What Does a Brexit Mean for Energy Markets?
On June 23, the United Kingdom—which is the European Union’s second-largest economy—held a referendum where 52 percent of the population voted to leave the Union. The vote is the first step in what will be a long, protracted, and multistep process to extract the United Kingdom from European institutions. Over the next months and years, assuming that the British follow through on the referendum, leaders from Europe and Britain will engage in negotiations over both the terms of the exit and how to unwind UK membership, as well as the future terms of the relationship between the United Kingdom and the European Union. While the exact nature of the exit and the future UK-EU relationship is still to be negotiated, it is expected that the United Kingdom will attempt to extract favorable terms in a new trading arrangement that still provides the country access to the European single market, while the European Union will resist such an arrangement (which could encourage further defections).
This will be the first time that a member has left the 28-country bloc, and the process is therefore fraught with significant uncertainties over substance, process, and timelines. Uncertainty is likely to persist for a period of at least many months, if not years. Furthering the case that the process will be drawn out, the current British prime minister has indicated that he will not rush the move to sever ties formally with the European Union, but will leave that process to his successor, who will not take office until the fall. In the interim period and while negotiations are ongoing, the legal status of the EU-UK relationship (and all attendant rules and regulations) will remain unchanged. Over the near term, uncertainty will be the defining feature of the direct and indirect impacts on energy markets. Nonetheless, it is possible to begin to outline some of the impacts on the energy system.
Direct Impact on Energy Markets
As evidenced in the immediate reaction to the Brexit vote, and because the status quo will remain in place on the regulatory and trade front, the direct impact on energy markets in the short term will be limited to the volatility of commodity prices, most prominently the price for crude oil. Brent crude fell as much as 6.6 percent the day after the referendum. Until there is further clarity (and especially if there is continued uncertainty about the future of the United Kingdom), volatility may be more likely.
Indirect Impact on Energy Markets
The indirect impact on energy markets is perhaps more significant in the near and medium term than the direct impacts and moderated through the effect the British referendum will have on global economic growth. A British withdrawal from the European Union comes at a time of globally slowing economic growth and significant uncertainty about the prospects for future growth, all of which have resulted in anemic energy demand growth. The British referendum amplifies that uncertainty and the already cloudy picture for growth around the world (and especially in emerging markets), which is likely to result in slowed demand for energy globally.
A lower-order, but still-important, indirect impact is the cost of access to credit. The risk premium on investments will likely rise, both in the United Kingdom and elsewhere. Furthermore, investors will remain risk averse until the long term is more predictable, and this will likely stiffen investments and restrict the flow of capital even further across global markets.
The third energy market indirect impact is mediated through a rising dollar. As investors flee to safe haven investments, the U.S. dollar will continue to strengthen (spot indices surged as much as 2.7 percent on Friday). The increased strength of the dollar in combination with slower economic growth will have an effect on oil demand, which will be somewhat dampened as it is priced in dollars. This will likely have an immediate fiscal impact on oil importing countries (and conversely, on oil exporting countries).
Uncertain Impact on Energy Markets
Going forward, much of impact on energy markets will be determined by the future contours of the UK relationship with the European Union and even more on the shape of the future Union itself, which will be determined in the months ahead by a complex web of political and technical factors. There are three major areas of uncertainty when it comes to the Brexit’s impact on energy and climate policy that will be influenced by these negotiations: the future of climate policy, the future of British access to the EU market, and additional potential EU exits. These areas are by far the most consequential for energy markets and policy, but are by no means the only areas of uncertainty when it comes to energy.
Climate policy: When it comes to multilateral climate policy, the United Kingdom—the European Union’s second-largest emitter—has participated in UN climate negotiations as part of the broader EU bloc, and its climate commitment to the recent Paris treaty was submitted as part of the broader European commitment. What will happen to the EU target—whether it will be resubmitted, and whether any resubmission would be more or less stringent without the United Kingdom—remains to be seen. Likewise, whether they will submit a new climate pledge, and the shape and scope of that pledge, is also up in the air. However, the United Kingdom is on a path to cut emissions by 2030 under a domestic law. The broader EU negotiating dynamic on climate moving forward may also change. The United Kingdom is often credited with both pushing for more stringent climate targets and for the adoption of market-based mitigation (rather than top-down EU-wide standards and goal setting). How the European approach to climate negotiations may change without the presence of the British remains to be seen.
Access to EU market: A considerable impact of a potential Brexit for energy markets will be determined by the shape of the future EU-UK economic relationship (as well as the future political future of the United Kingdom itself). There are, essentially, five possibilities for this relationship: 1) status quo; the United Kingdom does not leave the European Union and remains part of the common market; 2) the United Kingdom leaves the Union but retains full access to the EU single market (the Norway model); 3) the United Kingdom has restricted but significant access to the common market on a bilateral basis (the Swiss model); 4) the United Kingdom does not have access to the common market but negotiates a separate free trade agreement with the Union (the Canada model); 5) the United Kingdom and European Union are not able to negotiate preferential trading terms, and access to the common market would be premised on World Trade Organization rules.
While it would make economic sense for the United Kingdom to remain part of Europe’s internal markets for electric power and natural gas (50 percent of UK imported gas comes through the Union), that outcome remains to be negotiated. What is less clear, however, is whether the United Kingdom would drop some specific European measures, such as imposed renewable energy targets and Europe’s Industrial Emissions Directive, which controls emissions on power plants. The regulatory upheaval could be significant for energy development in the United Kingdom, with energy regulations currently set by the European Union likely to be the subject of future negotiations. Moreover, the status of access to the common market is also likely to impact the decision of whether the United Kingdom continues to participate in the EU emission trading system, which regulates greenhouse gas emissions.
Potential for more exits: Finally, the broader energy market impacts may be determined by the future of the European Union itself. The British vote to leave the Union is likely to prompt other anti-EU forces in other EU countries to hold similar referenda. If the Union were to break apart—either marginally or more substantially, or dissolve altogether—the consequences for energy markets could be profound.
It is uncertain how the outcome of the referendum will affect political fragmentation across the European Union. A number of countries, including Poland and Hungary, have incumbent euroskeptic governments, while many other member states have growing ranks of opposition parties to current governments who share a skeptical view of the European Union as an institution. If there are other referenda or movements toward exit among these member states, it is likely to have major impacts on global economic growth and confidence in the markets in general, which in turn would have severe effects on energy markets.
The political integrity of the United Kingdom is also in doubt, with Scotland and Northern Ireland favoring remaining in the European Union. Scottish leadership has said that an independence vote for Scotland is now once again on the table.
The United Kingdom’s momentous decision to leave the European Union—and whether and how it ultimately does so—will have widespread implications for a variety of economic, political, and security oriented dynamics, including energy and climate change. More integration is, as a general rule, more likely to result in orderly energy markets, and there may be a rough time ahead as integration becomes less politically palatable and Brexit is added to a growing list of economic troubles, from slowed growth in China and weak growth in Japan to trouble in major oil producing countries.
Michelle Melton is an associate fellow, and Andrew Stanley the program coordinator, of the Energy and National Security Program at the Center for Strategic and International Studies in Washington, D.C.
Commentary is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).© 2016 by the Center for Strategic and International Studies. All rights reserved.