That time of year….
April Fool! If in the previous edition we were writing about the Law of the Greater Fool in relation to the dislocation in the banking sector, this week it is about practical jokes: two of them, in fact, and both perpetrated by government ministers
Shapps’s energy ‘strategy’: you call that a plan?
First up, Energy Secretary Grant Shapps’s publication of what purports to be a strategic energy plan for the UK. Less a strategy and more an exaggerated and pious hope, it is a mere group of words on paper masquerading as a plan. This is a familiar complaint in these columns and sadly, little changes.

If he seriously thinks that relaxing the planning laws to allow easier development of onshore wind installations and the expansion of the acreage of productive farmland signed over to solar power industrial units is going to keep a reliable supply of electricity flowing to the world’s sixth biggest economy, he’s dreaming. And this is even before we see the huge prospective surge in demand when we are forced to adopt electric vehicles (EVs) and domestic heat pumps (and noting that as of next year, car manufacturers will be progressively financially penalised if they fail to meet minimum sales quotas for EVs despite no meaningful national infrastructure for drivers to recharge their vehicles and to have the unrestricted ability to travel that we enjoy with cars powered by the internal combustion engine).

The only encouragement is, in line with the Chancellor’s recent budget statement, a longer-term endorsement to develop small scale nuclear reactors to go alongside the large-scale generating fleet to allow a quarter of our base-load electricity generation to be met from a constant and enduring source. As hydrocarbon fuels are steadily withdrawn, that the majority of our demand will be met from innately variable and unreliable sources places the grid and consumers at the mercy of the wind and sun until such time as a reliable technology is developed to be able to store electricity in bulk.
Gove: from the deluded to the downright dangerous
Second are Levelling Up (or is it more accurately ‘Levelling Down’?) Minister Michael Gove’s much more insidious and dangerous plans to cattle-prod us all towards taking responsibility for cutting our own domestic energy consumption and minimising our emissions. In line with legislation already in place in Scotland, this week he unveiled proposals that in the domestic lettings market, as of 2028 (a mere five years away—time flies considering while March 2020 seems like yesterday, we have already passed the third anniversary of our all being forcibly confined to barracks by Boris at the beginning of the pandemic) it will be illegal for any landlord to let a property that fails the minimum energy rating of EPC Level C; contravention will be met by a £30,000 fine.

In Edinburgh, at the last of the Jupiter Merlin Roadshow presentations, a pertinent question from the floor was “what is the next big systemic threat to the financial sector?”. In the UK’s case, it would seem the obvious answer to that is Michael Gove.

Consider the facts (derived variously from the FCA, Money.com, Open Property Group): the UK currently has an estimated 24.7m residential dwellings; at the end of 2022, the total value of all outstanding residential mortgage loans was £1.675 trillion (12 zeros, in context the sum is equivalent to 70% of our annual GDP); the total value of buy-to-let (BTL) properties (including those owned outright with no mortgage) was estimated at £955 billion (9 zeros, just); 36% of all dwellings in the UK are rented, whether privately, or from Private Registered Providers (i.e. social housing) or councils; 60% of landlords have a mortgage; over three years since the beginning of 2020, an average of 63% of new mortgage business was granted on Loan to Value ratios (LTVs) of up to 75% with a further 32% between 76% and 90%; only 40% of all UK domestic dwellings currently meet EPC Level C, 60% fail the test.

From the data above, we can calculate that 8.9m dwellings are rented, over half owned by private landlords. If we assume that the BTL sector is representative of the total market, it implies that 5.3m (60%) of those fail to meet EPC Level C and will need to be upgraded with compliant boilers, insulation and double glazing in the next five years to remain legally lettable (the 60% proportion may well be higher in reality as BTL properties tend to be older). Estimates vary widely, and limited central government grants are available, but it is estimated that the average cost of remedial works is around £18,000 per property, implying total building costs of £95.4 billion, assuming the labour and materials are available to meet the demand (thanks to the compressed timeframe and the magnitude of the job, demand is likely far to outstrip supply of both materials and labour, pushing up prices and feeding inflation). Looked at another way, with gross rental yields averaging 4% and the average national nominal rent at about £1000pm, a landlord’s enforced building costs are going to amount to an estimated 18 months of gross rental income per property, nearly double that after tax.
Banks are already under pressure, so too house prices; why wittingly create a new systemic risk?
Leaving aside how landlords will fund the works, let us look at the risks to lenders. First, depending on how the banks choose to look at the individual’s circumstances, the effective loss of more than two years’ post-tax rent in building costs may render some BTL mortgages invalid. Second, should the works not be completed on time (or not at all), and the property is not legally lettable, that too may invalidate the mortgage with the possibility of foreclosure on the landlord. But the problem does not end there! Bearing in mind those LTVs above, if the property is unlettable, until such time as energy compliance is satisfied and the property remains unoccupied (and potentially unsellable too), what is its real value? To the bank or mortgage lender, have they recovered the asset they thought it to be over which they had a charge, or merely inherited another liability? This could potentially be happening to all mortgage lenders simultaneously.

Housing markets will distort until full compliance is reached: compliant housing will fetch premium prices while non-compliant housing will be frozen and with no discernible value. The financial consequences are plain. It seems bizarre in the extreme that the Bank of England and the Prudential Regulation Authority are not frantically waving big red flags, or at least bright amber warning ones at Gove’s proposal.

As if this all-stick-and-no-carrot idea is not quite risky enough, it had previously been suggested in an earlier kite-flying exercise that not only would properties failing to meet EPC Level C be unlettable, they should not be able to be sold either; even if the purchaser and the vendor reach agreement that in return for a reduced transaction price, the purchaser would assume responsibility for energy compliance (mortgage lenders would not be allowed to extend a loan to the purchaser without the warranty of a valid EPC Level C certificate). Were that the case and pushing accounting prudence to its limit, beyond the compliance cut-off date in theory whatever the book cost might be, while a property has no legal rental income and no legal right to be sold, arguably it is completely worthless until such time as compliance is satisfied. Imagine the effect on asset prices and mortgage lenders’ balance sheets were 60% of the UK’s housing stock to be deemed to have no value!

Clearly Gove is expecting that the prospect of a hefty fine will ensure full landlord compliance (and to be clear, with tenants’ rights protected, the full onus is placed on the property owner). Realistically, the risk boundaries in the rental market extend from full energy compliance to zero. From a financial systemic risk standpoint, the likelihood is that the relationship between full compliance and zero is not linear but exponential: once one domino falls, it becomes increasingly difficult to prevent them all tumbling.

And to the argument that “don’t worry, it’ll never happen”, the riposte is that it should not. But politicians of all hues have a habit of attempting to manipulate markets to achieve either a political or an economic or behavioural outcome. Look no further than the intervention into energy markets to control gas and electricity prices with all its consequences. Or again allegedly to alleviate the cost-of-living crisis, in Scotland the SNP/Green government freezing rents and suspending landlords’ rights to evict tenants, originally legislated for six months and now extended for a further six to the end of September. Never bet against well-meaning or mischievous politicians to be on the wrong side in the game of unintended consequences. As we have observed before in these musings, intelligence is no bar to stupidity.
Climate change politics and the bigger picture: beggar thy neighbour
But if this is down among the weeds of UK domestic climate policy, there is a much bigger picture emerging. At the annual COP comunes, amid all the high-level, holier-than-thou political grandstanding it is tempting to think that climate change is a common problem for which there are common solutions: we’re all in the same boat, the effect is universal. It engenders a warm fuzzy feeling of global community, that a problem shared is a problem halved.

However, the reality is a very long way from green and fluffy Kumbaya, everyone singing sunny songs surrounded by daisies. The hard edge of the transition to the nirvana of carbon net zero is one of significant competition for and control of the scarce resources required to achieve it, whether they be physical in the form of materials and commodities, or the labour to implement it and build the infrastructure to support it, or the capital to pay for it. Further, naked competitive positioning and protectionism are rife and accelerating. One only needs to look at Joe Biden’s Inflation Reduction Act (most of which is generous green subsidies to wean Americans off hydrocarbons but predicated on buying replacement products made only in the US) to see the competitive tensions and state aid responses it has aroused, particularly in the EU. Such behaviour inevitably warps and distorts markets.

Make no mistake: while the concern is for the planet, national opportunism and getting one over your neighbour is never far behind how you go about preserving it.

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The value of active minds – independent thinking

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Fund specific risks

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