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26/05/2016

The EU Referendum - An Energised Debate

On the 23rd of June this year, the UK will vote on its membership of the EU. For what initially sounds like a simple issue, the links between the UK and the EU are countless and diverse. When considering the current position of the polls, with the Remain side leading by only 4 points (44% Remain, 40% Leave with 16% undecided as of early May), it is clear that the final decision will be close. In this article, Sia Partners proposes to analyse the issue focusing on the Energy sector.

Figure 1 and 2 : EU Referendum Voting Intentions and Average UK Monthly Energy Spend

Figure 1 & 2 : EU Referendum Voting Intentions and Average UK Monthly Energy Spend

In true British fashion, the main factor affecting the public’s decision is the direct cost/benefit to their wallet resulting from EU membership[1], with a figure of just £25 enough to sway people from one position to the other. As UK Households spend approximately 5.1% of their income on energy costs, an average of £106 per month[2] (see Figure 2), the impact of the EU referendum on the UK’s Energy market should be carefully considered.

On the 24th of March, the government delivered a speech on the benefits to the UK Energy Market of staying in the EU[3], specifically stating that Energy costs would increase if the UK were to leave[4]. As with a lot of the information surrounding the referendum, guaranteed, cast iron facts are hard to come by. Therefore, the aim of this article will be to examine some of the points in that speech and clarify some of the other arguments for remaining in or leaving the EU, specifically in relation to the Energy markets.

Exploring the Government’s claim

The Government’s position consists of three main areas where, to their mind, leaving the EU will damage the UK’s ability to provide Energy to consumers. These included; an increase in Energy costs due to the loss of access to the cheap Internal Energy Market of the EU, a drop in investment from the EU due to increased barriers and decreased cooperation and finally a lack of energy security by acting as an independent player in an environment where there are multiple threats and risks involved.

Figure 3: Energy Import Dependency in the EU

Figure 3: Energy Import Dependency in the EU

 

The research referenced by the Government, acting as the basis for the speech, was completed by Vivid Economics for the National Grid. Its headline statement is that if Britain ends up leaving the Internal Energy Market it could force up energy costs by £500million a year by the 2020s[5]. These costs come from a broad range of areas (see Figure 3) including decreased liquidity and storage, both affecting the UK’s ability to cover short term increases, and decreased trading in cross border markets increasing the difficulty when managing capacities.

The paper goes on to state that facilitating investment in the UK’s energy network and supply chain would face some obstacles, particularly in relation to financing and the cost of imported equipment, labour and services.

Figure 4: Energy Dependency in the EU 

Figure 4: Energy Dependency in the EU

After discussing the results of the Vivid Economics paper, the speech went on to discuss the potential state of UK Energy security outside of the EU. It stated that outside of the EU, the UK may be more at risk to the energy security threats, specifically stating the example of gas imported from Putin’s Russia. The Government referenced expectations that even with developing the potential of the UK’s Shale Gas, the UK will likely import nearly 75% of its gas needs by 2030. With Russia using its position as Europe’s largest gas exporter to apply pressure in an attempt to achieve foreign policy objectives, there was an emphasis to “continue to work with our closest neighbours to deliver energy security in the future”.

A highly politicised argument

When discussing the EU referendum, especially when concerning the current Government, it is always prudent to look beyond the initial speech to determine the underlying position of the person giving it. In the case of this speech in particular, there are several relationships behind the scenes[6] that made it rather unlikely to expect arguments for leaving. In the days following the speech, several critics made sure to point this out when rebuking this argument.

Roger Harrabin, a BBC environment analyst, has criticised the Government’s claim stating that it would be unlikely for energy from the EU to become more expensive, as countries would need to take decisions against their own interest (such as cutting off connecting pipelines and electricity interconnectors[7]). This, at a time when Europe as a whole is suffering from shortages, becomes increasingly unlikely. Critics of the Government also disputed the impact that Russia could have on the UK’s Energy Security as very little gas is currently imported from Russia and the UK has a large, diversified source of supply including its own production and Norway’s. They went on to highlight the fact that, in the event of the UK leaving the EU, the UK would be free to strike bilateral trade deals with any and every major energy supplier, possibly improving on the currently available situation.

The truth behind the claim

As shown, there are several elements of the Government’s position that demonstrate a political wish to remain within the EU. However, there are several factors, some mentioned and some left unmentioned, that provide inherent risks to the UK Energy Market, and its consumers.

1 – Impact on energy security and access to the continent’s Energy markets

As was correctly argued by the Leave campaign, the comment that leaving the EU would leave the UK worse off at the negotiation table with Mr. Putin’s Russia is largely irrelevant given the negligible dependency that the United Kingdom has on Russia to source its natural gas supplies (dependency on Russia for crude oil and condensate stood at 8% of demand in 2014)[8].

More generally, the UK’s dependence on imported primary energy products is significantly less than the average of the 28 European members. The UK benefits from diverse and extensive gas import infrastructure (holding 25% of European LNG import capacity), balanced exposure to import sources (see figure 5) and overall a well-balanced energy mix[9].

Figure 5: Sources of UK gas supply 

Figure 5: Sources of UK gas supply

Assuming that, in a Brexit scenario, European and EEA trade partners (namely, Norway) will not “punish” the UK with heavy import quotas and tariffs on energy imports, access to primary resources at a reasonable price will not be restricted.

Restricted access to the European electricity network, the Government’s second argument against leaving the EU, could however prove to be a larger issue with respect primary resources access. If the UK were to leave the EU, the membership of the Internal Energy Market (which removed a number of obstacles and trade barriers and provided tax and pricing policies as well as environmental and safety regulations[10]) would need to be renegotiated or reformed.

Today, spare electricity capacity in the UK is at an all-time low (spare supply was 1.2% during winter 2015) and National Grid is effectively paying large energy users to limit their energy use and artificially increase that margin (to about 5%)[11].  

Figure 6: Sources of UK gas supplyFigure 6: Sources of UK gas supply

Source : Royal Engineering Academy, 2013

It is on this specific issue that the UK stands to benefit the most, by retaining access to European electricity markets. Interconnectors between the British Isles and mainland Europe will continue to play an increasingly important part in balancing the UK market and provide larger spare capacity, as coal and ageing nuclear plants are phased out (see figure 6). Basing their decision on the current situation, Ofgem has forecasted a significant increase in imports of electricity from the EU for the 2016/17 winter (1.1 GW net imports up from zero the previous winter)[12].

Through its interconnectors the UK is part of the day-ahead price market coupling program which connects 17 European countries and allows it to gain access cheaper electricity, balance the national grid, access greener power from integrated renewable sources and count on a source of power that is more reliable than most forms of generation (availability >90%). A study from National Grid[13] found that doubling interconnection capacity will save UK consumers £1bn yearly by 2020.

Keeping the benefits of electricity interconnections in mind, leaving the EU can, potentially, have two serious effects on the UK’s resilience to electricity demand or supply shocks:

  • Firstly, should access to the European Market Coupling program be restricted, Britain would suffer by losing many of the benefits brought about by interconnectors. Most importantly, should import tariffs and quotas be levied on electricity trade the economic rationale for these merchant interconnectors might be lost.
  • Secondly, the UK would not be able to benefit from EU support on the 26 Projects of Common Interests (PCI), some of which are planned interconnectors benefitting Britain, that the EU co-finances with grants (often to 50% of the project value) and that are meant to improve the UK’s energy security profile.

Finally, in abandoning its membership to the EU, the UK will put into question it’s adherence to the various European bodies and development funds which it is a part of today. The EU Cohesion policy, for instance, provides co-financing opportunities that are aimed to further energy policy objectives in the United Kingdom. In the period spanning from 2014 to 2020 the EU Cohesion Policy has earmarked £1.6bn to allocate for the realisation of energy efficiency, decarbonisation, R&D and the development of smart grids and storage projects[14].

The impact that a Brexit scenario would have on the energy security profile of the UK is, therefore, very dependent on the form and shape that collaboration would take between the former partners. With the already tenuous state of the relationship between EU nations, and the increase in separatism from Scotland to Catalonia, the EU may not be in a position to grant a favourable deal to an exiting UK. While all sides of the debate are basing their argument on speculation, it is likely that the EU will need to take a stronger approach to renegotiation with the UK in order to maintain some semblance of order within its remaining ranks. Should Europe, choose to take a hard stance in its negotiations with the UK, a significant worsening of energy security in the UK is a strong possibility.

2 – The UK’s Energy Regulation outwith the EU

A common statement of those wishing to leave the EU is that the additional regulation applied by the European markets and the Commission applies additional, unnecessary, costs directly to the UK. In fact, when discussing the alternative to the Secretary’s position, the Leave campaign cited research that stated that EU Energy Regulation cost the UK between £86.6bn and £93.2bn[15]. However, there are two points that may limit or nullify any savings expected from a scenario where the UK left the EU.

Figure 7: Impact Assessment of EU Regulation

Impact Assessment

Total Cost (Lower)

Total Cost (Upper)

Total Benefits (Lower)

Total Benefits (Upper)

Net Costs (Lower)

Net Costs (Higher)

EU Renewable Energy Directive

£98.9bn

£119.1bn

£6.2bn

£12.4bn

£92.7bn

£106.6bn

EU Climate & Energy Package & EU Emissions Trading Systems Directive

£20.6bn

£20.6bn

£9.2bn

£9.2bn

£11.4bn

£11.4bn

Directives concerning the Internal Market

£2.0m

£4.5m

£0

£0

£2m

£4.5m

Proposal to recast the Basic Safety Standards Directives

£124.2m

£127.8m

£0

£0

£124.2m

£127.8m

Industrial Emissions Directive (IED)

£3.4m

£20.6m

£0

£0

£3.4m

£20.6m

Regulations on the transport of radioactive waste

£0.7m

£0.7m

£0

£0

£0.7m

£0.7m

Energy End-Use and Services Directive

£377.3m

£378.2m

£547.8m

£551.5m

-£170.5m

-£173.3m

Oil Stocking Order

£126m

£126m

£554m

£554m

-£428m

-£428m

Energy Products Directive

£1.2bn

£1.7bn

£4.9bn

£6bn

-£3.8bn

-£4.4bn

Planning for Nationally Significant Infrastructure

£200m

£200m

£4bn

£5bn

£3.8bn

£4.8bn

Energy Performance of Buildings Directive

£7.1bn

£8.6bn

£9.9bn

£30.3bn

-£2.8bn

-£21.7bn

Totals

£128.7bn

£150.7bn

£35.4bn

£64.1bn

£93.2bn

£86.6bn

 

Source: Business for Britain

Firstly, it is important to consider the content of EU Energy Regulation, the majority of which consists of climate change, environmental and safety regulations. When stating that the costs of EU Energy regulations could be saved, much of these savings (if possible at all) would likely come from scrapping renewables targets (see Figures 7-8) set out under the EU Renewable Energy Directive[16] or from withdrawing EU legislation that constrained the UK to higher cost technologies, releasing the UK to make decisions on the environmental impact of its energy usage.

This leads to the belief that any savings would likely come at the expense of a higher carbon energy policy, looser environmental and safety regulations and the associated, intangible costs. It is also important to understand that as the UK’s domestic commitments to reducing emissions, coal closures and renewables are similar or stronger than current EU requirements, the UK would have to back down on its own regulations in order to make the referenced savings.Figure 8: EU Countries Renewable Energy performance Secondly, conventional thinking is that the easiest way for the UK to continue dealing with the EU Energy markets would likely be to negotiate some form of continued membership of the Internal Energy Market, the European Free Trade Association (EFTA) and the European Economic Area. When considering that these organisations were built on the idea of common standards, it is extremely unlikely that the UK will be able to negotiate a membership with which they will not be required to match these standards, the very regulations they are hoping to avoid.

3 – Energy investment

The final, and probably most certain, outcome of the hypothetical Brexit scenario is the impact on investment within the UK. As with the Scottish Independence referendum, the Remain/Better Together campaign has been largely focusing on the effects of the referendum on investment confidence. From the perspective of an investor, in order to incorporate the increased risk of poor post-Brexit conditions, higher returns are required. This increases the cost of financing, raising the cost of investment in the UK through this lack of confidence.

Figure 9: UK Trade Deficit in 01/2016

Figure 9: UK Trade Deficit in 01/2016

What must also be taken into account is the ability of the pound to pay for the investment needed in the UK’s Energy sector. When considering that the UK is a net importer (to the amount of £9.5 billion in January 2016[17] - see Figure 9) a large extent of the goods and services needed for the improvement of energy infrastructure will need to be brought in from abroad. What is clear from the EU referendum so far is that it brings uncertainty, and this uncertainty has so far affected the pound negatively[18] (see Figure 10). Major institutions such as HSBC and UBS[19] suggesting that there is enough downside potential in the sterling for it to reach parity with the Euro should the UK choose to leave. This devaluation of the pound will increase the cost of imported equipment and services for any work within the Energy Sector.

Figure 10: GBP to EUR Historical Exchange Rate 

Figure 10: GBP to EUR Historical Exchange Rate

The possibilities for increased import costs have been modelled here, in Figure 11. In February 2016, the UK imported just under 25 billion Euros worth (24.98bn EUR) of goods and services from the EU[20]. That cost the UK, via an average exchange rate of approximately 1.288, £19.4 bn.

Figure 11: Exchange Rate scenarios

Figure 11: Exchange Rate scenarios

The other examples in the model are what that same quantity of goods/services would have cost at different exchange rates, from a minimum of £18.1bn at the 2015 average[21] (before the pricing in of Brexit risk) to a top figure of £24.2bn based on HSBC’s worst case scenario of a 20% slide in sterling if Brexit were to occur. If this drop in sterling were to occur, the cost to the UK could be as much as £4.81bn a month, making goods and services upwards of £57bn more expensive over the course of year.

Figure 12a: UK Energy Gap

Figure 12a: UK Energy Gap

While several large companies and a long list of SMEs have stated that being outwith the EU would either improve their investment opportunities, or at least retain the status quo, the common opinion is that such a drastic change in the UK’s regulatory and market environment would lead to at best hesitation, if not more likely a distinct decrease in direct investment. In the current Treaty, from the point of notifying the European Council of the result there would be a 2-year period in which Britain would negotiate the terms of its withdrawal.

Figure 12b: UK Energy Gap

Figure 12a: UK Energy Gap

When considering the Energy Market in particular, with the upcoming closure of several plants and the impending supply gap[22] (a gap equating to the equivalent more than 146 million tonnes of oil), a pause of energy related investment for two full years (at a minimum) would drastically increase the UK’s supply deficit, heaping further pressure on any possible negative impact of the renegotiations. As with all elements relating to the referendum, there is no certainty. However, this time spent negotiating is very likely to hinder investment, right at the time when the UK Energy Market needs it most.

Conclusion

In conclusion, a vote for the UK to leave the EU will, without a doubt, have a profound effect on the UK Energy Market. The combination of increased investment costs, through both decreasing confidence and the buying power of the pound, and the extent of the infrastructure work that is required to deal with the approaching “Energy Gap” are an unavoidable issue in the event of Brexit. What is less predictable is the impact of the result on regulatory and trade conditions which will largely be determined by the resulting negotiations and whether the UK remains a member of the Internal Energy Market. The cost or benefit of these changes will only be known when the dust of the negotiations settles, however if the UK were to scrap EU renewables and environmental targets in order to achieve savings, this would not only put the UK at odds with Europe but also the rest of the western world.

 

Copyright © 2015 Sia Partners - Aneurin Gordon


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