Brexit and businesses: sectoral impact analysis

2. Implications for trade, inward investment and EU funding

Key findings

• Scotland is a small, open economy with several sectors which are heavily export orientated. It has benefitted from many aspects of EU membership including tariff-free and frictionless trade, inward investment as well as EU funding. Scotland’s export strengths compared to the rest of the UK are in food and drink (whisky, salmon, crustaceans and molluscs), and in energy and chemicals (petroleum, gas and chemicals materials and products).
• The introduction of tariffs and non-tariff barriers to trade will likely reduce the volume of trade between Scotland and the EU. This risks the viability of some key activities in Scotland in the short-term, but also as Scotland moves to new trading relationships with the EU and third-party countries. In particular, sectors that are most vulnerable include food and drink, chemicals, life sciences and high value manufacturing.
• Businesses in the chemicals, creative industries and food and drink sectors emphasised the importance of EU standards. This not only enables frictionless movement of goods across borders within the EU, but also facilitates trade with non-EU countries where EU standards are widely accepted.
• Scottish businesses have benefitted from EU funding that has supported productivity, e.g. the Common Agricultural Policy (CAP), Horizon 2020 and other targeted EU funding programmes^[30]. Losing access to EU funding could affect levels of demand in some sectors, e.g. construction, and affect viability and investment environment of some business, including many businesses in rural economies and the rate of start-ups and innovation spin-outs.
• A characteristic of a number of sectors of the Scottish economy, such as financial services, chemical, life sciences and key parts of the creatives industries sector, is that many businesses are located in clusters across Scotland. There is a risk that if businesses move activity out of Scotland this could start to undermine the agglomeration benefits of these clusters.
• The impact of Brexit on consumers in Scotland could be significant through price rises on all imported goods as a consequence of tariffs, border frictions and a weaker currency. This would likely be felt in food and drink most prominently (although this could be positive for domestic producers), but also potentially through higher energy prices which would also be of concern to energy-intensive businesses.

2.1 Brexit risks

A no deal Brexit on WTO terms would lead to the introduction of tariffs and non-tariff barriers to trade (e.g. additional customs processes), exit from a number of EU regulatory regimes, and the loss of EU funding from various programmes.

2.2 Evidence

2.2.1 Tariffs and non-tariff barriers to trade

Scotland is a significant exporter – in 2016, total exports were worth £29.8bn, of which £12.7bn went to the EU^[31]. In total, exports accounted for 50% of GDP in 2016-17^[32] compared with 30.5% for the whole of the UK in 2016^[33].

Key exporting sectors include:

• Food and drink (including agriculture and seafood), with total international exports of £5.5bn in 2016, with the EU accounting for approximately 37% of this trade^[34].
• Chemicals and energy, with international exports of petroleum and chemicals worth £2.6bn and mining and quarrying exports worth £2.0bn in 2016; EU trade accounted for 86% and 28% of trade in these products respectively^[35].
• Creative industries, with international exports of £1.0bn in 2016, and over a third going to EU countries^[36].

The introduction of any tariffs and non-tariff barriers to trade will likely reduce the volume of trade between Scotland and the EU. This risks the viability of some key activities in Scotland in the short-term, but also as Scotland moves to new trading relationships with the EU and third-party countries – in particular, sectors that are most vulnerable include food and drink, chemicals, life sciences and high value manufacturing.

The impact of tariffs on competitiveness was a primary concern for businesses, especially in the primary agriculture and aquaculture sectors. For example, WTO tariffs for meat products are between 50% – 100%, and for dairy products they could be between 42% – 45%. Although the Scotch Whisky Association’s stated position on the draft Withdrawal Agreement and accompanying Political Declaration on the Future UK-EU Relationship is that, on balance, is that they stand up well against the Scotch whisky industry's Brexit priorities^[37], whisky production currently benefits from EU trade agreements with third parties. Analysis by the Scotch Whisky Association indicated that the risk of losing lower tariffs for these countries would have amounted to around £53 million in 2017, with the equivalent figure under current arrangements being £3.3m^[38]. The Scottish potato sector may also be disproportionately affected (Insight 1).

Insight 1: Seed potatoes

Because of its climate, Scotland can produce superior seed potatoes compared to other countries^[39]. Seed potatoes make up roughly half of the potato sector in Scotland – a sector potentially worth £80-100m per year^[40] – and the EU is a significant export market (13.5% of production). The EU external tariff is around 40% and this would make Scottish seed potatoes uncompetitive compared with rival producers in the EU, particularly from the Netherlands, who, anecdotally, are ready to fill in lost supply from Scotland.

Source: EY dynamic consultation

Tariffs would also be damaging for lamb producers (Insight 2).

Insight 2: Scottish lamb exports and New Zealand tariffs

Scottish lamb exports may become subject to tariffs of around 13%^[41], and will face strong competitive challenge from New Zealand which has agreed a zero tariff on its lamb exports to the EU up to a limit of 228,000 tonnes. However, it was highlighted that there may be scope for Scottish producers to diversify export markets in the medium to long term. For example, opportunities for halal lamb meat for Middle East and North African markets were identified, although the feasibility and scale of this opportunity had yet to be assessed.

Source: EY dynamic consultation

Tariffs, both on exports and imports, were also a particular concern in the chemicals industry. Indeed, in a Chemicals Industry Association survey, 46% of the 94 respondents indicated that maintaining free trade with EU countries was the highest priority for their future success.

The low margin on products in the chemicals sector means that even the relatively low tariffs in this sector (between 3% to 4%) could be enough to make production uncompetitive. As a result there is a risk that value-add activity across the UK will shift elsewhere in Europe, which could lead to a loss of productive capacity in the sector. Across the UK, tariffs could eventually encourage activity across the energy intensive sector to move out of the UK, because WTO tariffs are typically greater on higher value add chemical products.

Higher import costs due to border delays would be compounded by any exchange rate depreciation, and the possibility that tariffs will need to be levied on EU goods. Construction products and primary materials are extremely price sensitive, with customers, at present, easily able to switch supply domestically/internationally (e.g. electrical components, marble).

The Construction Products Association estimates that approximately 20% of all construction products (by value) used in the UK are imported, while EU imports comprise 60% of all building material imports to the UK^[42]. Within the Scottish housebuilding sector there is particular dependence on timber imported from the EU; there is a much greater share of timber frame new build in Scotland (around 80% compared with around 10% in England), and around 60% of all sawn wood used in the UK is sourced from the EU.

Potential mitigations

The manufacturing and processing elements of the food and drink sector rely on inputs from other EU countries that will be subject to import tariffs as well as potential border delays. This could provide an opportunity for domestic suppliers, although it could lead to higher prices for consumers. Import substitution, e.g. replacing imports with domestic production, was identified as a potential opportunity for beef, pork and for dairy products, where one food manufacturer noted that it was seeking alternative UK sources of butter to its current Irish supply (tariffs would be around 40% to 50%)^[43]. Import substitution could also be possible in the wider supply chain for whisky (Insight 3).

Insight 3: Scotch whisky supply chain

The whisky industry uses domestically sourced barley and water, but glass bottles need to be imported, currently largely from the EU. Competitiveness could be put at risk by tariffs on supply chain inputs as average tariffs on glass and glassware are around 5%^[44]. In the absence of the UK pursuing maintained lower tariffs on the import of glass bottles, it also represents an opportunity for the development of local bottle manufacturing.

Source: EY dynamic consultation

Import substitution represents a cross-sectoral opportunity. In the dynamic consultation with the energy sector, opportunities to develop a domestic supply chain were highlighted; for example, in the renewables sector there may be an opportunity to grow the supply chain for manufacturing and maintenance of wind turbines to Scotland.

Scotland may also benefit, in the medium-term, from focusing on sectors in which there are lower levels of intra-industry trade, and hence would be less affected by EU tariffs. For example, SG could seek to develop further industries that are less exposed to tariffs such as television production or computer games (Insight 4).

Insight 4: Sectors for future investment

Television production and the computer games industry focus on creating value through design and intellectual property. For example, computer games are largely unaffected by tariffs and the need for physical goods trade between two countries to produce their products. A constraint, however, is making sure that these products can still be sold to the EU market, so regulatory alignment remains important.

Source: EY dynamic consultation

Post-Brexit investment in system changes and logistics may be required to facilitate continued trade with the EU. This may be more feasible for some sectors than others and it may also be more affordable for firms with wider margins. For example, in dynamic consultation, manufacturers operating on a just-in-time basis indicated that they had sought to procure extra warehousing to store spare parts in case of border delays; this will increase warehousing costs. However, this may not be feasible for all companies, for instance if these extra costs are too high or border checks mean time-crucial products do not get to market at a critical juncture.

Exploration of alternative international markets should also be considered. For example, from dynamic consultation it became clear that the life sciences sector in Scotland already exports globally, and in particular to the US. It may therefore have some resilience in respect of Brexit.

Finally, representatives from the energy sector (including oil & gas), were less concerned about barriers to trade, on the basis that the industry was largely domestic in focus (generation and transmission), or was highly global in nature, with minimal (or zero) tariffs, and used to operating under political uncertainty (extraction of oil & gas).

2.2.2 Regulatory alignment

In dynamic consultation, businesses in the chemicals, creative industries and food and drink sectors emphasised the importance of regulatory alignment to EU standards. This not only enables frictionless movement of goods across borders within the EU, but also facilitates trade with non-EU countries where EU standards are widely accepted.

The need for regulatory alignment or at a minimum, mutual recognition of standards, is of particular importance to the chemicals sector in Scotland, which is highly integrated in EU value chains, with products moving back and forth between Scotland and EU countries. In a Chemicals Industry Association survey, 36% of respondents said retaining regulatory consistency was a priority, second only to maintaining free trade with the EU.

For such activity to continue, it is crucial that businesses in this sector meet standards set by REACH. Businesses indicated in dynamic consultation that they had invested significantly to be compliant with REACH and want UK regulations to align to these same standards, or at least for any new UK regulations to be recognised by the EU. REACH is also widely accepted in markets outside the EU, for example, following recent changes in US regulation it is now seen as closer to US standards^[45].

Similarly, in life sciences, companies conducting clinical trials in the EU need to be compliant with the Clinical Trials Directive. EU regulation is changing in this area to facilitate large pan-European trials. If the UK is no longer subject to this EU regulation, then UK companies’ involvement in these trials could become administratively more complex. In dynamic consultation, a company in this sector indicated that they may consider relocating labs to the EU. Companies had also started the recruitment process for Qualified Persons (QP) in the EU, to oversee batch release and quality control testing for EU trade purposes in case of divergence.

Businesses in the creative industries in Scotland also rely on close regulatory alignment. In the Scottish screen sector for instance, European designation plays an essential enabling role in providing markets for Scottish television production companies’ output. Scottish television production companies, particularly independent producers, have benefitted from the designation of their work as European which means their productions meet requirements on broadcasting companies to show a minimum level of European content. The potential loss of designation of European status for Scottish screen works is perceived as a significant issue for the sector and may threaten the survival of some independent businesses, although further analysis would be required to assess the scale of this impact and potential mitigations.

Regulatory alignment also enables access to EU markets for the computer games industry in Scotland, for example, requirements on age labelling are set at the EU level, and compliance is necessary to sell into EU markets. The cost of developing games is too high to rely only on sales to UK markets and the industry requires a worldwide audience, as evidenced by trade body figures shared during dynamic consultation, e.g. 95% of the UK industry exports, and this is equally likely to apply to the Scottish parts of this sector. Further analysis is required to understand the full extent of risks associated with regulatory divergence in the video games industry.

Regulatory alignment in aviation is also crucial as it covers the whole system of engineering certification for materials, parts, components, aircraft and maintenance services governed by EASA, as well as the EU-US Open Skies agreement. Having certainty around the UK’s continued involvement in this agreement is crucial for airports and airlines to be able to operate normally post-Brexit. The UKG has taken actions to ensure that, in the event of a no deal Brexit, the UK would grant EU airlines permission to operate in the UK, and the UK would expect EU countries to reciprocate in turn^[46].

Post-Brexit, there may be opportunities for the UK and Scotland (via its devolved powers) to diverge from EU standards to, for example, reduce certain costs to businesses. Regulatory divergence could include lower tax rates, increased capital allowances, or incentives for expansion. However, it was noted that the benefits of divergence may not outweigh the costs if it means that exporters could no longer sell key products in EU markets, or if it raises the costs of exporting due to the need to demonstrate regulatory compliance.

2.2.3 EU funding

Scotland has benefitted as a recipient of EU funding across a range of areas, including:

• The Common Agricultural Policy (CAP) that provides over £500 million per year to Scotland.
• Scotland has been allocated €941 million through Structural Funds over the period 2014-2020 for economic development. These funds include the European Development Fund through which Scotland has an allocation of €476 million to invest in smart and sustainable growth^[47].
• The European Maritime and Fisheries Fund (EMFF)^[48] is also a Structural and Investment Fund. Scotland receives 44% (€108m) of the total UK allocation, of which 80% of this has been committed to projects to date^[49].
• The European Investment Bank (EIB) provides long-term loans to SG on a project by project basis; over the last decade this has amounted to £3bn^[50].

Farming and agriculture in Scotland have been very reliant on direct EU support, and funding in the fisheries and aquaculture sector has helped to develop port infrastructure to support seafood exports. The CAP also provides Scottish farmers financial certainty and funding over seven-year cycles, and is key for supporting the funding and finance environment to support agriculture investments.

Public sector spending accounts for around 50% of turnover in the construction industry in Scotland, of which a significant proportion comes via EU structural funds, though SG notes that this has been declining in recent years^[51]. If Scotland’s public sector budget for construction works falls as a result of Brexit, this could pose a risk for businesses which rely on these contracts.

The EU has provided funding through Social Enterprise Funds (SEF), the Connecting Europe Facility (CEF) and the Trans-European Transport Network Policy (TENTE) to benefit the logistics sector in Scotland; it has been particularly important to smaller fishing ports in Scotland.

For some key Scottish sectors, e.g. life sciences and newer offshore renewable technologies, research and development (R&D), supported by EU funding, has been important for developing productive capacity and driving productivity growth. For example, sectors including chemicals, life sciences and high value manufacturing in Scotland have benefitted from Horizon 2020 funding, and Scotland receives more per head from Horizon 2020 than the other UK nations^[52]. Losing EU funding could affect business start-ups including university spin-outs, which are perceived as important for the future of several of Scotland’s emerging sectors. Scotland’s share of business births in the UK (6.1%) is already lower than might be expected given that it constitutes 7.7% of the UK economy^[53]. Life sciences in particular have benefitted from Horizon 2020 funding (Insight 5).

Insight 5: EU funding supports productive capacity in the life sciences sector

Since 2015, €533 million of Horizon 2020 funding for R&D has been secured by Scottish organisations^[54]. This funding has supported growth in industrial biotechnology and university spin-outs.

Source: EY dynamic consultation

EU structural funds have supported construction activity in Scotland while Creative Europe and Erasmus have been beneficial for creative industries in Scotland, although further analysis would be required to assess whether Scotland disproportionately benefits compared to the rest of the UK.

Euclid estimated for Creative Scotland that Scottish arts, media and creative industries benefitted from at least £23mn of funding between 2007 and 2016 across a range of EU programmes^[55]. In the television production sector, membership of the EU MEDIA Programme has provided funding in Scotland for screen works which are pan-European in content. According to a small independent production company, this source of funding has been beneficial for the independent production businesses, which make up a significant proportion of the sector.

Companies in the Scottish energy sector could lose access to innovation funding and the significant amount of EU funding which has gone into community energy schemes. This has been important for renewables, especially given the rural nature of the population in the more remote parts of Scotland.

Through dynamic consultation, an organisation indicated that funding from the European Social Fund is also used in Scotland to support debt advice activities by housing associations and other organisations. These activities may be even more crucial after Brexit if it leads to higher poverty as a result of higher prices for consumers. SG could undertake further research to verify and confirm the scale of this issue.

2.2.4 Scottish industry characteristics

A characteristic of the Scottish economy is that a number of sectors, such as financial services, chemicals, life sciences and computer games, are located in clusters in Grangemouth, Edinburgh and Dundee respectively. In dynamic consultation, businesses indicated that there is a risk of activity moving out of Scotland, reducing the critical mass of the cluster and hence some of the agglomeration benefits^[56]. For example, in the financial services sector dynamic consultation, a firm indicated that they benefit from having the right supportive infrastructure for this business (e.g. specialist lawyers). An aerospace business in Prestwick noted that having lots of businesses in the same location increases the attractiveness of the area to other similar firms and encourages further activity in the sector.

In the life sciences sector, there is a risk that post-Brexit Scotland may lose out on investment and activity to London, Cambridge and potentially EU countries like Ireland (a business in this sector had been approached to invest in Ireland). According to feedback in dynamic consultation, more could be done to capitalise on the differences between England and Scotland to attract more business in this sector (Insight 6).

Insight 6: NHS Scotland has some advantages over the NHS in England for life sciences

NHS Scotland has a different approach to clinical trials which may make the Scottish sector more attractive for R&D. In the Scottish NHS there is one system for patient data and patients can make their data available for clinical research. This is not the case in England where different parts of the NHS use different systems for data. Furthermore, in Scotland medications are commissioned and paid for through fourteen NHS Boards which could be an opportunity to attract further activity in this sector. In the UK there is one approval body, the National Institute for Care and Excellence, which determines which drugs are made available through the NHS in England.

Source: EY dynamic consultation

There may be opportunities to strengthen clusters in Scotland by building links with clusters in EU countries. For example, in financial services, a trade body sees an opportunity to develop links between Scotland and Ireland to protect Scottish financial services against the challenges of Brexit, and in particular Scotland’s asset management activity. The purported benefits of strengthening this relationship include reducing Scottish and Irish reliance on London and for this “Scottish-Irish corridor” to act as a bridge for financial services between the UK and the EU. The trade body notes examples where existing companies in this sector have located offices in Dublin for the purposes of protecting, as well as expanding, their European business.

In some Scottish sectors, like high value manufacturing, financial services and logistics, between 20% and 30% of companies are foreign-owned. This could represent a Brexit risk as their presence in Scotland may at least partly be related to the ability to access EU markets. Foreign ownership also implies that decision makers are located within the parent company, and not in Scotland, which could make the investment more vulnerable.

2.2.5 Impact on consumers

The impact on the Scottish consumer from Brexit could be significant. In particular, prices could rise for all traded goods as a consequence of tariffs, border frictions and a weaker currency. This would be most keenly felt in food and drink, where the EU currently supplies around 30% of the food consumed in the UK, although this could also represent an opportunity for Scottish food producers via import substitution. According to a consumer umbrella organisation in Scotland, higher prices would have a significant impact on rural and island communities in Scotland which are already under financial strain.

The impact of Brexit on the price of energy would also be a concern. If the UK leaves the Internal Energy Market, it could still source energy supplies via interconnectors, for example, with Ireland and France. However, this access would be on a different basis than it currently is, potentially reducing the efficiency of the system and ultimately leading to higher prices. Businesses in dynamic consultation in the energy industry noted that any higher costs of electricity and gas would be likely passed directly onto consumers in the form of higher retail prices.

Higher energy prices were also a concern for business in terms of their competitiveness against EU producers. Businesses in dynamic consultation noted that energy costs were already higher in the UK than in other countries^[57].

2.3 Implications and policy response

SG’s overriding concern is to protect Scotland’s national interests. In Scotland’s Place in Europe^[58] published in October 2018, Scotland’s position on Brexit was for continued EU membership. Short of continued EU membership, a compromise plan is to keep Scotland and the UK in the European Single Market and Customs Union to limit the impact of Brexit as much as possible. SG has lobbied the UK Government (UKG) for a future trade deal that achieves as close alignment as possible. However, to prepare for a no deal Brexit on WTO terms some additional actions should be considered.

2.3.1 Maintain trade with EU and seek new markets for Scottish exports

• SG to lobby the UKG for a future trade deal that achieves tariff-free trade.
• SG to argue that the UKG should seek regulatory equivalence or mutual recognition of any UK regulatory standards with EU regulation.
• Business should explore opportunities to sell their products to new export markets outside of the EU, to seek domestic market opportunities, and to look for opportunities to re-shore their supply chain. In pushing for new markets, producers could focus on Scottish brand strengths which include the premium nature of Scottish products.
• SG and SG Enterprise Agencies to support business in the exploration of new markets, and routes to market – e.g. halal lamb meat, and alternative market routes for seafood exports. This would be informed by a series of sector specific papers analysing potential wider exporting opportunities post-Brexit, building on existing SG economic growth strategies.

2.3.2 Promote Scotland as an attractive place to do business

SG already undertakes extensive activity to promote Scotland as a place to do business and to work. However, exit from the EU will reduce Scotland’s attractiveness, and hence current approaches should be reviewed in this context.

• SG and SG Enterprise Agencies already focus on attracting foreign and inward investment the Scotland is Now campaign and other initiatives. However, the current approach could be reviewed in the context of the challenges presented by Brexit, with a focus on Scotland’s infrastructure strengths, overall attractive business environment and competitive and skilled workforce as enablers for competitive just-in-time production models.
• Life sciences – more could be made of Scotland’s different terms for drug trials for life sciences companies. In addition, business could further leverage NHS Scotland’s differences to the English NHS in medicines testing, and at the same time promote their products to Health boards.
• SG and SG Enterprise Agencies should conduct further research to understand the functions and/or productive capacity that both domestic and foreign owned firms have already shifted away from Scotland and what further activities are at risk.

2.3.3 Maintain access to key EU funding programmes or ensure appropriate UK replacement of funding programmes post-Brexit

Scottish sectors benefit from EU funding; it would be desirable for Scotland to find replacement sources of funding post-Brexit.

• SG to accelerate the development of policy proposals for an alternative to CAP post-Brexit. Although the UK Government has guaranteed funding until the end of 2020, alternative arrangements for the whole of the UK will be required post-2020, and SG should be ready.
• SG to explore options for replacement EU funding beyond the Brexit transition period – in particular, the extent to which the UK continues to seek membership (and hence make contributions) to EU programmes. This would require a detailed assessment of the various EU programmes that SG benefits from, and their impact on Scotland, as well as consideration and input from SG into future UK regional policy and funding^[59].

2.3.4 Consider mitigation opportunities for consumers

• SG to consider the differential pricing impact of energy on Scottish consumers, especially those at risk of fuel poverty.