantly over the past 12 months. This is primarily because gas prices set the wholesale price of electricity, despite a majority of electricity being generated from other, cheaper sources [1]. Electricity also faces an effective tax - in the form of environmental and social levies that are added to electricity bills but not gas bills - which currently acts as the opposite of a carbon tax.

[1] See Nesta’s 2022 blog post, How green is my tariff? for an explanation of this.

Recommendation 1: reduce the influence of gas prices on electricity prices

The UK government should seek to decouple the price of gas-fired electricity from renewable electricity as far as possible, while still maintaining the influence of overall market demand within renewables. This should make electricity overall much cheaper because renewable electricity is generally the cheapest type of electricity overall. Because renewables output is variable over time, this would also make flexibility in electricity use – another option included below – much more attractive.

There are several mechanisms which can help reduce the influence of gas prices – the pot zero approach, modelled in this paper, is just one limited option – but any effective decoupling should reduce the relative cost of heat pumps. In our analysis, this change could improve the relative lifetime cost per year of a heat pump by at least £70-£160.

Recommendation 2: remove levies from electricity bills

The UK government should remove the environmental and social levies on electricity bills as soon as possible. These levies add around £150 to the average bill under the October 2022 price cap. Shifting the cost of ECO to gas bills, and other levies to general taxation, would reduce the relative lifetime cost per year of a heat pump by £140-£330.

The UK government recently announced that it will be moving levies to general taxation for the next two years. However, we recommend that this change be made permanent, to improve the lifetime case for heat pumps, and that the ECO element of levies be moved to gas bills to provide a further incentive for electrification. Crucially, this shift should not increase bills for most gas boiler homes either [1].

[1] Gas boiler homes are likely to see 2%-5% savings in overall energy bills from the levy shifting proposed here.

Recommendation 3: encourage more efficient heat pumps systems across design, installation and manufacturing

More efficient heat pumps reduce energy bills and are significantly more financially beneficial to customers. The UK government should seek to raise heat pump efficiencies by including efficiency standards in the market-based mechanism for low carbon heating and the Energy Related Product framework. It should also conduct – or require the industry to conduct – more regular monitoring of efficiencies of all heat sources (including boilers and heat pumps) as they operate in homes, making this data more widely available to customers.

Recommendation 4: encourage flexible electricity use

There is significant scope for heat pump running costs to be reduced by using electricity more flexibly. The assumed benefit from flexibility included in our model – a 2% reduction in cost of heating bill for households with heat pumps – is fairly conservative. And while there is scope to realise higher payments from demand response services, there is even greater scope to achieve direct savings from energy consumption reduction with improved system design, energy storage options and controls.

Governments in the UK should promote the use of electric batteries and smart thermal storage more widely alongside low carbon heating. The UK government is right to propose a requirement on all electric heating systems to operate smartly, as this will reduce costs for consumers and for the wider energy system. The UK government and Ofgem should also push for more widespread reintroduction of flexible time-of-use tariffs, either by paying customers to flex their electricity use or encouraging lower tariffs at times where electricity is more abundant.

Recommendation 5: extend subsidies while the energy crisis persists

Given the high upfront costs of heat pumps, subsidies help to increase their attractiveness to customers. Nesta’s research, How to increase the demand for heat pumps, showed a £5,000 subsidy is the single most effective measure to increase demand for heat pumps. Although subsidies are expensive for governments, every heat pump installed will bring a significant fiscal benefit to the UK government for every year the energy crisis lasts, by significantly reducing gas imports. While gas prices remain at very high levels, there is a strong fiscal argument for continuing subsidies beyond the 30,000 per year currently budgeted for under the Boiler Upgrade Scheme. If combined with other policy changes, such as shifting levies or providing low-cost finance, governments could also consider scaling down subsidies to a lower value over time.

Alongside subsidies, governments should also provide or support low-cost financing for heat pumps. Nesta’s research, How to increase the demand for heat pumps, showed this has almost as big an effect on demand for heat pumps as a subsidy and is crucial to make the upfront cost of heat pumps affordable to most households.

Recommendation 6: increase the capacity of the heat pump industry

The supply of heat pump installations is limited and will take time to scale up. Nesta’s work on How to scale a highly skilled heat pump industry estimates there are currently around 3,000 skilled heat pump installers, and that this would need to increase roughly ten-fold in the next six years to keep pace with UK government targets for heat pump installations. Expanding the industry at this speed presents significant challenges, and governments in the UK may need to support training and business growth in the industry.