SFV Perspectives: Our Heat Pump Thesis
By Reid Carroll
As a built environment focused fund, we spend a lot of time thinking about heat pumps.
From ground source to air source, residential to commercial, new build to retrofit, and even European to American (you can hear the different accents if you listen closely), we continue to look across the heat pump landscape in search of venture-scale opportunities.
Yesterday we were thrilled to announce investment in Bedrock Energy, our second investment in the heat pump space (following Gradient). It presents a good opportunity to share our current thesis on the sector.
In short: we think that commercial heat pumps are a more interesting vertical than single-family-home heat pumps, and see two exciting opportunities within the commercial space.
For those who want to skip around, we’re going to cover:
- Why commercial heat pumps are interesting
- Why Bedrock can build a massive business in the GSHP space
- The multifamily building retrofit opportunity for heat pumps
- Our concerns with single family home heat pumps as a venture opportunity
1. Heat pumps for commercial buildings have compelling drivers
Regulatory Drivers
“If you’re evaluating purely on the economics, you couldn’t beat natural gas historically,” an east coast US engineering firm told us. “But almost none of our clients are considering natural gas heating for their new buildings”
There is already mass-market demand for new-build commercial heat pumps in the US Northeast and Mid-Atlantic, and regulations are the primary reason.
Commercial buildings (defined in our case as buildings over 20,000 SF of any vertical — multifamily, office, etc.) tend to be concentrated in cities, and these locations are increasingly implementing Building Performance Standards (BPS) that regulate commercial building emissions.
The first such standards, concentrated in the Northeast, Mid-Atlantic, and West Coast, have completely changed the way building heating systems are being selected. Each of these standards is designed to become more stringent in the 2030s, making it difficult for developers in these regions to justify investing in fossil-fuel heating systems that will be a liability within a decade. Natural gas boilers are out, heat pumps are in.
The number of building performance standards is set to greatly expand in coming years, a reality that is unlikely to be affected by national politics. In fact, the inverse might be true — Trump’s 2016 election directly led to the introduction of many standards, a phenomenon that could accelerate the adoption of the many upcoming standards.
There is of course no guarantee that all of these standards will be rolled out on-schedule, but we believe the underlying trend towards building performance standards — and therefore commercial heat pumps — is inevitable.
Financial Drivers
Regulations might be a primary driver, but they are just one piece of the equation. There are several others that factors that help commercial heat pumps achieve attractive payback periods:
- Commercial building owners or operators can secure electricity at favorable rates compared to residential customers, often reducing the spark gap (the difference between electricity and gas prices) and increasing energy cost savings.
- The cost premium for heat pumps in new buildings can be modest. Heat pumps can actually simplify commercial HVAC designs.
- Many northern cities are full of existing buildings that rely on especially expensive heating sources like fuel oil, propane, or district steam. The economics of retrofitting such buildings to heat pumps are strong.
- Heat pump efficiencies can be higher in new commercial buildings (compared to resi) because heat pumps can be used to offset simultaneous heating and cooling loads (heat extracted from one space can heat another).
- Electrification can increase rents and reduce lending costs for owners.
We think commercial heat pumps in Europe are similarly compelling (stringent regulations, attractive spark gaps, milder winters that boost efficiencies), and hope to see more innovative companies here on our side of the Atlantic.
2. Ground source heat pumps — and Bedrock Energy in particular — have a chance to be a big part of the commercial heat pump market
Okay, so the commercial heat pump market is primed for growth. What does this mean in terms of “investable” opportunities?
First, it’s worth clarifying what the main technologies are:
- The cheapest solution, and one that we expect to be most common, is rooftop air source heat pumps (ASHPs). These are typically “4-pipe” heat pumps that can simultaneously heat and cool, which boosts efficiencies. All the major HVAC OEMs produce versions of these — they’re functional in cold climates and are improving every year.
- The other option is ground source heat pumps (GSHPs). These work similarly to air source heat pumps, but instead of exchanging heat with ambient air they exchange it with the ground. This boosts efficiencies but requires boreholes to be drilled, which is expensive. The hardware (heat pump) side of this segment is again likely to be captured by incumbent OEMs, though it might be more up for grabs than ASHPs. The drilling side, on the other hand, is responsible for most of the cost but has received limited attention. This presents an opportunity for disruption.
In evaluating whether GSHP’s represent a venture-sized slice of the market, our first question was around the attractiveness of technology in general — can GSHPs be more than a niche solution? Our analysis showed that they are quite a bit more expensive than air source today, to the point where the energy-based payback compared to an air source heat pump can be lengthy. Given that, we were surprised to learn that they are a major part of the commercial market already. As it turns out, GSHPs provide many “hidden” advantages compared to air source heat pumps:
- Maintenance reduction: dozens of rooftop ASHPs operating in sub-freezing temperatures can provide a maintenance headache.
- Space constraints: many buildings can’t fit ASHPs on their roof.
- Lower peak loads: GSHPs can reduce a site’s peak load compared to ASHPs, making grid connections easier to secure and reducing demand charges.
- Design simplicity: a GSHP mimics the setup of a chiller and also provides heating. This eliminates several pieces of equipment and provides a design that developers are already comfortable with.
- A better story: GSHPs are the most sustainable technology, and owner/operators of campuses with long-term priorities are already opting for GSHPs (think: universities, hospitals, pharma, military, etc.)
These benefits explain why the US commercial GSHP market is already substantial ($1B+) and is growing rapidly. An engineering firm told us their clients are expressing interest in GSHPs on almost every project, and another engineer quoted in the NYT last year expressed a similar sentiment:
Five years ago, the company was working on two or three campus geothermal projects at one time. That figure has grown to between 20 and 30 projects, she said. “It really feels like it is doubling every year,” Ms. Olsen said.
To be clear, this move towards commercial GSHPs is happening without a slam dunk energy-only payback. What got us so excited about Bedrock is that their drilling technology will dramatically reduce up-front costs, resulting in energy-only paybacks vs ASHPs of less than five years (on top of all the other benefits). Bedrock is positioned to expand the market in a big way and win a large share of that market. We are fired up to be partnering with Joselyn, Silviu, and the Bedrock team.
3. Don’t forget about existing multifamily buildings
While Bedrock is making an existing solution (GSHPs) more compelling, Gradient is tackling a segment in desperate need of new solutions: retrofitting multifamily buildings.
Circling back to the building performance standards we introduced above, JLL estimates that there are nine times as many multifamily buildings that will be subject to fines by 2030 than the second most exposed sector, office.
In NYC alone, there are 405 million square feet of multifamily buildings that will require deep retrofits by 2030 to be compliant with Local Law 97 (deep retrofit = more than basic upgrades like air sealing & pipe insulation). For the thousands of affected buildings, the economics of switching to heat pumps are highly attractive. The graph shows how building performance standards, smaller spark gaps (vs resi), and inefficient distribution systems like steam make the operating cost of multifamily heat pumps dramatically lower than fossil fuel heating.
Unfortunately, incumbent technologies like mini-splits and VRF systems are prohibitively expensive to install in existing multifamily buildings due to the associated labor and complexity. By dramatically reducing installation costs & tenant disruption, Gradient has developed an elegant solution to this problem:
ASHPs for multifamily buildings are also the beneficiary of significant city, state, and utility rebates (often associated with building performance standards; independent of IRA credits), which results in Gradient units typically costing the same or less than a boiler replacement.
Gradient’s first commercial units are shipping now and we can’t wait to see what they achieve in 2025 and beyond.
4. What about residential heat pumps?
SFH heat pump retrofits have a massive TAM, and the direction of travel towards heat pumps is clear. That being said, the economic reality in the US tends to be underappreciated.
Natural gas is very cheap in the US, leading to large “spark gaps” between electricity and natural gas prices. This is particularly true in the most populated cold-climate markets like the Northeast and Midwest where spark gaps for homeowners often exceed 4 and even 5. This means heat pumps have to be 4x+ more efficient to be cost-neutral with gas. While heat pumps are perfectly capable of heating homes in cold climates, the seasonal heating efficiencies of Energy Star heat pumps (based on HSPF2 ratings) are between 2.5 and 3.3 (zone 4), 2.1 and 2.5 (zone 5), and even lower in zones 6 and 7.
As a result, paybacks are non-existent in much of the country, which is a tough reality given how expensive and disruptive these retrofits are. This partially explains why most of the heat pumps in the US have been installed in new homes in the south (the other reason: gas connections are less common). To visualize the economic reality of heat pump retrofits in cold climates, we put together the following charts:
As the market matures past early-adopters, we’re worried that the unit economics of selling heat pump retrofits to mass-market consumers will be challenging due to this financial reality. This will have a trickle down effect on startups selling heat pump workflow solutions to installers, too, as installer willingness-to-pay will be constrained.
We still spend a lot of time speaking with SFH heat pump startups (again, huge TAM), but would like to see solutions that are more in-touch with the economic reality. For example, Gradient, which is initially targeting multifamily, also has a strong value prop in the single family home space: installation is easy and can be done incrementally. Homeowners who want to fully electrify can avoid a single large up-front cost while securing tax credits year after year, and others can use Gradient for individual spaces that otherwise aren’t well-served by a central unit.
We’ll close by mentioning that there are strong SFH retrofit drivers in Europe — spark gaps are better, winters are milder, cultural awareness is higher, regulatory mandates are stricter, and home energy ratings help homeowners monetize upgrades. The big issue we’ve found is with the competitive landscape — a lot of money has flown into resi heat pump hardware & installation companies, which we expect to make strong unit economics a challenge. Given this, we’re not sure if a 5th, 6th, or 7th player can achieve a meaningful exit.
Thanks for reading to the end! Our thesis continues to evolve, and we hope to hear from many of you soon.
