European politics and regulatory outlook: creating stability amid adversity

Overview

It’s been a tumultuous year. A culmination of political turmoil and macroeconomic disarray have converged to create a perfect storm, the full effects of which remain to be seen.

With populism potentially making a comeback in Europe, the ongoing Ukraine conflict and turbulence with the UK government, we share our political and geopolitical Outlook for 2023. We also share our outlook on the regulatory side, focusing on digital assets, energy and ESG.

Outlook for politics and geopolitics

A wave of populism in Europe?

Recent election victories for far-right parties in Hungary and Italy may suggest another wave of populism is rising across Europe. It’s made political negotiations among member states more challenging. But so far, the EU has been able to maintain unity across the bloc on critical issues such as Russian sanctions.

There have also been early discussions around moving away from unanimity, which should reduce the ability of individual member states to hold the bloc to ransom.

The approach to the energy crisis has so far been fragmented. But we expect the positive momentum from the bloc’s response to Covid-19 to prevail. It could lead to a joint approach to energy price caps and reinsurance for member states supporting household and businesses with the cost of living.

The EU’s geopolitical role following the Russian invasion of Ukraine

The Russian invasion of Ukraine has reignited discussions around EU enlargement and the geopolitical role of the EU. Assigning Ukraine candidate status is a positive signal, but the EU has recognised that accession remains a long and tortuous process.

The European Political Community was first proposed by French President Emmanuel Macron to bring a broader cast of countries from the region together. While not an alternative to EU membership the goal was to discuss issues of common concern, including energy, migration, and defence. The long-term success of this new grouping is yet to be demonstrated. But it shows the EU’s increasing geopolitical aspirations in the region.

The calibration of the EU’s fiscal rulebook

The energy crisis, coming so soon after the pandemic, is straining national budgets and is reigniting debates around joint borrowing. Fiscal hawks continue to resist any additional joint borrowing. There is dry powder left in the current Covid Recovery and Resilience Facility (RRF) that could be redeployed. Instead, there are growing calls from member states to create some form of EU-level support mechanism to ensure that households and businesses can be supported through the winter.

This is a precursor to a larger debate around the long-term recalibration of the eurozone’s fiscal rulebook. The Stability and Growth Pact has been suspended since the pandemic, but a decision needs to be taken in May 2023 as to when and how these rules are reintroduced.

Currently, the focus is on having less rigid rules. This would provide more discretion to member states to define their path back into the black, but stronger enforcement where countries fail to adhere to their commitments. Another key discussion point will be whether investments in climate, digital and other such transitionary projects should be excluded from any fiscal tightening.
 

Outlook for EU policy and regulation

Legislation for digital assets

The EU have put in place a legislative framework for digital assets and service providers over the last six months. The year ahead will focus on the operational aspects of this, with the reins passing from the legislators to the regulators.

As a result, over the next year, issuers, service providers and other business operating in this space will be figuring out how the new framework will impact their operations. They’ll also seek to identify what growth opportunities exist because of greater clarity from the Markets in Crypto Assets (MiCA) Regulation and the Pilot Regime for Market Infrastructures based on Distributed Ledger Technology (DLT).

Meanwhile, the European Central Bank (ECB) will continue its exploratory work on the viability and utility of a digital euro, deciding by the end of the year whether to develop it further.

The energy crisis fallout

The short-term focus will be on navigating the fallout from the energy crisis. This will include introducing price caps on gas, which will be complemented by more medium-term priorities like reforming the way the EU determines electricity prices.

But work is also progressing on the EU’s Fitfor55 package. This is the package of measures that should align the bloc with ambition of reducing carbon emissions by 55% by 2030.

This includes reforming the EU’s cap-and-trade system for carbon, introducing a Carbon Border Adjustment Mechanism and banning the production of petrol and diesel cars from 2035.

ESG disclosure rules and reporting standards

The EU has already agreed to reform its corporate sustainability disclosure rules. Now, the technical work to define the reporting standards will take place. The critical question will be: to what extent the EU will align with the international standards being developed by the International Sustainability Standards Board (ISSB)?

The EU is also debating the potential introduction of a mandatory due diligence regime for companies. This mean they must undertake due diligence on their supply chains for environmental and human rights issues. It’s in addition to specific regimes banning products from the EU market that contribute to deforestation or that are the result of forced labour. 

Outlook for politics and geopolitics

A political merry-go-round

2022 could scarcely have been a more volatile period in UK politics, witnessing three different Prime Ministers and four Chancellors. Despite current Prime Minister Rishi Sunak’s more technocratic approach, we believe political volatility and uncertainty will persist through 2023 with an unruly governing party facing significant economic headwinds.

With the rising cost of living, the health system creaking and a wave of public service strikes throughout the winter, the Conservatives will likely continue trailing Labour in the polls, in our view. They’ll likely suffer losses at the local elections in May. 

As a Labour government (either majority or minority) becomes the most likely outcome of the next election, media scrutiny of Labour’s policy plans will likely increase. This could force Sir Keir Starmer’s party to reveal more detailed proposals.

Restoring fiscal responsibility

Following the failure of the September 2022 mini-budget, fiscal responsibility has been restored as a central plank in the government’s economic strategy. Institutions such as the Bank of England and the Office for Budget Responsibility have emerged with their independence strengthened. 

In our view, Fiscal policy will no longer work against monetary policy and independent economic and fiscal forecasts will, once again, be the cornerstone of future budgets.

There was a significant package of tax rises and spending cuts announced in the Autumn Statement. Despite this, we believe the combined effects of inflation, higher interest rates, potential recession and continued public spending pressures mean the public finances will remain under strain through 2023. 

With the perennial exception of the National Health Service, demands for significant spending increases (e.g. defence) will likely be rebuffed.

If the economy contracts more than predicted or revenues surprise on the downside, further tax hikes will test the limits of Conservative MPs’ willingness to support raising the overall tax burden. This is already forecast to reach the highest level as a % of GDP since WWII – yet further. 

Geopolitics: The Northern Ireland Protocol and security concerns

UK-EU relations, which have been strained since the Brexit referendum, could improve significantly if a lasting solution to the implementation of the Northern Ireland Protocol can be agreed. 

While the political mood music on both sides is encouraging and negotiations are ongoing, serious compromises are still needed on both sides to reach an agreement. 

Resolving the Protocol would remove the biggest piece of grit from wider UK-EU relations. It would enable greater cooperation across areas such as financial services regulation and scientific research.

The war in Ukraine and the threat of asymmetric Russian attacks against Western vulnerabilities (e.g. undersea pipelines and cables) will likely continue to be a dominant security challenge next year. But as cost-of-living bites, the government will need to work harder to persuade voters of the merits around continued military support to Ukraine.
 

Outlook for UK policy and regulation

Regulating cryptoassets

Proposals to bring stablecoins used as a means of payment within the regulatory perimeter for the first time will become law in 2023. The government also proposes to bring a broader suite of ‘cryptoassets’ within the regulatory perimeter, including applying financial promotion rules to crypto investments. 

The Treasury will also be empowered to develop financial market infrastructure (FMI) sandboxes for testing FMIs that utilise distributed ledger technology.

The Bank of England will continue its exploratory work on the concept of a UK central bank digital currency (CBDC). But even if the exploratory and development phases go to plan, we don’t expect a UK CBDC to be ready until at least the end of 2025.

Help for households and energy security

Support for households and businesses to cope with the rising cost of energy will remain an immediate focus. The Treasury will review the scope and cost of the Energy Price Guarantee for households ahead of an announcement in the Spring. 

The war in Ukraine has underlined the need to enhance energy security in parallel to decarbonisation. Fracking is firmly off the table again. The government’s focus will be on incentivising a faster rollout of new nuclear and renewables; and producing a workable package to improve home energy efficiency.