Brexit uncertainty: what are the implications for the energy sector?
12 September 2017
On 23 June 2016, the UK voted to leave the European Union. There are a number of Brexit outcomes that could be considered plausible, each reflecting differing priorities of negotiating parties, on issues of market access, and political and institutional sovereignty.
We explore what the implications might be for energy and climate policy in the UK and the EU, by taking stock of the analyses and think pieces published in recent months by a range of experts. We consider the following issues from both a UK and EU perspective – infrastructure investment, energy markets and interconnection, legislative uncertainty, and political influence.
While we focus on these sector-specific issues, it is worth noting that climate and energy policy will more broadly be impacted by the wider economic situation that prevails.
Energy infrastructure investment
The UK electricity system is undergoing significant transition, with all of the existing coal and nuclear generation capacity set to close in the 2020s, and a shift towards a decarbonised system through increasing investment in renewables, and new nuclear.
According to UK projections, generation from fossil fuels will drop from a 60% share in 2015 to around 13% in 2035. Coal, which is set to be phased out by 2025, and nuclear, with all current capacity likely closed by 2030, account for 48% of electricity supplied in 2015.
As a result, large-scale investment is required in the electricity system infrastructure (generation and networks), with an estimated investment pipeline for the sector of over £140 billion, with over £40 billion by 2020/2021.
A key risk to these system investments is the higher cost of financing arising from uncertainty. An analysis by Vivid Economics suggests 100s of millions of pounds in additional financing costs due to near term uncertainty, risking project delay and compromising system security.
In addition to the increased cost of investment, there is potential for a loss of momentum in developing new renewable energy (RE) projects if foreseen to be outside of the established framework provided by the RE Directive. There could also be implications for replacing the UK’s nuclear capacity.
UK energy projects may also lose access to the preferential loans from the European Investment Bank, which amounted to €1,872 million in 2015, and to funding and guarantees from the European Fund for Strategic Investments, which, for example, have been granted to the UK smart meters roll-out project. Finally, another financial-based risk is that any devaluation of Sterling would increase the costs for importing materials (and labour), thereby making energy infrastructure projects more expensive. This downside risk may be offset by increased foreign investment, as UK assets and companies become cheaper.
In the longer term, the imperative to build new capacity (to ensure reliable electricity supply) and push towards a decarbonised system should occur under any of the Brexit outcomes. However, the costs of doing so may be higher if the UK is unable to fully benefit from the Internal Energy Market (IEM), or deliver the interconnection projects currently foreseen, as described next.
Functioning of energy markets and interconnectors
Given the UK’s pioneering efforts to liberalise energy markets, its status of large gas producer and highly liquid gas trading point and the increasing interconnectivity of its electricity transmission system to Ireland and continental Europe, the UK undoubtedly plays a central role in the functioning of the IEM, as well as in the design of its rules.
Given that the infrastructure will remain in place, cross-border trading of gas and electricity will undoubtedly continue irrespective of any Brexit scenario. Interconnectors will still be used to carry energy from low-priced to the high-priced bidding areas. The introduction of border tariffs for energy products is unlikely. Nonetheless, there is a chance that the EU network codes aimed at fostering the efficiency of trading cease to apply post-Brexit.
The impact on gas markets would be minimal considering that the UK and the rest of Western Europe have diverse supplies and that gas markets are already well-integrated, with low price differentials and no congestion at the UK interconnectors. Risks would be more acute for electricity markets.
With less market integration, grid resiliency would be reduced. The UK and its EU neighbours would need to rely more on costlier domestic back-up capacity and would forego the possibility of more efficient distribution of the region’s intermittent renewable production and greater price stability on national power exchanges.
Profitable transactions would be missed without market coupling. Wrong-way flows (i.e. flows inconsistent with the price differential) and sub-optimal use of cross-border capacity would increase in frequency.
Excluding the UK from the cross-border balancing initiative would also imply higher service costs for the national TSOs. Finally, if cross-border interconnectors can no longer participate in capacity markets, UK customers will have to rely on more expensive domestic resources to guarantee their security of supply.
The Vivid Economics’ study suggests that losses from these various market integration initiatives would be significant (~£260m pa by the early 2020s), but relatively small compared to the UK’s overall electricity supply costs.
Implications for the Irish energy system
Since 2007, NI and IE operate a single wholesale electricity trading pool – the Single Electricity Market (SEM). The SEM operates in multiple jurisdictions with dual currencies and represents the first market of its kind in the world. A reform of the SEM is currently under development to ensure compliance with the Electricity Target Model and the new proposed market is called I-SEM or Integrated Single Electricity Market.
In its August 2017 position paper on Northern Ireland and Ireland, the UK government noted that negotiations with the EU will need to cover how best to avoid market distortions within the single electricity market following UK exit, and ensure that future legal and operational frameworks do not undermine the effective operation of an integrated market.
It was also proposed that a new framework relevant to the energy market in Northern Ireland and Ireland should seek to provide certainty on energy arrangements as soon as possible.
While Brexit should not put the current SEM at risk, the new I-SEM may face uncertainties, although this is unclear. The project is viewed as beneficial for the Island of Ireland and regulators from NI and IE have recently confirmed their intention to launch the I-SEM by May 2018.
However, the functional operation of the market may become more complex after Brexit, with potential challenges around market rules for dispute resolution and customer data protection, for instance.
The SEM is connected to the GB electricity market with two interconnectors. These linkages may expose Ireland to the vulnerabilities of the post-Brexit GB electricity system and influence decisions for further interconnection from Ireland to mainland Europe.
Security of supply is also a concern with regards to oil and gas supplies, for which Ireland is mainly dependant on UK transit. The UK will no longer be bound by EU legislation on the sharing of energy resources under tight supply conditions.
Without the EU 2010 Regulation on gas security of supply, there would be higher risks that the UK takes unilateral actions affecting supplies to Ireland in times of crisis. Likewise, the share of Irish oil stocks currently stored in the UK may need to move if the 2009 oil stocks Directive cease to apply to the UK.
UK energy and climate policy is closely tied to that which has been developed at the EU level, such as obligations to meet specific renewable energy targets, or delivery of domestic climate target via the EU ETS. There are real risks of repealing specific legislation on energy and climate obligations, particularly as a key argument of leave supporters was to remove the additional cost of EU rules.
The Committee on Climate Change (CCC) estimate that policies agreed by the UK at EU-level have contributed around 40% of the reduction in UK emissions since 1990. Furthermore, they estimate that EU policies, subject to strengthening, would cover 55% of the emissions reduction required in the UK to 2030, reducing the identified policy gap. Therefore, repealing or weakening of the legislation could impact on the policy package required for achieving climate targets.
Another perspective is that EU membership actually does not benefit UK climate policy. This is because domestic emissions reduction targets are relatively more ambitious, and policy instruments such as the EU ETS, while allowing for cost-effective compliance for UK industry, are not considered effective in decarbonising the sector.
If the UK were to leave the EU ETS as part of the negotiated agreement, it would mean that it could no longer tie its carbon budget setting for the currently traded sector to allowances under the scheme.
Domestic budget setting in the absence of the EU ETS would need to be determined on territorial emissions alone, and would perhaps benefit from lower levels of uncertainty concerning allowance levels in future years, and as some have argued for, be dependent on domestic action alone without opportunity for offsetting by other countries.
There would also be implications for Member States remaining in the EU ETS. Given that the UK is a net buyer, its withdrawal could see prices, already low, dropping further. There are also the transaction costs associated with re-adjustment of the EU wide cap, and administration of the scheme.
More broadly, it is questionable whether the EU can meet its 40% emission reduction target by 2030 without the UK on board. Even in the case of a downward adjustment, the EU may face a difficult negotiation across the EU27. The UK progress in mitigation is higher than the EU average, which means that the remaining Member States will need to accept a commensurately larger share of the burden.
All Brexit outcomes are likely to lead to a new political balance within the EU, which will influence future EU energy policy. The UK has been recognised as a leader in terms of stated climate ambition, and been an important proponent of initiatives such as the Internal Energy Market, as an early mover towards liberalisation.
Within Europe, on climate policy in particular, there is a question as to whether the EU would lose some of the political momentum brought by the UK, particularly at a time when it is most needed, post-COP21.
It could also shift away from the more market-based approach to energy and climate policy, supported by the UK, and potentially move forward with policy steps that were opposed by the UK, such as mandatory national targets for renewables, a more ambitious energy efficiency target or greater oversight powers for the European Commission in the context of the Energy Union project.
On the international stage, there is a question as to whether the UK would bring such clout without moving en bloc with its European neighbours. Specific commentators suggest that under any Brexit outcome, the UK would lose influence.
With recent political changes in the USA, strong leadership on this issue is at a premium. However, post-Brexit, the UK will need to find its global voice, and the climate agenda could be one on which it can perhaps speak with clarity.
The overriding challenge for the UK’s energy sector will be dealing with the ongoing uncertainty around the eventual outcome of Brexit, and the impact this has on the investment for new generation capacity and associated infrastructure needed.
As stated in his recent evidence to a Parliamentary select committee on the implications of Brexit, Prof Michael Grubb stated: “We deal with the fundamental challenge that energy is a very long-term business and what the industry wants more than anything else is certainty against which to invest.”
It is fair to say that climate and energy policy did not feature heavily in the referendum campaign on either side (although it is true that Brexiteers appear disproportionately lukewarm on climate change). While an exit could mean the UK would have greater flexibility in energy and climate policy, e.g. on state-aid rules or capacity markets, there is a question as to whether that greater flexibility would better help achieve UK energy and climate goals.
The IEM is likely to help with system flexibility both in the UK and for the wider EU. Isolating the UK from the rest of the European electricity system would require more domestic investments to maintain security of supply in a context of rising intermittent production.
In addition, EU legislation provides a ‘double lock’ for UK climate policy, bring more stability and predictability for investors. And if the Energy Union succeeds, the UK and other Member States are likely to meet their goals most effectively as a bloc.
You can hea Marie Donnelly, Former Director, DG Energy, European Commission and David Carson, Partner, Brexit Lead, Deloitte speak at the upcoming CPD Seminar: Applied Project Management in Uncertain Times.
Paul Deane and Steve Pye are with the Energy Policy and Modelling Group, MaREI Centre, Environmental Research Institute, University College Cork. Pye is also a senior researcher at the UCL Energy Institute, University College London. Carole Mathieu is a research fellow at the Centre for Energy of the French Institute for International Relations. The original version of this article is available online at Insightenergy.org.