After a lengthy and bad-tempered Brexit referendum campaign, Britons voted by 51.9 percent to server the country’s 43 year membership of the EU and triggered global financial market turmoil. Markets expected a Remain victory were caught completely off guard and in a frantic day of trading, the pound dived to a 30-year low setting an intra-day record swing of over 10 percent. Having lost the vote, Cameron announced that he was leaving office and there were renewed calls for Scottish independence.
Whilst the short term impact was felt most sharply in the FX and equities markets, the impact of Brexit on the commodity and energy spaces will be felt over the months and years to come. This post serves as a briefing on the possible implications of Brexit with a focus on the UK.
Brexit can be expected to weigh on commodities prices through their linkage to the US dollar and impact on risk appetite. A look back at previous major risk-off events shows commodities under-perform during periods of significant macro/political uncertainty, at least over the short term, whilst this macro impact could be compounded given that Brexit carries additional risk for the commodities in the form of US dollar appreciation.
Amid the Friday morning chaos of the referendum result across markets, global oil prices fell. The global benchmark of Brent, was trading at $48.30 a barrel. Its U.S. counterpart, West Texas Intermediate, also dropped 5 percent to $47.57 a barrel.
But oil analysts and traders were in agreement that this decline in price will likely hold only for the short-term. With the pound falling against the U.S. dollar oil prices were expected to fall slightly, with a strong dollar tending to suppress oil prices as a stronger dollar makes oil more expensive for holders of foreign currencies.
UK demand for Oil isn’t significant in global supply or demand terms and thus negative pressure on oil prices would be driven by risk aversion, not fundamentals. The dramatic shift from an oversupplied to a balanced market – which is currently taking place – would overwhelm the small fundamental impact of slightly weaker demand due to currency effects. While a Brexit may result in further sentiment-driven price declines at the front of the crude forward curve of around 5 percent (order of magnitude), we would expect any such weakness to be temporary
U.K. natural gas is one of the few commodities world-wide which is actually being boosted by the decision to leave the European Union but European gas markets are set for a week of uncertainty as traders process the impact of the UK’s decision to leave the European Union. On top of that, the Dutch government has proposed cutting the production cap for the country’s largest gas field, creating something of a perfect storm for European gas market participants to deal with.
U.K. natural gas is arguably the most important natural gas hub globally. It has the highest trade volume of any gas hub in Europe and is used to regulate supply across the continent, with the U.K. being capable of both importing and exporting volumes of pipeline gas and liquefied natural gas. Many gas traders, even in Asia, price their gas deals off the U.K. hub because of its liquidity and strength in prices.
U.K. natural gas is one of the few sterling-denominated commodities. Most European natural gas contracts are denominated in euros and world-wide, most commodities, including liquefied natural gas, are denominated in the U.S. dollar.
Bullish gas in the short term
The Brexit vote sent the British gas contract for next-day delivery and next-month delivery higher by about 1p/th, while prices in mainland Europe gas markets moved in the opposite direction.
British NBP gains came as sterling slumped to a 31-year low against the dollar and was more than 6% down on the euro. This has provided euro-backed traders with an incentive to buy sterling-denominated contracts, which helped to bolster NBP products. In the short term, the result will likely be bullish for the British gas market due to the depreciation in the pound.
U.K. natural gas prices could be supported at higher levels beyond a mere short rally, according to Hugo Batten, senior project leader at Aurora Energy Research. If the pound stays low, the phenomenon could be longer-lasting because of the natural trading arbitrage which will exist between the U.K. and Europe.
Adding further uncertainty to the already volatile markets, was the announcement on Friday afternoon that the Dutch government has proposed to reduce the cap for Groningen gas production by 11%, but with a provision to increase the cap in emergencies. Another fundamental factor that has impacted supply and demand in the British gas market has been an unexpected announcement that the Rough storage site will come offline for 42 days.
The announcement, which was made late Wednesday afternoon, has provided extra pressure on NBP prompt prices. This has been because shippers usually inject gas into storage during the warmer summer months. The reduced demand to fill the site could create a supply glut throughout July.
European Union carbon prices tumbled more than 15 per cent following the Brexit announcement. Huge market uncertainty in the wake of referendum result saw the EU price of carbon allowances for next year fall 15 per cent to €4.88 at 12.30pm GMT
As one of Europe’s largest contributors to greenhouse gas emissions, the UK is also one of the largest purchasers of carbon allowances within the EU ETS and higher carbon prices are seen as important in the drive towards a low carbon economy.
Several possible future scenarios for UK carbon trading going forward, including: the UK participating in the EU ETS similarly to how non-EU member Norway intends to join; the UK setting up its own cap and trade system; or instead implementing a carbon tax.
Whilst the entire EUA curve lifted, the UK will remain a member of the EU ETS until the terms of Article 50 are finalised, but the carbon price is going to reflect the uncertainty of those renegotiations until they are finalised.
UK Continental Shelf
The UK will have to decide whether to continue to apply the various EU Directives relating to oil and gas or whether to develop its own domestic policies. EU companies that have investments in UK waters could find themselves subject to two different regulatory regimes if the UK decides to develop its own regulatory framework.
The UK may well remain committed to the single European Energy Market which would require it to remain subject to the relevant European Energy Directives and Regulations, and to remain part of the institutions like ACER, ENTSO-E and ENTSO-G which regulate it.
Britain has a number of electricity and gas interconnectors and is in the process of developing more. It is likely that the effects of Brexit will be most keenly felt by existing and in particular future interconnectors as the relevant regulatory framework for interconnectors in the EU will fall away for UK interconnectors, and a reliable alternative regime will need to be negotiated which will likely have an impact on both costs as well as security of supply for the UK.
EU Member States cannot negotiate their own trade agreements, so it will be a matter for the UK and the EU as a whole to decide on their future use, such as whether these interconnectors would be able to enter the capacity market auctions. Change to the current interconnection arrangements may therefore have a negative impact on UK energy security as the UK is a net importer of electricity. In addition, the UK will have to decide whether to continue to adopt EU-wide electricity regulation or to develop its own set of policies.
When it comes to renewable energy targets, the UK set the bar high with its Climate Change Act, which leaves the country in a good position should the legally binding EU carbon-reduction commitments be removed.
Brexit removing legally binding carbon-free targets could dilute the political will to deliver green power and would lead to reduced subsidies.
Energy policy implications
International Energy Market (IEM)
One of the biggest decisions to be made for the energy industry is whether the UK remains in the Internal Energy Market (IEM). It is important to note that it is still possible to be part of the IEM without being an EU member.
The benefits of remaining in this market appear to outweigh the negatives. For instance, the IEM makes it easier to trade across borders, boosting liquidity and cross-border balancing. Its reinforcement through the Energy Union project would also make cross-border energy markets a reality, including capacity market integration.
Losing these benefits will undoubtedly impact the cost of energy as well as our security of supply. Non-commodity charges, interconnector volumes and security of supplies will only be affected if the EU decided to block the flow of electricity and gas to the UK – this is unlikely as the EU already supplies energy to countries outside the EU and it would reduce revenues of countries that export to the UK
If the UK does remain in the IEM, arrangements for the energy industry could look broadly similar to the status quo.
On climate change, even if the UK were to leave behind the EU Climate Change Package, it would still have the very stringent UK targets as well as any commitments arising from international agreements such as the Paris Agreement. It’s unlikely that Brexit will have much impact on the UK’s climate change policies, mainly because the UK government has already gone further than the EU when it comes to reducing carbon emissions. The Government has pledged to close all coal-fired power stations by the middle of the next decade, and has committed to zero carbon emissions by 2050.
This is one area that could be seriously impacted by the decision to leave the EU. The fact is that the UK requires up to £19 billion of investment in new infrastructure every year between now and 2020: that’s 60% of the UK’s total infrastructure costs for the rest of the decade. Much of our energy investment comes from foreign-owned organisations, from new nuclear to gas power stations and offshore wind farms.
Investors need long term stability and political certainty from the market they invest in. The negotiations that follow over the coming months, as we determine the future of a post-Brexit UK, will be watched keenly by potential investors – but it is clear that this will deter investors in the short term.
The UK’s system operator National Grid asked economics consultancy Vivid Economics to undertake an analysis of the possible effects of an exit from the EU. In its subsequent report published in March, Vivid Economics states:
“In the hotly contested Brexit debate, one thing is clear: Brexit will create economic uncertainty. This is because there are a wide range of possible outcomes from post-Brexit negotiations leading to a number of regulatory and market options for the UK’s relationship with the EU, with differing implications for investment and trade.”
The report concludes that, from an investor’s perspective, “higher returns are required to compensate them for the risk of less favourable post-Brexit arrangements. This puts upwards pressure on the cost of financing, raising the cost of investment in the UK energy sector.”
It added that Brexit “would also result in some opportunities if it were the case that EU legislation constrained the UK to higher-cost technology pathways. However, this is unlikely as the UK’s domestic commitments to reducing emissions, coal closure and deploying renewables are similar or stronger than current and planned EU requirements.”
Little change in the short term
The precise impact on the energy sector, post-Brexit is unclear at this stage. However, one certainty is that in the immediate future we are very unlikely to see any major changes to the current systems and regulation. The exit will take a significant amount of time to negotiate and plan and the EU and the UK will have to decide how access to each other’s energy markets would continue, if at all.
If there were a more radical approach which meant leaving the single energy market, then there would be more significant issues to be dealt with such as access to EU markets, especially through interconnectors, and access to UK markets for EU energy.
UK regulation of many energy topics, including carbon capture and storage for example, implement the relevant Directives and therefore conscious decisions would need to be taken to move away from them through new regulation. How far they would go is very difficult to estimate. Relaxations in other areas, such as State aid, may also have an impact on the energy system. Finally, there will be significant long-term funding implications for new projects given that access to European Investment Bank loans will be cut off by Brexit.
London as financial centre post Brexit
Over the past 30 years the City has become much more international, with US and other global banks now dominant. Crucial to their presence in London is the EU principle of “passporting”, which allows them to access the European single market without restrictions. Several banks have warned that Brexit will undermine the logic of basing so many staff in the UK. JPMorgan said it could axe up to 4,000 UK jobs, while HSBC has suggested up to 1,000 posts could move to Paris, where it has a sizeable subsidiary. Many other employers said in private in the run-up to the vote that they would move jobs to continental Europe
Some smaller groups will be excited by the prospect of being unshackled from onerous EU regulations, and bankers will welcome the likely end of the EU cap on bonuses. But, for many big city institutions, the mechanics of how they operate may be about to change profoundly.
FX is most at risk
If there is one activity that the City of London dominates it is foreign exchange trading. But its continued claim as the world’s principal location for trading the euro — a $2tn a day market — looks vulnerable. The European Central Bank has already attempted to bar clearing houses outside the eurozone from handling the euro. Last year, it failed, thanks to a ruling at the EU’s highest court. But many in the City and in policymaking circles believe the UK only prevailed thanks to its membership of the EU.
Banks to move operations out of the Britain
The big US banks — JPMorgan Chase, Goldman Sachs, Bank of America, Citigroup and Morgan Stanley — have large operations employing tens of thousands of people in the UK. They are now preparing to shift some of this work to cities such as Dublin, Paris and Frankfurt.
The danger to the UK’s financial services sector was highlighted in comments on Saturday morning from France’s central bank governor, who warned that banks would lose “passporting” rights to operate in the EU if Britain leaves the single market.
François Villeroy de Galhau said on Saturday it was “paradoxical” to allow the City of London to operate by the EU’s rules and not be a member of the European Economic Area in the manner of Norway.
The most likely outcome is that foreign banks with large operations in London will shift staff to a spread of eurozone locations where they already have operations — including Frankfurt, Dublin, Paris, Warsaw and Lisbon. That would fragment the financial services industry in Europe, potentially weakening the continent’s ability to compete internationally.