A Busy Monday in the UK—Above and Beyond Brexit

Editors’ Note: As always, MarketMinder Europe is politically agnostic. We favour no politician nor any party and assess political developments for their potential economic and market impact only.

Alas, Brexit. Three years on (and counting) and it still tends to hogs all the air in the room. This time, commentators we follow seemed completely focussed on Monday’s news that the UK and EU agreed a fresh deal governing trade with Northern Ireland, which hopefully resolves many of the frustrations we have observed on all three sides. This is no doubt welcome news for many, although we think its significance is probably more political than economic, and it likely still has plenty of political gridlock to clear. But in our view, more economically significant happenings flew under the radar Monday—namely, some small energy-related developments. We don’t think they are likely to pack a big punch for markets, but in our view, understanding them now may provide investors with some helpful context for understanding data that roll in down the road.

We don’t wish to dismiss the Brexit deal’s importance, mind you. The Northern Ireland Protocol, in its original form, was nice on paper but seemed unworkable in practice, according to the vast majority of analysts and market participants we follow.^[i] It did its job of enabling the government at that time to get Brexit done whilst complying with the Good Friday Accords. But in practice, keeping trade free and frictionless on the island of Ireland and between Northern Ireland and Great Britain proved impossible under the original solution. There was no simple system for designating British products for sale in Northern Ireland only, essentially requiring all goods entering from Great Britain to comply with EU customs rules on the mere possibility that they could be re-exported. Hence, there was a de-facto border across the Irish Sea that resulted in many headaches, according to coverage we read—and deprived Northern Irish people of British bangers and other delicious chilled meats. 

Monday’s agreement aims to fix this. It creates a new “green lane” for goods shipped for consumption in Northern Ireland, with the “red lane” of full customs checks limited to goods that will be exported to the EU.^[ii] The green lane will lose the vast majority of paperwork requirements.^[iii] Bangers will be back, too, as will certain medicines that had been absent from pharmacy shelves and British plants that are on the EU’s no-go list.^[iv] Northern Ireland will also be able to enjoy tax exemptions that apply to the rest of the UK, including reduced duties on alcohol and zero-rate value added tax on solar panels and other energy-saving supplies.^[v] Lastly—and perhaps most crucially from a political standpoint—the Northern Ireland Assembly will get a voice in EU goods trade rules.

If, that is, the deal passes in Parliament, where it will need support from the Conservative’s eurosceptic wing and approval from the Democratic Unionist Party (DUP). The DUP may only have eight seats in the House of Commons, but its year-long government boycotts prevented the formation of a power-sharing government at Stormont after last May’s elections. In our view, not winning their approval would be a rather massive blow for Prime Minister Rishi Sunak and may torpedo the bill in Parliament if the eurosceptic Tories side with the DUP and Sunak can’t corral Labour support. That could trigger a snap election, which would likely raise political uncertainty in the UK. It may only be a distant possibility, but we think it illustrates how high the stakes are as everyone gets down to the tricky business of reading the fine print.

Headlines in publications we follow will likely stay preoccupied with this debate, and we agree investors should probably monitor for a rise in political uncertainty. But we think the latest energy-related news perhaps has more significance in the near term. On Monday, energy regulator Ofgem confirmed its electricity price cap will fall in April, from an annual rate of £4,279 in the first quarter to £3,280 in Q2.^[vi] Yet this does not bring the good cheer of lower household energy bills, as the government has added a price cap on top of Ofgem’s price cap. To date, it has subsidised household costs in excess of £2,100 per annum. On 1 April, the subsidies will fall, raising the typical household’s average annual cost to £3,000.^[vii] Yes, you read that right—one price cap falls, one rises, and households pay more, likely reducing household budgets at a time when wholesale energy costs are back down below pre-Ukraine invasion levels.^[viii] Our research suggests this will probably be a wash as far as GDP (gross domestic product, a government-produced measure of economic output) maths are concerned, given spending on household energy is still spending, but discretionary spending could continue struggling, with this intervention a possible reason why.

As you might expect, the revelation that a falling price cap won’t lower household payments was big fodder for pols, particularly those in the Labour Party. Perhaps most amusingly, shadow climate secretary—and former party leader—Ed Miliband piped up with his purported solution: a “proper windfall tax to stop prices going up in April.”^[ix] We see a notable problem with this logic: The only long-term solution for high fuel prices is higher fuel supply, which we find windfall taxes discourage. The UK has of course had one in place since last year, and it got toothier in November. Whilst it includes exemptions for companies that raise investment, it doesn’t appear to be working as intended—at least not according to a new report from an industry trade group. Several large firms are cutting their investments in North Sea oil fields, and Offshore Energies UK reports “95 per cent of members surveyed had been ‘negatively impacted’ by the levy and were ‘looking to invest elsewhere,’ adding that ‘this leaves the UK reliant on overseas imports and puts the UK’s energy security at risk.’”^[x]

If the extant windfall tax is already discouraging new production even with its investment incentives, we have a hard time seeing how an even windfallier one would magically reduce prices and boost output. At risk of oversimplifying, we think a general principle is that the more you tax something, the less you get of it. In this case, simple financial incentives dictate profits are the primary motivator for firms to continue drilling in the North Sea. If the government is going to take an ever-larger bite of those—and if tax rates are ever-changing as the political winds shift—we think it likely becomes quite difficult to convince the board a long-term, potentially decades-long, project is feasible. Perhaps better, from a business standpoint, to gravitate toward friendlier oil fields where future profits are less of a wild guesstimate. 

In our view, it is tempting to write this off as one opposition politician trying to curry favour ahead of the next election. But successive Conservative prime ministers have taken energy policy inspiration from Labour. The aforementioned price cap was also Miliband’s idea back in the day—the Conservatives took it and ran.^[xi] Ditto last year’s windfall tax.^[xii] So if the political winds blow in favour of making the current one more draconian, it could happen, especially with Labour polling over 20 points higher than the Conservatives.^[xiii] 

In the meantime, the windfall tax probably means little to oil prices, which are a global phenomenon. Cutting planned investments doesn’t necessarily mean output drops now—it just means production probably doesn’t rise as much as it could have. We say could, not would, as oil prices are down from the high levels that were encouraging big investment plans last year.^[xiv] Meanwhile, US output is still rising, and global supply overall is inching higher.^[xv] So as much as the UK might benefit from having more oil produced locally—negating import costs—for global markets, it probably doesn’t change overall supply and demand forces much, in our view.