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Analysis

Renewables key to UK industrial strategy

by Ben Robinson

Renewables key to UK industrial strategy

 

Following the decision to leave the European Union, the British government has created a new Department for Business, Energy and Industrial Strategy, tasked with improving the business climate to encourage companies to remain in the UK.

One significant part of this approach involves ensuring continued access to low-cost energy for UK companies. The government is using subsidies and price guarantees, among other tools, to achieve this goal. This could provide significant opportunities for renewable energy investments in the UK.

UK has a big energy infrastructure deficit
The government’s contracts for difference scheme guarantees a set price per kilowatt hour of energy produced by low carbon projects, ensuring stable returns for renewable investments. When the market price falls below the strike price, the government makes up the difference. When it goes above, the government receives the additional revenue.

Demand in the first round of competitive bids in 2015 was high, with just over 25% of applicants winning a contract. The total investment generated by the first auction could be up to £14bn by 2020. The government has scheduled the second auction for April 2017.

These measures are important for securing new investment in UK energy. According to government estimates in the National Infrastructure Plan, the UK’s total energy infrastructure requirements are £275bn between 2015 and 2021. Independent estimates put the needs much higher.

Overseas investors have been responsible for around 40% of total energy and infrastructure projects in the UK since 2010. However, notwithstanding agreement on Hinkley Point – the first nuclear plant to be constructed in the UK in more than 20 years – in which the French and Chinese governments maintain significant stakes, the future of foreign investment after Brexit is in doubt. Approaches like the CFD scheme can help ensure this investment.

Weakened appetite for investment
The sustained decline in sterling since Brexit has raised import prices, increasing costs of new projects and reducing their appeal. Questions over UK growth prospects could limit inward investment in renewables, where foreign firms play a large role.

Renewables make up 25% of UK electricity generation, the second largest component after gas (30%) and ahead of nuclear (22%). Of this renewable energy, wind generates 51%, followed by solar (26%) and biomass (9%).

Over half of all UK wind energy projects are funded by foreign companies. Scottish Power, the main energy provider in Scotland, is owned by Iberdrola, a Spanish firm. It accounts for much of the country’s wind energy production, which normally provides around 50% of Scotland’s electricity generation (and provided 100% on a trial day in August).

Potential changes to the rules over EU citizens’ freedom to work in the UK energy sector, which depends on a multinational workforce, raise concerns for foreign investors. Uncertainties over the future relationship between England and Scotland could delay new investments.

UK may lose access
Following British withdrawal from the EU, the UK may lose access to Europe’s internal energy market. Given the dearth of UK-EU interconnectors, and the added distance and infrastructure costs, baseload market prices for electricity are already more expensive than in continental Europe.

This feeds into higher electricity prices for small, medium and large-sized industrial consumers, which are 31%, 41% and 70% higher respectively than the EU28 median. This differential could widen if access to the internal energy market is lost, and could total £500m a year on some estimates.

Rising energy prices would push up production costs for UK-based companies, reducing their competitiveness and harming the government’s attempts to persuade businesses to remain in the UK. Ensuring a competitive price for industry inputs, including energy, will therefore be crucial to the government’s new industrial strategy.

The focus on renewables is key to the success of this strategy. As well as reducing energy costs, greater renewable capacity could offset some of the risks of higher inflation associated with rising oil prices.

Without offsetting these increased costs, a tightening of monetary policy could be on the cards. According to research from the Bank of England and Swiss National Bank, the fall in oil prices has accounted for around half of the decline in inflation since the end of 2014. Oil prices are forecast to rise from an average of $43 p/b in 2016 to $51 in 2017. This could lead to higher interest rates which weaken growth.

Greater domestic renewable energy production could reduce reliance on imports and lower electricity costs for households, helping to offset a fall in real wages. Lowering business costs could help mitigate some challenges related to the fall in sterling, providing the BoE with greater monetary policy flexibility.

Industrial policy
Another important element is industrial policy. In the months following the UK referendum, the government has come under criticism for the ‘support and assurances’ it provided to Nissan, the Japanese car maker, to encourage continued manufacturing at its UK plant. The content of the assurances is unknown, creating speculation that it may include taxpayerfunded guarantees to offset any rise in tariffs on exports to the EU.

There is uncertainty over whether any other companies or industries may receive government support. This makes it appear as though the government is ‘picking winners’, and may increase pressure to support failing or non-profitable industries such as steel, adding significant costs to the budget.

If the government instead seeks to reduce key input costs by investing in or subsiding renewables, this could improve business conditions without having to pick which industries to support.

As well as increasing aggregate demand and offering some protection against rising costs and inflation, this would create a more stable business climate which could make UK investments more attractive. For the UK, renewable energy will be key to a successful industrial strategy.

Ben Robinson is Economist at OMFIF.

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