UK energy crisis calls for rethinking private debt mobilization
The UK faces an uphill battle to raise the funds needed to fund its ambitious energy program over the next two years, capping the cost of household energy bills.
The UK is expected to borrow through the bond markets to fund its energy program, but there is much uncertainty about how much it will need to raise. Estimates of the additional gilt issuance needed over the next two years range from £110 billion to £250 billion. This reflects the fact that no one knows for sure how much is needed, as it depends on wholesale gas prices. This figure will dominate the cost of the government subsidy, but the price of gas depends on many factors, including the harshness of winter in Europe.
One thing is certain – even an additional £110bn over the next two years will weigh heavily on the market. Assuming the £110bn is spread over the next two years under the responsibility of the UK Debt Management Office, this will lead to a record number of gilts entering the market, given the tightening program quantitative from the Bank of England.
Antoine Bouvet, senior rates strategist at ING, said total net gilt issuance would reach £113bn and £209bn in financial years 2022-23 and 2023-24 respectively, taking into account an additional supply of £55 billion per financial year. The £113 billion worth of gilts will represent a record amount in the hands of investors in a single financial year. Of the £388bn of gilts issued in 2020-21, at the height of the Covid-19 pandemic, £281bn was gobbled up by the BoE’s quantitative easing program.
That’s a lot of supply for gilt investors to take on, alongside an expected rising deficit and tax cuts all adding to market risk. There was also a newly formed government as well as BoE rate hikes. Jitters around the gilt market led to a halt in gilt issuance by public sector borrowers, with no new supply from this sector since reports of 10.1% consumer price index inflation in July. Inflation in the UK fell slightly to 9.9% in August.
Investors are already taking all of this into account. The 10-year gilt yield has been trading around 3.2% recently, while the 10-year gilt/Bund spread is around 125 basis points. But gilt yields still have room, with the 10-year gilt/Bund spread potentially reaching 200 basis points, which would put the 10-year gilt yield above 3.5%, according to Bouvet.
In addition to higher yields and the steepening of the gilt curve, gilt swap spreads have tightened as “the story of monetary policy becomes a story of fiscal policy,” as one noted. senior banker specializing in the pound sterling. Although the gilt curve is steepening, it remains incredibly flat, with only about 20 basis points between the three- and 50-year gilts.
One way the DMO could ease its debt burden is to transfer some of the borrowing to the private sector, for example through government-guaranteed loans through energy companies. But experts are skeptical of its effectiveness, given how much banks could reasonably shell out to cover the colossal sums required.
However, mobilizing private debt resources should be a priority for the UK, not only in the current energy crisis, but also for future crises and to help finance development. Until recently, the UK had no public sector agency or development bank, unlike European countries like France and Germany, both of which have a handful. The newly created UK Infrastructure Bank could play a key role in mobilizing private debt and reducing the DMO burden. Insurance companies will naturally look to infrastructure projects for asset-liability management purposes, so demand would be high. UKIB could then tap into the bond markets to bolster its firepower. Since the loss of funding from the European Investment Bank due to Brexit, the UK has faced a big hole in infrastructure and energy funding.
Burhan Khadbai is Head of Content at OMFIF’s Sovereign Debt Institute.