Brexit MonitorThe impact on the energy sector

November 2017

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Brexit impact on the energy sectorEnergy policy has been an important aspect of European integration since the creation of the Coal and Steel Community in 1951. In the 1990’s there was significant liberalisation and integration of the EU’s energy markets since the 1990’s and today the UK and EU27 markets are closely connected. Operators1 engage in joint projects in the North Sea, and real-time trade in power and gas across the English Channel is significant. As interconnectivity continues to increase cooperation between the EU27 and the UK becomes vital in any Brexit scenario.

Uncertainty related to Brexit will have two main effects in the energy sector. Firstly, augmented uncertainty increases the perceived risk for operators in the North Sea, which could halt or defer large new investments. And secondly, it may affect the downstream segment as further integration of the electricity and gas markets between the EU27 and the UK slows or comes to a halt.

This highlights the point that not all parts of the sector will be affected in the same way, and some parts of the sector will also be more severely affected than others.

The upstream oil and gas (O&G) sector is a truly globalised industry. Whether we speak about international (IOCs) or national (NOCs) oil companies, they are all global in reach, and accustomed to resisting external shocks and dealing with uncertainty.

Companies in this (sub-)sector navigate political uncertainties – from the deltas of Nigeria to sectarian wars in Yemen – and are used to mitigating such risks. For those players, Brexit constitutes only a minimal risk. On the margin they may be concerned about reduced UK influence on EU policy in critical areas, such as steel tariffs which make up a very large part of costs for capital expenditure for

those players. However, all in all, the oil price remains a more important variable than Brexit for the upstream O&G sector.

For downstream generation and distribution the effects will be very different. Electricity and gas supply markets are significantly integrated within Europe, and a key question is whether the UK will remain a member of the Internal Energy Market (IEM). Across the EU there has been a substantial merger wave with the emergence of a few large pan-European utilities. In this merger wave UK companies have been largely bought up and incorporated into other EU countries’ former incumbents. For those companies further market integration is essential.

If the UK were to leave the IEM, power and gas trades between the EU27 and the UK could be affected. The effects would be most felt on the UK side, which would forgo the benefits of further market integration initiatives, while for the EU this market integration would continue.

In the next section we will look at the macroeconomic effects in the short-, medium- and long-term, and their relevance for the energy sector. Additionally, our last section will address some broader topics of interest to the energy industry, from a commercial and regulatory standpoint.

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Brexit impact on the energy sector 21 Traditional oil and gas operators as well as offshore wind.

Macroeconomic effectsShort-term: exchange ratesHeightened uncertainty was the most immediate effect in the direct aftermath of the UK’s vote to leave the EU. While the impact on stock markets was short-lived, uncertainty has had a more sustained impact on the pound sterling exchange rate.

For the UK consumers the most immediate effect of Brexit is increased energy costs due to a weaker pound, as the UK is a net importer of energy, and imports oil, gas, coal and electricity.2 Higher prices may be particularly felt for oil imports, which are priced in US dollar. UK gas contracts, on the other hand, are stipulated in pounds. While the 20% value loss for the pound sterling that some predicted before the vote has not materialised, the current loss is significant enough for effects to feed down the supply chain.

For oil and gas production in the North Sea, the exchange rate may impact costs and margins. For UK operators, however, this may be rather positive, as a sustained depreciation of the pound sterling may benefit actors that will operate from a lower cost base relative to the US dollar.

Another aspect of the lower value of the pound is the upside it has provided to UK investments projects. The sharp drop of the pound has propelled an increase in UK inbound deals. The total value of the acquisitions of UK targets3 amounted to US$ 98.5 billion in 2017 so far, which constitutes an increase of 16.3% compared to the value of deals completed in the first three quarters of 2016.

For EU funded projects the UK retains its access to sources of EU funding during the two year period leading up to its departure, at least formally. In practise, however, there may be a bias against UK based or cross-border projects involving the UK even in the short term, as increased uncertainty raises the risk profile of these projects.

For EU players Brexit effects remain subdued. In the downstream segment, the UK mainly imports electricity from the Netherlands and France, through two interconnectors IFA (2GW) and BritNed (1GW), and it imports gas from Norway and the Netherlands.4 So far there has been no short-term effects of the sterling drop on EU power and gas prices following the Brexit vote.

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2 ts net import dependency rate was 38.6% in 2015. 3 Across all sectors. 4 Although the direction of the trade varies according to wholesale price differentials.

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Fig. 1 Power prices, the Netherlands wholesale prices (EUR/MWh and GBP/MWh)

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Fig. 2 Gas prices, the Netherlands wholesale gas prices (€/MWh)

Source: Thomson Reuters Datastream

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Day-ahead One year forward

Likewise, volumes of trade in gas between the EU27 and the UK seem so far to be unaffected by the decision of the UK to leave the EU. Trading on the UK’s National Balancing Point (NBP) was initially up after the vote, but volumes have since fallen on all main European markets including the UK, irrespective of any exchange rate effects.5

5 Main markets: the UK, the Netherlands, Germany and France in 2017.

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Source: Thomson Reuters Datastream

Fig. 3 Europe Brent crude spot price (US$ per barrel)

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Medium-term: decline in economic activityIn the medium-term, and as the UK economy slows, we expect UK energy demand to decrease, leading to price drops and some consequences for the EU countries that export energy to the UK. Since the Brexit vote consumer confidence has dropped, and higher inflation is expected to lead to consumer spending growth remaining subdued.

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Fig. 4 UK consumer confidence indicator

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If effects on growth and consumer spending persist, they may trickle through and impact trading volumes in gas and electricity from mainland Europe.6 Overall however, this effect is not expected to have any significant impact on GDP growth in the EU27, and in the Eurozone, which are now on a trajectory to sustained economic recovery, but may yet have a profound effect on specific companies that are particularly exposed.

Also in the medium term, cross-border investments involving the UK, may be hit by lower economic growth and increased uncertainty about regulation, as UK and EU policy may start to diverge. Higher returns may be required to compensate investors for the risk of less favourable post-Brexit arrangements. This could

put upwards pressure on the cost of financing, raising the cost of investment in the UK energy sector.

Once the UK leaves the EU, UK projects, or cross-border projects involving the UK, would no longer qualify for some types of EU funding. In theory however, vehicles such as the European Fund for Strategic Investments (EFSI) could continue to support cross-border projects with neighbouring countries, including the UK.

Overall, effects on growth are expected to be most felt once the UK. leaves the bloc by which time companies, would have had the chance to mitigate effects to the largest extent possible.

6 The Netherlands and France for electricity and the Netherlands for gas.

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Long-term: labour mobility and skillsIn the longer term, decreased mobility and a shortage of skills, particularly in the upstream oil and gas sector, could be exacerbated when the UK leaves the EU. Restrictions on mobility of workers between the EU27 and the UK could become a concern for both workers and companies. This would be particularly true where companies have “off-shored” teams or use shared service centres that currently cover all of the EU. In the future, separate centres and locations would need to be set up for the EU27 versus the UK.

Nonetheless, as remarked above, the oil and gas industry is largely a global industry and is used to dealing with both uncertainty and regulatory complexity. Our expectation is that the industry giants will be able to adapt rather quickly to an environment post-Brexit as they regularly move staff across borders outside and inside of the EU already today.

As such the effects on labour may be most felt by UK workers, and it may have some effect on unemployment rates in the UK. Additionally smaller companies that operate more locally in the UK may face difficulties in attracting the right skills. The effects on EU labour markets are likely to be minimal, as the EU27 remains sufficiently large for there to be a significant skills pool.

Industry topicsWhile the political outcome of the UK’s Brexit negotiations remain unknown, there are a few key variables which actors in the energy sector would be wise to watch.

The UK’s future role in European Energy MarketsWhether the UK will stay in the Internal Energy Market (IEM) post-Brexit is perhaps the most pressing question for companies in the downstream generation and distribution segment.

The UK is an important energy player, but has a relatively isolated electricity market, and is reliant on interconnectors to mainland Europe. Likewise approximately 50% of the UK’s gas imports comes through the EU, making it economically and strategically important for the UK to retain access to EU markets for electricity and gas. Additionally, from a commercial point of view, retaining access to those integrated markets has large benefits due to the price arbitrage that exists between the UK and the EU27.

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While the arguments in favour of greater interconnection, through access to the IEM, are clear, the outcome remains very much to be negotiated as part of the political discussions between the UK and the EU27. Access to markets for electricity and gas depends partly on the broader question of single market access, but not only.

For the UK to be able to participate in the IEM following Brexit, it would need to negotiate an appropriate partnership with the EU, and adopt and comply with the relevant EU legislation.

One way in which this could be envisaged would be similar to the agreement between the EU and the countries in South East Europe and the Black Sea region. Those countries are not EU members but are part of the so called Energy Community, which aims to extend EU Internal Energy Market rules and principles outside the EU’s borders.7

7 The Energy Community is an international organisation which brings together the European Union and its neighbours to create an integrated pan-European energy market. The key objective of the Energy Community is to extend the EU internal energy market rules and principles to countries in South East Europe, the Black Sea region and beyond on the basis of a legally binding framework. Albania, Bosnia and Herzegovina, Kosovo, Macedonia, Moldova, Montenegro, Serbia and Ukraine are contracting parties. Armenia, Georgia, Norway and Turkey hold observer status, with Georgia presently in the process of joining.

Fig. 5 50% of the UK’s gas imports comes through the EU

50%gas imports

UK EU

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Other arrangements could be envisaged, but experience suggests that the EU27 would be more inclined to working within a multilateral framework (as with the European Energy Community) than to adopting a new bilateral approach (as it currently does in its energy relations with Switzerland). Looking at the Swiss example, a bilateral approach may also be less attractive to the UK, as the EU is more likely to demand compliance with the EU’s free movement of people in exchange for full access to the IEM.

In neither scenario, would the UK have a say in the political process to formulate EU policies and regulations. Only if the UK would manage to negotiate to remain part of the institutions which interpret and coordinate EU energy regulations, such as the Agency for the Cooperation of Energy Regulators (ACER), European Transmission System Operators electricity (ENTSO-E), ENTSO-G for gas, and the Council of European Energy Regulators (CEER), could the UK have some say in shaping the direction of EU energy markets in the future. As a precedent some of these bodies already have representatives from non-EU countries.

Moreover, in the context of Brexit negotiations among the EU27, the UK could find ally in Ireland, which is heavily dependent on the free flow of gas and electricity through the UK market. Some observers have remarked that the creation of the Single Electricity Market in Ireland – linking the Republic of Ireland and Northern Ireland – and close cooperation on energy between the UK and Ireland is directly related to the undertakings in the 1998 Good Friday Agreement. Thus the political stakes are high and may work in favour of the UK retaining access to the IEM.

Even so, should the UK, either voluntarily opt out of the IEM, or fail to reach an agreement with the EU27, it is unlikely that the energy sector would be hit by high tariffs post-Brexit. Nonetheless tariffs and transfer pricing are already complicated issues, and for pan-European groups Brexit may complicate things further. Moreover, in the UK, the oil and gas industry remains the largest industrial investor in capital goods and it would be concerned if import tariffs rose even marginally.

The North Sea gridAs member states decarbonise further, interconnection will be vital to trading renewable energy smoothly across borders. At the EU level ENTSO-E coordinates the expansion of the North Sea grid through the Regional Group North Sea, as part of its Ten-Year Network Development Plan. This plan aims to improve interconnection between the separate synchronous power systems located in northern Europe.8

8 The UK, Ireland, Sweden, Norway and North West continental EU (Belgium, Denmark, France, Germany, Luxembourg and the Netherlands). 9 Differing scenarios based on projections by grid operator TenneT and the IABR consortium of the Netherland’s Ministry of Economic Affairs,

Van Oord, Shell, TenneT, Zeeland Seaports, European Climate Foundation, Natuur & Milieu, RWE, Port of Rotterdam Authority and Port of Amsterdam.

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Fig. 6 Current and projected offshore wind generation capacity

At the moment, the UK has more offshore wind powered generation capacity than any other country in the North Sea with 5.1 GW of installed capacity. However, it has relatively little interconnection – only an equivalent of 7% of generation capacity at peak demand, and the UK is planning to increase this significantly. Furthermore offshore wind power generation is set to increase rapidly in the years to come for all countries around the North Sea, including for the UK. In a scenario where offshore wind generation capacity could reach anywhere from 180–250 GW in 2050,9 interconnection across borders becomes more important than ever.

In 2016, the ten countries – nine EU member states plus Norway – signed a political declaration supporting the large scale deployment of offshore renewable energy, and encouraging, not only inter-connection, but also the development of an offshore cross border grid in order to accommodate large scale offshore wind energy.

In the context of Brexit, the UK’s continued membership in ENTSO-E becomes vital for the development of the North Sea grid. With significant expertise in offshore wind power, the UK’s continued involvement would be important for supporting the development of critical supply chains as part of the EU’s plans to reduce greenhouse gas emissions.

180–250 GWNorth Sea countries

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5,1 GWUK 2017

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Source: Thomson Reuters Datastream

Fig. 7 EU ETS emissions allowance spot price (EUR)

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The EU ETS schemeCurrently, the UK is the second-largest emitter of greenhouse gases in the EU, and as a result its utilities are important buyers of permits in the EU Emissions Trading System (ETS) scheme. For this reason the immediate aftermath of the Brexit vote saw a slump in EU carbon prices, but this development was short-lived and should be seen as a loss of confidence rather than a radical change in ETS market fundamentals.

Once the UK leaves the EU, effects on the EU ETS scheme could be significant. A sudden and disorderly exit of the UK from the EU – the ‘no deal’ scenario – could have negative effects on the price of carbon emissions.

In this scenario the EU emission price could take a severe hit, as UK firms would no longer be obliged to hold emissions allowances, and could move to sell them all at once. This threat has prompted the European Parliament to propose changes to the legislation that regulates the ETS scheme in a way that would automatically void emissions allowances issued in a country that is exiting the scheme.

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Needless to say, unless the UK government would move to compensate firms for their losses, it would be much better for companies in the UK holding emissions allowances, if the EU and the UK could agree to transitional and linking arrangements.

However, in the longer term the effect on prices, of the UK leaving the EU ETS scheme, may not be negative. Studies show that prices could even be expected to rise slightly, after an initial price slump, as the market would become scarce slightly earlier. Nonetheless the effects are likely to be small, and the system is expected to remain oversupplied throughout much of the 2020s, with or without the UK.

From a UK perspective, there are pros and cons of remaining in the EU ETS scheme. The UK has been a stark promoter of measures to drive up ETS prices as a market mechanism to regulate greenhouse gas emissions. As such it may want to remain in the scheme, but remaining is also likely to require accepting European Court of Justice (ECJ) jurisdiction – a stated red line of the UK government.

Should the UK opt out of the EU ETS scheme, it could set up its own carbon trading scheme and link this to the EU ETS, similar to the EU’s current set-up with Canada and South Korea. But the UK could also consider other alternatives to reducing emissions, such as a carbon tax.

Whether the UK continues to participate in the EU emission trading system will depend partly on the status of access to the single market, but not only. Because stakes are high on both sides, and there is already considerable alignment between the UK and the EU27 on energy and climate issues, there may be room for a political compromise.

For those forces within the EU27 working to strengthen the EU ETS, there is the risk that without the UK, the pace of reform of the EU ETS may slow if the balance of power in the remaining EU27 shifts.

The UK as a liberal voice in the EUThe biggest impact of Brexit on the EU itself may be for its energy policy as such. The UK has been an important proponent of liberalised EU energy markets and an important voice in shaping the EU’s Third Energy Package, a legislative package aiming to liberalise the European gas and electricity markets.

The question is open as to whether the EU will continue to reform the system in the current direction when the UK leaves. For example, countries in the Central and Eastern Europe (CEE) region hold more conservative views on energy policy, and could wish to see a different direction to both energy market liberalisation and to measures to reduce greenhouse gas emissions, including to the ETS scheme.

EU energy policy may get a stronger regulatory focus, and in the longer term regulation would therefore diverge between the EU and the UK. As such, companies operating in the EU post-Brexit may encounter more Brussels initiated red-tape in an EU where the UK’s voice is absent.

On the UK side, it is unlikely that the UK government’s energy strategy or climate goals would change. The UK government has been at the forefront of both efforts to liberalise markets, and to cut greenhouse gas emissions. Current UK policy is laid down at the national level, independent of Brussels, in the Climate Change Act from 2008.

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In terms of markets, it is likely that the UK would continue to implement and be supportive of many aspects of the Third Energy Package, for example the unbundling requirements, which require the separate ownership and operation of electricity/gas transmission systems and generation, production and supply interests; the level playing field; and the standards of transparency. It might therefore be that differences in regulation remain minimal, at least in the short-term.

However, it is still possible that the UK would choose to drop some specific European measures, such as renewable energy targets or the Industrial Emissions Directive, which controls emissions on power plants. Even small tweaks could be significant for the energy sector in the UK.

All in all, we have seen that effects of Brexit on the energy sector will be most felt in the UK due to slower economic growth and rising costs of investments. For the downstream segment, risks relate mostly to potentially stalled market integration between the UK and the EU27, and would be relevant to both UK and EU players.

Jan Willem VelthuijsenPwC Europe Chief EconomistTel: +31 88 792 75 58Mobile: +31 6 2248 3293E-mail: jan.willem.velthuijsen@pwc.com

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