A Busy Monday in the UK—Above and Beyond Brexit

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

Alas, Brexit. Three years on (and counting) from the UK’s departure from the EU, it still hogs all the air in the room. This time, headlines are ablaze with news that the UK and EU have agreed on a fresh deal governing trade with Northern Ireland, which hopefully resolves many of the frustrations on all three sides. Welcome news, although its significance is probably more political than economic, and it still has plenty of UK gridlock to clear. Meanwhile, more economically significant UK happenings flew under the radar Monday—namely, some small energy-related headwinds. We don’t think they are likely to pack a big punch for markets, but understanding them now may provide some helpful context for understanding data that roll in down the road.

We aren’t pooh-poohing the Brexit deal, mind you. The Northern Ireland Protocol, in its original form, was nice on paper but unworkable in practice, according to the vast majority of analysts and market participants. It did its job of enabling the government at that time to get Brexit done—as required by 2016’s referendum—while complying with the Good Friday Accords, which govern the peace agreement between Northern Ireland and the Republic of Ireland. 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, which kept Northern Ireland in the EU’s customs union while Great Britain left it. 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 for all—and deprived Northern Irish folks 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. The green lane will lose the vast majority of paperwork requirements. Instead, as The Telegraph reports: “A single supermarket truck, which previously had to provide 500 certificates, can instead make a straightforward commitment that goods will stay in Northern Ireland. Retailers will mark goods as ‘not for EU,’ with a phased rollout of this requirement to give them time to adjust.”^[i] 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. 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. 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 Party’s euroskeptic wing and approval from the Democratic Unionist Party (DUP). The DUP may only have eight seats in the House of Commons, but it is the largest unionist party in Northern Ireland and has been boycotting government there for a year—preventing the formation of a power-sharing government after last May’s elections. Not winning their approval would be a rather massive blow for UK Prime Minister Rishi Sunak and may torpedo the bill in Parliament if the euroskeptic Tories side with the DUP and Sunak can’t corral Labour support. That could trigger a snap election and raise political uncertainty in the UK. It may only be a distant possibility, but it illustrates how high the stakes are as everyone gets down to the tricky business of reading the fine print.

Headlines will no doubt stay preoccupied with this debate, and we agree investors should probably monitor for a rise in political uncertainty. But 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. Yet this does not bring the good cheer of lower household energy bills, as the government has added a price cap on top of a price cap. To date, it has subsidized household costs in excess of £2,100 per year. On April 1, the subsidies will fall, raising the typical household’s average annual cost to £3,000. Yes, you read that right—one price cap falls, one rises, and households pay more, reducing household budgets at a time when wholesale energy costs are back down below pre-Ukraine invasion levels. This will probably be a wash as far as GDP math is 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 UK politicians, particularly those in the opposition Labour Party. Perhaps most amusingly, shadow climate secretary—and the former party leader who lost 2015’s election—Ed Miliband piped up with his purported solution: a “proper windfall tax to stop prices going up in April.”^[ii] We see a teensy problem with this logic: The only long-term solution for high fuel prices is higher fuel supply, which windfall taxes discourage. The UK has had one in place since last year, and it got toothier in November. While 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.’”^[iii]

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, the more you tax something, the less you get of it. In this case, profits are the sole 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—it becomes quite difficult to convince the board a long-term, potentially decades-long, project is feasible. Better, from a business standpoint, to gravitate toward friendlier oil fields where future profits are less of a wild guesstimate. 

It is tempting to write this off as one opposition politician trying to curry favor 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. Ditto last year’s windfall tax. So if the political winds blow in favor of making the current one more draconian, it could happen, especially with Labour polling over 20 points higher than the Conservatives.^[iv] 

In the meantime, the windfall tax probably means little to oil prices, which are a global phenomenon. Cutting planned investments doesn’t 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. Meanwhile, US output is still rising, and global supply overall is inching higher. 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.