The Brexit discussion continues with the latest leaving date of 31st October 2019, generating increased uncertainty around the type of deal that will be agreed upon, if any. Teresa May’s decision to step down has sparked a long list of 10+ candidates for the Conservative leadership. The successor will have a huge challenge to overcome if the recent European election results are an indication – another poor result reflective of Brexit uncertainty.
The uncertainty about the elusive Brexit deal, and subsequent level of connection that remains with the European Union post 31st October, is where the uncertainty filters through to the energy market. The uncertainty is centred around supply and demand of energy and the associated economics, meaning C&I organizations need to be aware and will likely need to be prepared to manage a new element of risk.
The fundamental risks to energy market prices relate to the potential for new tariffs or increased bureaucracy, which could slow cross-border energy trading. Possible frameworks include Norway’s example (EEA), Switzerland’s (EFTA), or a no deal shift to WTO rules.
The energy market faces significant and direct risk from any change to UK participation in the European energy market. To the extent that any of these uncertainties reduce energy trade, the market would be exposed to the below risks:
- Increased exchange rate volatility
- This factor has already impacted the UK market regularly in the wake of the initial Brexit vote, with a weaker pound triggering higher pound-denominated prices for imports, including natural gas and electric power.
- Increased energy market seasonality
- The UK uses energy trade with EU members to balance out seasonal supply/demand shifts.
- In the summer, the UK sends excess natural gas supply to the continent. Conversely, the UK imports gas from the continent during the winter months to meet excess demand.
- The closure of the Rough storage facility has eliminated the only long-range storage option within the UK.
- Any exit terms that add barriers to UK gas trade with the continent would exaggerate existing price seasonality.
- Increased exposure to the global LNG market
- To the extent that UK access to continental gas supply is curtailed, the market will be forced to source alternative supply to meet demand.
- While some of this demand could be met by offline coal capacity, peak demand would likely become increasingly reliant on flexible LNG cargoes.
- The UK already has LNG import terminals, but utilization is limited due to high global prices. If demand conditions require additional LNG cargoes, NBP prices would have to rise sufficiently to compete with other markets that have typically maintained a heavy premium to NBP in recent years.
- Increased challenges to new renewable capacity
- Any reduction or complication of electricity flows between the UK and the continent could make balancing the power grid more difficult and less capable of balancing the challenges of intermittent, non-dispatchable renewable capacity
Physical Infrastructure is a Key Challenge
Uncertainty can be broadly grouped into two categories: existing interconnection capacity for gas and power, and planned interconnection projects between the UK and the EU. To the extent that Brexit limits energy trade between the UK and the EU through regulatory barriers or decreased physical interconnectivity, it would increase overall price volatility, and generally support UK energy prices relative to the continent.
In terms of current gas pipeline infrastructure, pipelines will most likely continue serving as price harmonizers between the continental hubs and NBP. Possible divergences will occur during interconnectivity restrictions, and major swings in FX rate changes. As the UK has been a net importer of energy since 2004 and is expected to increase its reliance on imports in the future due to dropping domestic production, this exposure is expected to become increasingly significant.
With the closure of Rough - the UK's largest and only long-range gas storage facility - increased seasonal volatility is expected. The current storage capacity without Rough is around 6.6% of total annual UK demand. This means that the UK market will increasingly rely on imported gas to meet the demand, particularly during the winter months.
In terms of power links, the UK currently has 4.6 GW cross-border power capacity with France, the Netherlands, and Ireland. A total of 12 GW additional capacity is planned to come online by 2023, which would be crucial for the UK to maintain its grid stability as it looks to the share of intermittent renewable generation.
These projects are expected to proceed despite current Brexit negotiations under our base-case scenario, but the exact conditions of the UK’s exit will have a major impact on the economic feasibility and margins of future operations.
Two key factors should be acknowledged in terms of the UK’s role in the European market:
1st - The UK has received almost a third of Norway’s total piped gas exports to Europe for the past five years. This means a significant amount of Norwegian gas will still need to flow through the UK if it is to ultimately supply the EU market.
2nd - Ireland is completely dependent on the UK for its energy imports as of today. While Ireland is looking to diversify its energy connectivity with the construction of the 700 MW “Celtic interconnector” with France, as well as the Shannon LNG terminal with a maximum re-gasification capacity of 28.3 mcm/d, it will not be in a position to disconnect from UK energy for the foreseeable future.
While the UK would appear to suffer the bulk of the pain from any decrease in energy interconnectivity with the EU, there are critical ties that still provide the significant leverage in terms of energy supply security for EU members. Unlike other areas under negotiation, it is relatively clear in terms of energy that any decrease of interconnectivity can be broadly harmful for both the UK and EU energy markets.
No deal scenario?
Switzerland demonstrates how a non-EU / non-EEA country can conduct cross-border energy trade with the EU. As the country sees about 11% of EU power flows due to its geographic location, it has distinct leverage compared to the UK, which may be considered a “one-way street” market. Despite this, Switzerland has been negotiating bilateral agreements on power trading since 2007 with its neighbors without reaching full agreement as of today. As a result, the Swiss market operates with a strong premium, since it has limited access to the EU grid, while it has a strong balancing need due to its heavy reliance on hydro.
An organization of UK energy suppliers, Energy UK, has warned that the latest official government proposal for a no-deal scenario is not detailed enough, only covering the nuclear industry to a satisfactory level. In addition, cross-border trading activity will require overcoming the same red tape as trade with other non-EU countries, such as applying for an Economic Operator Registration and Identification Number – EORI – among other things. This would also mean that flows between the UK and EU / EEA will need to be contractually named as imports and exports, as opposed to earlier when the UK was part of the Internal Energy Market.
After Brexit, the UK will technically become more dependent on 'foreign sources of gas': previously EU / EEA sourced gas will be deemed as foreign in the UK. Although this is only a legal change and the physical supply is to remain the same, we may see price changes in case the EU members decide to impose tariffs on flows. These conditions will depend on future negotiation results, however, given that both the UK and the EU as a whole are net importers, tariffs do not make much economic sense – unless one actor wishes to use it as a punitive political tool.
The key consideration
The most likely energy market impact of Brexit is an increased risk premium for UK energy prices and an overall higher volatility environment. The extent to which these factors influence the market will be primarily dependent on the degree to which market access and energy interconnectivity is maintained between the UK and the EU in a post-Brexit scenario. As negotiations approach key deadlines, we offer the following takeaways for physical supply and market price risk:
In terms of physical supply security, the risk is limited as the UK:
- Is well connected to continental Europe,
- Maintains relatively strong (although diminishing) domestic production,
- Can expect a steady gas supply from Norway, and
- Has enough LNG reception capacity.
Price premium and volatility, on the other hand, are likely to increase due to:
- Reduced access to Continental storage, exposing the UK to the global LNG markets.
- Difficulty in balancing cross-border electricity flows, which could directly impact wholesale energy prices.
- Currency exchange risk increasing, as overall UK market connectivity to EU markets decreases, reducing currency correlation and adding risk across all EU-UK trade, including energy.
In all cases, the degree and impact are proportional to the degree of market separation required under the final terms of Brexit negotiations.
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