February 16, 2017    5 minute read

The Upcoming Shock to the System

Gathering Storm    February 16, 2017    5 minute read

The Upcoming Shock to the System

In June 2016 Britain decided to leave the EU. So far, neither the UK’s economy nor its economic indicators have collapsed, despite what many had feared. However, it would be a mistake to assume that all the so-called ‘experts’ were wrong. The pound has taken the full brunt over the period, losing significant value, with some calling it an ’emerging market currency’.

The difference between the yen’s weakness and the pound’s is that one could hardly call Britain a currency manipulator. That said, it was a self-imposed decision, much like the Bank of Japan’s QE program – although QE in the UK hardly weakened the pound simply because everyone else was doing it too.

Delayed Impact

As with most economic crises, the negative impacts are not felt until some weeks later. When an earthquake occurs, the earth itself cracks, but that can unleash a significant tsunami, which in many cases does more damage than the earthquake itself. Brexit will have the same effect on the UK. The question is, which areas will be impacted the most?

The UK’s major sectors are finance and energy. The financial sector has, of course, received great coverage mainly because it is many more times bigger than the nation’s income. Energy is also a big issue.

The drop in the pound will result in higher imported costs for large firms, which in order to maintain similar margins for shareholders, will have no choice but to pass that cost onto their customers. This fact rings true not just for traditional retailers like Tesco or Zara, but for energy providers like EDF supplying electricity to households nationwide.

Who’s Paying the Bill?

A weaker pound creates higher costs, which by itself creates higher inflation as prices passed onto consumers are increased to compensate. The Bank of England forecasts inflation to rise significantly over the short/medium term, which will be accompanied by an increase in interest rates, slowing an already fragile economy.

For the energy sector specifically, this poses significant challenges. Many of the UK’s energy infrastructures are highly dated. Power stations across the country need to be revamped or dismantled completely. Currently, Britain’s largest energy project, a new state of the art nuclear power station being built by EDF, is going ahead due to Chinese investment. This was planned and negotiated a long time before the Brexit vote occurred, but EDF is committed to the project, mainly because they have already invested significant amounts of time and energy into the case.

But could this be the last large investment from an overseas investor? It is unlikely, but returns on investment will be higher to compensate for higher risks. As with any business proposition, this hurdle rate could be the difference between a project going ahead or not.

UK Trades

Although cost increases are important, particularly the importing of equipment from China or elsewhere in Europe, the degree of access or ‘market integration’ will be the main decider of Britain’s energy future.

At the current time, Britain is part of the Internal Energy Market (IEM). Leaving this would put in jeopardy the gains from trading electricity overseas and often with all of these things, the main party to be disadvantaged will be the person on the street.

Greater costs in trading from tariffs create less competition for both the EU and the UK, stifling innovation and capacity. Furthermore, because costs are higher, future investment in cross-border trading infrastructure will decline due to the lack of/lower returns for such projects. The costs imposed on the UK for exclusion from the IEM is estimated roughly to be £500m per year by the early 2020s.

Britain, however, could maintain membership in the IEM, similar to Norway’s arrangements. Exiting altogether would be the Switzerland scenario. The key issue is that because Britain’s infrastructure needs significant improvements over the next decade, any increase in the cost of funding will be material, not least as a result of a plummeting currency.

One Advantage

On the flipside, Britain is already taking the switch to renewables far easier than the EU as a whole. The UK has committed much longer to the sector with planned expenditure going to 4GW of offshore wind farms over the next 15 years. The introduction of the contract for difference, which replaces the renewable obligation contracts, should continue to encourage renewable investment take up.

In the household market, the continued feed in tariff scheme that pays people for producing solar power should again maintain its momentum.

Another big global issue is climate change, but the UK plans are roughly similar to the EU 2030 package, according to the latest report by Vivid Economics. As a result, the market should not slow materially over the coming years. That said, those plans were based on the status quo – i.e. being in the EU.

Conclusion

The industry is sitting and waiting for the politicians to do some work. Those benefitting will be the firms who embrace uncertainty and innovate bespoke power plants. The reason why many developed nations fall behind the typical emerging ones is the investment in current technology.

There is no incentive to invest in a new underground rail system if the 1960s version is still running, just. The investment will come when the system collapses, and there are casualties. Rather than waiting for the inevitable, developing new technologies now is key to prosper in the future.

Having the ability to get a power plant up and running in the time it takes to turn on your laptop will be the winning formula, particularly as the national grid increasingly prefers speed over cost to balance the system.

Time will tell the full extent of Brexit’s impact, but one thing’s for sure: Britain will receive a shock to the system.

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