Perspectives



Economic Review & Outlook: Implications for the UK

At last, after a long period of near-zero growth, it is encouraging that the UK has experienced three successive quarters of increasing growth. Forecasters have been revising upwards their estimates for economic growth for this year and next, whilst, in April, S&P reconfirmed the UK Government’s AAA credit rating. More good news is that employment is at an all-time high, inflation is on a downward trend to its goal of two percent whilst interest rates remain at 0.5 percent with a commitment to remain low until the unemployment rate falls to seven percent (it is currently 7.8 percent). Finally, the government has recognised that investment in infrastructure produces both growth and a good return on investment. As a consequence, there is a commitment to invest more public money into infrastructure from 2015, albeit the total levels of public sector investment in infrastructure will still be less than in 2010 when the coalition government came to power.

However, whilst there are more positive indicators to report than in previous editions of EFR, nonetheless there are still concerns, particularly at a global level. The eurozone inflation rate has been falling rapidly, prompting some commentators to speculate about eurozone deflation whilst the world anxiously awaits the US agreement on budget and debt levels due in January 2014.

Domestically, the recovery is also mixed. Recent figures produced by Experian in October 2013 showed that whilst UK construction output for economic infrastructure was increasing year on year, and projected to do so beyond the next general election in 2015, social infrastructure (excluding housing) continues to decline. Public non-residential construction continues to be affected by the reduction in funding for schools. It expects continued decline in 2014 and a bottoming out in 2015. Despite stronger occupancy and rent indices, commercial construction is still low and Experian doesn’t expect an upturn in office construction output until next year, whilst retail remains weak.

UK Economic Performance

The UK’s quarter-by-quarter GDP growth from 1991 through the third quarter of 2013 is shown in Box 1. The improvement in growth figures is ahead of forecasts produced earlier this year and has been supported by higher consumer spending. As incomes in real terms are lower, this is surprising but it is thought that households are spending rather than saving due to the very low interest rates available on savings accounts (typically 0.1 to 1.5 percent).

The Office for National Statistics has also published data on the performance of the construction sector relative to the whole economy GDP since 2008, and this is shown in Box 2.

The government’s independent Office for Budget Responsibility (OBR), in its Autumn Statement 2013 report produced on 5th December 2013, has estimated future growth figures as shown in Box 3.

The UK’s underlying deficit has been revised down by the OBR to 6.8 percent this year and to 5.6 percent next year. It is then expected to fall to 4.4 percent, 2.7 percent, and 1.2 percent in the subsequent financial years with a small cash surplus in 2018-19. Borrowing is expected to come in at £111 billion for this year, falling in 2014-15 to £96 billion, then down to £79 billion in 2015-16, £51 billion the year after, and £23 billion the year after that. Public debt this year will be 75.5 percent of GDP—£18 billion lower than forecast in March—rising to 78.3 percent next year, before peaking at 80 percent the next year. By 2017-18, debt is expected to be more than £80 billon lower than forecast in March.

The OBR has revised up its employment forecast, with total employment expected to reach 31.2 million in 2018. Unemployment forecasts show a fall to 7.6 percent this year and reaching the critical seven percent level in 2015 (at which point interest rates are expected to rise from their current sustained low of 0.5 percent). Unemployment is expected to fall further to 5.6 percent by 2018. The total number of jobs is expected to rise by 400,000 this year with 3.1 million jobs predicted to be created by 2019.

The OBR forecasts that the current inflation rate of 2.2 percent will fall back to the Bank of England’s two-percent target during 2016. However, the OBR’s house price inflation forecast has been revised up significantly, reflecting the change in house prices this year and supportive mortgage financing conditions. They expect house price inflation to be above five percent in 2014 and seven percent in 2015.

Prospects for UK Infrastructure

UK infrastructure is potentially in a better place than it has been over the past three years as demonstrated by the publication of the UK’s National Infrastructure Plan 2013. In transport, the newly announced transition of the Highways Agency (the manager of the strategic road network in England) from a government agency into a independently managed but government-owned institution with a five-year budget is an important first step in transforming the delivery and management of the roads network, and one in which the supply chain engaged in highway design, construction, maintenance, and operation expect to play a full part.

The devolved governments of Scotland, Wales, and Northern Ireland are also investing in their strategic road networks to increase capacity and provide greater certainty on journey times. However, local road networks are not in the same position and have suffered as government support to local authorities continues to reduce.

The rail sector is midway through an ambitious programme on its core network. High Speed 2 (HS2), the proposed new high speed rail line from London to Leeds and Manchester via Birmingham, has overcome a number of important hurdles. A hybrid bill for Phase 1 from London to Birmingham has now been deposited with Parliament and will be debated in 2014. A hybrid bill will not only grant the government planning permission to build the HS2 network, but will also give the government powers to operate and maintain HS2 and its associated works, along with other more detailed planning matters relating to existing infrastructure affected by HS2.

The aviation sector is awaiting the findings of the Airports Commission, which is due to report to government in 2015 with its recommendations on future UK aviation policy. The commission’s task was split into two phases and the emerging thinking from the first phase, looking at short-term options for increasing capacity, was published in October 2013. Its provisional conclusion was that some net additional runway capacity was needed in the south east of England in the coming decades. There will also need to be a focus on strengthening surface access links to airports. Phase two, looking at strategic longer-term options, starts in 2014 and the commission is due to report back to government in mid-2015, shortly after the next general election.

Investment in new social infrastructure has experienced several years of decline with building programmes being curtailed or cancelled for schools, hospitals, and other institutional buildings, for example. New housing is now increasing, whilst investment in water and waste services has remained constant. Commercial development was badly affected by the credit crisis in 2008 and continues to be, particularly outside of London with office construction output, lower but is starting to recover. Experian, in its Autumn 2013 forecast of construction output, takes the view that offices and industrial development will outperform retail. It expects retail to struggle to show any growth between now and 2016.

The energy market faces some big challenges. The UK has around 80 GW (gigawatt) of generation capacity generating approximately 360 TWh (terawatt-hours) every year. Over the next five years some 20 GW of capacity will be retired due to asset life or emissions compliance. Most of the UK generation plants are coal or gas with some nuclear, oil, and

renewable.The progressive reduction in carbon emissions required by the UK’s Climate Change Act1 means that the retiring 20 GW of plants cannot just be replaced on a like-forlike basis.

In addition, the government has been putting in place electricity market reforms (EMR) to incentivise construction of new generation plants that either produce low carbon electricity, such as renewable or nuclear, or are designed to generate over short periods to ensure security of supply. The legislation enabling this change should be enacted by the end of 2013 or early 2014 but, in the interim, there has been little appetite to invest in new generation plants other than renewables, which benefitted from a subsidy known as the “Renewables Obligation”. As a consequence, the capacity margin, or the amount of firm energy plants required over and above those required to supply the day-to-day demand of electricity consumers, is reducing from the 20 percent of a decade ago to single figures today.

The new legislation provides for a capacity mechanism that rewards generators with enhanced revenue if they can provide firm power when it is needed, and penalises them if they cannot. This will drive the business case for new investment in up to 30 new combined cycle and open cycle gas generation plants over the next 20 years to help satisfy security of supply concerns over the long term. The new legislation also provides a contract for difference (CfD) tariff for generators of low-carbon electricity, enhancing the wholesale electricity market price with a “top-up” to an agreed level that is necessary to meet the business case needs for new investment. Over £110 billion2 of new investment is needed in the electricity sector over the next 10 years, most of it for new generation plants but approximately £35 billion for investment in the transmission and distribution systems.

The challenges are that the Energy Bill and its contract-based mechanisms for investment are new, that the investment is required urgently, that other countries also have similar investment programmes, and that the leading political parties, ahead of the general election in 2015, have focused on the affordability of costs to electricity consumers as an electoral issue. As a result, there is some lack of clarity about how the £110 billion is to be funded, given that electricity consumers, rather than the taxpayer, are the ultimate funder. The level of investments required are approximately double those of the last 10 years and that is going to require consumer bills to rise, as well as place significant pressure on the supply chain to deliver an appreciable increase in new infrastructure.

Meanwhile, investors are being selective and withdrawing from projects that are perceived to be more challenging, either technically or logistically, as illustrated by the RWE announcement that it was terminating its work on the Atlantic Array project (a 1.2 GW offshore wind project in the Bristol Channel) and transferring the seabed lease back to the Crown Estate. However, Hinkley Point, a new 3.6 GW nuclear project being developed by EDF Energy, is progressing having secured a development consent and agreed on its contract with the government under the new Energy Act that guarantees its revenue stream for the next 35 years. However, it is still subject to a review by the European Union and completion of the investment agreement.

Conclusions

There is a sense of optimism, but it is not universal. Capital spending is on the increase and there is a greater focus from government on the importance of infrastructure. However, existing systems for delivering national infrastructure require reform, and these reforms, for example in the energy and highways sectors, take time to get right.

In addition, there are new challenges facing the infrastructure sector, for example from climate change impacts. In December 2013, the European Academies Science Advisory Council concluded that an increase in extreme weather throughout the continent would present major challenges to engineers and infrastructure owners. The issue was graphically demonstrated two days after its publication when the entire rail system connecting England and Scotland was shut down due to extreme winds and extreme weather warnings issued for tidal flooding along the entire length of England’s eastern coast.

As we move into 2014, there is optimism but also realism about the challenges that lie ahead.

 

Notes:

  1. The Act places a legal obligation on the Government to reduce carbon emissions to 80 percent of their 1990 level by 2050.

  2. Electricity market reform assumptions, Department of Energy and Climate Change

 

Image Header Source: Matt Buck (Creative Commons)


Geographies: United Kingdom & Europe
Sectors: Other
Topics: Economics