No-deal Brexit could add £bns to UK energy costs

Recent research found that leaving the European Union without a deal could increase UK energy costs by billions of pounds per year. With the UK a substantial net energy importer, a no-deal Brexit is expected to have negative effects on the UK energy sector.

Cutting ties with the EU could increase the cost of energy inputs and reduce previous benefits from integration with EU energy markets. Building on a project commissioned by British energy watchdog, Ofgem, recent evidence from UCL found that depreciation of the pound to parity with the euro (which may happen with no-deal) could add £1.5bn per year to British domestic energy bills. Other research, this time commissioned by British Transmission System Operator, National Grid, found that severing ties with EU energy markets and abandoning certain risky infrastructure investments could add a further £2.2bn/yr. Future benefits from further integration with EU energy markets would likely also be lost.

Parity between pound and euro is an outcome widely seen as increasingly likely from a ‘no deal’ Brexit, as estimated in reports from Morgan Stanley and others. A 2018 report from UCL traced the impact of the 2016 exchange rate depreciation on British energy prices, and from this evidence estimated that pound-to-euro parity could increase average domestic energy bills by £61 per year due to the higher cost of gas and electricity. Based on this study, Ofgem reported that the pound-to-euro and pound-to-US dollar exchange rates fell by 15% the year after the vote and that the lower exchange rate was the dominant influence that increased wholesale electricity and gas prices.

A report funded by National Grid found that severing ties with EU energy markets could add in excess of £2bn per year in domestic energy costs. This comes from numerous implications of exiting EU energy markets, including from: (a) an increased cost of energy sector investment programme; (b) abandoning EU energy market integration regulations, or ‘decoupling’; (c) decreased investment in future interconnectors; (d) decreased supply security for gas; (e) decreased trading in cross-border markets (for capacity and balancing); (g) decreased liquidity; (h) decreased access to energy storage; and (i) decreased access to lower cost gas, among other detrimental effects.

Another UCL report, from 2019, shows that the EU policy of ‘coupling’ markets has created efficient electricity trading between GB and its European neighbours. Inefficient trading means electricity flowing in the ‘wrong’ direction, i.e. from countries with high to low electricity prices. The latter creates welfare losses in the two connected countries. Instead, the EU policy of market coupling, the authors show, has substantially decreased trading inefficiency with GB’s largest connected neighbours, France and the Netherlands. The research also found that electricity trading with the Single Electricity Market of the island of Ireland became much more efficient after the EU regulation was introduced in 2018. Before then, inefficient trading occurred almost half of the time.

It is likely for electricity markets to decouple from EU electricity markets in the event of a no-deal Brexit. The resulting trading inefficiency causes welfare loss to domestic consumers and businesses on both sides of the transmission line, which other studies have already estimated as £160 million per year.

UCL’s 2019 report for Ofgem found that market decoupling alone would reduce imports of cheaper electricity from EU countries by 34%, reduce income to interconnectors by 9%, and reduce consumer benefits by 30%. Yet imports have, on occasion, been critical toward meeting British peak electricity demand.

Imports of electricity from EU countries made up about 7% of the UK’s total demand in 2017, and the UK is in the midst of further expanding its interconnections with the continent in order to enhance security and flexibility, with plans to potentially increase electricity imports to a substantial 20% by 2025.

Research financed by National Grid has found that a no-deal Brexit could lead to a reduced value of British interconnectors in the order of hundreds of millions of pounds per year due to uncertainty blocking interconnector projects.

GB is also on the verge of leaving the EU carbon market. The UK’s strong emission reductions in past years have generated surplus emission allowances; it is likely that Brexit would leave the UK no longer able to sell these allowances. This is estimated as potentially £1.1bn in carbon-credit revenue lost in the event of a no-deal Brexit.

Leader of the UCL projects, Dr Giorgio Castagneto Gissey – a Honorary Senior Research Fellow at UCL and a former Senior Consultant to Ofgem – said: “Research has shown that a no-deal Brexit could lead to an increase in domestic energy costs by potentially billions of pounds per year. Much of the impact will likely come from abandoning investments that became riskier, from the elimination of benefits from previous integration with EU energy markets, and from the higher cost of energy imports. While more research is needed to understand the impact Brexit may have, it is clear that a no-deal departure could be detrimental to the UK energy sector.”

• Dr Giorgio Castagneto Gissey is Senior Research Associate in Energy Policy at UCL

The full research

Here we review the literature to consider how a no deal Brexit could affect the cost of British energy.

It is clear that both the UK and EU energy systems benefit substantially from full integration, which has been pursued through common policies since 1973. The UK and EU gas, electricity and carbon markets are profoundly integrated and both economies rely on an integrated electricity and gas transmission system for energy security. On 23rd June 2016, the UK held a referendum and voted to leave the EU. More than 3 years after that referendum, the UK and its parliament remain deeply divided on the desired terms of exit. However, being endorsed by the current UK Government, it is possible for there to be a ‘no deal’ exit. 

Such a departure from the EU has been shown to potentially increase the cost of energy to the UK. These impacts could mostly be due to loss of trade benefits as well as macroeconomic uncertainty reducing investment and reducing purchasing power. Based on the existing evidence, we review the literature to consider what the cost of severing ties with the EU through a ‘no deal’ exit could be for the UK when it comes to the energy sector.

Background

The UK has been a net energy importer since 2004. In 2017, imports of energy into the UK were almost double the exports. Net imports accounted for 36% of UK energy needs, with the value of gross energy imports at £45 billion, or £18 billion greater than gross exports. Gas and oil accounted for about 90% of energy imports. It looks likely that the UK’s dependency on energy imports will continue to increase in the future (House of Commons, 2018). In 2016, total final energy expenditure in the UK was £139 bn, of which 43% were petroleum products, 25% was electricity, and 16% was gas, with the remaining 16% from coal, crude oil and other fuels (DUKES, 2017). Energy is a major source of tax revenue in the UK, raising £38bn annually, or 6% of total tax revenue (HM Treasury, 2016). The UK was in 2017 a net purchaser of ETS allowances with net purchases of nearly 29m (BEIS, 2017). 

Pollitt and Chyong (2017) note that the UK is less exposed to changes in its trading relationship with the EU in energy than in other sectors of the economy. The authors consider that the overall welfare impact of potential reductions of trade in electricity and gas is small in relation to the size of the EU-wide energy sector. The authors however discuss that Brexit is likely to reduce energy security for both the UK and EU, and that trade reductions will hurt interconnector owners, while higher UK prices would benefit generators and gas suppliers in the EU-27. They also note that “slower demand growth effects and exchange rate effects (due to Brexit-related macroeconomic slowdown in the UK) have the potential to be more significant for UK wholesale prices.”

Exchange rate impact

In a report commissioned by Ofgem, Castagneto Gissey et al. (2018) considered how the 15% exchange rate depreciation from the Brexit referendum affected GB domestic energy bills. About half of gas domestically consumed is imported, so a reduction in the value of the pound against the euro and US dollar could substantially increase GB gas bills. In addition, gas is widely used as a marginal fuel in GB electricity production, setting the price 65% of the time in 2017. Imported electricity amounted to 5% of the domestic generation mix, with nearly all of these imports from EU countries. The above implies that electricity bills can also be affected by a depreciation of the exchange rate. 

The research found that domestic consumers’ energy bills increased by £2 billion the year after the referendum (2017-2018) due to the lower value of the pound relative to the euro and US dollar. The average wholesale prices of electricity and gas rose by 18% and 16% respectively in the year after the referendum, with the exchange rate depreciation found to be the dominant factor (Ofgem, 2019). This translated into an increase of £35 for electricity and one of £40 for gas average domestic annual bills. Moreover, the variability of wholesale gas prices increased by 60% the year following the vote.  

Parity between pound and euro is an outcome seen as increasingly likely from a hard or ‘no deal’ Brexit. Recent analysis by Morgan Stanley  states that the pound’s fall to a two-year low against the dollar could be the start of a no-deal-Brexit-inspired wave of selling that ‘would push the pound towards a one-for-one exchange rate against the US currency’. Further analysis by leading markets operator and provider of post trade risk mitigation and information services, NEX Group ICAP, states that the pound is likely to fall to parity, or lower, against the euro. 

Castagneto Gissey et al. (2018) considered how parity between pound and euro could affect domestic energy bills, finding it could lead to an average rise of £61 per year. The authors break this down into £29 from electricity and £32 for gas and note this would correspond to an addition of £1.5 billion per year to domestic consumers’ annual energy bills. 
Leaving EU energy markets

Research commissioned by National Grid, from Vivid Economics (2016), points out several additional impacts on wholesale energy costs from a ‘no deal’ Brexit that could affect energy costs, including: 

• Increased cost of energy sector investment programme;
• Market decoupling;
• Decreased investment in new interconnectors in the longer-term;
• Decreased supply security for gas in the longer-term;
• Decreased trading in cross-border markets (for capacity);
• Decreased trading in cross-border markets (for balancing);
• Decreased liquidity;
• Decreased access to storage; and
• Decreased access to lower cost gas.

Although the evidence dates back to 2016, Vivid Economics (2016) studied the wider implications of Brexit on short-term electricity trade and long-term investment in the energy sector. They pointed out that a higher cost of financing of 50 basis points would lead to an increase of several hundred million pounds and would defer investment until Brexit-related uncertainties disappear. Note that energy is more capital intensive than the economy as a whole. In terms of short-term impacts, they find that Brexit could affect the UK electricity sector by creating: 
(a) a loss of market coupling  benefits of the order – of £160m per year;
(b) extra balancing services costs – of £80m per year;
(c) extra capacity market costs due to interconnectors not being part of capacity markets – of £20m per year; and
(d) the loss of future interconnectors such as Viking Link, IFA2, and FAB, which may not proceed – of £160m per year. 

The authors point out that, if both the short- and long-term value of having interconnection for both GB and Continental Europe is accounted for, then the case for greater interconnection and free trade in electricity and gas becomes stronger than by simply considering the loss to domestic GB generation from higher carbon and network charges. Similar considerations are made by both Oxera (2016) and Aurora Energy Research (2016). 

Geske et al. (2019) also studied the potential impact of Brexit on electricity costs in GB by looking at market uncoupling and economic losses from abandoning certain riskier planned interconnectors. They find that a less efficient market (from market decoupling) and the abandonment of several planned interconnectors would raise generation costs by £505m (€560m) a year (or 1.5%) compared to remaining in the Internal Electricity Market, with 60%, or £270m (€300m) of these welfare losses occurring  in GB.  The £270m figure corresponds to the sum of the above impacts (a) and (b), from above adding up to £320m, so the estimates are reasonably in accordance with those from Vivid Economics (2016).

Based on the findings in Vivid Economics (2017), Pollitt and Chyong (2017) conclude that a complete loss of integration with EU electricity, gas and carbon markets  could involve in the worst case a cost in the order of £2.2bn per year. This figure cited by Green Alliance (2018), who considered that a no-deal Brexit could cost the UK that amount. 

The authors also note that there would also be corresponding losses on the part of the EU-27, although these would be smaller in total due to the more elastic internal response of the EU-27 to loss of trading with the UK and they would also be spread over the much larger size of the bloc. The authors also note that the proportionate effect might be higher in Ireland because of its energy dependence on the UK. 

The UK is also expected to leave the EU carbon market.  The UK’s strong emission reductions in past years have generated surplus emission allowances and it is likely that Brexit would leave the UK no longer able to sell these allowances. This is estimated as potentially £1.1bn in carbon-credit revenue lost in the event of a no deal Brexit.  
 

References

Aurora Energy Research (2016), Brexit – implications for UK energy, available at: https://www.auroraer.com/wp-content/uploads/2016/10/Aurora-overview-of-p... Brexit-and-implications-for-UK-energy.pdf (Accessed July 2017) 
BEIS (2017), Annual Statement on Emissions, London: Department for Business, Energy and Industrial Strategy.
BEIS (2019). Trading electricity if there’s no Brexit deal. Available at: https://www.gov.uk/government/publications/trading-electricity-if-theres...
BEIS, 2019. Trading electricity if there’s no Brexit deal. Available at: https://www.gov.uk/government/publications/trading-electricity-if-theres....
Castagneto Gissey, G., Grubb, M., Staffell, I., Agnolucci, P. and Ekins, P., 2018. Wholesale cost reflectivity of GB and European electricity prices (Doctoral dissertation, Imperial College London).
DECC (2017), Digest of UK Energy Statistics 2017 [DUKES], London: TSO.
Financial Times, 2019. UK to lose £1.1bn in carbon-credit revenue in event of no-deal Brexit. https://www.ft.com/content/ff07fd54-6dc6-11e9-a9a5-351eeaef6d84
Geske, J., Green, R. and Staffell, I., 2019. Elecxit: The Cost of Bilaterally Uncoupling British-EU Electricity Trade. The University of Cambridge.
HM Treasury (2016), Autumn Statement 2016, London: HM Treasury.
House of Commons (2018). Energy imports and exports. Available at: file:///C:/Users/G.%20Castagneto%20Gissey/Downloads/SN04046.pdf
Lockwood, M., Froggatt, A., Wright, G. and Dutton, J. (2017), ‘The implications of Brexit for the electricity sector in Great Britain: Trade-offs between market integration and policy influence’, Energy Policy, 110 (November): 137-143. 
Office for National Statistics, 2019. Families and households: 2018. Available at: https://www.ons.gov.uk/peoplepopulationandcommunity/birthsdeathsandmarri...
Ofgem (2019). 2019 State of the Energy Market report. Ofgem: London. 
Oxera (2016), Brexit: Implications for the GB Electricity Market, available at: https://www.oxera.com/getmedia/dfc412a5-61cf-4031-934e-792969f9659c/Impa... Brexit-2016-06-10.pdf.aspx?ext=.pdf (Accessed July 2017)
Pollitt, M.G. and Chyong, K., 2017. Brexit and its implications for British and EU Energy and Climate Policy. Centre on Regulation in Europe (CERRE): Brussels, Belgium.
Pound Sterling Live, 2019. Pound Sterling to fall to Parity, or Lower, vs. Euro warn ICAP Technical Analysis. Available at: https://www.poundsterlinglive.com/eur/11813-pound-to-euro-exchange-rate-...
The Guardian, 2019. Pound could fall to parity with dollar on hard Brexit concerns. Available at: https://www.theguardian.com/business/2019/jul/17/pound-could-fall-to-par...
The Independent, 2019. Brexit: Losing energy links to Europe after no-deal will cost UK more than £2bn every year, experts warn. https://www.independent.co.uk/environment/brexit-no-deal-renewable-energ...
Vivid Economics, 2016. The Impact of Brexit on the UK Energy Sector. An Assessment of the Risks and Opportunities for Electricity and Gas in the UK.