Brexit and the Internal Energy Market – what should we expect?

By Ryan Gordon

So what might a future EU/UK settlement for the energy sector look like?

The bigger picture

We have, on a positive note, seen a drop in volatility in the financial markets with the announcements of Philip Hammond as Chancellor (who in an attempt to stimulate investor confidence, announced scaling back the austerity legacy of his predecessor) and pro-Remain Theresa May as the Prime Minister.

However this has been largely overshadowed by the economic shock that has been seen. With the UK being a net energy importer, an important question is how consumer prices will be stabilised in the face of this dip in sterling and whether government action towards reaching a favourable outcome will be fast enough to stop panic-buying in the commodity markets.

Whilst shares and sterling have dipped, the commodity markets have largely remained sideways with the biggest concerns being related to the most significant pass-through charges: DUoS, TNUoS, FiTs, the Renewables Obligation and the Climate Change Levy (a recent pre-Brexit supplier-report projected year-on-year increases for all five of these – a combined 47% of the commercial energy bill by 2017/18, with commodities only coming to 34% of the total cost).

These charges may only be set to increase. How much by, is largely dependent on whether the UK is able to negotiate continued access to the Internal Energy Market. However, Theresa May’s “we’re going to make a success of Brexit” optimism combined with a pro-EU Commons majority may be the ideal political catalyst in negotiating this – but until the first reports emerge from the negotiating tables of Brussels, a lot will remain to be seen. So what are the potential outcomes?

The Internal Energy Market (IEM)

The best-case scenario for the UK would be retention of the IEM (‘Norway scenario’) via joining the European Economic Area, which would carry with it (at the very least) an increased cost in energy sector investment. This outcome would result in the UK being bound to the majority of EU law, including the EU Third Energy Package (legislation with the central aim of liberalising the European commodity markets).

The worst-case scenario would involve leaving it (‘Swiss scenario’), which broadly speaking would constitute: decreased market coupling, decreased cross-border trading (capacity), decreased investment, higher energy-infrastructure costs and higher all-round consumer costs (the UK imports price inflation via the weak sterling and cross-border trade tariffs).

In the latter scenario, the National grid are estimating a potential 5% rise in fuel bills, and whilst the introduction of Contracts for Difference (CfDs) and the Capacity Market are targeted towards maintaining capacity up until the early 2020s, security-of-supply beyond then is uncertain.

This is due to both the slow commissioning of gas-fired CCGT plants, and the ongoing trend of low-commodity prices plus increased pressure from Government to move away from brown-energy causing generators to close unprofitable plants. As such, the outcome of this settlement will prove critical in light of the recent IMechE prediction of a 40-55% electricity supply gap by 2025.

Further impacts on the investment climate for energy assets could be exacerbated “by up to several hundred millions of pounds and occur even if the UK stays within the IEM.” And so, we may at this critical juncture see proposed reform of the Levy Control Framework, which has seen a fair share of criticism in attracting foreign investment.

In addition to the potential shift of flows, if a deal isn’t struck, it will be up to the government to ensure that the regulatory vacuum of leaving the market can be quarantined. This would require at the very least:

…the latter two of which (as we’ve seen before) are not resources in abundance when it comes to how Whitehall handles the energy sector. Combined with the Decc/BEIS shakeup and multiple departments of state competing for parliament attention during what could become a very busy period, energy may not find itself high on the agenda unless there is an abject risk of the ‘lights going out.’

So where’s the good news?

As well as the leading role that the UK has played in developing EU energy policy, the degree of interconnectivity between energy systems in the UK and the EU should be a strong enough reason on its own terms for an agreement favouring the IEM, particularly since a lack of an agreement would potentially leave EU member Ireland “out in the cold.”

Also to the benefit of the UK, and currently driving regulation in the commodity markets, are the G20 commitments made at the 2009 Pittsburgh summit which were:

“…at the national and international level, to raise standards together so that national authorities implement global standards consistently in a way that ensures a level playing field and avoids fragmentation of markets, protectionism, and regulatory arbitrage.”

Effectively committing the G20 sovereign states and the EU towards globalising standards in regulation which reduce burden to business and barriers to investment, this should give the government some legal leverage in protecting and maintaining the current regulatory environment for the markets during the costly/lengthy divorce proceedings that are to follow.

On the whole, there is certainly shared interest in maintaining some form of IEM model which retains its core functionality albeit does not require the free movement of labour, and as such can be sold to the British public (a variant of the ‘Norway scenario’).

Through such a hypothetical model, the UK would still enjoy the market benefits and have to comply with EU energy regulation but likely not make EU budget contributions and as such, have no say in policy direction.

Whether EU officials can, for the sake of pragmatism, accept this ‘contradiction on the terms of the EU’ is still an open question that may be slightly weighted towards refusal due to wider political barriers and the risk of EU-exit contagion.

Such a refusal of this would result in the UK being left to its very own ‘self-inflicted Swiss scenario,’ in which the costs incurred due to fewer interconnectors, decreased market coupling and reduced cross-border balancing may be factored into pass-through charges.

By Ryan Gordon, energy auditor, SSE Energy Solutions