Holger Frey
CAIA, Senior portfolio manager, Thematic Equities

On December 23, 2022, a dangerously cold winter storm caused by a plunging jet stream across North America hit the US Upper Midwest and Northeast.1 Temperatures fell as low as –46°C (50°F),2 putting critical energy infrastructure at risk. Gas wells froze, causing the worst one-day fall in US natural gas output in more than a decade,3 and pushing natural gas prices above USD 100 in Washington D.C. and parts of New England by Christmas Eve.4

This harsh winter storm was a fresh reminder of how today’s energy infrastructure is struggling amid more frequent extreme weather events that cut off customers from supply and cause large price shocks. The rise in such events has catapulted the issue of energy security and energy efficiency into living rooms, where, until recently, due to the COVID-19 pandemic, the focus had been on setting up Alexa smart home devices and Netflix streaming.

Climate change is of course not the only driving factor behind the increased interest in building energy efficiency. Since Russia invaded Ukraine in February 2022,5 Europeans have seen the picture of reliable and affordable energy supply fading in the rearview mirror. With politicians making frantic attempts to secure new natural gas supplies and floating liquified natural gas (LNG) terminals, it has become clear that there is no silver bullet for the European energy crisis. Although concerningly high winter temperatures in Europe6 helped to avoid the worst-case scenario in the short-term, energy security will remain under threat if no improvements in efficient energy use are made.

Higher energy efficiency provides a cushion against rising energy costs

The European energy crisis has triggered a sharp rise in energy bills. However, the magnitude of this increase depends to a large degree on the level of building energy efficiency in households. Homes that are more energy efficient have seen relatively lower absolute increases in energy bills, whereas less efficient ones saw 4.6 times higher cost increases (see Figure 1). For example, B-rated UK households saw their annual energy bills for 2022 increase by USD 820 compared to 2019, while the lowest rated, G-rated homes, saw a staggering increase of USD 3,376.7 This must be the strongest argument for improving energy efficiency in buildings in decades.

Figure 1: Increase in typical annual UK household energy bills by building energy performance rating (USD, 2022 vs. 2019)

Bar graph: Increase in typical annual UK household energy bills by building energy performance rating between 2019 and 2022 (B: USD 820; C: USD 1,113; D: USD 1,407; E: USD 1,920; F: USD 2,659; G: USD 3, 776).
Source: IEA. License: CC BY 4.0; Energy Efficiency 2022 – Analysis | IEA.

Increase in typical annual UK household energy bills by building energy performance rating between 2019 and 2022 (B: USD 820; C: USD 1,113; D: USD 1,407; E: USD 1,920; F: USD 2,659; G: USD 3, 776).

Heat pumps dampen price volatility of fossil fuels

As natural gas is the dominant global fuel, accounting for 42% of residential heating needs,8 the recent price shock is fundamentally questioning its role as an affordable, transitional form of energy. In fact, households that use electric heat pumps have been better protected from wild price swings. For example, the cost of operating a gas heating system for the average household in Denmark has risen by 330% amid skyrocketing gas prices, while heating the same floor space with an electric heat pump has risen by 100%.9 For households able to consume self-produced renewable energy, switching to efficient electric heating increases energy security and adds price stability, since electricity prices can be locked in for many years, and with that, avoid the price volatility of fossil fuels.

Reducing your carbon footprint pays off

Burning fossil fuels to heat homes is also a major contributor to global warming. In the US, heating and cooling accounts for 38% of greenhouse gas emissions from residential houses, with an additional 15% of emissions stemming from heating water.10 By switching to a heat pump heating system, homeowners can drastically lower their carbon footprint by 1 to 8 t per year.11 As a comparison, if you switch to a vegan diet for an entire year, you will save about 1 t of CO2 emissions,12 while the cost of emitting carbon is expected to rise in structural terms. On December 18, 2022, the European Parliament agreed to introduce a carbon price on buildings fuels, as part of the bloc’s Emissions Trading Scheme (ETS) reform, the biggest carbon trading market globally.13 From 2027 to 2030, carbon emissions from burning fossil fuels in road transport and heating will have a price ceiling of USD 45/t.14 This agreement goes further than the initial draft, with process heat from industrial activities and office heating now also included in the new ETS2.15

Figure 2: Environmental footprint of heating systems

Environmental footprint of heating systems in grams of CO2 equivalent per kWh of heat: solar thermal 10-35; ground source heat pump 50-125; air source heat pump 60-170; direct electric heating ~250; gas boiler 210-380; oil boiler 310-550.
Source: The Parliamentary Office of Science and Technology, BBC 2020.

Environmental footprint of heating systems in grams of CO2 equivalent per kWh of heat: solar thermal 10-35; ground source heat pump 50-125; air source heat pump 60-170; direct electric heating ~250; gas boiler 210-380; oil boiler 310-550.

How do heat pumps work?

The technology behind heat pumps is nothing new, being similar to that used in refrigerators and air conditioners. Heat pumps extract heat from the surrounding air, the ground (geothermal energy), water or factory waste heat. Unlike traditional gas boilers and electric heaters, heat pumps do not generate heat themselves, but rather transfer and amplify heat from a given energy source. The process itself starts with a compressor that moves a refrigerant through a refrigeration cycle, with a heat exchanger extracting the heat from the source. The heat is then passed on to a heat sink via another heat exchanger.

Figure 3: Basic process of a heat pump

Image of a heat pump - process steps: (1) Ambient energy: air, (2) Electric compression, (3) Useful heat: immersion heaters
Picture used with kind permission of Nibe Industrier.

Image of a heat pump - process steps: (1) Ambient energy: air, (2) Electric compression, (3) Useful heat: immersion heaters.

A typical home heat pump will be at around four for its coefficient of performance (COP) – the unit of electricity input required to provide a unit of heat output – which is three to five times more energy efficient than a gas boiler.16 Furthermore, during warm periods, heat pumps can be used in reverse: extract heat from a room and move it outdoors.

While air-sourced heat pumps used to be less efficient in cold climates, due to technology improvements, they now operate efficiently in temperatures of –23ׄ°C (–10°F) and below.17 Market penetration of 60% in Norway and over 40% in Sweden and Finland confirms this.18 Next-generation heat pumps aim to provide the highest COP possible for a wider temperature range, further reductions of noise levels, and optimization for dual use (heating and cooling). Research and development efforts include rolling out new compression technologies such as solid-state (e.g. magnetocaloric, thermoelectric, and elastocaloric) and gaseous ones (e.g. Brayton and Stirling cycles), with particularly promising initial results for elastocaloric‐based cooling systems.19

Installations set to reach new records

About 190 million heat pumps were in operation in 2021 worldwide, with air-source heat pumps being the most frequently installed type.20 Installations surged by nearly 15% to reach a record high in 2021, with the biggest growth in Europe, which crossed the two-million mark in terms of new installations, up 35% year over year. This trend is expected to continue, confirmed by doubling growth rates in Europe in the first half of 2022. In order to reach climate and energy goals, installations could even rise to between five and seven million per annum by 203021 in Europe alone.22 Looking at the policy changes underway, it is fair to assume that we will see more records broken in the future.

Figure 4: Residential heat pump installations in Europe expected to rise significantly

Bar graph: Residential heat pump installations in Europe are expected to increase from around 2 million in 2022E to more than 5 million in 2040E
Source: Based on Wood Mackenzie, 2022. Europe to install 45 million heat pumps by 2030 | Wood Mackenzie; retrieved on January 5, 2023.

Residential heat pump installations in Europe are expected to increase from around 2 million in 2022E to more than 5 million in 2040E

With Europe currently in the eye of the storm of the energy crisis, seven European countries, including the UK – representing 80% of the continent’s residential gas use – have announced plans to ban new gas heating connections.23 Several states in the US are also introducing a ban on gas and oil boilers. In addition, the Inflation Reduction Act (IRA) provides significant new rebates and tax incentives to homeowners. Rebates can be as high as USD 8,000 on the purchase of a heat pump for low- and middle-income households, with a tax credit of up to 30% available for high-income households.24 One of the bottlenecks hampering even stronger growth so far has been the availability of skilled, licensed professionals able to install heat pump systems, with the industry reacting by expanding and training up their workforce. Easy-to-install window heat pumps are another new option, which can be installed as quickly as common air conditioners but provide energy-efficient colling and heating. Prices start at USD 2,000,25 which enables retrofitting for low- to middle-income households.

Renewable energy production set to grow

The Russian invasion of Ukraine has triggered a global disruption to the fossil fuel supply, which has been felt particularly hard in Europe. The renewed debate about energy security has left its mark in fundamental policy changes like the REPower EU plan and the IRA. Furthermore, the increasing frequency of extreme weather events is putting additional pressure on today’s energy infrastructure. Improving the energy efficiency of heating in buildings is crucial to reduce dependency on fossil fuels and fight climate change. Heat pumps meet both of these needs, since they are three to five times more energy efficient than gas and oil boilers while significantly reducing carbon emissions and air pollution26 However, the ambitious growth plans for heat pump installations will also drive electricity demand, as electrification replaces fossil fuel burning in heating applications. Based on International Energy Agency (IEA) estimates, the share of electricity used in the global fuel mix for heating in buildings and industry is set to double to 16% by 2030.27

To enable this transition and reduce carbon emissions, renewable energy production must grow exponentially as well, while the capacity of the electricity grid and energy storage solutions also need to expand. The recently published IEA forecast for global renewable energy growth paints a similar picture; in its largest revision ever, the agency now expects 76% more growth than just two years ago,28 which means on top of last year’s projections, the equivalent of the entire electricity system of India will be built by 2026. With the strong capacity expansion of renewable energy pushing electrification forward, it might well be time to turn up your heat pump!

About the author
  • Holger Frey

    CAIA, Senior portfolio manager, Thematic Equities

    Holger Frey (FH, BSc, CAIA), Director, is the Lead Portfolio Manager for the Environmental Impact Equity strategy. He joined the Thematic Equity team in 2021. From 2016 to 2021, he worked at RobecoSAM in Zurich as lead portfolio manager for a circular economy strategy. Holger started his career in 2004 as a financial consultant. In 2006, he moved to Deutsche Asset and Wealth Management, where in 2008 he began focusing on nutrition, water, and environmental technology, becoming the lead portfolio manager for the water strategy at the company. Holger has a Dipl.-Inf. (FH) degree in Computer Science and Media from Fulda University of Applied Sciences and a bachelor’s degree in Musicology from Goethe University Frankfurt. He is a CAIA charterholder.

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