Running out of power – macro challenges for the UK’s energy sector

A slowing outlook…

The UK economy continues to slow according to the latest EY ITEM Club forecast. Although the UK has not yet left the European Union, the consequences of the vote to leave continue to shape economic performance. In particular:

• The depreciation in the value of sterling has led to an increase in inflation; and

• The decline in business confidence has reduced the appetite for risk-taking and investment amongst corporates.

In the absence of any acceleration of nominal wage growth, consumer price inflation is reducing real wages. At the same time, low confidence is holding back business investment and inhibiting companies from being more aggressive in pursuit of the export opportunities that a lower pound and a pick-up in global growth have created.

The overall impact of the combination of these effects is a slowing economy with growth below the trend rate that the UK had become accustomed to before the financial crisis. With the nature of the arrangements for Brexit likely to remain unclear for some time, EY ITEM Club expects these economic conditions to persist for the next 12 to 18 months and possibly longer.

…in a changing world…

This economic slowdown is, however, only one part of the macro context impacting the outlook for the energy sector. We may be on the verge of the greatest shift in economic policy since Margaret Thatcher came to power, over 30 years ago.

The drive for industry reform, a process that had privatisation of utilities at its core, emerged due to the crisis that the UK economy experienced in the 1970s. We may now be on the verge of a new fundamental shift as the UK economy continues to struggle to establish momentum following the financial crisis.

For over three decades, UK economic policy has been based on what is usually called “neo-liberalism”, which has manifested itself in the use of privatisation and competition as the primary anchors of sector policy wherever possible. In energy and other sectors, regulation has been deployed where competition was either deemed as unviable or insufficient to deliver desired outcomes.

This approach is now under intense pressure. Both of the UK’s two largest political parties have increasingly turned to policies based around greater intervention in the energy sector and polls suggest the public is open to public ownership of at least some of the energy and transport sectors. Privatisation was based on a number of objectives but depoliticising the sector and incentivising more competitive prices and greater investment were amongst the most important. As Dieter Helm’s review argued last week, the sector has not been depoliticised and has over time moved back towards a publicly controlled model in policy if not ownership terms.

…suggests difficult times ahead…

Being an out of favour sector in a slowing and uncertain economic environment is not a great place to be. Resources are squeezed and policy-makers will be looking at ways to ease the burden on consumers, especially at the lower end of the income spectrum. The moves to regulate tariffs recently announced are likely to be the tip of the iceberg. Ownership and financing are likely to be areas that politicians identify as requiring attention.

To date, foreign investment in the UK energy sector has held up reasonably well despite the slowing economy and increased policy uncertainty. Domestic capital investment has slowed relative to investment in the rest of the economy as shown below. EY’s latest survey of M&A intentions suggests the UK lagging behind Europe and the USA in terms of attractiveness to investors pointing to a potential slowdown in investment.

…and time to think out of the box.

The sector needs a new approach. In my view, the Helm review identifies many of the challenges, especially the complex policy and structural environment now facing the sector.

Business as usual is not an option: the industry requires a new framework based on clear policy objectives and simpler structure in which returns will be demonstrably related to the economic value created.

The Helm review sets out one clear way forward with all of the policy tools such as ownership, structure, competition, regulation and finance potentially up for change. Such an approach will not be comfortable but the combination of a slowing economy, Brexit and a shift in public mood means it can’t be avoided and should be embraced.

@MarkGregoryEY

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