An Industry View: What Will Brexit Mean in the Short Run?
This paper reviews the impact of Brexit on the following sectors:
- Agriculture and Food
- Financial Sector - Regulated Banks
Agriculture & Food Sector – Investors, Food Processors, Grain, Feed, Trade Companies
A British exit from the European Union could have an adverse impact on farmland value if subsidy payments were to be cut. Predicting the impact of Brexit on UK agriculture is difficult, nevertheless valuation and risk profiles of companies investing, owing and operating assets, or exposed to this sector via loans, debt, financing businesses is high.
Post-exit UK Farm sector will be governed by World Trade Organization rules, which of course will be influenced by post-Brexit negotiations with EU. Grain, feed, livestock, dairy, etc., processing/manufacturing and merchandising/trade companies should think about implications of the Brexit from a context of the time required for renegotiation with counterparts to avoid disruption of supply chains. There will likely be higher trade, administrative costs equivalent to tariffs on exports and imports of at least 5%1.
Farming sector economics are at a very high level affected by:
- Exchange rates
- Interest rates
- Policy items - Budget allocation, tariffs, subsidy framework etc.
- Migration policy and labor availability
For instance exchange rates, a decline in the UK sterling may be considered favorable; however interest rates (borrowing rates) could end up higher, resulting in a protracted period of higher volatility. The UK may attempt to offset any negative impacts by allocating more monetary assistance to the farming sector/food industry, but the potential impact in labor availability (employment) and potentially higher costs of labor could pose headwinds (farms reliant on a seasonal influx of workers from eastern European countries in the EU would suffer from disruption to the labor supply at lower costs).
For example, EU payments2 help farmers cope with swings in commodity prices. Wheat, for instance, has fallen dramatically from £180 per tonne in 2012/13 to £105 as of today, which is below the cost of production for some farmers, thereby cutting operating returns from around 2 per cent to 1.5 per cent.
The UK may need to work with the EU internal energy market in any Brexit scenario. Great Britain has been following an aggressive liberalization cross-border energy market policy, and this is likely to continue.
As we move towards Brexit, the UK may need to negotiate an appropriate partnership with the EU and comply with relevant European legislation. Any failure to agree might result in the divergence of Great Britain and EU energy regulatory regimes, whose impact is as of yet unknown.
The UK will likely follow the EU’s “third energy pack” policy - which specifies ownership unbundling requirements (separate ownership and operation of electricity/gas transmission systems from any generation, production and supply interests is required to level the playing field) and the standards of transparency. Furthermore, any energy sector subsidy will need to comply with the WTO subsidy regime.
UK’s climate change goals might remain unchanged; these are established at a national level under the Climate Change Act 1998. However the funding model for renewable projects will need to be independent of any EU led funding initiatives, and the UK will likely need to re-negotiate carbon offset limits and offset mechanisms.
UK energy companies are part of Europe-wide companies that engage in global energy markets. Only two of the UK’s “big six” utilities are UK-owned: Centrica and SSE. E.ON and RWE are German-based, EDF Energy is French and Scottish Power is part of Spain’s Iberdrola. Cross-border investment valuations and implications of Brexit to UK-domiciled assets would be of concern to these companies.
Long-term energy supply contracts; restrictions thereof under the current regulations; and the selling of capacity on a long-term basis or under bilateral contracts would all be examples of things that will need to be re-thought. In addition, the impact to market pricing models across interconnectors, export tariffs etc. would be important to sort out.
There are a number of EU initiatives to promote investment in energy infrastructure which represent an important source of funding for UK projects (EIB investments in the UK economy came to EUR 7 billion in 2014 with energy projects accounting for 50 per cent of this). The future of similar investments within the UK is unclear. Projects which are already funded will need to examine the terms of their credit or investment agreements to establish the impact of Brexit.
Financial Sector – Regulated Banks
UK’s dominance as an international finance center within Europe and globally will be recalibrated by the terms of a potential Brexit. The UK is not currently part of the Eurozone, but has been an important part of setting global prudential supervision and regulation for banks and financial services. This model of influence will likely be stressed post Brexit. The UK has a stake in free-trade agreements across Europe, and Brexit could risk some of these agreements (within the financial services space), as international banks ponder if to relocate base operations elsewhere within Europe.
The MiFID legislation ramifications in particular and the treatment of UK post-Brexit and its engagement model with the rest of the EU will be material to consider. There will be numerous other questions to think through. For instance:
- Would the UK banks still maintain their “passporting” rights?
- How would capital management and reporting requirements evolve considering Basel III and impacts from BASEL IV?
What would happen to regulatory expectations around:
- Risk Management and reporting?
- Liquidity Management the supervisory oversight of investment activities in relation to financial instruments?
- Would local UK policies mirror the EU, or deviate from them? What would happen to benchmarks for risk-free rates?
A Brexit could lead to a more costly operating model for businesses and banks in the UK and Europe, especially if several banking operations need to relocate and/or establish ongoing regulatory frameworks that are required to be re-calibrated.
What This Means For Clients
CFOs, CROs, Treasurers and risk managers should be prepared to manage sustained levels of potential volatilities in in FX, and Interest Rates pertaining to their balance sheet; and income statement exposures to the Pound Sterling, the Euro and other major currencies.
Management of companies in the Agricultural and Energy space will need to think through the broader ramifications of regulatory policy, market-traded mechanisms, restrictions on movement of investments, talent, and cost of funding in a post-Brexit world, on their own investment valuation and risk management approaches.
In addition to the above facets, senior management of banks and financial institutions will need to anticipate the impact of ongoing and developing regulatory frameworks governing prudential banking practices, capital risk management and reporting, and the operational risks; and having to potentially move talent and infrastructure across geographies to meet the evolving impacts of a Brexit.
Duff & Phelps experts within the Valuation, Complex Asset & Risk advisory, along with Regulatory, Compliance, Transfer Pricing, Restructuring, M&A and Taxation experts are actively working with our CFO, CRO and Treasurer clients to formulate company specific and sector wise strategies to manage through the near term uncertainty, and plan for the long term ramifications of the associated dislocations. Proactively managing the potential valuation and risk management ramifications in a dynamic way should give companies a head start in managing the costs and tail risks associated with upcoming dislocations.
Please contact Manish Das, Managing Director at Duff & Phelps for any questions or comments about this article.
1 According to Professor Alan Matthews, Trinity College Dublin
2 Financial Times, June 2016