Heat Pumps- Panacea or put in the bin?
The launch of Marginal Cost of Everything
So where to begin?
I am a former fixed income trader having been in the City for over 13 years. Over the years, what I’ve learnt is in order to become a good trader, you’ve got to be able to sieve through vast swathes of information, distilling down into key points and continuously optimising strategies. And the key driving force behind it all? The bottom line.
In 2018 among the multitudes of pieces I would read on a daily basis, I stumbled across some research by a group called Macrostrategy. Contained within their analysis was a framing of the way in which the economy works, “The Energy Pyramid”, where the most important building block was the marginal cost of energy. This was a lightbulb moment for me and I knew that if there was one problem I could use my background to help people with, this was the one.
As the world lurches between net zero and more recent rejections by the Trump administration and beyond, not enough time (and energy) is spent looking at the marginal cost of energy and how the bottom line is impacted for households and the economy at large. How do green innovations stand up to this analysis? How do we optimise the system for a green ecosphere? How do we ensure that the UK improves its marginal competitiveness and solve the growth enigma that has stymied both the previous Conservative government and the current Labour Government?
The idea with this substack is to present the facts and findings through an agnostic lens showcasing my workings along the way. Hopefully bringing attention to how best to optimise the system and potentially present some awkward questions for both sides of the moral debate, in what is undoubtedly the single most important issue facing both current and future generations.
Right where to start? I intend to cover all elements of the grid, energy security and green innovations in future posts but I thought I would start with Heat Pumps, which have been very divisive and suffered from poor uptake so far. So what do the numbers say?
Heat pump vs conventional boiler
The starting point is to look at the power required to run a heat pump. This is described by the Coefficient of power (COP):
Coefficient of performance (COP)= heat output/power input
The higher the coefficient of a heat pump the more efficient it is. So what COP do we need to achieve in the UK to be net flat on running costs alone? Current average Gas usage in the UK is 34 kilowatt hours per day(kwh/day). Now let’s take the current energy price cap for q1 2025 and run the numbers to see what the required COP is:
So far so good, a COP within the range of lab based testing. Now let’s work out what the breakeven would need to be based on 2020 unit energy prices:
Ok so less good, but still within the range. The key point here is that the COP hurdle is conditional on the difference between the unit charges for gas and electricity and the gas standing charge as an absolute. Taking the 2020 data, you can see the required COP is 3.4965 vs 3.031 now. I’ve held standing charges constant but that would have a small upward skew to 2020 COP.
How does that stack up to real life?
One issue is that real life observed COP data is lower than the lab. Indeed, the number is more like 2-2.2 as per the Energy Savings Trust, given in real life temps drop below the 7 degrees assumed in the lab scenario, and homes have different levels of insulation. A report in Energy Policy Volume 98 highlighted the below:
“When further field trials have been conducted in England and Scotland to test the findings of the Energy Savings Trust trial, the insulation situation has been conspicuous. West Lothian District Council in Scotland ran a trial of ten homes installed with air-source heat pumps. Critically, the study notes the “building fabric was upgraded prior to installation of the heat pumps,” including 120-mm insulation for the cavity walls and 200mm insulation in the ceiling. With the ‘fabric first’ retrofit, the annual COP for the ASHPs was 2.7 – significantly higher than the Energy Savings Trust trial but still below the German standard of 3.5. Harrogate Borough Council in North Yorkshire also ran a trial. This time monitoring ten social housing properties retrofitted with ground source heat pumps. Once again, prior to the heat pump installation, the homes had been “upgraded with cavity-wall insulation, double-glazing and additional loft insulation.”1
This from Energy Systems Catapult who found that to increase the COP they:
Included homes were those with “suitable levels of loft and wall insulation.” Excluded homes, or homes that were “triaged out,” were those that might be “harder to insulate,” or otherwise “not recommended for a heat pump installation.” Because Catapult was so careful to curate the profile of the homes in their trial, they were obliged to concede that the “suitability of the wider UK housing stock for heat pumps should therefore not be inferred based on this data.”2
So good news and bad news there. They work better but you will need to update your home accordingly. So lets start with the baseline, that the real life observed COP is 2.1. You get the below numbers for running costs:
A £451/year loss… ok that’s not great but then let’s retrofit the UK housing stock with insulation to bring it up to 2.7. The first thing to note is that 85% of the total stock of housing is existing with EPCs shown below as per the ONS. The median property is a 2-3 bed semi-detached (at 30% of the sample) so I will take that as the average here. Crucially this is why the average EPC rating is D (similar to Germany for those who like to compare)
We’re moving the average from D to C which means you only need 80.3% of the heating requirement and only 27kwh rather than the 34kwh before. This assumption is generous as you’re only moving slightly into the next band rather than moving the entire way but let’s run with it for now.
As per CheckATrade and Mybuilder the cost of loft insulation and cavity wall insulation is £900 and £2700 each. I’ve dismissed solid wall insulation given the costs are around 4 times as much. Let’s optimise and try not break the bank too much in the process:
Even factoring in the cost of the insulation you get to a not unreasonable number at only an £80 loss per year for a green ecosphere. This could be enough for people to swallow. Only one problem, this doesn’t factor in the cost of the heat pump itself.
I take a lower bound example of £7.3k for a 2-3 bed semi according to Uswitch. A conventional boiler costs £1500, plus higher bound time to install of 2 days at £600. So assume £2100. You then adjust for lifespan (HP 20y vs Boiler 10y) and reduced energy requirement from insulation. Below shows you the numbers both per year and over the full lifecycle of a heat pump:
The analysis here shows that heat pumps cost £235 per year for the average UK home, holding prices constant at the Q1 2025 energy price cap and £4,695 over 20 years. Now in terms of the EPC saving from insulation and the cost of the pump I’ve been generous so these numbers could be worse.
If people don’t get the insulation done, the numbers below show it costs over £12k over 20 years:
This looks like a bad deal either way you swing it and frankly if the Government is wondering why take up is low, even before factoring people’s ability to pay the initial up front costs, the economics make no sense on the basis of the above.
So how do you make it work?
For this I’ll take the better case example of 2.7 COP. Either the cost of energy needs to reduce to 18.5p/kwh vs 24.86p/kwh in the example, a 25.6% relative reduction in the price of electricity, or gas prices increase to 8.23p/kwh, a 29.8% relative increase that would need to be sustained. Alternatively, you decrease the price of the heat pump to £2,605, a 64% drop in the price versus now.
Is this feasible? Well just taking electricity, average wholesale prices are £89 per megawatt hour (mwh) currently. If you remove gas and rely on renewables, combined with Hinkley at £92.50 per mwh and then using the average strike prices of renewables contracts below (these are Contract for difference (CFD) strike prices and will be touched on in more detail in a separate piece), it’s unlikely you can hit the £66 per mwh required to breakeven.
As of Nov ‘24, the gas price per mwh stood at £77.48 per mwh and in the price cap is assumed at £63.4 per mwh vs £35 per mwh pre-Ukraine. So maybe if you use gas and the prices drop it works. This seems kind of defeating the point though. But here in lies some pragmatism; if the price drops and we retain gas in the mix, there is a world in which we can shift to a heat pump and by reducing the C02 from domestic central heating, we will have massively reduced our greenhouse emissions, albeit we won’t be a completely green ecosphere.
On the flip side what if gas prices shoot up? It’s certainly possible given in Aug ‘22 gas prices were £247.25/mwh. If Trump fails to drill drill drill and the price goes up through £82/mwh then the economics can start to make sense again. But if the USA floods the market with gas, do prices really move materially higher? Commenting on each scenario is highly subjective though, so instead I just present the options.
What about the cost of heat pumps? It’s a young industry so taking solar as a proxy, real costs in the last 10y have gone down by 10% according to government stats, and multiple online sites purport to 60-75% savings over the last 20y. It is therefore possible, but we’ll have to wait for it to play out.
Pulling it all together
At a household level the economics really do not stack up to use heat pumps currently, an increased cost to consumers of between £235 and £600 per year on average. There must be (and are as will be explored in other pieces to come) better solutions to reducing our CO2 impact and improving the UK’s competitive position.
What if the government were to come in and fill the gap with subsidies? Taking 74% of UK households as having central heating, that works out as between £103bn and £268bn required to fund it, but furthermore given Gilts are at near 5%; over 20 years this actually equates to between a £275bn and £711bn hit to nominal UK GDP given you won’t recoup the cost in savings to household balance sheets as you are just covering the loss. This clearly makes no sense.
A better use of money would be in trying to reduce the cost of heat pumps. At a much smaller outlay, in start-ups, you have the ability to create massive savings at an economy level. So if Ed Milliband is reading, this would be where I would suggest putting the money if you want to stick with heat pumps.
Personally (and I would argue for all households), for now, I’m putting heat pumps in the proverbial bin.