Sweden's district heating industry relies heavily on biofuels, especially wood-based biomass. In second-half 2022 and all of 2023, demand started outstripping supply, pushing up prices. Among other sources, biomass prices increased last because all Russian volumes completely stopped due to the war in Ukraine.

Now, the long and very stable operating run district heating companies have enjoyed, with remarkable cash flow stability over several decades, has thereby been broken. As prices for biomass started increasing in late 2022, district heating providers stood resilient to the increased cost of fuels as the following season was already largely contracted. Elevated electricity prices at the time also mitigated the impact on earnings. But since then, continuing high fuel prices have put operators under pressure due to the inability to pass through tariffs timely and effectively. The price mechanism only allows for annual adjustments in the beginning of the year, a half-year after the actual price discussion. In Sweden, prices on biomass used as fuel for incineration, such as wood chips, recycled wood, or processed wood-like pellets, have increased 50% or more since 2021.

So how difficult can it get for heating providers? Here, S&P Global Ratings answers questions from investors on Sweden's district heating industry amid rising operating costs, elevated inflation, and the increased cost of living for consumers.

Frequently Asked Questions

Why does you think Swedish heat providers face lower margins, and will the industry recover to historical levels?

We base our view on higher biofuel prices and the underlying price mechanism for heating. Companies have not been able to pass on the increased costs quickly enough, a situation that hasn't occurred before. We see a risk that district heating providers might not be able to pass on costs with tariff increases in the coming one-to-three years, with deteriorating earnings and cash flows resulting. While we do not expect significant losses, we see a risk of materially lower and more volatility in earnings, which we normally don't assume in our perceived risks of district heating operations. The industry has been very stable and predictable in the past few decades.

For example, we revised the outlook on our rating on Stockholm Exergi to negative from stable already in April 26, 2023, because we saw a material risk that increased biofuel costs would weigh on the company's 2023 performance (see "Research Update: Stockholm Exergi Holding AB Outlook Revised To Negative On Cost Pressure; 'BBB+' Ratings Affirmed," published April 26, 2023, on RatingsDirect). We forecast EBITDA for 2023 to decrease almost 20% to Swedish krona (SEK) 2.2 billion-SEK2.5 billion, from SEK2.9 billion in 2022. Stockholm Exergi has only a limited ability to pass such large price increases through to its customers within a year.

We assume in our base-case scenario that heat providers will continue to raise tariffs in 2024 and 2025 well above the historical average, in many cases above 10%. But it might not be enough. This comes against a heated affordability discussion from customers who object to the hefty price increases. We will continue to monitor developments.

Why don't operators just increase prices to cover the higher costs?

Operators have limited ability to pass fuel price increases on to customers in a timely manner because heat prices can be adjusted only once a year according to industry practice, or after a "price dialogue" introduced by the Swedish Energy Agency in 2013. Costs of recycled wood have more than doubled (up about 140%) by third-quarter 2023 from the start of 2022, and prices of wood chips have increased by more than 60%. During that time, the average tariff increase was about 8%.

Before 2023, tariff increases have broadly been modest, even considering lower inflation during that period, averaging 2.1% over 1997-2022. For 2023, heating bills have risen about 8% on average, and almost 30% for some. Despite this year's record increases, they are less than the operators' costs increases, where some biofuel costs have more than doubled.

Some heat providers might not be able, or even willing, to increase prices enough because of possible negative customer reactions and political actions, such as negative publicity or a change or amendments to the current pricing model. The market is not formally regulated via a regulator and a set regulatory framework. We understand heat providers have a preference to maintain the price mechanism structure, but large tariff increases in one year could enforce political reactions and lead to structural procedure changes.

Which rated heating companies might be most affected by rising biofuel costs?

District heating companies like Stockholm Exergi and Kraftringen mainly use biofuels. We anticipate a significant 10%-25% cut in EBITDA for Stockholm Exergi in 2023 from the increased biofuel costs and inability to raise increases quickly. Thanks to Stockholm Exergi's flexible production, we believe they could somewhat optimize output and therefore earnings deterioration. We think Tekniska verken is less affected and expect its earnings from its district heating activities to remain solid. Waste is the company's main fuel source, historically near 60%, followed by recycled wood at about 35% on average. This compares with Stockholm Exergi's fuel mix of about 30% waste. This makes Tekniska verken less vulnerable to higher wood product prices, since the price and contract structure for waste is very different from that for wood. Moreover, the company has its own waste-handling operations, which has thin margins but provides cheap fuel for the company's district heating operations. Tekniska verken and Stockholm Exergi also import waste, which they use as fuel, and both receive what's known as a gate fee for it. The imported waste is usually under long-term contracts. It appears, however, that waste supply was significantly lower in 2023 than historical levels. Also, prices for waste have not risen as much as biofuels, on average about 17% from 2020-2023. Vattenfall is a material district heating provider, which has a favorable fuel mix; however, most of the operations are in Germany and the Netherlands. In total, 5% of the group's underlying EBITDA streams from its heating operations.

Does you assess Swedish district heating as regulated?

Under our criteria, we view the Nordic district heating market as a regulated industry, albeit less so than other formal frameworks such as in the electricity distribution business, which we view as very supportive.

Heating companies operate under a natural monopoly, with a built-in self-setting price mechanism, and a government body (Swedish Competition Authority) monitors the tariff process from market abuse. Also, tariff flexibility is partly restricted by customers' ability to change heating sources.

Could the price-setting procedure change, and would that affect ratings?

We think a change in the price setting, with for example a formalized framework under watch of a regulator, is not likely in the near term.

In our rating approach, we view Swedish district heating companies as regulated, in part because they offer an essential service that has no practical substitute--they are monopoly-like markets because heating companies are naturally shielded from competition and subject to the decisions of a regulatory body, including on tariffs. However, we consider Sweden's framework only adequate, driving our assessments of Swedish district heating providers as having an adequate competitive advantage. This is because we view the operating environment as weaker than under formalized regulatory frameworks elsewhere in the Nordics. Notably, we assess the regulatory framework, and operators' regulatory advantage, as strong for Swedish power distribution system operators (DSOs) and transmission system operators in Finland and Norway, and strong/adequate for Finnish DSOs.

Historically, heating companies' EBITDA margins have been extremely stable. The volatility in earnings since late 2022, if it continues, might not be consistent with our ratings, all other factors unchanged. To date, district heating companies have been unable to offset the higher-than-expected costs of biofuels and their margins are being stretched. At this stage, we continue to expect this earnings volatility to be temporary in view of the very rapid increase in biofuel prices in 2022 and 2023 combined with the delay in raising tariffs.

However, if cost increases can't be passed on as part of the regulatory- or pricing mechanisms, we would likely take a more negative view of the industry, which consequently would affect providers' credit profiles. This could include a downward revision of our business risk profile assessments. Heat customers, in particular large real estate companies, are requesting a more modest rise in the price of heating, or none at all. This development would not only depress individual margins but also call into question margin stability across the industry. Furthermore, if we revised our view of the regulatory framework to adequate/weak, this would change the volatility table we use for district heating companies to standard from medial. This move would result in less allowed leverage under the same rating.

We cannot gauge whether a defined regulatory framework be positive or negative for credit quality without analyzing the prospective proposal. Nevertheless, the move to establish such a framework would signal a structural shift in the industry that could have credit implications.

Related Criteria

• Key Credit Factors For The Regulated Utilities Industry, Nov. 19, 2013

Related Research

• Research Update: Stockholm Exergi Holding AB Outlook Revised To Negative On Cost Pressure; 'BBB+' Ratings Affirmed, April 26, 2023