July 8, 2016

Brexit: Dark days for the UK energy industry?

On 23 June 2016 the UK electorate voted to leave the EU. Much water will pass under the bridge before Brexit occurs; and some commentators wonder whether the result of the non-binding referendum will, in fact, be translated into constitutional reality. This means that, to quote 90’s rock band Oasis, “all we know is that we don’t know”: we don’t know when the UK will leave the EU, and more to the point, what the terms of the UK’s new relationship with the EU will be.

Consequently, predicting the consequences of Brexit for the UK energy industry is as problematic as predicting Boris Johnson’s future political career. Much will depend on two factors:

A: Whether the UK strikes a new deal which continues to provide access to the Internal Energy Market (“IEM”)

If the UK joins the European Free Trade Association (“EFTA”) or the European Economic Area (“EEA”), or gets its own deal on similar terms, this would probably mean that the UK would remain part of the IEM and would continue to incorporate the principles of the Third Energy Package into UK law. If this happens, then little is likely to change. However, such an arrangement would probably require the UK to agree to the continued free movement of workers, as well as accepting EU laws and rules on competition policy and state aid, and to the UK having to contribute to the EU budget. Therefore it is possible – likely, even – that the UK will leave the IEM.

B: The effect of Brexit vote and Article 50 negotiations on the UK and European economies

The immediate reaction of the markets to the Brexit vote was negative: the FTSE and Sterling plummeted. The UK's credit rating has been downgraded by two key ratings agencies, and the Governor of the Bank of England said that the UK economy faced a "deteriorating outlook". EU member states' economies have also been hit hard, and it remains to be seen how the Eurozone's growth – which has been sluggish to say the least – will be affected by the departure from the EU of the EU's second-biggest economy by GDP and a significant contributor to EU funds. 

Although these points are obviously interconnected, they are considered sequentially below.

1. Leaving the IEM

The IEM employs a number of "market integration initiatives": market coupling (packaging electricity with interconnection capacity); cross-border balancing (where transmission system operators balance the differences between supply and demand by accessing energy in other member states) and cross-border capacity mechanisms (state schemes to ensure sufficient electricity supply to meet peak demand, e.g. the UK's Capacity Agreements). These would become matters for domestic energy policy after withdrawal from the EU, and UK-EU interaction would be dependent upon the negotiation of specific arrangements.

Existing gas and power interconnections between the UK and EU might be affected in the sense that the relevant EU regulatory framework would have to be replaced with a bilaterally (UK/EU)-negotiated replacement regime.  There may be a need to renegotiate some specific terms and existing contractual arrangements as well. Investment in new interconnector projects might be deterred by adverse economic conditions and uncertainty over the UK's right to access the single market and in particular whether these new interconnectors would be entitled to enter EU capacity market auctions.  This would detrimentally impact on the UK's energy security, which would be further threatened if a post-Brexit, post-IEM UK is excluded from the EU's "Energy Solidarity" initiative, under which EU member states agree to supply gas to their neighbours in the event of a gas supply crisis.

The EU requires member states to increase renewable use and cut CO2 emissions, and if the UK left the IEM these requirements would not apply. Moreover, the UK would not directly participate in the EU Emissions Trading System ("ETS") unless a new arrangement can be negotiated. However, in reality this is unlikely to have any effect on the UK - the UK's emissions targets are already more ambitious than EU-imposed targets (the Climate Change Act 2008 provides for the UK to cut its carbon emissions by 80% on 1990 levels by 2050 and to set "carbon budgets" every five years).  Moreover, the UK would still be bound by the United Nations Framework Convention on Climate Change and the Paris agreement ("COP21").

Similarly, the EU Industrial Emissions Directive 2010 (which requires new power plants to comply with strict emission caps and old plants to close or to reduce emissions) would no longer apply. However, the UK government has announced plans to close all coal-fired power stations by 2025 and so, again, this is unlikely to have a major impact.

The UK's departure from the EU might, however, detrimentally impact on the EU's ability to achieve its emissions targets because the benefit of the UK's renewables/low-emissions industry will not count towards the EU-wide figure. Other Member States may have to agree to make greater emission cuts as a result.  Moreover, since the UK's utility companies are some of the largest buyers of carbon allowances for the ETS, withdrawal of these players could damage the functioning of the ETS market.

2. Economic downturn

Uncertainty over the UK's access to the single market while Article 50 negotiations are underway could well cause an EU- and  UK-wide recession which would be likely to reduce demand for all forms of energy – electricity, oil and gas.  That would have knock-on effects on price and hence profitability, which in turn could decrease investment in new projects and increase disputes and insolvencies. If the UK does not negotiate continued access to the single market, then after the UK's departure from the EU, tariffs and import taxes might be introduced by both the UK and the EU, worsening economic problems.  EU-based electricity and oil & gas companies might be dissuaded from investing or even from continuing operations in the UK.

Ironically the UK oil & gas industry, which is relatively isolated from EU regulation and therefore on the surface less likely to be impacted by Brexit, might feel the effects of Brexit most keenly. As the Wood Review and a recent PwC survey found, even before the EU Referendum when the economy was comparatively buoyant and stable, various factors including the global drop in the oil price were exerting considerable economic pressure on the UK Continental Shelf ("UKCS") oil & gas sector, with some smaller players going into administration and tens of thousands of job losses. A Brexit-inspired recession would surely put even more pressure on the UKCS oil & gas industry, which many feel is close to a significant slowdown in any event.

The potential general economic downturn could be exacerbated by the loss of EU funding for UK energy infrastructure projects (e.g. offshore wind farms), which as "projects of common interest" would have been eligible access to financial support from the EU. 

However, this might be ameliorated by the fact that, unless the UK adopts an EEA/EFTA-type arrangement, EU state aid rules would no longer apply to the UK and hence the UK would have greater independence to allocate state funding for energy projects (albeit still having to comply with the WTO subsidy regime).  One of the rather surprising outcomes of the recent PwC survey into the UKCS oil & gas industry was that some industry players favoured a state-sponsored "super-joint-venture" structure to spread the costs of ownership, operation and decommissioning of infrastructure, or even re-nationalisation of the industry. That might be a more realistic possibility in a post-Brexit world.

3. Scotland

To add to all this uncertainty, there is the Scottish question. The majority of the electorate in Scotland voted in favour of remaining part of the EU, and there have been renewed calls for a second independence vote.  A new independence referendum would resurrect 2014's arguments about which country would be entitled to the revenues from UKCS oil & gas, and who would foot the decommissioning bill.

However, the impact on the UK's energy market would be bigger than that. Scotland produces 26.4% of the UK's renewable power generation and so independence would impact significantly on the remainder of the UK's ability to achieve CO2 targets. Two of the UK's "Big Six" energy companies - Scottish Power and Scottish and Southern Energy – are headquartered in Scotland, and Scotland is a net exporter of electricity.  There would therefore be significant repercussions for the UK energy market if the Scottish nationalists won a second independence vote.

Interestingly, there have also been calls for the EU to accommodate Scotland's continued membership of the EU. Could the UK (Scottish?) North Sea oil & gas industry be saved as Aberdeen becomes a trading hub for EU-based companies, funded by EU subsidies? Could an independent, EU-member Scotland use EU funding to further develop its renewables industry and export clean power to the UK and Ireland – and maybe even the continent, via a new interconnector? The scenario is unlikely, but perhaps an up-beat point on which to conclude this exercise in crystal ball-gazing.

4. Conclusion

It is impossible to forecast the impact of Brexit on the UK energy sector. It seems safe to assume that economically it is in for a bumpy ride over the next two years, and consequently the number and identity of participants in the sector might not be the same when the terms of the UK's departure from the EU are finalised. Beyond that, the energy sector is facing that most terrible of outlooks: uncertainty.